THE ECONOMIC SYSTEM

ELEANOR DOYLE

Copyright 2005

John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) 1243 779777

Email (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on www.wiley.com All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher. Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or emailed to permreq@wiley.co.uk, or faxed to (+44) 1243 770620. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the Publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought. Other Wiley Editorial Ofces John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USA Wiley-VCH Verlag GmbH, Boschstr. 12, D-69469 Weinheim, Germany John Wiley & Sons Australia Ltd, 33 Park Road, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 22 Worcester Road, Etobicoke, Ontario, Canada M9W 1L1 Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Cataloging-in-Publication Data The economic system / Eleanor Doyle. p. cm. Includes bibliographical references and index. ISBN-13 978-0-470-85001-5 (pbk. : alk. paper) ISBN-10 0-470-85001-9 (pbk. : alk. paper) 1. Economics. I. Title. HB171.5.D65 2005 330dc22 2004027116 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN-13 978-0-470-85001-5 ISBN-10 0-470-85001-9 Typeset in 11/15 New Baskerville by Laserwords Private Limited, Chennai, India Printed and bound in Great Britain by Scotprint, Haddington, East Lothian This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production.

CONTENTS
Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 The Economic System Market Analysis: Demand And Supply Beyond Demand: Consumers in the Economic System Beyond Supply: Firms in the Economic System Economic Activity: The Macroeconomy Competition in the Economic System 1 35 77 113 155 197 239 283 321 361 387

Chapter 7 Money and Financial Markets in the Economic System Chapter 8 Chapter 9 Glossary Index Challenges for the Economic System: Unemployment and Ination Developing the Economic System: Growth and Income Distribution

DETAILED
Preface Acknowledgements

CONTENTS
xiii xv 1 1 2 6 9 14 16 18 20 22 27 29 30 31 31 32 32 35 35 36 40 42 46 52 55 56 56

Chapter 1 The Economic System 1.1 Introducing the Economic System 1.2 Economic Resources and Markets 1.3 The Economics Approach: Theory-Based Analysis 1.4 Describing and Interpreting Economic Relationships 1.5 Microeconomics and Macroeconomics 1.5.1 The Environment for Economic Decisions 1.6 Resource Scarcity and Prices in the Economic System 1.6.1 Using Resources and Centralized Decision-Making 1.7 Resource Use, Opportunity Costs and Efciency 1.8 Alliance of Economic Perspectives 1.9 Positive/Normative Economics 1.10 Summary Chapter 1 Appendix Review Problems and Questions Further Reading and Research References Chapter 2 Market Analysis: Demand and Supply 2.1 Introduction 2.2 Exchange A Central Feature of Markets 2.3 Demand 2.3.1 Non-Price Determinants of Demand 2.4 Supply 2.5 Market Interaction: Demand and Supply 2.5.1 Changes in Equilibrium 2.6 Government Affecting Prices 2.6.1 Price Ceiling

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2.6.2 Price Floor 2.6.3 Problems of Price Ceilings and Floors 2.7 Information and Knowledge in the Market System 2.7.1 Decentralized Decision-Making The Optimal Form of Organization? 2.8 More on Equilibrium in the Demand and Supply Model 2.9 A Market at Work: The Labour Market 2.9.1 Labour Demand 2.9.2 Labour Supply: Individual Supply Decision 2.9.3 Equilibrium in the Labour Market 2.10 Summary Review Problems and Questions Further Reading and Research References Chapter 3 Beyond Demand: Consumers in the Economic System 3.1 Introduction 3.2 Demand and the Importance of Consumers 3.2.1 Consumption Goods 3.3 Consumer Satisfaction Utility 3.3.1 The Assumption of Rationality in Economics 3.4 Marginal Utility, Prices and the Law of Demand 3.4.1 The Law of Demand Income and Substitution Effects 3.5 Demand, Consumers and Consumer Surplus 3.5.1 Consumer Surplus and Consumer Welfare 3.6 Consumers Response to Price Changes 3.6.1 Price Elasticity of Demand 3.6.2 Applications of Elasticity Analysis 3.6.3 Other Elasticity Examples 3.7 Consumer Choice and Product Attributes 3.7.1 The Attribute Model: Breakfast Cereals 3.8 Aggregate Consumer Behaviour 3.9 Government Policies Consumer Focus 3.10 Summary Review Problems and Questions Further Reading and Research References

57 57 58 61 63 64 64 70 71 72 73 74 75 77 77 78 79 81 83 84 87 90 92 93 94 98 99 101 101 103 107 109 110 112 112

D E TA I L E D C O N T E N T S

ix

Chapter 4 Beyond Supply: Firms in the Economic System 4.1 Introduction 4.2 Firms in Economic Action 4.3 Why Organize an Economic System Around Firms? 4.3.1 Decisions of Firms and the Role of Time 4.3.2 Firm Revenue 4.3.3 Firm Output (Product): Marginal and Average Output 4.3.4 Firm Costs 4.3.5 Marginal and Average Costs 4.4 Maximizing Prots in the Long Run 4.4.1 Prot Maximization, Normal Prot and Efciency 4.4.2 Maximizing Prots Over the Short Run 4.5 Supply, Producers and Producer Surplus 4.6 Producers Response to Price Changes 4.7 Firms Investment Behaviour 4.8 Government Inuence on Supply and Production 4.8.1 Using Subsidies An Example with International Trade 4.8.2 Environmental Taxes Effects on Production 4.8.3 Tax Incidence 4.9 Summary Review Problems and Questions Further Reading and Research References Chapter 5 Economic Activity: The Macroeconomy 5.1 Introduction 5.2 Economic Activity and the Circular Flow 5.3 Real Output and the Business Cycle 5.3.1 Explanations/Causes of Business Cycles 5.3.2 Implications for Business and Government 5.4 Real Output and its Components 5.4.1 Other Measures of Economic Activity 5.4.2 Economic Activity: GNP, GDP and Income 5.5 Equilibrium Economic Activity 5.5.1 The Price Level 5.5.2 Aggregate Demand

113 113 114 115 116 117 120 123 125 131 133 137 139 140 142 144 145 147 149 150 151 153 153 155 155 156 158 161 165 165 167 168 170 171 172

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5.5.3 Aggregate Supply 5.5.4 Bringing AD and AS Together: The Short Run 5.6 Equilibrium Economic Activity and the Multiplier 5.7 International Integration 5.7.1 Explaining Growing International Trade 5.7.2 Benets and Costs of International Trade 5.8 Government Activity 5.8.1 Another Perspective on Economic Activity: The Economy as a Production Function 5.9 Summary Review Problems and Questions Further Reading and Research References Chapter 6 Competition in the Economic System by Edward Shinnick 6.1 Introduction 6.2 Competition in the Economic System 6.2.1 Competition as a Process 6.2.2 Entrepreneurship, Discovery and the Market Process 6.3 Alternative Models of Competition and Market Structure 6.3.1 Perfect Competition 6.3.2 Monopoly 6.3.3 Perfect Competition vs. Monopoly 6.3.4 Monopolistic Competition 6.3.5 Oligopoly 6.4 Austrian and Traditional Perspectives: A Comparison 6.5 When Markets Fail 6.5.1 Why Markets May Fail 6.5.2 Implications of Market Failure 6.6 Government Regulation of Competition 6.6.1 Competition Spectrum 6.6.2 Structure, Conduct and Performance 6.6.3 Competition Policy 6.7 Summary Review Problems and Questions Further Reading and Research References

175 177 178 181 182 184 187 190 192 193 195 195 197 197 198 199 201 204 206 209 211 213 215 221 223 223 225 226 229 229 230 236 236 237 237

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xi

Chapter 7 Money and Financial Markets in the Economic System 7.1 Introduction 7.2 Money and Exchange 7.3 Liquidity, Central Banks and Money Supply 7.3.1 The Money Multiplier 7.4 Money Demand 7.5 The Money Market: Demand and Supply 7.5.1 Which Interest Rate? 7.5.2 Nominal and Real Interest Rates 7.6 Quantity Theory of Money and Explaining Ination 7.6.1 Ination Expectations, Interest Rates and Decision-Making 7.7 The Foreign Exchange Market 7.7.1 Demand in the Foreign Exchange Market 7.7.2 Supply in the Foreign Exchange Market 7.7.3 Exchange Rate Determination 7.7.4 Causes of Changes in Exchange Rates 7.8 Speculation in Markets 7.8.1 Investment in Bond Markets 7.8.2 Bonds, Ination and Interest Rates 7.9 Monetary Policy 7.9.1 Difculties in Targeting Money Supply 7.9.2 Alternative Targets 7.9.3 Taylor Rules and Economic Judgement 7.10 International Monetary Integration 7.10.1 Considering the Euro 7.11 Summary Review Problems and Questions Further Reading and Research References Chapter 8 Challenges for the Economic System: Unemployment and Inflation 8.1 Introduction 8.2 Unemployment 8.2.1 Labour Market Analysis: Types of Unemployment 8.2.2 Analysing Unemployment: Macro and Micro 8.2.3 Unemployment and the Recessionary Gap 8.2.4 The Costs of Unemployment

239 239 240 242 244 246 247 248 249 251 253 255 256 256 257 258 260 263 266 268 269 270 272 272 274 278 279 280 280 283 283 284 286 291 293 295

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8.3 Ination 8.3.1 The Inationary Gap 8.3.2 Trends in International Price Levels 8.3.3 Governments Contribution to Ination 8.3.4 Anticipated and Unanticipated Ination the Costs 8.4 Linking Unemployment and Ination 8.4.1 A Model Explaining the Natural Rate of Unemployment 8.4.2 Causes of Differences in Natural Rates of Unemployment 8.5 Cross-Country Differences Ination and Unemployment 8.5.1 Employment Legislation 8.6 Summary Review Problems and Questions Further Reading and Research References Chapter 9 Developing the Economic System: Growth and Income Distribution 9.1 Introduction 9.2 Living Standards and Labour Productivity Relationships 9.2.1 The Dependency Ratio 9.3 Economic Growth over Time 9.4 Modelling Economic Growth: The Solow Growth Model 9.4.1 More on Savings 9.4.2 The Solow Model and Changes in Labour Input 9.4.3 The Solow Model and Changes in Technology 9.4.4 Explaining Growth: Labour, Capital and Technology 9.4.5 Conclusions from the Solow Model 9.4.6 Endogenous Growth 9.5 Income Distribution 9.5.1 Intra-Country Income Distribution 9.6 Summary Review Problems and Questions Further Reading and Research References Glossary Index

296 297 299 303 304 306 309 312 314 316 317 318 318 319 321 322 322 327 331 333 337 341 343 344 345 347 349 351 356 357 358 358 361 387

PREFACE
A good economics student manages to understand the workings of the components within the economic system. An excellent student manages to appreciate the broader picture of the system with all its complexity of networks, interrelationships and organization. This requires an ability to understand economic models and their role in supporting analysis of economic issues plus an appreciation of their usefulness when we attempt to understand economic phenomena at a particular point in time, within their specic, and often complicated, micro- and macroeconomic contexts. It was with this in mind that I wrote The Economic System. The aim of The Economic System is to provide an appropriate mix of topical and historical, practical and theoretical principles of economics that create a tool-box appropriate for understanding, analysing and addressing the economic issues that we face and attempt to understand. Any writer or reader of economics textbooks, particularly those aimed at the principles of economics market, is aware of the variety of alternatives currently available. The Economic System is novel in that it does not follow a strict compartmentalization of chapters into microeconomics and macroeconomics distinctions but rather groups material appropriate to the central focus of the chapter to guide learning. The essentials of micro- and macroeconomic theory and analysis are provided within a context where their overlap within the economic system is emphasized. A key focus of the book is on highlighting the relationships between microeconomic and macroeconomic analysis in a way that contributes to a better understanding of their intrinsic relationships and to a better appreciation of how the economic system works. This approach addresses a limitation I have experienced where often even those students who appear to solidly grasp concepts and models display weaknesses in using them to better understand or analyse problems and to transfer their application to alternative settings or examples. Transferability of concepts is a real challenge especially for a subject that focuses on being a problem-solving discipline where students should learn skills useful to support decision-making, i.e. criteria for choosing between alternatives. An explicit aim in The Economic System is to clarify how models and concepts in economics are useful as tools that support rigorous, methodical analysis and not simply useful to solve mathematical puzzles.

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The use of a small number of chapters, nine in total, that focus on related material to highlight these system features of the economy achieves this end. There are some further topics that could also have been included in the text; however, I followed the view that learning should not be rushed and that understanding what is here is a solid foundation for further learning. The activity of information integration requires time and to learn and derive knowledge from that information is a complex cognitive process. Another novel perspective is included with references to the Austrian approach to economics and to entrepreneurship activity in particular, which is explained and referred to several times in the text. This presents students with an interesting focus on the process element of economic analysis as well as the product element provided in the appropriately comprehensive standard neoclassical analysis.

Real world examples and learning features

Also included within the text are many topical issues including globalization, outsourcing, EMU and the advantages and disadvantages of a single currency. Extensive end-of-chapter material is provided including mini case studies, further reading and review questions and problems. Students are required to develop their range of problem-solving, numerical, analytical and argumentative skills in generating their answers to these questions.

Online resource package

For students and lecturers, a comprehensive online support package is provided with the text. The website includes PowerPoint slides, multiple choice questions, weblinks, online glossary, and further review questions and exercises, plus model answers to all of the end-of-chapter questions provided.

ACKNOWLEDGEMENTS
The contribution of a network of individuals made work on the text substantially more enjoyable and challenging. Thanks must primarily go to the many students in the Principles of Economics BA course at University College Cork who have contributed to the development of this book and whose feedback has been gratefully received and much appreciated. The teaching assistants, including Krystle Healy, James Nolan and Rory OFarrell, who have supplied their expertise to support the course delivery and test-driven the course materials, also deserve special appreciation. I am extremely grateful to many colleagues in the Department of Economics, UCC who have generated a positive working environment where the role of teaching is highly valued. For providing many references and nuggets to be followed up or just reected upon throughout this project sincere thanks to Connell Fanning. Edward Shinnick, the author of Chapter Six, whose timely and focused contribution was vital in achieving the end result, is deserving of many thanks. For valuable and timely feedback on various chapters that was much appreciated, I must thank Eoin OLeary, Brendan McElroy and Niall OSullivan. Thanks to Kay Morrison and Emer Doyle for editorial and proofreading assistance. For support with content and development of online materials I am very grateful to Eileen OSullivan, Krystle Healy and particularly Gerard Doolan who did trojan work. Staff at Wiley were supportive above and beyond the call of duty and Anna Rowe comes in for particular thanks here along with Deborah Egleton, Rachel Goodyear and Steve Hardman. Without family support from Fred and Robert, who bore the brunt of book time, no text would have been possible. Thank you. Any remaining errors of omission or commission are, of course, mine alone.

CHAPTER 1

THE ECONOMIC
LEARNING OUTCOMES

SYSTEM

By the end of this chapter you should be able to: Dene what is meant by an economic system. Describe the roles played by the main players in the system including individuals, rms and countries. Describe how and why: the principle of exchange; the existence of markets; and the role of prices are central to understanding how an economic system functions. Clarify the role played by concepts, theories and models in economic analysis. Explain how rules and laws facilitate and govern decisions within the economic system. Illustrate how each of the following concepts: scarcity; opportunity cost; and economic efciency underpins economic analysis.

1.1

INTRODUCING THE ECONOMIC SYSTEM

This chapter provides an introduction to the economic system to illustrate the interconnectedness between the different participants in and features of an economy, which contribute to economic decisions and outcomes. An economy can aptly be described as a system as it relates to the following denitions of what a system entails:

a group of interacting interrelated or interdependent elements forming a complex whole;

THE ECONOMIC SYSTEM

an organized set of interrelated ideas or principles; a functionally related group of elements; an organized and coordinated method; a procedure.

The main participants and features of an economy are outlined in the chapters that follow. The study of economics focuses on identifying and trying to understand the patterns and relationships between these elements. To begin it is useful to dene what a study of the economic system entails. It involves understanding how:

the production of goods and services is organized and inuenced by individuals, organizations (including companies both publicly and privately owned, trades unions, employer groups, etc.) and governments; products and services are used to satisfy the requirements of these same individuals, households, organizations and government.

Analysis of production includes the consideration of decisions regarding what is produced and how production decisions are made, which inputs to use in production (factors of production) and the way in which they are organized together to produce output. How production meets the demands of buyers is a central factor in analysis of the economic system. Factors of production: the resources necessary for production. They include:

land all natural resources (including minerals and other raw materials); labour all human resources; capital all man-made aids to production that have been produced (e.g. machines, factories, tools). It is used with labour to produce and/or market more goods and services; entrepreneurship in business organization and willingness to take business risks.

1.2

ECONOMIC RESOURCES AND MARKETS

A key focus of economists attention is the relationship between an economys resources, both in quantity and quality, and what it can produce again in quantity and quality. The concept of efciency helps in the analysis of this relationship.

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Economic efciency: optimum production given the quantity and quality of available factors of production and their cost. An economy is efcient if it is maximizing the output it can produce within the constraints of its available inputs or resources. These constraints may take the form of rules or laws governing how inputs may be used, such as limits to the hours people are permitted to work per week. Economists focus on output and production is driven by an inherent interest in trying to understand how society could be better off and this is evident as far back as 1776 in An Inquiry into the Nature and Causes of the Wealth of Nations by Adam Smith, the acknowledged father of economics. What is produced in an economy has a direct bearing on the income the ow of money earned and wealth the stock of money held of people in that economy. When an economy increases the quantity of goods and services it produces and can sell the output, economic growth occurs. Economic growth: an expansion in the quantity of goods/services produced and sold. Once economic growth is faster than population growth, material living standards can rise. Living standards: the level of material well-being of a citizen. It is generally measured as the value of a countrys production per person, e.g. UK national output divided by the population of the UK for a particular period of time. Some data on international living standards are presented in Figure 1.1 for 20 countries with the highest living standards in 2002 (as reported by the OECD, the Organization for Economic Cooperation and Development). To ensure the data reported in Figure 1.1 can be compared, each countrys output was initially converted to the same exchange rate here all values are in dollars. Because of the different international prices of goods, a further adjustment was made to the data to take account of these purchasing power differences. This is called the purchasing power parity adjustment as explained in the text box. Figure A.1 in Chapter 1 Appendix contains living standards data for 2000 over a broader selection of counties. Purchasing power parity (PPP) is a measure of the relative purchasing power of different currencies. PPP is the exchange rate that equates the price of a basket

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Spain Italy Iceland UK Sweden France Finland Germany Netherlands Australia Austria Japan Denmark Belgium Canada Ireland Switzerland Norway USA Luxembourg 0 10 000 20 000 30 000 40 000 50,000

F I G U R E 1 . 1 L I V I N G S TA N D A R D S , T O P 2 0 C O U N T R I E S 2 0 0 2 , ( U S D O L L A R S A N D P P P s )
Source: Main Economic Indicators, OECD, 2002 See the nearby key term box for more on PPPs.

of identical traded goods and services in two countries. PPP is often very different from the current market exchange rate.

Since 1986 The Economist magazine has published a regular Big Mac Index. It indicates how many Big Macs dollars buy internationally when exchanged for local currencies. The Big Mac PPP is the exchange rate that would leave the Big Mac costing the same in the United States as elsewhere. The logic underlying conversions using PPPs and not just standard exchange rates is that prices tend to be lower in poor economies, so a dollar of spending in a poor country buys more than a dollar in America. Using purchasing power parities takes account of these price differences. Comparing actual exchange rates with PPP often reveals differences. Some studies have found that the Big Mac Index is often a better predictor of currency movements than other more theoretically rigorous currency models. Since January 2004, The Economist also provides a Tall Latte Index where the focus is not on burgers but a cup of Starbucks coffee, another internationally available product.

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Economists are interested in understanding the reasons behind economies growth experiences and the reasons underlying the cross-country disparity of living standards. Several explanations as to why such disparities arise are offered and in our study of the economic system we will touch on some of these. To fully appreciate how an economy functions also involves an understanding of the political context within which economies work as this too has an inuence on the output produced and the available resources. Political economy is the term given to the study of how the rules, regulations, laws, institutions and practices of a country (or a state, region, province) have an inuence on the economic system and its features. Rules and laws on how resources and production can be organized and used inuence the incentives for individuals and rms to conduct business and hence the output of an economy. One example would be rules on setting up new businesses and the time this takes. Research indicates time needed for setting up a new business varies considerably internationally, taking only two days in Canada and costing US$280, and 62 days in Italy, costing US$3946 (Djankov, et al., 2001).

Rules and laws on how resources are shared or distributed among citizens also inuence their income and wealth if only a few receive most of the production (because of corruption or a caste system, for example) the income and wealth of the majority suffers. How the value of output produced is distributed among an economys stakeholders depends on the conguration of each economic system and the choices on distribution that are made. Stakeholders in the economic system are the individuals and groups that depend on the system to full their own goals (be it to meet demands, generate income, create employment, provide wages or salaries, provide goods and services . . . ) and on whom the economic system depends for its continued survival. According to the above description of what an economy is, it is possible to interpret individual countries as economic systems, each with its individual economy, but it may also be useful, depending on some issues of interest to economists, to consider provinces, regions or cities as economies in their own right. It is also often useful to examine an economy by focusing on sub-sections of organized resources within an economy, which are described as markets, e.g. the

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market for cars, apples, or labour. Knowledge of how the economic system functions based on analysis of markets, production and expenditure decisions and how economies grow will help to enhance understanding of why economies perform so differently. Markets: situations where exchange occurs between buyers and sellers or where a potential for exchange exists. Markets cover the full spectrum from physical locations where buyers and sellers meet to electronic markets (such as auction websites) facilitated by the Internet. The familiar notion of a market where people come together in a particular location to buy and sell goods or services is the most straightforward denition of a market. The economists denition is broader and does not limit a market to a specic time and place. For example, we can refer to the market for apples, which covers the opportunities that exist for buying and selling apples between individuals and rms. Markets for products or services can usually be examined by considering the price at which producers or sellers are willing to supply and sell the supply or production side of a market and the price buyers are willing to pay the demand or consumption side of a market. Depending on the price of a product (amongst other factors) sellers and buyers make their economic decisions about which products to produce/buy and the quantities to produce/buy. The model of demand and supply presented in Chapters 2, 3 and 4 and again in Chapter 6 develop these two elements of the economic system further. The basic elements of the economic system therefore, involve, the organization of production and supply, consumption and demand, markets, exchange, prices, and the rules or laws that facilitate and govern decisions by individuals, households and rms relating to all of these elements.

1.3

THE ECONOMICS APPROACH: T H E O R Y- B A S E D A N A LY S I S

In recent years the scope of economics has expanded considerably due to the breadth of applications that are possible based on the concepts, theories and models that constitute the foundations of the discipline. Concepts, theories and models are simplied representations of phenomena, which are intended to serve as tools to aid thinking about complex entities or processes.

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TA B L E 1 . 1 E C O N O M I C T H E O RY A N D T H E P R O C E S S O F E C O N O M I C A N A LY S I S
1. Identify a question/issue for analysis, e.g. the factors that explain why Luxembourg has relatively high living standards at a point/period in time. 2. Identify theory (and/or concepts and/or models) relevant to this issue, e.g. theory of economic growth that relates output and living standards to the quantity and quality of available factors of production. 3. From theory, formulate hypotheses about possible relationships between high living standards and high levels of education (affecting labour), investment (affecting capital) etc., e.g. one hypothesis would be that high living standards are caused by high levels of education. 4. Test the hypotheses against evidence (information/data) on high living standards in Luxembourg and competing potential explanations. From alternative explanations e.g. education, investment, luck! the economist must attempt to choose the most appropriate and convincing, given available evidence. To get to the root of the analysis it may also be necessary to focus on the causes of high levels of education or investment, which is not straightforward. If the cause of high levels of education (or investment) is high levels of income/living standards then the explanation is circular and is not very useful. Evidence used to test an hypothesis might be quantitative (numerical), or qualitative or a mixture of both, and might be published or might be collected by the economist themselves in interviews or surveys, for example. 5. Draw valid conclusions.

What constitutes what economists do is as much governed by the approach to analysis they use as by the issues they examine. Table 1.1 provides a framework illustrating how theory guides economic analysis. An economic method of analysis involves using concepts, theories and models (that are transferable to a multitude of issues), which serve to structure thinking and clarify the fundamental features of interest in addressing an economic issue or answering an economic question. This method helps economists identify and organize the main features causing an economic phenomenon and perhaps rank the most important causes and effects and essentially to understand the most important features that explain how economies actually work. It is not sufcient to identify correlations between economic phenomena high standards of living and education because correlation is not causation! Overly focusing on data relationships without an underlying logical theory of causation is bad economics and does not give rise to valid conclusions. In relation to the example in Table 1.1

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the essence of the issue is whether living standards in Luxembourg would be higher or lower at a particular time with different levels of education (or investment). Models are sometimes criticized because of how they simplify reality but they are constructed in order to take into account the most important features of the economic system relevant to analysing a specic issue. For example, the standard economic model of supply and demand abstracts from all the various factors that feed into the determination of supply and demand to focus on the relationship between the price of a product and

producers decisions of how much to supply at different prices (supply); buyers decisions of how much to purchase at different prices (demand). Supply: the quantity of output sellers are willing to sell over a range of possible prices. Demand: the quantity of output buyers are willing to buy over a range of possible prices.

The demand/supply model is the cornerstone of economic analysis (and is described in detail in Chapter 2) and is used throughout this book. We can acknowledge that a number of different factors feed into the decisions that suppliers (producers) make regarding what to produce, in what quantity and what price to charge. These decisions would take into account producers available resources of money, machinery, production technology and know-how. In their theories and models, economists abstract from all other factors to consider the essence of how economic units or phenomena are related. In focusing on the relationship between price and demand, for example, we consider how demand relates to price and price alone. The approach treats all the other potentially intervening factors as if they were unchanging, allowing one relationship to be considered in isolation. This method followed by economists is described as the ceteris paribus assumption. The ceteris paribus assumption: from the Latin the direct meaning of this term is all things being equal or unchanged. This could be rephrased as the economists are not stupid assumption! Economists know all things do not remain equal or unchanged. The power of the assumption allows them to construct models that highlight the fundamental nature of a relationship they are trying to describe and understand. Subsequently they use their models to incorporate other factors of most relevance to that relationship.

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Economic analysis of demand can be extended to consider, for example, the effect that a general rise in income would have on a peoples decision regarding Demand. In the case where consumers incomes rise, ceteris paribus, we would expect rational consumers to buy more apples, or beans or CDs for example more on this in Chapter 2! The objective of the model of demand is, therefore, not to simplify reality and assume that price is the only factor that feeds into consumers decisions but to create a model whereby the analysis of any factor that is relevant can be considered in a clear and concise framework. Many models are used in economics, which serve similar purposes of allowing the complexity of an economic issue to be understood and sometimes future behaviour (e.g. of suppliers or buyers, or economies) to be predicted. Clearly, despite their models and concepts, economists do not always predict future behaviour or outcomes correctly. Just like weather prediction, the models do not always allow for all relevant factors that affect the outcome to be considered or in some cases probabilities of occurrences are under/overestimated. This is due to the inherent uncertainty in trying to predict economic outcomes that arise due to individual behaviour and decision-making. It is precisely because the future is uncertain that economists try to argue logically which potential outcomes are most likely or not.

1.4

DESCRIBING AND INTERPRETING E C O N O M I C R E L AT I O N S H I P S

In attempting to draw sound conclusions, economists often use facts and gures to test their economic arguments. They compute percentages, they use index numbers, draw and manipulate diagrams and they analyse trends in data over time. If you are comfortable with such activities, you should skip this section. To compute a percentage we are interested in the proportionate change in a quantity or value. Saying that employment increased by 10 000 jobs does not provide as much information as if you know what the initial level of employment was. Consider an economy where 125 000 people are employed. Increasing jobs by 10 000 represents a percentage increase of 8% which is found by: Percentage change = (Change/initial value) 100 In this example the relevant gures are (10 000/125 000) 100 = 8%

10

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With data on changes in employment produced monthly and quarterly in many economies it would be possible to compute percentage changes over these periods and examine whether the general trend were up or down, or whether any patterns emerged such as seasonal increases temporary summer workers are usually employed for a few months and then are laid off, students return to college, etc. and this affects employment gures. Alternatively, quantities or values can be expressed in index number form allowing them to be presented relative to one base point in time. Consider UK employment statistics. Table 1.2 shows employment between 1999 and 2003 based to 1999 = 100. By setting a base year value (1999 = 100) it is easy to read off the relative percentage changes in employment, which declined for both women and men across manufacturing industries. The total gure is the weighted average of men and women. In 1999 men represented 72% of the workers while women accounted for the other 28%. Taking a weighted average of 72% of the 1999 value for men and 28% of the value for women gives 100 overall (0.72 100 + 0.28 100 = 100). The same weights apply for 2000 and 2001 and changed to 73% and 27% for the nal two years.

Index numbers are commonly used in describing trends in prices and in weighted averages of prices, such as the retail price index, consumer price index, wholesale price index. Assessing changes in prices is important for all economic analyses of any variables measured in money terms over time income, output, wages and so

TA B L E 1 . 2 E M P L O Y M E N T S TAT I S T I C S M A N U FA C T U R I N G INDUSTRIES: INDEX NUMBERS

Year
1999 2000 2001 2002 2003

Total
100 98 93 88 85

Men
100 98 94 89 86

Women
100 97 92 86 82

THE ECONOMIC SYSTEM

11

on. To see why this is so take the example of a car rm that produced 500m worth of output in 1990 and 800m in 2000. These amounts are in nominal or current terms which means they are the actual value of production not adjusted for price changes. Without further investigation you might consider that the economic activity of the rm increased over time since its output expanded by 300m or 60%. However, if you knew that over the same period average output prices increased too then without further information it is impossible to know what proportion of the extra 60% is due to rising prices or to any additional quantity of output. If prices rose by 60% then the rms quantity of output would not have changed at all only its monetary value. It is possible to disentangle the two separate effects of price and quantity if we know the extent of the price rise over time. Assume it is 25% relative to prices in 1990. Essentially what is required is to quote output values in real terms so that the effect of price changes is removed and only quantity or real effects remain, as explained in the text box.

Nominal and real amounts: price and quantity effects

Changes in nominal amounts are made up of price and quantity effects. Economists are concerned with quantity effects. e.g. Nominal change in value of output = change in price change in quantity In the above example the nominal change in the value of output is 300m. Using 1990 as a base year we can compute the following: Nominal output index 1990 = 100 2000 = 160 [1990 = 500 2000 = 800] Price index 1990 = 100 2000 = 125 A corresponding quantity index is found by dividing the nominal output index by the price index, i.e. (160/125) 100. Quantity index 1990 = 100 2000 = 128 [1990 = 500 2000 = 640]

To double-check this is correct, the product of the volume and price indices should equal the total change in the nominal index (128 125)/100 = 160.

The real value of output in 2000 expressed in 1990 prices was 640m, representing a 28% increase in the quantity or volume of output.

12

THE ECONOMIC SYSTEM

28 000 26 000 24 000 22 000 20 000 18 000 16 000 14 000 12 000 10 000 0 1 2 3 4 Household size in persons 5 6

FIGURE 1.2 ELECTRICITY CONSUMPTION AND HOUSEHOLD SIZE

Source: Statistics Norway, 2004

Diagrams provide some indication of whether relationships exist between variables. For example, using data on average household size and electricity consumption indicates if and how both are related. Sample data are shown in Figure 1.2 and were taken from Statistics Norway. Such data are known as cross-section data as they provide information on different variables for one point in time (Figure 1.1 also shows cross-section data). If data on electricity consumption were available over a number of time periods they would be called time-series data. For different household sizes (number of persons in the household) we see that smaller households had lower electricity consumption (measured in kilowatts per hour). Linear relationships apply between many economic variables. In practice relationships are approximately linear as shown by the trend line added to the data points in Figure 1.2. The trend line approximately describes the relationship since only one data point actually sits on the line (a standard spreadsheet package was used to construct the line). For any linear relationship if the causal variable (X) changes it always brings about the same or constant effect on the variable it affects. Usually in mathematics, the causal or independent variable is put on the horizontal or X-axis while the dependent variable is on the Y-axis. To draw a line we need: 1. The value of the dependent variable irrespective of the value of the causal or independent variable. This is called the intercept of the line.

Electricty consumption kWh

THE ECONOMIC SYSTEM

13

2. A measure of how one variable reacts to changes in the causal variable. This is called the slope of the line. A standard general expression for a line is presented and explained in the text box. General expression for a line: Y = c + mX where

Y denotes one variable, e.g. electricity consumption; c denotes the intercept, i.e. the value of Y irrespective of the value of X; m denotes the extent to which Y changes as X changes, i.e. how electricity consumption varies with household size; X denotes the variable causing changes to Y, e.g. household size.

The specic line described in Figure 1.1 is Y = 10759 + 3220.5X Electricity consumption is 10 759 kWh irrespective of household size and increases by 3220.5 with each additional one-person increase in household size. From this relationship it is possible to predict what electricity consumption would be if household size were seven (ceteris paribus !). Y = 10759 + 3220.5 7 = 10759 + 22543.5 = 33302.5

Figure 1.2 is an example of a positive relationship because both variables move in the same direction and it is reected in an upward sloping line. For negative relationships Y would fall if X rises, and rise if X falls, for example the relationship between the quantity of hours of sunshine per day and the quantity of umbrellas purchased. Not all economic relationships are linear. For example, the price you pay for apples might be lower if buying in bulk from a grower. The more bought, the lower the unit price the grower quotes why might a grower behave in this way? The reaction of quantity bought to changes in price may not be in constant proportion so that for each extra 10% decline in the price the quantity purchased increases at an increasing rate as shown in Figure 1.3. Here, the 10% drop in price from 30p to 27p increases purchases by 10 apples while the 10% drop from 15.94p (to 14.35p) increases purchases by an extra 40 apples. Why might a buyer behave in this way? Although mathematicians usually place the causal (independent) variable on the horizontal axis, economists by convention place quantity purchased on this axis. This goes back to Alfred Marshalls treatment of price as the dependent variable

14

THE ECONOMIC SYSTEM

Price

30.00

27.00 20

24.30 35

21.87 55

19.68 85

17.71 120

15.94 160

14.35 210

12.91 275

Quantity 10

30 28 26 24 22 20 18 16 14 12 10 0 50 100 150 200 Quantity purchased 250 300

FIGURE 1.3

Price

QUANTITY PURCHASED AND PRICE

and although most economists agree that price is the independent variable, and quantity purchased depends on price, they follow this convention. Alfred Marshall (18421924) was Professor of Political Economy at the University of Cambridge from 1885 to 1908. He founded the Cambridge School of Economics and taught renowned economists including Pigou and Keynes. Marshalls great work was Principles of Economics (1890), published in eight editions in his lifetime and considered the Bible of British economics, introducing and explaining concepts still conventionally used. A trend line has been added to Figure 1.3 to indicate how it would approximate the nonlinear relationship. The curved (nonlinear) trend is also included to show how it better describes the general pattern of the data. Further nonlinear relationships are observed between economic variables and will be met and considered later on in the text.

1.5

MICROECONOMICS AND MACROECONOMICS

A distinction is made in most economics textbooks between the areas of microeconomics and macroeconomics.

THE ECONOMIC SYSTEM

15

Microeconomics: study of the causes and effects of the behaviour of individual economic units within the economic system (or groups with broadly similar interests and goals) such as consumers, producers, trades unions, rms and their impact on the markets in which they interact e.g. the car, apple or labour markets. Consumer theory assumes consumers wish to maximize their benet or utility. The theory of the rm assumes producers wish to maximize prots. Many microeconomic decisions are based on prices, such as consumers buying more apples if price falls, more people trying to work in the IT sector if wages (the price of labour) rises and so on. Hence microeconomics is also referred to as price theory. In considering economic units economists attempt to model and understand how the unit or related group of people behaves. Economic units are assumed to behave rationally, in the sense that they try to achieve the greatest amount of benet, or utility, from their actions. With the assumption of rational behaviour the consideration of constraints on choices can be modelled in an attempt to estimate an optimal or most efcient outcome. For example, in attempting to increase utility by buying something I value, I am constrained by my income. I will try to maximize the utility I get from consumption, given my limited income. Many microeconomic issues are dealt with according to this optimal solution method using the supply and demand model. Once an analysis of individuals and units can be undertaken, it is possible to consider how all economic choices t together and we can move to an analysis of economic aggregates such as aggregate production not just of apples but of all goods and services. It is not always possible or feasible to consider the impact of an economic event across each of the individual units or markets that it may affect. Macroeconomic analysis is useful instead. Macroeconomics is the study of:

The relationships between aggregate or combined elements in the economic system such as national production and employment, for example. Causes of changes in aggregate economic performance including economic structure and economic institutions.

A model of the macroeconomy based on consumer, producer and government action is presented in Chapter 5. National exchange rates reect the price of one countrys currency in terms of other currencies, and ination rates indicate how average national prices

16

THE ECONOMIC SYSTEM

change over time and these are also examined as macroeconomic issues that affect economies. Furthermore, from a governments perspective macroeconomic policies constitute a key element in their attempts to maximize the performance of their economies to achieve policy goals such as high employment and rising incomes and living standards for their citizens. Hence, macroeconomics also focuses on the impact of government policies on output, employment, ination or exchange rates. Although there has been a traditional division of economics into micro- and macroeconomics, an understanding of economics requires the appreciation that they are not independent of each other. Individuals decisions feed into demand and supply in different markets. Aggregate or overall economic activity is clearly dependent on what happens in different markets, which is based on the choices and behaviour of individuals, rms and economic units regarding what buyers wish to buy and what producers wish to sell, for example. A key focus of this text is on highlighting the relationships between microeconomic and macroeconomic analysis in a way that contributes to a better understanding of their intrinsic relationships and to a better appreciation of how the economic system works. Hence, elements of both microeconomics and macroeconomics that provide useful frameworks for considering related issues are provided throughout the book.

1.5.1

THE ENVIRONMENT FOR ECONOMIC DECISIONS

Rules and laws also impinge on economic choices as rational people react to incentives with which they are faced. For example, interactions between consumers and rms are not independent of such rules because of the regulatory environment that exists, i.e. the rules and regulations, including laws, set down by governments in both national and international contexts which describe how citizens and businesses should operate.

Trade agreements are established by the international organization called the World Trade Organization (WTO) (see www.wto.org). Following prolonged discussions between government ofcials, the agreements are signed by governments. Firms in signatory countries must abide by the set rules and regulations or face penalties.

THE ECONOMIC SYSTEM

17

Various governments have appointed regulators of competition in attempts to promote greater competition in economies by tackling anti-competitive practices, and so contributing to an improvement in economic welfare. (Alternative market structures and their implications for competition, among other issues, are examined in Chapter 6.) Such practices might include rms:

agreeing to x prices not allowing prices to be determined freely in the economic system by demand and supply; limiting output to create articial scarcity and keep prices high; dividing business between them or abusing their market position with no benets to consumers.

Recently the issue of corporate governance has made the headlines because a number of big companies (e.g. Enron, WorldCom, Parmalat) have revealed poor and/or illegal methods of administration or accounting that resulted in a reduction of condence in their nancial reporting procedures, hence their reported earnings and most importantly their future performance. This impacts on peoples willingness to invest in companies and may weaken their condence in the ability of the economic system to operate efciently or fairly. Condence and expectations can play an extremely important role in economic success many surveys and barometers of consumer condence are reported and are considered to be key leading indicators of future economic performance. For one example, check out http://www.conference-board.org/economics/consumercondence/index.cfm. Why is consumer condence so important? If consumers are not condent about the future, if they are fearful for their jobs they may prefer not to make purchases of goods and services in the immediate future, opting to save their money rather than spending it on consumer goods. Consumer condence: the degree of optimism that consumers express (in surveys, for example) about the state of their economy through their saving and spending patterns. A worker who thinks their job may be cut will probably put off upgrading their car until such time as they feel more secure about their prospects. If consumers are not in the mood to buy, rms cannot sell as much of their output as they expected and so production might fall, leading to lay-offs and in worst-case scenarios slow economic growth (or even negative growth) for a period of time. Appreciating the role played by each of the different components of the economic system and how interactions between the components all impact on the outcomes

18

THE ECONOMIC SYSTEM

within the system itself is a key goal that guides this book. A good student manages to understand the workings of the components within the economic system. An excellent student manages to appreciate the broader picture of the system with all its complexity of networks, interrelationships and organization. This requires an ability to understand economic models and their role in supporting analysis of economic issues plus an appreciation of their usefulness when we attempt to understand economic phenomena at a particular point in time, within their specic, and often complicated, context.

1.6

RESOURCE SCARCITY AND PRICES IN THE ECONOMIC SYSTEM

A key issue that motivates the study of economics is how to resolve the discrepancy between scarce resources and the numerous potential uses for them (and how this is actually ordered and organized via the economic system). Resources are clearly scarce in the sense that we, the worlds citizens, cannot full all our economic desires, given our share of available resources. This arises to an extent because of difcult-to-defend policies on the distribution of income in some economies (which is discussed in Chapter 9). It arises also since some resources are nite such as oil, gas, etc. although new inventions and innovations allow new products to be developed constantly thus pushing out the boundaries we see for many resources (as Julian Simon explains in his article at http://www.cato.org/dailys/3-04-97.html). We make choices based on preferences regarding how and when we use our available resources to satisfy not simply our needs but our desires, and more generally throughout the economic system, choices are made based on subjective desires of individuals, companies and governments. Choice inevitably involves precluding alternatives. Using resources in a particular way means those resources are unavailable for simultaneous use in another way since an opportunity cost is incurred. If I use all income on food I cannot buy clothes, or if I establish a manufacturing plant for tables it is not suitable for making chemicals. Opportunity cost: This is the cost of what is given up in following one course of action such that other choices are no longer possible. It is subjective and can be estimated in terms of the cost of the next-best preferred alternative but only when the choice made cannot be reversed. It is via the economic system that decisions about how resources are used are made by the many buyers and sellers in markets. While we can view the economy as a system,

THE ECONOMIC SYSTEM

19

the economic decisions made within that system are based on human behaviour and preferences. At the heart of economic decision-making is the necessity to select between alternatives. In making a choice, decision-makers should be aware of the costs of their actions in terms of what they cannot do once they make one particular choice, i.e. the opportunity cost of their decision to ensure the best most efcient use of scarce resources. Consumers decide what to buy with their available income, and how much should be saved rather than spent, based on available information. For example, consumers decisions about what to buy depend on the prices and availability of various products, their personal tastes, needs and available income (in no specic order). Employment choices depend on the jobs that are available, on individuals qualications and abilities and the wage rate. Firms also make economic decisions as they attempt to produce and sell their products or services (at prices that consumers are willing to pay) basing their decisions on perceptions of what is happening in their market, which is affected by consumers demands, the available production technologies, the rms know-how, and how competing rms behave. A rms choices are, therefore, bound up in the network of decisions that result in what potential buyers want and what other rms are doing to compete. Decision-making by individuals and rms is facilitated by the prices they observe in most markets. This means that prices play a central role by signalling information to consumers regarding how best they should use their available resources (including monetary, entrepreneurial, land and labour resources). Prices also act as a signal to producers of the price they can expect to earn for their products which will lead them to make particular decisions about what inputs to use (employees, machines, computers, etc.) how much they can afford to pay for inputs and so on. Hence, the price mechanism provides a means for coordinating the goals and choices of the various decision-makers in a market-based economic system. Interestingly, from an objective point of view, not all economic outcomes might be considered to enhance the overall well-being of society. Take for instance the fashions that lead to rising expenditure on mobile phones and their accessories that might, arguably, be better spent on improving education or health. Instead of allowing the market system to organize the use of resources and what is produced based on the price mechanism and individuals and companies responses to prices, it would be possible to consider handing over total control for such choices to an ultimate decision-maker who knows best. But this would not necessarily lead to a better overall outcome. Economists

20

THE ECONOMIC SYSTEM

consider that it is through the dispersed decision-making by individuals and organizations in the economic system that the best use of dispersed economic knowledge regarding demands, supplies and markets is facilitated which allows prices to act as signals to all participants in the system. This highlights one issue at the heart of economic debate the costs and benets of centralized versus dispersed decision-making.

Economists argue that centralized decision-making about how resources should be used and what products should be produced leads to inefcient resource use where surpluses of some goods and shortages of others would be created (as in many former centrally planned economies). Furthermore, such systems take away individuals freedom of choice. In fact, the dependence of a substantial proportion of our market-based economic system on the price mechanism actually means that individuals choices are affected by the choices and decisions of other members of the system. This happens because the sum total of all individual choices (by producers on the supply side of the economy and buyers on the demand side) feed into the economic system to generate the market prices we observe (analysed in detail in Chapter 2). Hence, subsequent decisions by buyers and sellers are disciplined and organized by the price mechanism. This is what Adam Smith alluded to in his discussion of the invisible hand that guides the economy a guiding mechanism that is no one individuals responsibility, desire or goal, but is the outcome of myriad decisions taken by buyers and sellers. In the decisions made by governments, opportunity costs also apply to choices taken regarding how to use resources, e.g. how to divide up spending between building hospitals or schools or to build roads; choice between competing alternatives must be made. Clearly, however, political decisions relate not only to how best to use available resources but also to preferences made by governments and ministers with the knowledge that decisions may impact on their future election prospects. Thus, political economy concerns introduce additional complexity into the economic system.

1.6.1

USING RESOURCES AND CENTRALIZED DECISION-MAKING

In the case of centrally planned (or command) economies, it is possible to examine how resources were centrally controlled and allocated, guided by a visible hand of the central planner that focused mostly on the supply side of the economy and the organization of production.

THE ECONOMIC SYSTEM

21

The prevailing economic system in such economies was not based on markets driven by prices to guide decision-making. The price mechanism was not inuenced by consumers competing demands for various goods as prices were set by central government. Neither were prices used as signals to where protable opportunities lay for entrepreneurs and where they should best direct their resources. In most cases private property was not prevalent. Hence, free markets did not underpin how the economy was organized. A further implication of command economies is in terms of innovation incentives. Innovation plays an important role in improving the processes used and the types and quality of goods produced within rms and industries that feed into improving national labour productivity and living standards. Labour productivity: the average output of a citizen. It is generally measured as the value of a countrys production per worker, e.g. UK national output divided by the employed workforce of the UK for a particular period of time. Yet in economies where goods are provided based on central planning, and resources are largely centrally owned, individuals do not enjoy rights to own private property and hence lack the incentives of their counterparts in market economies to be as innovative or enterprising. The self-interested (not selsh!) desire to improve individual well-being that translates into broader benets for the larger community (via creating employment or better technology) is more difcult to operationalize in a society where property and resources are owned centrally because individuals see fewer of the direct benets. It is true, however, that the worlds economic system does not rely solely on the market system and price mechanism to provide all goods and services. A considerable portion of economic activity involves public provision of some goods and services where government ministers (and civil servants) are responsible for allocating resources to meet targets for street lighting, ood controls or defence, which are known as public goods. A public good is not provided by a private citizen or private company but by the government. Public goods: goods that would not be provided in a free-market system. They are goods that

if consumed by one person can still be consumed by others; non-rival in consumption. Private goods once consumed are not available to others. if provided, cannot be excluded from the consumption of anyone who desires the good, even if they do not wish to pay for it. Public goods are non-excludable in consumption.

22

THE ECONOMIC SYSTEM

The benets of a public good are available to all citizens who consume it and those benets cannot be withheld from any individual in the economy. Governments supply public goods because of the free-rider problem. The free-rider problem exists due to the non-rival and non-excludable nature of public goods. There is no incentive to supply or pay privately for goods with public-good characteristics. Such goods, if desired, are provided by governments and paid for collectively through taxes. The free-rider problem is one example of market failure, a reason why the market requires government intervention to change what would otherwise be produced. Some economies, such as the French and Swedish, display greater public provision based on national preferences than other economies such as the US or Japanese. Some goods have some public characteristics such as rail and road networks. Both networks are not fully non-rival since a completely full train does not permit further consumption. Toll costs and ticket prices are methods of excluding some potential consumers so the condition of non-excludability is not necessarily met either. However, it would be difcult to envisage either network being fully privately supplied, and collective preference and choice means they are publicly provided, for the most part. The price mechanism has traditionally played a less important role in governments decisions about how government-controlled resources should be allocated between competing uses. Governments internationally are increasingly examining both the provision of public (and other) goods and services and the processes by which they are provided in order to adopt more efcient provision. Indeed, the issue of the extent to which governments should provide goods is debated in many countries consider the complexity of the UK governments U-turn on owning and running the rail system, where they initially organized and ran the rail transportation system then privatized it only to take over its running once again.

1.7

RESOURCE USE, OPPORTUNITY COSTS AND EFFICIENCY

The concept of opportunity cost is a powerful and useful concept for considering how scarce resources are used in an economy and it can be considered

THE ECONOMIC SYSTEM

23

Films a 8 6 4 2 0 1

d e f

g 6 Food

a b c d e f g

Food 0 1 2 3 4 5 6

Films 8.00 7.80 7.50 7.00 6.00 4.75 0

FIGURE 1.4 PRODUCTION POSSIBILITY FRONTIER: E F F I C I E N C Y, S C A R C I T Y A N D O P P O R T U N I T Y C O S T

using a production possibility frontier (PPF) shown in Figure 1.4. The main productive resources or factors of production in an economy are land, labour, entrepreneurship and capital. Land and labour resources contribute to production and their quantities and qualities vary across economies. Entrepreneurship refers to the organization, management and assumption of risks of a business or enterprise and often implies an element of change or challenge and a new opportunity to exploit in a market. Sometimes entrepreneurship is successful, sometimes not. While it is possible to measure and compare the land and labour resources to some extent across economies, entrepreneurship is more difcult to measure. It may be reected in estimates of the number of new companies established, new products launched, or the development or adoption of new technologies in an economy but is a complex concept which serves to explain some of the reasons why some economies perform better than others. Capital goods are not used for consumption. Capital includes the factories that produce saleable output, apple trees grown to produce apples sold in the apple market, the machinery in factories or the computers in ofces used to produce further products and services (but not those home computers used for leisure rather than productive purposes!). Inventories held by shops and factories are also classied as capital goods and only become consumption goods when households buy the goods for consumption purposes the function served by the goods implies whether they can be classied as capital or consumption. Furthermore, when people engage in education, training or any activity that increases their personal productivity (how much they can produce with the factors of production at their disposal), they increase their human capital that can also contribute to producing further goods and services.

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THE ECONOMIC SYSTEM

Human capital includes all the skills, knowledge and expertise that people accumulate over time that allow them to increase their productive capacity as individuals, members of rms and within society more broadly. The production possibility frontier is a model useful for considering the maximum feasible combinations of goods an economy can produce. The differences between efcient and inefcient production can be considered via the PPF. The PPF is not an attempt to describe the complexity of decisions that feed into national production, instead just two products are considered, but the points illustrated by the model reveal its appropriateness for its purpose. Figure 1.4 presents a PPF showing all possible outputs of food and lms that could be produced by an economy. Production at points lying on the PPF indicate efcient production. Efcient production: all available resources are used to produce a maximum combination of goods/services with no resources unemployed. Resources are used in their most productive way, in Figure 1.4 in either food or lm production. An example of inefcient production would be if 4 lms and 4 food were produced since this point lies inside the PPF and would leave some resources unemployed in the economy. Any points outside (north-east) of the PPF cannot be produced given the economys scarce resources. Of all the possible output combinations that could be produced, the actual output choice will depend not only on production possibilities of the economy (what the economy can supply) but also on the demand that exists for lms and food. If the economys citizens prefer more lms than food output might occur at a point such as b . Where production takes place matters from the citizens perspective because they will be better off if resources are not left unemployed but are fully used to meet their needs and demands. The concept of opportunity cost can also be illustrated using the PPF. Specically, the opportunity costs associated with changing the output combination in the economy can be analysed. At Figure 1.4 point a output of 8 lms and 0 food is a feasible output combination: a unit of food can be thought of as a basket of various food items. At point b 7.8 lms are produced as well as 1 unit of food and at c 7.5 lms and 2 food are produced. The opportunity cost of food in terms of lms can be calculated based on the example. In changing output of the economy from a to b , less lms but more food can be produced as some resources are switched from lms to food

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25

production. Film production drops by 0.2 lm (from 8 to 7.8) while food production increases by 1 (from 0 at point a ). Therefore, the opportunity cost of switching from point a to b is the amount of lms that can no longer be made, hence the opportunity cost of lms in terms of food is 0.2 lms lost for 1 unit of food gained. If production changed from b to c , lm production would decline further from 7.8 to 7.5 lms while food production would increase from 1 to 2 units. Here, the opportunity cost is the decline of 0.3 of a lm for a 1 unit increase in food. The reduction in lm production releases sufcient resources to allow food production to increase by 1 unit. A further decline in lm production by 1 unit would move output from point c to d , allowing an additional unit of food to be produced. Hence, the opportunity cost changes over the range of the PPF: when no food is initially produced (Figure 1.4 point a ) switching some resources best suited to food production out of lm production allows more food to be produced than if the economy was already using a lot of its resources to produce food and wanted to produce more (points b or c or d ). As more food is produced, the amount of lms that must be sacriced to produce each additional unit of food increases. Therefore, the opportunity cost of lms in terms of food increases as more food is produced (moving from a towards d ). The same analysis can be conducted for the opportunity cost of food in terms of lms beginning at point e where only food is produced and moving back to points d , c , b and a . Again, the opportunity cost of food in terms of lms increases as more lms are produced in the economy. Increasing opportunity costs of production that underlie the curved shape of the PPF occur since not all of an economys resources are equally suited to the production of different goods. Rational producers use the resources most suitable to their output, where possible. Another way of thinking about this change in opportunity cost is to consider the marginal cost of producing goods. Marginal cost is the opportunity cost of producing one additional unit of a good. The marginal cost is different depending on how much of a good is already produced. Initially, resources least suited to producing lms would be transferred to produce food, but as more and more food is produced, the resources transferred from lms to food will be less and less productive in producing food. Hence, as

26

THE ECONOMIC SYSTEM

A Opportunity cost of food Films a 8 6 4 2 0 1 2 3 b c d

B Marginal cost of food 4.75

MC (films per food) 5 e 4 f 3 2 1 0.2 0.3 0.5 g 0 1 2 3 4 5 6 Food

1 4

1.25

6 Food

FIGURE 1.5 MARGINAL COST AND OPPORTUNITY COST

additional units of food are produced, the marginal cost of producing each extra unit (measured in terms of lms) increases, because more lms must be sacriced to release sufcient resources to make additional food. Rising marginal cost is shown in Figure 1.5. If all resources are devoted to lm production (a panel A), no food and 8 lms are produced. If 1 unit of food is produced moving from point a to point b the output of lms falls by 0.2. This provides a measure of the opportunity cost of this rst unit of food (shown in panel B). Moving production from b to c involves a further increase in food production of 1 unit and a decline in lm production of 0.3; producing the second unit of food requires a greater reduction in lm production than the rst unit. The marginal cost of each additional unit of food production is computed as 0.5, 1, 1.25 and 4.75 units of lms. Two further economic concepts are illustrated using the PPF. Points on the PPF represent static efciency where each point reects one state of efciency for the economy moving from any point on the frontier to any other point means that the economy uses its resources at their maximum efciency albeit to produce a different combination of goods. Over a short time period it is possible that an economy faces limits to its productive capacity because resources do not usually increase signicantly over short periods (unless theres an oil strike or gas is found, for example). However, over longer time periods it is possible that an economys productive capacity increases. Dynamic efciency (economic growth): the outward expansion of the PPF. Economic growth or dynamic efciency would be possible with:

Increased quantity of labour : if more people were available for work and could nd employment so more output could be produced.

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27

Improved quality of labour : if peoples skills and education improved sufciently for them to be more productive i.e. get more out of the resources they use. Improved technology: due to domestic or imported innovations technical progress occurs where more output could be produced from available resources. Ease of start-ups : if new businesses can easily be set up by entrepreneurs new products can be introduced to markets (or old products provided in new ways). Increased capital resources : if rms investment in new capital grows, workers have more capital to work with and could produce more output.

Importantly, however, growth would only occur if demand for the additional output also existed so rms could sell their extra production (the issue of economic growth is addressed explicitly in Chapter 9). Substantial challenges exist for economies regarding how to move closer to static efciency and encourage dynamic efciency. Economies do not necessarily produce to the maximum of their productive capacity some labour may be unemployed, machines and factories may be idle, entrepreneurs may not wish to engage in risky ventures so actual output might lie inside an economys potential production possibilities. The trick is to strike the right balance to maximize potential possibilities and actual output, while also taking account of environmental and any other social costs. It is worth noting that the PPF is not an attempt to describe reality but a model to help think about issues of interest to economists. Economists consider that most economic activity should be left to a market-based economic system for an economy to achieve an efcient state rather than via central planning. However, economists differ regarding the role they consider governments should play in the economic system and the quantity of public goods that should be provided.

1.8

ALLIANCE OF ECONOMIC PERSPECTIVES

There is a tradition in economics that emphasizes the need for government or government agencies to oversee the activities of the business community in order to protect consumers from being deceived or exploited by rms to protect what is referred to as the public interest. Using economic theories and concepts to make such arguments could be called a public policy perspective and holders of this view often consider that governments should enact policies that police the business sector and regulate the economy to ensure consumers are shielded from

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THE ECONOMIC SYSTEM

any negative or undesirable effects of business activities. Government regulation might take the form of competition policy and it may try to ensure that the rights of consumers are protected. This perspective acknowledges the role that governments can play in economic life. The actions of government can inuence an economy in many ways, not only through the regulation function, and have an impact on the general performance of the economy and its competitiveness over time. Competitiveness: a range of factors from measures of income and prosperity to economic creativity and innovative ability that describe the performance of one economy relative to others. The purpose of examining economic competitiveness is to get closer to understanding the process by which countries and economies (local or regional) can enjoy rising living standards. Policies relating to taxation, government spending, labour, education, business creation, technology, environmental protection and many other areas have direct and indirect effects on the ability of an economy to generate income to support its citizens over time and allow them to enjoy rising living standards. Viewing the business sector with mistrust or suspicion, however, ignores the critical role played by companies in generating wealth and employment and in leading and facilitating economic development. Businesses clearly play an active and contributory role in competition and the market process in economies; hence, the need to understand the economic system from a business perspective also. Applying economic theories and concepts to the business environment increases understanding of the role played by business rms in improving competitiveness and generating rising living standards in economies on a sustainable basis. In fact, an appreciation of both perspectives by economists is essential in order to understand the complex interplay that goes on between businesses and government sectors and how they both affect the outcomes in any economy. For example, economic efciency as presented in the production possibility frontier model clearly depends on what decisions are made by rms (e.g. what to produce) and the environment in which rms operate which, in turn, is affected by the policies followed by government. Participants in an economy need to be aware that both business and government sectors have a contributory role to play in developing the factors that allow economies to achieve their potential and raise the living standards for their

THE ECONOMIC SYSTEM

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citizens. This means that all participants need to work towards developing processes within the economic system so that citizens/clients receive high standards of goods and services from private businesses, public organizations and bodies and public representatives. This could mean that ethics and standards should be set and followed by both policy-makers and business people and that the actions of individuals, organizations and public representatives are transparent and open to scrutiny and that accountability for actions is enshrined. This would mean that citizens could have trust in their economic and political systems. These are admirable goals but they are certainly not always met in practice.

1.9

P O S I T I V E / N O R M AT I V E E C O N O M I C S

Economic analysis based on objective facts is called positive economics. Various reasons behind strong growth in the Irish economy have been proposed including a young well-educated English-speaking workforce, sound management of the government nances, moderate wage increases, and attracting investment by multinational companies. Although it is difcult to distinguish which factor is most important, economists generally agree that each of these reasons provides part of the explanation, offering analysis based on positive economics that attempts to get at how the economic system works. When economists make judgements about what should occur making statements such as education spending should increase, government spending should be reduced they move from objective analysis of facts to a more subjective analysis based on personal beliefs, values, norms or political persuasion. Such analysis is known as normative economics. The distinction between positive and normative economics matters because economists often differ regarding opinions on what should be done because of their personal opinions, which are based on factors including their education, background, culture, etc. Decision-makers in companies, government organizations and elsewhere, who rely on economists for advice, need to know the basis and reasoning underlying the advocation of a particular opinion or policy and sound objective analysis is a more reliable basis for selecting a policy than one based solely on personal beliefs.

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This does not mean that normative issues are ignored by the economics discipline. Such topics are studied in welfare economics. The focus of this stream of study is on assessing:

how efciently resources are used; the fairness of how the economic system functions from the perspective of various stakeholders.

Efciency can be examined adopting a positive economics approach based on objective analysis. The fairness issue, however, is rather more problematic and one on which people hold alternative normative positions.

1.10

SUMMARY

The economic system is a web of interactions between individuals, economic units and institutions that determine how resources are best used to satisfy competing demands. Choices about how resources are used, which goods are produced and in what quantities, are made via the economic system. Choices are made dependent on what is demanded and the factors of production and technology available, supported by the operation of markets where prices provide information on how best resources may be used. Political considerations also feed into the economic decisions as laws and regulations govern the activities and behaviour of the stakeholders within economies.

Studying economics is useful for understanding and improving how the best economic choices possible are made based on individual and/or organizational preferences and the available usually limited resources. An economics approach follows a logical method of analysis based on assessing, and sometimes estimating, causal relationships. The participants and features of the economic system are further discussed in the chapters that follow. Both macroeconomic and microeconomic concepts, principles and models are used to explain how the features interrelate within the economic system.

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CHAPTER 1
50 000 45 000 40 000 35 000 30 000 25 000 20 000 15 000 10 000 5000 0

APPENDIX

X SA R N G K E RL US PN D IN EL T E ER A R A ZL SP SR RT N C ZE K N ST L V AF U R R N D LU U NO CA HK DN CH I A J NL F B AU SW G FR GB IT N E I P SV GR C SV HU E PO HR Z LT TU BG CH IN

FIGURE A.1

L I V I N G S TA N D A R D S , $ , 2 0 0 2

Source: Excerpted from the Penn World Table 6.1 (Heston et al., 2002). Note: The Penn World Table is a great source of comparable data on 168 countries going back to 1950 in many cases. To see the range of information presented in the tables visit http://pwt.econ.upenn.edu/

REVIEW PROBLEMS AND QUESTIONS

1. How would you dene the economic system? Describe the role played by each of the following in the economic system: individuals, rms, countries. 2. What role is played by theory in economics? Does this mean we already as good as know the answer to a question before we begin analysis? 3. What differentiates microeconomics from macroeconomics? 4. What are the main differences between market-based and centrally planned economies? Refer to the principle of exchange, the existence of markets and the role of prices in your answer. 5. What is the relationship between resource scarcity and prices in economics? Refer to the signalling function of prices in your answer. 6. Draw a production possibility frontier for two goods, housing and entertainment. The maximum amount of entertainment and shelter that could be produced is 100 and 80 units respectively. a. Based on your drawing, what is the opportunity cost of producing 20 units of entertainment? 40 units? 80 units?

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b. Why does the opportunity cost change for different outputs of entertainment and shelter? 7. Which individuals in the economic system are most likely to have a public policy approach to economics? Which individuals in the economic system are most likely to have a business economics approach to economics? Why? Is it of any importance which perspective people hold? 8. Leaf through some good newspapers. Provide three examples of normative economic statements and three examples of positive statements they contain.

FURTHER READING AND RESEARCH

To put some context behind the data provided in Figures 1.1 and A.1 the OECDs Economic Survey publications provide comprehensive economic assessments of nations and recommendations for their future development. These contain information on some topics that will be new to you as you start out in economics, but by the end of the course should become substantially more comprehensible. The OECD also provides a range of specic articles from its research departments as well as free access to much of its data. For daily economics-related features and articles, the Financial Times provides timely national and international information and can be used to answer some of the review questions in this chapter. The weekly Economist magazine also presents accessible descriptions and analyses of current and topical national and international issues. Search through past editions and see how long it takes you to nd 10 articles that touch on issues discussed in this chapter! For those with an interest in nding out more about the European Union and its economy, see El-Agraa, 2001.

REFERENCES
Djankov, S., R. La Porta, F. Lopez de Silanes and Shleifer, A. (2001) The Regulation of Entry, CEPR Discussion Paper No. 2593. El-Agraa, A. (ed.) (2001) The European Union, Economics and Policies . 6th edn, Pearson. Heston, A., R. Summers and B. Aten (2002) Penn World Table Version 6.1. Centre for International Comparisons at the University of Pennsylvania (CICUP), October. OECD, Economic Outlook (2002) Annex Table 24, December (www.oecd.org).

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Smith, A. (1970) An Inquiry into the Nature and Causes of the Wealth of Nations. Penguin, Harmondsworth [original publication 1776]. Statistics Norway (2004) Energy statistics: energy consumption per household, Table 1: Average energy consumption by house type, household size and net income, kWh supply of energy per household, 2001.

CHAPTER 2

M A R K E T A N A LY S I S : D E M A N D A N D S U P P LY
LEARNING OUTCOMES
By the end of this chapter you should be able to: Outline the sources of benets from exchange that create incentives for economic transactions. Explain the most important factors inuencing demand and supply in the demand and supply model. Use the model to: Illustrate how price and quantity bought/sold are determined in any market by the interaction of demand and supply. Consider the impact of changes in the inuences on demand and supply on price and quantity bought/sold. Review the role of equilibrium in economic models and theories and comment on alternative perspectives on equilibrium. Clarify the importance of information for the efcient use of resources. Apply the supply and demand model to the labour market: Explain the underlying features of the demand for labour and the supply of labour. Use the model to show how wages and the number of workers are determined in the labour market.

2.1

INTRODUCTION

Knowing how markets function is fundamental to understanding the interactions between the various elements in the economic system. Through our desires not to be self-sufcient, we reveal how we need a system that can facilitate organized transactions. The market mechanism of buyers and sellers coming together allows the coordination of economic activities, although no one person or group have control over the free-market outcome; it is the result of all of the decisions made by individual buyers and sellers. Through this mechanism prices emerge and goods are

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bought and sold. Understanding how this process proceeds is crucial for economic analysis. In this chapter the market model of demand and supply is presented in sections 2.3 and 2.4 after the logical reasons as to why buyers and sellers exchange have been discussed in section 2.2. Attempts to organize prices in markets rather than allowing them to emerge from markets have interesting implications that are examined in section 2.5. The roles of information and knowledge in the economic system are also considered in this chapter in section 2.6. When we are involved in economic transactions to buy or sell goods we are engaged, to some extent, in the buying or selling of knowledge that we value but do not possess. We buy a computer because most of us do not have the required knowledge to make it ourselves. The logic applied in Chapter 1 to argue that resources should be used most efciently also applies to how information resources are used. Factors that increase the probability of using knowledge most efciently are considered. In section 2.7 the purpose and role of equilibrium in the demand and supply model is examined as alternative views exist, both of which provide arguments as to why the model helps in understanding the operation of economies. Finally, in section 2.8, the main features of the labour market are presented as one example of how the demand and supply framework can be used to consider the behaviour of sellers and buyers in this complex market. This example indicates the appropriateness of the demand and supply framework for understanding the complexity of how markets work.

2.2

E X C H A N G E A C E N T R A L F E AT U R E OF MARKETS

Markets are an intrinsic feature of economies, especially developed industrialized economies, and represent an important mechanism for coordinating economic activity. Facilitated by markets, buyers communicate explicitly or implicitly with sellers, and decisions about what transactions to make and when to make them are made. A key principle underlying the existence of markets is that people wish to engage in exchange, each party placing a lower value on what they give up in the exchange compared to what they receive from it. When I buy a can of beans I place greater value on the product than on holding onto the money it costs; the expected benet derived from the product is balanced against its cost. The concept of value is widely debated. Although value is entirely subjective the amount consumers are willing to pay for products provides some information

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regarding the value placed on purchases. The expected benet derived from a purchase is the incentive to buy in the rst place and it can be estimated using the principle of opportunity cost, i.e. what is the value of the next best alternative the consumer gives up in order to make their purchase? Consumers cannot be asked this question by economists for each and every purchase they make but the amount of goods or services they are willing to forego in order to make a purchase is reected in the money they are willing to give up in the transaction. (This is still problematic though because if I pay 55p for a tin of beans, this reects the market value of the product and I might have been willing to pay more than this based on my perception of my expected benet.) The benets or gains from exchange are related to differences in preferences and in the values sellers and buyers place on goods and services. Each consumers individual preferences feed into their purchasing decisions, their willingness to pay and ultimately their demand for goods and services. The economic concept of demand refers not just to a desire to make purchases, but to those desires that are supported by an ability to pay I would love to buy a Ferrari Enzo but I do not feature in the economic demand for it because I could not effectively purchase the product at its retail price (around 430 000 and 349 models only were manufactured!). Gains from exchange may also arise due to differences in productivity. An example can be used to illustrate this point. Consider the production possibilities of two regions North and South which produce both food and clothing and which have different quantities of available resources. If all Norths resources were devoted to food production then each worker could produce 2 baskets per day and if resources were devoted solely to clothing, 10 outts could be produced on average. The corresponding productivity gures for South are 10 baskets of food and 2 outts, shown Table 2.1. These gures for output indicate the opportunity cost (see Chapter 1) of producing one good in terms of another for each region. (For simplicity this example deals with two regions only but additional regions or countries could be added to the analysis and would not change the main conclusions made.) Table 2.1 indicates that for clothing Northerners are ve times as productive as Southerners (10 compared to 2) while Southerners are ve times as productive as Northerners in food. If each region specialized and exchanged any surplus production to buy the good in which they are less productive, both regions could be better off than if they tried to be self-sufcient in both goods. When a product is produced more efciently (using less resources) in one country, that country has an absolute advantage in that product. It is measured

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TA B L E 2 . 1 D A I LY P R O D U C T I V I T Y O F FOOD AND CLOTHING IN NORTH AND SOUTH

Food (baskets) North South
2 10

Clothing (outts)
10 2

by comparing relative output across countries, e.g. in Table 2.1 South is more productive in food than North. Economies that are self-sufcient and which produce efciently can be considered to produce and consume an output combination on their production possibility frontier, but by engaging in trade with another economy, it may be possible to consume more than what is produced in the economy itself. Imagine that North spends half a day producing clothing and the other half producing food so its total output is 1 basket of food and 5 outts. South could produce 5 baskets of food in half a day and 1 outt in the other half-day. Their combined output would be 6 baskets of food and 6 outts. This combined output is less than what could be produced across the 2 regions with specialization by each region in the good of its absolute advantage. With specialization, combined output increases as North can produce 10 outts and South 10 baskets of food. Assuming demand for both goods exists in both regions, trade would be required to allow both goods to be consumed in each region. International trade makes sense when countries have different opportunity costs of production and specialize in the good in which they have a productivity advantage a lower opportunity cost of production. Trade and specialization make sense even when one region (South) has no absolute advantage as illustrated in Table 2.2. Here North remains more productive in clothing but the regions are equally productive in food. When each region spends half a day producing both goods, total output is 10 baskets of food and 6 outts: 5 baskets of food and 5 outts in the North and 5 baskets of food and 1 outt in the South. With specialization, North could produce 10 outts and South 10 baskets of food so specialization still allows greater combined production than self-sufciency.

