ocr as as revision

8/11/2019 OCR as AS Revision

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Welcome to the OCR AS

Economics Revision Guide

Tejvan R Pettinger29 Campbell [email protected]

You are welcome to leave feedback and ask further questions on Economics

at:www.economicshelp.org/blog

Unless multi-user license is purchased, it is not permissible to copy this guidefor others. It is only available from www.economicshelp.org/

Copyright 2013Last updated March 2013


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AS Micro Economics

Unit 1 Markets in Action F581 Scarcity / Opportunity Cost Production Possibility Frontiers Positive / Normative Economics Supply and Demand Consumer and Producer surplus Market Equilibrium Labour Markets Elasticity Maximum and Minimum Prices Buffer Stocks Economies of Scale Efficiency Monopoly Market Failure Externalities

Demerit / Merit goods Public Goods Taxes and Subsidies Pollution permits Government Intervention Government Failure


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Basic Economic Concepts Fundamental Economic Problem. This is the issue of scarcity and how

best to produce and distribute scare resources. Positive economics: This is a statement based on facts and testable

theories - e.g. the inflation rate is 2%

Normative economics: This is based on opinion or a value judgemente.g. the government should increase taxes

Opportunity cost: This is the sacrifice of the next best alternativeforegone, e.g. opportunity cost of buying a CD, is a book foregone.

Non-Renewable Resources. Natural resources which are finite. Onceused they cannot be replaced. E.g., coal, oil and gas are all finite.

Renewable resources. Resources that can be replenished. Examplesinclude wood, fish, solar energy, water.

Sustainable resources. Even renewable resources can be depleted,e.g. overfishing can deplete fish stocks. Sustainable use gives time forstocks to replenish.

Production Possibility Frontiers:

A PPF shows the maximum output that an economy can produce if theeconomy is maximising the use of its resources and operating efficiently.

Points on PPF Curve

D= inefficient (Within PPF) A or B= Productively efficient. It is

impossible to choose more ofconsumer goods or environment unitswithout an opportunity cost.

C= impossible (without economicgrowth)


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services services

Opportunity Cost

A PPF can be used to illustrate the concept of opportunity cost. Forexample, if we move from point A to B, we gain an extra 3 units of theenvironment. However, the opportunity cost is we have to forego 4

units of consumer goods.

Constant Returns Diminishing Returns

The above diagrams show different slopes of PPFs In the first one theopportunity cost of increasing goods is always constant therefore wesay it has constant returns.

In the diagram on the right, the opportunity cost increases we havediminishing returns.

Economic Growth

Economic growth requires an increase in the productive capacity of theeconomy. This could occur due to:

Discovering more raw materials Increase in size of work force (e.g. immigration) Increase in capital stock (machines factories) Increase in labour productivity (due to better technology)

Economic growth will cause PPF to shift to the right

goods goods


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Q1 Q2

P

Q

D1

P1

P2

D2

Demand The individual Demand Curve illustrates the price people are willing to pay

for a particular quantity of a good.

A change in price causes a MOVEMENT ALONG the Demand Curve,E.g. if there is an increase in price from p2 to p1 then there will be a fall

in demand from Q2 to Q1

Shifts in the Demand Curve

This occurs when, even at the same price, consumers are willing tobuy a higher quantity of goods. E.g demand shifts from D1 to D2

A shift to the right in the demand curve can occur fora number of reasons:

1. An increase in disposable income; this can occur for a variety ofreasons such as higher wages and lower taxes

2. An increase in the quality of the good, e.g. computers are now morepowerful.

3. Advertising can increase brand loyalty to the goods and increase

demand4. An increase in the price of substitutes, e.g. if the price of O2 Mobile

phone calls increase the demand for Vodafone mobiles will increase.

5. A fall in the price of complements. E.g. a lower price of Play Station 2will increase the demand for compatible games.

Evaluation:

For some luxury goods income will be an important determinant ofdemand. e.g. if your income increased you would buy more CDs but

probably not salt. Advertising is important for goods in which branding is important,

e.g. coca cola but not for bananas


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P

P1

S1

Q

P2

Q1 Q2

S2

SupplyThis refers to the quantity of a good that the producer plans to sell in themarket.

As price increases firms have an incentive to supply more becausethey get extra revenue (income) from selling the goods.

If price changes, there is a movement alongthe supply curve, e.g. aAn increase in price from P1 to P2 causes an increase from Q1 to Q2.

Shifts in the Supply curve

An increase in supply occurs when more is supplied at each price, e.g. a shiftin supply from S1 to S2. This could occur for the following reasons:

1. A decrease in costs of production; this means business can supplymore at each price. Lower costs could be due to lower wages or lowerraw material costs.

2. An increase in the number of producers will cause an increase insupply.

3. Expansion in capacity of existing firms, e.g. building a new factory.

4. An increase in supply of a complementary good, e.g. beef and leather.

5. Climatic conditions are very important for agricultural products

6. Improvements in technology, e.g. computers / internet.

7. Lower taxes reduce the cost of goods.

8. Increase in govt subsidies will also reduce the cost of goods


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P

Pe

S

Q

Q1 Qe Q2

P2

P

P1

S

Q

Qe Q2

P2

D1

D2

Market Equilibrium

Market EquilibriumThe Price Mechanism refers to how Supply and Demand interact to set themarket price and the amount of goods sold.

If price was below the equilibrium at P2 then demand would be greaterthan the supply. Therefore there is a shortageof (Q2 Q1)

Therefore firms will put up prices and supply more. As price rises therewill be a movement along the demand curve and less will bedemanded.

Therefore price will rise to Pe until there is no shortage and Supply = Demand

Movements to a new Equilibrium

If there was an increase in income the demand curve would shift to the right.Initially there would be a shortage of the good, therefore the Price andQuantity supplied will increase leading to a new equilibrium at Q2


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P

P1

S

QQ1

P2D1

S2

D2

The Price Mechanism

Example: Factors that could explain a fall in the price

of a goodThe price of a good, such as coffee, would fall if there was a fall in demandand / or an increase in supply.

The demand for coffee could fall for various reasons such as:

i) Lower incomes mean that consumers cannot afford to buy as muchii) Less fashionableiii) Decrease in the price of substitutes such as teaiv) Fall in number of coffee shopsv) Health concerns about caffeine

The supply of coffee could increase for various reasons such as:

i) Increase in the number of suppliersii) Lower costs of productioniii) Govt subsidies

iv) Higher labour productivity in producing coffee, this will decrease thecosts of production

Economic effects of an increase in the Price of Coffee

1. Q.D. will fall, but it will only be a small amount because demand isinelastic.

2. Demand for substitutes will increase, however there are not anyclose substitutes for coffee therefore this will not be very significant.

3. If higher prices are caused by increased demand there will be an

increase in income for firms producing and selling coffee.


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Labour Markets

Demand for Labour depends upon:

Productivity of workers. If workers produce more benefit for firms, they canbe paid more.

Skills and qualifications. Workers with more skills will tend to be better paid Industry in question. Labour is a derived demand. If there is more demand

to see football games, there will be more money in the sport and footballerswill get paid more than other sportsmen.

Supply of Labour depends upon:

Skills required. If a job is highly skilled, less people will have the necessaryqualifications, therefore supply will be more inelastic

Non-monetary benefits. If a job is dangerous, unpleasant or boring, thesupply will be correspondingly less.

Wage. Higher wages will tend to attract more people to supply their labour. Tax. Higher income tax may discourage labour supply. Population and immigration. Immigration has increased supply of labour,

especially for certain jobs like plumbers and nurses. Trades Unions. Trades unions may be able to restrict supply of labour and

push up wages.

Example of Wage Determination

In the diagram on the left, supply and demand are both elastic. This couldbe an unskilled job such as a cleaner. Therefore, wages are relatively low.

On the right, supply and demand are inelastic leading to a higher wage.This could be a lawyer - where supply and demand are inelastic.


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P

MaxP

Pe

Q

D

S

Q1 Qe Q2

Min P

Pe

Q

D

S

Q1 Qe Q2

P

Government Intervention in Markets

1. Maximum Prices.

Under certain circumstances the govt may wish to reduce the price below themarket equilibrium. E.g. they could have a maximum price for renting houses.

