My economics

Common mistakes made by candidates

2010-01-11T11:53:00.004Z

- Not knowing the definitions or apply them in the questions. Usually you should define the economic terms in every question.

- Not labeling the diagrams. This is just a matter of awareness and basic knowledge so marks are gained easily.

- Not reading the question properly. This is the mistake committed the most.

- Not remembering the formulas. Some candidates tend to turn the formulas upside down.

- Not referring to price elasticity in their answer. According to the examiners report from the markets in action exam taken in 2009 only approximately 1 per cent of the candidates did this. For some of the questions this is necessary to gain a full mark.

- Not knowing the differences between the command words, such as discuss, explain, evaluate, comment and so on.

- Not using economics terms and language. This is especially important in the longer questions in the end.

- Spending too much time on the easier questions leaving less time for the longer ones. It is not necessary to answer more than what is asked for!

- Considering only one side of the argument. For example, in the economics exam in January 2009 many people tended to only focus on the disadvantages of a subsidy.

- Not knowing the business significance of the different elasticities.

- Not referring to the case study.

Revision

2010-01-07T11:21:00.003Z

Microeconomics:

Evaluate the case for and against governments intervening to try to stabilise the price of copper, for example through setting up a buffer stock scheme.

Price for copper can be volatile because, in the short term the supply is inelastic. Demand can change due to speculation causing prices to fall rapidly. Therefore a buffer stock scheme may be useful to stabilise prices and benefit both the consumer and producer from excess volatility in the price.

If there is and unexpected increase in supply pr a fall in demand, the government could intervene to buy excess supply and keep the prices high. If the prices fall then some businesses might go out of business, which again could lead to unemployment and/or a shortage in supply in the future.

Also, if prices increase, consumers will be faced with higher prices, and there would be a decrease in consumer surplus. If the government bought copper when the prices where falling they could increase supply when prices are rising.

Problems:

- Difficult to set up on a good produced in many countries. Several countries may try to prevent prices from falling, but some countries may continue to increase supply benefiting from higher prices.

- Can be expensive to implement.

- May distort market incentives. E.g. if prices fall this may be and indication of oversupply in the market. By buying this supply, it may encourage oversupply even more.

- Government may have poor information about future prices and supply, so they may buy too much or too little.

Starbucks, Café Nero and others have seen rapid expansion in the UK. Discuss the likely effects on the retail market fir coffee if there is a large increase in city centre rents.

An increase in city centre rents would increase the costs for the coffee shops. So supply shift to the right.

This might cause lover profits for firms, and also some firms may go out of business.

Positives:

- It is a cost that will affect all firms, so they should be able to pass on the cost increase to the consumers. Since demand for coffee is inelastic an increase in price is unlikely to discourage many consumers.

- It is only a part of a firms cost. So an increase in rent might not have such a big impact on the overall costs for the consumer.

- Demand for coffee is increasing, which also implies that the producers should be able to pass on the increasing costs on the consumers.

However, during a recession people may become more sensitive about price changes and then may decide to drink coffee at home.

In the UK, students face increasing fees. Discuss the benefits and costs to society abolishing all tuition fees.

It can be said that education is a merit good and has positive externalities for the rest of the society. Therefore, in a free market it may be under consumed. Therefore, abolishing the tuition fees would encourage more people to take education, which would be beneficial for society.

Also, tuition fees increase inequality.

Arguments against:

- People from low-income families might get financial support and can therefore get education anyway.

- External cost of higher education may be less than imagined. Most of those who get a degree end up with higher salaries, so they should pay for it.

- There is an opportunity cost. E.g. spending money on higher education might leave less money for primary and secondary education.

- Abolishing the fees encourage many more to g to university, so this might lead to more time-wasters and people who drop out. Making people pay a show that they are motivated.

Discuss whether the government is mistaken to worry about monopoly power?

Monopoly power occurs when a firms dominates the market.

Problems with monopolies:

- They are able to set higher prices than in a competitive market. Hence, a reduction in consumer surplus and allocative inefficiency.

- Because of less competition there is less incentives to offer good quality.

- Monopolies can use their market power to pay lower prices to suppliers.

Advantages:

- Economies of scale. This is important for businesses with high fixed costs and scope for economics of scale such as the steel industry and airline manufacture. It would be less convincing for supermarkets where there is less possibility for economies of scale.

- They can use their high profits to invest in research and development.

- They might be very efficient, because some argue that monopolies gain market power because they are dynamic and efficient.

Discuss the advantages and disadvantages of the government intervening in agricultural markets?

Features of market failure:

Prices can be volatile leading losses for firms or excess prices for consumers. To stabilise the government can intervene through buffer stock schemes. The benefits of this are that it prevent farmers from going out of business, it prevent prices going to high and the government act as an insurance if the farmers is hit by diseases which might ruin their produce/livestock.

Also, one can say that it has positive externalities for society. Therefore the government may choose to subsidies in agricultural markets.

Disadvantages of the government intervening:

- If the government guarantee minimum prices for food it may encourage farmers to increase supply as the much as possible. This would lead to surpluses ad therefore increase the cost to the government buying surplus food.

- To increase supply farmers may use chemicals, which damage the environment.

- Intervention distorts the market. It may be better to let market forces encourage farmers to diversify and start producing different groups.

- Government may have poor information about how crops to buy and at what price.

- Opportunity cost; there might be better policies to spend money on such as education and health.

Discuss whether the government should end free health care for people and make them take private health care insurance like in the US?

Health care is a merit good. Firstly, people may underestimate the benefits of seeing a doctor, especially for a check up. If people have to pay for health insurance, some people may choose not to do it. Secondly, it is said to have positive externalities. If people receive good health care treatment they will be more effective and the economy will benefit. Also since health care is an important part in people’s standard of living, it should be provided for free. If it were free there would be equality, but if it is left to private health care, some people might not get insurance.

On the other hand, it private health care might be more efficient and give better quality services, since there is a profit incentive. However, doctors might just be motivated by desire and passion for the job rather than the financial gain.

In addition, private health care would provide more choice for the consumers. Also it would reduce waiting lists. This would also enable the government to cut taxes, but this is just simply a switch from paying taxes to paying private health insurance.

Discuss the case for implementing a congestion charge for driving into Birmingham city centre.

This is a charge in form of tax imposed on cars driving into city centres. The externalities involved are the pollution caused and the congestion problems. The social cost of driving is much higher than the private cost and therefore there is over consumption of car journeys into city centres.

Petrol tax may not be sufficient to cover the whole external costs, therefore there is need for a congestion charge, which makes drivers pay the full social, cost of driving. This will raise revenue for the government, which can be used on improving public transport. Some people might also consider different methods of travelling such as cycling.

Problems:

- Not easy to charge motorists, because it requires taking a photograph of their number plate and making sure they pay.

- High administration costs.

- The charge may lead to a loss of business for firms living inside the congestion zone.

- The tax may increase inequality. People on low incomes will not be able to afford it, but people on high incomes will.

Discuss the microeconomics effects of finding and exploiting extensive oil reserves in the Antarctic.

This would lead to a higher supply of oil, which will cause a fall in the price. This may again cause a small rise in demand for its related products petrol and diesel, which again may cause an increase in demand for complements such as cars. However the demand for petrol is inelastic in the short term, so a lower price would only have a limited impact on demand. Over time the lower price may encourage low-income groups to purchase a car, and so increase demand for oil. Also, this might cause a decline in demand for developing techniques that provide an alternative to oil. This again may lead to higher pollution levels.

Since the demand is inelastic, the lower prices will result in lower revenues for oil producers. However, just because new oil fields are used in the Antarctic doesn’t mean that the price of oil will fall. It may be that this only deals with the decline in output from existing fields. Together with global demand the new supply may not stop the prices from rising. Another factor is that it will be quite expensive to produce oil from the Antarctic so firms will only produce here if the price remains high.

Cheaper oil may also contribute to environmental problems and congestions, as people most likely will drive more.

Macroeconomics:

Evaluate government policies, which might improve the UK Balance of trade in goods and services.

The balance of trade in goods and services measure the value of exports minus the value of imports. In order to reduce a trade deficit we therefore have to increase exports or decrease imports.

Policies:

- Reduce import spending. This can be done through contractionary fiscal policy. So, higher taxes and less government spending should reduce people’s disposable income, which again will cause a decrease in consumer’s spending on imports. The main problem with this policy is that it would lead to lower AD and therefore lower rates of growth and higher unemployment. However, if the government is experiencing high inflation it may be beneficial.

- Influence the exchange rate. If the government could depreciate or devalue the value of the pound exports would be more competitive and this would help to improve the balance of trade. They can devaluate it by selling pounds or cutting the interest rate. However, cutting the interest rates may increase consumers spending on imports. Also, it depends on the elasticity of exports and imports. If demand for exports is inelastic a lower price will lead to a fall in the value, therefore depreciation is only effective if demand is elastic.

- Supply side policies to improve competitiveness of exports. This could include education and training, because a more productive labour force would help increase the productivity of exports and so make UK good more competitive. However, it takes a long time to improve education and training standards and there is no guarantee that government spending in education actually improves productivity.

Discuss the role of supply side policies in improving rates of economics growth?

Supply side policies are government attempts to increase productivity and the efficiency or markets and the economy. The AS would shift to the right and there would be long-term economic growth.

On policy could be better transport and infrastructure, which may increase the competitiveness of industry by leading to lower costs. Also, the government could improve education and training. This might increase productivity and so lead to economic growth. The problems with these policies is that it takes long time to actually increase productivity and there is no guarantee that government spending will actually increase labour productivity.

Supply side policies might also try to make markets work more efficiently. The government could, for example, make labour markets more flexible by reducing power of trade unions and making it easier to hire and fire workers. This could encourage new firms to enter the market and so more investment and more growth. However, this mean that labour markets will be less protected from being fired and therefore lower motivation.

Another policy could be to reduce tax rates. Lower income tax may encourage people to work over-time and encourage more people to move to UK. However, this is no guarantee. It is more likely to be effective if marginal tax rates are over 60%.

It may also consider privatisation, which is selling state owned assets to the private sector. It is argued that the private sector is able to produce more efficiently because they have a profit motive. However, it is expensive and monopolies are more likely to emerge.

It is also important to consider the importance of demand. (fiscal and monetary policies)

Discuss how a government might try to deal with economic shocks.