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TA B L E 2 . 2 A LT E R N A T I V E D A I LY PRODUCTIVITY IN NORTH AND SOUTH

Food (baskets) North South
10 10

Clothing (outts)
10 2

The opportunity costs of production indicate where each region should specialize. The opportunity foregone in the North if only food is produced is 10 outts per day, i.e. the opportunity cost of each basket is 1 outt. In the South, the opportunity cost of each basket is one fth of an outt (and the opportunity cost of each outt is 5 baskets of food). The opportunity cost of producing each basket of food is lower in South than North one fth of an outt compared to 1 outt. Hence, it makes economic sense for South to specialize in producing food, the good in which its opportunity cost of production is lower. Since Souths opportunity cost of clothing is 5 baskets of food, compared to only 1 basket in the North, North should specialize in producing the good in which it has a lower opportunity cost of production a comparative advantage. When output is produced at a lower opportunity cost in one country, that country has a comparative advantage in production. It is measured by comparing relative opportunity costs between countries, e.g. in Table 2.2, the opportunity cost of food in South is 0.2 outts which is lower than the opportunity cost of food in North (1 outt). If Souths productivity dropped to 6 food baskets instead of 10, an incentive to trade would still exist. The opportunity cost of production would be unchanged in the North but the opportunity cost of producing each basket of food would still be lower in South one third of an outt compared to 1 outt in the North. The incentive to trade is present even when one economy is less productive in all goods once opportunity costs of production differ. Each region benets if it specializes based on its comparative advantage and trade occurs in surplus production. Once the regions can agree on a price for trading the

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goods, trade can occur. If price reects the opportunity cost of production, then trade between North and South makes economic sense. In exchange there are essentially two parties a buyer and a seller. Demand exists that might be met by supply once quantity demanded and quantity supplied coincide at a price which the buyer is willing to pay and which the seller is willing to accept. The next section explains the process through which prices are set.

2.3

DEMAND

The economic concept of demand is quite specic. Demand describes the desire to purchase, supported by an ability to pay together with an intention of making the purchase over a specic time period, e.g. the demand for cars in 2003 describes the quantity of cars that buyers intend to buy and can pay for in that period. Across all possible buyers demand (usually) exists over a range of prices. Demand can relate to a particular group of people, e.g. the demand for cars by eet buyers (company cars), or demand might be related to a specic geographical area as in the demand for sh in the UK, Germany, France, London, etc. Demand is the relationship between the quantity of a good (or service) buyers intend to buy and their willingness and ability to pay. Economists refer to a law of demand according to which at higher prices the quantity demanded of a good is expected to be lower than at lower prices. The price of a product is considered to be a central factor affecting the intention to make a purchase. Figure 2.1 presents demand for cars in Europe, i.e. the relationship between the price of cars and the quantity demanded in Europe. (See www.autoindustry.co.uk where quantities of cars sold across Europe are provided.) Graphs of demand conventionally present quantity on the horizontal axis and price on the vertical axis. This convention is followed despite the fact that quantity is the dependent (Y) variable while price is the causal (X) or independent variable. We saw in Chapter 1, that mathematicians place the independent variable (Y) on the horizontal axis. A negative relationship exists between price and quantity demanded, reected in the downward slope of the demand curve since, at relatively high prices, we expect quantity demanded to be low or, if price is relatively low, we expect quantity demanded be high.

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Price 24 18 12 6 0 7 9 15 a b Demand for cars c d Quantity

Price (000) 6 12 18 24

Quantity (millions/year) 30 15 9 7

30

FIGURE 2.1 THE DEMAND CURVE AND DEMAND SCHEDULE

The table presented in Figure 2.1 is a demand schedule of the quantity of cars demanded by those individuals with plans to buy cars over a range of prices. At a price of 6000, 30 million cars would be demanded. At a higher price of 12 000, the quantity demanded would be lower at 15 million. At higher prices, quantity demanded would decline further to 9 million at a price of 18 000 and to 7 million at 24 000. For a given demand curve and demand schedule, a change in price gives rise to a change in quantity demanded. Two reasons explain the negative relationship between price and quantity demanded. Most goods have potential substitutes goods that might serve a similar purpose from the buyers perspective. For cars, possible substitutes include public transport, bicycles or motorcycles. If the price of cars increases relative to the price of substitutes, it may change peoples behaviour in terms of their intended purchases of cars. As the price of one good increases, people buy less of it preferring its relatively cheaper substitutes. This is known as the substitution effect. If the price of one good changes, this affects buyers purchasing power which is their ability to buy quantities of goods and services. Purchasing power depends on income and prices; given their income, if car prices rise, car buyers purchasing power is adversely affected as their income allows them to buy fewer cars (or put another way, if they buy a car they have less to spend on other goods and services). At the level of individual car buyers, effects of higher car prices will include some

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buyers opting for cheaper brand cars, some opting for smaller cars than they would otherwise choose, some buyers postponing their decisions to buy, and some moving to substitute products. Alternatively if car prices dropped, the purchasing power of car buyers would increase and economists would expect that due to the income effect more cars would be bought. Economists expect that in the face of higher car prices and a xed income, buyers would plan to buy fewer cars. This is known as the income effect.

2.3.1

NON-PRICE DETERMINANTS OF DEMAND

Car buyers intentions are related to the price of cars but price is by no means the only factor that enters into the buyers decisions. Other relevant factors include:

prices of related goods/services; buyers income; preferences;

Population; Expected future prices; consumer condence.

The effect of each of these factors on demand, ceteris paribus, is considered in turn. In practice, any number of these factors might have an inuence on demand at any point in time.

Prices of related goods/services: complements and substitutes

Many products are consumed in conjunction with others as with cars and car insurance, or cars and petrol/diesel. Car insurance and petrol are described as complements to car consumption. Changes in the prices of complement goods like petrol and insurance can have a knock-on impact on the demand for cars. The price of oil has an effect on petrol prices. Oil prices hit a 25-year low of $11 per barrel in February 1999 but rose to a peak of almost $35 per barrel in the rst week of September 2000. In many European countries, soaring fuel prices brought protesters onto the streets and road blockades were common. Similar rises in oil prices in 1973/4 (when oil prices tripled) and 1979/80 (when prices doubled) are known as the oil-price shocks and these unexpected economic events had signicant consequences on most economies dependent on oil imports because resources that would have been spent on buying other goods and services had instead to be spent on oil imports.

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Increases in the price of complement products (petrol/diesel) can alter the demand for a good (cars). The effect may not be immediate as in the case of cars where owners require fuel for their transportation needs and the fuel costs may be small relative to the cost of the purchase itself; however, rising fuel costs might tempt some individuals to alternative modes of transport, where it is available. Cars come under the category of durable consumption goods (bought by households for nonbusiness use with a lifespan of at least three years cars, washing machines, PCs) that are not purchased regularly (by most people) and are therefore considered a lumpy or irregular type of purchase as opposed to other non-durable purchases made on a more regular basis (food, clothing, cigarettes). For both durable and non-durable goods, the usual expected effect of an increase in the price of a complementary good (e.g. petrol) is a decline in demand for the good for which it is a complement (cars). Further effects could include an increase in demand for low-fuel consumption or smaller and lighter vehicles or increased research into vehicles that can run on alternative fuels. Insurance costs are another complement good of cars and large increases in insurance premiums could cause some consumers to change their plans to buy a car, leading to a drop in quantity demanded at each price. Again, it is reasonable to consider that a substantial insurance price increase would be required to change demand behaviour as the decision to spend 12 000, for example, on a car will not be greatly affected by a minor change in the price of a complementary good. As explained above, changes in prices of substitute goods can also affect demand. If public transport becomes cheaper, relative to transport by car, demand for cars could conceivably decline. Congestion charges (5) were introduced for motorists driving in inner-city London from February 2003. Six months after its implementation 50 000 fewer cars were entering the congestion zone daily, a drop of 16%, meeting one objective of reducing congestion (estimated at 30%) and saving time (car journeys were reduced by 14%). If as is anticipated, this makes public transport a relatively more attractive option for some drivers, demand for cars in London will fall. Hence, council or government regulations impact Demand also (this point is further developed later).

Buyers income
Planned expenditure on any goods or services depends on disposable income (aftertax or net income; pre-tax income is known also as gross income). As a general rule

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of thumb, if disposable incomes rise, demands for most goods rise also. This is true for goods called normal goods. For inferior goods, demand falls as income rises. Examples of such goods might be cheap cuts of meat or lowest-priced products. If incomes rise, economists expect that the demand for cars would also rise, especially where the rise was believed to be permanent. Planned purchases might not change signicantly for a temporary or one-off increase in income (a tax rebate) but would be more likely to change following a salary increase. Consumers expectations about their future income also play a role in their buying decisions and although they cannot know with certainty what income will be earned in the future, they make plans based on available information.

Preferences
Consumer demand also depends on tastes and preferences, which are subjective and vary across consumers. Tastes are shaped by factors as diverse as culture, background, education, past experience and advertising. An environmentally conscious consumer with access to public transport has less demand for cars than other consumers.

Population
Generally speaking, in regions with large populations, the demand for all goods and services is greater relative to regions with lower populations. Demand for cars is greater in the USA than in the UK, in cities rather than rural areas and is greater in the UK than in Ireland. The ceteris paribus assumption is relevant here, though differences in living standards are also relevant. For example, in India or China, with low relative living standards, demand for some goods will be lower than in more developed countries, irrespective of population differences.

Expected future prices

Demand for some goods is affected by expectations of future price changes. If car prices are expected to fall in the future, many consumers will postpone car buying until prices fall as the opportunity cost of the car is lower in the future. Buyers choose to purchase at different points in time depending on their expectation of prices.

Consumer confidence
Surveys of consumer condence are conducted based on questions posed to a representative sample of consumers to gauge their opinions about their future buying plans.

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Consumer condence reects consumers opinions on their future purchasing plans. It relates to the psychology underlying decisions about spending or saving and if consumers are pessimistic about the future, they may prefer to save rather than spend, reducing demand for some goods and services. In times of weak consumer condence, purchases of durable goods such as cars usually fall. Often demand for non-durable comfort products like alcohol, books or chocolate increase simultaneously. The cause of weak consumer condence is uncertainty about the future. Fear of future income due to job insecurity could be one cause. Expectations of higher prices could be another and there is some evidence that higher energy prices in 2001 in the USA explained some of the decline in consumer condence. A decline in consumer condence may be explained in terms of a negative wealth effect, according to which some consumers who feel richer as stock markets climb perceive themselves to be poorer when the markets decline, not because their earnings or savings lose value but for psychological rather than wholly rational reasons. Businesses are concerned by consumer condence because around two thirds of economic activity consists of consumer purchases. If consumers are not buying, businesses are not selling, stocks of unsold goods (inventories) build up and it may only be a matter of time before employees are made redundant.

Implications of changes in the influences on demand

When all other factors that could affect demand are unchanging, the effects of a price change alone on the quantity demanded can be considered. Staying with the car example, if the price of cars changes there is a movement from one point on the demand curve to another point along the curve; quantity demanded changes. If price increases from 12 000 to 18 000 quantity demanded moves from point c to b in Figure 2.1, i.e. a decline in quantity demanded from 15 to 9 million cars. If any of the other factors inuencing demand change, however, it causes a movement/shift in the demand curve; demand for the product changes. If customer preferences for sports utility vehicles (SUVs) increase, and they are substitute products for standard cars, the demand for cars is affected as illustrated with a movement of the demand curve shown in Figure 2.2. At each price on the original demand curve (D1 ), the change in preferences causes a decline in quantity demanded resulting in a new demand curve (D2 ) that lies to the left of the original curve. The new demand schedule shows this decline

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Price 24 18 12 6 0 6 a* b* c* d* a b c d D2 12 30 D1 Quantity

Price (000) 6 12 18 24

Original New quantity quantity millions/year millions/year 30 12 15 6 9 3 2 7

FIGURE 2.2 A MOVEMENT OF THE DEMAND CURVE (AND NEW DEMAND SCHEDULE)
in demand for cars at each possible price caused by consumers plans to substitute away from cars towards SUVs. Alternatively, if D2 were the original demand function, a fall in preferences for SUVs would lead to a rise in demand for cars over the entire price range, to D1 for example.

2.4

S U P P LY

Consumers buying plans can only be satised if there are goods and services supplied to them. The economic concept of supply relates to the activities of rms that organize the factors of production to produce output and make it available to buyers. Producers have an incentive to engage in supplying output to markets if they see that a prot can be made, where prot is the difference between the costs of production and the revenue received from buyers. From an accounting perspective the nature of prot is evident from a companys accounts but the economic concept of prot is not equivalent. An economic prot is made if a producer earns enough from supplying their product (or service) to the market to cover all their costs and pay themselves for the cost of the time and effort put into the business. This economic denition of prot takes the opportunity cost of the suppliers efforts in their business into account and from an economic perspective a supplier

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should only stay in business if all the costs of supply including the opportunity cost of the owner of the businesss efforts are covered. Each business person has their own subjective view of how much they need to earn to cover their opportunity costs; it is impossible to say objectively what amount of income must be earned for a business person to remain in business rather than sell up and do something else. Factors apart from a desire to make an economic prot also affect supply. Suppliers must be able to supply output, which implies having the required resources, factors of production and technology to produce. Over a specic time period, suppliers will take all information available to them regarding their available resources, the type and costs of the factors of production needed for production and assess if it is worthwhile to produce. Similarly to their use of the law of demand, economists use the law of supply, which states that at higher prices the quantity supplied of a good is expected to be higher than at lower prices. Figure 2.3 presents the relationship between the price of cars in Europe and the quantity supplied for the year 2000. The logic of the law of supply is that rms are willing to supply greater quantities only if they receive higher prices because of the increasing marginal costs encountered in increasing output (see Figure 1.5). In terms of the supply curve, a rm is only willing to supply more output if it receives a higher price for a higher output since its marginal cost increases with production. This implies that the marginal cost of producing the 1000th car is higher than for the 999th car so suppliers require a higher price to cover their higher marginal costs. The logic of this assumption relates to the need to attract more resources into car production from other uses if suppliers want to increase output. There is an opportunity cost of using resources in car production rather

Price 24 18 12 6 0 7 15 18 20 Quantity Price (000) 6 12 18 24 Quantity (millions/year) 7 15 18 20

FIGURE 2.3

T H E S U P P LY C U R V E A N D S U P P LY S C H E D U L E

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than other alternatives, and hence the increasing marginal cost of production in a specic market is conceptually similar to the argument used earlier that there are increasing opportunity costs of production underlying a production possibility frontier. (When we consider differences in the supply decision in the short run and long run later, we will see that there are additional reasons why short-run supply curves are upward sloping.) Hence, we observe a positive relationship between price and quantity supplied and this is reected in the upward slope of the supply curve. The supply curve indicates the amounts all car rms plan to sell at different prices (not how much they actually sell). The table presented in Figure 2.3 is a supply schedule showing the quantity of cars supplied for a range of prices: at a price of 6000, 7 million cars would be supplied; at a higher price of 12 000, quantity supplied would be 15 million and, at higher prices, quantity supplied increases to 18 million at a price of 18 000 and to 20 million at 24 000. For a change in price, suppliers react by changing the quantity of goods supplied to a market. A supply curve is drawn ceteris paribus, as if factors apart from price affecting supply are unchanging. These other factors include:

prices of the factors of production (and technology); expected future prices; government regulations.

prices of related goods; the number of suppliers;

If any one of these factors changes, it causes a movement/shift of the supply curve.

Prices of the factors of production (and technology)

The price that a rm earns for its output provides the rms revenue. This can be calculated as the price of output times the quantity of output (e.g. if the price of a car was 12 000 and a rm supplied 20 000 cars its revenue would be 240 million). Using its revenues the rm hopes to cover its costs and make at least a normal (economic) prot. Normal (economic) prot: the minimum prot a rm is willing to make rather than go out of business. Any level of prot beyond this is called supernormal prot. In producing its output the rm uses factors of production and if the costs of the factors increase, this reduces the rms prots. Possible sources of increased costs would be higher wages, raw materials prices, rent, or interest rates on loans.

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Costs might also be changed considerably by the introduction of new technology. When economists refer to technology we mean not just machinery, equipment or robots but also the level of knowledge or know-how that exists about production at a specic point in time. The car industrys extensive use of robotics (for the welding of seats onto chassis, for example) represented a signicant investment by the rms in the industry but allowed considerable cost savings once the robots were functional on assembly lines since they could perform a number of tasks (placing and tting of components) more efciently, removing the necessity for thousands of manual workers. Many of the activities performed by robots were those in the harshest of working conditions, which were uncomfortable and even risky for workers and since a robot has an advantage of being able to perform repetitive tasks without feeling the boredom often associated with such activities, the accuracy and speed of output also improved.

Restructuring of organizations also allows for cost savings. The concepts of downsizing and rationalizations (used extensively in the 1990s) refer to the process of laying off considerable numbers of employees by rms that substantially reorganized their production. Quite often this occurred in conjunction with outsourcing which involved rms contracting out work to others that was previously performed by the rms themselves. The logic for such restructuring allows a rm to focus on its most important activities, what it does best, and buy in any other non-essential activities that could be more efciently supplied by other rms. There is a substantial debate on the downsizing that occurred over the 1990s and whether it made sense economically and socially. (Refer to www.geocities.com/WallStreet/Exchange/4280/ for an interesting discussion on the phenomenon.) Costs for rms can also be affected by government policies. If subsidies are provided, rms costs fall, such as happened in the UK in 1999 when the government provided more than 150 million to BMW to maintain production of Rover models at the Longbridge plant in Birmingham. BMW had threatened to move production to Hungary, where a free site was available and production costs were considerably lower. Since BMW was making substantial losses on the cars, the subsidies received served to cut their losses rather than increase prots. A further example of

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the effects of government policy on costs is the EU directive on End of Life Vehicles which attempts to make car makers responsible for dealing with the waste caused by cars that end their useful lives (approximately 12 million in the EU annually). If car manufacturers have to bear such costs (estimated at 50bn) then this will affect car supply.

The effect of higher costs on the supply curve for any product can be considered at any price on the supply curve. A supply curve is drawn for a given set of costs (ceteris paribus strikes again!). If costs change, this causes a movement of the supply curve. For example, any supplier willing to supply at a price of 12 000 incurs higher costs if labour costs rise. Given higher costs and the total cost outlay suppliers are willing to incur to earn revenues of 12 000 per car, suppliers are willing to supply a lower quantity of output at point x in Figure 2.4 than at point x (with lower costs). More generally, depending on their line of business, it is possible that some suppliers might wish to switch production to other products for which costs have not increased. With sufcient advance information of cost changes, suppliers will take any new information into account and may change their supply decisions. In Figure 2.4 there is a reduction of supply from 15 million cars to 8 million cars caused by an increase in production costs. At every price on the original supply curve, once production costs increase, producers cut back their production and this leads to a leftward shift in the supply curve from S1 to S2 . Beginning with S2 a cost reduction would have the opposite effect; some producers are enticed to supply greater quantities resulting in a shift of the supply curve to S1 for example.
Price 24 18 12 6 Quantity 0 8 15 18 20 x* x

S2

S1

Price (000) 6 12 18 24

Quantity (millions/year) 0 8 11 14

F I G U R E 2 . 4 A M O V E M E N T O F T H E S U P P LY C U R V E ( A N D N E W S U P P LY S C H E D U L E )

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Prices of related goods

Supply is inuenced by the prices of related goods, substitutes and complements. In car production, different types of vehicles can be produced from a given factory saloons or sports utility vehicles (SUVs) with minor alterations to the production line, which means they are substitutes in production. The quantity of saloons supplied is affected by the price of SUVs because if the price that can be earned from supplying SUVs increases, suppliers of saloons have the incentive to switch towards producing SUVs (so the supply curve for saloons moves leftwards). Complements in production also exist where at least two goods are produced jointly from the same resources, e.g. beef and leather. If the price of leather increases, leather suppliers have the incentive to supply more, which would lead to the joint additional supply of beef (the supply curve for beef would move rightwards).

Expected future prices

Suppliers who can store their output over time would have the incentive to do so if prices in the future were expected to be higher than the current price they could earn on their supply, hence a lower current supply would be offered on the market than if no change in the future price was expected. The alternative is also true. In the car market when new editions appear, previous models become more difcult to sell in buying a new car, many customers prefer to buy the most up-to-date model rather than earlier editions. If suppliers have stocks of the older models available and know that future models are about to be launched they often offer good deals on the old models to try to sell them before new models reduce the demand for the old. Expectations about the future prices that can be earned on the old models create incentives for suppliers to sell in the present rather than stock up their supply for the future.

The number of suppliers

The supply of cars or any product is the sum total of each car rms supply in that market. The entry of a new rm into the market adds extra supply moving the supply curve rightwards. This effect could be short term if the new rm supplies more attractive cars or better value cars than other rms. Reaction by competing rms may follow. Some rms might be forced out of the market if they can no longer compete with the new rm and the end result might be a replacement of a supplier with no signicant impact on the overall supply.

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Government regulations
The regulation function of governments permeates many different activities in an economy. It can affect supply through various channels, such as through the policy regarding End of Life Vehicles explained above, and various other environmental and safety regulations that limit the activities of suppliers across a range of industries. Various policies apply to the chemicals industry, for example, from food labelling requirements and the classication of dangerous substances to general health safety and environmental regulations. To the extent that new regulations force rms to deal with additional costs (e.g. to pay for anti-pollution systems, to employ people with regulatory expertise) the supply curve may move leftwards. This may not necessarily be all bad news for a rm, though. Some buyers might be attracted to products when they know the suppliers apply stringent standards. Some rms go beyond government regulations to make their products even safer or more environmentally friendly because the additional cost is more than covered by the extra demand generated by the product. Although costly to manufacture, cars that are capable of withstanding a 64 kmph (40 mph) head-on smash and a 48 kmph (30 mph) side-on collision are currently being engineered and developed to deal with European New Car Assessment Programme tests reported regularly on new cars for more on this see www.euroncap.com. Manufacturers realize that safety is an important selling feature for cars and invest substantial funds into safety improvements that increase their performance.

2.5

MARKET INTERACTION: DEMAND A N D S U P P LY

Each market consists of buyers and sellers, demand and supply. Bringing both together allows for analysis of how market prices are arrived at, showing how both sides of the market combine to give rise to the outcome in terms of the price and quantity of goods bought and sold. Using the example of the car market, the market demand and supply curves can be shown together as in Figure 2.5. There is only one price at which the quantity buyers are willing to buy coincides with the quantity sellers are willing to sell. This price is 12 000 and is called the market clearing price because if all good supplied at this price are sold, all buyers

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Price (000) 24 18 12 6 0 7 9 15 19 21 D a b c d Quantity (millions/year) S

30

FIGURE 2.5 MARKET

D E M A N D A N D S U P P LY : T H E C A R

wishing to buy at this price can do so. At this price rms do not build up stocks of unsold cars and no consumer demand is left unsatised. A market does not clear if demand cannot be met (shortage) or if suppliers provide more than is demanded in the market (surplus). This price is also called the equilibrium price. The term equilibrium is used widely in economics and it refers to a situation from which there is no tendency to change unless something to cause a change occurs. An equilibrium quantity corresponds to the equilibrium price. In Figure 2.5 this quantity is 15 million cars, the amount of goods that are bought and sold when the market is in equilibrium. The market for cars will tend towards the market-clearing equilibrium price and quantity. This happens if you consider the forces at work at any other price. If the price were 24 000, demand would be 7 million cars while corresponding supply would be 21 million. Such a high price means few buyers are willing and able to buy cars while quite a number of suppliers are willing to supply at such a high price. At a price of 24 000 the market does not clear because the quantity demanded does not correspond to the quantity supplied: QD < QS Quantity demanded is less than quantity supplied. The discrepancy between these quantities is 14 million cars which suppliers are willing to supply, for which no demand exists; hence, a surplus exists in the market. The expected reaction to this non-equilibrium situation is for rms to try to do something to sell their unsold

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stocks. One rational response might be to cut their price. If price declines to 18 000, quantity demanded increases to 9 million while quantity supplied falls to 21 million. This reduces the surplus or excess production to 12 million cars but does not eliminate it. Reducing the price further will further reduce the surplus. Only if the price falls to 12 000 will the surplus production be eradicated. If rms wish to sell all their output, the price needs to fall to this level, otherwise they are left with unsold stocks of cars. If the price were below the equilibrium level, that too would create problems and represent a disequilibrium situation in the market. Take the case where the price of cars was 6000. The quantity demanded at this price would be 30 million cars (high demand at such a relatively low price) but suppliers are willing to supply only 7 million cars. A shortage would exist in the market; 23 million more cars would be in excess demand compared to the available supply. QD > QS . Customers lucky enough to get their hands on cars at 6000 are surely very satised but a large number of potential customers willing and able to pay this amount just cannot buy cars as supply does not meet demand at this price. The method by which cars are allocated to customers could be extremely problematic rst come rst served might be a possibility but someone who really wanted the product might not be happy to settle for a straightforward queuing system. Attempts at bribery might occur, preferential treatment might be given to some customers, and corruption is a real possibility. Any supplier happy to supply at this price can sell their output but because the price is relatively low, the supply of cars is also low. If this situation existed in a market, suppliers would be aware of the excess demand and might try to react to it. Sellers might decide to increase the price a little which would have the effect of encouraging greater production of cars while reducing the quantity demanded. At any price greater than 6000 but less than 12 000 suppliers will have the incentive to charge a higher price which means that the quantity supplied will rise. As price rises, quantity demanded is reduced but since supply does not match demand, a portion of it is unsatised at prices below 12 000. Hence, in a free market where price and quantity are set by market demand and supply a tendency for the price and quantity to change exists if the market is not in equilibrium. In equilibrium, the market price is the equilibrium price and neither excess demand nor supply is observed as the market clears.

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2.5.1

CHANGES IN EQUILIBRIUM

Market analysis based on demand and supply can be used to consider the effects of changing circumstances on equilibrium. Staying with the car market, city councils in both London and Paris were considering banning SUVs due to their environmental impacts; they are big, relatively more dangerous to pedestrians and other motorists in crashes, and they generally have higher emissions than cars.

Figure 2.6A shows a possible scenario for the international car market, should a ban be imposed. D1 indicates initial demand for cars before the outlawing of SUVs, when P1 was the equilibrium price and Q1 represents equilibrium quantity. D2 shows the increase in demand for cars indicating that changes in regulation affecting the use of goods change demand. With no change to supply, the effect of the rightward shift of the demand curve is a new equilibrium at P2 and Q2. Increased demand leads to both a higher price and quantity in equilibrium. If such bans become commonplace internationally, many SUV producers might switch their production to more standard cars as their equipment and factories could be adapted without too much difculty. Should this lead to substantial new entrants into the market, Figure 2.6B indicates a possible outcome. Supply expands from S1 to S2 giving rise to another new equilibrium position. Focusing on D2 and S2 as the relevant demand and supply curves, P3 and Q3 represent the equilibrium position where price falls relative to P2 and where quantity expands to Q3.
A Price D1 D2 S

B Price D1 D2 S1 S2 P2 P1 P2 P3

Q1 Q2

Quantity

Q2 Q3 Quantity

FIGURE 2.6

POSSIBLE SCENARIOS FOR THE CAR MARKET

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2.6

GOVERNMENT AFFECTING PRICES

Attempts are sometimes made by government to inuence the price in a particular market. Examples are price ceilings and price oors, which are cases when the actual market price is not the same as the equilibrium price.

2.6.1

PRICE CEILING

A price ceiling or price cap is a price that puts an upper limit on the price that suppliers can charge. The purpose of a price ceiling is to allow consumers to buy products at relatively low prices. In January 2002 the Filipino government implemented a price ceiling on utility vehicles in an attempt to reform taxes in that industry. The price ceiling applied to basic models only and meant they were tax exempt.

The general effects of a price ceiling are shown in Figure 2.7 for the case of a price ceiling on cars of 6000. The result is excess demand of 23 million cars (30 7), but prices cannot adjust upwards to clear the market since it is illegal to charge more. Economists generally do not favour price ceilings because of the costs they generate. There is a cost to consumers who wish to buy the product at 6000 but who cannot because of the limited supply. Suppliers have an incentive to maintain supply at a relatively low level because of the low price and so industry
Price (000) 24 18 12 6 0 7 9
excess demand

15

30

Quantity (millions/year)

FIGURE 2.7

PRICE CEILING IN THE CAR MARKET

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output, employment and taxes paid to government may all be lower as a result. Furthermore, potential problems exist regarding how the 7 million cars will be allocated among the people demanding 30 million cars.

2.6.2

PRICE FLOOR

A price oor is a price that suppliers can be sure to receive for their output. A price oor is a minimum price with the purpose of helping the producer/supplier attain a price higher than the equilibrium price. It is common in the agriculture sector, as with Europes Common Agricultural Policy. The general effects of a price oor are shown in Figure 2.8. The price oor is set at 24 000. Suppliers are willing to supply 19 million cars, 4 million more than if the equilibrium price could be earned. The result is excess supply in this market since quantity demanded is 12 million cars less than quantity supplied of 19 million. The surplus output may be taken up by a government agency or perhaps exported. Prices cannot adjust freely downwards to clear the market and bring demand and supply to equilibrium.

2.6.3

PROBLEMS OF PRICE CEILINGS AND FLOORS

Economists generally do not support the use of price ceilings and oors as they interfere with the free working of the market system and mean that markets do not clear. Problems are created which are worse than those the policies are aimed at solving. Instead of allowing the accumulated choices taken by people on both demand and supply sides of markets to feed into the market price and quantity of goods bought and sold, individuals with decision-making power judge what the
Price (000) 24 18 12 6 0 7 9 15 19 Quantity 30 (millions/year)

D
<excess supply>

FIGURE 2.8

PRICE FLOOR IN THE CAR MARKET

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correct market price should be. This removes the contributions of some individuals to the market process meaning less collective information feeds into the market outcome. This means that some information of relevance to the market is not used, or is purposefully ignored, and hence, the economic outcome is not as efcient as it could otherwise be.

2.7

I N F O R M AT I O N A N D K N O W L E D G E IN THE MARKET SYSTEM

You will appreciate already that demand and supply curves are not simple features of an economy but relate to a complex range of factors that together reect the behaviour of individual buyers and sellers in markets. The behaviour results from all of the information used by buyers and sellers when making their economic decisions and is, therefore, the result of numerous independent decisions made by unrelated and non-directly communicating individuals seeking to satisfy their personal economic goals maximizing their utility. Information available to each individual informs their decision-making so all relevant information distributed across a range of individuals is reected in supply and demand. The market system is built on individuals use of information and their incentives about how best it should be used. Some of this information is generally available. Take the case of a rm trying to decide if it should hire an additional worker. It will know how much the employee will cost, based on the going or market wage rate, and it will have to make a guess about how much additional revenue the worker will be able to generate for the rm, maybe using information they already have about other workers. Using this information, the economic decision to hire or not is taken. General information or knowledge that we all possess provides no economic advantage to us relative to others in the economic system although it is useful for some decision-making. Specic knowledge is also used in the economic system. Specic knowledge differs from general knowledge because it is not generally known or available and can be difcult and/or costly to share with others. It includes:

Scientic knowledge e.g. the laws of quantum physics or astrophysics that are not easily shared with non-specialists. Assembled knowledge e.g. an administrator who has worked dealing with students in a university department has assembled knowledge about courses offered, timetables, the marks and standards of the courses, details of assignments,

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deadlines and so forth; e.g. the knowledge of how a machine works and how it can be xed if it breaks down. Such assembled information would take time to be learned by new staff. Idiosyncratic knowledge of particular circumstances which if not acted upon swiftly leads to missed opportunities and, hence, wasted resources e.g. if more output is required in a factory then information on whether a specic machine is operating to capacity will be known to individuals working closely with that machine; if more products must be distributed, information about which containers/lorries are not fully loaded is known to employees on the spot.

Some knowledge may be easily redistributed if it can be expressed in facts, phrases or drawings. Depending on the time it takes to distribute the knowledge, however, it may still be costly to transfer to other people. Other types of knowledge are of a tacit nature, made up of perceptions, beliefs, experience and other types of specic knowledge and can be impossible to explicitly transfer. The role of knowledge within rms and its central role within the economic system is discussed by Stewart (1997). Knowledge is more valuable and more powerful than natural resources, big factories, or fat bankrolls. In industry after industry, success comes to the companies that have the best information or wield it most effectively not necessarily the companies with the most muscle. WalMart, Microsoft, and Toyota didnt become great companies because they were richer than Sears, IBM, and General Motors on the contrary. But they had something far more valuable than physical or nancial assets. They had intellectual capital . . . Intellectual capital is the sum of everything everybody in a company knows that gives it a competitive edge. Unlike the assets with which business people and accountants are familiar land, factories, equipment, cash intellectual capital is intangible. It is the knowledge of a workforce: the training and intuition of a team of chemists who discover a billion-dollar new drug or the know-how of workmen who come up with a thousand different ways to improve the efciency of a factory. It is the electronic network that transports information at warp speed through a company, so that it can react to the market faster than its rivals. It is the collaboration the shared learning between a company and its customers, which forges a bond between them that brings the customer back again and again. In a sentence: intellectual capital is intellectual material knowledge, information, intellectual property, experience that can be put to use to create wealth. It is collective brainpower. Its hard to identify and harder still to

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deploy effectively. But once you nd it and exploit it, you win. (Stewart, 1997. Reproduced by permission of Currency Publishers.) From the perspective of encouraging an economy to be efcient it is a challenge to ensure that all resources, including knowledge, are used in the best way possible. As outlined in Chapter 1, economists generally believe that the free-market system provides the most appropriate form of economic organization to encourage efcient resource use. Each person or organization has the incentive to use their knowledge to maximize their utility. Adam Smith discussed the concept of the invisible hand when he referred to how the economic system performed as though it were guided towards getting the most out of its resources in spite of the fact that individuals in the economic system do not make their economic decisions with such a goal in mind. Within the free-market system any guiding activity is the result of how people and rms react to the prices and the market opportunities they observe. Prices are the signals that feed into economic decisions about what to buy and what to sell, how to use resources, or whether to supply labour or not. Hayek (1945) described how the price system operates in by allowing all relevant information and knowledge to be incorporated into the functioning of markets without the participants necessarily being fully aware of why changes occur, but by reacting to them and taking any new information into account in their decision making. It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes . . . [S]omewhere in the world a new opportunity for the use of some raw material, say, tin has arisen . . . All that the users of tin need to know is that some of the tin they used to consume is now more protably employed elsewhere and that, in consequence, they must economize tin . . . If only some of them know directly of the new demand and switch resources over to it, and if the people who are aware of the new gap thus created in turn ll it from still other sources, the effect will rapidly spread throughout the entire economic system. This inuences not only all of the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all things made of tin, and their substitutes and so on. All this takes place without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members surveys the whole eld, but because their limited individual elds

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of vision sufciently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity or rather that local prices are connected in a manner determined by the cost of transport, etc. brings about the solution which (if conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process. (Hayek, 1945. Reproduced by permission of the American Economic Association.) Economic decision-making in free markets is decentralized across all the individuals dispersed in each market and is synchronized or coordinated by the price system. Decisions in command economies are not made on the basis of price signals because the central planners decide what should be produced and in what quantities, without reference to supply and demand. Central planners attempt to assemble as much information as possible in making their decisions but given the dispersion of knowledge throughout an economy; it would be impossible for central planners to gather all relevant information for each economic decision that must be made. In the case of specic knowledge, even when it is possible to transfer knowledge it is often costly. Centralized decision-making creates problems for the effective use of information and knowledge within an economy and so leads to a less efcient use of resources than a free-market system. Another principle that differentiates free markets from centrally planned economic systems is the right to own private property. Private property rights are often taken for granted by those of us in free markets. Since we have the rights to personally own and use property as opposed to a system of centrally owned and operated property within a centrally planned economy both individuals and rms have the incentive to use their specic knowledge to maximize their utility. Economists argue that, in general, when decision-makers do not own resources that they may have control over, their incentive to make optimal use of the resources is reduced. Bring this close to home by focusing on the incentive to take care of a TV (or room) you rent rather than one you own!

2.7.1

DECENTRALIZED DECISION-MAKING THE OPTIMAL FORM OF ORGANIZATION?

Allowing economic decisions to be the outcome of market decisions rather than central planning appears to be Hayeks conclusion. Even the expressions free-market

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system or market economy indicate the central role of markets in how many economies are organized. However, it would be incorrect to argue that decentralized decision-making is always the most efcient form of economic organization. Look at how rms function by making many of their decisions centrally by the chief executive ofcer (CEO) or board of directors with staff lower down in the hierarchy making few, if any, decisions. Economic activity within the market system relies largely on rms for the markets to function. In principle, it would be possible for economic decisions to be made without the existence of rms if I want a new wooden table I could contact a timber supplier and organize a carpenter to assemble it. In practice, however, most tables are manufactured by rms and sold on to consumers because some transactions are more efciently conducted by rms rather than in markets. Consumers save time, effort and, therefore, money in buying from a rm rather than having to deal with what may be a multitude of different suppliers of individual parts and assemblers. Searching out suppliers is more time-consuming the more complex the product and such search costs represent just one element of what are called transactions costs. Transactions costs are the complete price plus non-price costs of a transaction, including search, information, bargaining and policing costs. Consumers incur information costs when they must nd out about suppliers or about the quality of different parts; they incur bargaining and decision costs when they must haggle to negotiate the nal price with the supplier and decide between alternatives; policing and enforcement costs when the consumer must ensure that the other party to the transaction is honouring the agreed terms of the transaction. The most efcient way of organizing a transaction minimizes transactions costs. Firms will make and supply goods and services and consumers will buy from them when the transactions cost to the consumer is lower than using markets. Firms too incur transactions costs in organizing their economic activities but exist when these costs are lower than the costs of organizing in markets. Usually transactions costs in rms increase as the rms grow and it becomes more difcult for the management to keep track of all relevant knowledge for their decision-making. Hence, there is a limit to the size of rms that is related to the cost of their transactions and this is one explanation as to why rms do not grow indenitely.

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2.8

MORE ON EQUILIBRIUM IN THE D E M A N D A N D S U P P LY M O D E L

The demand and supply model and the role of equilibrium within it outlined in this chapter is the foundation of the economics discipline, allowing analyses of different markets and assessment of the implications of changes across a range of factors on market outcomes. The demand and supply model, however, does not provide any answers. Rather, it provides a framework for economists who use the model as best they can for making sense of what they observe. Despite its place at the centre of the economists toolbox there is disagreement among economists as to the purpose of equilibrium analysis, which is viewed alternatively by some as a description of reality or by others as a theoretical construct.

Equilibrium as a description of reality: According to this view, real markets come sufciently close to being approximated by the supply and demand model tending towards equilibrium and in cases where an individual market does not, the supply and demand model allows us to make better explanations and predictions of that market than any alternative model available. Equilibrium as a theoretical construct : Holders of this view consider that the supply and demand model can help us to understand things that might occur in reality but it is through our observations of the economy that we gure out what is going on in any particular market and why. Allowance is made for a market that is in disequilibrium and this helps us to understand how markets change over time as individuals (on demand or supply sides of the economy) learn from available information and incorporate it into their economic decisions.

The denition of equilibrium as a state from which there is no tendency to change does not describe markets all of the time as the quantities of goods bought and sold change over time as does their price. Hence we need to understand what equilibrium means, how it comes about, its implications for sellers and buyers and causes and consequences of changes in factors that feed into economic decision-making. Irrespective of your preference for one description or other, the supply and demand model allows us to address these issues.

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2.9

A M A R K E T AT W O R K : T H E L A B O U R MARKET

The labour market can be analysed using the supply and demand framework but in many respects it is a unique market and a number of different elements require analysis in considering how it functions. As labour is one of the factors of production, the labour market is also described as a factor market. Since labour is an input into production, labour demand is a derived demand since it depends on the demand for goods and services. Firms demand labour taking into account, among other factors, the cost of the labour, which in turn depends on the wage rate that must be paid. At higher wage rates we expect rms to hire fewer workers than at lower rates. Labour supply refers to peoples willingness to make some of their time available for paid work and also depends on the wage rate. We expect more people to wish to supply their labour if wage rates are high rather than relatively low. When we discuss price in relation to the labour market we refer to the price of labour, which is the wage rate. The wage rate in a labour market is determined similarly to any equilibrium price, i.e. via supply and demand for labour, which are discussed in more detail below.

2.9.1

LABOUR DEMAND

Labour demand is graphed like other demand curves with quantity (of labour) on the horizontal axis and the price (wages) on the vertical axis, as in the example in Figure 2.9. Firms in the industry shown wish to employ 60 000 workers if wages are 10 per hour; at higher wage rates, rms would demand fewer workers because costs rise as wages rise.
Price /hour 20 15 10 5 0 0 30 60 Quantity (000, workers)

Labour Demand

FIGURE 2.9

INDUSTRY LABOUR DEMAND CURVE

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The wage rate enters into the labour demand decision of rms but the rm must also take into account the output that the workers they employ can produce for the rm, and the revenue the rm can earn from that output. The rm must try to work out how many workers it can protably employ. This process involves consideration of the output of each worker. The following example is considered to gure out the number of workers demanded by Safelock, a hypothetical company manufacturing steering locks (anti-theft devices for steering wheels). Given the available machinery and equipment in the steering lock factory, the rm considers that output could be produced as shown in Table 2.3. In the second column Table 2.3 shows the output that could be produced if the rm employed between one and 10 workers. One worker could produce 25 locks per day, rising to 55 if two workers were employed and so on. In the third column the marginal physical product of Labour is computed. The marginal physical product of labour is the change in the quantity of output ( Q) produced by each additional worker ( L).

TA B L E 2 . 3
No. of workers
1 2 3 4 5 6 7 8 9 10

LABOUR OUTPUT
Output (per day)
25 55 82 102 116 124 130 132 130 125

MPPL
25 30 27 20 14 8 6 2 2 5

A working day is assumed to consist of 8 hours.

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A Daily output 140 120 100 80 60 40 20 0 1 2 3 4 5 6 7 8 Workers 9 10 11

B 30 25 20 15 10 5 0 5 10 MPPL

5 6 7 Workers

9 10 11

F I G U R E 2 . 1 0 T O TA L O U T P U T A N D M A R G I N A L P H Y S I C A L PRODUCT OF LABOUR
For example, the change in output generated by hiring the rst worker is 25 ( Q/ L = 25/1) since when no workers are hired output is zero. In hiring the second worker output increases from 25 to 55, a change of 30. The second worker adds 30 steering locks extra to total output, the third adds 27 locks and so on. When a second worker is hired the two can cooperate to divide up the work between them and there are advantages of this division of labour that allows them to produce more than double the output of the rst worker (55 compared to 25). Hiring the third worker changes the division of labour too but in this case the additional output is 27 locks extra. This happens because of how the materials and equipment are shared and used among the workers. The total output increases with each worker up until worker 8 but when the next worker is hired, they do not add any additional output. In fact output falls by half a unit this is because given the available equipment, there is nothing for this worker to do. Hiring the ninth worker leads to a fall in output (from 132 to 130 locks) because the worker actually gets in the way of others trying to do their job. The total output of the factory and the marginal physical product of labour are shown in Figure 2.10. Once any more than two workers are employed, the additions to total output decline (from 30 to 27 to 20 to 14, etc.) by diminishing amounts. This is reected in the attening slope of the total output curve in panel A of Figure 2.10 and in the downward (negative) slope of the MPPL in panel B. This reveals the law of diminishing marginal returns. The law of diminishing marginal returns states that when a rm adds workers to a given amount of capital machinery, equipment, etc. it eventually leads to a

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less efcient match between labour and capital to the extent that if all capital is used by workers, hiring an additional worker will only lead to workers getting in each others way and the marginal product of labour declines. The law of diminishing returns helps us to understand why when capital input is xed supply curves slope up and the marginal costs of production rise. This is relevant over short periods of time when rms use their available capital rather than changing it by building new factories, buying new machinery, etc. Safelock uses the above information in considering how many workers it should protably hire. It also takes into account the price it can earn for its output. There are a large number of competing products and Safelock is aware that if it wants to be successful in selling its product it cannot charge above a price of 30. Using this price information, the rm can move from an analysis of output to the revenue it can expect to earn from its product. Each workers MPPL can be considered in terms of MRPL . MRPL marginal revenue product of labour. This is the change in total revenue (price of output number of units sold) generated by each additional worker. It is computed by multiplying the product price by the MPPL . In Table 2.4 these additional estimations are shown for the Safelock example, with some blanks left for you to ll in. Table 2.4 shows how the rst worker adds 750 to Safelocks total revenue which is computed as the workers MPPL P = 25 30. With the second worker, the total revenue (output P) earned by the rm increases to 1650 which represents an MRPL of 900 (since 1650 750 = 900). A nal element in the rms decision on how many workers to employ is the cost to the rm of the workers (the cost to the rm is assumed here to be the wage rate only). If the rm knows it will only attract workers by paying 10 per hour, it can calculate its labour costs for varying numbers of workers as shown in Table 2.5 and Figure 2.11. When the working day is 8 hours and the wage rate is 10, it costs the rm 80 to employ each worker each day. Hence, total labour costs per day rise steadily by 80 for each worker employed and the extra costs to the rm of employing each additional worker is computed as the daily wage. This is the marginal cost of labour for the rm. All of the previous information on the output of workers, the revenue they generate for the rm and the costs of employing them enter into the rms decision about its demand for labour. In particular, the information regarding marginal revenue and marginal cost are central to the demand for labour.

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TA B L E 2 . 4 A N A LY S I S
No. of workers
1 2 3 4 5 6 7 8 9 10
A

L A B O U R O U T P U T: E X T E N D E D
Output (per day)
25 55 82 102 116 124 130 132 130 125

MPPL
25 30 27 20 14 8 6 2 2 5

TR (P = 30)
750 1650

MRPL
750 900 810

3060 3480 3720

600

240 180

3960 3900 3750

60 60 150

working day is assumed to consist of 8 hours.

T A B L E 2 . 5 L A B O U R C O S T S : W A G E S O F 8 0 P E R W O R K E R D AY
Workers Labour cost: total () Labour cost: marginal () 1
80 80

2
160 80

3
240 80

4
320 80

5
400 80

6
480 80

7
560 80

8
640 80

9
720 80

10
800 80

It is possible to consider how many workers it makes economic sense for Safelock to hire at the (daily) wage rate of 80. Simply put, if the benets to the rm outweigh the costs they should continue to hire additional workers:

First worker: Second worker: ... Eighth worker:

benet = MRPL of 750 benet = MRPL of 900 ... benet = MRPL of 60

cost = 80 cost = 80 ... cost = 80

750 > 80 900 > 80 ... 60 < 80

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Daily labour cost

1000 800 600 400 200 0 1 2 3 4 5 6 7 Workers 8 9 10 100 80 60 40 20 0 1 2

Marginal labour cost

5 6 7 Workers

9 10

FIGURE 2.11

L A B O U R C O S T S : T O TA L A N D M A R G I N A L

When the decision of whether to hire the eighth worker is taken, the cost outweighs the benet so the most efcient workforce for Safelock is seven workers. This solution could also be found graphically by drawing marginal cost and MRPL on the same graph and examining where they intersect. The hiring decision would differ under different economic circumstances (another case of ceteris paribus ). For example, at a wage rate of 25 per hour (200 per day) it would make sense to keep hiring workers up to the sixth worker since the seventh worker would add more to the costs of Safelock (200) than to the revenue (180). The sixth worker will be hired as long as their MRPL is sufcient to cover their wage costs which means that once the wage rate does not rise above 30 per hour (240 per day) it makes economic sense to hire the worker. This process shows that Safelock continues to hire workers once their MRPL (marginal revenue product of labour) is greater than or equal to the MLC (marginal labour cost), i.e. the wage rate. We can also see from Table 2.4 that it will never make economic sense to hire any more than eight workers (if price remains at 30) because after this level, MRPL is negative given the available equipment and factory space more than eight workers leads to losses. The above information allows us to conclude that Safelocks demand for labour differs for different wage rates:

at a wage rate of 10 demand is seven workers; at a wage rate of 25 demand would be six workers and at 30, ve workers would be employed.

The demand for labour follows the general law of demand the higher the price, the lower the quantity demanded, ceteris paribus. To nd the demand for labour

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in an industry (or a country) requires the summing up of the demand for labour across each rm in the industry (or the country).

2.9.2

LABOUR SUPPLY: INDIVIDUAL SUPPLY DECISION

Whether to supply labour to rms is a subjective decision made by individuals who vary with regard to their incentives to supply their labour and the amount of time they are willing to supply. One factor that individuals usually take into account in this decision is the price that they expect to receive for their labour, the wage rate. Generally speaking, the higher the wage rate, the more attractive it is to work because the reward is higher. This can be restated in terms of opportunity costs. People wish to work or not, and those that do seek employment. There is an opportunity cost of working, which is the leisure time given up. Or, there is an opportunity cost of not working, which is the income foregone. In choosing between alternative employment possibilities, people also take the wage rate into account and will usually try to secure the highest wage possible, ceteris paribus. In the case of labour supply for individuals, supply does not keep rising indenitely as wages increase, simply because there is a limit to the hours any individual can and is willing to work. Someone who works 35 hours a week for 10 per hour might be enticed to work additional hours at a higher wage rate this would happen if the person placed a higher value on the extra income they could earn rather than the extra leisure time given up. Someone else working 55 hours a week might actually cut down on their labour supply if they could earn a higher wage because they consider 55 hours to be the limit of the time they are willing to devote to work. A higher wage rate would cause the person to cut back on their labour supply if they place a higher value on their leisure time compared to the income they forego. Hence, the labour supply decision is different for different individuals and opportunity cost of work (or leisure) is a subjective and personal value. The supply of labour for one worker is shown in Figure 2.12. A reservation wage indicates the lowest wage a worker will accept to take a job. No labour is supplied if wages are below 4 per hour, the reservation wage, as the worker does not consider it worthwhile to work for less than this wage. If the wage rate rises to 16, the worker is willing to work 55 hours (income = 880). At any

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Price /hour

24 20 16 12 8 4 0 0 25 50

Labour supply

55

Quantity (labour hours per week)

F I G U R E 2 . 1 2 I N D I V I D U A L L A B O U R S U P P LY C U R V E : BACKWARD BENDING
higher wage than 16, the worker prefers to cut back on hours worked and labour supply declines to 50 hours if the wage rises to 24 (income = 1200). Moving from the individual to industry labour supply, we can think of labour supply as consisting of a mix of different skills. High skills command higher wages, ceteris paribus. So too do more dangerous jobs, and some unpleasant jobs also attract a premium wage unrelated to skill levels but as recompense for the perceived unpleasantness. The supply curve for an occupation is likely to display a positive slope implying that to increase the quantity of labour supplied to one occupation the wage rate must rise.

2.9.3

EQUILIBRIUM IN THE LABOUR MARKET

By considering labour demand and supply together, as shown in Figure 2.13, we can see how equilibrium wages and hours worked are determined. The demand and supply curves shown are those for the European Steering Lock industry, for manufacturing workers. The equilibrium wage in the industry is 10 per hour in equilibrium, and 10 000 workers are employed in the industry. Safelock is one average rm in this industry, and it pays the equilibrium wage rate. As long as there are no changes in the factors determining either demand or supply, the equilibrium situation will prevail. Since information on the output of workers, the revenue they generate for the rm and the costs of employing them enter into the labour demand decision, a change in any one of these factors will impact on the demand curve. Going back to Tables 2.4 and 2.5, for instance any

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Price /hour 20 15 10 5 0 0 5000 10 000

Labour supply

Labour demand

15 000

Quantity (workers)

FIGURE 2.13

EQUILIBRIUM IN THE LABOUR MARKET

factor that changes element in these tables will give rise to a new demand curve. Any factors that change supply (such as a change in the rate of income tax) would generate a new supply curve, with implications for equilibrium workers and wages. Government policies too might have an impact if, for example, a minimum wage was imposed. The effects of all such changes can be analysed using the demand and supply model outlined in this chapter.

2.10

SUMMARY

The demand and supply model is the framework that allows us to examine how markets function. We can consider the most relevant features that need to be taken into account for any market we wish to consider. Both buyers and sellers benet from exchange. The equilibrium situation in a market is an outcome that is the intention of no single buyer or seller. It is the result of all buyers and sellers decisions in that market, and includes all available information used when making those decisions. Prices act as a signal that create incentives for exchange and help to explain the behaviour of both buyers and sellers in markets. If a market is in disequilibrium, that information creates incentives for the behaviour of buyers and sellers to change and move the market towards equilibrium. Where governments are unhappy with the prices determined in markets, they may intervene to change the market-determined outcome.

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One of the most interesting markets to analyse is that for labour because of the need to understand the underlying principles governing rms decisions to hire or demand labour and peoples decisions to supply labour. Once these principles are understood, however, equilibrium in the market is found just as in any other and it is possible to consider the effects of changes on demand, or supply on equilibrium.

REVIEW PROBLEMS AND QUESTIONS

1. Explain how differences in (1) preferences and (2) opportunity costs of production can give rise to gains from exchange. 2. Using examples, illustrate that you understand the concepts of absolute and comparative advantage. 3. Arguments are sometimes put forward that countries should reduce their imports from other countries reducing the amount of exchange that takes place. Does this argument make sense, given what you know about absolute and comparative advantage? 4. Use a diagram to explain what would happen to the quantity demanded of personal stereos if their price doubled, ceteris paribus. Add in supply curves to your diagram to indicate how the doubling of equilibrium price would be caused by a movement in supply. What possible effects on supply might be responsible for a doubling of the price? 5. Use a diagram to explain what would happen to demand for personal stereos if MP3s become a preferred substitute by a substantial portion of the population. Add in a supply curve for personal stereos and explain what happens to equilibrium price and quantity. 6. Explain how the principle of opportunity cost underlies the supply curve. 7. Use Table 2.4 to examine the equilibrium implications of a fall in workers output on the demand for labour. Update the table if output per worker falls by 5 units for each worker. What are the implications for MPPL , and MRPL (if price is 30)? What are the effects on the demand for labour? Would you expect any changes in the supply of labour? Can you think of any factors that might cause the average workers output to fall? 8. Read the following case study on the ELV initiative and answer the questions that follow.

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The end of life vehicle case

Each year across the EU somewhere between 8 and 10 million cars are scrapped (out of a car population of around 170 million). Before the 1990s the imperative to recycle had not been taken on board by car manufacturers and the issue was only beginning to be considered by consumers and governments. In May 2002, an EU directive came into force which means that from 2006 onwards endof-life-vehicles (ELVs) will be categorized as hazardous waste requiring careful disposal. The directive will force the nal owner of a vehicle to return their ELV to an authorized collection point to deregister the vehicle. Furthermore, the directive indicates that delivery of the vehicle to this point should not involve any cost for the vehicle owner. Essentially this means that car manufacturers must have networks in place to support the collection and treatment cost. Treatment of vehicles that reach their end of life between 2006 and 2014 must ensure that 85% of materials (based on the weight) must be reused/recovered. From 2015, this percentage rises to 95%. Currently, about 75% of materials are recovered. Support from car manufacturers for the directive has been generally positive except in relation to the decision to force them, from 2007, to bear recollection cost for all cars they produced (not just those produced from 2002). a. What do you see as the potential implications of the ELV initiative for each of the following: car manufacturers, dismantlers and recyclers? b. What arguments do you see for/against the initiative? c. Can you think of any obstacles to reaching high recycling targets? d. Do you expect any effects on either demand or supply of cars by the imposition of this law? e. Look up the websites of car companies or car associations (such as the ACEA) across Europe to consider their views on this directive and how they are currently dealing with meeting this directive.

FURTHER READING AND RESEARCH

An interesting example of market analysis can be found in Lindsey, 2003. Using this and other publicly available information, such as Coffee Research Institute: www.coffeeresearch.org International Coffee Organization: www.ico.org/ed/edmark.htm you could apply the demand and supply framework to explain: a. what has been happening to equilibrium price in this market;

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b. what has been happening to equilibrium quantity in this market; c. why equilibrium has changed. You should be able to identify demand-related issues of relevance, supply-related issues of relevance and any other relevant issues to a, b and c. Writings by Friedrich August von Hayek (18991992) are insightful and thought provoking for market analysis. Hayek was awarded the Nobel Prize in Economic Sciences in 1974 (jointly with Gunnar Myrdal). See Hayek, 1948, 1984. For statistical and other information on labour markets in terms of the proportion of the employed population, unemployment rates, check out the World Banks annual World Development Report, Eurostats Basic Statistics of the EU and Statistical Review and various OECD labour and employment-related publications.

REFERENCES
Hayek, F. (1945) The use of knowledge in society, American Economic Review , 35, 118. Hayek, F. (1948) The meaning of competition, in Individualism and Economic Order . University of Chicago Press, Chicago, 92106. Hayek, F. (1984) Competition as a discovery procedure, in Nishiyama, C. and Leube, K. (eds) The Essence of Hayek . Hoover Institution Press, Stanford, 254265. Lindsey, B. (2003) Grounds for Complaint? Understanding the Coffee Crisis , Trade Brieng Paper No. 16, CATO Institute, May. Smith, A. (1970) An Inquiry into the Nature and Causes of the Wealth of Nations. Penguin, Harmondsworth [original publication 1776]. Stewart, A. (1997) Intellectual Capital: The New Wealth of Organizations . Currency.

CHAPTER 3

BEYOND DEMAND: CONSUMERS IN THE ECONOMIC SYSTEM

LEARNING OUTCOMES
By the end of this chapter you should be able to: Identify how demand is related to consumers choices at a microeconomic level and to macroeconomic consumption behaviour. Highlight the importance of consumers spending across international economies. Explain consumers choices in terms of consumer satisfaction. Relate the law of demand to consumer satisfaction. Consider how price changes impact on consumer choices and demand. Illustrate how consumers welfare can be estimated using the demand curve. Show how consumers responsiveness to price changes can be measured and explain why it is useful for economic decision-making. Analyse how consumers choose between different varieties of similar products. Describe macroeconomic consumption behaviour using the consumption function. Discuss how governments try to inuence consumers at macro- and microeconomic levels.

3.1

INTRODUCTION

Understanding the demand side of the economy is important in appreciating how an economy works and this chapter delves into an important component of demand the consumer. Much of the economic system is organized to meet the demands of consumers. Consumers demands and moreover their willingness to pay for products and services provide incentives for entrepreneurs that attempt to meet their requirements and produce what consumers wish to buy. Purchases of consumption goods represent a substantial component of economic activity, as

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shown in section 3.2. The choices that consumers make are based on their expected benet or utility, which is discussed in section 3.3. As rational people, consumers take all available information into account in making their consumption decisions. As explained in section 3.4, information about prices is relevant to consumers decisions and, taken with consumers subjective views of their expected utility, serves to help us understand why consumers make the choices they do. Using demand analysis it is possible to examine the benet or utility that consumers earn when they consume and this is shown in section 3.5. How consumers decisions about what to buy are affected when prices change is examined, again using demand analysis, in section 3.6. Many consumer decisions are between different brands of quite similar products and section 3.7 focuses on how such choices are made. The focus of the chapter moves to macroeconomics when the behaviour of all consumers together is considered in section 3.7 through analysis of the consumption function. This allows for consideration of how consumption spending relates to a countrys national income. The nal section in this chapter considers some examples of how and why governments try to affect consumption decisions.

3.2

D E M A N D A N D T H E I M P O R TA N C E OF CONSUMERS

Governments buy goods and services both for current (everyday) use and to make capital expenditures that are expected to meet more long-term requirements (e.g. road building or providing funds for future pensions). Firms also make purchases for current and longer-term purposes. But consumers buy the vast majority of goods and services produced. The value of all economic activity is the sum of the output or income of that economy over a specic period of time this is discussed in more detail in Chapter 5. For now, note that national output or national income is conventionally denoted as Y . National output or income, denoted Y , is calculated as the value of

all the goods bought for consumption purposes; C plus all the investment expenditures by rms; I plus all government expenditures; G plus the net value of all goods traded by the economy, exports minus imports: X M.

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Economic Activity (Y ) = C + I + G + (X M ) When classifying the purchases and expenditure that occur in an economy (as C , I or G , X or M ), economists classify them according to their purpose or function. A pair of shoes bought by a consumer for the purpose of wearing them would be part of consumption expenditure (C ). The same pair of shoes in the manufacturers factory before being distributed for sale is a component of investment inventory investment (I ). If the pair of shoes were bought by the government for a member of the army the expenditure would be part of G government expenditure. Shoes produced abroad and imported appear under imports while if the shoes are produced for an external market they appear as exports. To ensure that output is not counted twice, imported shoes would not also be included in consumption or government expenditure. Each component of economic activity can be studied separately and in this chapter we deal with consumption, the most substantial component. Table 3.1 shows the percentage share of consumption expenditures out of the value of total economic activity for a number of economies. Table 3.1 illustrates the sizeable share of consumption in economic activity for those countries considered. Almost 70% of the income in the USA was spent on consumption goods and the value of US consumption is estimated at 20% of world output. It is important for economists to understand what impacts on this component of economic activity.

TA B L E 3 . 1 C O N S U M P T I O N S H A R E ( % ) O F E C O N O M I C A C T I V I T Y, 2 0 0 0
USA
Consumption Share 68

UK
75

France
66

Ireland
60

Germany
69

Japan
62

Source: Excerpted from the Penn World Table 6.1 (Heston et al., 2002).

3.2.1

CONSUMPTION GOODS

Consumers derive benet, satisfaction or utility from the goods they consume. Consumption goods are made up of three broad categories of goods that consumers demand durable and non-durable goods, and services.

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If consumer condence is low or declining, it indicates that consumers consider economic activity to be slowing down or that the economy is in a recession so they prefer to put off durable purchases because they expect the economy to improve in the future. An economy is in recession if economic activity declines for a substantial period. Recessions are characterized by periods when consumers buy fewer goods and services than previously and when many people who are willing and able to work lose their jobs as demand for their output declines. A recession that lasts for a long period is called a depression as in the Great Depression that followed the Wall Street Crash of 1929.

T H E G R E AT D E P R E S S I O N
Economically speaking, the roaring twenties were a good time in the USA for business growth, jobs, share prices and prots. Stock market speculation, riotous spending and real estate booms sent prices skyrocketing. On 24 October 1929, many shareholders began to lose condence and, believing that the prices of the shares they owned could not rise forever, decided to sell. Within the rst few hours of the stock market opening that day, prices fell so much that all the gains that had been made in the previous year were wiped out. Public condence was shattered because the stock market had been viewed as a chief indicator of the state of the American economy. The cause of the crash has been much debated. Some blame an interest rate increase a couple of months before, others the fact that na ve investors had bought stock with credit which was too freely available, believing that stock prices only moved in an upward direction. Some observers believed that stock market prices in the rst six months of 1929 were overpriced, but not all agreed. The most likely scenario is that a combination of factors united together to bring about such dramatic outcomes. Clearly, no one knew what the outcome of the crash would be. Given the economic uncertainty, many rms cut back their plans to purchase producer durables, until a clearer picture emerged. But this caused a further decrease in the demand for producer durables, and led to a fall in production. As production fell, rms needed fewer workers. Unemployed consumers and those who feared they might soon be out of work cut back on their consumer durable purchases. Therefore, rms producing consumer durables faced falling demand as well.

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The vicious circle continued as America sank steadily into the worst depression in its history. Millions of people lost every cent they owned. Half of all US banks failed, factories shut down, shops closed and almost every business seemed paralysed. By the end of 1930 more than 6 million Americans were out of work; by 1931 that had doubled to 12 million. Between 1929 and 1939 real output fell by 30% and living standards in 1939 were lower than in 1929. Over 5000 banks failed and over 32 000 businesses went bankrupt. The slide into the Depression, with increasing unemployment, falling production, and falling prices, continued until the effort for World War Two started. The USA was far from the only country affected by the Depression. Unemployment rates of over 30% in Germany into the 1930s provided an environment for the policies of the National Socialist German Workers Party, and the career of its leader Adolf Hitler, to ourish with the devastating consequences that ensued internationally.

Non-durable goods include food, clothes, petrol, drugs, and top-up cards for mobile phones and these are usually consumed in less than one year. Services include things like telephone calls, health services (a visit to the doctor, or an operation), or a trip to the cinema. Services are non-material or intangible items of consumption that are consumed as they are created. In proportionate terms, consumption spending in developed economies is made up of mostly services (60% plus of total consumption spending), with non-durable goods of approximately 30% and the remainder made up by durable goods. Services are the least volatile component of consumption tending not to vary too much over time, with non-durables next and durable goods the most volatile of the three.

3.3

C O N S U M E R S AT I S FA C T I O N UTILITY

Using the concept of utility, it is possible to consider consumer behaviour and how it underlies demand. Utility increases with the consumption of goods up to a point. For example, the utility or satisfaction from consuming a fth chocolate bar in a day will surely not be as great as that derived from the rst, and this is

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TA B L E 3 . 2 T O TA L A N D MARGINAL UTILITY: CONSUMING C H O C O L AT E B A R S

Number of bars (Q)
0 1 2 3 4 5 6

Total utility (TU)

0 33 53 65 71 71 65

Marginal utility ( TU/ Q)

33 20 12 6 0 5

the same for the majority of goods. Table 3.2 shows the total utility and marginal utility from consuming chocolate bars for one consumer who was asked to try to quantify and rank the satisfaction they derive from consuming chocolate bars over one day. Total utility (TU ) is the total benet perceived by the consumer from consumption of a good/service. Marginal utility is the change in total utility for each additional good/service consumed. It is estimated as TU / Q . Considering the total utility column in Table 3.2, we see that the satisfaction derived from consuming four bars is 71 and has risen with each bar consumed. Above four bars, the consumers utility rises no more and with six bars, total utility actually declines because the consumer has chocolate overload! Looking at the marginal utility column in Table 3.2, we consider the additional benet derived from each extra bar consumed. This shows a decline from 33 units of satisfaction from the rst bar, to 20 units from the second and so on. By the time the consumer consumes the fth bar, they derive no additional satisfaction as their appetite for chocolate has been adequately satised.

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A: Total utility per bar 80 60 40 20 0 1 2 3 4 5 6 7

B: Marginal utility per bar 35 30 25 20 15 10 5 0 5

FIGURE 3.1

T O TA L A N D M A R G I N A L U T I L I T Y: C H O C O L AT E

Consuming a sixth bar makes little sense because it leads to a decline in overall satisfaction, reected in negative marginal utility. This information is also presented in Figure 3.1, with total utility in panel A and marginal utility in panel B . When using the concept of utility, economists analyse consumption as if people can rank and quantify their preferences and can establish how much satisfaction they acquire from consuming different quantities of goods or services. In practice if you were asked to explain your satisfaction from consuming various quantities of chocolate, you might nd it difcult and even more so if a number of different goods and cross-rankings were involved. Economists do not assume that people engage in this process every time they consume something. However, economists do consider that rational people reveal their preferences by what they purchase and that they know what they like, what provides them with consumer satisfaction and that the utility generated from total and marginal consumption follow the general patterns as shown above; initially increasing and eventually falling total utility and declining marginal utility.

3.3.1

THE ASSUMPTION OF RATIONALITY IN ECONOMICS

When economists use the term rational in relation to consumers, the implications are that consumers are capable of estimating the satisfaction they derive from consuming goods or services, they can rank their preferences (e.g. if they prefer chocolate to cheese and cheese to sausages, they prefer chocolate to sausages) and that they act generally to maximize their own utility. Rationality assumes that consumers use all available information in making their decisions. It must be acknowledged that consumers do not have full information at all times to support their decisions, hence they are bounded by their knowledge and the

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available information, or, people possess, as Herbert Simon put it, bounded rationality. This means that people do not always make the choices that would objectively maximize their utility if they had more complete information their choice might be different. It is relevant in complex decisions where receiving, storing, retrieving, transmitting (i.e. processing) relevant information can be complicated and timeconsuming. In many economic models people are assumed to display approximately rational behaviour. If a choice arose between consuming a chocolate bar or a packet of crisps, the rational consumer would compare the utility they would derive from each product and make their preferred and subjective choice. They would also take an additional piece of information into account in this decision the prices of the goods. Why? Because consumption preferences are limited by individuals income and they rationally make decisions about what to buy with this in mind, taking prices into consideration.

3.4

M A R G I N A L U T I L I T Y, P R I C E S A N D THE LAW OF DEMAND

Consider a person trying to decide how to spend money she has received and who knows her top preferences are either nights out (including taxi fare, entrance to a night club and food/drinks) which cost on average 50 or call credit for her mobile phone, at the same price. Analysis of marginal utility for both goods is provided in Table 3.3. Her prime choice is a night out because the extra utility generated from one night out is greater than the extra utility generated by 50 call credit. After spending one night out, the next best choice for consumption would be a second night out because 19 units of utility is greater than 16 units generated from the rst unit of call credit consumed. The next preferred option is call credit and so on. If she has received 200, it is possible to list what her preferred purchases will be because she will be rational and consume the goods that provide her with the greatest utility. The preferences can be estimated simply as the marginal utility per pound generated by the goods. The marginal utility per pound for both goods is shown in Table 3.4 with the ranked preferences for consumption shown in parentheses. With 200 to spend, the top four choices are a night out, followed by a second night out, followed by 50 call credit, followed by a third night out. With more money to spend, the remaining choices would come into play. After making six

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TA B L E 3 . 3 M A R G I N A L U T I L I T Y: C A L L C R E D I T AND NIGHTS OUT

Marginal utility Quantity
1 2 3 4 5 6

Marginal utility nights out (50)

21 19 15 13 12 11

call credit (50)

16 14 12 10 9 7

TA B L E 3 . 4 M A R G I N A L U T I L I T Y A N D P R I C E R AT I O S
Quantity
1 2 3 4 5 6

MU call credit
16 14 12 10 9 7

MU/P (P = 50) MU nights out

0.32 (3) 0.28 (5) 0.24 (7) 0.20 (10) 0.18 (11) 0.14 (12) 21 19 15 13 12 11

MU/P (P = 50)
0.42 (1) 0.38 (2) 0.30 (4) 0.26 (6) 0.24 (7) 0.22 (9)

choices, the consumer is indifferent between either a night out or call credit because they yield the same marginal utility/price ratio. Such analysis indicates what the individuals demand for nights out and call credit are, given prices, income and preferences. All consumers demand decisions summed together give rise to the demand curve. From the information here, when the price of call credit or a night out is 50, and this individual has 200 to spend, one unit of call credit and three nights out are demanded.

