a) Red pens b) Green pens c) PPF

P (/pen) P (/pen)
S S1 Red pens
A S0
PPF
P1 B
P1 q1 B
P0 C
P0
q0 A
D1
D0 D1
q0 q1 Q1 Q0
Q/t (pens/year) Q/t (pens/year)
Q1 Q0
A An increase in demand for red B and since producers now Green pens
pens (D0 to D1) increases quantity reallocate scarce resources from
supplied green pens to red pens, supply
of green pens decreases from S0 C Assuming only two goods, red
and green pens, the reallocation of
to S1. resources from green pens to red
pens can be illustrated using a PPF.

Figure 7.2a) to c) illustrates how the flexibility of competitive markets leads to market
dynamism where prices change ultimately in accordance with the forces of supply
and demand. Assume two goods, for example red and green pens, and optimum efficiency
(Pareto optimum see next chapter) in an economy. Recall the basic issue of scarcity and
endless wants and how markets solve the basic economic problem via the signalling function of
prices.

Point A in figure a) illustrates an increase in demand for red pens which drives up the
price and signals suppliers (incentive function of price) to increase the quantity
supplied of red pens (q0 to q1).
Point B, figure b) and c): Since the economy is operating at optimum efficiency (point
A, figure c)), suppliers must reallocate resources from green pens to red pens, points A
to B in the PPF, figure c).
As resources used in the manufacturing of green pens become more scarce, the supply
for green pens decreases from S0 to S1 (figure b)). The increase in the price of green
pens (P0 to P1) signals consumers to decrease their consumption (rationing function of
price) of green pens quantity demanded for green pens decreases from Q0 to Q1.
Fig. 9.4 Demand for DVDs values of PED along a linear demand curve

A PED = (infinite)
10
Price (/DVD)

PED = 6.33

11 PED = 6.33
PED = 21
10 9
1 2
9
Point value of PED
PED = 3.4
8
PED = 2.14 B PED = 1 (unitary)
7
PED = 1.44
6
PED = 1
5 PED = 0.69
4 PED = 0.47
3
C PED = 0 (zero)
PED = 0.29
2 PED = 0.16
1 PED = 0.05
0 0 1 2 3 4 5 6 7 8 9 10 11
Quantity (1,000s)/week
 o Pareto optimum
The concept of societal efficiency in an economy was pioneered by the Italian/French
social-economist Wifredo Pareto (1848 1923) and is often explained using a PPF for
supporting illustration. For once, I shant be different. Societal efficiency is said to be
maximised when the economy is operating on the PPF; anything else would mean that
resources are not being used to the utmost. The PPF in figure 8.4 shows an economy
where output is divided into goods for IB teachers1 (such as TOK books and
comfortable shoes) and IB students (Nintendo games and m

Fig. 9.5 PED along a linear curve

P ($)
Infinite price elasticity; PED =
11
Elastic portion of demand curve; PED > 1

Unitary PED, PED = 1

5.5
Inelastic portion of demand curve, PED < 1

Zero price elasticity; PED = 0

Q/t
5.5 11

Determinants of PED
Thereareanynumberoffactorsthatwillhaveaninfluenceonthepriceelasticityofdemand,
allofwhichdealdirectlyorindirectlywiththestrengthofconsumerspreferencesandtheir
abilitytofind/acceptothergoodsinstead.Onerealisesintuitivelythattheelasticityofdemand
formedicineswilldifferfromthatofluxurycruisesintheCaribbean.Thedeterminantsofprice
elasticityofdemandcanbeoutlinedinthreeheadings;

1. Theavailability/closenessofsubstitutes;
2. Thetimespaninvolved;and
3. Theproportionofincomespentonthegood.

1
There are so many things Id love to put herebut my editor wont let me. Feel free to write to me with
suggestions!
Fig. 9.8 Total revenue (TR) along a demand curve

P ($) TR; $3 x 1 = $3

4
TR; $2 x 2 = $4
3
2 TR; $1 x 3 =$3
1
0 Q/t
0 1 2 3 4
Fig. 9.9 Total revenue for Linas Lemonade Emporium

Price ($/litre)

Remember, the
portion of the
10 demand curve above This is the point of unitary PED. Any
unit PED is the movement towards this point will
9
elastic portion. increase TR. Setting price/output at this
8 point maximises TR.
7

6
Remember, the
5 portion of the
demand curve below
4 unit PED is the
3 inelastic portion.

1
D
0 Q (litres per day)
0 1 2 3 4 5 6 7 8 9 10

The total revenue curve shows that

TR ($) maximum possible revenue is at a
quantity of 5. (Note that the P-axis is
now the TR axis.)
25
24

21

16

TR

0 Q (litres per day)

0 1 2 3 4 5 6 7 8 9 10
Fig. 9.12 Expenditure tax on a) Cigars & b) Almonds

a) Cigars b) Almonds

P ($/cigar)
S+tax P ($/hg) S+tax
S0
S0
1.6
1,11
Tax = $1 per 1 Dalmonds
cigar
1
0.6 Tax = $1 per hg
0,11
Dcigars
68 100 50 100
Q/t (millions cigars/month) Q/t (millions hgs/month)

Govt. tax revenue; $1 x Govt. tax revenue; $1 x

68 = $68 million 50 = 50 million

Note: We will re-do the issue of indirect taxation (e.g. expenditure tax) in Chapter 13.

Fig. 12.5 Time as a determinant of PES - supply of beef

Simmediate: The PES of beef in the immediate

term would be perfectly inelastic in a given
P ($) Simmediate market.
SSR SSR: Over longer time spans however,
SLR increases in demand can more easily be met by
increased stocks of frozen meat.
SVLR SLR: In the long run, larger herds and increased
land use for cattle (another re-allocation issue!)
increases the PES.
SVLR: In the very long run, improved genetic
Q/SR to VLR cattle strains resulting from crossbreeding and
genetic modification increase PES further.

Closelyrelatedtotheissueofthetimeinvolvedinincreasingquantitysuppliedwithinagiven
period,istheability(andcost!)incurredbyproducersinswitchingfromtheproductionofone
goodtoanother.Aproducersubstituteisagoodwhichsupplierscanswitchtoasanalternative
nottobeconfusedwithconsumersubstitutes.Theeaseordifficultyanygivensupplier
experiencesinmovingproductiveresourcesfromonegoodtoanotherwillbeamajorfactorin
determiningsupplyelasticity.Acommonclassroomexampleiswhiteboardpensandpermanent
markersbeingverycloseproducersubstitutes.Switchingfromwhiteboardpenstopermanent
markers2wouldinvolveverylittleinthewayoftoolreadjustment,machinemodifications,new
materialandknowledgeandsoforth.Supplywouldbeveryelastic.Switchingfromcompact
carstomidsizedcarsisalsofairlysupplyelastic.

Manyprimarygoodssuchasironore,teakwoodandagriculturalgoodswillbehighlyinelastic,
astheabilitytoswitchtosuchgoodsintheshortrunisverylimited.Thebasicpremisehereis
thatoncesuppliershavealargeamountofresourcessunkinacertainsector,thereapplicability
oftheseresourcesisthekeytoincreasingsupplyofothergoods.Justconsidercommodities
suchasironandcopper;ifyouhaveacoppermineanddemandforironincreasesitsgoingto
beabitdifficulttoswitchproductiontoiron.Imean,youhaveacoppermine

2
Afavouriteclassroomprankknowntoallmypeople,incidentally.
 Price (/jacket)
Market for jackets
210 Consumer surplus
200
A
190 P ()
B F
180
C G S S
170
D H
160
E I
150 P
V IX
140
IV VIII
130 D
III VII D
120 Q/t
II VI Q
110
I
100
Supplier surplus
90 I

0 1 2 3 4 5 6 7
Quantity (100s jackets/week)
 Remaining Sum of the net
consumer surplus losses of
consumer
surplus and
A + B: loss of A: govt tax B: net loss of
P (/pen) Tax per pen supplier surplus
consumer revenue paid consumer
= deadweight
surplus due to by consumers surplus
loss
tax
S

P1
B A A
P0 A B B
C D D D
C C
P*

D1 C + D; loss of C: govt tax D: net loss of

Q1 Q0 Q/t (pens/year) supplier surplus revenue paid supplier
due to tax by suppliers surplus
Remaining supplier
surplus

The tax decreases the quantity demanded and supplied from Q0 to Q1

Consumers pay more (P0 to P1) but suppliers earn less (P0 to P*) since they
have to pay the tax of P* to P1 shown by the red double-edged arrow
Total tax revenue to government is the tax per unit (P* to P1) times the
quantity (Q1) e.g. areas A and C
Since consumers are paying more for less then there must be a loss of
consumer surplus this is shown by areas A and B
Suppliers are receiving less for less which is a loss of supplier surplus areas
C and D
Total loss of supplier surplus and consumer surplus, societal surplus, are areas
A+B+C+D
However, government is part of society just like firms and consumers this
total (gross) loss of societal surplus is to an extent offset (= compensated) by
the increase in government revenue of A + C
The two areas of societal surplus lost which are not offset by governments
gain (tax revenue) are areas B and D this net loss of societal surplus is the
deadweight loss due to the expenditure tax on pens

<definition>
Deadweight loss: A deadweight loss is an efficiency loss to society since societal
surplus is decreased without a corresponding gain for another actor in society. It is the
net loss of consumer surplus and supplier surplus.
<end def>
 Definition: Ad valorem tax
An ad valorem tax (value added tax) is based on the base value (price) of a good sold, and as it
is a percentage the amount of tax per unit will increase as the base value increases.

Fig. 13.5 Expenditure tax on a) Cigarettes & b) Oranges

a) Cigarettes b) Oranges

P (/pack) P (/kg)
S+tax
S+tax
S0 S0
140

120
Tax = 50 per
100 Tax = 50 per 100 kg
90 pack
Doranges
70
Dpetrol

80 100 60 100
Q/t (millions packs/month) Q/t (millions kg/month)

Incidence of tax on Incidence of tax on

consumer; 40 x 80 consumer; 20 x 60
mn = 3,200 mn mn = 1,200 mn

Incidence of tax on Incidence of tax on

producer; 10 x 80 producer; 30 x 60
mn = 800 mn mn = 1,800 mn

Total incidence of tax. Total incidence of tax.

Govt. tax revenue; 50 Govt. tax revenue; 50
x 80 mn = 4,000 mn x 60 mn = 3,000 mn
 Summary and revision (need a cool pic here.maybe a pic of someone doing push-ups!)

Governments tax goods to either gain government tax revenue or decrease consumption of the good.

Expenditure taxes are indirect taxes. Consumers pay to firms which then pass on the tax to
government. This increases firms costs and thus decreases supply.

A specific tax or unit tax is an expenditure tax on goods based on a unit sold or consumed such as
2 per bottle of wine or pack of cigarettes.

An ad valorem tax is a percentage added on to the base value or price of the good.

Specific tax (unit tax) Ad valorem tax

P ($) Govt revenue from tax P ($) S+tax
S1
S+tax
S1
125 S0
P1 S0
P0 Tax (25%)
P0 100
Tax ($/unit) D
P* Q/t
D
Q/t
Q1 Q0 Q1 Q0

HL extensions
The more price inelastic demand is the higher the incidence of tax is on the consumer and the
greater is the overall incidence of tax (government revenue).

High PED Low PED

P ($) S+tax P ($) S+tax
S1 S0 P1 S1 S0
P1
Tax ($/unit) P0
P0 Tax ($/unit)
P*
P* D
D
Q1 Q0
Q/t Q/t
Q1 Q0

Incidence of tax on Incidence of tax on

producer consumer

<Def>
Definition: Subsidy
A subsidy is a money gift/grant from government which acts as a) an incentive to producers to
produce more; and b) lowers the (marginal) costs of production. Both of these forces serve to
increase supply.
<End def>
The main reasons for subsidies are:
 Increasing employment increased output in firms can create demand for labour and
unemployment falls (infrastructure projects such as bridges and dams)
Protecting a way of life and culture traditional way of life in farming/rural areas can
be upheld (farming subsidies in the EU)
Redistribution of income disadvantaged industries receiving subsidies can retain
wage levels for employees (mining industries in the UK in the 1980s)
Meet international competition and improve the trade balance as subsidies lower the
costs of production, domestic industries become more price competitive which can
increase exports and/or decrease imports (oil industry subsidies in the US)
Improve production potential and products subsidies to firms and universities serve
to increase research and development (R&D) spending which can increase productivity
and spur innovation (alternative energy in Spain and Denmark)
Provide more goods which are societally beneficial goods which have positive
effects not only on the consumer but other groups (third parties) are said to be under-
consumed without a subsidy (milk and dental care in Sweden)

Fig. 14.1 Incidence of a subsidy on wheat

The supply curve S+subsidy

Incidence (= benefit) of
shifts parallel to the subsidy on the supplier
original curve.
Incidence (= benefit) of
P (/tonne)
subsidy on the consumer
S0

105
S+subsidy
100 Subsidy/unit
Total incidence of the
= 10
95 subsidy, e.g. govt. cost
of the subsidy: 10 x
60,000 tonnes =
600,000

D
50 60
Q/t (1,000s tonnes/year)

(Small heading) Evaluation of subsidies (over dinner)

There are numerous issues arising in the area of subsidies that can and should be discussed. The
main three areas deal with costs, equity and developing countries.

Actual costs of subsidies: I once asked a lady at the milk section in a grocery store in
Sweden if she thought milk was expensive and to my amazement she said Not as
expensive as it would be without the subsidy! She had her mind screwed on right
just look at figure 14.1 and calculate the actual cost per tonne of wheat! Yes, the entire
subsidy from government comes from tax money. Milk buyers are paying for this
subsidy indirectly
o Inefficiency costs arise since the decision to take my tax money and give it to
wheat/milk producers is made by the government. It would be far more
efficient to let the price mechanism allocate resources.
o All of the subsidies will entail administrative costs.
 o The heaviest costs are of course the opportunity costs of the subsidies. Most
of us in the developed world could think of a number of better things to do
with the money than to give it to farmers.
Equity3: I also asked a French ex-wifes family at their dinner table one time what
do you think about me, the Swede, paying tax money so you French can enjoy cheap
cheese?4 Looooong silence and thenno answer. The fact is that Sweden is one of
the largest net contributors to the EU and thus the Common Agricultural Policy (CAP)
and France is one of the largest net beneficiaries. Even if I had been in Sweden I would
have asked the question of a Swedish farmer why are farmers considered so
valuablewhy not cobblers or thatchers The basic question here is on what
grounds government not the consumer! decides who gets subsidies.
Developing countries: I hate to run this in to the ground but heres another one. At a
dinner party here in Mexico I asked my hosts (who are still my friends!) so, how do
you feel about US subsidies on cotton, corn and pork? My ears are still burning from
the reply, which was along the lines of how US producers were dumping5 agricultural
products on Mexico and destroying domestic markets due to the fall in prices. (Like a
good economist, I looked it up. See the table below.) There are numerous examples of
how subsidies in high income countries create surpluses of agricultural produce which,
when dumped on LDCs causes not only loss of LDC export income but also the
destruction of domestic LDC markets. In Chapter 15 I shall return to the issue of how
rich world intervention on agricultural markets destroys livelihoods in poor countries.

