AS Edexcel Economics - A

Theme 1 – Markets and market failure

Unit 1

• 1.1.1 Economics as a social science

• 1.1.2 Positive and normative economic statements
• 1.1.3 The economic problem
• 1.1.4 Production possibility frontiers
• 1.1.5 Specialisation and division of labour
• 1.1.6 Types of economies (free market, mixed, command)

How markets work

• 1.2.1 Rational decision making

• 1.2.2 Demand
• 1.2.3 Elasticity of demand / income / cross
• 1.2.4 Supply
• 1.2.5 Elasticity of supply
• 1.2.6 Price determination
• 1.2.7 Price mechanism
• 1.2.8 Consumer / producer surplus
• 1.2.9 Taxes and subsidies
• 1.2.10 Alternative views of consumer behaviour

Market failure

• 1.3.1 Types of market failure

• 1.3.2 Externalities
• 1.3.3 Public goods
• 1.3.4 Information gaps

Government intervention

• 1.4.1 Government intervention in markets

• 1.4.2 Government failure

 Theme 2 - The UK economy -
Performance and policies

Unit 2 - starts on p.52.

Measures of economic performance

• 2.1.1 Economic growth

• 2.1.2 Inflation
• 2.1.3 Employment and unemployment
• 2.1.4 Balance of payments

Aggregate demand

• 2.2.1 Aggregate demand (AD)

• 2.2.2 Consumption (C)
• 2.2.3 Investment (I)
• 2.2.4 Government expenditure (G)
• 2.2.5 Net trade (X-M)

Aggregate supply

• 2.3.1 Aggregate supply AS

• 2.3.2 Short-run AS
• 2.3.3 Long-run AS

National income

• 2.4.1 National income

• 2.4.2 Injections and withdrawals
• 2.4.3 Equilibrium real national income
• 2.4.4 The multiplier

Economic growth

• 2.5.1 Causes of economic growth

• 2.5.2 Output gaps
• 2.5.3 Trade (business) cycle
• 2.5.3 Impact of economic growth

Macroeconomic objectives and policies

• 2.6.1 Possible macroeconomic objectives

• 2.6.2 Demand-side policies
• 2.6.3 Supply-side policies
• 2.6.4 Conflicts and trade-offs between objectives and policies.

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 Economics as a social science
Aims of economics
• Increase economic and social welfare.
• Provide information to help make informed judgements.
• Provide suggestions for how to deal with the fundamental economic
problem of a shortage of resources and unlimited wants.
• Look at how different economic models may predict certain outcomes.

Difficulties in economics
• The lack of complete information – for example, it can be difficult to know
how a firm would respond to a rise in the price of oil.
• There are many different variables that are difficult to control. For
example, if we consider the impact of higher oil prices, we don’t know
how much consumers need to save or how they will react.
• Economics is not an exact science. For example, the effect of higher
interest rates will vary depending on economic circumstances.
• In Maths 2+2 always equals 4. But, in economics the effect of increasing
taxes or interest rates will be uncertain because there are many variables
we can’t control. We cannot manage scientific experiments.
• Economics requires we make assumptions and develop models

Ceteris paribus
This means ‘all other things being equal’. It means we ignore other variables and
consider the effect of just one variable. For example,

• Ceteris paribus – higher oil prices should lead to less demand for oil.
• Ceteris paribus – higher interest rates should lead to lower economic
growth.

Positive economic statements

This is based on facts that can be tested as true of false. For example:
1. In May 2015, the UK inflation rate was 0.5%.
2. A higher indirect tax will shift the supply curve to the left.

Normative economic statement

This is based on an opinion or a value judgement. People can disagree with these
statements. For example:
1. The government should increase taxes on alcohol to improve the nation’s
health.
2. It is unfair students have to pay tuition fees in order to go to university.

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Combining positive and normative statements
• Because oil prices have increased over $100 (fact), I believe the
government should cut petrol tax (opinion)
• Because oil prices have increased over $100 (fact), I believe the
government should subsidise the development of alternative modes of
transport, such as cycling (opinion).
Note how the same positive economic statement (oil price increased) can lead to
different opinions (normative) on how to respond.

It can depend on what people think is more important.

a) With cutting petrol tax, economists may be concerned with equality and
making sure people can afford to travel.
b) With subsidising public transport, economists may be concerned with the
environment and the external costs of oil.

The economic problem

The fundamental economic problem is the issue of scarcity and how best to
produce and distribute these scarce resources.

• Non-renewable resources. These are natural resources that are finite.
Once used, they cannot be replaced. For example, coal, oil, precious metals
and gas are all finite.
o Using non-renewable resources has implications for future
generations – will future living standards be harmed by our
current consumption.
o Using non-renewable resources has an opportunity cost – If we
burn fossil fuels, we lose out on clean air.

• Renewable resources. Resources that can be replenished. Examples
include wind, wood, fish, solar energy, water.

• Semi-renewable resources. There are some resources that, in theory,
are renewable, but if they are over-consumed they can become extinct
and no longer available. For example, fish stocks can be replenished. But,
if we over-fish, fish stocks can become depleted and no longer available.

• Sustainable consumption. This occurs when we consume resources at a
rate that can be maintained in the long-term. If we cut down forests, but
don’t plant new trees, this is unsustainable. If we plant at the same rate as
cutting, this is sustainable.

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 Opportunity cost
Opportunity cost is the next best alternative foregone. For example:

• If the government spends tax income on defence spending, then this
money cannot be spent on health care.
• If the government cuts tax, the opportunity cost is that they have less to
spend (or use to reduce budget deficit).
• If we spend our time surfing the internet, we cannot spend this time
studying economics.
• If firms spend all their money on advertising their new product, they
cannot use that money to invest in developing new products.

Importance of opportunity cost

• Opportunity cost means we have to make decisions about the best use of
time, money and resources. Sometimes there are two options that are
good, but we need to choose the relatively best option.

Choice between study and leisure - Suppose we have 12 hours to spare. We
can use these 12 hours for study or we can use the 12 hours for leisure.

If we move from A to B, we can spend two hours on leisure. The opportunity cost
is that we lose 2 hours of study.

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 Production possibility frontiers (PPF)

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


Points on PPF Curve

• A or B = Productively efficient. It is
impossible to choose more consumer
goods or environment units without an
opportunity cost.
• C = impossible (unobtainable without
economic growth)
• D = inefficient, below potential

This is a simplistic production possibility frontier that shows a choice between
consumer goods and the environment.

• If we produce more consumer goods, it leads to a depleted environment.
• We could use all our natural resources and have many consumer goods,
or we could have only few goods and concentrate on preserving the
environment.

Opportunity cost and production possibility frontier

• At point A, we have 15 goods / 22 environment
• At point B, we have 11 goods / 25 environment.
• If we move from point A to B, we gain an extra 3 units of the environment.
• However, the opportunity cost is that we have to forego 4 units of
consumer goods.

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Possibility frontier and economic growth

The PPF shows a trade off between consumer goods and capital goods.

• Consumer goods – Goods that we can use and enjoy. The things we buy in
shops like food, clothes, etc.
• Capital goods – These are goods that are used in the productive process – for
example, a machine. Capital goods involve investment in increasing
productive capacity.

• If we move from A to B, there is a movement along the PPF curve enabling
more consumer goods to be produced (an extra 3). The opportunity cost
is that there are less capital goods (4 less).
• Increasing consumer goods enables higher living standards in the short
term, but in the long term we may not be able to produce as much
because of less investment in capital goods.
• Devoting a higher proportion of resources to current consumption has an
opportunity cost of less investment and less growth in the long run.

Economic growth and a shift in the PPF curve

• Economic growth enables the PPF curve to shift to the right, enabling
point C (more consumer goods and capital goods).

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 • Economic growth increases the productive capacity of the economy and
potential output.

Causes of economic growth

• Discovering more raw materials (e.g. discovering oil fields)

• Increase in the size of work force (e.g. immigration)
• Increase in capital stock (e.g. investment in new machines, factories)
• Increase in labour productivity (e.g. due to better technology)

Specialisation and division of labour

• Specialisation occurs when a country or firm concentrates on producing a
particular good or service.
• Countries will specialise in producing goods where they have a comparative
advantage. For example, Japan specialises in producing high-tech electronic
goods. Cuba specialises in producing sugar.

Division of labour

• This occurs when workers concentrate on different tasks within a firm.
• Rather than try to master all aspects of production, some workers will
specialise at a particular job. For example, in a car-building firm, some will
work on design, some on testing, and some workers will just do unskilled
jobs such as painting the car.
• Adam Smith in ‘Wealth of Nations’ found that the efficiency of a pin factory
was increased if workers specialised in a particular part of the pin production
process and worked on an assembly line.

Advantages of specialisation in the production of goods

• The division of labour gives workers time to gain skills for one particular
job. Overall, they need less time to be trained.
• With specialisation and the division of labour, firms can be more efficient
when producing on a large scale; it enables economies of scale, and lower
average costs.
• Without specialisation and the division of labour, one person may be
unable to produce a car on his own. But the division of labour makes a big
production task manageable by spreading the work out.

Problems of specialisation
• The division of labour can make jobs highly specialised and repetitive,
leading to boredom and possible diseconomies of scale.

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 • On an assembly line, if one person is absent, the whole production line
may slow down if other people can’t cover their job. Therefore, there
needs to be some flexibility.

Advantages of specialisation in trade

• Specialisation means countries don’t have to produce every good they
need, which would be impractical for small countries.
• Countries can make use of their best resources (e.g. low labour costs in
India and China or advanced technology in Germany).
• It enables countries to import goods that they otherwise wouldn’t be able
to produce (e.g. you can’t grow bananas in UK; African countries don’t
currently have a viable car industry).
• If countries specialise in certain goods, those industries can benefit from
economies of scale as they get bigger.

Problems of specialisation in trade

• Concentrating on producing a small number of goods can make an
economy vulnerable. For example, if sugar prices fall, countries that rely
on sugar exports will see a fall in income.
• It may hamper development if countries stick to producing primary
products, which have a low-income elasticity of demand.

Money
• Money is an object used as a medium of exchange between two parties. It
can have intrinsic value like gold or it can be in the form of notes and
coins distributed by a central bank.
• Money enables people to specialise in one job and use their earnings to
purchase goods and services from people who work elsewhere. For
example, a teacher gets paid money and can buy food from supermarkets.
• Without money, we would need a barter economy, which makes
specialisation harder. (e.g. a pig farmer is unlikely to sell me some pork in
return for a few hours of economics tuition)

Functions of money

1. Medium of exchange. Money should be accepted universally for the

payment of goods and debt.
2. Unit of account. Money measures the relative worth of goods (e.g. a TV
priced at £250, a banana at 25p).
3. Store of value. If you save money in the bank, you can keep part of your
income to spend in the future (inflation means cash tends to reduce value
over a period of time)
4. Standard of deferred payment. Money is used to pay back debt. This is
related to it being a unit of account.

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 Types of economy

A free market economy

A totally free market occurs where there is no government intervention in the
economy.

• Firms are privately owned.

• Decisions on what to produce and how to produce goods are left to
market forces.
• In reality, many ‘free market’ economies will have some limited
government intervention, for example, the protection of private property.

Advantages of free market economies

• Free markets tend to result in an efficient allocation of resources because
firms have a profit incentive to produce goods that are in demand.
• Firms also have an incentive to cut costs and be efficient otherwise they
will go out of business.
• Consumers have the freedom to choose the best products, which they
need.
• It avoids government bureaucracy which could lead to inefficiency and
corruption.
• The incentives of a free market encourages individuals to work hard and
set up new business

Disadvantages of free market economies

• Private firms can gain monopoly power, leading to higher prices for
consumers and greater inequality.
• In a free market, public goods, like street lighting, will not be provided.
Merit goods like education will be underprovided.
• There will be overconsumption of goods with negative externalities,
leading to pollution and damage to the environment. There will also be
over-consumption of demerit goods like alcohol and tobacco.
• Inequality will occur. In a free market, some will accumulate high levels of
wealth and have high salaries, but others may experience unemployment
and low wages.

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 Command economy
This is an economy where the government owns the means of production, and
the government decides what and how to produce. (e.g. the former Soviet Union).

Advantages of command economies

• The government can reduce inequality and make important public
services available to all.
• The government can take into account externalities and protect the
environment
• The government can prevent the abuse of monopoly power.
• The government can ensure full employment by giving people jobs.

Problems of command economies

• There is no profit motive, so people working for the government may
have little incentive to cut costs and innovate.
• When government agencies control all areas of economic life, it is prone
to bureaucracy, high administration costs and corruption.
• The government may be slow to respond to changing consumer
preferences; with price controls, we may end up with shortages or
surpluses.
• The government may have poor information about what to produce,
leading to shortages and surpluses.
• Consumers may face a lack of choice about goods to buy. People may be
unable to set up businesses that they want.