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Since demand decisions result from the marginal utility/price ratio, demand decisions would be different if prices changed. Consider what happens if the cost of a night out increased to 60. This changes the ranking of preferences since the marginal utility per pound changes, as shown in Table 3.5. The result is that with 200 to spend, two nights out and two units of call credit would be demanded. Consumers change their mind about what to consume in response to the changes in the marginal utility/price ratio. In other words the quantity demanded changes in response to price changes. Although the price of call credit is unchanged in Table 3.5, the relative price of call credit decreased as the price of a night out increased and so the quantity demanded of call credit increased. It is in terms of relative prices that economists conduct their analysis. Another way of stating the same idea in terms of the concepts already introduced is to say that following the price rise, the opportunity cost of a night out has increased. More call credit must to be foregone to release the money for a night out. When prices change the consumer rearranges their consumption choices, always preferring goods with the highest possible ratio of marginal utility to price. We can go further than this to say that the rational consumer will make their consumption choices so that the marginal utility/price is equal for all goods consumed. This is logical since consumers would always prefer to allocate their money to goods that yield the highest marginal utility per pound but each time they consume one more of any good, the marginal utility from that good declines while the marginal utility of another good which they buy one unit less of increases. In equilibrium, consumers make their consumption choices so that they end up

TA B L E 3 . 5 M A R G I N A L U T I L I T Y A N D P R I C E R AT I O S N E W P R I C E S
Q
1 2 3 4 5 6

MU call credit
16 14 12 10 9 7

MU/P (P = 50)
0.32 (2) 0.28 (4) 0.24 (6) 0.20 (8) 0.18 (10) 0.14 (12)

MU nights out
21 19 15 13 12 11

MU/P (P = 60)
0.35 (1) 0.32 (2) 0.25 (5) 0.22 (7) 0.20 (8) 0.18 (10)

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consuming quantities of goods where the last pound spent on each good yields the same marginal utility per pound as the last pound spent on every other good. If this were not the case total utility could be further maximized of consuming less of one good and more of another.

3.4.1

THE LAW OF DEMAND INCOME AND SUBSTITUTION EFFECTS

The foregoing analysis can be further examined making reference to Income and Substitution effects, as mentioned in Chapter 2. The income limits facing consumers can be presented using a graphical tool called the budget constraint, which shows the different combinations of goods that can be purchased with a set income, given prevailing prices. A consumers preferences can be illustrated using another graphical tool, the indifference curve, which illustrates various consumption combinations of two goods, which generate the same utility for a consumer. These tools are presented in Figure 3.2 using the information from Tables 3.3 and 3.4. Since the consumer has an income of 200 and the prices of credit or a night out are 50, the maximum amount of either good that could be purchased is 4 units, reected in the budget line/constraint. The indifference curve has a curved shape because of the diminishing marginal utility from consuming additional units of each good. The more of one good being consumed, say nights out, the lower the marginal utility from additional consumption of that good. If a consumer consumes many nights out, they would be willing to forego a night out for some call credit, and when little call credit is

Call 4 credit IC1 3 2 1

IC2

IC3

Indifference curves (IC)

Budget line/constraint

Nights out

FIGURE 3.2 BUDGET LINE AND INDIFFERENCE C U R V E A N A LY S I S

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THE ECONOMIC SYSTEM

consumed, its marginal utility is high. This is why different combinations of credit and nights out on the indifference curve give rise to the same level of utility. At different points on the indifference curve, the consumer is willing to trade different amounts of call credit for nights out reecting the marginal rate of substitution of the goods. This is also reected in the slope of the indifference curve at any point. Consumers have a set or map of indifference curves, each with the same shape, that reect their preferences. Each indifference curve refers to one specic level of utility. On indifference curve IC3 , the consumer has a higher utility level than on IC2 or IC1 . Rational consumers attempt to maximize their utility which is equivalent to a desire to consume on the highest possible indifference curve. The actual consumption decision results from preferences indicated by the set of indifference curves and limited income represented by the budget line. In line with our earlier observation, the consumer in Figure 3.2 chooses to consume 3 nights out and 1 unit of call credit with income of 200, prices of 50 for both goods and given their preferences. Consumption is at point x on IC2 . The indifference curves drawn for this consumer lie closer to the nights out axis than the call credit axis, which indicates this consumers tastes. Another consumer may prefer fewer nights out relative to call credit (if they are new to an area, have not yet made too many friends and prefer to chat to friends back home). The consumers demand decision changes with a price change. If the price of a night out rises to 60, then the maximum number that could be purchased with 200 is 3.3 (200/60 = 3.33). The budget line changes as shown in Figure 3.3 and consumption moves from x to y. The steeper slope of the line indicates that following the price rise, more call credit must be sacriced, in opportunity cost terms, to afford one night out. The consumers decision to change their quantity demanded of both goods can be broken down into a substitution effect and an income effect. A price change induces consumers to change their demand decisions. The substitution effect indicates the adjustment in quantity demanded by a consumer due to the change in relative prices alone. The income effect reects the adjustment in quantity demanded due to the change in real income alone. The substitution effect can be examined by considering the price effect alone on the consumers choice. To see this we draw a line with the same slope as the new

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Credit 4 IC1 IC2 3 2 y 1 Nights out 1 2 3 3.33 4 z x

FIGURE 3.3

CONSUMPTION WITH NEW BUDGET LINE

budget line and examine where it intersects the original indifference curve IC2 . In Figure 3.3, this occurs at point z . The substitution effect is measured from x to z . The change in relative prices alone leads to a reduction in quantity demanded of nights out but an increase in the quantity demanded of call credit. The rational consumer substitutes away from the relatively more expensive good towards the relatively cheaper good. The income effect involves examining the effect on quantity demanded of the reduction in real income caused by the price rise in one good holding relative prices constant. It is shown by the comparison of point z with point y where the same relative prices are used, reected in the same slope of the two lines. Less of both goods are consumed at point y on IC1 compared to point z on IC2 . The increased price reduces the consumers purchasing power and is reected in reduced demand for all goods, not simply for the good which has become more expensive. This is the pure income effect of the price rise for one good, a normal good. Normal good: one for which demand falls if real income falls or for which demand rises if income rises. Inferior good: one for which demand rises if real income falls or for which demand falls if real income rises. Inferior goods are bought when consumers do not have the required purchasing power to buy other preferred goods. Examples would be many of the goods bought by low-income households cheaper cuts of meat, non-brand items, etc. The pure income effect of a price fall leads to increased purchasing power and an increase in demand for all normal goods, which are most goods.

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CONSUMER PREFERENCES
Where do our preferences come from? Parents, school, friends, experience, advertising? Interesting new research has revealed that neuromarketing brain scanning via electroencephalogram mapping and functional magnetic-resonance imaging can be used to analyse consumers purchasing decisions and reveal how preferences feed into purchasing decisions. Neuromarketing is particularly useful for explaining the value of branding. Blind taste tests repeatedly put Pepsi ahead of Coke, which shows up in brain scans that identify greater response of reward centres in the brain to Pepsi. Yet Pepsi is not the brand leader. In non-blind taste tests, where subjects were told which cola they were tasting, Coke won out. Such consumer behaviour was explained in terms of the strength of its brand in the minds of the subjects, which was evident in activity in another area of the brain associated with thinking and judging. If such thinking and judging activity can be stimulated and inuenced by advertising, for example, companies will be able to shape our preferences more clearly! Such research is in its infancy but holds interest for anyone interested in processes that create and change our preferences. Before we get too carried away with such tests, it has also been pointed out that there is a clear difference between a taste test using a small quantity of product and consuming a larger quantity. Specically in the cola example, the immediate sugar reward from drinking Pepsi is apparently much higher and is preferred in taste tests for this reason. Drinking more than a taste changes the consumers perception and the product is found too sweet by a majority of the population no neuromarketing explanation required.

3.5

DEMAND, CONSUMERS AND CONSUMER SURPLUS

Since consumer satisfaction is examined by means of utility, it should be possible to consider the satisfaction of more than one person in isolation. A problem arises though because utility is subjective and while it is possible to consider one persons preferences, by asking them to rank them and try to quantify the satisfaction derived from consumption, it is impossible to sum up the satisfaction of more

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Price 150 100 75 50 S

D
18 27 36 Quantity (000)

FIGURE 3.4 DEMAND FOR CALL CREDIT AND CONSUMER SURPLUS

than one consumer or try to rank their different preferences. Economists try to get around this problem by means of moving analysis from utility to demand, in the knowledge that the sum of individuals consumption choices (based on their marginal utilities) are revealed in the demand for any good. (Economists also use community indifference curves as approximations for the preferences that may be gauged for a group of individuals, despite the difculties involved.) Consider the demand for call credit shown in Figure 3.4, with supply included also. Given demand and supply as shown, the equilibrium in the call credit market is for 36 000 units at 50 per unit (the single consumer considered in earlier analysis is just one buyer in the market). The demand at this price is the result of the decisions of many different individuals based on their derived utility from consuming call credit, and their marginal utility/price ratios. The overall satisfaction generated by the equilibrium consumption can be estimated using the concept of consumer surplus. Consumer surplus the benet to consumers due to the difference between what consumers actually pay to consume a good and what they would have been willing to pay. In Figure 3.4, although the equilibrium price is 50, many people are willing to pay a higher price. At a price of 75, 27 000 units are demanded while at a price of 100, 18 000 units are in demand. In fact the area under the demand function and above the price provides an estimate of the value of satisfaction generated from consumption of this product (shown as the shaded triangle). The area of this triangle is computed as 1.8 million (the area of a triangle is half the base perpendicular height which here is 18 000 100 = 1 800 000). This indicates the estimated value of the satisfaction generated from the consumption of equilibrium call credit.

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3.5.1

CONSUMER SURPLUS AND CONSUMER WELFARE

Welfare economics focuses on assessing the effects of economic policies on both consumers and producers. Such assessments depend to a large extent on the values (or normative judgements) of the assessors because issues of fairness come into play. Issues considered include the conditions under which an economy is most efcient and how goods and income are distributed within economies, and how different economic policies impact on stakeholders. The effect of an economic policy on consumers can be investigated by looking at changes to consumer surplus. For example, if a government ensures that there is additional competition in the taxi market (by allowing extra taxis to be registered), this could lead to an increased supply of taxis. This is shown in Figure 3.5 as the increase in supply in panel B compared to panel A. The result of expanded supply (from S1 to S2 ) with the same demand, is a lower price for taxi fares with a greater quantity supplied: compare P to P and Q to Q . The welfare effects can be considered by examining consumer surplus (CS) in both cases, which is the area above the price and below the demand curve. At lower taxi fares, in panel B, consumers welfare is improved since some consumers unwilling to pay higher taxi fares become willing to demand taxis and those who were willing to pay higher prices still benet given the gap between the price paid and willingness to pay. Consumer welfare can be said to have increased since a comparison shows that CS1 in panel A is smaller than CS2 in panel B.

A Price P S1 CS1 P* D Q Q* Quantity

B Price P

S1

S2

CS2 P** D Q Q** Quantity

FIGURE 3.5

C O N S U M E R W E L FA R E A N D T H E TA X I M A R K E T

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3.6

CONSUMERS RESPONSE TO PRICE CHANGES

The quantity of goods demanded changes in response to price changes, resulting from new marginal utility/price ratios. If the price of all goods fell by 10% consumers would demand more of most if not all goods, but the rise in demand in response to the price fall would not be the same across all goods. This is because consumers are more or less price-sensitive for some goods relative to others. No matter what price cows tongue is I will never choose to increase my demand for it from zero! While individual preferences play a key role in demand decisions and in reactions to price changes we know they are not the only explanatory factor for consumers responses to price changes. A 10% fall in the price of standard pens will not substantially change the quantity demanded for most people since pens are inexpensive and only a small portion of consumers income is spent on them. In the case of goods that are not bought very often, and for which the income share is very small, demand is usually not very price-sensitive. This information is useful in drawing a demand curve because it helps us to decide whether the demand curve is relatively steep or at. For pens the demand curve will be relatively steep indicating that a change in price has little impact on quantity demanded (see panel A in Figure 3.6). Demand for theatre tickets is somewhat more responsive to changes in price as they can be relatively expensive and are quite a discretionary purchase. Hence, the demand curve is relatively at such as in panel B in Figure 3.6. The extent to which substitutes are available for a good also impacts on its pricesensitivity. If the price of one brand of pen were to fall by 10%, rational consumers
A: Pens Price P1 P2

B: Theatre tickets Price P1 P2 D D Q1 Q2 Quantity Q1 Q2 Quantity

FIGURE 3.6

PRICE SENSITIVITY AND DEMAND

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would substitute away from more expensive pens to the cheaper available brand. For a specic brand, price sensitivity is higher than for a broad category of goods. In general it is also the case that the higher consumers income, the less pricesensitive they are because there are fewer limitations on what can be purchased than for people on lower incomes. This means that the demand curves of higher-income households would be steeper than for lower-income households and their quantities demanded would change relatively little in response to price changes. The issue of time is also relevant for analysis of price sensitivity since consumers can adjust their purchasing behaviour more easily over longer periods. If one supermarket chain cuts its prices overnight, many people will continue to shop at their usual shops until they become aware of the price cuts elsewhere and until they are willing and able to change their shopping patterns to take advantage of the cheaper prices (clearly convenience, location and other factors matter for the consumer). This may take time but over longer time periods economists expect consumers to be more price-sensitive than over shorter time periods.

FACTORS EXPLAINING SENSITIVITY OF QUANTITY DEMANDED TO PRICE CHANGE

Ceteris paribus, sensitivity of quantity demanded to price change is low

3.6.1

for inexpensive goods; for goods with a low income share (e.g. clothes pegs); for goods in general rather than a specic good, e.g. all pens vs. Papermate pens; for consumers on high incomes; over short relative to longer periods.

PRICE ELASTICITY OF DEMAND

In the taxi example, when supply expanded the result in equilibrium was a lower price. As predicted by the law of demand, at a lower equilibrium price consumers demanded more taxis. The reaction of quantity demanded can be quantied if information is available on the quantities demanded over a range of prices. The responsiveness of quantity demanded to a change in price is called the price elasticity of demand (PED). PED = % Qd /% P

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Price 150 125 100 75 50 Inelastic: PED < 1 D Quantity (000) 18 27 36 Elastic: PED > 1 Price 125 100 75 50 Q (000) 9 18 27 36 PED 2.5 1.0 0.5

FIGURE 3.7 ELASTICITY AND THE DEMAND FOR CALL CREDIT

If the quantity of taxi rides rose by 10% following a price fall of 5%, price elasticity of demand is 2 (% Qd is 10 and % P is 5 so PED is 2). Demand elasticities are always negative numbers but many economists report demand elasticities without the negative sign, assuming that other economists correctly interpret the number. As the following example shows, information on elasticity is of particular interest to rms in terms of the effects of price changes on their revenues. Returning to the call credit example, price elasticity can be computed, based on the formula above and the information in Figure 3.7.

Price rise from 50 to 75: PED = 25%/50% = 0.50 decline in quantity from 36 to 27 is 9, expressed as a percentage of 36 = 25% price rise of 25, expressed as a percentage of 50 = 50%. Price rise from 75 to 100: PED = 33%/33% = 1.00 decline in quantity from 27 to 18 is 9, expressed as a percentage of 27 = 33% price rise of 25, expressed as a percentage of 75 = 33%. Here, the percentage changes in price and quantity exactly cancel each other out. This is called unit elasticity. Price rises from 100 to 125: PED = 50%/20% = 2.50 the decline in quantity from 18 to 9 is 9, expressed as a percentage of 18 = 50% price rise of 25, expressed as a percentage of 125 = 20%.

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PED differs at different points on the demand curve. In absolute terms (ignoring the minus sign) PED is greater than one when the percentage change in quantity demanded is greater than the percentage change in price. This is elastic PED. PED is less than one when the percentage change in quantity demanded is less than the percentage change in price. This is inelastic PED. An alternative estimation method may be used. Instead of computing elasticity relative to one point on the demand function, it can be estimated as an average over a section of the demand function: Arc price elasticity of demand: Qd 1/2[P 1 + P 2] P 1/2[Qd 1 + Qd 2] Arc price elasticity differs to the earlier method by estimating average price and average quantity demanded. It is most appropriately used for large price changes. Re-calculating elasticities from the data above according the arc elasticity method reveals: 1/2[50 + 75] 9 = 0.72 25 1/2[36 + 27] 9 1/2[75 + 100] = 1.40 25 1/2[27 + 18] 9 1/2[100 + 125] = 3.00 25 1/2[18 + 9]

Price rise from 50 to 75: Arc PED =

Price rise from 75 to 100; Arc PED =

Price rise from 100 to 120; Arc PED =

Price elasticity of demand and total revenue

If a rm wishes to change the price of a good, it can estimate the impact on the quantity demanded of its product by using PED. Staying with Figure 3.7, if the rm is considering an increase in price it can consider the impact on its revenues. From consumers perspectives rm revenue is the same as consumers expenditure. A rms total revenue is price times the quantity of goods sold: TR = P Q

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Example: following Figure 3.7 P P P P P = 0 = 50 = 75 = 100 = 125 Q Q Q Q Q =0 = 36 000 = 27 000 = 18 000 = 9 000 TR TR TR TR TR = 0 = 1 800 000 = 2 025 000 = 1 800 000 = 1 125 000

Price 050 Price 5075 Price 75100 Price 100125

TR TR TR TR

Conclusion: increasing price can lead to rises in TR OR to falls in TR .

The relationship between quantity demanded, price, elasticity and total revenue is also evident from Figure 3.8. In the elastic part of the demand curve, where quantity demanded is very responsive to changes in price, a fall in price leads to an increase in total revenue. In the elastic portion of the demand curve, TR changes in the opposite direction to a price change: in the case of a price increase TR falls and in the case of a price fall TR rises. In the inelastic portion of the demand curve, TR changes in the same direction as a price change implying that if price increases TR rises also. Changes in the price of a good almost always result in changes in total revenue. The exception is at the point on the demand curve where PED = 1 at point c in panel
A Price 150 125 100 75 50 Elastic: PED > 1 a Unit elastic: PED = 1 b c d Inelastic: PED < 1 D 9 18 27 36 Q (000) 9 18 27 36 Q (000) B TR 2 025 000 1 800 000 1 125 000 a* c* d* b*

FIGURE 3.8

D E M A N D , E L A S T I C I T Y A N D T O TA L R E V E N U E

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A when the PED is neither elastic nor inelastic but unit elastic. We saw earlier that unit elasticity arises when the percentage change in quantity demanded is the exact same as the percentage change in price so that there is no change in total revenue.

Price elasticity of demand: some special cases

It is possible to envisage situations where irrespective of what price is charged for a product, the quantity demanded would remain constant. Some necessities would fall into such categories where irrespective of price consumers have to bear any price change. Demand functions for goods to which consumers are addicted might also display such characteristics. Such a demand function would be a vertical line, shown in Figure 3.9. Since quantity demanded does not react at all to any change in price, it is described as a demand function with perfectly inelastic demand. At a relatively high price of P1 in panel A, the same quantity is demanded as at the lower price of P2. At the higher price, the rms revenue and consumers expenditure is higher. At the opposite end of the spectrum it is also possible that demand exists for a product at only one price, also shown in Figure 3.9. This is possible if we consider the output of a single rm with many competitors which can only charge the market price for their product, i.e. the price determined by market demand and supply (this case is considered in more detail later in Chapter 6). Quantity demanded reacts perfectly to any change in price by completely disappearing! The rm can sell as much as it wishes to produce at P3 in Panel B of Figure 3.9. If the rm produces Q2 it will earn higher revenues than if it chooses to produce Q1.
A Perfectly inelastic demand Price P1 P2 Quantity Q1 Q1 Q2 D B Perfectly elastic demand Price D

P3

Quantity

FIGURE 3.9

PRICE SENSITIVITY AND DEMAND

3.6.2

APPLICATIONS OF ELASTICITY ANALYSIS

If a rm seeks to increase its revenue and wishes to change the price it charges for a product, it needs to know to what extent quantity demanded is responsive to the price change. The above analysis shows that there would be little point in a rm

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raising its price with the intention of boosting its revenues if quantity demanded was in the elastic part of the demand curve. In terms of a rms pricing strategy, therefore, it makes sense for the rm to have information on the price elasticity of demand for its product(s). Information on elasticity is not just of interest to business but can be useful for policy-makers also. If a government is thinking about increasing taxes on cigarettes with the intention of reducing the quantity demanded, it needs to have an estimate of the PED for cigarettes. If the function of the tax is to reduce aggregate expenditure on cigarettes, a price increase (via the tax) would have to result in the price rising to the elastic portion of the demand curve. The result of the tax would be that the percentage increase in price would bring about a larger proportionally percentage fall in quantity demanded consumers would buy fewer cigarettes, and the total revenue to cigarette rms would decline. Hence, the responsiveness of consumers to price provides useful information for decision-making.

3.6.3

OTHER ELASTICITY EXAMPLES

Income elasticity of demand

In general if a consumers income increases, it is expected that their demand for goods and services would increase too, but not necessarily by the same proportion. The relationship between the quantity demanded of any goods and income is described by the income elasticity of demand. Income elasticity of demand measures the responsiveness of the quantity demanded of a good to changes in consumers income (I ). It is computed as % Qd /% Y Goods are described as normal goods, if their income elasticities are greater than zero implying the quantity demanded changes in the same direction as a change in income. Most goods fall into this category we buy more of them if our income rises. In the case of inferior goods their quantity demanded declines if income increases. Income elasticities for inferior goods are negative because a percentage increase (fall) in income leads to a decline (rise) in quantity demanded of the good.

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Goods for which the percentage change in quantity demanded is greater than the percentage change in income are described as income elastic (with income elasticity greater than one). This would be the case if income rose by 15% and the quantity demanded of package holidays, for example, increased by 20%. Other goods are called price inelastic when a change in income results in a less than proportionate change in quantity demanded: an example would be a 3% increase in quantity demanded of electricity following a 15% increase in income. Income elastic goods are also known as luxury goods whereas income inelastic goods are necessities.

Cross-price elasticity
The relationship between the quantity demanded of one good and the price of another good is described by the Cross-price elasticity. Cross-price elasticity indicates the responsiveness of the quantity demanded of one good (good A) when the price of another good (good B ) changes. It is computed as % QdA /% PB Cross-price elasticity is of interest for goods that display some economic relationship, such as complement or substitute goods. If car insurance rises by 20%, this may have an impact on the quantity of new cars demanded, a complement good for car insurance, which might be expected to fall and so the cross-price elasticity would be negative. Since new cars are substantially more expensive than insurance, the effect on demand should not be close to 20% and so the cross-price elasticity would be less than one. Among young drivers and focusing on the rst-time drivers secondhand car market, the cross-price elasticity might be considerably higher, when annual insurance costs may even be greater than the price many pay for their rst car.

If Indian and Chinese takeaway food are substitute products, it would be expected that if the price of Chinese takeaways rises, the demand for Indian food would rise as consumers substitute away from the more expensive to the cheaper good, presuming the consumer is indifferent between the goods. This means that the cross-price elasticity would be positive since the price change (rise or fall) in one good leads to a change in quantity demanded of the substitute good in the same direction (rise or fall) as the price change.

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3.7

CONSUMER CHOICE AND PRODUCT AT T R I B U T E S

Many purchasing decisions are made not between very different products such as call credit and nights out, but between different brands or types of similar products. Such decisions can be analysed using the attribute model of consumer demand. This model explains that consumer utility, and therefore demand, is the result of product characteristics, performance features or attributes, other than price. In selecting one brand of a good over another, consumers compare and subjectively rank their preferred attributes, which are those that generate highest utility for them. The features or attributes that explain consumers decisions to buy one variety or brand instead of another are the basis for product differentiation.

3.7.1

THE ATTRIBUTE MODEL: BREAKFAST CEREALS

An individual considering buying one of the variety of competing cereals has decided on the two most important non-price attributes for their subjective purchasing decision as wholegrain cereal and low sugar content. Having evaluated four possible products, the product information is as shown in Table 3.6. This information is also presented in Figure 3.10 where each of the four products is drawn as a line against the two attributes and where the slope of each product line reects the computed ratio of the attributes. The difference in the slopes of the product lines reects the different trade-offs of the two attributes in the

TA B L E 3 . 6 P R I C E A N D AT T R I B U T E I N F O R M AT I O N F O R B R E A K FA S T C E R E A L S
Attribute rating (on scale of 110 where 1 is lowest) Brand
A B C D

Ratio of attributes
2.25 1.40 0.71 0.33

Price
2.35 2.59 2.85 2.99

Wholegrain
9 7 5 3

Sugar content
4 5 7 9

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Wholegrain

Brand A A

Brand B

B C D Brand D Sugar content Brand C

FIGURE 3.10

T H E AT T R I B U T E M O D E L

eyes of the consumer (similar to the concept of marginal rate of substitution discussed earlier). Points A, B , C and D in Figure 3.10 indicate the cost of acquiring each product (which can alternatively be called an attribute combination) as measured from 0 and the distance reects the budget the consumer wishes to allot to buying cereal and the price of each brand. We can simplify having to guess the budget the consumer wants to spend on cereals by assuming our consumer here has sufcient income to buy any of the four products but their purchasing decision is about buying one pack only (for their weekly shopping). This assumption corresponds more closely to how purchases actually occur in terms of one cereal brand versus others. Hence, points A, B , C and D are each one unit out from 0. Points A, B , C and D represent the buyers maximum satisfaction/utility frontier and, for example, reect that at point A the attribute combination corresponding to one unit of Cereal A is 9 for wholegrain and 4 for sugar content. In making the purchasing decision the consumer must evaluate their marginal rate of substitution between the attributes and these are shown by the addition of indifference curves as in Figure 3.11. The decision of which cereal to purchase is seen from selecting the brand that corresponds to the highest indifference curve, which is Brand B on IC4. The next best option is Brand C on IC3, next Brand A on IC2 and nally Brand D on IC1. The attribute model can also be used to consider the effect of price changes as this will impact how far on each product line the consumer can purchase and hence a change in price of one brand changes the utility frontier and the highest indifference curve that could be reached. If the price of Brand B increases, for

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Wholegrain IC2 IC1 A B

IC4 IC3 C D Sugar content

F I G U R E 3 . 1 1 T H E AT T R I B U T E M O D E L W I T H PREFERENCES
example, then with the same amount of money fewer attributes can be bought (or more must be paid for a given set of attributes). This would have the effect of moving the satisfaction frontier reecting brand B from point B to a point on the same line but closer to 0. Following the price change, Brand B might no longer be the consumers preferred choice.

3.8

A G G R E G AT E C O N S U M E R BEHAVIOUR

Moving from individual microeconomic consumer behaviour to macroeconomic behaviour we now turn our focus to the general trend that emerges from analysing macroeconomic consumption behaviour. The higher peoples disposable income gross income less direct taxes the more they plan to spend on consumption goods. If Y denotes income and t denotes the income tax rate, then disposable income Yd can be dened as Y tY = Yd . If Y is 30 000 and t is 25% then Yd is 30 000 less 7 500, which is 22 500. The relationship between planned consumption expenditure and disposable income for an economy is represented by the consumption function, as shown in Figure 3.12. Total expenditure on consumption is made up of two components, autonomous consumption (a ) and a fraction of disposable income (b ), in other words: C = a + bYd

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Consumption bn

C = a + bYd (e.g. C = 50 + 0.8 Yd)

50 a Yd

FIGURE 3.12

THE CONSUMPTION FUNCTION

From the consumption function in Figure 3.12, we see that even if disposable income is zero, some consumption still occurs. In the gure, this value of autonomous consumption is 50bn. This is the intercept value of the consumption function. Consumption expenditure that is independent of the level of income is called autonomous consumption. It occurs if people borrow to buy consumption goods or if they spend their savings (or borrow) when they have no income to pay for consumption goods. People also spend some of their disposable income. This portion of income is represented by b in Figure 3.12 and is the slope of the consumption function. The value of b is different in different countries, and varies over time in countries also. It is a fraction lying between 0 and 1. This means that if disposable income increases by 1, for example, planned consumption expenditure will rise but by less than 1. Any disposable income not spent on consumption is saved. The term b in Figure 3.12 is known as the marginal propensity to consume MPC. The MPC describes the relationship between a change in disposable income and the resulting change in aggregate consumption expenditure. As with demand, the ceteris paribus assumption applies to the consumption function. Many factors help to explain the shape of a consumption function for a group of consumers. Changes in the factors lead to changes in the consumption function, in either the autonomous component or in the marginal propensity to consume or sometimes in both. Disposable income is not the only factor that determines consumption behaviour. Other relevant factors include consumers wealth, and their expectations about future prices and income levels. The higher their wealth, whether measured as

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savings, inherited wealth, property or shares, the higher people tend to consume out of their current disposable income. The rationale is that those with higher wealth have less need to save than other less wealthy consumers. Expectations of higher future prices would induce rational consumers to purchase sooner rather than later as would the expectation of a higher future level of income. Income distribution across a population also affects consumption behaviour since poorer consumers tend to have a higher MPC and tend not to have the luxury of being able to save out of their low incomes. Tastes and preferences regarding borrowing and buying on credit also affect consumption and this is true both for individuals and groups or nationalities. A consumption function shifts with changes in:

Wealth : greater wealth increased consumption (reected in either higher autonomous consumption or a higher MPC). Expectations of future prices and future income : expectations of higher prices or higher income increased current relative to future consumption (reected in either higher autonomous consumption or a higher MPC). The specic effects depend on consumers opinions as to how long higher prices will prevail and the expected increase and size of the increase in income. Income distribution : the higher the share of rich people in the population the lower the marginal propensity to consume as rich consumers have more discretion in how to spend income. A rise in the proportion of rich people in the population would reduce the MPC and may change autonomous consumption also. Preferences regarding buying on credit : an increase in preferences to borrow for consumption purposes increases the MPC and may increase autonomous consumption also.

If the MPC is 0.8 this means that 80p out of every additional 1 is spent on consumption goods. Furthermore, it implies that the marginal propensity to save is equal to 0.2 and that 20p will be saved out of each 1. A savings function can be drawn to correspond to the consumption function above as shown in Figure 3.13. The savings function describes the relationship between income and the desired level of savings. If consumers in Figure 3.13 consume 50bn with an income of 0, they must be borrowing or dis-saving. This is why the savings function in Figure 3.13 begins at 50bn on the savings axis. Since whatever income is not used for consumption is saved, the slope of the savings function is (1 b ) which is 0.2 in this case.

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Savings bn S = a + (1 b)Yd (e.g. S = 50 + (1 0.8) Yd) Yd a 50

FIGURE 3.13

THE SAVINGS FUNCTION

The extent of borrowing or dis-saving in an economy is of interest since some economists have argued any growth in consumer credit can be benecial or detrimental for an economy. The value of economic activity increases when consumers borrow whether it is to buy cars, pay for holidays or whatever the consumption goods purchased. However, if consumers take on too much debt relative to their income, it is argued that there may come a time when consumers can no longer spend on new goods and services and focus instead on paying off old debts. Potentially, that could slow down economic activity. Consumers demand for credit also has a direct bearing on interest rates. Interest rates are the price of money determined in money markets by demand for money and the supply of money (both of which are considered in more detail in Chapter 7). As in any market, if the demand (for borrowed money) exceeds the supply (provided by lenders), prices (interest rates) rise. If demand for credit falls and lenders are trying to ght for customers, they may offer lower interest rates to attract business.

The paradox of thrift is an example of the fallacy of composition which holds that although a certain action might make sense for an individual it does not follow that the same activity makes sense for an economy overall. Increased saving by an individual consumer provides the consumer with increased opportunities for consumption in the future. It does not follow that an economy benets from increased savings. Why? An unexpected increase in savings implies decreased consumption expenditure. Firms will sell less than they planned and require fewer employees to produce output. Unemployment may rise with the result of lower incomes being earned at the level of the economy overall. Falling income has a knock-on effect

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of reducing consumption expenditure. If such a scenario unfolds, the paradox of thrift is observed. Further implications may follow with rms reducing their planned investments in line with lower expectations of consumer expenditure so the process continues on and on until the cycle is ended by changes in behaviour once again.

3.9

GOVERNMENT POLICIES CONSUMER FOCUS

Many government policies are microeconomic in focus and attempt to inuence the demand for specic products such as in the case of cigarettes. Annual government budgets often include increased taxes on alcohol and petrol as governments try to increase their tax revenues. Following the law of demand, with an increase in the price of a good, whether caused by an increase in taxes on the goods or any other factor, the expectation is that quantity demanded will fall. We saw earlier that the extent to which quantity demanded changes in response to a price change depends on the price elasticity of demand for the product, which is related to the initial price and quantity demanded of the good it may be price elastic, unit elastic or inelastic. Macroeconomic policies are also used to affect consumer spending at a broader level. Since consumption expenditure is such a substantial share of economic activity, governments sometimes try to focus policies on increasing consumer demand. This is particularly relevant before and during recessions when consumer demand slows down as people put off purchases that are not entirely necessary. During recessions consumer condence is low and unemployment can be high as rms lay off workers when their output is not in demand. One policy that governments use to affect macroeconomic consumption behaviour is through the tax system. During recessions governments often cut income taxes so that consumers have more disposable income that they can spend on consumer goods. This is one example of how government attempts to affect the consumption function. By cutting taxes, consumers have more disposable income, and hence their consumption expenditures would probably rise. Any change in the tax rate alters consumption behaviour via the consumption function, as explained in this worked example.

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T H E TA X R AT E A N D C O N S U M P T I O N
Consider the following consumption function: C = 50 + 0.8Yd If the net tax rate is 20%, this means disposable income is 80% of national income or Yd = 1 0.2Y = 0.8Y A change in the net tax rate to 30% would affect consumption behaviour by changing the amount of disposable income to Yd = 1 0.3Y = 0.7Y This indicates that when the net tax rate changes consumption is affected. If the change in disposable income had no effect on autonomous consumption or the marginal propensity to consume then the function itself would remain at C = 50 + 0.8Yd However, the impact of having lower disposable income would imply lower planned consumption by consumers. If consumers reacted to higher taxes by saving less, the MPC could increase. The change in tax rate would probably have no impact on autonomous consumption. Alternatively, governments trying to slow down activity in a booming economy might attempt to make savings a more attractive option. Special savings accounts might be introduced such as in the case of the Irish Special Savings Investment Accounts (announced in the Finance Act 2001). In this case the Irish Government provided an additional 25% on each 1 saved in these special accounts (minimum monthly savings were 12.70: maximum were 254), which would be valid for a ve-year period. To qualify for such attractive returns, savings could not be withdrawn before the ve-year period or taxes equivalent to the governments contribution would have to be paid. Approximately 40% of the adult population opened such accounts, which should mature for withdrawals around the time of the next General Election, should the government serve its full ofce. Another government policy that focuses on trying to inuence aggregate consumption is the expansion of public sector employment, which includes teachers, police,

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civil servants, nurses, doctors, etc. By increasing employment in this way fewer people are unemployed and the wages and salaries of the public sector workers can be spent on consumer goods, boosting demand. Unfortunately there are some examples of cases where governments created additional public sector jobs, which although resulting in generating extra consumer demand in the short term also created longterm problems of inefciency in certain parts of the public sector and increased government expenditure via wages and salaries (see Johnson and Scholes, 2001). Other less direct policies are also used by governments to stimulate consumer demand as in the car industry example in the Philippines (outlined in Chapter 2). Because a price ceiling was set, consumer demand for a certain type of utility vehicle was boosted; however, since demand outstripped supply, many consumers willing and able to make their purchase were unable to do so due to the limited supply. This is interesting since it shows how government policies do not always have the desired effects. Governments also try to affect consumer behaviour by policies such as banning smoking in the workplace, as in Norway, New York and Ireland. This means such governments have decided that the social costs of smoking outweigh the benets to consumers who wish to smoke. Many debates rage regarding the right of government to affect consumption behaviour so drastically and point to the tension between protecting the public on the one hand and impinging on individual freedom from a nanny state, on the other.

3.10

SUMMARY

Expenditure on consumption goods is a substantial component of economic activity. Consumption activity can be analysed from a number of perspectives how individual rational consumers make their consumption decisions, how this is reected in the demand for a product in a specic market and how this relates to aggregate consumption.

Concepts that allow us to understand the choices consumers make include total utility, marginal utility and consumer preferences. Price changes impact on planned consumption expenditure, i.e. on quantity demanded, which can be analysed using the marginal utility/price ratio or using budget line and indifference curve analysis.

Consumer welfare can be analysed using the concept of consumer surplus. Economic decision-making regarding consumer behaviour can be supported by analysis of price elasticity.

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The attribute model allows for analysis of demand for differentiated consumer products. Aggregate consumption behaviour is described by the consumption function. Government can inuence aggregate consumption and/or demand for individual products.

REVIEW PROBLEMS AND QUESTIONS

1. Using the information provided, ll in column 3 by computing the marginal utility of car and motorbike consumption. Marginal utility ( TU/ Q) Marginal utility ( TU/ Q) 20 15 11 7 3 0

No. of cars (Q) 0 1 2 3 4 5 6

Total utility (TU) 0 50 88 115 135 150 162

No. of bikes (Q) 0 1 2 3 4 5 6

Total utility (TU) 0

2. If the consumer in question 1 had 60 000 to spend and a car or bike cost 15 000: a. Compute the marginal utility per pound for car and bike consumption. b. Rank the consumers preferred consumption choices. c. What difference does it make to your answers to (a) and (b) if the price of the bike is 10 000? 3. Given the following information on demand for roses in a small town: Equilibrium price Quantity demanded when price is zero Quantity demanded when price is 20.00 10.00 480 0

a. Estimate the consumer surplus. b. If there is a change in the supply of roses that leads to an increase in the equilibrium price to 12.00, estimate the change in consumer surplus. Answer this question by drawing supply and demand curves. Can you think of any reasons that might cause supply to change?

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4. List ve products that you consume and explain why you are/are not pricesensitive in the case of each one. Which products do you think have the steepest and attest demand curves? Why? 5. Using the given information, consider if Fair Furniture Ltd should or should not increase its price of tables (hint: compute the total revenue ). Current price Quantity sold Proposed price Expected sales at price = 325 275 500 325 480

In increasing price from 275 to 325, does this correspond to the elastic or inelastic portion of the demand for tables? Explain your answer. 6. For an economy with a consumption function of C = 50 + 0.8Y and a tax rate of 0.2 (or 20%) a. Rewrite the consumption function in terms of disposable income rather than national income. b. Sketch both consumption functions to consider the effect of taking account of taxation. c. If the tax rate rises to 0.4, what effect does this have on the consumption function? 7. What other products, apart from breakfast cereal, could be analysed using the attribute model? For one of the products you selected, ask two friends to indicate the most important attributes they consider in purchasing the product. Ask each of them to rank their preferences for each attribute (on a scale of 110) for four alternative products. Construct a table like Table 3.6 and draw a gure like Figure 3.10 showing the relative performance of the products in terms of their attribute ratings. 8. Read the following brief case study and answer the questions that follow.

The European car industry: consumers being taken for a ride?

The price of cars across the EU varies considerably for some makes and models. Many consumer groups have voiced concern over this issue and campaign for reform in this market that will result in greater standardization of prices. Despite the introduction of the euro, price divergences were still widespread in 2002, although recent information points to some convergence of prices within the euro zone. An examination of manufacturers recommended retail (pre-tax) prices showed considerable diversity between the cheapest and most expensive countries in the euro zone with the average difference being approximately 10%

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in November 2002, down slightly on the previous estimate of May 2002. The euro zone countries where cars are cheapest are Denmark, Greece and the Netherlands while the most expensive are Germany and Austria. The most expensive EU country is still the UK. For individual cases, some very wide price differences have been recorded, the greatest being for the Fiat Seicento, which costs 59.5% more in the UK than in its cheapest source, Spain. In theory, at least, it should be possible for a European consumer to source a car from a cheaper location. However, in practice the process is not straightforward. For reports on car price differentials across the EU visit: http://europa.eu.int/comm/competition/car sector/price diffs/ a. Would you expect that manufacturers recommended retail (pre-tax) prices would differ for consumers in different countries? Why or why not? b. Why might the introduction of the euro have been expected to reduce any price discrepancies across the euro zone? c. What obstacles might stand in the way of a consumer wishing to purchase a car from another country?

FURTHER READING AND RESEARCH

For more on Simons concept of bounded rationality see Simon, 1957. Interesting recent research on the implications for economics of research into human behaviour was published in Kopcke, Sneddon Little and Tootell, 2004. For related reading see Jensen and Meckling, 1994.

REFERENCES
Heston, A., R. Summers and B. Aten (2002) Penn World Table Version 6.1. Centre for International Comparisons at the University of Pennsylvania (CICUP), October. Jensen, M. and W. Meckling (1994) The nature of man, Journal of Applied Corporate Finance , Summer, 419. Johnson, G. and K. Scholes (2001) Exploring Public Sector Strategy. Prentice Hall. Kopcke, R., J. Sneddon Little and G. Tootell (2004) How humans behave: implications for economics and economic policy, New England Economic Review , First Quarter, 135. Simon, H. (1957) A behavioral model of rational choice, in Models of Man . John Wiley & Sons, Inc., New York.

CHAPTER 4

B E Y O N D S U P P LY: F I R M S IN THE ECONOMIC SYSTEM

LEARNING OUTCOMES
By the end of this chapter you should be able to: Describe the main activities of rms in the economic system. Clarify why rms are necessary within the economic system. Compare and contrast accounting and economic denitions of prot. Use marginal analysis to consider efcient production for a rm taking its costs and revenues into account. Explain how producer surplus is a measure of producer welfare. Apply the concept of price elasticity of supply and explain how it is useful for economic decision-making. Outline the reasons why rms invest and how investment contributes to economic growth. Apply the demand/supply model to discuss how government tries to inuence producers with specic reference to: production subsidies; environmental taxes.

4.1

INTRODUCTION

Just as the economic system relies on consumers for its existence, suppliers play an equally important role in the organization and functioning of an economy. Suppliers facilitate the exchange of goods and services, which is a cornerstone of the economic process. But to see their function as simple intermediaries between people and goods and services would miss the variety of contributions made by rms to the continuation, growth and expansion of the economic system. In section 4.2, these contributions are discussed. The reasons why rms exist at all are presented in section 4.3 and the basic building blocks for microeconomic analysis of rms are presented in detail throughout this section, i.e. output, revenue and costs. This

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analysis is developed further to examine the concept of efcient production from a single rms perspective in section 4.4 in the context of a prot-maximizing rm. Efcient production in the face of a lower cost competitor is also considered here and the extent to which the production decision differs for rms in the short run or long run is examined. Producers welfare is analysed in section 4.5 by estimating producer surplus and this is followed by consideration of how producers react to changes in prices in section 4.6. The discussion turns to focus on aggregate macroeconomic investment behaviour by rms in section 4.7, since the investment function fullled by businesses is a vital contribution by rms to the economic system. The role played by government in attempting to inuence production is dealt with in section 4.8 where the examples of using subsidies and environmental taxes are analysed.

4.2

FIRMS IN ECONOMIC ACTION

Producers make and supply products and/or services to consumers. Most rms operate in the private sector which means those companies are owned and operated by private individuals. Firms owned and/or operated by governments make up the public sector. Firms contribute to economic life in many ways through:

the goods and/or services they provide; the employment they offer; the wages and salaries they pay employees; the money they spend on buying goods and services from other rms; the money they spend on improvements to their businesses (to buy new premises or new machinery and equipment, for example); the taxes they pay for their employees and on their prots; their expenditure on innovation to advance and increase the quantity or quality of products/services they provide.

As we saw in Chapter 3 the consumption behaviour of consumers provides rms with revenue so in terms of attempting to approximate the contribution of rms to economic life, this provides some information. If we consider the overall amount of economic activity conducted in an economy (whether measured as income or output) we note that rms also contribute to each of the other components of activity by:

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providing some of the goods and services that are provided to government and which appear under government expenditure ; supplying goods and services for exports and by importing such goods also, appearing under net exports ; their attempts to maintain and improve the level of capital stock of their companies, and thereby the economy, classied as investment.

The monetary value of rms involvement in economic activity in no way exhausts all the ways in which rms contribute to economic life. Indeed it would be difcult, if not impossible, to put a value on the utility that individual entrepreneurs derive from setting up and running their own businesses rather than working for other employers.

4.3

WHY ORGANIZE AN ECONOMIC SYSTEM AROUND FIRMS?

As outlined in Chapter 2, hypothetically speaking, economic life does not need to include rms. However, it does make better sense for rms to organize some economic activities because it is a more efcient way to use economic resources than if individuals instead engaged in those same activities. Hence, one reason why rms are needed is to save on unnecessary transactions costs that would arise if economic activity were conducted by individuals, instead of by rms. If you were to ask those people actually running rms, the chief executive ofcers or managing directors, why their rms exist, they probably would not explain that it is to help society save on transactions costs. Similarly, although society benets from rms advances to create new and innovative products, most rms would probably not rate societys benet as their reason for existing. Firms exist rather to generate income for their owners or shareholders and such income is generated as long as the rms total costs (in the economic sense) are less than its total revenues. This excess of revenue over costs amounts to a rms economic prots. Economists generally assume that rms exist to generate the maximum possible economic prot they can. This is the principle of prot maximization. This means rms make their decisions about how much to produce and what price they should charge with the aim of making the largest economic prot possible.

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4.3.1

DECISIONS OF FIRMS AND THE ROLE OF TIME

Economists constantly use the terms short run and long run and the distinction is particularly relevant when considering the decisions taken by rms. The short run and long run are not just set periods of time and are rm- and industry-specic. The short run describes the period of time it takes for a rm to change its scale of production and this depends on its xed factor of production usually capital. In the short run a rm has one or more xed factors of production, which constrains its possible output. An ice-cream seller who travels around in his van selling ice-cream cones cannot sell more than his machine, van and supplies can produce unless he decides to put another van on the road. This would take some time depending on his nances and the ease of nding a suitable van, equipment and driver but could possibly be done quite quickly so the short run would be quite short, i.e. the time to get another van up and running.

On the other hand for a ship-building company the short run would be much longer. A signicant amount of equipment and machinery is required to build ships and it could take a long time to build new hangars, buy the necessary equipment and nd the skilled labour if a ship-builder decided to expand its scale of production. The short run in that case could run into several years.

Usually we consider capital to be the xed factor in the short run. When economists conduct analysis in the short run it is also assumed that there are a xed number of rms in an industry, there is no entry of new rms or exit of existing rms. The expressions short-term, medium-term and long-term are also commonly used in economic forecasting and refer to time-periods of up to three years, three to ve years and ve years plus respectively. The long run when a rms output is not limited by xed factors of production the amount of any factor of production can be changed and rms can enter or leave an industry. Essentially the distinction between short run and long run is useful for dealing with day-to-day decisions a rm takes, i.e. short-run decisions and more long-term or

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strategic issues the rm has to deal with, i.e. long-run decisions. The distinction is useful in the context of how theory is applied in economics because it provides a framework for focusing on a more constrained set of decisions in short-run analysis which can be extended as required to focus on long-run issues. In considering how rms try to maximize their prots the sections that follow highlight relevant issues for rms separately for the short and long run. This requires consideration of the revenue and costs of a rm. Decision-making based on economics such as the decision to produce the quantity of output that allows a rm to maximize its prots uses marginal analysis and this is why not only total revenues and costs but also marginal revenues and costs are examined in the sections that follow. Marginal analysis is the process of considering the effect of small changes in one factor relevant to an economic decision (e.g. on output levels or pricing) and identifying whether an economic objective will be met. The objective may relate to prot maximization, benet maximization, cost minimization or revenue maximization as examples. The logic of marginal analysis is that a small incremental change should be made once an economic objective is met there is economic rationale to increasing price only if prots rise, if that is the economic objective. If no change enhances the economic objective (if it is already maximized/minimized) the decision variable should be changed no further. Marginal analysis a method for optimizing decision-making within a reasonably well-dened setting.

4.3.2

FIRM REVENUE

The general pattern followed by the total revenue of a rm with a standard linear downward sloping demand function was presented in Chapter 3 and is repeated here in Figure 4.1. Total revenue received by a rm is calculated as price quantity (in equilibrium) so if price is 20 and quantity sold is 50, total revenue is 1,000. Depending on the amount of output the rm sells its total revenue varies. Since quantity demanded varies with price (higher price corresponding to lower quantity demanded and vice versa), then the price the rm charges has a bearing on its revenues. A rms demand curve provides the information needed to sketch its total revenue curve. Consider the total revenue curve in panel A of Figure 4.1. We refer to the call credit example used in earlier chapters except here we deal with one rm supplying some of this market. If the rm charges a price of 150, consumers are not willing to

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A TR 202 500 180 000 c* b* a* d*

B Rev

112 500

MR

TR1

18

27

36

Q (00)

18

27

36

Q (00)

FIGURE 4.1

T O TA L R E V E N U E A N D M A R G I N A L R E V E N U E

buy its product and no revenue is earned (shown as TR1 in the bottom left corner of Figure 4.1) At a price of 125 the rm would sell 900 units and earn revenue of 112 500 (see a ). If price is relatively lower at 100, more consumers buy the product and 1800 units are sold. Hence, total revenue rises to 180 000 (see b ). If price is cut further to 75, more consumers are enticed to buy the product, 2700 units are sold and total revenue rises further to 202 500 (see c ). Two effects are associated with the quantity increase from 1800 to 2700 for example. On the one hand there is a negative impact on rm revenue since the price has dropped from 100 to 75. However, the effect of increasing quantity demanded more than offsets the price effect and so total revenue rises. Any further cuts in price still increase the quantity sold (e.g. 3600, etc.) but the extra sales at the lower price required to entice more consumers to make their purchase result in lower total revenue for the rm; the effect of the price reduction offsets the rise in sales. The rm maximizes its total revenue if it sells the quantity 2700 but this amount of output can only be sold if the rm chooses the correct price. If revenue maximization is the rms objective it needs to consider what demand for its product is in order to set the required price to sell the optimal amount of output. In panel B of Figure 4.1 marginal revenue (MR) is graphed. Marginal revenue is dened as the change in total revenue associated with a change in quantity demanded. The marginal revenue function shows the amount of additional revenue generated for a rm at different levels of quantity demanded. It is computed as the change in total revenue divided by the change in quantity demanded: TR / Q .

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To understand the linear MR curve, take the example of a rm that sets a high price for its product (say 800 for a wooden table) so that quantity demanded is just one unit. The rm earns total revenue of the price of the table 1 unit = 800. If the rm drops its price to 725, it could sell two tables. If it did so it would earn total revenue of 725 2 = 1450. Since total revenue changes when different prices are charged, so too does marginal revenue. The change in total revenue when two tables are sold compared to when one was sold is 1450 800 = 650. Therefore, the marginal revenue for the rst table sold is 800 while the marginal revenue for the second table is 650. To sell additional tables the rm would have to cut its price further so that the marginal revenue declines further as quantity demanded and sold rises.

Focusing on Figure 4.1 marginal revenue can be computed as: Total revenue 0 112 500 180 000 202 500 180 000 MR TR/ Q 0 125 77.20 25 25

Price 150 125 100 75 50

Quantity 0 900 1800 2700 3600

TR 0 112 500 67 500 22 500 22 500

Q 0 900 900 900 900

Conclusion: marginal revenue declines as quantity demanded rises. Firms must lower price to increase quantity demanded and this impacts on total revenue and on marginal revenue. In Figure 4.1 panel A, total revenue rises up until its maximum at 2700, after which it drops. This means that a small, marginal increase in output from 2699 to 2700 corresponds to the change in output where the effects on total revenue of the drop in the price and increase in quantity of output exactly cancel each other out. Beyond quantity demanded of 2700 any change in total revenue is a decline and this is reected in the MR function, which dips below 0 beyond this level of output.

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The effect of the price reduction beyond 75 has a greater negative effect on total revenue than the effect of increasing quantity demanded. Firm revenue is just one component in the prot-maximizing decision of the rm. The next relevant component is output.

4.3.3

FIRM OUTPUT (PRODUCT): MARGINAL AND AVERAGE OUTPUT

What a rm can produce depends on the inputs available to it, both in terms of the quantity and quality of those inputs. At its simplest, what comes out of a rm depends on what goes in. The exact relationship between inputs and output will be different for each rm since different rms are in different lines of business and will have very different input requirements, different resources, both capital and human. Even for rms within the same industry or line of business, the relationship between inputs and outputs will vary as rms will have different inputs available to them and different strengths and weaknesses in successfully converting their inputs into output. A general relationship between inputs and output, however, can be graphed, as shown in Figure 4.2. Putting one input (labour) on one axis, total output, also referred to as total product, can be drawn. If we consider the output of a rm in the short run, we assume that its capital input is xed while its labour input can be varied. This is the simplest case that we can use to display the relationship between output and factors of production. The S-shape of the total product curve represents the general relationship between variable input(s) and output for any rm, where L1, L2 and L3 represent different numbers of workers. In the short run, the more workers a rm employs, the higher its total output up to a point. Beyond that point (C), additional workers just get in each others way and total output begins to fall.

Output Q2 A B

Total product curve

L1 L2

L3

Labour

FIGURE 4.2

T O TA L O U T P U T ( P R O D U C T )

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The relationship between output and labour input is not a simple linear relationship, as the S-shape indicates. Up to a certain number of workers L1 total output rises more and more with each additional worker. This is reected in an increase in the slope of the total output curve up to point A in Figure 4.2. This is the portion of the total product curve that reects increasing marginal physical product of labour (the MPPL was discussed in Chapter 2). Marginal physical product of labour: the change in the quantity of output produced by each additional worker: Q / L . When L1 workers are employed, MPPL is at its maximum, as seen in Figure 4.3. After point A, the MPPL declines implying that although total output still increases as the quantity of workers increases, its rate of increase slows down. This is reected in a decrease or attening of the slope of the total output curve beyond point A in Figure 4.2. The pattern in the average product of labour can also be considered with reference to Figures 4.2 and 4.3. Average product of labour: total output divided by the number of workers: Q /L . For example, with L2 workers, the rm shown in Figure 4.2 produces Q2 output at point B on the total product curve. If this output corresponds to 200 tables, produced by 160 workers, each worker produces 1.25 tables on average. For all values of total output below Q2 (and the corresponding number of workers below L2 ) the average product of labour is less than at point B . For example, at L1 120 workers produce 140 tables, a lower average of 1.2 tables each. For all values of total output above Q2, and the corresponding number of workers above L2, average
Output Marginal product a b Average product c Labour

L1 L2

L3

FIGURE 4.3 MARGINAL AND AVERAGE OUTPUT (PRODUCT) OF LABOUR

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product of labour is lower than at point B . (At any point apart from B on the total product/output curve, the slope of a line drawn between zero and that point on the total product curve is lower than at point B . The slope expresses the vertical distance between zero and the output quantity relative to the horizontal distance between zero and the quantity of labour, i.e. the measure of average output per worker: Q /L .) At L3 with 260 workers, output is 240 tables, or 0.92 of a table. This explains why in Figure 4.3, point b is the highest point on the average product of labour curve. From this gure we see that:

When the marginal physical product of labour lies above the average product of labour, hiring one extra worker leads to an increase in the average product of labour. When the marginal physical product of labour lies below the average product of labour, hiring one extra worker leads to a fall in the average product of labour. The marginal physical product of labour curve intersects the average product of labour curve from above at the highest point on the average product of labour curve.

The shape of the marginal product curve can be understood from the analysis of the labour market and the discussion of the law of diminishing marginal returns discussed in Chapter 2.

M A R G I N A L A N D AV E R A G E R E L AT I O N S H I P S
Linda is taking a course with ve continuous assessment exercises, each counting for 20% of the overall course mark. Linda would like to do well in all exams but her key objective is to score 50% overall so she can pass the course and move on to the next year of her studies. Linda scores as follows in the exams: Exams Total marks: #1: 60% 60 #2: 65% 125 #3: 52% 177 #4: 60% 237 #5: 64% 301

Lindas average mark after the rst exam was 60%. Her average mark over the rst two exams is [60 + 65]/2 = 62.5%. Her average mark over the rst three exams is [60 + 65 + 52]/3 = 59.0%. Her average mark over the rst four exams is [60 + 65 + 52 + 60]/4 = 59.25%. Her average mark over the ve exams is [60 + 65 + 52 + 60 + 64]/5 = 60.2%.

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The marks received in each exam correspond to the denition of marginal marks the change in total marks for each extra exam completed: the change in marks after the second exam is the total marks 125 minus the marks for the rst exam or 125 60 = 65. You can see that:

When the marginal mark rose (eg. 60% to 65%), the average also rose (from 60% to 62.5%). When the marginal mark fell (eg. 65% to 52%), the average also fell (from 62.5% to 59%). When the marginal mark was greater than the average, the average increased (look at exams #1 and #2). When the marginal mark was less than the average, the average declined (consider exams #2 and #3).

4.3.4

FIRM COSTS

Firms must pay a range of different costs, depending on their circumstances and line of business costs for rent, rates, insurance, taxes, wages, salaries, production inputs, machinery, computers, refuse collection, accountants fees, etc. A rms total costs are the sum of variable and xed costs. Total costs (TC) are the sum of variable costs and xed costs. Variable costs (VC) or total variable costs (TVC) depend directly on the amount of output the rm produces, such as the costs for production inputs and workers. The higher the quantity produced the higher the variable costs. Other costs such as rent and rates must be paid even if the rm produces no output and these costs are called xed costs (FC) or total xed costs (TFC). TC = TVC + TFC Total xed costs can be graphed easily, as shown in Figure 4.4, since they do not change as output changes. If when adding up all a rms xed costs, total xed costs are 2750 per week, then these costs must be paid by the rm if output is zero or not. In panel B of the gure, average xed costs are shown. The average xed cost of the rst unit of output is 2750/1 = 2750; for the second unit it is 2750/2 = 1375;

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A Costs FC = 2 750

B Costs TFC AFC 1000 3000 Output 1000 3000 Output

F I G U R E 4 . 4 T O TA L F I X E D C O S T S ( T F C ) A N D AV E R A G E FIXED COSTS (AFC)

for the third unit it is 917 and so on, so the more the rm produces the lower its average xed cost as the xed costs can be spread across a greater amount of output. The average xed costs of 1000 units of output would be 27.5 while the average xed cost for 3000 units would be 0.92. Variable costs change with output, which was shown above as total output. The total variable costs curve for any rm follows an inverted S-shape since it is related to the total output curve. It is drawn based on available information on the price of inputs and knowledge about the best available techniques (technology) for converting inputs into output. In short-run analysis, technology is assumed to be xed so the cost curves are drawn assuming a certain level of technology. The best technique for transforming inputs into output can depend on the amount of output produced. It may make sense for a large car producer to invest in robotic technology because of the quantity produced but this technology would be too expensive and make no economic sense for a small-scale car producer. Large dairy companies use large container vats for cheese-making; such investment in equipment would be unsuitable and too expensive for smaller homemade cheese producers. The general shape of any rms total variable cost curve (TVC ) is shown in Figure 4.5. The rst units of output generate high initial costs for a rm the rst worker is hired, initial inputs must be bought (often in bulk) and the most efcient ways to produce output are yet to be learned by the workforce often it is only from working on-the-job (learning by doing) that the best ways to produce efciently are understood and put into practice. Hence, in the initial stages of production, until point a on the TVC curve, total costs rise proportionately faster than output. Once efciencies are realized, production costs still increase but not as quickly as output. Beyond point b , there is no point in producing extra output as costs rise signicantly faster than output.

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A TVC Cost b a

B Cost A

TC B

FC Output Output

FIGURE 4.5 COST (TC)

T O TA L VA R I A B L E C O S T ( T V C ) A N D T O TA L

A rms total costs are found by adding up its total xed and total variable costs. Graphically this gives rise to a gure similar to Figure 4.5 panel A, the only difference being it does not start at zero cost when output is zero since xed costs (FC ) must be paid. This is shown in Figure 4.5 panel B , which differs from panel A only with respect to xed costs that have been added on at each point on the total cost curve.

4.3.5

MARGINAL AND AVERAGE COSTS

The marginal and average cost curves that correspond to the total cost curve is shown in Figure 4.6. Average cost (AC) is total cost per unit of output. AC is computed as total costs divided by output (TC /Q ). Average total cost (ATC) is made up of average variable cost (AVC) plus average xed cost (AFC): ATC = AVC + AFC. Marginal cost (MC): the change in total costs as output changes ( TC / Q ). Firms average cost (AC) curves tend to follow a general U-shaped pattern. The AC curve for a rm with relatively low costs would lie below the AC curve for a higher-cost rm. The minimum point on a rms AC curve corresponds to the level of output the rm should produce in order to produce at its minimum average cost. However, an individual rm cannot always sell this amount of output there may not be a market for it. Producing at minimum average cost would be a welcome outcome from the perspective of making efcient use of economic resources but rms do

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Cost MC C AC A B

Q1

Q2

Q3

Output

FIGURE 4.6 COST (AC)

MARGINAL COST (MC) AND AVERAGE

Notes: If TVC = 2500 when 250 units are sold, AVC = 2500/250 = 10. If TVC rise to 3000 when 275 units are sold, the MVC of the additional 25 units of output is 500 in total or 12 per unit.

not always produce this amount of output as it does not always coincide either with demand for their products or with the output level that allows rms to maximize their prots. This is explored further below. From Figure 4.6 we see that:

When the marginal cost curve lies below the average cost curve, producing one extra unit of output leads to a fall in the average cost. When the marginal cost curve lies above the average cost curve, producing one extra unit of output leads to an increase in the average cost. The marginal cost curve intersects the average cost curve from below at the lowest point on the average cost curve.

Explaining U-shaped cost curves

The reasons for U-shaped cost curves differ in the short run and long run. In the short run the rm has some xed (usually capital) and some variable (usually labour) factors of production. A short-run cost curve is drawn for one specic size or scale of plant. Because capital is xed in the short run and the scale of the plant is limited, a rm nds that beyond a certain amount of production the xed factor leads

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to diminishing returns to other factors of production meaning that average costs rise as we see in Figure 4.6 beyond point B when output is greater than Q2. This also helps to explain the shape of the short-run supply curve. When selling ice cream, when one van operates and with both the driver and another employee selling cones, beyond a certain amount of sales trying to expand output by employing an extra worker would only lead to the workers getting in each others way, given space and machine constraints, and would not necessarily expand output at all although the worker would have to be paid and so costs would rise.

In the long run, all factors are variable and each rm can decide on what scale of production it wants, such as how many ice-cream vans to operate and what technology to use. The implications of these decisions will be evident in a rms costs and will depend on its size or scale of production. The U-shape of the average cost curve arises because of the ways efciencies may initially be generated within rms over a certain range of output and how inefciencies may eventually result beyond a certain scale of output. Efciencies and inefciencies arise that are associated with a rms scale of output which can vary over the long run. They are known as economies and diseconomies of scale. Economies of scale are enjoyed when average costs of output decline as output increases. Diseconomies of scale are experienced when average costs of output rise as output increases. For a given set of input prices, if all a rms inputs were increased by 20% and a) its output increased by more than 20% it enjoys economies of scale and its average unit costs would fall as output rises. See Figure 4.6 up to point B . OR b) its output increased by less than 20% it experiences diseconomies of scale and its average unit costs would rise as output rises. See Figure 4.6 from point B on. OR c) its output increased by 20%, it would experience constant costs (more on this below).

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There are a number of potential reasons as to why falling average costs might be observed in the long run: 1. specialization; 2. indivisibilities in production; 3. returns to large-scale production. Specialization: It was Adam Smith who rst explained with his example of a pin factory that splitting up a manufacturing process into separate tasks (18 for pins) made for greater productivity from a given set of inputs. The focus of some workers on specic limited tasks allowed them to specialize and develop the skills most suited to those tasks as opposed to trying to carry out all of the various tasks in the production process. This logic underlies assembly lines that still characterize many manufacturing processes including those for vehicles. Indivisibilities in production : Fixed costs by their nature are a source of economies because the greater the output, the more units over which xed costs can be apportioned. Such costs are also known as indivisibilities in production because they are independent of output. Returns to large-scale production : There are physical or engineering reasons that explain why, in some circumstances, large-scale rms can achieve lower average costs than smaller rms. The engineers rule of two thirds explains how the volume of cylinders expand by 100% if the surface area rises by only 66% (based on the mathematical formula for the area of a cylinder). Similarly for some machines and factories, where their cost represents only two thirds of the value of the additional output they can produce. Large-scale rms might also be able to benet by being in a position to buy machinery and equipment appropriate for large-scale production only. A large furniture manufacturer might be able to buy sophisticated technology that is both appropriate and cost-effective for its high output level allowing it to have relatively low average costs compared to a smaller-scale operation producing lower output and for which the same equipment would not be cost effective because its associated xed costs would be simply too high and inappropriate for the scale of output. Any output greater than Q2 in Figure 4.6 leads to a rise in average costs or diseconomies of scale. This is usually due to the fact that, as the scale of the rms

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Cost

SRAC1 SRAC2 LRAC SRMC1 D SRMC2 Output E

1500

5000

7500 8000

FIGURE 4.7 LONG-RUN AVERAGE COST (LRAC) AND C O N S TA N T R E T U R N S T O S C A L E

operations becomes so complex and bureaucratic, management nds it increasingly difcult to coordinate the operations and average costs rise with scale. At point B on the average cost curve, average costs are neither rising nor falling but constant. This corresponds to a size of plant where there are constant returns to scale. For some rms constant returns to scale are possible not just at one point on their average cost curve but over an entire portion of it as shown in Figure 4.7 between points D and E when output is between 5000 and 7500 units. The rm that might have such a cost curve needs to produce a lot of output before its costs decline to their minimum level but once a large scale of output is produced (5000 units in this case), minimum average costs apply until output expands beyond 7500 units. This cost curve could describe the situation for a large-scale car producer. Once at least 5000 cars can be produced, it makes sense for the rm to buy sophisticated and expensive robotic equipment that can be used to produce such a large quantity of output efciently, so technology can give rise to economies of scale. Point D is referred to as the minimum efcient scale (MES) of production. The minimum efcient scale (MES) of production is the size/scale of plant required if a rm wishes to produce sufcient output to allow it to produce at its lowest long-run average cost. If the car rm in Figure 4.7 has markets for its output it would continue expanding its production to achieve economies of scale implying it could efciently produce up to 7500 cars.

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CHALLENGES FOR CAR PRODUCERS

The car industry in developed countries is often described as mature because growth in the market is relatively modest compared to the growth observed in markets for newer products such as for MP3s. In the mature car market, rms face a challenge since most people who wish to have a car have already purchased. Demand still exists because consumers replace their vehicles over time but no substantial jump in sales is expected as the penetration of cars is considered to have levelled off. Large-scale producers in the market have adopted similar technologies of production and have similar average cost curves. Large-scale production is required to minimize costs and diseconomies of scale set in beyond a certain scale of organization. One approach to competing in such saturated markets is to attempt to take market share from other competitors by offering more valued attributes. Alternatively, companies can acquire or buy out competitors and increase scale, which may be protable once increased coordination costs do not outweigh scale benets. For some companies it might be possible to develop new technology that effectively creates a new market for them such as Ryanair and easyJet in the air travel market. For car manufacturers the tendency over recent years has been towards consolidation across companies via mergers and acquisitions: Daimler acquired Chrysler while Nissan and Renault have merged. Analysts of the industry predict that over the next decade three main international players will dominate the market. It is possible to link long-run and short-run average cost curves since each short-run average cost curve (SRAC ) corresponds to one scale or size of plant; in other words, one xed level of capital. In the short run, with a xed level of capital, a range of output can be produced depending on how many workers are employed, and each quantity of output within that range has an associated cost. In Figure 4.7, two examples are shown for outputs of 1500 and 8000. These SRAC curves indicate the costs associated with producing output when plant size is limited to either a small or a large scale. Neither of these plant sizes allows the rm to produce at its minimum average cost because in the rst case economies of scale cannot be fully exploited because of the small size of the plant while in the second case, the plant size is too big to be optimally efcient and diseconomies of scale have kicked in.

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Finally, you will see that the LRAC in Figure 4.7 does not pass through the minimum points on SRAC1 or SRAC2.

The long-run average cost curve is not a map of minimum SRACs

The LRAC displays all the minimum average cost methods of producing output when all factors of production can be varied. The SRAC displays the average cost of production of a range of output for one plant.

4.4

MAXIMIZING PROFITS IN THE LONG RUN

If rms are to make the most efcient use of their resources, they should produce as much output as possible from the factors of production they use. To decide how much output each rm should produce rms need to consider their prots. Initially here, the case of the long-run output decision is considered. Using analysis as in previous sections, we can examine the marginal revenue and marginal cost position of a sample rm to work out what the best or optimal output should be to maximize its prots. These are shown in Figure 4.8. The rm faces the downward sloping demand curve shown in Figure 4.8. The corresponding MR curve for this demand curve is also shown. The costs facing the

Cost/ revenue/ price

MC

D Q* MR Output

F I G U R E 4 . 8 P R O F I T- M A X I M I Z I N G O U T P U T: R E V E N U E , COST AND DEMAND

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rm are graphed by the marginal cost curve (the corresponding average cost curve is not included to keep the diagram clear initially). To maximize its prots the rm wants to produce output up to the point where the additional revenue earned on its last unit of output covers the costs of that unit. This occurs at output of Q and is found by examining the point where the MR and MC curves intersect and checking the level of output that corresponds to this point. It makes sense to produce output up to Q because up to this output level the marginal revenue curve lies above the marginal cost curve increasing output adds more to revenues than to costs. Beyond Q , this is no longer the case as the marginal cost curve lies above the marginal revenue curve and the marginal costs of further units of output are greater than the marginal revenue earned by the rm. The prot-maximizing output level is found by identifying the quantity that coincides with MC = MR . Once the decision regarding output has been made, this also suggests the protmaximizing price that the rm should charge, as shown in Figure 4.9. If the rm wishes to produce Q , this quantity corresponds to one price only on the demand curve and that price is shown as P . If price were other than P , a quantity other than Q would be demanded. To maximize prots in the long run a rm should:

Establish the quantity that coincides with the point where its marginal costs and its marginal revenues intersect. Based on this quantity, set the price of its product from its demand curve. Ensure that the price it charges customers is sufcient to cover its average production costs.

Cost/ revenue/ price P*

MC

D Q* MR Output

F I G U R E 4 . 9 P R O F I T- M A X I M I Z I N G P R I C E : R E V E N U E , COST AND DEMAND

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This nal point is of huge importance. Consider Figure 4.10, which now also includes the average cost curve. In Figure 4.10 it is possible to compare the price the rm receives if it sells Q to the average cost it incurs for this output. The price and average cost of Q units of output are P and AC respectively. The difference between P and AC indicates that at Q , the price earned is more than sufcient to cover the rms average costs, meaning economic prots are earned. The size of the prots is given by the shaded rectangle. If P = 100, AC = 50 and output at Q = 1800 total revenue (P Q) = 180 000, total costs = 90 000 and prots = 90 000.