(Marcia: needs disguising!)

3
Equity means fairness in distribution of societal resources.
4
Yes, I actually did this. Nothing like a little light chit-chat to make a dinner pleasant. Dessert
waschilled, shall we say.
5
This has a very specific definition in economics. It is the selling of goods on foreign markets
at below the cost of production at home.
Summary and revision (need a cool pic here.maybe a pic of someone doing push-ups!)

1. A subsidy is a gift or grant of money to firms which lowers (marginal) costs of production and
serves as an incentive for firms to increase output.

Governments subsidise industries in order to create employment, preserve a way of life/culture, create equity
in society, improve the home economys international competitiveness, facilitate R&D, and increase
consumption of goods considered to be beneficial to society.

The effects of a subsidy:

Lower price for consumers (P0 to P1)

P ()
S0 Increased quantity on market (Q0 to Q1)
P* Increase in income for firms (areas A, B and
S+subsidy C)
A Cost of subsidy to govt (areas A, B and D)
P0
Incidence of subsidy on consumers (areas B
D B
P1 and D)
Incidence of subsidy on suppliers (area A)

D
Q0 Q1 Q/t ()

Subsidies have been seriously criticised for, amongst other things

The hidden costs of administration
Efficiency losses
Opportunity costs of foregone societal goods in other sectors
Questionable equity
Dumping of excess produce on LDCs
 a) Producer revenue b) Consumer spending

Subsidy = 2 Subsidy = 2
P (/tonne) per tonne P (/tonne) per tonne
Cost to govt (= total
S0 incidence of subsidy) S0
5 5 5
S+ subsidy S+ subsidy
4 4 4

3 3 3

D D

6 10 6 10
Q/t (1,000s tonnes /month) Q/t (1,000s tonnes /month)

Producers revenue before Consumers decrease in

subsidy spending due to subsidy

Producers increase in Consumers increase in

revenue due to subsidy spending due to subsidy

Subsidy in open economy

 1. New Q of M; 60
2. Cost to govt: USD20 x 40 = USD800 (areas A and B)
3. CS: unchanged since there is no change in Q or P!
4. Change in dom prods TR; initial TR is USD100 x 10 = 1,000. New TR
is USD120 x 40 = 4,800. Change is USD3,800.
5. NPOSprobably, inc of subsidy on cons is ZERO. All goes to dom
prods.

Market faiulure (any situation where the MSB MSC)

1. Externalities
a. Negprod (pollution)
b. Negcons (de-merit goods and bads)
c. Poscons (merit goods [def; high pos extsand good for user
in LR], public goods [def; non-excl and non-rivalrous)
d. Posprod (stoopid)
2. Imperfect competition (use mons as ex)
3. Info asymmetry (used cars, health/fire insurance)
4. Common access resources (tragedy of the commons today the sea!)

Definition: Market failure

When the price mechanism fails to allocate resources towards the socially optimal amount, i.e.
there is suboptimal resource allocation, one speaks of market failure; there is a non-Pareto
outcome.
Fig. 2.4.3 Negative externalities of plastic production

P($/unit) MSC
MPC
MPC MSC; extent of the negative
externality in production
Psoc opt
P0 Welfare loss in producing Qsoc opt to Q0
more units of plastic each unit has a
higher MSC than MSB
MSB (= MPB)
Qsoc opt Q0 Q/t (units/month)

Definition: Demerit good

A demerit good has negative externalities and users do not realise or choose to ignore the
costs to themselves in the long run. Common examples are tobacco and alcohol.
Fig. 17.3 Taxing away negative externalities of production
P($)
Extent of negative externality with
expenditure tax added
MSC

MPC + tax

MPC0
Psoc opt
Expenditure tax per unit
P1

P0 Extent of negative
externality without tax
MSB (= MPB)
Q/t
Qsoc opt Q Q
1 0

Welfare loss before tax

Welfare loss after tax

 Fig. 18.2 Positive externalities of education

P($)
Government subsidies or government provision
MSC0 (= MPC) increase supply from MSC to MSC+subsidy, bringing
total output to Q1 and closer to the societally optimal
MSC1 output of Qsoc opt.
Psoc opt Government incentives such as paying families for
every day their children are sent to school will increase
demand for education, shown by the shift from MPB0
P0
MSB to MPB1 again, output is closer to the societally
optimal level of Qsoc opt.
MPB1

MPB0
Q0 Q1 Qsoc opt Q/t (school hours/year)

Extent of positive
externality

Potential welfare
gain

Definition: Merit good

A merit good is a good where individual consumption benefits the user in the future and others
in society, e.g. there are positive externalities. It is commonly under-consumed/under-provided
due to consumers underestimating or ignoring the long run personal and societal benefits.
Examples include health care and education.

1) Consumersignorethebenefitstoothers:Theinabilitytoseehowpersonal
consumptionspillsoverandbenefitsothersocietalmembersisperhapsoneofthe
largestobstaclesinpeopleconsumingthesociallyoptimalquantity.Theexistenceof
positiveexternalitiesinitselfmeansthatthegoodwouldbeunderconsumedand
thereforeunderprovided.

2) Consumersignoretheirownfuture
benefits:Anotherexplanationforunder
consumptioncanbefoundinwhateconomistscalltimeinconsistentbehaviour.
Thisariseswhenthebenefitstotheuser/consumerarefarinthefuturewhilethecosts
areimmediate.Insuchsituations,peoplearenotinclinedtogivethebenefitsenough
weightinweighingthecostsandbenefits.Givinguppresentenjoymentinorderto
learnFrenchwouldincreasepossiblefuturebenefitsintravelandemployment
possibilitiesbuthowmanywouldactuallythinkalongtheselines?! 6

Oneofmyfavouriteexamplesoftimeinconsistentbehaviourwaspointedoutbyoneofmy
6

students.InthemovieBridgetJonessDiarytheresthescenewhereshewrites;Monday
28thofApril.Gymvisits,zero.Numberofgymvisitssofarthisyear;1.Costofgym
membershipperyear;370.
 Summary and revision (need a cool pic here.maybe a pic of someone doing push-ups!)

Positive externalities in production are when the marginal private costs are higher then the marginal
social costs (MPC > MSC). In terms of resource allocation, the good is underprovided. Fire breaks
protecting individual properties is an example of a good with positive externalities in production.

Positive externalities in consumption exist when an individuals consumption of a good has positive
effects on non-users/consumers. Thus the marginal social benefits are greater than the marginal
private benefits (MSB > MPB) and the good is under-consumed. Health care, education and pension
schemes are examples of goods with positive externalities in consumption.

Merit goods are goods which have benefits to the user in the future and also positive spillover effects
in consumption.

Since merit goods are under-consumed in terms of societal optimum (e.g. where MSC = MSB),
government policies aim to increase demand and or increase supply of merit goods:
Increasing demand: positive advertising campaigns for bicycles, incentives for households in
developing countries to send children to school, and information to households about recycling are
all possible government measures.
Increasing supply: government or the municipality can supply the good at break-even price or even
at a loss, subsidise the good, and offer various forms of incentives for firms to provide more of the
goods.

Figure19.1classiceconomicdivisionofgoods

Division of goods Exclusion of non-payers (excludability) is it

Competition in
consumption (there is
rivalry or diminishability
in consumption) does
my use diminish others
use?
possible to charge users separately and based
on the quantity consumed?
YES NO
YES Private goods: Common access resources:
food, cars, natural environment, open
houses, clothing range grazing land, fish
stocks in international waters
NO Club goods: Public good: police force,
clubs, private lighthouses, air traffic
schools, public control, street lights,
parks, TV fireworks displays, military
broadcasts defence, earthquake or
tornado warning systems,
flood banks

(Type 4 Smaller heading) Non-rivalry

ByputtingonmymantaraybootstogouptoTonis,Ihinderedothersfromconsumptionof
thegood,whichisanexampleofrivalrymyuseofmybootsbarsothersfromuse.Myboots,
carandMP3playerareexamplesofrivalryinconsumption,sincemyusedecreasesthe
availabilityofthegoodforothers.Apublicgood,bycontrast,doesnothavethiselementsince
thegoodcanbeusedsimultaneouslybyotherpeople.Myuseoftheroad,roadsigns,police
force,andstreetlightsdoesnotreduceavailableconsumptiontoothers.Thuspublicgoodsare
subjectto(varyingdegreesof)nonrivalry,meaningthatonepersonsusedoesnotdiminish
theavailabilityofthegoodforothers.GetoffofmycloudbytheRollingStonesisactuallyfar
moremeaningfulthanGetoutfromundermystreetlight!7

(Type 4 Smaller heading) Non-excludability

Whatabouthinderingsomeonefromusingthegoodinthefirstplace?Yes,thisisactuallythe
definitionofprivategoods;oncethegoodhasbeenprovided,theprovidermustbeableto
excludeyoufromuseinordertobeabletochargeyou.Thustheprovidercanexcludenon
payersfromuse,justliketheboots,carandMP3player.Thishighlightspreciselytheproblem
withgoodssuchasroads,roadsigns,andstreetlights;oncetheyhavebeenprovidedtheycan
beusedbyanyonepayersandnonpayersalike!Thismeansthatthereisanelementofnon
excludabilitybuiltintosomegoods,andthisisthesecondprerequisiteofapurepublicgood;
onceprovided,onecannotexcludeanyonefromusingit.

Free rider problem

Thisisalsoknownasthefreeriderproblemandshouldbewellknownamongststudents
whohaveeverdoneagrouppaperwherethreestudentsdidalltheworkandthefourthwasa
uselessslacker.Thetermfreeriderisactuallytakenfrompublictransport,wherethe
provisionofabusservicewouldbefreeforthosewhodidntpaythefareyetprovidedforby
thosewhodid.Hencefreerider.

7
But theres no way Im not going to tell the following little story! My friend Toni lives in a gated
community e.g. an area behind gates where you have to show ID to get in. After some heated discussion
in the community about who was paying for the streetlights or not, the community leaders assigned
streetlights! Anyone who didnt pay their bill found themselves on a very dark street. Another favourite
example in economics bites the dust
 Definition: Public goods
A public good is distinguished by high positive externalities but also non-rivalry (my use does
not diminish your use) and non-excludability (non-payers cannot be excluded once provided)
in provision. It is very difficult to charge individual users and is thus often provided by public
monies.

Provision of public goods

Thereisaverynoticeablecommondenominatoramongsttheexamplesofpublicgoodsabove,
namelythattheyareinfactconsideredofsuchimportancethattheyaresupplied!Therearein
otherwordsgoodswhichcannotreallybechargedformuchlesslimitedtousersonlyyet
areprovidedforinvirtuallyeverymodernsociety.Why?How?Theanswertothefirstquestion
isbynowselfevident;anygoodwhichisconsideredtobeofsuchobviousgaintosociety
roads,lighthouses,drainagesystems,waterfiltration,electricitygrids,militaryandcivil
defence,airtrafficcontrol,policeforce,judiciarysystem,etcwillultimatelybebothdesired
andsuppliedsomehow.Theremainingquestion,How?mustenablepotentialsupplierstobe
abletoprovidethegoodeconomicallyinspiteofnotbeingabletochargeforitsuse.This
wouldexcludetheprivate(freemarket)sectorimmediately.Theansweristaxationandpublic
sectorprovisionofthegood.Everybodypayssinceeverybodybenefits.Endofstory.As
everyoneisreapingthebenefitsofconsumptionitisonlyfairthateveryonepullastrawfrom
thestackandhelppayforit.

Summary and revision

Public goods have two basic characteristics other than high positive externalities:
Non-excludability once the good has been provided it is impossible to prevent non-payers
from consuming the good
Non-rivalry on persons consumption does not diminish (or rival) another persons
consumption

Free rider problem means that it is possible to consume a good or resource without paying
for it. This is a problem common to public goods and thus precludes provision by a free
market.

Examples of public goods are police force, lighthouses, air traffic control, street lights,
fireworks displays, military defence, earthquake or tornado warning systems and flood
banks

The solution to market failure in the case of public goods is to provide the goods via
taxpayers money.
Theory of the firm

Fig. 2.3.23 The PCM firms supply curve

Potato market Firms demand

P (DKK/tonne) P, costs (DKK)

D1 MC
D0
S
11 11 D, AR, MR1
D2
10 10 D, AR, MR0
9 9 D, AR, MR2

2,500 5,000 7,500 220 300 350

Q(tonnes/week) Q(kgs/week)

8888

Fig. 2.3.24 Short run possibilities in a PCM firm

Normal profit Abnormal profit Loss

P, costs ($) P, costs ($) MC P, costs ($)

AC
MC MC
AC AC
P
AR, MR, D
Loss/unit
P AR, MR, D
AR, MR, D
Profit/unit P

Q/t Q/t Q/t

Q-max Q-max Q-max = Qloss-min

Normal profit; at Q-max, Abnormal profit; at Q-max, Loss; at Q-max,

AR = AC (AR AC) x Q (AR AC) x Q

Recallthatprofitistheresultofsubtractingtotalcostsfromtotalrevenue,whichintheunitcost
picturecorrespondstosubtractingaveragecostsfromaveragerevenue.Figure2.3.24shows
threepossibilities:

Normalprofit:WhenthemarketpriceequalstheACofthePCMfirm,thefirmwill
breakeven,i.e.itwillenjoynormalprofits.Thisisshowninthediagramtothefarleft
above,astheMR=MCpointcoincideswithaveragecosts.AsAR=ACthereisa
normalprofit.

Abnormal/supernormalprofit:Themiddlediagramillustratesasituationwherethe
marketprice(andthustheMR,ARcurve)isabovetheaveragecost.Thefirmsets
outputatQmaxandearnsanabnormalprofit,shownbytheredarea.

Loss:Finally,whenthepriceisbelowanypointontheACcurve,thefirmwilloperate
ataloss,asprofitmaxoutput(Qmaxwhichisthesameasthelossminimisinglevel
ofoutput;Qlossmininthediagram)resultsinanARbelowAC.Thelossisshownbythe
darkgreyareainthefarrightdiagram8.

Definition: Productive efficiency

Productive efficiency occurs when goods are produced at the lowest possible cost per unit,
taking into account all costs arising. For a firm, this is when output level is at ACmin.

Definition: Allocative (economic) efficiency

When there is no waste in resources in the production of goods, allocative efficiency is
optimised. This point is reached when there is zero excess supply or demand on the market and
the marginal revenue is equal to the firms marginal cost. S = Dand P (AR) = MC.

