1

IGCSE Economics

Opportunity cost and the basic economic problem

Definition
Opportunity cost: the cost of any activity measured in terms of the value of the next best
alternative forgone (that is not chosen)
Production: the act of creating output, a good or service which has value contributes to
the utility of others
Producer: people who make and sell goods/services
Consumption: The final purchase of goods and services by individuals
Consumer: Individuals who purchase the good/services to satisfy their wants and needs
Consumption Expenditure : Spending of consumers
Exchange: A marketplace in which securities, commodities, derivatives and other financial
instruments are traded
Trade: An economic activity that involves multiple parties participating in the voluntary
negotiation and then the exchange of one's goods and services for desired goods
and services that someone else possesses.
Entreprenuers: individuals who, rather than working as an employee, runs a small business
and assumes all the risk and reward of a given business venture, idea,
goods,
or service offered for sale.
Human resources: the company department charged with finding, screening, recruiting
and training job applicants, as well as administering employeebenefit programs. Also known as Labor.
Natural resources: resources occurring in nature that can be used to create wealth
Also known as Land. Examples include, seas and rivers.
Factors of Production;
Definition : inputs that are used in the production of goods or services in the attempt to
make an economic profit. The factors of production include land, labor, capital
and entrepreneurship.
Factors
1. Land
Land refers to the resources available including the seas nad rivers, forests and deserts
all manner of minerals from the ground; chemicals from the air and earths crust.
2. Labor

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Labor refers to the physical and mental effort produced by people to make
goods/services. The size and ability of a economys labor force are very important in
determining the quantity and quality of the goods/services produced. The greater the
number of workers the better educated and skilled they are, the more an economy can
produce.
3. Enterprise
Enterprise refers to the ability to run a production process, employ and organize
resources in a firm (an organization that owns a factory or a number of factories and
even shops, where goods/services are produced).
4. Capital
Capital refers to already-produced durable goods that are used in production of goods
or services. It is not wanted for itself but for its ability to help in producing other goods.
It is also known as man-made resources.
Division of labor/Specialization
Definition: A system whereby workers concentrate on performing a few tasks (instead of
finishing the entire product by themselves) and then exchange their production for
other goods/services
Advantages
1. More goods/services can be produced
When workers become specialists in the jobs they do, repetition of the same operation
increases the skill and speed of the worker and as a result more is produced.
2. Full use is made of everyones abilities
With the division of labor there is greater chance that people will be able to do those
things at which they are best and which interest them the most.
3. Time is saved
Time is wasted when a worker has to switch from one task to another. Time can also be
saved when training people. It would take many years to train someone to be able to
build a car, for example, but a person can be trained quickly to fulfill one operation in
the production process.
4. It allows the use of machinery
As labor is divided up into specialist tasks, it becomes worthwhile to use machinery
which allows a further saving in time and effort. For example, cars are painted by
machines instead of by hand. This, in turn, allows machinery to take over peoples jobs
leaving many unemployed.
Disadvantages
1. Work may become boring
A worker who performs the same operation every day is likely to be unsatisfied/low
morale. To combat this, many firms play music to their labor forces, or allow them to

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have a rest during part of each hour. Longer rest hours and annual holidays may also be
introduced although this will shorten the working week.
2. People become too dependent on each other
Specialisation and divisiol of labour means that people come to rely on others for the
provision of goods/services. For example, people who produce food rely on the provision
of tractors, fertilizers, etc.
3. Workers may feel alienated
Workers may feel unimportant because they can no longer see the final result of their
efforts. Some firms are trying to reverse this by introducing workers to a greater variety
of tasks
4. Standardization of goods
Goods produced under a system of specialization are usually turned out in vast numbers
and share the same design. Whether this is a disadvantage depends on peoples
opinion. For example, there is probably variation in the color and design in clothes to
please most people. However, it is not possible to please everyone because in most
factories it would be difficult and expensive to change the production process to suit
one persons wants since most factories practice mass production in order to produce
the greatest number of goods in the lowest cost possible.
What is economics?
Economics is the social science that analyzes the production, distribution, and consumption of
goods and services. It studies how individuals, governments, firms and nations make choices
on allocating scarce resources to satisfy their unlimited wants. Economics can generally be
broken down into: macroeconomics, which concentrates on the behavior of the aggregate
economy; and microeconomics, which focuses on individual consumers.

Market Systems
Definition:
Market: One of many varieties of systems, institutions, procedures, social relations and
infrastructures whereby parties engage in exchange. It consists of all those people
or firms who wish to exchange a given good or service.
Market system: Any systematic process enabling many market players to bid and helping
bidders and sellers interact and make deals. It is not just the price
mechanism but the entire system of regulation, qualification, credentials,
reputations and clearing that surrounds that mechanism and makes it
operate in a social context.
Price mechanism: Refers to the consumers and producers who negotiate prices of goods or
services depending on demand and supply. This is also known as market
forces.

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Types of market systems

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Market
system
Definition

Advantages

Disadvantag

Free economy

Mixed economy

Planned economy

An economy in which
decisions regarding
investment, production
and distribution are
based on supply and
demand and the prices
of goods and services
are determined in a
free price system.
Capital return.
Capital flows to
where it will get the
greatest return,
expanding the total
size of the economy
to its maximum
level.
Supply and
Demand. Supply
and demand are
closely linked:
Someone who has a
good idea or
product can quickly
put it into the
market so that it is
available to those
who want it.
Conversely, when a
certain type of
product is desired
by enough people, it
is a simple matter
for someone to
provide it.
Economic
freedom. In a
market economy, it
is easier for
someone with
initiative and virtue
to create a better
life for themself and
their family;
economic freedom
makes it eaiser to
transform hard work
and perseverance
into material wealth.
Unequal wealth

An economic system in
which both the state and
private sector direct the
economy, reflecting
characteristics of both
market economies and
planned economies.

An economic system in
which decisions regarding
production and
investment are embodied
in a plan formulated by a
central authority, usually
by a government agency.

Provides fair
competition. The
presence of private
enterprise ensures that
there is fair competition
in the market, and the
quality of products and
services are not
compromised.
Well regulated.
Market prices are well
regulated. The
government with its
regulatory bodies
ensure that the market
price do not go beyond
its actual price.
Efficient use of
resources. Optimum
utilization of national
resources. In a mixed
economy, the resources
are utilized efficiently
as both government
and private enterprises
are utilizing them.
It does not allow
monopoly at all.
Barring a few sectors, a
mixed economy does
not allow any monopoly
as both government
and private enterprises
enter every sector for
business.

Inefficient. It's

Stability. Long-term
infrastructure
investment can be
made without fear of
a market downturn
leading to
abandonment of a
project.
Meeting collective
objectives. Planned
economies may be
intended to serve
collective rather than
individual needs. The
government can
harness FOP to serve
the economic
objectives of the
state.
Advantages over
free economy. It is
not subject to major
pitfalls of market
economies and
marked-oriented
mixed economies. A
planned economy
does not suffer from
business cycles, does
not experience crises
of overproduction. It
does not result in
asset bubbles
massive
misallocations of
resources.

Inefficient resource

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es

Examples

distribution. a
small percentage of
society has the
wealth while the
majority lives in
poverty.
No economic
stability. greed and
overproduction
cause the economy
to have wild swings
ranging from times
of robust growth to
cataclysmic
recessions.
Too competitive. A
competitive
environment creates
an atmosphere of
survival of the
fittest. This causes
many businesses to
disregard the safety
of the general public
to increase the
bottom line.

USA, Japan, Brazil

efficiency property
reduces in
progressively higher
degree, the more its
mixed nature embraces
more and more of
government / state
intervention and State
planning and reduces
the reliance on
competitive market
economy management
mechanisms.
Less reliance on
competition.Mixed
economy system has a
natural tendency to
move further and
further away from
reliance on competitive
market mechanism to
greater and greater
bureacratic controls and
interventions.
Encourage state
monopolies. Mixed
economy systems tend
to encourage more
state monopolies,
higher and higher tax to
GDP ratio and dominant
public finances, making
the government a large
economic player as
compared to corporate
or individual entities.
Canada, Germany, UK

distribution.
Planners cannot
detect consumer
preferences,
shortages, and
surpluses with
sufficient accuracy
and therefore cannot
efficiently co-ordinate
production.
Suppression of
economic
democracy and selfmanagement.
Without economic
democracy there can
be troubles with the
flow of knowledge as
is shown with the
initiative for backyard
furnaces and other
efforts in the Great
Leap Forward.

China, Cuba, North Korea

The ownership of the factors of production controls:

What is produced
Where to produce
How to produce the method of production (labour intensive/ capital intensive)
How much goods and services to produce
Economic sectors
Primary: The extraction of natural resources e.g. oil drilling, quarrying, forestry
Secondary: The manufacturing of goods using natural or man-made resources e.g. car
assembling,
property construction, toy manufacturing

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Tertiary: The provision of services to consumers or producers e.g. education, accounting,
marketing
Quaternary: The provision of R&D, software development and information processing e.g.
research
into fiber optics, development of search engines.
Production Productivity & Wealth
Definition

Creation

Productivity: A measure of the efficiency of production. It is the amount of output that can be
produced from a given amount of resources
Labor productivity: the amount of goods and services that a worker produces in a given
amount of
time
Production Possibility Frontier: A graph that compares the production rates of two
commodities
that use the same fixed total of the factors of production.
Profit = Revenue Cost ( Productivity ( CELL; FOP) Cost)
Productivity
Labor productivity = Output No. of workers
o E.g. Firm A: 10 units of labor & 20 units of output
Firm B: 20 units of labor & 60 units of output
Ways to increase productivity may mean:
Using same number of Factors of Production to produce more output
Using less Factors of Production to produce same amount of output.
What is increased productivity = lower business cost
Increased productivity means greater wealth for owners of firms and the economy
(in general) PPF shift outwards (economic growth)

How

to

improve

productivity of land

Increased use of fertilizers Fertilizers allow previously barren land to produce crops,
and
fertile lands to improve higher yields
Improved drainage Reduces soil erosion and assists in the reduction of phosphorus in
streams.
It allows crops such as hay, corn and soybeans to produce
higher yields.
Improved irrigation In dry areas, improved irrigation will allow plants to receive more
water and produce a higher yield.
Increased use of machinery Machinery such as tractors help take in the yields much
more
quickly.
Introduced genetically-modified high-yield crops Genetically-modified crops produce
higher yield as they can be altered to
fight against pests, herbicides, cold,
disease or drought.
Build multi-functioned buildings (e.g. skyscrapers) - By building multi-functioned
buildings,
land can be allocated more
efficiently as
buildings such as
skyscrapers can
accommodate a wide range
of business
activities

How to improve productivity of labour

Implement division of labor Division of labor allows production to be more efficient.

Increase use of machinery (to aid tasks) Machinery allows the increase of
production as
well as the quality of the finished
product to be
better.

Specialization There is a higher output. Total output of goods and services is raised
and
quality can be improved. A higher output at lower costs means more
wants
and needs might be satisfied with a given amount of scarce
resources.

Skill training Skills training increase productivity. In addition to learning how to

complete
new tasks and take on more responsibility, employees can learn
advanced
techniques to help those complete everyday tasks more efficiently.
Also, it
improves job satisfaction of the employee. Investing time and
money in

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employees skills make them feel valued and appreciated, and it
challenges
those to learn more and get more involved in their jobs. Higher job
satisfaction ultimately results in reduced turnover and higher
productivity.

Motivate workers with financial incentives (pay raises, profit sharing), increase job
satisfaction (better working environment)

Nationalization
Definition: The process of taking an industry or assets into government ownership by a
national
government or state. It usually refers to private assets, but may also mean
assets
owned by lower levels of government, such as municipalities, being transferred
to the
public sector to be operated and by the state.
Advantages
The ability of the state to direct investment in key industries
The distribution of state profits from nationalized industries for the overall national good
The ability to direct producers to social rather than market goals
Greater control of the industries by and for the workers
The benefits and burdens of publicly funded research and development are extended to
the wider populace
Disadvantages
Costly management. The management of the nationalized industry is complicated
and unwieldy. There are numerous departments and paid persons i.e. directorate,
regional office conduct its management.
Lack of decision making. All the necessary matters are decided by various official
and committees. In case of conflicting views, quick decision cannot be made for the
urgent matters which are dangerous in business.
Lack of efficiency. Nationalized industries are managed by salaried persons who are
generally found less efficient as compared with privately owned concerns. There is also
lack of flexibility and adaptability which are asset of private ownership.
Bureaucracy. There is extensive and rigid procedure of the state machinery by which
event is dealt. Such stipulated rules has made the process of work very complicated
which results in delay and loss of initiative.
Absence of profit motive. The salaried persons are not concerned with profit.
Therefore, nationalized undertaking hardly run successfully due to lack of personal
interest
Chances of loss. The loss of the nationalized enterprises is regarded as the loss of the
nation. So the structure of nationalized economy will greatly affected by the failure of
such scheme.
Limited investment. Investors hesitate to invest large sum of money due to risk of
nationalization. Therefore the volume of investment remains limited in private sector.