4.4.1

PROFIT MAXIMIZATION, NORMAL PROFIT AND EFFICIENCY

For the example shown in Figure 4.10 we can comment on the efciency of the production of the rm in question. The rm is producing the quantity of output for which its average costs are minimized. The quantity Q corresponds to the lowest point on its average cost curve so the rm is operating at the minimum efcient scale of production. The price charged of P is greater than the costs of AC so this rm earns supernormal prots (explained in Chapter 2) because its revenue more than covers the average costs. Remember that the rms costs include payment to the owner of the business that is sufcient to keep them in business, i.e. enough to cover the opportunity costs of the time and efforts of the owner. Quite often it is considered that industries where rms make supernormal prots are not as efcient as they could be because prots are being made beyond normal

Cost/ price/ revenue 175 125 100 75 50 AC* MR 9 Q* 18 27 36 D Output (00) P* MC AC

FIGURE 4.10

P R O F I T M A X I M I Z AT I O N A N D AV E R A G E C O S T

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levels. Rather than having a portion of societys resources used as prots, the argument is sometimes made that excess prots (excess relative to what business owners would be satised to receive to keep them in business) would be better be used for some other purpose. One way of trying to reduce such supernormal prots would be to encourage greater competition in industries where supernormal prots exist and are considered high. This is the function of national competition authorities and national competition policies which is discussed in more detail in Chapter 6. Competition between rms could lead to a new lower-cost rm coming into the industry (if it has access to a more cost-effective technology for example) but as we will see in Chapter 6 whether this is possible depends on the overall structure of the market and how rms compete with others. Also, we already know that rms compete more than just on price (other attributes also matter from consumers perspectives) so charging a lower price might in itself be insufcient to create a real alternative product in the eyes of consumers. Finally, having noted that the rm in Figure 4.10 is operating efciently in production terms, this is not the only possible outcome, as Figure 4.11 indicates. Another rm with different cost structures could have the cost curves as shown. Here the rms prot-maximizing level of output is found where its MR intersects its MC which occurs at the output level Q1. This rm also makes supernormal prots since the price of its output P1 is greater than the average cost of production of Q1. The extent of the supernormal prot is indicated by the grey rectangle.

Cost/ revenue/ price MC AC AC1 MinAC Q1 MR

P1

D Output

F I G U R E 4 . 1 1 P R O F I T M A X I M I Z AT I O N : O U T P U T N O T AT MINIMUM AC

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If we knew that P 1 = 75, that Q 1 = 2700 and AC1 = 35, the rms total revenue (P Q) = 202 500, total costs = 94 500 and prots = 108 000. This rm, facing the same demand conditions as the rm in Figure 4.10, would produce a higher level of output (900 units extra) at a lower cost (25 lower) but manages to make greater prot given its cost conditions. Comparing Figures 4.10 and 4.11, the rm in Figure 4.11 (despite its higher supernormal prots) could be argued to operate less efciently than the rm in Figure 4.10 since its output level does not coincide with the quantity at which it could minimize its average costs. However, Q1 makes economic sense for the rm because this is the quantity that generates maximum prots. Because of cost conditions and demand conditions, prot-maximizing rms do not necessarily produce the level of output that minimizes costs. If substantial supernormal prots are being made in an industry, it is usual to expect that some other rms would be anxious to enter the industry to try to compete and earn some supernormal prots for themselves. A competitor rm might be tempted to enter the industry and charge a price slightly less than the price that would maximize its prots so it would grab the market for itself. Such behaviour, however, could lead to a price war in the industry with different rms cutting price in a tit-for-tat strategy that might end up with all competing rms cutting prices down to their average costs. The only way that rms can earn supernormal prots over the long run is if there are some obstacles or barriers to entry in the way of other rms entering and competing in the industry. Barriers to entry exist when new rms cannot freely enter and compete in a new market. With no barriers all rms competing in the same market would have access to similar technology allowing them to have similar cost structures. Many examples of such barriers to entry exist including:

product differentiation, where rms attempt to offer attributes that differentiate their products from available substitutes; absolute cost advantages, where one rms costs may be so low that no others can compete efciently (if the rm has a patented technology which others may not legally use, for example);

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scale economies, where established rms producing on a large scale have such low costs that a new rm producing a smaller share of the market output would not expect to compete.

Government-granted licences might confer rights to some rms but not to others. Patent restrictions operate somewhat similarly in terms of their impact on potential competitors. For example, newly developed drugs that are patented cannot be manufactured by competitors so pharmaceutical companies enjoy supernormal prots and benet from barriers to entry for whatever period of time the patent is applicable. Such rms enjoy a rst-mover advantage because they are the rst to come up with the drug even though others may have been trying to do so also. Any innovative rm that successfully launches a new product (or invents a new process) will wish to protect its investment in innovation to maximize its return and will benet as long as imitators lack the required expertise or legal permission to imitate and if they operate in an environment where their patent is respected. Society, however, also benets from the dissemination of new inventions and innovations as resources can be used in more efcient ways and to produce previously unavailable products or services. The benet from imitation can be perceived where increased supply of a product leads to a lower equilibrium price for consumers. However as prices fall, the return on the initial investment by the innovating rm declines. Hence, there can be a social effect of the private invention in the sense that society gets the benet of lower prices and/or new previously unavailable products but the original developer loses out. The economist Joseph Schumpeter pointed out that without the incentive of making supernormal prots, some business would never be created and so some inventions and innovations might never occur. Supernormal prots should not be considered always to reect inefciency in the economic system but rather may be the stimulus for creativity that leads to benets both for users of invention or innovations and more broadly if economic resources are used more efciently. This explains why patents, which slow down the dissemination of inventions and innovations, are used as a policy to create incentives for producers to engage in some research activities. It also provides reasons for public i.e. government funding of basic research in universities, in government-owned laboratories and in private industry.

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4.4.2

MAXIMIZING PROFITS OVER THE SHORT RUN

We know that the short run is distinguished by the existence of a xed factor, or factors, of production. In the short run, a rm has xed and variable costs whereas in the long run all factors of production are variable, and hence long-run total costs are variable also. Figure 4.12 includes the cost information for examining the short-run prot-maximizing decisions for a rm. Short-run average total costs are equal to short-run average variable costs plus short-run average xed cost. SATC = SAVC + SAFC The marginal cost curve SMC drawn is relative to the average total cost curve SATC. The decision about what output level to produce in the short run is based on the same logic as for the long-run decision i.e. where SMC = MR. One important distinction, however, between short- and long-run output must be noted. The rm in Figure 4.12 chooses its prot-maximizing output in the short run, Q , from the SMC = MR decision rule. The rm also sets its price from the corresponding point on the demand curve, P . If you compare P to the average cost of producing this level of output, you see that AC lies above the price while AVC lies below. This means that the price is sufcient to cover average variable costs but not to cover total costs. Should this rm remain in business? What is in the rms best economic interest?

Cost/ revenue/ price AC* P* AVC*

SATC SAVC

SMC Q* MR

SAFC Output

FIGURE 4.12

P R O F I T M A X I M I Z AT I O N I N T H E S H O RT R U N

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If the rm decides to produce and sell its output at the price P , it makes an economic loss because its average costs are not covered. However, all average variable costs can be paid and some of its average xed costs. If the rm did not produce in the short run, its xed costs would still have to be paid. The rm has to choose between:

producing zero output and paying for its xed costs; or producing Q at a short-run loss. As long as a rm can generate at least enough revenue to cover its short-run average variable costs of production, it should stay in business in the short run.

The rm needs to cut its costs somehow (or earn a higher price) to ensure the price covers average total costs in the long run or else the rm faces closure. The rm might be able to negotiate new prices with its suppliers, or lower rent from its landlord, or use its equipment more efciently, for example, so that it can reduce its costs and its short-run cost curves would move down over time. A rm that cannot cover its average variable costs in the short run should stop production. Its losses are lower at no output than if its variable costs cannot be covered by the price it earns on output.

Economic analysis
To follow the economic analysis of prot maximization conducted above, economists use demand, cost and revenue curves. The general patterns of the demand, cost and revenue curves have emerged from economists analysis of how rms operate and are analytical tools that help the economist to think about and examine the decisions facing rms. Many rms would probably not be able to draw exact or even inexact diagrams of these curves, however, in their knowledge of how their businesses operate day-to-day and over the longer term, they learn and understand how much they should produce to make prots, when they should cut back on production as their costs rise faster than revenue, and how their customers react to changes in prices. Such information allows rms to change their output in order to improve their prot position. Hence, the analytical tools of the economist are grounded in the reality facing rms and contribute to our understanding of how rms behave.

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4.5

S U P P LY, P R O D U C E R S AND PRODUCER SURPLUS

The supply curve shows us the amount of output suppliers wish to supply at different prices and the upward slope of the curve indicates that the higher the price, the more suppliers are willing to supply, which is related to the increasing marginal costs of production. The benet or utility that producers generate can be analysed using the concept of producer surplus. Producer surplus the benet to producers due to the difference between the price suppliers are willing to receive for their output and what they actually receive. To calculate producer surplus we need to examine the supply curve in equilibrium, as shown in Figure 4.13. In equilibrium, the quantity of output bought and sold and the price charged are shown as Q and P . If price were P0 producers would supply no output in this market because there is no economic incentive supply costs would not be covered. At a price above P0, for example, P1, Q1 would be produced as only those producers who have sufciently low costs would be willing to supply to the market. In equilibrium, however, the price is higher at P so more suppliers produce for this market. While price is P , this means that all the suppliers who would have willingly supplied at a lower price can earn P for their output, thus they benet from receiving a higher price than they require as an incentive to supply the market. The shaded area in the gure above the supply curve and below P represents the sum total of the benet to all such suppliers a measure of producer welfare.

P S P* P1 P0 Q1 Q*

D Q

FIGURE 4.13

S U P P LY A N D P R O D U C E R S U R P L U S

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4.6

PRODUCERS RESPONSE TO PRICE CHANGES

From the shape of the supply curve we know that at different prices producers wish to supply different quantities of output. The extent to which they wish to supply more or less of their output if price changes is measured by the price elasticity of supply. Price elasticity of supply (PES) is the responsiveness of quantity supplied to changes in price. It may be elastic, inelastic or unit elastic. It is computed as the proportional change in quantity supplied divided by the proportional change in price: % QS /% P Arc PES is computed as QS 1/2[P 1 + P 2] P 1/2[QS 1 + QS 2]

If price increases we would expect producers to supply more and for a price fall, we would expect producers to cut back on their output. Thus, price elasticity of supply is usually a positive number. For a PES of 1.5, for every 10% rise in price, quantity supplied would rise by 15%. For values of PES greater than 1, quantity supplied is elastic or relatively responsive to changes in prices. Where PES is less than 1 PES is inelastic a price change of 10% would lead to a quantity change of less than 10%. Where PES is 1, a small change in price has the same proportional effect on quantity supplied. The extent to which suppliers are able to change their output in response to a price change depends on the business and time frame being considered. A ship-builder cannot expand its capacity as quickly as a car manufacturer and the same is true for a car manufacturer relative to an ice-cream van.

In the case of all businesses, however, price elasticity of supply will be lower in the short run than in the long run because in the short run rms will be unable to respond as completely to the change in price as in the long run. The supply curve is atter in the long run than in the short run. In the long run, rms can fully adjust to the price change.

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The long-run/short-run consideration also has implications in terms of the availability of factors of production. The elasticity of supply of factors of production is relevant in determining the elasticity of supply of the products for which they are inputs. If suppliers cannot source inputs required to expand their production when the price of their product rises, they simply cannot expand output. A factory producing cars that cannot source extra steel required to produce additional cars (or that can only source extra steel at relatively high prices) will have little ability or incentive to respond to expected price increases in cars. The quantity rms are willing to supply to a market may not always respond to changes in the price. If the price of potatoes doubled overnight, growers would be unable to adjust their supplies quickly to the new price. Over a short time period, supply would be perfectly inelastic (vertical) where quantity is stuck at the output growers selected before the price change. Rational producers would react over time and where possible expand their output. Some new entrants would switch from growing other crops and still others might establish new businesses in the industry. If the price of cinema tickets doubles, the short-run capacity of a cinema is xed and supply cannot respond immediately. In other markets supply may be perfectly elastic (horizontal) implying that quantity supplied is unlimited at one price only.

Information on price elasticity of supply can be useful for those interested in the future supply of products. Within the EU estimates of supply elasticities are useful in the context of agricultural prices. The EU has an overproduction of many agricultural products milk, butter, beef, mutton, etc. due to its practices of supporting the prices of the products via oor prices. Since the EU wants to reduce the output of these products it has decided to cut the prices gradually over time.

To examine the effect of cutting prices, it would be useful to carry out research on the price elasticities of supply of the products to provide information on the expected supply effects of price changes.

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PRICE CEILINGS, US OIL, INCENTIVES AND PRICE E L A S T I C I T Y O F S U P P LY

In the United States prior to 1978/9 a price ceiling was in place on domestically produced oil. The country was heavily dependent on imported oil, the price of which was determined by demand and supply. Limits on supplies by the Organization of Petroleum Exporting Countries (OPEC) kept the price high. Although the objective of the US oil-price policy was to keep oil prices low for consumers and businesses, the low price was reducing incentives for rms in the industry to engage in more exploration and drilling. A debate followed that focused on the effect of removing the price ceiling in terms of domestic producers responses. How much extra would suppliers supply at higher prices? Estimates of the price elasticity of oil put it at just under 1, meaning that to increase quantity supplied by 10%, the price would need to rise by just over 10%. When the price ceiling was removed the price increased and quantity supplied rose also. Rational consumers and businesses reacted by using oil somewhat more conservatively. Rational suppliers reacted to the higher prices by engaging in further exploration.

4.7

FIRMS INVESTMENT BEHAVIOUR

A key function of rms in the economic system is to maintain and upgrade the productive capacity of their companies; rms engage in investment. Investment leads to the creation of capital assets. Firms invest in xed capital which is plant, machinery and equipment and in working capital, which is stocks of nished goods (inventories) waiting to be sold. In the national accounts, investment also includes the construction of business premises and residential construction. Investment by rms is also called private investment. If a rm wishes to produce a set level of output into the future it must invest sufciently to cover the depreciation of its xed capital. Depreciation is the decline in value of an asset over time attributable to deterioration due to use and obsolescence.

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If a rm wishes to increase its output in the future it needs to invest sufciently in its capital to cover more than just depreciation. An increase in investment by most rms increases an economys productive capacity pushing out its production possibility frontier and leading to economic growth, assuming of course that consumers buy the additional output produced with the new capital (this is expanded on in Chapter 9). Net investment is the term used to describe only that investment which creates new capital assets, whereas gross investment includes the value of capital depreciation plus new capital investment. Expectations about the future play a central role in a rms investment decisions and rms make their best guesses today on what future demand for their products will be and attempt to make the most appropriate investment decisions on that basis. Firms expectations about the future vary over time and the investment component of aggregate demand is actually the most changeable or volatile portion of aggregate demand in the national accounts. Much of the volatility derives from rms behaviour regarding their inventories. Firms inventory levels uctuate widely depending on their expectations about business conditions. While holding a lot of inventories might not make sense due to storage costs or perishability, it makes sense for rms to have some stocks as their predictions about demand are not perfect and having inventories allows them a buffer to deal with unexpected demand so shortages are minimized. In analysing the investment behaviour of rms using the denition of economic activity as planned consumption plus planned investment, planned government expenditures plus net exports, economists usually begin with the assumption that planned investment demand (denoted I ) is autonomous, i.e. independent of the level of national income. This assumption is not far removed from reality because the level of national income today is not a crucial decision variable for a rm thinking about investing; rather the focus for rms is on their expectations of the future and demand for their output in the future. Graphically, this can be represented by the investment function as in Figure 4.14. The investment function describes the macroeconomic or aggregate investment behaviour in an economy. In Figure 4.14, the level of autonomous investment I is constant, whatever the level of national income, Y . Since much of rms investments are nanced by loans, investment decisions are sensitive to changing interest rates, and hence investment

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Investment Investment function Y

I*

FIGURE 4.14

THE INVESTMENT FUNCTION

can be inuenced by policies and activity in the nancial sector of an economy that cause rates to change (these are discussed further in Chapter 7).

4.8

GOVERNMENT INFLUENCE ON S U P P LY A N D P R O D U C T I O N

As the EU agriculture and US oil examples indicate, governments sometimes wish to inuence production. In the case of oil the objective was to increase domestic supply whereas the EU agricultural policies focus on reducing production. For governments trying to increase the output of certain industries, targeted industrial policies may be used. Subsidies are one instrument used by governments to try to support domestic industries. Subsidy: a payment or a tax concession from the government that reduces producers average production costs. A government might wish to use subsidies for an industry that is not competitive and facing a declining market share. Or a strong lobby group with its own particular interests might be successful in negotiating subsidies to stave off competition in the future. In the car industry in the 1970s and 1980s both European and US producers faced stiff competition from Japanese car manufacturers that were using new ways of organizing their factories lean production which facilitated the Japanese rms reduction of their average production costs. In attempts to support domestic car producers, policies were used to try to support domestic output and producers at the expense of foreign output and producers. This meant reducing imports of cars allowing domestic (and higher-cost) producers to serve their home market.

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A P S1

B P

Subsidy: vertical distance between S1 & S2 S1 S2

P* P^ D Q1 Q* Q2 Domestic imports supply Q

P^ D Q1 Q2 Q

Domestic supply

FIGURE 4.15

S U P P LY A N D S U B S I D I E S

4.8.1

USING SUBSIDIES AN EXAMPLE WITH INTERNATIONAL TRADE

By using subsidies, the government transfers some of its revenue (paid to it by various taxpayers) to businesses. This affects the supply curve of the industry receiving the subsidy as shown in the example described in Figure 4.15. In panel A, S1 represents the supply curve of the European bicycle industry, D represents the European demand for bicycles so that P and Q are the equilibrium price and quantity of bicycles bought and sold in Europe. Foreign bicycle manufacturers decide to sell on the European market but they can produce bicycles protably for P and consumers are happy to buy at this price. At the lower price, some European producers cannot protably produce because their costs are too high so they go out of business and European suppliers supply Q1 (which is less than Q ). At the lower price consumers increase their demand from Q to Q2 which means the difference between Q2 and Q1 is made up of bicycles produced by foreign suppliers imported bicycles. The European bicycle industry, unhappy at losing some of its market to producers from outside the EU, lobbies the EU for subsidies to protect the EU market from foreign supplies (imports). The EU agrees and offers a subsidy of 40% of the international price P . If P is 180, the subsidy received by each European bicycle manufacturer is 72 per bicycle. Subsidizing an industry results in a rightward shift of the supply function. The size or amount of the subsidy per unit of output is the vertical distance between the original and new supply functions. (See S1 and S2 in Figure 4.15B ).

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This affects the European supply curve because all producers who were previously willing to supply to the market can now supply more bicycles at each possible price, at no additional cost. Looking at Figure 4.15 panel B , compared to the original supply curve, S1, suppliers who receive the subsidy will supply extra bicycles at each price, which means the post-subsidy supply curve is S2. With the new supply curve and no change in the demand curve a new equilibrium position arises with equilibrium price of P and equilibrium quantity of Q2. Since the new European supply curve intersects the demand curve at a price of P there is no longer any incentive to purchase from abroad, hence imports fall to zero. Economists generally consider subsidies to be an inefcient use of societys resources. To see why this is so, look again at Figure 4.15 panel B . At a price of P on S1 European suppliers wished to supply Q1 bicycles. Once the subsidy is offered, however, this increases to Q2. From the cost-curve perspective this means because of the subsidy, rms average cost curves have shifted downwards. Suppliers who were unable to produce competitively at P prior to the subsidy have been attracted by the subsidy to bring some of their resources into the market. Without the subsidy the resources would be used in some other way and economists consider the best use of resources occurs when people freely react to the prices of products that emerge from markets where demand and supply are set by the market without government intervention. The use of subsidies as shown here has become increasingly less prevalent for a number of reasons. Take the case where the foreign producers, unhappy at being shut out of the European market, would probably complain to their own government who would retaliate by subsidizing some of their industries to keep some European products out of their markets. Such policies are not efcient because the situation where subsidies are paid to different industries in different countries creates articial prices that provide poor signals within the economic system as to how best resources should be allocated to different uses. There is also the argument that it is unfair to use subsidies to protect domestic markets and keep foreign products out, especially in the case of poorer countries that are attempting to develop economically via their agricultural and basic manufactured exports. Such countries may be unable to retaliate against subsidies, thus affecting their economic development (this argument is followed up in Chapter 9). For these reasons industrial subsidies attract a lot of attention internationally and under the agreements signed by countries party to the World Trade Organization (WTO) agreements about the use of subsidies have been reached. WTO rules indicate that any subsidies on exports that distort trade are forbidden and while industry-specic subsidies that harm trade are not allowed either, it is sometimes

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difcult to differentiate between illegal subsidies and permitted practices like providing research assistance and support for taking new environmental technologies on board.

4.8.2

ENVIRONMENTAL TAXES EFFECTS ON PRODUCTION

In the case of some industries that create pollution there is pressure, through the Kyoto Protocol for example, to regulate the amount of pollution created and reduce it where possible. (Named after the city in Japan where the agreement was signed, the Kyoto Protocol set national targets for greenhouse gas emissions.) Governments can inuence pollution production by the process of limiting the quantities of pollutants allowed in products or by imposing taxes. The costs of pollution that are not borne by the rms that generate pollution and are external to the transactions that give rise to the pollution in the rst instance are an example of what are known as externalities. Externalities either positive or negative effects of a transaction by one set of parties on others who did not have a choice and whose interests were not taken into account. Pollution is an example of a negative externality when producers have no incentive to take account of the pollution that is a by-product of production. Expenditure on successful research and development may have positive externalities if rms learn the technological advances achieved and can put them into practice. By imposing taxes on polluting rms, governments force them to take account of the pollution they create. Imposing taxes on producers of pollution increases their costs and pushes their cost curves upwards. The imposition of taxes would have consequences as shown in Figure 4.16. Figure 4.16 panel A shows the equilibrium position for an industry that produces aerosol deodorants which use CFC gases (chlorouorocarbons) that are harmful to the environment due to damage they cause to the ozone layer which is not legally bound to take the cost of the pollution it creates into account. Figure 4.16 panel B presents the situation for the same industry where the government has decided to tax the producers in an attempt to reduce pollution. The amount of the tax is measured as the vertical distance between S1 and S2. Because suppliers have to pay tax on every unit they produce, there is a wedge or difference between the price they receive and the revenue they can keep. When

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A P P^ D Q^ Q S1

B P

Tax: vertical distance S2 between S1 and S2 S1

P2 P^ D Q1 Q2 Q^ Q

FIGURE 4.16

S U P P LY A N D E N V I R O N M E N T A L T A X E S

no tax must be paid (Figure 4.16 panel A), at a price of P suppliers were happy to supply Q in equilibrium. When the tax must be paid and if the market price of the product were P , the producers would receive P less the tax. The reduced revenue received by the suppliers means they no longer have the incentive to supply the same quantity to the market. At the price of P on S2 in Figure 4.16 panel B , suppliers wish to supply Q1. Once a tax must be paid, suppliers wish to supply less output at every price, hence the new supply curve S2. With the new supply curve and no change to the demand curve, a new equilibrium is the outcome with P2 a higher equilibrium price and Q2 a lower equilibrium quantity. We can see that although the tax is the vertical distance between S1 and S2, the price has not increased by the full value of the tax which means suppliers have not passed on the whole tax to the consumers. The amount of tax paid, or the tax revenue received by the government, is shown by the shaded rectangle in Figure 4.16 panel B , which is equal to the amount of the tax (vertical distance between S1 and S2 ) multiplied by the amount of goods bought and sold (Q2 ). If Q 2 = 27 000 units, P 2 = 50 and the vertical distance between S1 and S2 is 20, the amount of tax paid is 540 000. If Q were 36 000, the decline in output resulting from the tax is 9000 units or 33%. If the amount of pollution is directly related to output, pollution will decline by 33% also.

Taxing a polluting industry results in a leftward shift of the supply curve. A new equilibrium ensures with a lower quantity of output and a higher taxinclusive price.

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4.8.3

TAX INCIDENCE

Tax incidence focuses on who ends up paying taxes. In the case of Figure 4.16 we see that when a tax is imposed the effects in equilibrium lead to a reduced level of output but at an increased price. The post-tax price of P2 is higher than the pre-tax price of P ; however, the price has not increased by the entire amount of the tax. A portion of the tax is paid by consumers via higher prices, but some of the tax is also absorbed by the producers. The incidence of tax falls approximately 66% on consumers (prices are 66% higher) and 34% on producers. Consumers pay 13.20 of the tax on each unit with producers absorbing the remaining 6.80. The tax incidence or the degree to which taxes are paid by producers or consumers depends on demand and supply conditions reected in demand and supply curves. Consider the case shown in Figure 4.17. In Figure 4.17 panel A, a tax has been imposed (the same amount as in Figure 4.16); however, the demand curve in this case is quite at, indicating relatively higher consumer responsiveness to price changes. The outcome after the tax is imposed is similar to the previous case. The supply curve moves left or upwards and a lower equilibrium quantity, Q3, is produced at a higher price, P3. The tax revenue generated for the government is shown as the shaded rectangle. With similar supply conditions, and the imposition of the same tax (20 per unit), but a atter, more price elastic demand curve the increase in equilibrium price is less than in Figure 4.16. The quantity decline is greater and the tax incidence is not the same. Here the tax incidence falls more on producers than consumers as the price consumers pay has risen from P to P3 which is approximately 40% of the tax (8 per unit); hence producers absorb the difference of 60% (12 per unit). If Q3 is 20 000 units, the tax revenue collected is 400 000. If suppliers did not absorb a large proportion of the tax, the fall in equilibrium quantity would be much larger, as shown in Figure 4.17 panel B . Here the demand
A P P3 P^ S2 S1 P4 D P^ D Q4 Q^ Q B P

Q3

Q^

FIGURE 4.17

TA X I N C I D E N C E

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curve is presented and the pre-tax price P is shown along with P4 where P4 represents the tax-inclusive price that would prevail if suppliers passed on the full cost of the tax to their customers. The quantity on the demand curve corresponding to the full tax-inclusive price is Q4. The quantity Q4 is substantially less than Q or Q3. Thus, suppliers react by absorbing some of the tax because they know their market and appreciate how price-sensitive their consumers are. The more price-sensitive consumers are, ceteris paribus, the greater the proportion of a tax that suppliers are willing to absorb. High price-sensitivity is reected in a relatively at demand function.

4.9

SUMMARY

The contribution of the business sector (the supply component of the demand and supply model) within the economic system is substantial. We assume rms operate in order to maximize their economic prots. Firms decide on the amount to produce and what price to charge for their output to maximize their prot. A useful distinction for examining some of the most important decisions rms must make is between short- and long-run decisions. To decide on the prot-maximizing level of output requires some analyses of the general patterns exhibited by rms costs and revenues, i.e. total, average and marginal. A supply-side welfare perspective is possible by examining the concept of producer surplus. Economic decision-making by suppliers in response to price changes can be analysed using the price elasticity of supply. Firms investment behaviour has a direct bearing on both the state and growth of a countrys capital stock. Several factors feed into rms investment decisions. Governments affect rms supply decisions in many ways. Examples presented here refer to subsidies, shown here for an industry where international trade is conducted, and environmental taxes. Both are analysed using the Demand and Supply framework.

The effect of government intervention when taxes are imposed can be analysed using the tax incidence approach.

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REVIEW PROBLEMS AND QUESTIONS

1. Identify which of the following are short-run decisions and which are long-run decisions for a business. Explain your rationale in each case. a. hiring one extra worker, b. buying a new computer, c. building an extension to a factory, d. producing 20% more output.

2. Grandons Nursery sells roses and their demand curve is presented below. a. Compute total and marginal revenue that correspond to the demand information in the table below. b. Sketch the companys demand, total revenue and marginal revenue curves.

Price 20 15 12.5 10 7.5 5 0

Demand 0 25 37.5 50 62.5 75 100

Total Revenue

Marginal Revenue

3. Information on Grandons costs are presented below. a. Using the table below and data from question 2, decide on the protable level of output for the rm. Hint: you need to compute marginal costs. b. Sketch marginal revenue and marginal cost on one graph.

Output 0 25 37.5 50 62.5 75

Total costs 100 325 337.5 425 525 750

Average cost

Marginal cost

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4.

5.

6.

7.

8.

a. If Grandons xed costs are 80, compute Grandons Average Fixed Costs and Average Variable Costs. b. Graph Total Average Costs, Average Fixed Costs and Average Variable Costs on one graph. Comment on how the three sets of costs are related. Given the protable level of output for Grandons you chose in question 3, what price should the rm charge for its roses? a. Does the rm earn prots at this price? b. Are supernormal prots earned? c. Explain if the rm should charge either a higher or lower price. Consider that Grandons can produce their prot-maximizing level of output. a. How would you expect Grandons to react in terms of their supply if they could increase the price they receive by 12.5% in one months time? b. How would you expect Grandons to react in terms of their supply if they could increase the price they receive by 12.5% in six months time? As part of a government policy to boost the horticultural industry, a subsidy is to be paid to all nurseries growing organic products. Grandons nursery receives a subsidy of 12.5%. a. Show, using a diagram, the effect of the subsidy on Grandons supply of roses. b. What is the impact of the subsidy on Grandons equilibrium price and quantity of roses? c. Do you think this policy makes good use of the resources available to the Government? Read the following brief case study and answer the questions that follow.

The grey market for cars

Based on the principal of comparative advantage, economists agree that free trade improves welfare. An example of trade is the substantial number of cars, both used and new, imported into the EU each year, which are known as grey or parallel imports. Such grey imports are a feature across many different product markets. Parallel imports/grey imports occur where the goods of a particular producer are imported into a particular territory by a third party in competition with the licensed distributor in that territory. They are called grey imports in allusion to the black market as grey products are sometimes considered to be legally questionable. Producers are usually not in favour of grey imports citing that goods that are distributed through normal distribution channels are targeted and correspond to the needs of buyers in the markets for which they are designed.

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Consumers are sometimes happy to buy grey products because they cost less than the real thing but problems can occur later when they realize that grey products may not meet the standards of the same product that was designed for their market. This is certainly the argument put forward by car manufacturers and there are countless examples of issues relating to grey car imports: lack of warranty because the specication of the car is different for different markets, failure to meet national emission standards, fewer features, failure to meet crashtest standards of domestic cars, etc. Consumers argue that because suppliers try to charge different prices for the same product in different countries (see the case study at the end of Chapter 3), the consumer is right to attempt to source the product legally from another market. Governments appear to be unable to agree on a consistent approach to the resolution of whether parallel imports are justied or not. Therefore, it is left to intellectual property rights to determine the position (intellectual property refers to intangible property that includes patents, trademarks, copyright and any registered or unregistered design rights). a. Use demand and supply analysis to consider how trade has an impact on welfare consider the affects of trade on both consumer and producer surplus. b. Show, using demand and supply analysis, the impact of grey imports on the market for standard (non grey-import) cars. c. Why do you think suppliers (car manufacturers) are unhappy with grey imports are they not still managing to sell their cars?

FURTHER READING AND RESEARCH

There is a rich variety of accessible academic research on supply, rms and rm behaviour. A brief selection is cited below, all of which are worth reading, but which focus on different aspects of rms purpose or functions in the economic system. Coase, 1937; Williamson, 1991; Jensen and Meckling, 1976; Foss, 1997; Penrose, 1955.

REFERENCES
Coase, R. (1937) The nature of the rm, Economica , 4, 386485. Foss, N. (1997) Austrian insights and the theory of the rm, Advances in Austrian Economics , 4, 175198.

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Jensen, M. and W. Meckling (1976) Theory of the rm: managerial behavior, agency costs, and ownership structure, Journal of Financial Economics , 3(4), 305360. Penrose, E. (1955) Limits to the growth and size of rms, American Economic Review , 15(2), 531543. Williamson, O. (1991) The logic of economic organization, in Williamson, O. and Winter, S. G. (eds), The Nature of the Firm Origins, evolution, and development . Oxford University Press.

CHAPTER 5

ECONOMIC ACTIVITY: MACROECONOMY

LEARNING OUTCOMES
By the end of the chapter you should be able to:

THE

Explain how income and resources circulate in an economy between consumers, rms, government, nancial and international sectors using the circular ow of income model. Describe and sketch the business cycle of short-run output trends. Discuss causes of business cycles and their implications for government and business. List the components of real output. Compare alternative approaches to measuring real economic activity: relating personal income and national output/product. Apply the aggregate demand (AD) and aggregate supply (AS) model to: determine equilibrium economic activity and aggregate prices; analyse how changes in aggregate demand and supply affect equilibrium. Apply the concept of the multiplier to assess the effect on equilibrium economic activity of changes in planned expenditure. Examine governments effect on economic activity via government expenditure, budget, decit and debt. Apply a production function approach to analysing economic activity.

5.1

INTRODUCTION

Economic activity for an economy is the outcome of the various decisions taken by consumers (households), rms at home and abroad, and government; in other words the sum of C + I + G + (X M ). When the value of economic activity is analysed over time, it follows a cyclical pattern in the sense that short periods of growth in economic activity have been followed by periods of contraction and the pattern is observed across all developed economies over the last century.

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One approach to examining economic activity is to consider the ow of income generated within an economy over a specic period such as a year, a quarter, a month, etc. using the circular ow model as presented in section 5.2. This allows for analysis of the various sources and destinations of ows of income and resources around an economy. From analysis of such income ows over time, short-term uctuations in economic activity are evident and are referred to as the business cycle, which is examined in section 5.3 (economic growth over the longer term is considered separately in Chapter 9). Economic debate on the possible causes of the cyclical pattern in output is also addressed. The components of economic activity dened according to expenditure categories (C + I + G + [X M ]) are considered in section 5.4 and alternative measures of economic activity based on value-added and income methods are also presented. In section 5.5 a model is introduced that helps to understand how macroeconomic equilibrium economic activity is reached. Using this model of aggregate demand and aggregate supply the equilibrium effects of changes of either aggregate demand or supply can be considered. In section 5.6 the multiplier an important feature of this model is examined in some detail. This analysis provides information as to how changes in expenditure have repercussions in an economy that can give rise to changes in equilibrium output and prices. The contribution of international trade in economic activity is examined in section 5.7. In section 5.8 an alternative and equally valid model for considering aggregate economic activity is presented and its main features are discussed.

5.2

ECONOMIC ACTIVITY AND THE CIRCULAR FLOW

Economic activity over any period is the result of all the decisions of the many different economic units in an economy over that period consumers (households), rms at home and abroad, and government. Production and consumption are the results of the various transactions between these groups, as they buy and sell their goods and services, labour and nancial assets. These transactions are shown in Figure 5.1. The circular ow denotes all transactions in the economic system describing how products, services, resources and money ow around the economic system. Beginning with the market for products and services, we see that goods and services ow from rms to households (consumers). In payment for the goods and services money ows from consumers back to rms. The government also buys some goods

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Market for domestic products and services

for goods and services (G&S) Goods and services (G&S)

Taxes Savings Domestic market for resources Households G&S TP* Resources Government

Taxes Firms G&S G&S Investment

International market for products/ Imports services/ for imports resources

for resources Foreign markets Exports for exports

FIGURE 5.1 THE CIRCULAR FLOW OF INCOME, RESOURCES AND OUTPUT

TP denotes transfer payments, explained further below.

and services from rms and pays for them while the government also provides some goods and services to households, which are partly paid for in the form of taxes paid to it by households and rms. Many of the goods provided to households by government are called public goods, as outlined in Chapter 1. When government provides goods or services that the private sector is unwilling to provide, this is known as market failure since the market incentives do not exist that entice private rms to supply (this issue is further discussed in Chapter 6). An additional transaction involves the government making transfer payments to households. These are payments made to individuals who are not part of the production process, i.e. they do not supply either capital or labour to the economic system. These payments include unemployment benet, pensions, disability payments, income supplement programmes and subsidies. They are called transfer payments since the government transfers some of the money paid to it by rms and consumers (via taxes) to those who qualify for the payments due to their age, level of income, or economic status. Incidentally, to avoid counting transfer payments twice in national income, the receipts of the government count in national income, since they are derived from the income of individuals and rms, but not the transfer payments themselves. Moving to the market for resources, this refers to the various factors of production used by rms to produce their output. For example, households supply their labour

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resource to rms and receive payments in return. Out of households savings in banks and other nancial institutions, rms can also borrow and thus some rms capital is also derived from households resources. The nal set of transactions conducted in the circular ow involves foreign markets. Imports are purchased from foreign markets and payments are sent to the foreign markets to pay for them and nally exports are sent to foreign markets and payments are received for them. In the circular ow of income, injections of income into the ow include:

investment expenditure by rms; government expenditure; income earned as payment for exports.

Leakages of income out of the circular ow include: savings; taxes; income paid for imported goods.

Although not mentioned explicitly in Figure 5.1, the nancial sector, which consists of banks and various national and international nancial institutions, plays a role in facilitating transactions within the economic system. The role of this sector in the economic system is considered in more detail in Chapter 7. Underlying the two-dimensional representation of the circular ow in Figure 5.1 are all the varied and complex institutions that support and underlie its activities. These include (in no specic order) the local, domestic and international nancial systems, systems of corporate governance, legal and political environments, social and cultural background, technological capability and the myriad standards, business and personal ethics, and codes of conduct that are embedded in the economic system. Keeping these in mind helps us to better understand the functioning of the various resource, factor and money markets that are outlined in the circular ow diagram.

5.3

REAL OUTPUT AND THE BUSINESS CYCLE

Economies across the world appear to follow cycles in their production. Graphing countries output over time reveals business cycles a tendency for real output to rise and fall over time in a reasonably regular pattern.

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As explained in Chapter 1, economists focus on real output because it provides a more accurate picture of how much an economy produces in quantity terms over time than the actual or current value of output. Quoting values in real terms effectively means that the effect of price changes is removed and only quantity or real effects remain. Examining real output trends in Figure 5.2, we see that periods of growth in real output are followed by declines in growth. There are periods when real output

A: Business cycle

Real output Peak

One cycle Boom Trough

Boom

Business cycle: short-run fluctuations in real output Trend line: long-run growth in real output

Recession

Recession

Time Contraction Expansion

B: International business cycles

14 France 12 10 % Real output growth 8 6 4 2 0
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19

Germany Ireland Japan United Kingdom United States

20 00

F I G U R E 5 . 2 PAT T E R N S I N R E A L O U T P U T T H E BUSINESS CYCLE

Source: (Panel B ) International Financial Statistics of the International Monetary Fund

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grows quickly and when this growth slows down in a cyclical fashion. The length of a business cycle is measured from peak to peak (also described as boom to boom) where peaks imply the summit of growth of real output. Following a peak/boom although growth remains above its long-run trend for a period, it eventually begins to slow down or contracts. Over time the growth rate falls below the long-run trend and the contraction becomes a recession (trough). The next phase corresponds to the growth rate expanding and ultimately the expansion brings the economy into another boom. Over the course of a business cycle, rms are not always operating at full capacity as there is not always sufcient demand to meet their planned supply. The business cycle is a short- to medium-term phenomenon and usually, although not always, booms (periods of high or fast growth) or recessions (periods of slow or sometimes negative growth) last months rather than years. In comparing Figure 5.2 panels A and B it is clear that observed business cycles are not as regular as the stylized or model case. However, we see that booms are invariably followed by recessions although the regularity varies from cycle to cycle. From examining the average periods for economic expansions and contractions, economists have concluded that economies spend more time in the expansion phase (lasting three to ve years) rather than the contractionary phase (lasting around one year) of business cycles. While business cycles are observed in the short to medium term, long-run growth follows an upward trend. A graph of real output over the last century, for example, shows that internationally real output grew on average by over 3% per annum. This means that the quantity of output produced internationally increased each year by approximately 3%. Since 3% is an average gure, growth was lower in some periods and higher in others depending on the prevailing business cycle. Sometimes output is above the long-run trend (if an economy is booming, workers may be working a lot of overtime and capital equipment may be used at more than recommended full capacity) and at other times it lies below trend. If output is below trend an output gap is said to exist. The output gap is the difference between potential output (also known as full employment output) and actual output. To gure out whether long-run economic growth was of benet in welfare terms we would need to gure out whether the international population grew faster or slower than 3%. If population growth were also 3%, then the growth in output just kept pace with the population and average living standards would be unchanged. In other words people, on average, were no better or worse off (ceteris paribus ). If population growth were 1%, then output growth exceeded population growth

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and people experienced a welfare improvement. This issue is considered again in Chapter 9. (See exercise 5 at the end of this chapter to draw a conclusion regarding the welfare effects of growth.)

5.3.1

EXPLANATIONS/CAUSES OF BUSINESS CYCLES

The question of what causes business cycles is of interest to economists since one of their challenges is to advise on how to increase real output. Because of the interdependent nature of the economic system, an economic shock could have adverse consequences on elements in the system that lead to the cyclical pattern observed in real output. An economic shock is an unexpected event that affects the economy. Some economic shocks affect one economy or a part of one economy more than other economies or other parts of an economy. Such shocks would be described as asymmetric shocks. For example, oil price shocks affect countries dependent on imported oil more than others and affect manufacturing rms more than services rms. Central to the pattern of business cycles are peoples perceptions of what is happening in their local, domestic and international environments and their expectations of what will happen in the future. In terms of trying to identify specic causes of business cycles economists have put forward a number of possibilities but no single source can be identied. In fact some economists view business cycles as the efcient reaction of markets to new information or events somewhere in the economic system while others view them as a signal that markets are not operating efciently. Contractions and recessions may be caused by consumers, who fear a future downturn where unemployment will become a problem and who prefer to hold on to more of their income rather than to spend. In such circumstances a recession could arguably be caused by a change in demand or consumer expenditure. However, the ultimate cause would be the information that led to the initial change in demand. This could be because rms output becomes difcult to sell as it is too expensive and not competitive either at home or abroad (for export goods) and so rms cut back on production. Or maybe rms cut back on their investment expenditure because they are pessimistic about the demand for goods and services in the future (and hence their future prots) or because the loans they need to take out for investment are too expensive. Booms could be explained by opposite economic effects.

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Particular features of the nature of investment might serve to exacerbate business cycles. There is much evidence to indicate that much of the investment undertaken by individual rms is lumpy, meaning it is discrete and takes place occasionally rather than steadily. If different rms make their investments at the same time as others, investment activity will be decidedly cyclical. Rising productivity levels in rms may also drive investment since increases in current output will put upward pressure on the amount of capital equipment required to produce the output and on capital requiring replacement or renewal. As mentioned in Chapter 4, investment is the most volatile component of national income. The explanation of cycles may also have some relationship to cycles in governments, which change regularly every ve years or so if no early elections are called and often patterns of political business cycles are observed. Before elections there is a lot of evidence to indicate that incumbent governments try to present themselves in the best possible light with their electorate by announcing extra government spending, or tax cuts, or both which would boost economic activity. The new government must then deal with any pre-election spending, which might require cutbacks later, contributing to a cycle of economic activity. Variation in the money supply in an economy represents another potential cause of business cycles. While the money market is discussed in detail in Chapter 7, what we can say here is that central banks decisions about how much money to supply to an economy has an effect on an economys interest rate (which is the price of money); and the interest rate, in turn, is assumed to feed into rms decisions about production and employment. An alternative view (of proponents of real business cycle theory) is that changes in money supply and interest rates are reactions to changes in output and/or employment. Real business cycle (RBC) theory is quite a recent approach to explaining business cycles. Real business cycle theory is based on the view that changes in technology, long considered to provide an explanation for long-run economic growth (and expansion of the PPF), also explain business cycles.

The deterioration in technology that followed the oil price shocks of the 1970s meant that the standard production technology became substantially and unexpectedly more expensive over a short period of time due to increased energy costs.

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Such unexpected and adverse technology shocks change the decisions of

rms that wish to cut back on costly production and attempt to pass on the price increases to customers; consumers who demand higher wages to compensate them for price increases and who plan to spend less when faced with such price increases; investors who reduce planned investment since they are pessimistic about a future of high energy prices.

Under such circumstances the market signals lead to reductions in employment, low wage increases (if any), and reduced investment. A positive technological change would have quite the opposite effects. Because of its technology-based approach, RBC theory offers a supply-side explanation for business cycles. There are many similarities between the relatively new RBC theories and the creative destruction explanation of the economic system put forward by the Austrian economist Joseph Schumpeter (e.g. in 1911 and 1939). Schumpeters view of economic development centred on the role of the entrepreneur whose function in the economic system involved spontaneous and persistent (but irregular) introductions of innovations. Schumpeter linked the business cycle to the process of innovation in an economy. When inventors or entrepreneurs try to launch new products they often meet resistance but if a protable opportunity is exploited imitation is likely with new variants of successful products being launched in imitation of successful rst-movers. Production rises until the market becomes saturated and an economic downturn is experienced until the next wave of innovation and new products come along and the process repeats itself again. To fund such innovation requires the supply of credit to entrepreneurs, which highlights the role of the nancial system in innovation and economic development. Entrepreneurs relying on bank loans are found in clusters within the economic system and as successful innovations emerge economies experience booms, while recession phases occur as the economy deals with creative destruction as described by Schumpeter (1975). As we have seen in the preceding chapter, the contents of the labourers budget, say from 1760 to 1940, did not simply grow on unchanging lines but they underwent a process of qualitative change. Similarly, the history of the productive apparatus of a typical farm, from the beginnings of the rationalization of crop rotation, plowing and fattening to the mechanized thing of today linking up with elevators and railroads is a history of revolutions. So is the history of the productive apparatus of the iron and steel industry from the charcoal furnace to our own type of furnace, or the history of

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the apparatus of power production from the overshot water wheel to the modern power plant, or the history of transportation from the mailcoach to the airplane. The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation if I may use that biological term that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in. (Schumpeter, 1975, pp. 8285) An alternative view that business cycles are indicative of markets failing to workis attributed to John Maynard Keynes who wrote The General Theory of Employment Interest and Money (1936). Writing in the aftermath of the Great Depression of 19291932, the focus of Keyness work was on explaining how economies might in some circumstances be unable to prevent themselves from addressing the joint problems of low output and high unemployment and might need some intervention by governments to help them proceed and grow. Economists argue regarding which, if any, markets should be aided by government goods markets where there may be insufcient competition, examined later in Chapter 6, or labour markets if wages are too high, examined in Chapter 8. There are also arguments that the nancial sector through providing insufcient credit represents another example of market failure and any one or all three markets failing to operate as they should could provide an explanation for business cycles. Economists have come a long way from the sunspot theory expounded in the nineteenth century by Jevons, who believed that storms on the sun, observed through telescopes as sunspots, caused crop failures. Since the nineteenth century economy was heavily organized around agricultural production, sunspots were considered an explanation for low production and recessions. Better harvests were associated with booms. This sunspot theory of business cycles had no basis in fact but since it was the initial focus on the question of what causes business cycles, it still receives economists attention. As Benjamin Franklin said, A question is halfway to wisdom. To date, economists have come up with many theories, some of them competing, that provide explanations for business cycles. Despite the lack of agreement on any single cause, what economists appear to agree on is that peoples expectations of what will happen in the future (rms, consumers, government) underlie the pattern displayed in real output.

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5.3.2

IMPLICATIONS FOR BUSINESS AND GOVERNMENT

The fact that business cycles appear as regular short/medium-run features of economies means that business and government are regularly faced with them. Businesses must take account of them in their planning cycles and in the development and execution of their business strategies. Declines or increases in sales should not be interpreted as major strategic problems if they are just part of a business cycle, but a business must somehow be able to analyse whether such a feature is simply a reection of a business cycle or a symptom of a more serious problem that must be identied for their rm to retain and improve its competitive position. Firms need to manage their production and inventories in the knowledge that there will be cycles in demand, sales and prots, over which they have little if any control. In managing their factors of production, management of labour is vitally important. Firms may need to reduce output, which will sometimes require making people redundant. In doing so they must try to ensure minimal adverse impact to their reputation as they may well require additional staff once the economy experiences its next boom period. Given that many countries labour laws are quite strict regarding redundancies and labour regulations generally, letting workers go is not easy in many situations, which sets constraints on rms exibility in dealing with the business cycle. As well as the argument that governments may play a role in causing business cycles, governments are also faced with the challenge of dealing with them. Governments attempt to manage expenditures and tax revenues in their economies, where the business cycle creates some problems. For example, in recessions, when unemployment rises, governments will pay out substantial amounts in benets and at the same time receive fewer tax receipts as economic activity slows down, and may nd that it must borrow to meet its requirements. The hope would be that, when the recession ends and economic growth recommences, enough resources are raised through taxes and reduced benets to cover the costs of any borrowing. How governments try to deal with business cycles is discussed further below and again later in Chapter 8.

5.4

REAL OUTPUT AND ITS COMPONENTS

Any estimate of economic activity, whether over the short or long run, involves measuring the total value of the ow of income/output generated by an economy over a specic period. The denition of economic activity presented in Chapter 3

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corresponds to real output if all components are in real terms, i.e. real output (Yr ) consists of real consumption (Cr ) plus real investment (Ir ) plus real government expenditure (Gr ) plus real net exports (Xr Mr ) as follows; Real economic activity: Yr = Cr + Ir + Gr + (Xr Mr ) This approach to measuring economic activity is called the expenditure approach as it consists of summing up the various parts of economic expenditures by consumers, rms and government. This measure of economic activity is called gross domestic product (GDP). Gross domestic product (GDP) is a location-based measure of economic activity. It measures the value of real output produced in an economy Not all real output remains in the economy where it is produced creating a wedge between the values of real output produced and earned by the citizens of a country. Prot repatriation may occur where foreign companies send some of their prots back to their headquarters in their home country. Property income from abroad may be earned by citizens earning returns on assets they own in other countries. When real output takes all the ows of real output to and from an economy into account, gross national product (GNP) is measured. Gross national product (GNP) is the value of real output that is retained by the citizens in a country after all inows and outows are allowed for. The difference between GDP and GNP is called net property income from abroad. If a countrys net income ows from abroad are positive, then inows exceed outows and GNP is greater than GDP. If net income ows are negative, GDP is greater than GNP. For most countries the difference between GDP and GNP is minor, although countries that have many multinational companies that repatriate substantial prots usually experience a large wedge between GDP and GNP (GDP is larger than GNP). Since both GDP and GNP are used to measure economic activity nationally and internationally it is worth remembering the distinction between them. GNP is also called gross national income (GNI), since national economic activity is the same whether measured in terms of output (the product in GNP) or income that is generated by citizens providing their factor resources to markets for payment.

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5.4.1

OTHER MEASURES OF ECONOMIC ACTIVITY

The income method and the value-added method are alternative approaches to measuring economic activity. The income method involves summing up all income received by an economys citizens in payment for supplying resources to the economy. Payments of wages or salaries are received by owners of labour, interest by owners of capital, rent by owners of land, and prot by those who apply their entrepreneurial ability successfully. In each countrys national accounts (published annually or in many cases also quarterly) the corresponding income categories are called employee compensation, interest, corporate prot, rental income and proprietors income. Summing up these payments gives us an estimate of national income. The value-added method involves summing up the value added by different economic units (usually rms) as products or services are provided for the market. In the example in Table 5.1 four rms are involved in the transactions that produce wooden tables. Initially the tree grower sells trees to a sawmill for processing. The tree grower receives 125 from the mill for each tree it produces. Once the mill transforms the tree into planks of wood, the value of the wooden planks bought by a carpenter is 200. The value added by the sawmill is 75 (200 125). Once the carpenter transforms the planks to tables, their value has risen to 550. The carpenter has added value of 350 to the planks he bought (550 200). The carpenter supplies the tables to a furniture shop which sells the tables for 1000 adding value of another 450. If the market values of each transaction are added up the total is 1875 while totting up value added gives rise to 1000. In assessing the value of economic activity, value added is the relevant amount to be considered because summing up the value of each transaction gives rise to double counting. For example, payment

TA B L E 5 . 1
Firm
Tree grower Sawmill Carpentry rm Furniture shop

VALUE ADDED
Product
Trees Wood planks Tables Tables

Market value
125 200 550 1000

Value added by rm
125 75 350 450

Total

1875

1000

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for the planks sold by the sawmill for 200 includes the payment to the tree grower of 125. To avoid double counting, the value of intermediate goods is ignored in computing the value of economic activity. Intermediate goods are sold by rms to other rms and are used in making nal goods (goods that are not resold to other rms). Final goods are not purchased for further processing or resale but for nal use. In measuring national economic activity it is the total value of all nal goods and services produced in an economy over a specied period that is of interest. In theory, whether economic activity is measured using the expenditure, income or value-added method, the same amount of activity is measured. In practice, some statistical discrepancies are common due to how data are collected.

5.4.2

ECONOMIC ACTIVITY: GNP, GDP AND INCOME

The relationship between measures of economic activity is illustrated in Figure 5.3 where it is possible to see at a glance the components of the different measures and their relationship to each other. Beginning on the left of Figure 5.3 in column 1, GNP and GNI are presented. The relationship between GNP (GNI) and GDP is clear from the rst two columns,
1 GNP/GNI: GDP + NPIFA Net property income from abroad G 4 Income: factor earnings 6 GNP/GNI: NI(bp) + NNP at mkt indirect taxes + prices depreciation 5

2 GDP

3 Expenditure estimate

Depreciation Indirect Taxes Rent Profit Income from selfemployment Wages and salaries NI/NNP at basic prices NI/NNP at market prices

GDP

GDP

I XM C

F I G U R E 5 . 3 C O M PA R AT I V E M E A S U R E S O F ECONOMIC ACTIVITY

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which show that GNP is made up of GDP plus net property income from abroad (assuming NPIFA is a net inow into the economy). If NPIFA is a net outow then GDP would be greater than GNP. Figure 5.3 column 3 shows the expenditure components of GDP. Next we see that the sum of income (factor earnings) plus indirect taxes add up to national income at market prices, which include indirect taxes. Basic prices exclude indirect taxes. Indirect taxes are paid on expenditure whereas direct taxes are paid on income. Adding on the value of depreciation to NI (national income) at market prices provides a measure of GNP or GNI. Depreciation is included because it is the rate at which the capital stock is reduced each year (for annual accounts) due to wear and tear. If economic activity of 100bn is generated in a year, the economy loses some of its capital stock since it deteriorates over the year and net measures of economic activity subtract the value of depreciation from measured economic activity. To summarize, there are several measures of economic activity and sometimes it is necessary to decide which is most suited to a particular purpose. GDP is generally accepted as a sound measure but for countries where a signicant amount of net property income ows to or from abroad, GNP might be a more appropriate measure. There are several ways to compute GNP (adding indirect taxes and depreciation to national income at basic prices or adding net factor inows from abroad to the components of GDP) but irrespective of which method is used the same measure is being estimated.

W H AT G N P O R G D P D O N O T M E A S U R E
Not all economic activity is measured and reported in national statistics. A black economy is said to exist where people do not declare income for tax purposes and hence the activity is not accounted for in national statistics. The extent of hidden economic activity varies across countries and some countries are culturally more comfortable with not reporting income than others. Some economic activity goes unmeasured if not unnoticed because it is unpaid. Stay-at-home women/men who take over childcare or household duties for no pay do not have their contribution to economic activity measured although the value of their activity could be measured by using estimates of market costs for childcare and housekeeping.

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Arguably the production of pollution, noise, and congestion should be deducted from measured economic activity since they are also part of economic activity but represent negative outcomes. However, this would be difcult to put into practice since there is wide debate about how to decide on the value of their output or to place a cost on it. Hence, measures of economic activity are not perfect but do provide us with some information about economic activity and allow us to make comparisons across countries and for countries and regions over time.

5.5

EQUILIBRIUM ECONOMIC ACTIVITY

Different methods can be used to estimate the value of economic activity. An interesting question arises as to what determines whether a countrys economic activity is relatively high or low. Many economists enter the discipline with a desire to understand better how to encourage higher rather than lower economic activity. Another way of thinking about the same question is to try to imagine what factors generate high expenditure on each of the components of economic activity, i.e. C , I , G, X M. Having considered short-term business cycle uctuations in economic activity it is also possible to think about modelling equilibrium economic activity, the longrun trend. This involves assessing those factors we think are the most important determinants of economic activity. A number of different approaches have been used to examine the determinants of economic activity. It is necessary to identify whether the issue of interest is:

the determination of the level of economic activity; or the determination of growth in economic activity;

as the determinants are related but not exactly the same in both cases. In this chapter we focus on the rst issue and return in Chapter 9 to the second. At the level of an economy, analysis of both the demand and supply is required to consider equilibrium economic activity. However, different concepts are used to examine demand and supply in relation to national economic activity compared to those we have met so far. National economic activity is the sum of activity by all of the economic decisionmakers including households, producers and government. For this reason it is also called aggregate economic activity.

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Aggregate economic activity is examined by using the concepts of aggregate demand and aggregate supply and an examination of equilibrium economic activity requires both.

5.5.1

THE PRICE LEVEL

Aggregate supply (AS) is the amount of output rms are willing to supply at different price levels. The price level of interest for aggregate economic activity is, not surprisingly, aggregate prices. National statistics providers collect information about prices on a regular basis using survey techniques and estimate the average price level, which is a weighted average of the prices of all goods and services. Taking a simple example, if citizens main expenditure is 30% on food, 25% on clothing and 45% on entertainment and if in 2002 and 2003 average prices of food, clothing and entertainment are as shown in Table 5.2, the change in price level can be estimated. If the average price level rises, ination is observed while if average prices fall, deation occurs. (Ination is discussed further in Chapter 8.)

TA B L E 5 . 2 AV E R A G E P R I C E L E V E L S A N D I N F L AT I O N A N E X A M P L E
Food
Value of expenditure 2002 (2002 prices) Value of expenditure 2003 (2003 prices) A: Weights 2002 prices B: Weights 2003 prices Ination rate ((B A)/A) 100 5150

Clothing
2850

Entertainment
3250

Total
11 250

5325

2915

3450

11 690

1545 1597.5 3.40%

712.5 728.75 2.28%

1462.5 1552.5 6.15%

3720 3878.75 4.27%

Note: Weights used are those given in the text: 30% on food, 25% on clothing and 45% and are assumed to be the same for 2002 and 2003.

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While we know there is no such aggregate good as food, we can consider that it is made up of rice, pasta, cheese, fruit, etc. a representative basket of goods bought by the average person. We can further assume that an average price for all the various components of food can be computed with information on expenditure shares. Similarly for an aggregate good such as clothing or entertainment. In Table 5.2 the prices of the same amounts of the same goods are measured in both years so a like-with-like comparison can be made. In practice, this is almost impossible to implement since many goods are not exactly the same from month to month or year to year. The quality of food goods might increase or decline or different materials might be used in clothing, for example. In trying to measure price levels over time, however, we assume that quality is reasonably similar to allow reasonable comparisons to be made. The level of average prices is shown for each year in rows 4 and 5 of Table 5.2. The same quantities of goods that cost 3720 in 2002 cost 3878.75 in 2003. This indicates that the average level of prices went up. The extent of the increase is found by measuring the increase in the average price levels between 2002 and 2003 and expressing it as a percentage of the average price level in 2002. Thus, the annual ination rate for the economy is computed as 4.27%, with components for each of food, clothing and entertainment as shown. Ination was highest in entertainment and lowest in clothing. Ination is often measured using the consumer price index, which is essentially a weighted average of a comprehensive list of the prices of goods and services taking into account their shares in expenditure. It is a more complex but essentially similar process to the example in Table 5.2.

5.5.2

AGGREGATE DEMAND

Aggregate demand is the demand for output (of all goods and services) at different price levels. Demand for output can be thought of in terms of the demand for consumption, investment, government and traded goods (remember C , I , G , X M ). As a result the aggregate demand curve is a far more complex concept than the demand curves considered so far. This becomes evident when considering its shape and how it is derived. Before examining aggregate demand, it is necessary rst to understand the link between aggregate expenditure and aggregate demand, shown in Figure 5.4. Figure 5.4 panel A shows two aggregate expenditure functions which graph planned expenditure against national income (Y ): planned expenditure consists of C , I , G , X M.

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A Planned expenditure AE1 a AE2 b 45 Y2 Y1 c

B Aggregate price level PH b

PL

a AD

Y Y2 Y1

F I G U R E 5 . 4 A G G R E G AT E E X P E N D I T U R E A N D A G G R E G AT E D E M A N D
An aggregate expenditure function indicates total planned expenditure in an economy for different levels of income or output (denoted Y ). The aggregate expenditure functions slope upwards indicating that the higher national income (Y ), the higher planned expenditure. This makes sense since plans to spend depend on income and the higher (lower) income is, the higher (lower) planned spending will be. Each aggregate expenditure function is drawn for a specic price level so we can see citizens, rms and governments expenditure plans at different levels of income for one specic price level. If the price level changes, peoples planned expenditures change too. In the case of an increase in the price level, planned aggregate expenditure falls. We see this in a comparison of AE1 with AE2 where AE2 is the aggregate expenditure curve after an increase in the price level. Beginning at point a on AE1 when income is Y1, this corresponds to the lower price level. If the price level rises, then with the same amount of income, Y1, people will cut back on planned expenditure to point c on AE2 because they cannot buy the same amount of goods with the same amount of income. At the higher price level, planned aggregate expenditure falls (from AE1 to AE2 ). The dashed line in Figure 5.4 panel A needs some explanation. At all points on this line, planned expenditure coincides with national income (output): AE = Y .

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An economy in equilibrium generates sufcient income (output) to match planned expenditure; hence this occurs at only one point on each AE function, such as a on AE1 and b on AE2. In Figure 5.4 panel B the aggregate demand function is shown. Each point on an aggregate demand function is taken from the point on a corresponding expenditure function where the economy is in equilibrium where planned expenditures = national income. When the price level is relatively low at PL, the corresponding level of income shown in Figure 5.4 panel B is at a (and this corresponds to the point of equilibrium at a on AE1). When the price level rises to a higher level at PH, this corresponds to a lower amount of national income at point b (which corresponds to the equilibrium point b from AE2 ). Each point on an aggregate demand curve corresponds to an equilibrium point on an AE function. There are three reasons why the aggregate demand curve slopes down:

the real wealth effect; the interest rate effect; the international trade effect.

The real wealth effect: When there is a change in the price level, this has an impact on consumers utility because with the same amount of income they can buy more consumption goods if the price level falls (or less if the price level increases). In real terms a change in the price level affects consumers because of the effect on their purchasing power. A 10% increase in the price level means for a given amount of income, 10% less goods can be bought. Because consumption is such a signicant portion of aggregate expenditure, the change in planned consumption brought about by a change in the price level is clearly reected in a negative relationship between the price level and income observed in the aggregate demand function. The interest rate effect: If the price level increases, people need and demand more money for their purchases (some purchases can be put off until the future but others cannot). In the short run the amount of money in an economy is xed (by the relevant central bank, to be explained later in Chapter 7). Any increase in the demand for money puts upward pressure on the price of money, the interest rate. Higher interest rates have implications for many components of aggregate expenditure. If the interest rate rises, this has implications for business investment, since much of it is nanced by bank loans. Buying consumption goods on credit is also adversely affected by increased interest rates and some government expenditure may also be reduced due to a higher interest rate. An increase in the price level

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that leads to a higher interest rate leads to lower aggregate demand hence the AD curve slopes down. The international trade effect: Any change in a countrys price level relative to the price level of its trading partners has an impact on the attractiveness of international trade. A countrys exports become less attractive if the exports become relatively more expensive. If an exporting countrys prices rise faster than its importing partner countries, rational buyers will prefer the products for which prices are not rising so rapidly (this will be the case where similar products substitutes are available and where the prices were quite similar before the exporters prices rose). Changes in price levels affect both export and importing activities and since both exports and imports are components of aggregate demand the effect of an increasing price level that reduces net exports (X M ) is reected in the downward slope of the aggregate demand curve.

5.5.3

AGGREGATE SUPPLY

To consider aggregate supply, it is useful to return to the concept of efcient production discussed (in Chapter 1) when we dealt with the production possibility frontier. There is a constraint on the maximum amount of output rms in an economy could produce irrespective of the price level because an economys resources are limited. An economy that produces the maximum feasible output with all resources fully employed operates at potential output and this is shown as Y in Figure 5.5. The relationship between the average level of prices and aggregate supply is shown here. Potential output is a countrys output level if all resources were fully employed.
Aggregate price level P4 P3 AS

P2 P1 P0 Y1 Y2 Y^ National income

FIGURE 5.5

A G G R E G A T E S U P P LY

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The shape of the aggregate supply curve indicates that the relationship between output and the price level varies, depending on the economys output level. Initially aggregate supply is at, then slopes gently upwards only to become steep as it coincides with potential output. This relationship describes how rms react to the price level. There is a minimum price level required for rms to consider it worth their while to supply a market with goods. In Figure 5.5 this level is P0. This corresponds to a situation where an economy has low income (recession phase of the business cycle), rms have a lot of spare capacity and many resources are unemployed. Firms are willing to sell at the going market price and would like to sell more output at the going price. If an economy is producing output Y1 at a price level P1, any change in the price level will cause rms to change their output. A decline in the price level would lead to lower output because rms would perceive that they would have to cut their prices to sell their output and lower prices would make some rms uncompetitive; they would stop producing and output would fall (in Chapter 8 we will look at the factors that might bring about such a fall in the price level). An increase in the price level from P1 to P2 would have the opposite effect and output would expand from Y1 to Y2 indicating rms willingness to expand supply as the higher price level allows them to remain competitive and charge higher prices. A proportional increase in the price level from P3 to P4, however, does not have the same impact on output. If the economy begins from a position where the aggregate price level is P3 then the economy is producing very near its potential output. Any rise in the price level, such as to P4, has no signicant impact on output because rms have little extra capacity. Analysis of aggregate supply depends on whether the short run or long run is of interest. In the long run, it is assumed that an economy will operate at full employment and hence the long-run aggregate supply curve is that shown in Figure 5.6. The long-run aggregate supply (LRAS) curve is a vertical line drawn at potential output. The quantity and quality of the available factors of production and the available technology (for converting inputs into output) determine the amount of potential output an economy can supply. Hence, LRAS is not inuenced by the price level the same amount is produced irrespective of the price level. (The aggregate supply curve illustrated earlier in Figure 5.5 may be considered to correspond to the short-run aggregate supply,

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Aggregate price level

LRAS

Y^

National income

FIGURE 5.6

L O N G - R U N A G G R E G A T E S U P P LY

or it can be treated as a combination AS curve that combines elements of both short-run and long-run behaviour.) The determinants of Y are inuences on the quality and quantity of factors of production including the local, domestic and international nancial systems, systems of corporate governance, legal and political environments, social and cultural background, technological capability and the myriad standards, business and personal ethics, codes of conduct that are embedded in an economic system, as referred to earlier in the discussion of the circular ow.

5.5.4

BRINGING AD AND AS TOGETHER: THE SHORT RUN

A countrys equilibrium output and price level are determined jointly by its aggregate demand and aggregate supply functions, as shown in Figure 5.7 for the short run. Here, equilibrium output is SRY (where SR denotes the short run) and the equilibrium price level is P corresponding to the intersection of aggregate demand and aggregate supply. The economy shown is not producing its potential output, so some resources are not being employed and the government might want to try to boost output. There are different avenues to encouraging the use of more resources boosting either aggregate demand or aggregate supply. (You may wish to sketch this situation using Figure 5.7 as your starting point: this analysis is further considered in Chapter 8.) Any increase in aggregate demand moves the AD curve upwards (to the right) bringing about a new equilibrium position involving increased output and an increased aggregate price level. Any expansion in aggregate supply moves the AS rightwards leading to a new equilibrium position involving higher output but a lower aggregate price level than P .

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AS

P*

AD Y

SRY*

F I G U R E 5 . 7 S H O R T R U N : A G G R E G A T E S U P P LY A N D A G G R E G AT E D E M A N D
The challenge in intervening in the economy is to implement policies that have the desired outcome. While this may appear straightforward using the theory of AS-AD presented here, in practice it represents a problem for governments and businesses alike for a number of reasons considered in more detail in Chapter 8.

5.6

EQUILIBRIUM ECONOMIC A C T I V I T Y A N D T H E M U LT I P L I E R

When there is a change in aggregate demand, whether caused by a change in C , I , G or (X M ), equilibrium output changes. In sketching a movement in the AD curve, however, we lose sight of the process according to which this change occurs in the economy. Take the example of a change in consumption expenditure. Autonomous consumption drops by 25bn from 50bn, for example. This leads to a new consumption function (this can be sketched using Figure 3.12 as the starting point) and also a new AD curve. The immediate effect of a drop in autonomous consumption is that equilibrium income drops by the same amount (as the AD shifts down or to the left). The initial drop in autonomous consumption, however, has knock-on or domino effects. The drop in income caused by the drop in consumption also causes a further drop in consumption because consumption also depends on the level of disposable income (refresh your memory by returning to section 3.8 if required). This further drop in consumption causes a further drop in income, causes a further drop in consumption . . . and so on. The total effect of the drop in autonomous consumption is greater than the initial change that caused it, with a multiplicative effect. This implies that if autonomous consumption falls by 25bn, the effect on

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equilibrium output will be an even greater fall. Each economy has its own national income multiplier. The multiplier indicates how much income/output changes after a change in autonomous expenditure. The size of the multiplier for an economy that does not engage in international trade (and therefore has no exports or imports) can be found according to the following formula: Multiplier = 1 (1 MPC )

The value of the multiplier depends on the value of an economys marginal propensity to consume out of national income (MPC ). In Chapter 3, the marginal propensity to consume out of disposable income was discussed (MPC ). The relationship between the marginal propensities is: MPC = MPC (1 t ) where t is the tax rate. If the tax rate is 0.2 (equivalent to 20%) and peoples marginal propensity to consume out of disposable income is 0.95, then the marginal propensity to consume out of national income, according to the above equation, is 0.95 (1.0 0.20) = 0.76.

The ratios of disposable income to GDP for 2001 were 71.3% for the euro area, 73.3% for the USA, and for Japan, 60.3%. These data are from the international statistics of the European Central Bank, http://www.ecb.int/stats.

To compute the multiplier if the MPC is 0.76, then 1 MPC is 0.24 and the multiplier is 1/0.24 = 4.16.

This implies that any change in autonomous expenditure (e.g. autonomous consumption, I or G where each is independent of the level of national income) leads to a new equilibrium income/output of 4.16 times the initial change.

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For a higher tax rate, this would change the MPC and the value of the multiplier, as shown in Table 5.3. As the tax rate rises, a greater proportion of aggregate income is paid in taxation, representing a leakage out of the circular ow. As the leakage increases (with t ), the impact of any change in autonomous expenditure declines, as shown by the fall in value of the multiplier. The size of the multiplier for an economy that is involved in international trade is different to that presented above and is found as: Multiplier = 1 [1 (MPC MPM)]

where MPM denotes the marginal propensity to import.

TA B L E 5 . 3 RISES
MPC
0.95 0.95 0.95

V A L U E O F T H E M U LT I P L I E R A S TA X R AT E
(1 t ) 0.80 0.70 0.60

t
0.20 0.30 0.40

MPC : MPC (1 t )
0.76 0.665 0.57

1 MPC 0.24 0.335 0.43

Multiplier:

1 (1MPC )

4.16 2.99 2.33

Conclusion: for a given MPC, an increase in the tax rate leads to a reduction in the multiplier.

TA B L E 5 . 4 MPM

V A L U E O F T H E M U LT I P L I E R I N C L U D I N G
Multiplier:
[1 (MPC MPM )] 0.49 0.585 0.68 1 [1 (MPC MPM )] 2.04 1.71 1.47

MPC
0.95 0.95 0.95

t
0.20 0.30 0.40

(1 t ) 0.80 0.70 0.60

MPC
0.76 0.665 0.57

MPC MPM
0.51 0.415 0.32

Conclusion: inclusion of the MPM reduces the value of the multiplier because it represents an additional leakage of income from the circular ow.

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TA B L E 5 . 5 T R A D E S H A R E S O F E C O N O M I C ACTIVITY (% GDP) 2002

USA X : exports M : imports X M : net exports
6.5 11 4.5

UK
18 21 3

Ireland
72 43 29

Germany
30 24 6

Japan
10 7.5 2. 5

Source: Economist Intelligence Unit, Country Data except for Ireland: Trade Statistics of Ireland, Irish Central Statistics Ofce.