An economic shock ca be both supply side or demand side. For example, a terrorist might cause a fall in aggregate demand. This is because:

- Lower confidence by consumers.

- Fall in investment, especially investment from overseas.

- Fall in stock markets.

- Decline in tourism.

There is a fall in aggregate demand and this may cause a negative multiplier effect. Therefore, the government might encounter a recession.

Fiscal policies:

- Cut income tax to encourage people to spend more.

- Spend more on public goods.

- Send more on security services.

Monetary policies:

- Lower interest rates, which will cause people to borrow more, and so spending and investment will increase. However, a cut in interest rates may not be effective if confidence is too low.

Also the impact of terrorist attacks on the economy might be overstated. E.g. even 9/11 in America only caused a short-lived fall in consumer spending. They avoided recession by cutting the interest by only 1%. But, in keeping the interest rates too low, they cased an asset price bubble, which later was devastating.

If the government responds too much and increase aggregate demand, it might cause inflation.

If it is a supply side shock such as a sharp rice in oil prices, it will cause cost-push inflation. This will cause the AS to shift to the left and cause inflation and a lower rate of growth.

Resources:
AS/A2 Economics OCR.

Economics – by John sloman.

Tutor 2u.com

Economicshelp.com

John Sloman

2009-12-02T02:09:00.005Z

John sloman is formerly head of Schol of economics at the university of west England and is now visiting professor at UWE. He is an author of several economic related books such as lecturing capture of the handbook and Sloman economics. which is widely used today. I have myself found his books very useful.

On Thursday the 3^rd of December he is going to give a talk about Market solutions at a conference in London.

This talk might then include:
Imperfect markets, where monopolies and oligopolies creates imperfect competition. Then, how can such be corrected by government policies. Problems with imperfect competition and why monopolies is undesirable may also be considered. Furthermore, it is likely that nationalization versus privatization and encouraging competition will be discussed.

Market failures arising from for instance externalities, inequality and the distribution of income and how to correct this will possibly be talked about as well.

Costs and benefits of trade

2009-10-30T22:57:00.003Z

Todays economists tend to favour free trade between countries. This means that there are no barriers to trade and this is beneficial for the following reasons:

Specialisation

The theory of comparative shows that world output can be increased if countries specialise in what they are relatively best at producing. For, instance it makes little point for the UK to produce bananas, when it can be grown much more cheaply in Latin America.

Economies of scale

Trade allows the economies of scale to be maximised and consequently cost reduced. Economies of are source of comparative advantage. Small countries can import goods and services that are produced a lot of in other countries, while they themselves producing and exporting goods and services where they have economies of scale.

Choice

Trade allows people to chose what to buy from the whole world and not only what is produced in their own country.

Innovation

Free trade creates competition. If free trade is not present the market might be dominated by a few firms who avoid competition who avoid competition among themselves. Competition provides a strong encouragement to innovate. Not only are goods and services put into the market, but firms are trying to find new methods which cut costs and improve quality of their products. The few countries in the world that as decided to isolate themselves from trade and be self-sufficient, like North-Korea, have found that over time their economies have tended to decline. On their own, they simply do not have the resources to keep up with the innovation in the outside world.

Trade as you can see be beneficial, but it can also have costs.

Overdependence

Countries can become to dependent on trade. Small countries in particular can become dependent of export of on or two products. If the price of those products fall, it will cause could cause serious harm on that country’s GDP.

Jobs

Changes in demand can lead to unemployment. For example, parts of the UK experienced high unemployment during the second half of the twentieth century as manufacturing industries shrank in size due to competition from imports.

Risk

1) There are many risk related to trade.

2) Demand for a country’s export may decline or their prices may fall.

3) Supplies may be cut by foreign countries.

4) There can be a credit crisis which may cause a country not to have enough money to buy imports.

5) The cost of borrowing to buy imports may suddenly rise.

Distribution of income

The benefits of trade may go mainly to rich elites within a country and the poor may even end up worse off. This increases inequalities within a trading country.

The environment

Trade can lead to environmental deprivation and flawed development. For instance, the demand for timber has led to much deforestation in today’s world.

Loss of sovereignty

When a country lose sovereignty, it means they loose the ability to make decisions about matter that affect the. The UK, for instance, has lost sovereignty by joining the EU.

Loss of culture

Trade brings foreign products and ideas to other countries. Some argues that this leads to a loss of rich traditional native culture.

Resources:

Heinman economics (AS and A2 for OCR).

Economics A2 (OCR)

Economics A level (fifth edition - edexcel)

Economics (John Sloman - fifth edition)

Absolute and comparative advantage

2009-10-30T22:46:00.004Z

Absolute advantage:

When a country can produce a good with less resources than another country, it is said to have an absolute advantage in that good. If France can produce wine with less resources than the UK, and the UK can produce gin with less resources that France, then France has an absolute advantage in wine and the UK has an absolute advantage in gin. This is shown in the PPC below.

In this case there is a reciprocal absolute advantage: where, in a theoretical world of two countries and two products, each country has an absolute advantage in one of the two products. So, France should export wine and import gin, whereas the UK should export Gin and import wine.

Comparative advantage:

The trade between countries can still be beneficial even if one country could produce all gods with less resources than the other, providing the relative efficiency (measure of time, cost and effort) with which goods can be produced differs from the two countries. Lets take the case of a developed country that has an absolute advantage over a developing country in producing wheat and cloth. With the same amount of resources the developed country can produce 8 meteres of cloth and 4 kilos of what whereas the developing can produce 1 meter of cloth and 2 kilos of wheat. Despite the developed country having an absolute advantage in both of them, the developing country has a comparative advantage in what, and the developed country has a comparative advantage in cloth.

A country has a comparative advantage over another in the production of a good if it can produce it at a lower opportunity cost: i.e. if it has to forgo less of other goods in order to produce it.

In the developing country only 1 metre of cloth has to be sacrificed to produce 2 kilos of wheat, whereas 8 metres of cloth have to be sacrificed in the developed country to produce 4 kilos of wheat. In other words, the opportunity cost of wheat is four times higher in the developed country (8/4 compared with ½)

On the other hand, cloth is relatively cheaper in the developed country. Here the opportunity cost of producing 8 metres of cloths is only 4 kilos of wheat, whereas in the developing country 1 metre of cloths cost 2 kilos of wheat. The opportunity cost of cloth is four times higher in the developing country (2/1 compared with 4/8)

If countries are to gain from trade, they should export those goods in which they have a comparative advantage and import those goods in which they have a comparative disadvantage. This is the law of comparative advantage, which sais that “provided opportunity cost of various goods differ in two countries, both of them can gain from trade if they specialise in producing (and exporting) those goods that have relatively low opportunity cost compared with the other country”.

Now, watch this video.

Resources:

Heinman economics (AS and A2 for OCR).

Economics A2 (OCR)

Economics A level (fifth edition - edexcel)

Economics (John Sloman - fifth edition)

Causes of economic growth

2009-10-30T22:33:00.004Z

Short run

In the short run economic growth is caused by an increase in AD.

The aggregate demand can increase due to the following reasons.

- Lower interest rates – reduces the cost of borrowing which may encourage spending and investment

- Increased wages – increase disposable income and encourage consumer spending

- Increased Government spending

Long run

Long-term economic growth is caused by a shift in AS, or in other words, increase in the quantity and quality of the factors of production.

Land

Some countries grow because of their natural resources. Such as finding new raw materials or posses a lot of oil would most likely influence the AS significantly.

Labour

The main source of growth within labour is an increase in the quality of the workforce, through better education, training and experience. An increase in population may cause growth but it may not mean that income per head is growing.

Capital

Another source of growth may be an increase in stock and making more efficient use of it. Equipping workers with better machines is likely to make those workers more productive. In other words, each worker will be able to produce more in the same amount of time.

Resources:

http://www.economicshelp.org/macroeconomics/economic-growth/causes-economic-growth.html

http://tutor2u.net/economics/content/topics/econgrowth/longrun_growth.htm

Globalisation is good - Johan Norberg

2009-10-22T23:27:00.001+01:00

"The world is an unequal and unjust place, in which some are born into wealth and some into hunger and misery. To explore why, in this controversial Channel Four documentary the young Swedish writer Johan Norberg takes the viewers on a journey to Taiwan, Vietnam, Kenya and Brussels to see the impact of globalisation, and the consequences of its absence. It makes the case that the problem in the world is not too much capitalism, globalisation and multinationals, but too little".

Here is the video related to this: http://video.google.com/videoplay?docid=5633239795464137680&ei=idvgSu2YB8aA-Ab_pszeBQ&q=globalization&hl=en&client=safari#

It is really interesting!

"The Logic of Life" - uncovering the new economics of everything

2009-10-18T20:17:00.003+01:00

Recently I read the book The Logic of Life by Tim Harford. In this book he argues that rational behaviour is more widespread in our society than most of us knows.

Harford writes, “Economics is a world in which people can generally be expected to make rational decisions, and where those rational decisions suggest some astonishing explanations for many of life’s mysteries”. Even how implausible this may sound, he is absolutely right and his answers will certainly “astonish” most individuals. Some of the questions he answers in the book are;

What are the costs, benefits and likely consequences of a blowjob?

Why may racism be rational?

Why your boss is overpaid.

In addition to this he writes about game theory, divorce and history to mention a few.

This is a book I enjoyed, as Tim Harford always comes up with answers I did not expect and never could have thought of myself. For instance, he writes about how addiction may actually be a rational choice (which I wrote about some posts below). What I also liked was that he doesn’t purely speculate, but uses research to prove the rational trend in our behaviour.

It was not merely the content itself that made the book interesting, but the language as well. This is because Harford does not write like most economists, but uses a language and tone that is much more suitable for the general public.

Thumbs up for this book!

The negative output gap

2009-10-18T01:23:00.004+01:00

“The immediate problem facing the UK economy is a large output gap and a decline in aggregate demand”.

In this post we’re going to take a look at the former and the latter and what can be done to solve this.

An output gap is the difference between an economy’s actual and potential real GDP. When there is a positive output gap the economy’s actual output is above its potential output. A negative output gap occurs when the economy’s actual output is lower than the potential output.

A fall in GDP, low inflation and a rise in unemployment are the main reasons for such a negative output gap.

To obtain an increase in AD the government have to take more demand side policies (fiscal and monetary) in use. It is important that an economy don’t have a consistent negative output gap over a large period of time since this will cause a great loss to an economy. This is because the potential output is not achieved.