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Privatization
Definition: The incidence or process of transferring ownership of a business, enterprise,
agency, public
service property from the public sector (the state or government) to the private
sector
(businesses that operate for a private profit) or to private non-profit
organizations.
Advantages
Increased efficiency. Private companies and firms have a greater incentive to produce
more goods and services for the sake of reaching a customer base and hence increasing
profits. A public organization would not be as productive due to the lack of financing
allocated by the entire government's budget that must consider other areas of the
economy.
Specialization. A private business has the ability to focus all relevant human and
financial resources onto specific functions. A state-owned firm does not have the
necessary resources to specialize its goods and services as a result of the general
products provided to the greatest number of people in the population.
Improvements. Conversely, the government may put off improvements due to political
sensitivity and special interestseven in cases of companies that are run well and
better serve their customers' needs.
Capital. Privately held companies can sometimes more easily raise investment capital
in the financial markets. While interest rates for private companies are often higher
than for government debt, this can serve as a useful constraint to promote efficient
investments by private companies, instead of cross-subsidizing them with the overall
credit-risk of the country. Investment decisions are then governed by market interest
rates. State-owned industries have to compete with demands from other government
departments and special interests. In either case, for smaller markets, political risk may
add substantially to the cost of capital.
Disadvantages
Job Loss. Due to the additional financial burden placed on privatized companies to
succeed without any government help, unlike the public companies, jobs could be lost
to keep more money in the company.
Natural monopolies. Privatization will not result in true competition if a natural
monopoly exists.
Profit. Private companies do not have any goal other than to maximize profits. A
private company will serve the needs of those who are most willing (and able) to pay,
as opposed to the needs of the majority.
Goals. The government may seek to use state companies as instruments to further
social goals for the benefit of the nation as a whole.

Demand theory
Definitions
Demand: The ability and willingness to pay a price to purchase a good/service

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Quantity demanded: The total amount of goods or services that are demanded at any given
point in time.
Ceteris Paribus: The relationship between both the price and the quantity demanded of an
ordinary good.
Effective demand: the demand for a product or service which occurs when purchasers are
constrained in a different market
Notional demand: The demand that occurs when purchasers are not constrained in any
other
market
Individual demand: The ability and willingness of a consumer to purchase a good/service
Derived demand: Demand for one good or service occurs as a result of the demand for
another
intermediate/final good or service
Types of income

Real. Income of an individual or group after taking into consideration the effects of
inflation on purchasing power.

Disposable. Amount of money that households have available for spending and saving
after income taxes have been accounted for. Disposable personal income is often
monitored as one of the many key economic indicators used to gauge the overall state
of the economy.

Discretionary. Amount of an individual's income that is left for spending, investing or

saving after taxes and personal necessities (such as food, shelter, and clothing) have
been paid. Discretionary income includes money spent on luxury items, vacations and
non-essential goods and services.

Factors that affect the demand for goods/services

Good's own price. The basic demand relationship is between potential prices of a
good and the quantities that would be purchased at those prices. Generally the
relationship is negative meaning that an increase in price will induce a decrease in the
quantity demanded. This negative relationship is embodied in the downward slope of
the consumer demand curve. In other words, the lower the price, the higher demand,
ceteris paribus

Price of related goods. The principal related goods are complements and substitutes.
A complement is a good that is used with the primary good. Examples include hotdogs
and mustard, beer and pretzels, automobiles and gasoline. If the price of the
complement goes up, the quantity demanded of the other good goes down. The other
main category of related goods is substitutes. Substitutes are goods that can be used in
place of the primary good. If the price of the substitute goes down, the demand for the
good in question goes down.

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Personal Disposable Income. In most cases, the more disposable income (income
after tax and receipt of benefits) you have the more likely you buy. Any changes in the
level of income tax rates and allowances are therefore likely to result in a change in the
quantity of goods/services demanded. In a normal good, demand for a product tends
to rise as incomes rise. If the demand tends to fall as incomes rise the product is said
to be an inferior good.

Tastes, preference or habits. The greater the desire to own a good the more likely
you is to buy the good. There is a basic distinction between desire and demand. Desire
is a measure of the willingness to buy a good based on its intrinsic qualities. Demand is
the willingness and ability to put one's desires into effect. It is assumed that tastes and
preferences are relatively constant. For example, if consumers around the world are
demanding good/services that are environmentally-friendly, the derived demand for
those goods/services will increase. Advertising also plays a part. Persuasive and
informative advertising tends to increase brand awareness and as a result, increase the
demand for the good/service.

Consumer expectations about future prices and income. If a consumer believes

that the price of the good will be higher in the future he is more likely to purchase the
good now. If the consumer expects that her income will be higher in the future the
consumer may buy the good now. In other words positive expectations about future
income may encourage present consumption.

Seasonal demand. A hot summer can boost sales of cold drinks and ices while a cold
winter can boost the demand for fuel for heating.

Higher interest rates can increase the demand for savings schemes but reduce the
amount of money people want to borrow, including mortgages for house purchases.

Population change. An increase in population tends to increase the demand for many
goods and services in a country. For example, in a country where there is an aging
population, demand for walking sticks and retirement homes may increase.

Location of consumers. There is unequal distribution of income and wealth in

different areas of the country. In a richer area of the country, the demand for superior
goods will be higher in an area of low income.

Price Elasticity of Demand

Definition:

PED. A measure used to show the responsiveness, or elasticity, of the quantity

demanded of a good or service to a change in its price. The elasticity of the

demand
curve will also affect the amount of revenue as the price changes

Formula
PED = % change in Quantity Demanded
% change in Price

PED = (New QD Old QD) x100

,
(New P Old P) x 100

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Inelastic : The PED value is between 0 and -1. It tends to have few substitutes, is necessities,
and/or can be
addictive, e.g., alcohol, cigarettes, or petrol.
Elastic
: The PED value is between -1 and -. It has a lot of substitutes and may be an
inferior good.
Revenue
Definition:Revenue is the amount received by the producer from the sale of the goods or
service. It is calculated by the multiplying the price charged by the quantity sold (R = P x Q).
The only difference between revenue and profit is the costs
Price elasticity of Supply
Definition:
PES: A measure used to show the responsiveness, or elasticity, of the quantity supplied of a
good
or service to a change in its price. The PES is always a positive number
Formula
PED = % change in Quantity Supplied
% change in Price

PED = (New QS Old QS) x100

,
(New P Old P) x 100

Inelastic : The PED value is between 0 and 1. It tends to have few substitutes and takes time
to alter the
quantity of production.
Elastic

: The PED value is between 1 and .

Note: The amount supplied is not always equal to supply and may create shortages
and surplus.
Economies of scale
Definition:
Economies of scale:

The cost advantages that an enterprise obtains due to expansion.

Diseconomies of scale:

The forces that cause larger firms and governments to

produce goods and services at increased per-unit costs.

Advantages of large-scale production

Internal

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Lower average unit costs. Scale of production because of a change in the way a firm
is run. For example, larger firms can afford more effective advertising. They can spread
the cost of advertising over a larger number of products.

Efficiency. For example companies can shut down small firms and open one large firm
and paying fewer managers to run it. Another is technological economies, meaning
that larger firms can buy more efficient and larger machinery and equipment, leading to
lower average unit costs

Research and Development. Firms can afford to spend large amounts on research
and development

Purchasing. They can afford to buy materials in bulk and therefore the unit costs are
cheaper as they may be given discounts for buying in large quantities.

External
`
Geographical advantage. An area has an excellent reputation for producing a
particular good/service or a pool of skilled labour may develop in an area where many
firms are concentrated. This helps reduce training costs and probably makes
recruitment easier.

Risk-bearing economies. When borrowing from a large loan, the company can use
assets from profitable firms are collaterals and spread the risk of the loan over several
firms.

Firms may cooperate with each other.

Similar and related firms. There may be firms in the area in related industries with
similar expertise and knowledge.

Disadvantages of large-scale production

Managerial deos. Breakdown of communication as firms get too large. This can lead
to a delay in making decisions.

Labor deos. Decrease in staff morale as it is difficult to retain close personal contact
with staff because of the size of the organization

Jobs may be broken down into specialist parts and the workers may find their jobs too
repetitive and boring.

Advantages of small firms

Flexibility. Small firms can adapt readily to consumer needs, designing products to
meet individual requirements, whilst some products cannot be mass produced.

Industrial relations. The boss of the small firms tends to have a wide general
knowledge of the performance of their employees, and may have a friendly relationship.
This could increase morale and motivation. There is also less chance of poor
productivity as there are less people in small firms.

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Customer relations. Likewise, small firms are more likely to know their customers and
to be able to offer personalized services to their customers. Personal attention is more
feasible in small businesses, such as private music/sports tuition.

Local monopoly. Some firms supply only to a small market, and specialist businesses
are not interested in these markets.

Public and Merit Goods

In a mixed economy the government exists alongside the free market to provide certain goods
and services. These tend to be public goods and merit goods because a free market would
either fail to provide them or not provide them in sufficient quantities.
Public Goods
These are things like street lighting, coast guard, police, fire brigade, and the army. It is clear
that people want streets to be lit and to be kept safe from attack so why doesnt the market
react and satisfy these wants? Why do you believe that private firms would be reluctant to
provide these? They have two distinctive features: They are non-rivalry, meaning that
anyone can use it, and they are non-excludable, meaning that they cant stop people from
using it and it is difficult to prevent free riders.

Merit Goods
Merit goods are not provided enough by the private sectors because it is not
profitable. They are things like healthcare, education, libraries, sports centers, country parks,
public housing, and public hospitals. Public housing and hospitals are public because the
people who use these facilities have no or low income to afford it. Again, people want to be
kept well and want to be educated. The market can provide these goods; ESF is a private
education provider whilst in the USA healthcare is almost exclusively carried out by the private
sector. Why then in many countries do governments step in and provide healthcare?
Trade Unions
Definitions
Trade Unions:An organization of workers that have banded together to achieve common
goals, promote and protect the interests of their member.
Collective bargaining: a process of negotiations between employers and a group of
employees
aimed at reaching agreements that regulate working conditions and
pay.
Open shop : A firm that can employ unionized and non-unionized labour
Closed shop : All workers in a place of work have to be union members. The closed shop is
outlawed in some countries because it gave unions too much power to dictate
who a firm could employ

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Shop Steward: One of the firms employees who is granted time off, during working hours,
to deal with trade union matters. In some larger companies, a shop steward
may be employed full-time on industrial relations. His or her

Wage Councils: These organisations set minimum wages (not National) for their relevant
industries. Wage councils have declined dramatically in numbers since 1979.
Employment Laws: Laws passed by the government or the European Union that set out rules
of
behaviour for workers, employers and trade unions with regard to employment
Single union agreement: An agreement between an employer and a union such that the
union will
represent all the workers at a particular workplace. This means that one
union can represent all the workers, whatever their occupation, in the
same workplace.
Industrial relations: The relationships between employees and employers
Trade Unions Past and Present The change of trade unions
Since their establishment, the membership and influence of trade unions continued to grow
until the early 1980s. The Conservative government at that time responded to public anger
over strikes by introducing laws that restricted the unions activities. In addition, rising
unemployment and the decline in the manufacturing industries (that formed the traditional
base of the unions) have reduced union membership.
The increase in part-time jobs and the increased number of women working have also had an
impact on union membership. In the past, neither of these groups have been strong
supporters of trade unions. In addition, the 1980s and 1990s have seen a dramatic increase in
the number of self-employed people - who are not usually unionized.
In response, unions have tried to improve their image by making their services more
appealing and relevant to todays world - e.g. the ATL union (Association of Teachers and
Lecturers) has a no strike policy. Many unions now offer their members loans, mortgages,
insurance, credit cards, discount holiday vouchers and discount car hire.
Today, some trade unions also provide grants for college courses, or arrange retraining
programmes (the process of developing new skills), for their members who have been made
redundant.
In addition, they also provide representatives for members in cases of
redundancy, grievance, disciplinary hearings and legal action (e.g. on equal pay).
Trade Union Membership Around the World
According to the International Labour Organisation, only 25% of the worlds 1.3bn workers
were members of trade unions in November 1997. However, since the ILO also concluded that
trade unions are adjusting to the realities of today, it is likely that trade union membership will
increase over the next ten years.
In a recent ILO survey of 92 countries, only 14 had a unionised workforce of over 50% (and 48
countries had less than 20%). Results of selected countries are shown below
Trade Union Density in selected countries (ILO):

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Country
Sweden
Italy
South Africa
Australia
UK
Germany
New Zealand
Japan
USA
South Korea
France

1995 density
91.1
44.4
40.9
35.2
32.9
28.9
24.3
24.0
14.2
12.7
9.1

% change
since 1985
+8.7
-7.4
+130.8
-29.6
-27.7
-17.6
-55.1
-16.7
-21.1
+2.4
-37.2

Source: adapted from ILO Labour Report 1997

Types of Trade Unions
Although the number of trade unions and the number of members in unions have declined
steadily since 1979, we can still distinguish between four different types of trade unions:
1.
Craft Unions
These are the oldest type of unions, which were formed originally to organize workers
according to their particular skill. For example, engineers and printers formed their own
respective unions. Today, the GPMU (Graphical, Paper and Media Union) has members
working in the printing, paper, publishing and media industries. The decline in the demand for
some particular crafts has led to many of the older unions to recruit semi-skilled and unskilled
workers.
2.
Industrial Unions
These unions attempt to organise all workers in their industry, irrespective of their skills or the
type of work done. The National Union of Mineworkers (NUM) is an example. National
Union of Teachers (NUT), Trade Union Congress (TUC)
3.
General Unions
These unions are usually prepared to accept anyone into membership - regardless of the place
they work, the nature of work, or industrial qualifications. These unions have a very large
membership of unskilled workers. The TGWU (Transport and General Workers Union) is a
very large General Union in the UK. Their members include drivers, warehouse workers, hotel
employees and shop workers.
4.
White Collar Unions
Also called non-manual unions and professional associations, these recruit professional,
administrative and clerical staff (salaried workers) and other non-manual workers. They are
very strong in teaching, banking, the civil service and local government.
The Role/Functions/Aims of Trade Unions
The primary role of Trade Unions is to protect the workers interests. Examples include:

18

Collective pay bargaining trade unions are able to operate openly and are
recognized by employers, they may negotiate with employers over wages and working
conditions.