Payments for imports represent a further leakage of income from a countrys circular ow, hence the multiplier is different. For a country with an MPM of 0.25, the impact on the multiplier is shown in Table 5.4, which extends Table 5.3. The extent to which imports and net trade is important for different countries is shown in Table 5.5 which presents the share of exports (X ) and imports (M ) as values of each countrys GDP, for a sample of countries. Both the USA and UK experienced trade decits in 2002 because the value of their imports exceeded their exports. Japan, Germany and Ireland displayed trade surpluses. Countries comparative advantages (see Chapter 2) help us to understand a considerable portion of the international trade that takes place between them.

5.7

I N T E R N AT I O N A L I N T E G R AT I O N

A key characteristic of the current international economic system is the extent to which individuals, rms and countries are exposed to inuences from foreign goods, services, rms, capital and labour. Individuals and economies are increasingly faced with contributions by far distant people and places to their lives. Evidence for this is found, for example, in the growth in international trade. World growth in exports outstripped world GDP growth between 1995 and 2000 by a factor of more than two (7% per annum compared to 3%). Over the longer period spanning 19482002, the gures are 6% for exports and 3.7% for GDP (see www.WTO.org for more national and international trade information and statistics).

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Trade provides outlets for countries output when domestic demand is insufcient to allow rms to sell all produce. The trade option also provides rms in some industries with the possibility of reaping scale economies, allowing them to reduce their average costs of production as their output expands. Hence, not only can trade lead to greater quantities of output produced in an economy in response to access to more markets, but it can also generate greater efciency in terms of how resources are used within economies.

5.7.1

EXPLAINING GROWING INTERNATIONAL TRADE

A number of factors explain the growth in world trade. Declines in trade barriers such as tariffs and quotas certainly play a role. Trade barriers are policies or practices that reduce the amount of imports into a country. Examples include tariffs and quotas. Import tariffs operate like a tax on goods originating in a different customs area. Tariffs raise the price paid by consumers for imported goods making them less attractive to buy. Tariff rates are decided by governments but are increasingly outlawed under the WTO. Sufciently high tariffs on goods for which domestically produced substitutes exist can eliminate any incentive to buy the imports. Governments receive the revenue generated by tariffs. Quotas raise the price paid by consumers for imported goods making them less attractive to buy. Quotas are quantitative restrictions set by governments on the amount of imports permitted from another customs area. Because quotas limit the supply of a good, they drive the price of the goods up. Declining trade barriers reduces the costs of buying foreign goods for consumers and provides them with greater product choice. Another important explanation lies in the form of falling transportation costs allied to the types of goods currently being traded. Historically when the majority of goods traded were agricultural products, raw materials and processed commodities like steel and meat, their cost of transportation was high given their weight and bulk. In such a world it made most sense to trade with countries in close proximity. A commodity is an undifferentiated product such as wheat or oil or computer memory chips. Commodities are usually of uniform quality, often produced by

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many different producers where each producers output is considered equivalent or interchangeable. Futures markets exist for many commodity products. The majority of traded goods today are nished manufactured products. Due to technological developments these products often consist of low-weight components (relative to steel) and micro technologies (microprocessors replacing heavy control panels) that mean their value relative to their transport cost is high. For many rms, low and relatively stable transport costs make shipping such goods beyond the nearest countries an increasingly viable option. Shipping technology itself was reorganized from the 1950s with the advent of containerization, which involved substantially less unloading and reloading of cargo and hence, lower related labour costs. Ships were redesigned to transport such containers more efciently. In the 1970s road and rail transportation began to be reorganized and deregulated in the USA until then the government was involved in decisions on transport costs and often licensed lorries to ship goods only on one leg of a return journey. (The Japanese waited until the 1990s before beginning such transport deregulation.) Currently, air transportation is being deregulated. Transport deregulation to date has allowed costs to fall, encouraged greater trade and generated productivity gains for rms in time and resource savings. Transformation of the transport sector has not just impacted shipping nal goods to customers but also rms coordination of transport and production of components and intermediate goods produced internationally. Computer and car manufacturers are prime examples of industries where global coordination of the manufacturing process has been facilitated by reductions in international transport (and communications) costs. It often makes economic sense to source some components in East Asia, others in the USA and others in Europe and to conduct some sub-component assembly and nal assembly in different locations. The complex set of activities that go into sourcing raw materials and components and organizing them to create the product sold to customers is all associated with a rms supply chain. A supply chain describes the resources and processes that are involved in acquiring components and raw materials and includes delivery of end products to nal consumers. It includes the activities of sellers, distributors, manufacturers, wholesalers and any other service providers and contributors to the buyers decision to buy. To help rms coordinate such activities, supply chain management companies have emerged. By outsourcing successfully, rms are able to reduce costs substantially.

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An outsourcing rm can hold inventories to save on storage costs for its clients, for example. It is also often possible to shorten the time to bring a product to market because the logistical maze of procuring components is left to the expert outsourcing rm which can do so at lower cost by exploiting scale economies. More cost-effective and efcient distribution can also result. The benets of greater efciencies and improvements in time to market can allow businesses that outsource to reorient their focus towards their most important business activities. Offshore outsourcing (known as offshoring in the United States) involves relocation of elements of the supply chain to a foreign location for more efcient production. Both production and services may be outsourced. Because of its low cost base, China has become an important player in production offshoring while India has emerged as a competitive provider of services. (The website of the National Association of Software and Service Companies www.NASSCOM.org provides information on offshoring activity in India.)

5.7.2

BENEFITS AND COSTS OF INTERNATIONAL TRADE

Heated debates ensue about international trade in general and offshoring in particular. Trade and international integration are viewed, by some, as threats to economic stability and growth. On the one hand this is strange since, as we saw in Chapter 2, specialization and comparative advantage generate a better international outcome for all countries that trade. As Adam Smith pointed out in 1776, it is possible for Scotland to produce grapes suitable for wine-making using glasshouse-technology but it would cost approximately 30 times more than available imported wine; it would be difcult to argue in favour of tariffs to encourage Scottish wine production.

Smith highlighted the opportunity cost of limiting trade and encouraging production in goods for which a country may have no inherent comparative advantage. It may make economic sense for Scottish grape growers to respond to import tariffs by producing wine yet the resource cost (products not produced by those resources devoted to wine production) means more efcient and productive use of the resources is not possible. Trade without barriers would leave the Scottish economy free to produce and specialize based on its comparative advantage. If this is true for Scotland and wine then why not for the USA or France or Japan and why not for components or services as well as products?

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Smiths Scottish wine example is interesting because the Scots were not producing wine in sufcient quantities for producers to have a strong voice to complain about cheaper imports. Nor were sufcient Scottish workers employed in the industry to lobby for the protection of their jobs. These are crucial issues in the context of todays trade debates. Industry, trade associations and trades unions are often unhappy about the effects of cheaper imports on their companies protability and members jobs and wages, respectively. And so they should be they are correctly looking out for their own and their members interests. Certainly we can all come up with examples of jobs which have been moved abroad due to the current international trading environment or similar explanations which essentially boil down to lower opportunity costs of production elsewhere. At various points in time, it seems that some jobs are inevitably displaced to other locations by imports. We know that offshoring and imports help domestic companies maintain their competitiveness and, hence, support rather than displace domestic jobs. US imports of steel make the Caterpillar tractor company more competitive, allowing it to sell more, allowing it to provide more jobs. Distributors of tractors could sell more vehicles and farmers get more tractor for their money, allowing them to be more competitive. But fewer jobs in the US steel industry result from steel imports. Unemployed steel workers suffer. Others gain. Price changes and the economic adjustment they bring about always create winners and losers and real income is redistributed as a result. Deciding to restrict imports protects some industries and domestic jobs but it is not without costs. In the 1980s US restrictions on textile and apparel imports kept prices of such goods relatively high. This meant fewer jobs in the clothing retail sector and higher consumer prices. Estimates of the cost of protecting textile jobs where annual wages were approximately $15 000 to $20 000 was put at about $50 000 per job (Hufbauer and Elliott, 1994).

As a group of disparate consumers and taxpayers funding protectionism, we do not feel the direct link between our tax payments, higher prices and trade policy but it is denitely there. Logically, workers whose jobs are threatened or lost to trade feel the pain and voice their dissatisfaction.

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Some jobs are displaced by technological change or product innovations but we rarely hear protests in favour of limiting technological improvements or innovation. Arguing for limits on trade seems to be an easy target, implicitly placing more value on jobs under threat from lower-cost foreign production rather than jobs that may be created elsewhere in the economy based on its comparative advantages. From a political perspective this makes sense. Workers who lose their jobs often reect this in their voting patterns. Workers who gain jobs often do not attribute it to free trade or the policy of the government of the day. Nor do increased product variety and lower costs for consumers often appear as underlying peoples voting preferences. At the microeconomic level for individuals and for rms, arguing against imports can sometimes seem logical but if it occurred across all areas of an economy, the macroeconomy would suffer and lower aggregate output and per capita incomes would result. The fallacy of composition arises here. Although the net effect of trade is positive, this does not necessarily translate into positive effects for every individual in trading countries. The results of trade availability of a broader variety of goods and services at lower prices is easily forgotten by an unemployed worker whose job has been lost to imports. From the perspective of developing countries, it is also worth noting that both the United States and the European Union maintain trade restrictions that harm such countries by limiting their ability to export goods. Through the WTO (and its predecessor, the General Agreement on Tariffs and Trade) improvements have been attempted but reform has been promised for many years without substantial results. It is still the case that average tariff levels in agriculture (predominantly exported by developing countries) are about nine times those in manufacturing. Industrial countries subsidize agriculture, effectively cutting world prices because of the supply incentive subsidies create for farmers in industrialized countries. Not only does the EU spend around 2.7bn per year to make sugar protable for European farmers but it also shuts out low-cost imports of tropical sugar through trade barriers. Minimizing or overlooking the negative microeconomic effects of trade is a problem with many free-trade advocates. It may well make the freetrade argument more palatable and popular if these issues were dealt with explicitly. There is a link between the arguments for free trade and for greater focus on national income distribution, addressed in Chapter 9. Both require examination of

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the economic repercussions on the least well off of economic measures that may well favour an economy overall and perhaps even the majority of its citizens. Yet, economic models or explanations indicative of welfare improvements for average or representative citizens should not ignore costs borne by minority groups, which are insufciently compensated for their losses.

5.8

GOVERNMENT ACTIVITY

Government exerts its economic inuence in a number of ways through its interactions with consumers and rms both domestic and foreign. A governments actions are important for an economy in terms of its role in setting the tone for how business is conducted generally. While the extent of government activity within the economic system varies from country to country, governments activities are generally focused on a number of goals such as:

Stabilization policy: Stabilizing the economy by minimizing the short-run uctuations of GDP (output) and unemployment associated with the business cycle. Dealing with AS and AD shocks : these are any unpredicted events that cause changes in equilibrium national output and the price level. Making transfer payments. Public good provision. Taxation : to enable government to make transfer payments, to pay for national administration and the provision of public goods. Countries that have larger public sectors need relatively high taxes to pay for them. Allocating (or reallocating) resources : by making transfer payments and imposing taxes, the government reallocates/redistributes the economys resources. Regulation : some markets are regulated by imposing tariffs, quotas, etc. Other markets are regulated depending on what competition laws are enacted and enforced (more on this in Chapter 6). Governments also assume responsibility for ensuring law and order. Creating an environment to support expansion of AS : implementing appropriate policies education, research and development, business support, etc.

Despite a considerable amount of research (e.g. Slemrod, 1995), no clear link can be established between the size of the public sector and the state of countries economies. What does seem to be important for economies is the effectiveness of the public sector rather than its size.

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When a government manages its economy well, its spending plan or budget can be met by the revenue generated by the economy. If spending is greater than revenues, the government generates a budget decit while, if revenues are greater than expenditure, a government surplus results. Whether the revenue is sufcient to cover the budget depends on the amount of government spending (G ), the tax rates (t ) levied, and the level of economic activity. Governments use scal policy whenever they affect G or t (which affect aggregate demand). An expansionary scal policy is followed if the government manages to increase activity by injecting extra income into the circular ow. A scal policy that results in lower activity is described as contractionary and results in a reduction in the circular ow of income. If a government tries to stabilize economic activity, this means attempting to maintain a regular growth rate in real output, with no signicant uctuations up or down. To implement a stabilization policy, governments should follow contractionary scal policy in booms and expansionary policies in recessions to mitigate the affects of the business cycle; such polices would be countercyclical. Countercyclical scal policies have the opposite effect on economic activity to that caused by the business cycle, reducing income ows during booms, increasing income ows in recessions. To gure out whether governments follow contractionary or expansionary policies, what is at issue is whether the government tries to affect equilibrium output over and above the effects of automatic stabilizers. Examples of automatic stabilizers include income tax rates, VAT rates and unemployment benet. Automatic stabilizers result in reducing the response of national income to changes in autonomous spending. They are measures that automatically counter the business cycle without government action. For example, in a boom, government net tax receipts rise, taking income from the circular ow. In the case of a demand shock, such as an unexpected fall in investment demand, aggregate demand falls, leading to a new equilibrium situation in the short run with lower output and a lower price level (sketch this situation using Figure 5.7 as your starting point). Depending on the size of the fall in output, this might also lead to a rise in unemployment. Firms might keep on all their workers if the drop in output is

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small, but would be more likely to make workers redundant if there was a big drop in output. We know that due to the multiplier effect the total effect on output would be larger than the initial cause of the drop in income/output. However, automatic stabilizers act to stabilize the economy because the drop in income/output would automatically result in a fall in the governments tax take (due to lower income, the government takes in less revenue in taxes) and, if workers are unemployed, a rise in payments for unemployment benet. The drop in tax receipts and rise in payments to the unemployed helps people to deal with the decline in income/output. These changes occur automatically in the economy. Depending on the stage of the business cycle, a government might be receiving high or low tax revenues or be paying out high or low amounts in benets. To correctly assess the discretionary scal policy stance of the government requires removing the business-cycle impact on government revenues and expenditure. When this is carried out the result is a cyclically adjusted budget, which may show a decit or surplus. A cyclically adjusted budget provides information about the discretionary scal policies a government has followed to deliberately achieve specic macroeconomic goals. These might include trying to achieve a particular level of ination, or employment or government decit, for example. Quite often, as is evident from Table 5.6, governments end up with budget decits. Borrowing must be repaid and the extent of past borrowing is revealed in countries national debts. Most countries in Table 5.6 ran decits in 2003. Sweden alone ran a surplus. Japan is an outlier in terms of its debt situation it owed the value of over 154% of its 2003 GDP in debts.

TA B L E 5 . 6 OF GDP)

B U D G E T A N D D E B T S I T U AT I O N , 2 0 0 3 ( A S %
USA UK
3.1 51.4

Ireland
0.2 32.4

Japan
7.4 154.6

France
4.1 69.1

Sweden
0.1 52.8

Germany
4.0 63.9

Budget balance Public debt

3.5 62.4

Notes: Negative data imply budget decits were run. This corresponds to the denition used under the Maastricht criteria relevant for European Monetary Union (more on this in Chapter 7). Source: Country Data, Economist Intelligence Unit.

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When public debt increases, economists tend to open the issue to debate. Debts generated for sound economic reasons are not considered problematic but the issue of whether debts are sustainable i.e. if they can be repaid is often raised. Debts need to be repaid in the future so the cost will be borne by tomorrows taxpayers if the government borrows today. While voters may desire high levels of government spending, high debts may require future high tax rates, and hence will not be popular with voters. The effects of high tax rates on incentives to work, employment and running a business may very well create headaches for a government trying to repay future debts and could very well deepen the problem. Some economists consider that since much of national debt is owed to domestic citizens, it may not be a problem; the most important consideration regarding debt is how it is used. Debts generated to invest in infrastructure or education that will increase future economic activity should help pay for the debt. Debts generated to pay for day-to-day costs like public sector pay or the running of government departments is more difcult to defend because such expenditures should really be met by day-to-day revenues where at all possible, since in many cases they are unlikely to generate their own revenue streams to be selfnancing in the future. Economists should be concerned with the purpose of expenditures and the efciency of expenditure when analysing the sustainability of public debt.

5.8.1

ANOTHER PERSPECTIVE ON ECONOMIC ACTIVITY: THE ECONOMY AS A PRODUCTION FUNCTION

Depending on the issue of interest, different models of economic activity are useful. Earlier the model of aggregate demand and supply was presented. For some purposes, however, it is useful to view an economy as a production function. The production function is a relationship describing how economic activity, specically output, depends on the factors of production and technology. It describes a technically efcient use of the factors of production and technology necessary to produce output, i.e. no resources are unemployed. Examples of standard production functions are: Y = F (K, L, T ) Y /L = F (K /L, T ) Y /L = F (K /L, E ) PF1 PF2 PF3

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For each production function output, Y , is related to the factors of production, which are capital (denoted K ), Labour (denoted L ) and technology (denoted T ). The term F indicates that there is some functional relationship between output and inputs but because these are general equations, the precise relationship or functional form is not specied. The above relationships hold for rms, industries and economies. If you look back to Figure 4.2, you will see a sample production function for a rm for the short run when capital is xed. For the focus and purpose of this chapter we refer here to economies. While the three production functions are quite similar, PF2 and PF3 are expressed in per worker terms. In PF1, output depends on inputs and technology. In PF2 output per capita depends on capital per worker (K /L ) and technology. (Remember these factors of production were highlighted earlier as contributing to aggregate supply.) The capital/labour ratio (K /L ) of an economy provides information on the capital intensity of the economy. Capital intensity is the amount of capital each worker in the economy (on average) has at their disposal. Usually in economies that generate a high level of economic activity, the K /L ratio is relatively high. In terms of policy options for government, trying to increase this ratio ranks quite high. An economys capital intensity rises if investment expenditures on capital machinery and equipment grow faster than what is required just to replace depreciation of an economys capital stock. In PF3 output per worker depends again on capital per worker and on the efciency of labour (E ). The efciency of labour itself depends on both technology and the efciency of business and general market organization. Explicit inclusion of the efciency of labour allows for the consideration of learning in the process generating economic activity. For example, the efciency of labour can improve if nothing else in the economy changes except workers ability to work smarter from using their specic knowledge of their job more efciently. It is often only by on-the-job experience that workers gure out the best ways to achieve their work goals via learning by doing. Output (or output per worker) can grow if factors of production increase and are used for production. If the amount of capital in an economy rises due to increased capital investment, for example, that economy can grow. This can happen only if the capital can be put to productive use to produce something in demand, i.e. for which people are willing to pay. If labour increases output can grow, once (as discussed in Chapter 2):

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1. there are jobs for the additional labour; and 2. those jobs generate sufcient return to cover workers wages/salaries, other business costs and the opportunity cost to the owner of the business. If technology improves more output (or output per worker) can be produced from a given set of inputs which implies improved production methods either through innovations, invention or better management and organization. These improvements will lead to lower production costs once the technology is not too costly. This production function approach to describing economic activity allows for analysis of many interesting questions regarding economic activity, although unlike the aggregate demand/aggregate supply approach, the aggregate price level is not an explicit feature of the approach. Hence, ination is not directly part of the model, nor indeed is unemployment. However, the relationship between output and inputs, technology, the efciency of labour and the role of learning can be considered using the production function approach. Hence, the most appropriate model to use when considering economic activity must be chosen based on the issue of interest and the model most suited to that issue. In Chapter 9 we return to the production function approach in discussing economic growth and its sources.

5.9

SUMMARY

Macroeconomic or aggregate economic activity is represented by the circular ow diagram encompassing all income ows between the various markets in the economic system. These include markets for products and services, labour and other factors of production.

Standard measures of economic activity are GDP and GNP. Methods for measuring GDP or GNP include the expenditure, income or value-added methods. All methods should lead to an equivalent measure. The distinction between short and long run is relevant for aggregate economic activity. In the short run, economic activity displays business cycles. In the long run, a trend growth rate can be estimated. The aggregate demand and aggregate supply model can be used to analyse economic activity at macroeconomic level and helps us to understand how aggregate national output (or income) and the average aggregate price level are determined.

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The concept of the multiplier is crucial to understanding how changes in autonomous spending ultimately impact on economic activity. Given the various functions of government, governments affect equilibrium economic activity through a number of channels. For open trading economies, trade creates aggregate benets, but costs of trade also arise for some economic units. A production function approach is one appropriate model for aggregate economic activity. This method can be appropriate in analysis of economic activity, depending on the issue of interest.

REVIEW PROBLEMS AND QUESTIONS

1. Separately in the case of rms, households and government, explain all of the transactions that they are involved in within the circular ow. Make sure to discuss their role regarding products, services, resources and money. 2. Separately in the case of resource, factor and money markets, explain how you think local, domestic and international nancial systems, systems of corporate governance, legal and political environments, social and cultural background, technological capability and the myriad standards, business and personal ethics, and codes of conduct that are embedded in the economic system all play a role in understanding the circular ow. 3. a. Using data for ve countries of your choice, graph their long-term growth path from 1950 to the last year of available data (use data from the Groningen Growth and Development Centre website http://www.eco.rug.nl/ ggdc/index-dseries.html). Compute the average rate of growth for the period overall and for each decade. Try to identify boom periods and recessions from your graph. b. For the same ve countries as in 3a, compare the growth rate of population with real output growth and comment on whether welfare can be argued to have improved for each country. The data are also available from the same source. 4. Go to the website of your national statistics provider. Find the section on prices and plot the trends in average consumer prices for the last ve years. Has the trend been rising or falling? Compare this trend with the Harmonized Index of Consumer Prices for all EU Member States (which is available from http://www.cso.ie/principalstats/princstats.html under the Prices heading).

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5. Use an aggregate expenditure curve and an aggregate demand curve (similar to Figure 5.4) to explain what you would expect to happen to equilibrium output and the price level if the average price level fell by 5%. Explain the individual effects you would expect for aggregate demand in terms of the real wealth effect, the interest rate effect and the international trade effect. 6. a. Use the following table to compute the multiplier when the MPC is 0.90 and the tax rate is 20%.

MPC 0.90

t 0.20

(1 t ) MPC : MPC (1 t ) 1 MPC

Multiplier: 1 (1 MPC )

b. Indicate in the following table what happens to the multiplier if the MPC falls to 0.85. Explain why this is so.

MPC 0.85

t 0.20

(1 t ) MPC : MPC (1 t ) 1 MPC

Multiplier: 1 (1 MPC )

c. Indicate in the following table what happens to the multiplier if the tax rate falls to 15%. Explain why this is so.

MPC 0.85

t 0.15

(1 t ) MPC : MPC (1 t ) 1 MPC

Multiplier: 1 (1 MPC )

d. If an MPM of 0.20 is included in the tables above, compute the new multiplier in each case. 7. For your domestic economy look up appropriate sources to nd out and explain what your government has done in relation to each of the following over the last three to ve years.

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Stabilization policy, reaction to economic shocks, transfer payments, provision of public goods, taxation, resource reallocation, regulation, policies likely to encourage expansion of aggregate supply. 8. Use the latest available data from your national statistics provider or the WTO (www.wto.org) to identify the main sectors and goods that your country exports and imports. Do the same exercise for 10 years previously. What does your information reveal about your countrys comparative advantages?

FURTHER READING AND RESEARCH

Two of the greatest minds in economics Hayek and Keynes provided theories of business cycles. See Hayek, 1975 and Keynes, 1936. For research on economic performance and the size of government see Slemrod, 1995. For analysis of trade related issues, Foreign Affairs contains topical articles. Regarding the offshoring/outsourcing debates see Drezner, 2004. Some good books on international integration have been published recently, including Wolf, 2004 and Bhagwati, 2004.

REFERENCES
Bhagwati, J. (2004) In Defence of Globalization . Oxford University Press, New York. Drezner, D. (2004) The outsourcing bogeyman, Foreign Affairs , May/June, 2234. Hayek, F. (1975) Monetary Theory and the Trade Cycle [original publication 1933]. Augustus M. Kelley, New York. Hufbauer, G. and K. Elliott (1994) Measuring the Costs of Protectionism in the United States . Washington: Institute for International Economics, 5, 13. Keynes, J. (1936) The General Theory of Employment, Interest and Money. Macmillan, London. Schumpeter, J. (1975) Capitalism, Socialism and Democracy [original publication 1942]. Harper & Row, New York. Slemrod, J. (1995) What do cross-country studies teach about government involvement, prosperity and economic growth?, Brookings Papers on Economic Activity, 2, 373431. Smith, A. (1776) An Inquiry into the Nature and Causes of the Wealth of Nations . Wolf, M. (2004) Why Globalization Works . Yale University Press, New Haven.

CHAPTER 6

COMPETITION IN THE ECONOMIC SYSTEM

By EDWARD SHINNICK

LEARNING OUTCOMES
By the end of this chapter you should be able to: Explain why competition is a complex process in the economic system. Explain the Austrian perspective on competition as an ongoing process within an economy which includes an explicit function for entrepreneurs. Describe the traditional models of competition (non-Austrian) using gures including demand, costs and supply. Compare and contrast the assumptions and outcomes for consumers, producers and society as a whole, of alternative models of competition. Compare and contrast the traditional and Austrian approaches to competition. Use the ve forces framework to highlight the factors that explain why some industries are more attractive more protable than others. Discuss what is meant by market failure, how it may arise and its implications. Explain what is meant by the structure, conduct, performance paradigm and how it provided a foundation for competition policy. Explain the implications of changes in the formulation of the SCP paradigm for competition policy. Provide some examples of why competition may give rise to problems for an economy. Analyse how competition policy can be used to address competition problems.

6.1

INTRODUCTION

Previous chapters have outlined the demand and the supply sides of the economy and how these two elements interact within the economic system. This chapter explores this interaction further by analysing how and why rms compete in the

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marketplace. Pick up any business magazine or newspaper and undoubtedly you will nd a reference to competition in a report on the economy. The term is widely used yet we may not fully understand what it means and its importance. The role of this chapter is to explore the meaning of competition and the benecial consequences of competition for the economy and society as a whole. The Austrian inuence is present again in this chapter with the Austrian perspective on how competition can be viewed as an ongoing process in the economic system outlined in section 6.2. This incorporates the concept of discovery and provides an explicit role for entrepreneurship as a factor of production. This is followed in section 6.3 by presentation of the main economic models of competition that characterize different industries. These complementary perspectives on competition in sections 6.2 and 6.3 are compared and contrasted in section 6.4. In section 6.5 the focus shifts to why markets may not always work to the satisfaction of governments and what can be done to correct such outcomes. This re-introduces the role of government in the economic system and what it can do in the form of a national competition policy to address market problems. Analysis of competition policy, its aims and how it is implemented completes the chapter.

6.2

COMPETITION IN THE ECONOMIC SYSTEM

When economists use the term competition or advocate greater competition they generally have in mind some mechanism that brings about an increase in supply leading to a reduction in equilibrium price and an increase in equilibrium quantity (ceteris paribus ). However, the term competition involves much more than just an increase in supply. The extent of competition in an economy has implications for a whole set of interacting issues such as innovation, efciency, availability of a variety of goods and services, and prices that together inuence and enhance the welfare of individual consumers. When individual consumer benets are aggregated, the economy too is better off as a result of competition. Within the economic system we have a series of interacting agents that act independently of each other and yet are part of a complex interrelated web. In the context of competition, the marketplace is a crucial element in this web where the interaction of different economic units, each motivated to maximize their utility, results in an outcome that benets both these individuals and the entire economy.

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Despite the potential benets from economic interactions, markets do not always operate to generate positive outcomes. Instead markets can become distorted and can end up serving one group of people at the expense of others. For example, some market conditions result in producers gaining the most from market exchange, while consumers end up with fewer benets (from a consumer surplus/producer surplus analysis). In such cases, the government may deem it necessary to intervene in the market to achieve a more balanced outcome, from a public-policy perspective. Such intervention can take the form of removing restrictions on, for example, quantity restrictions on supply, on prices or on foreign trade. Arguments for interventions also come from lobby groups or vested interests whose focus is on maximizing their own benets and depending on the lobby group will adopt either a public-policy or business perspective. When governments intervene in markets truly open, competitive free markets do not exist. There are many examples of how competition is limited by the entry of new rms being blocked or in some way made more difcult. Government intervention is by no means the only way in which entry can be restricted but it is one example of restricting competition by setting a limit on the number of competitors in an industry a case in point is the pub industry where competition is limited as pubs require licences from the government to operate in that market. Naturally occurring restrictions also occur where a rm has access to the sole supply or knowledge required to produce a good, and examples include oil, and coke, for different reasons. Barriers to entry can arise due to the type of product (standardized or differentiated), the existence of economies of scale, initial or ongoing capital requirements or cost disadvantages independent of size, such as access to distribution channels. Standardized products: products for which many substitutes are available and which use readily available technology in their production. Differentiated products: products for which several different varieties are provided (e.g. cars). Differentiation between varieties depends on producers choices of the product attributes for which consumers are willing to pay. Competition, therefore, is a complex concept that is often not fully understood in terms of what it actually means and its implications in the marketplace, for prices and supply, and therefore for economic growth and employment.

6.2.1

COMPETITION AS A PROCESS

One view of competition is that it is a process whereby through learning over time, economic units on the demand and supply sides of the economy reach a state where

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their plans become mutually consistent. Hayek, in particular, and the Austrian School of Economics in general, would subscribe to such a view where competition is a discovery procedure, where people discover knowledge on an ongoing basis. Competition is perceived as being similar to a game of gathering knowledge and exploiting that knowledge for economic gain. The concept of competition as a game has several useful implications. For example, in any game, we do not know the results beforehand, skill is required to inuence the outcome and the outcome is unpredictable. The following quote from Hayek (1978) illustrates this point: Competition is valuable only because, and so far as, its results are unpredictable and on the whole different from those which anyone has, or could have, deliberately aimed at. (p. 180) Unlike in standard games where there are winners and losers (also called zero-sum games), competition often generates greater gains than losses or costs. For example, the result of a new more efcient competitor entering a market and charging lower prices might be to put some other rms out of business, but consumers gain from the lower prices charged and more efcient use of societys resources is made. An important implication of Hayeks description is that we cannot set out to create an outcome that is in itself unpredictable. If competition is a discovery procedure, then we cannot know beforehand what is to be discovered. In addition, the outcomes of a game can only be temporary because as new knowledge is discovered and used, new outcomes are likely to emerge. Therefore, rather than analysing whether competition has achieved a particular outcome, we should instead focus our attention on making comparisons across similar markets, across industries and/or across countries and consider which outcomes are economically superior. This concept of competition is appealing because the knowledge that exists and that is developed over time within a marketplace is unlikely to be generated as efciently through any other mechanism. Therefore the miracle of the marketplace is that it allows the market system to achieve results that are not only unpredictable but are also the best outcome possible. In a similar vein to Hayek, Schumpeter offered us the notion of competition as creative destruction (discussed in the treatment of business cycles in Chapter 5). Schumpeter viewed competition as a dynamic process that is based on innovation and change, arguing that in the process of economic growth and in the development and expansion of new products, technological change results in the displacement of old products and old technologies by new products, jobs and technologies. Old jobs and factories become obsolete and defunct and are no longer productive within the economic system.

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Knowledge and the use of this knowledge are central to this process-view of competition. As outlined in Chapter 2, such knowledge is dispersed throughout the economic system and its application is central to the functioning of this system. Prices become signals of this knowledge. Again Hayek (1978) illustrates this point: Utilisation of knowledge widely dispersed in a society with extensive division of labour cannot rest on individuals knowing all the particular uses to which well known things in their individual environment might be put. Prices direct their attention to what is worth nding out about what a market offers for various things and services. This means that the, in some respects always unique, combinations of individual knowledge and skills, which the market enables them to use, will not merely, or even in the rst instance, be such knowledge of facts as they could list and communicate if some authority asked them to do. The knowledge of which I speak consists rather of a capacity to nd out particular circumstances, which become effective only if possessors of this knowledge are informed by the market which kinds of things or services are wanted, and how urgently they are wanted. (p. 257) Hayek highlights several useful ideas worth noting. Knowledge plays a central role in the view of competition as a process, where each individual knows something but nobody knows everything. The existence of tacit knowledge is also recognized, as is the role of the entrepreneur in discovering and using knowledge in a protable way. Tacit knowledge: is highly personal, not easily visible or expressible and cannot easily be copied. It usually requires joint, shared activities in order to transmit it. Examples of tacit knowledge include subjective insights, intuitions and hunches. Finally, the concept of demand is referred to in terms of things or services wanted and how urgently they are wanted.

6.2.2

ENTREPRENEURSHIP, DISCOVERY AND THE MARKET PROCESS

At the heart of the use of knowledge in market economies lies the entrepreneur. Entrepreneurs exploit knowledge by converting knowledge discovered into profitable gain. Crucial to entrepreneurs ability is the freedom to enter existing markets or develop new markets so discovery is fundamental to the notion of an entrepreneur. The

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entrepreneurs skill lies in discovering knowledge and then using the market process to exploit it for protable gain. Entrepreneurship is about being alert to a set of opportunities, having a subjective expectation as to the value of such opportunities in the market and having the resources (or ability to generate them) to realize this value. This may be no more than exploiting a price difference in two markets by buying cheap in one market to sell at a higher price in another market. Such an entrepreneurial discovery will eventually result in the disappearance of the price difference (consider the role of the speculator as described in Chapter 7) thereby bringing continual change to the market. The notion of equilibrium in the Austrian view of competition can only be temporary since new opportunities continually arise that cause future change. Entrepreneurship can also involve combining resources in a unique way that represents value to the consumer something for which consumers are willing to pay. Entrepreneurship, by denition, cannot be predicted. It brings chaos to markets in the sense that it generates price movements and resource allocation and reallocation decisions and all this is done in the search for economic prot. In the process mistakes can be made either by incorrectly interpreting knowledge or by incorrectly judging the value consumers would place on such knowledge. Hence, we have some unsuccessful product launches, unsold inventories and bankruptcies. But through the discovery process more knowledge is gained which feeds back into entrepreneurial decision-making and so the cycle continues. Competition in the context of entrepreneurship means one thing free entry into any market. This is also known as contestable markets. Contestable markets: markets where entry costs and exit costs from markets are low. Without this free-entry condition, discoveries cannot be made and so entrepreneurship is restrained. Discoveries could take the form of new technology, resulting in lower production costs (lower average cost curves), or new product attributes, resulting in more value to consumers (reected in new or higher demand functions). Such discoveries would lead to resources being redirected in the economy to where their productivity is highest, and the impact of changes in markets would be reected in changes in prices. Discoveries might include a perception on changing consumer tastes. If consumers demand more computers and fewer typewriters then, through the market

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mechanism, the price of computers rises while the price of typewriters falls. As the equilibrium quantity changes so too can prots, and increasing prot levels would provide incentives for more producers to engage in the production of computers and fewer producers to engage in the production of typewriters. Changing prot opportunities result in increased computer production. As more computers are produced the price of computers will eventually start to decrease, whereas falling demand for typewriters will result in less production and falling prices in that market. This outcome reects societys change in preferences and it unfolded as individuals pursued their own self-interest without anyone or any government directing them to do so. Moreover, the market mechanism also operates as a check on individual self-interest. Any increases in price by one entrepreneur to take advantage of an additional prot opportunity may well be met with prices actually being bid down by more efcient entrepreneurs entering the market or through a switch to substitute goods. Markets are organized by a self-regulating process and what may seem at the rst instance to be chaotic and disorderly is, in fact, not. The marketplace by its very nature is constantly changing with knowledge being discovered, and any equilibrium state is only transitory. A major factor in causing such change is innovation. Adam Smith explained that as markets increase in size, this leads to more specialization as producers seek better ways to produce goods and more ways to improve existing products. So both product and process innovation can be as a result of increased specialization. This is consistent with Schumpeters views, introduced above, that market forces push down prots on existing goods, incentives are created to introduce new products and processes and avail of greater prot opportunities. Accordingly innovation is a critical feature in the marketplace and again the entrepreneur is central to this process. This has led to debate on how best to increase the level of innovation and its by-product economic prosperity. Patents are one way to increase innovation activity by providing the entrepreneur with added security through a system guaranteeing protection from imitation, thus encouraging them to undertake costly research and development expenditures searching for knowledge to be exploited in the market. Consumers gain immediately from patent-protected innovations in terms of the availability of previously unavailable products or processes. Consumers may also gain over time as the discovery embodied in patents eventually becomes dispersed more widely in the economic system once the patent runs out. A limit to competition in the theory of entrepreneurship is the monopoly control of unique resources. This control can occur naturally, through ownership rights (that

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is, property rights) or through government regulations and the issuing of patents, for example, both of which have the effect of restricting entry to markets. The presence of patents in some markets indicates the precedence given to benets from innovation over potential costs from greater market competition. There is a trade-off and decisions must be made on how the greatest benet is provided to society. Other types of barriers to entry that can limit competition are government regulations including licensing agreements. This is again related to what role governments should play in the marketplace. Depending on political ideology, some argue for an extensive role for government involvement in the market. Others, such as the Austrian school, believe that government involvement should be kept to an absolute minimum on the basis that any government intervention to prevent a free-market solution attempts to devise alternative allocation mechanisms that are rarely, if ever, better than the free-market solution. The role of government in this latter case would then be limited to supplementing the market process, to facilitate its smooth functioning.

6.3

A LT E R N A T I V E M O D E L S OF COMPETITION AND MARKET STRUCTURE

Traditional models of competition evolve around four types of market structure, each of which is examined separately below in terms of its implications for a rms ability to earn prots, which we see is related to a rms market power. Market structure refers to certain characteristics of an industry, such as the level of concentration, the extent of entry barriers and the extent of product differentiation. Market concentration refers to the number of rms in a specic market and their relative market share. Market power exists when rms in a market hold a sufciently large market share that their actions can change the market price of a product producing more results in a falling equilibrium price, producing less leads to a rise in equilibrium price, ceteris paribus. At one extreme there can be just one rm in a market and we call this monopoly. At the other extreme a market can be characterized by many rms; each small, relative to the overall size of the market this is called perfect competition. All examples

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of market structure apart from perfect competition come under the heading of imperfect competition. Between the extremes of monopoly and perfect competition there are two additional forms of market structure: monopolistic competition and oligopoly. Monopolistic competition is characterized by many rms each with some power to set the price of their product, which they hold because they supply a particular brand of product they differentiate their product. Oligopoly is characterized by a few rms of large size relative to the total market, so each rm has some degree of market power. Market concentration is often used as the primary measure of market structure. To calculate the level of concentration in a market, a concentration ratio (CR) can be calculated. A concentration ratio measures the market share of the biggest rms in the market. For example a CR4 calculates the market share of the largest four rms. Even though a concentration ratio only counts the top rms this can be quite accurate since if the purpose is to calculate the degree of market power in an industry, it is assumed the biggest rms have the most power. The Herndahl Index is a more accurate measure of concentration. The Herndahl Index measures the market share of all rms in the industry by summing the squares of each individual rms market share:
N

H =
1

Si2

where Si denotes each rms market share and summation is from rm 1 to N , the total number of rms in the market. The squared term indicates that rms with large market shares will have higher weight. Market share can be measured in terms of, for example, total sales, net output, numbers employed or capital asset values. However, depending on the measure used, the calculation of market share will differ. In the airplane manufacturing industry, different measures resulted in different results. Boeing and Airbus have both claimed to be the largest in the industry. With just two rms in this industry it should have been obvious that both

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could not be correct in their analysis. But as it happens both were right! This happened because each rm used a different measure of market share. Boeing, the older rm and once also the dominant rm in the industry, used the number of airplanes delivered as their measure of market share. Airbus, the younger but rapidly growing rm, used the number of airplanes ordered. Using these different measures both rms could claim to be the largest rm.

Concentration and market structure are the key ingredients in market analysis.

6.3.1

PERFECT COMPETITION

Assumptions underlying this model are:

Products are homogeneous all products are alike and so no perceived differences exist. All participants in the market have perfect knowledge full information on prices, costs and product availability exist. There are a large number of buyers and sellers in the market. Each rm provides a fraction of the output of the industry. Firms have no control over price and are, therefore, price takers. Each rms demand curve is perfectly elastic. At the market price, rms can sell as much output as they like. No barriers to entry or exit exist in the market.

Further characteristics of this market structure include:

Prices are set by market supply and demand. Market demand is a downward sloping relationship, while market supply is upward sloping. At the market price, rms earn normal prots in the long run, no opportunities exist to earn supernormal prots in the long run. Factors of production are fully mobile and can be easily transferred from one industry or market to another. There is efcient use of resources.

How equilibrium emerges in the short run and long run are considered separately below.

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Short-run equilibrium
Figure 6.1 presents the short-run equilibrium for the industry in panel A and the rm in panel B . Industry price is determined by the intersection of the demand and supply curves in panel A. At the short-run equilibrium price P one rm in the industry (panel B) can sell as much output as it likes, but will selling nothing either above or below this price. The rm faces a horizontal demand curve at this price. Industry output is Q I , while the rms prot-maximizing output Q F is determined by the intersection of its MR and MC curves. Since there are many rms in this industry, the quantity each rm produces, Q F , is very small relative to the total output of the industry, Q I . In Figure 6.1, the rm is making supernormal prots since the lower section of its AC curves is below the price. With each individual rm in a perfectly competitive industry able to earn only P for its output, P represents a rms additional revenue (MR ) if it sells extra output. Since the price the rm receives on any unit of its output is P , this price also represents the rms average revenue (AR ) on each unit of output. With perfectly elastic demand at the price P , marginal revenue and average revenue are all given by P . At Q F the rms supernormal prot per unit is equal to the distance between price and the AC curve. The rms total supernormal prots is represented by the dashed area in Figure 6.1 panel B . If the distance between the price and the AC curve at Q F is 2 and the rm produces 1200 units (Q F = 1200), then the total supernormal prots earned by the rm in the short run is 2400. Conversely, if the rms AC curve is above price then the rm is losing money and it will only survive in the short run if it can cover its average variable costs. As explained in Chapter 4,

A: Industry

B: Firm S P MC AC D = AR = MR

P*

P* AC D QI Output QF

Output

F I G U R E 6 . 1 S H O RT- R U N E Q U I L I B R I U M I N P E R F E C T COMPETITION

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the critical short-run survival decision for the rm is whether or not it can cover its average variable costs.

Long-run equilibrium
Logically, the supernormal prots earned in Figure 6.1 will encourage new rms into the industry and result in the supernormal prots declining as rms compete by charging lower prices. Firms will not compete by offering different quality goods, as goods are presumed to be homogeneous. Existing or incumbent rms may wish to take advantage of such protable opportunities and may also increase their output. The net result is a shift of the industry supply curve to the right as in panel A in Figure 6.2. A new lower industry price results at P 1 . Panel B outlines the effect of this price reduction for the same rm considered in Figure 6.1. The rms price and AR fall in response to the corresponding fall in the industry price. This reduction in both industry price and rms AR continues until such time as the AR is tangential to the rms long-run average cost curve (LRAC ). Additional industry supply continues until equilibrium emerges where it is just economically protable for the rm to stay in business, since it can cover long-run average costs. Were the industry price to fall any further, the rm would be better off exiting the industry in the long run. No further incentive for new rms to enter the industry exists. No supernormal prots are earned by a rm in a perfectly competitive market in the long run.

A: Industry

S0 S1

B: Firm

LRAC

P0 P1 D Output

P0 P1

D0 = AR0 D1 = AR1

Output

FIGURE 6.2 LONG-RUN EQUILIBRIUM FOR THE INDUSTRY AND THE FIRM UNDER PERFECT COMPETITION

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Output is produced efciently in a perfectly competitive industry:

Production occurs at the minimum point of each rms average cost curve. The price charged to consumers is the minimum price that could be charged while encouraging rms to stay in the industry. Economic resources are used to their maximum efciency by all rms since prices cover marginal costs (this is allocative efciency). Firms earn normal prots but not supernormal prots, so consumer surplus is maximized.

All outcomes indicate the model of perfect competition to be efcient in theory. Of course, very few examples, if any, of perfectly competitive industries exist in todays business world. Instead economists tend to use the outcomes of the model as benchmarks for comparison across all types of market structure.

6.3.2

MONOPOLY

In a monopoly, one rm supplies the entire market. Such cases are quite rare but do exist. In focusing on the model, we can compare and contrast its implications with the perfect competition case. The assumptions underlying monopoly market structure are:

There is only one rm in the industry. Entry barriers exist to prevent entry by other rms. The monopoly rm maximizes its prots. The monopoly product has no close substitutes, therefore each monopoly rm has control over price.

In a monopoly, the rms demand function and the industry/market demand function are one and the same a downward sloping demand curve. The monopoly rm sets its price depending on what it considers the market will bear, evident in the demand function for its product, given its costs. The monopolist has a large degree of market power or control over price. The rm sets price so as to maximize prots, i.e. sets MC = MR at point X in Figure 6.3, leading to the monopoly price P m and quantity Q m shown. At this price the rm earns supernormal prots because the price is above average cost. The dashed area in Figure 6.3 represents the total amount of supernormal prots

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P MC Pm AC

AC

X D MR Qm Output

FIGURE 6.3

E Q U I L I B R I U M U N D E R M O N O P O LY

earned by the monopolist. New rms cannot bid these prots down due to barriers to entry in the industry. If scale economies imply that only one rm could supply efciently, i.e. at low cost to the market, a natural monopoly exists. Monopolies sometimes have a different shaped AC curve to that shown in Figure 6.3. This can arise from the existence of substantial economies of scale in the industry (see Figure 4.7 to refresh your memory). Scale economies result in average costs continually falling over large levels of output. This would be the case in, for example, capital-intensive industries such as the rail industry or electricity provision. Figure 6.4 illustrates the characteristics of the AC curve and equilibrium in such an industry. Here the monopolists AC curve is falling over a large range of output

D MR

Pm

MC

MC = MR Qm

LRAC

Output

FIGURE 6.4

N A T U R A L M O N O P O LY

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and starts to rise only at very large output levels. Again, the prot-maximizing monopolist sets MC = MR to maximize prots and earns supernormal prots at price P m and output Q m . This ability to earn supernormal prots under monopoly market structure can be a major cause of concern for governments and competition watchdogs since such prots imply lower consumer surplus than if prots were lower.

6.3.3

PERFECT COMPETITION VS. MONOPOLY

The extent of the impact on welfare and consumer surplus is evident from Figure 6.5 where perfect competition and monopoly market structures can be compared and contrasted. One striking difference between monopoly and perfect competition is the equilibrium price and output levels when facing an identical market demand curve. Under monopoly price is higher and output is lower than under perfect competition. This implies that consumer surplus is lower and producer surplus higher under monopoly, due to this redistribution of income away from consumers and towards the monopoly producer. There is also an area that is lost completely in welfare terms, which neither consumers nor producers gain: dened by the triangle abc. This is called a deadweight loss. A deadweight loss represents the welfare lost to society from relatively inefcient production.

P MC Pm Ppc c Qm a b AC

MR Q pc

D Output

FIGURE 6.5 PERFECT COMPETITION AND M O N O P O LY C O M P A R E D

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Unlike under perfect competition, a monopoly rm does not produce at maximum efciency since it does not produce at the minimum point of the AC curve (Q pc ). Hence, resources are not used at maximum efciency since under monopoly output is restricted. Given these seemingly negative consequences of monopolies, why do they exist at all? Because the underlying assumptions of product homogeneity and free entry and exit in the perfect competition model rarely if ever hold true in the business world! The challenge for the economic system is to acknowledge that perfect competition is not achievable and to ensure that the benecial effects of competition are maximized. Barriers to entry exist in many industries and these impede the ability of new rms to come into the market and bid down price. Barriers to entry may be based on:

Type of product : standardized versus differentiated products. The ability of rms to differentiate their products and thereby create brand loyalty can make it difcult for new entrants to gain a foothold in a market, especially if consumers are unwilling to switch from a brand they know and trust. Economies of scale : Some industries require the rm to produce a relatively large output in order to operate at or near the minimum point of their average cost curve. In this case the ability of the rm to secure a large output will determine whether they can protably enter the market. In the extreme case of the average cost curve continuing to fall over large output ranges, only very large rms could compete or, in the natural monopoly case above, just one rm would be protable. Experience curve effects : Sometimes experience by the incumbent rm in the industry can result in lower average costs for that rm. New entrants who therefore do not have this experience are faced with higher average costs. This puts them at a competitive disadvantage. Capital requirements : Some industries require a large amount of initial capital in order to set up production. A rms ability to access such capital may determine their ability to enter the market. Cost disadvantages independent of size : Incumbent rms may have longestablished relationships with suppliers or distributors that give the rm valuable access to important resources. Dealing with a long-established

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supplier over a period of time can provide the rm with access to a reliable source of high-quality raw materials at competitive prices at a time that suits the rms production schedule. A new entrant, not having such access, may be at a competitive disadvantage. Legal protection : The rms ability to secure patents can prevent a new entrant from competing in the market. Licences granted by, for example, national governments, or trade agreements between countries would have similar effects.

Benefits from monopoly?

Despite the potentially negative aspects of monopolies, there are instances where monopolies generate economic benets. Central to the positive aspects of monopolies is their potential for innovation, emphasized by Schumpeter. The supernormal prots that monopolies earn can be used for investment into R&D facilities. However, this is only a positive result for society if rms carry out such investment rather than squandering their prots. There are some incentives that may encourage monopoly rms to invest, at least, a proportion of their prots back into the rm and these incentives centre around the ability to earn higher prots in the future as a result of successful innovation and thereby securing their dominance in the market. Other arguments in favour of monopolies centre on their ability to exploit economies of scale in production such that society reduces wasteful inefciencies. If a monopolist can gain efciencies over and above those that could be gained in a perfectly competitive market (if small output shares are produced only at relatively high average cost) then monopolies have advantages. Coupled with such advantages is the potential, which always exists in monopolies, to exploit a market position and in doing so harm consumer interests. Critics of monopolies point to this potential damage as outweighing any potential advantages and will therefore be sceptical of them, especially as there are many cases where innovation and R&D take place in non-monopolistic industries.

6.3.4

MONOPOLISTIC COMPETITION

Markets characterized by monopolistic competition, rst described by Edward Chamberlin, involve many sellers producing products that are close, but not perfect substitutes there is product differentiation. Each rm has a monopoly in its own variety of the product. Examples of monopolistic competition include restaurants, petrol stations, corner shops and builders. This market structure is illustrated in Figure 6.6.

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MC LRAC

P*

D MR Q* Output

FIGURE 6.6 LONG-RUN EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION

The assumptions of market structure characterized by monopolistic competition are:

Large number of sellers each with a relatively small market share. Firms do not have to be overly concerned with what rivals are doing and how they are likely to react. Firms produce differentiated products gives them some power over price but close substitutes are available demand is elastic. Freedom of entry to the industry exists. Supernormal prots in the short run attract new entrants and new varieties so that long-run supernormal prots are not made. There is full and symmetric information a new entrant takes market share from all competitors equally.

In the short run, any supernormal prots earned by a rm will disappear as new entrants enter the market, offering substitute products and attracting some customers, resulting in the demand curve facing each other rm declining shifting to the left. In the long run, the demand curve is tangential to the long-run AC curve and normal prots are earned at price P and quantity Q . The industry is competitive containing several competing rms where none makes supernormal prots. Each rm produces along the negatively sloped portion of their LRAC, implying scale economies are not fully exploited, implying there is excess capacity in their plant. With respect to efciency, each rm does not produce at the lowest point on the LRAC curve; therefore, production is not efcient. Also since price exceeds marginal cost, each rm has some degree of monopoly power, created through the existence of brand loyalty.

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M A I N T A I N I N G A N D E N H A N C I N G B R A N D L O Y A LT Y I N MONOPOLISTIC COMPETITION
Incumbent rms purchase advertising and other promotional activities, while new entrants may have to spend substantially more in order to gain a foothold in the market. Advertising is one example of non-price competition and it is a major feature of this type of market structure. By spending on advertising, rms not only want to gain new customers but also keep existing customers; that is they want to make their customers demand curves more inelastic. Yet advertising is expensive so rms must balance the perceived benets of advertising against the actual costs of advertising. How do rms do this? They continue to spend on advertising so long as the additional (marginal) revenue the advertising brings in exceeds the additional (marginal) cost of the advertising. Firms prots increase as long as MRadvertising > MCadvertising . Advertising exhibits diminishing marginal returns, such that more and more advertising will yield less and less revenue so eventually MRadvertising = MCadvertising and the rms advertising adds nothing to prots.

6.3.5

OLIGOPOLY

The nal type of market structure considered is oligopoly. The underlying assumptions of oligopoly are:

Few sellers exist in the market each taking account of the decisions of their competitors. Products of each rm are similar but not identical. Each rm produces a substantial amount of output and so has market power. Barriers to entry exist.

Oligopolies occur where a market has room for a few large rms. This could be because of cost advantages through scale economies or through economies of scope. Economies of scope exist when a rm produces many products and can share resources across them such that the unit costs of each product is lower than if they were produced by separate rms. Shared marketing or distribution costs may be sources of economies of scope.

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In industries where mergers and acquisitions are commonplace (such as the car industry discussed in Chapter 4) the number of competitors decline as rms business strategies guide them to grow not by expanding the market, which is becoming saturated, but by buying up rivals, which may reduce competitive behaviour and allow for increasing prot margins once barriers to entry exist. The essence of oligopoly markets is that rms decisions are interdependent. When making decisions on output, for example, each rm takes account of how their rivals are likely to respond, as this will affect the protability of such decisions. This complicates rms decision-making processes because it can be very difcult to predict how each rival will respond and precisely how such responses will impact on the rm. Very often rms will seek out a simpler solution. For example, instead of trying to guess how a rival will respond, rms may wish to seek agreements with their rivals on output (or other decisions) so as to maximize the protability with the minimum of risk. With few rms in an industry this is not as difcult as it may rst seem. Yet at the same time there are incentives for each rm to go it alone so that it can get one step ahead of its rivals. This inherent conict in oligopoly markets make for fascinating study. Formal collusion by rms can take the form of a cartel where rms make explicit output agreements, for example, with the intention of maintaining a high price for the product. A cartel is an agreement between rms to cooperate in restricting the amount of output they produce, thereby inuencing the price. OPEC (the Organization of Petroleum Exporting Countries) is possibly the most well-known cartel and its agreements on levels of oil production (or extraction) for each country effectively controls the price of oil on world markets (this example is discussed in terms of its effects on international ination in Chapter 8). However, there are two problems with cartels that inhibit their usefulness. First, cartels tend to be unstable because of each members incentive to cheat on the agreement and make extra prots in the short term. When other rms see the agreement breached they would follow suit and, in the case of OPEC, increase oil production, thereby causing the world price to fall. Second, in a lot of countries, including Europe and the USA, cartels are illegal and any such agreements are prohibited under competition law. As a result rms may engage in less obvious forms of collusion. Implicit collusion may take the form of price leadership, where either

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a dominant rm in the industry sets price and all others follow and set their price with this information at hand; or a well-established rm becomes the leader in the industry and is trusted with setting the price that all rms will charge.

Such a leader has usually gained the respect of the other rms and has a lot of experience in the industry. All types of implicit collusion are also illegal and therefore rms may not readily engage in such activities, despite the potential business benets.

Oligopoly and game theory

Without collusion in oligopoly markets, rms make assumptions on how rivals react. Such interdependence can be analysed using game theory. Game theory is a microeconomic approach or tool of analysis applied to understand the behaviour of individuals and rms. Pay-offs generated by following different strategies can be compared. In game theory, a rm makes assumptions on how the other rm(s) will react and then chooses its best option. In such games the rm seeks a dominant strategy. A dominant strategy is one that provides one rm with the best outcome, irrespective of the strategy another rm (or rms) chooses. Firm interdependence and dominant strategies can be illustrated using the example shown in Table 6.1. Here we have two rms; A has two strategic options, X or Y , and

TA B L E 6 . 1 G A M E T H E O RY: S T R AT E G I C O P T I O N S A N D D O M I N A N T S T R AT E G Y
Firm Bs strategic options I (high) Firm As strategic options X (high) Y (low)
(3, 4) (4, 3)

II (low)
(2, 5) (4, 5)

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rm B has two strategic options, I and II . For rm A, Strategy X could be to set a high price and strategy Y to set a low price while for Firm B , Strategy I is high price and II is low price. By examining the pay-offs from each strategy we can analyse if a dominant strategy exists. Here, if rm A chooses strategy X (high price) and rm B chooses strategy I (high price), then A earns 3 in prots and B earns 4. If A chooses strategy Y (low price) while rm B still chooses strategy I (high price), then A earns 4 and B earns 3 since lower prices entice consumers to buy more from rm A. When rm B chooses I (high), strategy Y (low) earns rm A higher prot. When rm B chooses strategy II (low), rm A earns 2 with strategy X (high) and 4 with strategy Y (low). Again strategy Y earns Firm A higher prots. Therefore strategy Y is a dominant strategy for rm A; no matter what strategy rm B chooses, rm A will always do best by choosing strategy Y . Similarly for rm B , no matter what strategy rm A chooses, rm B always does best by choosing strategy II , so II is B s dominant strategy. The equilibrium outcome in this game has rm A choosing strategy Y and rm B choosing strategy II . This outcome earns 4 for rm A and 5 for rm B . Dominant strategies for either one or both rms result in a relatively easy determination of the outcome. However, dominant strategies do not exist for all cases. Consider the Game in Table 6.2. Firms A and B again have two strategic options but with different pay-offs. In this game no rm has a dominant strategy. The rms are faced with two possible options:

Option 1: Firm A chooses X and rm B chooses I each rm earns 10 prot. Option 2 : Firm A chooses Y and rm B chooses II each rm earns 5 prot.

TA B L E 6 . 2 G A M E T H E O RY: S T R AT E G I C O P T I O N S W I T H N O D O M I N A N T S T R AT E G Y
Firm Bs strategic options I Firm As strategic options X Y
(10, 10) (0, 0)

II
(0, 0) (5, 5)

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This is an example of a game with two Nash equilibria (after John Nash, the Nobel Prize winner in economics, 1994), where each rm is doing the best it can, given the strategy being pursued by the other rm. A Nash equilibrium exists when each player in a game chooses their best strategy given the strategies followed by other players. The two remaining options are less likely since both rms earning zero prots. Therefore, it is crucial that each rm chooses either option 1 or 2 and option 1 is preferable to option 2 for the rms concerned. But how can the rms ensure that either of these options will prevail? Collusion would ensure they do not end up with the worst outcome of 0 prots each. In the absence of collusion there is still a way for the rms to achieve the better outcome. If one rm invests in a commitment of resources that will make it clear to all other rms that it intends to pursue one particular strategy, then this can guide the second rm in its strategy decision. For example, if rm A invests in a system of production that makes it clear it must pursue strategy X , then rm B , will do best by choosing strategy I and the resulting prot outcome for both rms is 10. Such an investment must be both visible and irreversible in order to convince rm B that strategy Y will be the strategy pursued by rm A. Pay-offs as before. To make this example more tangible, consider that strategy X (and I ) involve abiding by an agreement to restrict output and strategy Y (or II ) represent cheating on such an agreement. If both rms abide by the agreement, they both earn 10; if they both cheat, they earn 5. Any deviations from these two strategies will result in zero prots for both, due to, for example, resulting price wars. To achieve the best possible outcome one rm could invest in machinery, or a production line, which is capacity-constrained only a certain capacity can be produced. Such a rm could credibly commit a certain level of production. An agreement could then be made to set this level of production to maximize their prots.

Prisoners Dilemma
An interesting outcome unfolds if the pay-offs to this game were as shown in Table 6.3. Such a game is an example of the Prisoners Dilemma. A Prisoners Dilemma exists when the equilibrium from a game generates a sub-optimal outcome for all parties involved. With commitment (or a binding contract) between the rms, higher pay-offs could be achieved to the benet of both players.

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TA B L E 6 . 3 G A M E T H E O RY: S T R AT E G I C O P T I O N S W I T H S U B - O P T I M A L S T R AT E G Y
Firm Bs strategic options I Firm As strategic options X Y
(10, 10) (15, 3)

II
(3, 15) (5, 5)

High price (or low output) strategies are X and I in Table 6.3, while low price (high output) strategies are Y and II . If both rms have low price strategies (Y and II ), industry output is high and prots are relatively low at 5 per rm. With both rms following high price strategies resulting in low industry output, prots rise to 10 per rm. Firms prots are maximized at 15 if one rm follows a low price (high

TA B L E 6 . 4 S U M M A RY O F M A R K E T S T R U C T U R E CHARACTERISTICS
Type of product Perfect competition Monopolistic competition
Homogeneous Differentiated

No. of rms
Many Many

Examples
None Retailing, building and restaurant trades Steel, car and computer industries Microsoft

Power of rm: price

None Some

Barriers to entry
None Low

Non-price competition
None Advertising and product differentiation Advertising and product differentiation Advertising

Oligopoly

Standardized or differentiated Unique

Few

Some

High

Monopoly

One

A lot

Very high

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output) strategy when the other rm adopts the alternative strategy (earning 3); combined prots of 18 would be generated. If rm A thinks B will select strategy I (high price), As best option is to choose Y (low price) since its prots of 15 > 10. If B selects II , As best option remains Y since 5 > 3. Similarly, B s best option is to select strategy II . Hence, when no co-operation is possible between rms a non-cooperative equilibrium emerges with pay-offs of 5 to each rm. This is sub-optimal when both could earn 10. Some co-operation such as a binding commitment or a contract between the rms could generate an incentive for them both to simultaneously choose X and I (where prots of 20 shared equally are possible). This would be an example of a co-operative equilibrium.

Summary of market characteristics

To sum up this section, the main differentiating characteristics of each market structure are presented in Table 6.4.

6.4

AUSTRIAN AND TRADITIONAL PERSPECTIVES: A COMPARISON

The previous two sections present very different perspectives on competition, i.e. the Austrian competition as a process view and the perspective of competition as a timeless state of events. Competition is a dynamic process in the former and a static process in the latter. Knowledge and its use are key issues distinguishing the traditional view of competition from the Austrian view. In perfect competition, knowledge is perfect or available to all. Decision-making becomes a problem not so much of making choices, but one of maximizing a series of price possibilities from a given set of resources. Individuals are in a sense programmed to select a transaction that is a maximum outcome attainable. Since knowledge is given, in effect, there is nothing to compete over. All producers and consumers know what is to be known about products and prices and there is no need to compete for anything. In reality, characteristics of goods and what makes them scare and valuable are not known in advance and these are some of the issues that the events we call competition attempt to discover. In perfect competition, the decision-maker does not exercise genuine choice; everything is known in advance so there are no choices to be made. Consequently, it is assumed that no errors are made in this decision-making/maximization process.

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To many consumers and producers the perfect competition dramatization of the marketplace is not realistic. In making decisions, individuals rank objectives and available resources and in this process new knowledge is gained. This new knowledge becomes, in turn, part of future ranking processes. In addition, outcomes are not known in advance; instead individuals are confronted with choices to be made. The Austrian perspective acknowledges the experience and learning of individuals where knowledge is not only limited, it is also constantly developing over time. Knowledge is crucial and central to the process of competition itself. It not only emerges from competition but also creates competitive forces. Every player in the market possesses different degrees of knowledge and can use it in exchanges to maximize their utility, the more specic in nature is the knowledge (as discussed in Chapter 2). This approach is intuitive from our own experiences as consumers. When we purchase goods we do not, and cannot, know everything there is to know about the good we are buying, the number of sellers of that good and the prices charged in different markets. Yet we do not need to know all this information in order to trade. We simply assess the amount of value or utility that we can derive from the product and decide whether the price subjectively represents good value to us. Another feature of the perfect competition model is that no one rm can gain market power. Firms do not interact, they are price takers and accept given world prices. Yet in business we see many rms with market power and they achieve this through, for example, superior use of knowledge or resources. Microsoft has become a very large and successful rm by developing a useful operating system for personal computers. In the process it displaced IBM, the previous leader in the industry. The amount of knowledge and, in particular, the use of knowledge that each rm had discovered allowed this situation to emerge. Equilibrium, central to the traditional model of competition is considered in the Austrian approach as contradictory to the whole notion of competition. Equilibrium, by its very nature, assumes a steady state where the market has absorbed all relevant information and is in a position of stability from where there is no tendency to move there is no more competition. As we can see from our discussion of the Austrian perspective, though, this can never be the case as knowledge constantly changes. Therefore equilibrium not only does not exist, moreover it cannot exist. A further point that sets the Austrian perspective apart from the traditional model is that markets are unpredictable. Competition is more like a game of chance rather than a set of predictable moves and counter moves. This unpredictability

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comes from the central economic problem facing society, that is, the problem of the utilization of knowledge which no one individual possesses. Furthermore, this economic problem always arises due to changes occurring in the economy. Hayek (1978) sums up his position as follows: the point to keep constantly in mind is that all economic adjustment is made necessary by unforeseen changes; and the whole reason for employing the price mechanism is to tell individuals that what they are doing, or can do, has for some reason for which they are not responsible become less or more demanded. (p. 261) Such change brings with it certain opposition. Competition is generally seen to benet the consumer and indeed some producers, but it also introduces new ways of doing things that are better than current methods, the old being replaced by the new. With such displacement comes changing fortunes of those involved. Competition brings with it increased rewards for some and diminished reward for others. As explained in relation to trade in Chapter 5, such diminished rewards form the basis on which competition is usually opposed.

6.5

WHEN MARKETS FAIL

The portrayal and outcomes of competition describe how the self-motivated actions of consumers and producers leads to production and consumption of goods and services in an efcient, effective manner, given the incentives generated by the prices of goods and services. However, there are some events that occur that can interfere or even prevent this outcome markets can sometimes fail. Market failure occurs when economic resources are not allocated efciently caused by the price system working imperfectly.

6.5.1

WHY MARKETS MAY FAIL

The principal types of market failures are public goods, externalities, natural monopolies and monopoly power and information asymmetries. These are important in the context of policy as they provide the rationale underlying much of the government intervention in markets that we observe.

Public goods
Public goods (introduced in Chapter 1) are generally available to all, such that it is difcult if not impossible to exclude any person, even if they have not paid for

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the good, from consuming it. Markets often fail to encourage private rms from supplying such goods.

Externalities
As outlined in Chapter 4, an externality may result from a production or consumption process that affects some individual(s) not directly involved in the process. Positive externalities are private timber forests providing scenic benets to all or immunization against contagious diseases in a community. Negative externalities are pollution from a factory harming local farmers or cigarette smoke reducing the enjoyment of a meal by another person.

Often, the prices of products do not fully reect the true costs including the external effects of their production. It is the negative externalities that economists are mostly concerned with as they reduce the economic welfare of producers and/or consumers.

Natural monopoly and monopoly power

Monopoly power, or substantial power over price, is closely associated with the natural monopoly case such that a lower level of output may be produced and a higher price charged than in a more competitive market. These negative aspects can be sustained due to barriers to entry in the market, which facilitates the redistribution of income away from consumers and towards producers, thus harming consumer interests. Monopoly power also provides rms with the opportunity of engaging in anti-competitive practices, either on their own against other producers or potential producers or against consumers, which effectively means raising prices above competitive levels.

Information asymmetries
Information asymmetries exist when one party has more information than another party in an exchange agreement. Information asymmetries usually arise where a producer has more information on a product or service than consumers who are open to potential exploitation, usually in the form of high prices and/or poor quality. The functioning of competitive markets depends on the ability of consumers to adequately judge competing products. A

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lack of information naturally impedes this. If rms have market power they may have few incentives to produce relevant information for consumers or the information may be of such a technical nature that few consumers would be properly able to interpret and use it. The information asymmetry problem is most pronounced for experience goods as against search goods. Experience goods are goods where their quality attributes can only be assessed through trial (or experience) whereas the quality of search goods can be gained before purchase. The resulting problems are of inefciency and welfare loss.

6.5.2

IMPLICATIONS OF MARKET FAILURE

One implication of market failure is the redistribution effects from producers to consumers. Society may also suffer a deadweight loss, as considered earlier in Figure 6.5. This is particularly damaging since potential benets are lost to the economy. By preventing such a loss someone in the market place would gain. In Figure 6.7 panel A we have a market performing efciently where price and quantity emerge from the interaction of demand and supply as P E and Q E . If the quantity of output is limited below its free-market level (for example, because producers can set high prices as fewer goods than the equilibrium quantity may be sold due to distribution agreements) to Q L , consumers pay higher prices at P H . At a higher price, consumer surplus falls and producer surplus rises but we see that some of the original surplus is no longer part of consumer or producer surplus this is a deadweight loss shown as a triangle in Figure 6.7 panel B .
A P Consumer surplus S PE PH PE B P Consumer surplus Deadweight loss S

Producer surplus QE

Producer surplus QL QE

Output

Output

FIGURE 6.7

DEADWEIGHT LOSS

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Preventing or correcting market failures can create positive economic benets and can provide a justication for government involvement in the market. In an extreme case market failures can prevent a market from existing at all hence the provision of public goods. A government can control the behaviour of producers and consumers through indirect command where they provide incentives by making certain activities more or less rewarding. Government involvement can take the form of intervention in the market, either as a direct supplier of a good or service, or as a policy instrument to force a positive outcome arising from a market failure. For example, governments will usually provide public goods such as national defence and security and also may provide the goods associated with natural monopoly characteristics, such as in the utilities industry where governments have in the past supplied electricity, gas, telecommunications, water, etc. Less direct government involvement arises in attempts to reduce the impact of other types of market failure.

To reduce information asymmetries governments can introduce regulations compelling producers to release accurate and affordable information in the form of standardized product labelling, setting minimum safety and health standards or banning false or misleading advertising. Governments can also step into the market, in the form of regulation, to reduce welfare losses arising from negative externalities. To reduce monopoly power and reduce the effects of anti-competitive practices, the government can introduce a specic legal instrument in the form of competition law, to enforce standards and a policy of competition in the economy.

6.6

G O V E R N M E N T R E G U L AT I O N OF COMPETITION

Across Europe, governments role in reducing monopoly power and in anticompetitive practices has evolved substantially over recent decades, particularly from the 1980s on. One traditional response for governments to step in and take ownership of natural monopolies and to impose strict regulations on business activities was considered to be an efcient method until the realization emerged that it may also generate signicant costs. This conclusion arose from:

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weighing up of the costs versus the benets of regulations; comparing whether the restrictions imposed under regulation were proportionate to the potential harm done in their absence; examining whether there was a more efcient way of achieving the goals of regulation.

Furthermore, it was possible in some circumstances that governments regulations might harm consumers. This occurs if business interests are put ahead of consumer interests and if there is a weak consumer voice. Both of these can result in regulatory capture. Regulatory capture occurs where regulations set up to protect consumers to lead to greater competition and lower prices become captured by the industry for the benet of producers in that industry. This happens where producers can convince the government or a regulator to introduce rules favouring producers. Furthermore, the notion of a natural monopoly and the role of governments in running such enterprises began to change. Advances in technology and the development of nancial markets, for example, both helped to change the perception of natural monopolies. No longer were such industries considered to be optimal if operated by one rm and instead many were broken up into small sub-industries. For example, in the electricity market, four sub-industries were developed comprising:

generation : the production of electricity by either hydro, nuclear or fossil fuels, for example; transmission: the transfer of electricity from the generation site through the national grid to different parts of the country; distribution : the transfer of electricity from the national grid to local grids and sub-stations; supply: the transfer of electricity to homes and industries.