Mixed economies
A mixed economy involves a degree of government intervention in parts of the
economy. Many firms remain privately owned. However, the government will:

• Implement taxes on income and goods (e.g. VAT).

• Provide services that are under-consumed in a free market (health care,
education, welfare state and national defence).
• Regulate markets, e.g. monopolies, regulations on the environment and
demerit goods (smoking bans).
• A mixed economy tries to get the best of free markets (efficiency,
enterprise, innovation) but deals with some of the problems of market
failure, including pollution, monopoly and inequality.
• Most modern economies are mixed, with different levels of government
intervention.
• For example, in the UK, the government spends approximately 40% of
GDP. In Sweden, government expenditure amounts to over 50% of GDP.
In the US, government expenditure is 35% of GDP.

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 Rational decision making
In economics we assume firms and consumers are rational. This means that they
try to maximise their economic welfare and make decisions to enable this.

Utility
This is the concept of how much benefit people get from consuming a certain
good.

• If we get high utility from eating at a restaurant, we will be willing to pay

a large amount of money.
• We assume consumers wish to maximise their utility. For example, they
will spend money on goods only if they believe the utility gained is
greater or equal to the cost.
Profit
This is the amount of money a firm gains after subtracting costs from its total
revenue (profit = total revenue – total costs).

• We often assume firms wish to maximise profit (either in the short run or
long run). For example, if a good is no longer profitable, they will try
switch to something else. Firms will try to cut unnecessary costs.
• Firms may try to increase market share as a method to increase profit in
the long term.
Irrational behaviour

• In the real world, people may not always behave as we assume.

• For example consumers may use demerit goods (alcohol, tobacco) that
damage their health. Consumers may purchase goods that are expensive,
but offer little utility.
• Firms may not always maximise profits, but have other objectives.
• For example, a firm may keep on workers out of loyalty even though they
don’t need them any more.
• Firms and consumers may also have altruistic aims – for example, they
may be willing to put environmental, political or charitable concerns
above issues of profit.

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 Demand
The individual demand curve illustrates the price people are willing to pay for a
particular quantity of a good.
The market demand curve illustrates the price consumers in the whole economy
are willing to pay.
Movement along the demand curve

A change in price causes a movement along the demand curve.

• A higher price reduces demand.

• A lower price increases demand.

• For example, if there is an increase in price from 9 to 12, then there will
be a fall in demand from 30 to 22.
• As the price falls, people are usually willing to buy more of the good. If the
price is higher, this discourages people from buying the good.

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Shifts in the Demand Curve
This occurs when, even at the same price, consumers are willing to buy a higher
quantity of goods – for example, demand shifts from D1 to D2

A shift to the right in the demand curve can occur for a number of reasons:
1. An increase in disposable income, such as higher wages and lower taxes
giving consumers more spending power.
2. An increase in the quality of the good. For example, mobile phones are
now more versatile and powerful, making them more attractive.
3. Advertising can increase brand loyalty to goods and increase demand.
4. An increase in the price of substitutes. For example, if the price of O2
Mobile phone calls goes up, the demand for Vodafone mobiles will
increase.
5. A fall in the price of complements. For example, a lower price for Apple
apps will increase demand for Apple iPhones.

Evaluation

• It depends on the type of good. A rise in income will not have any effect on
demand for salt, but it will have a bigger effect on demand for luxury cars.
• Some goods will vary due to seasonal factors like the weather and time of
year (e.g. scarves and air conditioners).

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Diminishing marginal utility
Marginal utility is the satisfaction that you gain from the last unit of consumption.

• The first chocolate bar of the day is likely to give the highest utility. The
second chocolate bar usually gives less utility than the first.
• If you have already eaten three chocolate bars, you are unlikely to enjoy a
fourth. Therefore, the utility from the fourth chocolate bar is much less
than the first.
• As you consume more goods, the utility of the extra goods usually
declines. This is why the demand curve is downward sloping. You
wouldn’t want to pay as much for the fourth chocolate bar as the first.
• To buy one diamond ring, you are willing to pay a high price, but the
utility from a second diamond ring is reduced. Therefore, as quantity
increases, we are willing to pay a lower price.
• This is why an individual’s demand curve is downward sloping. They are
willing to pay lower prices for a higher quantity.

How to calculate a percentage

To calculate a percentage (%), we calculate as:

Example:
If the price increases from £60 to £72, what percentage increase is that?

• (72-60) = 12. (Therefore, the price rises by £12)

• 12/60 = 0.2
• 0.2×100 = 20%
• We have a 20% increase in the price.
(Exam Tip: For AS economics, you don’t need much maths, but you do need to be
confident in calculating percentages.)

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 Elasticity
The price elasticity of demand measures the responsiveness of demand to a
change in price.

Price elastic demand

• Demand is price elastic if a change in price causes a bigger percentage

change in demand.

Example of elastic demand

• If the price of Tesco bread increases 5% and demand falls 15%, the PED is
(-15/5) = -3.0. This is price elastic.

Characteristics of elastic demand

• Luxury goods are sensitive to price because they represent a big
percentage of disposable income, such as sports cars and foreign holidays.
• Competitive markets. Goods that have many substitutes and a very
competitive market will be elastic - for example, if the price of Tesco
bread increased, consumers could switch to several other varieties.
• Frequently bought. With goods that are bought frequently, we are more

likely to compare prices, and switch if necessary.

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

Example of inelastic demand
• If the price of tobacco increases 10% and demand falls 2%, the PED = -0.2

Characteristics of inelastic goods

• Few substitutes. e.g. petrol and cigarettes have few close alternatives.
• Necessities, e.g. if you have to drive to work, you need to buy petrol.
• Addictive. If you are addicted you will pay higher price e.g. cigarettes,
coffee.
• Small percentage of income – means you don’t worry if price rises.
• In the short term, demand is usually more inelastic because it takes time
for consumers to find and switch to alternatives.

Evaluation
1. Demand for a good like coffee is likely to be inelastic, as there are few
substitutes to coffee. But demand for individual brands of coffee is likely
to be more elastic, as there are substitutes to Starbucks coffee (e.g. Costa).
2. Elasticity may change over time. In the short term, demand for petrol is
inelastic, but over time, people may be more willing to switch to
alternatives, such as cycling to work, so that demand for petrol becomes
more elastic with time.

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Using Knowledge of Elasticity

1. Revenue
If demand is inelastic then increasing the price can lead to an increase in revenue.

In this example, the price of oil rises from $110 a barrel to $190, and the quantity
falls from 9 million to 8 million.

• Revenue was $110 × 9 = $990 million

• Revenue is now $190 × 8 = $1,520 million
• An increase in revenue of $530 million
This is why OPEC tries to increase the price of oil, because higher oil prices are
more profitable.

What is the PED of oil in this example?

• % change in Q.D 1/9 = -0.11 (-11.1%)

• % change in price 80/110 = 0.727 (72.7%)

Therefore PED of oil = -11.1 / 72.7 = -0.15 (inelastic)

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If demand was elastic

• Price rises from £110 to £130 – (20/110) = 18%
• Quantity falls from 9 to 4 (5/9) = 55.5%
• Revenue was 110 × 9 = £990
• Revenue has now fallen to 4 × £130 = £520
• A fall of £470

PED of this example -55/18 = - 3.05 (elastic demand)

2. Advertising and elasticity

• Firms have an advantage if demand for their good is price inelastic. If

demand is inelastic they can increase price and make more profits.
• This is why many firms spend money on advertising to create brand
loyalty.
• Because of strong brand loyalty, Coca Cola can charge a higher price than
other brands like Sainsbury Cola.
• Firms can make demand more inelastic by offering more add-on features
and better quality products that stand out from the competition.

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The impact of elasticity on tax

• In this example, the tax is £70 per unit.

• After tax is placed on the good, supply shifts to S2.
• Demand falls from 80 to 72. The price rises from £80 to £140.
• The total tax revenue equals 72 ×£70 = £5,040
• The tax is £70, and consumers end up paying an extra £60.
• In this case, consumers face most of the tax burden. (60 × 72) = £4,320
(consumer burden)
• Producers get £10 less after the tax. (10 × 72) = £720 (producer burden)

Income elasticity of demand (YED)

Income elasticity measures the responsiveness of demand to a change in income.

E.g. If your income increases by 5% and the demand for mobile phones increases
by 20%, then the YED = 20 / 5 = 4.

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Types of good
• Inferior good. This occurs when an increase in income leads to a fall in
demand. Inferior goods will have a negative YED. Examples include
clothes from charity shops and Tesco value rice. As your income increases,
you buy better quality goods instead.
• Normal good. This occurs when an increase in income leads to an
increase in demand for the good, therefore YED>0. Most goods are normal
goods.
• Luxury good. This occurs when an increase in income causes a bigger
percentage increase in demand, therefore YED >1. It means demand is
income elastic. Examples include jewellery and sports cars.
• Income inelastic. This means an increase in income leads to a smaller
percentage increase in demand. Therefore 0 > YED < 1.

Importance of income elasticity of demand

• In a recession, with falling incomes, demand for luxury goods will fall
significantly. Demand for inferior goods will increase.
• Budget pound shops may do well with falling incomes, but luxury car
sales will not. Supermarkets may respond to a recession (falling income)
by supplying more ‘inferior’ goods.

Cross elasticity of demand

Cross elasticity of demand measures how the demand for one good is affected by
the price of another.

• E.g. if the price of milk falls by 10%, demand for tea may increase 1%.
Therefore XED = (1/-10) = -0.1
Substitute goods. These are two goods that could be used as alternatives. With
two substitute goods, XED will be positive.

• Weak substitutes like tea and coffee will have a low XED.
• Tesco bread and Sainsburys bread are close substitutes so XED is higher.
Complements goods. These are goods that are used together. Therefore XED is
negative.

• For example, if the price of DVD players fall, then there will be an increase
in demand for DVD discs.

Unrelated goods. If the price of lamb increases, we would expect it to have no

effect on the demand for beer or computers. If the price of lamb increases and
demand changes for computers, it is just a co-incidence and not related.

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 Supply
The supply curve refers to the quantity of a good that the producer plans to sell
in the market.

• As price increases, firms have an incentive to supply more because they
get extra revenue (income) from selling the goods.
• If price changes, there is a movement along the supply curve.
• E.g. an increase in the price from £40 to £50 causes an increase from 30 to
33.

Joint supply

Joint supply occurs when two goods are supplied together from the same source.
For example, the supply of beef and leather are linked because both come from
the cow. With an increase in the supply of beef, you also get more leather.

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Shifts in the supply curve

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

• A decrease in costs of production. This means that business can supply

more at each price. Lower costs could be due to lower wages or lower raw
material costs.
• An increase in the number of producers will cause an increase in supply.
• Expansion in the capacity of existing firms, e.g. investment to extend the
size of a factory.
• An increase in the supply of a complementary good, e.g. beef and leather.
• Favourable climatic conditions, which are very important for agricultural
products, e.g. good weather will give a good harvest.
• Improvements in technology, e.g. computers and the Internet enables
more to be produced for a lower cost.
• Lower taxes on the good, e.g. lower petrol tax.
• Government subsidies on the good (government paying part of the cost).

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 Price elasticity of supply
This measures the % change in quantity supplied after a change in price.

Inelastic supply

• Inelastic supply means a change in price causes a smaller percentage
change in supply (PES <1).
• Perfectly inelastic means a change in price has no effect on supply.
• In the example on the left: % change in Q = 3/50 = 6%
• % change in price = 6/60 = 10%
• Therefore, PES = 6/10 = 0.6 (inelastic supply)

Supply could be inelastic for the following reasons:

1. Operating close to full capacity. If firms are operating close to full
capacity, it is difficult to increase supply.
2. Low levels of stocks; therefore, there are no surplus goods to sell.
3. In the short term, capital is fixed, therefore firms do not have time to
build a bigger factory and increase supply.
4. Difficult to employ factors of production, e.g. it may be difficult to find
relevant skilled labour to increase output.
5. With agricultural products, supply is inelastic in the short run because
it takes at least 6 months to grow crops.

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

• Perfectly elastic supply means that at a given price, supply is unlimited.

• On the left: Price increase from 60 to 63 and Q increases from 50 to 60.
• % change in Q = 10/50 = 20%
• % change in price = 3/60 = 5%
• Therefore PES = 20/5 = 4.0 (elastic supply)

Supply could be elastic for the following reasons:

• If there is spare capacity in the factory.

• If there are stocks available.
• If it is easy to employ more factors of production.