8
Students often ask why the firm continues to set output at MC = MR even when average costs are
higher than the price. The answer is that this point is also the loss minimising point of output, i.e. the
firm would make an even greater loss by setting output at any other level than the MC = MR point.
Fig. 2.3.30 Short run loss in a perfectly competitive market firm

Allocative efficiency: The PCM firm produces where

P (AR) = MC. Market equilibrium is attained as no
excess supply or demand exists.

PCM firm Market

P, costs ($) MC P ($)

AC S

P AR, MR, D P

D
Q/t Q/t
Q-max Qmkt

Productive efficiency: PCM firm

produces where AC is minimised.
Summary and revision

The perfectly competitive market model is based on five main assumptions; 1) a large
number of firms; 2) the firms are producing homogenous goods; 3) the individual firm is a
short run profit maximiser; 4) there is perfect knowledge and information; 5) there are no
barriers to entry.

The assumptions result in each individual firm on the perfectly competitive market being a
price taker. Thus; P = AR = MR = Dfirm (Price is murder).

The profit maximising level of output is where MC = MR. The firms supply curve is the
marginal cost curve since any change in the market prices will move the profitmax point of
output along the upward sloping portion of the MC curve.

Profit is shown by (AR AC) x Q.

In the short run, the PCM firm can be making an abnormal profit (AR > AC); a normal profit
(AR = AC); loss (AR < AC).

In the long run the PCM firm will make a normal profit. Abnormal profits will attract market
entry and the price will fallwhile losses will cause market exit and the market price will rise.
Hence, in the long run, the PCM firm will be operating where P = MC = AR = AC min = AR.

The break-even price for a firm is the quantity at which P (AR) = AC.

The shut-down level of output is where P = AVC.

The sum of the individual MC curves for firms on the perfectly competitive market is the
market supply curve. MCindividual = Smkt

Using factors of production in order to create the highest possible output per unit of input is the measure
of efficiency productive efficiency. In other words, when goods are produced at the lowest possible
cost per unit there is optimal allocative efficiency. This is where Q = ACmin. The issue of efficiency is
basically Firms are doing things right!

The question of whether consumers are then willing and able to buy the amount of goods produced is
also a measure of efficiency allocative efficiency. When firms are producing goods in the correct
quantity as defined by market demand then there is no excess in supply or demand and firms are
allocating factors of production allocatively efficiently. This is when output is set where P = MC. The
issue of efficiency is basically Firms are doing the right things!
 Assumptions of the oligopoly model
Anoligopolyhassomekeydefiningcharacteristics,namelythatthemarketisdominatedbya
fewlargefirmsandthatpotentialentrantsfacehighbarrierstoentrythelatterbeingakey
differencetothemonopolisticallycompetitivemarket.Furthermore,productscanbeboth
homogeneousanddifferentiatedforexamplebothcement(homogeneous)andbreakfast
cereals(differentiated)areoligopolisticmarkets.Withtheseoutliningassumptionsinplacethe
oligopolisticmarkettakesonanumberofratheruniquefeatureswhichsubsequentlydefinethe
market.

Definition: collusive and non-collusive oligopolies

A collusive oligopoly is when firms in an oligopoly market collude (cooperate) on prices,
output or sales venues in order to maximise profits. If oligopoly firms instead compete
independently one speaks of a non-collusive oligopoly.
Fig. 2.3.47 Kinked demand curve

The kink in the demand curve means that the MR curve will be
discontinuous broken.
P, costs ($)
The dotted extensions of the curves are only to show how each
MR curve will cut halfway on the Q-axis. (Dont include
Elastic these in your own diagrams!)
demand

Inelastic demand (note that since only the inelastic portion of the
PEQ D-curve is used, MR will be negative)

D, AR
MR
Q/t
QEQ D, AR

MR

P, costs ($)
MC0 The broken MR curve enables a range of
possible MC = MR points. The diagram shows
MC1 that marginal costs can change without the
QEQ oligopolist having to change output in order to
MC2 stay at the profitmax level of output.

D, AR
Q/t
QEQ
MR
Fig. 2.3.51 Normal profit and loss in monopoly

Outside the syllabus: Note that the finer the demand segment, the more
consumer surplus is captured by the firm. Remaining consumer surplus is
shown by the increasingly saw-toothed blue triangles in the diagrams.

C: Further price discrimination

P($)

Net addition to total

abnormal profit ;
8 $10,000 x 2 = $20,000
By ever-finer division of the total
7 By ever-finer division of the total
MC market into segments, the price
market into segments, the price
6
discriminating firm increases total
discriminating firm increases total
abnormal profits.
abnormal profits.
5

4 AC

1
MR D, AR
0
0 10 20 30 40 Q/t (1,000s /week)
Summary and revision

Price discrimination occurs when firms with market power set different prices for the same good according to
different price elasticities of demand amongst consumers.

Economics identifies three types of price discrimination:

First degree price discrimination: firms charge whatever the market will bear and attempts to get each
individual consumer to pay whatever he/she is able and willing.
Second degree: this is when firms set per-unit prices lower when the buyer purchases larger quantities a
bulk-buyer discount.
Third degree: when sellers identify different groups of buyers and sells goods according to the PED for each
group.

Firms price discriminate for several reasons. The obvious reason is that since average costs do not change the
can increase profit by selling some of the units at higher prices. Other reasons include market capture by a
firm wishing to expand and/or attain economies of scale; earn goodwill by setting prices lower for
disadvantaged groups; public monopolies might price discriminate in order to increase output to a more
societally beneficial level; a loss-making monopoly can use price discrimination to recoup some/all of the loss.

There are many ways for a price discriminating firm to segment the market into groups. The more
commonly used segmentation variables are age, sex, time, income and geographical location.

The necessary preconditions for successful price discrimination are: 1) There must be distinctly identifiable
groups with different PED values; 2) The seller must have a degree of market power; 3) The seller must be
able to limit arbitrage e.g. groups getting the good at a low price selling to groups prepared to pay a higher
prices.

When sellers divide the market into ever smaller segments, profit for the seller rises and consumer surplus
decreases.

Possible advantages for firms of price discrimination are increased profits, possibility of increasing market
share and then attaining economies of scale, and societal goodwill.

Possible advantages for consumers include lower prices for some groups, improved products if firms use
increased profits for R&D, and in the case of a loss-making monopoly getting the good produced at all.

Possible disadvantage for firms is that separating the market increases administration costs.

The potential disadvantages to consumers would be that some consumers end up paying a higher price (and
they will not necessarily be the poorest groups), the loss of consumer surplus, and increased abnormal profits
might help finance predatory pricing.

A publicly owned monopoly can increase societal welfare via price discrimination by setting the price at a loss
making level (MC pricing) and then recouping some/all of the losses by charging certain groups more for the
good/service.
Macro
Intro to macro; main macro goals
1Growthdefinedastheincreaseingrossnationalproduct(GDP)orgrossnational
product/grossnationalincome(GNP/GNI)andmeasuredinmoneytermsandadjusted
forinflation

2Pricestabilitydefinedasastableincrementalincreaseinthepricelevel(inflation)
andmeasuredbytheconsumerpriceindex(CPI9)andtheGDPdeflator.10

3Lowlevelsofunemploymentdefinedasthenumberofpeople,outofthetotal
availableworkforce,whodonothavejobsandgivenasapercentagevalue

4Externalequilibriumdefinedasstablea)exchangeratesandb)curraccbalance
betweenimportsandexports(thisisthefocusofSection4)

Inadditiontotheabovefourmainstreamgoals,economistsincreasinglybringup
issuestobefoundwithinthefollowingcaptions:

5Environmentalconcernsoftendefinedaseconomicgrowthincompliancewith
nondepletingandnondegenerativeresourceuseandmeasuredusingvarious
environmentalindicatorsofpollutionovertime

6Distributionofincomedefinedashowwellincomeisspreadbetweentherichest
andpoorestsectionsofthepopulation

7Productivityoffactorsdefinedastheoutputperunitofinput(factorsof
production)andoftenmeasuredbylabourproductivityindicesandcapitaluseper
moneyvalueofoutput

Tradeoffs:1and2;2and3;1and5;1and6;(1and4a;1and4b)

Alltheabovearesubjecttoavarietyofgovernmentpoliciesaimedatachievingthe
goalsortargets.Theproblemisthatitisimpossibletoachieveallofthegoalsatonce.
Infact,virtuallyeverymacroeconomicgoalwillconflictwithatleastoneothergoal.A
simpleillustrationiswhenaneconomyexperiencesincreasedoutput(goal1above)
thisoftenleadstoinflation(makinggoal2moredifficult)andpossiblyan
environmentalburden(conflictingwithgoal5).AsweshallseeinChapters57and59,
theseconflictinggoalswillcreatenumeroustradeoffsforgovernmentswhichinturn
addstoanalreadyheatedtheoreticalandpoliticaldebate.

Definition: National income

National income is the real money value of the sum total of all final goods and services produced in
an economy during a given time period usually one year. This give the identity of expenditure
output income, in money terms. As income is measured as an amount between periods, it is a flow
concept.

9
TheCPIisalsoknownastheretailpriceindex(RPI).
10
Thereareanumberofotherindicesdesignedtocalculateunderlyingorcoreinflation.
Moreonthislater.
(Type 4 Medium heading) 2. Expenditure method of accounting
Thebasicaccountingpremisehereisthatallexpenditureflowsfromeconomicagents
(households,firms,government,andforeigners)constitutetotalexpenditureandthusincome.
Basically,thismethodofaccountinglooksattotalspendingduringaperiodoftimeanddivides
thespendersupintogroupsinordertofollowtheflowsandseewhoisspendingonwhat.Total
expenditureinaneconomybecomesthesumofconsumptionexpenditure(C),investment
expenditure(I),governmentexpenditure(G),exportexpenditure(X)minustheimport
expenditure(M).WhileyouskimthroughIrishexpenditureinFigure3.1.4,trytofigureout
whywesubtractimportsfromGDP.

F
F GrossdomesticproductinIreland2001expendituremethodofaccounting
Expendituretype Amount(millionsof)

Householdconsumption(C) 55,202

Totalprivateexpenditureoncapital(plusphysical
27,461
changeinstocks)(I)

Governmentexpenditure(G) 15,413

Exports(X) 112,938

Imports(M) 95,702

lesstaxesonexpenditure 14,572

plussubsidies 2,697

statisticaldiscrepancy 569

GDPatfactorcost 102,869

Consumptionmeasurestheamountofpersonalmoneyspentongoodsandservices
duringtheyear.Consumptionisoftendividedintodurables(cars,refrigeratorsetc.),
nondurables(beerandDonegaltweed)andservices(suchascarrepairs,hotelstays
andbanking).
Investmentisfirmsexpenditureoncapitalgoodssuchasmachines,equipmentand
factories,oftenreferredtoasfixedcapitalformation.11
11
The total figure on investment also includes changes in stocks, circulating capital, since any
unsold goods produced in the time period are part of inventory and still represent output even
though they have not been sold. Unsold and unfinished goods are accounted as expenditure by
the firm. Say a firm produces 100,000 worth of Widgets but sells only 90,000 worth. If we
 Governmentsbuildroads,hiremoreteachersandbuyfighteraircraftfromdomestic
firmsthisissimplyyourtaxmoneybuyinggoodsandservices;government
spending.Sinceitisfareasiertoaccountforthemarketpriceofajetfighterthan
100,000schoolhours,manyservicesareestimatedatthecostofprovisionratherthan
marketprices.
IfanIrishcompanysells1millionworthofknitwearbutdomesticexpenditurefor
thisgoodisonly900,000,thentherewouldbeadiscrepancybetweenthevalueof
expenditureandoutput,i.e.EO.Thisexplainswhyexportexpenditure
foreignersspendingonIrishgoodsisadded,sinceweareestimatingthetotal
expenditureongoodsproducedinthecountry.
Inadherencewiththis,anyexpenditurebyIrishonnondomesticgoodsmustbe
deducted.Thisimportexpendituredoesnotrepresentanydomesticoutputand
representsaflowofmoneyoutofthesystem.Oftenoneseesthetermnetexports
used,whichistheproductofexportrevenueminusimportexpenditure.
WenowarriveatGDPatmarketprices,whichmustbeadjustedfortwosystematic
inconsistencies;taxesandsubsidies.Sincewearemeasuringexpenditure,mostgoods
willincludeaproportionofindirect(expenditure)taxes,suchasvalueaddedtaxes
(VAT)andexciseduties.Sincethesetaxesdonothaveanycorrespondingoutputthey
mustbesubtracted.Subsidiesskewthefiguresintheoppositemanner,sincethevalue
ofsubsidieslowersthefinalmarketpricebelowtheactualfactorcost.Therefore
subsidiesmustbeaddedon.
After,onceagain,adjustingforstatisticalerrorswearriveatGDPatfactorcost,whichisthe
samevalueasintheincomemethodusedearlier.Thesetwomethodsshowtheflipsidesofthe
coin,asincomeinaneconomymustequalexpenditure,whichinoneofthemostcommon
formulaicexpressionsis;Y=C+I+G+XM.Wenowfinishwiththemethodusedto
calculatethephysicaloutputinmoneyterms.

Inflation

Def: general...consistent rise in aver P lev.....CPI

Definition; Inflation
Inflation is defined as a consistent increase in the general (i.e. average) price level, measured
by the consumer price index (CPI) or GDP deflator.

Definition; Deflation
When the average price level, determined by the CPI or the GDP deflator, falls consistently
during a time period, there is deflation, or negative inflation.

Definition; Disinflation
When there is a fall in the rate of inflation, say from 5% to 4%, one speaks of disinflation.

Measuring inflation using the consumer price index (CPI)

Thebasisfordeflatingnominalvaluesintorealvaluesisanindexshowingpricechanges.The
counted only the expenditure the firm has received then actual periodic output would be
underestimated by the additional Widgets valued at 10,000 now in the firms warehouse. This
addition to stock must therefore be included in the accounts. Similarly, had inventory fallen by
10,000 then 10,000 must be subtracted, since total expenditure exceeds the actual amount
produced in the time period. Circulating capital also includes the elements of completed work in
long term projects, works in progress, such as airports and roads.
mostcommonlyusedpriceindexistheConsumerPriceIndex(CPI).Thisindexseriesis
basicallyarrivedatbyfollowinganidenticalbasketofgoodsinacountryovertimeinorder
toshowthechangeintheoverallpricelevel.Figure52.2belowfollowssuchabasketin
Irelandoveraperiodofsixyears.TheCPI,whichisastockconcept,ismeasuredinDecember
eachyear.Itsstartdatewas1995.Thisisthebaseyear,i.e.theyearallcomingindexvalues
(e.g.thepriceofthebasket)willbecomparedwith.Theformulaforconcoctingapriceindexis
todividethenominalpriceofthebasketofgoodswiththepriceatbaseyearvalues:

P basket in tn Where tn is the year being looked at and t0 is the

- 100
CPI at t 0 = -----------------------------
P basket in t0 base year values, i.e. the original price of the basket.