Subscription Early trade unions, like Friendly Societies, often provided a range of
benefits to insure members against unemployment, ill health, old age and funeral
expenses. In many developed countries, these functions have been assumed by the
state; however, the provision of professional training, legal advice, support for members
that are mad redundant and representation for members is still an important benefit of
trade union membership.

Political activity Trade unions may promote legislation favorable to the interests of
their members or workers as a whole. To this end they may pursue campaigns,
undertake lobbying, or financially support individual candidates or parties (such as the
Labour Party in Britain) for public office.

Industrial action Trade unions may enforce strikes or resistance to lockouts in

furtherance of particular goals.

Aims of the Trade Union

Defending their employee rights and jobs
Securing improvements in their working condictions, including hours of work and health
and safety of work
Improving their pay and other benefits, including holiday entitlements
Improving sick pay pensions and industrial injury benefits
Encouraging firms to increase worker participation in business decision making
Developing and protecting the skills of Union members.
Aims of the workers:
Workers will aim to maximize:

Higher Wages matching inflation (index-link salaries to CPI)

Job security no sacking without notice or reasons

Working conditions - Health & Safety; working hours

Career progression opportunities: Training and up-to-date information

Health and Safety at work

Perks, Health insurance, pensions, car, education allowance

Aims of the employers

For the employer, targets to maximise may include:

19

Profits

Sales

Lower costs

Industrial disputes
Definition: Disputes with the workforce and/or their representatives - and any resulting
industrial action - are costly and damaging to both the business and workers.
Causes
1. Economic Cause
Demand for increase in wages on account of increase in all-India Consumer Price Index
for Industrial Workers.
Demand for higher gratuity and other retirement benefits.
Demand for certain allowances such as: House rent allowance, medical allowance,
demand for paid holidays and reduction of working hours, Better working conditions,
etc.
2. Personnel Causes. Sometimes, industrial disputes arise because of personnel problems
like dismissal, retrenchment, layoff, transfer, promotion, and more vacations etc.
3. Indiscipline. Industrial disputes also take place because of indiscipline and violence on
the part of the workforce. The managements to curb indiscipline and violence resort to
lock-outs
4. Misc. causes. Some of the other causes of industrial disputes can be workers' resistance
to rationalization, introduction of new machinery and change of place, non-recognition of
trade union, rumors spread out by undesirable elements, working conditions and working
methods, lack of proper communication behaviour of supervisors to inter-trade union
rivalry.
How collective bargaining is organized
Definition: the process whereby representatives of the workers (in a particular industry)
negotiate
say pay settlements - with representatives of the employers (in that industry).
Generally, an individual worker is in a weak bargaining position - the main purpose of a trade
union is to remove this weakness by forcing the employer to negotiate with the
representatives of his/her work force.
Trade unions are autonomous bodies - they have complete freedom to act in their own
interests. Most unions, however, are affiliated to the Trade Union Congress (TUC), which is the
largest trade union. It has an important role in bringing trade unions points of views on a
national scale, possibly affecting government decisions - e.g. the TUC have been at the
forefront of the National Minimum Wage negotiations.

20
If the more powerful unions make full use of their bargaining strength, they could succeed in
getting larger and/or more frequent wage increases than the weaker unions. This highlights
the importance of unionisation within trade unions - the larger and more united the union,
the better the bargaining position, ceteris paribus.
How is it organized
Collective bargaining is organized depending on the relationship between a union and firms
that employ unionized labor.
In a open shop, a firm can employ unionized and non-unionized labor
In a closed shop all workers in a place of work have to be union members. The closed
shop is outlawed in some countries because it gave unions too much power to dictate
who a firm could employ. A union could also call the entire workforce in a firm/industry
out on strike. In these ways, a union may act like a monopoly and restrict the supply of
labour so as to force up the market wage for a job/occupation.
A single union agreement allows a union to represent all the workers, whatever their
occupation, in the same workplace. This is usually in return for certain commitments
from the union on pay or production levels, and for agreeing not to take strike action.
Negotiating with a single union rather than several at a time is much easier for a firm.
The Challenges facing Trade Unions

Decline of manufacturing industries

Growth in part-time employment

Switch from male to female employment (in terms of percentage increases.

Co-operation with management

Government legislation (which seeks to reduce union influence)

The Basis for Wage Claims

Trade union demands for higher wages are normally based on one or more of the following:
1.

A rise in the cost of living (e.g. due to inflation) has reduced the real income of their
members.

2.

Workers in comparable occupations have received a wage increase.

3.

The increased profits in the industry justify a higher return to labour.

4.

The productivity of labour has increase

How can Trade Unions raise wages?

21
1.
Restricting the Supply of Labour
Unions can restrict the supply of labour in an industry, for instance, by pushing for longer
apprenticeships or tough examination (entry) requirements. This increases the wage rate in
the industry from W1 to W2 in the diagram below.

S2

S1

W2
W1
D

Q2

Q1

Employment

However, a problem has arisen - the quantity of labour able to enter the industry is restricted
by Q1 to Q2.
2.
Increasing the Demand for Labour
Unions can influence the demand for labour by use of productivity deals. They try to
persuade workers to increase productivity (which in turn helps to increase the Marginal
Revenue Product of Labour - recall that the MRP L is the demand for labour). In return, trade
unions negotiate wage increases for their members, justified by their increased productivity.
SL
W2
W1
D2 = MRPL2
D1 = MRPL1
Q1

Q2

Employment

Productivity
deals
have the effect of
raising
the
MRPL
curve from D1 to D2,
thereby
raising
wages from W1 to W2.
The advantages of
this method are that
productivity
deals
help to increase the
supply
of
and
demand for labour.

22

Externalities
Calculations
Social Costs = Private + External Costs
Social Benefits = Private + External Benefits
Definition
Social costs and benefits are therefore the costs and benefits incurred by the
entirety of society (producer, consumer and third party) as a result of the
production and/or consumption of a good or service.
Private costs and benefits are the costs and benefits incurred by individuals
directly involved in the production and/or consumption of a good or service.

Where no market failure exists social costs would be equal to private costs.
If external benefits exist more of the said good should be produced and consumed (it is
being under-consumed or under-produced) thus the market system is not supplying the
optimum resource allocation.
If external costs exist than less of the said good should be produced and consumed (it is
being consumed or produced in excessive quantities) thus the market system is not
supplying the optimum resource allocation.
Firms and individuals will not consume/produce any good or service unless the private
benefit of their activity exceeds the private cost incurred in their activity.

The government will make sure that:

Merit goods (goods with external benefits) are encouraged (to prevent underconsumption or under-production from occurring.)
Demerit goods (goods with external costs) are discouraged (to prevent overconsumption or over-production from occurring.)
Demerit goods do not have prices which account for their external costs.
Smoking and alcohol are examples of demerit goods.
The government will:
Subsidize merit good producers to reduce the costs of production and thereby
encourage production of such goods whilst causing prices to be lowered as a result of
the increase in supply and the decrease in prices of production caused by subsidization.
Tax demerit good producers to increase the costs of production and thereby discourage
production of such goods whilst causing prices to increase as a result of the decrease in
supply caused by taxations as well as by the increase in the price of production.
Sometimes the government may choose to nationalize certain industries that are
producing externalities to regulate and control them and so force them to produce at
the socially optimum level.
Laws and regulations Limits on the level of emissions of certain chemicals through
use of the law and a fining system to punish firms for infringement.
Ban on the use of certain chemicals which may result in significant external costs
through use of the law and a fining system to punish any infringement.
Forcing firms to internalize all costs: Pollution permits (these can be traded to firms
who can then pollute more at a reasonable price). Pollution permits are given out to
firms by the government before any trading is done. (Equivalent and derived from the
Carbon Credits used internationally to restrict national pollution). But this scheme is

23

costly (administration costs are high) to implement, it is difficult to measure pollution

levels accurately, rich firms may simply buy their permits off poorer firms and so
pollution may not have been decreased at all, it is hard to calculate how many pollution
permits to give out.
If external benefits exist then the public would be willing to pay more for a certain good
to assure that it is produced at the socially optimum level. (Increase in demand,
extension along the supply curve).
If external costs exist that the public would be willing to pay more to assure that it is
produced at the socially optimum level. (Decrease in supply, contraction along the
demand curve.)

Government Regulation
These are used to:

Promote competition.

Resolve externalities where market failure exists:

Provision of public goods.

Taxing demerit goods.

Enforce law and order.

Influence the location of firms:

Prevent overcrowding in cities.

Prevent regions from being neglected.

Governments do not desire oligopolistic or monopolistic markets as such markets
are uncompetitive when compared with competition based markets. Often, a
government will restrict the formation of such markets by:

Breaking up larger firms into smaller ones

Providing incentive for other firms to set up in the market
Preventing merges that may prove detrimental to competition

How does the government regulate private enterprises?

Investigate existing monopolies and suggesting ways in which competition may be

introduced into these monopolist-dominated markets.
Investigate proposed mergers and prevent such merges from taking place if they are
believed to be detrimental to competition.
Influencing the Location of Firms:
Why is this done?
o Some regions may be economically depressed, usually due to the decline of a
traditional industry (this may lead to regional unemployment).
o Some regions may be overcrowded with too much pollution, traffic congestion,
insufficient housing and public services as a result of too many firms choosing to set up
in the said regions.
How is this done?
Give firms incentives to set up in depressed regions:

Low loan interest rates.

Grants for the construction of infrastructure.

Grants for the training of workers.

24

Tax holiday/allowance.
Low rent/free premises.
By building and improving the infrastructure present in the said depressed region.
Persuade firms in congested regions to move to depressed regions (stop granting
licenses to operate in a congested region).

Monopoly
Definition: A monopoly is a situation where the market is dominated essentially by one firm.
The
legal definition of monopoly is a firm that has 25% or more market share in the
market.
Advantages and Disadvantages of Monopolies
Advantages
Firms usually makes higher profits
The firm can use profits to invest in new or improve upon existing products
Price Maker because does not face any competitors
Economies of Scale: Increased output will allow average unit prices of production to
drop. This can be passed onto consumers in the form of lower prices, so customers may
be more inclined to buy the firms products in the future.
A firm may become a monopoly through efficiency; A monopoly is thus a sign of success
and not inefficiency.
Disadvantages
Consumers may have to pay higher prices due to lack of competition
Consumers have less choice because market is dominated by the monopolistic firm.
Less innovation of products
Firms may not be efficient with allocation and utilization of resources because they do
not have any pressure to reduce costs.
Oglipoly
What is it?
An oligopoly exists when there are several dominate firms in one market.
If there are only two sellers in one market than that the market structure of the said
market is a duopoly which is a special case of an oligopolistic market.
Examples include the petroleum industry, TV broadcasting industry (duopoly in HK),
supermarket industry and the banking industry.

Please note that, as a general rule of thumb, even if a market has hundreds of
providers, if the top 3 7 providers together possess 50% or more of the markets total
market share then that market is said to be oligopolistic.

Main Features
A few sellers dominate market supply/or a few sellers supply a major part of the total
market supply irrespective of the total number of smaller suppliers in the market
The same goods but which are heavily differentiated by use of advertising, branding
and other such methods.
These firms produce similar but heavily differentiated products; this differentiation
makes the goods look different to the consumer. (Heterogeneous goods)

25

These firms engage in many forms of non-price competition but rarely deign to involve
themselves in price based competition as such competition can lead to price wars which
only benefit the consumers and no one else.
Brand image is often very important for such firms. (Coke and Pepsi test).

1. Oligopolistic firms will advertise a lot more than monopolists in the attempt to build a strong
brand image and to differentiate their goods from the products of their competitors.
2. If one firm has a better brand image, even with an inferior product, the said firm may be
able to sell more of its product than another firm with a worse brand image.
Entry into such markets is restricted either because of governmental decrees or
because of the huge startup capital or technology requirements needed in order to open
shop in the said market. Furthermore, because of the furious level of competition
between existing oligopolistic firms, these firms generally produce at a very low price, a
feat which would be very difficult for smaller firms which do not wield the same level of
economies of scale as the larger oligopolistic firms.
Market information is restricted and often incomplete as no firm knows what another
competitor will do. To combat this, such firms often collude to form cartels (trade
agreements) and conduct themselves with all the advantages, and disadvantages, of
monopolists. These agreements are generally illegal.
The actions of one firm will affect what the other competing oligopolistic firms will do as
such firms will react very quickly to the actions of a competitor. (Sellers are highly
interdependent).
Barriers to Entry
Existing firms are well established and have strong brand images.
Existing firms enjoy economies of scale and are much more efficient.
Existing firms enjoy customer confidence.
The government may have issued rules that govern entry, sometimes for a certain
number of years, into a certain market. These rules would have been put in place to
encourage entrepreneurs to enter into a market where one would require large startup
capitals. (Mobile phone industry in China).
Pricing Strategies:
Price wars.
Price Leadership:
When the dominate firm in a market determines the price of a good other firms have
no choice but to follow their example or lose market share unless they choose to
lower their prices even further and risk a price war.
Sometimes they will even collude to prevent price wars from happening.
Price collusion:
Forming a cartel.
Predatory pricing otherwise known as destruction pricing.
Advantages
Economies of scale (low average cost achieved on account of a high level of output).
Excess (abnormal or supernatural) profits.
Promotes research and development because these firms can spread the potential costs
involved in R&D over a much larger range of income sources thus lowering the risk of
R&D.
Disadvantages
Lower output levels and higher prices as these firms control such things
Less choice for consumers.