As it is about a decline in demand that causes this, we must concentrate on monetary and fiscal policies to increase the AD. In theory an increase in government spending and/or a decrease in taxation would cause an increase in AD. But, as most of us know, this is not easy as the UK has one of the biggest budget deficits in the whole developed world. So, in order to reduce the deficit, the government may have to do the opposite, which is to increase taxation and reduce spending.

What about monetary policy? Monetary policy includes the interest rate, money supply and exchange rate. For instance, to influence the AD we may change the money supply. If the government prints more money or makes it easier for banks to lend more money, people will have more money to spend. An increase in money supply also causes the interest rate to go down, as the amount that banks have to lend has increased. A lower interest rate not only causes higher consumption, but most likely an increase in firm’s investment as well, which again increase the AS. An increase in AS leads to a higher potential output.

I think the Conservative’s suggestions (mentioned in the post below) may be a way to solve this crisis. Especially regarding fiscal policy. However, it is extremely hard to predict how the economy reacts on new policies like this. Who knows, it may even make the situation worse.

Conservative economic policy

2009-10-14T23:58:00.008+01:00

There are two main parties’ in Britain, the Labour party and the Conservative party. As the Labour party won the last election, they are now the ruling party, with Gordon Brown as the Prime minister. However, after weak performance in the financial crisis the Labour party has experienced a downfall on the polls and is now behind the Conservative party with a big margin.

So, as it looks like the Conservative party, with David Cameron in front, is going to win the next election, I want to take a closer look at their economic policy. Or more specifically, how they plan to solve the financial crisis.

“We will freeze council tax for two years by reducing wasteful spending on advertising and consultancy in central government”.

Council tax is a tax based on the value on ones property, which means that the higher the value of your property/properties the higher tax you have to pay. The revenue raised from the tax is added to funding supplied by central government to pay for services such as schools, roads, street lighting, libraries, rubbish collection and so on. In addition to this it also pays for the services provided by the Police and the Fire Brigade. Councils in the different counties set the council tax.

As Labour took over as the ruling party, the council tax has increased by over a 100% and is now on about 1 400 pounds a year in average. If the Conservatives win the next election they will offer a deal to the councils: If a council can prevent the council tax rising more than 2.5%, the government will provide sufficient resources to fund the last 2.5 %. Councils that accept the offer will therefore be able to offer their citizens a complete freeze, or even reduction, in council tax for two years in a row. According to the Conservatives, this will save each person about 200 pounds a year.

They say that they will fund this by reducing wasteful spending on advertising and consultancy in central government. Today, the government spends about 390 million pounds on advertising and consultancy. That is 260 million pounds more than they did in 1997. The Conservative party seeks to reverse the spendings on this back to the levels in the year mentioned.

“We will introduce a £50bn National Loan Guarantee Scheme to underwrite bank lending to businesses and get credit flowing again”.

They want to create a 50 billion pound National Loan Guarantee Scheme to keep businesses lending during downturns. The intention behind this is to keep the credit (money available for a client to borrow) rate stable. Funding this is no problem, since the borrowed money will have to be paid back to the bank, plus the interest rate. The interest rate is the charge for borrowing money and the amount paid for lending money.

“We will provide tax cuts for new jobs with a £2.6bn package of tax breaks to get people into work, funded by money that would otherwise go on unemployment benefit”.

The conservatives want to cut tax for businesses that create new jobs. Their plan is to spend 2.6 billion pounds on this tax reduction and according to them, this will create about 350 000 new jobs the next year which will reduce the unemployment significantly. Unemployment is a situation where people are out of work but are willing and able to work. At the moment the unemployment rate (the percentage of the labour force who are out of work) in Britain is on about 8 %. They will fund this by taking money that would otherwise go to unemployment benefit (payments made by governments or other authorised bodies to unemployed people).

“We will cut the main rate of corporation tax to 25p and the small companies' rate to 20p, paid for by scrapping complex reliefs and allowances”.

Corporation tax is a tax on a firms profit. So, a cut in the corporation tax increases the amount of profit firms can keep. This is to be funded by eliminating several business tax exemptions. When a business has a tax exemption it basically don’t have to pay a certain type of tax.

“We will give small and medium-sized businesses a six-month VAT holiday, funded by a 7.5% interest rate on delayed payments”.

VAT stands for Value added tax and is a tax that is imposed on the sale on goods and services at different rates. The standard rate is 17.5%. The Conservatives implies that a VAT holiday will prevent many businesses form “hitting the wall”.

They want to fund this with a 7.5 % interest in delayed payments. The interest rate is the charge of borrowing money and the amount paid for lending money. When you have for instance, a mortage and you are paying after the deadline it is a delayed payment.

“We will cut National Insurance by 1% for six months for firms with fewer than five employees, paid for from the above changes to the company tax regime”.

The national insurance is a tax paid by most people who is working. The money from the national insurance is used to pay for a number of benefits and retirement pension. According to the Conservative party a tax cut of this kind could offer immediate help to small firms struggling to pay their bills. They estimate that this could save them up to 600 pounds. This is also going to be funded by the money left from eliminating tax exemptions in businesses.

“We will abolish Stamp Duty for nine out of ten first-time buyers and raise the Inheritance Tax threshold to £1 million. Both of these changes will be funded by a flat-rate charge on non-domiciles”.

Stamp duty is a tax levied on documents. Anyone who buy their first home under 250 000 pounds will pay no stamp duty. The Conservative party want to take 200 000 people out of stamp duty a year, which means one million over a parliament. This will save the average first time buyer about 2000 pounds.

An inheritance arises when property of any nature passes on a death to any person. So, this is a tax of the total value of the money and property, of a person who has died. When the Conservative party say that they want to raise threshold for inheritance to one millions they mean that only those who earn one million or above a year have to pay the tax.

They will fund this with a flat-rate charge on non-domiciles. Or in other words, the fixed rate charged on people whose own home is not in the UK but they still live there.

I certainly look forward to see if the Conservative party manage to keep its lead and win the election, as it would be very interesting to see their economic policy in action.

“It falls now, to all of us, to take our place in the great story of this great Party. We have changed our Party to face the modern world. Now let us change our country." – David Cameron

David Cameron on Concervative economic policy

Further reading:

http://conservativehome.blogs.com/torydiary/files/tax_cuts_for_new_jobs.pdf
http://www.conservativebusinessrelations.com/article.asp?ref=11
http://www.conservatives.com/Policy/Where_we_stand/Economy.aspx

Can addiction be rational?

2009-10-13T15:24:00.006+01:00

When I first looked at this question, I thought the answer was obvious; since, for instance, taking heroin or smoking is addictive and can have horrible effects, people that chose to take up these habits must be irrational.

However, Kevin M. Murphy and Gary Becker were not quite so sure. They actually came to the conclusion that addiction is entirely rational. They said that “people who consume addictive products – cigarettes, alcohol, slot machines – calculate that the pleasure of the habit will outweigh the pain”.

It can also be rational to get “hooked” in the first place. You can actually compare it to marriage. It might not work out, it will restrict your future freedom of choice, and quitting if things turn out wrongly is going to be very painful and difficult. But it will probably be a lot of fun, too. According to Becker and Murphy the first-time drug user might be making a mistake, but he/she thinks that on balance the decision will pay off.

Regarding not kicking the habit, we may use the slot machines as an example. Tim Harford writes in his book, “the logic of life” that “Yes, the slot machines players were losing money. Some of them might even be addicted. But, they made a rational decision to start to play the machines, knowing there was a chance they’d end up miserable and hooked, and now they were making a rational decision to continue playing rather than endure the greater misery that would be involved in kicking the habit”.

Becker and Murphy also made some predictions of how rational addictives behave in certain situations. Rational addicts respond to predictable price changes before the price itself actually change. They actually found, even how ridiculous it might seem, that addicts may pay more attention to price than light users do. The light users can cut back if the price increases, while the heavy users might prefer to stop entirely. For instance, when price of liquor taxes are raised, the consumption of alcohol falls but the death rate of liver cirrhosis falls more sharply.

So, is addiction really rational, as Murphy and Becker implies? Or is it irrational, as most people would assume? The American economist and professor Thomas Schelling thought neither of them was true. He argued that it is impossible to bring together the sense that said it was crazy to risk addiction with the logic and evidence that said it was rational. For Schelling, addiction was a battle for self-control, a battle that an addict could win if only he had the right tactics.

Resources:

"The Logic of Life" by Tim Harford

Monopoly and price discrimination

2009-10-12T00:42:00.003+01:00

A monopoly is a situation where there is only one seller or producer of a service or good. In the UK a firm is said to have monopoly power if it has more than 25 % of the market share. In this blog post are we going to take a closer look at how monopoly practices price discrimination and how this influence the consumer.

Price discrimination is basically a pricing strategy that charges different prices for the same product or service. A firm with price setting power, such as a monopoly, practices this. It is also important that the product cannot be reselled.

Perfect discrimination involves separating out each consumer and finding out what they are willing to pay for the product. In this way the consumer surplus can be extracted and turned into revenue.

As an example price discrimination often occurs in International trade. A Russian aluminium producer might sell aluminium for less in the United States than in Russia. The reason is that in the United States the demand for aluminium is elastic since there are several substitute suppliers available. But in Russia, where the producer have monopoly power and trade barriers that prevent imports, the consumer demand is less elastic.

We can divide price discrimination into first, second and third degree price discrimination. We are going to take a closer look at the former.

First degree price discrimination occurs when identical goods are sold at different prices to each individual consumer. This is also called pure price discrimination. In such, there is no consumer surplus since the seller charges the maximum price the consumer is willing to pay. For instance, you can see this type of price discrimination in the sale of cars. People will pay different prices for cars with identical feature, and the salesperson is of course trying to maximise the price at which the car can be sold.

So, how do first degree price discrimination influence consumer welfare? The goal of first degree price discrimination is to extract as much as possible of each individual’s consumer surplus. And since the consumer surplus decrease, the level of welfare also decreases as the consumer have to spend more money on per unit.