Dec 1995 (t0) Dec 1996 (t1) Dec 2001 (t6)

Rory,
baskets!
20 pints of Guinness: 30 20 pints of Guinness: 32 20 pints of Guinness: 33
10 kgs of mutton: 35 10 kgs of mutton: 36 10 kgs of mutton: 39
10 cans of crab pat: 40 10 cans of crab pat: 41 10 cans of crab pat: 42
100 kgs potatoes: 20 100 kgs potatoes: 19 100 kgs potatoes: 18
. . .
. . .
. . .
and 1,000 other and the same 1,000 and the same 1,000
consumer goods goods as before goods as before
__________________ __________________ __________________
Total cost of basket in Dec Total cost of basket in Dec Total cost of basket in Dec
1995 = 200,000 1996 = 203,200 2001 = 238,000

CPI (t0) = 200,000 x 100 CPI (t1) = 203,200 x 100 CPI (t6) = 238,000 x 100
200,000 200,000 200,000

CPI95 = 100 CPI96 = 101.6 CPI01 = 119

Terms:

Infl: general and constant rise in aver P levCPI

Reflation: increase in the RATE of infl (e.g. from 5% to 6%)

Disinfl: fall in the RATE of infl (e.g. from 6% to 5%)

Deflation: decrease in the Plev(e.g. negative infl or CPI goes from 123 to 122)
Summary and revision
Inflation is a general and consistent rise in the average price level as measured by the CPI
or the GDP deflator.

Deflation is a general and consistent fall in average prices as measured by the CPI or the
GDP deflator.

Deflation can be benign (caused by an increase in AS whereby the price level falls but GDP
increases) or malign (a decrease in AD causes both deflation and negative growth).

The consumer price index (CPI) is an index which shows the price of a basket of goods at
the base period (year) and over consecutive periods (years). The difference in the CPI is
inflation.

Core inflation is the CPI with highly volatile goods removed these are usually oil/energy
and food/agricultural goods. When the most volatile goods are removed, the index has a
better predictive value for future inflation.

Weaknesses of measurements of inflation include

The CPI and GDP deflator are both based on average price changes.
Consumption and quality bias the goods compared over time are often far superior to the
same ones in the basket 10 years ago.
Substitution bias lower priced goods often replace higher priced goods over time as a
natural process.
Weight and content bias the CPI doesnt change at the same rate consumers habits to and
the lag makes inflation figures unreliable.

The producer price index (PPI) is a measurement of the change of prices in inputs used by
firms. Raw materials, goods in process and finished wholesale goods are price indexed and
computed. It is posited though highly uncertain in many cases that the PPI will precede
the CPI and thus act as good lead indicator of future inflationary movements.

The consequences of inflation are:

Redistribution effects households on fixed incomes will lose more than those who can
bid up their wages. Lenders (creditors, e.g. banks) will lose at the expense of borrowers
(debtors, e.g. households) since inflation eats away at real debt and the real value of money
repaid to banks. The financially strong will lose more than the lower income groups.
Negative influence on growth higher inflation makes both households and firms
reluctant to spend/invest due to the insecurity of future prices.
Shoe leather costs the increased time and resources spent on finding the lowest prices.
Menu costs firms will need to change prices frequently to keep up with inflation.
Possible breakdown of monetary economy hyperinflation can lead to widespread
abandonment of money and the emergence of a barter economy.
GDP and GNI

Definition: Gross national product (GNP)

GDP is an account of the money value of goods and services produced within an economy
regardless of domestic or foreign ownership of the firms. GNP takes into account foreign
ownership in the economy and domestic ownership of firms abroad by adding on net property
income from abroad.

GDP + property income from abroad property income paid abroad = GNPor

GDP + net property income from abroad = GNP

Definition: Real and nominal national income

Nominal national income is expressed in the current prices of the output period and thus
contains an element of inflation. Real national income is the nominal value put into base year
(or constant) prices to allow real comparisons of output over time. The formula for deflating
nominal GDP is:

GDPnom of year measured

GDPreal = x 100
GDP deflator of year measured

Four real issues you must address:

1. Real income (see above)
i. The GDP deflator is used because the CPI only measures
C infl
2. Real wages: Wnom at tndivided by CPI at tntimes 100
3. Real prices: Pnom at tndivided by CPIat tntimes 100
4. Real interest: rnom minus infl
 Fig. 3.1.14 Pricking the balloon deflating nominal GDP in Ireland 1995 2001

Deflating nominal GDP by using

the GDP deflator. This shows
the real GDP.
Rory: these are supposed
GDPnom, GDPreal ( bn) to be balloons!

GDPnom
114.7

GDPreal
89,3
58.1
56.9
89.3
52.6 56.9
52.6
Year
1995 1996 2001 1995 1996 2001

Inflationary element Real GDP, i.e. deflated

nominal GDP

Nominal GDP: year 1995 = 52,641 bn 1996 = 58,080 bn; 2001 = 114,744 bn.

GDP deflator: 100 102 128.5

Real GDP: year 1995 = 52,641 bn; 1996 = 56,891 bn; 2001 = 89,320 bn

(Type 3 Medium heading) Comparing GDP between countries

Inadditiontotheabove,anumberofweaknessesinnationalincomefiguresbecomeapparent
whendifferentcountriesarecompared.Theseinclude(butarenotlimitedto!):

1. Compositionofoutput:PerhapsthemaincriticismofGDPasameasureofwelfareis
thathoweveraccuratethefiguresareforoutput,thefinalGDPfiguredoesnotshow
whatisbeingproducedwerebacktoagunsorbutterproblem.TheSovietUnionof
the1930sputgreateffortintocompetingwiththewestintermsofoutputandgrowthin
ordertoshowthesuperiorityofthecentrallyplannedsystem.Goingbyofficialoutput
figurestheUSSRwontherace,butwhatthefiguresdonotshowisthattheSovietsput
themajorityofresourcesintoproducingcapitalgoodsandneverreallygotaroundto
providingforthewantsandneedsofitscitizensintermsofconsumergoods.Acountry
withdoubledigitgrowthratesandemptyshelvesissomethingofananomalybutquite
possible,whichisalsooftenthecaseintimesofmajorconflictswhenarmaments
accountforeconomicgrowthwhichinnowayrepresentsanincreaseinthestandardof
living.
2. Compositionofexpenditure:Inaveinsimilartotheabove,nationalincomefiguresare
oftenskewedbythesimplefactthatdifferentcountrieswillhavedifferentexpenditure
patterns.ThecoldandicyNordiccountriesspendasizableproportionoftheirincomeon
 heatinghomesandofficesbutthisdoesntmeanahigherstandardoflivingthanin
temperateclimate.ComparingFinlandsGDPfigureswithBermudascouldgettricky
indeed.
3. Distributionofincome:Allpercapitanationalincomefiguresareaveragesand
thereforeneglecthowincomeisdistributedamongstcitizens.Thethirdrichestcountry
intheworld,theUSA,hadapercapitaGDPofUSD35,200in2000whilethesecond
richest,Norway,hadUSD37,200.12Yetthehighest10%ofallincomeearnersin
Americaaccountedfor30.5%ofnationalincomeandatthesametimethecountryhad
some30millionpeoplelivingbelowtheofficialpovertyline.13InNorway,ontheother
hand,21.8%ofincomewenttotherichest10%therebyaccountingforonethirdless
thantheUSAsrichestupperdeciles.
4. Unaccountedforactivity:Statisticalinaccuracieswillbeenhancedbythefactthata
portionofeconomicactivitywillbehidden;parallelmarketsforgoodsandlabourare
notableexamplesofatypeofsystematicerrorsincerealoutputisconsistentlyunder
reported.ThelargeelementofbarterandnonmoneyeconomicactivityinLDCswill
leadtoconsistentunderreportingofrealoutputfigures.Moredevelopedcountrieswill
alsohavealargesectionofunreportedactivity,butinthiscaseprimarilyduetotax
avoidanceandevasionoflabourlaws.
Note: large parallel markets can seriously underestimate economic activity. For example,
unreported national income on a global basis amounts to almost 31% of the worlds
GDP.14 The range is from 9% of GDP in the US to over 70% in Bolivia and Georgia.
Indonesia is estimated by the OECD to have a parallel market of close to 80% of all
economic activity. Such figures seriously undermine the validity of national income
accounting figures.

5. Exchangeratesdistortions:SincethecomparisonofdifferentcountriesGDPmustbe
putintosomeformofcommonlanguage,asinglecurrencyisused,oftentheUSD.In
doingthis,themarketexchangeratesfordifferentcurrenciesareusedwiththe
unfortunatesideeffectofgrosslyunderestimatingaverageincomesoflowcostcountries
whenpurchasingpoweristakenintoaccount.Seepurchasingpowerparity(PPP)below.
6. Externalitiesandenvironmentaldamage:GDPfiguresdonotshowsoilerosion,air
pollution,landdegradation,deforestation,depletednaturalreservesofresourcesorthe
oftenmonumentaldisruptionstovaluesandtraditionsasaresultoflargescaleeconomic
growthinarelativelybriefperiodoftime.
Inspiteoftheheavycriticismleviedabove,GDPpercapitaadjustedforpurchasingpower(see
below)isstillthebestsingleindicatorofdevelopmentavailable.Thereisrelativelyclear
positivecorrelationbetweenmoststandardoflivingindicatorsandeconomicgrowththe
problembeingthatitisverydifficulttoseewhichcomesfirst,i.e.thereisacausalityproblem.

12
NationalAccountsofOECDcountries,Mainaggregates,Volume1,updatedversionfrom
2003
13
PovertyintheUnitedStates,USCensusBureau2000,page3
14
Schneider, Buehn, Montenegro, Shadow economies all over the world: New estimates for
162 countries from 1999 to 2007, World Bank Discussion Paper at
http://www.econ.jku.at/members/Schneider/files/publications/LatestResearch2010/ShadEcWorl
d10_2010.pdf
Summary and revision
GDP is accounted for via three methods; the output method (sum of value-added in an
economy); the income method (sum of wages, rents, interest and profits); and the expenditure
method (sum of consumption expenditure, investment, government spending, and net exports).

GNP is GDP plus net property income from abroad.

Domestic means produced within a countrys borders.. and disregards who owns the
factors. National looks instead at who owns the factors regardless of where production
takes place

Real GDP (or GDP at constant base year values) is nominal GDP adjusted for inflation. To
calculate real GDP, divide nominal GDP by the GDP deflator (a broad price index) and then
multiply by 100. (Rory, could you put the formula here please?)

Per capita GDP or GNP is calculated by dividing GDP or GNP by the population.

National income figures are used to compare the overall success of an economy with others
and to provide statistical material for governments to base future decisions on.

There are several weaknesses of national income accounts:

Changes in population and money values skew the figures
New and better products are not represented in the money-value-of-output figures in
GDPGNP
Simple calculating errors are all too common
What is produced is not shown in the figures e.g. composition of output is not reflected in a
GDP value
National income per capita is an average and does not show income distribution
Many economies have large unaccounted-for sectors in the economy so called parallel
markets
Exchange rates tend to distort comparisons between economies
Environmental impact of production is notoriously missing (and difficult to estimate!) from
GDP/GNP figures
Aggregate demand
Summary and revision

Simple demand shows the ability and willingness of consumers to buy a single good. The sum
of total demand, the aggregate, shows the demand for all goods and services in an economy.

Our AS-AD model uses the overall price level instead of price and total output adjusted for
inflation real GDP instead of quantity.

The AD shows the correlation between the overall price level (GDP deflator) and the demand
for consumption, investment, government and net export expenditure.

The AD curve is downward-sloping due to

The real income effect; a fall in the price level means that real incomes rise which leads to
increased consumption, investment and net exports
The real balance effect; a fall in the price level means that the real value of savings has
increased and households can save less and spend more
The international substitution effect; a fall in the price level ceteris paribus! means that the
relative price of exports has fallen and the relative price of imports have risen export revenue
increases and import spending decreases

Shifts in AD
Expectations
inflationexpectationsCAD..or..inflationexpectationsCAD
perceivedwealthS&CADorperceivedwealthS&C
AD
expectedincomeCADorexpectedincomeCAD
Householddebt:During2007theimpendingeconomiccrisisbecameincreasingly
evidenttoeverybodyexceptbanks,financialadvisers,fundmanagers,government
officials,centralbankers,households,journalistshm,OK,maybeitwasntthat
evident.15Inanycase,Americanhouseholdsdebtreachedtheastronomicallevelof
closeto140%ofgrossdisposableincome(incomeaftertax)during2007whilethe
overheatingUSeconomydroveupinterestrates.Theresultwasanaveragehousehold
interestpaymentof12to14%ofdisposableincome.Naturallythishadaseriously
dampeningeffectonhouseholdconsumption;duringthefirstquarterof2008,
consumptionexpenditureinhouseholdsfellby1.0%andatotalof10%overthefull
year.16

15
Possibly the most famous predictor of the impending crisis was Dr Nouriel Roubini (aka Dr
Doom) of New York University who warned about the impending US housing bubble and
economic effects as early as September 2006. See www.economicpredictions.org/who-
predicted-the-financial-crisis.htm
16
See the US BEA at www.bea.gov, Table 2.3.1
Fiscalpolicy:Governmentscanusefiscalpolicese.g.changingvarioustaxratesoraltering
governmentspendingtoinfluenceaggregatedemand.Forexample,anincreaseinincome
taxeslowersthehouseholdsdisposableincomewhichinturnlowersconsumptionand
aggregatedemand.Increasedexpendituretaxes,e.g.VAT,havethesameeffectduetothe
decreaseinrealincome.

TCADorTCAD

Monetarypolicy:ThisisamacropolicytoolinthehandsoftheCentralBank(ornational
bank)andinvolvesadjustinginterestrates(r)orchangingthesupplyofmoney.Tight
monetarypolicy,hereanincreaseininterestrates(r),hasatwofoldeffect;

1)Theopportunitycostofconsumptionrisessincethereismoreinterestforegonebykeeping
moneyinthebank;and

2)Thecostofservicingloans(theinterestpayments)increases.