The idea then was to introduce competition into as many of these sub-industries as possible. Generation and supply were sub-industries where competition was seen to be possible whereas transmission and distribution were considered to have natural monopoly-type characteristics. Hence, it did not make economic sense to have duplicate transmission and distribution networks when the product could be transferred more efciently through just one.

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When introducing different competitors in rail transport, it would not make economic sense to have separate tracks and stations for each train operator. If this were to happen, hundreds of train stations would be scattered around the country, along with thousands of miles of train track. Exactly the same scenario applies to gas, water and other utility industries.

In addition, governments also reconsidered their ownership of certain industries, driven in some cases by EU policy. Moves towards privatization were not only an attempt to bring the benets of competition to industries, including improving efciency, but also to reduce bureaucracy and political interference. Privatization: the sale of government-owned businesses (and associated assets) in whole or in part to the private sector. Examples include electricity, gas and telecommunications industries. Governments entire industry philosophy changed, becoming broadly less interventionist in industry with a redirection of their efforts to other policy issues. The idea was to introduce competition where competition was possible and to have regulation where it was not. Such regulation could take the form of access/price regulation so that competitive supply industries could gain access to a product at a fair price and then sell it on to the end user for a reasonable prot where the relevant regulator would decide on the interpretation of fair and reasonable. Many regulations no longer serving their purpose either because they were outdated, or had been captured by industry encouraged a process of deregulation or re-regulation of private industry where old rules were abandoned or amended to reect current market conditions. At the same time the EU pushed for greater liberalization of markets as part of its drive for a single European market. The result was a changing competitive landscape in many industries including airlines, utilities and some professional services. Market liberalization: reducing barriers to the free movement of goods and services to encourage entry by new competitors. With liberalized markets came government competition policy to ensure a fair and level playing eld for all competitors. Broad-based competition policy is seen as less burdensome than industry regulations in attempting to create a well-functioning marketplace.

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Competition policy at the national level mirrors EU competition policy established under the Treaty of Rome. Two sections of the treaty form the foundations of national competition policy in individual EU countries. Section 81 of the Treaty of Rome prohibits any collaborative agreement between rms whose aim is to prevent, distort or restrict competition within the EU. Section 82 prohibits rms with market power from distorting competition within the EU. Competition law is the legal instrument used to enforce competition policy. The nal stage in this process was the establishment of competition agencies to monitor and police government competition policy at the national level.

6.6.1

COMPETITION SPECTRUM

If we consider competition as a spectrum with perfect competition at one end and monopoly at the other, then the role of government in the competition arena is to try to maximize the positive effects associated with perfect competition and avoid or minimize the negative aspects associated with monopoly. Even though these two positions are extremes, and thus rarely exist in practice, they are still very useful concepts if we consider them as representing two opposite ends of the competition spectrum. As theoretical abstractions, models of market structure are useful in so far as we know that the greater the level of competition, the greater are the incentives to:

drive price down towards costs; provide incentives to reduce costs; and develop new products that consumers are willing to buy.

So the closer an economy moves towards the perfect competition end of the spectrum, the greater the possibility of achieving efcient allocation of resources, efcient production and dynamic efciency.

6.6.2

STRUCTURE, CONDUCT AND PERFORMANCE

Much of the basis for thinking on competition originates from the structure, conduct, performance (SCP) paradigm. When this rst emerged in the 1950s (e.g. Bain, 1956), a one-way causal relationship was considered to exist between the

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structure of a market, the conduct of rms within that market and the performance of the rms. Structure: e.g. the number of rms and the market share of each, the extent of entry barriers and the extent of product differentiation. Conduct: e.g. the ability to practise price discrimination (charging different market segments different prices for the same product as with airline seats in the same class) the pursuit of efciency improvements, the setting of prices (high or low) and the pursuit of strategies aimed at preserving monopoly power or discouraging competition. Performance: e.g. protability, efciency levels or the quality of the product. Empirical studies of different industries indicate that the proposed one-way causal relationship was in fact multidirectional, with all three issues affecting each other. So, for example, the competitive conduct of rms pursuing efciency improvements can result in other rms nding themselves unable to compete and thus leaving the industry, thereby affecting the structure of this industry. The result was a reformulation of the paradigm as SCP This paradigm provided insights for thinking about how to change the performance of rms. Governments realized that if they wanted market performance to change then market conduct and/or market structure had to change rst. Explicit rules were introduced as part of achieving such change. The result was government competition policy.

6.6.3

COMPETITION POLICY

Competition policy has both economic and social objectives. The economic objective is based on the view that markets are an efcient mechanism for the allocation of scarce resources. Building on the ideas of Hayek, the knowledge contained within the market therefore exceeds the knowledge that even the best regulators or government legislators could possess. The aim of a policy of competition is to break down barriers to new entry or dismantle business practices that discourage competition among existing rms. Once this can be achieved, the market makes decisions of resource allocation. The anticipated result is one of increased resource efciency, increased innovation and a reduction in prices at the microeconomic level. These microeconomic effects then can lead to macroeconomic effects such as

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increased employment and productivity, through the efcient production of more goods and services, leading to increased prosperity for society. The social objective of competition policy can be achieved only if the above economic objectives are rst achieved, since the social objective is based on the aggregate (positive) outcome of the economic effects in the wider economy. These include the diffusion of economic power and the maximization of opportunities for all. There is an inherent conict within competition policy. It may allow rms to become:

large enough to gain efciency through economies of scale; protable enough to enable rms to invest in R&D and develop new products/processes.

But large scale may: generate market power; lead to harmful anti-competitive practices for other (smaller) rms and consumers.

A delicate balance needs to be struck between these two potential conicts, and competition policy attempts to achieve such a balance.

Principles of competition policy

The USA and the EU are at the forefront in advancing competition policy. Over the years both US and EU competition policy have converged and common standards of evaluation have been developed. In the USA competition policy (or Antitrust as it is referred to) began with the Sherman Act of 1890, which was enacted largely in response to growing consolidation of big companies. The Act made illegal any restraints on competition. Interestingly, the one exception to this was any monopoly that was based on applying a superior technology or offering new products. This was an attempt to encourage innovation by providing rms with the opportunity to gain substantial prots from successful innovations. The Clayton Act of 1914 further strengthened competition policy by restricting specic practices if they could substantially lessen competition or if such practices could lead to a monopoly. This Act was introduced to restrain instances of economic power that were beginning to emerge. The goal of EU competition policy is to establish a system which safeguards against the distortion of competition, either by restraints placed by private rms or

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by government involvement. It explicitly acknowledges the potential for national governments to distort competition and this has signicant effects on the provision of state aid (as in the airline industry, for example). EU competition policy was established under the EU Treaty of 1957 and the two pillars of this policy are Articles 81 and 82, cited above, which prohibit contractual restraints on competition and prohibit an abuse of a dominant position. Rules governing mergers came into effect in 1990. Table 6.5 summarizes the benets of competition broken down into the benets to consumers, businesses and the economy as a whole.

Implementation of competition policy

If the objectives of competition policy are to be met then proper and full implementation of the policy is essential. This involves an analysis of some key issues, such as the identication of competitors, the identication of a rms product market and identication of the rms geographical market, which may be more complicated than they rst appear. Identication of competitors is typically based on the degree of substitution between two products, where substitution is measured by the cross-price elasticity of demand.

TA B L E 6 . 5 S U M M A RY O F B E N E F I T S O F COMPETITION
Consumers: Price, quality, choice, innovation and bargaining power Example: airline industry prices reduced by: 25% (UK), 33% (USA), 50% (Spain), 65% (Ireland) accompanied by large increases in demand Business: Freedom to enter new markets and win market share Benets as buyers of production inputs as for consumers above Economy: One-off effect of increased competition Lower prices and higher output over time Increased productivity, innovation and competitiveness

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It is important to make a distinction here between direct and indirect competitors. Indirect competition arises when the strategic choice of one rm affects the performance of the other due to strategic reaction by a third rm. For example, innovation in the tyre market can bring about new competitive pressures in the car market if one car manufacturer uses the tyre innovation to attract customers. This recognizes the dynamics taking place in the market where action by one rm provokes a reaction by a series of other rms. With direct competitors, two products tend to be close substitutes when they have similar uses and are sold in same geographic area.

In the world aviation market, Boeings 737800 jet and the Airbus A321 jet were considered by both Ryanair and easyJet to be close substitutes when they entered negotiations with both producers to add to their eets. Both aircraft have similar passenger and range capabilities. In a local housing market two houses of similar size, in the same neighbourhood, may be considered close substitutes. Identication of a rms market is important, but difcult. Two rms are in the same product market if they constrain each others ability to raise price. There are two markets that need to be considered: the product market and the geographical market. A market is well dened if customers could not switch between available substitutes in response to a hypothetical small but permanent relative price increase by all rms in the market. In other words, would a rms customers switch to available substitutes or to a different supplier located elsewhere in response to a proposed permanent price increase of say 5%? If substitution were possible and this made the proposed price increase unprotable, due to the resulting loss in sales, then these substitutes would form part of the same market. For a geographical market denition the ow of goods and services across geographic regions must be analysed. The idea here is to rst nd out where customers come from and then nd out where the customers shop. A crucial issue in this analysis is transportation costs. Where such costs exist this would imply that identical products in two different geographic markets might not be substitutes.

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As we saw in Chapter 5, advances in technology can reduce the importance of transportation cost, and the same is true with Internet shopping, for example. Once the market is dened, the most appropriate measure of market share must be identied and the relevant data accessed in order to compute accurate market shares. Examples to illustrate the main issues in competition policy are provided below. The rst example deals with mergers and the problem of dening the market in order to measure market share and therefore potential power/dominance. For those interested in case materials, a good starting point for EU material is http://europa.eu.int/comm/competition/index en.html and for US material is http://www.ftc.gov/ftc/antitrust.htm.

COMPETITION POLICY EXAMPLE 1: ACQUISITION

In 1986 Coca-Cola wanted to acquire Dr Pepper and the US authorities investigated whether such an acquisition should be allowed. In that year Coca-Cola was the largest seller of carbonated soft drinks in the USA, while Dr Pepper was the fourth largest. Coca-Cola wished to expand Dr Peppers market by applying its own skills in marketing and at the same time keeping up with its main rival Pepsi-Cola also expanding at the time. How to dene the market became the central issue in the case to determine whether the acquisition could proceed. Coca-Colas market could potentially be dened as the market for carbonated soft drinks, the market for cola drinks or the market for all drinks (including tap water). Depending on the denition used, the proposed merger would have left Coca-Cola with either signicant or no signicant market share, and this would naturally have very different effects on competition. Coca-Cola considered the relevant market denition to be the wider all drinks market. However, in this case the market was dened as carbonated soft drinks and data was produced to show that the proposed merger could increase Coca-Colas market share by over 4.5% at the national level and by as much as 10% to 20% in many geographical markets. On this basis the proposed merger was blocked.

COMPETITION POLICY EXAMPLE 2: SUBSIDIES

At the EU level, the issue of state aid where national governments provided subsidies to companies of national interest arose in several cases. One of

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the most common industries affected was airlines. In the early 1990s the European Commission announced that airlines would no longer qualify for state aid and put forward a proposal that aid could be given to assist with restructuring on a one last time basis under which Iberia Airlines received almost $1bn in 1992. In 1994 the Spanish government provided Iberia with a further $1bn in aid to avert bankruptcy. The credibility of the one last time policy was further diminished when, also in 1994, the Belgian government gave nancial aid to Sabena. The EU then adopted the market economy investor principle in deciding whether state aid is anti-competitive. This principle stated that if state aid takes place in circumstances that would not be acceptable to a private investor under normal market economy conditions, then such aid would be banned. In 2001 Belgian airline Sabena requested state aid to ght off bankruptcy arising from industry shocks. It was refused and the airline subsequently went out of business. The Irish airline, Aer Lingus, also requested state aid in 2001 and was also refused. It faced the stark choice of restructuring or going out of business. Following restructuring the company subsequently turned signicant losses into substantial prots, indicating that state aid is not the only option for a company facing bankruptcy.

COMPETITION POLICY EXAMPLE 3: MARKET ABUSE

This case involved British Airways (BA) and Virgin Airlines and concerned the issue of market abuse. Here BA had 40% of the market for ticket sales in the UK and the next largest competitor had sales of 6%. BA was subsequently deemed to have dominance when other factors such as number of routes and its control over a large number of landing slots were factored in. Virgin took issue with BA over its commission scheme to travel agents. The scheme paid agents 7% for ticket sales on top of a performance reward, which paid up to an additional 3% on international ights and 1% on domestic ights, by matching current year sales to levels of performance in the previous year. This incentive scheme was seen as persuading agents to sell more BA tickets, thus giving BA an unfair advantage against other airlines. BA claimed that these rewards were linked to cost savings and efciencies and had no damaging effects on other airlines. The European Commission did not accept these arguments and ruled that such a scheme was abusive.

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6.7

SUMMARY

Efcient functioning of a market economy depends on a robust state of competition. Through competition knowledge is discovered and exploited in the marketplace through the use of the price system. If markets are not contestable, entry barriers result in different market structures, ranging from monopolistic competition to oligopoly to monopoly, each with different effects on consumers, in terms of their ability to maximize their welfare and on producers in terms of their ability to earn supernormal prots.

Market failure is used to justify government intervention in markets in the form of direct controls (becoming increasingly uncommon), or it can take the form of regulations or rules governing the behaviour of rms. Since all such rules impose costs on businesses it is important to assess the perceived benets of these rules against their costs.

Competition policy is an instrument to impose strict rules of competitive behaviour on rms. One aim is to reduce the role of government involvement in the economy and yet curb any negative effects from market failures. Competition law is the legal enforcement for competition policy and creates incentives for rms to obey such a policy.

REVIEW PROBLEMS AND QUESTIONS

1. How does Schumpeters view of competition as creative destruction link with the idea of competition as a process? 2. Patents prevent rms from copying inventions or innovations by other rms. Discuss what you think might happen if patents were eliminated so that rms could imitate successful innovations by other rms. 3. What are the key features of the following market structures: perfect competition, monopolistic competition, oligopoly and monopoly? If perfect competition does not exist in practice, what is the purpose of the model? 4. Use a diagram to show equilibrium price and quantity for a monopoly rm. Explain why supernormal prots result under monopoly. What are possible negative effects resulting from monopoly? Why do monopolies persist, given their possible negative effects?

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5. With reference to the pay-off matrix below explain what you understand by the terms dominant strategy; Nash equilibrium; co-operative equilibrium. Firm Bs Strategic Options I Firm As Strategic Options X Y (10, 10) (5, 15) II (15, 5) (18, 18)

6. In comparing the Austrian and traditional approaches to competition, what are the main conclusions? Would you see the Austrian and traditional views as being substitutes for or complementary to each other? 7. What is meant by market failure and what might cause markets to fail? What, if anything can be done in response to market failure? 8. What is the structure, conduct, performance paradigm? What is the relationship between this paradigm and competition policy?

FURTHER READING AND RESEARCH

For analysis of the US, UK and German manufacturing sector considering the efciency of large scale production see Chandler, 1990. For the SCP approach to industry analysis see Bain, 1956, esp. pp. 119. For a modern applied perspective on markets, market structure and efciency (among other issues) see Kay, 2003, particularly Parts 3 and 4. For consideration of a range of mythical examples of market failure see Spulber, D. (ed.), 2002.

REFERENCES
Bain, J. (1956) Barriers to New Competition . Harvard University Press, Cambridge, Mass. Chandler, A. (1990) Scale and Scope: The dynamics of industrial capitalism . Harvard University Press, Cambridge, Mass.

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Hayek, F. (1978) New Studies in Philosophy, Politics, and History Ideas . University of Chicago Press, Chicago. Kay, J. (2003) The Truth about Markets: Their genius, their limits, their follies. Allen Lane. Spulber, D. (ed.) (2002) Famous Fables of Economics: Myths of market failures . Blackwell, Mass.

CHAPTER 7

MONEY AND FINANCIAL MARKETS IN THE ECONOMIC SYSTEM

LEARNING OUTCOMES
By the end of the chapter you should be able to: Explain the three functions of money and describe how money underpins exchange. Dene what is meant by money and clarify alternative denitions (broad or narrow). Describe how banking systems work to create money. Outline the main motives underlying demand for money. Use the demand and supply model to describe how demand for and supply of money interact to determine the equilibrium interest rate and quantity of money. Describe the relationship between real and nominal interest rates. Explain the relationship between money supply and ination. Apply the demand and supply model to the foreign exchange market to study: how demand for and supply of currency interact to determine equilibrium exchange rates and quantity of currency exchanged; the causes and consequences of changes in equilibrium exchange rates. Illustrate how the activity of speculators has potential to generate both costs and benets in the economic system. Describe how monetary policy works and outline difculties experienced in implementing such policies. Explain the logic underlying adoption or non-adoption of single currencies.

7.1

INTRODUCTION

So far we have implicitly used the concept of money in our discussion of the economic system. We mentioned the circular ow of income and output which we

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measure in money terms. Quite often the role of money is taken for granted but given its central role in the operations of an economy, it requires specic analysis. In fact the role played by money in the economic system is complex. Focusing on money and its place in the economy we realize even more the organized and interdependent nature of the various features and units within the economic system. For instance, what we consider as money today has no value other than that which we are happy, by convention, to afford it. To be used as money, coins, notes, plastic cards (or whatever) must meet a number of criteria, set out in section 7.2. The supply of money in an economy is organized via central banks and commercial banks as explained in section 7.3. To allow us to analyse the money market we next consider demand for money in section 7.4 focusing on motives that explain demand. Bringing supply and demand together in section 7.5, we can consider how equilibrium is determined. The difference between real and nominal data is addressed once again, although here it is with reference to the price of money the interest rate. The potential relationship between money supply and ination is addressed in section 7.6, which also focuses on how monetary policy might be used to try to control ination and affect interest rates. The focus then moves to broader international money markets with consideration of how exchange rates are determined, again using a demand and supply approach. This has relevance for central banks since one of their functions is to maintain the stability of their national currency. The activities of speculators in foreign exchange markets has received much attention in recent times and this activity is examined in section 7.8 with interesting outcomes regarding the potential benets speculators may bring to markets. Section 7.9 focuses on monetary policy and how it can be used to affect economic activity. The nal section assesses the arguments underlying monetary integration focusing on the specic case of the euro.

7.2

MONEY AND EXCHANGE

Life would be considerably more complicated were it not for money to the extent that we almost take it for granted and certainly do not consider the various functions it serves. The various functions of money are:

medium of exchange;

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unit of account; store of value.

Starting with the medium of exchange function, we know when we hand over the agreed amount of money in any transaction, we receive something we want and value in return. Whether we hand over cash, cheque or plastic (credit card) we know that there is agreement that our money will be accepted in transactions. The fact that money is light and easily portable certainly facilitates exchange and just thinking about how barter systems work (where goods rather than money are exchanged for other goods) reveals how much more straightforward it is living in a monetary rather than a barter economy. That we treat money as a unit of account means that it is the general language we use to quote prices and compare them. It would be possible to use any good as a unit of account if we were all happy to measure prices in mobile phones, for the sake of argument. This would mean that the price of tables, chairs, books and groceries would all be quoted in terms of the number of mobile phones required to buy them. In theory its sounds possible, but in practice who would want to carry around mobile phones to pay for everything they buy? And what about the different phones that are available this would require an exchange rate relationship to be developed where the purchasing power of one phone would be quoted relative to another. Even if all prices were quoted in a more basic unit of account, like gold, this still would not get around the problem of having to carry around the gold to pay for purchases. History also reveals that when gold coins were used as an acceptable unit of account, some dishonest people engaged in shaving off some of the gold from the coins, thus devaluing them, but without the knowledge of the person accepting the gold. Since we are generally unwilling to treat commodities such as gold or phones as a unit of account, we require an alternative. This alternative is at money. Fiat money exists where paper with no intrinsic value itself fulls the functions of money, and government legislation ensures that it must be accepted for transactions. By convention and tradition we are willing to accept paper and certain coins as payment because we have monetary systems that we trust sufciently. Since not all of consumers purchases are made out of current income people save and borrow money must also be durable enough to allow for purchases to be made in the future or loans to be paid back. Money fulls this function since it can be kept from one period to another although its purchasing power may not be exactly the same. In that way it can be said to be a store of value.

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7.3

L I Q U I D I T Y, C E N T R A L B A N K S A N D M O N E Y S U P P LY

Different examples of nancial assets exist that full the functions required to dene them as money; for example, notes, coins, bank deposits, credit cards, travellers cheques. Other nancial assets such as stocks, shares, or government bonds could not be described as money since they cannot be exchanged for goods and services until they are rst converted into money. The easier it is to use a nancial asset to buy goods or services, the more liquid it is said to be. In general a countrys currency and money are managed by its central bank, which deals with the formulation and implementation of monetary policy and tries to promote a sound and efcient nancial system in which its citizens have condence in the sense that they trust that their currency fulls all the functions money should. Later in this chapter examples of monetary policies and their effects are considered. Monetary policy is the broad term used to describe how the supply of money is regulated in an economy, including how ination is controlled and how the stability of the currency is maintained. The amount of money held by banks in their reserves plus the currency in circulation is known as the monetary base. Different central banks have their own denition of what constitutes money in the sense of which more and less liquid assets are included. For example according to the Federal Reserve, the central bank in the United States (the Fed), there are three denitions of what is included as money, from very narrow M1 including essentially the notes and cash and bank deposits available immediately for purchases (including travellers cheques) to broader denitions called M2 and M3 that include less liquid nancial assets. (The denitions used by the European Central Bank (ECB) are similar but not exactly the same.) The monetary base is smaller than M1 or M2 and only changes with specic activities of the central bank (explained later in this section). Recent gures for the different denitions of money are provided in Table 7.1 for the USA and Europe. We can draw the supply curve for money (dened as M1, for example) as shown for the USA for April 2003, shown in Figure 7.1. The money supply is drawn as a vertical line because the decision about the quantity of money to supply to an economy is independent of the rate of interest. When discussing the price of money,

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TA B L E 7 . 1 M O N E Y I N C I R C U L AT I O N , U S A A N D EUROPE, APRIL 2003

US ($bn) Currency
642

EU (bn) M2 M3
8600

M1
1236

Currency
337

M1
2423

M2
5027

M3
5949

5921

Sources: http://www.federalreserve.gov and http://www.ecb.int

MS

1236

Quantity ($bn)

FIGURE 7.1

M O N E Y S U P P LY : U S A , A P R I L 2 0 0 3

again like any other price we refer to its opportunity cost. The price of money is the rate of interest since the cost of holding onto money in its most liquid forms is the interest that could be earned if it were on deposit or used to buy a nancial asset. The main channel open to the central bank for affecting money supply is through open-market operations. When the central bank buys or sells government bonds it conducts an open-market operation. Government bonds are issued to generate funds for the government and usually mature after ten years or more. Buyers of bonds pay money in return for an agreed rate of return on their investment in the future. If the central bank wants to increase money supply it buys government bonds from the public thereby releasing additional money into supply. To reduce the money supply the central bank could sell some of its own reserves of government bonds thus taking money out of circulation and transferring it into its reserves.

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A further mechanism central to the determination of the money supply in an economy is the required reserve ratio held by banks. The required reserve ratio is the percentage of all deposits received by banks that must be held in the bank and not used for loans or other purposes. Through the required reserve ratio, banks manage to create money, thereby increasing the supply of money, in an economy. Central banks indicate what the desired reserve ratio is and commercial banks must retain that specied amount of reserves. Reserves are held so that any depositors requiring to withdraw their deposits are sure to be able to do so and will have condence in their banking system. If on average, the central bank observes that banks need to hold 8% of their deposits for customers wishing to withdraw their deposits, this will be the preferred reserve ratio. For a ratio of 8%, a bank that has deposits of 50m must retain 4m in reserves but it is free to loan out the remaining 46m as it sees t, within the guidelines set out by its central bank. Since banks must hold a fraction of their deposits in the form of reserves, the banking system is known as a fractional reserve system. The incentive for banks to loan out funds is generated once the interest they pay on deposits is less than the interest they can charge on loans so they can make prots. Since the banking market contains several competitors, each bank needs to ensure that its interest rates compare well to those offered by other competitors.

7.3.1

THE MONEY MULTIPLIER

If loans are created, they produce money in the economy in a multiplicative manner based on the money multiplier. This is easily explained using an example. Taking the case of the hypothetical BankOne, which has reserves of 4m and deposits of 50m. We can consider what happens to the money supply if the bank receives an additional deposit of 1000 from a customer, Moneybags Inc. BankOnes deposits rise to 50 001 000 so it needs to increase its reserves at the central bank by 80 (8% of 1000). When the reserves have increased by 80, the remaining 920 can be loaned out by the bank. If a loan of 920 is issued to Grandons, Ltd, their account at the bank is credited with this amount, thus increasing deposits by 920 to 50 001 920. As deposits rise, reserves must increase

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TA B L E 7 . 2 M O N E Y C R E AT I O N V I A T H E M O N E Y M U LT I P L I E R
Assuming a required reserve ratio of 8% Deposit
Moneybags Grandons Next customer Next customer ... Total 1000 920 846.4 778.7 ... 12 500

Required reserves
80 73.6 67.7 62.3 ... 1000

Loan
920 846.4 778.7 716.4 ... 11 500

in line and 8% of 920 is 73.60. When 73.60 is held in the banks reserves, again the remainder of 846.40 (920 73.60) can be used for loans by the bank. Then the bank can issue a further loan to Safelock Ltd, which is credited to their account in the bank, increasing bank deposits, requiring an addition to the banks reserves . . . and so on as shown in Table 7.2. This process ensures that the initial addition to the banks deposits generates an increase in the money supply considerably greater than the initial change. The money multiplier describes how a change in money supply leads to an ultimate change in money supply by a multiple of the initial change. The size of the money multiplier depends on the required reserve ratio according to the formula: Money multiplier = 1 required reserve ratio

Since the ratio is 8% in the example, the money multiplier is 1/0.08 = 12.5. This means that any change in deposits will lead to an increase in the money supply 12.5 times the initial increase. If the initial change is 1000 it generates 12 500 in additional money supply as shown by the process in Table 7.2. Hence, banks create money.

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7.4

MONEY DEMAND

Taken together, money supply and money demand determine the equilibrium price and quantity of money in the money market. We hold money or demand money (in more liquid forms) for different purposes for transactions, as a precautionary measure and for speculative purposes. These are known as the motives for holding money. The transactions demand for money relates to the medium of exchange function of money in that it is the demand for day-to-day spending on things like groceries, bus fares, and so on. The amount of money people demand for their transactions will vary depending on their income generally those earning more spend more and on the general price level if prices are high, then relatively more money is needed to pay for purchases. The precautions demand for money relates to the money demanded for unexpected emergencies and is again associated with the moneys medium of exchange function. The amount of money demanded for precautionary purposes again depends on individuals incomes, and their age. The transactions and precautionary demands for money are known as the demand for active balances because the money is actively used to buy goods and services. The price of money the interest rate is not of interest in explaining the demand for active balances. The third motive for money demand is for speculative purposes. This motive is related to moneys store of value function because individuals concerned about the value of nancial investments in the future who are afraid the value of their investments will fall prefer to hold money rather than nancial assets. The speculative demand for money is also called the demand for idle balances since it relates to the desire to demand money to avoid potential losses from holding interest-bearing nancial assets. The demand for speculative purposes depends on the interest rate, which is the opportunity cost of holding money. With a relatively high rate, people will prefer the more attractive option of holding interest-bearing assets rather than more liquid forms of money. Figure 7.2 shows the demands for active, idle and total money balances. Note that the price of money P is the interest rate. This demand for money or the liquidity

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A P Demand for active balances

B P Demand for idle balances

C P Demand for total balances

FIGURE 7.2 MONEY DEMAND: LIQUIDITY PREFERENCE CURVE

preference curve is shown in Figure 7.2 panel C , which is the sum of the demand for active and idle balances. This indicates the desire for holding assets in liquid form, i.e. cash rather than in other nancial asset forms.

7.5

T H E M O N E Y M A R K E T: D E M A N D A N D S U P P LY

Equilibrium in the money market requires an assessment of both demand and supply together, as presented in Figure 7.3. The opportunity cost of money is determined by the intersection of demand and supply, and this is shown as r in Figure 7.3 panel A. If there is a xed quantity of money supply then, depending on the demand for total balances, the interest rate may vary as shown in the comparison between Figure 7.3 panels A and B . In both panels the money supply is the same and money demand is different. The intersection between demand and supply gives rise to an interest rate r in panel A, while it is higher at r in panel B . The demand for money in panel B is greater than in A (the demand curve in panel B is above and to the right of that in panel A) but because supply is xed the price must rise to bring the market to equilibrium. If the interest rate did not rise the demand for total balances at r would exceed the available supply there would be a shortage of money and the market would not clear. In Figure 7.3 panels C and D we can examine what happens when the central bank conducts open-market operations and expands the money supply (when it buys government bonds). Initially the interest rate is r but once the open market operation increases the supply of money the interest rate declines to r +.

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THE ECONOMIC SYSTEM

A Interest rate Money supply

B Interest rate r^ r* Demand for total balances r* Money supply Demand for total balances

Q C Interest rate Money supply D Interest rate

Demand for total Money balances supply

r*

Demand for total balances

r* r+

FIGURE 7.3

M O N E Y M A R K E T: D E M A N D A N D S U P P LY

The interest rate must decline when the supply expands because, as shown in Figure 7.3 panel D , at the original interest rate of r the expanded money supply is greater than demand at that price. The market only clears if the interest rate drops to bring demand and supply together.

7.5.1

WHICH INTEREST RATE?

Figure 7.3 simplies the process by which the interest rate is determined because there is more than one interest rate determined in an economy at any time. For example, one interest rate is charged for mortgages. Mortgages are a feature of the capital rather than the money market since they are long-term debts debts shorter than one year are features of the money market. Another interest rate is earned on deposits held by savers, while another is earned on deposits held for one month, or three months, and so on. Two main elements help to explain differences in interest rates:

Loan term : loan repayment periods vary in time; some are short like the overnight borrowing that some banks engage in with their central bank, others

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like mortgages are for up to 30 or 35 years. Generally speaking long-term rates are higher than short-term rates, although mortgages do enjoy lower rates than other types of loan Risk associated with borrower : not all loans are repaid as individuals go bankrupt and businesses shut down. Lenders are free to take into account the probability of default when providing loans and higher interest rates are associated with riskier loans.

All of the above interest rates tend to change together following a similar trend, however, which means the simplifying assumption that there is only one rate can be used.

7.5.2

NOMINAL AND REAL INTEREST RATES

Economists are interested in real variables because this allows for comparisons to be made in terms of purchasing power over time. Interest rates, like any prices, can be quoted in real or nominal terms. The nominal interest rate on deposit accounts, for example, is the rate quoted by banks say 0.75% meaning that you could earn 0.75% interest on any deposits held for one year. When nominal interest rates change, individuals incentives to save or borrow are affected. An increase in the nominal rate raises returns for savers but makes borrowing more expensive while a cut in the nominal rate has the opposite effects. Since savings create the deposits that banks use for creating money via providing loans, the amount of savings in an economy is of crucial importance for the real interest rate, which takes purchasing power into account. The real interest rate (r ) is computed as the difference between the nominal interest rate and the rate of ination. r =i where i denotes the nominal rate and is the rate of ination. If the annual rate of ination is 4% while the nominal interest rate is 0.75%, then the real interest rate is 3.25%. This means that any deposits held in a bank will buy 3.25% fewer goods at the end of a year as the purchasing power of money has declined prices rose faster than the rate of return on money. The real interest rate is a positive number once the ination rate is less than the nominal rate of interest. If real interest rates are expected to be negative, it may be logical for consumers to make purchases today rather than hold onto money that will buy

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fewer goods in the future so savings might be relatively low. Hence, via individuals consumption behaviour, nominal and real interest rate effects have implications for aggregate demand. With negative real interest rates, borrowers debts would decline in real terms so people might be happy to borrow knowing that without making any repayments the real value of their borrowings will decline! In this case, consumption and aggregate demand are also affected. There is evidence that, when real interest rates are negative and large, consumers prefer to spend and can even cause asset prices and/or property prices to rise rapidly if supply cannot expand sufciently quickly to meet demand. Furthermore, if share prices rise rapidly as well due to increased demand for such nancial assets this can cause further increases in consumer spending and may even lead to ination (if aggregate demand shifts rightwards intersecting aggregate supply at a new equilibrium point with higher output and a higher price level). Financial or property bubbles are often associated with negative real interest rates as people are willing to invest or speculate on assets with an amount of certainty that because real returns on assets are falling, their losses will be partially protected. In markets where bubbles exist, there tends to be an over-enthusiasm on the part of investors who believe that increases in asset values will continue into the future and so they are increasingly willing to invest, pushing up the price of the asset and as long as people expect that asset values will continue to rise, the bubble gets bigger and bigger and may eventually burst, as in the case of the technology stock market in 2000. Alan Greenspan the Chairman of the Federal Reserve famously asked in a speech in late 1996: How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? His concern was in relation to monetary policy and his fears were that there could be effects that would impact the real economy, its production, jobs, and price stability. Clearly expectations about the future play a key part in bubbles but as Mr Greenspan pointed out can affect the real economy in adverse ways if the bubbles burst. For rms thinking about making investments and who need to nance those investments via bank loans, the nominal and real interest rates also play a central role in their decisions. Their strategies regarding buying and selling shares in both their own and other companies will also be affected by the interest rates. Ceteris paribus, rms will be most likely to borrow when nominal interest rates are low and this is why you often hear business analysts arguing that cuts in interest rates by the Federal Reserve or the European Central Bank are needed to stimulate

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business activity. If interest rate cuts lead to consumers buying more, then both the investment and consumption effects in the economy would boost economic activity via a shift in the aggregate demand function. In May 2003, commentators correctly predicted a cut in the ECBs interest rate from 2.5% to 2% given the poor economic growth in the French and German markets and the fact that ination of 1.9% was below the target rate of 2% for the euro zone. In fact some analysts were predicting falling prices (deation) in the German market and argued one way to attempt to avoid this was to cut interest rates signicantly by half a percentage point to 2.0% stimulating consumption (and thereby aggregate demand) and reducing any downward pressure on the price level. Such a drop in the interest rate to 2.0% when ination was at 1.9% would imply a real interest rate of 0.01%.

Finally, in relation to Figure 7.3, the real interest rate is determined if real money supply and real money demand are considered, while if nominal supply and demand are of interest, the nominal interest rate is determined.

7.6

QUANTITY THEORY OF MONEY A N D E X P L A I N I N G I N F L AT I O N

From the motives for holding money considered earlier, we know that people demand money in order to make transactions and logically the more money needed for expected transactions, the more money people will want to hold. Another way of stating this is via the quantity equation: M V =P Y where M denotes the nominal money supply in an economy, V denotes velocity of money, P denotes the average price level, Y denotes the level of real economic activity and hence P Y is the nominal value of economic activity (i.e. income or output). The velocity term is a measure of how often an average unit of money is used in a period of time. If 100bn-worth of nominal output is produced in an economy

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in a year and the stock of money in that economy is 10bn, then the velocity term is equal to 10, implying that each unit of money (1) is used ten times per year appearing as ten separate transactions in the circular ow. If any of the terms in this equation change, there is an impact on one or more of the other variables so if the quantity of money falls and the velocity is unchanged, either the price level or the level of activity must fall. Another way of expressing the quantity equation is in terms of velocity where: V = P Y M

which denes the velocity of money as the ratio of nominal income to the quantity of money in the economy. In practice the velocity of money does not change hugely over time and it can be assumed that V is constant. If this assumption is made the quantity equation becomes a relationship between the quantity of money and the nominal level of income in an economy whereby any change in the amount of money in an economy would lead to a similar change in nominal income: when V is constant, if the quantity of money increases by 10%, so too will the nominal value of income. To see what this implies (assuming still that V is constant) take the case where an economy produces 100bn of real output in a given year and has an average price level, P , so nominal output is given by P 100bn. The same economy has 10bn of money. Any change in the quantity of money must lead to a change in the price level in the economy because the real output is the actual quantity of output produced (if this causes you problems think of real output as 100 bags or bales of output!). If the money supply rises by 20% to 12bn, the effects are felt through P , which rises also by 20% as the bags of output produced are 100, whatever happens. A change in P , the aggregate price level, is caused by a change in money supply. An increase in the price level is called ination. Hence, ination is caused by increasing the money supply. By implication, central banks through their setting of money supply can affect the rate of ination. Analyses of the correlation between ination rates and money supply growth (according to the M1 denition) reveal a strong positive relationship over the long run. In order for the money supply to be the sole determinant of ination, we assumed no change in real output. This would be true for an economy operating in the long run at its potential output level with all resources fully employed. From our previous analysis of economic activity, however, we know that real output tends to be cyclical

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in the short run. We know too that there is a marked upward trend in real output in developed countries over time. Hence, a change in the money supply results in the same proportional change in P , the aggregate price level, if we treat real output as constant. We can go one step further and consider what that would imply for the demand for money. If real output (income) rises by 5%, the demand for money should do so too to buy the extra output/to spend the extra income. If money supply grows by 8% then prices need rise only by 3% because 5% of the extra money supply is needed due to the growth in economic activity. By implication, long-run ination should equal the rate of growth of the money supply minus the real rate of growth in economic activity. Ination = rate of money supply growth rate of real output growth e.g. ination = 8% 5% = 3%

7.6.1

INFLATION EXPECTATIONS, INTEREST RATES AND DECISION-MAKING

If I lodge money into a deposit account preferring to save rather than buy consumption goods, I expect to earn some interest, depending on the deposit account I select. I know that if there is a change in the interest rate announced by the central bank, that change, or at least a portion of it, will be passed on to me by my bank. This means that I cannot be sure of the nominal return I will earn on my account. Since I also do not know what ination will be in the future, I cannot compute the real interest rate with certainty. I can, however, make my best guess at the ination rate and hence the real interest rate. Similarly for borrowers taking out loans where the nominal interest rate varies depending on what the central bank dictates and the real repayments can be guessed with varying amounts of accuracy depending on how close the economic outcome is compared to the decision-makers forecast. In decision-making when we base our choices on our best guesses of what we expect the ination rate to be, we use an ex-ante real interest rate. This is our best guess given available information about a future occurrence. The actual real interest rate that we can measure once we know what the ination and nominal interest rates are is called the ex-post real interest rate.

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The ex-ante real interest rate is r = i e where e is expected ination. Rearranging this expression, the nominal interest rate i = r + e . (This is known as the Fisher equation and is explained below.) The ex-post real interest rate is r = i where is actual ination. Expectations regarding future ination are central to economic decision-making when current and future ows of income must be considered. This has implications for our analysis of the role of a central bank in setting the interest rate via its money supply. Consider the case where a central bank conducts an open-market operation by increasing the money supply, i.e. it buys bonds and pays money in return, which it takes from its reserves. Increased money supply implies excess supply for money at the original interest rate and the money market can clear only if the nominal interest rate falls. This may not always happen. If money market analysts interpret the increase in money supply as a policy direction of the central bank to indicate that there will be rise in the rate of growth of the money supply (not just an increase in its level), they may predict further increases in money supply in the future. This would mean that the expected rate of ination would rise, from the relationship described as: % ination = % money supply growth % real output growth. From the Fisher equation, a rise in the expected rate of ination would put upward pressure on the nominal interest rate since it depends on the real interest rate and expected ination. Fisher showed that if expected ination increases by 1% then the nominal interest rate also rises by the same amount. If the money market analysts got it wrong in predicting faster growth of the money supply, over time people would see that the expectations of higher ination were mistaken and the expectation would disappear. In that case the nominal interest rate would certainly fall. A central bank has only limited control of the interest rate in the short run. Changes in ination expectations can change the outcome predicted by the money demand and supply model. If a central bank really wants to lower interest rates, it should lower ination or, more specically, inationary expectations. It can attempt to do this by reducing the rate of growth in money supply and by being a credible institution. Credibility in its policies basically implies that the central bank means what it says and if it sets a policy target of 2% ination (for example) it will stick to this target. This

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credibility of policy generates certainty for consumers and rms facilitating their economic decisions. The credibility of central banks policies is tied to their independence. By independence we mean the extent to which the central bank is free to set its own targets for ination and interest rates without political interference from a government, Minister for Finance, or Chancellor of the Exchequer. Studies have shown that economies with the most independent central banks have lower ination performance and less variable ination (DeLong and Summers, 1993). The countries did not appear to have any higher unemployment, lower real income growth or larger short-run uctuations in real output. In order to establish credibility, it appears central banks have to prove themselves as sticking to their word if they set an ination target then the policy is credible if they have managed to successfully stick to previously declared targets for ination. Central banks are often judged on their ability not only in terms of ination but in terms of maintaining a stable value for their currency, which is addressed next.

7.7

THE FOREIGN EXCHANGE MARKET

The price of a currency (in terms of other currencies) depends on demand for the currency and supply of that currency. The demand for euros on the foreign exchange market is called a derived demand, derived from the demand for goods or nancial assets. Holders of other currencies US dollars, for example purchase euros in order to pay for European goods and services or European nancial assets, e.g. shares, government bonds and property. The price of one currency in terms of another is called an exchange rate. When exchange rates change currencies either appreciate or depreciate. An appreciation of the euro occurs when 1 buys more foreign currency today than it did yesterday (when it costs more in terms of foreign currency to buy 1). A depreciation of the euro occurs when 1 buys less foreign currency today compared to yesterday (when it costs less in terms of foreign currency to buy 1). Exchange rates are considerably more volatile than most prices, as you will know if youve ever had to buy foreign exchange when the price varies day-to-day if you buy from a bank or in real time as currencies are traded on international money markets. On 9 June 2003, 100 would have bought almost $118 whereas ve months

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earlier on 9 January 2003, it would have bought less than $105. As a given quantity of euros bought more dollars, the euro can be said to have appreciated in value. The corollary is that the dollar depreciated. To consider how exchange rates are determined we consider both demand for and the supply of foreign exchange.

7.7.1

DEMAND IN THE FOREIGN EXCHANGE MARKET

In Figure 7.4 the demand curve for euros is shown in terms of dollars. Three different prices or exchange rates are shown. At the highest price of the euro, when it costs $2 to buy 1, the quantity demanded of euros is Q1. If the price were lower at 1 for $1, a higher quantity of euros is demanded at Q2 while if the price is only $0.50 for 1, the quantity demanded is higher again at Q3. Hence, as you would expect, when the price of the euro is high, the quantity demanded of euros is relatively low. At a high exchange rate (1/$2) holders of dollars would prefer to buy domestic goods and services, where possible, rather than those from Europe and so their demand for euros is relatively low. At cheaper exchange rates, the incentive to buy European goods and assets increases.

7.7.2

SUPPLY IN THE FOREIGN EXCHANGE MARKET

Supply of foreign exchange is also derived and is shown in Figure 7.5. Holders of euros want dollars to buy US goods and services and US nancial assets. When people buy goods/assets they supply euros in exchange (if they are going on holidays and exchange their currency, for example). Or European importers make purchases from US producers and pay in dollars. The supply of US goods, services or nancial assets is greater the cheaper the price of dollars in terms of euros, as shown in Figure 7.5. When 1 buys $2, Europeans have an increased incentive to buy US goods, services or nancial assets compared to when the price is higher, e.g. when 1 buys only $0.50.
/$ 1/$2 1/$1 1/$0.5 Q1 Q2 Q3 Q

FIGURE 7.4

FOREIGN EXCHANGE: DEMAND

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/$ 1/$2 1/$1 1/$0.5

FIGURE 7.5

F O R E I G N E X C H A N G E : S U P P LY

7.7.3

EXCHANGE RATE DETERMINATION

The exchange rate between any two currencies is based on their relative demands and supplies. Equilibrium in the foreign exchange market is found in the usual way, where demand and supply intersect, shown in Figure 7.6. From the demand and supply curves the equilibrium exchange rate is 1 = $1. We know that exchange rates change quickly, meaning information that changes either demand or supply of foreign exchange occurs frequently and the exchange rate required to clear the foreign exchange market changes quickly. Consider what might happen to the exchange rate if holders of euros want to buy extra US goods and need to buy dollars to pay for them. This might happen if, for example, US computer producers use some new technology that allows them to produce better machines at a lower price than European competitors. If the supply of euros (for dollars) rises as shown in Figure 7.7, then at the original exchange rate, the market does not clear and supply is greater than demand and at the original exchange rate a surplus exists. This means that at the original exchange rate there are more euros on the market than people holding dollars wish to buy. This surplus of euros can only be eliminated if the exchange rate falls. As the
/$ 1/$2 1/$1 1/$0.5 S Q D

F I G U R E 7 . 6 D E T E R M I N AT I O N O F A N E X C H A N G E R AT E : THE EURO IN TERMS OF DOLLARS

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/$ 1/$2 1/$1 1/$0.5

D A B

Excess supply

S1 S2 Q1 Q2

FIGURE 7.7 R AT E

CHANGE IN THE EQUILIBRIUM EXCHANGE

exchange rate falls, the quantity of euros demanded by holders of dollars increases. The new equilibrium emerges at Figure 7.7 point B .

7.7.4

CAUSES OF CHANGES IN EXCHANGE RATES

Many different factors affect exchange rates, due to interdependencies of foreign exchange markets internationally. These can be examined using the demand and supply framework and considering equilibrium changes derived from changes in either currency demand, supply or in some cases changes in both currency demand and supply. The main factors causing exchange rates to change include:

interest rate differentials; ination differentials; growth differentials; speculation.

An interest rate differential exists between the euro zone and the USA when their interest rates differ and would be expected to have an effect on the eurodollar exchange rate. Take the case where the euro interest rate is set (by the European Central Bank) at a rate above that in the USA (set by the US Federal Reserve). Holders of dollars might wish to earn a higher interest rate on their savings, demand more euros and supply more dollars to the foreign exchange market. An increase in demand for euros would mean a rightward shift of the demand curve drawn in Figure 7.7, bringing about an appreciation of the euro. Furthermore, if holders of euros are also less willing to buy US assets, fewer euros may be supplied and the supply curve may shift to the left (at each exchange

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rate, the supply of euros falls). The result of a leftward shift in supply is, again, to increase in the value of the euro against the dollar. The net effect of the interest rate differential depends on the extent of the changes on both demand and supply but in this example brings about an appreciation of the euro. The appreciation of the euro results in reducing the benet of the initial interest rate differential! An ination differential exists between the USA and Europe if prices are rising faster in one economy relative to the other. European goods become relatively more expensive if a positive ination differential exists between the euro zone and the USA. As euro goods are more expensive, demand for them may fall, reducing demand for euros by holders of dollars a leftward shift of the demand curve. If US goods also become more attractive for European buyers, the supply of euros increases also a rightward shift in the supply curve. The net result is a depreciation in the value of the euro versus the dollar. In the case where one economy is growing faster than another (e.g. faster growth of GDP in the EU) a growth differential exists. We know from earlier analysis that additional income results in extra consumption, some of which is met by imports. As import demand increases, so does the supply of euros to pay for them, resulting in a depreciation in the value of the euro for the dollar. The vast majority of demand for and supply of foreign exchange takes place not in order to pay for goods or services but for the purpose of speculation, which amounts to gambling on the future movements of an exchange rate. We know this because the amount of foreign exchange traded greatly exceeds the value of international purchases of goods and services (including tourism). In 1998, for example, the average daily turnover in foreign exchange markets was equivalent to the annual GDP of Germany! Estimates of the amount of foreign exchange transacted worldwide on a daily basis over the period 1998 to 2001 are $1.2tr. (This gure is down 14% from 1998, as quoted by the Bank for International Settlements in their Central Bank Survey of Foreign Exchange and Derivatives Market Activity available from http://www.bis.org.) The most traded currencies are the dollar, euro, Japanese yen and sterling. In percentage terms each currencys respective share of foreignexchange trade is 90%, 38%, 23% and 13% (note that the sum of all foreign currency shares adds to 200% not 100% since two currencies are involved in each transaction). People trade in foreign exchange because of arbitrage opportunities. Arbitrage is the possibility of buying an asset (e.g. foreign exchange) in one market and selling it at a higher price in another market.

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Speculators speculate on the price they expect to earn on an asset in another market or in the future. Given the ease and speed with which traders in foreign exchange gather and receive information on exchange rates, currency exchange rates tend to converge quickly between the various foreign exchange markets (London being the largest) so that arbitrage opportunities in money markets are less common.

7.8

S P E C U L AT I O N I N M A R K E T S

Speculators can only make a prot if they have information not available to the rest of the market. We argued earlier that holders of specic information should use it for their economic decision-making to make best use of economic resources. We also considered that the market system allowed individuals to use their specic information and generated incentives for them to use such information. Hence, speculators must guess (and bet on) changes in exchange rates from which they can benet. Since speculators cannot know future currency rates with certainty, speculation is a risky activity. In many cases speculators can act in such a way as to bring about their expectations. If speculators believe that a currency will fall in value, the rational action is to sell any holdings of that currency and buy others. If a large number of speculators follow the same strategy and sell a particular currency, its supply on the market increases and so the price of the currency will fall as supply exceeds demand. The role played by speculators in exchange rate determination is quite substantial and estimates for the level of speculation on the London ForEx (foreign exchange) market are up to 80% of all trades. Despite the actions of speculators, economists argue that if a countrys economic fundamentals are right, its currency should not be too volatile and the exchange rate should remain steady. Quite often we hear economic commentary that a currency is over- or under-valued based on an economys fundamentals. Economic fundamentals is a very broad term and includes such economic measures as interest rates, the governments budget decit, the countrys balance of trade account (relating to exports and imports), the level of domestic business condence, the ination rate, the state of (and condence in) the banking and wider nancial sector, and consumer condence. The fundamentals are elements of the economic system that need to t well together or else speculators might try to sell the currency. If speculators see any of the fundamentals as a potential problem, they may sell the currency, changing its

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exchange rate(s). Speculators operate across all kinds of markets such as art, rare coins, property (real estate), and agriculture. Some speculative activities relate to futures markets. In futures markets agreements are made relating to a payment that will be made for delivery of goods in the future. In spot or cash markets money changes hands today for goods or services received today. The usual goods exchanged on futures markets are primary (unprocessed) commodities like agricultural output, wheat, barley, corn, coffee as well as stocks and bonds. Futures markets provide information to growers/producers today about how prices are expected to change in the future. If the futures price of a kilo of wheat in 12 months time is 3.50, and is 2.50 today, this indicates that given predictions about future plantings, expected weather conditions (and whatever other factors affect corn output) the expert opinion based on the best specic information available is that wheat prices will rise. Speculators often receive bad press as individuals or businesses that exploit the market system to make a prot. Interestingly, however, speculators who accurately predict the future price of corn, as an example, can help to stabilize the price and output in a market. Take the case for the corn market shown in Figure 7.8. The market for this year and next year are considered respectively in panels A and B . Demand is considered to be the same for both years. Initially we examine the situation if no speculation occurs but there is an expectation that next years crop will be smaller than this years. If no speculation occurs, the contraction in production of corn from S1 to S2 results in different equilibrium prices and output over both periods. However, if speculators are correct in predicting that prices will rise in period 2 their rational behaviour would be to buy at the cheaper price this year and hold onto some of the output until the following year, selling it at the higher price. This activity would change supply for periods 1 and 2 as shown in Figure 7.8 panels C and D . For year 1, supply drops back (to SS 1) as shown in panel C , if speculators store some of the wheat. For year 2 supply expands in panel D (to SS 2) and the outcome is an equilibrium price that is equalized over the two periods the price is 3 in both periods and consumption is 50 million kilos. If speculators were completely correct in predicting year 2s supply then prices and output (and hence, consumption) could remain stable over time. Both price and consumption would be smoother over both periods compared to the situation that would prevail without speculative activity.

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Without speculation: A: Year 1

B: Year 2

S1

S2

3.5 2.5 D Q (millions of kilos) D Q (mill. kilos)

60
With speculation: C: Year 1

40

D: Year 2

SS1

S1

SS2

S2

3 2.5

D Q (mill. kilos)

3.5 3

D Q (mill. kilos)

50 60

40 50

F I G U R E 7 . 8 S P E C U L AT I O N A N D CONSUMPTION SMOOTHING

When speculators expectations are incorrect, however, they can exacerbate problems further. This occurs if a speculator buys at one price, expecting it to rise. If the price is already high and speculators are wrong about future price rises, their purchase today of goods will drive todays price higher still (because of the leftward shift of the supply curve, ceteris paribus ). If prices in the future fall, the speculator sells their purchases and drives the price further down (as the supply curves moves rightwards) by releasing their goods onto the market. In such circumstances the speculators only serve to magnify the trend in prices and consumption over both periods. A similar analysis can be conducted for the money market although we know currencies to be considerably more volatile than other prices. A key difference with speculation in currencies is the possibility that comprehensive nancial crises can result with devastating consequences for the affected economies. It is little solace

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to the victims of the Asian currency crises that the speculative attacks of the 1990s led to the identication of problems in the economic fundamentals and the crises forced the economies to try to address these economic weaknesses and problems (for more on this topic, see Further Reading and Research). It is also unfortunate that speculative attacks on a currency can cause effects over very short periods and can be passed quickly onto neighbours and trading partners yet the time required to rebuild a shattered economy in which investors have little condence takes years. A possible solution to the potential cost of currency speculation, facilitated by the ease with which capital can ow internationally, would be to set limits on such ows (such as existed until the 1980s in many countries) or impose taxes on such ows. However, not all speculation is bad and some speculation, as we see above, leads to stability in currency prices, hence using taxes or limits on speculation could create the very price differences that speculators try to exploit and therefore it is difcult to know how to deal with the issue. What we can say with certainty is that:

Speculators dealing with uncertainties are experts in their elds and they have the incentive to be as well informed as possible before investing in uncertain future events. Society benets when specic information is used by economic decision-makers and when speculators get it right. Speculators who are consistently incorrect are pushed out of business by their losses. There are both costs and benets associated with speculative activity.

7.8.1

INVESTMENT IN BOND MARKETS

Speculation takes place in markets where uncertainty prevails regarding the returns on speculative activity. An alternative, safer investment strategy exists by investing in bonds. A bond represents an agreement between two parties in a transaction where one party lends money to the other for an agreed rate of interest (usually) over a specied period and where the lender receives back the total value of their investment when the bond matures. Both governments and companies issue bonds when they wish to raise funds for investments they could not otherwise afford. When attempting to raise funds, businesses have the option of debt or equity nancing.

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Debt nancing results in borrowing money that must usually be repaid with interest. Debt nancing is described as short-term if repayments are made within one year or else is denoted as long-term debt. Equity nancing involves selling a share of the business (shares) in exchange for nance where no specic future payment is dened. With equity nancing there is often a fear that ownership interests will be reduced and that a certain amount of control reverts to the additional shareholders. Clearly, governments do not have the option of equity nancing; however, they use bonds to nance some of their activities. Clearly, while companies can become bankrupt, countries cannot (notwithstanding nancial problems experienced by some developed and developing countries). This implies that riskier corporate bonds must offer higher returns than government bonds. The extent of the difference in bond returns depends on the belief that market participants have in the ability of a corporation to repay the purchaser of the bond. In the same way as shares are traded on the stock exchange, a market for bonds also exists, which is known as the securities market. As with any other market, demand and supply analysis allows us a framework for considering how the prices of bonds are determined. Bonds are less risky investments than shares but as a consequence generate lower returns for this lower risk. Some bonds must be retained until maturity while others may be sold before that date, depending on the initial agreement. Different bonds have different regulations attached to them.

Convertible bonds can be exchanged for a predetermined number of common stocks in a company although once converted, stocks cannot be reconverted back into bonds. Zero-coupon bonds do not pay interest. They are purchased at a deep discount from their face value. On maturity investors receive a sum equal to the initial investment plus interest that has accrued. Foreign (or international) bonds generate returns in foreign currency, which means the value of the bond issuers currency must also be considered when thinking of making such investments. In some countries municipal bonds are sold to nance public works (i.e. street lights, fountains, etc.).

In attempting to decide between investing in various bonds it is possible to consider their relative rankings.

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Companies such as Moodys and Standard & Poors provide rankings of bonds that are determined by their expected ability to generate interest payments and repay the principal. The best ratings is triple A (AAA), next is double A, next A followed by BAA, BA, B, CAA, CA and C.

Any changes in rankings by these companies clearly have repercussions for investors willingness to buy them. In terms of its size the bond market has a similar market value to the stock market (around $31 000 bn in 1999). Government bonds represent 45% of US and euro zone bonds but in 1999 were over 70% of the Japanese bond market. Together the USA, euro zone and Japan represent over 88% of the world bond market with shares of 47%, 23% and 18% respectively.

A substantial amount of businesses corporate investment is made through selling bonds and, hence, businesses desire to sell bonds (the supply of bonds) is related to the amount of investment they plan. The ip side of the price of bonds, both government and corporate, is the return that investors are willing to earn on their investments, i.e. the interest rate. Hence, the demand for bonds is dependent on their rate of return or interest. Remembering that people have the choice between saving and consumption, the demand for bonds is a mirror image of individuals planned savings. Therefore, rms investment decisions, the supply of bonds, households savings decisions and the return on bonds versus other nancial assets feed into the determination of equilibrium bond quantities and prices. Firms investment decisions include their analysis of the marginal revenue product of investment which is the revenueproducing potential of additional investment (and this is analytically similar to the marginal revenue product of labour examined in Chapter 2). In terms of the main options for saving, bank deposits are one possibility while bond purchases are another. The return on either investment in a stable economic environment will have to be approximately similar, otherwise destabilizing movements of investment funds to the more protable savings option (increasing its supply and pushing down its price/return) would occur. We can say, therefore, that interest rates on deposit accounts and returns on bonds, which are similar

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in risk level and for which the maturity period is similar (e.g. the purchase of a ve-year bond and a savings deposit to be withdrawn in ve years time) will be similar. If interest rates are high, so too are returns on bonds, also known as bond yields. Bond yields are closely related to expectations of future interest rates. The reasons for this have to do with how central banks deal with ination and use interest rates in conducting their monetary policy. If the Bank of England, which sets the interest rate for the UK, announces that it does not expect ination to be a problem nancial analysts expect no changes in the interest rate. (If the bank considers ination to be too high it tries to reduce the amount of money in circulation, which leads to upward pressure on the interest rate.) If expectations are that interest rates are not going to change in the short run then bond yields will be assumed similarly not to change. Expectations about what future interest rates will be are important in the determination of bond yields.

7.8.2

BONDS, INFLATION AND INTEREST RATES

Holders of standard bonds receive an agreed xed return over time on their investment. This agreed return is based on the markets best guess of future economic conditions, which is uncertain. If the agreed return on the bond is 5% per annum and ination unexpectedly jumps to 6% over one year of the life of the bond, the real rate of return the nominal return less ination is negative and holders lose 1% of their return. The real value of the xed-income investment is reduced when ination is greater than the rate of return. Thus, anyone earning a xed income dislikes ination because the value of a xed income is eroded. Index-linked earnings are preferable to xed income payments because they are linked to the ination rate and rise if ination rises. An indexlinked pension, for example, has a built-in facility that ensures it increases by 4% if the general price level rises by 4%. If an economy experiences ination, higher interest rates usually follow as the monetary authority or central bank tries to deal with it by reducing money supply. We know that increased ination reduces real earnings from xed-income investments. Interest rate reductions are often welcomed by bond-market analysis as they affect the present value of the investment. A 1000 bond to be repaid in 10 years is worth

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less than 1000 received today due to expected ination and the cost of having to wait rather than use the money for consumption today. To compare the future receipt of the bond with a current receipt of the same value requires a method for comparing benets in different time periods known as the present value determination. The present value of 1000 to be received in ten years time is the amount of money that would need to be set aside today to receive that specied amount at the specied future date. What must be determined is the amount of money that should be set aside to earn sufcient interest (or rate of return) to yield 1000 in ten years. The standard formula used to determine present value is PV = X (1 + r )T

where PV denotes present value; X is the amount to be received in the future; r is the market interest rate; T is the number of years before the investment is repaid.

If a bond of 1000 will be repaid in 10 years time, its present value can be calculated once the current interest rate is known. If r is 3% the present value is computed as 1000/(1 + 0.03)10 . This is computed as 1000/1.34 = 744.09. Thus, the present value of a 1000 10-year bond is just over 744. The present value of an investment varies with T and with r . If the bond is repaid in nine rather than ten years, this changes the present value, which is recalculated as 766.42. If the period is eight years the present value rises to 789.41 and if the period is two years the value is 952.50. The present value increases as the period of the investment declines because of peoples preference for 1 today rather than one year, two years, etc. from now. To undertake an investment a rational person must be paid for the inconvenience and risk of foregoing their money now for its use only in the future. The further away the return on the investment, the more we expect the purchasing power of money to decline, and hence the lower its present value (I would prefer 1000 next year to the same amount the following year and so on).

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As r varies so too does present value. If r is 2% rather than the 3% used in the above example the present value for T = 10 changes to 820.35. When interest rates fall, the present value of bonds rises representing a capital gain for holders of bonds, which is why bond market analysts often consider it positive news when interest rates fall. A lower interest rate increases the present value of a bond.

7.9

M O N E TA R Y P O L I C Y

In recent times, monetary policy has largely become synonymous with central banks attempts to control ination. Alternative targets for monetary policy include output growth and employment but since central banks deal with interest rates and reserve requirements, effects on real economic variables such as output and employment are indirect. A central banks inuence on ination is also indirect via changes to the money supply and through the monetary instrument of the setting of short-term interest rates. Central banks usually make the public explicitly aware of what their ination target is and depending on whether it can be achieved and maintained they are judged to be credible or not. Credibility is a key characteristic required of a sound central bank. We know that expectations play a central role in the determination of interest rates and in the bond market and the extent to which a central bank can follow through on its stated objectives is considered as an important factor that allows markets to deal with some of the uncertainty with which they must deal. Independence from government is another factor that is important for central bank credibility. Central bank independence usually implies that a government has no direct input into the economic decisions taken by the central bank regarding money supply, interest rates and ination. However, some central banks are independent only in the choice of how they meet targets set by their government. Independence matters because traders in nancial markets trade based on their best analyses of how supply and demand are determined. Any attempts by a government to manipulate supply or demand for their own purposes would create additional uncertainty in the market. There may be grounds to argue that governments should produce additional money in an economy to pay for decits it runs but unfortunately any additional money just

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serves to initially lower interest rates (by increasing money supply) but after a time the extra money in the economy would lead to higher ination and invariably to higher interest rates. Governments might be liable to follow unsuitable monetary policies prior to elections to increase the likelihood of re-election but central bank independence mitigates this potential problem.

7.9.1

DIFFICULTIES IN TARGETING MONEY SUPPLY

In designing its monetary policy, an economy could choose particular targets for its money supply, its ination rate and its exchange rate. From the quantity equation, the relationship between money supply and ination is described and this can be used as the basis to target the money supply and bring about the desired rate of ination. Unfortunately, this is not as simple as it sounds because the quantity theory relates to long-run changes in the price level and central banks are interested in stabilizing short-run ination (among other things). Controlling ination in the short run is difcult because:

Not only are there different denitions of the money supply (M1, M2, etc.), but they do not always move together. This means that targeting a specic rate of growth of money supply is difcult and in practice central banks have often switched from targeting one measure to another Central banks have no way of ensuring that the commercial banking sector fully passes on changes in interest rates to their customers. If the central bank changes (i.e. drops) the interest rate expecting the money supply to increase, commercial banks may not fully pass this on and limit the extent of any increase in the money supply. Assumptions are made about aggregate supply. Given the quantity theory, the rate of change of money supply and its relationship to ination involves taking account of the rate of growth of long-run output growth. Whether output growth is 1% or 4% makes a difference when planning on achieving a specic ination target via targeting money supply growth. Furthermore, if an economy is operating at capacity or potential output, an expansion of the money supply should lead to an increase in aggregate demand (caused by a drop in interest rates) and the result would be a rise in the price level. However, in dealing with an economy in the short run, it may well not be operating at its potential output. Hence the results of a rise in aggregate demand would be both an increase in the price level and in national output.

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Unexpected events economic shocks occur. Unexpected changes to aggregate supply, for example, imply that the best targeted policies may not have the desired outcome. The standard examples used are the oil-price shocks which resulted in aggregate supply contracting (moving leftwards) increasing the average price level and reducing equilibrium output. If such effects are short-term they are of less importance than if the effects endure over time.

7.9.2

ALTERNATIVE TARGETS

Some economies use exchange rate targets as part of their arsenal of monetary policies. Many countries x their exchange rate to the dollar (e.g. Argentina, Hong Kong), or a basket of currencies (the most important trading partners, for example), in the hope that they can control ination. This could be achieved by ofcially depreciating or appreciating the currency by altering interest rates, as required. If exchange rates are set by demand and supply they are known as oating exchange rates. If one countrys exchange rate is tied to another countrys rate, it follows a xed exchange rate regime.

Fixed or floating exchange rates?

More precisely, countries usually x their currency over a range rather than to one particular value, otherwise the central bank would be forced to intervene every time the currency was not at its xed value. Only if the currency moves outside its range, its target zone, would the central bank intervene, buying up excess supplies of the xed currency if required or supplying additional currency in times of excess demand. If the central bank did not follow such policies then excess supply could lead to depreciation of the exchange rate or excess demand could lead to appreciation. Altering interest rates to create interest rate differentials could similarly be used to entice capital to ows into or out of the country, as desired by the central bank. Countries with xed exchange rates should have similar ination rates as the country to which the currency is xed because of how currency demand and supply function. For example, if two countries have different levels of ination and are economically linked via trade, holders of currency in the high-ination country can buy fewer goods and services domestically than in the lower-ination country. People will have an incentive to sell some of their high-ination currency for the other currency, causing supply of the high-ination currency to increase resulting in its depreciation. For an exchange rate to remain xed and for markets to nd this

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a credible monetary policy, holders of the xed currency must have no preference for one currency over the other and, therefore, ination would have to be similar. A lack of credibility in a xed currency could generate speculation on the currency, as discussed earlier. The business sector is generally in favour of xed exchange rates because of the increased certainty generated. Speculators have no incentive to buy or sell the currency against the currency to which it is xed. Governments with xed exchange rates cannot follow irresponsible expansionary policies, scal or monetary. Since such polices lead to rising aggregate demand and a higher aggregate price level (ination) they make exports more expensive and imports less expensive, creating a tendency towards a trade decit. While this could be cleared by a devaluation of the currency (caused when the central bank allows it or forces it to depreciate) it is not a policy option when the exchange rate is xed. Ination cannot be out of line with competitors rates. In oating exchange rate systems no such central bank intervention is required as market demand and supply alone determine equilibrium. This means no reserves of international currencies are required to purchase any excess supply. Governments have more discretion in selecting the level of aggregate demand it deems suitable while the central bank selects the interest rate it deems suitable given its targets. A major difference between xed or oating exchange rates is on how they can be used to bring about changes in the domestic economy. A country that has decided to x its exchange rate but which might be at a different position in its business cycle to the country to which its currency is xed is limited in how to deal with its domestic economy. One reason often voiced to explain the fact that the UK has not adopted the euro is that its business cycle is different to that of mainland Europe. Different interest rates being set by the ECB and the UKs Monetary Policy Committee are indicative of the different needs of both economies. There is consensus that exchange rate and money supply targeting are difcult tools to use to achieve the goal of stable prices and that strict rules on money supply targets or xing (or quasi-xing) of rates do not leave economies with much room for manoeuvre. Many central banks instead have explicit publicly stated goals for their ination targets. Their expectation is that via public announcements and communication, markets can be reasonably sure what monetary policies will be used and why. This recent behaviour is in marked contrast to previous secretive and closed-door deliberations on monetary policy but points to and reects an understanding of the important role played by expectations within the economic system.

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TA B L E 7 . 3

TAY L O R R U L E

Nominal interest rate = equilibrium nominal interest rate plus

a percentage of the output gap a percentage of the ination gap

plus

7.9.3

TAYLOR RULES AND ECONOMIC JUDGEMENT

Because of the nature of the economic system, with so many separate features related to others, it is a difcult feat to control ination. Rather than targeting any one measure, an alternative exists in the form of Taylor rules (Taylor, 1993). These rules describe how interest rates are set by a central bank. A general form of such a rule is shown in Table 7.3. The rule indicates that three pieces of information feed into the determination of the nominal interest rate set by a central bank, each of which requires some clarication.

The equilibrium nominal interest rate is the real interest rate plus the ination target of the central bank. As identied in Chapter 5, the output gap is the difference between potential output (also known as full employment output) and actual output. The ination gap is the difference between the actual rate of ination (or some banks use the future expected rate of ination) and the central banks target for ination.

The decision on what percentages to use in the rule vary from bank to bank based on their assessment of how sensitive ination and output are to changes in the interest rate. In the USA, 0.5 is the percentage of the output gap used and 1.5 is the percentage of the ination gap used by the Federal Reserve. Essentially economic judgement is brought to bear on the expected relationships between output, the price level and nominal interest rates.

7.10

I N T E R N AT I O N A L M O N E TA R Y I N T E G R AT I O N

As we have already discussed in relation to trade (in Chapter 5) there are many signs to indicate that economies are becoming more interdependent. So too with

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money and currency markets which are intrinsically related internationally as goods, assets and services are bought and sold across borders. On the one hand if only one currency existed all international exchanges would be simpler. However, it is quite likely that different regions would have different requirements of monetary policy and interest rates. Forces leading to different business cycles might mean, for example, that Ireland requires policies appropriate to dealing with a boom at the same time as the USA requires policies to focus on recession, while the UK requires policies to deal with an expansionary phase of their business cycle. Whether any single currency will be economically successful depends on whether the members constitute an optimal currency area (OCA). Optimal currency area (OCA) theory identies the factors that determine whether a single currency maximizes single-currency benets for members given the costs generated. Four factors have been identied as playing a central role in the determination of the success or failure of any common currency: 1. 2. 3. 4. Extent of trade with currency partners. Effect of economic shocks vis-` a-vis currency partners. Extent of labour mobility between currency partners. The extent of scal transfers between currency partners.

Countries that trade substantially with each other enjoy economic linkages that are enhanced by stability in their exchange rates. Exchange rate volatility has been found, in some cases, to increase the perceived costs of trading and so reduce the amount of trade that could take place if that volatility were removed. If countries with the same currency do not experience similar effects of economic shocks, they have limited scope in how best they can react to deal with the shock. With one currency, monetary policy is guided by what is required by the majority or the largest countries an example of a one size ts all policy. Should another country require an alternative policy, they must bear the cost of not having an independent monetary policy. With easy labour mobility between countries, the labour market becomes the short-run adjustment mechanism in the absence of monetary policy. If two countries experience differences in their business cycles at the same time with one booming and another in recession, both will have the same interest rate. The booming country cannot increase its interest rate and attempt to slow its economy down. Neither can the other cut the interest rate to create incentives for investment. With

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exibility in the labour market, however, unemployed workers can move to the other country experiencing the boom. In the absence of high labour mobility, sufcient transfers of income enable redistribution from higher-income areas that can help ease the plight of countries experiencing recession.