“Price discrimination can never be in the consumer’s interest” - Dennis Paschke

Resources:

http://tutor2u.net/economics/presentations/a2economics/micro/MonopolyPriceDiscrimination/default.html

http://books.google.com/books?id=hlwqualKNjEC&pg=PA209&lpg=PA209&dq=firms+practising+price+discrimination&source=bl&ots=OFtglUf_Fp&sig=r1VZiRChVcRkK_42V3EPbO-Ix8o&hl=en&ei=9VDSSoCQDIe14QaHnpSiAw&sa=X&oi=book_result&ct=result&resnum=9&ved=0CCkQ6AEwCA#v=onepage&q=&f=false

http://www.wisegeek.com/what-is-price-discrimination.htm

http://www.depaweb.de/StudiumDownloads/Essay3001.pdf

http://tutor2u.net/economics/revision-notes/a2-micro-price-discrimination.html

http://www.nowsell.com/marketing-guide/pric

Is a manager a leader?

2009-10-11T01:54:00.000+01:00

Some may think that managers and leaders are the same, but from my point of view they are not similar. Shortly spoken we can divide them by saying that managers have subordinates and leaders have followers.

Managers are persons that have a position of authority, for example by being the head in a firm or being the manager for a football team. They have subordinates that work for them and who usually do what they are told to. A manager tends to avoid risks and seek big challenges, as they want to maintain their position.

Leaders are able to get people to follow them by acting as moral compasses and appealing to people’s desire. For example, a good captain on a football team is able to encourage his team to do its very best in a match. In order to pursue their vision, leaders usually consider it natural to encounter problems and hurdles that they must be overcome. In other words, they tend to take risk.

Being a manager does not necessarily mean that you are a leader. Good managers are managers that possess leadership qualities. In a business they are able to encourage the workers to do their job as effectively and good as possible in order to achieve high productivity. A manager with leadership qualities is not only good for the subordinates, but also for the society as a whole, as high productivity is crucial in a well functional economy.

http://changingminds.org/disciplines/leadership/articles/manager_leader.htm

http://www.maninthemirror.org/weeklybriefing/wb0150.htm

http://www.4hoteliers.com/4hots_fshw.php?mwi=2123

http://www.inddist.com/article/170545-The_difference_between_a_leader_and_a_manager.php

Correlation

2009-10-10T20:26:00.006+01:00

“The correlation is one of the most common and most useful statistics. A correlation is a single number that describes the degree of relationship between two variables”.

Here is an example:

We want to find out if there is a correlation between the people`s political participation and years of education. So we have to collect data from each person in the study. Below may be how the result would look like.

To make it easier to see the correlation, we may put the points in a X-Y graph. This is shown below.

We can clearly see that the overall trend is an increase in political participation along with more years with formal schooling. There is, however, one problem. Correlation does not provide enough evidence for the two factors being directly linked. This is because there are other factors influencing as well.

Let us take the levels of income and amount of spending on consumer goods as an example. The level of income may be an important factor for why a consumer spends more or less, but consumer spending may also be influenced by, for example, the interest rate as well. If the interest rate goes down, people tend to borrow more and ergo spend more.

But what about the correlation between miles travelled by car and gasoline in the tank. Again, gasoline is a very important determinant of how far a person can drive by car, but other factors like speed and the quality of the car is central as well.

There is a mathematical approach on measuring the significance of the correlation between two factors. The formula is:

The answer will be somewhere between -1 and 1. A answer at -1 means perfect negative correlation, 0 means zero correlation and 1 means perfect positive correlation.

Resources:

https://records.viu.ca/~johnstoi/maybe/maybe4.htm

http://www.socialresearchmethods.net/kb/statcorr.php

Chapter 6 summary

2009-10-08T21:17:00.007+01:00

Fiscal policy

Fiscal policy is the taxation and spending decisions of a government. It is a demand-side policy. The key aim of fiscal policy is to change AD (can also aim to encourage consumption of merit goods, discourage consumption of demerit goods, altering the distribution of income, altering incentives and simplifying the system). The government can raise AD either by increasing spending and/or reducing taxes.

Rises in government spending and cuts in taxes designed to increase AD are referred to as reflationary, expansionary or loose fiscal policy. In contrast, deflationary, contractionary or tight fiscal policy involves measures that reduce AD, that is, cuts in government spending and/or rises in taxes. Below, we see the effects of and deflationary fiscal policy.

The nature of fiscal policy

If a government wants to change the AD to match AS and so avoid both unemployment and inflation. If private sector demand (C+I+(X-M)) is low, a government may try to increase AD and vice versa. Such action can be referred to as acting counter-cyclically – the government is seeking to create greater economic stability by offsetting changes in private sector spending.

To achieve this objective, a government can use what is called discretionary fiscal policy (deliberate changes in government spending and taxation designed to influence aggregate demand) or allow automatic stabilisers (forms of government spending and taxation that change automatically to offset fluctuations in economic activity) to operate. Not all forms of spending and taxation are automatic stabilisers. For instance, spending on child benefits is not linked to the economic cycle. This is the tendency for economic activity (boom) to negative economic growth (recession).

Types of taxes

The two most important sources of tax revenue in the UK is:

Income tax: Income tax is a direct and progressive tax (takes a higher percentage from the income of the rich). As a person’s income rises, both the amount and the percentage that a person pays in tax rises.

Value added tax (VAT): VAT is an indirect and largely regressive tax (takes a greater percentage from the income of the poor). It is imposed in on the sale of goods and services at different rates.

Other taxes include excise duty (indirect tax on specific products), capital gains tax (tax on the increase in the value on items such as stocks), corporation tax (tax on the profit of firms) and inheritance tax (tax on transfers of wealth above a certain amount).

Government spending

- Capital expenditure – e.g. hospitals, schools, roads.

- Current spending – public services (e.g. teachers´ pay)

- Transfer payments – money transferred from taxpayer to recipients of benefits (e.g. pensioners and unemployed)

- Debt interest payments – money transferred from holders of government debt (e.g. interest paid to holders of National Savings certificate)

The five most important individual areas of government spending in the UK recently have been social protection, health, education, defence and debt interest.

The budget

The budget position shows the relationship between government spending and tax revenue. A budget deficit arises when government spending exceeds tax revenue. In contrast, a budget surplus occurs when tax revenue is greater than government spending.

Recession: a fall in real GDP over a period of six moths or more.

Monetary policy

Monetary policy instruments or measures include interest rate, the money supply and the exchange rate. This is also a demand-side policy.

The monetary policy instrument that is most used is the interest rate. A higher interest rate tends to reduce consumption and lower firms` investment. This is also likely to encourage foreigners to place more money into UK financial institutions because of their higher return. This rise in demand for pounds will push up the value of the pound. A higher exchange rate will make exports more expensive and imports cheaper. This is likely to reduce net exports. So, a rise in the interest rate is likely to decrease AD by reducing consumption.

Money supply can also be used to influence AD. An increase in money supply is likely to increase AD. if the government prints more money or makes it easier for banks to lend more money, people will have more money to spend. Changes in money supply and interest rates are inversely related. A rise in the money supply, by increasing the amount that banks have to lend, reduces the interest rate.

If an economy want to change the exchange rate, it can lower interest rate or sell pounds.

The monetary policy committee

The monetary policy committee (MPC) of the Bank of England sets the rate of interest with the main objective of achieving the government’s target annual rate of inflation of 2%, as measured by the consumer price index.

Supply-side policies

Supply-side policies seek to influence aggregate demand. These policies always aim to increase AS. If they are successful, they will increase productive potential and can help prevent inflation, reduce structural and frictional unemployment and improve the country’s trade position.

Examples of supply-side policies

Education and training: Spending money on this may lead to increased output per worker, which means that the potential output of the economy will rise.

Government assistance to new firms: To help new businesses establish, a government may provide them with grant and low corporation tax.

Reduction in direct taxes: This may cause lower incentive for firms, workers and potential workers.

National minimum wage (NMW): whether to introduce a national minimum wage or not.

Reduction in unemployment benefit: A reduction in job seeker’s allowance will widen the gap between income from employment and the benefit, likely causing the unemployed to seek jobs more often and at lower wages.

Reduction in other benefits: reduce other benefits for those who are economically inactive.

Reduction in trade union power: this may cause either an increase in the efficiency in labour markets if a reduce in employment by pushing wage rates above the equilibrium level causes people to engage restrictive practices.

But this can also work the other way if it helps labour markets work efficiently.

Privatisation: Some economists argue that there should be more power in the private sector because they believe private sector firms are in the best position to make decisions about what to produce, how to produce and what to charge.

On the other side it is argued that government ownership of firms is beneficial in a number of cases where there is a high risk of market failure.

Deregulation: Deregulation is the removal of rules and regulations that affect firms in the belief that will give the firms greater freedom to make their own decisions and to increase competition by making it easier for new firms to enter an industry.

Policies to reduce unemployment

Demand-side policies:

Expansionary fiscal and/or monetary policy can be used to create jobs. A government, using fiscal policy, could increase its spending and/or cut taxes in order to rise AD.

Increases in money supply or lower interest rates are also likely to rise AD. For instance, a fall in interest rates and/or an increase in the money supply should stimulate consumption and investment. It may also raise net exports if it causes a fall in the exchange rate. The diagram below shows the effect of expansionary monetary policy.

One consequence of a rise in AD may be a rise in the price level if the economy moves close to full employment. The higher level of spending may also increase any existing deficit on the current account of the balance of payments as UK residents buy more imported products.

Supply-side policies:

Supply-side policies can be implemented to increase economic incentives and the quality of labour services offered by the unemployed. The quantity and quality of information available to the unemployed about job vacancies and to employers about those seeking jobs can be increased. Improved education and training and the provision of work experience may raise the skills of the unemployed. Greater provision of low-cost child-care may enable more lone parents to work. Legislation and the subsidising of special equipment and adaptation of buildings may facilitate the employment of more disabled workers.

Policies to control inflation

Cost-push inflation: There are several policy measures a government can take to control cost-push inflation in the short run. For instance, if the government believes that inflation is caused by excessive increase in wage rates, it may try to restrict wage rises. Or, a government may try to lower firm’s costs by reducing corporation tax.

Demand –pull inflation: To reduce demand pull-inflation, a government may use deflationary fiscal and/or monetary policy instruments. There are ones that seek to decrease AD, or at least the growth of AD. A government could, for example, raise income tax. This would reduce people’s disposable income and so their ability to spend.

The main short-run anti-inflationary policy instrument being employed is changes in the interest rate. A higher interest rate is likely to reduce AD by reducing consumption, investment and net exports. Below we see the impact of a deflationary policy instrument.