Thecompoundedeffectofanincreaseininterestrateswillbethatsaving(S)increasesand
borrowingdecreases.Bothleadtoadecreaseininvestment(I)andconsumption(C)theseare
componentsofaggregatedemandintheeconomy.Conversely,loosemonetarypolicyof
loweringinterestrateswillhaveastimulatoryeffectonaggregatedemand.

rS&I&CADorrS&I&CAD
Investment and AD
Profitandrevenueexpectations:Firmsrelyagreatdealonexpectedexpenditureinthe
economyfortheirplannedinvestment.Whenfirmsexpectfutureprofitstorisetheywill
bemorewillingtoinvestinthepresent.Accordingly,newtechnologywhichmightserve
toincreaseproductivityandquicklyregaininvestmentcostswilladdtofirms
willingnesstoinvest.Thiswasoneofthereasonsforthemassiveincreasein
InformationTechnologyspendingintheUSduringthelatterpartofthe1990s.

profitexpectationsIADorprofitexpectationsIAD
Policy expectations: All the main actors on the macro scene will adjust their behaviour when
possible changes in government policies appear on the horizon. For example, the mere rumour
of proposed interest rates hikes can cause a change in expenditure patterns when firms and
households advance investment and consumption in order to avoid higher loan burdens in the
future. An expectation of higher profit and income taxes will induce firms and households to cut
back on expenditure in anticipation of falling net profits and incomes.

Govt spending
GADorGAD

Net exports
Exchangerates:Ifthevalueofthedomesticcurrencyfallsthenimportswillbemore
expensivefordomestichouseholds/firmsjustasexportgoodswillbecomecheaperfor
foreignhouseholds/firms.AssumethattheArgentinepeso(ARS)isatanexchangerate
ofUSD0.23foroneARS(orUSD1=ARS4.33)andthatakgofbeefcosts$US10in
AmericaandARS43.3inArgentina.Thepriceintermsoftheexchangerateisthe
sameinbothcountries;ARS43.34/4.33=$US10.
NowpositthattheArgentineanpesodepreciates(falls)toARS1=$US0.20(e.g.thattheUSD
appreciatesto$US1=ARS5.00):
o The Americans experience that Argentinean beef has fallen in price and now
need only $US 8.67 (ARS 43.34 x 0.20) to buy the 43.3 pesos necessary to
buy a kg of Argentinean beef that still costs ARS43.3 since we are assuming
ceteris paribus.
o The Argentines, conversely, will see how the price of American beef has risen
to ARS 50.0 per kg. Ceteris paribus, one can expect Argentinas exports of
beef to increase and the imports of American beef to decrease. Both variables
are forces in increasing aggregate demand. (Note that this is a shift in
aggregate demand not a movement along! It is the price of the foreign
currency that has changed not the domestic price levels.)

exchangerateX&MADorexchangerateX&M
AD
tradepartnersYXADortradepartnersYXAD
tradepartnerspricelevelX&MADortradepartnersprice
levelX&MAD
Summary and revision (need a cool pic here.maybe a pic of someone doing push-
ups!)

Aggregate demand is comprised of the components consumption expenditure, investment

expenditure, government expenditure, export revenue and minus import expenditure.

Any change in the economy affecting one of these components will shift the AD curve.

Consumption is affected primarily by changes in interest rates, consumer confidence,

expectations of future inflation, wealth (and perceived wealth), income, personal income
tax rates and level of household indebtedness.

Investment (= changes in physical capital in firms) will be affected by interest rates,

business confidence, profit taxes (also called corporate taxes) and level of corporate debt.

Government spending is a political decision whereby the governments decision to change

spending on infrastructure and public services affects aggregate demand.

Export revenue and import expenditure is affected by exchange rates, trade partners
income, trade barriers, relative prices and relative inflation.

Price
level SRAS will shift primarily due to
changes in the price of factors
SRAS and legislation on taxes and
2 SRAS labour.
P2
0
SRAS
P0
1
P1

AD0
Y2 Y0 Y1 GDPreal/t
Summary and revision (need a cool pic here.maybe a pic of someone doing push-
ups!)

Aggregate supply is the planned output of goods and services in an economy during a
period of time. The short run aggregate supply curve is shows positive correlation between
the price level and planned output.

A key assumption of the SRAS curve is that factor prices and factor availability are
considered constant. Any change in these variables will shift the SRAS curve.

Shifts in short run aggregate supply are primarily caused by the price, availability,
efficiency and quantity of factors of production. Short run aggregate supply shifts due to:
changes in factor prices (wages, raw material, capital)
changes in factor efficiency (new technology, production methods)
taxation (profit taxes, labour taxes, environmental taxes)
government regulations (overtime regulation, subsidies)
external shocks (natural disasters, weather)

(a) Consensus: Short-run equilibrium (b) Disagreement: Long-run equilibrium

Price level LRAS AS

(index) (new-classical) (Keynesian)

SRAS
SRAS
(new-
P0 P0 classical)

AD AD
AD

YEQ GDPreal/t YFE GDPreal/t YFE GDPreal/t

 Note: For reasons of diagrammatic
simplicity, long-run potential GDP
Inflationary has been held constant rather than
Real GDP
gap increasing.
C
Y2
Amplitude B D Potential
of cycle Y1 GDPreal

Y0 L e n g t h o f
Deflationary A
c y c l e E
gap
Time
t0 t1 t2 t3 t4

Inflationary
gap

Price Deflationary Pric Price

level LRAS gap e LRAS level LRAS
level
SRAS SRAS
SRAS
AD0 B P2
C
A P1
P1
P0 P0
AD2
AD1 AD1
AD0
Y0 YFE GDPreal/t Y0 Y1=YFE GDPreal/t YFE Y2 GDPreal/t
II: Below full employment III: Full employment LR IV: Over-full employment
deflationary gap equilibrium inflationary gap

Keynessview:

Marketsareinherently(=essentially)unstableanddonotnecessarilyclear.Itisquite
possibleforlabourmarketstorenderhighlevelsofunemploymenteveninthelong
run.Keynesharshlycriticisednewclassicalthinkingforfallacyofcomposition;
simplybecauseindividualmarketsmightcleardoesnotmeanthatthisholdstruefor
theaggregate.Loweringwagesmightwellincreasethedemandforandamountof
labourersinoneindustrybutnotinallindustries.
Wagesaredownwardsticky,i.e.labourers/unionsaremostunwillingtoacceptcuts
inwagerates.Thisaddstolabourmarketdisequilibriumbykeepingwagesabove
marketclearinglevel.Realwagessimplydonotfallenoughtocompletelyclearthe
marketandrestorefullemployment.(ReviseminimumpriceinSection2.1.)
Sincelabourmarketsareimperfect,noninterventionistpoliciesdonothelp
unemploymentandinfactmayservetokeepunemploymentrateshighoverlong
periodsoftime.

ThetraditionalKeynesianaggregatesupplycurve,AS,showsthreepossiblerangesofoutput:

Horizontalportion:Thedepressionrangeofmassunemployment(uptoY0)follows
thecourseofthepreviousaggregatesupplycurve,whereoutputincreaseswithoutan
increaseinthepricelevel.ThehorizontalportionoftheinvertedLshapedcurve
showsthatincomecanincreasetoY0withoutariseinthepricelevel.Thisisbasedon:
 o Keynesspremiseofdownwardstickinessoflabour.Sincelabourers/unions
areunwillingtoacceptlowerwages(thisisthedownwardstickinessof
labourpricespart17)duringaperiodofdemanddeficiencyandresulting
unemployment,asituationofhighunemploymentmaypersistinthelongrun.

o Duetotheabundanceexcesssupplyoflabourandotherfactorsatlow
incomelevels,labourerswillbehighlyreluctanttobidupwagesevenas
outputincreases.ImaginethatoutputincreasesfromanyoutputleveluptoY1
withtheensuingincreaseindemandforlabour.Bothnewlyhiredand
existingworkerswouldnotbeinapositiontobidupwagessincethereare
thousandswaitinginlinefortheirjobs.Thusitispossibletoincreaseoutput
withoutcreatingupwardpressureonwagesandfinalprices,resultingina
horizontalaggregatesupplycurve.

Tradeoffportion:AtY0theeconomyismovingclosertothefullemploymentlevelof
outputandfirmsarerespondingtohigherfinalpricesfortheirgoodsandservices.This
middlerangeportraysthecorrelationbetweenahigherpricelevelandincreasingreal
output(explainedearlier)leadingtheaggregatesupplycurvetobeupwardsloping.
Thisrange,Y0toYFE,illustratestwoimportantpoints.

o Thefirstisthataggregatesupplywillincreaseonlywhenfirmsareableto
enjoyhigherfinalpricesfortheiroutputandthuscoveradditionalcosts
arisingfrombottlenecksinsupply.

o Thisportionhighlightsoneofthemostimportantpolicydebatesin
economics;theapparenttradeoffbetweenunemploymentandinflation.
RecallthatoneofthekeyconclusionsofKeynesiantheoryisthatmarketsare
imperfectandthusgovernmentinterventionisnecessaryinordertocreate
labourmarketclearingandthusfullemployment.Themiddlerangeofthe
aggregatesupplycurveindicatesthatgovernmentswillfaceamacroeconomic
opportunitycostissue;increasedgovernmentspending(whichstimulatesAD)
mightresultinlowerunemploymentatthecostofahigherpricelevel,i.e.
inflation.Thistradeoffbetweeninflationandunemploymentisacentral
subjectofChapter54,thePhillipscurve.

Verticalportion:TheverticalrangeofASatYFEandbeyondisthesameasthe
physicallimitillustratedearlier(Figure3.3.2SRAS)wherefirmssimplycannot
increaseoutputwhatevertheincentivesoffinalprices.Thecompletepriceinelasticity
ofsupplybeyondpointYFEillustratestheeffectofevermorescarcefactorsof
productionandthusincreasingoutputconstraints.Thisisthefullemploymentlevelof
output,YFE.Firmswillnotbeabletohireadditionallabourandnoincreaseinoutput
ispossible;theaggregatesupplycurveisvertical.Anyincreaseinaggregatedemand
willbepurelyinflationary.

F Keynesianaggregatesupply

17
Ioftenexplaindownwardstickybyreferringtogoodandbadwines.Itseasytogetusedto
goodwinesandmostdifficulttomovebackdownonthequalitylistonceoneisusedtothe
goodstuff.Acquiredtasteisthusdownwardsticky.
 Price level
(index) AS Beyond YFE firms are unable to
increase output no matter what the
P2 price level is the AS curve becomes
vertical.
P1

P0

GDPreal/t
Y0 YFE

Depression and mass When the economy nears the full employment level of output,
unemployment at low YFE, higher costs will induce firms to raise prices the AS
levels of income. As curve slopes upwards. (For full explanation, see the Phillips
labour will have difficulties Curve, Chapter 54.)
in bidding up wages and
firms will have excess
(unused) capacity, costs
in firms do not rise when
output increases.

Price level
(index)
AS At the full employment level of
output, any increase in aggregate
demand is purely inflationary.
P3

AD3
P2
At low levels of income it is possible
AD2 for aggregate demand to increase
P1 without causing inflationary pressure.

AD0 AD1

Y0 Y1 GDPreal/t

YFE

Monetarist view of AS
1. The starting point for the monetarist school was that People are not fooled by
having more money. In other words, as income increases when moving along
the short run aggregate supply curve people would realise that the higher price
level would hollow out their unchanged wages. Labourers in the
monetarist/new classical view thus do not suffer from money illusion but are
well aware of the negative effects of a higher price level on real wages.
2. This view (new-classical from now on) therefore strongly disagreed with the
Keynesian assumption that wage rates would remain unchanged in the long run.
 Wages are market-based and therefore highly flexible - workers inflationary
expectations (see Section 3.5) would force them to use their bargaining power
to bid up wages when the price level increased in order to retain their purchasing
power.
3. Since higher wages eat up the distance between the final price firms get for
their goods and the costs of producing them, the short run aggregate supply
curve will shift to the left when wage levels in the economy are bid up. (This is
no different from saying that an increase in factor prices decreases supply, i.e.
aggregate supply.) Thus there will be a separate short run aggregate supply
curve for every wage and factor price rate.

When the economy is operating above potential

Price output, there will be overfull employment. As
level real wages rise, labour markets adjust, and both
LRAS factor and goods markets will clear, restoring the
unemployment level to long run equilibrium. The
economy returns to its long run equilibrium, YFE.

SRAS
When the economy is operating below
P
potential output, there will be
additional unemployment. In the long
run, factor prices will adjust, real wages
will fall, and both factor and goods
AD markets will clear. The economy will
again be operating at long run (general)
equilibrium, YFE.
YFE GDPreal/t

B to C: As factor prices are bid up by

both firms and workers, in the long run
the short run aggregate supply will shift
to the left, back to the original LRAS
curve but at a higher price level.
Price level The economy will thus move from point
(Index) A to C via point B. Again, any increase
LRAS in AD which is not matched by the long
run potential of the economy will be
LRA inflationary shown by the increase of
SRAS1
S the price level from P0 to P2.
C
SRAS0
P2
(D) B
P1
P0 A to B: An increase in AD will increase
AD1 output in the short run, but also make
A
factors scarce and decrease real wages
AD0 for workers.
YFE Y1 GDPr/t
AtoB:Theincreaseinaggregatedemandduetofiscal/monetarystimulationincreases
aggregatedemandfromAD0toAD1;realincomeincreasesfromYFEtoY1andthepricelevel
risesfromP0toP1.Sincewagelevelsandfactorpricesareassumedtoremainconstantduring
theshortrun,theshortrunsupplycurvedoesnotshift.Insteadfirmsexperiencehighercosts
duetobottlenecksandscarcerfactors.

BtoC:TheshortruneffectisaninflationarygapatpointB.Inlinewithderiveddemand
effectsonfactors,thiswillresultineverscarcerfactorsofproductione.g.capital,raw
materialandlabourandtheincreaseinthepricelevelfromP0toP1willleadtoahollowing
outofwagesforworkers.Factorpriceswillultimatelybeforcedupwardsasfirmsbidon
availablefactorsandworkerswilldemandhigherwagestomakeupforlostrealpurchasing
power;shortrunaggregatesupplywilldecreaseinthelongrun,shownbytheshiftfromSRAS0
toSRAS1.Theeconomyhasreturnedtothefullemploymentlevelofoutput,YFE,butata
higherpricelevel,P2.ThisispointCinthediagram.

TheABCseriesinfigure46.5onceagainshowstheimportanceofthelongrunaggregate
supplyinthenewclassicalASADmodel.Anypointofshortrunequilibriumbeloworabove
thelongrunpotentialshownbytheLRAScurveinthemodelwillultimatelybecorrected
asfactormarketsclear.

AfallinADpointCtoDtoA:Ibrieflyillustratethenewclassicalviewofthelongrunby
assumingthattheeconomyisinitiallyinequilibriumatpointC,andthataggregatedemand
insteadhasdecreased,shiftingaggregatedemandfromAD1toAD0movingtheeconomyto
pointDandaresultingdeflationarygap.Asfirmslowerpricesinaccordancewithfalling
demand,thegapbetween(falling)finaloutputpricesandwagepricesnarrows,thisinfact
meanshigherrelativelabourpricesforfirms.Firmsrespondbydemandinglesslabourandas
thelabourmarketresponds,labourpricesfallwhichenablesfirmstoincreaseoutputand
increaseshortrunaggregatesupply.ThisincreasestheshortrunaggregatesupplyfromSRAS1
toSRAS0bringingtheeconomybacktogenerallongrunequilibriumatpointA.