26

The need for government regulation to prevent oligopoly firms from overusing their
powers.

Economic growth
Definition
Recovery: The period where the economy moves between a recession and a boom.
Boom: This period is fast economic growth. Output is very high due to increase in demand,
and
unemployment is very low. Additionally, consumers may be confident about the
economy
so this may lead to extra spending
Recession: Economic Growth slows down and level of output may have a negative impact.
Unemployment increases and consumers are likely to save instead of spend, so
there is
less money circulating in the economy.
Slump: A period where output starts to decrease. Consumer confidence may also begin to
deplete.
GDP: The total or national output of a country over a period of time.

GDP
It measures the total amount of income earned in a macro economy national
income.
Changes used to measure economic growth Real change in GDP over time.
National Output = National Income = National Expenditure
Total value of output produced by all domestic firms within economy.
GDP = Consumption + Government Expenditure + Investment + Net imports
Some of the output income will flow overseas, as people from other countries may
achieve output in your economy
GDP is measured in terms of money.
However, money is subject to change in its value and inflation. To solve this problem,
the real value of output or GDP is adjusted for inflation so we know how much is
really generated from economic growth and how much is simply due to rising prices.

Inflation
Definition
Inflation: A general and sustained rise in the level of prices of goods and services prices of
vast
majority of goods and services on sale to consumers keeps rising over time.
Stagflation: Persistent high inflation combined with high unemployment and stagnant
demand in
a country's economy.
Hyperinflation: Prices rise at phenomenal rates in short periods of time, rendering money
worthless. Usually, the inflation rate is in double digits

27
Deflation: The prices of goods and services fall. This is usually negative inflation.
Disinflation: Fall in the rate of inflation.
Ideas

Price change over time (inflation) is always given per period of time.
Deflation can be a cause for concern deflation will usually occur when demand for
goods and services are falling, causing firms to lose profits, profits and reduce
workforce.
This will reduce household incomes, causing further reduction in goods and services.
The value of debts held by people and firms will rise in real terms as prices fall and
burden of making loan repayments rises.
Eventually the economy goes into recession.

How to measure inflation

Measured by
CPI (Consumer Price Index)

RPI (Retail Price Index)

1. A base year or starting point is chosen. This becomes the standard against which price
changes are measured.
2. A list of items bought by an average family is drawn up. This is facilitated by the Living
Costs and Food Survey.
3. A set of weights are calculated, showing the relative importance of the items in the
average family budget - the greater the share of the average household bill, the greater
the weight.
4. The price of each item is multiplied by the weight, adjusting the item's size in proportion
to its importance.
5. The price of each item must be found in both the base year and the year of comparison
(or month).

This enables the percentage change to be calculated over the desired time period.

Calculating the CPI/RPI:

Indices express change in prices of a number of different products as a movement in a

single number.
Average of basket of products in first year calculation or base year is given the
number 100.
If on average the basket rises overall by 25% next year, then index becomes 125.
If in second year it rises another 10%, then 125 x 1.1 = 137.5 37.5 becomes average
price rise in two year period.

28

To construct a CPI, a sample of households are taken and surveyed their spending
patterns observed for 12 months which is the base year. The proportion of income
spent on each category is recorded.
Average prices of different goods and services (minus fuel and food) are recorded from
a sample of shops.
The proportion of income spent on each category is used to weight average prices of
each type of good/service to find their weighted average prices.
This shows how big an impact a change in price of a particular type of good or service
will have on cost of living for the average household.
The proportional of household income spent on a certain type of good/service is
multiplied by the average price of the good/service purchased in the category, to
generate its weighted average price these weighted prices are then all added
together, which is the overall average price for goods and services in the basket.
The weighted total price of the basket can be compared each year to work out
percentage changes in average consumer prices.

Uses of CPI/RPI Data:

1. As economic indicator CPI is widely used measure of price inflation, and therefore is
measure of changes in cost of living. Governments try to control inflation using macroeconomic policies. The CPI will be used by workers to seek wage increases, and used by
entrepreneurs in business making concerning purchases and setting wage and prices.
2. As a price deflator Rising prices reduce purchasing power, value, of money. Rising
prices can therefore affect real value of wages, profits, pensions, savings, interest
payments, tax revenues and other economic variables important to people and decision
making. CPI therefore used to deflate other economic series to calculate real inflationfree values. i.e. wages go up 10% but inflation is 15%, therefore real wages fallen by
almost 5% less.
3. Indexation involves tying certain payments to rate of increase in CPI. E.g. pensions
may be indexed. Similarly, savings may be index-linked, meaning interest rate is set
equal to CPI, protecting real value of peoples savings. Many workers may also be
covered by collective bargaining agreements that tie wage increases to CPI changes.
Government may also index threshold at which people start to pay tax or higher tax
rates to stop people paying more or less tax.
Problems with Price Indices:
Over time typical household basket of goods and services will change.
CPI needs to take account of this, but deciding how and when to make them can be
difficult.
Changes due to:
o Fashion and taste
o Introduction of new goods and services
o Change in population and household size due to migration, birth/death rates,
marriage timing and numbers etc.
o Similarly CPI needs to take into account changes in quality of goods and services
over time, how and where households buy goods and services such as internet
and new shops.
o International comparisons of CPIs are hard to make due to different household
compositions and spending patterns.
o Argued that exclusion of food, energy, house prices and income taxes means CPI
cannot accurately measure change of living cost.
Inflation
Economists today tend to agree main cause of inflation is too much money chasing
too few goods.

29
This means people are able to increase spending on goods and services faster than
producers can supply goods and services, boosting aggregate demand and forcing
prices up.
A government can allow supply of money to increase in an economy by issuing more
money or allowing banking system to create more credit lending more to people and
firms.
A government may do so to :
o Increase total demand in economy to reduce unemployment.
o In response to increase in demand for goods and services for goods.
o In response to workers demand for higher wages, or rise in other production
costs.
o As money supply rises, peoples purchasing powers rise and inflation can occur.
o To stop excessive inflation, a monetary rule governments should follow is to
only allow supply of money to expand at same rate as increase in real output or
real GDP over time.
o If money supply increases faster than output, then inflation will occur.
o Stagflation when inflation and unemployment are both high and increasing
often due to rising living costs causing increased demand for higher wages and
less labour demand.
Causes of inflation
Increase in Money Supply an increase in money supply would increase the
spending
power of the average consumer, thus increasing demand and hence pushing up prices.
This then causes inflation.
Demand Pull Inflation When aggregate demand is increased, firms are no longer
able to
meet demand in production and thus prices inflate. To finance this, firms may borrow
more or money supply increased.
Cost Pull Inflation When the cost of producing goods is increased, firms may want to
offset these increased costs to consumers to keep a certain level of profit, thus the
extra cost is added to price of the good or service, causing inflation. Wage Price
Spiral is when workers demand higher and higher wages, causing cost push inflation
and prompting them to ask for higher wages again.
Imported Inflation rising prices in one country may be exported to another country
through international trade in many different goods and services. Many countries have
been able to enjoy stable inflation as Chinas large supply of goods and services is
produced through cheap labour.

Consequences and Costs of Inflation:

Personal Costs:
o Reduce purchasing power
o Real income falls
o People like pensioners and students on fixed incomes will suffer from inflation.
o Low paid and non-unionized workers often fail to get sufficient rises to stop real
income falling.
o Professional workers may ask for wage increases that protect or cause increases
in real wage levels.
o Savers and lenders may be hurt by inflation rate if interest is less.
o People who borrowed may benefit.
o Demand-pull inflation increased spending can boost company profits, while costpush may reduce profits. Rising profits could yield more tax, however
government may have to pay more for goods and services.

30
o

Economical Costs:
Possible unemployment purchasing power drops, less demand
Some people save more, reducing economic activity and overall output
Causes goods and services to become uncompetitive internationally
Benefits:
Economic growth
Reduce debt values falling value of money reduces real debt
values
Higher stock value
Values of fixed assets could rise financial security
Possible increased employment
Stimulate technological advancement

Economic Growth and Inflation

Most governments hope that they can achieve steady economic growth without it causing
acceleration in demand-pull and / or cost-push inflationary pressures. The dangers of a
booming economy is that inflationary pressures build and that the economy must slow down
or fall into recession for these inflation risks to be controlled.

During the early part of the last decade, the British economy enjoyed a period of steady
growth and relatively low and stable inflation
In 2007-08 the trade-off between growth and inflation worsened
Inflation surged higher mainly because of external factors such as high food and oil
prices
The economy suffered a steep descent into recession following the global financial crisis
In early 2009 the economy experienced recession and higher inflation some
economists warned of a lengthy phase of stagflation conditions
Inflation fell back largely because of the recession. But in 2010 and into 2011, inflation
has been rising again whilst GDP growth has been weak with the risk of a second
downturn (a double-dip)

31
Stagflation
Stagflation is a period of economic stagnation accompanied by rising inflation. In other words,
both of these key macro objectives are worsening. It can happen when an economy goes into
a downturn or a recession but when other external forces are bringing out higher inflation. The
obvious example of this is when recession is afflicting a country but the prices of imported
products are surging causing prices to rise and real incomes and profits to fall. The rise in the
cost of imports can be shown by an inward shift in the short run aggregate supply curve
leading to a contraction in real national output and an increase in prices.
One of the dangers of stagflation is that the fall in real incomes causes consumer and
investment spending to fall and thus the rate of economic growth suffers too (a deterioration
in a third objective of policy). Wage demand may also pick up as people experience rising
prices. The central bank needs to consider appropriate policy responses to this. Too severe a
tightening of monetary policy for example will help to curb inflation but risk causing a deep
recession. The combination of deflation and a sustained drop in economic output is termed an
economic depression
An improvement in aggregate supply can help to resolve the growth inflation trade off. We
see in the diagram how aggregate supply has moved outwards and this allows aggregate
demand (C+I+G+X-M) to operate at a higher level without threatening a persistent increase in
the general price level (inflation).
Overcoming a conflict between economic growth and inflation increases in AD and
AS

32
Conflicts between objectives the economics of deflation

Deflation is a sustained fall in the prices of goods and services, and thus the opposite of
inflation. Increased attention has focused on the impact of price deflation in several countries
in recent years notably in Japan (inflation -0.3% in 2010) and in some Euro Area countries
such as Ireland Greece where prices have been falling, national output has dropped and
unemployment has been rising.
It is normally associated with falling level of AD leading to a negative output gap where actual
GDP < potential GDP. But deflation can be caused by rising productive potential, which leads
to an excess of aggregate supply over demand.

Greece has suffered from a severe rise in unemployment (right hand scale) and is now seeing
her relative living standards fall. A deflationary depression is a risk for Greece

33
Possible damaging consequences of persistent price deflation
Holding back on spending: Consumers may postpone demand if they expect prices
to fall further in the future.
Debts increase: The real value of debt rises when the general price level is falling and
a higher real debt mountain can be a drag on consumer confidence and peoples
willingness to spend. This is especially the case with mortgage debts and other big
loans.
The real cost of borrowing increases: Real interest rates will rise if nominal rates of
interest do not fall in line with prices. If inflation is negative, the real cost of borrowing
increases and this can have a negative effect on investment spending by businesses
Lower profit margins: Lower prices hit revenues and profits for businesses - this can
lead to higher unemployment as firms seek to reduce their costs by shedding labour.
Confidence and saving: Falling asset prices including a drop in property values hits
wealth and confidence leading to declines in AD and the threat of a deeper recession.
Resolving the threat of price deflation
Using expansionary Monetary Policy
o Interest rates: Deep cuts in interest rates can be made to stimulate the demand
for money and thereby boost consumption
o Quantitative Easing printing money in the hope that, by injecting it into the
economy, people and companies will be more likely to spend.
Using expansionary Fiscal policy
o Keynesian economists believe that fiscal policy is a more effective instrument of
policy when an economy is stuck in a deflationary recession and a liquidity trap
o The key Keynesian insight is that a market system does not have powerful selfadjustments back to full-employment after there has been a negative economic
shock. Keynes talked of persistent under-employment equilibrium an economy
operating in semi-permanent recession leading a persistent gap between actual
demand and the potential level of GDP.
Keynes argued that this justified an exogenous injection of aggregate demand as a stimulus to
get an economy on the path back to full(er) employment and to prevent deflation.
Unemployment
Definition
Frictional Unemployment: Occurs as workers change jobs and spend time without jobs
during this
period.
Seasonal Unemployment: Occurs when consumer demand for certain goods and services
are seasonal, and as a result people are only employed during periods of time.
Cyclical Unemployment: Occurs when there is too little demand for goods and services in
the
economy during a recession, and firms are producing less as a
result,
employing less labour as a result.
Structural Unemployment: Occurs when the labour market is unavailable to provide jobs
for all
workers because of a mismatch between the workers skills
and the

34
skill requirement of the jobs. It arises from long-term changes
in the
structure of the economy, as entire industries close down due
to lack of
demand for goods and services they produce. Workers who
become
unemployed and have skills no longer needed
are occupationally
immobile.
Voluntary Unemployment: Voluntary unemployment includes workers who reject low wage
jobs
whereas involuntary unemployment includes workers fired due
to an
economic crisis, industrial decline, company bankruptcy, or
organizational restructuring.
International labour organization
The International Labour Organization (ILO) measure of unemployment assesses the number
of jobless people who want to work, are available to work and are actively seeking
employment. It is used internationally so comparisons can be made between countries. It also
enables consistent comparisons over time. The ILO measure is calculated using data from
surveys of a countrys labour force; it can therefore be subject to sampling differences
between one country and another. It differs from the claimant count unemployment tmeasure,
which only includes people claiming unemployment-related welfare benefits. The ILO measure
gives a higher figure than the claimant count measure as it includes those who are classified
as available for work but who are not claiming jobless benefits. The ILO measure may include
students who are actively seeking work but may not qualify for jobless benefits. Similarly,
second earners within a household may be reluctant to claim jobless benefits but would be
classified as unemployed under the ILO measure as they are available for work.
Government Policy
Definition
Monetary policy: The process by which the government, central bank, or monetary authority
of a
country controls the supply of money, availability of money, and cost of
money
or rate of interest, in order to attain growth and stability of the economy.
Fiscal policy: Government policy that attempts to influence the direction of the economy
through
changes in government taxes or through some spending.
Expansionary policy:
Contractionary policy:
Government macroeconomic objectives and policies
Most of the governments round the world have four main objectives. These are
Keep inflation under control
Maintain a low level of unemployment
Achieve a high level of growth rate
Maintain a healthy balance of payments.