Inflation targeting: This can lower both cost-push and demand-pull inflation by reducing expectations of inflation. If people are convinced that a central bank has the determination, experience and ability to meet its target, they will act in a way that does not cause inflation.

Long run: In the long run, a government is likely to seek to reduce the possibility of inflationary pressure by increasing AD. If the productive capacity of the economy grows in line with AD, with rightwards shifts in the AD curve being matched by rightwards shifts in the AS curve, the economy can grow with the price level rising.

To ensure the quantity and quality of resources rise to supply more products, supply-side policies may be used.

Policies to promote economic growth

Short run: Increases in output in the short run can occur due to increases in AD if the economy is initially producing below full capacity. Such an increase may be stimulated by expansionary or fiscal policy.

Some monetary and fiscal policies have the ability to change both AD and AS. For instance, a lower rate of interest is likely to stimulate both consumption and investment.

Long run: In the long run, increases in the country’s output can continue to be achieved only if the productive capacity of the economy increases. This is why AS are so important. For instance, measures that raise investment will increase AS. The extent of increase will depend on the amount of extra investment, its type, and how efficiently it is used.

A way to increase to increase the productive capacity of the economy is through investment in human capital. Human capital is education, training and experience that a worker, or group of workers, possesses.

Stable growth: Stable growth is for actual growth to match trend growth and for that trend growth to rise over time. Governments try to avoid AD increasing faster than the trend growth rate permits, since this can result in the economy overheating with inflation and balance of payments problems arising. They also try to prevent AD rising more slowly than the trend growth rate, since this would mean a negative output gap developing with unemployed resources. In other words, governments seek to avoid economic cycles.

Policies to improve the balance of payments

There are several policy instruments a government can use to improve its balance of payments position.

Short run

Exchange rate adjustment: A country may want to reduce the exchange rate if it believes that its current level is too high and as result is causing its products to be uncompetitive against rival countries` products. A lower Exchange rate will cause export prices to fall and import prices to rise. To succeed in increasing export revenue and reducing import expenditure, it is important that demand for exports and imports is price elastic, that other countries do not devalue and do not increase any import restriction.

Deflationary demand management: To discourage expenditure on imports, a government may adopt deflationary fiscal and monetary policy instruments. Higher tax, lower government spending and/or higher interest rates may reduce domestic spending. The risk is that a reduction in spending may cause aggregate output to fall and unemployment to rise.

Import restrictions: A country may seek to reduce expenditure on imports by imposing import restrictions including tariffs (tax on imports) and quotas (a limit on imports). However, these measures may inflationary side-effects. For instance, imposing tariffs will increase the price of some products bought in the country, raise the cost of imported raw materials and reduce competitive pressure on domestic firms to keep costs and prices low.

Long run: The most appropriate approach to long-run solutions would be to implement supply-side policies. How successful supply side policies are depends on the appropriateness of the policies.

Current account surplus: A disequilibrium may also arise because of a current account surplus. A government may seek to reduce or eliminate a surplus in order avoid inflationary pressure and to raise the amount of imports it can enjoy. To reduce it a government may seek to raise the value of its currency, introduce reflationary fiscal policy and monetary instruments and/or reduce imports restricitons.

Effectiveness of fiscal policy

Advantages:

Number of taxes and forms of government spending adjust automatically to offset fluctuations in real GDP.

Some forms of government spending and taxation, including cuts in corporation tax and training grants, have the potential to increase both AD and AS.

Disadvantages:

It takes time for government spending and tax to affect the economy and it takes time to recognise the need for a change in policy and at which base to change.

There is an time lag between introducing fiscal policy instruments and that instrument having an impact on the economy.

Number of government spending is inflexible (e.g. difficult to cut spending on health care and pensions).

Need to be based on accurate information (e.g. radio predict recession might lead to a change in expectations)

Households and firms may react in unexpected ways (e.g. cut in income taxes may not lead to higher consumption and investment if households and firms lack confidence).

May have an adverse effect on incentives and other macroeconomic objectives. (e.g. rise increase in state benefits may discourage some people from working).

Can be offset by changes in the economic activity in other countries.

Effectiveness of monetary policy

Disadvantages:

Can be difficult to control the policy instruments (e.g. keep inflation in check by controlling the money supply)

The use of interest by MPC may be overestimating the prospects of inflation and so keeping the interest rate too high and limiting economic growth.

Take time for interest rate to work through the economy.

The interest rate may not change the AD s much as expected (e.g. if people are optimistic about the future, they may not reduce spending even after a rise in the interest rate).

A central bank’s ability to change its interest rate may be limited by the need for it to remain in line with other countries` interest rates (noticeable difference may cause inflow or outflow of hot money flows, which can disrupt financial markets).

When interest rates falls to very low levels, a further cut is likely to be ineffective in stimulating economic activity.

If interest rates is low when inflation is low and stable, it may not have big effect on the economy to change the interest if there is an increase in inflation.

Tend to be more concentrated on certain groups (e.g. rise in interest rate will hit firms that export a high proportion of their output more than it will affect other firms).

May have undesirable side-effects. A rise in the exchange rate, designed to reduce inflationary pressures, may worsen the balance of payments position.

The effectiveness of supply-side policies

Economists agree that if the supply-side performance of the economy can be improved, it may be easier for a government to achieve its objectives. However, increasing the productive potential on its own will not be sufficient in raising economic performance if there is a lack of AD.

Some supply-side policies take a relatively long time to have an effect, they can be exoensive to operate and there is no guarantee that they will work.

Possible conflicts between policy objectives

The objectives of economic growth and low unemployment may benefit from expansionary demand-side policy measures. In contrast, such measures may make it more difficult for a government to achieve low inflation and a satisfactory balance of payments position.

MPC may face a conflict when setting the interest rate because it may want to raise interest rate to reduce inflationary pressure but be concerned about the effects such a move will have on the exchange rate and so on the balance of paymenst and employment.

Advantages that may be gained from international trade

International trade involves the exchange of goods and services across national borders. These are the benefits from international trade:

- lower prices and high quantity because of high competition

- greater variety of products

- high competition leads to firms accessing larger markets in which to sell their products and buy raw materials.

There are some challenges with international trade as well. Competition from other countries and access to their markets result in some industries contracting and some expanding. This requires the shifting of resources, which can be unsettling and may be difficult to achieve due to, for example, occupational immobility of labour (difficulty in moving from one type of job to another).

What also happens in international trade is that some countries put restrictions on the exports of certain products if they become in short supply.

Methods of protection

International free trade occurs when there are no restrictions imposed on the movement of goods and services into and out of countries. In contrast protectionism results in the deliberate restriction of the free movement of goods and services between countries and economic blocks. A government engage in protectionism when it introduces measures to protect its own industries from competition from the industries of other countries.

Tariffs: Tariffs are taxes on imported products.

Quotas: This is a limit of supply of a good or service.

Voluntary export restraint: Voluntary export restraint (VER) is a limit placed on imports from a country with the agreement of that country’s government.

Foreign exchange restrictions: Governments may seek to reduce imports by limiting the amount of foreign exchange made available to those wishing to buy imported goods and services or to invest or to travel abroad.

Embargoes: An embargo is a ban on the export or import of a product and/or a ban on trade with a particular country.

Red tape: Time-delaying procedures may be used to discourage imports.

Other measures: Two additional measures are quality standards and government purchasing policies. Quality standards may be set high and complex requirements may be put in place with the intention of raising the costs of foreign firms seeking to export to the country. A government may also try to reduce imports by favouring domestic firms when it places orders.

Fiscal policy

2009-10-08T00:43:00.007+01:00

You could also watch this video about fiscal policy and the multiplier effect.

Chapter 5 summary

2009-10-05T00:04:00.007+01:00

Key performance indicators

Economic growth: in the short run, an increase in real GDP, and in the long run, an increase in productive capacity, that is, in the maximum output that the economy can produce.

Unemployment is a situation where people are out of work but are willing and able to work. Not everybody aged between 16 and 65 are in the labour force (the people who are employed and unemployed, that is, those who are economically active. These people are said to be economically and are not regarded as unemployed.

Another important indicator is Inflation. A economy may also experience deflation, which is a sustained fall in the price level.

Balance of payments is a record of money flows coming in and going out of a country.

Economists may also examine income redistribution.

Current trends

Between 1992 and 2007 UK as experienced high economic growth. This has been a result of high employment and a low inflation rate (the percentage increase in the price level over a period of time). UK`s supply curve seem to have become more elastic (responsiveness to a change in market conditions), up to the full capacity level. This means that aggregate supply can be close to full employment level without causing inflation. This is shown below:

The UK however faces a number of challenges.

Objectives of government economic policy

Economic growth:

Governments want to obtain sustainable economic growth, which is growth that can continue over time. The first type of sustainable economic growth is achieved if increases in AS match increase in AD. Governments try to achieve economic growth matching trend growth. Trend growth is the expected increase in potential output over time. It is a measure of how fast the economy can grow without generating inflation.

Employment and unemployment:

Another government policy is high employment and low unemployment. Full employment is a situation where those wanting and able to work can find employment at the going wage rate.

Inflation:

A third macroeconomic policy is low inflation. This can also be reffered to as price stability., which is a low and consistent rate of inflation.

Balance of payments:

Nowadays, a government may not be too concerned in the short term if import expenditure exceeds export revenue, if the deficit is likely to be self-correcting (e.g. import of raw materials can be converted to fishing products which can be exported).

Current account deficit: when more money is leaving the country than entering it, as a result of sales of its exports, income and current transfers from abroad being less than imports and income and current transfers going abroad.

Economic stability:

This can be achieved through a satisfactory balance of payments, avoid fluctuations and avoid unstable increases in AD and then falling periods of AS.

Income redistribution:

Government may seek to redistribute income. This can be done in order to ensure everyone has access to basic necessities and/or to correct what is seen as an inequitable distribution of income.

GDP and real GDP

A country`s output is measured by real GDP. Economists first calculate what is called money or nominal GDP (output measure in current prices and so not adjusted for inflation). Then they convert nominal into real GDP.

To calculate the rise in the volume of output, the effects of changes in the price level are taken out by multiplying GDP by the base year index divided by the current year price index.

GDP figure x base year price index

Current year price index

So, if the price index in 2008 was 100 and 104 in 2009, real GDP was:

880bn x 100 = 846.15 billion

104

In real terms, GDP has risen by 46.15 billion/800 billion x 100% = 5.77 per cent.