Figure51.2Equilibriuminthelabourmarket
 a: Supply and demand for labour b: Full employment on labour market

PL (real PL (real
wage rate) wage rate)
ASL TLF
ASL TLF

U0 U1 U2 NRU
W* W*

ADL ADL
FE U* QL/t FE U* QL/t

Equilibrium
unemployment

There will always be a degree of unemployment even when the labour market has
cleared. Equilibrium unemployment is therefore the same as the natural rate of
unemployment (NRU) shown as the difference between FEU*.

Heresaclue;cyclical/demanddeficientunemploymentisalsoknownasKeynesian
unemployment!RecallthatKeynesianeconomicsviewsmarketsasimperfectlyfunctioningin
general,andthatlabourmarketsspecificallysufferfromdownwardstickiness.Theconceptof
cyclicalunemployment,inaccordancewithKeynesianassumptions,meansthatrealwageswill
notfallintheshortrunandthemarketwillbeindisequilibrium.Inotherwords,sincelabourers
willbehighlyunlikelytoacceptlowerwages(andfirmswillalsobereluctanttolowerthem)
therealwageratewillremainatW*andcreateanexcesssupplyoflabouratthegoingwage
rate.Whilethelabourmarketmightultimatelyclear,theproportionofpeoplenotaccepting
jobsatlowerratesmightlastforsometime,withunemploymentratesabovethemarket
clearinglevelofW1.Keynesianeconomicslooksuponmarketsasinherently
unstable/imperfectwhichexplainsthepropensitytowardsgovernmentintervention.

Definition: Cyclical (or demand deficientor Keynesian) unemployment

Cyclical unemployment is the addition to equilibrium unemployment (full employment)
resulting from a contractionary economy. Since the demand for labour is largely derived from
the demand for goods and services, a fall in aggregate demand (and/or aggregate supply)
during a recessionary period will decrease the demand for labour. The term derives its name
from the cyclical variations in economic activity.

Figure51.3Disequilibriumunemploymentcyclicalordemanddeficientunemployment
 I: Aggregate supply and II: with the total labour
demand for labour force

Cyclical
addition to
PL (real PL (real
unemployment
wage ASL wage
ASL TLF
rate) rate)

NRU
W* W* Natural rate
of
W1 W1 unemployme
ADL0 ADL nt0

ADL1
QL/t ADL
U0 U1 FE U0 U1 FE U*1 QL/t

Due to downward stickiness of wages, the real wage rate does

not fall to W1 when ADL falls from ADL0 to ADL1 but remains at
W*. This creates disequilibrium on the labour market and
cyclical unemployment of U0FE. Total unemployment is U0U*.

Accordingtonewclassicalviews,whentherealwagerateisabovemarketequilibriumwage,
W*infigure51.6,therewillbemorelabourerswillingtoacceptjobsthanthereisdemand
fromfirms.Morelabourersarewillingtoacceptajob(e.g.thereisamovementalongtheASL
curve)atW0butthereislessdemandfromfirms,shownbythequantitydemandedforlabourat
U0.Thereisnowmorelabourwillingtotakejobsthanthereareoffersofjobs.Accordingtothe
newclassicalview,disequilibriumunemployment(e.g.unemploymentabovethenaturalrate)
existsbecauselabourmarketforceshavenotbeenabletoclearthemarketbyloweringthereal
wageratesufficiently.ThewagerateofW0isabovethemarketclearingrateofW*,creating
realwageunemploymentofU0U2.TotalunemploymentisthusU0U1,abovewhatwouldbe
thelevelofunemploymentifthelabourmarketclearedatawagerateofW*thenaturalrate
ofunemploymentofFEU*.

Howistherealwageratesetatabovemarketclearinglevel(W*infigure51.6)andwhycanit
remainthere?Thenewclassicalviewgivesthreemainreasons:

1. Onemainreasonisthatthegovernmentmighthaveinstigatedminimumwage
legislationwhichsetsthepriceoflabourhigherthanthelabourmarketwould.

2. Anothercommonargumentisthatsocialwelfarestatesmighthave
social/unemploymentbenefitswhichwoulddecreasethepropensityofpeopleinthe
labourforcetoacceptwagesbelowacertainrate.Highunemploymentbenefitsmean
thattheopportunitycostofremainingunemployedisrelativelylowlabourerslack
incentivestotakejobsatthegoingrealwagerate.

3. Tradeunionpowermightservethesamepurpose;bysuccessfulbargainingofwages,
wagesarebidupaboveequilibriumlevel.(Notethattheconceptofdownwardsticky
wagesisrelevantheretoo.)

Allinall,thesethreefactorsareconsideredtobuildinmarketimperfectionsandhinderthe
labourmarketfromclearing.Theresultofthesestructuralimpediments(=hindrances)isa
higherlevelofunemploymentthanthefullemploymentlevel.
Figure51.6Disequilibriumunemploymentrealwageunemployment

U0U1: Real wage unemployment arises

since at W0, U2 labourers are willing to work
but only U0 are demanded by firms. The real
wage is too high and total unemployment is
U0 to U1.

PL (real
wage rate)
ASL TLF

W0

NR
W*
U

AD
L

U0 FE U2 QL/
U* U1 t
Figures 3.4.2 I, II and II; Demand management, business cycle and aggregate demand

Real GDP (index) I: The business cycle and demand management

Peak
Potential real GDP

Aimed-for business cycle

Real GDP trend

Trough

Contractionary fiscal policy & Expansionary fiscal policy &

tight monetary policy loose monetary policy

t0 Time
t1
II: Contractionary policies III: Expansionary policies
and
Price AD
level and level
Price AD
LRAS LRAS
AD1
AD0 SRAS
SRAS
P0
P1
P1
P0
AD0
AD1
YFE Y1 Y0 GDPreal/t Y0 Y1 YFE GDPreal/t

Fiscal policies: increased taxation, lower Fiscal policies: decreased taxation,

government spending increased government spending
Monetary policies: tight monetary policies = Monetary policies: loose monetary policies =
increase in interest rates (outside the decrease in interest rates (outside the
syllabus: decrease in money supply) syllabus: increase in money supply)
Monetarist/new-classical view

B to C: As factor prices are bid up by

both firms and workers, in the long run
the short run aggregate supply will shift
New-classical view of an increase in AD in LR to the left, back to the original LRAS
curve but at a higher price level.
The economy will thus move from point
Price A to C via point B. Again, any increase
in AD which is not matched by the long
level run potential of the economy will be
LRA SRAS1 inflationary shown by the increase of
S the price level from P0 to P2.
C SRAS0
P2
(D) B
P1
P0 A to B: An increase in AD will increase
AD1 output in the short run, but also make
A
factors scarce and decrease real wages
AD0
for workers.
YFE Y1 GDPreal/t

Marcia: I cant shade the blue in AD1,Y1 and P1 or the dotted lines its
either one blue or another. Can you?

What did the mon/N-C side advocate?

I: The LR effects of demand-side II: The LR effects of supply-side

policies policies
Price Price
level SRAS1 level LRAS0 LRAS1 LRAS2
LRA
S C SRAS0
P2 C
B B
P1 A
P0 A
AD1 AD2
AD1
AD0 AD0
YFE Y1 GDPreal/t Y0 Y1 Y2 GDPreal/t

An increase in AD beyond YFE will be Long-run output can be increased

purely inflationary in the long run. by focusing on supply-side.
(Type 3 Medium heading) Supply-side policies
Supplysideeconomicsaroseoutofthesamemouldasthemonetarist/neoclassicalschool
duringthe1980sandfocusesonpolicieswhichenhancethelongrunoutputpotentialinthe
economybywayofcreatingwellfunctioningfactormarketsandincentivesforbothproducers
andlabourers.Supplysidepoliciesareinessencemicroeconomicpolicies,sincethepolicies
targetspecificmarketssuchasthelabourorcapitalmarket.Supplysidepoliciesarehighly
marketorientated,aimingtoliberatemarketswhicharehinderedfromclearingduetovarious
formsofmarketimpuritiessuchaslabourlegislationandgovernmentintervention.Ihave
collectedthevarioussupplysidepoliciesunderthreemainrubrics;labour,capitaland
competition.

1. Labour:Supplysideeconomicsinlabourmarketscentreonincreasinglabourmobility
bothintermsofgeographylocation,industryandtimebetweenjobsbyincreasing
theincentivesoffirmstohireandlabourerstoacceptjobs.Thebasicidealistoincrease
thesupplyandoverallqualityoflabourwhilecreatingmechanismsforwellfunctioning
labourmarkets.Thefollowingpointsareoftenputforward:
Changelabourlawsandmakeiteasierforfirmstohireandfire,reducingsearchcosts
andrisksforfirmswhiledecreasingbetweenjobtimeforlabourers.
Educationandretrainingschemeswillincreasethequalityoflaboure.g.labour
capitalandincreasethespeedbywhichredundantlabourcanbereallocated.Such
schemescanbeencouragedbygivingtaxbreakstofirmswhichimplementthem.
Reducing/abolishingregionalsupportschemesinordertohighlightdifferencesin
regionalunemploymentlevelsandthusencouragepeopletomovetonewjobsinother
regions.
Cuttingbackonsocialwelfare/unemploymentbenefitsinordertoencouragepeopleto
acceptjobsbyincreasingtheopportunitycostsofunemployment.
Reducingunionpowersay,bymakingsympathystrikesillegalandmaking
collectivebargainingharderinordertoreducewagestickiness.
Abolishminimumwagestoallowmarketforcestosetwages.
Decreasemarginaltaxratesonincomeasanincentiveforlabourerstoworkmore;and
decreaselabourtaxesinordertodecreaselabourcostsforfirms.

2. Capital:Byincreasingboththequalityandquantityofcapital,supplysideeconomics
aimstoincreasethelongrunaggregatesupply:
Taxbreaks/deductionstofirmsfor(re)investmentwillstimulateinvestment
expenditure.
Lowertaxesondividends(ashareofcompanyprofitspaidtoshareholders)can
increaseinvestmentfundingforfirmssincemorepeoplewillbewillingtobuyshares.
Lowerprofit(corporate)taxesencouragefurtherinvestmentbyfirms.

3. Competition:Finally,supplysideeconomistspointtotheimportanceofcompetitionin
aneconomyasanoverridingelementinincreasinglongrunaggregatesupply:
Privatisationofgovernmentrunbusinessesandderegulationofmarketsarestaple
supplysidemeasuresinincreasingcompetitiveforcesinaneconomy.
Deregulation.
GrantsubsidiesortaxreductionsforfirmsfundingR&Dcentres.
Encourageentrepreneurshipbygrantingtaxholidaysandcreatingbeneficialfunding
schemesforstartups,e.g.newfirms.
Tradeliberalisationreducingtariffs(=importtariffs)andotherbarrierstofreetrade
andfreecapitalflows(easierforeigninvestment)arepoliciesoftenputforwardby
 supplysiders.

Themainthemeinsupplypoliciesisthatmarketforcesarefarbetteratcreatingoutputinthe
longrunthangovernmentinterventionintheformofdemandmanagement.Sustainablelong
runincreasesinGDPcanonlybeincreased,accordingtothisneoclassicallyorientatedview,
byincreasinglongrunaggregatesupply.Allowingfirmstomakeaprofitundercompetitive
forcesandcreatingconditionsforfactormarketstoclearwillshiftthelongrunaggregate
supplycurveandthereforedecreasethenaturalrateofunemployment.

(Type 3 Medium heading) Advantages of demand-side policies

Thetheoreticalbenefitsofdemandmanagementhaveprettymuchbeenoutlinedabove:

Macrogoals:Byadjustingmonetaryandfiscalpolicies,itispossibletoinfluencethe
levelofeconomicactivityandthereforeoutput,unemployment,inflationandthetrade
balance.Inotherwords,demandmanagementgivespoliticianstoolstoachievethe
macroeconomicgoalsofsociety.

Stability:Builtinfiscalstabilisersautomaticstabilisershelpevenouttheeconomic
cyclesandcreatestabilityandpredictabilityintheeconomy,whileeveningoutsome
oftheexcesses/surplusesinproductivecapacityovertime.

Governmentgoals:Discretionaryfiscalpoliciesinturnallowgovernmentstosteerthe
economyinlinewithbothconsensusviewsofeconomicgoalsandideological
underpinningsandidealsofsocial/economicwelfare.Fullemploymentincreases
livingstandardswhiletaxrates,unemploymentbenefitsandgovernmentspendingall
helpinimprovingsocialwelfaresystemsandredistributingincomesintheeconomy.
NotethattheconceptssuchasfairnessandequalityareNOTentirelynormative.
Thereareinfactagoodmanysoundeconomicargumentsunderliningsocial
redistributionbywayoftaxesandtransferpayments,inthatagreatmanyeconomic
andsocialcostsshowstrongpositivecorrelationtoincreasedinequalityofincomeand
wealth;crime,alcoholismanddrugabusearenotableexamples.Thisisasubjectof
Section3.6.

TheKeynesianmultiplier:Keynesianeconomicsalsostressestheelementofself
perpetuationisstimulatingaggregatedemandviafiscalpolicyduringrecessionary
periods;themultipliereffect(HL,seebelow).TheeffectisbuiltintotheKeynesian
modelandshowshowthenetfinaleffectofincreasedgovernmentspendingorlower
taxesisincreasedoversuccessiveroundsintheeconomy.Forexample,if
governmentspendingincreasesby10billionsaytobuildroadsandother
infrastructurethenjobswillbecreatedandunemploymentwillfall.Itdoesntstop
there;manyofthosewhohavebeenunemployedforsometimewillhavepentup
consumptiondemands,sotheywillspendmostoftheirwages.Thisspendingwillin
turncreatemoredemand,whichcreatesmorejobs,whichlowersunemployment
etc.Thus,accordingtoKeynesians,amajorbenefitofdemandsideeconomicsisthat
thereisaleverageeffectofusingfiscalstimulation,sincethefinalincreasein
nationalincomeisgreaterthaninitialbudgetcosts;Yfinal>Ginitial(orYfinal>
Tinitial).Theincreaseinnationalincomewillultimatelypadgovernmenttaxcoffers
andhelptomakeupforpossibledeficitspendingdoneinthefirstplace.

(Type 3 Medium heading) Weaknesses of demand management

Keynesiandemandmanagementwasvirtuallyunchallengedasthemacroeconomicmethodof
choiceduringthe1950sand60s.Highgrowthratesandlowunemploymentseemedtojustify
demandmanagementpolicies.However,duringtheearly1970s,anumberofweaknessesof
demandmanagementbecameevident.
 Thebusinesscycleswereoftenerraticanduntamedorevenaggravatedbydemand
managementpoliciestherewereincreasingindicationsofpoliticallyinclinedbusiness
cyclesoverthecourseofchangesingovernments.