Problems of Maximum prices

The lower price will cause a shortage, therefore some tenants will beworse off because they cannot find any houses to rent. Therefore the govtwould have to increase supply in order to overcome the shortage

2. Minimum Prices

This occurs when the govt wishes to raise the price above the equilibrium. Forexample in agricultural markets, the govt often wishes to increase the incomeof farmers by increasing the price of goods.

Problem of Minimum Prices

They encourage farmers to increase supply leading to a surplus which is

not bought on the market. Therefore the govt is obliged to buy the surplusQ2- Q1 to maintain the target price.


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Min Wage

We

Q labour

D

S

Q1 Qe Q2

Wage

P

Target Price

QD

TP

P1

Q1 Q2

3. Minimum Wages

Minimum wages are a policy designed to increase the wages of the lowestpaid, reducing relative poverty. In the UK, the NMW is 5.93 for people over21. (2011)

If labour markets are competitive then a min wage could cause unemploymentof Q2- Q1. However in the real world a minimum wage may not causeunemployment because:

Demand for labour may be very inelastic. (firms willing to pay higherwage)

A higher minimum wage may increase worker productivity. This isbecause, now wages are higher, workers may feel more loyalty to thecompany.

4. Buffer Stocks.

This is a policy designed to stabilise prices primarily in agricultural markets.The purpose of buffer stocks is:

i) Protect farmers incomes by guaranteeing a min priceii) Protect consumers from high prices by guaranteeing a maximum price

leveliii) Ensure adequate supplies of food

S2S1Buffer Stock


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P

S2

S1

D

P1

P2

i) Demand for agricultural products isinelastic, this is because they are asmall % of total income. A lowerprice of potatoes wouldnt reallyencourage people to eat more!

ii) Supply is inelastic

iii) Supply can fluctuate due to variablefactors such as the weather and

If there was an increase in supply the equilibrium price would fall belowthe target price.

To maintain the price at the target the govt will need to buy the surplus(Q2-Q1)* TP. This will effectively increase demand and therefore price.

This excess supply could be stored in a buffer stock. If there was a

shortage in the next year then the govt could sell from its buffer stock toreduce the price.

Problems of Buffer Stocks

1. It is expensive for the govt to buy the surplus and also to store it.

2. Some foodstuffs cannot be stored for a year.

3. The govt may have poor information about how much to buy, e.g. itmay be difficult to know whether there is going to be a shortage.

4. A minimum price may encourage over supply amongst farmers.

Why Prices are Volatile In Agricultural Markets

Advantages of govt intervention in Agriculture:

1. Stable prices help maintain farmers incomes.

2. Stability enables investment in agriculture.3. Farming has positive externalities e.g. helps rural communities.

4. Stable prices prevent excess prices for consumers.

5. Food supplies are assured.

Disadvantages of govt intervention in Agriculture:

1. Cost of buying excess supply.

2. Min prices and Buffer stocks encourage over supply.

3. Govt subsidy to farmers may encourage inefficiency amongst farmers.

4. Some goods cannot be stored in buffer stocks.5. Govts may have poor information e.g. what price to set.

6. Administration costs.

Q


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P

DD

P

QQ

P P

QQ

D

D

ElasticityPrice Elasticity of Demand (PED)= % change in Quantity Demanded

% change in Price

Elastic Demand

Demand is elastic if a change in price leads to a bigger % change indemand.

The PED will therefore be greater than -1. E.g. PED = -2.5

Elastic Demand PED > 1 Perfectly Elastic

Characteristics of Elastic Goods1. Luxury goods (e.g. organic food)2. They are expensive and a big % of income (e.g. sports cars and holidays)

3. Goods with many substitutes and a very competitive market. E.g. if Tescoput up the price of its bread there are many alternatives, so people wouldbe price sensitive.

4. Bought frequently.

Inelastic Demand

Demand is inelastic if a change in price leads to a smaller % change in Q.D. PED will be less than -1 e.g. -0.5

Inelastic demand PED


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P

S1

S2

D

Q

$30

$15

80 100

Characteristics of Inelastic Goods

They have few or no close substitutes, e.g. petrol, cigarettes. They are necessities They are addictive

They cost a small % of income or are bought infrequently

In the short term demand is usually more inelastic because it takestime to find alternatives

Using Knowledge of Elasticity

1. If demand is inelastic then increasing the price can lead to an increasein revenue. This is why OPEC try to increase the price of oil.

Income Elasticity of Demand YED

This measures the responsiveness of demand to a change in income.e.g. if your income increase by 5 % and your demand for mobile phonesincreased 20% then the YED = 20 / 5 = 4.

Income Elasticity of Demand (YED) = % change in Q.D% change in Income

Inferior GoodThis occurs when an increase in income leads to a fallin demand. It will have a negative YED. Examples include clothes fromcharity shops.

Normal Good This occurs when an increase in income leads to anincrease in demand for the good, Therefore YED>0

Luxury Good This occurs when an increase in income causes a bigger% increase in demand, therefore YED >1. (Note a luxury good is also anormal good)

Income inelastic This means an increase in income leads to a smaller% increase in demand. Therefore 0 > YED < 1

Revenue was$15 * 100= $1,500

Revenue is now$30 * 80= $2,400

PED = -20% / 100%= -0.2


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P P

Q

SS

Q

Inelastic

Cross Elasticity of demand

Cross Elasticity of Demand (XED) = % change in Q.D good A% change in price good B

Substitute goodsThese are alternatives to a good. Therefore XED will be positive,

Weak substitutes like tea and coffee will have a low XED. Tesco bread and Sainsburys bread are close substitutes so XED is

higher

Complements goodsThese are goods which are used together. Therefore XED is negative.

E.g. If the price of DVD players fall, then there will be a increase indemand for DVD disks,

Price Elasticity of Supply

This measures the % change in QS after a change in Price

Price Elasticity of Supply PES = % change in QS% change in Price

Inelastic Supply

This means that an increase in price leads to a smaller % change in supply.Therefore PES


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S

P

Q

P

Q

S

Elastic Supply

This occurs when an increase in price leads to a bigger % increasein supply, therefore PES >1

Elastic Supply Perfectly Elastic

Supply could be elastic for the following reasons:

1. If there is spare capacity in the factory

2. If there are stocks available

3. In the long run supply will be more elastic because capital can bevaried.

4. If it is easy to employ more factors of production.

Multiple Choice Style Question

PES is 2.0 for CDS: and the firm supplied 4,000 when the price was 30.

Q. If the price increased from 30 to 36, what will be the new Q?

QS increases by 6, therefore as a % 6/30 = 0.2 = 20%

2.0 = % change in QS20

40 = % change in QS

Therefore new Q = 4000 *140/100 = 5,600


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Specialisation

Specialisation occurs when a country or firm concentrates on producing aparticular good or service. Countries will specialise in producing goods where they have a

comparative advantage. For example, Japan specialises in producinghigh-tech electronic goods. Cuba specialised in producing sugar.

Division of Labour

This occurs when workers concentrate on different tasks with a certain firm. Rather than try to master all aspects of production, some workers will

specialise in various aspects.

For example, in a car building firm, some will work on design, some on

testing and some workers will just do unskilled jobs such as painting the car.

Advantages of Specialisation

Firms can concentrate on producing goods where they are relatively mostefficient.

It means countries dont have to produce every good they need, but cantrade to increase overall economic welfare.

By specialising in production, firms can benefit from economies of scale.This means lower average costs. This is important for industries with highfixed costs.

Problems of Specialisation

Concentrating on producing a small number of goods can make aneconomy vulnerable. For example, if the sugar price falls, the Cubaneconomy suffers.

Division of labour can make jobs highly specialised leading to boredomand diseconomies of scale.

Free Market Economy

A free market economy occurs where there is an absence of governmentintervention. Firms are privately owned and decisions on what to produceand how to produce goods are left to market forces.

Free markets tend to result in an efficient allocation of resources.However, they can also lead to monopoly power and great inequality. In afree market, many public goods will be unprovided

Mixed Economies

A mixed economy involves a degree of government intervention. Many firmsremain privately owned. However, the government: Raises taxes e.g. VAT (indirect tax) and income tax (direct tax) Provides services like health and education Regulates industries, e.g monopoly power and environmental laws.


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P

Q 1 Q se

Q

SMB = Social Benefit

D = PMB = Private Benefit

S = PMC = SMC

P1

P2

Market FailureMarket Failure: This occurs when there is an inefficient allocation of

resourcesin a free market.