Measuring economic growth

Economic growth is usually measured by the annual percentage change in real GDP. Real GDP can be calculated by totalling up the output, income or expenditure of the country and economic growth can be calculated by changes in any of these.

Production and productivity:

Production is what is produced. So, when real GDP increases, it means that output has risen. Labour hour, in contrast, is output per worker hour. For example, if productivity rises by more than wages, then labour costs will fall and a country can become more price competitive.

Difficulties in interpreting changes in real GDP

One problem of interpretation that economists can eliminate is that a rise in output may be exceeded by a rise in population. So, what economists often assess is GDP per capita (real GDP per head). This is found by dividing real GDP by population.

In comparing a country’s real GDP over time and between countries, other problems may occur. One is the existence of what is known as the informal economy. This is unrecorded economic activity. The existence of an informal economy has a number of consequences. One is that it distorts a range of economic data. For example it may understate both unemployment and inflation.

Tax revenue is lower than it would be possible if all economic activity were taxed. This can have consequences for tax rates and government spending. An informal economy can also result in lower productivity. Firms in the informal economy tend to stay small to avoid attention from the authorities. This limits their ability to use advanced technology and take advantage of economies of scale. Economies of scale are the advantage of producing on large scale, in the form of lower long-run average cost.

In deciding how the level of, and changes in, real GDP affect peoples living standard, it is important to consider the composition of GDP.

Measuring unemployment

Economists measure the number of people who are unemployed and from this find the unemployment rate. The unemployment rate is the percentage of the labour force who are out of work.

The unemployed x 100%

Labour force

In the UK there are two main measures used; first, the Labour Force Survey (LSF) which uses the International Labour organisation (ILO) definition and second, the claimant count. . LSF is a measure of unemployment based on a survey using the ILO definition of unemployment. ILO is a member organisation of the United Nations that collects statistics on labour market conditions and seeks to improve working conditions.

The claimant count is a measure of unemployment that includes those receiving unemployed-related benefits.

Difficulties of measuring unemployment

There is no perfect measure of unemployment, since both the LSF measure and the claimant count measure have their advantages and disadvantages.

LFS is though to capture more of those who are unemployed. Some people can be actively seeking work but not be entitled to claim unemployment-related benefits (e.g. people under 18 who are looking for work). These people would not appear in the claimant count but would apper in the LFS measure.

The LFS is used widespread internationally an is very suitable for international comparisons. It also collects a lot of information but is more expensive to collect than the claimant count. The claimant account is relatively cheap and is usually quicker than the LFS.

A disadvantage of the claimant count is that it is not suitable for international comparisons. This is because the categories of people entitled to benefits vary over time and between countries.

Measuring inflation

The main measure of inflation is the consumer price index (CPI). The consumer price index is a measure of change sin the price of a representative basket of consumer goods and services. Differs from the retail price index (RPI) in methodology and coverage. The CPI and most other measures of inflation are weighted price indices.

The CPI and other measures of inflation

Another measure of inflation in the UK is the retail price index (RPI). This is a measure of inflation that is used for adjusting pensions and other benefits to take account of changes in inflation and frequently used in wage negotiations. Differs from the CPI in methodology and coverage.

The CPI and RPI are calculated using the same underlying price data. They are both measure of the average change from month to month in the prices of consumer goods and services bought in the UK. As mention they differ in methodology and coverage.

Difficulties of measuring inflation

First, inflation measures doesn’t take into account that a rice in price may not be the same product becoming more expensive, but that the change in price is actually due to a change in quality.

Secondly, the measures of inflation often tend to overstate inflation, as it does not take into account people’s ability to alter what they are buying that year.

The structure of the current account of the balance of payments

The main elements of the balance of payments are the current account, the capital and the financial accounts and net errors and omissions.

The current account includes trade in goods, trade in services, income and transfers. Trade in goods records the earnings from exports and the expenditure on import goods. Trade in services include, for example, travel, insurance, financial and computer and information services. The income part of the current account covers largely investment income. Transfers cover the transfer of money mad and received by the government and individuals.

The capital and financial accounts show the movement of direct investment. Net errors and omissions is added to ensure that the balance of payments does balance.

The causes of economic growth

In the short run, an economy with spare capacity can experience economic growth as a result of an increase in aggregate demand. For instance, a fall in the exchange rate may increase net exports and result in export-led growth. This is shown below.

There may also be consumption-led growth, which may be cause by, for instance, a cut in income tax.

Government spending and net investment may also cause economic growth. An advantage of net investment is that it increases both aggregate demand and aggregate supply. The main reason for economic growth in the long run may be improvement in quantity/quality of resources.

An economy may also grow as a result in a rise in labour force. Below we see how more people entering the labour force affect the economy.

The cause of unemployment

Cyclical unemployment, which can also be demand deficient unemployment, arises due to a lack of aggregate demand. In this the demand for most products will be low and the unemployment rate may be high. The figure below show an economy operating with spare capacity and cyclical unemployment.

Structural unemployment: Unemployment caused by the decline of certain industries and occupations due to the changes in demand and supply.

Frictional unemployment: short term unemployment occurring when worker are in-between jobs.

The causes of inflation

Inflation can be put into two categories.

Demand-pull inflation arises from aggregate demand increasing at a faster rate than aggregate supply. When the economy is producing near its productive capacity, increases in aggregate demand are likely to push up the price level, as shown below.

One reason why there may be excessive growth in aggregate demand is the money growing faster than real output.

Cost-push inflation in contrast, in contrast, arises when the price level is pushed up by increase in the cost of production. This is shown below.

A common cause of cost-push inflation is a rise in wage rates above increases in costs of production.

The causes of a deficit on the current account of the balance of payments

A deficit in the current account occurs when the country’s expenditure abroad exceeds its revenue from abroad. There are two main reasons for this. Firstly, because the country’s inhabitants have spent more on goods and services abroad than overseas residents have spent on the country’s products and/ or secondly, because there has been a net outflow of investment income.

The causes of a surplus on the current account of the balance of payments

A surplus on the current account is experienced when a country’s revenue from abroad is greater than its expenditure abroad. It may occur due to the country’s revenue from exports exceeding its expenditure on imports and/or because the country is a net earner of investment income.

The consequences of unemployment

Lost output: Having people who are willing and able to work without jobs is a waste of resources.

Lost tax revenue: Unemployment results in tax revenue being lower than possible.

Government spending on unemployment benefits: If unemployment rises, the government will have to spend more on unemployment related benefits, principally job seeker’s allowance.

Pressure on other forms of government spending: Unemployment put pressure on other forms of government spending as well. For example, when people are unemployed they are more likely to suffer health problems. More health problems mean higher waiting lists for health care, unless the government spends more on the sector or raises the sector’s productivity.

Cost to the unemployed: Loss in income and status.

Hysteresis: Hysteresis is when unemployment causes unemployment. The longer people are out of work, the more difficult it can be for them to gain another job. The long-term unemployed, which is unemployment lasting for more than one year, tend to seek work less actively over time.

The costs for other economies

Unemployment in a country’s trading partner is likely to reduce its demand for exports, this will in return reduce the economy’s aggregate demand and cause unemployment.

The benefits of exports

There are few possible benefits of unemployment, however, the existence of unemployment makes it easier for firms, wishing to expand, to recruit workers. It may also reduce demand pull and cost push inflation. The figure below show when an economy moves from producing at full employment to a lower level of output and some unemployment, causing the pressure on the price level to fall.

The significance of unemployment

The higher the unemployment the higher the costs are likely to be. For example, a 10% unemployment rate would involve a greater loss of output, higher government spending on benefits and a greater loss of tax revenue. Is also depends on how long people remains unemployed.

Generous unemployment benefits reduce the costs of unemployment but they have an opportunity cost for the economy. The costs will also tend to be high of there is cyclical unemployment. This is because such unemployment is widespread and can be on a significant scale. Cyclical unemployment tend to have the costs and frictional tend to have the lowest. Structural unemployment is more serious than frictional and is likely to cause problems in particular areas of the country.

The consequences of inflation

Fall in the value of money: With the price level rising, each pound coin and other units of the country’s money will buy less.

Menu costs: Menu costs are the costs of changing prices due to inflation. This can involve considerable time and effort and can increase labour costs.

Shoeleather costs: Shoeleather costs relate to the costs involved in reducing holdings of cash and money in current accounts and seeking the highest rate of interest. During periods of inflation, households and firms cannot afford to have money lying idle, not earning interest, as it will be losing value. They have to place it in financial institutions and have to search out the most rewarding rate of interest.

Administrative costs: Administrative costs, may be reduced if staff time is devoted to adjusting accounts, assessing raw material costs, negotiating with unions about wage rises and estimating appropriate prices.

Inflationary noise: This is the distortion of price signals caused by inflation. It means that market prices do no signal the relative scarcity of products efficiently.

Random redistribution of income: Inflation increases the cost of living, as people have to pay more to but the same basket of goods and services. What will determine the outcome for a household will be the relationship between the change in its income and the price level.

Inflation can cause some people to gain and some people to lose in a way that is not basednon economic or social merit.

Fiscal drag: One specific form of redistribution of income that can occur as a result of inflation is from taxpayers to the government. Fiscal drag is when people’s income is being dragged into higher tax bands as a result of tax brackets not being adjusted in line with inflation.

Uncertainty: Inflation often creates uncertainty. If firms are uncertain about what their cost will be and what prices they will receive from selling the products, they may be reluctant to invest.

Inflation causing inflation: The experience of inflation can lead people to behave in a way, which causes inflation to continue.

Loss of international competitiveness: If the country’s inflation rate is above that of its main competitors, its goods and services will become less price competitive.

The benefits of inflation

If there is a steady rise, firms may increase its output. Generally workers increase in their pay and even if these increases are matched with higher prices, it feels more achieving for the normal individual. Finally, the ability that inflation gives firms to alter workers` real pay can help labour markets operate more efficiently and reduce unemployment.

Deflation

Deflation is a decrease in general goods and services. This may be beneficial arising from the supply side. A fall in the price level arising from a cut in the costs of production will enable consumers to enjoy more goods and services and will increase the country’s international competitiveness.

In contras, deflation caused by a fall in aggregate demand may be harmful. Lower aggregate demand will cause firms to cut back production, which will lead to higher unemployment.

The significance of inflation

The impact of inflation depend on factors like rate of inflation, it’s cost, whether it is fluctuating, whether it was correctly anticipated and its rate relative to that of other countries.