7.10.1

CONSIDERING THE EURO

The euro was launched by 11 European countries (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain) at the beginning of January 1999. When euro notes were introduced in 2002, Greece also joined the euro zone. For some this was the culmination of the post-World War Two attempts by European countries to ensure a repetition of the causes and consequences of war was not possible through the strengthening of economic and political ties between them. Some of the main European events that preceded the euro were:

1951: The European Coal and Steel Community (ECSC) was set up, with six members: Belgium, West Germany, Luxembourg, France, Italy and the Netherlands. This organization was proposed by the French Foreign Minister Robert Schuman to integrate the coal and steel industries of Western Europe. 1957 : The same six countries signed the Treaties of Rome and European Economic Community creating the European Atomic Energy Community (EURATOM) and European Economic Community (EEC) respectively. The aim of the EEC was to remove trade barriers to form a common market. 1967 : The institutions of the three European communities (ESCS, EURATOM and EEC) were merged to create one European Commission, one council of ministers as well as the European parliament. 1973 : Expansion of Community to Denmark, Ireland and the United Kingdom. 1981: Expansion of Community to Spain and Portugal. 1987 : Single European Act (SEA) came into operation in July. The goal was to create a single market in goods, capital, labour and services by 1992. 1992 : The Treaty of Maastricht (1992) introduced new forms of intergovernmental co-operation, for example on defence, and in the area of justice and home affairs thus creating the European Union (EU). 1995 : Expansion of Union to Austria, Finland and Sweden. 2003 : Given past and future expansions of the Union, the Treaty of Nice came into force laying new rules governing the size of EU institutions and how they work.

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2004 : Expansion of Union to Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia.

By adoption of the SEA, members of the EC conrmed their aim to realize an economic and monetary union (EMU). The Delors Report on EMU of 1989 proposed how this might be achieved in a series of stages in a process to coordinate economic and monetary policy. A European system of central banks would take charge of monetary arrangements via a committee of central bank governors. The nal stage would be the irrevocable xing of exchange rates and introduction of a single currency. Phase 1 began in earnest in 1990 when increased economic cooperation was required by the submission of currencies to the European Monetary Systems exchange rate mechanism (ERM). The EMS had been created in 1979, before the road to EMU was begun. Its aims were to assist the maintenance of stable currencies by keeping currencies within exchange rate bands. The bands were altered from time to time and realignments occurred. Realignments are simultaneous and coordinated devaluation or revaluation of currencies of several countries. Stability was not always achieved. The UK joined in 1991 but withdrew along with Italy in 1992. In September 1992, there was widespread uncertainty on the outcome of the French referendum on the Treaty of Maastricht. This contributed to speculation on the weakest ERM currencies, sterling and the lira. Despite substantial increases in domestic interest rates, the markets were subject to intense speculation and sterling left the EMS in 1992. Over the four months that followed, the interest rate in the UK was cut by four percentage points to meet the requirements of a country dealing with a recession. The currency had depreciated by over 15% but subsequently appreciated as the economy recovered. The French franc, thanks to substantial intervention by the German central bank, the Bundesbank, survived speculative pressure in September 1992. The Irish pound succumbed to pressure from speculators and was devalued by 10% in January 1993. ERM bands had to be widened to 15% in August 1993. In hindsight it appears currencies had been over-valued in the sense that their exchange rates were out of line with a sustainable balance of payments and devaluations were required. The balance of payments is one account in a countrys national accounts. It includes transactions between domestic residents and the rest of the world over a specied period. It consists of a current account and a capital account.

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The current account includes all trade transactions where the balance of trade might be in surplus or decit. It also includes all income and current transfers. The capital and nancial account tracks transactions relating to ownership of nancial assets, including inward and outward direct investment. Devaluations lead to increased competitiveness for export goods, boosting the balance of payments through the balance of trade. Import goods become less attractive as they are more expensive following devaluation. The German economy had been a source of uncertainty in the EMS also because of its need to nance unication on the one hand and a desire not to increase taxes to fund it on the other. The increased demand for money to fund reunication meant the German interest rate was driven up. Through the EMS links, interest rates in other countries were also high. Over time, the credibility of the EMS was re-established and by the end of 1996 all but Ireland were within 2.25% bands. The EMS survived largely because many governments wished to full requirements to qualify for EMU under the Maastricht criteria. These included:

Ination : a countrys ination rate (CPI) could be no higher than 1.5 percentage points above the three best performers for one year. Interest rate : a countrys average nominal long-term interest rate (e.g. on government bonds) could be no more than two percentage points higher than the same three best performers above. Budget decit : a countrys current budget decit could not be excessive taken to mean it should not be higher than 3% of GDP. Currency stability: a countrys exchange rate should have operated normally within the ERM for two years with no pressure to devalue against other members. Public debt : although not specically mentioned it was considered that it should be no higher than 60% of GDP.

These specic convergence criteria are not supported by objective rationale or theory, e.g. why not choose 65% of GDP? No mention of unemployment is made, although what is happening in the labour market helps to determine success or failure of OCAs. (Indeed, as we will see in Chapter 8, the relationship between ination and unemployment should not be overlooked in focusing solely on ination.) Rather the 60% and 3% decit gures were the trends or averages at the time. The need for movement toward convergence, in the light of the OCA discussion above, is however unquestionable if the currency is to be successful.

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The advantages of one European currency include:

Elimination of currency conversion costs associated with buying foreign exchange. Competition and efciency improvements as prices of the same goods in the euro zone would be more comparable and create incentives for arbitrage and be pro-competitive and pro-consumer especially for high-cost markets. Removal of exchange rate volatility within the euro zone that results in enhancing trade and reducing possibility for speculation on individual currencies (as occurred in 1992 and 1993). Investment by foreign-owned companies is also sensitive to exchange rate volatility effects on their potential costs and revenues. The experience of the UK post-euro has been a decline in its share of EU-destined inward investment from 39% in 1999 to 24% three years later. Lower ination and interest rates are possible once the European Central Bank is perceived as independent and achieves credibility. This boosts the markets impression of the euro as a strong currency, which can maintain low long-term interest rates, stimulating domestic and foreign investment in the EU.

Despite these potential advantages, the difculties in meeting some of the OCA criteria remain too signicant for some countries to concede that joining is optimal for them, or that on economic grounds the adoption of the euro made sense. Clearly, adoption of the euro is not the result of economic decisions but political decisions also.

HOW DOES THE EURO SCORE IN TERMS OF THE FOUR OCA FACTORS?

In terms of the euro, member countries conduct between 55% and 75% of their trade with other euro-zone members. Belgium, France, Germany, Italy and the Netherlands display highly correlated GDP growth patterns. The business cycles of other countries including Finland, Greece, Ireland and Portugal indicate lower correlations which implies they may nd the transition to the single currency more difcult. Relatively speaking, the correlation appears higher among all euro-zone members than among all states of the USA, which has its single currency.

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European labour markets tend to be less exible and labour less mobile than in the USA. (More on this in Chapter 8.) The language barrier explains much of this as well as historical relatively low labour mobility rates. Fiscal transfers between euro-zone member states are quite small and do not compare to the federal tax and expenditure system of the USA.

Not all four factors are fully satised. It does not follow, however, that the costs of the euro outweigh its benets. Some explanation is provided for the alternative stances taken by countries on the euro. The UK appears to follow a different business cycle to its European partners. France, Germany and the Benelux countries trade highly and follow similar business cycles. Greece and Italy may benet from lower ination under the euro than if they followed independent national monetary policies (such as with Ireland following its membership of the previous European monetary system). The more problematic factors may become less important over time if/as the single market becomes more developed.

7.11

SUMMARY

To qualify as money, three specic functions must be served: medium of exchange, unit of account and store of value. The supply of money is regulated by each countrys monetary authority (central bank or Federal Reserve), which operates monetary policy focused on maintaining a sound nancial system in which people have condence. Open-market operations are the main way that money supply is increased or reduced. Another mechanism is via the required reserve ratio.

The banking system creates money according to the money multiplier relationship between deposits, the required reserve ratio and loans offered by banks. The demand for liquid money can be specied as precautions, transactions and speculative demands. Interest rates are determined in the money market (by money supply and money demand).

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The real interest rate is the difference between the nominal rate and ination. Both nominal and real interest rates are taken into account for consumption, saving and investment decisions, hence they affect aggregate demand. The quantity theory of money describes the relationship between money supply and ination. Ination expectations also have a role in the determination of ex-ante real interest rates used for decision-making. Credibility of central bank policies matter for the stability of a countrys nancial system. Exchange rates are determined in the foreign exchange market (by currency supply and demand). Speculation in money and other asset markets is widespread in the economic system. There are costs and benets associated with speculation. Monetary policy can focus on a variety of targets.

REVIEW PROBLEMS AND QUESTIONS

1. Show, by using your own examples, that you understand the three functions of money. 2. Fill in the following table to consider the impact on money creation of deposit of 1000 according to the method explained in Table 7.2 taking into account here a required reserve ratio of 10%. Deposit 1000 Required reserves Loan

Moneybags Grandons Next customer Next customer ... Total

...

...

...

3. Use supply and demand curves to explain how equilibrium emerges in the money market to determine the interest rate the price of money. Explain the impact of open market operations (if the government sells bonds) on equilibrium.

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4. What are the nominal and real interest rates? How do changes in i) nominal and ii) real interest rates affect: borrowers; savers; consumers? 5. What is the quantity equation and what relationship does it describe? 6. Use the demand and supply model to show: a. how exchange rates are determined; b. causes of uctuations in exchange rates. 7. What is a bond and what is the bond market? What is the relationship between the price of a bond and the rate of interest? 8. Explain using some examples what you understand by the term monetary policy. Using the example of controlling ination, what difculties may arise in implementing monetary policy?

FURTHER READING AND RESEARCH

For an insight into how cigarettes fullled the main functions of money in a prisoner-of-war camp, see Radford, 1945. In relation to the Asian currency crisis see Nouriel Roubinis Global Macroeconomic and Financial Policy Website at http://www.stern.nyu.edu/globalmacro/ See also Krugman, 1998. For more on the European exchange rate mechanism see El-Agraa, 2001, pp. 12448; and Mayes, 2001.

REFERENCES
DeLong, J. and L. Summers (1993) Macroeconomic policy and long-run growth in Federal Reserve Bank of Kansas City. Policies for Long-run Economic Growth. El-Agraa, A. (ed.) (2001) The European Union, Economics and Policies . 6th edn, Pearson. Krugman, P. (1998) Whatever happened to Asia? Mimeo; online at http://web.mit. edu/krugman/www/ Mayes, D. (2001) The European monetary system, in El-Agraa, A. (ed) The European Union, Economics and Policies , 36587.

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Radford, R. (1945) The price system in a microcosm: a POW camp, Economica , 12, 189201. Roubini, N. Global Macroeconomic and Financial Policy website at http://www. stern.nyu.edu/globalmacro/ Taylor, J. (1993) Discretion versus policy rules in practice, Carnegie-Rochester Conference Series on Public Policy, 39(0), 195214.

CHAPTER 8

CHALLENGES FOR THE ECONOMIC SYSTEM: UNEMPLOYMENT AND INFLATION

LEARNING OUTCOMES
By the end of this chapter you should be able to: Explain why unemployment and ination periodically emerge as short-run economic problems. Describe alternative denitions and categories of unemployment. Use the labour demand and supply model to examine the effects of minimum wages on employment and wage rates. Apply the aggregate demand and supply model to compare/contrast alternative approaches to unemployment and how an economy deals with it. Explain the recessionary gap approach to unemployment. Outline the main costs associated with unemployment. Apply the aggregate demand and supply model to compare and contrast alternative approaches to ination and how an economy deals with it. Explain the inationary gap approach to ination. Describe recent trends in international rates of ination, and their causes. Outline the main costs associated with ination if it is anticipated or not. Describe what the Phillips curve predicts for unemployment and ination. Explain the alternative perspective to the Phillips curve offered by the natural rate of employment model.

8.1

INTRODUCTION

We have seen that in the context of economies experiencing business cycles over the short to medium terms, there is the possibility that an economy can nd

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itself in an equilibrium situation where aggregate demand intersects with aggregate supply at a point where the economy is at less than full employment. Another potential macroeconomic equilibrium is possible where the average level of prices is unstable which, as we will see below, is possible with increasing aggregate demand or decreasing aggregate supply in the short run. In the case where the price level rises over time ination can be a feature of the short- to medium-term experience for an economy. The two issues of unemployment and ination have focused the minds of many economists over the years as they attempt to argue how economies should best deal with the challenges created by either unemployment or ination, or sometimes both together. In this chapter we consider the issues separately initially (in sections 8.2 and 8.3) and examine the causes of unemployment and ination using standard economic theory based on both the microeconomic demand and supply and the aggregate demand and aggregate supply concepts and tools introduced in earlier chapters. We examine some alternative explanations for unemployment and ination and in section 8.4 discuss the logic behind theories that hold that the one is a trade-off for the other and consider what implications that view has for government policy. We also examine the causes of different equilibrium rates of unemployment and nd in sections 8.5 and 8.6 that it is possible under certain circumstances to observe both ination and unemployment in the short run.

8.2

UNEMPLOYMENT

In any economy a number of individuals are willing and able to work. The number of people aged 16 (or in some countries 15) and over who are employed plus the number of people unemployed those who do not have jobs but who are actively looking for work makes up an economys labour force. Not every individual in an economy falls into either the employed or unemployed category. For example, retired people, people who choose to take on home or childcare duties, and discouraged workers are not included in the calculation of the labour force. Discouraged workers have tried to nd work in the past and are willing to take on a job but have given up on looking for work because they feel, or know, that nothing suitable is available. The unemployment rate measures the percentage of the labour force that cannot nd work.

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285

If 9 million people are employed in an economy and 1 million are unemployed, the unemployment rate is: 1 100 = 10% 9+1

Across the countries of the OECD a standardized unemployment rate is reported as the measure of unemployment. This measure is also used by the International Labour Organization (ILO). The standardized unemployment rate measures those unemployed as people of working age without work who are available to start work within two weeks and who are actively seeking employment. Some recent statistics for unemployment (using the standardized rate) are shown in Table 8.1. France and Germanys performances have been poor relative to the other countries shown. Countries report standardized unemployment statistics based on labour force surveys conducted on a regular basis (often each quarter). An alternative measure of unemployment is found by counting all those who receive unemployment payments; however, those unemployed but ineligible for benets are excluded in

TA B L E 8 . 1 U N E M P L O Y M E N T R AT E S , % , S E L E C T E D COUNTRIES 1998 2003

Year
1998 1999 2000 2001 2002 2003

Germany
9.1 8.4 7.8 7.8 8.6 9.3

France
11.4 10.7 9.3 8.5 8.8 9.4

Japan
4.1 4.7 4.7 5.0 5.4 5.3

Sweden
8.2 6.7 5.6 4.9 4.9 5.6

Ireland
7.5 5.6 4.3 3.9 4.4 4.6

UK
6.2 5.9 5.4 5.0 5.1 5.0

USA
4.5 4.2 4.0 4.7 5.8 6.0

Source: Excerpted from Table A, OECD, 2004.

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this measure. Neither measure is perfect since the standardized measure excludes those in receipt of payments but not actively looking for work.

8.2.1

LABOUR MARKET ANALYSIS: TYPES OF UNEMPLOYMENT

Within the broad heading unemployment it is useful to distinguish between frictional, structural, cyclical and seasonal unemployment. Frictional unemployment is unemployment that arises because of changes or friction in particular markets. Frictional employment reects changes in peoples preferences or tastes, or the introduction of new technologies that alter demand for products over time, with knock-on effects on the demand for labour to produce them. The most appropriate ways to supply also change with technological developments, which can also impact on the demand for labour. Thus, within the normal activities of the economic system some rms go out of business while others open up. This means there are always people losing their jobs, switching from one job to another, and entering or leaving the labour force. Frictional unemployment is regarded as natural, and it is associated with the natural rate of unemployment. The natural rate of unemployment is the rate of unemployment that would prevail when the labour market is in long-run equilibrium some people choose to change jobs and even in boom periods it can take a worker time to nd a job best suited to their skills. The natural rate of unemployment is also called the non-accelerating ination rate of unemployment NAIRU to emphasize that since it is a long-run phenomenon, it puts no pressure on prices to increase. Hence, frictional unemployment is also regarded as voluntary. Structural unemployment refers to unemployment arising from a permanent decline in employment in industries located in a particular region or area. Structural unemployment differs signicantly from frictional. It may be due to mismatch between job vacancies and the skill/occupations of the unemployed, e.g. there may be job vacancies for carpenters, but this will do little to alleviate unemployment among plumbers. It is a more serious types of unemployment than frictional unemployment because it takes time for mismatches to be addressed via reskilling, for example, or for new industries to be attracted to an unemployment

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287

black spot. Such unemployment is particularly harsh if a recession is prolonged. The natural rate of unemployment could be reduced if some of the structural unemployment were eradicated. Cyclical unemployment is associated with the recessionary phase of the business cycle. When the growth rate of economic activity slows down in a recession, there is a fall in aggregate demand and some rms will react to this fall in planned expenditure of consumers by reducing their output and may make some of their employees redundant. When the economy picks up again and the growth rate of economic activity rises, planned expenditures will rise and in response rms who wish to expand their output accordingly may hire additional workers. Cyclical unemployment refers to short-run employment. Seasonal unemployment occurs in seasonal industries such as tourism and shing. People in these industries may become temporarily unemployed over the winter months when the industries slow down. In the long run, the labour market is in equilibrium at the natural rate of unemployment. In the short run, unemployment can be higher than the natural rate, in which case economic policies are often used to try to address the problem. In the short run it is also possible to have unemployment below the natural rate the implications are discussed in a later section of the chapter. Like other markets, labour supply and labour demand determine the equilibrium price wage rate and the quantity of workers employed. Many countries impose wages not determined by market forces as in the case of the minimum wage. Minimum wage: wage rate set by the government below which employers are not legally permitted to pay workers. Employers are free to pay workers above this wage rate if they choose. Minimum wages are implemented to address arguments that workers would otherwise earn wages that are too low to allow them a reasonable standard of living. The determination of what constitutes reasonable depends on the views of those involved in negotiations that lead to the decision to implement a minimum wage. In situations where a minimum wage applies the effects on employment can be analysed (similar to the situation of price oors considered in Chapter 2). The possible effects of a minimum wage are shown in Figure 8.1 where in panel A the wage is set above the free-market level and where resulting effects on consumer

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A P wmin Unemployment LS

B d b1

LS e c1

w*

LD

b a

c LD

QLD

Q* QLS

FIGURE 8.1 MINIMUM WAGES (PRICE FLOOR) AND THE L A B O U R M A R K E T: C A S E 1

and producer surplus are considered in panel B . LS refers to labour supply and LD to labour demand. In Figure 8.1 panel A, with no intervention in the labour market, the equilibrium quantity would be Q and the equilibrium wage would be at w . However, a minimum wage is set at wmin which is higher than w . At the wage wmin, labour supply is greater than labour demand implying an excess supply of labour. More workers wish to work at this wage rate than rms demand. The results of the minimum wage when it is set above the market wage is that the number of workers employed is lower Q LD is lower than Q although those who can nd employment at the higher wage (wmin compared to w ) do earn a higher wage. Since a lower quantity of workers earn the higher wage it is difcult to determine which situation is best for workers in general. A worker who can nd work at the higher wage will probably think it is a fairer situation than a worker who is unemployed when wages are high but can nd work at the lower wage w . Welfare analysis can be conducted to consider the changes resulting from a minimum wage. In Figure 8.1 panel B there is a direct transfer of consumer surplus to producer surplus arising from the implementation of the minimum wage. In the labour market, rms that employ workers are consumers of labour while workers offering their labour for payment are the producers. Producer surplus increases, as suggested by the increase in the area between the prevailing wage and the supply curve. Producer surplus is the area above the supply curve and below the price. Before the minimum wage, producer surplus is the area abc which rises to ab1c1 if the minimum wage is used.

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289

With the minimum wage consumer surplus falls. Without a minimum wage, consumer surplus (the area between demand function and price) is the area bcd. With the minimum wage consumer surplus falls to b1de. Some of the loss in consumer surplus, bb1ec is transferred to producer surplus. The area cc1e, however, is a net gain to producer surplus (not a transfer). This area represents the cost in welfare terms of the minimum wage. It indicates the extra wages received by some suppliers over and above what they require to supply their labour. It could be called excessive since it entices some labour to enter the labour market for a wage beyond what is required to provide them with an incentive to work. Unfortunately, since the demand for labour is lower than the supply at wmin, all labour above QLD cannot nd work. Therefore, the minimum wage increases producer surplus, decreases consumer surplus and creates a cost for the economy. In terms of the outcome regarding employment, fewer people are employed, although those who can nd work earn the higher minimum wage. Such unemployment is explained by examples where trades unions negotiate wages above market-clearing levels. If wages reach such levels it is quite easy to offer a solution to the problem wage rates need to fall. In practice, however, workers in employment and their union representatives will be unwilling to let this happen. A further potential problem with a drop in the average wage occurs if the decline is too large and workers overall respond by reducing their consumer expenditure which could lead to a decline in aggregate demand with no positive net impact on unemployment. A similar situation is presented in Figure 8.2 with one signicant difference, however, since the minimum wage is set below the free-market level. Such a minimum wage could arise if the government is incorrect in its assessment of labour

LD

LS

Unemployment w* wmin QLS Q* QLD Q

FIGURE 8.2 MINIMUM WAGES (PRICE CEILING) AND THE L A B O U R M A R K E T: C A S E 2

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demand and labour supply and there are instances where such mistakes have been made. Here the effects of a minimum wage would be that some workers wishing to supply their labour at the higher wage w no longer have the incentive to work at the lower wmin and so labour supply is lower at QLS than if the free equilibrium position prevailed at Q . At the lower wage of wmin, rms demand for workers is higher than at the wage of w hence, QLD is higher than Q . Demand for workers outstrips supply and there is a shortage of workers at wmin. This shortage can be cleared only if wages are allowed to rise to w . The impact on unemployment in this situation is that fewer workers wish to supply their labour at the lower wage, hence unemployment is higher than under the free-market situation. Since policy-makers do not know with certainty what the labour demand and labour supply curves look like, any attempt to impose a minimum wage represents their best guess or guesstimate which may have either the consequences shown in Figures 8.1 or 8.2. The better the economic analysis provided to policy-makers, the more focused and successful the policy may be, but setting wage rates is never a policy without costs. In practice, fears about reductions in employment as a result of minimum wages have appeared largely unfounded, i.e. the outcome has been different to that suggested in Figures 8.1 and 8.2. Employers have not reacted to the minimum wage by reducing their numbers of employees. Why? One plausible reason is that rms choose to absorb any additional costs generated by minimum wages, which essentially means they lowered their preferred prot margins. Firms may be happy to do this in the short run if workers become more productive when paid a higher wage so that an initial jump in rms average costs caused by paying the minimum wage is balanced by a decline in average costs over time as productivity improves. It is also plausible that higher wages act as a signal to attract higher-skilled workers. The concept of efciency wages may also provide an explanation. An efciency wage rate lies above the market clearing wage rate to provide motivation for workers, to keep worker turnover low (avoiding costs of hiring) and to act as a signal to attract appropriately skilled workers. The implication of efciency wages is that rms may have an incentive to pay higher wages than the market clearing rate or a minimum wage. Firm protability may ultimately be higher due to the motivation, turnover and signalling effects provided by efciency wages. In many countries the actual process through which wages are determined is through collective wage-bargaining where government representatives, trades union

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representatives, employer representatives and sometimes others, negotiate wages for periods of one year, two years and sometimes longer. Some negotiations take place at a national level, others take place locally. There appears to be support for the view that the more coordinated are wage-bargaining negotiations i.e. the more trades unions are involved collectively the better the outcome for the unemployment rate. If unions negotiated unilaterally for wage rates for only their workers, each union would try to negotiate the highest wage possible. If all unions have to negotiate together with all employers and the government then it is clear to all that excessively high wages for all unions workers would just lead to higher unemployment. More modest wage negotiations are more likely, as is lower unemployment.

8.2.2

ANALYSING UNEMPLOYMENT: MACRO AND MICRO

The macroeconomic aggregate demand and supply framework can also be used when analysing unemployment. Beginning with the long-run case, where an economy faces a downward sloping aggregate demand function and a vertical aggregate supply function, unemployment occurs if the level of equilibrium national income is below potential output. In such circumstances the challenge for business and government is to get the economy to its long-run equilibrium position at or at least closer to potential output, so that a minimum of economic resources are unemployed. Such analyses follow in later sections.

Classical approach
One school of thought in economics, known as the classical school, maintains that labour markets would operate to ensure that unemployment did not exist and that in the long run economies would tend towards their full employment level of output. In a labour market with exible wages and no intervention by governments, wages would adjust to clear the market and, therefore, any unemployment would necessarily be voluntary, i.e. only frictional or equilibrium unemployment would exist. Wages would fall in times of low demand for labour (relative to its supply) so that unemployed resources could be put to work. If demand for labour was high (relative to its supply) wages would rise to bring the labour market and eventually the economy back to equilibrium. Supporters of the classical view see unemployment as a possibility in the short run where distortions exist that do not allow wages to change (perhaps due to a minimum wage policy, or to negotiations with trades unions or due to generous

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THE ECONOMIC SYSTEM

unemployment benets). Solving such unemployment problems would be possible by allowing wages to be more exible. With wages free to move up or down, unemployment would not be a feature of the long-run performance of an economy.

Classical vs. Keynesian approach

An alternative view was put forward by John Maynard Keynes (in 1936), who believed that unemployment and slow growth in economic activity could persist over the short run and maybe even for long periods and become ingrained in an economy. Such unemployment is also called demand-decient unemployment since rms do not demand labour because consumers demand too few goods. Keynes argued that reducing wages to deal with such an unemployment problem would be inappropriate because wage cuts would lead to lower incomes which in turn lead to lower planned expenditure, lowering aggregate demand and further lowering employment and raising unemployment. In the Keynesian approach to the economy, unemployment could be involuntary due to problems faced by economic agents who, for whatever reasons, do not have the capacity to boost aggregate demand to the degree required to cause rms to hire more workers. Accordingly, a possible solution for an unemployment problem would be for governments to increase their expenditure, increasing aggregate demand, recirculating more income so that demand for unemployed labour will increase. Keynes acknowledged, however, the potential for problems of persistent budget decits that might be generated by such a strategy. A comparison of the classical and Keynesian views on unemployment is presented in Figure 8.3 using microeconomic analysis of the labour market. In panel A the classical position is sketched where the prevailing real wage is w1 and is higher than the level required to clear the labour market. There is involuntary unemployment, which could be reduced in the short run and ultimately eliminated by a fall in real wages towards w . In the classical approach, such involuntary unemployment would not prevail very long because real wages are assumed to adjust down to clear the labour market. In Figure 8.3 panel B the differences between classical and Keynesian views can be highlighted. In panel B , involuntary unemployment exists at the wage rate w1. In the Keynesian explanation of unemployment real wages do not simply fall to eliminate unemployment as real wages are essentially xed or sticky workers are unwilling to accept cuts in wages required to bring the labour market into equilibrium. This could be a feature of an economy where nominal wages were set through a centralized bargaining approach regarding what level of wages and wage

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A Classical unemployment P LD involuntary unemployment w1 w* LS

B Keynesian unemployment P involuntary LD unemployment LS

w1

Q*

Q**

F I G U R E 8 . 3 U N E M P L O Y M E N T: C L A S S I C A L A N D KEYNESIAN APPROACHES
ination is acceptable. With such agreements there is no scope for cutting wages, or indeed for increasing them beyond agreed levels. In Figure 8.3 panel B the unemployment problem could be remedied if labour demand increased to the dotted demand line indicated in panel B . Hence, unemployment here is caused by demand deciency. A reduction in wages to below w1 would lead the market to clear but the labour demand curve drawn represents demand for labour in an economy where demand for rms output is below the full employment level. This means that an equilibrium position could prevail in the short run and persist as long as demand is less than the full employment level of output. Also, if wages are below w1, workers may reduce their planned expenditures, making the demand deciency even worse. So which model is correct the classical or Keynesian? There is disagreement among economists on that issue in the sense that many believe that there is a self-correcting mechanism operating in the economy that brings the economy back towards equilibrium over time. However, the speed of this correction is what gives rise to the disagreement. Those who believe that the speed is rather quick consider that no action is required to induce the economy to move more quickly to equilibrium. Those following the Keynesian view support a more activist approach since the speed of economic adjustment is considered to be slow.

8.2.3

UNEMPLOYMENT AND THE RECESSIONARY GAP

The macroeconomic aggregate demand and supply model illustrates the problem of unemployment from both classical and Keynesian perspectives. In Figure 8.4 we have an economy in short-run equilibrium at a level of output below its long-run

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LRAS AD SRAS

P* P*LR SRY* Y*

recessionary gap

FIGURE 8.4

RECESSIONARY GAP

potential level. Since the economy is not operating at its potential level, this implies the economy has some unemployed resources and the level of unemployment is above the natural rate. The economy is in recession. Note in Figure 8.4 that both long-run and short-run aggregate supply curves are included. We do not treat the SRAS as a combination aggregate supply curve. Over the (almost) vertical portion of the SRAS lying to the right of the LRAS, the economy is producing at its maximum but unsustainable level of output. Many workers are working overtime, capital is being utilized over several shifts, for example, but the level of output could not be retained at such high levels without pressure on prices and wages. At any point on the LRAS, the prices of all outputs and inputs have fully adjusted to clear all markets in the long run. In a recession, the difference between the level of potential output and the lower actual output is described as the recessionary gap. This recessionary gap is shown as the difference between short run output SRY and potential output Y , indicating that actual output falls short of its potential level. In comparing short-run to long-run equilibrium we also see that the price level differs in both cases. The short-run price level P lies above the long run level of P LR. Following a classical theory of adjustment, wages, as one of the prices prevailing in the economy, are too high and must fall to bring the economy to long-run equilibrium. Hence the economys price level would fall as the economy adjusts over time from its short-run to its long-run equilibrium, from SRY and P to Y and P LR. Firms would hire more workers at lower wage rates and output could expand. At a lower price level of P LR, aggregate demand would increase. According to a Keynesian theory of adjustment, wages are xed or sticky in the short run and what is required is government intervention to increase injections into the economy (increase government expenditure) or reduce withdrawals (taxes) to

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LRAS AD2 AD1 SRAS

P*

recessionary gap

SRY* Y*

FIGURE 8.5 CLOSING THE RECESSIONARY GAP: KEYNESIAN APPROACH

close the recessionary gap. This implies a shift of the aggregate demand function. For example, if the government increases its expenditure it can, through the multiplier, close the gap as shown in Figure 8.5. Aggregate demand rises from AD1 to AD2 as the government increases its expenditure or cuts taxes via its discretionary scal policy. Moving from the shortrun equilibrium of P and SRY (from the intersection of SRAS and AD1) to the long-run equilibrium of P and Y we see that the boost in aggregate demand gives rise to a higher output level at the same aggregate level of prices.

8.2.4

THE COSTS OF UNEMPLOYMENT

At the level of the macroeconomy, unemployed resources mean unproductive resources. Output is less than what it could be and income is below its potential level (at SRY relative to Y ). Economic activity is lower than if the economy operated at its full employment level. Some unemployment a natural rate is normal for any economy but non-voluntary unemployment generates costs. As well as reduced output and income, unemployment reduces governments revenue from tax income. With high employment, there is likely to be high demand for goods and services from rms. Firms may even make higher prots as consumers are able to buy more goods and services, but this depends on market structure, which we saw in Chapter 6. With high unemployment, prots surely suffer as demand is weakened. Within modern welfare states, governments provide transfer payments as benets to the unemployed (under certain conditions) and therefore, this represents an additional cost. Managing to create jobs for the unemployed would therefore increase national output, allow workers to earn a wage/salary, allow rms to make

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THE ECONOMIC SYSTEM

prots, allow the government to collect more in taxes and, if demand for labour were substantial, allow those already employed to increase their supply of labour. All of the costs described above are at the level of the macroeconomy. Arguably, there are even more serious costs of unemployment if we consider the microeconomic, individual and social costs of unemployment. Even short-term unemployment can be disheartening and stressful for individuals and their families. This may result in higher personal costs for physical and mental health care, which can result from stress. Some authors have associated crime and delinquency with unemployment. In addition, individuals human capital can decline. A broad assessment of the costs of unemployment would take these issues into account also.

8.3

I N F L AT I O N

In Chapter 5 an example was used to illustrate how ination is measured using information on peoples general expenditure patterns and the prices of goods and services. It is possible to consider the causes of ination using the aggregate demand and supply model to examine what happens to the equilibrium price level if there are changes to either the demand or supply sides of the aggregate economy. In Figure 8.6, beginning with panel A, we see a rise in aggregate demand, i.e. the AD curve shifting to the right from AD to AD1. The initial equilibrium occurs at P and Y while the new equilibrium arises at P1 and Q1. An increase in aggregate demand leads to both higher output for the economy and a higher aggregate price level as the economy was not initially operating at potential output.

A: Demand pull P AD AS

B: Cost push P AD AS1 AS

P1 P*

P1 AD1 P*

Y* Y1

Y1

Y*

FIGURE 8.6

D E M A N D - P U L L A N D C O S T- P U S H I N F L AT I O N

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297

An increase in the price level of an economy caused by rising aggregate demand is called demand-pull ination. Demand-pull ination is associated with boom periods in an economy where planned expenditures rise with the increasing income generated in a boom. This means the aggregate demand curve moves up or rightwards on a continual basis over a period of time. Firms react to the increases in planned expenditures by producing more, if they can, and by raising prices. If an economy is operating at capacity where all rms are producing to capacity, or beyond its long-run level, which can occur for short periods if workers are willing to work overtime, any rise in aggregate demand leads to increases in prices only and no increase in output. An alternative source of ination is presented in Figure 8.6 panel B where aggregate supply falls in response to rms reducing their output (in reaction to a rise in costs). For example, if rms wages increase then at any level of prices, rms would cut back on their production and this is observed in a leftward shift of aggregate supply. Cost-push ination occurs when rms react to increased costs by reducing their output. This occurs because when rms face increased costs, they react by raising their prices, and pass on the cost increase, to some extent (depending on price elasticity of demand for different products) to their consumers. The resulting equilibrium is seen at P1 and Y1. The new equilibrium reects a higher level of prices but a lower level of national output than the initial equilibrium. If the economy was not operating at full employment in the initial equilibrium of P and Q , this implies that more resources are unemployed if output drops to Y1 from Y . Rises in rms costs might come from other sources than wages. For example, import-price push ination occurs with an increase in the price of raw materials (such as oil or inputs) that are imported. Cost-push ination could also be due to rms raising prices to increase their prot margins. It is possible that both demand-pull and cost-push ination occur simultaneously, with some forces pushing aggregate demand rightwards and the aggregate supply curve leftwards.

8.3.1

THE INFLATIONARY GAP

Just as with unemployment, ination is considered essentially as a short-run problem for an economy but one that can persist depending on the speed and process of

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P SRP*

LRAS

SRAS inflationary gap AD1 AD2

Y* SRY*

FIGURE 8.7

I N F L A T I O N A R Y G A P : K E Y N E S I A N A N A LY S I S

adjustment of an economy from the short to the long run. When an economy operates above its short-run capacity, an inationary gap is said to exist. An inationary gap is dened as the difference between equilibrium output and actual output when an economy is producing above its potential long-run level. In Figure 8.7 there is an example of an economy in short-run equilibrium at a level of output above its long-run potential level. The economy is experiencing a boom in its real growth rate and is operating above potential output. Here the short-run equilibrium output SRY is greater than the long-run level Y . In comparing the short-run to long-run equilibrium we see that the price level is the same in both cases, which corresponds to a Keynesian analysis of ination. Although Keynes focused more on the issue of recessionary gaps, he also acknowledged that economies can be in short-run equilibrium as shown here. The unemployment rate is less than its natural rate, due to high demand for labour for which rms are willing to pay attractive overtime wages or higher wages than are sustainable in the long run with the given aggregate demand, AD1. Producing beyond potential output puts pressure on the price level and is not sustainable over time without a change in aggregate demand or aggregate supply. The inationary gap could be eliminated through an active or interventionist Keynesian policy by the government that implements policies to reduce aggregate demand to AD2. This would be achieved through scal policies such as a fall in government expenditure or an increase in the tax rate. According to a Keynesian theory of adjustment, wages are xed or sticky in the short run and, in order to close the inationary gap, injections into the economy must decline and/or withdrawals increase to slow the economy down.

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299

P LRP* SRP*

LRAS

SRAS

AD1 inflationary gap Y

Y* SRY*

FIGURE 8.8

I N F L AT I O N A RY G A P : C L A S S I C A L A P P R O A C H

According to a classical approach (as shown in Figure 8.8) no intervention by the government would be required, prices and wages would not be sticky in the short run and the economy would adjust from its initial short-run position by the price level rising from SRP to LRP and output would decline back from SRY to Y .

8.3.2

TRENDS IN INTERNATIONAL PRICE LEVELS

From Figure 8.6 we see that changes in either short-run aggregate demand (a rise) or short-run aggregate supply (a fall) give rise to ination with different consequences for national output. A one-off jump in prices caused by rising aggregate demand or falling aggregate supply is not considered particularly damaging to an economy but policy-makers and analysts consider that attempts should be made to curtail persistent ination, whatever its cause, if at all possible. A relevant question, though, is why we observe ination in economies at all. In looking at the trend in price levels in a historical context we nd that between 1661 and 1930, average UK prices did not show any continual upward trend and in fact it was not until the twentieth century that prices increased sharply (based on price data that were compiled by B.R. Mitchell, 1988; gures for the US display a similar pattern). More recent ination data are presented in Figure 8.9, which shows trends in the consumer price index (CPI) of some selected countries over the last three decades. We see that ination has been observed for most countries shown for the vast majority of the last 30 years, being highest over the initial decade, and highest on average for the United Kingdom and Ireland. Deation was observed in Germany for 1986, Sweden in 1998 but more persistently for the nal four years of the sample period in Japan.

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25.0 20.0 Aggregate price inflation 15.0 10.0 5.0 0.0

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

1971

France Japan United States

Germany Sweden

Ireland United Kingdom

FIGURE 8.9 1971 2002

I N T E R N AT I O N A L I N F L AT I O N R AT E S :

Source: International Financial Statistics of the International Monetary Fund

The CPI is one measure of prices; alternatives exist in the form of indices of producer input and output prices, and the GDP deator. An index of producer input prices provides information on the trend in prices of inputs experienced by suppliers, while producer output prices provide information on the sales prices in wholesale terms, i.e. to distributors or retailers, excluding any consumer taxes. Anyone with an interest in the trend in consumer prices should also examine producer output prices as it would be reasonable to expect any changes in the latter to be reected to some extent in the former. The GDP deator is another quite commonly used measure of prices. Earlier, nominal and real GDP were dened and discussed. Since nominal GDP includes both changes in quantity and prices and real GDP measures only the quantity of output produced when price changes have been removed, the ratio of nominal GDP to real GDP provides a measure of ination. Because GDP measures domestically produced output, however, using the GDP deator as a measure of ination focuses only on the prices of domestically produced output, excluding imports which are included in the CPI measure of ination. No measure of ination is particularly better or worse than the others and since they each include different items and

2001

5.0

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301

goods they do not follow exactly the same trends over time; however, over the long run they tend to move together.

W H Y I N F L AT I O N ?
Why do the prices of goods and services generally tend to rise over time? Several possible reasons have been put forward. It could be because:

Firms increase their prices trying to make higher prots and consumers cannot react by buying cheaper substitutes. Firms facing increased costs pass them on to consumers. Improvements in the quality of products mean goods cost more due to either better inputs or technology and consumers are happy to pay the increased price. Consumers nominal incomes are rising and, following the quantity theory (and assuming money supply and velocity are constant), if income rises then so too will prices to keep real income unchanged.

Each potential explanation sounds plausible and provides a contribution to our understanding of why the average level of prices is upward over time. Unfortunately, no single or indeed simple explanation for ination exists but as Figure 8.9 indicates it is a very pronounced international phenomenon. The role of oil prices in international ination is considered in the text box.

O I L P R I C E S A N D I N F L AT I O N
Across most developed countries ination increased in the period following the rst oil price shock of 1973 (see www.wtrg.com/prices.htm for trends in oil prices). The Organization of Petroleum Exporting Countries (OPEC) was formed in 1960 with ve founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela, and by the end of 1971 six new members Qatar, Indonesia, Libya, United Arab Emirates, Algeria and Nigeria had joined too. These countries operated a cartel (as explained in Chapter 6). The aim of such collusion is to increase prot by reducing competition. These nations had experienced a decline in the real value of their product since foundation of the OPEC. Throughout the Post-World War Two period, exporting countries found increasing demand for their crude oil and a 40% decline in the purchasing power of a barrel of crude.

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In 1972 the price of crude oil was about $3.00 per barrel. By the end of 1974 it had quadrupled to $12.00. The Yom Kippur War started with an attack on Israel by Syria and Egypt on 5 October 1973. The USA, among other western countries, showed strong support for Israel. As a result Arab oil-exporting nations imposed an embargo on the nations supporting Israel. Arab nations reduced production by 5 million barrels per day (MBPD). About 1 MBPD was made up by increased production in other countries. The net loss of 4 MBPD extended through to March 1974 and represented 7% of the free-world production. The extreme sensitivity of prices to supply shortages became all too apparent and is known as the oil-price shock. Since oil is a signicant input into so much of the production process machinery, equipment, transportation etc. the oil-price shock had substantial inationary implications as seen from Figure 8.9. From 1974 to 1978 nominal crude oil prices increased at a moderate pace from $12 per barrel to $14 per barrel, but in real terms, i.e. when adjusted for ination, the prices were constant over this period of time. A further sharp increase in oil prices in 1979 occurred on the back of the Iranian Revolution and became known as the second oil-price shock. The decline in production that occurred in 1985/86 was triggered by Saudi Arabias rebellion against its role as the worlds swing producer. It implemented a new and ultimately successful pricing strategy to regain its market share, which became the third oil-price shock. Although prices jumped up again in 1990, in response to Iraqs invasion of Kuwait, this was not sustained and, therefore, is not generally classied as a fourth shock.

It is worth remembering that as long as people are compensated in their earnings for rises in the average price level, people are no worse off in real terms as a result of ination. This is an important point because when it comes to wages, in particular, we have seen already that under the Keynesian view of economic activity, wages tend to be sticky or xed in the short run, and that the short run can persist for some time. Not only do wages not tend to fall in times of unemployment, but neither do wages tend to adjust upwards unless workers can put credible pressure on their employers to increase wages. Since wage-bargaining does not take place continually but occurs periodically there tend to be discrete jumps in wages rather than a steady increase. Where trades unions are involved in wage-bargaining, they argue for the best outcome possible for their members and attempt to secure the highest

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possible wage increases from employers rather than focusing on addressing the needs of the unemployed, who are not part of their membership an example of an insideroutsider model where insiders look after their own interests. For non-unionized workers, their effective credible threat in negotiating wage increases is that of nding work elsewhere, which is only really credible in boom times if there are shortages of workers with their specic skills set. As well as standard ination in average prices of consumer goods and services, wage ination is also of interest to economists. If at all possible, economies should avoid creating an environment conducive to escalating price ination where price rises used to argue for increases in wages are in turn used by rms to argue for increasing their prices to cover costs, which is used to argue for increases in wages, in an unending spiral of rising prices and wages that leaves no one any better off and wastes time and energy, which are scarce resources best spent on other more productive activities. Furthermore, the pattern emerging from trends across several countries is that their ination rates tend to move together. This indicates that countries economies are inextricably linked so that the tendencies for price rises often coincide across countries. Because countries trade with each other and given that capital ows across borders for investment and speculative purposes, many economic variables such as ination tend to behave similarly across different countries.

8.3.3

GOVERNMENTS CONTRIBUTION TO INFLATION

Reference was made earlier to government decits where governments must borrow to make up for their overspending compared to their receipts. Governments that persist in running decits can inuence ination in two ways: via aggregate demand and the money supply. If a decit is run because of a government increasing its expenditure (a rise in G ) or because of a reduction in the tax rate (a fall in t ), the result is an increase in aggregate demand, i.e. a rightward shift in the AD curve. This leads to an increase in the price level in the short run, presuming no change to aggregate supply. However, if consumers anticipate that a government running a decit today may be likely to increase tax rates in the future to pay for the decit, consumers may very well react to increased government expenditure or lowered tax rates by reducing their current spending. Savings would rise and, hence, some of the inationary effects of a decit can be reduced and maybe even eliminated, depending on consumers behaviour and expectations. Sometimes when a government issues debt its central bank purchases the debt, thereby increasing the money supply. The central bank, through its open-market

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operations, releases money into the economic system as it buys the debt in the form of government bonds, for example. While the central bank is under no obligation to purchase the debt, it may choose to do so if it prefers to maintain the interest rate constant. Depending on the scale of the debt, if the general public bought the bonds the impact could be to increase the demand for credit and put upward pressure on interest rates. As we know from the quantity theory, any increase in the money supply results in an increase in the price level, hence the link between the decit, money supply and ination.

8.3.4

ANTICIPATED AND UNANTICIPATED INFLATION THE COSTS

Economic analysts regularly provide and publish forecasts on their ination expectations. These can then be used by parties engaging in wage negotiations (for example) to use in supporting arguments for specic rises in wage rates: if ination of 5% is predicted for each of the next two years, workers will want to earn increases of at least 5% each year to keep their real income levels constant. If workers expect prots to rise also then individually and through their trades unions they try to negotiate increases higher than expected ination. Ination forecasts can also be used by those with responsibility for setting interest rates in the knowledge that savers and investors are more likely to save and invest when positive real returns are possible, ceteris paribus. Any anticipated ination can be taken into account to some degree, at least, but no matter how people attempt to plan for ination, because its extent is uncertain, any adjustments will probably not be perfect (either over- or under-predicting the rate) and any adjustments will take time to implement. Anticipated ination: expected ination that is taken into account in economic decision-making. Unanticipated ination is ination that takes people by surprise. Governments and individuals dislike unanticipated ination, because they have not allowed for it in interest rate changes, bond issues, wage-bargaining, etc. Anticipated ination is built into peoples/governments terms of borrowing and lending, but unanticipated ination is not. Both types of ination are associated with certain costs, but the costs are more severe in the case of unanticipated ination. Specically, the costs of ination are outlined in the text box. Points 1 to 3 occur with both anticipated and unanticipated ination, being more severe when ination is unanticipated. Points 4 to 8 are particularly relevant to unanticipated ination.

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C O S T S O F I N F L AT I O N
1. Loss of purchasing power : ination lowers purchasing power, and people living on xed incomes suffer a decline in living standards as a result. 2. Shoe-leather costs : during periods of ination, people hold less currency. Therefore, they must make more trips to the bank to withdraw cash. These extra trips are known as shoe-leather costs of ination, i.e. the extra time and effort that people put into transactions, when they try to get by with lower real money balances. 3. Menu costs : during periods of ination, prices may change frequently. This imposes costs on rms and shops, which have to reprint price lists. Also, customers have to go to some trouble to keep up-to-date with price changes. 4. Effects on income distribution: ination can result in a redistribution of income. Savers are penalized, borrowers gain by going into debt and repaying the loan in money which value has declined. This amounts to a transfer in wealth away from savers to borrowers. 5. Fiscal drag : when tax rates are not fully ination-adjusted, scal drag occurs. This means that people are pushed into higher tax brackets in a progressive income tax system. A progressive income tax system is one in which individuals pay a higher percentage of their income in tax, the more they earn (alternative tax systems are either regressive or neutral). 6. Effects on international competitiveness : ination can have serious effects on the ability of domestic rms to compete with international rivals if domestic prices are rising faster than for competitor rms in other countries. Exports may fall, causing growth and employment to fall also. 7. Balance of payments effects : countries with high ination relative to others nd their quantity of exports decline as the prices of their goods become less competitive and imports rise. In the national accounts, the value of exports falls while imports rise and a decit on the trade account is possible. This might lead to a drop in demand for the countrys currency and have an effect on the exchange rate or interest rate. 8. Business uncertainty and lack of stability effects : ination increases the complexity of making long-term plans, e.g. investment. Also, most people are generally risk-averse, and prefer to make plans and contracts in real terms, rather than in nominal terms. With unanticipated ination, this may not be possible.

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8.4

LINKING UNEMPLOYMENT AND I N F L AT I O N

It may appear from the foregoing analysis that unemployment is a problem associated with recessionary periods in an economy while ination is often associated with boom periods. Both unemployment and ination appear to be linked, under a Keynesian approach to the economy, to aggregate demand and differences between short-run and long-run macroeconomic equilibrium. This implies that unemployment and ination are problems that occur in the short run. Inadequate aggregate demand is associated with recessions and unemployment while excessive aggregate demand is associated with booms and ination. From policy-makers point of view, they would either have to attempt to deal with unemployment or ination. This pattern appeared to hold true for over 100 years until the mid-1960s but thereafter, it oversimplies the inationunemployment relationship. Based on analysis of wage ination and unemployment data from 1861 to 1957 (hence, not based on theory but observation) the economist William Phillips (in 1958) considered that ination and unemployment tended to move in opposite directions. High wage ination was associated with low unemployment and low ination was associated with high unemployment. This relationship became known as the Phillips curve. A similar curve describes the relationship between price ination and unemployment. The relationship between unemployment and ination, called the Phillips curve, is negative, meaning that high unemployment is associated with low ination and vice versa. Central to our understanding of the Phillips curve today is the role of the expected ination rate predicted by the general public, based on their best guesses given all available information, including advice from ination forecasters. The original Phillips curve made no mention of ination expectations, however, following the work of other economists (Edmund Phelps and Milton Friedman) both ination expectations and the natural rate of unemployment have been incorporated into the Phillips curve. The Phillips curve presented here is correctly called the expectationsaugmented Phillips curve. The expectations-augmented Phillips curve explains ination in terms of a negative relationship between ination and unemployment and a positive relationship between actual ination and expected ination.

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Think of the situation where people predict an ination rate of, say, 2%, for both wages and general prices. If there is an increase in aggregate demand above the level producers expected so that demand for rms output is higher than rms envisaged, rms prices may be driven up by more than 2%, say by 4%. This would occur via a rightward movement of the aggregate demand curve, caused by rising consumption expenditure, leading to a new macroeconomic equilibrium. However, wages are usually negotiated for relatively long periods so wages are xed in nominal terms for some period of time. When nominal wages are xed and are associated with rising price levels, the implication is that real wages decline. Since economic decisions are made on the basis of what happens to relative prices, a fall in real wages creates an incentive for rms to hire extra workers since labour costs have become cheaper, and with increased demand for rms output it makes economic sense for rms to hire additional workers. The result is a fall in unemployment associated with the increase in ination. The formula for the expectations-augmented Phillips curve is Actual Ination rate = expected rate of ination + X (natural unemployment rate actual unemployment rate) where X denotes a positive number, which is different for different economies. The actual rate of ination in an economy will be the same as the expected rate if output and unemployment remain at their equilibrium levels so that unemployment is at its natural level. Where this is not the case, actual and expected ination will differ. If the natural rate of unemployment is 8%, if X is 0.75 and ination is expected to be 4% then actual ination is 4% if unemployment is 8%. If instead unemployment is 10%, ination must be 1.5 points less than expected (since 0.75 (810) = 1.5) which would be 2.5%.

The negative unemployment/ination relationship is logical in this case since with higher-than-equilibrium unemployment due to insufcient aggregate demand, producers have an incentive to moderate any increase in prices. Hence price ination is less than expected although since nominal wages are xed, wage ination remains at the expected level. The effect is an increase in real wages (relative to what was expected) so that labour is more expensive and some workers lose their jobs. When ination is lower than expected, unemployment goes up.

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Inflation

Inflation expectations

Phillips Curve

Natural rate

Unemployment

FIGURE 8.10

THE PHILLIPS CURVE

The alternative would also hold that when ination is higher than expected, unemployment would fall. Graphically the Phillips curve as described above is shown in Figure 8.10. This gure shows a negative relationship between unemployment on ination and vice versa. When ination is in line with expectations, unemployment is at its natural rate. Since wages are sticky only in the short run but will be renegotiated in the light of actual ination and expectations in the future, the ination unemployment relationship underlying the Phillips curve is something we expect to observe in the short term only and, hence, government intervention would require action to affect aggregate demand in the short run only. The policy choice for government implied by the relationship described in the Phillips curve was in terms of trading off ination for unemployment. The cost of low unemployment would be higher ination while low ination would be associated with higher unemployment. From the mid-1960s onwards, outcomes implausible under the Phillips curve relationship were observed across developed economies both rising unemployment and rising ination. Some economists argue that over time the Phillips curves of individual countries move around, the position being determined by factors unrelated to aggregate demand explanations of ination and unemployment. Such explanations include frictional and structural unemployment and cost-push ination and expectations-generated ination. The Phillips curve moves to the left if any of these factors changes leading to falling ination or unemployment (or to the right if the result is rising ination or unemployment). The next section on determinants of the natural rate of unemployment explains how it is possible to observe ination and unemployment in certain circumstances.

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8.4.1

A MODEL EXPLAINING THE NATURAL RATE OF UNEMPLOYMENT

Given the earlier denition of the natural rate of unemployment, several economic features help us to understand why some countries tend to have higher natural rates of unemployment (e.g. Spain, Italy, Greece) than others (USA, Austria, the Netherlands). Remember the natural rate is a long-run equilibrium rate. By appealing to analysis we have already conducted in the labour market and in terms of rms pricing behaviour we can develop a model to understand how the natural rate of unemployment comes about. (This section draws on the model presented in Miles and Scott, 2002, ch. 8). We saw in Chapter 2 that real wages and the number of workers employed is determined as shown in the labour market model of labour demand and labour supply. We saw how rms demand for labour reected the marginal revenue product of labour. We also saw in Chapters 4 and 6 that rms attempting to maximize prots, when facing downward sloping demand curves, can earn prots above the normal level once their cost curves lie below the demand curve. Wages represent a large portion of rms costs and we see that when supernormal prots are earned, rms earn more than required to pay for all their costs. In thinking about how the natural rate of unemployment is determined, we assume here that rms over the long run set themselves rates of prot that they wish to earn expressed as mark-ups over their costs. The mark-up would depend on the line of business a rm is in, the mark-up targeted by competitors, the rms strategy (i.e. how it tries to compete in its chosen market, e.g. by offering lower prices or higher quality). The prot margin, also called the price-cost margin, describes the mark-up over costs that a rm makes or wishes to make. Some rms will be happy to earn low mark-ups, other rms wish to earn high mark-ups. In attempting to set prices for their output and generate a desired mark-up, when costs rise over time rms put pressure on the real wage rate to fall. Higher prices on average feed into lower real wages. Workers too can affect real wage rates. This happens most directly if we think about the role of labour unions in wage-setting negotiations if they try to use their bargaining power to increase wages for their members. Non-unionized workers can also exert an inuence on real wage rates because employers generally wish to minimize the turnover rate of good staff because it is costly:

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Real wage Equilibrium real wage Margin-setting curve Real wage-setting curve Unemployment

Natural rate

F I G U R E 8 . 1 1 D E T E R M I N AT I O N O F T H E N AT U R A L R AT E O F UNEMPLOYMENT

to have a post vacant since the post generates no revenue product of labour; to advertise, interview and train new staff.

The extent to which individual workers or unions try to negotiate higher nominal wages with their employers will vary with the unemployment level, as high rates of unemployment mean there is greater competition for available jobs and neither workers nor unions wish to price themselves out of a labour market which is characterized by high unemployment. This information is presented graphically in Figure 8.11. The margin-setting curve (MSC) indicates the long-run real wage corresponding to rms average desired prot margins. This prot margin in the gure is assumed to be constant, hence the MSC is a horizontal line. The real wage-setting (RWS) curve is downward sloping reecting the tendency for workers and unions to link demands for real wage increases to the level of unemployment. The intersection of the MS and RWS curves determines the natural rate of unemployment. The equilibrium position generated by this model indicates that there is one real wage rate that unions (and workers) are willing to accept that corresponds to what rms are willing to accept. There is only one real wage rate and one level of unemployment where rms desired prot margins match the wages desired by unions and workers. As we have seen earlier, the macroeconomy can be away from its long-run equilibrium position for certain periods. The model shown in Figure 8.11 can be used to consider what we can expect if the economy is out of its equilibrium position. We begin with an example where the natural rate of unemployment lies above the equilibrium level, as shown in Figure 8.12.

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Real wage

Real wage-setting curve Margin-setting curve

Equil. real wage W1 Natural rate High rate

Unemployment

F I G U R E 8 . 1 2 D I S E Q U I L I B R I U M : H I G H E R T H A N N AT U R A L UNEMPLOYMENT
With a rate of unemployment above the natural rate, demands for real wage levels by unions and workers are moderate at W1. With such moderate wage rates, rms can hire more workers so unemployment tends to move to its long-run natural rate. As the economy adjusts towards the natural rate, unions and workers wage demands will rise. Up until the natural rate, rms still have incentives to hire more workers to produce additional output (for which they perceive a demand). Although real wage rates rise from W1, as long as wage demands are below the equilibrium level, there is no pressure on the average price level so not only does unemployment fall in this case, but so too does ination as the economy moves back to its equilibrium position. Next we look to the opposite situation in Figure 8.13 where the economy begins in a disequilibrium situation initially with lower than natural unemployment and a higher than equilibrium real wage rate of W2. Workers and unions have high wage demands in this case as they are aware that rms have little choice in a limited

Real wage W2 Equil. real wage

Real wage-setting curve

Margin-setting curve

Low rate

Natural rate

Unemployment

F I G U R E 8 . 1 3 D I S E Q U I L I B R I U M : L O W E R T H A N N AT U R A L UNEMPLOYMENT

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labour market. With too high real wage demands, rms will start letting workers go because the costs are out of line with rms desired prot margins. Firms might respond to the cost pressure by increasing their own output prices (in an attempt to cover high wage costs) to maintain their margins. Increasing unemployment will lead to lower wage demands and the wage rate declines from W2 towards equilibrium. Hence, in this case rising ination and unemployment would be observed as the economy moved towards the long-run equilibrium position.

8.4.2

CAUSES OF DIFFERENCES IN NATURAL RATES OF UNEMPLOYMENT

From the model shown in Figure 8.11, we can conclude that there are three determinants of the natural rate of unemployment. Each is considered below. 1. Firms desired margin reected in the height of the MS curve. If rms set relatively high prot margins, this is associated with relatively high prices of goods implying lower real wages. The MS curve for rms setting high margins would, therefore, lie below those shown in Figures 8.12, 8.13 and 8.14 and would have the effects as shown in Figure 8.14. We see from Figure 8.14 that higher desired margins by rms are associated with a lower real wage and a higher natural rate of unemployment. Higher margins imply higher prices of goods and we know from the law of demand that higher-priced output is demanded in relatively lower quantities by consumers. Lower quantities of output demanded by consumers require fewer workers to produce the output, so the end result is higher equilibrium unemployment. 2. The responsiveness of unions and workers wage demands to the level of unemployment reected in the position and slope of the RWS curve.

Real wage

Real wage-setting curve

Real wage 1 Real wage 2 Natural rate 1 Natural rate 2

Low margin-setting curve High margin-setting curve Unemployment

F I G U R E 8 . 1 4 N AT U R A L U N E M P L O Y M E N T A N D F I R M S MARGIN-SETTING

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3. The strength/negotiating power of labour unions reected in the share of unionized workers. The strength and responsiveness of unions and workers wage demands to unemployment can be seen from the comparison presented in Figure 8.15.
Real wage

Real wage-setting curve 1 Margin-setting curve Real wage-setting curve 2 Natural rate 1 Natural rate 2 Unemployment

Equil. real wage

F I G U R E 8 . 1 5 N AT U R A L U N E M P L O Y M E N T A N D UNIONS BEHAVIOUR
When unions and workers have a lot of bargaining power the real wage-setting curve lies above the curve for lower bargaining power. A relatively atter real wagesetting curve (such as curve 2 in Figure 8.15) indicates a greater responsiveness of wage-setting behaviour to unemployment. The bargaining power of workers and unions is usually high when:

The share of workers affected by unions negotiations is high. Many non-union members are still affected by the wage negotiations agreed by unions with other decision-makers. Unemployment benets are high and long-term. This affects some individuals incentives to nd new jobs. This explains a general tendency by countries to offer sliding scales of unemployment benets that decline over time. Reasonable levels of benets also increases the likelihood that workers will search out jobs best suited to their skills maximizing their potential productivity. If the cost of becoming unemployed is low in the sense that the benets are high, this can lead to high demands for wages by those in employment. The share of long-term unemployed is high. A high proportion of long-term unemployed signals that those individuals are not competitive in the job market their skills may be out of date and this problem is exacerbated the longer an individual remains long-term unemployed and is outside the active labour force.

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There is substantial mismatch between labour demand in various locations within a region or between skills available and skills in demand. The tax wedge is high. When the tax wedge is high, unions and workers demand relatively higher real wage rates to compensate for higher taxes that must be paid.

Tax wedge: the difference between the real wage paid by an employee and the real wage received by an employee. Differences are accounted for by payroll taxes (usually related to social insurance/security contributions), income taxes, consumer price taxes.

8.5

CROSS-COUNTRY DIFFERENCES I N F L AT I O N A N D U N E M P L O Y M E N T

The general pattern evident in international prices (Figure 8.9) is that consumer prices tend to move similarly internationally. This is largely explained by the substantial economic linkages between industrialized countries due to the size and nature of ows of traded goods and services, nancial capital and people. Firms competing internationally are under pressure to keep abreast of best practice. Manufacturing rms attempt to source inputs from their most cost-effective location (as with outsourcing see Chapter 5) and so similar pressures are extended on rms operating out of different locations. Consumers become aware of international availability of products through their own travel patterns and through the information increasingly available via the national and international media facilitated by information technology developments. Greater disparity exists in terms of international unemployment rates, which is evident from publications such as the OECD Employment Outlook, the source of the data in Table 8.1. From the discussion of the determinants of the natural rate of unemployment, it is possible to identify ways of addressing a rate of natural unemployment, which is higher than desired by identifying its cause and by focusing policies, where possible, on

reducing rms desired prot margins; reducing the strength/power of labour unions and workers in negotiating wage increases.

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Governments do not generally enact laws governing the prot margins that rms are permitted to set because this goes against all economic arguments regarding the ability of the market system to bring about the most appropriate resource allocation by allowing most prices to be set freely within the functioning of markets. However, governments do keep a watchful eye on the conduct of rms in terms of whether rms follow pro-competitive or anti-competitive practices. If rms are setting high desired prot margins, this could only occur in practice on a sustained basis if there are some barriers to competition, as considered in Chapter 6. A low-cost competitor producing a similar good to an incumbent can take over a market if they set a lower price for consumers. The extent to which goods are differentiated from each other in terms of the attributes of the goods or the levels of quality may create switching costs for consumers to buy from one supplier than another. As long as entry to a market is easy, however, we would expect rms who identify protable opportunities, as reected in high prot levels, to have incentives to enter and compete in such markets. Competition would generally mean that more low-cost competitors would exist in markets and pass on benets to consumers in the form of lower prices. Hence, governments focusing on addressing high prot margins in some sectors of the economy could focus on supporting increased competition in those markets by removing any obstacles to new entrants, where they exist. This might involve increasing licences where they are required to compete, as in the taxi market cited in Chapter 3. To address the power of labour and workers in wage negotiations the process by which wages are negotiated appears important since collective wage-bargaining, as mentioned earlier, increases the likelihood that adverse unemployment effects of strong unions will be low. A set of policies known as active labour market policies (ALPS) is the term given to the various measures governments use to focus on increasing employment and reducing unemployment. Examples of ALPS include:

increasing information on available vacancies via employment agencies, providing retraining and reskilling programmes; providing courses on lling application forms, presenting CVs and interview techniques; providing subsidies to rms that hire unemployed workers; providing nancial and other supports to people wishing to start their own business.

Furthermore, given the reference to the tax wedge earlier, government policies that try to reduce the taxes that create large differences between wages paid and received would change incentives regarding the demand for and supply of labour.

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8.5.1

EMPLOYMENT LEGISLATION

Labour market exibility is a term often used in the explanation for differences between unemployment rates across countries. Labour market exibility: the ability of the labour market to adjust to economic shocks. Countries differ signicantly in their legal requirements in terms of hiring and ring workers. These differences can be found, for example, in redundancy payment requirements, notice requirements prior to redundancy, and in government policy on corporate restructuring. Research shows that the labour market of the United States is the most exible in the OECD since there are few administrative requirements rms must observe before they can make workers redundant and neither notice nor severance pay are general legal requirements. By contrast, employment protection policies across Europe are much stronger. There is, however, a debate on the effects of more exible labour markets on income inequality (which we address in Chapter 9) that indicates that labour market exibility is not without costs. Theoretically at least, better worker protection can have positive labour market effects through increasing workers motivation following on from job security. Negative effects are also possible since rms hiring decisions are in the knowledge of the difculties of letting people go, if required, and so with higher redundancy costs, lower employment levels are likely. There is some general consensus on the effects of labour protection legislation from research on OECD countries experiences (published in their Employment Outlook ). First, low employment rates are associated with countries that have strong labour protection policies because it is more costly to hire workers. Second, there is no statistical correlation between unemployment and labour protection legislation. This is due to effects of the legislation regarding part-time workers, who have similar rights to full-time workers. There is a lower incentive to rms to offer part-time jobs when employment legislation is strong. A signicant portion of workers who work part-time are women, hence, there are implications for female participation in the workforce. Lower participation is a corollary of strong employment legislation. Third, job security is higher and people hold jobs for longer when employment legislation is strong. Fourth, unemployment tends to last longer, on average, when employment legislation is strong. Somewhat paradoxically the conclusion is that unemployed workers appear to carry the costs of strong labour legislation while the employed carry

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the benets. This is logical in terms of political economy explanations where strong unions can lobby government to enact legislation protecting their membership. As with most economic issues nding a solution to unemployment is complex and can require a range of coordinated policies to achieve a satisfactory outcome. Since countries (and regions within them) are characterized by specic economic circumstances, what addresses one problem would not be appropriate in dissimilar situations. Economic analysis helps to understand what precisely characterizes the unemployment situation so that appropriate remedies can be found and enacted.

8.6

SUMMARY

When the economy is out of long-run macroeconomic equilibrium, ination and/or unemployment can result in the short run. Minimum wages and their effects can be considered via the labour market model although efciency wages should be considered before drawing conclusions based on the model alone. Classical and Keynesian analyses of unemployment incorporate different assumptions about how the economy adjusts. Unemployment may be analysed by considering the recessionary gap approach using the aggregate demand and aggregate supply model. The sources of ination demand-pull and cost-push can be analysed using the aggregate demand and aggregate supply model. The same model allows for consideration of an economy operating above its short-run capacity when an inationary gap is said to exist. Both classical and Keynesian approaches can be used to analyse how the economy can eliminate an inationary gap.

Several hypotheses have been put forward to explain why aggregate prices tend to increase over time. International trends in oil prices have played a role in international ination patterns. Governments may contribute to creating ination. Several costs arise from ination, both anticipated and unanticipated. The relationship between unemployment and ination, called the Phillips curve, states that high unemployment is associated with low ination and vice versa.

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A model of the determination of the natural rate of unemployment implies that ination and unemployment can occur simultaneously in an economy. Conclusions can be drawn on how to try to address the unemployment problem.

REVIEW PROBLEMS AND QUESTIONS

1. Use the labour market supply and demand model to show and explain the effects of the imposition of a minimum wage on unemployment and the wage rate. What factors outside your model might also have an impact on your conclusions regarding the level of unemployment? 2. Use the labour market supply and demand model to explain the different approaches of Keynesian and classical economists to how an economy reacts to unemployment. 3. Explain what is meant by a recessionary gap. a) From a Keynesian perspective how can a recessionary gap be eliminated? b) From a classical perspective how can a recessionary gap be eliminated? 4. Explain, using a gure of aggregate demand and aggregate supply, the difference between demand-pull and cost-push ination and their respective impacts on macroeconomic equilibrium. 5. Explain what is meant by an inationary gap. a) from a Keynesian perspective how can a inationary gap be eliminated? b) from a classical perspective how can a inationary gap be eliminated? 6. What are the main trends evident in the CPI of industrialized countries? Can you identify reasons behind the trends? 7. What is the Phillips curve (include a graph in your answer) and what are its implications for government policy on employment or ination? 8. Describe the main elements of the model of the natural rate of unemployment. How according to the model is the natural rate determined?

FURTHER READING AND RESEARCH

For an examination of labour mobility within the EU see sections 21.4 onwards in Mayes, 2001, ch. 21, 472497. For literature on the effects of minimum wages see Brown, 1988; and Economic Journal, 2004.

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319

For recent consideration of the Phillips curve see Lansing, 2002; and Mankiw, 2000.

REFERENCES
Brown, C. (1988) Minimum wage laws: are they overrated? Journal of Economic Perspectives , 2(2), 133145. Economic Journal (2004), 114(494), 86116, March. Friedman, M. (1968) The role of monetary policy, American Economic Review , 58(1), 117. Lansing, K. (2002) Can the Phillips curve help forecast ination? Federal Reserve Bank of San Francisco Economic Letter, No. 200229. Mankiw, N. (2000) The inexorable and mysterious tradeoff between ination and unemployment, Economic Journal , 111, c4561. Mayes, D. (2001) Factor mobility, in El-Agraa, A. (ed.) The European Union, Economics and Policies . 6th edn, Pearson, 472497. Miles, D. and A. Scott (2002) Macroeconomics: Understanding the wealth of nations . John Wiley & Sons, Ltd. Mitchell, B. (1988) British Historical Statistics . Cambridge University Press, London. OECD (2004) Standardised unemployment rates in 27 OECD countries, OECD Employment Outlook. Phelps, E. (1967) Phillips curves, expectations of ination and optimal employment over time, Economica , 34(3), 254281. Phillips, A. (1958) The relation between unemployment and the rate of change of money wage rates in the United Kingdom, 18611957, Economica , 25(2), 283299.

CHAPTER 9

DEVELOPING THE ECONOMIC SYSTEM: GROWTH AND INCOME DISTRIBUTION

LEARNING OUTCOMES
By the end of this chapter you should be able to: Describe the relationship between the level of peoples living standards and their economys level of labour productivity. Reason as to why economic growth matters for peoples living standards. Illustrate why rising productivity may not always translate into rising living standards. Explain the main elements of the Solow model of growth and its main conclusions. Use the model to illustrate the effect of changes in savings for an economy. Use the model to illustrate the effect of changes in the labour input on an economy. Use the model to illustrate the effect of changes in technology on an economy. Assess productivity growth patterns across countries to identify their main sources of growth. Clarify the extension to the Solow model as outlined in newer (endogenous growth) models. Comment on the main trends in international income distribution and their implications for welfare and equity.