Difference between long run and short run

• In the short run, supply is more likely to be inelastic because the firm
does not have the ability to increase the size of the factory.
• But, in the long run, supply can be more elastic as the firm is able to invest
in more capacity and therefore increase supply.

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Elasticity calculation
Suppose PES for computers is 2.0. When the price was £30, the firm supplied
4,000. If the price increased from £30 to £36, what will be the new Q?

• Price increases by £6. Therefore as a %, (6/30 =0.2) = 20%

(PES) 2.0 = % change in QS

20 (% change in P)
Therefore 40 = % change in QS
Therefore new Q = 4000 *140/100 = 5,600

Market equilibrium
The price mechanism refers to how supply and demand interact to set the
market price and the amount of goods sold.

Market equilibrium occurs when supply = demand and there is no tendency for
the price to change.

26
Excess demand

If the price is below equilibrium (p2), demand is greater than supply (Q2 – Q1) –
causing a shortage.
• Therefore, with consumers wanting to buy more firms will put up prices
and supply more
• As price rises, there will be movement along the demand curve and less
will be demanded.
• Prices will rise until supply equals demand.

Excess supply

27
 • If the price is above equilibrium (p2), supply is greater than demand (Q2-
Q1) – causing a surplus.
• To sell the unsold goods, firms reduce the price and reduce supply
(movement along supply curve). The lower price also encourages more
demand.
• The price falls to P1 where supply equals demand.

Impact of increase in demand

• If consumers saw an increase in income, we would see an increase in
demand for goods like TV’s; the demand curve would shift to the right.
• Initially there would be a shortage, but the higher demand would cause
the price to rise and suppliers to supply more.

The increase in demand causes an increase in market price (P1 to P2) and an
increase in quantity (Q1 to Q2).
In the long-term, the higher prices may encourage more firms to enter the
market and the supply curve will shift to the right.

28
Fall in supply
If the availability of oil decreased, we would see a fall in supply.

• The fall in the supply of oil causes the price to rise and a small fall in
demand.
• Since demand for oil is inelastic, we see a relatively bigger increase in the
price.
Impact in long term

• If the price of oil increased, it may start to make it profitable to produce

oil from new places, such as Alaska and Antarctic. Previously it was too
costly to produce oil from here, but the higher price may make it
worthwhile.
• If the price of oil rises, in the long-term people may respond to higher
prices by switching to other forms of transport or cars which don’t use
petrol.

29
Factors that could explain a fall in the price of a good, such as coffee.

• The price of a good, such as coffee, would fall if there was a fall in demand
and/or an increase in supply.

Fall in the price from P1 to P2
The demand for coffee could fall for various reasons such as:

• Lower incomes mean that consumers cannot afford to buy as much.
• Coffee becomes less fashionable.
• A decrease in the price of substitutes such as tea.
• A fall in number of coffee shops.
• Health concerns about caffeine.

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

• An increase in the number of suppliers or countries producing coffee.
• Lower costs of production, e.g. lower wage rates in coffee-producing
countries.
• Government subsidies, e.g. Latin American countries may wish to
subsidies the coffee farmers.
• Higher labour productivity in producing coffee, which will decrease the
costs of production.

30
 Price mechanism
The price mechanism refers to how market forces respond to changes in supply
and demand.

Rationing effect
• If there is a shortage of the good, the price will tend to increase.
• The higher price causes movement along the demand curve. Less is
demanded at the higher price. This helps to ration the scarce demand.

Incentive effect
• If there was increased demand for a new good (like phone apps), this
would push up the price.
• This higher price makes the good more profitable. Therefore, it acts as an
incentive for producers to increase production.

In the long term, firms respond to higher prices by increasing supply.

Signalling
The price mechanism can provide a signal to firms and consumers.

• If we see higher demand, prices will rise and this creates a signal to
producers that there is high demand.
• A high wage for certain types of work can signal to workers that firms
need to fill these jobs.

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 Consumer and producer surplus
• Consumer surplus is the difference between the price that consumers pay
and the price that they would be willing to pay.
• For example, if a book costs £10, but the demand curve shows that they
would have paid £16, the consumer surplus is £6.

• Consumer surplus tends to be higher when markets are competitive and

prices are low.
• A monopoly that can set prices will be able to reduce consumer surplus.
• Peak fares are an attempt to charge higher prices to those commuters
willing to pay the higher price.

Producer Surplus

• Producer surplus is the difference between the price suppliers receive

and the price that they would have been willing to supply the good at.
• If the market price is £10, and their supply curve shows that they would
have supplied it at £8, they have a producer surplus of £2.

32
Producer surplus after fall in supply

• If we had an increase in the cost of production, we would see the supply

curve shift to the left.
• In this case, we see a decline in consumer surplus. Producer surplus also falls.
• In the case of a monopoly, firms are able to charge consumers a higher price;
this reduces consumer surplus and increases producer surplus.

Consumer and producer surplus after a fall in supply.

33
Tax
Tax increases the cost of the good and shifts the supply curve to the left.

• In this example, the specific tax is £35 per unit (80-45).

• The tax increases the price from £50 to £80. Quantity falls from 90 to 82.
• The total tax revenue for the government will be: 82 × £35 = £2870

The burden of tax

The burden of the tax is shared between consumers and producers.

• The consumer burden shows the extra amount that they pay (how much
tax raises price).
• Producers also lose out from tax because they get a lower price after
paying tax to the government.

34
Diagrams showing consumer and producer burden of specific
tax

• If demand is inelastic, then most of the tax will lead to higher prices and
consumer burden of the tax will be greater than the producer burden.
• In the diagram on the right, demand is price elastic and there is a
proportionally smaller effect on price and consumers. Producers have a
greater burden from the tax. Consumer burden is relatively less.
• Governments often increase tax on goods with inelastic demand –
because this leads to the biggest increase in tax revenue. Often tobacco
manufacturers will be able to pass 100% of the tax increase onto
consumers because demand is so inelastic.

35
 Subsidy
A subsidy means the government pays a part of the cost of a good. For every
good sold, the government will give firms a proportion of the cost.

In this case, the subsidy is £10 per unit. The subsidy increases Q from 90 to 98.

• The total cost to the government is 98 × 10 = £980.

Why subsidise goods?

1. Goods that have positive externalities (benefits to other people) are
subsidised. For example, taking the train to work helps reduce congestion.
The government may wish to make trains cheaper, and therefore reduce
traffic congestion.
2. To make important public services available to those on low income, e.g.
people may not be able to afford dental treatment without subsidies from
the government.

36
The impact of a subsidy depends on elasticity of demand.

• If demand is price elastic (right) there is only a small fall in price, and
producers have the most benefit from the subsidy.
• If demand is price inelastic (left) there is a bigger percentage fall in price.
Consumers benefit proportionally more from a subsidy than producers.

1.2.10 Alternative views of consumer behaviour

We assume consumers are rational – seeking to maximise their utility. However,
they may not behave rationally.

• Consumers may buy out of habit. E.g. they may keep buying brand names
(Heinz ketchup) even though they are more expensive than cheaper
brands that are the same.
• Consumers tend to be poor at working out which goods are cheaper.
• Impulse purchases; buying goods we don’t really need.
• Consumers are heavily influenced by advertising.
• Support for local businesses rather than buying cheaper products online.

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 Market Failure
Market failure occurs when there is an inefficient allocation of resources in a free
market. Market failure can occur for various reasons.

• Externalities – a cost or benefit imposed on a third party, leading to

under or over-consumption.
• Information asymmetries – lack of complete knowledge by one party.
E.g. people may under-estimate the benefits of education (merit good) or
underestimate the costs of smoking (demerit good).
• Monopoly – When a firm has market power and can set higher prices.
Monopolies may also be more inefficient because they face less
competitive pressures.
• Immobilities – Geographical immobilities occur when it is difficult for
people or firms to move to another area. E.g. unemployed coal miners in
Yorkshire find it difficult to move to London because of housing costs.
Occupational immobilities occur when it is difficult for people to retrain
and get skills in new high-tech industries.
• Public goods – Goods that are non-rival and non-excludable. They tend to
be under-provided or not provided in a free-market. Examples include
law and order, national defence and street lighting.

Externalities and social efficiency

Social benefit

• Social benefit is the total benefit to society.

• Social benefit = private benefit + external benefits.

• Social marginal benefit (SMB) = the additional benefit to society of

producing an extra unit.
• SMB = PMB (private marginal benefit) + XMB (external marginal benefit)

Social cost

• Social cost is the total cost to society.

• Social Cost = Private cost + external costs.

• Social marginal cost (SMC) = private marginal cost (PMC) + external

marginal cost (XMC)

38
Negative externality
A negative externality occurs when there is a cost imposed on a third party.

• For example, if a firm produces chemicals, the external cost is the

pollution that causes damage to the river and the lost earnings for
fishermen.
• If you drive into a town centre, the negative externality is the congestion
and pollution that affects other people in the town.
• With a negative externality, the social marginal cost is greater than the
private marginal cost.

In a free market, the equilibrium will be at Q1, P1, where Supply (S) = Demand
(D).

• However, at Q1, the SMC is greater than the PMC.

• Q1 is socially inefficient because the SMC is greater than the SMB – this
illustrates an area of deadweight welfare loss.
• In this example, there is overconsumption of the good with negative
externalities.
• The socially efficient level of output would be at Q2, where SMC=SMB.

39
Positive externality
A positive externality in consumption occurs when there is a benefit to a third
party from your consumption.

• For example, if you cycle to work (rather than drive), other people benefit
from reduced congestion and pollution.
• If you keep bees, then a nearby apple farmer benefits because your bees
help to pollinate his apple trees.
Diagram of positive externality

In a free market, the equilibrium will be at Q1, P1, where Supply (S) = Demand
(D).

• However, this is socially inefficient.

• At Q1, the SMB is greater than the SMC, leading to an area of deadweight
welfare loss.
• With a positive externality, there is under-consumption.
• Social efficiency occurs at Q2, where SMB=SMC.

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Private good
A private good is a good where the benefits accrue to the individual and others
are prevented from consuming it.

• The private good is rivalrous and excludable. If you eat an apple, no one
else can eat it.

Public good
A public good, by contrast, has two characteristics:

• Non-rivalry. When a good is consumed, it doesn’t reduce the amount

available for others, e.g. street lighting.
• Non- excludability. This occurs when it is not possible to provide a good
without it being possible for others to enjoy, e.g. national defence.

Public goods suffer from the free-rider problem.

• The free rider problem means that people can enjoy the goods without
paying for it. Therefore, there is no incentive for firms to provide goods
because it is difficult to charge consumers for using it.
• The consumer can enjoy it for free.
• Public goods usually require the government to provide the good directly
and pay for it out of general taxation.

Quasi—public goods.
Some goods have part of the characteristics of public goods, e.g roads are to an
extent non-rivalrous and non-excludable, but not completely, e.g. if too many
people use roads, it causes congestion. Some people are not qualified to drive.

• Some public goods can be provided by the free market. E.g. Someone may
provide a beautiful garden and not mind if people enjoy it for free.
Exam tip: Be careful - not all goods provided by the public sector (government)
are public goods.
For example, the NHS is provided by the public sector (government). But, it is not
a public good, because resources are limited (waiting lists) – so there is rivalry
and excludability. If you see a doctor, no one else can.

The NHS would be considered a merit good – people may underestimate the
benefits of getting vaccinations and a healthy workforce has positive
externalities.

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Information gaps
• Symmetric information means both parties share the same knowledge.
For example, if you go to a market, you can see the price of apples and
also look at their quality.
• Asymmetric information occurs when one party has more information
than other parties. For example, if selling a car, a car dealer may know it is
a faulty engine that won’t last. But, as a consumer, you may not know this.

Problem of asymmetric information

• People may be reluctant to buy second hand cars if they don’t trust what
they are buying. This leads to lower prices for all second hand cars.
• People make the ‘wrong’ decisions and reduce their economic welfare.

Merit good
A merit good occurs where people may underestimate or be unaware of the
benefits of consuming a good.

• For example, students may underestimate the benefits of studying and

therefore leave school early. Or people may be reluctant to get a
vaccination from diseases.
• Merit goods often have a positive externality as well.
• Merit goods are under-consumed in a free market.

Demerit good
A demerit good occurs where people under-estimate or ignore the costs of
consuming a good.

• For example, people may not be aware of the dangers of smoking.

• Demerit goods often have negative externalities as well (e.g. passive
smoking effect to others).
• Demerit goods are over-consumed in a free market.

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 Government intervention to correct market failure
1. Tax
• Tax shifts the supply curve to the left and makes the good more expensive.
This will reduce demand.
• The government can use tax for demerit goods and goods with negative
externalities.

Specific tax

A specific tax places a certain per unit tax on the good. It is the same whatever
the price, for example, tobacco duty or alcohol excise duty.
In this case the specific tax is £15, and it reduces the quantity from Q1 to Q2. The
price rises from £52 to £60.

43
Ad valorem tax

An ad valorem tax places a certain percentage on the good. For example, VAT in
the UK is 20%. The higher the price of the good, the more tax is paid.

Tax to overcome market failure

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 • The Ideal tax would be equal to the external marginal cost.
• This makes consumers pay the full social marginal cost.
• Tax shifts the supply curve to S2 and reduces demand to Q2, which is the
socially efficient level (SMC=SMB).

Advantages of taxes
• Raises revenue for the government to spend on alternatives.
• Internalises the externality (tax makes people pay the full social cost).
• Creates incentives in the long-term to encourage firms to reduce pollution
or provide alternatives.
• Tax can also alter consumer behaviour in the long-term. For example,
higher petrol tax may encourage consumers to buy a bicycle to avoid fuel
duties.

Evaluation of taxes
• If demand is very inelastic, tax will only have a minimal effect in reducing
demand. This may occur if there are no alternatives to the good, e.g. petrol,
tobacco.
• High taxes may encourage tax evasion, e.g. cigarette tax encourages
cigarettes to be smuggled on the black market. A tax on rubbish may
encourage fly-tipping.
• High specific taxes will be regressive. They take a higher percentage of
income from the poor than high-income earners.
• There may be administration costs in implementing new taxes, e.g. it
would be difficult to implement a congestion charge for driving into small
cities, like Oxford or Cambridge.
• It can be difficult to measure the external cost and how much tax should
be increased.

Subsidy
• The aim of subsidies is to encourage consumption of goods which are
underprovided / under-consumed in a free market.
• A subsidy shifts supply to the right and reduces the price.

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Subsidy to overcome market failure

• In this example, the free market equilibrium is at Q1, P1 (S=D).
• A subsidy of P0-P2 shifts the supply curve to S2 and reduces price to P2.
At this price, the quantity demanded is Q2. This is a socially efficient level
because at Q2, SMB=SMC.

Evaluation of subsidies
• Cost to the government. Subsidies will be expensive and will require
higher taxes on other goods.
• Elasticity. If demand is inelastic, a subsidy will be ineffective in
increasing demand. For example, a subsidy on train travel may be
ineffective if it is a poor substitute to driving a car.
• Effect of subsidy on firm. A firm that receives a subsidy is more likely to
be inefficient, as they become reliant on the government subsidy.
Subsidies may keep inefficient firms in business.
• There may be government failure, e.g. the government has poor
information about who to subsidise.
• Combination of policies. Subsidies may be most effective if combined
with other policies, e.g. tax on driving and using money to provide
alternatives to driving into town, e.g. cheaper buses.

46
Maximum prices
A maximum price occurs when the government sets a price limit and prevents
prices from rising above that level.

For example, if renting a house in London is £120 a week, the government may
decide to have a maximum price of renting of £100 a week to make housing more
affordable.

Problem of maximum prices

The problem of a maximum price is that if the price is set below the equilibrium,
we get a shortage. At Max Price, demand is greater than supply (Q3-Q1). This
leads to waiting lists and encourages a black market.

• The extent of the shortage depends on the elasticity of demand and

supply. If supply is inelastic, there will be little reduction in availability.
• Note: if the maximum price was placed above the equilibrium, it would
have no effect.

Minimum Prices
A minimum price occurs when the government sets a price floor, and doesn’t
allow prices to go below that level.
With minimum prices, the government may be committed to buying the surplus.

47

The problem of a minimum price is that we get a surplus. At Min price, supply is
greater than demand (Q3-Q1). To maintain the Min price, the government has to
buy the surplus..

• Note: a minimum price below the equilibrium would have no effect.

Tradeable pollution permits

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

• If the firm produces less pollution, it can sell its permits to other firms.
• However, if it produces more pollution, it has to buy permits from other
firms.
• There will be a market for pollution permits. If firms pollute a lot, there
will be low supply and high demand; therefore the price will be high for
permits.
• Therefore, there is a financial incentive for firms to cut pollution.

Problems of Tradeable Permits

• Difficult to know how many permits to give in the first instance.
• It may be difficult to accurately measure pollution levels. There is an
incentive for firms to hide pollution.
• In most markets, it requires global co-operation to make it effective,
otherwise the industry will move to countries with lower environmental
legislation. Also, pollution is very much a global problem requiring global
solutions.

48
 • High administration costs of measuring pollution and enforcing permits.

State provision of public services

For some merit goods and public goods, the most efficient solution for market
failure is for the government to provide services directly.
For example, the government could subsidise private doctors to treat people, but
there are advantages to the government paying for a national health service
directly:

• It ensures everyone has access to this important merit good and provides
greater equality in society.
• A national health service may be able to benefit from economies of scale,
leading to lower average costs than small independent hospitals.
• For services like health and education, workers do not need the same
profit motive of a private manufacturing firm. Therefore, there is less
likely to be government failure due to a lack of incentives.
• Public goods like law and order may not be provided at all in a free
market.

Advantages of the private sector providing public services, e.g.

NHS
1. Increased demands are being placed on the public sector due to
demographic changes. If more people went private, this would enable the
National Health Services to have shorter waiting lists.
2. Provides consumers with more choice.
3. If less people use the NHS, it would enable the government to lower taxes
and reduce borrowing.
4. The private sector has a profit incentive to cut costs and provide a more
efficient service, e.g. public bodies may have over-staffing because of
political fears about job cuts.
5. Possible diseconomies of scale in the National Health Service.

Disadvantages of the private sector

1. It is difficult to introduce a profit motive into public services such as
health care; for example, it is not practical to give performance related
pay to nurses / doctors. Also, the private sector may cut costs by reducing
the quality of service, e.g. cutting back on cleaning.
2. May increase inequality. People on low incomes cannot afford private
health.
3. Health is a merit good and will be underprovided in a free market.
Therefore there is a justification for government subsidy.

49
Advertising / Information
The government may seek to overcome market failure through providing
information about certain goods.

• For example, the government may run campaigns to warn about the
health dangers of tobacco and alcohol. These are demerit goods, where
people may not know the costs of consumption.
• Providing information can help overcome information asymmetries.

Evaluation

• Government advertising campaigns will cost money and require higher

taxes.
• There is no guarantee people will listen or take note of government
campaigns. Young people may choose to ignore campaigns about the
dangers of alcohol because they enjoy a sense of rebelliousness.
• However, over time, people have become aware of the dangers of tobacco
and long-term smoking rates have been falling.

Regulation
To overcome market failure, the government may use laws and regulations to
prohibit certain behaviour.

• For example, rather than try and tax cocaine to make people pay the full
social cost, they may just prohibit its production and consumption.
• Alternatively, the government may ban certain chemicals because they
are too dangerous.

Evaluation

• Regulation is simple and can be effective in preventing damaging goods

and services from being produced. However, sometimes no pollution is
not the most efficient level of production in society. Cars create negative
externalities, but it is not desirable to ban cars completely.
• It depends on the enforceability. For example, when the US prohibited
alcohol, it was very hard to enforce. People kept drinking but organised
crime became more powerful and more successful because illegal alcohol
was in high demand.

50
 Government failure
Government failure occurs when government intervention in the economy
causes a net welfare loss. People also refer to government failure when efforts to
overcome market failure do not succeed.

Causes of government failure

1. Lack of incentives working for the government. Government bodies do not
have the same profit motives of private companies. Therefore managers and
workers may feel no incentive to work hard or cut costs. The result can be
government agencies that are inefficient, with higher costs and not producing
what people need.

• To some extent, this can be overcome by rewarding government workers

with performance targets.
• Incentives may be less important in services like health care, where
doctors value patient health.
2. Unintended consequences. Often government intervention tries to solve one
problem, but another problem is created. For example:

• Minimum prices in agriculture were an attempt to stabilise farmers’

incomes. However, the unintended consequence of guaranteed minimum
prices was that it encouraged over-production. Farmers used chemicals to
maximise yields – knowing the government would buy any surplus. This
proved expensive and inefficient.
• By increasing taxes on tobacco, the government made it more
profitable for people to smuggle cigarettes from Europe.
• A maximum price on renting property could lead to a decline in
available housing for renting – worsening the housing crisis rather than
helping.
• Higher income tax may discourage people from working.

3. Lack of information. Government bodies can suffer from a lack of knowledge

about how to intervene – just as we can get a lack of information in a free market.

• For example, it can be difficult for a government body to calculate the net
external costs of a new airport or nuclear power.
• Governments may fail to predict future trends, e.g. the impact of
minimum prices on incentives in the long-term.
4. Administration costs. Any government intervention is likely to have some
administration costs and bureaucracy.

• For example, setting up a congestion charge for small cities could be

difficult because the costs of administering the scheme will be relatively
high. With some new taxes, the cost of bureaucracy may be close to the
revenue gained.

51
 Theme 2: The UK Economy
Economic growth
• GDP (Gross Domestic Product) measures the value of goods and services
produced in an economy. GDP also measures national income / national
expenditure.
• Nominal GDP measures the monetary value of GDP (this may include the
effects of inflation in raising prices).
• Real GDP measures GDP adjusted for effects of inflation. It measures the
actual purchasing power of consumers in an economy.
• GDP per capita is the level of GDP divided by population. E.g. if Real GDP
increases by 3% and the population rises by 1%, the real GDP per capita
has increased by 2%.
• The volume of goods and services is the quantity produced.
• The value of goods and services is the quantity × the price.
• Economic growth means an increase in real GDP, referring to an increase
in the total value of goods and services produced in an economy.
• The rate of economic growth measures the annual % change in real
GDP

• This graph shows the quarterly change in real GDP. E.g. in Q2 2014,
economic growth was 0.7%. (this is roughly an annual rate of 2.8%).
• In 2008/09, economic growth was negative – Real GDP was falling.
• The long run trend rate of economic growth: This is the sustainable
rate of economic growth in an economy. For example in the UK, this is
about 2.5%.

52

This shows the growth in real GDP compared to the trend rate of growth. This
shows that in the recession of 2008/09, growth was much lower than the trend
rate.

Long term economic growth

UK economic growth since 1949. It shows the recent recessions of 1980/81,
1991 and 2008/09.

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Other measures of national income
Gross National Product (GNP) GNP = GDP + Net property income from abroad.
Net income from abroad includes, dividends, interest and profit.

• GNP includes the value of all goods and services produced by nationals
whether in the country or not. It does not include output produced by
foreign nationals.

Gross national income (GNI) is based on a similar principle to GNP. It includes:

• The value of the services and products a country produces in an economy

(whatever their nationality). It also includes interest payments and
dividends from citizens living in other countries.
Comparison of rates of growth between countries over time

This shows economic growth rates in six selected European countries. It shows
how closely economies are tied together. All economies went into recession in
2009. Post 2010, Italy’s economic recovery has lagged behind that of other
countries.

54
Purchasing power parity (PPP)
• Real GDP at purchasing power parity (PPP) takes into account relative
costs of living.
• It is a better guide to actual living standards and a reflection of the value
of goods and services that people can buy in the economy.
• When comparing real GDP per capita between different countries, we
need to take into account that the face exchange rates may not reflect
local purchasing power.
• If you spend $10 in the US, you may be able to buy one meal. If you
convert $10 into Indian Rupees, you will get about 600 Rupees. But, with
this 600 Rupees you can purchase two meals.
• In other words $1 goes further in some countries than others.

Big Mac Index

The Big Mac index, published by the Economist magazine, offers a rough
illustration of this. It shows the Dollar cost of a Big Mac in different countries. In
theory, the ingredients are the same, so a difference in price reflects different
exchange rates.

• The price of a Big Mac can vary from $1.50 in South Africa to $4.00 in
Japan.
• When making comparisons of living standards, we need to bear this in
mind.

Limitations of using GDP to compare living standards between

countries
Even if we use GDP per capita at PPP, there may be many limitations in
comparing living standards between different countries.

• Defensive spending. Output may not increase living standards, e.g. a cold
country will spend a significant amount of GDP on heating; this will be
reflected in higher GDP, but it doesn’t mean living standards are higher
than a country where there is no need to spend money on heating.
• External costs of GDP. Some output may increase GDP but cause external
costs, such as pollution and congestion – which reduce living standards.
For example, China’s recent growth has been very high, but pollution is
now a serious problem.
• It depends on what GDP is spent on. If a country spent 40% of GDP on
military spending, this would have a very different impact on living
standards than spending the same money on education and health care.
• Equality of distribution. Real GDP per capita may be high, but if 90% of
the country’s wealth is owned by just 1% of the population, then many
people may be in poverty and have low living standards. A more equitable
distribution would be better.
• Hours worked. A country may have high real GDP per capita, but if it
requires people to work very long hours, there is little time for leisure -
an important factor in determining living standards.

55
 • Living standards depends on many factors other than GDP. To get the
best comparison we need to consider factors like health care, life
expectancy, environment, housing, freedom of press, etc.

Evaluation

• Although there are limitations to using GDP, don’t forget that it is a good
starting point. Higher GDP enables more goods and services to be
consumed. Higher GDP enables better public services, such as health and
education. Generally, countries with higher real GDP per capita have
better living standards.

National Happiness
The UK now publishes a measure of ‘National well being’. This includes ten
segments of life that make up wellbeing, including the economy, relationships,
personal finance, natural environment, education and skills, governance, what
we do, and health.

• The index includes positive statements, e.g. unemployment rate, voting

rates, crime rates.
• The index also includes surveys which are normative opinions from
people about whether they are satisfied, e.g. rating of social life, rating of
personal health, relative satisfaction with life and the environment.
• The index measures how these index tools change over time, e.g. the
overall index of national wellbeing would rise if more people responded
positively to questions about personal wellbeing.
• By combining statistics and surveys, it attempts to get a better overall
snapshot of living standards and whether people are likely to be happy
with life.
• It is an attempt to move away from relying on purely financial indicators,
such as GDP – which on their own may not increase wellbeing.

Limitations of National Wellbeing index

• Surveys are normative. People’s perceptions of satisfaction may change
due to unexpected factors.
• People may not always respond honestly or certain people may not want
to be in surveys at all.
• Surveys could be influenced by temporary factors, such as an early World
Cup exit for the national team.
• It is so wide ranging that it can be hard to see overall trends.

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 Inflation
• Inflation. This means a sustained increase in the general price level. If
there is inflation, the value of money declines and there is an increase in
the cost of living.
• Deflation. This means there is a fall in the price level (negative inflation
rate).
• Disinflation. This means there is a falling inflation rate – prices are
increasing at a slower rate.

Measuring inflation
The main method of calculating inflation in the UK is the consumer price index
(CPI). This is calculated through different steps.
1. Household expenditure survey. This seeks to measure what people
spend their money on. From this we get a typical basket of the most
popular 1000 goods and services. The basket of goods is updated each
year to take into account changes in expenditure
2. Weighting of different goods. The goods and services in the inflation
index are given a weighting depending on what percentage of spending
they generate. For example, petrol may have a weighting of 5% of the
total basket of goods. Bus travel will have a lower weighting of say 0.4%
3. Price changes. Every month, changes in the prices of goods and services
are measured. The price changes are then multiplied by their weighting
and combined into a single index figure that shows the percentage change.

Problems with calculating CPI

• The expenditure survey does not include everybody e.g. pensioners are
excluded, but pensioners have different spending habits e.g. heating is
more important. Young people will benefit more from falling prices of
mobile phones.
• Changes in quality: Computers have many more features than 10 years
ago, so it is difficult to compare prices because they are different goods.
• CPI ignores some housing costs and is often lower than the old RPI
method.
• It is impossible to measure all prices in the economy.

Retail price index (RPI)

• The RPI is another measure of inflation. It is similar to CPI, but includes
more factors.
• RPI includes the cost of mortgage interest payments. This can make RPI
more volatile, e.g. if interest rates rise, we will see RPI inflation increase
more than CPI because mortgages are more expensive.

57
Effects and costs of inflation
If inflation is high (above the governments target), we get several negative
impacts on the economy.

On consumers

• Fall in value of savings. Consumers who have cash savings will see a fall
in the real value of their savings. If inflation is higher than interest rates,
savings will decrease in value.
• Fall in value of debt. High inflation will reduce the value of debt, making
it easier for consumers and firms to pay back their debt. With high
inflation, borrowers are likely to become better off - lenders are likely to
become worse off.
• Fall in real wages. High inflation could be damaging to workers. If
inflation is higher than nominal wage growth, real wages will fall. In
periods of high inflation, workers will need to bargain for higher nominal
wages to maintain their real incomes.

• Between 2001 and 2008, wages grew at a faster rate than CPI inflation.
Real wages are rising.
• Since 2008, wages have been mostly growing at a slower rate than
inflation. Therefore, real wages are falling.

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Exam tip – Inflation doesn’t mean people automatically buy less. Inflation could
be caused by rising demand, where people are spending more.

• However, inflation could cause less spending if prices are rising faster
than wages.

Effects of inflation on firms

• Uncertainty. High inflation may create uncertainty and confusion for

firms. In periods of high inflation, firms may be less willing to invest
because they don’t know what their future costs and incomes will be. Less
investment can reduce the rate of economic growth.
• Menu costs. High inflation can create menu costs, which means firms
have to adjust price lists. Firms and consumers may also spend more time
checking prices.

Effect of inflation on economy

• Less investment. If inflation is high, firms are likely to reduce investment

due to uncertainty, leading to low economic growth. It is argued that
periods of low inflation are beneficial for promoting investment and
sustainable economic growth.
• Decline in competitiveness. Relatively higher inflation in the UK can
make UK firms less competitive, leading to lower exports and
deterioration in the current account (or depreciation in the exchange
rate).
• Higher interest rates. Governments may be concerned about inflation
because of the uncertainty and potential for declining living standards.
The Central Bank (or the government) may feel the need to increase
interest rates. Higher interest rates can reduce inflation, but at the cost of
lower economic growth – and a boom and bust economy.

Problems of deflation
If prices fall, this can also cause problems for the economy.
1. Falling prices may deter people from buying goods (they wait for them to
be cheaper later); this leads to lower aggregate demand.
2. If prices and wages are falling, then the real value of debt increases.

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 Causes of inflation
1. Demand pull inflation

• If aggregate demand (AD) rises faster than aggregate supply (AS), then we
will get inflation.
• Demand pull inflation occurs if economic growth is too fast – i.e. if growth
is above the long run trend rate.

As the economy reaches full capacity, rising AD leads to more inflation. Demand
pull inflation could occur due to various factors. For example:

• Lower interest rates. A cut in interest rates reduces the cost of borrowing
– encouraging spending and investment.
• Rising house prices, which increases consumers’ wealth and confidence.
• Boom in exports from rising global demand.
• Income tax cut, which gives consumers more disposable income to spend.

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• The UK’s last period of demand pull inflation was the late 1980s.
• In this period, growth was very high at 4-5% a year – it was fuelled by
income tax cuts, rising house prices and relatively low interest rates.
• Inflation was close to the government’s target of 2% between 1992 and
2008. This period was known as the ‘great moderation’ because economic
growth was sustainable and did not cause inflation.
• Inflation did not increase until 2008, when it reached over 5%. This was
due to rising oil prices.

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2. Cost push inflation
This occurs when there is a rise in the costs of firms, leading to short run
aggregate supply (SRAS) shifting to the left.

Cost push inflation could occur due to:

• Rising oil prices / raw material prices. This would increase the costs of
most firms, due to higher transport costs.
• Rising wages. If wages are pushed higher by trade unions or a shortage
of workers, this will increase the costs of firms. (Rising wages may also
cause demand-pull inflation as consumers spend more increasing AD.)
• Import prices. One third of all goods are imported in the UK. If there is a
depreciation in the exchange rate then import prices will become more
expensive, leading to an increase in inflation.

Effect of a devaluation in the exchange rate on inflation

If the exchange rate falls in value, it tends to cause inflation for three reasons.
1. Higher AD. Cheaper exports increase export demand. More expensive
imports reduce import spending and encourage consumers to buy from
UK firms. Therefore, we see rising AD.
2. Imports are more expensive. Many goods are imported; after a
devaluation, they will be more expensive.

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 3. Less incentive to cut costs. A devaluation makes firms cheaper without
much effort so that they may have less incentive to cut costs.

Cost push inflation in UK 2008 – 2011

• In 2008, the UK had a cost push inflation of 5%. This was caused primarily
by rising oil prices.
• In 2011, the UK had more of a cost push inflation of 5% - despite a lengthy
recession. The inflation in 2011 was caused by higher taxes, depreciation
in the pound and higher raw material / food prices.

3. Growth of the money supply

• The money supply is the stock of notes and coins, plus bank deposits.
The money supply could grow if the Central Bank printed more money.
• The velocity of circulation is the number of times money changes hands.
In a boom, the money stock changes hands more frequently, and this can
cause inflation.
• Higher money supply will tend to cause inflation. For example, if the
Central Bank printed more money, it would generally cause more
inflation – though the link between the money supply and inflation may
not happen in a recession.

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 Unemployment
Unemployment is defined as when someone is not working, but is actively
seeking work and willing to take a job.

Under-employment occurs when someone is working part-time (e.g. on a zero
hour contract), but would prefer to work full-time.
Economic inactivity. This occurs when people are not in the labour force. They
are neither in work or looking for work. They could include categories, such as
early retirement, disillusioned long-term unemployed, long-term sick, disabled,
etc.

Economic costs of unemployment

• Loss of earnings for the unemployed, leading to lower living standards.
• More difficulty getting work in the future, as the unemployed lose ‘on-the-
job skills’ and may become less attractive to future employers.
• Stress and health problems of being unemployed.
• Increased government borrowing. The government will have to spend
more on unemployment and related benefits, and will receive lower
income tax revenues because fewer people are working.
• Lower GDP for the economy and possible negative multiplier effect.

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 Measuring Unemployment
1. Claimant count method. This is the official government method of calculating
unemployment. It counts the number of people receiving benefits (Job Seekers
Allowance).
Problems with claimant count

• The claimant count excludes many who might be looking for work. It
excludes people over 60 / under 18, people on government training
schemes, and married women looking to return to work.
• Very strict rules mean that you can lose your Job Seekers Allowance if you
miss an interview.
• Some people may claim benefits whilst still working in the “black market”.

2. The Labour Force Survey

This was a survey asking 60,000 people whether they are unemployed and
whether they are looking for a job. It includes some people not eligible for
benefits but who still meet the criteria of being unemployed.

• UK unemployment % since 1992.

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 Causes of Unemployment
1. Frictional unemployment. This is unemployment caused by people moving
between jobs, e.g. graduates or people changing jobs. There will always be some
frictional unemployment as it takes time to find a job.
2. Structural unemployment. This is unemployment due to a mismatch of
skills in the labour market. It can be caused by:

• Occupational immobilities. This refers to the difficulties in learning new

skills applicable to a new industry, and technological change, e.g. a former
manual labourer may find it hard to retrain in a high tech new industry.
• Geographical immobilities. This refers to the difficulty in moving
regions to get a job; e.g. someone unemployed in South Wales may find it
difficult to move to London, where housing is expensive. We often see
higher unemployment in depressed regions.
3. Classical or Real Wage Unemployment. This occurs when wages in a
competitive labour market are pushed above the equilibrium. This could be
caused by minimum wages or trades unions.

4. Demand deficient or ‘cyclical unemployment.’ This occurs when there is a
fall in AD, leading to a decline in national income. If there is less demand for
goods, firms will employ less workers. Also, some firms will go bankrupt, leading
to more unemployment.

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The fall in AD, leads to a decline in real GDP. With less output, firms demand
fewer workers.

Unemployment peaked in 1983, 1993 and 2012 – these were after recessions.

5. Voluntary unemployment. Generous unemployment benefits may encourage

people to stay on benefits rather than get work; this is sometimes known as
“voluntary unemployment”.

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 Policies to reduce unemployment
1. Fiscal and Monetary Policy (demand side)
The government could pursue expansionary fiscal policy by cutting income tax to
boost consumer spending and aggregate demand. Or the Bank of England could
cut interest rates to reduce the cost of borrowing and encourage spending.
Higher AD would lead to higher output and should encourage firms to take on
more workers.

• However, demand side policies may cause higher rates of inflation and
will not reduce supply side unemployment, like structural unemployment.
2. Education and training. Structural unemployment could be solved by
offering retraining and new skills for the long-term unemployed. This gives a
better opportunity for the unemployed to find work in new industries.

• However, it would cost money, and it may prove difficult for some older
workers to retrain in new industries and develop new skills.
3. Better job information and interview practice. This could help reduce
frictional unemployment by giving the unemployed better information about
available job vacancies, and also offering tips for the unemployed to get work.
4. Lower benefits and taxes. Lower benefits and income tax may increase the
incentive for the unemployed to look for work rather than stay on benefits. This
could reduce frictional unemployment.

• However, benefits in the UK are already quite low; reducing benefits may
increase poverty but will not create any jobs.
5. Reduce minimum wages. If the minimum wage is above the equilibrium,
reducing it to the equilibrium will enable firms to employ more workers, which
reduces real wage unemployment.

• However, demand for labour may be quite inelastic; cutting wages may
just make firms more profitable.
6. Regional grants. These can help overcome geographical unemployment by
encouraging firms to set up in depressed areas or helping workers to move to
areas of high demand.

• However, subsidies may prove ineffective for encouraging workers to

move because they may be attached to their local community. Firms may
have a similar reluctance to set up in depressed areas because of a lack of
infrastructure.

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Impact of immigration on labour markets

The UK has had a period of net immigration; more people come into the UK than
leave to work elsewhere.

Impact of net migration to the UK

• Increase in the supply of labour. The increased supply of labour has often
filled gaps in jobs that firms have found difficult to fill, e.g. cleaning, fruit
picking.
• Skilled labour. The government have set criteria making it easier for
skilled labour to migrate. This has meant migration has played an
important role in filling vacancies such as nurses and doctors.
• Offset the impact of an ageing population. The UK has an aging population
that places greater strain on government finances. Net migration of young
workers helps the budget situation because they pay tax and don’t receive
pensions.
• In periods of rising unemployment, migrants often return home. Thus
migration can be a counter-cyclical factor.

Problems of net migration

• UK experiences overcrowding especially in areas like London; migration
and the rise in population places strain on housing and public amenities.
• Migrants may be more likely to work in the black market, avoiding
regulations like minimum wages.
• Some may feel migrants take existing jobs. But, net immigration also
creates jobs through the additional demand in the economy.

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 The balance of payments
The balance of payments is a record of a country’s transactions with the rest of
the world. It shows the receipts from trade, and consists of the current and
financial account.

Current account
The current account is primarily concerned with the balance of trade in goods
and services. The full components of the current account include:
1. Trade in goods (visibles) e.g. cars, computers, food
2. Trade in services (invisibles) e.g. tourism, insurance, banking
3. Net income flows (interest, dividends and investment income from
abroad)
4. Net current transfers (e.g. government aid, payments to EU)

• A deficit on the current account means that the value of imports is greater
than the value of exports.
• A deterioration in the current account means that we get a bigger deficit
or we go from a surplus to a deficit.

Financial account
This is a record of all transactions for financial investment. It includes financial
flows (e.g. saving in banks) and net investment (e.g. foreign firm’s building
factory in the UK).

In the past ten years, the UK has run a persistent deficit on the current account.

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 Factors that cause a current account deficit
1. Overvalued exchange rate. If the currency is overvalued, imports will be
cheaper and therefore there will be a higher quantity of imports. Exports will
become uncompetitive and therefore there will be a fall in the quantity of
exports.
2. Economic growth. If there is an increase in real wages, people will have more
disposable income to consume goods. If domestic producers cannot meet the
domestic demand, consumers will imports goods from abroad. Consumer-led
growth often causes a deterioration in the UK current account.
3. Inflation / decline in competitiveness. If there is relatively high inflation in
the UK compared to our competitors, there will be less demand for UK exports
and British consumers will prefer buying imports.

• A decline in competitiveness could be caused by factors such as poor

infrastructure, higher wages and lower productivity.

Policies to reduce a balance of payments deficit

1. Devaluation. This involves reducing the value of the currency against others,
and making exports cheaper and imports more expensive. This should increase
the quantity of exports and reduce imports.
We would expect a devaluation to lead to an improvement in the current account.
However, it does depend upon the elasticity of demand for exports and imports.
Demand needs to be relatively elastic for a devaluation to improve the current
account.

• A problem with devaluation is that it can lead to imported inflation. This

will reduce competitiveness in the long run and will mean the
improvement in the current account might only be temporary.
• Also, in a floating exchange rate, the UK government does not set the
exchange rate; therefore, they would need to rely on a market
depreciation in the exchange rate.
2. Reduce consumer spending. The government could pursue tight fiscal policy
(higher tax to reduce consumer spending) or the Bank of England could increase
interest rates. Lower consumer spending will lead to less spending on imports,
improving the current account.

• The UK has a high marginal propensity to import; therefore, a reduction

in AD improves the current account significantly.
• Deflationary policies will also put pressure on manufacturers to reduce
costs; this will lead to more competitive exports, and so exports will
increase.
• However, this policy will conflict with other macroeconomic objectives.
With lower AD, economic growth is likely to fall, causing higher
unemployment. The government is likely to feel growth and employment
are more important than the current account deficit.

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3. Supply side policies. These are policies aimed at increasing productivity and
competitiveness. If successful, they will make UK exports more competitive and
export demand will rise. For example, the government could try to deregulate
labour markets to reduce wage costs and lower costs for exporters.

• Supply side policies will take a considerable time to have an effect (e.g. it
takes time to build new roads). Also, there is no guarantee that more
flexible labour markets would improve competitiveness because lower
wages may reduce worker morale.
• However, supply side policies would help other areas of the economy like
economic growth and unemployment.

Effect of a current account deficit in the UK

If the UK has a current account deficit, it has the following effects.

1. Lower AD. A deficit (X-M) represents a leakage from the economy – money is
being spent in other countries, and therefore, ceteris paribus, it reduces UK
aggregate demand.

• On the other hand, a current account deficit may occur due to high levels
of consumer spending and economic growth. The deficit is often smaller
in a recession.
• A UK current account deficit could be due to low economic growth in
Europe. A recession in the Eurozone would reduce demand for UK
exports.
2. Depreciation. A current account deficit could cause a depreciation in the
value of the exchange rate because we are buying imports and therefore buying
foreign currency.

• A depreciation will act as a stabiliser to improve the current account

because it makes exports more competitive.
3. Capital flows. A current account deficit requires flows of capital to finance the
deficit. This could be in the form of capital investment (e.g. a Japanese firm
building a car factory) or short-term capital flows (e.g. a Russian saving money in
a British bank).

• If we have a foreign investment in the UK, e.g. building a factory, this

could have a benefit to the economy. But, if it is financed by short-term
capital flows, these could prove quite volatile.

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 Aggregate demand
Aggregate demand (AD) is the total demand for goods and services in the
economy. AD = C+I+G+(X-M)

• C = Consumer expenditure on goods and services (60%)

• I = Gross capital investment (spending on capital goods, e.g. machines)
• G = Government spending
• X = Exports
• M = Imports

Shift in AD and movement along the AD curve

An increase in the price level (P1 to P2) causes movement along the AD curve.

• At a higher price level, ceteris paribus, consumers have less disposable

income (money to spend).
• At a higher price level, UK exports will be relatively less competitive,
leading to lower export demand.
• A shift in the AD curve would occur if there was a change in factors like
real income; higher income would shift AD to the right. Consumers would
buy more at the same price level.

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Shift in AD

• If there was an increase in income, the AD curve would shift to the right
(AD2).
• AD could shift to the right if there was a rise in investment, exports or
government spending.

Consumer spending (C)

Consumer spending is the biggest component of AD (approx. 60-65% of AD).
Consumer spending is determined by:

• Disposable income. This is income after taxes and benefits. Rising real
wages would increase disposable income and shift AD to the right.
• Saving. The alternative to spending disposable income is to save. If
income stays constant, but consumers want to increase their savings, then
consumption will fall.
• Consumer confidence. If consumers are pessimistic about the future,
they will prefer to save, pay off debt and reduce their current spending.
Low confidence will shift AD to the left. High confidence will encourage
spending.
• House prices / wealth. Rising house prices tend to increase consumer
spending through a positive wealth effect. In the UK, many people own
their houses. If house prices rise, they could gain equity withdrawal – re-
mortgaging their house and take money to spend. They will also feel more
confident if their house is worth more.
• Income tax / VAT. A cut to income tax will increase consumers’
disposable income, encouraging spending.
• Interest rates. Lower interest rates reduce the cost of borrowing
encouraging spending. Lower rates also make consumption more
attractive than saving in a bank.
• Cost of living. If wages stay the same, but the cost of living goes down (e.g.
a fall in petrol prices), people will have more disposable income and
spend more. (This factor causes movement along the AD curve)

2.2.3 Investment
Investment means expenditure on capital goods – factors that increase the
productive capacity of the economy, e.g. machines and factories.

• Investment accounts for about 15% of AD.

• Investment affects both AD and AS.
• Investment is relatively more volatile and is strongly influenced by
confidence and changes in the rate of economic growth.

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Factors that affect investment

• Confidence. If businesses are optimistic about future demand, they will
need to increase productive capacity and start to invest now. If
businesses face uncertainty, they will cut back on risky investment.
• Animal spirits. Keynes said investment was heavily influenced by the
‘animal spirits’ of businessmen – did people expect their business to
grow? This confidence can quickly change depending on the state of the
economy.
• Interest rates. Investment is often financed by borrowing or using
savings. Lower interest rates make it cheaper to finance investment and
make more projects worthwhile.
• Availability of finance. Businesses may wish to borrow and invest, but
access to credit is a big issue. Banks may be reluctant to give a small
business a loan because it is a risky investment. In this case it may depend
on businesses finding other sources of credit, such as the stock market or
private investors.
• Government regulation. Some businesses may be put off investment
because of the heavy cost of regulation, e.g. the need to meet
environmental standards and labour regulation. On the other hand,
governments could encourage investment through offering regional
subsidies.
• Economic growth. A key factor in determining investment is the rate of
economic growth. Improvements in the rate of growth and AD will tend to
increase investment. Also important is the demand from overseas and the
demand for exports.

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Government expenditure (G)
Government spending includes transfer payments (e.g. benefits) and direct
spending, such as capital investment on public roads. In 2013/14, the UK
government spent a total of £722.9 billion (44% of GDP). Government spending
is influenced by:

• Fiscal policy. The government may choose to use fiscal policy to try and
influence AD, e.g. in a recession, the government could borrow more and
spend on capital investment, such as building new roads and railways.
• Economic cycle. In a period of high economic growth, tax revenues tend
to rise; this gives the government more money to spend on services like
the NHS.
• Political cycle. Government may cut spending after an election to try and
reduce budget deficit, but then increase spending shortly before an
election.

Net Trade (X-M)

The UK’s main trading partner is the EU (60% of trade). Though the proportion
of trade with developing economies, like China and India, is rising.

Factors that affect (X-M)

• Exchange rates. If there is a depreciation of the exchange rate, exports
will be cheaper and imports more expensive. This will tend to increase (X-
M) and increase AD.
• Economic growth. If UK growth is relatively higher than other countries,
we will see a rise in import spending and this will reduce net (X-M). But, if
there is strong growth in Europe, this will lead to higher (X-M) and higher
AD.
• Competitiveness. If the UK has a lower inflation rate than our
competitors, then UK exports will become relatively cheaper. Improved
competitiveness could be due to lower wages or higher productivity.
• Non-price factors. In addition to price, the quality and desirability of UK
goods and services will be important. If UK firms can produce better
quality goods and services with unique selling points, demand for UK
exports will rise and demand will be more inelastic.
• Tariffs and protectionist measures. If a country faced high tariffs on
exports, this would reduce demand. For example, if the UK left the EU, it
may find that there are higher costs / tariffs on exports to Europe.

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 Aggregate supply (AS)
Aggregate supply (AS) is the total productive capacity of the economy. It is the
sum of all the individual supply curves for particular goods.
The AS curve shows maximum potential output; there is a strong correlation
with a Production Possibility Frontier (PPF) curve from unit 1, which also shows
the maximum potential of an economy.

• In the diagram on the left, the AS curve has shifted to the left, leading to
a higher price and lower real GDP.
• In the diagram on the right, there is a shift in AD. This causes a higher
price level (P1 to P2) and movement along the AS curve.

Short run and long run

In the short run, firms may be able to increase capacity in response to higher
prices and demand. For example, firms can pay workers to do overtime. But,
there is a limit to how much supply can increase in the short run.
In the long run, AS is determined by the stock of capital and quantity of labour,
etc.

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• Short run AS tends to be more elastic; higher prices encourage firms to
supply more.
• In the long run, AS is determined by factors of production – land, labour,
capital.

Factors affecting SRAS

In the short run, AS can be determined by factors that affect the cost of
production. These include

• The price of raw materials, e.g. oil, metals, food, gas and electricity.
• The exchange rate. Devaluation would increase the cost of many imported
raw materials, such as oil.
• Taxes and subsidies. A rise in VAT or excise duty would increase the cost
and shift the SRAS to the left.

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Impact of rising oil prices on SRAS

• If there is a rise in the oil price, firms face higher transport costs, and
therefore the cost of production rises. This causes SRAS to shift to the left.
• It leads to movement along the AD curve, leading to a higher price level
and lower real GDP.
• A fall in the prices of raw materials would have the opposite effect - SRAS
would shift to the right.

Long run aggregate supply (LRAS)

In the long run, AS is determined by the quantity of factors of production and the
productivity of labour / capital. (Labour productivity means output per worker.)
Factors affecting LRAS

• Population. A rise in the number of working age people will increase the
labour force and increase productive capacity. The working age
population can be affected by birth rates and net migration. The UK
labour force has increased due to net migration in the past decade.
• Technology. Technological improvements are one of the biggest factors
affecting labour productivity, e.g. the Internet makes it easier for firms to
check costs and prices.
• Investment. If firms or the government invest in increasing the capital
stock, we will see higher AS in the long run
• Education and skills. Improved education and vocational skills enables
workers to be more productive and offer higher added value, increasing
productive capacity.
• Infrastructure. Improved transport links reduce the cost of transport
and encourage trade; this is important for boosting productive capacity.

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 • Government policies. The government can affect LRAS by its supply side
policies on education, competitiveness and regulation. For example,
privatisation and deregulation may increase efficiency and competitive
pressure in industries like gas and electricity.
o Note: there is a limit to how much the government can influence
productive capacity. Most technological improvements come from
the private sector.
• Attitudes to enterprise. A stable economic and political climate may
encourage entrepreneurs to invest and develop business.

Different views of the LRAS

Different economists have different views about the LRAS.

• On the left, the classical view is that LRAS is inelastic. In this case, a rise in
AD will cause inflation in the long run. Economic growth requires LRAS to
shift to the right.
• On the right, the Keynesian view is that there can be spare capacity in the
long run (e.g. prolonged recession), therefore an increase in AD can cause
higher real GDP (if there is spare capacity).

Which AS curve to draw?

• Many students ask, which curve should I draw? We have SRAS and two
LRAS.
• On many occasions, it doesn’t matter because the important thing is to
show the basic idea of AD and AS.
• However, it can be important to distinguish between SRAS and LRAS. A
rise in oil prices shifts SRAS. Capital investment would affect LRAS.
• If you want to show how AD can increase real GDP, it is helpful to draw a
SRAS or Keynesian LRAS.

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 National Income
The circular flow of income shows how money flows from households to firms
(to buy goods). Then firms pay households wages to produce goods.

The circular flow of income shows three ways to calculate GDP (Gross Domestic
Product).

1. Total national income (wages, dividends,)

2. Total national expenditure (consumption and investment)
3. Total national output (value of goods and services produced)
Income and wealth

• Income is a flow concept. It is the amount of money a person/firm

receives in a certain time frame, e.g. annual salary of £20,000.
• Wealth is a stock concept. It is the amount of assets that a person/firm
has at a particular time, e.g. the value of a person’s assets (e.g. house,
shares, savings) is £150,000.

Injections
This is an increase of expenditure into the circular flow of income, leading to an
increase in aggregate demand (AD). Injections can include:

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 1. Exports (X) – spending from abroad on domestic goods.
2. Government spending (G).
3. Investment (I) - spending on capital goods by firms.

Withdrawals (W) (leakages)

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

• Saving (S) – depositing money in banks.

• Imports (M) – spending on foreign goods.
• Taxation (T) – the Government raising money from consumers and firms.

Equilibrium national income

Equilibrium national income occurs where AD=AS.

• In this example, there is a fall in AD, leading to a change in equilibrium
national income. Real GDP falls from Y1 to Y2.

Increase in AD
Suppose that we have an increase in injections into the circular flow. For
example, a rise in export demand due to increased economic growth in Europe.
This will lead to higher AD and higher real GDP.

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The Multiplier
The multiplier effect occurs when a change in injections causes a bigger final
change in real GDP.

For example, if the government increased G (government spending) by £10
billion, and this led to an increase in real GDP of £16bn, we say the multiplier
effect is 16/10 = 1.6

Why do we get a multiplier effect?

• Suppose we have a depressed economy with spare capacity and

unemployed workers. If the government spends £10bn on building roads,
they will employ workers. Income and spending will rise by £10bn.
• But, the unemployed will now have extra money to spend. They will buy
products from shops, and shopkeepers will now see improved incomes
and spend more.

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 • In other words, the initial spending doesn’t just stay with one person.
There are knock on effects. Higher spending leads to more income for
others, and therefore further rounds of spending.

Initially a rise in injections causes AD to increase to AD2. But, because of the
multiplier effect and further rounds in spending, we get another increase in AD
to AD3 - causing a bigger final increase in real GDP.
What determines the multiplier effect?

• Marginal propensity to consumer (MPC) is the % of extra income that
is spent. E.g. if confidence is high, the MPC will be higher.
• Marginal propensity to save (MPS) is the % of extra income that is
saved, (e.g. bank savings). Higher interest rates may encourage more
saving.
• Marginal propensity to tax (MPT) is the % of extra income that goes in
tax payments. This is determined by income tax rates and VAT rates.
• Marginal propensity to import (MPM) is the % of extra income that is
spent on imported goods (and leaves the UK economy).
• Marginal propensity to withdraw (MPW) = MPS+MPT+MPM.

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Calculating size of multiplier
The multiplier effect is determined by the marginal propensity to consume
(MPC).

• The higher the marginal propensity to consume, the bigger the multiplier.
• If consumers received extra money, but none of this was spent directly in
the UK, there would be no multiplier effect.
• If consumers have a high marginal propensity to withdraw, then the
multiplier effect will be low. For example, if consumers received extra
money, but this is saved or spent on imports, there is little effect on UK
demand.

If the government increased spending by £20bn (financed by borrowing), and:

• MPS = 0.2
• MPM = 0.15
• MPT = 0.4

In this case, the MPW = 0.75. Therefore the MPC = 0.25.

1. The multiplier effect = 1/0.75 = 1.33
2. The final increase in real GDP will be £20bn × 1.33 = £26.666bn

• The multiplier effect may also be limited by spare capacity. If the
economy is close to full capacity, rising demand may just lead to inflation.
• In the diagram above, a rise in AD causes a relatively bigger impact on the
price level than real GDP.

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 Economic Growth
• Economic growth means an increase in real GDP. An increase in GDP means
an increase in the volume of goods and services produced in an economy.
• The rate of economic growth measures the annual % change in real GDP.

This graph shows the UK’s quarterly economic growth between 2008 and 2014.
A quarterly growth rate of 0.5% means an annual growth of around 2.0%.

• An increase in the productive capacity (LRAS) of an economy is known as an

increase in potential growth.
• The long run trend rate of economic growth is the sustainable rate of
economic growth in an economy. For example, in the UK this is about 2.5%.
The trend rate of growth is related to the increase in LRAS.

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This graph shows that in the recession of 2008-12, UK real GDP growth fell
behind the trend rate of economic growth. This was due to a lack of AD.

Causes of economic growth

1. Increase in AD. If there is spare capacity in the economy, then a rise in AD will
lead to higher real GDP.

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Demand side factors that can increase economic growth could include:

• Lower interest rates – reducing the cost of borrowing and leading to

higher investment and higher consumption.
• Rising house price – leading to a positive wealth effect, encouraging
consumer spending.
• Lower taxes – increasing disposable income.
• Higher confidence in the economy – encouraging spending and
investment.

2. Increase in LRAS (supply side factors)

This diagram shows economic growth in the long run, with an increase in LRAS
and AD. Factors that could increase LRAS include:

• Increased investment in productive capacity.

• Better education and training to increase labour productivity.
• Improvement in technology, leading to lower costs of production.
• (See factors affecting AS for more.)

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Output gaps
The output gap is the difference between potential GDP and actual GDP. In the
real world, the rate of economic growth is rarely constant. We can have positive
and negative output gaps.

Positive output gap

• A positive output gap will occur when actual economic growth is above
the sustainable potential. E.g. if the long run trend rate is 2.5%, but we
have growth of 4.%.

In this diagram, firms are temporarily producing at Y2, which is greater than Yf
(full employment). They have increased output in the short run (e.g. getting
workers to do overtime). But, this is stretching potential output and is
unsustainable in the long run.
A positive output gap occurs when AD increases faster than AS. A positive output
gap leads to:

• Inflation as firms put up prices and increase wages.

• Lower unemployment as there is greater demand for workers.
• A deterioration in the current account as consumers buy more imports.
• The Central Bank may deal with the inflation by putting up interest rates.
• The ‘boom’ will be unsustainable and may lead to an economic downturn.

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Negative output gap
A negative output gap occurs when economic growth is below the sustainable
potential, e.g. it could be due to very low economic growth at 0.5% or a recession
with negative economic growth (-1.2%).

With a negative output gap, the real GDP will be less than potential. This will be
due to low aggregate demand.

The trade cycle

The trade cycle (or economic cycle) refers to how the rate of economic growth
can be variable. We can see high periods of economic growth, followed by
periods of low economic growth.

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Boom
A boom will lead to a positive output gap. It is characterised by:

• High rates of economic growth

• Higher inflation
• A deterioration in the current account
• Lower unemployment
A boom could be caused by very high confidence or an increase in high prices.
Booms tend to be short-lived because Central Banks tend to put up interest rates
to reduce inflation. Also, consumers may run out of money to spend; there is only
so much you can borrow, and there may come a time when high confidence turns
to pessimism.

Recessions
A recession is defined as a situation where we see a fall in real GDP for two
consecutive quarters (6 months).

This graph shows that the EU economy was in recession 2008/09 and 2012/13.

Characteristics of a recession:
1. Real incomes will fall, reducing living standards.
2. Unemployment tends to rise. This is because some firms will go out of
business, making many jobs redundant. Also, with lower demand, firms
will have less demand for workers.
3. Higher government borrowing. In a recession, tax receipts will be lower
(e.g. less income tax, less VAT). Also, the government will need to spend
more on benefits, such as unemployment benefits.
4. Fall in asset prices, such as houses.

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 Benefits of economic growth
1. Higher incomes. Consumers will be able to enjoy more goods and services
2. Lower unemployment. With higher output, firms will employ more
workers. A sustained period of economic growth will lead to lower
unemployment.
3. Lower government borrowing. Economic growth creates higher tax
revenues (i.e.. people earn more, so they pay more income tax). Also, there is
less need to spend money on unemployment benefits.
4. Improved public services. With higher tax receipts, more can be spent on
health care, infrastructure and education.
5. Firms make more profit. Firms will make higher profits; this may
encourage more investment, which can lead to a virtuous circle of higher
growth.

Costs of economic growth

1. Inflation. If AD increases faster than AS, then economic growth will be
unsustainable and inflationary.

• If economic growth is unsustainable (i.e. it occurs too fast), it causes a
positive output gap and inflation.
• However, if growth is not above the trend rate and AD increases at the
same rate as AS, economic growth will not cause inflation.

2. Boom and bust economic cycles. If economic growth is unsustainable, then

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

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3. Balance of payments deficit. Higher consumer spending causes an increase
in imports, causing a deficit on the current account. However, if growth is export-
led, this will not occur.

4. Environmental costs. Increased economic growth will lead to increased
output, and therefore will cause increased pollution and congestion, which
reduces living standards. If growth damages the environment, it may have a
negative impact on future living standards. However, higher growth may enable
more resources to be spent on the environment.

5. Increased inequality. Higher rates of economic growth have often resulted in
increased inequality. However, this depends upon things such as tax rates and
the nature of economic growth

Macro economic objectives

The primary economic objectives of a government are likely to be:
1. Economic growth. Most governments would try to maximise sustainable
economic growth to increase living standards and help create
employment.
2. Low inflation. The government’s inflation target is currently CPI 2% (+/-
1). The government wishes to both avoid high inflation and also the threat
of deflation.
3. Low unemployment. Most governments will aim for full employment.
Full employment would be an unemployment rate of around 3% (there is
always some frictional unemployment).
4. Satisfactory current account / balance of payments. A large current
account deficit could be an economic concern (e.g. weak export growth,
reliance on capital flows, finance deficit). Therefore, governments may
wish to have a reasonable low deficit/surplus,
5. Low government borrowing. Governments often commit to fiscal
targets for both annual borrowing, and total debt (public sector net debt).
6. Stable exchange rate. A rapid depreciation in the exchange rate could
cause inflationary pressures and instability. Therefore, governments may
prefer a stable exchange rate (e.g. a fixed exchange rate system).
Other minor objectives

• Issues of equality. High economic growth may be at the expense of

income inequality. Making sure growth is fairly distributed may be an
objective of some governments.
• Environment. High economic growth could cause environmental
problems and issues for long-term sustainability. Looking after
environment may require some sacrifice in terms of economic growth.
Exam Tip – If you have a question like “Discuss the effect on the UK economy of
x,y,z”, a good starting place is to consider all these macro-economic objectives,
e.g. consider how higher interest rates affect growth, inflation, unemployment
and current account.

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 Demand side policies
Demand side policies involve attempts to influence AD. The two main demand
side policies are:
1. Fiscal policy – the government changing levels of spending (G) and taxes
(T).
2. Monetary policy – Changing interest rates. In the UK, monetary policy is
managed by the Bank of England; they may also use other monetary
instruments, such as quantitative easing.

Fiscal policy
Fiscal policy is the governments attempt to influence AD. The aim could be to:
1. Stimulate economic growth in a period of a recession
2. Maintain low inflation
Expansionary fiscal policy (loose fiscal policy).
This involves lower tax rates and/or higher government spending, with the aim
to increase AD.
Effect of expansionary fiscal policy:

• Expansionary fiscal policy will increase AD and increase the size of the
budget deficit. It may cause inflation.

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Deflationary fiscal policy (tight fiscal policy)
• This involves higher tax rates and/or lower government spending.
• The aim of deflationary fiscal policy is to decrease AD and inflation.
• Deflationary fiscal policy will also improve the budget deficit.

Evaluation of fiscal policy

1. Poor information may reduce the accuracy of forecasting future
economic growth and inflation. Therefore, the government may be unsure
whether they need to boost AD or reduce AD. In practise, governments
find it difficult to ‘fine tune’ the economy with fiscal policy. But, in major
recession, they may try expansionary fiscal policy.
2. It depends on other components of AD. For example, if the government
cut income tax to increase AD, it may be ineffective if consumer
confidence is low and people just save the extra income.
3. Disincentives to work. Higher income tax to reduce inflation can create
disincentives to work, reducing productivity and AS.
4. Time lag involved in influencing AD. If the government wanted to
increase AD, they could commit to more government spending. But, there
will be delays in actually implementing higher spending, and then delays
in this spending affecting the wider economy.
5. Budget deficits. Expansionary fiscal policy (higher spending, lower tax)
will increase government borrowing. This could lead to higher interest
rates in the long term or even cause markets to lose confidence in debt
levels.
6. Crowding out. If the government spend more by borrowing from private
sector – it may reduce the amount of money the private sector has to
spend.

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Public Sector Net Debt PSND (The National Debt)

This is the total (cumulative) amount of debt that the government owes the
private sector.

• In January 2015, the net debt was £1,483.3 billion, equating to 80% of GDP.
• UK national debt as a % of GDP peaked after the First and Second World
Wars. It fell during the post war period as economic growth led to higher
GDP – making debt a smaller percentage.
• Net debt as increased since the financial crisis of 2007

Government borrowing
• The budget deficit is the annual amount the government needs to borrow
from the private sector.
• The budget deficit will be the difference between government spending
(G) and tax revenue.
• The budget deficit is also referred to as net borrowing.

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This shows public sector net borrowing (budget deficit) in the UK.

• In 1999-00 and 2000-01, the UK ran a budget surplus. Government

spending was less than tax revenues.
• Borrowing peaked in 2009-10 because of the financial crisis and
recession. In the recession, tax receipts fell and spending on
unemployment benefits rose.
• In 2009/10, the government also pursued expansionary fiscal policy
(cutting VAT rates to boost AD).
The budget deficit is measured through stats, such as Public Sector Net Cash
Requirement (PSNCR) and net borrowing.

Taxation
The government collects tax revenues from a variety of sources. The two main
types of taxation are:
1. Direct taxation – income tax, NI contribution. These taxes are taken
directly from a person’s wages. Income tax is progressive because it takes
a bigger % of tax from people with high incomes.
2. Indirect taxation – VAT, excise duty. Consumers pay these taxes
indirectly; when a good is bought, the firm has to pay the VAT rate to the
government (20%). Indirect taxes also include excise duty (e.g. alcohol,
tobacco) and petrol taxes.

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 Monetary Policy
Monetary policy involves changing the interest rate or manipulation of the
money supply by the monetary authorities.

• In the UK, monetary policy is managed by the Bank of England, Monetary

Policy Committee (MPC).
Aims of monetary policy
1. Control the rate of inflation. Inflation target for MPC is CPI - 2.0% +/-1
2. Maintain sustainable economic growth
3. Influence the exchange rate (not so important)

UK monetary policy
• Every month, the MPC meet to decide future interest rates. If they feel the
inflation rate is likely to go above the target (e.g. due to a higher rate of
economic growth) then they will increase interest rates to moderate
demand and keep inflation low.
• If the MPC feel that inflation is likely to fall below the target and there is
slow economic growth, they are likely to decrease interest rates to boost
economic growth and prevent unemployment.
To determine future inflation, the MPC will look at various statistics such as:

• The rate of economic growth compared to the long run trend rate. If
growth is faster than the trend rate, inflation is likely to occur.
• Wage growth. Higher wage growth can cause both cost-push and
demand-pull inflation.
• Temporary factors like tax rises and commodity price rises will be given
less importance because they do not indicate underlying inflation.
• Unemployment. High unemployment will tend to reduce wage inflation
and so the MPC is more likely to cut interest rates to boost AD.

Effect of higher interest rates (Tight monetary policy)

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

• Makes borrowing more expensive, therefore people spend less on credit.

• Firms will be less willing to invest by borrowing money.
• The cost of mortgages increases, therefore people have less disposable
income causing a fall in consumption. Therefore AD decreases.
• Saving money in a bank is more attractive therefore there is less spending
and relatively more saving.
• Exchange rate increases due to hot money flows into the UK (people take
advantage of a better rate of return on UK savings).

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Evaluation of monetary policy
1. The effect of interest rates depends on the situation of the economy. If the
economy is close to full employment, a cut in interest rates is likely to just cause
inflation significantly with only a small increase in real GDP. (AD3 to AD4)

• However if the economy has spare capacity, (e.g. at Y1 to Y2) higher AD

will increase GDP, with only a small amount of inflation.

2. Other components in the economy. The effectiveness of monetary policy

depends upon other variables in the economy, for example:

• If confidence is low, a reduction in interest rates may not increase

demand.
• If taxes are rising, this may counter a fall in interest rates.
• If the world economy is slowing, this will reduce exports and AD; this
would keep spending low - even if there was a reduction in interest rates.

3. Time lags. There may be time lags for lower interest rates to have an effect.
E.g. higher interest rates may not reduce investment in the short term because
firms will continue with existing investment projects.
4. Conflicts of objectives. Monetary policy may conflict with other macro
economic objectives. If the MPC reduces inflation, this may lead to lower growth
or higher unemployment.

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Demand side policies in great recession

In mid 2008, the global economy experienced a deep recession. This was due to:

• Banking crisis that led to banks cutting back on lending. Lower bank
lending led to less investment and less consumer spending.
• Fall in investment and consumer confidence due to the banking crisis.
• Fall in overpriced house prices, leading to negative wealth effect.
• Decline in exports, due to the global economic downturn.
• Rise in oil prices in early 2008, causing cost-push inflation.

Responses to great recession

• In the UK, interest rates were cut from 5% to 0.5%

• The UK government pursued some expansionary fiscal policy (VAT rate
cut from 20% -17.5%).
• Government borrowing increased sharply.
• Quantitative easing was tried from 2009. This is a policy of the Central
Bank to increase the money supply. The aim was to increase spending and
bank lending through increasing the money supply and also reducing
interest rates on government bonds.

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 UK Economy 2008-2014

• There was a time lag, but some economic recovery by 2010.
• From 2010, the new coalition government pursued austerity measures
(spending cuts) designed to reduce the budget deficit.
• Some economists feel these austerity measures contributed to a double-
dip recession. Other economists argue that there were many factors
causing slow growth in the UK, such as the recession in Europe.
• From 2013, austerity was eased and real government spending increased.
• The UK economy recovered in 2013/14, with positive growth and falling
unemployment..

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 Supply side policies
Supply side policies are government attempts to increase productivity, make the
economy more efficient and shift aggregate supply to the right. Supply side
policies can be either:
1. Interventionist - involving government spending to overcome market
failure, e.g. building new roads to reduce congestion.
2. Market oriented - policies to reduce regulation and allow free markets to
function more efficiently, e.g. reduce minimum wages.

Supply side policies can help the economy in various ways:

1. Lower inflation. Shifting AS to the right will cause a lower price level.
2. Lower unemployment. Supply side policies can help reduce structural,
frictional and real wage unemployment.
3. Improved economic growth. Supply side policies will increase economic
growth by increasing AS
4. Improved trade and balance of payments. By making firms more
competitive, they will be able to export more.

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Examples of market oriented supply side policies
1. Privatisation. This involves selling state owned assets to the private
sector. It is argued that the private sector is more efficient in running
businesses because they have a profit motive to reduce costs and develop
better services.
2. Deregulation. This involves reducing barriers to entry in order to make
the market more competitive. Greater competition creates incentives to
reduce prices and costs. For example, UK telecoms markets are now more
competitive and this has helped reduce prices and increase efficiency.
3. Reducing taxes. It is argued that lower taxes (income and corporation)
increase incentives for people to work harder, leading to higher output.
4. Reducing state welfare benefits. Lower unemployment benefits may
create a bigger incentive for people to look for work and stay off benefits
5. Reduced bureaucracy for firms. If rules and regulations are removed
then firms will have lower costs and be more productive.
6. Labour market reforms. Some economists argue that many European
labour markets are too heavily regulated. For example, removing laws
about hiring and firing workers and fixed hour contracts would increase
labour market flexibility and encourage firms to hire workers. On the
downside, greater labour market flexibility may lead to greater job
insecurity for workers.

Examples of interventionist supply side policies

• Increased education and training. Better education can improve labour
productivity and increase AS. Often there is an under provision of
education in a free market, leading to market failure. Therefore, the
government may need to subsidise suitable training schemes.
• Providing better information about available jobs.
• Improving transport and infrastructure. In a free market, there is
likely to be an under provision of public transport. If transport networks
were improved, firms would benefit from lower costs.

Evaluation of supply side policies

• They will take time to have effect, e.g. it will take several years to create a
more educated workforce.
• It will cost money to improve information and education, and therefore
taxes will need to rise.
• Deregulation, such as lower benefits and reduced minimum wages, may
cause side effects, such as increased poverty.
• Government failure may occur. For example, the government may have
poor information about what to spend money on. For example, the
government may finance the wrong kind of scheme, such as a new train
line that is not used very much.

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 • In a recession, increasing AS may be insufficient. In a recession the most
important thing is not supply side policies but policies to increase
aggregate demand.

In this example, we successfully increase LRAS, but the economy is stuck in a
recession, so the output is relatively small. In this situation, the economy needs
an increase in AD (demand side policies).

• There is only so much the government can do. It is important to bear in

mind that technological improvements and productivity gains come
largely from the private sector.
• It is difficult for the government to transform productivity and create new
technology. At best, the government can create a climate for private
sector innovation to occur.

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Conflicts and trade-offs between objectives and policies
A government will struggle to meet all the macro-economic objectives at once.

Unemployment vs. inflation

• If the government pursued demand side policies to reduce unemployment,

we could see a fall in unemployment, higher economic growth, but also a
rise in inflation.

Expansionary fiscal policy

• If the government increased spending (G), we would see an increase in
AD. This leads to a rise in real GDP (Y1 to Y2).
• As output increases, firms will hire more workers.
• Real GDP rises from A to B, and we get higher inflation (P1 to P2).

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Short run Phillips Curve

Therefore, we go from (A) unemployment (6%) and low inflation (2%), and
move to point (B) unemployment (3%) and higher inflation (5%).
This shows a trade off between inflation and unemployment. Fiscal policy
reduces unemployment and causes higher economic growth, but leads to higher
inflation.
There may be other trade offs as well:

• Higher AD could cause a bigger current account deficit because of higher

import spending, and higher inflation reducing the competitiveness of
exports.
• Expansionary fiscal policy (higher G / lower tax) will lead to a bigger
budget deficit.

The trade off can work in reverse. If we reduce AD (e.g. higher interest rates), we
can get lower inflation, but we may cause unemployment.

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Evaluation

• In the long run, it may be possible to achieve higher growth and lower
unemployment, without causing inflation.
• If AD increases at the same rate as AS, we can get economic growth
without inflation.

If we also use supply side policies, we can reduce structural unemployment,
without causing any inflation.

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Other potential policy conflicts
• Higher economic growth may cause environmental problems – e.g. the
overuse of scarce limited resources acts as a constraint on future living
standards.
• Lower income tax and corporation tax may provide a boost to growth, but
may also increase inequality because high earners benefit most from
these tax cuts.
• Cutting down benefits may provide an incentive for the unemployed to
get a job, but it may cause increased inequality.
• Policies to reduce a current account deficit (deflationary fiscal policy)
may cause lower economic growth and higher unemployment.

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