A stable inflation with a low rate is not very likely to cause problems.

Cost-push inflation tends to be more harmful for an economy than demand-pull inflation. This is because cost-push inflation is often accompanied by a fall in real GDP and a rise in unemployment.

A high rate might cause problems, for example, hyperinflation might leads to very significant menu, shoeleather and administrative costs and considerable inflationary costs. Also, if prices is rising it is hard to judge what are the best buys and unanticipated inflation (surprised by the inflation rate) is more harmful than anticipated inflation.

The consequences of a deficit and a surplus on the current account of the balance of payments

A deficit means that a country is consuming more than it is producing. The income from this extra output, however, is going to people abroad. If a deficit increases it, will reduce the aggregate demand in the economy.

In contrast, a surplus means a country is consuming less than it is producing and is experiencing a net inflow of money and income.

The significance of a current account deficit

The significance of this depends upon its size, duration, cause and what is happening in the capital and financial account.

A deficit forming a small percentage of the real GDP or one that last shortly is unlikely to be significant.

A deficit may indicate several things in an economy. If the output of an economy is increasing, it is possible that, for a time, firms will buy more foreign raw materials and the higher income may result in more import of finished goods. An economy with a high inflation rate and low productivity is also likely to have a deficit, but this time it may continue for some time unless there is a change in economic performance.

The cost of economic growth

If an economy is using all its resources, and thus producing on its PPC, the only way it can increase its output is to switch resources from making consumer goods to making capital goods. This is shown below.

In the long run, the extra capital goods will enable more consumer goods to be made.

If economic growth is achieved in a way that is not sustainable there will be damage to the environment. There is also the risk that economic growth may result in the cutting of non-renewable resources.

In addition is may reduce the quality of some peoples lives. Because in an growing economy some people have to adopt new skills and change jobs and the pace of work also increase. Some people find these changes stressful.

The benefits of economic growth

- Rise in people’s living standard, if the GDP per head increases.

- Enables poverty within a country to be reduced without having to redistribute existing income.

- May increase employment.

- Raises the level of a country’s real output and can thereby increase its status and power in international organisations and international negotiations.

Determination of exchange rates

An exchange rate is the price of a currency in terms of another currency or currencies. The Bank of England Monetary Policy Committee’s main indicator of the pounds value is the Bank’s trade-weighted index. This measures the pound’s exchange rate against a basket of currencies, given each country’s currency a weight in proportion to the amount of trade, both in goods and services, that the country has with the UK.

The market forces of demand and supply determine most countries` exchange rates. If demand for the currency rises, this will increase the exchange rate whereas if the supply of the currency increases, the exchange rate will fall.

A rise in the exchange rate of a currency means that each of the currency will buy more units of another currency or currencies.

These are the factors affecting the demand and supply for a exchange rate:

- The demand for pounds is likely to be high and supply is likely to be low if UK products are internationally competitive.

- Changes in income abroad influences the exchange rate.

- Rising incomes at home may put downward pressure on the value of the pund.

- A rise in UK interest rates, relative to other countries` interest rates, will be likely to increase demand for pounds.

- Pounds are also bought and sold by those wishing to undertake foreign direct investment (FDI).

- Speculation is also an important influence, since a high percentage of the dealing in foreign exchange markets is accounted for by speculation.

The relationship between the exchange rate and the interest rate

Changes in both of them are closely linked. If, for example, the UK`s exchange rate rises, export prices expressed in terms of foreign currencies will rise. Demand for exports will fall and this will reduce AD. Lower ad will reduce inflationary pressure. This may mean that the MPC will reduce the interest rate.

A reduction in the interest will tend to reduce the exchange rate. This is because it will reduce the return on money kept in the UK financial institutions.

The effects of a change in exchange rate on export and import prices

A fall in the exchange rate, called a depreciation if caused by market forces, will reduce the price of exports in terms of foreign currencies.

Most exporters would be likely to let their export prices fall in line with the change in the exchange rate. Selling at a lower price in their export markets should enable them to increase their sales. Those exporters facing inelastic demand for their products may decide to leave their prices remain unchanged abroad.

While a fall in the exchange rate causes a fall in export prices, it will increase the price of imports in term of domestic currency. In contrast, a rise in the exchange rate increases export prices and lowers import prices.

Changes in the exchange rate and the macroeconomy

A reduction in the exchange rate is likely to improve the current account position of the balance of payments. A fall in the price of exports will result in a rise in export revenue if demand is inelastic. A rise in import prices will reduce expenditure on imports, again if demand is inelastic.

A lower exchange rate, by boosting exports and reducing imports, will also increase aggregate demand. If the economy was previously operating at below full capacity, such an increase will also raise employment and real GDP.

There is a risk that a lower exchange rate will put upward pressure on inflation (price on imported raw material will rise, thereby increasing the cost of production and the price of imported finished products that count in the calculation of the country`s inflation rate.

A rise in exchange rate is likely to increase a current account deficit.

One possible advantage of higher exchange rate is the downward pressure it is likely to put on inflation.

chapter 4 summary

2009-10-04T04:48:00.018+01:00

Aggregate demand

Aggregate demand (AD) is the total demand for a country’s goods and services at a given price level and in a given time period.

Price level is the average of each of the prices of all the products produced in an economy.

Consumer expenditure (C) is the spending by households on consumer products. Consumer expenditure is also known as consumption.

Investment (I) is spending on capital goods.

Government spending (G) is spending by the central government and local government on goods and services. It does not include transfer payments such as housing benefit, job seeker’s allowance and state pensions. Transfer payments is the money transferred from one person or group to another not in return for any good or service. Job seeker’s allowance is a benefit paid by the government to those unemployed and trying to find a job.

Exports (X) is products sold abroad

Imports (M) is products bought from abroad

Net exports are the value of exports minus the value of imports. If a country has a trade surplus, with exports being greater than imports, then adding net exports to C+I+G will increase aggregate demand. In contrast, the existence of a trade deficit, with imports being greater than exports, would mean that aggregate demand would be lower than total domestic demand.

So, AD = C+I+G+(X-M)

Consumer expenditure

There are many influences on how much a household spend. They include:

- Real disposable income. This is the main influence on consumer expenditure. Richer households usually spend more than the poor ones. The proportion of income that is spent, which economists call the average propensity to consume (APC) may, however, fall as disposable income rises.

- Wealth (a stock of assets, e.g. property, shares and money held in a savings account). The more wealth people have, the more they usually spend. Wealth can be spent and can be used to borrow against. It also results in greater consumer confidence, which is how optimistic consumers are about future economic aspects.

- Consumer confidence and expectations (e.g. optimistic about the future).

- The rate of interest (the charge for borrowing money and the amount paid for lending money). Usually a fall in the interest will cause the consumer to spend more.

- The age structure of the population. It is generally thought that the young and the elderly spend a relatively high proportion of their disposable income.

- Distribution of income (how income is shared out between households in a country). Poor people usually spend a bigger proportion of their income than the rich people, so government measures that redistribute income from the rich to the poor are likely to increase total consumer spending.

- Inflation (a sustained rise in price level). For example if consumers predict that the prices are going to rise, they may increase their spending now.

Saving

Saving is real disposable income minus spending.

The influences include:

- Real disposable income. Rise in real disposable income may cause the average propensity to save (APS) to rise. APS is the proportion of disposable income saved. It is saving divided by the disposable income.

- The rate of interest. A rise in interest makes the reward for saving higher so people will usually save more. However some people are target savers, which is people who save with a target figure in mind.

- Confidence and expectations. Households and firms tend to save more when they are uncertain about the future.

- Saving schemes. Some saving is contractual, like insurance and pension schemes.

- The range of financial institutions. For example in a country with many and trusted financial institutions people will usually find it easy to place their savings within these institutions.

- Government policies. For example tax-free saving schemes will encourage people to save more.

- The age structure of the population. It is found that young people usually save very little but increases their savings in their middle age and elderly usually dissave, which means that spending is higher than disposable income.

Investment

The influences include:

- Changes in real disposable income. If real disposable income is increasing, demand for consumer goods and services is also likely to be rising. This may encourage firms to expand their capacity.

- Expectations. Firms are much more likely to invest if they fell optimistic about the future.

- Capacity utilization (the extent to which firms are using their capital goods). Firms are more likely to infest if they are currently operating at full capacity.

- Current profit levels. High profit levels can encourage investment in two ways. They provide the finance to invest, and they are likely to contribute to firms` optimism about the future.

- Corporation tax (a tax on firms` profits). Cuts in tax increase the profit and might increase investment, since more money is left to spend.

- The rate of interest. A rise in the rate of interest would be likely to reduce investment for four main reasons. First, it will increase the opportunity cost of investment because the return at the bank is getting higher. Second, higher interest will make it more expensive to borrow. Third, as well as affecting the cost of investment it will also affect the expected return on the investment. Finally, it reduces the demand for shares. This will reduce their price level and so decrease the funds that firms can raise for investment.

- Advance in technology. New technology may cause lower unit cost, which is the average cost per unit of output.

- Price of capital equipment. A reduction in the price of capital equipment may also increase investment. It will become affordable for more firms to buy new machinery.

Government spending

Real GDP: the country’s output measured constant prices and so adjusted for inflation.

Gross domestic product: The total output of goods and services produced in a country.

The influences include:

- The government’s view on the extent of market failure and its ability to correct it.

- The level of economic activity in the economy. If there is a high level of unemployment, a government may rise its spending in a bid to increase aggregate demand and the output of the economy (vice versa)

- A desire to please the electorate. Spend more money on for example education to satisfy the voters.

- War, terrorist and rising crime. These may increase government spending.

Net exports

The influences on export revenue and import expenditure include:

- Real disposable income abroad. A rise in income in a country abroad means the consumers will have more money to pay for imports, increasing the net export for the country we are looking at.

- Real disposable income at home. A rise in income at home may cause a fall in exports. This is because firms may divert some products from the export market to the home market to meet the rising domestic demand.

- The domestic price level. If the domestic price level rises relative to the price levels in the country’s trading partner the value of export fall and the value of import rise. So, if domestically produced products become more expensive, firms and households at home and abroad will switch from them to products made in other countries.

- The exchange rate (the price of one currency in terms of another currency).

- Government restrictions on free trade. A country’s exports may rise if other countries` governments remove trade restrictions.

The relationship between aggregate demand and the price level

The diagram above represents inflation.