35
Government Economic Policies
Government influences the economy through its economic policies. These are
Fiscal Policy
It is related with taxes and government spending. This policy is there to control inflation and
demand in the economy. Usually government collects money in the form of taxes and spends
money through its development expenditure such as building roads, bridge, defense,
transports etc. Government constantly monitors the aggregate demand in the economy.
Inflation rate gives the correct measure of the aggregate demand in the economy.
When the aggregate demand in the economy is high, prices rise, this shows that the economy
is spending too much. In this case, the government will lower is expenditure budget and cut
back on investment spending, such as on road construction and hospital equipment. On the
other hand the government might also increase the taxes, which would take spending power
out of the economy by leaving consumers and businesses with less income to spend.
In the opposite scenario, when the economy is heading for a recession and unemployment
is rising, the government might increase its expenditure plans. There might be a reduction in
taxes so as to leave consumers and businesses with higher disposable incomes.
Monetary Policy
Monetary Policy is related with a change in interest rates by the government or the Central
bank. When the forecast for inflation is that it will rise above the targets set by government,
then the Central Bank will raise its base rate and all other banks and lending institutions will
follow. It is usually done when the economy is at the boom stage of the business cycle.
A higher interest rate will result inbusiness will not be able to expand as they have to
pay more interest to the bank for their loans and they have less profit left. Businesses that are
planning to take loan for expanding may postpone their decisions and wait for a cut in interest
rates. Consumers demand will also fall as they will not be getting cheap loans to pay for the
buying new houses and luxury items.
If inflation is low and is forecasted to remain below governments targets, then the Central
Bank may decide to reduce interest rates.
Supply side policies
It includes all those policies which aim at improving the efficient supply of goods and services.
These might include:
Privatization
Imparting training and improving the education level of the workforce resulting in higher
skills.
Increase competition in all industries by removing entry barriers, thus leading to more
efficiency.
Factors causing a change in components of AD
Change in consumption
A change in consumption is caused by any of the following factors
Changes in income: Income increases consumption increases and vice versa.
Changes in interest rates: Fall in interest rates will make borrowing money cheaper.
Consumers will now be tempted to take loans and purchase goods and services.
Consumption will rise. On the other hand if the interest rates increase, borrowing
becomes expensive. Consumers will be more tempted to save rather than spend.
Consumption will fall.

36

Changes in wealth: A rise in house prices or the value of stock and shares makes a
person feel wealthy. Consumers feel more confident and tend to spend more .
Changes in consumer confidence: Higher consumer confidence is likely lead to
increased consumption.

Change in Investment
Interest Rates: If interest rates are low firms will find it easy to borrow funds for
investment. Investment increase when interest rates fall.
Changes in National Income: If the national income increases, firms will have to
invest further to increase output (induced investment).
Technological change: Regular changes in technological front demand firms to invest
in order to keep up with the changes and remain competitive.
Business Confidence: The economic environment in an economy is a major factor in
determining the investment level. When an economy is showing signs of healthy
growth, firms will have positive expectation and will invest in expanding their facilities
and to meet higher demands in the future. During troughs firms will be more
conservative in their investments and thus AD will be affected.
Change in Government Expenditure
Government Expenditure depends on
Macroeconomics objectives: If the government is considering increasing employment
then it might increase its spending on public projects.
Condition of the economy: During phases of slow economic growth, government is more
likely to increase its spending in order to stimulate the economy.
Changes in net exports
Exports are domestic goods bought by foreigners. Exports will rise when
Foreigners income rise
Exchange rate of the exporting country is falling.
The economy follows a more liberal trade policy i.e. free trade increase
Inflation rate in the economy is comparatively lower than its trading partners.
Imports are the goods bought from foreign country. Imports will rise when
Domestic income rises. This is because people will increase their consumption and thus
imports will increase.
Exchange rate of the importing country increase. Now it becomes cheaper for the
country to purchase from outside as their currency is stronger than their trading
partners.
If the economy is following a liberal trade policy i.e. free trade increases.
Inflation rate is high
Possible conflict between macroeconomic objectives
It is rare for a country to achieve all of its main objectives at the same time
Frequently conflicts appear between the different aims and as a result, choices might
have to be made about which objectives are to be given greatest priority.
This will vary from one country to another since the needs of different nations will differ
according to their stage of economic development.
Here are some possible policy conflicts:
Inflation and unemployment: Falling unemployment might create demand-pull and
cost-push inflationary pressures leading to a fall in the value of money

37

Economic growth and environmental sustainability: Rapid economic growth and

development frequently puts extra pressure on scarce environmental resources
threatening the sustainability of living standards in the future
Economic growth and inflation an overheating economy may suffer accelerating
inflation which then has negative effects on trade performance, business profits and
jobs
Economic growth and the balance of payments: Strong GDP growth fuelled by high
levels of consumer demand for goods and services might lead to a worsening of the
trade balance. This is particularly true when an economy has a high marginal propensity
to import.

Unemployment and inflation the Phillips Curve concept

Falling unemployment might cause rising inflation and a fall in inflation might only be
possible by allowing unemployment to rise
If a Government wanted to reduce the unemployment rate, it could increase aggregate
demand but, although this might temporarily increase employment, it could also have
inflationary implications in labour and the product markets.
The key to understanding this trade-off is to consider the possible inflationary effects in both
labour and product markets from an increase in national income, output and employment.
The labour market: As unemployment falls, labour shortages may occur where skilled
labour is in short supply. This puts pressure on wages to increase and prices may rise as
businesses pass on these costs to their customers.
Other factor markets: Cost-push inflation can also come from rising demand for
commodities such as oil, copper and processed manufactured goods such as steel,
concrete and glass. When an economy is booming, so does the derived demand for
components and raw materials.

38
Product markets: Rising demand can lead to suppliers raising prices to increase their profit
margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity
leading to excess demand (i.e. a positive output gap.)

Fiscal policy
The two main instruments of fiscal policy are government spending and taxation.
Changes in the level and composition of taxation and government spending can impact on the
following variables in the economy:
Aggregate demand and the level of economic activity.
The pattern of resource allocation.
The distribution of income.
How fiscal policy work
High rate of inflation
High rate of inflation is caused by too much aggregate demand in the economy. Government
will use deflationary fiscal policy. Government will try to influence aggregate demand by
reducing its public spending. The government will spend less on construction of roads, bridges
and other public spending and thus aggregate demand will fall. On the other hand,
Government may increase the tax rates. An increase in tax rates will take away the extra
disposable income out peoples pocket resulting in a lower demand.

39

Low rate of inflation

In an economic recession, aggregate demand, output and employment all tend to fall. Now the
Government wants to increase employment in the economy, it can attempt to do so by
increasing aggregate demand. The Government will increase the public spending resulting in a
rise in aggregate demand. Government may reduce the tax rates so that people have more
disposable income to spend and instigate demand in the economy.

Role of fiscal policies

The two main instruments of fiscal policy are government spending and taxation.
Changes in the level and composition of taxation and government spending can impact on the
following variables in the economy:
Aggregate demand and the level of economic activity.
The pattern of resource allocation.
The distribution of income.
AD=C+G+I+(X-M)

40
As we can see in the above equation that G (Government Expenditure) is a component of AD,
it can be used by Government to influence AD in the economy. The government can use
expansionary or deflationary fiscal policy to get the desired results. Lets discuss each policy in
detail.
Expansionary fiscal policy
Expansionary fiscal policy is used to increase the Aggregate demand in the economy. If the
economy is having a deflationary gap, the government can use expansionary fiscal policy to
reduce the gap or totally eliminate it.
Deflationary gap
Deflationary gap is the difference between full level of employment and the actual level of
output of the economy. We can see in the diagram below, that the economy is operating a
level a below the Yf (full level of employment).

The consequence is that due to deflationary gap all the resources of the economy are not
being used in the optimum level and they are idle. This results in unemployment and low level
of output. This is not desirable for any government. In order to reduce/eliminate the
deflationary gap, the government uses expansionary fiscal policy.
Government will either increase its spending or reduce taxes (or both) in order to stimulate the
aggregate demand. Increase Government spending will result me more projects being funded
by the government and thus employment and output will increase. Even a lower tax rate will
result in more disposable income for households and encourage consumption.
Increased G and C will lead to higher AD. However, this might also lead to higher
prices/inflation in the economy.
Contractionary fiscal policy
Contractionary fiscal policy involves the reduction of government spending and increase taxes
as a measure to control inflation/AD in the economy. With reduced government spending, the
AD will fall and thus reduce pressure on the economic resources and the average price level in
the economy will come down. Similarly, increased taxes will take away the excess disposable
income from the households and result in a fall in AD. Contractionary fiscal policy is thus used
to reduce the inflationary gap.

41
Inflationary gap
Inflationary gap is when the Aggregate demand exceeds the productive potential of the
economy. As we can see through the diagram, the economy is operating at a level above the
full employment level of the output. Due the limitation of the economy to fulfil this increased
demand the average price level in the economy increases resulting in inflation.

Problems of fiscal policy

Reduce incentive to work
Raising taxes on income and profits reduce work incentives, employment and economic
growth. An effort to reduce aggregate demand may cause disincentives to work, if this occurs
there will be a fall in productivity and Aggregate supply could fall.
Adverse effect of lowering Public Spending
Reduced government spending to Increase Aggregate demand could adversely affect public
services such as public transport and education causing market failure and social inefficiency.
Crowding out effect
With an increase in government expenditure, there will be greater competition for limited
resources. This will offset private investments resulting in shrinking of the private sector.
Inaccurate forecasting
If the Governments estimate or forecasting is wrong or inaccurate the fiscal policy will suffer.
For example, if a recession is expected and the government practices deficit budget, and yet
the recession turns out to be a boom, this will cause inflation.
Implementation of the Policy
Planning for the spending is done once by most of the governments. If there is a delay in the
implementation of the fiscal policy, it might reduce the effectiveness of the policy. Thus the
time lag is important.

42
Poor Information
Fiscal policy will suffer if the government has poor information. e.g. If the government
believes there is going to be a recession, they will increase AD, however if this forecast was
wrong and the economy grew too fast, the government action would cause inflation.
Time Lags
If the government plans to increase spending this can take a long time to filter into the
economy and it may be too late. Spending plans are only set once a year. There is also a delay
in implementing any changes to spending patterns.
Budget Deficit
Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the budget
deficit which has many adverse effects. Higher budget deficit will require higher taxes in the
future and may cause crowding out (see below
Other Components of AD
If the government uses fiscal policy its effectiveness will also depend upon the other
components of AD, for example if consumer confidence is very low, reducing taxes may not
lead to an increase in consumer spending.
Depends on Multiplier
Change in injections may be increased by the multiplier effect; therefore the size of the
multiplier will be significant.
Monetary Policy
Monetary policy is generally referred to as either being an expansionary policy, or
a contractionary policy.
An expansionary policy increases the total supply of money in the economy and is
traditionally used to combat unemployment in a recession by lowering interest rates. Lowered
interest rates encourage the household and the firms to increase their consumption and
investment respectively. This will shift the AD to the right and result in higher real output and
more employment.

Contractionary policy decreases the total money supply and involves raising interest rates
in order to combat inflation. The result will be that investment will fall, and consumption will
fall. All of these changes will shift the AD to the left.

43

It is argued that an increase in the money supply causes an increase in the rate of inflation.
Maintaining a low and stable inflation is one of the main macroeconomic objectives of the
Government. Government does so by controlling the supply of money to the economy. This
policy is known as monetary policy.
Monetary policy in any country is usually controlled by the Central Bank of that country. The
Central bank alters the interest rates in the economy after assessing the inflationary pressures
in the market.
Monetary Policy tools
Central Bank has three tools of monetary policy:
Open market operations
Open market purchases: The central bank buys government securities to increase
the monetary base.
Open market sales: The central bank sells government securities to decrease the
monetary base.
Open market operations have a number of advantages:
They are under the direct and complete control of the central bank
They can be large or small.
They can be easily reversed.
They can be implemented quickly
Discount loans
When a bank receives a discount loan from the central bank, it is said to have received a loan
at the discount window. The Central Bank can affect the volume of discount loans by setting
the discount rate:
A higher discount rate makes discount borrowing less attractive to banks and will
therefore reduce the volume of discount loans.
A lower discount rate makes discount borrowing more attractive to banks and will
therefore increase the volume of discount loans.
Discount lending is most important during ?nancial panics:
When depositors lose con?dence in the ?nancial system, they will rush to withdraw their
money.
This large deposit out?ow puts the banking system in great need of reserves.
The central bank stands ready to supply these reserves by making discount loans. In
such situations, the central bank acts as a lender of last resort.