Inflationrosetohithertounseenlevelsandbudgetdeficitsgrewsincegovernment
spendingduringrecessionaryperiodswasevermoreseldommadeupforduring
booms.

Thisincreasedgovernmentindebtednessledtomostdebilitatingexchangerate
problems(seeSection4.6).Increasinglyopeneconomiesmeantthatgovernment
spendingand/orlowertaxeswouldnothavethesamemultiplicativeeffectonthe
domesticeconomy,asanincreasedproportionofdisposableincomegainsflowedout
ofthecountrytobuyimports.

Thesemainweaknessesinusingdemandmanagementtocontroltheeconomyaregivenbelow
underthreeheadings;

1. Tradeoffproblems;

2. Timelagsandexacerbationofthecycle;and

3. Neoclassicaleconomistscritiqueofdemandmanagement.

Fivepossiblemacroeconomictradeoffsemergefromthediscussionabove:
A. Growthpricestability
B. Unemploymentpricestability
C. Unemploymentbalancedbudget
D. Growthtradebalance
E. Domesticmonetarypolicy(interestrate)freedomstable(orfixed)exchange
rate

(Type 3 Medium heading) Weaknesses in supply-side policies /

Keynesian critique of the neo-classical school
Manyoftheweaknessesofsupplysidepoliciesputforwarddealwiththenegativesideeffects
onsociety.Thelistofsupplysidepoliciesgivenisampleindicationofthepossibleeffectson
householdscomprisedoflowincomeearners,peoplewithonlybasiceducation,andolder
workerswhowouldhavedifficultyswitchingjobs.Thesegrinandbearitpolicies,asKeynes
calledthem,canbecompoundedasfollows.

INCENTIVE FUNCTION OF TAX CUTS IS LIMITED

Whilemosteconomistsacceptthatpositivecorrelationexistsbetweenmarginalincometax
ratesthetaxpaidonthelastmoneyearnedandthesupplyoflabour,studiesshowarather
weaklink.Forexample,thelargetaxcutsgivenintheUSduringtheReaganadministrationare
estimatedtohaveincreasedlaboursupplybybetween0.4%and0.9%.18Anotherargumentput
forwardbysupplysideristhatreductionsintaxesandsocialbenefitshaveastrongincentives
effectandthereforeincreaseproductivityintheeconomy.Thishasbeenstronglycontestedby
manyKeynesianeconomistswhopointtothefactthatlabourproductivitygrowthwasvirtually
thesameinthetenyearsbeforeandafterReaganssupplysidemeasures.Criticsofsupplyside
measuresdoacknowledgethatcutsintaxeswhichaffectoutput,suchasprofitandlabourtaxes,
havehadsomemeasureofsuccessinsupplysideterms.However,theyhastentoaddthatsuch
policiestakealongtimetoaffecttheeconomy10yearsormoreduringwhichtimethereare
considerableopportunitycostsinvolved,suchas
18
Abel&Bernake,page578
SOCIAL COSTS
Demandmanagementhasoftenbeenusedasabuffer(=shockabsorber)againstalarming
unemploymentratesinvariousindustrialsectorsandgeographicalareas.Targetedincreasesin
governmentspending,transferpaymentsandsocialprogramshavebeenusedbothinincreasing
aggregatedemandandinsocialengineering,i.e.spreadingwealthandcurtailingincome
inequalities.Supplysidetaxcutshavetendednotonlytoincreasebudgetdeficitsbutalsoto
starvethegovernmentsectoroffunds,whichcanleadtonegativeeffectsforpoorerhouseholds
whentransferpaymentsandsocialprogramsdiminish.Thereforegovernmentsruntheriskof
increasingunemploymentintheshortrunsincethesupplysidepolicieswillinitiallyhavethe
effectofloweringaggregatedemand,causinggreateconomicandsociallossduringthetimeit
takesforthesupplysidepoliciestotakeeffect.Thelongruneffectisincreasedinequalityin
incomedistribution,somethingthatoneofthemostvocalKeynesians,PaulKrugman19,has
pointedoutinAmerica,simplystatingthatReaganomicsmadethingsworse,pushing
millionsofpeopleoverthepovertyline20.Criticsalsopointoutthatdiminishingthesize
ofgovernmentanditsspendingisnotonlydifficultandpoliticallydangerousbutcanhave
negativeeffectsonthelongrunpotentialoftheeconomy.Costcuttinginschools,healthcare
andsocialprogramsprovestobeeconomicallyfoolishasitwilladverselyaffectthelongrun
potentialoftheeconomy.

IMPERFECTLY FUNCTIONING MARKETS

Keynesianeconomistsgenerallyviewmarketsasimperfectlyfunctioningmechanisms,where
interventionbygovernmentisseenaswellmotivatedandnecessarytocorrectsomeofthe
moreglaringmarketfailures.Disequilibriumunemploymenti.e.employmentratesbelow
fullemploymentisseenastheresultofdemanddeficiency(seeSection3.5)andwage
stickinessratherthantheneoclassicalviewthatmarketimpedimentssimplydonotallow
labourpricestofall.Inthismanner,Keynesiansarguethatwhilethelabourmarketmight
ultimatelyclearandreturntheeconomytofullemployment,therewouldbeconsiderable
economiclossinthetimebeingasfactorslayidleandoutputwasbelowpotential.The
correctionofdemandinsufficiencyintheeconomyliesinthehandsofgovernment
interventionismanddemandmanagement.

Finally,afewwordsonthealluringanderroneousconclusionthateconomistsofdemand
sidecutareagainstallformsofsupplysidepolicies.Infact,oneoftheareasofconsensusin
economicpolicytodayisthatsupplysidepoliciesindeedincreaselongrunaggregatesupply.
However,itisinthechoiceofsupplysidepoliciesthatdisagreementisstilltobefound.Neo
classicaleconomistsfavourpoliciesbasedonfreemarketsandincentives,suchaslowertaxes
andprivatisation.Keynesianeconomistsprefersupplysidepoliciesofinterventionisttype,
suchasgovernmentfundingofworkerrecruitment/educationandretrainingcentres.

Costpushinflation

19
Nobel Laureate in economics, 2008
20
1993articlebyKrugman,publishedat;
http://www.pkarchive.org/economy/ConservativeMirage.html
 I: Supply-side shock II: Cost-push III: Cost-push
Price inflation
Price spiral
Price LRAS
level LRAS level LRAS SRAS level SRAS4
2 H
D
P3 P7 G SRAS3
SRAS1 SRAS1 P6
P2 F SRAS2
SRAS0 SRAS0 P
B C 5
P1 P1 P4 E
B P3 AD3
P0 A P0 A
D AD2
AD1
AD0 AD0 AD1
Y1 YFE GDPreal/ YFE GDPreal/ YFE GDPreal/
t t t

A B; an increase in B C D; the decrease D E H; Should

factor costs causes a
decrease in SRAS. This is
a supply-side shock.
in real wages causes labourers continue to bid
labourers to bid up wages up wages after the
and SRAS continues to increase in AD (point D),
decrease (SRAS1 to another round of cost-
SRAS2). When higher push inflation
commences. We now
wages fuel consumption,
have a cost-push spiral:
AD increases from AD0 to
AD1. Weve now seen a
price level wages
costs to firms price
complete round of cost- level, etc.
push inflation.

Demand pull inflation

I: Demand-side II: Demand-pull III: Demand-pull
shock LRAS
Price inflation
Price LRAS spiralLRAS
Price SRAS3
level level level H
P7
SRAS1 SRAS2
D P6 G
P3 P5 F SRAS1
SRAS0 SRAS0
B P2 P4 E
C
P1 P1 P3 AD4
P0 A P0 A B AD D AD3
AD1 AD AD
2
AD0 AD0 1 2

YFE Y GDPreal/ YFE GDPreal/ YFE GDPreal/

1
t t t

A B; the increase in B C D; anticipation D E H; if

demand for exports
increases AD, causing a
demand-side shock.
of higher inflation
increases AD further (AD1
to AD2) and the price level
increases to P2. The
subsequent fall in real
wages causes a bidding-
up of wages and as costs
rise for firms, SRAS
decreases from SRAS0 to
SRAS1 and the price level
continues rising to P3. This
is a round of demand-pull
inflation.
households again
anticipate higher inflation
at point D, then AD might
again increase (AD2 to
AD3). This leads to
another demand-pull
inflationary round and a
demand-pull spiral; high
inflation expectations
AD higher costs for
firms SRAS higher
price level, etc.
 Foreign
Leakages (0.4) sector
Round 2: 20 bn.

Round 3: 12 bn. Financial

institutions
Round n.

Govt.
M S T Total increase in Y:

Round 1: 50 bn.
Round 1: 50 bn.
Round 2 + 30 bn.
C = 30 bn Round 2: 30bn. = 80 bn.
Households Firms
Round 3 + 18 bn.
C = 18 bn Round 3: 18bn. = 98 bn.

Round n + ? .
C...n Round n.. ?
Final increase = ?

Wages, Round 1: 50 bn.

rents, Round 2: 30 bn.

Round 3: 18 bn.
interest

and profits Round n.

(Type 4 Smaller heading) Marginal propensity to consume (MPC)

IntheKeynesianmodel,householdsmarginalpropensitytoconsume,MPC,isthe
proportionofanyincreaseinincomeusedfordomesticconsumption.TheMPCisthechangein
consumptionoverthechangeinincome;C/Y.

Thisproportionofincreasedconsumptionintheexampleis0.6(i.e.60%ofanyincreasein
householdincomegoestoconsumption),whichisthemarginalpropensitytoconsume.Inthe
firstroundinfigure47.1,theincreasein(Y)of50billioningovernmentspendingresultedin
anincreaseinconsumption(C)of30billion.

C 30 billion
MPC= ---
Y---- = --50
---------billion
------------ = 0.6

(Type 4 Smaller heading) Marginal propensity to leak (MPL)

Correspondingly,the0.4proportionwhichdoesnotgotoconsumptionisleakingoutofthe
system;savings,taxesandimports.Thisproportionofachangeinincomewhichdoesnot
returntothesystemintheformofconsumptionisthemarginalpropensitytoleak,MPL,
whichiscomprisedofthemarginalpropensitytosave(MPS),themarginalpropensityto
import(MPM)andthemarginalpropensitytotax(MPT).21

S M T
MPS= -Y
------- MPM= --Y
------ MPT= -Y
------

Letusassumethatoutofthe50billionincreaseinincome,householdssave2.5billion(5%
or0.05),use7.5billion(15%or0.15)forimportsandhavetopay10billionintax(20%).

2.5 7.5 10
MPS = -50
--------- MPM = --50 ------- MPT = 50
---------
MPL = 0.05+ 0.15+ 0.2 MPL = 0.4
MPL = S + M + T 20 billion= 0.4
----------------Y
--------------------- -50
-----------
----------
billion

21
YoudontneedtobeWernervonBrauntorealisethatthesumofthemarginalpropensityto
consumeandthemarginalpropensitytoleakmustalwaysequalone.Thismakesperfectsense,
sinceanyincreaseinhouseholdincomewilleitherbeusedfordomesticconsumptionor
savings/taxes/imports.Thus;MPC+MPL=1,and1MPC=MPL.
Section 3 trade
Why trade?
1. Factor endowment Nicaragua has weatherSweden has forests
2. Increase in div of labourspecialisationeff
3. Variety and choice
4. Peace dividend
5. EOS
6. Transfer of knowledge and technology
7. Consuming outside PPF theory of comp adv CPF arises!
THEORY OF COMPARATIVE ADVANTAGE

Definition; Absolute and comparative advantage

If the US can produce more agricultural goods and textiles than Mexico using the same amount
of resources, than the US has an absolute advantage.

If Mexico has a lower opportunity cost (in terms of foregone production of agricultural goods)
in the production of 1 unit of textiles, then Mexico has a comparative advantage in the
production of textiles.

I: US PPF and CPF II: Mexicos PPF and CPF

Agricultural goods Agricultural goods

10 US exports 3.2 units of Mexico produces 8 units of textiles and zero

agricultural goods agricultural goods. The CPF is drawn between
trading zero textiles (consumption = 8 textiles
and zero agricultural goods) and trading all
textiles for agricultural goods (consumption is
B 8 x 0.8 = 6.4 agricultural goods and zero
6.8 6.4
A CPF Mexico imports textiles).
3.2 units of
agricultural goods CPF

4 PPF D
3.2
PPF
2
C

3.2 4 8* 10 Textiles 4 8 Textiles

US imports 4 units Mexico exports 4

of textiles units of textiles
Protectionism
1. Def: any govt intervention which skews the ratio of Px over Pmin
other words, which makes X (or dom goods) relatively cheaper and/or
M relatively dearer.
2. Infant ind (use LRAC plus Sw cure)
3. Protect dom empl
a. Higher prices for dom consumers means real y falls.
i. Dom demand falls!
ii. Say that a US hospital outsources X-rays to Indiathis
costs less than 1/5 of US pricesaving US consumers 8
bn in this alone.
b. Forward linkage effects domestic producers see imported FoPs
rise in price (a tax on Japanese steel means higher production
costs for Ford)
i. Tax on Nippon Steel in USA means that the tonne price
of steel rises.60% of the raw material costs in building
a car is steel
ii. India taxes imported tractorswhich raises the cost of
producing food
c. BTT mean LOST jobs in the import industry
d. Empirically NO JOBS HAVE EVER BEEN SAVED in LR via
BTT!
2. Anti-dumping (dumping; selling abroad at below MC of prod) popular
in US
a. Pop in US becausefirms that file a complaint with a US court
get to keep the fines if they win in court!
3. Environment.
4. Health and safety
5. Political easier to understand I am protecting your job than I know
that U will rise due to BTT!
Definition: Tariff
A tariff is a tax levied on imported goods. The tariff can be both an ad valorem
tax, e.g. a percentage of the import price, or a specific tax, e.g. a tax based on a
measurable unit such as tonnes or bottles.

I: Closed economy II: Open economy III: Protected economy

P (/kg) P (/kg) P (/kg)

Sdom Sdom Sdom
Tariff
P0 P0
P2 Sworld + tariff

P1 Sworld P1 Sworld

D D D
Q0 Q QS1 Q0 QD1 Q QS1 QS2 QD QD1 Q
2
(tonnes (tonnes (tonnes /
/year) Imports /year) Imports year)

A+B+C+D; loss of
consumer surplus (HL)

P
Sdomestic A A; gain of domestic
(/kg) supplier surplus (HL)

B; efficiency loss I =
B Green loss to society

1.2 Sworld + tariff C; tax revenue to govt.

C (40,000)
A B C D Tariff (0.2)
1 Sworld
D; efficiency loss II = net
E F G D loss of consumer surplus
D
E & G; foreign suppliers
500 600 800 900 Q loss of revenue (200,000)
(tonnes/
Imports post-tariff year)
= 200 tonnes E F G

F; remaining revenue
of foreign suppliers
(200,000)
QUOTAS
Wenowturntootherformsoftradebarriers,i.e.nontariffbarriers.Acommonmethodto
protectthedomesticeconomyisbysettingactualquantitativelimitsontheamountofimports,
aquota.

Definition: Import quotas

A quota is a quantitative (physical) limit on imports set by the importing country. The
effect of a quota is that domestic suppliers will replace some of the imports at a higher
than world market price. Foreign suppliers will have an incentive to raise the price of
their goods, thus making a windfall gain.

A+B+C+D; loss of
consumer surplus (HL)

P
Sdomestic A A; gain of domestic
(/kg) supplier surplus (HL)

B; efficiency loss I =
B Green loss to society

1.2 C; windfall gain to foreign

C suppliers (40,000)
A B C D
1 Sworld
D; efficiency loss II = net
E F G D loss of consumer surplus
D
E & G; foreign suppliers
500 600 800 900 Q loss of revenue (200,000)
(tonnes/
Import quota = year)
200 tonnes E F G

F; part of original
revenue of foreign
suppliers (200,000)

SUBSIDIES
Anyactionbygovernmentwhichlowerstheratioofdomesticpricestoimportprices(inother
wordsraisestherelativepriceofimportsorlowerstherelativepriceofdomesticgoods)will
serveasabarriertotrade.Therefore,whendomesticproducersreceivedirectpaymentsfor
productionorindirectproductionincentivessuchastaxbreaksorlowinterestloans,theeffect
isthatofasubsidy.Asubsidylowerstheproductioncosts(HL:marginalcosts)fordomestic
producersandenablesthemtobemorecompetitivewithforeignproducers.

F TheeffectsofasubsidyoncottonTshirts
 Total cost of subsidy to
government; $600,000 ($2
x 300,000) per year (HL)
P ($/shirt)
Sdo S+subsidy
m

12 Subsidy/uni
t = $2 (HL)
10 Sworld

D
200 300 400 Q/t (1,000s
shirts/year
Decrease in )
Imports after
imports subsidy

Possible (probable?!) effects of protectionism:

1. Loss of effmisallocation (see diags)
2. Cost of subsidies (see diag)
3. Loss of CS
4. Rise in M pricesneg effect on consumption powerand choice
5. Lack of competition.higher pricesless innovationlower quality
6. Builds in comforts zones for domestic suppliers they will have govt in
their pockets in monopolies(India)
7. Reciprocity! (See what happened in 1930s USA due to Smoot-Hawley
bill!)
8. Save jobsno, not empirically in LR maybe in ONE industry in SR
but rising prices for HHs means less real yand lower AD
9. Forward linkage effect (good argument!) a rise in the price of steel in
USA due to a tariff will raise costs for GMFord and Chrystlerand
make them less competitive towards Honda!
Exchangerates
Iwilllimitthediscussiontotwocurrencies,theEUROandtheUSdollar,inordertomake
thingsabitsimplerandtoimpressuponyouthatsincethepriceoftheEUROisintermsofthe
USdollarandviceversathentheactivitiesinonemarketwillaffecttheothermarket.(Note
thatweareassumingthattheexchangerateisoperatingundermarketforces;i.e.afloating
exchangerate.)

Definition: Exchange rate

The exchange rate is the price of a currency expressed in terms of another currency. Thus the
exchange rate for the US dollar can be expressed in the amount of British pounds, EURO or
Mexican pesos needed to buy one dollar. (The exchange rate can also be expressed as the price
of a currency against a basket of other currencies.) Note that when we refer to the exchange
rate for the dollar we use the price of the US dollar in terms of, say, pounds. The exchange
rate for the pound would naturally be expressed as the price of pounds in another currency
here, US dollars. Thus; 1 = USD1.58 and USD1 = 0.63.

ThesupplycurveforEUROsisupwardsloping(diagramIinfigure4.6.2)sinceahigherprice
fortheEUROceterisparibuswouldenableEuropeancitizenstobuymoreAmericangoods,
andindoingsomoreEUROswouldbeavailableontheUSmarket.Thedemandcurveis
downwardslopingtoindicatethatAmericanswillbuymoreEUROswhentheygetmore
EUROsandthusgoodsfortheirUSdollars.

F IandII;TheexchangeratesfortheEUROandtheUSdollar

I) EURO II) USD

P of in USD P USD in
Initial S$0
S equilibrium:
1 = 1.28 USD S$1
1.30 and thus
0.78
1USD = 0.78
1.28 0.77

New
D1 equilibrium:
D0 1 = 1.30 USD D$
and thus
Q Q 1USD = 0.77
Q Q
Q Q$ (millions/day)
0 1 0 1
(millions/day)
DiagramIinfigure4.6.2aboveshowshowaninitialequilibriumintheexchangerateforthe
EUROissetatUSD1.28.ThisgivesanexchangeratefortheUSdollarof0.82,shownin
diagramII.SaythatthereisincreasedAmericandemandforEuropeangoodsoranincreasein
AmericantouriststoEurope:
 EURO:thedemandforEUROswillincreasefromD0toD1indiagramI,andthe
exchangerateforEUROswillrise(appreciateseefurtheron)fromUSD1.28to
USD1.30.

USD:AsmoredollarswouldflowintoforeignexchangeofficestobuytheEURO,the
supplyofUSdollarswouldincrease.ThisisshownindiagramII,wherethesupplyof
USdollarsincreasesfromS0toS$1,andtheexchangeratefortheUSdollarfalls
(depreciates)from0.78to0.77.ThenewexchangeratefortheUSDisnaturallythe
inverseofthepriceoftheEURO(1/1.30).

PleasenotethatIusetwodiagramssimplytoillustratethepriceofoneintermsoftheother,
andtheshiftsindemandandsupplyforacurrencyintwomarketstheEUROmarketandthe
USdollarmarket.Intheremainderofthischapter,Iwillillustrateusingonecurrencyatatime.

US dollar; change in demand US dollar; change in supply

P of $US P of $US
(TWI) (TWI)
SUSD2
SUSD SUSD0
104 SUSD1
104
100
100
96
96 DUSD1
DUSD0
DUSD2 DUSD
Q2 Q0 Q1 Q$ (millions/day) Q Q Q Q$ (millions/day)

2 0 1
Increase in demand for the US dollar: Increase in supply of the US dollar:
US exports of goods/services US imports of goods/services
in foreign investment in US in US foreign investment abroad
in US interest rates in foreign interest rates
in US inflation rate in foreign inflation rate
speculative buying of US dollar speculative selling of US dollar
US central bank buys dollars (= decrease US central bank sells dollars (= increase
in foreign reserves) in foreign reserves)

Decrease in demand for the US dollar: Decrease in supply of the US dollar

US exports of goods/services US imports of goods/services
in foreign investment in US in US foreign investment abroad
in US interest rates in foreign interest rates
in US inflation rate in foreign inflation rate
HOW A FIXED EXCHANGE RATE WORKS
Intheshorttomediumterm,afixedexchangeregimeisupheldbykeepingtheexchangerate
withinanarrowbandbycentralbankintervention.UsingtheBrettonWoodssystemasan
example,diagramsIandIIinfigure4.6.3illustratehowBritainscentralbank,theBankof
England,peggedthepoundtothedollaratanexchangerateofUSD2.8.

Inordertomaintainthefixedexchangerate,theBankofEnglandwouldusetheforeign
reservestobuyandsellthepoundonadaytodaybasis:

Keepingthepounddown:DiagramIshowshowthelongrungoalofanexchangerate
ofUSD2.8tothepoundiskeptatpointA,atS0andD0.Thepoundwasallowedto
fluctuatewithinanarrowbandof2UScentsupordownwhichthepoundhadto
remainwithin.Anincreaseddemandforthepound,D0,whichthreatenedtoputthe
exchangerateabovetheceiling,USD2.84atpointC,wouldbemetbyintervention
sellingofthepoundbytheBankofEngland.22Thiswouldincreasethesupplyof
poundsontheforeignexchangemarket,S0toS1,andbringtheexchangerateforthe
poundbackdownwithintheupperlimitofthebandatpointDUSD2.82perpound.

Keepingthepoundup:Inthesameway,whentheexchangerateforthepoundfell
belowthelowerlimit,saytopointCatUSD2.76perpound,S2andD0in
diagramII,theBankofEnglandwouldinterveneandbuypoundsusingforeign
currencies(e.g.USdollars)fromtheforeignreserves.Thisincreasedthedemandfor
thepound,D0toD1bringingtheexchangeratebackuptothelowerlimitof
USD2.78perpoundatpointD.Inessence,theEnglishcentralbankusedUSdollars
tobuybackitsowncurrency.23

F FixedexchangeratetheBrettonWoodssystem

22
Ineffect,theBankofEnglandbuysupUSdollarswiththepound.
23
Perhapsthishelpsclarifytheconfusingissueofhowaminusvalueintheforeignreservesin
capitalaccount(Section4.5)meansthatinfacttheforeignreserveshaveincreased.When
theBankofEnglandbuysforeigncurrency,poundsflowoutofEngland(minusvalueinthe
capitalaccount)andnowtheBankofEnglandhasincreaseditsholdingofforeigncurrencies.
 I: Keeping the pound down II: Keeping the pound up

P of in USD
D2 Outside the band!
D1 When the exchange rate falls below
S2 2.78 the Bank of England will have
D0 C S0 to buy up Q1Q3 pounds (D0
2.84
B shifts right to D1) on the foreign
2.82
D Ceiling
exchange market to keep the pound
A P of in within the band.
2.80 LR target $US
2.78 Floor
D0 S0 S1 S2
Q 2.82 D1 Ceiling
Q0 Q1 Q2 Q3
(millions A
/day) 2.80 LR target
When the exchange rate rises
above 2.82 the Bank of England 2.78 D Floor
will have to sell Q1Q3 pounds (S0 B
2.76
shifts right to S1) on the foreign C
exchange market to keep the pound Q (millions
within the band. Q0 Q
1
Q2 Q3 /day)
Outside the band!

(TYPE 4 SMALLER HEADING) Exchange rate is too high

Positiveeffectsofovervaluedcurrency:
Importerswillwinsincetheywillpaylessforimportedgoodsandreceivetheir
revenuesindomesticcurrency.
Thiscouldalsowellhavebeneficialeffectsonthedomesticinflationratesince
competitiveforceswillcauseimporterstopassonsomeoftheircostsavingsto
consumers.
Firmswhichrelytoalargeextentonimportedrawmaterials,componentsandother
factorsofproductionwillseetheircostsgodown.Thiscaninfactmakethemmore
competitiveontheinternationalmarket.
Householdswillseethatimportsandtripsabroadwillbecheaperintermsofthe
quantityofdomesticcurrencyneededtobuyimportsandtravelabroad.
Agovernmentwhichhasalargeexternal(foreign)debtwouldseethatthedebt
servicing(amortisationandinterestpayments)wouldbeeasier.
Exportfirmsinacountrywithastrongcurrencymightbeforcedtobecomemore
efficientinordertobeabletocompeteoninternationalmarkets.

Negativeeffectsofovervaluedcurrency:
Thecurrentaccountinthebalanceofpaymentscanbeadverselyaffectedifthestrong
 currencyleadstoincreasedimportexpenditureand/ordecreasedexportrevenue.There
hasbeenclearcorrelationbetweenastrongerdollarandtheUScurrentaccountdeficit.
Astronglyexportorientatedcountry,forexampleChina,wouldfeartheeffectsofa
higherexchangerateongrowthandunemployment.Theofficialfiguresshowthat
exportsaccountfor37%ofGDPandonecanwellimaginetheeffectsondomestic
growthandunemploymentduetoastrongcurrency.24
Domesticfirmswhichhavelargeforeigninvestmentswillseethatprofitsdeclinewhen
theyarerepatriated.

(TYPE 4 SMALLER HEADING) Exchange rate is too low

Positiveeffectsofundervaluedcurrency:
Naturallythepositiveeffectsofanundervaluedcurrencyaresomethingofamirror
imageofthenegativeeffectsgivenabove:Aweakercurrencylowersthepriceof
exportsandwillbenefitexportersanddomesticindustry;asthepriceofexportshas
fallenandthepriceofimportshasrisentherewillbeapositiveeffectonthebalanceof
payments(HL:seetheMarshallLernerandJcurveinsection4.7.);jobswillbe
createdinexportindustries;countrieswithahighproportionofexportsinrelationto
GDPwillseegrowth;andinternationalfirmsrepatriatingprofitswillenjoygreater
returnsintermsofdomesticcurrency.

Negativeeffectsofundervaluedcurrency:
Anundervaluedcurrencywillhavethefollowingeffects:Importersandfirmsreliant
onimportedfactorsofproductionwillseecostsrise;householdswillcutbackon
importedgoodsandforeigntravel;andgovernmentswithahighproportionofforeign
debtwillseehowdebtservicingbecomesdearer.
Acountrywithaloworundervaluedexchangeratewillinalllikelihood
experienceinflation.Therearetwocontributingcauses:
o Astrongexportingnationwillexperiencerisingaggregatedemandand
demandpullinflation.
o Anationwithahighvolumeof(HL:relativelypriceinelastic)imported
factorsofproductionwillseeincreasedexpenditureonimportedfactors.This
willdecreaseaggregatesupplyandthuscontributetocostpushinflation.

Extended response question

a) Explain why a competitive market firm would not be able to earn an

abnormal profit in the long run. (10 marks)

24
The official figure of 37% of GDP should be taken with scepticism. There are some serious
studies showing that the official figures are seriously inflated and the real value lies closer to
10%. See for example
Basic answer: Due to charsof PCM.of no BTEand perf kn/infoand
homog good, any abn profit will attract new firms (mkt entry) leading to an
increase in S lower mkt price and since the PCM firm is a P-taker, the fall in
price results in a LR situation where AR = AC.
Def; PCM and abn , 2p
Assumptions of PCM, 2p
Diagr showing mkt and firm, clear that MC = MR in both t0 and t1, 3p
Expl of how perf kn/info and low/no BTE cause mkt entry when firms
see abn , 2p
Clearly linking to points in diags (e.g. profitmax and profit) in SR and
LR, 2p

b) Evaluate whether a competitive market is always more societally desirable

than a monopoly. (15 marks)

Basic answer: Having one firm (mon)is usually considered less desirable
because of higher prices and lower Q consumed, which CSand leads to a
DW loss and sub-opt all/prod eff yet; there are situations such as nat mons
and large EoS where society gains from mon.
Def/assume; monone firmunique goodhigh BTEimperf
kn/infopossible LR , 2p
Diag series showing DW lossetc, 3p PLUS expl of issues herein e.g.
profit LReffDW loss mon is indeed less desireable!, 3p
Eval, up to 5p each (expl plus diags):
o Eos
o Nat mon
o AC-pricing in public utilities
o Existence of high neg exts