There are three reasons why the demand curve is sloping downwards.

1) The wealth effect. When the price level is low you can buy more with your money.

2) The rate of interest effect. A rise in the price level means that some people will sell financial assets, such as government bonds (a financial asset issued by the central or local government as a means of borrowing money), to obtain more money to pay the higher prices. The resulting increase in the supply of government bonds reduces their price. Such a change in the price of bonds raises the percentage rate of interest.

3) The international trade effect. A rise in price level in a country will make your country more expensive for foreign countries so exports will fall. Causing the AD to decrease.

Shifts in the aggregate demand curve

A change in any of the components will cause a shift of the AD curve, while a change in the price causes a movement along the AD curve. Examples of what causes the AD curve to shift is changes in the exchange rate, government policy and population size. A decrease in AD may be caused by a fall in share prices on global markets. This is because wealth would decline, which would be likely to reduce consumption, and if firms find it more difficult to raise finance, investment may decline.

Below we see an increase in the AD to the right.

Aggregate supply

Aggregate supply is the total amount that producers in an economy are willing and able to supply at a given price level in a given time period.

The shape of the AS curve is influenced by the level of the capacity in the economy. When output and unemployment is high, as shown over the range 0 to Y in figure 4.3, AS is perfectly elastic. This means that more can be supplied without raising the price level. Any increase in output can be achieved by offering unemployed workers jobs at the going wage rate and paying the going price for raw materials and capital equipment. Between Y and Y1, AS is at first elastic and then it becomes increasingly less responsive to changes in the price level. Ass resources become scarcer; producers have to employ les efficient workers and machinery. This pushes up unit costs of production and the price level. At Y1 all resources are employed and AS becomes perfectly inelastic. At full capacity it is not possible to produce more, irrespective of how high the price level rises.

Shifts in the aggregate supply curve

The main causes of changes in AS in the short run are changes in costs of production (e.g. raw materials, transport). In the long run the two main causes of shifts in the AS curve, which alter the productive capacity, are changes in the quantity and quality of resources (e.g. quantity of labour increase so productivity increase as well). Below we see an increase in aggregate supply, which increases productive capacity.

Macroeconomic equilibrium

Macroeconomic equilibrium is a situation where aggregate demand equals aggregate supply and real GDP is not changing. Below is an example:

The circular flow of income

Circular flow of income is the movement of spending and income throughout the economy.

Factors services are the services provided by the factors of production.

Leakages are withdrawals of possible spending from the circular flow of income.

Injections are additions of extra spending into the circular flow of income.

The multiplier effect

The multiplier effect is the process by which any change in a component of aggregate demand results in a greater final change in real GDP. The multiplier effect occurs when people spend money, that expenditure becomes the income of those who sell them the product. They, in return, will spend some of the money they receive. So there is a knock of effect, with AD rising by more than the initial amount. Below is an example of the multiplier effect.

The diagram above shows the initial increase in AD of 5 billion from a rise in government spending, and the final increase in AD of 15 billion. The existence of the multiplier effect means that a government has to recognise that any change in government spending or taxes will have a knock-on effect on the economy. So that, for instance, if the government wants to raise real GDP by 10 billion and the multiplier has been estimated at 2, it would have to raise its spending by 5 billion.

Changes in aggregate demand

If the AD shifts to the right there are three main possibilities:

If the economy is initially operating with considerable spare capacity, an increase in AD is likely to raise the output of the economy, reduce unemployment and leave the price level unchanged.

A rise in AD may increase both output and the price level. When there is not that much spare capacity left within an economy or there are shortages of resources, the increase in AD will increase the price level and the real GDP.

The economy is already operating at full employment level, with no spare capacity, an increase in AD will be pure inflationary.

Changes in aggregate supply

When AS is changing there are two main possibilities.

An increase in AS occurring when the economy is at, or close to, full capacity will raise the output of the economy and lower the price level.

An increase in AS may have no impact on the economy. This situation will occur if the economy was initially operating at a low level of output with a high level of unemployed resources.

Changes in AD and AS

There are two main possibilities:

If increases in AS can match increases in AD, the economy can enjoy higher output without encountering inflationary pressures.

If AD grows more rapidly than the growth in productive capacity, inflation will occur. The diagram below shows an economy overheating (the growth in aggregate demand outstripping the growth in aggregate supply, resulting in inflation.

Output gap

An output gap is the difference between and economy’s actual and potential GDP. In the diagram below the output gap is a/d.

Resources:

The last 8 diagrams is taken from here:http://pepijnvaneck.blogspot.com/

Chapter 3 summary

2009-10-04T00:12:00.009+01:00

What is meant by market failure?

Market failure is where the free market mechanism fails to achieve economic efficiency. The free market mechanism is the system by which the market forces of demand and supply determine prices and the decisions made by consumers and firms.

Efficiency revisited and the concept of inefficiency

There are two types of efficiency. One of them is allocative efficiency (max consumer satisfaction) and the second one is productive efficiency. Productive efficiency is where production takes place using the last amount of scarce resources.

It is only when both allocative and productive efficiency are present that economists can conclude that scarce resources are being used in the most efficient way from a consumer’s standpoint. This is known as economic efficiency. When there is inefficiency economic efficiency is not achieved.

Information failure

Information failure is when a lack of information resulting in consumers and producers making decisions that do not maximise welfare.

Some typical examples are:

Where consumers are not aware of benefits and, in some cases, the harmful effects of consuming a particular product.

Where persuasive advertising result in consumption levels that are not in the best interest of consumers.

When you are given Asymmetric information, which is information that is not equally shared between two parties. For example, you trust your doctor when he says something about your health because he has more knowledge about it.

Externalities

An externality is an effect whereby those not directly involved in taking decision are affected by the actions of others. For example, anglers may not be able to fish in a river if a chemical factory nearby discharges waste into the river, killing fish stocks.

Those people or groups not directly involved in decision-making are known as third parties. So, in the above example the anglers are the third parties.

Cost and benefits

There are three types of costs and benefits that arise out of the actions of others:

1) Private costs and private benefits. Private costs are the costs incurred by those taking a particular action. Private benefits are the benefits directly accruing to those taking a particular action.

2) External costs and external benefits. External costs are the costs that are the consequence of externalities to third parties. External benefits are benefits that accrue as a consequence of externalities to third parties.

3) Social costs and social benefits. Social costs are the total costs of a particular action (private cost + external cost). Social benefits are the total benefits of a particular action (private benefit + external benefit).

Negative externalities

Negative externalities exist where the social cost of an activity is greater than the private cost. What it means is that there are costs imposed on a third party over and above the cost directly paid for by those who carry out the activity. An example of a negative externality is illegal dumping of waste (almost no private cost, but high external cost).

At P/Q only the private cost is taken into account. If we take the external costs into account as well the supply curve will shift to the left (P1/Q1). The problem with negative externalities is that there is over production of Q-Q1 and that the price paid is lower than it should be. Too many scarce resources are being used.

Positive externalities

Positive externalities exists where the social benefit of an activity exceed the private benefit. For example education and training because this contribute to the community.

At P/Q the external benefits is not taken into account. If they were taken into account the market equilibrium would be at P1/Q1. Where the market fails to operate this way, there is under production (to few scarce resources are being used). This is shown by the difference in Q1 and Q.

Merit goods and demerit goods

Merit goods have more private benefit than the consumer actually realise (e.g. inoculations). If there is not given enough information about the merit goods, there will not be enough people consuming them.

Demerit goods: their consumption is more harmful than is actually realised. (e.g. cigarette smoking). We should consume less of these goods.

Public goods

Public goods are goods that are collectively consumed and have the characteristics of non-excludability and non-rivalry. It is difficult, if not impossible, to charge for them directly, so there is a need for them to be financed by the government from general tax revenue.

Non-excludability is a situation existing individual consumers cannot be excluded from consumption. In other words, they are provided for everyone. Thos who are not paying, but enjoying the benefit of a public good are called free riders.

Non-rivalry is a situation existing where consumption by one person does not affect the consumption of all others.

A further type of public good is a quasi-public good. This is a good having some but not all of the characteristics of a public good (e.g. motorway). Mostly have the non-excludability characteristic.

Government intervention to correct market failure

It is possible to distinguish in to types of approach:

- Methods that involve some manipulation of the market mechanism – subsidies, indirect taxation and the provision of information. These are generally referred to as market-based solutions.

- Non-market methods – direct provision and various forms of regulation and control.

Taxation

There are two types of taxation

Direct taxes: one that taxes the income of people and that cannot be avoided.

Indirect tax. A tax levied on goods and services.

When indirect taxes are introduced on a demerit good, producer often tend to pass the tax to the producer by increasing the price of the product. This is shown in the diagram above.

With indirect taxation the government may want to tax pollution, they can do this by using the polluter pays principle. This is any measure, such as green tax, whereby the polluter pays explicitly for the pollution caused.

Difficulty with this apply for four reasons:

1) There are difficulties determining the exact amount of the tax, since it is invariably difficult to estimate the cost of the negative externality.

2) Producers may not pay the full amount of tax, because they might charge the consumer for the tax they have to pay.

3) The price elasticity of demand for many demerit goods is inelastic, meaning that consumption may not be reduced as much as intended, with the result that production is higher than intended.

4) Better quality information for consumers might also be used to further reduce consumption.

Subsidies

A subsidy is a direct payment made by government to producers of a good or service or, in some cases, to its consumers. It is supposed to reduce the cost in order to provide higher level of production.

In the diagram above we see how a subsidy cause the supply curve to shift to the right causing the price to decrease and the quantity supplied to increase.

Regulations, standards and legal controls

The government is not only using the price mechanism to correct market failure. They also use forms of regulations, standards and legal controls. Below are some examples:

- Environmental – legislation relating to the emission of pollutants into the atmosphere, for the handling, storage and disposal chemicals and nice levels from pop concerts.

- Transport – legislation governing the compulsory use of seat belts, the construction and use of motor vehicles, railway trains and aircraft, vehicle speed limits, licensing of drivers and operators of buses and trucks.

Tradable permits

Tradable permits are a market-based means of correcting market failure. Tradable permit is a permit that allows the owner to emit a certain amount of pollution and that, if unused or only partially used, can be sold to another polluter.

The market determines the price of the permits and the quantity supplied is set by the government. When there are more firms that “want” to pollute, demand will increase for the tradable permits, which will make the price go up. This is shown in the diagram below: