Economicsint2h tcm4-193222

Economics
Microeconomics, The UK Economy and The International Economy
[INTERMEDIATE 2; HIGHER]
Martin Duguid
abc
The Scottish Qualifications Authority regularly reviews the arrangements for National Qualifications. Users of all NQ support materials, whether published by LT Scotland or others, are reminded that it is their responsibility to check that the support materials correspond to the requirements of the current arrangements.
Acknowledgement Learning and Teaching Scotland gratefully acknowledge this contribution to the National Qualifications support programme for Economics. First published 2005 Learning and Teaching Scotland 2005 This publication may be reproduced in whole or in part for educational purposes by educational establishments in Scotland provided that no profit accrues at any stage. ISBN 1 84399 082 2
Learning and Teaching Scotland
CONTENTS
Introduction: Student Induction Pack Unit 1: Microeconomics Topic 1: The basic economic problem Topic 2: Demand Topic 3: Supply Topic 4: The operation of markets Topic 5: Types of market (for Higher only) Unit 2: The UK Economy Topic 1: National income Topic 2: Inflation and unemployment Topic 3: The role of government in the economy Topic 4: Government economic policies (for Higher only) Unit 3: The International Economy Topic 1: International trade and payments Topic 2: The international economic environment
23 32 44 70 79
85 104 122 143
179 206
INTERMEDIATE 2/HIGHER ECONOMICS
STUDENT INDUCTION PACK
INTRODUCTION
Introduction
The aim of this pack is to provide information which will help you during your Economics course at Intermediate 2 or Higher level. Rationale All societies, organisations and individuals face the economic problem of allocating scarce resources among competing uses. Economics is the social science which provides the knowledge and skills required to make decisions about the production and consumption of goods and services. This course is concerned with the ways in which such decisions are made and the implications which these decisions have for individuals, organisations and society. The course will help you to build up knowledge of economic principles. You will develop skills in interpreting and analysing economic information as well as evaluating the costs and benefits of decisions. This economics course looks at both the world of business and the economic environment in which business is set. It will benefit anyone thinking of a career in central or local government, commerce, finance or industry. Course aims The course aims to develop: a knowledge and understanding of the basic economic problem of allocating scarce resources among alternative uses an understanding of the economic roles and responsibilities of the individual as a consumer, employee, producer and citizen an understanding of the economic roles and responsibilities of firms and governments in the use of resources an understanding of the environmental and social costs involved in economic decisions an understanding of the economic relationships between countries an ability to explain and analyse economic problems and to suggest possible solutions an ability to communicate economic ideas in a logical and effective manner.
Course details
The course is made up of three units: Microeconomics The UK Economy The International Economy Each unit is divided into topics. It will help you to organise your notes if you have a ring binder for each unit with a separate section for each topic. The topics are: Unit 1: Microeconomics 1. 2. 3. 4. 5. The Basic Economic Problem Demand Supply The Operation of Markets Types of Market
Unit 2: The UK Economy 1. 2. 3. 4. National Income Inflation and Unemployment The Role of Government in the Economy Government Economic Policies
Unit 3: The International Economy 1. 2. International Trade and Payments The International Economic Environment
Methods of teaching and learning

Different methods of teaching and learning will be used during your course but emphasis will be placed on examining, explaining and analysing current economic events and issues in the UK, European and world economies. You will be using articles from newspapers, magazines and journals and programmes recorded from TV or radio. The Internet is a very valuable source of material. You may also use computer simulations of the economy and economic statistics drawn from a variety of sources. It is important that you keep up with economic events and you should regularly listen to or watch news bulletins. You will also find
it useful to scan radio/TV listings to look for and record relevant programmes. Reading a newspaper and compiling a file of articles will also be of great benefit to you.
Homework
Your teacher will give you homework. This may consist of written exercises, completing work started in class or researching information. Study is also important and you should spend time as soon as possible after each lesson reading and learning your notes and textbook. It is important that you identify any problems of understanding as soon as possible and ask your teacher for help. Do not let problems drift they will not go away by themselves. Keeping up with events (as outlined above in Methods of Teaching and Learning) should also be considered as part of your homework. It follows that planning, setting deadlines and sticking to them is vital for homework and study. This will contribute greatly to your success.
Absence
If you know in advance that you are going to be absent, inform your teacher and ask for any work which will be covered in your absence. In the case of sickness or other unavoidable absence, ensure that you obtain a copy of all notes, homework, etc. before the next class. It is your responsibility to catch up on the work that you have missed. Because part of your assessment is continuous, it is important that your attendance is good. Poor attendance, together with a failure to cover any work which has been missed, will inevitably result in lack of success.
Assessment
You will be assessed on your performance in two main ways internal assessment and external assessment. Internal assessment There are three internal assessments, one for each unit. Each assessment will be one hour long.
External assessment At the end of the course you will sit an examination. This assessment will be set and marked by the Scottish Qualifications Authority. If you pass you will awarded a grade AC. You must pass all the internal assessments and the final examination to pass the course. Intermediate 2 The examination will be a written paper and you will be allowed 1 hour 45 minutes. Part 1 Part 2 Two data response items. One question from a choice of five. Each question will be normally divided up into three sections. You will have to write extended answers. TOTAL 40 marks
20 marks 60 marks
Higher The examination will be a written paper and you will be allowed 2 hours 30 minutes. Section A Section B Two data response items. Two questions from a choice of six. Each question will require you to write extended answers. TOTAL 50 marks 100 marks 50 marks
Prelim examination You will also be given an examination in the spring which will be of the same type as your final examination. The prelim exam is to give you practice and may be used for an appeal if you fail to reach the grade your school expects. This exam is not part of your assessment for the course.
Learning outcomes
The following pages provide you with a checklist for revision purposes. You should tick each learning outcome when you have revised it in preparation for (1) an internal assessment, (2) your prelim exam, (3) your final exam. You will also find it useful to compare your performance in internal assessments and in your prelim exam with these learning outcomes.
Unit 1: Microeconomics Topic 1 The Basic Economic Problem

Prelim exam Internal assessment Final exam
For Intermediate 2 and Higher, you should be able to:
explain the basic economic problem. explain the meaning of scarcity. explain with examples the meaning of opportunity cost as it is faced by individuals, firms and governments. describe the choices (what, how, for whom) faced by different economic systems. describe three different types of economic system (see also Topic 3 in Unit 2: The Role of Government in the Economy). classify resources/factors of production and describe their characteristics. explain the meaning of economic efficiency and why countries seek to achieve it. explain the meaning of substitution of resources. explain the meaning of geographical and occupational mobility of resources. describe measures to increase the substitution and mobility of resources. and in addition for Higher, you should be able to: explain how substitution of resources and mobility of resources may contribute to improved economic efficiency. explain the term potential output. draw production possibility curves. calculate opportunity costs from production possibility figures or curves. explain the factors which may shift a production possibility curve. explain the term equity.
10
Unit 1: Microeconomics Topic 2 Demand

11
define the term effective demand. distinguish between individual and market demand. distinguish between total and marginal utility. draw a demand curve and explain its shape in terms of marginal utility. define the law of demand in words and in graph form. describe factors which influence demand and explain the effects of changes in these factors on demand. distinguish between movements along and shifts of demand curves. outline the economic objectives of consumers in terms of marginal utility. and in addition for Higher, you should be able to: describe price elasticity of demand in words and in graph form. calculate price elasticity of demand. describe the effects of price changes on revenue for different price elasticities. explain the factors which may influence price elasticity of demand. describe and calculate income elasticity of demand. explain the significance of positive and negative income elasticity. outline the significance of price and income elasticities of demand for firms and governments.
Unit 1: Microeconomics Topic 3 Supply

define the law of supply and draw a supply curve. explain the factors which influence supply. describe the effects on supply of changes in these influencing factors. distinguish between movements along and shifts of supply curves. and in addition for Higher, you should be able to: explain and calculate elasticity of supply. analyse the importance of time in influencing elasticity of supply.
12
Unit 1: Microeconomics Topic 3 Supply Cost, Revenue and Profit

13
explain the meanings of specialisation and division of labour by product and by process. describe the advantages and disadvantages of specialisation to employees, employers and consumers. distinguish between the short and the long run period of time. define the law of diminishing marginal and average returns. explain why varying a factor of production eventually leads to diminishing returns. define fixed and variable costs of production. calculate total, average costs and marginal costs from a given set of figures. draw fully labelled graphs of total, average and marginal costs as they vary with output in the short run. explain the shape of the short run average cost curve in terms of increasing and diminishing returns. define optimum output. explain the shape of the supply curve in terms of the marginal cost curve. define economies of scale; internal and external. describe the different internal economies of scale. explain diseconomies of scale. describe the trends and motives towards globalisation amongst multi-national enterprises. describe the process and motives for downsizing.
Unit 1: Microeconomics Topic 3 Supply Cost, Revenue and Profit (contd.)

Prelim Exam Internal Assessment Final Exam
explain the relationship between long run output (returns to scale) and average cost. draw a fully labelled graph showing the behaviour of average cost in the long run. define optimum size. define and calculate total, average and marginal revenue. define and calculate profit. describe the role of profit for a firm.
14
Unit 1: Microeconomics Topic 4 The Operation of Markets

15
define what a market is, and give examples. describe and explain, both in diagrams and in words, how equilibrium or market-clearing price is arrived at in a free competitive market. describe and explain the effects on equilibrium price and output of changes in demand and supply. define what is meant by market intervention and describe the types of such intervention. explain why intervention in free markets may take place. and in addition for Higher, you should be able to: explain the meaning of ceteris paribus. show on a diagram the effects of intervention such as maximum price, minimum price, tax, subsidy. analyse data, in textual, numerical or graphical form, of given market situations.
Unit 1: Microeconomics Topic 5 Types of Market

This is for Higher level only, and you should be able to:
distinguish between a perfect and an imperfect market. describe and analyse the different types of competition in markets, i.e. competitive, oligopolistic, monopolistic and monopsonistic in terms of the number and size of firms in the market. describe how firms may differentiate their products. outline the possible barriers to entry to a market and the effects of such barriers explain and analyse how prices are determined in perfect and imperfect markets
16
Unit 2: The UK Economy Topic 1 National Income

17
explain the term national income. describe the relationship between national output, income and expenditure. describe what national income statistics are used for. identify the problems of measuring national income. describe the circular flow of income. explain the meaning of injections and withdrawals and their effects on output, employment and income. and in addition for Higher, you should be able to: distinguish between GDP, GNP and national income. explain the difference between nominal and real measurement. describe the difficulties in using national income statistics for making comparisons over time, or between countries. describe aggregate demand and its components. describe aggregate supply (including potential/full employment supply). explain how equilibrium national income is arrived at, using an aggregate demand and supply diagram. explain reasons for change in equilibrium national income. describe and explain, using the circular flow of income diagram, how the multiplier process works. calculate the multiplier and its effect on national income. describe the phases of the business cycle.
Unit 2: The UK Economy Topic 2 Inflation and Unemployment

define inflation. explain how the rate of inflation is measured in terms of the Retail Price Index (headline rate) and the Consumer Price Index (underlying rate). list and describe the factors which can cause inflation. explain the difference between measuring prices and incomes in money terms and in real terms. explain the effects of inflation on individuals, firms, government and the economy. and in addition for Higher, you should be able to: describe what is meant by money. explain the quantity theory of money and the role of money in inflation. describe and explain the main trends in inflation in recent years. For Intermediate 2 and Higher, you should be able to: define unemployment in terms of unused resources. describe how unemployment may be measured using the claimant count and labour force survey. list and explain the demand side causes of unemployment. list and explain the supply side causes of unemployment. explain the effects of unemployment on individuals, firms, government and the economy. and in addition for Higher, you should be able to: explain patterns and trends of unemployment from given statistics.
18
Unit 2: The UK Economy Topic 3 The Role of Government in the Economy

19
describe the characteristics of different economic systems, namely free market, planned, mixed. describe the economic objectives of government. describe the main types of government expenditure in terms of programme and type, i.e. capital or current. explain the reasons for government expenditure on nonmarketable goods (public and merit) and transfer payments. describe the changes in recent years in government provision of goods and services. list the main sources and types of government income. explain direct, indirect, progressive and regressive taxes. describe the change in balance between direct and indirect taxation in recent years. explain the Budget and its role. explain the effects of changes in the Budget on individuals and the economy. state the meaning of economic growth. describe how economic growth is measured. describe the sources of economic growth. distinguish between private and external costs and benefits. In addition for Higher, you should be able to: distinguish between macroeconomic and microeconomic objectives. list government macroeconomic objectives and identify the possible conflicts between them. list government microeconomic objectives.
Unit 2: The UK Economy Topic 4 Government Economic Policies

This is for Higher only and, you should be able to:
explain fiscal policy and how it may be used to achieve a governments macroeconomic objectives. explain monetary policy and the role played by the Bank of England in attempting to achieve a governments macroeconomic objectives. explain supply-side policies and their impact on workers and firms. explain the meaning of and give examples of market failure. explain the reasons for market failure. describe and explain the policies which a government may use to address failings of the market mechanism.
20
Unit 3: The International Economy Topic 1 International Trade and Payments

21
describe and explain the gains from trade in terms of absolute advantage and comparative advantage. describe the benefits of international trade to countries and consumers. analyse patterns and trends in trade from given statistics. outline the main trends in recent years in the pattern and direction of UK trade. describe the barriers to free trade. describe the purpose and structure of the current account of the balance of payments. explain what is meant by an exchange rate and how it is determined. explain the effects of changes in an exchange rate for visitors and travellers and on prices of exports and imports. describe the progress towards and features of European Monetary Union. In addition for Higher, you should be able to: explain the reasons for governments imposing barriers to free trade. explain the effects of trade barriers on consumers, firms and the economy. describe the purpose and structure of the capital account of the balance of payments. explain the factors which influence the capital account. explain the relationship between exchange rates and interest rates, and capital movements. distinguish between fixed, floating and managed exchange-rate systems. outline the advantages and disadvantages of fixed, floating and managed exchange rate systems.
Unit 3: The International Economy Topic 2 The International Economic Environment

describe the main economic features of the European Union. describe the main characteristics of developing countries. describe the main characteristics of newly industrialised countries. In addition for Higher, you should be able to: list and explain the advantages and disadvantages of monetary union. explain the economic problems of developing countries. explain the role of developed countries in promoting development. describe the work of the World Trade Organisation and its recent achievements. explain the role of international trading and monetary organisations in the world economy.
22
MICROECONOMICS
UNIT 1
Topic 1: The Basic Economic Problem

1 1.1 Scarcity The basic economic problem is scarcity. In economics scarcity means that there are not enough resources to produce all the goods and services which consumers want. Scarcity arises because human wants for goods and services are unlimited but the resources required to produce them are limited. Scarce goods and free goods. Scarce goods, also called economic goods, are those which have a price, i.e. something has to be sacrificed to obtain them. Free goods are those goods of which there is enough to satisfy everyones wants, e.g. fresh air, sea water. Free goods have no price. All scarce goods have an opportunity cost whereas free goods do not. Scarcity is not the same as shortage. A shortage is when the demand for a product is greater than its supply. Scarcity is when wants for a product are greater than its supply. Demand means what consumers want and can afford to buy. Therefore if there is enough of a product to meet the demand of those consumers who want and can afford to pay the prevailing price there is no shortage. However the product will remain scarce because of all those consumers who want the product but cannot afford to pay the price. 2 2.1 Choice and opportunity cost Because of the problem of scarcity it follows that choices have to be made. Consumers must choose what to buy out of their limited incomes. Producers must choose what to produce with their limited resources. Governments must choose what services to provide out of their limited tax revenues. Every choice involves a sacrifice and this sacrifice is called opportunity cost. Opportunity cost is the sacrifice of the next best
1.2
1.3
2.2
23
MICROECONOMICS
alternative choice. For a consumer the opportunity cost of choosing a product is the next item on his/her scale of preference. For a producer the opportunity cost of producing a good is the next most profitable product which could have been produced with the resources used. For a government the opportunity cost of providing a service is the next best service which it could have provided with the resources used. 2.3 In economics we assume that people are rational, i.e. when faced with a choice they will always choose the alternative that will give them the greatest satisfaction. This involves weighing up all the alternatives and then choosing the one that has the lowest opportunity cost. Resources: factors of production Resources may be classified as natural, human or man-made. They are sometimes called factors of production and are then classified as land, labour, capital and enterprise. Land refers to all the gifts of nature and includes not only land itself, but also all the minerals in and on the land, the sea and everything in the sea, the air, sunlight, etc. Labour refers to any human effort (manual or mental), which is directed to the production of goods or services. Capital refers to those man-made resources which are used to produce goods or services. Capital may be categorised as industrial, social, private or financial. Industrial capital is used by firms, e.g. factories, offices, plant and machinery, tools, vehicles. Social capital belongs to the whole community, e.g. schools, hospitals, roads. Private capital belongs to individuals, e.g. houses. Financial capital is money waiting to be used to buy capital goods. When capital goods are bought this is called investment. (Note the difference between saving and investment!) 3.5 Enterprise refers to the decision making and risk taking of entrepreneurs. The entrepreneur decides how many of each factor is to be used, how they are to be combined to make the most profit and how the work should be done. He or she also bears the risks
3 3.1
3.2
3.3
3.4
24
MICROECONOMICS
caused by business uncertainties. An entrepreneur is an organiser and a risk taker. 4 4.1 Mobility of resources Modern industrial economies are dynamic. This means that they are in a continual state of change. Changing consumer demands and changing production methods mean that some industries will be growing, e.g. electronics, finance while others are declining, e.g. coal, shipbuilding. In such a world there is a need for resources to be mobile to be able to change their location or their use. Resources which cannot change either their location or their use run the risk of becoming unemployed. Factor or resource mobility is the speed and ease with which a resource can move from place to place (geographical mobility) or can change use (occupational mobility). In practice there are obstacles to factor mobility and to ensure that resources are used efficiently these obstacles need to reduced. Land tends to be geographically immobile. Its mineral wealth and the crops it produces are commonly transported from one area to another but the great majority of land is used where it is. For this reason, attention is focused not so much on where it might be used as on how. People may become geographically and occupationally immobile. Many factors influence peoples mobility. Willingness to move elsewhere is determined largely by age and by family and cultural ties. Willingness and ability to do another type of job is closely linked to age, education and training. Capital has varying degrees of mobility. Some capital is highly specialised. As a result it is difficult to adapt it to other uses. Power stations and swimming pools are examples, as also are screwdrivers and staplers. The geographical mobility of capital is determined largely by its size and weight. Money capital is much more mobile. It can be moved about the world quickly and cheaply by electronic means.
4.2
4.3
4.4
4.5
4.6
25
MICROECONOMICS
5 5.1
Economic efficiency All countries have the problem of scarce resources and so should find ways of making best use of them. Best use of resources is called economic efficiency. Economic efficiency in the use of a countrys resources is achieved when the following three conditions are met: (a) when technical efficiency is achieved, i.e. when products are produced at minimum unit cost, in other words when the fewest necessary resources are used to produce each product.
5.2
Example In building a bridge, using the least amount of steel while ensuring the bridge will not collapse. Building a bridge strong enough to take 1000-ton lorries would be wasting steel, which could be used for making other products. (b) when allocative efficiency is achieved, i.e. when resources are allocated (used) to produce those goods and services which consumers most want.
Example One hundred bridges could be built over the River Don in Aberdeen in a technically efficient way, but this would be a wasteful use of resources if consumers dont want 100 bridges. The resources could have been used to make products which consumers want more. (c) when all resources are employed. Idle resources will result in lost output.
Equity Equity concerns social justice or fairness. The aim of economic efficiency can conflict with the aim of equity, e.g. a country with a free-market economy could be achieving economic efficiency by satisfying many of the wants of a few rich people at the expense of a large number of poor people.
26
MICROECONOMICS
7 7.1
Economic systems All nations face the problem of scarcity, i.e. they have insufficient resources to produce all the goods and services which their citizens need and want. Three basic questions have to be addressed: What goods and services will be produced? How will these goods and services be produced? This means who will do the production and which methods of production will be used. To whom will the goods and services be distributed? This means who will consume the goods and services after they been produced how will it be decided who receives them.
7.2
To address these questions a nation needs an economic system. There are three different economic systems: the command or planned economy, the market economy, and the mixed economy. Each has different ways of allocating resources and of distributing goods and services to consumers. The command or planned economy All decisions about resource allocation are made by government. The government owns the resources and directs them into the production of the goods and services decided on. This system is based on the principle of equity. This was the type of economic system which used to exist in the communist countries of Eastern Europe. A command economy answers the three questions in the following ways: What to produce? government planners estimate what their population need. They fix the quantity of each good to be produced. How to produce? government sets quotas for each factory and decides how many resources should be employed in producing the goods. For whom to produce? prices and incomes are controlled so that each citizen has an almost equal entitlement to what has been produced.
8 8.1
8.2
27
MICROECONOMICS
9 9.1
Free-market economy The features of a market economy are: Resources are owned by private individuals. Producers are free to produce what they wish. Consumers have consumer sovereignty (literally meaning the consumer is king) and rule the market, i.e. the freedom of consumers to decide what to buy influences what producers produce. Decisions are made on the basis of self-interest. Producers aim to maximise profit. Consumers aim to maximise value for money. Competition exists between producers and between consumers. Resources are allocated by the price mechanism. Price acts as a signal to producers. Products which consumers demand will rise in price thus encouraging producers to supply them. Producers will need more resources. They will attract them by offering higher incomes to those who own them. Falling demand for products will result in lower prices and lower rewards to owners of resources so that they will then be encouraged to move their resources to where the rewards are greater.
9.2
A market economy answers the three questions as follows: What to produce is decided by consumers. How to produce is decided by producers using the most efficient methods of production in order to keep down cost so that they can compete and maximise profit. To whom products is distributed is decided by the buying power of those consumers who earn the highest incomes from the resources which they own.
10
The mixed economy In this system there is a private sector and a public sector. In the private sector the price mechanism allocates resources but the public sector, i.e. government, intervenes when the private sector fails to produce in an efficient way the goods and services which consumers want. In practice, all economies are mixed what varies is the degree of mix. Some are planned rather than free, e.g. North Korea, while others are more free than planned, e.g. the UK. Please note that Economic Systems is dealt with in more detail in Topic 3, The Role of Government in the Economy of Unit 2, The UK Economy.
28
MICROECONOMICS
Higher only
11 Production Possibility Curves (PPC)
11.1 Production possibility curves can be drawn (in theory) for a country or firm to show the possible combinations of goods that can be produced. 11.2
Capital goods
Consumer goods
On the diagram above, A is the maximum amount of consumer goods that a country could produce if all resources were devoted to their production. B is the maximum amount of capital goods that could be produced. The production possibility curve joins all the possible maximum combinations of consumer and capital goods. This maximum output is called the countrys potential output. 11.3 Points on the curve are possible if all existing resources are being fully and efficiently employed, i.e. if resources are being used in a technically efficient way. If the economy is producing at a point inside the curve then it is producing less than it could. This could be because some resources are unemployed, or because some resources are being used inefficiently. Points outside the curve are not possible because the economy does not have the productive capacity. Given that any point on the curve represents a technically efficient use of resources, an economy still has to make the decision about which combination of goods to produce. Remember that to use resources in an economically efficient way, the combination chosen must be that which satisfies most wants.
29
MICROECONOMICS
11.4 A production possibility curve can be used to show the opportunity cost of producing a product, e.g. the opportunity cost of producing OD consumer goods is EB capital goods. The resources required to produce OD could have been used to produce more capital goods, i.e. EB.
Capital goods
Consumer goods
11.5 A production possibility curve (PPC) can also show the opportunity cost of a change in production, e.g. the opportunity cost of increasing the production of consumer goods from OD to OF is EG capital goods.
Capital goods
Consumer goods
30
MICROECONOMICS
11.6 The usual PPC curves outwards from the origin because the opportunity cost of producing one good usually increases as more of it is produced. This is because more resources are required to produce each extra unit. Notice that as more consumer goods are produced the opportunity cost in terms of lost capital goods increases.
Capital goods
Consumer goods
11.7 If an economys productive capacity increases, the PPC will move outwards and more of both goods can be produced. This is known as economic growth This would result from an increase in the quantity of a countrys resources, e.g. discovery of North Sea oil; an advance in technology, e.g. the invention of the microchip; or an increase in the efficiency of resources, e.g. training of workers.
Capital goods
Consumer goods
31
MICROECONOMICS
Topic 2: Demand
1 1.1 Consumer behaviour Consumers gain satisfaction from consuming goods and services. Economists call this satisfaction utility. The utility gained from consuming a product is difficult to measure accurately but three possible ways of measuring it are by noting: how people react when they are consuming how much of the product people consume the price that people are willing to pay for it. Note that none of these measures is totally reliable, but the third is the most commonly used. 1.2 Total utility is the total satisfaction gained from consuming a product in a period of time. Marginal utility is the satisfaction gained from consuming an extra unit of a product. Total utility, then, is the total of the marginal utilities gained from each unit consumed. Diminishing marginal utility. As a person consumes more of a good or service in a certain period of time, the utility gained from each extra unit (the marginal utility (MU)) decreases. Total utility will continue to increase, although at a decreasing rate, until a maximum is reached. At this point there is no further satisfaction to be gained from consuming more of the product. Marginal utility will be zero. Example Using the price the consumer is prepared to pay as a measure of utility: Pints of beer (per night) First Second Third Fourth Marginal utility 2.00s worth 1.80s worth 1.50s worth 1.10s worth Total utility 2.00s worth 3.80s worth 5.30s worth 6.40s worth
1.3
32
MICROECONOMICS
This is the same as saying that: if price were 2.00 the consumer would because he gets 2 worth of utility if price were 1.80 the consumer would because he gets 2 worth of utility from worth from the second if price were 1.50 the consumer would if price were 1.10 the consumer would pints. be willing to buy 1 pint be willing to buy 2 pints the first pint and 1.80s be willing to buy 3 pints be willing to buy 4
Marginal utility of pints of beer
Total utility of beer consumed
1.4
The information in 1.3 can be converted into a demand schedule: Price 2.00 1.80 1.50 1.10 Quantity demanded per night (in pints) 1 2 3 4
33
MICROECONOMICS
1.5
The same information can be shown on a graph as a demand curve.
Demand for beer
Note that the demand curve and the marginal utility curve you drew in para. 1.3 are the same curve. 1.6 Consumer surplus is the difference between how much a consumer would be prepared to pay and what is actually paid, e.g. if beer were 1.80 per pint, 2 pints would be bought. The consumer was prepared to pay 2 for the first pint so he gets 20p of utility free i.e. he gets a consumer surplus of 20p. If the price were 1.50, he would gain consumer surplus of 80p (50p + 30p) of utility free. Rational consumer behaviour. Economists assume that consumers act in a rational way i.e. they spend their money in the way that gains them maximum utility or, in plain English, best value for money. Of course, in practice, this does not always happen. Several factors may prevent this, e.g.: imperfect knowledge of the product or of rival products the actions of other people (both positive and negative) lack of self-control the consumption of some addictive products may be involuntary.
1.7
34
MICROECONOMICS
Assuming rational behaviour, a consumer will achieve maximum utility in the spending of their income when the marginal utility (MU) per p, spent on the last unit of each good is equal, i.e. when:
MU of last unit of good A Price of A MU of last unit of B Price of B MU of last unit of C Price of C
Example A student has 10 to spend one day on her lunch. There is only beer and sandwiches available. She gives a score out of 100 for the utility she thinks she would gain from each pint and each sandwich. Beer costs 1 per pint and sandwiches cost 1 each. How should she spend her 10 in order to gain maximum satisfaction? See the following table. Beer Marginal Marginal Sandwiches Marginal Marginal (pints) utility utility per p utility utility per p 1 2 3 4 5 6 7 8 9 10 100 90 80 70 60 50 40 30 20 10 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 1 2 3 4 5 6 7 8 9 10 50 45 40 35 30 25 20 15 10 5 0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05
At 7 pints of beer and 3 sandwiches, satisfaction is maximised. If she were to buy an eighth pint of beer she would gain 0.3 units of utility per p, but this would have an opportunity cost of 0.4 units of utility per p from the third sandwich given up. If a fourth sandwich were bought, 0.35 units of utility would be gained but at an opportunity cost of 0.4 units of utility from the seventh pint of beer given up.
35
MICROECONOMICS
2 2.1
Demand Definition. Demand (sometimes called effective demand) is the quantity of a good or service which consumers are willing and able to buy at a particular price in a certain period of time. Individual demand and market demand. Individual demand refers to the demand of an individual consumer for a product. Market demand is the sum of all individual consumers demand for a product, i.e. total demand. The Law of Demand states that the demand for a product varies inversely with its price. As the price of a commodity goes up then there is a fall in the quantity which consumers are willing and able to buy. This happens for two main reasons: The income effect. As the price of a good rises then a persons real income (i.e. their buying power) falls. They are not able to buy the same quantity. The substitution effect. As the price rises then the marginal utility per p of the last unit(s) consumed falls. The rational consumer would switch to substitutes which would give a higher marginal utility per (better value for money). They are less willing to buy. Remember from para 1.7 that a consumer will arrange his spending until:
MU of last unit of good A Price of A MU of last unit of B Price of B MU of last unit of C Price of C
2.2
2.3
2.4
If the price of apples were to rise then the MU per p gained from the last apple would fall. The consumer would switch that spending to bananas or chocolate until equality of MU per p was restored. By consuming fewer apples the MU per p from the last apple will rise and by consuming more bananas or chocolate the MU per p from the last unit of these will fall.
36
MICROECONOMICS
2.5
Exceptions to the Law of Demand Goods of prestige or ostentation, e.g. the demand for certain brands of jeans, training shoes or cars may rise as their price rises. Assumption of link between price and quality consumers may equate a rise in the price of a product as meaning that its quality has improved. Expectation of future price rises, e.g. speculators may react to a rise in the price of shares by buying more, expecting them to rise even further. Giffen goods Giffen, a nineteenth-century economist, observed that during the Irish potato famine, the demand for potatoes rose as their price rose. This was because living standards were so low that most people spent nearly all their income on potatoes, a filling food, so that when the price rose they had so little money to buy meat, etc., that they bought more potatoes. This effect can apply to any basic foodstuff in conditions of poverty. The demand curve in any of the above situations will slope upwards but note that above a certain price it will resume its normal shape, as the income effect will reduce peoples ability to buy the product.
37
MICROECONOMICS
3 3.1
Changes in conditions of demand Ceteris paribus. One difficulty in economics is predicting the effect of a change in a variable because there may be a number of different causal factors. The economists way round this is to assume ceteris paribus. Ceteris paribus is a Latin phrase meaning other things remaining the same. Ceteris paribus is assumed so that the effect of one changing variable can be predicted. Example Price is only one of many factors which determines the demand for a product others include changes in income, prices of other goods, population, etc. With all these conditions affecting demand, one cannot predict a fall in demand as price rises unless these other conditions remain the same. Ceteris paribus is therefore assumed in the Law of Demand, i.e. the only changing influence is price, and all other conditions which could cause demand to change have not changed. Of course, in real life things are not so simple!
3.2
What are the conditions of demand? These are the factors, other than the price of the product, which may cause demand to change. They include: number of consumers (think of the effects of a change in total population and of a change in age distribution) disposable income (think of the effect on normal goods and on inferior goods) prices of other goods (think of complementary goods e.g. central heating and gas, and of substitute goods, e.g. gas and electricity) tastes and preferences, e.g. the influence of fashion and advertising.
38
MICROECONOMICS
3.3
Note the different ways of showing the effect of a change in price on a demand curve and the effect of a change in a ceteris paribus condition. A change in price is shown by a movement along the demand curve, whereas a change in a condition is shown by a shift in the curve. Change in price
Change in a demand condition
39
MICROECONOMICS
Higher only
4 Elasticity of demand You need to know about two types: price elasticity income elasticity. Note that when writing or talking about elasticity of demand you should state what kind of elasticity of demand it is, i.e. price or income. 4.1 Price elasticity of demand (PED). This is a measure of the responsiveness of demand to a change in price. Price elasticity measures the reaction of consumers to a change in the price of a product. It is measured by comparing the percentage change of demand to the percentage change in price, i.e.
Price elasticity of demand =
% change in demand % change in price
If PED is greater than 1, i.e. if the % change in demand is greater than the % change in price, then demand has been very responsive to the change in price. Demand is said to be price elastic. If PED is less than 1, then demand is price inelastic. If PED is 0, then demand has not changed at all. Demand is perfectly inelastic. If PED is equal to infinity (meaning that demand changed without a price change) then demand is perfectly elastic. If PED =1, then demand has unitary elasticity. This means that the % change in demand and the % change in price are the same. Note that the value of PED will usually be negative because an increase in price will cause a decrease in demand and vice versa. PED would only be positive in cases where demand does not follow the normal law of demand. This would be when demand increases as price rises (see para. 2.5).
40
MICROECONOMICS
4.2
Effects of price elasticity on sales revenue

Graph A Graph B
Revenue gain
Revenue gain
Revenue loss
Revenue loss
Graph A shows that demand is price inelastic. A rise in price from P to P1 leads to a fall in demand from Q to Q1. The % fall in demand is less than the % rise in price. The revenue gained as a result of the rise in price is greater than the revenue lost as a result of the drop in demand so that revenue rises. You should also be able to say what would happen to revenue if price fell.
Graph B shows that demand is price elastic. A rise in price from P to P1 leads to a fall in demand from Q to Q1. The % fall in demand is greater than the % rise in price. The revenue gained as a result of the rise in price is less than the revenue lost as a result of the drop in demand so that revenue falls. You should be able to explain what would happen to revenue if price fell.
4.3
Factors affecting price elasticity of demand Availability of substitutes. The closer the substitute the more elastic is demand (the more responsive are consumers). Price relative to total spending. If low then consumers take little notice of a change in price, e.g. the demand for a box of matches will tend to be price inelastic consumers will take little notice of a 10% (1p or 2p) change in price.
41
MICROECONOMICS
Habit. The more a commodity is considered to be a necessity then the more demand will be price inelastic, e.g. petrol, cigarettes, a newspaper. Fashion. Products which are in fashion will tend to have a price inelastic demand, e.g. certain brands of jeans, toys, hairstyles. Frequency of purchase. Products that have to be bought frequently have price inelastic demands, e.g. fresh milk. Where purchase can be postponed, e.g. consumer durables (TVs) demand tends to be price elastic, in the short run at least. 4.4 The importance of price elasticity of demand (a) Businesses will want to know the effects on sales revenue if they change their prices. raising the prices of goods that have an inelastic demand will raise revenue lowering the prices of goods that have an elastic demand will raise revenue. Note that firms cannot predict exactly what will happen to revenue since they cannot predict accurately the response of consumers to a change in price, and of course ceteris paribus does not exist in the real world. (b) Government will want to know the effect on tax revenue if they change an expenditure tax. An increase in an expenditure tax increases the price of a good. Whether revenue increases depends on demand for the taxed product being price inelastic.
4.5
Income elasticity of demand Income elasticity of demand measures the responsiveness of demand to a change in income. It is calculated by:
% change in demand % change in income
42
MICROECONOMICS
If a persons income rises by 10%, it does not follow that he will buy 10% more of all that he was previously buying. (a) Some commodities will still be out of his reach 0 income elasticity. Some commodities he will buy no more or no less of, e.g. a newspaper 0 income elasticity. Some commodities he may buy only a little more of, e.g. food income inelastic demand. The demand for necessities in a high-income economy such as the UK tends to be income inelastic. Some he may buy significantly more of, e.g. meals out, entertainment income elastic demand. Luxury goods/ services tend to have an income elasticity of demand greater than 1. Some he may buy less of, i.e. inferior goods such as bread, cheap brands of clothing negative income elasticity.
(b)
(c)
(d)
(e)
4.6
The importance of income elasticity (a) If sellers know the income elasticity of demand for their products they will be able to predict what will happen to their total revenue in times of changing incomes, e.g. if demand for a product is income elastic then in times of rising incomes sellers can expect a significant rise in demand and in revenue. For products which have an income inelastic demand then the rise in incomes will increase demand but not by much sellers can expect a small rise in revenue. For inferior products which have negative income elasticity demand then demand would fall and so would revenue. On the other hand in a period of falling incomes, say in a recession, the demand for inferior goods and services should rise. The Government would also be able to predict changes in revenue from taxes on products.
(b)
43
MICROECONOMICS
Topic 3: Supply The Nature of Production

1 Specialisation Modern production is based on the principle of specialisation. Specialisation is the use of a resource for that productive activity for which it is best suited. Resources are scarce, so it is desirable to use them efficiently, i.e. to achieve maximum output from each resource. Specialisation in the use of resources is a means of achieving efficiency. 2 Benefits of specialisation increased productivity reduced unit costs of production efficient use of scarce resources. 3 Applications of specialisation The concept of specialisation is applied at different levels of production: At national level, countries specialise in different products, e.g. copper, coffee. At regional level, regions of a country specialise, e.g. farming, manufacturing industry. At industry level, specialisation takes place, e.g. whisky distilling, car manufacture. At firm level, specialisation between firms occurs, e.g. whisky distilling, barrel making, bottling. At worker level, where specialisation is called division of labour. 4 4.1 Division of labour Advantages for the worker (a) (b) (c) (d) Increased productivity increased income. Skill and dexterity are more easily acquired. Worker can specialise in the job she/he is best at and which gives the most satisfaction. Opportunity of employment for workers of all abilities is increased because out of the large variety of occupations, even the least qualified will be able to do some simple task.
44
MICROECONOMICS
4.2
Disadvantages for the worker (a) Increased risk of unemployment a fall in demand for a workers output will make him/her redundant. This risk increases the more specialised and the less occupationally mobile the worker is. Interdependence each person is dependent on others in the workforce; any break in the chain of production will have a wide effect. Monotony in certain repetitive jobs may lead to loss in productivity through absenteeism, carelessness and spoiled work.
(b)
(c)
5 5.1
Production decisions in the short run and long run Producers aim to maximise profit. One way of doing this is to seek the most efficient method of production in order to keep cost of production per unit to a minimum. A distinction is made between the short-run period of time and the long-run. The distinction is not made in terms of days, weeks or months, but in terms of how long it takes a firm to change its size. The size of a firm is measured by its capacity. Capacity is the maximum output which it could produce (its production possibility). The short run is that period of time when the capacity of the firm is fixed. At least one factor of production is fixed in quantity. This could be the size of the building, the number of machines, the number of skilled workers, etc. The long run is that period of time when the capacity of the firm can be increased or decreased. In the long run the size of the firm can be changed. The length of the short run varies from firm to firm and industry to industry. A window cleaner could increase his capacity (by buying another ladder and bucket, and employing another worker) very quickly. An electricity-generating firm would take years to obtain planning permission, commission a builder, and build and equip a new power station.
5.2
5.3
5.4
5.5
45
MICROECONOMICS
Section 6 is for Higher only

6 6.1 Production in the short run: the law of diminishing returns Returns is a name given to what a producer gets back in output when she/he employs more of a factor of production, e.g. returns to labour means the output gained when more workers are employed. In deciding what output is the most efficient to produce in the short run a firm needs to consider the law of diminishing returns. The law of diminishing returns states that if a producer uses more of a factor of production when at least one of his other factors is fixed then returns to the variable factor will increase at first, but diminishing returns will eventually set in. Illustration serving meals in a school canteen Assumptions Labour is a variable factor of production. All other factors of production, land capital and enterprise are fixed. Each worker is equally efficient. The state of technical know-how remains fixed. Workers Total output 0 1 2 3 4 5 6 7 8 0 20 54 100 151 197 230 251 234 Marginal output* 0 20 34 46 51 46 33 21 17 Average output** (meals per hour) 0 20 27 33.3 37.75 39.4 38.3 35.9 29.25
6.2
6.3
6.4
(meals per hour) (meals per hour)
* Marginal output is the extra output produced when an extra worker is employed. ** Average output = total output no. of workers.
46
MICROECONOMICS
You should draw: (a) (b) a graph to show how total output varies with workers (workers on the horizontal axis) a graph to show how marginal output and average output vary with the number of workers.
6.5
Observations Total output Until the employment of the fourth worker, total output increased at an increasing rate. Between the employment of the fourth and seventh workers total output increased at a decreasing rate. After the employment of the eighth worker total output fell. Marginal output Marginal output increased until the employment of the fourth worker (there were increasing marginal returns). Marginal output decreased after the employment of the fifth worker (there were diminishing marginal returns). Average output Average output increased until the employment of the fifth worker (there were increasing average returns) Average output decreased after the employment of the sixth worker (diminishing average returns).
6.6
Explanation Increasing Marginal Returns. When the second worker was employed an extra 34 meals per hour were served. Total output did not rise to 54 because one worker served 20 and the other served 34. The two workers specialised and worked as a team to produce 54 meals. Diminishing Marginal Returns. After the employment of the fifth worker, the additions to output fell because there was less opportunity for further specialisation. When the eighth worker was employed, there were so many workers that they got in each others way so much that output fell.
47
MICROECONOMICS
7 7.1
Production in the long run: returns to scale In the long run all factors of production are variable. A firm is able to change its capacity, up or down. Changing capacity is also called changing the scale of its operations or changing its size. If a firm increases its scale by increasing the amount of resources it uses, output does not necessarily increase in proportion. The relationship between changes in output and changes in scale are called returns to scale. There are three possibilities: Increasing returns to scale. Output may increase faster than the size of the firm. In other words, the firm is becoming more efficient as it grows in size. This is also called economies of scale. Constant returns to scale. Output may rise at the same rate as the size of the firm. The firms efficiency remains unchanged as it grows. Decreasing returns to scale. Output may rise more slowly than the size of the firm. The firm is becoming less efficient as it grows bigger. This is also called diseconomies of scale.
7.2
7.3
Economies of scale. Economies of scale occur when output rises faster than the size of the firm, i.e. when there are increasing returns to scale. Economies of scale may be of two types: Internal economies of scale are the improvements in productivity as the firm grows in size. External economies of scale are the improvements in productivity which a firm gains from the growth of its industry.
Internal economies of scale These can be grouped under the following headings: Technical Financial Purchasing Managerial Marketing Research and development (R & D) Risk bearing Welfare.
48
MICROECONOMICS
8.1
Technical economies of scale (a) Increased division of labour and specialisation the larger the firm the greater the opportunities for specialisation of men and machines. Increased dimensions when any container is increased in size, its volume increases by more than its surface area. This means that its building cost per cubic centimetre falls as it increases in size. This economy applies to all types of containers, e.g. storage tanks, warehouses, ships, buses, aircraft. Savings will also be made in labour, e.g. drivers, and in energy, e.g. fuel. Indivisibility the minimum size of some types of capital is large and they can only be used efficiently by large firms with sufficiently large outputs, e.g. a car assembly line, an oil-rig. Principle of multiples a production process often requires several linked processes using different machines with different capacities. For example, a process using three machines A with a capacity of 20 units per hour, B with a capacity of 30 units per hour and C with a capacity of 40 units per hour would require to be producing at least 120 units to give a balanced team of fully employed machines (6 As, 4 Bs and 3 Cs).
(b)
(c)
(d)
8.2
Financial. Large firms find it easier to: (a) (b) attract investors from a wider variety of sources due to the lower risk element and because they are more widely known. borrow money at lower rates of interest.
8.3
Purchasing (a) (b) Larger firms can negotiate larger discounts from buying in bulk. Very large firms are able to dictate to their suppliers the price, quality and delivery date they want.
8.4
Managerial. Large firms can employ specialists because there is sufficient work to fully occupy accountants, marketing managers, etc.
49
MICROECONOMICS
8.5
Marketing (a) (b) Selling costs (advertising, salespeoples salaries) can be spread over larger volumes of sales. Transport costs per unit of sales can be lowered due to full lorry, ship or train loads.
8.6
Research and development (R & D) (a) (b) (c) Large firms can afford costly research. R & D enables innovation to take place giving firms a competitive advantage. Market share can be maintained or improved by product development.
8.7
Risk bearing. Large firms can diversify: (a) (b) (c) products to offset demand fluctuations. markets nationally and internationally to offset demand fluctuations. sources of supply to reduce risk of fluctuating prices and availability.
8.8
Welfare. Large firms can afford to provide: (a) (b) (c) (d) pensions medical services fringe benefits recreational facilities.
All of these improve the motivation and efficiency of the workforce. 9 External economies of scale These are particularly important when the firms of an industry concentrate in a particular area. Advantages may be gained from: (a) (b) (c) lower training costs because the concentration of the industry justifies the existence of specialised facilities at a local college ancillary services provided by specialist suppliers, e.g. transport, materials, machinery, repairs co-operation among firms.
50
MICROECONOMICS
10
Diseconomies of scale Increasing size may eventually bring inefficiencies and rising costs.
10.1 Internal diseconomies (a) Management problems larger firms find it more difficult to keep control of the activities of the organisation. Communication through many layers of management becomes more difficult. Waste is more difficult to detect and control, e.g. overmanning, pilfering.
(b)
It is partly because of diseconomies of scale that in recent years many firms have reduced their size (the jargon for this is downsizing). This has been achieved by changing their management structures by removing layers of management (known as delayering). They have also reduced their size by contracting out work to other firms (known as outsourcing) and laying off many of their staff. 10.2 External diseconomies. Growth of firms in an area may lead to extra costs for those firms: (a) (b) (c) shortages of skilled labour and higher wage costs shortages of raw materials congestion and higher transport costs.
51
MICROECONOMICS
The Costs of Production

1 Introduction Costs of production are the money values of resources used in producing a good or service. Costs involve payments to those people who have provided the resources, e.g. rent to a landlord, wages to workers, interest to a bank. The owner of a firm may provide some of the resources, e.g. his/ her labour or capital. In calculating the cost of production the value of the owners resources should be included as a cost. Since there may not have been any money paid, the value of the resource is measured by its opportunity cost (what it could have earned in the next-best occupation): e.g. if the owner could have got a job with another firm as a manager earning a salary of 20,000, he should include as a cost to his firm a salary of 20,000. 2 Normal profit as a cost The owner of a firm will have provided enterprise. Enterprise is a factor of production; therefore, the value of the enterprise is included as a cost. The opportunity cost of enterprise the profit which the owner could have earned in another venture is called normal profit. This means that if the revenue earned is equal to cost of production then the firm has earned a normal profit. If the revenue is greater than cost of production, then the excess revenue is supernormal profit. 3 Definitions Fixed costs are costs which remain the same within a range of output and they are incurred even when there is no output. Fixed costs are also called overheads. Variable costs are costs which vary with output and are zero when output is zero. Total costs are the sum of fixed costs and variable costs. Average cost =
Total cost Output
52
MICROECONOMICS
Average cost is sometimes called unit cost. Average cost may also be calculated by Average fixed cost + Average variable cost Average fixed cost =
Fixed cost Output Variable cost Output
Average variable cost =
Marginal cost (MC) is the extra cost of producing one more unit of output, e.g. the marginal cost of the 50th unit of output is the total cost of 50 units minus the total cost of making the first 49. Marginal costn = Total costn Total costn1 Since the costs which change with extra production are the variable costs, marginal cost is the additional variable cost when one extra unit of output is produced. Marginal cost can also be: Marginal costn = Variable costn Variable costn1 4 4.1 Short run and long run The short run is that period of time when the capacity of the firm is fixed. At least one resource is fixed in quantity. Some of the costs of production will be fixed costs, e.g. the rent of the factory, the interest payments and depreciation for the machines, the salaries of the managers. The rest of the costs will be variable costs. The long run is that period of time when the capacity of the firm can be increased or decreased. In the long run, all costs are variable. Short-run cost behaviour See table on the following page.
4.2
53
54
Output (4) = (2) + (3) 0 200 280 330 360 450 600 770 960 1260 140 120 13 11 110 14 100 17 90 20 90 25 65 70 83 96 108 129 110 33 77 140 50 90 200 100 100 100 100 80 50 30 90 150 170 190 300 (5) = (4) (1) (6) = (2) (1)
Fixed cost
Variable cost
Total cost
Average cost
Average fixed cost
Average variable cost
Marginal cost
(1)
(2)
(3)
(7) = (3) (1) (8) = (4) or (3)
100
100
100
MICROECONOMICS
100
180
100
230
100
260
100
350
100
500
100
670
100
860
100
1160
You should draw
(a) (b) (c)
a graph to show how fixed cost, variable cost and total cost vary with output a graph to show how average cost, average fixed cost and average variable cost vary with output a graph to show how average cost, average variable cost and marginal cost vary with output.
MICROECONOMICS
5.1
Total costs (see graph). When output increases in the short run then: Fixed costs do not change. Variable costs increase, but not necessarily at a constant rate. Total costs increase at the same rate as variable costs.
5.2
Average costs (see graph). When output increases then: Average fixed cost falls. This is because total fixed cost is the same amount regardless of the volume of output. Total fixed cost is being spread over an ever-larger output. Average variable cost falls until a certain output is reached and then it rises. It falls because of improving efficiency and increasing returns. It rises because of inefficiency and diminishing returns. (For a fuller explanation of this, see the note on the law of diminishing returns on p46). Average cost falls while average variable cost and average fixed cost are falling. Average cost then rises when the increases in average variable cost exceed the falls in average fixed cost.
5.3
Optimum output in the short run. The optimum output is the output where the firm would be technically efficient. At this output, average cost is at its lowest. Marginal cost. Marginal cost falls and then rises as output increases. There is a special relationship between marginal cost and average variable cost: Marginal cost is less than average variable cost when average variable cost is falling. Marginal cost is greater than average cost when average variable cost is rising. Marginal cost is equal to average variable cost when average variable cost is at its lowest, i.e. the MC curve cuts the AVC curve at its lowest point. A similar relationship exists between marginal cost and average cost.
5.4
55
MICROECONOMICS
6 6.1
The short run and the law of diminishing returns The law of diminishing returns explains what happens to marginal and average cost as output is increased. Diminishing returns and costs in the short run. Using the earlier canteen illustration, assume workers are paid 4 per hour and that there are no other variable costs.
Total Variable output cost (per hour) Marginal Average output cost per worker per meal* Average output worker Average variable cost per meal 20p 15p 12p 11p 10p 10p 11p 14p
6.2
Workers
1 2 3 4 5 6 7 8
20 54 100 151 197 230 251 234
4 8 12 16 20 24 28 32
20 34 46 51 46 33 21 17
20p 12p 9p 8p 9p 12p 19p
20 27 33 38 39 38 36 29
* Marginal cost per meal = marginal cost per worker marginal output 6.3 Observations Increasing marginal returns leads to falling marginal cost. Diminishing marginal returns leads to rising marginal cost. Increasing average returns leads to falling average variable cost. Diminishing average returns leads to rising average cost. 7 The firms output decisions in the short run If we assume that firms aim to maximise their profits then how much they will produce depends on the relationship between their sales revenue and their costs.
56
MICROECONOMICS
7.1
Revenue Total revenue is the total money earned from selling output, i.e. quantity sold price per unit. Average revenue = total revenue quantity sold. If a firm sells only one product then average revenue is the same as selling price. Marginal revenue is the addition to total revenue earned when an extra unit of output is sold. Marginal revenue is calculated by: Marginal revenuen = total revenuen total revenuen1
7.2
When a firm can sell all its output at the same price, price and marginal revenue will be the same. The profit-maximising output in the short run. This can be determined in two ways: Method 1 Maximum profit is where the difference between total revenue and total cost is greatest. Method 2 This method involves making decisions on a unit-by-unit basis. If the cost (MC) of making an extra unit is less than its revenue (MR), the firm will add to its profits by making and selling the extra unit. The unit will be worth making. If the MC of an extra unit is equal to its MR, bearing in mind that cost includes normal profit, it will be worth making and selling that unit. If the MC of an extra unit exceeds its MR, making and selling that unit would reduce the firms profit, so it would not be worth making. A firm will maximise profit at the output where marginal cost = marginal revenue. See diagram on next page.
7.3
57
MICROECONOMICS
Marginal cost
Marginal revenue
7.5
Shut-down position in the short run. A firm needs to make at least normal profit in the long run to remain in an industry. In the short run the firm will continue to produce as long as total revenue covers total variable costs. Remember that in the short run, fixed costs have to be paid, so if no output is produced and sold the firm will make a loss equal to the fixed costs. As long as the revenue from an order covers its variable cost it will be worth accepting since the money left after variable costs have been covered can contribute towards the fixed cost and so reduce loss. Therefore the shut-down condition in the short run is when: Total revenue is less than total variable cost, or where Price is less than average variable cost.
58
MICROECONOMICS
Marginal cost
Average variable cost
At price P1 the firm would shut down in the short run, as price is less than AVC. At any price above P2 the firm is more than covering its variable costs and could use any surplus to help pay off its fixed costs. In this way the firm minimises its loss per unit. The firms supply curve In the short run, the firms supply curve is the marginal cost curve above average variable cost. Applications of the shut-down price In times of recession and falling prices there may be situations when a firm is so short of trade that it has to consider shutting down by mothballing plant and equipment. Examples Oil producers facing low prices for crude oil. Many of the existing oil reserves become uneconomic at low price levels and platforms can be mothballed until market prices recover. Semi-conductor (microchip) plants were mothballed around the world when prices collapsed because of stagnant demand.
59
MICROECONOMICS
Costs in the long run

1 Introduction In the long run all factors of production and costs are variable. 1.1 Economies of scale. Internal economies of scale are when a firms average costs fall as the firm grows in size. Diseconomies of scale. Increasing size may eventually bring inefficiencies and rising average costs. Average cost in the long run. As a firm increases its size, average cost falls because of economies of scale. Beyond a certain size, average cost may rise because of diseconomies of scale. The longrun average cost curve is U-shaped. The long-run average cost curve encloses a series of short-run cost curves joining them at their optimum points. The point at which the firm achieves lowest average cost on the long-run average cost curve would be the optimum size of the firm.
1.2
1.3
1.4
Short-run average cost
Long-run average cost
Optimum size
60
MICROECONOMICS
Economies of Scale and Industry Structure

1 Introduction In industries where the optimum size of a firm is small, i.e. where there are few economies of scale to be gained, then those industries consist of a large number of small firms. In industries where the optimum size is large then there is likely to be a small number of large firms. 1.1 Where are small firms found? Where a market is small and there is insufficient demand for large-scale production, then small firms will survive, e.g. luxury products such as Porsche cars. Where a market is diversified, i.e. where customers want a wide variety of choice then large-scale production is not possible. The industry will consist of a large number small firms, e.g. clothing, footwear. Where a personal service is required then a small firm is more able to deliver this. This explains why a large number of firms in the service sector are small. Where it is easy for people to set up a business. This will be where small amounts of capital are required or low-level technical expertise. Again this explains why so many service firms are small. 1.2 Where are large firms found? where the market for the product is large usually national or global where the demand is for a standardised product, i.e. where consumers do not look for individuality where large amounts of capital are required where there is a need for substantial research and development.
61
MICROECONOMICS
Multinational Enterprises
1 Introduction In recent years there has been considerable growth in the number and size of multinational enterprises. A multinational enterprise is a firm which produces goods outside its country of origin. It does this in branch factories or through subsidiary firms which it owns. 1.1 There are about 500 multinational companies in the world. Most are American but the UK is the second most important country of origin. In the UK, half of the top 20 companies are multinational. Some are British, e.g. BP and Cadbury, and some are foreign. Most of the incomers are from the USA, e.g. Ford and IBM, although there has been a rapid increase in recent years from Japan, e.g. Nissan, Toyota, Sony. Motives for overseas expansion (a) To reduce production costs by taking advantage of lower wage costs in some countries. by specialising internationally, i.e. producing different components in those countries where they can be manufactured most cheaply, e.g. Ford produces different components in different countries. to spread the fixed costs of research and development over a very large output, e.g. General Motors has a world car concept, i.e. the same models are produced in different countries (although they may have different brand names). (b) To reduce transport costs. Components may be cheaper to transport than the bulkier finished article. Multinational companies frequently reduce the cost of transportation by transporting components from their countries of production to be assembled in the country of sale. To penetrate markets protected by import controls. A major reason for the presence of US and Japanese firms in Europe is to evade the tariffs imposed by the EU on goods coming from outwith the EU.
(c)
62
MICROECONOMICS
(d)
To take advantage of host-government financial assistance. Many governments are keen to attract foreign firms various incentives are offered, e.g. low-cost premises, grants, low-interest loans, training subsidies. To escape government regulations at home. Multinationals are tempted to move if a government imposes restrictions, e.g. minimum wage, anti-monopoly or minimum working conditions regulations. To earn higher after tax profits. This can be achieved by moving production to countries with low profits taxes. (Transfer pricing may also achieve this.)
(e)
(f)
Benefits of multinational companies (a) Trade if investment by a multinational allows a host country to produce more cheaply than other countries then imports will be cut and exports boosted. Employment is created both in the multinational firm and in firms asked to supply services and components. New technology and management techniques are brought in. These will be copied by other firms and lead to improved efficiency, e.g. many UK firms have copied the efficient management styles of Japanese and American firms. Economies of scale the large scale of operation enables the firm to enjoy economies of scale and to be efficient workers share in this, e.g. employees in multinationals in the UK earn on average 20% more than those in domestic firms.
(b)
(c)
(d)
Problems with multinational companies (a) Trade imports may increase if a multinational imports its components, e.g. Ford imports 40% of the cars it sells in the UK. Employment in some cases the jobs created are low-skill assembly jobs, the high-skilled research jobs being kept in the country of origin. The management jobs are often taken by people from the home country.
(b)
63
MICROECONOMICS
(c)
Financial transfers profits are transferred out to be spent by the shareholders in the home country. Conflict of interest with host government in developing countries, multinationals may dictate the growing of a particular raw material at the opportunity cost of food crops. tax avoidance robs a government of funds to finance public services.
(d)
64
MICROECONOMICS
Supply
1 Introduction Supply is the quantity of a good or service that firms are able and willing to supply at a certain price over a certain period of time. 1.1 As with demand, a distinction is made between: an individual firms supply, which is the quantity of the good that the firm is willing and able to supply at a certain price; and market supply, which is the total quantity of the good that all firms in the market would be willing and able to supply. 2 Supply and output may not be the same In a particular period, output may be greater than supply, i.e. stocks are being increased, or output may be less than supply, i.e. stocks are being run down. 2.1 Stocks may be built up in readiness for unexpected or urgent orders, or to even out the need for seasonal fluctuations of output, e.g. fireworks, ice cream. However, holding stocks involves costs warehouse costs, opportunity cost of capital tied up in stocks, loss of goods through deterioration or obsolescence. Factors affecting supply Price. As the price of a product rises its supply rises (ceteris paribus). This is because: (a) (b) existing producers are willing to supply more as they earn a higher profit per unit and, new firms enter the market as it now becomes profitable for less efficient firms to produce.
3 3.1
Price and supply data may be shown in a table: Price per pint 1.10 1.50 1.80 2.00 Quantity supplied per day (pints) 10,000 20,000 30,000 40,000
65
MICROECONOMICS
or in a graph:
Note that a change in supply resulting from a change in price is shown by a movement along the supply curve. 3.2 Prices of other commodities Competitive supply a farmer switching resources away from supplying one product, e.g. milk, to supplying more of another, e.g. wheat, in response to a fall in the price of milk Joint supply a rise in the price of one commodity may encourage an increase in its supply and the supply of joint products, e.g. an increase in the price of petrol may lead to an increase in the supply of other oil products such as bitumen, etc. 3.3 Costs of production A fall in the cost of any factor of production will lead to an increase in supply. A change in a tax or subsidy will also change the costs of production. 3.4 Change in availability of resources
66
MICROECONOMICS
3.5
Note that any of the changes (in the ceteris paribus conditions) outlined in paragraphs 3.2 to 3.4 is represented by a shift in the supply curve.
Change in supply condition
67
MICROECONOMICS
Higher only
4 Price elasticity of supply Price elasticity of supply is a measure of the responsiveness of supply of a good or service to a change in its price, i.e. it measures how suppliers react to a change in the price of their product.
% change in supply Price elasticity of supply = % change in price

If price elasticity is greater than 1, then supply is price elastic. Supply is very responsive to a change in price. If price elasticity is less than 1, then supply is price inelastic. Supply is not responsive to a price change. If price elasticity is zero, i.e. if supply did not or could not change in response to a price change, then supply is said to be perfectly inelastic. 4.1 Factors affecting elasticity of supply Time The length of the time period being considered has an important effect. Short run (a) In the very short run, if a firm is operating at full capacity it will be unable to respond to an increase in price. Supply will be perfectly inelastic. The supply curve would be a vertical straight line.
68
MICROECONOMICS
(b)
If the firm has spare capacity and stocks then it will be able to increase supply. The more spare capacity or the more goods it has in stock then the more elastic will be its supply.
Long run In the long run, supply will be elastic. Firms have time to increase their capacity and new firms can enter the industry.
69
MICROECONOMICS
Topic 4: The Operation of Markets

1 1.1 What is a market? A market is formed when buyers and sellers of a good, service or resource come in contact with each other in order to agree a price and exchange. The concept of a market in economics goes beyond the idea of a place where people meet to buy and sell goods. Any arrangement where buyers and sellers are in contact to exchange a product is a market. Markets may be worldwide, e.g. oil, wheat, cotton and copper when a single world price may be established, others may be more localised, e.g. the housing market when prices for a similar house will vary from area to area. Markets exist for: goods, e.g. cars, houses services, e.g. bus travel, haircuts resources, e.g. labour, land, raw materials money, e.g. credit, foreign exchange.
1.2
1.3
Each of these markets has common features, i.e. something to be exchanged, buyers, sellers and a price. Price may be known by different names, e.g. bus fare, wage, rent, interest, exchange rate but all are determined in similar ways. 1.4 Suppliers are usually firms but may in some markets be individual citizens, e.g. car boot sales or local government departments, e.g. council housing or central government, e.g. prescribed medicines. Buyers may be individual citizens or households in the case of consumer products, firms who buy raw materials, machinery or labour and government who buy the supplies needed to provide services. Free market A free market is one where: there are no barriers to firms competing with each other the price is set in the market by the total demand and supply; firms have to accept this, i.e. they are price takers not price makers there is no government intervention.
1.5
70
MICROECONOMICS
Equilibrium price In a free market an equilibrium price will be established. At the equilibrium price: Quantity demanded by consumers is the same as quantity supplied by suppliers. The market is cleared, i.e. there will be no unsatisfied customers (shortages) and there will be no unsold supplies (surpluses). This is why the equilibrium price is also called the market clearing price. The price will not change unless there is a change in demand or supply conditions.
(a)
At a price of P1 this market is not in equilibrium. Suppliers are willing to supply B, and consumers are willing to demand A; therefore, there would be a surplus of AB. Suppliers will react to the unsold stocks by cutting production and reducing price. At a price of P2, suppliers are willing to supply C and consumers are willing to demand D; therefore there would be a shortage of CD. Consumers will compete with each other for the available quantity by offering to pay a higher price and suppliers will supply more. At a price of P, there is no upward or downward pressure on price. The market is in equilibrium.
(b)
(c)
71
MICROECONOMICS
Changes in demand conditions
a rise in demand (D curve shifts to the right) leads to a rise in equilibrium price and in the quantity exchanged in the market. a fall in demand (D curve shifts to the left) leads to a fall in equilibrium price and in the quantity exchanged. Note that the extent of change in price and quantity is affected by the elasticity of supply. The more supply is elastic then the less will be the change in price, but the more will be the change in quantity exchanged.
72
MICROECONOMICS
Changes in supply conditions
(a)
An increase in supply (S curve shifts to the right) leads to a fall in equilibrium price and a rise in the quantity exchanged. A fall in supply (S curve shifts to the left) leads to a rise in equilibrium price and a fall in the quantity exchanged.
(b)
Note that the extent of change depends on the price elasticity of demand. The more demand is elastic then the less the change in price but the more the change in the quantity exchanged. 6 Intervention in free markets Governments may intervene in markets to alter the price or the quantity exchanged. (This topic is also dealt with in Unit 2, The UK Economy, Topic 4, under Market Failure and Government Policies.) 6.1 Governments may intervene in a market by: setting a minimum price setting a maximum price imposing tax giving a subsidy setting a quota.
73
MICROECONOMICS
6.2
Minimum price above equilibrium. Governments may do this because they feel that the equilibrium price is too low. However, it may create the problem of surpluses as is shown by AB in the following diagram.
Two examples of this include: Setting of minimum prices for farm products by the EU. This was done to ensure that farmers got a decent income. However, it has created the problem of surpluses and what to do with them. A number of options is possible. The EU buys the surplus then stores it, or gives it away as aid to the third world. To prevent surpluses the EU has set production quotas for some products, i.e. limits to what farmers should produce. Setting a minimum wage for low-paid workers. Critics said that this would create unemployment, i.e. surpluses of workers, although in practice this has not happened, as the introduction of the minimum wage coincided with a rise in demand for labour.
74
MICROECONOMICS
6.3
Setting a maximum price below equilibrium, because they feel that the equilibrium price is too high. Governments have done this in order to help low-income consumers or as part of an antiinflation strategy.
Fixing prices below equilibrium may create black markets to which black marketeers will divert supplies at a price above the official price. In the diagram consumers demand B but can only get A. For quantity A, consumers are willing to pay Z. This sort of intervention and effect was common in planned economies such as the Soviet Union. This explains the scenes of long queues at shops for bread, etc. Governments may counteract a black market by rationing by issuing coupons of entitlement to each family so that each family has a fair allocation. Rationing was used in the UK during and after the Second World War when supplies were restricted. 6.4 Imposing expenditure taxes. A tax on expenditure has the same effect as increasing the cost of production, since the suppliers have to pay it to the government. Producers will raise their selling price to recover this increased cost, although they may absorb part of the cost by taking a reduced profit.
75
MICROECONOMICS
Tax of EG. Supply curve moves up vertically by EG. Of the tax, consumers pay EF, i.e. price goes up from P to P1 and the producer pays FG out of his profit. Share of the tax burden depends on the proportion which the supplier can pass on to the consumer, which in turn depends on how responsive the consumer is to an increase in price. If the supplier believes that consumers will not cut their demand significantly, i.e. if demand is price inelastic, then more can be passed on.
76
MICROECONOMICS
6.5
Subsidies have the opposite effect to taxes. Subsidies are given to encourage supply and keep prices low, e.g. rural bus services. Costs of production are reduced and the producer may pass this on to the consumer by lowering price. The extent to which it is passed on depends on the price elasticity of demand. The more demand is price inelastic, the more will be passed on. In the following diagram, XZ is the subsidy, the consumer benefits by XY and the supplier gains by YZ.
77
MICROECONOMICS
6.6
Quotas. Government may intervene to set a maximum quantity which can be supplied to a market. An example is the total allowable catch by UK fishermen of white fish (cod, haddock). This yearly quota has been fixed to try to conserve white-fish stocks. Economic analysis would suggest that the price of white fish would rise. This has not happened to any great extent because some fishermen have been catching above the quota and selling on the black market to processors. (Hence the term black fish.) Supply has also been boosted by imports.
78
MICROECONOMICS
Topic 5: Types of Market This topic is for Higher only

1 Introduction Markets are of two main types; perfect and imperfect. Perfect markets do not exist in the real world but some markets are closer to this perfect model than others, e.g. some agricultural products. It follows then that most markets are imperfect. 2 Perfect markets A perfect market is assumed to have the following characteristics: (a) Large number of firms. No firm is big enough to influence price. Firms are price takers, i.e. they have to take the price which is set in the market. Large number of buyers. No one buyer is big enough to influence price. Freedom of entry and exit from the industry. There are low barriers to entry. Struggling firms can leave the industry quickly and easily. Perfect knowledge. All consumers and producers know the price being charged by every producer so that if one producer increased his price the demand for his product would fall to zero. Homogeneous product. The output of each firm is identical and there is no branding or product differentiation.
(b)
(c)
(d)
(e)
Imperfect markets An imperfect market is any market which does not have any one of the characteristics of a perfect market. There are different types of imperfect market depending on the extent of competition within them. The extent of competition depends on the number and size of suppliers and buyers within the market. There are four types of imperfect market: monopoly oligopoly
79
MICROECONOMICS
monopolistic competition monopsony. 3.1 Monopoly. In a monopoly market, there is only one firm. The strength of its monopoly position is determined by the strength of barriers to entry to new firms and the availability of substitutes. A monopoly may exist in a national market, e.g. the Post Office with letter post, or in a local market, e.g. a village shop. Monopoly gives the sole supplier power to charge above normal price, restrict supply or generally not bother too much about improving the product or quality of service. Note that the monopolist cannot charge whatever price it likes there is a limit to what consumers are able or willing to pay! Because of the power which monopoly gives a supplier the Government may investigate a monopoly, or a merger which may lead to monopoly, and it may order the break-up of a monopoly or stop a merger taking place. Government also recognises that in some industries monopoly may be the most technically efficient structure because of the economies of scale which can be gained, e.g. Railtrack, Transco. In such cases the Government allows the monopoly, but has the power to regulate prices and quality of service. (Monopoly regulation is covered in more detail in Unit 2, The UK Economy, Topic 4.) 3.2 Oligopoly. This is a market dominated by a few large firms. It is a common market structure, and examples include soap powder (where Procter & Gamble and Unilever each have over 40% of the market), burgers (dominated by McDonalds and Burger King), and petrol. (A two-firm oligopoly, such as in the market for salt or soap powder, is sometimes called a duopoly.) Each firm is large, has branded or differentiated products and has a lot of influence in the market to affect its own and its competitors market share. However, each firm is aware of the potential strength of competitors and as a result must predict their reactions before it makes any decision about changing its own product, price, or supply. To expand or maintain market share in an oligopoly market, firms tend to use non-price methods, e.g. advertising and branding, rather than price competition because price competition involves costly price wars. Firms may even collude (make agreements) to fix
80
MICROECONOMICS
prices, limit output, or agree to share out the market. This is now illegal. Barriers to entry exist to limit easy entry of new firms. 3.3 Monopolistic competition. There are a large number of firms but each firm produces a branded or differentiated product. This gives each firm some control over the price it can charge and over its market share. There are weak barriers to entry. Examples include hairdressers, restaurants. Monopsony. A monopsony is a market where there is only one buyer. This gives the buyer the power to dictate price, product design, delivery, etc. to the supplier or suppliers. The supermarket and fast-food chains are so large that they have a degree of monopsony buying power over many suppliers who are almost entirely dependent on their custom. Product differentiation With product differentiation, suppliers try to create differences between their products and the products of others. These differences might be real, e.g. product design, quality of service; or imaginary, created by packaging, advertising and brand image, e.g. designer labels. 5 Barriers to entry. Barriers to entry prevent potential competitors from coming into an industry. Barriers to entry may be deliberately set up by existing firms or they may be natural. Deliberate barriers to entry Marketing barriers. High spending on advertising and marketing creates a powerful brand image and sense of brand loyalty in the minds of the consumer, e.g. washing powder, breakfast cereals. Restrictive trade practices. A restrictive trade practice is a strategy used by a firm to restrict competition in its market.
3.4
5.1
81
MICROECONOMICS
Examples A manufacturer may refuse to sell to a retailer which buys the products of a rival (common in the market for beer). A manufacturer may refuse to sell a good unless the buyer buys its whole range of goods (also common in the alcohol market). A firm may engage in predatory pricing, i.e. cut prices to customers in the whole of its market, or in the part of the market where competition is strongest, for just long enough to drive out a new entrant. Large firms may be able to do this because of their ability to cross-subsidise from customers or from products where there is less competition. Aberdeen Journals were found guilty of such an offence in trying to drive a free advertising newspaper out of business and were fined 1million. 5.2 Natural barriers to entry Capital costs. Entry costs to some industries are very high, e.g. cars, steel. The vast amounts of capital required to set up prevents new firms from entering. Sunk costs. These are costs which cannot be recovered if the firm folds. High sunk costs such as advertising or research and development deter new firms from taking the risk of entering an industry and failing, e.g. washing powder, cars. Economies of scale. In some industries where a few firms are very large and enjoy considerable economies of scale it will be difficult for a new firm to break in and compete with the low average cost. Legal barriers. The law gives some firms particular privileges. Patents (e.g. to drug companies) and copyrights (e.g. to software publishers) give certain firms exclusive rights to produce or publish certain products. Licences may be given to TV companies, bus companies or airlines to operate exclusively in certain areas or on certain routes (but note that there has been considerable deregulation in recent years). 6 6.1 Pricing in markets Perfect markets. In perfect or near-perfect markets the price of the product is determined by the interaction of market demand and market supply. Each firm has to accept this market price each firm is said to be a price taker. The price of coffee, cotton, wheat, etc. is established in the world market and individual farmers have to accept this price.
82
MICROECONOMICS
6.2
Imperfect markets. In imperfect markets, firms adopt a range of pricing strategies and the decision as to which strategy to choose is based upon the competition facing the firm. Pricing strategies fall into two groups cost-based pricing and customer-orientated pricing. Cost-based pricing Cost-plus pricing Price is set by calculating the average cost of production and adding a mark-up for profit, e.g. average cost 5 plus mark-up of 20% would give a price of 6. Firms that have little competition can use cost-plus pricing. Advantages quick and easy method ensures sales revenue will cover total costs and make profit. Disadvantages fixed mark-up could be a problem if new competitor(s) were to enter the market. Contribution (marginal cost) pricing Price is set to cover the variable costs of production. So as long as price more than covers variable cost a contribution is being made towards the fixed costs. If the firm receives enough orders so that contribution equals fixed cost then the firm breaks even. If contribution exceeds fixed costs then profit is made. Advantages more flexible than cost plus successful products can be priced to make a large contribution, less successful products can be priced more competitively. pricing of products can take account of competitors prices and consumer demand. can be used during poor trading conditions when firms may have to accept prices at below cost as long as variable costs are covered then a contribution can be made to the fixed costs which have to be paid, thus reducing loss.
6.3
83
MICROECONOMICS
6.4
Customer-orientated pricing Competition-based pricing. Many firms operating in imperfect markets still face strong competition, e.g. monopolistic competitive markets. In such markets, there are many competitors and firms are forced to take the market price and work out how to produce at cost that gives them an acceptable profit. Prices charged by competitors are the main influence on a producers price. In oligopoly markets, even where there are only a few firms, it is common for competitors to charge the same price. One firm becomes the price leader and others follow, e.g. petrol. This avoids costly price wars. Penetration pricing. New entrants to a market may set prices below those of present suppliers in order to gain a foothold in the market. Consumers are encouraged to develop the habit of buying the product so that when prices eventually rise they will continue to buy. Predatory pricing. This is a method used by a firm to force out a new entrant. An established firm may be able to reduce its price to such a low level that the new entrant cannot cover its costs. The established firm can cover its losses out of reserves or by cross-subsidising from other products. Firms may use the following pricing methods in short-term or longterm monopoly situations: Charging what the market will bear. Suppliers of products which are unique may charge the highest price which they think consumers are prepared to pay. Skimming pricing. Suppliers of new products may charge a high price for a limited period in order to maximise revenue before competitors come into the market. It is also used by firms whose products have a short life, e.g. toys, fashion clothes. Psychological pricing. Products may be priced above the existing competition to create the perception of better quality, e.g. Haagen-Dazs, Stella Artois. The success depends on the consumer believing this. Price discrimination. This is when a firm offers the same product at different prices to different consumers. The success of price discrimination depends on the consumers paying the cheaper price being unable to sell to those paying the higher price. This strategy is quite common think of package holidays, air and rail fares, telephone calls.
84
THE UK ECONOMY
UNIT 2
Topic 1: National Income

1 1.1 What is national income? National income is the value of all goods and services that are produced by an economy in a year. It is a measure of a countrys economic performance. A countrys economic performance can be measured in different ways. Three common measures are: Gross Domestic Product Gross National Product Net National Product. Gross Domestic Product (GDP) is the output of goods and services produced within the UK in a year. Gross National Product (GNP) is the output produced by UKowned resources. This differs from GDP in that some output produced within the country is produced by foreign-owned resources and some of the output from UK-owned businesses is produced overseas. GNP is GDP plus the value of output produced overseas by UK-owned resources minus the value of output produced in the UK by foreign-owned resources. Net National Product is GNP less depreciation, i.e. the loss in value of capital goods during the year. NNP is new output, i.e. the addition to the countrys stock of goods (i.e. its wealth). Net National Product is the true measure of national income but you will find that commentators may use any of these three measures as national income. 2 National income and inflation: nominal income and real income All of the above measures of economic performance may be expressed in nominal terms or real terms.
1.2
85
THE UK ECONOMY
2.1
Nominal or money terms. When national income is expressed in nominal terms (sometimes called money terms), this means that its value has been calculated by using the prices of the time, i.e. current prices. Measuring value in money terms makes it difficult to compare one years output with another years since an increase in national income could have been caused by inflation, i.e. the value may have gone up because of a rise in prices and not by an increase in output. To measure changes in output, it is necessary to convert figures to real terms. Real terms. Expressing national income in real terms means measuring output as if there had been no inflation, i.e. at constant prices. It means that value has been adjusted to remove the inflation element. So an increase in real national income means that there has been an increase in the quantity of goods and services produced. Method of adjustment Real national income =
2.2
2.3
Nominal national income Price index of base year 1 Price index of current year
Example Year 1 Money value of national income Index of prices Calculation: Real national income for Year 1 = Real national income for Year 2 = 10,000m 100 Year 2 12,000m 105
10,000m 100 = 10,000m 1 100

12,000m 100 = 11,429m 1 105
Nominal income increased by 20%. Real income increased by 14%. 3 3.1 National income may be calculated in three different ways The output method. This method adds the value of goods and services produced by all firms in both the private and public sectors.
86
THE UK ECONOMY
Care must be taken to avoid double counting, i.e. counting the same output more than once, e.g. when the output of one firm, steel, becomes the input of another, cars. Only the value added to each stage of production, i.e. the value of work done by each producer, should be included. 3.2 The income method. The incomes earned by the owners of all resources used in production are added up, i.e. the total amount of rent, wages, interest and profit earned. Transfer incomes such as pensions and benefits should not be included as those who receive them are not involved in producing output. 3.3 The expenditure method. This method totals the spending of individuals, firms, government and foreign buyers on goods and services. Spending on imports is deducted as it represents output created by other countries. 4 Uses of national income statistics National income is a measure of economic activity in an economy. The figures have a number of uses. They can be used: (a) to measure economic growth and changes in the standard of living in a country to help government assess the state of the economy and plan future policy to compare the economic performance and standards of living of different countries to identify countries that are in need of aid to calculate the contributions which countries should make to international organisations, e.g. the World Bank and the EU.
(b)
(c)
(d) (e)
87
THE UK ECONOMY
Problems of measuring national income If national income figures are to be used for measuring and comparing economic activity then they need to be accurate. However there a number of reasons why the statistics may be inaccurate: (a) Errors and omissions occur in collecting and calculating the statistics. People deliberately hide what they earn or what they produce in order to avoid tax or claim benefit this is known as the black economy. Under-recording of output where the production of some goods and services is not recorded because they are not exchanged for money, e.g. housework, barter trade and DIY activities. Over-recording of output where double counting occurs (see 3.1). Over-recording of income when transfer incomes are included (see 3.2).
(b)
(c)
(d)
(e)
Difficulties in using national income statistics for making comparisons over time or between countries National income figures are used to compare changes in standards of living but there are difficulties: (a) Methods of calculating national income may differ over time or between countries. Levels of self-sufficiency may differ the more self-sufficient people are, the more output will be under-recorded. Standard of living is measured by income per person (per capita) so population changes must also be measured. Accuracy of comparisons between years or between countries therefore also depends on the accuracy of population figures. Statistics have to be adjusted for inflation accuracy depends on accuracy of inflation figures.
(b)
(c)
(d)
88
THE UK ECONOMY
(e)
Statistics do not show differences in the range, design and quality of goods and services. Statistics do not show differences in working conditions, hours and leisure time. Statistics do not show differences in income distribution distribution of an increase in national income amongst citizens may be inequitable, so although the average per capita income rises, the standard of living of all citizens may not. Social costs are not taken into account, e.g. the output of cars is recorded but their associated social costs of pollution and congestion are not. Spending on defence or space may account for an increase but may do little for the standard of living of the people.
(f)
(g)
(h)
(i)
Circular Flow of National Income
Introduction In its simplest form an economy consists of firms and households (a two-sector economy). Households own factors of production which they provide to firms. In return for land, labour, capital and enterprise to firms they receive income in the form of rent, wages, interest and profit. These incomes are spent in buying the output
89
THE UK ECONOMY
of goods and services made by firms and this expenditure becomes incomes for firms which in turn is used to pay incomes to households and so on. Thus a circular flow of income is created. Therefore the total value of output should equal the total expenditure on goods and services and should equal the total income of households. National output = National expenditure = National income. 2 Consumer spending (C) This is the value of consumer goods and services demanded in a particular period of time. Consumer spending is a function of income. This means that as income changes then so does consumer spending. The average propensity to consume (APC) is the proportion of total income which is spent. APC =
Consumption Income
An APC of 1 means that 100% of income is spent. An APC of 0.9 means that 90% of income is spent. People on low incomes are likely to have an APC of 1. As income rises, average propensity to consume tends to fall as consumers increase the proportion of their income which they save. (Note that although the proportion of income spent on consumption falls, the amount spent rises.) It follows that if a consumer has an APC of 1 there is no saving, i.e. average propensity to save (APS) = 0, and if APC = 0.9 then APS = 0.1. APC + APS = 1 The marginal propensity to consume (MPC) is the proportion of any increase in income which consumers would spend on consumption. MPC =
Increase in Consumption Increase in Income
A MPC of 0.8 means that 80% of any increase in income would be spent on consumption. It follows that the marginal propensity to save (MPS) would be 0.2 MPC + MPS = 1
90
THE UK ECONOMY
Injections and leakages from the circular flow
Injections An injection is any spending in the economy which is not consumer spending. Investment, export buying and government spending are injections into the circular flow of national income. Note that their size is not determined by the size of national income. Injections are said to be autonomous of national income.
Leakages A leakage is a withdrawal of funds from the circular flow of income between firms and households. Savings, imports and taxation are leakages from the circular flow of income. Note that the size of each depends on the size of national income. Leakages are said to be a function of national income.
Investment spending (I) This is the value of capital goods demanded in a particular period. This is mainly determined by producers expectation of profit which in turn depends on: potential sales revenue the interest rate on the loans to buy the capital goods.
91
THE UK ECONOMY
Export buying (X) This is the value of goods demanded by overseas firms and individuals. This is mainly determined by the size of national incomes in foreign countries. Other determining factors include: the prices and quality of exports compared to those of competing countries delivery times and quality of after-sales service.
Government spending (G) This is the value of spending by the public sector. This includes the demand for goods and services by central and local government departments; social benefits; and grants to the private sector. The level of government spending is mainly determined by political decisions taken by government.
Savings (S) These are the amount of money saved by individuals in a particular period of time. The main determinant is the level of income the higher the level of income, the greater the proportion of income saved. The proportion of income saved is called the propensity to save. At very low levels of income consumption is greater than income, and dis-saving occurs, i.e. savings from a previous period are used, or the savings of others are borrowed to finance spending. Other influences on savings are: interest rates habit and attitude to saving extent of the precautionary motive.
Import spending (M) This is the amount spent by the resident firms and individuals of a country on overseas goods and services. The main determinant is the level of income. Other influences are: the prices of imports relative to home-produced goods their quality and after-sales service.
92
THE UK ECONOMY
10
Taxation (T) This is the amount of revenue collected by central and local government from taxation. The amount of revenue collected depends on the level of income and spending in the economy.
This section (to page 101) is for Higher only The Determination of National Income
There are two schools of thought about how national income is determined. Some economists believe that aggregate demand is the main determinant whilst others believe that it is aggregate supply. Others believe that both aggregate demand and supply are relevant. Economists who believe in the demand side of the economy as being the more important are called Keynesians, named after the economist John Maynard Keynes who developed the theory in the 1930s.
Keynesianism: the Demand Side of the Economy

1 Link between national income and employment The higher the level of national income (remember this is the same as national output) then the greater the number of workers who will be needed to produce it. 2 Full employment level of national income This is the potential output of an economy, i.e. the maximum output which could be produced if all resources are employed in producing those goods and services which they are best at producing. 3 Actual national income may be less than the full employment level Why is this? One suggestion was provided by J M Keynes in an attempt to answer the massive unemployment of the 1930s when the economy had gone into a slump. The basis of his theory was that national income may settle at an equilibrium level which is below the full employment level.
93
THE UK ECONOMY
4 4.1
Equilibrium national income in a two-sector economy The two-sector economy assumes that there is no government sector and that the economy is closed, i.e. there is no foreign trade. Equilibrium level of national income is where aggregate demand equals income/output or where saving = investment. Aggregate demand is total expenditure. It is equal to consumption plus investment, i.e. the spending of consumers plus the spending of firms on capital goods. In the following diagrams, an average propensity to consume of 0.8 and an average propensity to save of 0.2 are assumed.
4.2
Diagram A: Equilibrium
Consumer Spending 80b
Aggregate demand = C + I = 80b + 20b = 100b National income/output = 100b Aggregate demand = National output Saving (20b) = Investment (20b)
94
THE UK ECONOMY
Diagram B: not equilibrium
Aggregate demand = C + I = 72b + 20b = 92b National income/output = 90b Saving 18b < Investment 20b Demand is greater than output, so producers will increase production and hire more resources. This in turn will raise incomes and this will continue until equilibrium is reached.
95
THE UK ECONOMY
Diagram C: not equilibrium
Aggregate demand = C + I = 88b + 20b = 108b National income/output = 110 Demand < National income/output Savings 22b > Investment 20b Demand is less than output, so producers will notice the build-up in stocks and will cut back production. Workers will be laid off and incomes will fall until equilibrium is reached.
96
THE UK ECONOMY
5 5.1
Changes in equilibrium Change in propensity to save. If consumers wish to save more out of their incomes, i.e. if the average propensity to save rises, it follows that they wish to spend less on consumption. Aggregate demand will fall, output/income will fall and so will employment. National income will fall until a new equilibrium is reached, i.e. where saving = investment. Change in investment. An increase in investment raises aggregate demand. National income and employment will rise until equilibrium is restored, i.e. where savings = investment. A decrease in investment has the opposite effect. However, national income will change by more than the change in investment. This is because of the multiplier effect. The multiplier Keynes also developed the idea of the multiplier. He suggested that if there were any change in demand then national income would change by more. Any change in any component of aggregate demand would have a multiplier effect on national income. This can be explained by the investment multiplier. The investment multiplier measures the change in national income resulting from a change in investment. Change in national income = Change in investment Multiplier
5.2
6 6.1
6.2
6.3
How the multiplier process works. Assume that in a two-sector economy with no government or external trade, consumers have a marginal propensity to consume of 0.9 and a marginal propensity to save of 0.1. (a) If a car manufacturer invests 100m in a new plant then this becomes 100m of income to those households which provide the resources. These households will spend 90m of their increased incomes on consumer products and save 10m. This 90m of consumer spending becomes 90m of income to those individuals who provided the resources to produce these consumer products. These individuals in turn will
(b)
97
THE UK ECONOMY
spend 81m of this 90m of income on consumer products and save 9m. (c) This 81m of spending becomes income to those individuals who provided the resources . . . etc. This process continues until national income is back in equilibrium. At this point saving will again equal investment. In this example national income would increase 1000m. Not only should you be able to describe the process in words, but you should also be able to show it in a circular flow diagram.
1 2 3
PRODUCERS
1 2 3
Investment + 100M
Income 100m 90m 81m + ...
Consumption 72.9m 81m 90m + ...
CONSUMERS
Saving 1 2 10m 9m 3 8.1m + ...
6.4
The size of the multiplier effect depends on the % of income spent on consumption and the % saved with each round of income. This depends on the marginal propensity to save. The marginal propensity to save is the proportion of any change in income which is saved.
98
THE UK ECONOMY
Change in savings MPS = Change in income

Multiplier =
1 1 or MPS 1 MPC
If the MPS = 0.1, then the multiplier would be 10. National income would increase by ten times the amount of the increase in investment of 100m to a new equilibrium level of income which would be 1000m higher than before. Savings would have increased by 100m which is equal to the increase in investment. 7 7.1 Equilibrium national income in an open economy In a two-sector economy it is assumed that the economy is closed and that there is no government activity. In an open economy, there is government activity and international trade. This means that, as well as savings withdrawing income from the circular flow there will also be taxation and spending on imports. Government spending and the selling of exports will, in addition to investment, inject income into the circular flow. Aggregate demand in an open economy is therefore: Aggregate demand = C + I + G + (X M) 7.2 Equilibrium national income will still be where aggregate demand = national output/income. Because of the extra leakages and injections, at equilibrium: S+T+M=I+G+X 7.3 The multiplier in an open economy. A change in any injection, I, G or X will have a multiplier effect on national income. Remember from para 6.4 that the size of the multiplier effect depends on the proportion of any change in income which is consumed. In an open economy the MPC will depend not only on the MPS but also on the proportion of any change in income which is spent on imports (the marginal propensity to import) and which is taken in tax (the marginal rate of tax). Spending on imports and taxation reduce the multiplier effect. For an open economy: Multiplier =
1 1 MPC
1 or MPS + MPM + MRT

INTERMEDIATE 2/HIGHER ECONOMICS 99
THE UK ECONOMY
7.4
The importance of the multiplier (a) An increase in any injection into the circular flow of income will increase national income by more than the increase in the injection. A decrease in any injection will decrease national income by more than the decrease in the injection. If government is planning to increase national income, e.g. to full employment level by increasing government spending then the increase does not have to be so large as the shortfall in national income.
(b)
(c)
The importance of Keynesianism Keynes not only explained how national income was determined but also how it could be managed. The 1930s, when he published his theory, was a time of great depression in the worlds major economies. He suggested that governments should intervene to increase aggregate demand in their economies by lowering taxes and increasing government spending. Many governments adopted this policy and were able to reduce their unemployment. Governments continued to use demand-management policies after the Second World War until the late 1970s but when they found it difficult to control inflation there was a dramatic switch to monetarist policy.
100
THE UK ECONOMY
Monetarism The Supply Side of the Economy

1 Introduction While Keynesians believe that demand is the main determinant of national income, in contrast, monetarists believe that it is aggregate supply. They believe that national output is determined by the quantity of resources available to an economy and their productivity. If resources are plentiful, easily available and cheap then producers will put them to work and this will create income for their owners which in turn will finance the demand for the output produced. Note the contrast in views: Keynesians believe that demand creates supply, whereas Monetarists believe that supply creates demand. 2 Quantity and efficiency Monetarists believe that an economy can increase the quantity and efficiency of its resources if it has the following characteristics: (a) Private enterprise, operating in competitive markets, with minimum government intervention. The desire to make profit encourages producers to make as much as output as possible as efficiently as possible. Low taxes on incomes. High taxes discourage firms from earning high profits and discourage workers from earning high incomes. A flexible labour market. It should be easy for firms, facing falling demand for their products, to lower wages and shed labour; conversely, firms facing rising demand should find it easy to recruit labour and raise wages. Unemployment benefit should be low. Government should keep to a minimum regulations which add to firms costs, e.g. Health and Safety, minimum wage legislation, limits to working hours. Government should concentrate its efforts on improving the quality and efficiency of the workforce through education and training.
(b)
(c)
(d)
(e)
101
THE UK ECONOMY
Business/Trade Cycles
1 Introduction It has long been observed in economies that income and employment tend to fluctuate regularly over time. These fluctuations are known as business cycles or trade cycles. The figure below shows the various stages of a business cycle.
Time in years 2 Peak or boom When the economy is in a boom, some or all of the following characteristics are likely: 3 Income and employment will be high. Wages and profits will be rising. Consumption and investment spending will be high. There will be inflationary pressures. Demand for imports will be high. Tax revenues will be high.
Recession A recession is said to exist when there have been two successive quarters (3-month periods) of negative growth of real GDP (i.e. falling real GDP).
102
THE UK ECONOMY
Some or all of the following may happen: Income and employment fall. Note that unemployment is a lagging indicator it tends to rise some months after the recession starts but continues to rise even after a recovery starts. Wage demands moderate as unemployment rises. Consumption falls and investment spending falls as firms lose confidence in the future. Inflationary pressures moderate. Imports decline. Tax revenues begin to fall and government expenditure on benefits begin to rise. 4 Slump In a slump, economic activity is low compared with surrounding years. Mass unemployment exists. Consumption and investment is low. Aggregate demand is low. There are few inflationary pressures. Demand for imports is low. Tax revenues are low and there is a large demand for state benefit.
Recovery Income and output begin to increase and so does employment. Consumption and investment begin to rise. Inflationary pressures begin to mount as workers feel more confident about demanding wage increases. Import spending begins to rise. Tax revenues start to rise and government spending on benefit starts to fall.
103
THE UK ECONOMY
Topic 2: Inflation and unemployment Inflation

1 Definition Inflation is a rise in the general level of prices. It does not mean that all prices are rising; some may rise while others fall or stay the same. The rate of inflation is the percentage increase in the general level of prices in a period of time. 2 2.1 How is the general level of prices measured? The Government measures changes in the prices of a number of different groups of goods and services and it publishes a number of price indices. Three such price indices are: (a) (b) RPI the Retail Price Index the headline rate of inflation. RPIX the RPI without mortgage interest payments the underlying rate of inflation. Consumer Price Index the RPI without housing costs and council tax costs this is the measure now used by the UK Government to calculate the rate of inflation.
(c)
2.2
Retail Price Index. The RPI is a weighted average of the prices of those goods and services most commonly bought by households in the UK. It is calculated in the following way: (a) (b) The Family Expenditure Survey is used to identify a basket of the products bought by the majority of households. Each item in the basket is weighted according to the amount of spending on it, e.g. if 5% of consumer spending went on petrol then it would have weighting of 5%. A point in time is chosen as the base for the index. Each month the price of each item is compared and expressed as a percentage of its price at the base date. This price is called a price relative, e.g. if petrol increased in price from 50p per litre at the base date to a current price of 70p per litre it would have a price relative of 140.
(c) (d)
104
THE UK ECONOMY
(e) (f) (g)
The price relative is multiplied by its weighting and it would be included in the index as 140 5% = 7. This calculation is repeated for each item and the figures are added to give the weighted average total. Notice that the RPI at the base date would be 100.
Although no longer used by the UK Government to measure the general level of inflation it still uses changes in the RPI to uprate benefit levels. 2.3 RPIX. The Government believed that measuring changes in the RPIX was a better measure of inflation for the following reason. The RPI includes mortgage costs which depend on interest rates. In recent years changing interest rates has been the main policy weapon used by UK governments to control inflation. Increasing interest rates reduces inflation. However, a rise in interest rates has the more immediate consequence of raising mortgage costs and the RPI (seemingly the opposite of what was intended). Excluding mortgage interest payments and using RPIX gave policy makers a better guide to how well their anti-inflation policy was working. 2.4 Consumer Price Index. In 2003 the Government introduced this new index. Its official title is the Harmonised Index of Consumer Prices but this mouthful is usually referred to as the Consumer Price Index. What is it? It is similar to the RPIX. Both give a measure of the changes in the cost of buying a representative basket of goods and services. But the main difference is that where the RPIX excluded mortgage payments, the CPI will exclude mortgage payments and other housing costs such as repairs, insurance and council tax. Why the switch? The main reason is that the CPI is closer to the method used in the rest of the EU and this will make it easier to compare the UK inflation rate with the rest of the EU. This is an important part of judging when would be the right time for Britain to join the euro. The Government is now using changes in the CPI, instead of the RPIX, as its measure of inflation.
105
THE UK ECONOMY
2.5
Calculating the rate of inflation. Using the CPI the annual rate of inflation is calculated each month: e.g. if the CPI was 500 on 30 September 2003 and 525 on 30 September 2004 then the rate of inflation would be 5% (25 500 100). The formula is: (Current index Last index)/Last index 100 A note of caution The rate of inflation measures the rate at which prices are increasing; e.g. a rate of inflation of 3% means that on average prices are rising by 3%. A fall in the rate of inflation does not mean that prices are falling but that they are rising at a slower rate; e.g. if the rate of inflation fell to 2%, this means that prices are now rising at 2% rather than 3%.
Price index at Jan 1 Year 1 Year 2 100 102
Price index at 31 Dec 102 106
Annual rate of inflation (102 100)/100 100 = 2% (106 102)/102 100= 3.9%
Comment Price level increased by 2% Price level increased by 3.9% Rate of inflation increased from 2% to 3.9% Price level increased by 0.9% Rate of inflation decreased from 3.9% to 0.9% Price level increased by 0.9% Rate of inflation stayed constant
Year 3
106
107
= 0.9%
Year 4
107
107.96
= 0.9%
106
THE UK ECONOMY
3 3.1
Harmful effects of inflation On individuals (a) It reduces the standard of living of those whose incomes are fixed or which do not rise as fast as the rate of inflation. Their real incomes fall as money loses its purchasing power. It reduces the disposable incomes of those on low wages because an increase in their money wage arising from inflation may make them liable for income tax and they may also lose means-tested social benefits. This is called fiscal drag. It reduces the real value of savings if the interest rate is less than the inflation rate. If the real rate of interest is negative then a saver will lose. The rate of interest quoted on savings is called the nominal rate of interest. The real rate of interest is the nominal rate adjusted for inflation. Real rate of interest = Nominal rate of interest rate of inflation e.g. with a nominal rate of 8% and a rate of inflation of 12%, the real rate would be 4%. However, even when the purchasing power of savings is falling people still save. Why is this? Much of their saving is habitual. Much saving is contracted into for long periods of time. It is not easy for savers to get out of insurance or pension fund contracts. People need to save if they wish to buy a product which they cannot afford out of one weeks income. Many people are ignorant of the effects of inflation on the real value of their savings. (d) It causes unemployment because: wage inflation may force some firms to reduce their labour costs by laying off surplus labour in order to remain competitive. reduced competitiveness in domestic and foreign markets may force firms out of business.
(b)
(c)
107
THE UK ECONOMY
3.2
On firms (a) It reduces the real value of profits of firms which operate in markets where there is foreign competition. Foreign competitors may produce in economies where inflation is lower. UK firms may not be able to raise their prices sufficiently to cover inflated costs. It reduces the willingness to invest. Inflation creates uncertainty about future costs and prices firms uncertain about the future profitability of a new project may cancel any plans to invest. This will also cause unemployment both within the firm and for workers in firms which supply machinery and components. It encourages inefficiency. Firms which operate in markets where there is little competition may be able to mask inefficiency by raising prices.
(b)
(c)
3.3
On the economy (a) The balance of payments may deteriorate. If the rate of inflation is higher than that in other countries then this leads to: dearer exports which become less attractive to foreign buyers. cheaper imports which become more attractive to domestic buyers. (b) It reduces economic growth if firms are discouraged from investing (see 3.2 (b) above). It distorts the balance of taxation. The balance between direct and indirect tax may be distorted because: income tax revenue rises automatically with inflating incomes. expenditure taxes, e.g. excise duties which are fixed in money terms, tend to fall in real value. (d) A period of inflation creates an expectation that it will continue and this expectation will ensure that it does, e.g. if workers expect inflation to be 5% in the coming year, they
(c)
108
THE UK ECONOMY
will demand a 5% increase in pay this year in order to protect the real value of their incomes. If this increase in pay is not matched by an increase in productivity then employers will be faced with increased costs and will increase prices, thus causing the very inflation which workers expected. This then confirms the expectation and so the process continues. (e) It threatens the use of money in countries where hyperinflation renders money worthless. Advantages of inflation Not everyone suffers from inflation. Some parts of society may actually benefit from it: (a) Borrowers gain because they have the use of money now when its purchasing power is greater. Some firms are able to increase prices and profits before they pay out higher wages. The government finds that people earn more and so pay more income tax.
(b)
(c)
Causes of inflation Disagreement exists among economists and politicians about the causes. There are basically two schools of thought: (1) Keynesianism, and (2) monetarism. Keynesianism Keynesians believe that there are three possible causes of inflation: (a) Demandpull inflation which is caused by a desire by citizens, firms or government to spend excessively. Costpush inflation which is caused by increased production costs. Expectations of inflation.
(b)
(c)
Monetarism Monetarists believe that inflation is the result of an excessive growth in the money supply.
109
THE UK ECONOMY
4.1
Keynesian demandpull inflation. This arises when the economy is booming and when aggregate demand is greater than full employment output. Output cannot be increased, prices rise in response to the excess demand. Demandpull inflation may occur in particular sectors of the economy even when there is less than full employment in the whole economy, e.g. it may arise when demand exceeds supply in an area of the country such as the south east. House prices, land prices, wages, etc. may rise, which then spreads to other parts of the country.
4.2
Keynesian costpush inflation. If costs of production increase faster than productivity then this will lead to increases in unit costs. If producers wish to maintain their margin of profit between price and unit cost they have to increase prices. This type of inflation may occur even when the economy is not at full employment. Reasons for cost increases increases in the cost of raw materials increases in the price of energy increases in wage rates fall in the exchange rate of the which increases the prices of imported materials and energy.
4.3
Expectations of inflation. See para. 3.3 (d) above. This is sometimes referred to as a wageprice spiral, in which inflation becomes a permanent feature of the economy. Monetarism The quantity theory of money Monetarism is the belief that increases in the money supply which are greater than increases in output lead to increases in prices. Monetarism was developed in the 1950s by a famous American economist, Milton Friedman, and is based on the quantity theory of money. The quantity theory of money as developed by Friedman states that: MV = PQ
5 5.1
110
THE UK ECONOMY
where: M = the money supply V = the velocity of circulation, i.e. the number of purchases made in a period of time P = the price level Q = the quantity of output per period. Monetarists believe that the velocity of circulation is stable, e.g. in simple terms they think that the number of shopping trips we make is constant from year to year. Any increase in the money supply which is greater than the increase in output causes the price level to rise. 5.2 The money supply In a modern economy, money consists of: (a) (b) (c) coin bank notes bank deposits, which nowadays are the most important form of money.
Bank deposits are entries in banks books which are created when a customer deposits money or when a bank gives a loan. Bank deposits are transferred between debtors and creditors by cheque, standing order, direct debit or by electronic means (Switch, etc.). There are many different kinds of bank deposit distinguishable by how much notice has to be given before they can be withdrawn. Increases in the supply of money There are two major causes: (a) Bank lending. Interest on bank loans is a major source of income for a bank and banks will therefore lend as much as they prudently can. Government borrowing from banks. You will find out in Topic 4 that governments often spend more than they take in tax revenue and therefore have to borrow. If they borrow from banks it increases the banks ability to lend even more money to their customers. For Higher Economics you do not need to know how this process works.
(b)
111
THE UK ECONOMY
5.3
Monetarists then believe that excessive bank lending or government borrowing from banks are major causes of inflation. Once inflation is in the economy, as with the Keynesian view, expectations of inflation cause further inflation. Monetarists believe that demandpull and costpush inflation are both symptoms rather than causes of inflation since both result from excessive growth in the money supply. (a) Demandpull, they say, results from excessive credit (money supply) being available to consumers and firms which increases their purchasing power. Costpush can only be passed on in higher prices if firms have access to cheap excess credit i.e. they borrow to cover increased costs and pass on the borrowing costs to customers.
(b)
112
THE UK ECONOMY

6 The inflation record since 1990
Retail price inflation Headline inflation (annual % change)
Before 1990, the UK had a poor inflation record compared with the other main industrialised countries. However, since the mid1990s prices in the UK have been much more stable. 6.1 1990 to 1992 recession The economy went into recession between 1990 and 1992 and inflation fell steadily as the crisis in consumer and business confidence reduced aggregate demand. At this time the UK was a member of the Exchange Rate Mechanism (ERM) and interest rates were kept high to maintain the value of the within the ERM. The high interest rates also kept demand low. 6.2 1993present day The recovery in demand which started in 1993 was not accompanied by the usual increase in inflation and apart from slight rises in 1995 and 1998 inflation has remained low. Reasons for this include: (a) pay awards have been low: job insecurity has produced a labour force which is more prepared to tolerate low wage rises.
113
THE UK ECONOMY
wage bargainers now expect inflation to be low so pay claims are low. the bargaining power of trade unions has been reduced many workers are now casually employed or are employed on individual contracts. (b) low increase in prices of imported raw materials and energy because global inflation has been low. firms ability to raise prices has been limited by low inflation in other countries and because of the intense competition from the Far East. tight control of inflation by the government, particularly since 1997 when the control of inflation was handed over to the Bank of England. The Bank does not need to consider the political disadvantages of raising interest rates and it has not hesitated to raise them when it considered inflationary pressures to be rising.
(c)
(d)
Deflation Deflation occurs when the general price level is falling. It is tempting to think that if inflation is bad then deflation must be good. This is not so because: falling prices usually occur because of falling demand, which makes it harder for businesses to profit and makes redundancies more likely. falling prices of shares and houses reduces peoples wealth. This creates a feelbad factor which reduces consumer confidence and spending. the real value of debts increase, making it harder for borrowers to repay them.
114
THE UK ECONOMY
Unemployment
1 1.1 Measuring unemployment Who is unemployed? An economist would define an unemployed person as anyone who is able, available and willing to work but cannot obtain a job. The claimant count. Traditionally the government has used the claimant count. Each month it publishes the number of people eligible to claim the Job Seekers Allowance (JSA). Unemployment is also expressed as a percentage of the working population (workforce). The workforce consists of employees in work, the self-employed and the unemployed. This method has been criticised as being inaccurate, because: frequent changes in the method of calculation have made it difficult to make long-term comparisons. some unemployed people are not included because they choose not to register for unemployment benefit. some people who are included are working in the black economy but fraudulently claim benefit. the strict eligibility criteria for JSA prevents some unemployed people from being claimants. the change from unemployment benefit payable for 12 months to JSA payable for only 6 months has reduced the number of claimants.
1.2
Claimant count unemployment % of the labour force (seasonally adjusted)
115
THE UK ECONOMY
1.3
Seasonal adjustment. The claimant count is usually seasonally adjusted. This removes the effects of regular and predictable seasonal fluctuations in unemployment, e.g. building workers in the winter, ski instructors in the summer, etc. When seasonal variations are taken into account then underlying trends can be identified. The Labour Force Survey. Since April 1998, the Government has also published unemployment data, each quarter, based on the Labour Force Survey. This is a method similar to that used by other countries so it is more suitable for international comparison. The Labour Force Survey surveys a sample of 150,000 people each quarter and counts as unemployed those who were unemployed and who: were available to start work in the next two weeks, and had actively looked for work in the last four weeks, or had found a job and were waiting to start. The numbers unemployed as counted by the Labour Force Survey are higher than those given by the claimant count and are considered to be more accurate.
Claimant count and LFS measures of unemployment % of the labour force (seasonally adjusted)
1.4
Claimant count LFS measure
1.5
Why is unemployment measured? Unemployment is a key indicator of the performance of the economy and is a major social problem. Government needs to know the scale of the problem before deciding what policy to use to improve it. The problem is not just one of the number of people unemployed. It is also important for policy makers to know for how long people have
116
THE UK ECONOMY
been unemployed and to know which age groups, regions and industries are worst affected. Statistics are available for all of these. 2 2.1 Types and causes of unemployment Cyclical or general. This type of unemployment is associated with recession in the economy when the level of aggregate demand in the economy has fallen. The rate of unemployment is likely to be high. Structural. This is associated with the changing structure of an industry. New technology. An industry becoming more mechanised may need fewer workers. Note that in the long term new technology is a creator of jobs. Firms become more competitive and win new markets. New products can be made, again resulting in new markets. However, in the short run, jobs may be lost in particular firms or industries. The faster that workers and industry can adapt the less will be the problem of this technological unemployment. Falling demand. An industry facing long-term decline in demand for its products because they are obsolete or cannot compete with foreign products will reduce labour. Structural unemployment may exist even when the aggregate demand within the economy is high. 3.3 Frictional. This occurs when there are barriers to the free movement (i.e. friction) of the unemployed into vacancies. This may be caused by a lack of knowledge about job opportunities occupational immobility, e.g. an unemployed worker not having the required education, experience or skills geographical immobility, e.g. an unemployed worker not being able to move to the location of job vacancies cost of moving, social ties such as childrens schooling, elderly parents to care for disincentives to work, e.g. a worker may calculate that because of lost welfare benefits, transport costs and extra direct taxes s/ he is no better off working. 2.4 Seasonal. This occurs in industries such as agriculture, tourism and building where employment fluctuates with the seasons.
2.2
117
THE UK ECONOMY
Full employment, the natural rate of unemployment and NAIRU Full employment does not mean that everyone who is looking for work has a job. There will always be some people unemployed for structural, frictional or seasonal reasons. Full employment is difficult to define precisely and there have been a number of definitions since the Second World War. An early definition stated that it would exist if the number of unfilled vacancies equalled the number of unemployed people and it was suggested that full employment would be achieved when there was an unemployment rate of 3%. Today economists and politicians are more cautious about stating a figure and talk more in terms of a concept. They would say that full employment is where unemployment equals the natural rate of unemployment. The natural rate of unemployment is seen as the level of unemployment below which there will be a rise in inflation. Below this level, labour shortages in certain sectors and high demand increase the pressure on wages and prices. The remaining unemployment is frictional and structural. The natural rate is sometimes called the NAIRU (the nonaccelerating inflation rate of unemployment).
4 4.1
Effects of unemployment For the individual Economic effects reduced income while major spending commitments continue, e.g. mortgage, credit agreements, etc. reduced standard of living reduced efficiency as an unemployed worker loses his skill, fitness and motivation. Social effects reduced status social exclusion from friends because of loss of work and income increased health problems both physical and mental, e.g. stress, reduced quality of diet, increased risk of marital break-up.
4.2
For businesses Negative consequences fall in demand for goods and services fall in revenue and profits knock-on effect on suppliers (multiplier effect).
118
THE UK ECONOMY
Positive consequences bigger pool of labour available less pressure to pay higher wages less risk of industrial action from employees because of fear of job loss. 4.3 For the economy Economic costs lost output real GDP will fall economy will be operating well within its production possibility curve multiplier effect of reduced demand reduced spending of the unemployed or those fearing unemployment affects jobs of others reduced taxation revenue for the Government fall in revenue from income tax and taxes on consumer spending; fall in corporation tax on company profits increased burden on taxpayers to fund benefits and training measures. Social effects increased crime civil unrest increased burden on healthcare system. 5 All types of unemployment have been in evidence in recent years Cyclical. During the recession of 1990 to 1992 there was a fall in aggregate demand. Structural. There has been a continued decline in employment in manufacturing industries for the following reasons: inability of some industries to compete with foreign firms particularly those in the tiger economies, e.g. China, Hong Kong, Singapore, Taiwan and Korea rapid mechanisation privatisation of nationalised industries led to large-scale job reductions after privatisation, industries continued to shed labour in large numbers, e.g. BT. 5.3 Frictional. There is a lack of flexibility in the labour market for the causes, see para. 2.3.
5.1
5.2
119
THE UK ECONOMY

6 6.1 Trends in unemployment Total unemployment has fallen
UK claimant count unemployment
120
% of the labour force
Since 1993 unemployment in the UK has been on a downward trend. A number of factors can account for this: sustained economic growth a slowdown in the numbers of school leavers entering the labour market more students staying on in further and higher education the success of the Governments Welfare to Work programme.
THE UK ECONOMY
6.2
Regional differences in unemployment remain

Regional unemployment in the UK % of the labour force
North-East
London N. Ire
Wales
North West Yorks
UK Total
Eastern SW
SE
Scotland
W. Mid
E. Mid
Labour Force Survey, unemployment rate (%) June to August 2001
For the UK those regions closest to London and the south east continue to have the lowest rates of unemployment whereas those such as Scotland, Northern Ireland and the north-east of England have the highest. The growth in service jobs in the prosperous south and the decline in primary and manufacturing jobs in other regions account for these differences. Within Scotland there are also wide differences. The Edinburgh area with its growing number of service jobs and its success in attracting electronics businesses is prosperous. The oil industry explains the lower level of unemployment in the north east. Higher rates of unemployment exist in west-central Scotland because of the decline in manufacturing jobs and in the Highlands and Islands because of their remoteness. However rates of unemployment have also been falling in these areas. 6.3 The pattern of employment has changed. The numbers employed in the primary and secondary sectors have continued to fall whilst the number employed in the tertiary sector have risen. Most of these jobs were full time and taken by men. An increasing number of new jobs in services are part time, temporary and are taken up by women. These changes help to explain why men account for a growing proportion of the unemployed.
121
THE UK ECONOMY
Topic 3: The Role of Government in the Economy Economic Systems

1 1.1 The basic economic problem All nations face the problem of scarcity, i.e. they have insufficient resources to produce all the goods and services which their citizens need and want. Three basic questions have to be addressed: What goods and services will be produced? How will these goods and services be produced? This means who will do the production and which methods of production will be used. To whom will the goods and services be distributed? This means who will consume the goods and services after they been produced and how will it be decided who receives them. 1.2 To address these questions a nation needs an economic system. There are three different economic systems: the command or planned economy, the market economy and the mixed economy. Each has different ways of allocating resources to producers and of distributing goods and services to consumers. The command economy The economies of various communist countries such as China and the Soviet Union were command economies. During the Second World War, the UK economy was a command economy as government took charge of production decisions. The main features of a command economy are: Resources are owned or controlled by the Government. Government plans what will be produced and allocates resources accordingly. Producers have limited freedom to change methods of production or to develop new products. Government controls prices. No private profit. Little competition.
2 2.1
2.2
122
THE UK ECONOMY
2.3
What to produce and how to produce are decided by the Government. To whom goods are distributed is also strongly influenced by the Government because incomes and prices are controlled. Problems of a command economy include: Inefficient allocation of resources because of the Governments failure to plan accurately for societys wants leading to shortages of some products and surpluses of others. Control of prices makes it impossible to judge the real wants of consumers. Inefficient production resulting from lack of profit motive and lack of competition. Limited freedom of choice for consumers.
2.4
2.5
Possible advantages of a command economy may include: Basic necessities are made available to everyone at a price they can afford. A fairer distribution of income and wealth.
3 3.1
The market economy The main features of a market economy are: Private individuals own resources. Producers are free to produce what they wish. Consumers have consumer sovereignty (literally meaning the consumer is king) and rule the market, i.e. the freedom of consumers to decide what to buy influences what producers produce. Decisions are made on the basis of self-interest. Producers aim to maximise profit. Consumers aim to maximise value for money. Competition exists between producers and between consumers. Resources are allocated by the price mechanism. Price acts as a signal to producers. Products which consumers demand will rise in price, which in turn will raise profits, thus encouraging producers to produce them. Producers will need more resources. They will attract them by offering higher incomes to those who own them. Falling demand for products will result in lower prices, falling profits and lower rewards for resources so that producers will be encouraged to move to where rewards are greater.
123
THE UK ECONOMY
3.2
What to produce is decided by consumers. How to produce is decided by producers using the most efficient methods of production in order to keep down cost so that they can compete and maximise profit. To whom products is distributed is decided by the buying power of those consumers who earn the highest incomes from the resources which they own.
3.3
Advantages of a market economy may include: Efficient allocation of resources, i.e. resources are used to produce those goods and services most wanted by consumers. The clearing of markets of surpluses or shortages by the price mechanism. Technical efficiency in production as producers strive to keep down costs. Freedom of choice for consumers.
3.4
Disadvantages of a free-market economy may include: Failure of producers to produce public goods, i.e. goods and services whose benefits are shared by the whole community, e.g. defence, law and order. Failure of producers to produce sufficient merit goods, e.g. healthcare and education. They may be provided for richer consumers but not for those who cannot afford to pay. The production of undesirable goods, e.g. addictive drugs. Production methods which take no account of external costs, e.g. pollution. The development of monopolies, oligopolies and restrictive practices which eliminate the benefits of competition. Wide inequalities in income and wealth. For more detail on this, see the section on Market Failure in Topic 3.
124
THE UK ECONOMY
4 4.1
The mixed economy There has long been a debate about the efficiency of the allocation of resources in the free-market system compared with the command economy. From 1945 to 1979, the UK saw a substantial increase in Government intervention, with many industries being nationalised (e.g. steel, coal, rail). During the 1980s, there was a reversal of this policy, and privatisation returned most of these industries to the private sector. By the early 1990s, it was apparent that extreme Government intervention as practised by the planned economies of the former communist countries in Eastern Europe had been a failure in terms of increasing living standards at the same rate as in the west. Despite the move towards free-market-type economies, there is still a need for government intervention. This is because of what is known as market failure. Summary of the role of Government in the UK mixed economy: Providing public goods and services defence, law and order, roads which the private sector could not provide. Providing merit goods and services education, healthcare, art galleries which the private sector does not provide in sufficient quantity. Controlling and regulating the private sector protecting workers and consumers health and safety, dangerous products, minimum wage and employment conditions, monopolies. Dealing with market failure. Controlling overall economic performance unemployment, inflation, economic growth, balance of payments imbalance. Redistributing income tax and benefits, regional policy.
4.2
4.3
4.4
4.5
125
THE UK ECONOMY
Increasing the Role of the Private Sector

1 Introduction Since 1979, there has been a major shift in the provision of public services. Many industries have been privatised whilst other services, although still financed by Government, are contracted out for private firms to provide. Government has also reduced much of the red tape which limited competition in the private sector a policy called deregulation. 2 Privatisation This is the sale of assets owned by the public sector. This includes selling nationalised industries (e.g. steel, coal, rail) and assets of central government departments (e.g. land, houses) and local government (e.g. land, water, council houses). 2.1 Methods of privatisation Stock market flotation shares were advertised for sale in national newspapers at a fixed price. Subscribers bid for shares at that price and the government then allocated the shares, e.g. British Airways, British Telecom. Sale by tender minimum price was set and prospective buyers bid for shares at or above that price. The shares then went to the highest bidders, e.g. Britoil. Private sale asset is sold to a single buyer, e.g. Rover sold to British Aerospace (since sold to BMW); council houses sold to tenants. 3 Contracting-out This is where a service previously run by civil servants or local government employees is contracted out to the private firm which offers to provide it at the lowest cost, e.g. school cleaning, school meals, refuse collection. This process is also called compulsory competitive tendering. 4 Private finance initiative (PFI) This is a step further than contracting out. Private-sector companies are invited to pay for and provide capital investment projects such as school, prison and hospital buildings, rail links
126
THE UK ECONOMY
(e.g. Channel Tunnel Rail Link); bridges (e.g. Skye Bridge). The Government then takes out a long lease, e.g. for 25 years and pays for the service over that time out of tax revenue. 5 Deregulation Deregulation involves the removing of government regulations which have been barriers to competition, e.g. removing BTs sole right to provide the telecommunication service; removing opticians sole right to supply spectacles; removing bus route licences which allowed only one company to service a particular route. 6 6.1 Aims of privatisation To improve efficiency. Governments intention is to improve both: technical efficiency, where competition is an incentive to cut unit costs and improve quality allocative efficiency, where resources are more likely to be allocated to produce the goods and services which consumers most want to buy and which will therefore create the highest profit. 6.2 To reduce Government interference in the market to reduce interference by government ministers in the making of commercial decisions by firms. This frequently happened for political reasons, e.g. a nationalised firm (e.g. electricity) not being allowed to raise prices or close down a loss-making plant, or being forced to open up a plant in a high-unemployment area even when it was not the most efficient location (e.g. steel). to allow industries to diversify into new and profitable lines of business, e.g. nationalised industries were restricted to a narrow range of activities; now they are free to pursue any profitable activity, e.g. electricity companies are now involved in supplying gas, telecommunication services, etc. 6.3 To reduce the power of trade unions in the public sector Nationalised industries usually had a monopoly of the service they provided. Trade unions had great power because industrial action had a large impact on consumers. By breaking up
127
THE UK ECONOMY
nationalised industries and introducing competition there were alternative suppliers to whom consumers could go in the event of industrial action. Firms no longer owned by Government could not submit to wage demands and expect Government to subsidise large pay awards. 6.4 To reduce Government borrowing Privatised firms which make losses can no longer borrow from Government. Privatised firms now have to raise new capital on the private capital market and not through Government borrowing. With a private finance initiative (PFI), companies borrow the cash to build and run new schools, hospitals, etc. 6.5 Political motive Privatisation has been a very popular policy with voters and, once started, Governments had encouragement to continue. 7 7.1 Problems Inefficiency Some privatised companies have had to operate in highly competitive markets, e.g. British Airways and British Steel and have had to improve their efficiency. However, a number of those industries which have been privatised are natural monopolies (a natural monopoly is where the most efficient market structure is a monopoly e.g. in domestic water supply where it would be a waste of resources for a second supplier to build a second network of pipes). The incentive to improve efficiency has not been so great in those, even although the Government has appointed regulators such as Ofgem, Ofwat and Oftel (see 8.1). Critics argue that the regulators have not been tough enough in controlling the prices and quality of service of the public utilities. 7.2 Excess profits Profitability has varied enormously, but those firms which have a high degree of monopoly power have made very large profits, e.g. British Gas and BT at the expense of consumers.
128
THE UK ECONOMY
Critics of PFIs argue that although they are portrayed as using private money, taxpayers still have to pay. They will end up paying more because private capital is more expensive to borrow than public capital and they will have to pay for a longer period. 7.3 Lost jobs and poorer working conditions There have been large redundancies in some industries as they have sought to improve efficiency, e.g. British Steel and British Airways; although supporters of privatisation would argue that such industries were over-manned. Many workers in firms providing contracted-out services now have poorer wages, poorer working conditions and less job security. 7.4 Reduced services Cross-subsidisation was common in nationalised industries for social reasons. For example, on the railways a loss-making service was subsidised by profitable services. Privatisation may harm consumers if they have to pay the full cost of the service or if the service is withdrawn because it is non-profit making. However, Government has ensured the continued provision of many socially necessary services by subsidising them. 7.5 Widening of share ownership An aim of the privatisation policy was to encourage a larger percentage of the population to become share owners. This has occurred, but not by as much as Governments would have hoped for because: Many who bought shares sold them quickly (mainly to financial institutions) to profit from the rapid rise in their price. Many shareholders hold the shares of only one privatised industry. Most shares are still owned by large financial institutions such as insurance companies and pension funds. 7.6 Assets sold too cheaply Critics have claimed that many nationalised industries were sold too cheaply and much potential revenue for the Government was lost. Government argued that they had to be offered at a low price to ensure their sale.
129
THE UK ECONOMY
8 8.1
Government control of privatised industries Privatised enterprises which operate in competitive markets need no regulation, e.g. British Steel has to compete with international producers in the world market. Privatised enterprises which operate in markets where there is insufficient competition are regulated. Regulatory agencies have been set up to oversee certain industries e.g.: Oftel (telecommunications) Ofgem (gas and electricity markets) Ofwat (water).
8.2
Objectives of regulation to protect consumers from exploitation to encourage efficiency and innovation to promote competition.
8.3
Forms of regulation Price regulation regulator fixes a maximum price usually RPI less a certain percentage. Yardstick competition, e.g. the electricity and water industries have been split up geographically with different companies in different parts of the country. The regulators then compare the performance of the different companies.
130
THE UK ECONOMY
Public Expenditure and Finance in the UK Economy

1 1.1 Public-sector expenditure Public-sector expenditure is the name given to spending by central government, local government and public corporations, e.g. the Post Office, the BBC. Plans for public-sector spending are published annually along with the Budget. These plans show intended spending for the coming 3 years. Types of public sector spending Capital spending. This helps to create productive capacity, e.g. hospitals, urban renewal and transport infrastructure. Current spending. This covers day-to-day running costs of government, e.g. the pay of public-sector workers. Transfer payments. A transfer payment is defined as a payment to an individual or firm for which there is no economic benefit given in return, e.g. pensions, unemployment benefit, child benefit, grants and subsidies. They are called transfer payments because money is transferred from taxpayers to those who qualify for benefit. The distinction between types of spending is important because capital and current spending diverts resources from the private sector; whereas transfer payments do not absorb resources but redistribute income and spending power within the private sector. Most of the Governments capital and current expenditure is on public and merit goods and services. 1.3 A public good or service is one which benefits everyone in society, e.g. defence, street-lighting. A public good cannot be provided by the private sector because of the difficulty in getting all its consumers to pay. Government, therefore, has to provide public goods and raise the required revenue from general taxation. Merit goods or services, e.g. healthcare, education, are considered to be socially desirable but would be under produced if left to private enterprise. Merit goods or services are given to those people who merit (i.e. need) them, either free or at reduced price. These are paid for out of taxation and in some cases, e.g. medical prescriptions, by charging consumers a proportion of the price.
1.2
1.4
131
THE UK ECONOMY
1.5
Trends in public-sector expenditure Changing total In recent years there has been an increase in Government expenditure in the economy. This has been due mainly to increases in spending on health, education and transport. Changing pattern Increases in spending on health and education have been proportionately greater than on other programmes. Defence spending has fallen because of the end of the cold war, which has given us a peace dividend. Social security spending has increased because the ageing population has led to more spending on retirement pension. However, there have been reductions in areas such housing where as part of its privatisation policy government has limited its spending on building new council houses. Spending on support for industry has also become less important. There is strong debate among economists and politicians about the merits of public-sector expenditure.
1.6
Case for reducing growth in public spending Income tax can be reduced which will increase incentives and increase consumers freedom to choose how to spend their incomes. Government borrowing can be reduced. Resources can be released for use by the private sector. It is thought by some that the private sector uses resources more efficiently.
1.7
Case against cuts in growth of public spending Most public-sector spending is on UK-produced output which creates employment in the UK. If given back to consumers by reducing tax, it may be spent on imports. Capital spending is the easiest for government to cut but this reduces the countrys infrastructure, which in turn reduces the efficiency of the economy, e.g. there have been major cuts in recent years in housing.
132
THE UK ECONOMY
Resources released from the public sector are not automatically taken up by the private sector. They may remain unemployed. Lower-income groups are the most dependent on public spending, not only on benefits but also on services such as housing and public transport. 2 2.1 Taxation Types of taxation Direct taxes Direct taxes are defined as those taxes which are taken directly from individuals and firms. They are levied by the Inland Revenue department. They are mainly taxes on income and wealth, e.g.: income tax national insurance contributions although not called a tax, in fact it is corporation tax levied on company profits council tax levied on the value of a householders house capital gains tax levied on the increase in value of assets inheritance tax levied on a deceased persons estate stamp duties levied on the change of ownership of houses and land. Indirect taxes Indirect taxes are levied indirectly, i.e. the payer of the tax to government passes on the burden of the tax, usually to a customer. These are collected by the Customs and Excise Department. They include: Value Added Tax (VAT) levied on a wide range of goods and services. Some goods, e.g. childrens clothes, books and basic foodstuffs are zero-rated customs duties taxes on imports excise duties taxes on petrol, tobacco and alcohol petrol revenue tax tax on North Sea oil companies motor vehicle duties.
133
THE UK ECONOMY
2.2
What makes a good tax? Adam Smith, the famous eighteenth-century Scottish economist laid down four principles (or canons, as he called them) for a good tax. (a) (b) Equity. Taxes should relate to the taxpayers ability to pay. Efficiency. Taxes should be reasonably inexpensive to collect, i.e. the cost of collection should form a small percentage of the revenue collected and they should not have negative side-effects such as reducing work incentives for individuals. Certainty. The taxpayer should be clearly aware how much is due, and when and where to pay. Convenience. Taxes should be payable at a time and place that suits the taxpayer.
(c)
(d)
Not all taxes levied in the UK adhere to these principles. 2.3 Progressive and regressive taxes A progressive tax is one which takes account of peoples ability to pay, i.e. it follows Smiths principle of equity. A progressive tax takes a larger percentage of income as income rises. Most direct taxes are of this type. A regressive tax takes no account of peoples ability to pay. Lowerincome earners pay a higher percentage of their income in tax. Most indirect taxes are regressive, e.g. duties on alcohol, petrol, road tax are fixed amounts of money which are the same for everybody. VAT, although an indirect tax, takes some account of ability to pay in that some essential items such as food, childrens clothes and shoes, which account for a large proportion of a low income earners spending, are zero rated and household fuel is rated at 5%. Nevertheless VAT is a regressive tax.
134
THE UK ECONOMY
2.4
Trends in taxation Cuts in business taxes, e.g. corporation tax and business rates The aim has been to allow firms to earn higher profits and so encourage investment. The UK now has lower business taxes than most other European countries, which helps to attract inward investment. Shift from direct to indirect tax In the 1980s Conservative Governments started to restructure taxation by shifting the balance away from direct taxation towards indirect taxation and this policy was continued in the 1990s. The restructuring was done by simplifying and reducing rates of income tax. The Conservatives believed that lowering rates of income tax would encourage enterprise and effort. The top rate has been cut from 83% in 1979 to 40%; standard rate from 33% to 22%. There is also now a starting rate of 10%. The share of income tax in total tax revenue has fallen from 45% to 25%. The loss in revenue from income tax cuts was largely recouped from VAT which has been raised and extended to a wider range of goods and services. Excise duties on tobacco, alcohol and motoring have been increased by more than inflation. The effect of the restructuring has been to tilt the balance of taxation away from earning to spending and to make the tax system more regressive. A further effect has been a widening of the gap between rich and poor. The Labour Government elected in 1997 gave a promise that it would not raise income tax nor extend VAT. However, it has started to narrow the richpoor gap by a reform of other taxes.
2.5
Case for cuts in income tax Tax revenue may increase. High rates of income tax encourage people to exploit every possible loophole to avoid tax and they encourage some people to break the law in order to evade tax. Cutting rates may remove this evasion. Incentives are increased. If marginal rates of tax are reduced then people will be able to keep more of any additional income they earn. This may act as an incentive to work harder or to seek promotion. Lower tax rates may also encourage some of the voluntary unemployed to work. As people work harder and earn more, the tax revenue in total may rise.
135
THE UK ECONOMY
The potential revenue from income tax cuts can be illustrated by the Laffer curve (Laffer is a US economist). Since no revenue can be expected from tax rates of 0%, the curve of tax revenue rises as tax rates rise but eventually falls because of disincentives, evasion and avoidance, until at 100% rates tax revenue would return to zero. The difficulty for a Government is knowing which tax rate would yield the highest tax revenue.
Tax revenue
0%
100%
Tax rate
2.6
Case against cuts in income tax Some economists argue that tax revenue may not increase. A higher disposable income from working the same or fewer hours may encourage people to take more leisure time. The demand side of the economy may be over stimulated. This leads to inflation. Inequalities are likely to widen. Since income tax is progressive, cuts are likely to favour those on higher incomes while those on low incomes who are not liable to income tax will gain no benefit. If, as has been the case, government switches to more taxes on expenditure, which tend to be regressive, then those on low incomes are further disadvantaged.
3 3.1
Public Sector Net Cash Requirement (PSNCR) PSNCR. The PSNCR is defined as the borrowing of the public sector, i.e. central government, local authorities and public corporations. There is a need for the public sector to borrow if its expenditure is greater than its income. The main factor in this is
136
THE UK ECONOMY
usually a central government budget deficit. The PSNCR is measured in billion and as a percentage of GDP. It is financed by selling bonds, gilt-edged securities and treasury bills to financial institutions and to citizens. In some years the PSNCR may be negative. In this case the government is running a budget surplus and is then able to repay debt. 3.2 The Budget. A Government must plan what it wants to spend and how it is going to finance its expenditure. This plan is usually done once a year and is presented to parliament as the Budget. However, the Budget may be used for purposes other than just a financial plan. This is covered in Topic 4 Government Economic Policies. Budget deficit If central government income is less than central government spending, this is called a budget deficit. You should note that the Budget is as much a political exercise as an instrument of economic policy. For example, in the run-up to an election measures in the Budget may be taken to win political support which may be against the interest of the economy at that time. 3.3 National debt. The national debt is the total amount of accumulated debt, i.e. the total amount which the public sector owes to those who have loaned it money. If in one year there is a PSNCR, then the national debt will increase. A budget surplus will reduce the national debt. Why government needs to control the PSNCR. A high PSNCR may cause the following problems: Crowding out high Government borrowing may starve the private sector of funds for investment. Interest rates may have to rise to encourage lenders to lend to Government. The UK Government usually has little difficulty in borrowing money because lenders have confidence in its ability to repay. However, when the borrowing requirement is large it may have to offer higher rates of interest to attract extra funds. This also increases the cost of borrowing for the private sector. Inflation. Monetarists believe that if Government borrowing is financed by borrowing from banks then the money supply increases and causes inflation.
3.4
137
THE UK ECONOMY
National Debt is increased this leads to higher repayments of debt interest in the future which have to be financed by higher taxes or reductions in other spending programmes. EMU. A condition for membership of Economic and Monetary Union (EMU) in Europe is that in any year the PSNCR should be no more than 3% of GDP and the national debt should be no more than 40% of GDP. Government therefore has to try to stick to these requirements. 3.5 Difficulties in controlling Government borrowing. It is difficult for governments to control their borrowing because of the difficulty in predicting the economic cycle. The amount of money the government spends and receives from taxation fluctuates with the economic cycle. In periods of economic growth and rising employment spending on benefits decreases while tax revenues increase from higher incomes, consumer spending and business profits. The opposite happens during a recession! UK trends
3.6
The recession of 19902 had increased the PSNCR. Tax revenues fell but public expenditure on unemployment benefits and social security payments increased. The government could have increased tax rates to reduce the Public Sector Net Cash Requirement (PSNCR) but the economy was too weak to stand this.
138
THE UK ECONOMY
From 1994 to 1997, the PSNCR fell. As the economy recovered from recession, tax revenues increased as GDP increased and government felt able to increase taxes. The new Labour Government of 1997 set a tough target for government borrowing and intended to achieve it by maintaining strict control of public-sector spending, and raising some taxes (although it had a commitment not to raise income tax or extend VAT). It restored the golden rule of fiscal policy.
Golden Rule of Fiscal Policy The golden rule is that in the long run government borrowing should only be allowed to finance capital expenditure rather than current expenditure. The thinking is that capital spending, such as new hospitals and roads, will benefit present and future generations and should be paid for by those who benefit now and in the future. Current spending, such as teachers salaries, school books, etc. should be paid for now by taxing the generation who benefit from this spending. The Chancellor has modified this by stating that borrowing to fund current spending should be neutral over the economic cycle, i.e. it may need to borrow during years of recession but that this should be repaid out of budget surpluses in years of growth.
The 1997 and 1998 Budgets were both tight, i.e. taxes were higher than spending. The public finances improved to the extent that instead of having to borrow the Government was able to repay debt. In 1999 and 2000 public finances continued to improve and the Chancellor was able to reduce tax receipts in the Budget of 1999 without having to borrow. Since 2001 public borrowing has grown as the economy and tax revenues have not grown as fast as the Chancellor predicted and because of very large increases in capital spending in health and education. Note that although the figures are very large, they are a small percentage of GDP, e.g. the national debt of the UK will be 35% of GDP in 2005, compared with 50% in the USA and Germany and 80% in Japan.
139
THE UK ECONOMY
Government Economic Objectives

1 Introduction The role of government in a mixed economy is to: provide goods and services which cannot be provided by the private sector regulate the private sector in order to protect the consumer, employee and the environment set objectives of economic policy and choose instruments of policy. 2 Objectives Government may set itself microeconomic objectives and macroeconomic objectives. Microeconomic objectives relate to the performance of a part of the economy, whereas macroeconomic objectives are concerned with the performance of the economy as a whole. Different governments will set themselves different objectives and it does not follow that all governments will aim for all the objectives given below. 2.1 Macroeconomic objectives to achieve economic growth to achieve low and stable inflation to reduce unemployment to keep the current account of the balance of payments in balance.
2.2
Microeconomic objectives to prevent market failure to distribute income and wealth more fairly to reduce regional disparities.
Policies To achieve its objectives, a government has a number of different policy instruments available and it is likely to use a number of them at the same time. These include: fiscal policy monetary policy
140
THE UK ECONOMY
supply-side policies exchange rate policy* external trade policy* regional policy
* Covered in the notes for Unit 3, Topic 1, International Trade and Payments. 4 Problems of reconciling conflicting objectives Governments face a number of problems in trying to achieve their economic objectives. These include: 4.1 Conflicting advice. Governments depend on economists for advice and since economics is not an exact science they may receive different suggestions for solving a particular problem. You have already seen the difference in views between Keynesians and monetarists. Inadequate information. Government economists and politicians depend on accurate information about the size and extent of a problem. This information depends on the accuracy and methods of gathering statistics. Information may be inaccurate and out of date. Government also depends on forecasts which are often inaccurate. Time lags. It takes time for government to recognise the existence of a problem, to implement a policy and for consumers or producers to react to it. Meanwhile economic circumstances may have changed, so that the policy makes the problem worse, e.g. Government may believe that the economy is in for a period of inflation and so introduce an anti-inflation policy but in the meantime demand may have been falling anyway so that the policy drives the economy further into recession. Policy constraints. The UK is a member of the European Union (EU). This means that there are certain policies which it cannot use, e.g. introducing restrictions on trade, removing VAT from certain products, and if the UK joins the euro it will have to accept a common interest rate which is set by the European Central Bank.
4.2
4.3
4.4
141
THE UK ECONOMY
4.5
Political pressures. In the run-up to an election, governments are unlikely to introduce harsh economic policies even if they may be necessary. Conflict between policy instruments. A policy to solve one problem may cause another, e.g. to improve the balance of payments, the Government may raise interest rates in order to reduce consumer demand for imports, but this in turn may increase the exchange rate. A higher exchange rate then raises the price of exports and reduces the price of imports, which is harmful to the balance of payments. Similarly, in trying to boost economic growth, the Government may take steps to increase demand but this may lead to inflation.
4.6
You need to know the policy instruments which a government may use as well as how they are used in trying to reach objectives. In the following topic you will find the main policy instruments which governments use, followed by how particular objectives may be achieved.
142
THE UK ECONOMY
Topic 4: Government Economic Policies This topic is for Higher only Demand and Supply Sides of the Economy
The demand side of the economy This refers to aggregate demand for goods and services produced in the UK. You will remember that this consists of consumer spending, investment spending, government spending and the spending by foreign buyers on UK exports. Spending on imports is subtracted. The shorthand for all of this is C + I + G + (X M). The level of demand in the economy has an important influence on its performance, i.e. if there is too much demand then inflation ensues; too little then there is cyclical unemployment. Government can change the level of aggregate demand by: fiscal policy, or monetary policy. These are called demand-side policies. The supply side of the economy This refers to that part of the economy which produces goods and services. The performance of the economy is in effect limited by its productive potential, i.e. its production possibility frontier. This in turn is affected by the quantity of resources available and the efficiency of those resources. Government can influence the supply side by what are called supply-side policies.
Fiscal Policy
1 Definition Fiscal policy is when Government changes its spending or taxation in order to influence the performance of the national economy. Fiscal policy aims to change the level of aggregate demand.
143
THE UK ECONOMY
2 2.1
The Budget You saw in the last topic that a government must plan what it wants to spend and how it is going to finance its expenditure. This plan is usually done once a year and is presented to parliament as the Budget. As well as financial planning the Budget may be used: to alter tax rates or introduce new taxes to achieve macroeconomic targets such as growth, employment, inflation to achieve microeconomic targets by changing the economic behaviour of certain groups, e.g. taxing alcopops at a high rate.
2.2
3 3.1
Fiscal policy and macroeconomic objectives If a Government decides to use fiscal policy to influence demand in the economy, it can choose either to change its expenditure or taxes. Remember from your previous notes that: Aggregate demand = C + I + G + (X M)
3.2
4 4.1
Unemployment If there is high unemployment caused by insufficient demand then government could increase demand: (a) by spending more itself (G), e.g. capital spending on new hospitals, roads, etc. or current spending, e.g. employing more nurses, teachers, etc. This extra spending would be an injection into the economy. by reducing taxation, e.g. reducing corporation tax allows firms to keep more of their profits which they may use for investment (I), or reducing income tax allows individuals more after-tax income to spend (C). The Government would be reducing a withdrawal.
(b)
144
THE UK ECONOMY
4.2
Whether government spending is raised or taxation is cut, the increase in the injection or the reduction in the withdrawal will have a multiplier effect on national income and employment. If either of the above fiscal policies were adopted then the Budget would be in deficit and the PSNCR would rise. Inflation If there is inflation caused by too much aggregate demand then government could cut demand by: (a) (b) cutting its own spending (G). increasing taxation to cut either consumer spending (C) or firms spending on capital goods (I).
4.3
5 5.1
5.2
If either of the above fiscal policies were adopted then the Budget would be in surplus and debt could be repaid. Problems with fiscal policy Conflicting objectives. Governments aim for: full employment economic growth balance in the current account of the balance of payments low inflation.
6 6.1
A fiscal policy which raises aggregate demand in order to increase employment and encourage economic growth could damage other aims; it could: (a) worsen the balance of payments if consumers and businesses spend their extra disposable incomes on imported consumer goods, machinery and raw materials cause inflation if demand increased faster than supply or by too much.
(b)
Fiscal policy to reduce demand in order to lower inflation or correct a balance of payments deficit could: (a) (b) cause unemployment, or lower economic growth.
145
THE UK ECONOMY
6.2
Forecasting the required changes in demand (a) Data on which plans have to be made are not reliable because collecting information on large totals such as national income or consumption is subject to time lags and errors. The multiplier effect of increased G or of reduced T is difficult to predict. When the policy will take effect is difficult to estimate.
(b)
(c) 6.3
Fine tuning Fiscal policy is therefore not a precise policy instrument. During the 1930s, unemployment was so great that the bluntness of fiscal policy did not really matter. In the post-war economy, shortfalls or excesses in demand have been much smaller and fiscal policy frequently missed the target. Either too little demand was injected into the economy so that unemployment remained or too much demand was injected and there was a problem with inflation. It was difficult to fine-tune the economy.
7 7.1
Changing importance of fiscal policy The use of fiscal policy to control demand, employment and prices was unheard of until the 1930s when the famous economist, Keynes, explained how it could be used. In the post-war period until the late 1970s fiscal policy was the main policy used to control aggregate demand in the economy. Monetary policy was secondary to fiscal policy. The control of bank credit and the rate of interest were used to fine-tune demand between budgets. The high rates of inflation and rising unemployment in the 1970s questioned the effectiveness of fiscal policy and when the Conservatives came to power in 1979 they changed the policy. Monetary policy was to become the main weapon and fiscal policy was not to be used to manipulate demand in the economy. In fact, the aim was to balance the Budget and eliminate the PSNCR. The Labour Government elected in 1997 continued this policy. The Chancellor has no intention of using fiscal policy to control demand but to use it in support of monetary policy by curbing the Budget deficit. Remember that a Budget deficit and high PSNCR is inflationary and also puts upward pressure on interest rates. (See also your notes on Monetary Policy.)
7.2
146
THE UK ECONOMY
The notes from page 147 to page 156 are for Higher only Monetary Policy
1 Introduction Monetary policy is the policy which uses interest rates or controls the supply of money as a means of achieving a governments macroeconomic objectives. 2 The Bank of England The Bank of England is the UKs central bank. It has certain key functions: 2.1 The Governments bank It handles the enormous amounts of money in the governments accounts, e.g. the social security and defence accounts. It borrows money for the government from private individuals and financial institutions and repays loans and interest to lenders when they are due, i.e. it manages the national debt. Note that the government does not borrow from the Bank. It is responsible for the issue of notes and coins into the UK economy. 2.2 It is responsible for carrying out monetary policy The Government sets a target for inflation and the Monetary Policy Committee of the Bank has to change interest rates to meet that target. It acts as the Governments agent in the foreign currency market buying and selling foreign currency as well as intervening to manage the exchange rate of the . 2.3 It is the bankers bank All commercial banks hold accounts at the Bank of England. If one bank owes another bank money, a transfer between their accounts at the Bank settles the debt. It is the lender of last resort the Bank assists the banking system when it is short of cash. It inspects and controls banks in order to protect their customers.
147
THE UK ECONOMY
3 3.1
Monetarism You will remember from Topic 2 on inflation that monetarists believe that if the money supply grows faster than output then the result is inflation. In their view control of the money supply is vital for controlling inflation and this control must be aimed at (a) (b) (c) bank lending, or at borrowing from banks, or at government borrowing from banks.
Controlling banks ability to lend (i.e. the supply of money) This would involve intervention by the Bank of England to control bank lending. Because of the difficulties involved in monitoring and controlling the activities of banks, many of which are foreign, this policy is no longer used.
Controlling borrowing from banks (i.e. the demand for money) Changing the rate of interest can influence the demand for loans by firms and households. Increasing the rate of interest will reduce demand for credit; lowering the interest rate will make borrowing cheaper.
Controlling government borrowing from banks Government can reduce its demand for loans by reducing the public sector net cash requirement (PSNCR). To reduce the PSNCR it needs to reduce public sector spending or raise taxation.
7 7.1
Monetary policy and government objectives Inflation. If a government wanted to reduce demand in an attempt to lower inflationary pressures it would run a tight monetary policy, i.e. raise interest rates or reduce the money supply. Raising interest rates would also increase the exchange rate. A higher exchange rate can reduce inflation in three ways: It lowers the price of imported finished goods. It lowers the price of imported raw materials. It puts pressure on domestic firms to lower their costs to remain competitive.
148
THE UK ECONOMY
7.2
Economic growth and employment. If a government wanted to boost demand in the economy, say, in times of a recession, it could lower interest rates. Lower interest rates also lowers the exchange rate which in turn makes exports cheaper. Increased demand for exports increases employment. Balance-of-payments deficit. An increase in interest rates will cut aggregate demand including the demand for imports. Changing importance of monetary policy: the Monetary Policy Committee Since 1979 monetary policy has been the main policy used to control inflation and since 1990 interest rates in particular have been the chief instrument. Until 1997 the Chancellor of the Exchequer set interest rates in the UK with advice from the Treasury and the Bank of England. This, at times, particularly during the run-up to an election, meant that government could lower interest rates or postpone increases to help their chances of re-election, even when the correct economic action was to raise them. A major change took place in 1997 when the new Labour Government gave the Bank of England independence in setting the interest rate required to achieve and maintain the underlying inflation rate, i.e. the RPIX at annual average of 2.5% (note that the target is now a 2% rise in the Consumer Price Index). This, therefore, removed the political influence from the setting of interest rates.
7.3
8.1
The Monetary Policy Committee At the centre of the new arrangement is the Monetary Policy Committee of the Bank of England which sets interest rates each month. This committee of economists monitors various indicators of inflationary pressure, such as house prices, factory gate prices, average earnings, and the amount of bank lending, and it takes steps to reduce these inflationary pressures before they result in a rise or fall in the 2% target. If the inflation target is missed by more than 1% above or below 2%, the Governor of the Bank of England, as chair of the MPC, must write an open letter (i.e. available to the public) explaining the reasons why the target has been missed and what the Bank proposes to do to bring inflation back on target.
149
THE UK ECONOMY
8.2
How do interest rates affect inflation? When interest rates are changed, demand can be affected in a number of ways: Spending and saving decisions an increase in interest rates will make saving more attractive and borrowing less attractive, which in turn will reduce spending for both consumers and firms. Cash-flow a rise in interest rates will reduce consumers and firms cash-flow, e.g. those with mortgages and loans will have to pay more in interest and will have less to spend on goods and services. Exchange rates a rise in interest rates in the UK will attract foreigners to invest in the UK. This leads to an increase in the exchange rate against other currencies. An increase in the reduces the price of imports which helps to lower the CPI. Prices of UK exports rise and demand for them falls, which in turn reduces aggregate demand and inflationary pressure.
Supply-Side Policies
1 Introduction You saw in Topic 1, National Income, that there is a conflict of view about what determines the level of national income and employment. The Keynesian view is that the level of aggregate demand is the main factor. The opposing view is that the supply side of the economy is more important. Followers of supply-side policies believe that unless potential output (i.e. supply) can be increased, any increase in demand will result in inflation or balance-ofpayments problems. They believe that government should target policy towards either increasing resources or improving their efficiency. Most economists now accept that to achieve economic growth and increased employment both aggregate demand and aggregate supply need to be raised.
150
THE UK ECONOMY
Supply-side policies Supply-side policies are mainly microeconomic measures designed to improve competition in product markets (where goods and services are bought and sold) and those that aim to improve the working of labour markets.
2.1
Supply-side policies and product markets. The main thrust of these is to increase competition in the belief that competition between producers increases their efficiency and improves incentives. These policies have included: Privatisation. This was the main policy on the product market side in the 1980s and 1990s. The privatisation of various large former state-run industries was designed to break up state monopolies to create more competition. Deregulation. This involved government reducing its control and regulation of private industry, e.g. in bus transport, air travel, parcel delivery, telecommunications, gas and electricity supply. These industries had been protected from competition by government barring new entrants. The aim of deregulation was to open up these markets to greater competition leading to greater cost efficiency and wider choice for consumers. Commitment to free trade. The UK Government has signed up to trade agreements made by the World Trade Organisation (WTO), and the UK is a full member of the European Single Market. Free trade promotes competition. Reduction in corporation tax. High rates of corporation tax reduce incentives to make profit. Lower tax rates encourage firms to invest in capital, so making them more efficient. Strict control of inflation. Inflation creates uncertainty about the profitability of investment and therefore acts as a disincentive to introducing new or replacement capital.
2.2
Supply-side policies for the labour market. A perfect labour market is one that can quickly clear surpluses or shortages. This is called a flexible labour market. An imperfect or inflexible labour market is one where it is slow for the market to adjust, e.g. difficult for employers to shed labour or reduce wage rates at a time of falling demand, or where it is difficult to recruit when demand is rising.
151
THE UK ECONOMY
Supply-side policies are designed to improve the quality and quantity of the labour. An expansion of the labour supply increases the productive potential of the economy. Increased quality will improve the productivity of labour. Trade union reforms Many legal protections enjoyed by the trade unions have been taken away including the right to take industrial action and enter into restrictive practices agreements with employers, e.g. demarcation. The result has been an increase in the flexibility of the labour market, a decrease in strike action and an improvement in industrial relations. Increased spending on education The UK Government has increased spending on education as a percentage of GDP. There has been an expansion in the number of students at university. The aim is a well-educated workforce capable of working in the new highly productive technological or knowledge-based industries. A well-educated workforce also acts as a magnet for foreign investment in the economy. Increased spending on training The New Deal (Welfare to Work) Programme is designed to make the unemployed without skills more employable it consists of a subsidy to employers to recruit and train those unemployed under 25 and the long-term unemployed. Improved incentives to work This can be achieved by the following methods: Reducing income tax. Income tax is paid directly from earned income. Many economists believe that lower rates of tax improve incentives for people to work longer hours or take on more responsibility because they get to keep a higher percentage of the money they earn. In the 1980s the Conservative government cut income tax rates across the board but the biggest reductions were given to higher income groups. The basic rate of tax has come down more gradually from 33% in 1979 to 22% today. Attention has focused in recent years on lower-income households. In the mid-1990s a lower starting rate of tax of 10% was introduced and since then the band of income on which this is paid has widened. This is designed to reduce the unemployment trap where people calculate that they may be better off unemployed than working.
152
THE UK ECONOMY
Adopting a make work pay policy the gap between unemployment benefit and the lowest rates of pay has been allowed to widen by linking unemployment benefit to the rate of inflation rather than to the growth of earnings. (Earnings grow faster than prices.) Eligibility for Job Seekers Allowance has also been tightened up by claimants having to prove that they are actively seeking work. The introduction of the minimum wage has helped to encourage the unemployed into jobs which previously were considered to pay wages not worth working for.
153
THE UK ECONOMY
Policies to Reduce Unemployment: Summary

Possible cause of unemployment Policy Cyclical unemployment Demand-side policies take steps to increase demand in the economy, perhaps by: Fiscal policy lower taxation to increase consumer spending higher government spending. Monetary policy lower interest rates allow/encourage banking system to lend more. Supply-side policies take steps to improve the supply of resources: improve the flexibility of labour reduce direct taxes to improve enterprise and effort control inflation deregulate and privatise. Exchange-rate policy devalue to lower the price of exports. External-trade policy impose restrictions on imports. Frictional unemployment Supply-side policies to improve flexibility of labour. Regional policies to attract inward investment.
Structural/regional unemployment
154
THE UK ECONOMY
Policies to Reduce Inflation: Summary

Possible cause of inflation Demandpull Policy Demand-side policies take steps to reduce demand in the economy, perhaps by: Fiscal policy raising income tax to reduce consumer spending reducing government spending. Monetary policy raising interest rates restricting banks ability to lend. Costpush (wages) Supply-side policies de-regulate labour markets encourage greater productivity in industry. Costpush (import prices) Exchange-rate policy raise the exchange rate by raising interest rates imports become cheaper. Fast growth in money supply Monetary policy raise interest rate to reduce demand for credit reduce bank lending reduce government borrowing. Expectations of inflation Follow strict anti-inflation policies which show governments determination to reduce inflation.
155
THE UK ECONOMY
Policies to Improve Balance of Trade: Summary

Possible cause High demand for imports Policy Demand-side policies Fiscal policy increase income tax to reduce consumer demand. Monetary policy increase interest rates to reduce consumer borrowing restrict bank lending. Exchange-rate policy devalue to make import prices dearer. External-trade policy introduce restrictions on imports. Supply-side policies encourage greater efficiency in domestic industries. Low demand for exports Supply-side policies encourage greater efficiency in exporting industries. External-trade policy subsidise exporters extend soft loans to foreign buyers.
156
THE UK ECONOMY
Economic Growth and Environmental Policy

1 1.1 The meaning of economic growth Economic growth is the rate of growth of a countrys potential output. This can be represented by a shift to the right of the countrys production possibility curve.
Consumer goods
Capital goods
1.2
In theory, economic growth is the growth in potential output, but, in practice, potential growth is impossible to measure, so growth in actual output is the usual measure. Economic growth in the UK is the annual percentage change in real GDP. Causes of economic growth Supply side of the economy Potential growth an increase in the quantity of resources, or an improvement in the quality (productivity) of a countrys resources. Quantity of resources Land usually fixed in quantity but may increase in the long run if new supplies of natural resources are found, e.g. oil in the UK. Labour supply of labour is measured in man hours, so any increase in the numbers of people willing and able to work or in the hours worked will increase the labour supply.
2 2.1
157
THE UK ECONOMY
The workforce may be increased by: an increase in the number of people of working age, e.g. through immigration, an increase in the participation rate (the percentage of the working age group looking for work), e.g. in recent years there has been a large increase in the number of women workers. Capital an increase in investment is usually the most important cause of economic growth. This could be financed by encouraging an increase in savings or by attracting inward investment from overseas. Productivity of resources can be improved by: (a) Moving resources from low-productivity industries to higher-productivity industries. This depends on making resources occupationally and geographically mobile, e.g. a policy of the present UK Government is to encourage the growth of knowledge-based industries. These are industries which use highly educated and skilled workers to produce sophisticated products which cannot be produced by low-wage countries. (b) Improving the quality of resources, e.g. Land drainage, applying fertilisers. Labour education and training, improvements in living and health conditions, improvements in industrial relations between workers and management. Capital research and development into new technologies. (c) Using resources in a more economically efficient way, e.g. specialisation; producing on a large scale to gain economies of scale.
Actual growth Actual growth is determined by two factors: (a) (b) the growth in potential output the growth in aggregate demand.
158
THE UK ECONOMY
4 4.1
Government policy and economic growth There are two possible approaches: (a) Left-wing politicians and economists believe that government should intervene in the economy. The interventionists would have government investing in industries and providing subsidies to private-sector firms to help them to invest. They also believe that government should invest heavily in the infrastructure of the country, e.g. in transport, communication and housing. This would help to increase the potential output of the economy. Government should also where necessary increase aggregate demand in the economy through appropriate fiscal and monetary policies. Right-wing politicians and economists believe that privatesector initiative and enterprise generate growth, and that government should restrict itself to removing as many as possible of the controls and regulations on the private sector in order to allow enterprise to thrive. A key part of the policy is to reduce direct taxes on incomes and profits to encourage enterprise and effort. Strict control of inflation is also necessary to allow industry to compete and thrive in world markets. A boost in supply of goods and services would create its own demand.
(b)
4.2
Present UK Government policy combines parts of these two approaches and its aim is to achieve sustainable economic growth. Sustainable economic growth is growth in demand and output without increasing inflation. Benefits of growth Standards of living improve. (But note that general prosperity will only increase if increased income is shared out among all sections of the population.) Increased productivity may allow more to be produced in less time hours of work may be reduced shorter working weeks; longer holidays. Increased incomes for those in employment yield higher tax revenues for government. More and better public services can be provided.
5 5.1
5.2
5.3
159
THE UK ECONOMY
6 6.1
Costs of growth In the short run, living standards of consumers may fall if resources are switched from making consumer goods to making capital goods. In the long run, economic growth may cause external costs such as: pollution depletion of non-renewable resources increased pressure of industrial and urban life, e.g. crime, stress.
6.2
Britains performance
UK economic growth (annual % change in real GDP)
Since the recession of 1990 to 1992 the UK economy has grown each year. This is the longest period of continuous growth since the 1970s. For most of those years growth has been at or above the long-term trend of 2.5% per annum. Although this is a good performance for the UK, its growth rate is lower than that of other major industrialised nations such as the USA, Germany and France. A notable feature of the UK economy has been the poor performance of the manufacturing sector compared with the service sector.
160
THE UK ECONOMY
7.1
Sources of growth In recent years growth has resulted from both demand and supply factors. On the demand side: Since the late 1990s there has been strong consumer demand: with low unemployment consumer confidence has been high consumers have been able to increase their borrowing using higher house values as collateral interest rates have been low, making borrowing cheap. Low inflation and low interest rates have encouraged firms to increase investment. Since 2001 there has been a significant increase in government spending on health, education and transport. Against this the growing trade deficit has moderated the rise in aggregate demand. On the supply side: The increase in the female participation rate has increased the size of the workforce. The increasing flexibility of the workforce has increased productivity. Higher investment has added to the countrys productive capacity.
161
THE UK ECONOMY
Environmental Policy
1 Environmental problems The impact of economic activities (production and consumption) on the environment has become a matter of great concern in more recent times. Problems include: global warming air pollution water pollution traffic congestion depletion of non-renewable energy resources landfill waste.
Environmental problems are an example of market failure, i.e. they are external costs which are not considered by the producers or consumers who create them. 2 Government policies Governments are taking greater interest in implementing policies that are designed to protect or improve the environment. These policies may be: market based non-market based. 2.1 Market-based policies. Market-based policies are those that aim to influence producers or consumers by the price which they have to pay. They aim to discourage producers or consumers by making them pay for the external costs they create. This is usually done by imposing taxes or imposing charges. This is often called the polluter pays principle. Examples include the landfill tax, climate change levy, car parking charges, congestion charging and taxes on road vehicle fuel. Landfill tax This is a tax for every tonne of waste used for landfill. It is designed to encourage businesses and councils to minimise waste and encourage recycling. Climate change levy The UK Government introduced this energy tax in 2001. The tax is
162
THE UK ECONOMY
paid by companies on the energy they use and is designed to encourage energy efficiency and cut industrial emissions. This tax is designed to help the UK move towards the governments target of a 20% reduction in carbon dioxide emissions between 1990 and 2010. The revenue raised will be recycled to business through a reduction in the rate of employer National Insurance contributions. The background to this tax is the Kyoto Treaty on Global Climate Change, a global treaty to reduce emissions of greenhouse gases which was agreed in Kyoto, Japan. This commits developed countries to make reductions in emissions of carbon dioxide by 2010. The UK is making good progress towards this. Road pricing This involves charging motorists a fee for travelling on a congested road. It is designed to encourage motorists to: substitute their car with a cheaper means of travel which is more environmentally friendly, e.g. public transport conserve fuel, e.g. by cutting out unnecessary journeys. Road pricing has been introduced in London and is being considered by a number of local councils, such as Edinburgh. Petrol tax Rates of duty on diesel and petrol have for a number of years been rising faster than inflation (the fuel tax escalator). This is designed to persuade motorists to use their vehicles less often. VAT on domestic fuel VAT on domestic fuel (now 5%) was introduced in 1993, supposedly to cut fuel consumption.
2.2
Non-market policies. Non-market policies are those which impose direct controls on polluters or which involve government investment with the taxpayer paying the bill. These are financed out of taxation or are self-financing. Direct controls include setting pollution standards and enforcing them, e.g. firms may be fined for discharging pollutants into the atmosphere and water.
163
THE UK ECONOMY
Government investment has included: investing in park-and-ride schemes investing in improved sewage disposal investing in research into renewable forms of energy providing for recycling projects such as bottle banks, waste paper collections, aluminium can collections.
2.3
Other factors. Many firms are becoming environmentally friendly because they have discovered that Green business is good business. A reputation for being environmentally friendly attracts customers. Cutting down on waste, conserving energy and recycling can save money. Pressure groups such as Friends of the Earth and Greenpeace can mobilise consumer opinion against irresponsible companies.
164
THE UK ECONOMY
Market Failure and Government Policies

1 1.1 Introduction You will remember that the main function of markets is to allocate resources efficiently. This includes both technical efficiency and allocative efficiency. Competition in markets encourages firms to keep down their costs by using efficient methods of production. Competition also encourages firms to be enterprising and innovative using resources to make those products most wanted by consumers. Definition Market failure occurs when a market fails to supply the type or quantity of goods or services demanded by consumers. This means that there is economic inefficiency in that market. The main causes of a market failing are when: (a) (b) (c) (d) Competition is restricted. External costs and external benefits are ignored. Public goods cannot be provided. Merit goods are not provided to all consumers who need them.
1.2
1.2
1.3
When a market fails then there is a case for government intervention to make the market work efficiently. Restricted competition Competition encourages producers to increase efficiency. Any restriction of competition by, e.g. monopolies, mergers or restrictive trade practices results in poorer-quality goods limited supplies inefficient use of resources or higher prices.
2 2.1
2.2
Government policy on competition. The aim of competition policy is to encourage competition. This involves taking action to prevent or remove anti-competitive behaviour. The Office of Fair Trading is responsible for investigating breaches of competition
165
THE UK ECONOMY
law and for enforcing the law as set up in the Enterprise Act 2002. It investigates and, if necessary, stops monopolies and mergers, and any practice which restricts trade such as cartels. 2.3 Monopoly investigations. Any firm with a market share of above 25% may be referred to the Competition Commission for investigation if it is suspected of acting against the public interest. Merger investigations. Any takeover or merger, which would result in a combined market share of 25% or if assets exceeded 30 million, may be investigated and disallowed if thought to be against the public interest, e.g. Lloyds TSB was prevented from merging with Abbey National because it would have led to reduced competition in the market for personal and small-business banking services. Restrictive trade practices. Restrictive trade practices aim to control the market in some way. These practices include: Resale price maintenance. This is when suppliers try to force retailers to charge a certain price. This is illegal although it was allowed in the markets for books and non-prescriptive medicines up until recently. Predatory pricing. This is when a supplier charges a very low price in a market to drive out a competitor. Where this has happened the predator has been usually a large company which can afford to subsidise the low price from its other profitable activities. Distributing only to certain retailers, e.g. Tesco recently complained that Levi Strauss refused to supply it with jeans. Cartels. A cartel is an agreement between suppliers to fix prices, share out markets or contracts. All of the above practices, which restrict trade and free competition, are now illegal. 2.5 Monopolies or mergers may be allowed if they are in the public interest. This is when: Competition is maintained. A market, which consists of a smaller number of more equally sized firms, may be more competitive than one which consists of a large firm and a number of small firms. The market may be international so that even if there is only one firm in the UK, it may still face competition from overseas.
2.3
2.4
166
THE UK ECONOMY
The competitive strength of a UK company is increased in overseas markets. The development of new products is more likely. Costs of production are reduced as a result of economies of scale. The interests of consumers are improved, e.g. lower prices, better quality, increased choice, and safer products. 2.6 EU competition law. In addition to UK government legislation, the European Commission may also investigate a proposed merger or takeover which is on a European scale. External costs and benefits In a free market, the costs which a firm takes into account when making decisions are those which it has to pay, i.e. private costs. Similarly a consumer when making decisions about what and how much to buy only considers private benefit, i.e. the benefit (utility) which (s)he receives. However, the production and consumption of a product may have spillover effects on people not directly involved in its production or consumption. These spillover effects are called external costs and benefits. External cost. External costs (or negative externalities as they are sometimes called), are those costs which are not paid for by the producer and are not included in the calculation of the price charged to the consumer. These are incurred by others. Examples: a paper mill does not include in its costs of production the cost of cleaning up a polluted river which has been used for the disposal of its waste; a chip shop does not include in its costs the cost of tidying up discarded wrappers. These costs will be borne by taxpayers for the clean-up or by those who are harmed in some way, e.g. fishermen, local residents. 3.4 Social cost. Social cost is the cost to society of all the resources used as a result of the production and consumption of a product. Social cost = Private cost + External cost
3 3.1
3.2
3.3
167
THE UK ECONOMY
3.5
External benefit. The production and consumption of some products give benefit to some consumers who dont pay for them. Examples: the price paid for a drug to cure an infectious disease reflects the benefit to the patient but there are external benefits to others who will not now catch the disease. The building of a new motorway brings benefit to those who do not directly use it, e.g. those who own motorway cafes.
3.6
Social benefit. Social benefit measures the total benefit obtained from the consumption of a product. Social benefit = Private benefit + External benefit
3.7
Market failure. If producers of a good, e.g. alcohol, do not consider external costs then the output will exceed what it ideally should be, and resources will have been over-allocated to the production of this good. In the diagram below: (a) If a free market exists, the quantity produced will be Y at price Py, i.e. where the demand and supply curves meet. If social costs (including crime, health costs) were taken into account, then the output should be X at price Px, demand would be lower and fewer resources would be used.
(b)
168
THE UK ECONOMY
3.8
If an industry creates external costs, government can intervene by: (a) imposing direct controls on the industry, e.g. limit pub opening hours or limit the number of consumers by age imposing a tax (e.g. in the previous diagram) equal to the external cost. This has the effect of moving the supply curve to the left. Price would rise and the quantity consumed and produced would fall.
(b)
3.9
If producers of a good do not consider external benefits then the output will be less than it ideally should be, e.g. an external benefit of an urban bus service is the reduction of road congestion. The bus operating company will not consider this benefit because it does not receive any money for it. The company may not provide the service or may not provide it so frequently because it is nonprofit making. In the diagram below: (a) if a free market exists, the amount of the good produced will be A at price PA, i.e. where the demand and supply curves meet. if social benefits (including reduced pollution, less congestion) were taken into account, then the output should be B at price PB, demand would be greater and more resources would be allocated to this service.
(b)
169
THE UK ECONOMY
3.10 To encourage the provision of 0B, government could intervene and give a subsidy equal to the external benefit (XZ) to the bus company. Price would fall and consumers would use the service more. 4 Public goods Note that most of what we call public goods are actually services, although you should still call them public goods. 4.1 A public good such as defence or street lighting has three main characteristics: A consumer can consume it without reducing the amount available to others contrast this with a private good like a bag of salt and vinegar crisps. The producer, i.e. the Government, cannot exclude any consumer from consuming the service. Contrast this with a bag of crisps where the producer can exclude you if you dont pay the price. A consumer cannot choose not to consume the service, whereas with a bag of crisps if you dont like them you dont have to buy them. 4.2 Public goods would not be provided in a free market system because there is a free-rider problem, i.e. consumers could consume without paying so producers would not receive sufficient income to cover costs. Government therefore has to provide public goods and raise the required revenue from general taxation. Merit goods Merit goods are so called because they are given to those people who merit (i.e. need) them, either free or at reduced price. Merit goods are goods or services which are socially desirable but which would be under-produced if left to private enterprise. They would only be provided to those who could afford to pay the full economic price.
4.3
5 5.1
170
THE UK ECONOMY
Notice that in contrast to public goods they are: Rival if you are using a hospital bed or university place this prevents someone else from using them. Excludable you can be excluded from using a merit good, e.g. hospital beds or university places are only given to those who merit them. Rejectable in most cases a consumer can decide not to consume the service. 5.2 In a free-market economy there would be wide differences in income and wealth so that citizens on low incomes could not afford certain desirable services. In a mixed economy, government may intervene by providing merit goods such as education and healthcare, and benefits such as unemployment compensation, child benefit, etc. The finance comes out of taxation, much of which bears more heavily on the rich. Many economists and politicians argue that interfering with income distribution does little to improve economic efficiency but they accept the need for it on the grounds of equity, i.e. fairness.
5.3
171
THE UK ECONOMY
Inequalities of Income and Wealth

1 Equity A characteristic of market economies is inequality of income and wealth. Governments intervene to reduce inequalities and this is done to promote equity, i.e. fairness. 2 2.1 Income Income is the amount that people earn in a period of time and includes earnings from investments, from work, and from social benefits. Income is unevenly distributed because of: age and unemployment uneven distribution of skills and talent different education opportunities across families and across the country unequal ownership of wealth. 2.3 Income has become more unevenly distributed since the 1980s. The gap between rich and poor has widened because of: fewer jobs in manufacturing but more in services, many of which are part time and low paid. reduced bargaining power of many workers. an ageing population structure so that there are more retired people on lower incomes. taxation becoming more regressive, which has benefited highincome earners more than low-income earners. social benefits being linked to prices rather than earnings as they were before average earnings have been rising faster than prices. 3 3.1 Wealth Wealth is what people own. It refers to their assets: real, e.g. houses; and financial, e.g. bank accounts and share portfolios. Wealth is unevenly distributed: savings distribution of income affects peoples ability to save inheritance.
2.2
3.2
172
THE UK ECONOMY
4 4.1
Government policies All governments have policies for reducing inequalities, but the debate is usually about the extent of redistribution rather than the principle. For a government wanting to reduce inequality, policies could include: introducing a national minimum wage helping more people into employment providing more job training making income and wealth taxes more progressive reducing tax and national insurance contributions on low incomes restructuring welfare payments to target those in greatest need linking welfare payments to earnings rather than prices providing more merit goods and/or raising the cut-off points for free provision.
4.2
Case against further intervention Higher direct taxation may damage work incentives, job search incentives, saving and risk taking Reduced incentives would lower national income out of which higher social benefits can be paid the trickle-down effect.
173
THE UK ECONOMY
Regional Policy
1 Introduction Differences in prosperity exist between different parts of the country. These disparities are usually due to industrial decline and/ or a failure to attract new industry. In areas of decline there will be a number of economic and social problems, e.g. above-average unemployment, low average income, migration of population. In the UK reference is often made to a northsouth divide which indicates that the south of England is more prosperous than the rest of the country. The south is said to be more attractive to modern manufacturing and service industries. The attractiveness of the south has created problems in the south, e.g. shortages of labour, high house prices, traffic congestion, etc. There has been much debate about how far government should intervene to reduce these inequalities. 1.1 Non-interventionists argue that: Wage rates, if left to free-market forces, will be less in the poorer regions, attracting firms to move there. Prosperous regions will become overcrowded and congested, and high costs will drive firms away. 1.2 Interventionists argue that: Labour is geographically immobile so there is a need for government assistance to encourage new firms to move to less favoured areas. Areas of industrial decline need to be made attractive to new firms by improving their infrastructure, e.g. motorway network, rail, port and air facilities, housing, etc. Labour is occupationally immobile so training is required. 2 2.1 Regional policy Government policies towards helping regions with economic problems have gone through many changes. The present policy aims to: direct resources to the poorest areas make regional aid cost effective.
174
THE UK ECONOMY
2.2
Certain parts of Scotland have been designated Assisted Areas. Assisted Areas fall into two categories: Development Areas Intermediate Areas.
2.3
Firms expanding in Assisted Areas can apply for Regional Selective Assistance (RSA). Under RSA, grants are offered for investment projects which create or safeguard employment. The amount given is the minimum sum necessary to ensure the project goes ahead. In Development Areas, which are areas of greater need, new or expanding small firms are also eligible for Regional Enterprise Grants which cover 15% of investment cost. In 1990, Scottish Enterprise (SE) and Highlands and Islands Enterprise (HIE) were set up to oversee economic development, environmental improvement and training in Scotland. SE and HIE dispense money to Local Enterprise Companies (LECs) and authorise how they spend it. A board made up mainly of privatesector business people who are supposed to be aware of the problems and potential of their local area runs each LEC. The LECs are responsible for designing and delivering projects in their areas and for operating training schemes. Scottish Enterprise is also responsible for the Locate in Scotland Agency whose main task is to market Scotland internationally as a business location and to attract foreign firms to Scotland. European regional policy The European Regional Development Fund provides support to more depressed industrial and rural areas within regions of the EU. In Scotland, the industrial areas of Strathclyde, parts of Fife, Tayside and West Lothian have received help and the rural areas of the Highlands and Islands have been eligible for European assistance. Grant aid was given for tourism and manufacturing investment as well as for major infrastructure projects, such as road building, new harbour facilities, telecommunications, etc. However, with EU enlargement, a number of the much poorer countries from Eastern Europe now have a bigger claim on assistance from the Regional Development Fund.
2.4
2.5
2.6
3 3.1
175
THE UK ECONOMY
The Scottish Economy

1 1.1 Changing pattern and structure in recent years Output. The importance of services and energy has increased at the expense of manufacturing. In common with the rest of the UK economy, manufacturing output has failed to grow because of the declining competitiveness of manufacturing industry. For more detailed reasons, see previous notes. Note that there has been a decline in traditional manufacturing industries such as steel and shipbuilding and also a decline in the numbers employed in modern industries like electronics. Rising real incomes have increased the demand for services, e.g. the growth in output of the hotel and catering industry can be attributed to the increasing number of people who go for meals out, weekend breaks and second holidays; the growth in financial services has arisen from rising incomes and house ownership. Unlike manufacturing, service industries are more insulated from foreign competition. Energy output increased throughout the 1970s and 1980s although it slowed in the late 1980s and 1990s. Output in coal declined markedly while oil and gas production rose, although this has now flattened out. 1.2 Employment Manufacturing employment has fallen. Some industries, e.g. shipbuilding and textiles, have declined and others have become more capital intensive. Employment in the energy sector has fallen mainly in the coal industry. Employment in the service sector has risen because of rising output of service industries and the increasing number of parttime workers. 1.3 Regions Changes in output and employment have been reflected in the regions of Scotland.
176
THE UK ECONOMY
Borders and Lothian regions have increased their share of Scottish GDP. This reflects the importance of service industries in these regions. Grampian has increased its share of GDP as a result of the continued success of oil and gas production. Strathclydes share of GDP has fallen because of its heavy reliance on manufacturing. 2 2.1 Regional differences within Scotland Between the regions of Scotland, inequalities exist in rates of unemployment, GDP per head and average earnings. In Strathclyde and Tayside: There was a high proportion of declining industry, e.g. shipbuilding, textiles, steel and coal. The new expanding industries, which tend to be capital intensive, have not grown sufficiently to absorb the excess labour. Even some of the new manufacturing industries, which developed after the Second World War, have declined. The old urban areas have been less attractive to modern industry. 2.3 In south-west Scotland and in the Highlands and islands: Agriculture, forestry and fishing are the dominant industries demand for labour is low. Tourism is largely a seasonal employer and incomes are low. 2.4 North-east Scotland has prospered with oil and gas related industries. Lothian and Borders have prospered. Edinburgh is the administrative and financial centre of Scotland. Although the electronics industry is widely scattered, the main concentrations are in the Edinburgh and south Fife areas.
2.2
2.5
177
THE UK ECONOMY
3 3.1
Foreign firms in Scotland These have been very important to the Scottish economy. Approximately 10% of manufacturing plants are foreign owned, and 50% of these are American. The proportion of Scots employed in foreign firms is higher than the UK average. Advantages for foreign firms skilled labour force low wage rates relative to some other areas of the EU inside the EU tariff barrier good infrastructure financial inducements from central and local government external economies of scale (particularly for electronics), e.g. a concentration of local suppliers and services.
3.2
3.3
Advantages for Scotland employment incoming firms come with advanced technical and managerial skills existing firms have copied these skills wider choice of products for consumers profitable companies pay good wages and provide good working conditions; local multiplier effects benefit people working in other industries, e.g. local services boost Scottish exports.
3.4
Disadvantages for Scotland Research and development may take place in country of origin. Plant in Scotland may be a screwdriver plant, i.e. only providing low-skilled assembly jobs. Branch factory problem, i.e. multinational may close or reduce size of branch factories more readily in times of recession than Scottish firms. When grants run out there is nothing to tie the firm to Scotland.
178
THE INTERNATIONAL ECONOMY
SECTION 3
Topic 1: International Trade and Payments International Trade

1 Gains from trade International trade occurs when firms in different countries specialise and trade with one another. Two theories help to explain why this trade occurs: Theory of absolute advantage. Theory of comparative advantage. 1.1 Theory of absolute advantage. The theory of absolute advantage states that if two countries are each more efficient in a product than another, then each country should specialise in producing the product they are better at and they should trade. Why do countries have absolute advantages in products? All countries are limited to the amount and type of products they can produce. This is because, e.g.: Some countries have supplies of certain natural resources, while others dont, e.g. UK has oil, Japan doesnt. Some countries have climatic advantages, e.g. Spain can grow oranges, the UK cant. Some countries have workers with skills and know-how. To overcome these problems, countries specialise and trade with each other, exchanging those goods in which they have an absolute advantage. 1.2 Theory of comparative advantage. The theory of comparative advantage states that: Even when a country has an absolute advantage in all products, it will benefit it to specialise in those products in which its advantage is greatest. and
179
Even when a country has an absolute disadvantage in all products it should specialise in the product in which its disadvantage is least. For example, if UK producers are ten times better than Malaysian producers at producing computers and two times better at producing TVs it would be to the advantage of both countries for UK producers to specialise in computers and for Malaysian producers to specialise in TVs. Note that the UK has an absolute advantage in both computers and TVs but a comparative advantage in computers. Comparative advantage means the advantage which a country has in one product compared with its advantage in another. In this example the UKs advantage in computers is greater than its advantage in TVs. Malaysia has an absolute disadvantage in both products but a comparative advantage in TVs, i.e. its disadvantage in TVs is not so bad as its disadvantage in computers. You will find in textbooks that comparative advantage is sometimes measured in opportunity costs. Example Output per week: Computers 100 10 TVs 200 100
UK producer Malaysian producer
The opportunity cost per computer is lower in the UK (2 TVs compared to 10 in Malaysia). The opportunity cost per TV is lower in Malaysia (0.1 computer compared to 0.5 in the UK). The theory states that production should take place in the country where opportunity cost is lower and that the two countries should trade. 1.3 These two theories explain why countries specialise and trade. The gains from international free trade include: efficient use of world resources goods will be produced where it is most efficient to produce them the gains from specialisation and economies of scale, i.e. more efficient use of resources, reduced unit costs, greater output and better quality
180
increased competition for producers leading to increased efficiency increased choice of goods for consumers. lower prices for consumers closer political links between countries, e.g. this is how the EU began. 2 2.1 Trade restrictions Despite the advantages of specialisation and trade, countries may find reasons to impose restrictions on the free movement of goods and services. Those who support trade restriction see it as a way of: protecting employment in industries affected by foreign competition protecting employment in new or infant industries, which have not yet grown to a size big enough to allow them to compete maintaining industries which are considered strategic, e.g. food supplies, defence supplies, energy supplies reducing imports in order to improve a weak balance-ofpayments position retaliating against those countries which protect their industries and markets preventing dumping; dumping is the selling of goods, by foreign producers, at prices below the cost of production; this may be done to gain a foothold in new markets or to get rid of surpluses helping the environment, e.g. banning the import of hardwoods from tropical rain forests; products from rare animals, e.g. rhino horn, furs. protecting consumers from harmful products, e.g. illegal drugs, dangerous animals exerting political pressure, e.g. the UN embargo on Iraq. 2.2 Methods of protection Tariffs taxes on imported goods or services which raise their price and reduce their competitiveness. Quota restrictions on the quantity of an import allowed in. A variation of the quota is voluntary export restraint, i.e. agreement between two countries to limit exports, e.g. until recently Japan had agreed to limit exports of cars and videos to EU countries.
181
Embargoes complete ban on certain goods or imports from certain sources or exports to certain destinations. Subsidies to domestic producers which allow them to compete more strongly in their home and in foreign markets. Soft loans governments may give loans at low rates of interest to foreign buyers or guarantee credit offered by exporters in order to boost exports. Favouring home producers with government contracts even when there are cheaper foreign suppliers. Imposing strict health and safety standards on imported goods. To meet these standards might involve extra cost for the producer, which increases the price. 3 Effects of restrictions Trade restrictions may help an economy in the short run but in the long run they lead to problems: Restricting imports often results in retaliatory action being taken against a countrys exports. Protection reduces competition, which allows inefficiency among domestic producers leading to rising costs and rising prices for consumers. Consumer choice is reduced. The volume of trade is reduced, which leads to unemployment in industries dependent on exporting their output. Political ill-will arises between countries. 4 4.1 Removing trade barriers The EU. There are a number of free-trade areas in the world where barriers to trade are being removed. The most relevant example for us is the European Union (EU) which is now described as a single market. This means that restrictions on the free movement of goods and services between member countries have been removed. The EU has, however, maintained trade restrictions on goods coming from countries outside the EU. But the EU is a member of the World Trade Organisation (WTO) which is in the process of reducing restrictions on trade throughout the world economy. For more detail on the EU see Topic 2 of Unit 3, The International Economy.
182
4.2
World Trade Organisation (WTO). The WTO consists of about 120 countries. The WTO was formed in 1995 and replaced GATT (General Agreement on Tariffs and Trade), but with much stronger powers of enforcement. It exists to negotiate reductions and removal of trade barriers between member countries. A country can complain to the WTO about unfair restrictions taken against it by another country, and if the complaint is justified the WTO can order the offender to change their policy or offer compensation.
183
Balance of Payments Account

1 Introduction A Balance of Payments Account is a statement of the flows of money between the UK and the rest of the world in a year. The government collects the information from businesses which must give details of any trade and financial dealings with people abroad. 1.1 The UK balance of payments account is split into two parts: (a) (b) the current account the capital and financial account
The UK balance of payments for 2003 ( billion) Current account Money in + (exports) Trade in goods Trade in services Goods and services balance Investment income Current transfers Current account balance 126.34 13.16 104.23 23.02 187.85 89.69 Money out (imports) 235.14 75.08 Balance 47.29 14.61 32.68 22.11 9.86 20.43
Capital and financial accounts Money in + (exports) Capital account Financial account Direct investment Portfolio investment Other investment Reserve assets Net errors and omissions Capital and financial account balance 9.77 91.26 253.28 32.05 34.75 271.61 22.28 56.51 18.33 1.56 1.73 22.43 2.72 Money out (imports) 1.48 Balance 1.24
184
2 2.1
The current account The current account records trade in goods, services, investment income and transfers. Earnings are shown with a positive sign. Payments are shown with a negative sign. Formerly a distinction was made between visible trade (exports and imports of goods) and invisible trade (trade in services, investment income and transfers). Textbooks and old statistics still make this distinction. The trade in goods balance is shown as a trade deficit. For years the UK has had a trade deficit. Services include government services, sea transport, civil aviation, travel and financial services. Government services involve earnings and payments for embassies overseas, troops overseas. Sea transport and civil aviation include earnings by British shipping companies and airlines from providing passenger and freight transport for foreigners and payment for the use of foreign-owned ships and airlines by British companies and citizens. Travel covers the earnings from foreign tourists and spending by UK tourists abroad. Financial services are fees and commissions paid to foreign banks and insurance companies or earned by UK banks and insurance companies.
2.2
2.3
2.4
2.5
Investment income consists mainly of interest, profits and dividends. Interest includes payments for loans made by foreign banks to UK firms and earnings from loans given by UK banks. Profits made by foreign-owned companies in the UK are sent back to the home country and profits from UK-owned firms overseas come back to the UK. Dividends are earnings from shares owned overseas and payments to foreign shareholders of companies in the UK.
185
2.6
Current transfers include government transfers and private transfers. Government transfers include grants to developing countries in cash or in kind, e.g. technical assistance, as well as contributions and receipts from the European Union. Private transfers include individual transfers of assets to foreign bank accounts, e.g. immigrants sending money back to relatives in their home country.
2.7
The current balance is the sum of all earnings less payments for goods, services, investment income and transfers. A surplus exists when export earnings are greater than import payments, i.e. when the balance is positive. A deficit exists when import payments exceed export earnings, i.e. when the balance is negative.
186
Sections 3 and 4 are for Higher only

3 3.1 The capital and financial accounts The capital account shows the transfer of ownership of fixed assets. The financial account records both short-term and long-term monetary transactions between the UK and other countries. Financial flows are classified into three main types: (a) (b) (c) 3.3 direct investment portfolio investment other investment.
3.2
Direct investment is investment in land, premises and equipment by UK companies setting up branches overseas and vice versa. When BP invested in a new oilfield in Alaska this counted as an outflow () of money from the UK. When BMW re-equipped its Mini plant in Oxford this counted as an inflow (+). Note that profits from these investments appear in later years in the investment income section of the current account. Portfolio investment is flows of money to buy stocks and shares overseas. Dividends from these appear in later years in the investment income section of the current account. Other investments include UK bank lending overseas; borrowings from overseas banks by UK firms and the UK government. It also includes deposits placed by overseas firms and governments in UK banks and this is very liquid. Investors respond quickly to changes in interest rates and exchange rates and will move these deposits at short notice. For example, if interest rates in the US rise above those in the UK then investors will move their funds out of the UK to the US to take advantage of the better return. This is often referred to as hot money. Reserve assets reserves of foreign currencies are kept and managed by the Bank of England on behalf of the government. They are used to balance the overseas accounts and to deal in the foreign exchange market (although now that the is floating there is little intervention in this market).
3.4
3.5
3.6
187
The balance of payments account must balance. A deficit in the current account has to be financed. This may be covered by a surplus in the capital and financial account. If the capital and financial inflows are insufficient then the Bank of England draws on reserves of foreign currencies to finance it. If, on the other hand, the UK has a surplus of inflows from the current balance and capital flows then the Bank of England adds this surplus to the UKs foreign currency reserves. The UKs foreign currency reserves are held abroad in a variety of liquid financial assets which earn interest. Note Additions to reserves involve money flowing out of the country into accounts overseas, so they carry a negative sign. Drawings on reserves involve money flowing back to the UK, so they carry a positive sign. This is why it can be said that the balance of payments account always balances since the account shows how a net surplus inflow is used or how a deficit is financed. A simple analogy is to think of your income and spending. If you spend more than you receive in a particular week you have to draw on your reserves. If you spend less than you receive you can add to your reserves. If the balance of payments always balances why do we hear in the media of a balance of payments deficit? This is because they are referring to the current account. 4 4.1 Net errors and omissions The balance of payments accounts are made up from many different returns from firms engaged in foreign trade. It is inevitable that there are errors and omissions. The Bank of England knows the total net effect of inflows and outflows. A correcting figure is added to make the accounts balance.
188
Factors which influence the balance of payments
The current account 5.1 Price competitiveness Price competitiveness is important when there are substitutes available in international markets. Price competitiveness is reduced when: Productivity of home producers is less than that of foreign firms. Unit wage costs are higher. The exchange rate of the rises against other currencies. 5.2 Non-price competitiveness The loss of non-price competitiveness is more serious in products which are bought by high-income consumers. Factors which influence a countrys non-price competitiveness include: Quality, reliability, delivery time, after-sales service Marketing Research and development investment in R & D is essential, since an increasing part of world trade is in high-technology products. 5.3 Lack of production capacity Lack of production capacity and skills shortages may give problems if demand rises rapidly.
189
The rest of Section 5 is for Higher only

The capital account 5.4 Direct investment How willing foreign companies are to invest in the UK depends on: long-term prospects for economic growth in the UK; foreign investors need to be confident that the size of the market will justify capital investment in the UK rather than exporting to the UK from existing factories a supply of labour with appropriate skill and wage rates labour relations the level of financial assistance given by government. 5.5 Portfolio investment How willing foreigners are to invest in stocks and shares in the UK depends on: rates of return degree of risk. 5.6 Short-term capital flows (hot money) The extent of short-term investment in banks and institutions depends on: actual or anticipated changes in exchange rates changes in interest rates economic or political events which influence the confidence of overseas investors.
190
Composition of UK trade in goods
Exports 1975: % of total

7% 3% 4%

5% 2% 9% Food, drink and tobacco Raw materials Fuels Manufactured goods
86%
84%
6.1
UK exports. Manufactured goods are the most important category of UK exports but their importance has been declining. A number of reasons can be given for the loss of comparative advantage in a number of manufacturing industries such as steel, textiles, shipbuilding and engineering: other countries have lower labour costs and have found these industries easy to enter over-valued exchange rate under-investment in new equipment poor management outdated designs. The UKs manufacturing base has contracted since 1975 and some industries, such as motorcycles, have disappeared altogether. The importance of fuels increased significantly between 1976 and 1985 due to North Sea oil. Rising production and prices help to explain why fuels accounted for over 20% of exports in 1985. Note, however, that production has fallen back since then. Nevertheless, the UK has comparative advantage in specific knowledge-based industries where unit labour costs are less important in winning sales overseas, e.g. fashion design, electronic equipment, biotechnology.
191
Imports 1975: % of total

18%

8% 3% 5% Food, drink and tobacco Raw materials
8% Fuels 56% 18% 84% Manufactured goods
6.2
UK imports. Manufactured goods are the most important category of imports, and their importance has been increasing. This reflects the loss of competitiveness of UK manufacturing industry. It is said that consumers in the UK have a high propensity to import manufactured goods any increase in income tends to be spent on imported goods. This of course is a result of UK goods being less competitive and attractive than foreign goods, or simply not being available because of deindustrialisation. Geographical pattern of UK trade in goods
European Union Non-EU
The EU is the UKs most important market and its importance has been increasing. This is due to: the UK being a member of the EU its proximity the EU being a high-income market suitable for UKmanufactured goods.
192
The EU is also the UKs most important source of imports. This reflects: the UK being a member of the EU its proximity the fact that the industrialised countries of the EU make the type of goods favoured by UK consumers. 8 Trends in current balance of payments
UK current balance of payments in billion 1997 1998 1999 2000 2001 2002 Trade in goods and services 1 8.5 15.9 19.5 27.6 31.4 Investment income 3.9 2.9 1.1 5.2 10.7 22.3 Transfers 5.9 8.3 7.3 9.7 6.6 8.6 Current balance 0.9 3.9 24.4 24 23.5 17.8
2003 32.4 23.3 9.7 18.7
For the period shown: (a) The trade in goods and services has been nearly always in deficit. this is because of the continual and rising deficit in the trade in goods (trade deficit) from 1996 to 2000 the rose in value against European currencies and stayed high until 2002 prices of exports rose and import prices fell the trade in services is always in surplus this reflects the UKs advantage in this sector particularly in financial services but apart from 1997 was insufficient to cover the trade deficit, (b) Investment income has been growing because of receipts from interest, profits and dividends from large investments made overseas. The trade deficit dominates and is the main reason for the continual deficit in the current balance. However, although the current deficit of 18.7 billion in 2003 is a seemingly massive sum, when measured as a percentage of GDP it comes out at less than 2%!
(c)
(d)
193
9 9.1
The importance of deficits and surpluses Does a current deficit matter? This is a topic for debate amongst economists.
(a)
Competitiveness problem. Some economists argue that a current deficit is not a problem if it can be financed by incoming capital. The UK has a sophisticated capital market attractive to foreign investment. The situation is different in developing countries where they may have difficulty attracting capital investment or borrowing. However, others argue that the current deficits in the UK are caused by trade deficits and this reflects poor competitiveness in manufacturing industry. If this were to continue it could cause problems in the future since the UK economy depends heavily on international trade (exports account for over 20% of GDP, compared to less than 10% in major economies such as Japan and the US). Growth of services. Those who argue that deficits are not a problem also point to the UKs success in trading in services and the large earnings from investment income. However, critics point out that exports of services account for only a third of exports of goods and their continued growth cannot be relied on. Effect on exchange rates. Those concerned about current account deficits also argue that bad trade figures lead to a fall in the value of the which in turn leads to inflation. Those against argue that this used to be the case when the buying and selling of currencies to buy and sell goods was a major part of the dealings on the foreign exchange market but that nowadays the value of the is affected more by buying and selling of currencies for capital movements. Size of the deficit. As you read above those economists not concerned about current deficits point out that although the deficit seems large in money terms it is small in relation to GDP. Present UK Government policy would appear to support the view that in the short term the current account deficit is not much to worry about since it is mostly covered by large capital net inflows. The long-term view is that the UK needs to improve its competitiveness and that this can be achieved by supply-side policies.
(b)
(c)
(d)
194
9.2 (a)
Problems of a current account surplus Effect on trade. Japan is a country which has a continually high current account surplus due to its large trade surplus. This trade surplus arises because Japan has traditionally had a strong protectionist policy limiting imports. This causes problems for those countries trying to export. Effect on the exchange rate. Surpluses lead to a rise in the exchange rate which in turn makes exports dearer and imports cheaper. From a macroeconomic view this is desired since it will self-correct the surplus by lowering the demand for exports and raising the demand for imports. However, at a microeconomic level, individual exporters will be harmed and jobs may be lost.
(b)
Exchange Rates
1 Introduction The exchange rate of a currency is its price in terms of other currencies. It may be expressed as a value against another currency, e.g. 1 = $1.5, or against a basket of currencies, e.g. the sterling tradeweighted index measures the value of the against a weighted average of the currencies of its main trading partners. The second method gives a more realistic picture of the position of sterling. This is because it could be possible for a currency to be stable against one currency, e.g. the against the $, but rising against other currencies, e.g. the and European currencies. 2 2.1 Effects of a rising exchange rate Effects on prices of exports Example A Scotch whisky distiller manufactures luxury malt whisky at a cost plus profit of 10 per bottle (ignore tax). France is an important buyer of whisky. How much the Scottish firm charges for the whisky depends in part on the exchange rate.
195
Assume an exchange rate of 1 = 1.5
Whisky made and sold in Scotland for 10
Sold in France for 15 Revenue when converted = 10
Exchange rate changes to 1 = 2
Sold in France for 20 Revenue when converted = 10
i.e. exporter raises price in euros in order to receive the same revenue in s, or exporter holds price in euros and accepts lower revenue in s
Sold in France for 15 Revenue when converted = 7.50
The exporter could also set the price at somewhere between 15 and 20, i.e. raise price but receive less revenue in s. What strategy an exporter adopts depends on market conditions. If the exporter is confident that the market can bear an increase in price then price will be raised; but if the market is highly competitive then he may have to settle for holding the price and accepting less revenue. In general, exporters are likely to have to raise prices in foreign markets. This will reduce their competitiveness and may have harmful consequences on demand for their products and on employment.
196
2.2
Effects on prices of imports Example A French wine company manufactures wine at a cost-plus profit of 9 per bottle (ignore tax). Assume an exchange rate of 1 = 1.5 Wine made and sold in France for 9
Sold in Scotland for 6 Revenue when converted = 9 Exchange rate changes to 1= 2 Sold in Scotland for 4.50
Revenue when converted = 9
Wine made and sold in France for 9
i.e. import falls in price. The French exporter also has the option of holding the price at 6 and receiving more revenue 12. What happens depends on demand conditions in the UK wine market. In general when the rises in value, the prices of imports fall. This in turn has implications for inflation in the UK since the prices of finished products will fall as will the cost of imported materials, which will reduce costs for UK manufacturers. 2.3 Effects on balance of trade. The balance of trade compares earnings from exports of goods with payments for imports. If exporters raise their prices then this is likely to lead to a drop in demand. However what happens to export earnings depends on elasticity of demand. If demand for UK exports is inelastic then earnings will rise. On the other hand, if demand is elastic then earnings will fall. If imports fall in price and UK demand is inelastic then total payments for imports will fall. If, however, demand is elastic then payments will rise.
197
A combination of elastic demand for exports and elastic demand for imports would worsen the balance of trade. Export earnings would fall and import payments would rise. The position for the UK is that demand for imports and exports tend to be inelastic in the short term so that a rise in the exchange rate improves the balance of trade but that in the longer term when buyers have time to adjust their demands then the balance of trade is likely to worsen. Note. You should also be able to explain the effects on prices of exports and imports, employment and the balance of trade if the were to fall in value, i.e. the usual effects are a rise in the price of imports and fall in export prices. 3 3.1 How are exchange rates determined? An exchange rate is determined on the foreign exchange market by demand and supply forces. The demand for sterling is determined by three major factors: the demand from foreigners who wish to buy British goods and services the demand from foreign companies wishing to invest in the UK the demand from speculators, foreign companies and governments wishing to hold surplus funds in sterling. 3.3 The supply of sterling is determined by: the supply of s from UK firms converting into foreign currencies in order to buy foreign goods and services the supply of s from UK firms converting into foreign currencies to invest overseas the supply of s from speculators and companies wishing to hold surplus funds in foreign currencies.
3.2
198
The notes on pages 199 to 205 are for Higher only

4 4.1 Floating exchange rates With floating exchange rates there is a free market, with no government intervention and the exchange rate is allowed to find its equilibrium level. The demand curve is downward sloping because if the falls in value, UK exports become cheaper in foreign currency terms. As they become cheaper the demand for exports rises and so does the demand for s to pay for them.
4.2
Exchange rate of the
4.3
The supply curve is upward sloping because a fall in the increases the price of imports. The demand for imports, therefore, falls, so that fewer s come onto the exchange market to be exchanged into foreign currencies. The exchange rate will alter if there is a change in either demand or supply of sterling. For example, the demand for sterling will increase if: UK exports UK interest There is an There is an become more attractive to foreign buyers. rates rise and attract more hot money into the UK. inflow of funds for long-term investment. increase in speculative activity in favour of the .
4.4
199
The demand curve for sterling would then shift to the right and the exchange rate would rise as shown below.
Exchange rate of the
4.5
In the short term, speculative activity tends to be the dominant influence on the day-to-day changes in an exchange rate. In the long term the value of the is determined more by economic fundamentals such as the competitiveness of UK goods. Advantage of floating exchange rate. An imbalance in the balance of payments is automatically corrected and there is no need for government to introduce policies to control demand. Example If inflation in the UK is higher than in other countries, then UKproduced goods will be less competitive. Exports will be relatively dearer and imports relatively cheaper. The demand for exports will fall and demand for imports will rise. The balance of trade deficit will worsen. Demand for sterling to buy exports will fall and the supply of sterling needed to buy foreign currency to pay for imports will rise. The sterling exchange rate will fall. The fall in value of the will then lead to an increase in the price of imports and a fall in the price of exports, thus restoring UK manufacturer competitiveness.
4.6
4.7
200
4.8
Disadvantages of floating exchange rates Speculators are attracted to any market where prices move freely and where it is possible to make profits by guessing future prices correctly. Speculators may destabilise the exchange market. Uncertainty about future exchange rates, and profitability, may inhibit firms from engaging in foreign trade. This has a negative effect on output and jobs. Inflation results from a sharply falling exchange rate. Imported raw materials rise in price and increase production costs. Dearer imports of manufactured goods trigger wage demands.
5 5.1
Fixed exchange rate Governments in the past have fixed their exchange rate, e.g. from 1949 to 1967 the was fixed at 1 = $2.80. The government had to maintain this rate by intervening in the foreign exchange market. When there was downward pressure on the in the foreign exchange market, the government would buy sterling using reserves of foreign currency and when there was upward pressure, the Government would sell s and buy foreign currencies. Managed exchange rate (dirty float) From 1967 to 1992, the was in various managed floating systems. This meant that the was allowed to float within specified limits but when it approached either its upper or lower limit, the Government would intervene. The most famous managed exchange rate system was the Exchange Rate Mechanism (ERM). The Exchange Rate Mechanism (ERM) was an agreement among EU countries to promote stability between their exchange rates. The ERM was set up in 1979 and ended when 11 of the 15 countries joined the single currency on 1 January 1999. Britain was a member of the ERM from 1990 to 1992. Each country had a central parity rate for its currency, e.g. for the UK it was 1 = DM 2.95. The exchange rate of a member country was allowed to fluctuate around the central rate by plus or minus 2.25% (6% for the UK). Currencies were kept within limits by intervention. If a countrys currency strayed too much from its central parity then: its central bank (e.g. the Bank of England in the case of the UK) would intervene, sometimes with the help of other central
6 6.1
6.2
201
banks, to buy its currency in order to push its value up, or sell to push its value down. If this did not work, then interest rates could be changed raised to attract hot money; or lowered to make short-term investment less attractive. If intervention failed to work, then as a last resort currencies in the ERM could be re-aligned, i.e. the central parity rate was reset. 6.3 Advantages of ERM membership Exchange rates were stable so that traders were more certain of future exchange rates. This promoted more international trade. Lower interest rates were possible because holders of currency, e.g. those with short-term investments (hot money) were more certain of future values. It imposed a discipline on industry and government to keep inflation in line with the lowest rates of inflation in the EU. You will remember from above that if a countrys inflation rate is higher and its exchange rate is fixed then its goods become less competitive. 6.4 Britain left the ERM in September 1992 when the crashed through the floor of its parity rate and when the government decided that it could not support it. Since leaving the ERM, sterling has been allowed to float freely. Until 1996 the floated down (e.g. it devalued by 24% against the mark between 1992 and 1995) helping UK manufacturers become more competitive. From 1996 the rose considerably in value against European currencies. Although of benefit to tourists going to Europe this severely harmed the competitiveness of some of the UKs manufacturing firms. However, since 2002 the has again fallen against the euro. On 1 January 1999 11 of the 15 EU countries joined the single currency and fixed their exchange rates with each other in preparation for full monetary union in 2002 when they adopted the euro and their individual currencies ceased. Britain, Sweden and Denmark decided not to join at that time. For more detail on this, see Topic 2, The International Economic Environment.
6.5
6.6
202
Balance of payments deficits: policies

1 Financing a temporary deficit A temporary deficit in the balance of payments need not be a serious problem if it has been caused by unusual imports such as North Sea oil installations or by growth in industry attracting imports of raw materials and machinery. 1.1 A temporary deficit is financed by the Government: drawing on its reserves of foreign currency. The Bank of England draws on deposits made overseas or it sells some of the more liquid foreign currency assets. If the deficit is large or more persistent then the Government may finance it by: borrowing from the International Monetary Fund (IMF), or by borrowing from the central banks of the G7 countries. The group of seven (G7) richest nations have agreed to swap currencies in order to support each other when in temporary balance-of-payment difficulties. increasing interest rates to attract short-term investment (hot money) to the UK and to discourage money from leaving the UK. 1.2 There is a limit to drawings on reserves, borrowing or trying to attract hot money. When it becomes obvious that there is a more deep-seated problem, then the Government must apply other policies. Policies for persistent deficits Deficits which persist are a problem for the economy because a deficit reduces aggregate demand. (Remember: Exports less imports (X M) is a component of aggregate demand.) An increased demand for imports and reduced demand for exports will result in falling UK output and rising unemployment.
203
2.1
Medium-term policies. In the medium term there are three possible policies: reducing aggregate demand devaluation imposing trade restrictions. Reduce aggregate demand Government could use fiscal or monetary policies to reduce the demand for imports. The disadvantage of such a policy is that it may lead to an increase in unemployment since these policies may also reduce the demand for home-produced goods. Devaluation By allowing or encouraging the to fall in value, the desired result is a rise in import prices and a fall in export prices. There may be problems with this policy, e.g.: Producers may choose not to alter prices. If import prices rise there may be inflationary effects since raw material prices may rise, adding to the cost of finished goods, and rising prices of imported finished goods feed directly into the RPI. The balance of payments is affected by the total payments for imports and the total earnings from exports. The effects on these values depend on the reactions of buyers to the changes in prices, i.e. it depends on the price elasticities of demand for imports and exports. If demand for imports is inelastic then a rise in their price will increase the import bill. If the demand for exports is also inelastic then a fall in their price will reduce export earnings. This policy of devaluation will not be available to the UK if it joins the euro. Impose trade restrictions The aim is to reduce imports. This policy may not be possible if a country has free-trade agreements with other countries, e.g. the UK with the rest of the EU. There is also the danger of retaliation. Note that present UK Government policy does not include any of these medium-term policies.
204
Long-term policies A long-term deficit can only be reduced by a country improving its competitiveness. This can be achieved by: reducing the rate of inflation below the inflation rates of major competitors increasing productivity developing new products by investing in research and development improving marketing, delivery times and after-sales service. Government can play a part in this, e.g. anti-inflation policy and supply-side policies such as education and training, and helping to fund research and development. Note that this is the present UK Government policy to improving the balance of payments position.
205
Topic 2: The International Economic Environment The European Union: Main Economic Features
1 Introduction The EU is one of a number of international economic associations of countries. Formed by 6 countries in 1957 it now consists of 25 countries. The EU has a common market or, as it is now called, the Single European Market. 2 Europe: the single market The European Community has created a single market. This single market has three key features: (a) A free trade area which allows free movement of goods and services. This has involved: removing all restrictions on imports such as tariffs and quotas between member states agreeing a common set of product, health and safety standards. (b) A customs union has been established. This means that a common external tariff has been agreed, i.e. all members charge the same tariffs on goods imported from countries outside the EU. A single factor market. There is now free movement of resources such as capital and labour between member countries, e.g. a UK citizen has the right to work in any country in the EU and vice versa.
(c)
Advantages of the single market (a) (b) The removal of trade barriers has created more trade. Economies of scale have been gained and resources have been used more efficiently as the size of the market has increased, e.g. British firms now have access to over 500 million people in Europe compared with 60 million in the UK.
206
(c)
Competition has increased. Resources have been used more efficiently as firms have been encouraged to innovate and reduce costs. Mobility of resources has been allowed so that labour and capital are free to move to where they may be most efficiently employed.
(d)
Disadvantages of the single market (a) The common external tariff has diverted trade, e.g. before entry to the EU, Britain had low tariffs on imported foodstuffs and it bought from the lowest-cost producers, e.g. New Zealand and the USA. After entry the UK had to impose the common external tariff which then made it cheaper to buy food from the EU countries although these are higher-cost producers. The British consumer has, therefore, had to pay more for food. Firms have transferred to the prosperous geographical centre of Europe where transport costs are lower and where rewards are higher. This has widened the disparities between the richer regions and the poorer regions on the fringe of Europe, e.g. the Highlands and islands of Scotland, and southern Italy although the Common Agricultural Policy (CAP) and Regional Fund exist to assist such areas.
(b)
Remaining problems Complete harmonisation has not yet been achieved in the single market. Differences remain in VAT. There are wide variations in VAT rates and in coverage which distort prices, e.g. the UK has zero rating of books, childrens clothes and food, and a reduced rate of 5% on domestic fuel. excise duties which distort shopping patterns and affect producers, e.g. tax differences on alcohol and tobacco encourage UK shoppers to buy these products in France. taxes on company profits. The low rate of corporation tax in the UK has been successful in attracting inward investment from the USA, Asia and from other EU countries.
207
income tax. Again the low rates in the UK relative to other EU countries may distort the labour market. the adoption of a single currency and full monetary union. Three of the 15 members at 2005 had yet to join. The UK Government has resisted tax harmonisation and has adopted a wait and see strategy towards joining the single currency.
The Social Chapter

1 Introduction The Maastricht Treaty of 1992 included a Social Chapter, which is an agreement between member states to introduce a common social policy. The UK Conservative Government opted out of the Social Chapter because they believed that it would impose extra costs and regulations on business that would harm UK competitiveness with the rest of the world. However, the Labour Government elected in 1997 has opted in, which means that the UK must apply EU law in a number of areas including: 2 the the the the Works Council Directive Working Time Directive Directive on Part-time Workers and Parental Leave Directive.
The Works Council Directive This directive gives workers in a multinational company the right to a works council. This will allow consultation between staff and management about major changes in business strategy such as shifting production from one country to another and large-scale redundancies.
Working Time Directive This directive gives workers the right to: a maximum working week of 48 hours at least 1 day off per week 4 weeks annual holiday
208
a rest period of 11 consecutive hours in any day a maximum working day of 8 hours for night workers. Workers are free to opt out of these rules. 4 Part-time Workers Directive This directive gives part-time and casual workers the same rights as full-time workers in areas such as training and holidays. 5 Parental Leave Directive This directive allows fathers and mothers three months unpaid leave after the birth or adoption of a child.
Economic and monetary union (Single currency)

1 1.1 Introduction To achieve a complete single market, the EU is moving towards Economic and Monetary Union (EMU). An economic union is where barriers to the movement of products and resources are removed, and the economic policies of member governments are converged. Monetary union aims to achieve a common currency and a common monetary policy. There are two main aspects to EMU: (a) By 2002, a common currency, the euro, was used for everyday transactions by those countries that had joined the monetary union. A European central bank has been set up and it is responsible for: issuing euros conducting monetary policy on behalf of the central banks of member countries, e.g. setting a Europe-wide interest rate acting as lender of last resort to all European banks
1.2
1.3
1.4
(b)
209
managing the exchange rate of the euro against other currencies. 1.5 To join the monetary union members had to achieve convergence of their economic policies and economic performance (a) (b) (c) (d) by by by by matching achieving matching matching their inflation rates stable exchange rates interest rates budget deficits.
Eleven countries more or less achieved these targets and formed a euro zone in late 1998. Greece joined later but Britain, Sweden and Denmark have decided not to join (yet!). 2 2.1 Advantages of EMU A single currency eliminates the need for euro-zone firms to convert currencies when they trade with each other. This will reduce their transaction costs, i.e. the costs of buying and selling currencies. A single currency eliminates the problem of fluctuating exchange rates between euro-zone currencies and this will reduce uncertainty for firms. Firms costs and revenues will be measured in the same currency. When revenues are in a different currency from costs a firm faces an exchange-rate risk, e.g. between agreeing the price for a contract, receiving payment and converting the currency, the exchange rate may have shifted to such an extent that the profit on the contract turns into a loss. Reducing this uncertainty should increase trade. There will be greater price transparency. Consumers will be able to make direct comparisons of prices for the same products in different countries and put pressure on manufacturers who charge different prices for the same product in different markets, e.g. cars. A single currency will force governments and firms to control inflation. Devaluation will not be available as a means of improving competitiveness.
2.2
2.3
2.4
210
2.5
The European Central Bank (ECB) will be independent of political control. This could be a major factor in the control of inflation. When central banks were under government control there was often strong pressure before an election to create a boom in the economy and governments were tempted to order their central bank to reduce interest rates. Disadvantages of EMU A single currency removes the advantage of floating exchange rates. If the UK has a trade deficit with the euro-zone then with a flexible exchange rate the would fall against the euro. The weaker pound would make British goods cheaper for foreign consumers and would make euro-zone goods dearer for British consumers. This would help to restore the balance. Governments lose the ability to control their monetary policy. The European Central Bank sets a common interest rate throughout the euro-zone. This can create difficulty in an economy which is out of step with others, e.g. the ECB may lower the rate of interest if most of the EU countries are in recession. If, however, one or more country is in a boom period with rising inflationary pressures then a cut in the rate of interest will make their inflation problem worse. Firms incurred high costs in having to change their price lists, tills, vending machines, computer and accounting systems. A key issue for the UK will be the exchange rate at which it joins the euro. If the country joins at too high a rate (as happened when the UK joined the ERM) then this will damage the competitiveness of UK industry. Britains position The UK did not join in the first wave because the Government felt that the UK economy had not sufficiently converged with the others. It met the targets for inflation, budget deficit and national debt but interest rates were higher than in the euro-zone. The UK was at a different point in the business cycle. Interest rates were high in the UK to dampen down demand whereas the euro-zone was in recession. If the UK had joined interest rates would have been cut to euro-zone level and this would have allowed inflation to increase in the UK.
3 3.1
3.2
3.3
3.4
4 4.1
211
4.2
The UK Labour Government intends to adopt the euro but it is waiting until five economic tests have been met. The chancellor will decide when these have been met, and then the Government is committed to holding a national referendum. The five economic tests are: (a) Convergence of the economic cycles between Britain and the countries of the euro-zone. The Government also wants to see convergence in the housing mortgage market so that more UK mortgages are on a fixed-interest basis. At the moment the UK has a higher percentage of mortgages on variable interest rates than in the euro-zone where more mortgages are at fixed interest. This makes UK households more sensitive to interest-rate changes. Sufficient flexibility in the new system to cope with economic change. Because the UK will lose the flexibility of a floating to correct trade deficits, the Government wants to see other flexibilities develop such as more flexibility of production costs and prices. For example, if demand for UK goods were to fall, suppliers should be able to react by reducing costs and prices. Favourable effect on investment. Benefits for Britains financial services industry. The euro must be good for UK employment.
(b)
(c) (d) (e)
Common Agricultural Policy

1 1.1 Background The Common Agricultural Policy (CAP) is the policy of the European Union that is applied to all farmers in the EU. Its original aims were to: increase farmers productivity ensure a fair standard of living for farmers stabilise markets guarantee reasonable prices for consumers.
212
1.3
How it worked A guaranteed price, called the intervention price, was set for different farm products. If the free-market price was below the intervention price then the EU bought and stored any surplus output. The original idea was to release these surpluses on the market in years of shortage. But these rarely happened. If farmers could export their surplus then they received a subsidy equal to the difference between the world price and the intervention price. This allowed them to sell their product at the world price. EU farmers were also protected from outside competition by tariffs on imported farm products.
Intervention price
World price
Quantity per year
1.4
Benefits prevented food shortages reduced price fluctuation stabilised farm incomes.
1.5
Problems Intervention prices were set above free-market prices this encouraged overproduction of many products, e.g. cereals, milk products, beef, wine, olive oil. European taxpayers had to pay for the buying and storing of the surpluses. Prices to consumers were high compared with world prices.
213
Import tariffs and export subsidies distorted world markets and are particularly harmful to developing countries (again, European taxpayers had to pay for the subsidies). Harmful impact on the environment. Guarantees to buy surpluses encouraged farmers to produce more and more. In turn, this encouraged them to use intensive production by increased use of fertiliser and pesticides, drainage of wetlands, ploughing up of grassland. This was harmful to the environment and to animal habitats. It also promoted more factory farming of animals which harmed animal welfare. 2 1992 reforms The high cost of the CAP (accounting for 75% of the total EU budget), vast overproduction and high prices prompted reform. These reforms started cuts in the guaranteed prices and introduced the set-aside scheme, i.e. farmers were paid to leave some of their land fallow. It also introduced an early retirement scheme to encourage farmers to leave the industry. 3 2003 reforms In the late 1990s pressure for further change came from two sources. (a) (b) The WTO wanted the EU to remove subsidies and tariffs. The impending entry of ten new members to the EU in 2004 meant that the existing subsidy system would be unaffordable.
So EU ministers agreed to: Freeze the CAP budget. Decouple subsidies from production, i.e. farmers will continue to get some income support but this is to be related to the size of their farm not to their production. The subsidies are to be conditional on farmers improving animal welfare; looking after the countryside, e.g. planting trees and hedgerows; or diversifying into non-farming activities, e.g. creating tourist activities such as golf courses, fishing lakes and providing accommodation. Farmers now have to plan what to produce on the basis of market prices, rather than on which crop gives the biggest subsidy.
214
Benefits should include: lower prices for the consumer reduced production and removal of surpluses more environmentally friendly farming methods.
EU enlargement
In May 2004 ten more countries joined the EU. Eight of these Latvia, Lithuania, Estonia, Poland, Hungary, Slovakia, the Czech Republic and Slovenia are former communist countries. The other two are Malta and Cyprus. 1 Conditions of admission In order to join, applicants had to show: a commitment to democracy a commitment to the mixed economy a willingness to accept all EU standards, rules and regulations. 2 Benefits The main benefits for new entrants relate to trade and investment. New entrants gained funds from the EU to help them prepare for entry. They will be part of a huge single market they will have access to a wider market with no trade barriers. An increase in FDI (Foreign Direct Investment) as western capital will be attracted by the lower costs in the new entrant countries. EU consumers may benefit from the cheaper output. For existing members, EU enlargement means: increased political stability an even larger market with no trade barriers allowing greater specialisation and economies of scale.
215
Costs New entrants have much lower national income per capita and have large agricultural sectors, so: There is increased demand for help from the CAP and Regional and Structural Funds. These budgets are now more strictly controlled so that areas of the old EU which previously received help now get less, e.g. the Highlands and Islands of Scotland. Wealthier members of the EU are concerned that firms will relocate to the cheaper east. Wealthier members are also concerned, because of the freedom of movement of labour allowed in the EU, about a sudden influx of cheap labour from Eastern Europe. However, governments have been able to impose temporary controls for a few years to restrict this type of immigration.
Funding the EU budget

1 Sources of finance There are four main sources of finance for the EU budget: (a) (b) (c) (d) a VAT-based contribution each member state has to contribute 1% of its VAT receipts a percentage of members GNP (1.2%) receipts from agricultural tariffs which are charged on certain foodstuffs customs duties on imports from non-EU countries members have to give over their receipts from the common external tariff.
Since the mid-1980s, the UK has received a rebate on its contributions. It was agreed that the UK was paying more than its fair share because its relatively more efficient agricultural sector received less in subsidies than other members.
216
Budget reform Pressure has been building for the need to reform EU finances because: Germany, the Netherlands, Austria and Sweden have complained that their contributions are excessive. These four countries have said that the UK no longer needs a budget rebate. If the EU is enlarged to include poorer countries of Eastern Europe, more finance will be needed to help them modernise.
Developing and Newly Industrialised Countries

1 Introduction Economically, the world can be divided into groups of countries: First world a small group of rich industrialised countries, e.g. in Western Europe, North America, Australasia and Japan. Second world (not so rich as first world) former communist countries of Eastern Europe, e.g. Russia, Poland, Hungary. Third world a large group of poor countries in Asia, Africa and Latin America. These are also called developing countries or sometimes less developed countries (LDCs). Even within this group there are wide variations in prosperity, e.g. the newly industrialised countries of Hong Kong, Malaysia, Thailand, Taiwan, Singapore, and South Korea the so-called Asian tigers have achieved rapid rates of economic growth in recent years and have closed the gap in living standards between themselves and the developed world. 2 Characteristics of developing countries The characteristics of developing countries are different from each other but they do face some common problems. 2.1 The root of the problem. The production possibilities of an economy depend on: the quantity of its resources (land, labour, capital and enterprise), and the quality or efficiency of these resources.
217
Developing countries lack resources, particularly of capital, which has driven the economic growth of the developed world. Labour is not highly productive because of malnutrition, poor health and limited education. Land is often infertile due to climatic factors and past over-farming. 2.2 Characteristics Poverty. Three-quarters of the worlds population have incomes which are considerably lower than those in the first world. However, even within developing countries there are also wide differences in income and wealth. Even the poorest countries have a rich elite. High population growth. Birth rates and death rates are higher than in the developed world but death rates are falling with improvements in disease control and public health, such as clean water and improved sanitation. Agricultural dominance. About 70% of the population live off the land. Agriculture is largely at subsistence level backward and threatened by natural disasters such as drought and manmade disasters such as civil wars. Manufacturing, therefore, contributes very little to GNP. Unemployment and underemployment. In the countryside there is underemployment caused by the seasonal nature of traditional farming outside the growing season there is little to do. In urban areas there is high unemployment, but higher wages in the towns attract people in from the country in the hope of gaining a job. Lack of industrial capital and hence of a lack of investment in factories, offices and machinery. Lack of infrastructure. There is a shortage of social capital facilities like ports, roads, railways, electricity, schools, sewage disposal, etc., which are vital to economic development. High dependence on one or two exports. These are usually primary products such as food or raw materials. 3 3.1 Domestic constraints on economic growth Problems with investment. Growth depends on investment in capital. However, this raises a cruel dilemma because investment diverts resources away from the production of basic goods and services. In the short run, developing countries have to worsen their standard of living in order to improve it in the long run. Investment has to be financed. This finance may come from saving,
218
taxation or borrowing from abroad in the form of aid or commercial investment. In most developing countries the level of saving is low because people cannot afford to save. Banking systems are not sufficiently developed to gather and channel savings to potential investors. Tax revenues are low because incomes are low. Aid and foreign investment is insufficient. Inefficiency. Industry is inefficient because of the lack of investment in industrial capital and infrastructure. The quality of the labour force suffers from underinvestment in human capital, i.e. in healthcare, education and training. Population growth. The rapid rates of population growth tend to cancel out the abilities of these economies to increase their output. This results in a lower output and income per head of population. Migration to urban areas. The movement of underemployed workers from rural areas to urban areas, i.e. from farming to more productive manufacturing industry, is essential for development. However, in many countries migration has been so rapid that the urban labour supply has grown faster than job opportunities. This has increased unemployment, and overcrowding has added to pollution and congestion. Social and cultural factors. In some countries, people are attached to a traditional way of life and are unwilling to change. 4 4.1 External constraints on economic growth Falling export earnings. Developing countries typically depend on the exports of one or two primary products to earn foreign currency which they need to pay for imports of food, fuel, machinery and to repay debt. World production of agricultural products has expanded rapidly in recent years, forcing prices down. Demand for such products tends to be price inelastic so that exporters have suffered falling revenues. Demand also tends to be income inelastic, so although the developed world has experienced rising incomes, demand for agricultural products has not risen substantially. Trade barriers. Trade problems have been made worse by some developed countries erecting protectionist barriers against food products, e.g. the EUs Common Agricultural Policy, and imposing controls on manufactured goods such as textiles which they claim are unfairly produced by cheap labour.
4.2
219
4.3
Multinational company activity Multinationals bring benefits to developing countries (see notes in Unit 1, Microeconomics, Topic 3, Supply). However, they also create problems. Multinationals have great power and may use the resources of a country to produce a product that is in their companys interest rather than in the interest of the producer country. Methods of production have at times created great environmental damage. Profits are returned to shareholders in the home country of the company and not spent in the producer country. Tax may be avoided by a process known as transfer pricing, thus reducing the revenues of the host government.
4.4
Debt crisis In the 1970s the price of oil increased sharply and non-oil producing developing countries had to borrow heavily from overseas banks to pay the increased bills. The major oil-producing countries such as Saudi Arabia and Kuwait invested their increased revenues in foreign banks. These banks in turn needed to lend out these funds to make a profit, and developing countries were targeted. The 1980s were a disaster for the third world. Falling export earnings and rising interest rates reduced their ability to repay their debts. Particularly affected were Mexico and Brazil. African countries suffered too, e.g. Uganda spends more on debt repayment and interest charges than on education and health combined. So third-world countries had four options: Borrow more to finance their debt repayment, thus storing up more problems for the future. This has resulted in some countries now paying out more than they receive. Default on their debts and risk not getting future loans. Reduce imports by imposing tight fiscal and monetary policies in order to reduce demand. Appeal to the IMF for help. The IMF supplied funds and renegotiated the terms of debt repayment with the creditor countries but in return insisted on the tight fiscal and monetary policies referred to above. These policies often harm the poorest citizens of the debtor countries and have led to social unrest, e.g. in Indonesia.
220
Different countries have used all four options but each has had the effect of restraining economic growth. 5 Development strategies Strategies which can be used to improve economic development vary according to the individual circumstances of the country concerned. Those which are appropriate for one country may be inappropriate for another. Policies should aim to improve the demand side, e.g. increasing the demand for third-world exports and the supply side, i.e. increasing the quantity of resources, particularly capital, and improving the quality of resources. Strategies are now aimed at sustainable development, i.e. development that brings lasting gains in employment and living standards, reduces poverty and does not damage the environment. 5.1 Strategies include: Increasing productivity in agriculture. This has the effect of increasing food supplies and raising incomes in the rural economy, which in turn reduces the need for imports and creates a market for industrial goods. Encouraging an increase in savings. Funds are then available for investment. This has been successful in the Asian tiger economies. For poorer nations, aid from the developed world is needed for initial projects. The nature of this aid has changed in recent years. Early aid was aimed at capital-intensive projects such as steel plants and chemical works but now it is targeted at labour-intensive projects which make use of intermediate technology that is cheap, easy to maintain, simple to use and environmentally friendly. Export-led growth. This requires switching from low-earning primary commodities to industrial products in which the country has a comparative advantage. In the early stages of development these will rely on labour-intensive, low-technology methods. This was successful in the newly industrialised countries of Latin America and Asia. Cheap imports of textiles, shoes, televisions, toys and others created some problems in developed countries and protectionist measures were adopted. However, the World Trade Organisation has been successful in starting to have these reduced.
221
Investing in infrastructure. In the richer developing nations, e.g. the tiger economies, as incomes have increased governments have used increased tax revenues to invest in roads, ports, research, education and training, etc. In poorer countries, there is an ongoing need for aid from the developed world. This aid has been targeted towards low-cost housing, water supplies and sanitation, primary schools and preventative healthcare which is cheaper than curative medicine. Population policy. Some developing countries have initiated campaigns to limit family size and provide cheap birth-control facilities. 6 6.1 Aid from the developed world Motives for giving aid (a) (b) (c) humanitarian political both communist and non-communist gave aid to countries to win political friends economic if the developing world becomes more productive and prosperous they will be able to contribute more to the world economy and provide markets for other countries.
6.2
Types of aid (a) (b) Gifts of foodstuffs for humanitarian reasons. Grants and loans. Grants dont have to be paid back and have no conditions on how they are spent. However, because of corruption, developed nations are reluctant to give this type of aid. Loans may be at commercial rates of interest or they may be soft, i.e. at rates below commercial rates. Writing off debt. A recent initiative has seen the US and British governments write off the debts of certain countries on condition that the money saved is used for the relief of poverty. Tied aid. Grants or loans may be tied to the purchase of equipment from the donor country. Technical assistance and education. Technical experts may give technical advice and wealthier nations provide facilities
(c)
(d)
(e)
222
and finance for overseas students to attend universities and colleges. (f) Bilateral and multilateral. Bilateral aid is given by one country to another. Multilateral aid is given by the main international agencies, the World Bank and the IMF, which are in turn given the funds by member countries.
6.3
Disadvantages of aid (a) Aid may not reach those most in need. It may be diverted into military investment or into prestige projects which benefit those already well off. Donors may finance capital expenditure on a project such as new roads, but fail to support current expenditure such as repairs and maintenance. Tied aid may force a developing country into buying equipment, etc. from the donor when it may have been cheaper to borrow and look for a cheaper supplier. Aid can lead to dependency on rich countries and can reduce the poorer countrys incentive to grow from its own resources. Food aid can destroy local agriculture by driving down prices.
(b)
(c)
(d)
(e)
7 7.1
Newly industrialised countries (NICs) A number of countries previously categorised as LDCs have developed their economies and have become important players in the global economy. These include Taiwan, South Korea, Singapore, Hong Kong, Mexico and Brazil. They have characteristics which separate them from other LDCs: large increases in growth rates rapid development of manufacturing industry rising exports rising standards of living.
223
7.2
Reasons for rapid development: High rate of capital investment financed by a high rate of consumer saving and from growing export sales. Much of the new investment has been in knowledge-based, highvalue-added industries. Large investment in education and training has improved the quality of the labour force. Movement of labour from low-productivity industries, e.g. agriculture, into high-productivity industries.
International Trading and Monetary Organisations

1 The World Trade Organisation (WTO) The WTO consists of about 120 countries. The WTO was formed in 1995 and replaced the General Agreement on Tariffs and Trade (GATT), but with much stronger powers of enforcement. It exists to negotiate reductions and removal of trade barriers between member countries. A country can complain to the WTO about unfair restrictions taken against it by another country and if the complaint is justified the WTO will enforce the offender to change their policy or offer compensation. 2 The International Monetary Fund (IMF) The IMF was set up in 1947 to promote world recovery after the Second World War. It has continued to this day and now has over 160 member countries. It acts as an international bank which aims to: encourage the growth of world trade provide conditional financial support to member countries with balance of payments difficulties help members facing currency collapses with large-scale loans offer assistance on matters of economic policy. In recent times it has given substantial help to Russia and to several Asian countries such as Indonesia and South Korea. The IMF has been criticised for propping up inefficient, mainly third-world economies by giving loans at less than commercial rates, but on the other hand it has tried more recently to give
224
loans conditional on governments imposing tight economic controls on their expenditure. 3 The World Bank (International Bank for Reconstruction and Development: IBRD) The World Bank was set up at the same time as the IMF. While the main aim of the IMF is to help countries with short-term difficulties in their balance of payments, that of the World Bank is to provide long-term assistance for development. It is now the worlds largest source of multilateral aid. Member countries contribute funds in proportion to their national income and loans are made chiefly to developing countries at low rates of interest. At first loans were given for infrastructure projects, but more recently they have been targeted at projects that relieve poverty in the longer term, such as healthcare and education.
225

Economicsint2h tcm4-193222

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Economicsint2h tcm4-193222

Uploaded by

Copyright:

Available Formats

Economics

Microeconomics, The UK Economy and The International Economy

Learning and Teaching Scotland

85 104 122 143

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

Methods of teaching and learning

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

Unit 1: Microeconomics Topic 1 The Basic Economic Problem

For Intermediate 2 and Higher, you should be able to:

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

Unit 1: Microeconomics Topic 2 Demand

For Intermediate 2 and Higher, you should be able to:

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

Unit 1: Microeconomics Topic 3 Supply

For Intermediate 2 and Higher, you should be able to:

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

Unit 1: Microeconomics Topic 3 Supply Cost, Revenue and Profit

For Intermediate 2 and Higher, you should be able to:

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

Unit 1: Microeconomics Topic 3 Supply Cost, Revenue and Profit (contd.)

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

Unit 1: Microeconomics Topic 4 The Operation of Markets

For Intermediate 2 and Higher, you should be able to:

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

Unit 1: Microeconomics Topic 5 Types of Market

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland

STUDENT INDUCTION PACK

Unit 2: The UK Economy Topic 1 National Income

For Intermediate 2 and Higher, you should be able to:

INTERMEDIATE 2/HIGHER ECONOMICS

Learning and Teaching Scotland