44
Changes in reserve requirements
The portion (expressed as a percent) of depositors' balances banks must have on hand as
cash. This is a requirement determined by the country's central bank. It affects the money
multiplier; changes in the required reserve ratio can lead to changes in the money supply. This
is also referred to as the "cash reserve ratio" (CRR).
How money supply works
Money supply includes all the notes and coins in circulation with the public plus the money
with banks. It also includes the deposits in banks and building societies. The later is more
significant supply of money and is usually the target of Governments monetary policy. The
ways through which Government controls the money supply are:
Open market operations
Government usually sells treasury bills and bonds to raise money. Private individuals invest in
these bonds and bills in order to get a healthy rate of interest. This reduces the deposits with
banks and the money supply.
Variation of legal reserve requirements
Usually, the commercial banks have to maintain a certain percentage of their assets as
deposit with the Central Bank. When the Central Bank wants to reduce money supply it will
increase the limit of the deposit kept by the banks. The commercial banks are left with less
money to lend to their customers.
Central banks
Central Banks are charged with regulating the size of a nations money supply, the availability
and cost of credit, and the foreign-exchange value of its currency. Regulation of the availability
and cost of credit may be designed to influence the distribution of credit among competing
uses. The principal objectives of a modern central bank in carrying out these functions are to
maintain monetary and credit conditions conducive to a high level of employment and
production, a reasonably stable level of domestic prices, and an adequate level of
international reserves.
Function of a Central Bank
A central bank usually carries out the following responsibilities:
Implementation of monetary policy.
Controls the nation's entire money supply.
The Government's banker and the bankers' bank ("Lender of Last Resort").
Manages the country's foreign exchange and gold reserves and the Government's stock
register;
Regulation and supervision of the banking industry
Setting the official interest rates- used to manage both inflation and the country's
exchange rate - and ensuring that this rate takes effect via a variety of policy
mechanisms
Role of taxation in promoting equity
Tax is a fee charged ("levied") by a government on a product, income, or activity.
Why taxes are imposed?
There are different reasons for imposing taxes.
To finance government expenditure. One of the most important uses of taxes is to
finance public goods and services, such as street lighting and street cleaning.

To reduce consumption of goods that creates negative externalities.

To control the amount of imported goods i.e. tariffs
Used as a part of fiscal policy to control aggregate demand in the economy.

45

To control income inequality.

Classification of taxes
Progressive taxes
A progressive tax is a tax imposed so that the tax rate increases as the amount subject to
taxation increases. In simple terms, it imposes a greater burden (relative to resources) on the
rich than on the poor. It can be applied to individual taxes or to a tax system as a whole.
Progressive taxes attempt to reduce the tax incidence of people with a lower ability-to-pay, as
they shift the incidence disproportionately to those with a higher ability-to-pay. The result is
people with more disposable income pay a higher percentage of that income in tax than do
those with less income.
Regressive Tax
The opposite of a progressive tax is a regressive tax, where the tax rate decreases as the
amount subject to taxation increases. It imposes a greater burden (relative to resources) on
the poor than on the rich. Regressive taxes attempt to reduce the tax incidence of people with
higher ability-to-pay, as they shift the incidence disproportionately to those with lower abilityto-pay.
Proportional Tax
A proportional tax is one that imposes the same relative burden on all taxpayersi.e., where
tax liability and income grow in equal proportion. In simple terms, it imposes an equal burden
(relative to resources) on the rich and poor. Proportional taxes maintain equal tax incidence
regardless of the ability-to-pay and do not shift the incidence disproportionately to those with
a higher or lower economic well-being.
Types of taxes
Direct Taxes
It is a tax paid directly to the government by the persons on whom it is imposed.
Examples
Tax imposed on peoples income-Income tax
Tax on wealth wealth Tax
Tax on firms profits.- corporate tax
Indirect Taxes
Indirect tax is a tax collected by an intermediary (such as a retail store) from the person who
bears the ultimate economic burden of the tax (such as the consumer). The intermediary later
files a tax return and forwards the tax proceeds to government with the return.
Indirect taxes are generally included in the price of goods and services, so are less obvious to
those paying the taxes than direct levies. Thus indirect taxes are also known as expenditure
tax or consumption based tax.
Examples
GST (Goods and service tax)
VAT (Value added tax)
Consumers are charged a percentage of tax while purchasing a good/service and then
the seller pays the tax collected to the Government.
Other measures to promote equity
The governments also undertake expenditures to promote income equity. These include

46
Subsidies
Provide directly, or to subsidize, a variety of socially desirable goods and services. These
include health care services, education, and infrastructure that include sanitation and clean
water supplies.
Transfer payments
Government provides various kind of assistance to low income groups in the society. The
objective is to support them in maintaining a reasonable standard of living and to lower
inequality. These payments are given directly to these groups in the form of monetary help.
Examples include Social Security, unemployment compensation, welfare, and disability
payments.
Government policy to control inflation
Government uses a number of policies to deal with the different types of inflation. These are:
Demand Side policies-to control demand pull inflation
Deflationary fiscal policy: This involves an increase in taxes and lowering of government
spending. Increasing taxes will result in lower disposable income for household and thus less
consumption. Moreover, increased taxes will result in lower profits for firms and thus less
investment by firms. All these factors will lower the AD in the economy.
Deflationary monetary policy: It involves rising of interest rates and reducing money
supply. Higher interest rates mean higher loan and mortgage repayments. This will deter
households and firms to borrow, leading to fall in consumption and investment respectively.
Supply side policies-to control cost push inflation
It includes all those policies which aim at improving the efficient supply of goods and services.
These might include:
Privatization
Imparting training and improving the education level of the workforce resulting in higher
skills.
Increase competition in all industries by removing entry barriers, thus leading to more
efficiency.
Exchange rate policies to control imported inflation
This involves increasing the value of currency to reduce imported inflation. Increase currency
rate will also lead to fall in demand for exports (component of AD).
International aspects
Definition
Exchange rate: The price of ones currency in terms of another currency
Foreign exchange market: The market where currencies are bought and sold.
Exchange control: Limits on the amount of foreign currency available to importers, which
consequently limit imports
Appreciation: The rise in value of a currency against others. Exports will become more
expensive
abroad and imports cheaper at home.
Depreciation: The fall in value of a currency against others. Exports will become cheaper
abroad

47
and imports expensive at home.
Devaluation: Depreciation brought about the government, normally by a government which
fixes
the value of its currency.
Exports: The movement of goods or commodities out of the country.
Imports: The movement of goods or commodities into the country.
Protectionism: Policy of protecting domestic industries against foreign competition by means
of
tariffs, subsidies, import quotas, or other handicaps placed on imports.
Free trade: A system of trade policy that allows traders to trade across national boundaries
without interference from the respective governments.
Globalisation
What is it?

It is the increasing integration of countries individual economies.

It is the global movement towards trade, financial and communications integration
through the development of free trade, free flow of capital, and the freedom to tap into
cheaper foreign factor markets. (Official definition)
Benefits

Most efficient form of production:

Because firms will choose to produce where costs are lowest.
Stimulates the economy, particularly that of LEDCs, by drawing in more foreign direct
investment.
Employment opportunities

Opening jobs.
Training
Introduces skills and technology to nations through a companys implementations of such:
This increases the productivity of a nations workforce, etc.
Opening new industries in LEDCs such as the white phosphorus mining industry in Yemen.
Increases competition:

Lowers prices

Less inflation.

Better quality goods.

Better efficiency.
Costs
Environmental damage.

Because the company is so powerful that it can afford to operate inefficiently for
conveniences sake.
Creates uncertainty:

Foreign firms own most of the market share in a country, not domestic firms.
May choose to source their resources from abroad and not from locally:
Thus local resource producers will go out of business.
Human rights abuses.

Infringements on indigenous rights.

48
Terrorism.
Investments in nations facing political sanctions as a result of their wrong-doings.
Leaching from government funds:

Large MNCs may be too important for a government to allow to go bankrupt thus
whenever said MNC is facing troubles they will be given aid by their government.
Price manipulation.
Labour abuse:

Child labour.

Bad working conditions.

Poor healthcare.

Sweat shops.

Bad wages.

Restrictions to resting hours.

Anti-Labour-Union policies.
Using tactics detrimental to competition:

Predatory pricing.
Monopoly power.
Tax evasion:

Through transfer pricing.

Using illegal methods and materials to produce goods and services.
Or to force people to buy their goods or services:

Great American Streetcar scandal.

Blocking of technologies:
Bribery.

Blocking battery technology for hybrid cars so one can sell more oil.

Concealment of imports.

Causing trade deficit:

Wal-Mart is accused of being one of the largest sources of the trade deficit in the USA.
Objections
Third world debt.
Debt in the developing, less developed or least developed third world countries in
Africa, Asia, Latin America and the Middle East.

Globalization is leaching resources from these countries and the revenue generated
from this leaching is not fed back into these countries. Furthermore, with population
growth causing the needs and wants of these countries to also grow, these countries
are falling into debt in order to pay for these needs and wants.
Animal rights.
Child labour.
Anarchism.
Anti-capitalist
Exchange rates
Demand for and Supply of a currency
This is what determines exchange rate in a free-floating exchange rate system:
When a currency has strong demand it will appreciate in value.
In contrast, when there is a large scale selling of a currency it will depreciate.
Demand for a currency:
Exports and imports of goods/services
o If a country has a decline in export industries and earnings, yet its people continue
buying imports, the exchange rate is likely to fall.

49
This is possibly not true for countries such as Hong Kong which are dependent
on imports of oil and food.
o Fewer exports will mean less demand for the currency to pay for them, so the
demand for the currency will decrease.
o This will lead to depreciation
o When a currency has depreciated, this makes the countries exports cheaper abroad.
o Thus, exports should become more competitive overseas.
Price elasticity of demand for imports
o When a currency depreciates, imports become more expensive.
o If the demand for imports is price elastic, this should lead to a fall in expenditure on
imports
o This situation is found where imports compete with home-produced alternatives.
o When countries import necessities, such as food and oil, demand tends to be price
inelastic so expenditure rises when the currency falls.
Pure speculative demand.
o Speculators often purchase currencies that they think will appreciate in value against
their own currency.
Official buying of the currency by the central bank.
o This might be done for investment or speculation or security or other reasons.
Comparatively higher domestic interest rate.
o Thus savers will be likely to convert their own money into your currency to save in
your nation and enjoy the comparatively higher domestic interest rates you offer.

Supply of a currency

Imports of goods and services.

Outflows of direct investment.

Outflows of portfolio investment.

Speculative selling of the currency.

Official selling of the currency by the central bank.

Rate of interest abroad.

Appreciation and Depreciation
Foreigners will tend to save money in ones nation.

Thus the demand for ones currency rises which can cause ones currency to appreciate
in general.
Depreciation means that the value of the currency in terms of other currencies goes down:
If the USD depreciates against the RMB then it will take fewer RMB to buy each USD.
If 1 Euro was worth HKD 10.2 at the start of the year.
It may depreciate if the Greek government declared that it would withdraw from the
Eurozone and go back to using the Drachma in order to depreciate their currency.
This will cause others to lose confidence in the Euro and speculation will cause people
to sell the Euro.

This may end up causing the Euro to depreciate to HKD 7 per Euro.
In this case the Euro has depreciated against the HKD because it now takes more Euros
to purchase each HKD.

But the HKD has appreciated against the Euro because it now takes fewer HKD to buy
1 euro
Advantages of a Strong Currency
Lower import prices This boosts living standards of consumers.

An increase in the real purchasing power of HK residents traveling overseas for

business and leisure purposes.

50

Cheaper to import raw materials, components and capital inputs causes an outward
shift in short-run aggregate supply.
Improvement in the terms of trade (lower import prices).
Helps to control RPI inflation Domestic producers face stiff international competition
and must keep their prices down. Lower inflation allows the MPC/HKMA to keep nominal
interest rates at a lower level than if the exchange rate was weak.
An increase in a countrys relative position in international league tables showing real
GDP per capita when expressed in a common currency:
Even if ones GDP, as measured in ones own currency, is no more than previously,
because ones currency has appreciated in value, the GDP of ones nation will also
increase when it is translated into another currency.

Disadvantages of a Strong Currency

Cheaper imports lead to rising import penetration and large trade deficit:
Import penetration means that a larger portion of the goods and services provided by a
nations firms is now provided by foreign firms.
Exporters also lose price competitiveness and market share thus causing a trade deficit.
Damaged profit and employment in some sectors to which exporting is the key means of
generating revenue.
Negative impact on economic growth (exports injections of aggregate demand, imports
- leakages of wealth form the circular flow of income).
Some regions which have a higher than average dependency on exporting industries are
more affected than others.
Balance of Payments on Current Accounts
What is it?

It is a set of accounts that record a countrys international transactions and which

(because double entry bookkeeping is used) is always in balance with no surplus or
deficit shown on the overall basis.
It serves to highlight a countrys competitive strengths and weaknesses and helps in
achieving balanced economic growth.

Because the international market is so large it is unlikely to adhere to the

business cycle.
Therefore, a country which has a healthy BoP account will likely have balanced growth
because the levels of investment, consumption and capital of the international market
is unlikely to fluctuate much and will grow steadily.
The demand from the international market is unlikely to fluctuate much and will grow
steadily therefore investment and capital will also grow steadily (this growth happens
because people are getting richer, world population is growing, etc.).

Capital in this case should indicate the money invested in businesses to generate
income:

If investments grow so too will capital because capital is the money already invested
and investments are the source of capital.
The Balance of Payments Account

The current account, capital account and financial account.

The capital and financial accounts used to known collectively as the capital account.

51
The BoP is always balanced

When the news talks about a BoP surplus or deficit they are usually referring to the net
transactions of the Current Account or just the Balance of Trade.

Calculated by subtracting the total value of imports from the total value of exports
BoT is Balance of Trade
Positive figure (surplus) Value of imports < Value of exports.
Negative figure (deficit) Value of imports > Value of exports.

A negative BoP indicates that a countrys exports are not competitive enough
to compete with those produced by other countries:

Thus there is a net leakage of wealth from the country.

Correcting trade imbalances
Large trade imbalances, whether a big deficit or a big surplus, can cause problems for a
national economy.
Problems with a trade surplus
There may be political and economic pressure on the government from other countries
to reduce its trade surplus so they can reduce their trade deficits
Exporting firms will enjoy significant overseas revenues profits and wages may rise
but the increase in demand may cause demand-push inflation
A surplus causes the value of the currency to appreciate or stay high, and may
eventually reduce demand for exports and cause a loss of jobs.
Problems with a trade deficit
If more money is paid out for imports than is earned from exports then this loss of
money from an economy may mean less can be spent on domestic goods and services.
Domestic firms facing a fall in demand for their products may cut back production and
their demand for labour resulting in higher unemployment.
The value of the exchange rate will fall, causing imports to become more expensive and
resulting in imported inflation. If demand for price-inelastic goods or services falls, more
money will be paid out for imports and the demand for domestically-produced
goods/services will decrease.
The trade deficit might be a symptom of a declining industrial base, with fewer firms in
the economy over time producing goods and services for export.
Economic growth and trade balance
A period of fast growth may come into conflict with the balance of payments. Much depends
on the income elasticity of demand for traded goods and services. In the case the UK, the
evidence is that consumers have a high propensity to consume imports; the income elasticity
of demand is strongly positive. Say for example, real disposable incomes grow by 3% and that
the income elasticity for imports = +2.5. That would lead to a 7% rise in the volume of
imports. Unless there is a corresponding rise in exports, we expect to see a worsening of the
balance of trade (i.e. a widening trade deficit).
In a recession, this effect works in reverse as demand for imported products including raw
materials, components and ready to consume goods and services declines. The trade balance
will improve although the root cause is a drop in economic activity.
Correcting trade balances
1. Do nothing, as a floating exchange rate will correct it.

52
Trade deficits and surpluses can be self-correcting if allowed to adjust freely.
2. Fiscal policy
A contractionary fiscal policy is when the government may cut public expenditure and
raise taxes to reduce the total demand in their economy so people have less to spend
on imports. This will help reduce the trade deficit. However, a fall in demand may also
affect domestic firms, who may cut output and employment in response to the fall in
demand
An expansionary fiscal policy is when the government lowers tax rates and raise public
expenditure. This boosts spending on imports and help to correct a trade surplus.
However, it may also help domestic firms if demand for their goods and services also
rises, and may help to halt any decline in the industrial base.
3. Monetary policy
An expansionary monetary policy is when the government attempt to attract more
inwards investments to their economy to help offset a trade deficit by raising interest
rates. Higher interest rates will also make borrowing more expensive and reduce the
demand for loans by consumers and firms that may be used to pay for goods and
services supplied overseas.
A contractionary monetary policy is when the government lowers interest rates to help
correct for a trade surplus by lowering the cost of borrowing from firms and consumers,
and will lower the return overseas investors can expect on their inward investments in
the economy so that they invest elsewhere instead.
4. Protectionism
This is when a country uses trade barriers such as tariffs to make imports more
expensive or limit the amount of imports in order to correct a trade deficit.
Visible and Invisible
Visible Trade
Visible trade involves trading of goods which can be touched and weighed. Examples include
trade in goods such as Oil, machinery, food, clothes etc.
Visible Trade consists of
Visible exports: Selling of tangible goods which can be touched and weighed to other
countries.
Visible imports: Buying of tangible goods which can be touched and weighed from
other countries.
Balance of trade
It is the difference between the value of visible exports and value of visible imports of a
country.
If the value of visible exports is more than visible imports the country will have a surplus
balance of trade.
If the value of visible imports is more than visible exports the country will have an
Unfavourable balance of trade.
Invisible trade
Invisible trade involves the import and export of services rather than goods. Example include
services such as insurance, banking, tourism, education.

53
If a UK student comes to Singapore to study, it would be invisible export for Singapore as it is
earning foreign exchange by providing educational services.
If a Singapore citizen travels to UK for a holiday. It will be invisible import for Singapore and
invisible export for UK.
Balance of invisible trade
It is the difference between the value of invisible exports and value of invisible imports of a
country.
Comparative advantage
The theory of comparative advantage states that a country should specialise in the production
of good or service in which it has lower opportunity cost and it should import commodities
which have a higher opportunity cost of production.
Example
Suppose for example we have two countries of equal size, Northland and Southland. Both
produce and consume two goods, Food and Clothes. The productive capacities and
efficiencies of the countries are such that if both countries devoted all their resources to Food
production, output would be as follows:
Northland: 100 tonnes
Southland: 200 tonnes
If all the resources of the countries were allocated to the production of clothes, output would
be:
Northland: 100 tonnes
Southland: 100 tonnes
Assuming each has constant opportunity costs of production between the two products and
both economies have full employment at all times. All factors of production are mobile within
the countries between clothing and food industries, but are immobile between the countries.
The price mechanism must be working to provide perfect competition.
Southland has an absolute advantage over Northland in the production of Food. Both countries
are equally efficient in the production of clothes. There seems to be no mutual benefit in trade
between the economies. The opportunity costs shows otherwise. Northland's opportunity
cost of producing one tonne of Food is one tonne of Clothes and vice versa. Southland's
opportunity cost of one tonne of Food is 0.5 tonne of Clothes. The opportunity cost of one
tonne of Clothes is 2 tonnes of Food. Southland has a comparative advantage in food
production, because of its lower opportunity cost of production with respect to Northland.
Northland has a comparative advantage over Southland in the production of clothes, the
opportunity cost of which is higher in Southland with respect to Food than in Northland.
To show these different opportunity costs lead to mutual benefit if the countries specialize
production and trade, consider the countries produce and consume only domestically. The
volumes are:
Food

Clothes

Northland

50

50

Southland

100

50

World total

150

100

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Production and consumption before trade
This example includes no formulation of the preferences of consumers in the two economies
which would allow the determination of the international exchange rate of Clothes and Food.
Given the production capabilities of each country, in order for trade to be worthwhile
Northland requires a price of at least one tonne of Food in exchange for one tonne of Clothes;
and Southland requires at least one tonne of Clothes for two tonnes of Food. The exchange
price will be somewhere between the two. The remainder of the example works with an
international trading price of one tonne of Food for 2/3 tonne of Clothes.
If both specialize in the goods in which they have comparative advantage, their outputs will
be:
Food

Clothes

Northland

100

Southland

200

World total

200

100

Production after trade

World production of food increased. Clothing production remained the same. Using the
exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland are able
to trade to yield the following level of consumption:
Food

Clothes

Northland

75

50

Southland

125

50

World total

200

100

Consumption after trade

Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now
consume at points outside their production possibility frontiers.
Assumptions in Example 2
Two countries, two goods
o The theory is no different for larger numbers of countries and goods, but the
principles are clearer and the argument easier to follow in this simpler case.
Equal size economies
o Again, this is a simplification to produce a clearer example.
Full employment
o If one or other of the economies has less than full employment of factors of
production, then this excess capacity must usually be used up before the
comparative advantage reasoning can be applied.
Constant opportunity costs
o A more realistic treatment of opportunity costs the reasoning is broadly the same,
but specialization of production can only be taken to the point at which the
opportunity costs in the two countries become equal. This does not invalidate the
principles of comparative advantage, but it does limit the magnitude of the
benefit.
Perfect mobility of factors of production within countries

55
This is necessary to allow production to be switched without cost. In real
economies this cost will be incurred: capital will be tied up in plant (sewing
machines are not sowing machines) and labour will need to be retrained and
relocated. This is why it is sometimes argued that 'nascent industries' should be
protected from fully liberalised international trade during the period in which a
high cost of entry into the market (capital equipment, training) is being paid for.
Immobility of factors of production between countries
o Why are there different rates of productivity? The modern version of comparative
advantage (developed in the early twentieth century by the Swedish economists
Eli Heckscher and Bertil Ohlin) attributes these differences to differences in
nations' factor endowments. A nation will have comparative advantage in
producing the good that uses intensively the factor it produces abundantly. For
example: suppose the US has a relative abundance of capital and India has a
relative abundance of labor. Suppose further that cars are capital intensive to
produce, while cloth is labor intensive. Then the US will have a comparative
advantage in making cars, and India will have a comparative advantage in
making cloth. If there is international factor mobility this can change nations'
relative factor abundance. The principle of comparative advantage still applies,
but who has the advantage in what can change.
Negligible Transport Cost
o Cost is not a cause of concern when countries decided to trade. It is ignored and
not factored in.
Assume that half the resources are used to produce each good in each
country.
o This takes place before specialization
Perfect competition
o This is a standard assumption that allows perfectly efficient allocation of
productive resources in an idealized free market.
o

Absolute advantage
A country has an absolute advantage over another in producing a good, if it can produce
that good using fewer resources than another country.
For example if one unit of labor in Australia can produce 80 units of wool or 20 units of wine;
while in France one unit of labor makes 50 units of wool or 75 units of wine, then Australia has
an absolute advantage in producing wool and France has an absolute advantage in producing
wine.
Australia can get more wine with its labor by specializing in wool and trading the wool for
French wine, while France can benefit by trading wine for wool.
Example 1
Country A can produce one widget using one unit of labour.
Country B can produce one widget using two units of labour.
Country A has an absolute advantage over Country B in producing widgets.
Example 2
Country A has 100 units of labour. It uses 20 to produce 80 units of Parachutes, and 80
to produce 20 units of Barbie dolls.
Country B has 100 units of labour. It uses 40 to produce 100 units of Barbie dolls, and
60 to produce 20 units of Parachutes.
If the countries maximized their potential, Country A could produce 400 units of
Parachutes, and country B could produce 250 units of Barbie dolls. Through trade, the

56
two countries would achieve a more efficient allocation of resources and increase their
prosperity.
Free trade
Definition: International trade left to the mechanisms of demand and supply without
influence of protectionist
methods.
Reasons for Free Trade
Domestic Non-availability
o A nation trades because it lacks the raw materials, climate, specialist labour,
capital or technology needed to manufacture a particular good. Trade allows a
greater variety of goods and services.
Cost effectiveness
o It is cheaper to buy from other countries rather than producing themselves.
Benefits of Trade
Lower prices for consumers
o When there is free trade, consumers can free to buy goods from the producer
who is willing to sell at the lowest prices. Hence consumers gain from lower
prices.
Greater choice for consumers
o With free trade, consumers have access to variety of goods and services from
different producers across the globe. This means more choice.
Ability of producers to benefit from economies of scale
o Producers have access to a larger market thus they can produce more at lower
cost and benefit from economies of scale.
Ability to acquire needed resources
o Through free trade producers can not only sell in a large market but also gain
from purchasing from suppliers across the world.
More efficient allocation of resources
o When there is free trade, the most efficient producers get the opportunity to
produce due to their cost efficiency. This leads to productive efficiency.
Increased competition
o In free trade producers from different regions can compete with each other in
terms of price, quality and variety. Increased competition leads to efficient
allocation of resources.
Source of foreign exchange
o Free trade involves the transaction of goods and services between nations. In
order to purchase goods from abroad (imports), we need foreign currency. This is
possible through exporting of goods to other countries.

57
Free Trade diagrams

Protectionism methods
The chief protectionist measures, government-levied tariffs, raise the price of imported
articles, making them less attractive to consumers than cheaper domestic products. Import
quotas, which limit the quantities of goods that can be imported, are another protectionist
device.
Tariffs
A tariff is a tax on foreign goods upon importation. Tariff rates vary according to the type of
goods imported. Import tariffs will increase the cost to importers, and increase the price of
imported goods in the local markets, thus lowering the quantity of goods imported.

58

Quotas
An import quota is a type of protectionist that sets a physical limit on the quantity of a good
that can be imported into a country in a given period of time. This leads to a reduction in the
quantity imported and therefore increases the market price of imported goods. Quotas, like
other trade restrictions, are used to benefit the producers of a good in a domestic economy at
the expense of all consumers of the good in that economy.
Administrative Barriers
Countries are sometimes accused of using their various administrative rules (eg. regarding
food safety, environmental standards, electrical safety, etc.) as a way to introduce barriers to
imports.
Embargo
An embargo is the prohibition of commerce and trade with a certain country, in order to
isolate it and to put its government into a difficult internal situation, given that the effects of
the embargo are often able to make its economy suffer from the initiative.
Subsidies
Government subsidies (in the form of lump-sum payments or cheap loans) are sometimes
given to local firms that cannot compete well against foreign imports. These subsidies are
purported to "protect" local jobs, and to help local firms adjust to the world markets.