Externalities: These occur when a third party is affected by the decisionsand actions of others.

Social benefit: is the total benefit to society =Private Benefit (PMB) + External Benefit (XMB)

Social Cost: is the total cost to society =Private Cost (PMC) + External Cost (XMC)

Social Efficiencyoccurs when resources are utilised in the most efficientway. This will occur at an output where

Social Cost (SMC) = Social Benefit. (SMB)

Positive Externalities

This occurs when the consumption or production of a good causes a benefitto a third party.

When you consume education you get a private benefit. But there arealso benefits to the rest of society. E.g you are able to educate otherpeople and therefore they benefit as a result

Therefore with positive externalities the benefit to society is greaterthan your personal benefit. Social Benefit > Private Benefit

Positive Externality


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Q se Q1

P1

P2

In a free market consumption will be at Q1 because private benefit =private cost.

However this is socially inefficient because Social Cost < Social Benefit.Therefore there is under consumption of the positive externality.

Social Efficiency would occur at Q se where Social Cost = Social Benefit.

For example: In the real world without govt intervention there would be toolittle education and public transport.

Negative Externalities:

Negative externalities occur when the consumption or production of agood causes a harmful effect to a third party.

For example, if you play loud music at night your neighbour may not beable to sleep.

If you produce chemicals but cause pollution then local fishermen will notbe able to catch fish. This loss of income will be the negative externality.

Therefore with a negative externality, Social Cost > Private Cost

In a free market people ignore the external costs to others thereforeoutput will be Q1 where D=S.

This is socially inefficient because at Q1: Social Cost > Social Benefit

Social Efficiency occurs at Q se where Social Cost = Social Benefit E.g. In a free market there would be over consumption of cars and

cigarettes.

SMC

S=PMC

Q

P

D = PMB = SMB

Negative Externality


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Q se Q1

P1

P2

P0

Government Intervention1. Taxes

DISADVANTAGES of taxes

1. Difficult to measure the level of negative externality e.g. what is thecost of pollution from a car?

2. If Demand is inelastic then higher taxes will not reduce demand much.

3. Indirect taxes will cause inequality. (take a bigger % of income from the

poor)4. Cost of administration.

5. Possibility of evasion. E.g. with tax on disposing of rubbish there hasbeen an increase in fly tipping (illegal dumping of rubbish)

ADVANTAGES of Taxes

1. Provides incentives to reduce the negative externality such aspollution. e.g. cars have become more fuel efficient

2. Social efficiency, 1stbest solution.(where MSC = MSB)

3. Taxes raise revenue for the govt, which can be spent on alternatives

SMC = S + Tax

S = PMC

Q

P

D = PMB = SMB

Tax on a negative externality

Tax = P2 P0 : Supply curve shifts to the left

Consumers now pay the social cost SMC

Market price increase from P1 to P2

Output will now be Q se where SMC = SMB


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P

Q fm Q seQ

SMB = Social Benefit

D = PMB

S = PMC = SMC

P1

P2

P0

S2

Impact of Tax and Elasticity

This diagram shows how the impact of a tax depends on the elasticity ofdemand.

If demand is price inelastic, then a tax causes only a small % fall indemand.

If demand is price elastic, then a tax causes a bigger % fall in demandand a smaller % rise in price.

2. Subsidies

This involves the government paying part of the cost to the firm toencourage more consumption, therefore supply shifts to the right.

Subsidy on a positive externality


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Subsidy = P2- P0

The supply curve shifts to S2 and Price falls to P0

People will now consume more at Q se

Advantages of Subsidies:

1. Increases social efficiency (increases output to Qse)

2. Provides an alternative to negative externalities e.g. buses for cars

Disadvantages of Subsidies:

1. Is expensive and the govt will have to increase taxes.

2. Difficult to estimate the benefits of the positive externality and therefore itis difficult for the govt to know how much subsidy to give.

3. Giving subsidies to firms may encourage inefficiency as the firms can relyon government aid.

3. Tradeable Pollution Permits

These involve giving firms a legal right to pollute a certain amount, e.g.100 units of Carbon Dioxide per year.

If the firm produces less pollution it can sell its permits to other firms.

However if it produces more pollution it has to buy permits off other firms. Therefore there will be a market for pollution permits. If firms pollute a lot

there will be low supply and high demand, therefore the price will be highfor permits.

Therefore, there is an incentive for firms to cut pollution.

Problems of Tradeable Permits:

Difficult to know how many permits to give. May be difficult to accurately measure pollution levels. There is an

incentive for firms to hide pollution. Requires global co-operation to make it effective, otherwise industry will

move to countries with lower environmental legislation. High admin costs of measuring pollution

4. Laws Prohibiting undesirable behaviour

E.g. Legal Age for smoking / Ban on drink driving

Advantages of legal restrictions

Simple and easy to understand

When the danger is great, it may be better to ban it all together When a decision needs to be taken quickly, a tax may be too

cumbersome


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Disadvantages of legal restrictions

There is little incentive for a firm to develop more efficient mechanisms It may be socially inefficient to ban everything

5. Advertising

The govt could advertise the dangers of smoking and alcohol; this mayovercome problems of poor information consumers may have aboutdemerit goods.

However consumers could still ignore the govt

Merit Good This is a good with 2 characteristics:

i) People do not realise the true benefit of consuming the goodii) Usually these goods have positive externalities

In a free market they will be under consumed. Examples include health,education.

Demerit Good This also has 2 characteristics:

i) People dont realise or ignore the costs of consuming the good e.g.smoking, alcohol

ii) Usually these goods have negative externalities.

Therefore they are usually over consumed in a free market

Public Good These goods have two characteristics:

i) Non-rivalry: When a good is consumed, it doesnt reduce the amountavailable for others. E.g. street lighting

ii) Non- excludability:This occurs when it is not possible to provide a goodwithout it thereby being possible for others to enjoy e.g national defence

Therefore there is a free rider problem as people can consume without payingfor them therefore in a free market they will not be provided.

Benefits of Govt providing Public Services

1. Merit Goods: people do not realise or underestimate the benefits ofeducation.

2. Positive Externalities. The consumption of health care services hasbenefits to the rest of society. Therefore will be underprovided in theprivate sector.

3. Economies of scale in providing National Service.

4. Providing a universal service leads to greater equality of distribution.

In a free market some would be unable to afford to pay.5. Minimum Service Standards: important for public services such as health.

The private sector may cut costs by cutting quality of products


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Government Failure

This occurs when govt intervention leads to an inefficient allocation ofresources. E.g. it could fail to overcome market failure and / or lead to aninefficient allocation of resources. Govt failure can occur for various reasons:

1. Poor information. The govt may have poor info about the type ofservice to provide.

2. Political interference, e.g. politicians may take the short term viewrather than considering long term effects.

3. Administration costs of govt bureaucracy in running public services.

4. Lack of incentives: There is no profit motive working in the public sectorand this can lead to inefficiency. For example there could beoverstaffing because there is no incentive to make redundancies.

Advantages of the private sector providing publicservices

1. Increased demands being placed on the public sector due todemographic changes. If more people went private this would enablethe NHS to have shorter waiting lists

2. Provides consumers with more choice.

3. If less people use the NHS it would enable the govt to lower taxes andreduce borrowing.

4. Private sector has profit incentive to cut costs and provide a moreefficient service, e.g. public bodies may have over staffing because of

political fears about job cuts.5. Diseconomies of Scale in the NHS

Disadvantages of the private sector

1. It is difficult to introduce a profit motive into public services such asHealth care, for example it is not practical to give performance relatedpay to nurses. Also the private sector may cut costs by reducing thequality of service.

2. May increase inequality. People on low incomes cannot afford privatehealth.

3. Health is a merit good and will be underprovided in a free market.Therefore there is a justification for government subsidy.

EfficiencyProductive Efficiency: This means it is impossible to produce more of one

good than another this occurs on PPF. It will also occur at the lowestpoint on the firms short run average cost (AC) curve.

Allocative Efficiency: This occurs when consumer preferences are met. Thisinvolves an optimal distribution of resources i.e. it is impossible toincrease the economic welfare of on without reducing it for another.


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Q

Long run average costs

Q1 Q2

AC1

AC2

Economies of Scale: This occurs in the long run when increased outputleads to loweraverage costs and therefore increased efficiency. E.g. byincreasing output from Q1 to Q2 the firm is able to reduce Average costs fromAC1 to AC2

Types of Economies of Scale:

1. Specialization and division of labour:In large scale operations, workers can do more specific tasks. With littletraining they can become very proficient in their task; this enables greaterefficiency and lower average costs.

2. Technical.If a firm has high fixed costs, e.g. building a large factory, then the firm willreduce average costs if it makes better use of its existing capacity.

3. Bulk buying:If you buy a large quantity then the average costs will be lower. This isbecause of lower transport costs and less packaging.

4. Financial economies.

A bigger firm can get a better rate of interest from a bank than small firms.5. Spreading overheads.

If a firm merged it could rationalise its operational centres, e.g. it couldhave one head office rather than two.

6. External economies of scale:This occurs when firms benefit from the whole industry getting bigger. Forexample, if an industry concentrates in one area, there will be bettertransport and communication in that area.

Diseconomies of Scale:

This occurs when increased output leads to higher average costs. This can occur due to factors such as difficulty of controlling and

monitoring workers in a big firm. Also in a big firm, which is highly specialised, workers may become

alienated and bored with little motive to work hard. A larger firm may experience difficulties communicating across the

different aspects of the business.

LRAC = Total CostQuantity


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Monopoly This is a market structure with one dominant firm. Monopoly power occurs when a firm controls over 25% of the marketFor a monopoly to occur there need to be barriers to entry, these areconditions which make it more difficult for a firm to entera market: e.g.

1. Economies of Scale.A new firm would find it difficult to competebecause its average costs would be much higher than the incumbentwho has a higher output and lower average costs.

2. Natural / Geographical Barriers. Only a few countries can producediamonds because they only occur in small parts of the world.

3. Brand Loyalty. Through advertising firms can differentiate their brandand encourage consumers to be loyal to the product. It makes it moredifficult for new firms to enter because they would have to spend a lotof money on advertising which is a sunk cost. (non recoverable)

4. Vertical Integration. By controlling supplies, firms can deter entry.E.g. oil companies can limit supply of petrol to new petrol stations.

5. Legal Barriers. This prevents competition by law. For example apatent or government monopoly (like Royal Mail used to be)

Disadvantages of Monopolies

1. Higher Prices.Consumers have only a limited choice, thereforedemand is inelastic. This enables the firm to increase prices, thereby

causing a fall in consumer surplus.2. Allocative inefficiency.Firms dont respond to consumer needs and

preferences. Therefore monopolies tend to be allocatively inefficient.

3. Productive inefficiency. Because competition is limited firms haveless incentive to cut costs therefore could beproductively inefficient.

4. Monopolies can pay lower prices to suppliers E.g. car companieswith monopoly power can pay lower prices to suppliers.

5. Diseconomies of scale. If a firm gets too big and unwieldy, averagecosts will start to rise.

Advantages of Monopolies

1. Economies of Scale. If there are high fixed costs in the industry thefirm will be able to benefit from economies of scale and lower averagecosts as output increases. This enables lower prices for consumers.

2. Research and Development. A firm can use its supernormal profits toinvest in new products which will benefit the consumer. This isimportant for many industries such as pharmaceuticals.

3. Some firms may gain monopoly power because they are efficientand innovative. E.g. google is considered an innovative company; thisgave it monopoly power in search engines.

4. International competition.A domestic monopoly may facecompetition from abroad.


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S = S+ sub

Q

SMB

D = PMB

S = PMCP

Q1 Q2

Q. Discuss whether govt subsidies to bus companieswould increase economic welfare?

Subsidies involve the govt paying part of the firms cost therefore Supply shifts

to the right and leads to an increase in demand.

Buses have positive externalities. This means that when you travel by busthere is a benefit to a third party. For example if you travel by bus rather thancar there will be a fall in pollution and congestion. Congestion costs theeconomy a lot because firms have an increase in costs and there is lost.Therefore the Social Benefit of travelling by bus is greater than the privatebenefit.

However in a free market people ignore the social benefit therefore thereis under consumption

In a free market the equilibrium output will be at Q1 where PMB = PMC.However social efficiency occurs at Q2 where SMC = SMB. Therefore there isa case for subsidising the buses to overcome market failure. A subsidy of (Ps P2) will shift supply to the right and increase demand to the socially efficientlevel

Another argument for subsidising buses is that it is an important publicservice and it is important to ensure that all groups of people are able to useit, therefore the govt could subsidise cheap tickets for poor people to ensuregreater equality.

However the problem with subsidising buses is that giving subsidisesto bus firms may encourage them to be inefficient. This is because thecompany has less need to cut costs because it can get money from the govt.However this may not necessarily occur, it could depend on how competitivethe bus industry was.

Subsidising buses will mean the govt will have to increase taxes; thiscould cause disincentives in the economy, because higher taxes may reduceincentives to work. However this problem could be overcome by taxing goodswith negative externalities like cars.

Ps

P2

P1

Subsidy = Ps P2


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Another problem with govt intervention is that the govt may have poorinformation about how much to subsidise and who to give it to. Politicians areusually worse at making economic decisions because they do not haveeconomic pressure but political pressures.

A more significant problem is that demand for buses may be veryinelastic. Buses only go certain routes therefore it is less suitable for somepeople, therefore making buses cheaper may not increase demand, it may benecessary to also increase the range of bus services and make them moreattractive to consumers.

To conclude there is a good economic reason to subsidise buses butthe govt will need to be careful that it gives the correct amount and that it isnot wasted. Furthermore to reduce congestion, it may be necessary to adoptother measures such as taxing cars.


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AS Macro Economics

Unit 2 National and International Economy F582

Aggregate Demand Aggregate Supply Economic Growth Inflation Supply side policies Unemployment Fiscal Policy Monetary Policy

Exchange Rates Balance of Payments Conflicts of Macro Objectives

Advice on the Evaluation component of the exam Model Essay on Economic Growth


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Macro Economic Objectives of the Government:

1. Sustainable Economic Growth2. Low unemployment3. Control of inflation. (Inflation target is CPI = 2%, +/-1)

4. Satisfactory Balance of Payments5. Supporting a stable exchange rate6. Low government borrowing7. Environment8. Equality

Nominal GDPA Measure of national income, output and expenditure.This is the monetary value of all goods and services produced in theeconomy

Real GDPThis is National income measured in constant prices. Real GDP = Nominal GDP *100/ price index Real GDP per Capita = This is the Real GDP / population

AD = C+I+G+(X-M) : ADisthe Total Demand for goods and services. Itincludes

C= Consumer expenditure on goods and services. I = Gross Capital Investment (spending on capital goods) G = Government Spending X = Exports M= Imports

An increase in AD(shift to the right) could be caused by a variety offactors:

1. Increased Consumption: due toi) An increase in consumers wealthii) Lower Interest Rate which make borrowing cheaperiii) Higher wages which increase disposable income.iv) Lower Taxesv) Increased consumer confidence about the future

Consumer Expenditure accounts for about 66% of AD and therefore is avery important component of AD.

2. Increased Investment: due toi) Lower interest rates, this makes borrowing for investment

cheaperii) Increased confidence in the economic outlook.iii) Improved technology making investment more efficient.iv) Increased economic growth.

3. Increased Government spending

4. Increased exportsi) Increased growth in other countries,ii) Lower value of Sterling, this makes exports cheaper

5. Decreased Mi) UK more competitiveii) Lower value of Sterling


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Aggregate Supply AS

Short Run Aggregate Supply curve SRAS.

Shifts in the AS can be caused by:

1. Changes in Labour costs2. Changes in Raw Material costs3. Taxation and subsidies

A fall in oil prices would cause SRAS toshift to right (SRAS 1 to SRAS2)

Long Run Aggregate Supply Curve LRAS

In the Long Run, classical economists argue that the productive capacity ofthe economy is determine by factors other than price and demand. Theyargue that in the long run AS is determined by:

1. The Labour Force2. The Capital Stock3. Available Land4. Technology5. Productivity6. Enterprise7. Attitudes to work8. Strength of banking system e.t.c

Price Level

Real GDP Y

SRAS 2

SRAS 1

P L

Y

LRAS

AD

Yf

P LLRAS

Y

AD2

AD1

CLASSICAL VIEW

KEYNESIAN VIEW

Keynesians believe that in thelong run there can be sparecapacity in the economy

Therefore they argue that theLRAS can be elastic when there

is a recession


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Economic Growth Economic growth means an increase in real GDP. An increase in GDP

means an increase in the volume of goods and services produced in aneconomy.

The rate of economic growth measures the annual % change in real GDP

An increase in the productive capacity (LRAS) of an economy is known asan increase in potential growth.

The Long Run Trend Rate of Economic Growth: This is the sustainablerate of economic growth in an economy. For example in the UK this isabout 2.5%.

The trend rate of growth is related to the increase in LRAS.

Benefits of Economic growth:

1. Higher Incomes. Consumers will be able to enjoy more goods andservices

2. Lower unemployment: With higher output firms will employ moreworkers. A sustained period of economic growth will lead to lowerunemployment.

3. Lower Government Borrowing. Economic growth creates higher taxrevenues and there is less need to spend money on unemploymentbenefits. This reduces government borrowing.

4. Improved public services. With higher tax receipts more can be spent

on health care and education.5. Firms make more profit. Firms will make higher profit; this mayencourage more investment, which leads to a virtuous circle of highergrowth.

Costs Of Economic Growth

1. Inflation. If AD increases faster than AS then economic growth will beunsustainable and inflationary. There will be a positive output gap andfirms will respond by putting up prices. However, if growth is not abovethe trend rate and AD increases at the same rate as AS, growth will not

cause inflation.2. Boom and Bust Economic Cycles. If economic growth is

unsustainable then high inflationary growth may be followed by arecession. This occurred in the late 1980s and recession of 1991.

3. Balance Of Payments Deficit. Higher consumer spending causes anincrease in imports therefore causing a deficit on the current account.However, if growth is export led, this will not occur.

4. Environmental Costs. Increased economic growth will lead toincreased output and therefore will cause increased pollution andcongestion which reduces living standards. However, higher growth

may enable more resources to be spent on the environment.5. Increased Inequality: Higher rates of economic growth have often

resulted in increased inequality. However this depends upon thingssuch as tax rates and the nature of economic growth


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Circular Flow of Income

The circular flow of income shows how money flows from households to firms(to buy goods). Then firms pay households wages to produce goods. It showsthree ways to calculate GDP.

1) Total National income (wages, dividends,)2) Total National expenditure (consumption and investment)3) Total National output (value of goods and services produced)

Injections

This is an increase of expenditure into the circular flow of income, leading toan increase in Aggregate Demand. Injections can include:

Exports spending from abroad on domestic goods. Government spending. Investment. Spending on capital goods by firms.

Withdrawals (leakages)

A reduction of money in the circular flow. Withdrawals can include:

Saving depositing money in banks Imports spending on foreign goods Taxation Government raising money from consumers and firms.


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Trends in Economic Growth

The average sustainable growth rate in the UK is about 2.5% (average

quartely growth rate = 0.7%) In the late 1980s, the UK experienced rapid growth, but this caused

inflation and the growth was unsustainable. To reduce inflation, thegovernment increased interest rates and this caused the recession of1990-91.

Fall in Growth Rate

Between 1987 Q3 and 1989 Q3 there is a fall in the growth rate. Thismeans Real GDP increased at a slower rate. GDP only falls if there is a

negative growth rate, e.g. 1990 and 2008.

Sustainable Growth

Sustainable economic growth means that the growth can bemaintained for a long time. It implies that inflation will remain low andAD increases at a similar rate to AS. It may also refer to environmentalsustainability.

Output Gap

The output gap is the difference between potential GDP and actualGDP.

A negative output gap implies that actual GDP is less than potential.(e.g. in a recession, with spare capacity and high unemployment)


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A positive output gap occurs when actual GDP is above the sustainablepotential. A positive output gap leads to inflation.

Inflation Inflation means a sustained increase in the general price level If there is inflation the value of money declines and there is an increase in

the cost of living

Measuring Inflation Consumer Price Index (CPI)

1. Household expenditure survey- This seeks to measure what people spendtheir money on. From this we get a typical basket of goods which is used tomeasure typical prices.

2. This basket of goods gives a relative importance to each different item. E.g.

if price of petrol increased this would have more effect than an increase inthe price radios because petrol has a higher weighting.

3. The basket of goods is updated each year to take into account changes inexpenditure

4. Every month changes in prices of goods and services are monitored andcombined into a single figure with using the weights in the basket.

Problems with Calculating CPI

1. Family Expenditure survey does not include everybody e.g pensioners are

excluded, but pensioners have different spending habits e.g. heating ismore important. Young people will benefit more from falling prices of mobilephones.

2. Changes in Quality: Computers have many more features than 10 yearsago, so it is difficult to compare prices because they are different goods.

3. Ignores housing costs and is often lower than old RPI method.

Costs of Inflation

1. Cost of reducing inflation:

High inflation is deemed unacceptable therefore governments feel it isbest to reduce it. This will involve higher interest rates, the reduction inAD will lead to a decline in economic growth and unemployment

2. International competitiveness:Higher prices will make British goods less competitive, leading to a fallin exports. However this may be offset by a decline in the exchange rate

3. Confusion and Uncertainty:When inflation is high people are uncertain what to spend their moneyon. Also, when inflation is high firms may be less willing to investbecause they are uncertain about future profits.

4. Menu Costs.

This is the cost of changing price lists5. Income redistribution.

Borrowers will become better off, lenders will become worse off,however it depends on the real rate of interest.


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Y1 Y2

P

P2

Causes of Inflation

Demand Pull inflation

If AD increases faster than AS inflation will occur

Cost Push Inflation

If there is an increase in the costs of firms then AS will shift to the left causinginflation. This can be caused by:

1. Wage Push Inflation . Trades unions can bargain for higher wages, thiswill lead to an increase in costs for firms. It may also cause demand-pullinflation as consumers spend more increasing AD.

2. Import prices. One third of all goods are imported in the UK. If there is adevaluation then import prices will become more expensive leading to anincrease in inflation.

3. Raw Material PricesIf raw materials such as oil prices increase then thiswill have a significant impact on costs and inflation.

4. Declining productivity. Lower productivity increases costs.

Price Level

AD1

LRAS

Y

AD2


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Supply Side PoliciesSupply side policies are government attempts to increase productivity andshift AS to the right. Supply side policies can help the economy in variousways:

1. Lower Inflation.Shifting AS to the right will cause a lower price level.

2. Lower UnemploymentSupply side policies can help reduce structural, frictional and real wageunemployment.

3. Improved economic growthSupply side policies will increase economic growth by increasing AS

4. Improved trade and Balance of Payments. By making firms morecompetitive they will be able to export more.

Examples of Supply Side Policies

1. Privatisation.This involves selling state owned assets to the private sector. It is arguedthat the private sector is more efficient in running business because theyhave a profit motive to reduce costs and develop better services.

2. DeregulationThis involves reducing barriers to entry in order to make the market morecompetitive.

3. Reducing Taxes.

It is argued that lower taxes (income and corporation) increase incentivesfor people to work harder, leading to more output.

4. Increased education and trainingBetter education can improve labour productivity and increase AS.Often there is under provision of education in a free market, leading tomarket failure. Therefore the govt may need to subsidise suitable trainingschemes.

5. Reducing State Welfare BenefitsThis may encourage unemployed to take jobs.

6. Providing better information

7. Improving Transport and infrastructure.In a free market there is likely to be under provision of publictransport. If this was increased firms would benefit from lower costs

Evaluation of Supply side policies

1. They will take time to have effect.

2. It will cost money to improve information and education.

3. Lower benefits and reduced Minimum wages may cause poverty toincrease.

4. Govt failure may occur, this is because the govt may have poor info aboutwhat to spend money on, e.g the govt may finance the wrong kind ofscheme.


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Unemployment

Economic Costs of Unemployment

1. Loss of earnings to the unemployed

2. More difficult to get work in the future

3. Stress and Health problems of being unemployed

4. Increased govt borrowing: Tax revenue falls, spending on benefits rises.

5. Lower GDP for the economy, this is pareto inefficient.

Measuring Unemployment

1. Claimant Count Method. This is the govt official method of calculatingunemployment. It counts the number of people receiving benefits (JobSeekers allowance)

Problems with Claimant count

o The Count excludes those over 60, under 18, those on govttraining schemes, and married women looking to return to work

o Some people may claim benefits whilst still working in theblack Market

2. The Labour Force Survey. This is a survey asking 60,000 people whetherthey are unemployed and whether they are looking for a job. It includes some

people not eligible for benefits

Types of Unemployment

1. Frictional Unemployment:

This is unemployment caused by people moving in between jobs, e.g.graduates or people changing jobs. There will always be somefrictional unemployment.

Also high benefits may encourage people to stay on benefits rather

than get work this is sometimes known as voluntary unemployment

2. Structural Unemployment

This occurs due to a mismatch of skills in the labour market it can becaused by

1. Occupational immobilities. This refers to the difficulties inlearning new skills applicable to a new industry, andtechnological change.

2. Geographical Immobilites. This refers to the difficulty in movingregions to get a job.


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Y2

P1

P2

3. Classical or Real Wage Unemployment:

This occurs when wages in a competitive labour market are pushedabove the equilibrium. This could be caused by minimum wages ortrades unions.

4. Demand Deficient or Cyclical Unemployment

This occurs when the economy is operating below full capacity. In a

recession when AD falls there is a fall in output therefore firms willemploy less workers. Some firms will go bankrupt leading to moreunemployment.

Demand deficient unemployment is often the biggest cause ofunemployment in the UK. E.g. after recession of 1991 and 2009,

unemployment rose close to 3 million.

Wage

Ql

S

D

Wtu

We

Q1 Qe Q2

Price Level

AD1

LRAS

Y

AD2

Y1


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LRAS

AD2

AD1

Y1 Y2

P2

P1

Policies To Reduce Unemployment

1. Fiscal and Monetary PolicyThis involves cutting interest rate or taxes to increase AD. Higher outputwill cause firms to demand more workers. This will be effective forreducing demand deficient unemployment.

However demand side policies may cause higher rates of inflationand will not reduce supply side unemployment.

2. Lower benefits and taxes.

These increase the incentive for the unemployed to look for work ratherthan stay on benefits. This will reduce frictional unemployment, but willcause a fall in AD and increase relative poverty.

3. Better job information.This could help reduce frictional unemployment by giving the unemployedbetter information about available job vacancies.

4. Education and Training.By improving labour productivity and the skills of the workforce there willbe a reduction in occupational immobilities making it easier for workers to

switch jobs.o However this will cost the govt money, also there could be govt failure

with the wrong kind of training subsidised.

5. Reform Trades Unions and reduce Minimum WagesThis will help reduce real wage unemployment.o However the effect on employment may be small if demand for labour

is inelastic.

6. Regional GrantsThese can help overcome geographical unemployment by encouraging

firms or workers to move.o However subsidies may prove ineffective for encouraging workers to

move because they may be attached to their local community

PriceLevel

Y


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Monetary PolicyThis involves changing the interest rate or manipulation of the Money Supplyby the monetary authorities.

Aim of Monetary policy

1. Control the rate of inflation. Inflation target for MPC is - 2.0% +/-12. Maintain sustainable economic growth.3. Influence the Exchange rate

Effect of Higher Interest Rates.(Tight monetary policy)

If inflation is forecast to rise above the inflation target, the MPC are likely toincrease interest rates. This will help reduce AD and inflation because higher

interest rates:1. Makes borrowing more expensive, therefore people spend less on credit.

2. Firms will be less willing to invest by borrowing money.

3. The cost of mortgages increases, therefore people have less disposableincome causing a fall in consumption. Therefore AD decreases

4. Saving money in a bank is more attractive therefore there is less spending

5. Exchange rate increases, due to hot money flows into the UK. Theappreciation in the exchange rate depresses demand for UK exports

Evaluation of Monetary Policy1. The effect of higher interest rates depends on the situation of theeconomy. If the economy is close to full employment, a rise in interest ratesis likely to reduce inflation significantly without reducing Real GDP.

However if the economy has spare capacity, (e.g. at Y3 to Y4) reducedAD may not reduce inflation but only reduce GDP


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AD1

LRAS

AD2

Y2

P1

P2

2. The effectiveness of Monetary policy depends upon other variablesin the economye.g.

a) If confidence is low, a reduction in interest rates may notincrease demand

b) If taxes are rising this may counter a fall in interest ratesc) If the world economy is slowing this will reduce exports and AD,

this would keep spending low even if there was a fall in interestrates

3. There may be time lags for lower interest rates to have an effect. E.g.higher interest rates may not reduce investment in the short term becausefirms will continue with existing investment projects

4. Monetary policy may conflict with other macro economic objectives.If the MPC reduces inflation this may lead to lower growth or higher

unemployment. The below diagram shows the effect of higher interestrates in leading to lower growth.

5. Interest rates may conflict with the exchange rate. If the Bankincreased interest rate this would cause a fall in AD but also would causean increase in the exchange rate (due to hot money flows). This wouldharm manufactures who export the most.

6. Monetary Policy may also affect the Balance of Payments. If AD fallspeople buy less imports, improving the current account However if interest rates increase the exchange rate will and may

lead to a worsening of the deficit, because exports are moreexpensive.

7. Fine Control of Monetary Policy is not possible. It is difficult to getaccurate information about the economy. Time lags in policy meaninterest rates affect the economy too late.

8. Monetary Policy will have a big effect on the housing market. This isbecause they effect mortgage payments. E.g. an increase in interest rateswill reduce the attractiveness of buying a house.

Price Level

Y

Y1


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Fiscal PolicyFiscal Policy involves the government changing the levels of Taxation andGovt Spending in order to influence AD.

The purpose of Fiscal Policy is to:1. Maintain low inflation2. Stimulate economic growth in a period of a recession

Expansionary or loose fiscal policy involves lower tax, higherspending to increase AD.

Deflationary or tight fiscal policy involves higher tax and lowerspending to reduce AD.

The Multiplier

This states that if there is an initial injection (e.g. higher govt spending)into the economy, then the final increase in AD and Real GDP will begreater.

Problems of Using Fiscal Policy

1. Poor info may reduce accuracy of forecasting economic growth andinflation

2. It depends on other components of AD, e.g. consumer confidence.

3. Higher Taxes can create disincentives to work, reducing productivity.

4. Time lag involved in increasing AD.5. Expansionary fiscal policy will increase government borrowing.

Budget DeficitA budget deficit occurs when government spending is greater than taxrevenues. Therefore the government has to make up the shortfall byborrowing from the private sector.

Public sector net Borrowing(PSNB). The annual amount thegovernment needs to borrow

Public Sector Net Debt PSND (The National Debt): This is the total(cumulative) amount of debt that the government owes the privatesector at the moment this is over 800bn (or 57% of GDP)

Annual interest payments on the debt are close to 40bn (N.B. Dont get a government budget deficit confused with the Trade

Deficit which occurs when omports are greater than exports)

Problems of a Government Borrowing

1. National Debt will increase leading to higher debt payments in the future2. Govt may have to increase taxes in the future which may create

disincentives to work.3. Govt may have to cut govt spending which leads to deterioration in public

services. (for more details see: A2 notes)


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Exchange Rates

Factors which influence the exchange rate

1. InflationIf inflation in the UK is lower than elsewhere, then UK exports will becomemore competitive and there will be an increase in demand for s. Alsoforeign goods will be less competitive and so UK citizens will supply less.

2. Interest RatesIf UK interest rates rise relative to elsewhere it will become more attractiveto deposit money in the UK, Therefore demand for Sterling will rise. Thisis known as hot money flows. Therefore the value of will appreciate

3. SpeculationIf speculators believe the sterling will rise in the future They will demand

more now to be able to make a profit. This increase in demand will causethe value to rise.

4. Strong EconomyIf the British economy is growing strongly interest rates are likely to rise tokeep inflation low. Therefore the is likely to appreciate in value.

5. Current Account.A large deficit on the current account, is likely to cause a depreciation inthe value of the exchange rate. This is because a deficit implies a flow ofexchange out of the country to buy imports.

Government Intervention in the Foreign ExchangeMarket

1. Changing interest ratesHigher interest rates will cause hot money flows, increase demand forsterling and increase the value of the currency.

2. Reduce Aggregate Demand

By decreasing AD, consumers will spend less and purchase less importsand so will supply less pounds. This will increase the value of thecurrency. Lower inflation rate will also help as British goods become more

competitive. Thus demand for Sterling will rise. However this policy has an obvious side effect because lower AD will

cause lower growth and higher unemployment

Economic Effect of a Devaluation of the Currency

1. A devaluation of the exchange rate will make exports more competitiveand appear cheaper to foreigners. This will increase demand for exports

2. Imports will become more expensive. This will reduce demand for imports

3. Inflation is likely to occur because:

o Imports are more expensiveo AD is increasingo With exports becoming cheaper manufacturers may have less

incentive to cut costs and become more efficient


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P2

P1

4.AD = X-M Therefore higher exports and lower imports will increase AD

Higher AD is likely to cause higher Real GDP and inflation. The size of this increase depends upon factors such as

a) Spare capacity in the economyb) Other determinants of AD

6. Current Account. There is likely to be an improvement in the currentaccount balance of payments. This is because quantity of exports areincreasing and imports are falling

Evaluation: The impact on the current account depends upon the elasticity ofdemand for exports and imports. If demand for exports isinelastic, a depreciation will only cause a small increase inquantity.

Economic Effects of an Appreciation

1. Exports more expensive, therefore less UK exports will be demanded

2. Imports are cheaper, therefore more imports will be bought.

3. A fall in AD, causing lower growth

4. Lower inflation because:o import prices are cheapero Lower ADo More incentives to cut costs

5. Current account deficit will tend to deteriorate.

In a period of high growth and high inflation, an appreciation may help. In arecession an appreciation is likely to lead to lower growth and higherunemployment.

P L LRAS

Y

AD2

AD1

Y1 Y2


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Balance Of PaymentsThe Balance of Payments is a record of a countrys transactions with the restof the world. It shows the receipts from trade. It consists of the current andfinancial account

1. Current accounti) Balance of trade in goods (visible)ii) Balance of trade in services (invisibles)e.g. tourism,

insuranceiii) Net income flows (wages and investment

income)iv) Net current transfers (e.g. govt aid,

payments to EU)

2. Financial account(note this used to be called the Capital Account)This

is a record of all transactions for financial investment. It includesfinancialflows and net investment

Factors which cause a current account deficit

1. Overvalued Exchange RateIf the currency is overvalued, imports will be cheaper and therefore therewill be a higher Q of imports. Exports will become uncompetitive andtherefore there will be a fall in the quantity of exports.

2. Economic Growth

If there is an increase in AD and National Income increases, people willhave more disposable income to consume goods. If domestic producerscannot meet the domestic AD, consumers will have to imports goods fromabroad.

3. Decline in Competitiveness.If there is high inflation or a decline in productivity there will be lessdemand for UK exports and British consumers will prefer buying imports.

Policies to reduce a balance of Payments Deficit

1. Devaluation.

This involves lowering the value of the currency against others, makingexports cheaper and imports more expensive.

Therefore we would expect a devaluation to lead to an improvement inthe current account. However it does depend upon the elasticity ofdemand for exports and imports.

2. The Marshall Learner Condition(note: ML condition not explicitly required for AS, but could count towards evaluation)

This states that a devaluation will improve the balance on the current account,on the condition that the combined elasticitys of demand for imports andexports is greater than one.

If (PED x + PED m > 1) then a depreciation will improve current accountand an appreciation will worsen the current account


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A problem with devaluation is that it can lead to imported inflation. Thiswill reduce competitiveness in the long run and will mean theimprovement in the current account might only be temporary.

3. Reduce Consumer Spending. If govt reduces AD by raising interest

rates or increasing taxes then people will have less money to spend sothey reduce consumption of imports.

i) The UK has a high marginal propensity to import therefore a reductionin AD improves the current account significantly.

ii) Deflationary policies will also put pressure on manufacturers to reducecosts and this will lead to more competitive exports and so exports willincrease

iii) However this policy will conflict with other macroeconomic objectivesWith lower AD, growth is likely to fall causing higher unemployment

4. Supply Side PoliciesThese can improve the competitiveness of the economy and exporters, but

this will take time to have effect

5. Protectionism.This involves restricting trade through tariffs, however it is likely to fail

because it will lead to retaliation (other countries place tariffs on UKexports.

Definitions Investment: This refers to an increase in the level of the capital stock,

e.g. the purchase of machines. (dont confuse with saving money in bank)

Labour productivity: This refers to output per worker

Output Gap. A positive output gap means output (GDP) is above potential(growth above long run trend rate. A negative output gap means there isspare capacity output less than potential.

Economic Cycle the cyclical nature of economic growth.

Economic Stability This refers to sustainable economic growth, lowinflation and low unemployment with low inflation. Macro economic stabilitywill avoid booms and busts

Savings Ratio This is the % of a persons income that is not spent butsaved

Human Development Index (HDI) A measure of economic welfare thatincludes GDP, health care and education standards.


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International TradeSince 2000, the UK has experienced a current account deficit. This means weimport more goods and services than we export.

Benefits of International Trade

Comparative advantage. Comparative advantage occurs when a country

can produce a good at a lower opportunity cost. If countries specialise ingoods where they have a comparative advantage there will be anincrease in economic welfare.

Lower prices for consumers. Consumers will benefit from lower pricesof imports. This is due to competition and gains from comparativeadvantage.

Greater competition. International trade gives firms more competitionwhich helps to reduce costs and increase efficiency.

Economies of scale.International trade allows firms to adopt greaterspecialistion. This can lead to lower average costs of production.

Protectionism

This occurs when a government seeks to protect domestic industries fromfree trade and foreign competition. Protectionism can include: Tariffs.This is a type of tax on imports. It increases the cost and

discourages domestic consumers from buying. Non-tariff barriers. These are other obstacles to trade. They may include

complicated rules and regulations which make it more expensive forforeign companies to adopt.

Reasons for Protectionism Protects domestic industries and allows them to develop.


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Help countries diversity into new industries. (important for developingcountries)

Raise revenue (though tariffs would be a minor source of income)

Conflicts of Macro Economic ObjectivesConflicts of Policy Objectives

In practise it is difficult to achieve all policy objectives at once. For example,increaing the rate of economic growth could lead to inflation and a biggerdeficit on the current account.

Increase In AD

A period ofnegative growth(1991 and 2009)caused a rise inunemployment


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In this diagram an increase in AD leads to an increase in economicgrowth. However, as the economy gets closer to full capacity, there isan increase in the rate of inflation.

Also as consumer spending increases, the level of imports will rise.This tends to cause a deterioration in the current account.

However, higher economic growth will help:

1. Reduce the level of unemployment. Higher output leads to higheremployment levels

2. Improved government finances. Tax receipts increase with highergrowth.

Evaluation

Higher economic growth doesnt have to cause inflation and adeterioration in current account. If AS increases at same rate as AD,growth can be sustainable and non-inflationary. If growth is export led,(like China), the economy can have a current account surplus.

Phillips Curve

The Phillips curve shows a trade off between unemployment andinflation.

A rise in AD leads to higher growth. This higher growth causes inflation

but helps reduce unemployment. Therefore, in the short term, policy makers face a trade off between

unemployment and inflation.


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Evaluation Evaluation requires more than knowledge, but also the ability to

consider a question in more detail and apply critical distance to thequestion.

Evaluation questions start with words such as:

1. Discuss2. Evaluate3. To what extent4. Assess5. Examine

Usually they will be the longer questions towards the end of the paper,

however this isnt always the case, it is most important to check the key wordat the start.

Methods of Evaluation:

1. How important is a factor? For example: Consumption is 66% of ADtherefore higher C has a significant effect on AD. A fall in exports to theUS, would have a limited impact on its own.

2. Time lags involved.A cut in govt spending may reduce AD, however itmay take time for this to affect the economy. Interest rate changes can

take up to 18 months to have an effect on economy, one reasons couldbe because some people may have a two year fixed mortgage.

3. It depends upon the situation of the economy.An increase in ADwill only increase economic growth if there is spare capacity. Thereforethe elasticity of AS is important.

4. Conflicts of the policy involved:An increase in taxes may reduce thebudget deficit, however it may reduce incentives to work. Higherinterest rates may reduce inflation, however it may cause the exchangerate to increase reducing demand for exports

5. It depends upon other variables in the economy.An increase ininterest rates is likely to reduce AD and inflation, however if consumerconfidence is very high and wages are increasing, this is likely to keepAD high despite the increased interest rates.

These same concepts can be used for different questions. The most important idea is that you dont give a simple answer but

always consider another viewpoints as well.


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Price Level

AD

LRAS

Y

AD

P

P

Y Y

Q. Evaluate Policies that the government can use toincrease the rate of economic growth.

The rate of economic growth measures the annual % increase in Real GDP.To increase economic growth the govt can increase either AD or AS

If the economy is below full employment and there is spare capacitywithin the economy. The govt can use demand side policies to increase therate of economic growth.

For example the govt could use fiscal policy to increase the rate of AD.This could involve cutting taxes and increasing the level of govt spending.AD = C+I+G+X-M. Therefore higher G will increase AD and lower taxes willincrease disposable income thereby increasing C and AD.

Also the MPC could cut interest rates. This reduces the cost ofborrowing and reduces monthly mortgage payments. Therefore there will bean increase in the level of borrowing, consumption and investment.

However demand side policies do have some problems, firstly there

will be time lags between changing taxes or interest rates and having aneffect on AD. Also if consumer confidence is lower interest rates may not havemuch effect on increasing consumption. Also increasing AD can conflict withthe govt objective of low inflation. If the economy is close to full capacityhigher AD will cause inflation.

Classical economists argues that higher AD will always cause inflation,because the LRAS is inelastic. Therefore in the long run there will not be anyincrease in economic growth

Increase in AD


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Price Level

Y

LRAS LRAS 2

AD

Y1 Y2

AD2

P1

To increase economic growth in the long run it is necessary to increaseproductivity and shift the LRAS to the right, this can be done through supplyside policies. For example the govt can increase the incentive to work bycutting taxes and reducing benefits. However there is no guarantee that lowertaxes do increase work incentives. Also inequality may increase.

The govt can overcome market failure by increasing spending oneducation and training, this will increase labour productivity and thereforeefficiency in the economy. However this policy will take time to have effect.Also govt intervention may not be very successful because of poor informationleading to subsidising of the wrong types of training.

A third type of supply side policy could be to follow a programme ofprivatisation and deregulation. Privatisation involves selling govt ownedindustries to the private sector. The advantage of this is that the private sectorhas a profit incentive to increase efficiency. However there are dangers that aprivate monopoly may exploit consumers. The example of rail privatisationalso showed that privatisation may not be successful, private firms underinvested in the network because they took the short term view.

Supply side policies may help improve productivity in the long term.

However there is a limit to how much the govt can increase productivity, forexample it is difficult for the govt to improve technology and working ethics.Also the rate of economic growth is likely to be effected by global events overwhich the UK govt has no control.

Commentary

1. It is important to consider both the demand and supply side causes ofeconomic growth.

2. To evaluate the policies it is important to give their limitations anddisadvantages, alternatively you could say how important the policy

was.3. AD/AS diagrams are very helpful to explain points4. To get a high marks it is important consider points critically.

Classical View ofEconomic Growth


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P

P1

S

Q

Q1 Q2

P2

D1

D2

Case Study Housing Market

An important element of the AS exam is the ability to use the micro and macroconcepts in real life markets. For example, you could get asked about themicro and macro effects of the housing market. These pages are just anexample of how the above information can be applied for certain questions.

Factors That Effect House Prices

House prices are affected by a combination of supply and demand factors.

Demand Side Factors

Demand for houses can increase for the following reasons

1. An increase in real income.This could be due to higher wages or lower taxes

2. Lower interest rates.

This will reduce the cost of having a mortgage. Interest rate are veryimportant, as mortgage repayments are usually the biggest part of apersons monthly spending.

3. An increase in consumer confidencePeople more willing to take out a mortgage.

4. Lower Unemployment

5. Demographicfactors such as an increase in the population or anincrease in the number of single people wanting a house. In the UK thishas occurred for various reasons such as:o an increase in divorce rateso

Increase in life expectancy therefore more old single peopleo Children leaving home early

6. An increase in the price of rented accommodation, which is asubstitute to buying a house

An increase indemand causes abig increase in pricebecause supply isinelastic


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Price Level

AD

LRAS

Y

AD

P

P

Y1 Y2

7. Inherited wealth. Many people use inherited wealth to buy houses

Supply Side Factors

In the short run Supply of housing is fixed because it takes time to buildhouses. Therefore in the short run demand affects prices more than supply

However if the supply of housing is inelastic then an increase indemand will lead to a big increase in price.

In the long Run the supply of housing is affected bymany factors

o Availability of planning permission. This is difficult to obtain in rural areaso Opportunity cost for builders e.g. are there better returns from other types

of investmento Existing houses may be knocked down because they are deemed unfit to

live in.o An increase in the cost of building new houses will shift supply to the left

How The Housing Market Impacts the rest of theeconomy.

Housing is the biggest component of most households wealth. Therefore ithas a big impact on the economy. The UK has one of the highest rates of

property ownership in the UK. It is roughly 77% compared to 50% in France.

1. Effect on AD.If there is a boom (or increase) in the housing market then there will be apositive wealth effect as people enjoy capital gains. This will lead to anincrease in AD, because people are more confident about the economyand some people will re-mortgage their house (equity withdrawal) to spendmore money.

2. Effect on Economic Growth (Real GDP)An increase in AD is likely to cause an increase in Real GDP, however this

depends on the situation of the economy. In the below diagram there isspare capacity in the economy therefore there is an increase in Real GDP


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However if the economy is close to full capacity then the increase mayonly be small.

Also the effect on AD depends upon other components of AD.

For example if taxes are rising or exports are falling this willkeep AD low despite rising house prices

3. Effect on InflationAn increase in house prices will cause an increase in the cost ofmortgages and therefore will lead to an increase in the RPI. Also theincrease in AD could cause demand pull inflation, However again it doesdepend upon the slope of the AS curve and other factors in the economy.

4. The MPC is responsible for setting interest rates. It is committed to keeping

inflation within its target of RPIX 2.5% +/-1. If house prices are rising this may put pressure on inflation thereforethey may be more likely to increase interest rates

However house prices are only one factor affecting monetary policy

5. High House prices could cause some workers to be unable to afford to buthouses. High property values has caused a shortage of workers in Londonand the South East.

6. Increased Supply of Houses: With High house prices there is a greaterincentive to build new houses. Therefore house-building firms will do well.

The Housing Market and Market Failure

Despite the shortage of houses the government has put a limit on buildingnew houses. This is because new houses will cause the loss of greenbelt land. This loss of the environment could be said to be a negativeexternality

Other negative externalities of new houses include increased traffic on theroads causing congestion and pollution.

Those on low incomes may not be able to afford to buy or rent a house.This has become more of a problem with the boom in housing prices.

Boom and Bust in the Housing Market. This involves rapid movements inthe price of housing.

In times of falling house prices, some house owners can experiencenegative equity causing lower AD.

Rising house prices increase AD maybe causing inflation. Boomsencourage speculation and make houses unaffordable for many people


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Government Intervention in the Housing Market

Legislation about building houses on greenbelt land

Govt subsidies for building houses. However this has been quite low inrecent years.

Provision of council houses. However in the 1980s many council houseswere sold to the occupants at reduced prices. This has reduced thequantity of housing. Also council houses have often been associated with higher levels of

crime and vandalism, especially in many of the new tower blocks builtin the 1960s.

To reduce fluctuations in house prices the MPC can change the interestrate. However the problem is that housing prices are only a small effectpart of the economy. Despite recent increases in house prices (95-02)interest rates have not been cut because inflation has been low.

Maximum Prices. The aim of this is to reduce the price of rented houses,however this could result in a shortage of houses in the rented sector.

Also problem of black market

Housing Benefit. Those on low incomes can apply for housing benefitwhich enables them to rent housing.

Policies to reduce speculation in the housing market Stamp Duty (this is a tax on selling a house) Abolition of MIRAS ( this was a tax relief on having a mortgage)

Elasticity and Housing

Elasticity of Demand for Housing

The sharp rises in house prices suggest that demand is quite inelasticbecause the higher prices have not discouraged demand.

There are not many substitutes for housing . Renting is a possibility butin the UK people are keen to buy a house as it is a form of investment.

Demand is more inelastic in popular areas such as London

Elasticity of Supply for Housing: In the Short runsupply will be inelastic because it takes time to build

new houses. In the long runthe supply of housing will be more elastic because

increased prices will encourage people to buy them However in certain areas supply will be still inelastic because there is a

shortage of space or space is protected by greenbelt land regulations

Income Elasticity of demand

ocr as as revision

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