59

Anti-dumping legislation
Supporters of anti-dumping laws argue that they prevent "dumping" of cheaper foreign goods
that would cause local firms to close down. However, in practice, anti-dumping laws are
usually used to impose trade tariffs on foreign exporters.
Externalities, Market Failure and Import Controls
Protectionism can also be used to take account of externalities and dealing with de-merit
goods. Goods such as alcohol, tobacco and narcotic drugs have adverse social effects and
are termed de-merit goods. Protectionism can safeguard society from the importation of these
goods, by imposing high tariff barriers or by banning the importation of the good altogether.
Non-Economic Reasons
Countries may wish not to over-specialise in the goods in which they possess a comparative
advantage. One danger of over-specialisation is that unemployment may rise quickly if an
industry moves into structural decline as new international competition emerges at lower
costs.
The government may also wish to protect employment in strategic industries, although
clearly value judgments are involved in determining what constitutes a strategic sector. The
recent trade dispute arising from the decision by the United States to introduce a tariff on
steel imports is linked to this objective. The US steel tariff was declared unlawful by the WTO
in July 2003 and eventually the United States was pressurized into withdrawing these tariffs in
the late autumn of 2003.
Tariffs are not usually a major source of tax revenue for the Government that imposes them. In
the UK for example, tariffs are estimated to be worth only 2 billion to the Treasury, equivalent
to only around 0.5% of the total tax take. Developing countries tend to be more reliant on
tariffs for revenue.
Economic Arguments against Import Controls
Protectionism hurting customers
Tariffs, non-tariff barriers and other forms of protection serve as a tax on domestic consumers.
Moreover, they are very often a regressive form of taxation, hurting the poorest consumers far
more than the better off. In the EU for instance, the nature of existing protection means that
the heaviest taxes tend to fall on the necessities of life such as food, clothing and footwear.

60
According to Professor Jagdish Bhagwati, the fact that trade protection hurts the economy of
the country that imposes it is one of the oldest but still most startling insights economics has
to offer.
The folly of protection has been confirmed by a range of studies from around the world. These
indicate that that it has brought few benefits but imposed substantial costs. Among the main
criticisms of protectionist policies are the following:
Market distortion: Protection has proved an ineffective and costly means of sustaining
employment.
a. Higher prices for consumers: Trade barriers in the form of tariffs push up the
prices faced by consumers and insulate inefficient sectors from competition.
They penalise foreign producers and encourage the inefficient allocation of
resources both domestically and globally. In general terms, import controls
impose costs on society that would not exist if there was completely free trade in
goods and services. It has been estimated for example that the recent tariff and
other barriers placed on imports of steel into the US increased the price of every
car produced there by an average of $100
b. Reduction in market access for producers: Export subsidies, depressing
world prices and making them more volatile while depriving efficient farmers of
access to the world market. This is a major criticism of the EU common
agricultural policy. In 2002 the EU sugar regime lowered the value of Brazil,
Thailand and South Africas sugar exports by over $700 million countries where
nearly 70 million people survive on less than $2 a day.
Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer
surplus arising from a loss of allocative efficiency. Welfare is reduced through higher
prices and restricted consumer choice.
Regressive effect on the distribution of income: It is often the case that the higher
prices that result from tariffs hit those on lower incomes hardest, because the tariffs
(e.g. on foodstuffs, tobacco, and clothing) fall on those products that lower income
families spend a higher share of their income. Thus import protection may worsen the
inequalities in the distribution of income making the allocation of scarce resources less
equitable
Production inefficiencies: Firms that are protected from competition have little
incentive to reduce production costs. Governments must consider these disadvantages
carefully
Little protection for employment: One of the justifications for protectionist tariffs
and other barriers to trade is that they help to protect the loss of relatively low skilled
and low paid jobs in industries that are coming under sever international competition.
The evidence suggests that, in the long term, tariffs are a costly and ineffective way of
protecting such jobs. According to the DTI study on trade published in 2004, since 1997
UK employment in textiles manufacturing has fallen by 45%, in clothing manufacture by
nearly 60%, and in footwear manufacturing by around 50% - and this despite the
protection afforded to European Union textile manufacturers. The cost of protecting
each job runs into hundreds of thousands of Euros for the EU as a whole. Might that
money have been spent more productively in other ways? Often there is a huge
opportunity cost involved in imposing import tariffs.
Trade wars: There is the danger that one country imposing import controls will lead to
retaliatory action by another leading to a decrease in the volume of world trade.
Retaliatory actions increase the costs of importing new technologies
Negative multiplier effects: If one country imposes trade restrictions on another, the
resultant decrease in total trade will have a negative multiplier effect affecting many
more countries because exports are an injection of demand into the global circular flow

61
of income. The negative multiplier effects are more pronounced when trade disputes
boil over and lead to retaliation.
The diagram below shows the welfare consequences of imposing an import tariff

In a new study of the benefits of global trade and investment published in May 2004, the UK
Department of Trade of Industry outlined their opposition to import controls (protectionism)
Higher taxes and higher prices
Protectionism imposes a double burden on tax payers and consumers. In the case of
European agriculture, the cost to tax payers is about 50 billion a year, plus around 50 billion
a year to consumers via artificially high food prices together the equivalent of over 800 a
year on the annual food budget of an average family of four.
Furthermore huge distortions in international agriculture markets prevent the worlds poorest
countries from trading in the products they are best able to produce. Continuing barriers to
trade are costing the global economy around $500 billion a year in lost income.
Protectionist policies rarely achieve their aims. They can be costly to administer and they
nearly always provide domestic suppliers with a protectionist shield that encourages
inefficiencies leading to higher costs.
Protectionism is a second best approach to correcting for a countrys balance of payments
problem or the fear of rising structural unemployment. And import controls go against the
principles of free trade enshrined in the theories of comparative advantage. In this sense,
import controls can be seen as examples of government failure arising from intervention in
markets.
Economic nationalism
Economic nationalism is a term that has become used more frequently in recent years. It is
used to describe policies which are guided by the idea of protecting a country's home
economy, i.e. protecting domestic consumption, jobs and investment, even if this requires the
imposition of tariffs and other restrictions on the movement of labour, goods and capital.
Economic nationalism may include such doctrines as protectionism and import substitution.
Examples of economic nationalism include China's controlled exchange of the yuan, and the
United States' use of tariffs to protect domestic steel production. The term gained a more

62
specific meaning in 2005 and 2006 after several European Union governments intervened to
prevent takeovers of domestic firms by foreign companies. In some cases, the national
governments also endorsed counter-bids from compatriot companies to create 'national
champions'. Such cases included the proposed takeover of Arcelor (Luxembourg) by Mittal
Steel (India). And the French government listing of the food and drinks business Danone
(France) as a 'strategic industry' to pre-empt a potential takeover bid by PepsiCo (USA).
Sample IGCSE Questions
1. When the exchange rate of a currency depreciates, the balance of trade
improves. Do you agree with this statement? Give reasons for your answer.
(6)
Depreciation is referred to as the decrease in the value of currency relative to another
country. It is often linked with the balance of trade, the amount of exports subtracted by
the amount of imports. When the balance of the trade improves, this means the value
of exports is greater than the value of imports; a trade surplus. This means that the
value of exports is cheaper overseas so people are able to buy more of the countrys
exports so demand for the good increases and thus they would have higher purchasing
power to buy your good. This causes the country to export more. Another reason is that
because of depreciation, imports become more expensive so demand for imports
decreases as prices for imports rise.
However, exports may not rise if another country has depreciated its currency even
further or produced that good at a lower cost. Exports may not even increase if there
are a lot of substitutes for the good, such as coffee beans. If the exports are inelastic,
there is little change in quantity demanded. Countries like Hong Kong are dependent on
food and oil, they are forced to pay a higher price and quantity demanded will not fall
too much.
In general, currency depreciation should improve the balance of trade.
2. Apart from depreciation of the currency, identify and briefly explain two
measures that a government may use to increase exports. (4)
a. Demand-side policy promotion of products made in the country, for example,
The British Council has an annual trade fair on British goods to attract more
buyers. Similarly, for Hong Kong, it is the Hong Kong Trade and Development
Council (HKTDC).
b. Supply-side policy Subsidies to export companies to lower production cost and
increase supply. For example, Chinas subsidies to solar panel producers.
3. To what extent is international borrowing by a developing country likely to
lead to an increase in the standard of living? Give reasons for your answer. (6)
International borrowing is when countries or government borrowing money from banks
overseas. Standard of living is the welfare of individuals. One example of international
borrowing is when the Chinese government borrowed from the International Monetary
Fund (IMF) to build the Three Gorges Dam. By building this dam, it allows people in
China to have access to clean water which reduces cholera and other water-borne
diseases outbreaks and increases their health. Another added benefit of building this
dam is that it is a hydroelectric plant and produces a large supply of electricity to power
businesses and therefore increase productivity. Irrigation can also be provided by the
dam to improve the marginal agricultural areas. Thus, farmers in these areas can
produce more agricultural products and increase their standard of living. Another

63
important benefit is that by building this dam, it creates jobs for construction workers as
well as engineers, architects and many others.
However, international borrowing results in high interest rates and in the long-term,
debt. The disadvantage of building a dam is that the surrounding wildlife and habitat
will be destroyed and some people will be relocated and thus, this will decrease their
standard of living.
In conclusion, for the majority of the people, the standard of living will increases due to
international borrowing.
4. How does combatting inflation affect the exchange rates? (6)
Raising benchmark interest rates is the preferred plan of action when it comes to the
central bank's fight against inflation. It's the easiest and simplest strategy, and the
results can sometimes be quicker compared to other methods. All a monetary body
does, in this instance, is increase the benchmark that most commercial and retail
banks refer to when creating client loans. These products include mortgage, student
and car loans, along with commercial loans for businesses. Once these rates rise, the
cost of money increases. This isn't a good thing for customers or companies. (For more
on the relationship between interest rates and inflation. Global investors constantly
search for high interest rate returns combined with relatively low risk. The same goes
for foreign exchange investors. So, when a central bank elects to raise rates, you can
be sure that demand for that currency will rise. For example, the Australian dollar
benefited from this phenomenon beginning in June 2010. The central bank of Australia
raised rates several times between late 2009 and early 2011. By January 2011, the
Australian dollar had risen by 26% compared to the U.S. dollar in response As the
Australian economy rebounded quickly amid a slumping global economy, the country's
central bank was forced to raise rates more than once by 25 basis points each time
in order to fight inflation. The decisions led to higher demand for the Aussie, especially
against the U.S. dollar, during that time.
An equally effective strategy for central banks is to raise the reserve requirements of
banking institutions. When a central bank elects to raise the reserve requirements, is
limiting the amount of money or cash in the system - referred to as the monetary base.
An increase in the reserve requirement increases the minimum cash reserve that a
commercial bank is governed to hold, so this adjustment prevents the bank from
lending out that cash. This restriction of money will slow the rise in prices as there will
be less money chasing the same expensively priced goods (hopefully suppressing
demand). The Chinese government favors this policy due to its own semi-fixed currency
policy. Since the beginning of 2011, the People's Bank of China has elected to raise the
reserve requirement three times increasing the rate by 50 basis points each time.
The decision to raise reserve requirements should eventually slow down the inflation of
a nation's currency. More often than not, such a decision also helps to fuel the foreign
exchange rate's upward trend in value due to speculators. So, the central bank's
decision holds significance for the foreign exchange investor.
By increasing the reserve requirement, the central bank is acknowledging that inflation
is a problem and is aggressively dealing with it. However, this could increase a
currency's attractiveness to forex investors, as they anticipate another round of reserve
requirement increases. As the supply of money thins - a result of higher reserves held
by banks - speculation helps to support and even propagate a higher currency valuation
(thus lowering inflation). Referring back to the Chinese yuan, the effects of speculative
demand are apparent: The currency gained by almost 4% following a series of reserve

64
rate increases from June 2010 to January 2011, as speculators anticipated further
reserve quota increases for Chinese domestic banks.
5. Changes in rate of exchange meant that exports of good from Egypt
decreased a they became more expensive in other countries
a. Explain what is meant by a rate of exchange. (3)
A rate of exchange is the rate at which one currency can be exchanged for
another on the global foreign exchange market. It is therefore the market price of
one currency in terms of another currency, for example, the price of euros in
terms of US dollars
b. If exports from Egypt become more expensive, how might that affect
production and employment both in Egypt and in countries importing
Egyptian goods? (7)
If exports from Egypt become more expensive, global demand for them is likely
to fall. Unless global demand is price inelastic this will
lose revenue and their
profits will fall. In response, exporters may cut back their production and reduce
their employment of labour. If exports are a major source of revenue for Egypt,
this could result in a significant loss of income and high unemployment.
In the country importing Egyptian goods there could be inflation, especially if the
Egyptian goods make up a significant proportion of total imports and are used by
firms in the production of other goods and services. However, consumers in this
country may be able to buy similar products from domestic producers instead.
Domestic firms are likely to respond by increasing their output and demand for
labour rise. However, if consumers also switch some of their demand to other
imported goods from other countries then the potential for growth and
employment in their country will be reduced.
c. Describe the structure of balance of payments on current account of a
country (4)
The balance of payments of a country records international transactions with
other countries. The current account within the balance of payments records
payments made to other countries for visible and invisible imports and payments
received from overseas from the sale of visible and invisible exports. The balance
of trade is therefore the difference between the value of goods exported and the
value of goods imported by a country. The balance of invisibles is the difference
between the value of services purchased by overseas firms and residents and the
value of services purchased from by domestic firms and residents.
The current account also records income flows into and out of a country including
wages earned by residents working overseas or paid out to migrant workers from
overseas, and any international payments of interest, profits and dividends. It
also records current transfers including payments of taxes and excise duties by
visiting residents of other countries, or similar payments mad overseas.
d. Discuss what might lead to an improvement in the current account of a
country (6)