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9.1

INTRODUCTION

One of the most fundamental and important economic issues, especially from a macroeconomic perspective, is that of economic growth. This issue focuses on how an economy can achieve a sustainable level of growth in economic activity that generates improvements in peoples living standards real output per capita. Although this is of macroeconomic interest, given our earlier examination of how rms operate and attempt to maximize their prots, it is clear that what happens at the rm and microeconomic level impacts on living standards also rms and their employees produce the real output. Understanding the determinants of economic growth is vital for identifying the links that exist within the economic system that impact on the level of aggregate economic activity and on its rate of growth. This is the focus of the rst four sections of this chapter. In section 9.2 trends in living standards are presented and the relationship between living standards and labour productivity is explained. While rising labour productivity is one necessary condition for economic growth we will see that it is not sufcient on its own to ensure rising living standards, which is of key interest to economists. The rate at which an economy grows or expands is usually quoted in terms of the annual percentage increase (or decrease) in GDP or GNP. The long-run implications of high or low economic growth are considered in section 9.3. The central model used to consider growth the Solow growth model is presented in section 9.4, where the effects of changes in savings behaviour, in employment, in capital investment and in technology for economic growth are all considered. Recent extensions to the model are also considered in terms of examining potential causes of changes in technology. In section 9.5 the focus turns to the manner in which the spoils generated by economic activity are distributed. The distribution of income across and within countries is examined and the extent to which these have changed over time is considered.

9.2

L I V I N G S TA N D A R D S A N D L A B O U R P R O D U C T I V I T Y R E L AT I O N S H I P S

Examining the trend in living standards over time reveals the pattern of living standards across economies. Table 9.1 provides some data on living standards over time.

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TA B L E 9 . 1 G D P P E R C A P I TA G R O W T H , I N % , SELECTED COUNTRIES, 1960 2000

196080 High HDI a
Austria Belgium Cyprus Czech Republicb Denmark Finland France Greece Hungary Ireland Italy Japan Latviab (from 1965) Luxembourg Netherlands Polandb Portugal Spain Sweden United Kingdom United States (from 1970) 104 102 160 133 68 105 102 182 170 106 126 241 103 50 86 50 167 137 64 49 55 71 15 168 229 77 0.22 0.6 35 30

19802000
42 67 122 0.5 49 56 40 34 4 144 43 54 22 122 47 25 82 68 34 55 56 180 102 85 10 53 26 6 37 60

Change

Middle HDI

Chinab Indiab Malaysiab Romaniab Turkeyb

Low HDI

Burkina Fasob Malib Nigerb Sierra Leoneb

Source: Excerpted from Table 1 in Weisbrot, Naiman and Kim (2000). a HDI denotes the human development index reported by the United Nations, and explained in the text. b Data taken from Penn World Table 5.6 (Heston et al., 2002). Czech Republic and Latvian data nish in 1997. Note: As mentioned in Chapter 1, updated Penn World Tables (version 6.1) are available at the Center for International Comparisons at the University of Pennsylvania. See http://pwt.econ.upenn.edu/

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A broad cross-section of countries is included in Table 9.1 ranked in groups according to their human development index (HDI) score in 2004. The HDI is based not on income solely but also includes criteria including health, education, life expectancy, income, poverty levels and environmental quality. The broad trend that emerges is there has been a slowdown in economic growth, measured as GDP per capital internationally over the periods 1960 to 1980 and 1980 to 2000. The rst period includes the Golden Age period between 1950 and 1973 following World War Two and prior to the rst oil-price shock when economies internationally, particularly the industrialized countries, expanded substantially. A minority of countries (highlighted in italics in Table 9.1) experienced higher growth in GDP per capita in the second period. While real output per capita provides an indicator of living standards, another measure real output per person employed provides information on the productivity of an economys workforce. This measure is called labour productivity. Labour productivity: the amount of real output, on average, produced by each worker in the economy. It is computed as Real output . Workers employed Measurement of labour productivity differs from living standards in terms of the denominator used because living standards is computed as Real output . Population

In 2003 Finlands real output was approximately 137bn (quoted in 2000 prices) and the number of workers employed was 2 365 000 (see http:// www.stat. for statistical information; gures for real GDP are taken from http: //www.stat./tk/tp/tasku/taskue kansantalous.html while numbers employed is available at http://www.stat./tk/tp/tasku/taskue tyoelama.html). Computing Finnish labour productivity yields a gure of 57 928. Comparing this to 2002 when real output was 134.5bn (in 2000 prices) and 2 372 000 workers were employed indicates that labour productivity was 56 703. Repeating this exercise for 2001 gives rise to a gure of 55 555 (131.5bn/2 367 000). Hence we can say that real labour productivity increased

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in this economy between 2001 and 2003. This means that each worker on average increased the quantity of goods/services they produced. The corresponding gures for living standards can be computed using gures for population. The population gure for 2001 was 5 201 000 and for 2002 (latest available data) was slightly higher at 5 213 000. Hence, living standards for each Finnish resident in 2002 were 25 801 and in 2001 were 25 284 indicating a rise in living standards of 2.04%. Over the same period the rise in labour productivity was quite similar at 2.06%.

When labour productivity rises over time this means that output is growing at a faster rate than the number of workers employed (the labour input). The importance of labour productivity for economic growth is evident if we consider that increased labour productivity reects an increase in the productive efciency of an economy. An economy that is able to increase the real output of the average worker may be making more efcient use of available resources, using them in more productive ways. In terms of our discussion of the production possibility frontier (refer back to Chapter 1), an economy that increases its average labour productivity with no change in the amount of available resources or technology over time experiences efciency that allows it to increase its output and move its production point closer to its PPF. This would represent an improvement in the technical efciency of the economy as better ways of using the resources are put in place. If more and more rms in an economy adopt the best practice methods for producing their goods and services, technical efciency would improve. Logically, any barriers to the dissemination of best practice methods have repercussions for efciency and it would be in the economys interest to eliminate such barriers where possible. Firms that are in industry or trade associations whereby they visit each others premises or are in regular contact and are aware of how best to produce their output are usually quick to implement and imitate improvements introduced by their peers, which has a positive impact on the rms and on the economy as labour productivity could also be expected to rise in an economy that applies improved technology. In the 1970s and 1980s many international manufacturing companies tried to imitate the best practice production methods originating in Japan that allowed Japanese producers to become efcient and competitive in many consumer

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electronics products and in the car/automobile markets. Many rms in the USA, and elsewhere, found it difcult to produce products that could compete on price and quality relative to the available Japanese alternatives. Some rms went out of business, others attempted to adopt best practices, although this proved difcult since the Japanese model of production had many cultural aspects not easily imitated in non-Japanese rms.

Alternatively, an economy that experiences rising labour productivity might be enjoying the results of an increase in its resources (of capital, for example) available to each worker, allowing each worker to produce more. If the capital input expands because rms invest more in new machinery and equipment, for example, the countrys production possibility frontier moves outwards reecting increases productive capacity of the economy. Again a higher amount of output can be produced caused by the rise in capital resources. If capital increases with no change in the labour input and output produced rises, once again labour productivity increases. A complex mix of economic factors affect labour productivity and are, therefore, important in the context of economic growth. For example, 1. The income taxation structure within an economy can have signicant implications for individuals incentives to work as individuals will not necessarily be willing to give up welfare payments if faced with poverty traps. A poverty trap (also sometimes known as an unemployment trap) exists when the opportunity cost of moving from unemployment benets to paid employment does not exist. Unemployed workers are often entitled to various benets in addition to unemployment payments. These may include housing or rent allowances, reduced medical costs, food vouchers, etc. On taking up paid employment, especially of a low-paid nature, the benets foregone may be greater than the wages earned. A vicious circle of poverty can be created which is difcult to break. 2. Women (and men) who opt to take care of children and not work outside the home may not be enticed into the workforce unless sufcient incentives exist to compensate them for childcare costs so that even if more employees are in demand by rms, they cannot attract additional workers without increasing wages. 3. High taxes on rms prots affect the location decisions of multinational rms and high employers taxes reduce their incentives to increase their workforce.

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4. If a government attempts to attract rms via capital grants and/or the provision of buildings they essentially change the relative prices of capital and labour making capital relatively cheaper which again impacts rms incentives to increase employment. 5. The ease and availability of nance for investment matters for investment purposes. Overall business condence in an economy in terms of favourable expectations of future demand and economic developments feeds into rms decisions regarding how much to invest in capital and research and development which ultimately contributes to economic growth. The myriad of factors that affect economic growth (not exhausted above) implies that it can be extremely difcult to attempt to address the problem of slow economic growth. Given the relationship between living standards and labour productivity, however, adopting a perspective of economic growth based on improving labour productivity through a more efcient use of resources is central.

9.2.1

THE DEPENDENCY RATIO

Unfortunately labour productivity improvements do not necessarily or immediately lead to higher living standards because the dependency ratio must be taken into an account. A countrys dependency ratio is the portion of the population not in employment (including the unemployed, those who have retired and children) relative to the total population in employment. The percentage of employed people in the population is known as the participation rate. Dependents are also often classied as non-economically active as they are considered to consume but not produce economic outputs. Table 9.2 provides information relating to 2001 on dependency ratios for a selection of countries. For Austria 16.5% of its population is between 0 and 14 years of age, 11.8% is in the segment between 15 and 24, etc. The dependency ratio is the sum of the shares of the non-economically active segments (dened as children up to 14 years and those of 65 years and older) stated as a percentage of the rest of the population (those between 15 and 64 years).

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TA B L E 9 . 2 I N T E R N AT I O N A L D E P E N D E N C Y R AT I O S A N D P O P U L AT I O N S H A R E S , 2 0 0 1
Dependency ratio
Austria Belgium Chinaa Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Indiaa Ireland Italy Japan Latvia Lithuania Luxembourg Netherlands Poland Portugal Slovakia Slovenia Spain Sweden United Kingdom United States 47.2 52.5 46.4 51.8 43.7 50.3 49.0 49.4 53.8 47.7 47.9 46.4 62.5 53.7 48.4 46.8 47.9 50.2 48.8 47.2 44.8 48.1 44.0 42.6 46.2 55.0 52.8 50.6

014 years
16.5 17.6 36.4 22.7 16.1 18.7 17.6 18.0 18.8 15.4 15.3 16.5 54.4 21.4 14.4 21.6 17.0 19.3 18.8 18.0 18.5 16.0 19.0 15.6 14.6 18.3 18.9 21.2

1524 years
11.8 12.1 15.4 14.8 11.2 14.7 12.7 13.0 11.3 14.1 14.3 17.2 11.4 14.6 14.5 11.5 11.9 17.0 14.2 16.9 14.3 13.8 11.6 12.1 14.0

2564 years
56.1 53.5 50.5 53.5 55.3 52.4 54.3 52.0 56.4 53.5 54.0 43.4 56.0 53.0 52.1 55.7 56.1 52.1 53.4 52.2 55.8 54.6 52.9 53.3 52.4

65+
15.5 16.9 10.0 11.4 13.8 14.8 15.3 15.1 16.2 16.9 17.1 15.2 8.1 11.2 18.2 25.2 15.4 14.1 14.0 14.1 12.4 16.5 11.4 14.3 17.0 17.2 15.6 12.4

Sources: Data compiled from United Nations, 2003; except for countries marked a where data taken from United Nations, 2002.

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The percentage of each countrys population that falls into different age groups is shown in Table 9.2. The dependency ratio for Austria is 47.2 which is found by 1. summing up the share of the population between 0 and 14 (16.5%) and the share over 65 (15.5%) = 32%; 2. summing up the economically active population between 15 and 64, i.e. 11.8% + 56.1% = 67.9%; 3. expressing 32 as a percentage of 67.9 = 47.2%. This dependency ratio implies that for every 100 people in the population, 47 are dependents. Note these measures do not account for unemployment.

It is also possible to compute separate young dependency and elderly dependency ratios. Concern has been raised recently in industrialized countries about increased life expectancy (rising elderly dependency) and the pressure thus created on pension-systems. The proportion of the worlds population over 65 is predicted to double by 2030, from about 8% to more than 16%. For members of the Organization for Economic Cooperation and Development the percentage is expected to rise from 18% to 32% over the same period. Coupled with falling fertility rates this means smaller populations will have to support greater shares of non-economically active people. Fertility rate: the number of children born in a year, usually expressed per 1000 women in the reproductive age group.

In 1970 average international fertility rates were 3.33; currently they are 2.96 and are expected to drop to 2.5 by 2020. In fact Ireland had the distinction in the 1990s of being the sole European country where the fertility rate was sufciently high to lead to a rise in the overall population in all other European countries populations were declining as the fertility rate was less than the replacement rate, i.e. that required to replace deaths.

These international trends create challenges that will have to be faced by governments, pensions-administrators and by workers in the not too distant future. (For more on the pensions debate see Cato, 1998.)

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The importance of the dependency ratio for understanding trends in labour productivity and living standards can be considered using an example. Before the 1990s in Ireland, labour productivity growth did not translate into proportional growth in living standards because of high levels of unemployment and dependency. However, during the 1990s growth in labour productivity eventually coincided with improved living standards because it reected a more efcient use of resources and allowed Irish goods and services to become more competitive relative to those produced elsewhere. Up to the late 1980s high Irish unemployment reected general international recessions and the inability of many inefcient Irish producers to compete either domestically or internationally. By the mid 1990s the Celtic Tiger had emerged (a reference to the name often used to denote the four Asian Tiger economies of Hong Kong, Singapore, Taiwan, and South Korea that achieved relatively high rates of growth over the 1960s to the mid-1990s) and rising employment meant that growth in productivity translated into living standards gures also, as shown in Table 9.3.

Table 9.3 shows that real output of the Irish economy accelerated from 1993 onwards at 8.3% on average each year to 2000. To explain this jump we see that from 1993 annual growth in employment also increased substantially to

TA B L E 9 . 3 E C O N O M I C G R O W T H , P R O D U C T I V I T Y A N D EMPLOYMENT
Annual average growth rates % Period 19601980 19801993 19932000 GDP
4.1 3.3 8.3

Population
0.9 0.4 0.8

Employment
0.5 0.0 4.7

Living standards, i.e. GDP/capita

3.1 2.9 7.4

Productivity, i.e. GDP/worker

3.5 3.3 3.5

Source: Kennedy, 2001. Data taken from Irish National Income and Expenditure, various issues; ESRI Quarterly Economic Commentary, December 2000; and Kennedy, K. (1971) Productivity and Industrial Growth: The Irish experience. Clarendon Press, Oxford.

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4.7%. Living standards too jumped dramatically from 1993 onwards. Although the growth in labour productivity was almost stable since 1960, because increasing numbers of people could nd work since 1993, the overall output of the economy increased substantially. The dependency ratio fell as the unemployment rate dropped from 15.5% in 1993 to 4.2% in 2000. The gap between the population and the employed population explains why growth in living standards was below that for productivity until the period beginning 1993. As employment increased this gap closed, allowing living standards to grow faster than productivity and allowing a greater proportion of the population to share in the economic growth through their new-found jobs.

9.3

ECONOMIC GROWTH OVER TIME

Economies are not static entities. The ceteris paribus assumption helps economists theorize about the economy and facilitates their analyses of the economy but factors do not remain constant for very long. Economic decisions are made, goods and services are bought and sold, demand conditions change, supply conditions change, population and unemployment rise and fall, real output is produced and real income is earned and spent. Ideally economies should expand or grow over time meaning more real output is produced. The more output produced, the more income generated for the citizens of a country. We all probably hope that our children and grandchildren will be materially (and non-materially) better off than ourselves, which implies that there will be more real output/income generated by their economies to be shared among the population. Table 9.1 indicates quite different outcomes across various countries in terms of their growth experiences as revealed by average living standards internationally over the last 40 years. The rate at which an economy grows matters if we consider what happens to real income if long-run growth is 3% each year. Real national output for Ireland in 1978 was IR15 815m (expressed in 1995 prices). We can compute how long it would take for real income to double (to 31 630m) assuming a growth rate of 3%. The following formula applies: Future value = initial value (1 + growth rate)n ; where n denotes time period (i) To compute n rearrange the above: Future value (FV ) = (1 + growth rate (GR ))n Initial value (IV )

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(ii) It is true that log (FV /IV ) = n log (1 + GR ) (iii) Dividing both sides by log (1 + GR ) gives log (FV /IV )/log (1 + GR ) = n (iv) To compute GR rearrange the above: Future value (FV ) = (1 + growth rate (GR ))n Initial value (IV ) (v) This can be rearranged as (FV /IV )1/n = (1 + GR ) (vi) Finally GR can be found as [(FV /IV )1/n ] 1 = GR Applying the formula to this example:

(i) 31 630m/15 815m = (1 + 0.03)n : 2 = (1.03)n (ii) log (2) = n log (1.03) (iii) log (2)/log (1.03) = 0.301/0.013 = 23.15 This means that it would take 23.15 years for real output to double assuming the above information holds. What we would nd for a lower growth rate of say 1.5% (half of 3%) is that it would take twice as long over 46 years for output to double. This indicates that the rate of economic growth really matters for economies, for their real output and hence for living standards. In actual fact 23 years after 1978, in 2001, Irish real output was 67 615, more than trebling over the period. This implies a substantially higher rate of growth than 3%. We can compute what the growth rate was again using the above formula. This time the future value is 67 615m and the variable we wish to compute is the growth rate (GR). (For simplicity the time period used is 23 years rather than 23.15.) (v) (67 615m/15 815m)1/23 = (1 + GR ) = 4.281/23 = (1 + GR ) (vi) 1.0653 = (1 + GR ) = 1.0653 1 = 0.0653 A growth rate of over 6.5% corresponds to the observed real growth in Irish output between 1978 and 2001. This gure of 6.5% is an average computed over the entire period but in fact, as Table 9.3 showed earlier, real Irish output grew mostly after 1993.

To understand the processes underlying economic growth Solows growth model is considered further in the sections that follow.

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9.4

MODELLING ECONOMIC GROWTH: THE SOLOW GROWTH MODEL

In 1956, Robert Solow, who received the Nobel Prize in Economics in 1987, developed a model of economic growth that focuses on long-run economic growth and its determinants, as opposed to the short-run uctuations we considered earlier in the discussion of the business cycle. (This approach to modelling economic growth is also called the neoclassical growth model.) Long-run growth is related to the production possibilities or productive capacity of an economy, which usually change very little over short periods of time but which can change over longer periods. In terms of the tools we have already met, economic growth corresponds to an outward expansion of the production possibilities frontier or a rightward shift of the aggregate supply curve. Solows growth model uses the production function approach discussed in Chapter 5 (see section 5.8). The production function summarizes the relationship between the factors of production (K and L ), the level of technology (T ), and output (Y ), as: Y = F (K, L, T ) From this relationship, any change in the quantity or quality of the productive factors or technology has an impact on the level of output the economy can produce. Just how changes in K or L actually affect Y (e.g. Y increasing by 5% if L rises by 10%) is not covered in this text but would be described in a more specic production function than the general function presented here as Y = F (K, L, T ). One example of a more specic functional relationship between Y , K , L and T would be Y = T (K ) (L ) with values provided for T , and (these values could be estimated from analysis of available economic data). Where the value of plus is less than 1, e.g. 0.3 and 0.5 (summing to 0.8), it would imply that decreasing returns to scale describe the relationship between the factors of production and output if inputs both doubled, output would rise but by less than double. If plus sum to greater than 1, increasing returns to scale are described (output rising faster than a joint input rise) and if they sum exactly to 1, constant returns to scale apply to the economy. Relating the production function to our discussion of labour productivity (and assuming that resources are used efciently) any change in labour productivity is

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due to either a change in the quality or quantity of capital available to each worker or to a change in available technology. In the Solow model, technology is assumed not to be inuenced by K and L implying that changes in the capital stock, K , or labour input L do not affect technological progress. In other words, technology is assumed to be exogenous to the Solow model as it is determined outside the model itself and not inuenced by other variables in the model: technological change just happens without explanation. (A number of economists have examined this exogeneity assumption with interesting results but before discussing these it is necessary to initially consider the Solow model and its implications). Figure 9.1 presents an illustration of a production function. To draw the production function in two dimensions here we use output and capital we assume that the production function is drawn for one given level of technology and for a given level of labour supply. This allows us to focus on how output is related to the capital input, given T and L . The production function indicates the amount of output produced for different levels of capital input (given T and L ). We see that long-run output depends on the level of the capital stock in the economy. If the level of capital stock is K1, output is Y1; when it is K2, output is Y2. Furthermore, for any two economies with similar production functions if the level of capital in one country is K1 while it is K2 in the other country, the output levels in both countries will differ substantially. We also see that output rises as the stock of capital employed increases but the relationship is nonlinear. This implies that output does not rise by a constant

Output: Y Y2 Y3 Y1 Production function

K1

K3

K2

Capital: K

FIGURE 9.1 PRODUCTION FUNCTION IN THE SOLOW GROWTH MODEL

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amount if the capital stock changes. For example as the capital stock rises from zero to K1, output rises relatively sharply from zero to Y1. As the capital stock rises further from K1 to K3 (an increase of roughly 200% here), output also rises but by a smaller proportion approximately 50%. This nonlinearity illustrates diminishing returns to capital. For a given number of workers, adding more and more capital contributes ever declining amounts to total output. The initial benet of doubling capital when the capital stock is low allows workers to increase their output substantially. Doubling capital when the capital stock is high and each worker already has a lot of capital with which to work generates lower additional increases in total output. Since the level of output in the long run depends on the level of capital stock, any change in the capital stock causes a change in output. If an economy has a level of output at Y1 and wishes to expand output to Y2, investment in more capital stock is required. Such investment is undertaken by both rms and governments; rms make private investments that change the stock of private capital and governments engage in public investment that change the amount of public capital. To increase the capital stock investment in new capital must be sufcient to more than cover any depreciation that normally occurs as capital is used for productive purposes. Once capital investment is greater than depreciation the capital stock rises and so too does output (assuming that the output is in demand!). If investment is less than depreciation, an economy experiences a decline in its capital stock and in output. If investment just covers or offsets the capital lost due to depreciation, the levels of capital stock and output remain constant or unchanging. Solow called this case the steady state. At any level of investment, either above or below the level required to cover depreciation in the economy, the economy is not at its steady-state level of output and the capital stock will either rise or fall with knock-on effects on the level of output. The steady state is the term used by Solow to describe the equilibrium state of output and capital stock in the long run. (The term is also used in physics.) An economy that reaches a steady-state level of capital stock and level of output has no tendency to change from these levels, ceteris paribus . Figure 9.1 can be extended to consider investment and depreciation further. Having discussed investment in Chapter 5, we know that expectations play a key role in rms determination of their investment levels. Predicted future demand is central to the investment decision.

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Many factors enter into governments decisions regarding public investment but it is closely related to the level of development of the economy classied as low, medium or high and to the governments policy goals. It may take the form of hard investments in physical infrastructure or soft investments including services, education or technology. If we consider that national savings is the main source of actual investment funds we can describe actual investment as equal to national savings, which itself is a fraction of national income (equating investment with national savings is strictly true only if there is no government expenditure or trade). Including government and foreign sectors implies: Investment = savings government decit (or + government surplus) + foreign nancing. If Y denotes national income then savings or the funds for investment is a fraction of Y . If the fraction of Y saved were 25% we can add this as the savings = actual investment function shown in Figure 9.2. To include depreciation in the diagram, it is assumed that a constant fraction of the capital stock requires replacement annually as it becomes obsolete. If this fraction is 20% then 20% of K depreciates each year and will be written off in the national accounts; if no investment takes place the capital stock declines. It is reected in Figure 9.2 by a straight line with a slope of 0.20. The linear relationship between depreciation and capital stock implies that for any change in capital stock, depreciation will always be 20% of this change (so if the level of K is 10, depreciation is 2).
Output/ depreciation/ investment Y2 Y* Y1

Production function

Depreciation Savings = actual investment K1 K* K2 Capital: K

FIGURE 9.2 SOLOW GROWTH MODEL WITH INVESTMENT A N D D E P R E C I AT I O N

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In Figure 9.2, K denotes the level of the capital stock required for investment to just cover depreciation. This is the steady-state level of capital stock, the only level from which the economy has no tendency to change, ceteris paribus. At other levels of capital stock, this is not the case. If K1 is the level of capital stock and Y1 the output of the economy, investment is greater than depreciation and the tendency is for the capital stock to rise with an impact on output also. For levels of capital stock above K such as K2, depreciation is above investment, and investment is insufcient to replace depreciating capital stock, hence the tendency is for the capital stock level to decline and, therefore, for output to fall. Whenever the level of the capital stock is not at K , it tends to move towards K . The steady-state level of capital stock K corresponds to a level of output of Y on the production function. Another implication of the production function drawn here is that of convergence. Convergence is the tendency for poorer countries to grow faster than richer countries for a given increase in capital stock. Hence, poorer countries would be expected to catch up with richer countries if the countries share similar steady states. Richer countries (i.e. those with higher per capita income levels) have higher levels of capital stock than poorer countries. Given the assumption of diminishing returns to capital, this implies that for any increase in the capital stock the additional output produced from the capital will be lower in the richer country than the poorer country starting from a lower level of capital stock and lower level of income. The productivity of capital will be higher in the poorer country. Historically, following World War Two, Japan and Germany invested heavily in renewing and improving their capital stock relative to the USA and UK and this is one of the factors that is considered to explain their relatively better productivity. Similar arguments are used to explain the Asian Tiger phenomenon.

9.4.1

MORE ON SAVINGS

Savings rates for many countries are published on a regular basis. A recent report by the Organization for Economic Cooperation and Development (OECD) provided the information presented in Table 9.4 on household saving rates across a range of industrialized countries. Countries ranking are presented in the nal column while an indication of the general trend is shown in the second-last column of the table. The predominant trend in household saving has been a decline. In some countries,

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TA B L E 9 . 4 I N T E R N AT I O N A L H O U S E H O L D S AV I N G S R AT E S
Country
Australia Austria Belgium Canada Czech Republic Denmark Finland France Germany Ireland Italy Japan Korea Netherlands New Zealand Norway Portugal Spain Sweden Switzerland United Kingdom United States

1985
10.8 10.5 15.9 15.8 3.4 8.9 12.1 10.6 30.7 16.5 14.8 5.6 3.3 11.1 3.2 9.8 9.2
b

1990
9.3 14.0 18.0 13.0 11.2 2.2 7.8 13.9 6.5 27.8 14.0 22.0 11.6 0.5 0.8 12.3 0.0 8. 7 8.0 7.8

1995
4.8 11.7 18.8 9.2 20.6 6.9 5.2 11.2 11.2 8.5 22.5 11.9 16.8 14.9 3.6 4.6 13.6 14.4 8.3 9.4 10.0 5.6

2000
3.4 8.3 13.4 4.8 13 4.8 0.9 10.8 9.8 6.0 14.5 9.8 11.5 6.7 3.8 4.5 9.5 10.6 2.4 8.3 4.3 2.8

2002a
0.3 7.5 13.7 4.4 11.3 6.2 0.3 12.2 10.4 7.5 16.0 5.8 9.6 10.7 0.3 7.0 11.9 10.1 8.2 9.0 5.2 3.7

Change

Rank 02
19 12 2 17 5 14 20 3 7 12 1 15 9 6 20 13 4 8 11 10 16 18

Source: OECD, 2002 Notes: a 2002 gures are projections. b Data unavailable.

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the decline has been dramatic Australia, Canada, Italy (from a very high share), Japan, the USA, and the UK. There are many possible reasons why the savings rate varies a lot across countries. Different demographic patterns between countries lead to different savings rates as countries with a high proportion of the population in older age groups tend to have higher savings rates. National tax policies affect peoples saving/consumption incentives and decisions. Cultural differences also play a role, as does the level of development, and political and economic stability. Savings rates tend to be highest in countries with high income-levels, which could mean also that high income promotes high rates of saving. Economists have not identied which of the many possible explanations is most important to explain international differences in savings rates. The Solow model can be used to consider what happens if a countrys savings rate changes. A decision to increase the proportion of income saved, for example, moves the savings = actual investment function up, as shown in Figure 9.3. With the higher savings rate, at any level of capital stock the amount of investment is higher, so the new savings function 2 lies above the initial function. We can consider the implications of this change beginning at the initial steady state. Using savings function 2, we see that at K , savings = actual investment lies above the depreciation line. This means there is a tendency for the economy to move from its steady state and the capital stock rises due to increased net investment. In fact, the capital stock increases until K2 is reached (where the new savings function intersects the depreciation line and where savings = actual investment just covers capital depreciation). The higher capital stock of K2 denotes a new steady state involving both higher capital stock and higher output. Governments sometimes intervene to affect savings. Remember consumers have the options to either save or spend on consumption goods. High levels

Output/ depreciation/ investment Y2

PF1

Y1

Depreciation Savings 2 Savings 1 Capital: K

K1

K*

K2

FIGURE 9.3

I N C R E A S E I N T H E S AV I N G S R AT E

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of consumption correspond to low levels of saving. High levels of aggregate demand correspond to booms and to encourage consumers to change their savings behaviour government might be anxious to try to reduce aggregate demand (if ination or ination expectations were rising, for example). Or to encourage greater savings for pensions, governments often offer tax concessions as an incentive to change savings behaviour. But is there an ideal or optimal savings rate for an economy? Imagine that consumers wish to maximize their consumption out of the income generated in their economy and income is either consumed or saved (i.e. used for investment). There are, in fact, unique levels of capital stock (K ) and output (Y ) that correspond to maximizing consumption, which are shown graphically in Figure 9.4. The production function indicates the maximum levels of consumption possible if no income/output is diverted for savings/investment (and if no taxes were diverted to government and if no external trade occurred!). Even if no income is saved a certain amount of capital depreciates each year, reducing the amount of income available for consumption. For Figure 9.4 panel A we can consider just by looking at the graph where the biggest difference exists between output and depreciation; this indicates the unique values of output (Y ) and capital stock (K ) at which consumption would be maximized. The intuition behind this result is that only at these points is the marginal return to capital (the slope of the production function) the same as the rate of depreciation. At any higher (lower) capital stock

A Output/ depreciation

Production function

B Output/ depreciation

Production function

Y*

Y* Depreciation

Depreciation Savings

K*

Capital: K

K*GR Golden rule level of capital

Capital: K

FIGURE 9.4 SOLOW GROWTH MODEL: SAVINGS AND CONSUMPTION

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the rate of deprecation would be greater (less) than the return of the capital in the economy. Only at these points is there no incentive to change the capital stock. In Figure 9.4 panel B a savings function is added. The golden rule level of capital (K GR ) corresponds to the point where depreciation = savings and consumption is maximized. This outcome is far from certain for an economy. One unique savings function must apply, as shown in Figure 9.4 panel B . For any other savings function, the optimum level of consumption does not occur and the level of capital stock differs from K GR.

9.4.2

THE SOLOW MODEL AND CHANGES IN LABOUR INPUT

Using the Solow model to examine the impact of changes in labour on output and economic growth is complicated. Why? Because using the production function approach we assumed T and L are xed. Relaxing this assumption for a while, take the case where the labour input increases and we assume the economy is initially operating efciently. With a rise in quantity of the labour input (L ) only and no change in capital, each worker (on average) has less capital with which to work. The net effect on output depends on the relative effects of 1. lower average productivity due to the drop in capital per worker; 2. rising total output produced by the extra workers. See the box for examples. An economy produces output efciently. It has 100 workers and average productivity is 10 baskets of output. Therefore, national output is 100 10 = 1 000. Example 1 Labour rises by 5% to 105 workers. Capital does not change. Each worker has less capital and so their productivity declines by 10% to 9 baskets. New national output is 105 9 = 945. This represents a drop of 5.5%. Example 2 Labour rises by 10% to 110 workers. Capital does not change. Each worker has less capital and so their productivity declines by 5% to 9.5 baskets. New national output is 110 9.5 = 1045. This represents a rise of 4.5%.

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Thus, the impact on output depends on the precise relationship between output, capital, labour and technology for the economy at that point in time, i.e. its production function! There is a further possibility. It could be envisaged that an increase in the labour input could occur either if more workers become available or if the quality of the workforce improves (due to better education or skills, for example). In such a case, greater numbers of more efcient or productive workers might reduce or even cancel out the effect of having less capital with which to work. All of this implies that it is difcult to predict exactly what the effect of changes in the labour force will have on real output. If the quantity of workers and capital are both increasing, however, the Solow model is useful for considering the effects of increasing labour inputs for output and economic growth. A rising labour input reduces capital per worker (as with depreciation). In order to maintain a constant amount of capital for each worker in the economy if the labour input is rising, investment must cover not only depreciation but also the capital required to supply all new workers with capital: capital widening is required. In an economy where the capital stock increases at the same rate as the labour force and covers depreciation, capital widening occurs. Capital deepening occurs when the capital stock increases faster than the labour force so that the amount of capital per worker rises. At the level of the macroeconomy, if capital widening occurs, a given level of capital per worker (K1 for example) can be maintained, which is associated with a specic level of output (Y1). To maintain Y1 if the labour input is rising requires greater investment than if labour is unchanging. Capital deepening would be funded through savings leading to higher investment. In an economy with a workforce growing by 5% each year, for example, investment would have to grow by 5% just to keep a constant amount of capital available to each worker. This is apart from the investment required to replace depreciating capital. If our economy above experiences 20% depreciation and 5% labour force growth then investment to the value of 25% of the capital stock is required to maintain a constant level of capital stock per worker. A rise in labour coupled with capital deepening would lead to a further expansion of the production function. In an economy where constant returns to scale prevail, output grows at the same rate as input growth. In other words if both capital and labour increase by 5% then output grows by 5% also, reected in an upward shift of the production function.

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In measuring the changes in labour input, economists usually use average annual hours worked in an economy, which is estimated based on broad surveys of companies usually carried out by national statistical agencies. This measure of labour input is preferred to a measure of the number of workers because of the changing patterns of work for many individuals. Focusing solely on the numbers of workers employed reveals that numbers employed internationally have risen (this is true using historical data going back to 1870) but since part-time work is quite commonplace and given labour policies and regulations, hours worked per person have actually fallen internationally.

9.4.3

THE SOLOW MODEL AND CHANGES IN TECHNOLOGY

The Solow model assumes a given level of technology. Allowing technology to improve, ceteris paribus, allows more output to be produced from a given amount of inputs. This means the production function moves up as shown in Figure 9.5. An economy with an amount K1 of capital can increase its output from Y2 to Y1 given better technology. If the economy begins with K2 capital its output increases from Y3 to Y4. The country with the higher initial capital stock experiences a greater absolute rise in output. We can extend this gure to illustrate that technology improvement is a more important source of growth than increased capital for more industrialized countries, ceteris paribus. This case is shown in Figure 9.6. Imagine two countries with production functions like PF1 that both experience technology improvements allowing their production functions to move to PF2. One country is relatively poor with a low capital stock of K1; the second country has a higher capital stock of K2. Both countries experience the same absolute increase in capital stock.

Output

Y4 Y3 Y2 Y1

PF2 PF1

K1

K2

Capital: K

FIGURE 9.5

IMPROVED TECHNOLOGY

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Output Y2* Y2 Y1* Y1 Improved technology explains a portion of increased output Higher capital stock explains a portion of increased output Capital: K PF2 PF1

K1 K1*

K1 K2*

FIGURE 9.6 IMPROVED TECHNOLOGY: RICH VS. POOR COUNTRIES

K1 rises to K1 as shown in Figure 9.6 while K2 rises to K2 . Since the marginal product of capital is higher for the poorer country with the lower stock of capital, the expansion of its capital stock is responsible for approximately half of its increase in output from Y1 to Y1 . Compare this to the rise in output for the richer country. Because the production function is relatively atter for the richer country since its capital stock is higher, most of the expansion in its output from Y2 to Y2 is caused by the shift in the production function. This implies that developing or non-industrialized countries benet more from increasing their capital stock than do more advanced economies. Advanced economies can expand their output but technology improvements are a relatively more important source of their growth.

9.4.4

EXPLAINING GROWTH: LABOUR, CAPITAL AND TECHNOLOGY

Any change in national output can be explained by changes in capital or labour or technology. More specically a technique known as growth accounting categorizes the separate sources of output changes. Growth accounting is a method of identifying the proximate causes of changes in output and its rate of growth. The main causes are: 1. The marginal product of capital linked to where on the production function an economy produces, ultimately explained by past investment decisions inuencing the capital stock.

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2. 3. 4. 5.

The amount of capital in use. The marginal product of labour. The amount of labour in use Total factor productivity a measure of the efciency with which inputs are employed to produce output. TFP is a catch-all term that measures the effect on output not only of any changes in technology, but also in the social and political systems that affect the quantity and quality of output that an economy can produce from its labour and capital resources. TFP is effectively that portion of output change that cannot be accounted for by changes in the quantity and quality of labour and capital.

Any change in output not accounted for by changes in capital accumulation or changes in labour input is called total factor productivity (TFP). It is also known as the Solow residual growth left unexplained after inputs have been accounted for. The extent to which differences in the quality and quantity of inputs explain differences in productivity across countries is shown in Table 9.5. The rst column indicates each countrys labour productivity expressed as a percentage of that of the United States. The other columns present counterfactual analysis, best interpreted by taking an example. Australias output was measured as 83% of that of the USA. If Australias labour and TFP were the same as in the USA, with capital being the only different factor, its labour productivity would have been 109% of that in the USA. This implies greater relative capital productivity in Australia but since its output is less than the USA, differences in its other input (labour) and/or TFP reduce its overall relative productivity performance.

9.4.5

CONCLUSIONS FROM THE SOLOW MODEL

The level of output is determined by the amount of capital in an economy, given labour and technology. This supports the general observation that countries with substantial capital investments (per worker) have relatively high levels of output and productivity. The long-run equilibrium level of output and capital depends on the savings rate of an economy. In equilibrium the level of capital (and output) is constant. Investment is sufcient to cover depreciation and any growth in the labour force. International evidence indicates high correlations between savings rates and living standards (e.g. Summers and Heston, 1991). An increased savings rate leads to a new equilibrium with higher capital investment and higher output level. A higher savings rate leads to economic growth temporarily until the new equilibrium is reached.

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TA B L E 9 . 5 S O U R C E S O F I N T E R N AT I O N A L PRODUCTIVITY DIFFERENCES
Country
Australia Austria Belgium Canada China Czechoslovakia Denmark Finland France Germany (west) Greece Hungary India Ireland Italy Japan Korea Netherlands New Zealand Norway Portugal Spain Sweden Switzerland United Kingdom

Output per worker as % of US output

83 71 84 94 6 21 69 73 82 82 47 31 9 58 83 59 38 81 72 76 37 68 79 87 73

Capital
109 108 102 100 89 115 108 120 109 112 102 112 71 105 106 112 86 106 112 120 96 102 103 119 89

Labour
90 67 84 91 63 76 91 86 67 80 68 93 45 77 65 80 76 80 102 91 50 61 85 83 81

TFP
86 98 98 103 11 24 71 73 113 91 67 29 27 71 121 66 58 95 63 70 76 111 90 88 101

Source: Excerpted from Data Appendix for Hall and Jones (1999).

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Hence, high savings rates do not generate persistent economic growth.

Growth in the population or labour force matters for living standards. With a growing labour force, ceteris paribus, labour productivity falls. Correlations indicate that countries with fast rates of population growth experience relatively lower levels of living standards. In the steady state, growth can only occur via TFP changes.

The Solow model does not deal with causes of technology improvement since technology is exogenous or not explained within the growth model itself. We can allow technology to become an endogenous factor and such endogenous growth models are considered in section 9.4.6, which follows. The conclusions do not help us understand why some countries do not experience convergence of income levels. We need to look elsewhere to understand this phenomenon. Nor do we have an indication of welfare implications of economic growth, which is also examined in section 9.5.

9.4.6

ENDOGENOUS GROWTH

Endogenous or new growth models essentially try to explain how and why changes in technology occur. Technology is not assumed to be unchanging and the result of things occurring outside the models. Some endogenous growth models discard the assumption of diminishing marginal product of capital so that a change in capital leads to a constant proportional increase in output irrespective of the initial level of capital stock. This implies a rising but linear production function, as shown in Figure 9.7. This means that every one-unit increase in the capital stock increases output by the same amount, irrespective of an economys initial level of capital stock. Adding our assumption about savings being a constant proportion of output, we draw a corresponding savings function, which is also linear. By further including the depreciation line, we complete the essential elements of the model. By denition the steady state occurs where there is no tendency to change from one level of the capital stock. But in Figure 9.7 no such point exists. Investment lies above depreciation indicating that the level of capital stock can rise indenitely without any technological change, allowing output to rise also. Another interesting result from the model occurs with an increase in the savings function. If peoples savings behaviour changes so that savings increase and the savings function moves up, the result is an increase in the economys stock of capital and in its rate of output growth the production function also moves up indicating

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Output

PPF

Savings

Depreciation Capital: K

F I G U R E 9 . 7 P R O D U C T I O N F U N C T I O N W I T H C O N S TA N T MARGINAL PRODUCT
a positive link between savings and a permanent rise in output growth (a new steeper slope of the new PPF indicates a change in the rate of growth). A key issue arises as to the credibility of assuming a constant marginal product of capital. This may be possible if we allow investment to have an impact on the quality of labour, and vice versa. The greater the amount of physical capital (buildings, equipment, machines, etc.) in an economy, the greater the output that human capital (skills, education, etc.) can produce and the higher the return on further investment to improving education and skills to maximize the productivity of physical capital. Each separate component of capital may exhibit diminishing marginal product but in combination, they could give rise to a constant marginal product of combined, or total, capital. Poorer countries with not only low levels of physical capital, but also of human capital, face a double disadvantage in trying to catch up. Not only is investment in physical capital required but spending on training and education is also required and by its nature the return on such investments takes years to yield rewards. Many poorer countries with very limited budgets do not have the luxury of spending in the hope of generating future growth as the opportunity cost of such spending is considered too high. What is important for long-term growth is subordinated to urgent expenditures required today. Growth benets from investment may go beyond individual rms who undertake the investment indicating that diminishing returns to capital may be relevant for a rm but not for society overall. Consider the effect on economic growth of a utility company investing in providing broadband technology. The provider will decide to invest in the broadband technology taking account of its own costs and potential revenues. The provision of broadband technology, however, can increase output and productivity of those rms that adopt it allowing them to increase their

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output for a set amount of inputs. The social benet may outweigh the private benet and create constant or even increasing returns to capital investment for the economy. The potential for such a scenario creates challenges for government and whether or not it should try to encourage capital investments by private rms that generate economy-wide benets. Private rms usually do not take social benets into account in their investment decisions (and consider only their private costs and benets) so maybe government should subsidize investments that give rise to broader economywide benets? This sounds somewhat logical. Yet investment by rms is often in new products and innovations that can be quite costly and often very risky. Innovation that underlies many technological improvements is based on research and development, which does not have a certain outcome. Governments will not be able to correctly gauge which investments will yield positive economic results no more than rms themselves can so it will be a guessing game to decide on how much support to provide for investment purposes. Many examples exist of such supports via favourable treatment of savings, investment, or the provision of R&D tax incentives or tax credits. A generally sound economic system organized around markets and rms where people enjoy property rights that are supported by law, where money fulls its main functions, where modern infrastructure is provided (publicly and/or privately), and where people are free to buy, sell and invest as they choose usually provides an environment that facilitates growth. The extent to which governments facilitate such an environment may be even more important in the context of growth than the funding they might provide in support of research and development.

9.5

INCOME DISTRIBUTION

Information on economic growth provides a partial perspective on living standards across countries because it is an average measure. The living standards of some people in an economy lie above the average while that of others lie below it so that real income is not divided up equally across the population. How real income is divided up both internationally and within countries is an issue of interest from a welfare perspective. Are citizens actually better off if their average national living standards rise? Arguably, you need to examine income distribution as well as living standards in order to get a more comprehensive and

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accurate indication of if and how economies develop and to identify the trend in living standards for the majority of the population. For example, in a country of 5 million people, consider what happens if the income of the richest quarter of the population increased by 5m while the income of the least-well-off quarter fell by 2.5m (all in real terms). Although total real income and average income per capita have undoubtedly risen it does not automatically follow that the society overall is better off because in this example the gap between rich and poor widens. Its a matter of being clear on how economic growth is measured and on what it actually means. Rising average living standards do not necessarily mean that the welfare of all, a majority or even the worst-off citizens in an economy improves. The extent to which income is shared depends on where and by whom the factors of production (land, labour, capital, entrepreneurship, etc.) are held in an economy. If the factors are concentrated in the hands of a small number of individuals (or in a particular region), these individuals (or their region) will be disproportionately wealthier than the vast majority of their fellow citizens (or other regions). Within countries, policies (e.g. tax) are often used by governments to redistribute income to increase some peoples consumption possibilities beyond those provided by their income, in an attempt to close the income distribution gap. The extent to which countries consider this as an issue to be addressed is revealed by their actions and related policies. Addressing income inequality between rather than within countries is somewhat more complicated since it requires international cooperation and formal agreement. Information in Table 9.6 indicates the extent to which income was distributed internationally over the last 40 years relative to world population. It indicates that the developing world (all countries except industrialized countries and Eastern Europe) increased its share of the world population from 71% to 81% since 1960 and also its share of world income from 29% in 1960 to 42% in 2000. While on the basis of Table 9.6 it appears that income is better shared internationally in 2000, income remains concentrated in the countries that make up less than 20% of the worlds population. Since the table does not deal with withincountry income distribution, we cannot say whether inequality has changed within any country. Many people and NGOs (non-governmental organizations) disagree with the international income distribution and attempt to change it through supporting programmes for economic development and cancelling debt repayments for the poorest countries. Clearly, much still remains to be done to bring about a more equitable or fairer international income distribution.

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TA B L E 9 . 6 I N T E R N AT I O N A L I N C O M E A N D P O P U L AT I O N S H A R E S
1960 Region
Developing world

1980 Pop.
71

2000 Pop.
79

Incomea
29

Income
33

Income
42

Pop.
81

of which China and India

Developed world Total

8
71 100

36
29 100

7
67 100

39
21 100

17
58 100

38
19 100

Source: Adapted from Tables 2.2 and 2.3 in Bhalla (2002). a Income is estimated as GDP in PPP terms based to 1993, provided by the World Bank.

Equity in terms of income distribution is an example of vertical equity whereby people with intrinsically different characteristics (education, experience, abilities) would be treated differently in order to reduce the disparate income resulting from their differences. Horizontal equity is a related concept but refers to treating identical people in an identical manner (i.e. not discriminating based on gender or race between individuals who are economically identical and can perform similar tasks). In developed countries, laws and practice appear generally to attempt to achieve horizontal equity. The extent to which countries attempt to achieve vertical equity is more varied, depending on political ideology, preferences and culture.

9.5.1

INTRA-COUNTRY INCOME DISTRIBUTION

Measurements of income of the richest and poorest proportions of a population are used to estimate inequality and allow us to consider the extent to which income has been distributed more or less equitably within countries over time. From Table 9.7 it appears that over the last 40 years income inequality within countries has not substantially changed or improved. Contrary to the data in Table 9.7, Sala-i-Martin (2002) found that global income inequalities fell over the 1980s and 1990s. But in further research published in 2002, Milanovic estimated that the richest 1% of the world population received as much as the worlds poorest 57% . He also found that the ratio between the average

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TA B L E 9 . 7 I N T E R N AT I O N A L I N C O M E D I S T R I B U T I O N WITHIN COUNTRIES
Incomea of poorest 20% Country
Austria Belgium China Czech Republic Denmark Estonia Finland France Germany Greece Hungary India Ireland Italy Japan Latvia Lithuania Luxembourg Netherlands Poland Portugal Slovakia Slovenia Spain Sweden

Incomea of richest 20% 1960

36.6 36.1 36.7 35.1 41.2 32.7 49.3 53.7 37.7 41.7 34.8 41.4 42.2 42.0 45.1 32.8 32.9 34.0 48.4 35.2 46.3 34.2 36.1 35.1 44.0

1960
6.8 7. 9 7.9 8.2 5.0 10.0 2. 4 1.9 10.5 6.4 9. 2 8. 4 4. 8 7.0 5.3 10.4 10.6 10.2 4. 0 9.5 5.8 10.4 10.1 8. 2 4.4

1980
6.6 7.9 7.9 11.4 7.0 10.0 6.6 8.3 6.6 6.4 10.8 8.5 4.9 7.9 6.3 10.4 10.6 10.2 8.4 9.8 5.5 10.4 10.1 8.2 7.0

2000
10.4 9.5 5.9 10.2 6.4 7.0 10.6 7.2 8.2 6.2 9.9 8.7 6.7 8.7 10.6 7.5 6.7 9.4 7.3 7.8 7.3 9.3 9.1 10.2 9.6

1980
38.3 36.1 36.7 32.1 38.0 32.7 40.0 38.5 39.0 41.7 32.4 40.9 43.6 39.1 39.6 32.8 32.9 34.0 36.7 34.5 42.5 34.2 36.1 35.1 39.5

2000
33.4 34.5 46.6 36.4 39.5 45.1 33.6 40.2 38.4 41.2 34.5 41.8 42.9 36.3 35.6 40.4 41.7 36.5 40.0 40.1 43.4 38.6 37.7 33.1 34.6

(continued overleaf )

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353

TA B L E 9 . 7

(continued )
Incomea of poorest 20% Incomea of richest 20% 1960
36.9 41.3

Country
United Kingdom United States

1960
9.4 4.8

1980
10.2 4.3

2000
6. 6 3. 6

1980
37.6 43.6

2000
42.9 49.4

Average: Table Total Average East Europe Average China/India Average Others

7 10 8 6

8 10 8 7

8 8 7 8

39 34 39 42

37 33 39 39

39 39 44 39

Source: Excerpted from Appendix Table C.1 in Bhalla (2002). a Income is income per capita based on survey data measured as GDP in PPP terms based to 1993.

income of the top 5% in the world to the bottom 5% increased from 78 to 1 in 1988 to 114 to 1 in 1993 indicating greater inequality. So what is the correct welfare interpretation of these disparate data? It is a hotly debated issue, as shown by the discussion at www.foreignaffairs.org and an interesting article in The Economist of 11 March 2004 entitled More or less equal?. The Milanovic results are based on household survey data (rather than national income data) which are considered to provide more reliable estimates of income that people actually earn and, hence, more reliable estimates of poverty and inequality. The data period is quite short, however, and probably does not allow for a fair comparison with Sala-i-Martins research. Milanovics nding that inequality increased between 1988 and 1993 due to slower income growth in highly populated Asian countries relative to richer OECD countries also changes if a longer period is examined. Because almost 40% of the worlds population live in China or India, the impact of strong economic growth in both has a considerable impact on measures of inequality that focus on average incomes in these countries (see how these countries fared in Table 9.1). However, again from a welfare perspective, some economists argue that if inequality within China is considered then there are widening urbanrural income disparities emerging there. Further difculties arise in assessing the equality question depending on whether exchange rates or purchasing power parity data are used. Disagreement among economists in the equality debate is more than just an academic exercise. Many critics of capitalism argue that widening inequality is

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THE ECONOMIC SYSTEM

simply a reection of the problems inherent in the capitalist system of order and organization. The above data are not especially helpful in this debate since world income distribution has improved while individual country inequality remains. Irrespective of the debate around rising or falling inequality a renowned Indian economist and Nobel laureate for Economics, 1998, Amartya Sen, considers that the sheer scale of world poverty is still too high, with the concentration of over 80% of world income in the hands of the wealthiest 20% of the worlds population. He argues for greater focus on addressing this central issue. Fortunately, there appears to be agreement among several different researchers that the proportion of the worlds population living on less than a dollar a day (a standard poverty measure) has fallen sufciently over the 1980s and 1990s to offset rising population in developing countries (see Table 9.5). The United Nations goal (announced in its millennium development goals) to reduce the number of people living on less than a dollar a day in 1990 by half by the year 2015 has, they have claimed, been achieved already. Not everyone, however, agrees with these ndings and the debate goes on.

Evidence on convergence?
And what of the convergence debate? Have poor countries (those with low living standards) enjoyed higher growth than rich countries? This is another substantial research area in economics yielding disparate results depending on denition and measurement. In considering this question Fischer (2003) illustrated that if you graph countries levels of living standards in 1980 and their growth until 2000, there is no evidence of convergence. The upward sloping trendline in panel 1 of Figure 9.8 indicates that countries with lower income (in 1980) grew more slowly than countries with higher income (in 1980). He also showed that if you plot each country taking into accounts its share of the worlds population thereby allowing consideration of the number of people in the poorest countries rather than simply the poorest countries you observe convergence since the poorest are catching up in terms of living standards. Many countries, however, still lack the political, social and economic structures required to allow them to reorganize as required to benet from the convergence potential.

Trade and development

In the context of the discussion of developing countries, it is also worth noting that both the United States and European Union maintain trade restrictions that harm developing countries by limiting their ability to export goods. Through the WTO (and its predecessor the General Agreement on Tariffs and Trade)

DEVELOPING THE ECONOMIC SYSTEM

355

An alternative view
Growth in GDP per head 6 Growth in real GDP per head 19802000, % pa 4 2 + 0 2 4 0 5 10 GDP per head 1980*, $000 Growth in GDP per head, proportional to population in 1980 6 Growth in real GDP per head 19802000, % pa 4 2 + 0 2 4 0 5 10 15 GDP per head 1980*, $000 China India 15

Sub-Saharan Africa 1

20

25

USA

20

25
*1996 prices

Sources: Penn World Table: Stanley Fischer.

FIGURE 9.8

C O N V E R G E N C E F O C U S I N G O N P O P U L AT I O N

Source: The Economist Newspaper Limited, London (11 March 2004).

improvements have been attempted but reform has been promised for many years without substantial results. It is still the case that average tariff levels in agriculture (predominantly exported by developing countries) are about nine times those in manufacturing. Industrial countries subsidize agriculture, effectively cutting world prices because of the supply incentive subsidies create for farmers in industrialized countries.

356

THE ECONOMIC SYSTEM

Not only does the EU spend around 2.7 bn per year to make sugar protable for European farmers but it also shuts out low-cost imports of tropical sugar through trade barriers.

Minimizing or overlooking the negative microeconomic effects of trade is a problem with many free-trade advocates. It may well make the free-trade argument more palatable and popular if these issues are dealt with explicitly. In this context the link between the arguments for free trade and for greater focus on national income distribution appear quite close. Both relate to normative judgements on the fairness and equity of the economic repercussions on the least well off of economic measures that may well favour an economy overall and maybe even the majority of its citizens. Economic models showing the welfare improvements to an average or representative citizen hold little weight for those interested in costs borne by minority groups who are not adequately compensated for their losses.

9.6

SUMMARY

Economies undergo transformations as they change and develop. The pace and extent to which real output expands is one measure used to assess economic growth. A broader measure is the human development index of the United Nations. Living standards indicate the average output of an economy per person. Trends in living standards are directly related to and affected by trends in labour productivity

but the two do not necessarily move together.

The Solow growth model provides a useful framework for considering the main causes of economic growth using a production function approach. Persistent growth cannot be explained by investment/savings behaviour. Improvements in technology can explain persistent growth. Technology improvement is a more important source of growth than increased capital for more industrialized countries, ceteris paribus. In the steady state, growth can only occur via total factor productivity changes. Endogenous growth models provide explanations as to why and how changes in technology occur.

DEVELOPING THE ECONOMIC SYSTEM

357

How real income is distributed both internationally and within countries is an issue of interest from welfare and equity perspectives. Some improvement in international income distribution has occurred in the last 40 years with little change in national income distribution Depending on denition, there is some evidence of international convergence in living standards. Internationally trade has been growing faster than production, creating opportunities and generating threats in terms of economic growth, development and restructuring. Focusing on the effects on those worst affected by economic developments (be it trade, growth, etc.) and how they might best be addressed would enhance understanding and functioning of the economic system.

REVIEW PROBLEMS AND QUESTIONS

1. For each of four countries, draw a graph showing both its living standards and productivity. Compare the trends across the two measures in terms of their similarities and dissimilarities. Can you explain their similarities or dissimilarities over time? 2. Draw a production function. What assumptions are made when drawing the production function? Explain why at low levels of capital stock a rise of 100m in the capital stock has a larger effect on output than at relatively higher levels of capital stock. 3. Draw a production function. (a) Add a savings = investment function. Explain why the savings = investment function has a similar shape to the production function you have drawn. (b) Add a depreciation function. Explain why the depreciation function has a dissimilar shape to the production function you have drawn. (c) Use your diagram to explain how the equilibrium output and capital stock are determined. 4. You are given the following information about an economy: number of workers = 8 million average productivity = 124 000 per annum. (a) Compute the value of output of the economy for the year in question. (b) Explain what might happen to: total output; productivity;

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THE ECONOMIC SYSTEM

5.

6.

7.

8.

if 50 000 migrant workers found work in the economy with no change to the capital stock. (c) If you were told that average productivity in the following year changed to 135 000, how would you explain this outcome? What is total factor productivity and how might it be measured? For four countries in Table 9.5 explain whether labour, capital or TFP explains the countrys productivity differential with the USA. Explain the central difference between the Solow growth model and endogenous growth models. Draw a production function that assumes endogenous growth and explain how and why it differs from the standard production function you have drawn for earlier answers. What questions and issues can be analysed by considering (a) the international distribution of income? (b) national distributions of income? What factors, in your opinion, explain recent trends in the international distribution of income? the national distribution of income? (Refer to any three countries in Table 9.7 to answer this question).

FURTHER READING AND RESEARCH

For more on the Japanese model of economic growth and development take a look at Porter et al., 2000. For the original articles providing apparently opposing evidence on inequality see Sala-i-Martin, 2002; Milanovic, 2002. For comprehensive and topical analysis of growth and inequality see Bhalla, 2002. For Sens perspective on economic development see Sen, 1999.

REFERENCES
Bhalla, S. (2002) Imagine Theres No Country. Institute for International Economics, Washington. Cato Online Policy Report (1998), 20(2) March/April, at http://www.cato.org/pubs/ policy report/cpr-20n2-6.html

DEVELOPING THE ECONOMIC SYSTEM

359

Fischer, S. (2003) Globalisation and its challenges, American Economic Association Papers and Proceedings, American Economic Review, 93(2), 130, May. Hall, E. and C. Jones (1999) Why do some countries produce so much more output per worker than others? Quarterly Journal of Economics, 114(1), 83116. Data Appendix as it appears on the link from Halls website at www.stanford.edu/ rehall/CV.htm Heston, A., R. Summers and B. Aten (2002) Penn World Table Version 6.1. Centre for International Comparisons at the University of Pennsylvania (CICUP), October. Kennedy, K. (2001), Reections on the process of Irish economic growth, Journal of the Statistical and Social Inquiry Society of Ireland , 30, read before the Society on 26 April 2001. Milanovic, B. (2002) True world income distribution 1988 and 1993: rst calculation based on household surveys alone, Economic Journal , 112, 5192, January. OECD (2002) Economic Outlook, Annex Table 24, December (www.oecd.org). Porter, M., M. Sakakibara and H. Takeuchi (2000) Can Japan Compete? Macmillan. Sala-i-Martin, X. (2002) The disturbing rise of global inequality, National Bureau for Economic Research Working Paper 8904, April. Sen, A. (1999) Development as Freedom . Oxford University Press, Oxford. Summers, R and A. Heston (1991) An expanded set of international comparisons 19501988, Quarterly Journal of Economics , 327368, May, Supplement (Mark 5.6) to the Penn World Table (Mark 5). United Nations (2002) World Population Ageing, 19502050 . Population Division of the United Nations, Dept of Economic and Social Affairs. United Nations (2003) Trends in Europe and North America, The Statistical Yearbook of the Economic Commission for Europe. United Nations Economic Commission for Europe (available online in the Demographic Database of the Population Activities Unit (PAU-DB) at http://w3.unece.org/stat/pau.asp). Weisbrot, M., R. Naiman and J. Kim (2000), The emperor has no growth: declining economic growth rates in the era of globalization, Centre for Economic and Policy Research, Brieng Paper.

GLOSSARY
Absolute advantage When a product is produced more efciently (using less resources) in one country, that country has an absolute advantage in that product. It is measured by comparing relative output across countries. See also comparative advantage. The demand for output (of all goods and services) at different price levels. See national economic activity. Indicates total planned expenditure in an economy for different levels of income or output (denoted Y ). The amount of output rms are willing to supply at different price levels. Expected ination that is taken into account in economic decision-making. See also unanticipated ination. The increase in value of an asset over time. An appreciation of sterling occurs when 1 buys more foreign currency today than it did yesterday (when it costs more in terms of foreign currency to buy 1). See also depreciation. The possibility of buying an asset in one market and selling it at a higher price in another market. A method for estimating elasticity of demand, based upon average price and average quantity demanded. It is calculated as follows: Qd 1/2[P 1 + P 2] P 1/2[Qd 1 + Qd 2]

Aggregate demand (AD) Aggregate economic activity Aggregate expenditure function Aggregate supply (AS) Anticipated ination Appreciation

Arbitrage Arc price elasticity of demand (arc PED)

362

THE ECONOMIC SYSTEM

It is most appropriately used for large price changes. Arc price elasticity of supply (arc PES) A method for estimating elasticity of supply, based upon average price and average quantity supplied. It is calculated as follows: 1/2[P 1 + P 2] QS P 1/2[QS 1 + QS 2] Asymmetric shocks Economic shocks that affect one economy or a part of one economy more than other economies or other parts of an economy. Measures that automatically counter the business cycle without government action. They result in reducing the response of GDP to changes in autonomous spending. Consumption expenditure that is independent of the level of income. It occurs if people borrow to buy consumption goods or if they spend their savings (or borrow) when they have no income to pay for consumption goods. Total costs per unit of output. AC is computed as total costs divided by output (TC /Q ). Total output divided by the number of workers: Q /L . Average variable cost (AVC) plus average xed cost (AFC): ATC = AVC + AFC. A countrys national account which includes transactions between domestic residents and the rest of the world over a specied period. It consists of a current account and a capital account. Exist when new rms cannot freely enter and compete in a market. With no barriers, all rms competing in the same market would have access to similar technology allowing them to have similar cost structures.

Automatic stabilizers Autonomous consumption

Average cost (AC) Average product of labour Average total cost (ATC) Balance of payments

Barriers to entry

GLOSSARY

363

Bond

Represents an agreement between two parties in a transaction where one party lends money to the other for an agreed rate of interest (usually) over a specied period and where the lender receives back the total value of their investment when the bond matures. The tendency for real output to rise and fall over time in a reasonably regular pattern. A factor of production that has been produced (e.g. machines, factories, tools) and is used with labour to produce and/or market more goods and services. A countrys national account which tracks transactions relating to ownership of nancial assets, including inward and outward direct investment. See also current account, balance of payments. Where the capital stock increases faster than the labour force so that the amount of capital per worker rises. See also capital widening. The amount of capital each worker in the economy (on average) has at their disposal. Where the capital stock increases at the same rate as the labour force and covers depreciation. See also capital deepening. An agreement between rms to co-operate in restricting the amount of output they produce, for example, thereby inuencing the price. See spot or cash markets. Usually implies that a government has no direct input into the economic decisions taken by the central bank regarding money supply, interest rates and ination. From the Latin, meaning all things being equal or unchanged. An assumption that allows economists to construct models that highlight the fundamental nature

Business cycles Capital

Capital account

Capital deepening

Capital intensity Capital widening

Cartel

Cash markets Central bank independence Ceteris paribus assumption

364

THE ECONOMIC SYSTEM

of a relationship they are trying to describe and understand. Subsequently they use their models to incorporate other factors of most relevance to that relationship. Circular ow Commodity The way in which products, services, resources and money ow around the economic system. An undifferentiated product such as wheat or oil or computer memory chips. Commodities are usually of uniform quality, often produced by many different producers where each producers output is considered equivalent or interchangeable. Futures markets exist for many commodity products. When output is produced at a lower opportunity cost in one country, that country has a comparative advantage in production. It is measured by comparing relative opportunity costs between countries. See also absolute advantage. A range of factors from measures of income and prosperity to economic creativity and innovative ability that describe the performance of one economy relative to others. Measures the market share of the biggest rms in the market. For example a CR4 calculates the market share of the leading four rms. Simplied representations of phenomena, which are intended to serve as tools to aid thinking about complex entities or processes. The degree of optimism that consumers express (in surveys, for example) about the state of their economy through their saving and spending patterns and plans. The benet to consumers due to the difference between what consumers actually pay to consume a good and what they would have been willing to pay.

Comparative advantage

Competitiveness

Concentration ratio

Concepts, theories and models Consumer condence Consumer surplus

GLOSSARY

365

Contestable markets Contractionary scal policy Convergence

Markets where entry costs and exit costs from markets are low. A scal policy that results in lower activity and a reduction in the circular ow of income. See also expansionary scal policy. The tendency for poorer countries to grow faster than richer countries for a given increase in capital stock. Hence, poorer countries would be expected to catch up with richer countries if the countries share similar steady states. Caused by rms reacting to increased costs by reducing their output. These are: loss of purchasing power, shoe-leather costs, menu costs, effects on income distribution, scal drag, effects on international competitiveness, effects on balance of payments and business uncertainty and lack of stability. Policies which have the opposite effect on economic activity to that caused by the business cycle, reducing income ows during booms, increasing income ows in recessions. Indicates the responsiveness of the quantity demanded of one good (good A) when the price of another good (good B ) changes. It is computed as % Q d A /% P B . A countrys national account which includes all trade transactions where the balance of trade might be in surplus or decit. It also includes all income and current transfers. See also capital account, balance of payments. Unemployment associated with the recessionary phase of the business cycle. Provides information about the discretionary scal polices a government has followed to deliberately achieve

Cost-push ination Costs of ination

Countercyclical scal policy

Cross price elasticity Current account

Cyclical unemployment Cyclically adjusted budget

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THE ECONOMIC SYSTEM

specic macroeconomic goals. These might include trying to achieve a particular level of ination, or employment or government decit, for example. Deadweight loss Debt nancing Deation Demand Demand for active balances Demand for idle balances The welfare lost to society from relatively inefcient production. Debt nancing results in borrowing money that must usually be repaid with interest. A fall in the average price level. See also ination. The quantity of output buyers are willing to buy over a range of possible prices The transactions and precautionary demands for money are known as the demand for active balances because the money is actively used to buy goods and services. The speculative demand for money is also called the demand for idle balances since it relates to the desire to demand money to avoid potential losses from holding interest-bearing nancial assets. An increase in the price level of an economy caused by rising aggregate demand. The portion of a countrys population not in employment (including the unemployed, those who have retired and children) relative to the total population in employment. Dependents are also often classied as non-economically active as they are considered to consume but not produce economic outputs. The decline in value of an asset over time attributable to deterioration due to use and obsolescence. See also appreciation. Products for which several different varieties are provided (e.g. cars). Differentiation between varieties depends on producers choices of the product attributes for which consumers are willing to pay. See also standardized products.

Demand-pull ination Dependency ratio

Depreciation

Differentiated products

GLOSSARY

367

Direct taxes Discouraged workers

Taxes paid on income. See indirect taxes. Those who have tried to nd work in the past and are willing to take on a job but have given up on looking for work because they feel, or know, that nothing suitable is available. They are excluded from calculations of the labour force, together with groups such as retired people or people who choose to take on home or childcare duties. Inefciencies that are associated with a rms scale of output which varies over the long run; diseconomies of scale are experienced when average costs of output rise as output increases. See also economies of scale. A strategy that provides one rm with the best outcome, irrespective of the strategy another rm (or rms) chooses. The outward expansion of the PPF. Optimum production given the quantity and quality of available factors of production and their cost. A very broad term which includes such economic measures as interest rates, the governments budget decit, the countrys balance of trade account (relating to exports and imports), the level of domestic business condence, the ination rate, the state of (and condence in) the banking and wider nancial sector and consumer condence. An expansion in the quantity of goods/services produced and sold. An economic prot is made if a producer earns enough from supplying their product (or service) to the market to cover all their costs and pay themselves for the cost of the time and effort put into the business. An unexpected event that affects the economy.

Diseconomies of scale

Dominant strategy

Dynamic efciency (economic growth) Economic efciency Economic fundamentals

Economic growth Economic prot

Economic shock

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THE ECONOMIC SYSTEM

Economies of scale

Efciencies that are associated with a rms scale of output which varies over the long run; economies of scale are enjoyed when average costs of output decline as output increases. See also diseconomies of scale. These exist when a rm produces many products and can share resources across them such that the unit costs of each product is lower than if they were produced by separate rms. Shared marketing or distribution costs may be sources of economies of scope. An efciency wage rate lies above the market clearing wage rate to provide motivation for workers, to keep worker turnover low (avoiding costs of hiring) and to act as a signal to attract appropriately skilled workers. All available resources are used to produce a maximum combination of goods/services with no resources unemployed. See price elasticity of demand. Entrepreneurs exploit knowledge by converting knowledge discovered into protable gain. Entrepreneurship is about being alert to a set of opportunities, having a subjective expectation as to the value of such opportunities in the market and having the resources (or ability to generate them) to realize this value. Selling a share of the business (shares) in exchange for nance where no specic future payment is dened. r = i e where e is expected ination. Rearranging this equation gives the Fisher equation. See also ex-post real interest rate. The price of one currency in terms of another. A policy whereby the government manages to increase activity by injecting extra income into the circular ow by changing government expenditure or the tax rate. See also contractionary scal policy.

Economies of scope

Efciency wage

Efcient production Elastic PED Entrepreneurship

Equity nancing Ex-ante real interest rate Exchange rate Expansionary scal policy

GLOSSARY

369

Expectationsaugmented Phillips curve

The expectations-augmented Phillips curve explains ination in terms of a negative relationship between ination and unemployment and a positive relationship between actual ination and expected ination. The formula for the expectations-augmented Phillips curve is actual ination rate = expected rate of ination + X (natural unemployment rate actual unemployment rate) where X denotes a positive number, which is different for different economies. See also Phillips curve.

Experience goods Ex-post real interest rate Externalities

Goods where their quality attributes can only be assessed through trial (or experience). See also search goods. r = i where is actual ination. See also ex-ante real interest rate. Either positive or negative effects of a transaction by one set of parties on others who did not have a choice and whose interests were not taken into account. These are the resources necessary for production. They include land, labour, capital, entrepreneurship in business organization and willingness to take business risks. The number of children born in a year, usually expressed per 1000 women in the reproductive age group. Paper with no intrinsic value itself which fulls the functions of money; government legislation ensures that it is accepted for transactions. Goods that are not purchased for further processing or resale but for nal use. A cost of ination whereby people are pushed into higher tax brackets in a progressive income tax system because tax rates are not fully ination adjusted.

Factors of production

Fertility rate Fiat money

Final goods Fiscal drag

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THE ECONOMIC SYSTEM

Fiscal policy

Governments use scal policy whenever they affect government spending or tax rates (which affect aggregate demand). See also contractionary scal policy, expansionary scal policy, countercyclical scal policy. The nominal interest rate i = r + e . Rearranging this equation gives the ex-ante real interest rate. Costs, such as rent and rates, that must be paid even if the rm produces no output. See also variable costs. An exchange rate that is tied to another countrys rate. An exchange rate that is set by currency demand and supply. Describes the requirement of the banking system that banks must hold a fraction of their deposits in the form of reserves. See also required reserve ratio. Exists due to the non-rival and non-excludable nature of public goods. There is no incentive to supply or pay privately for goods with public-good characteristics. Such goods, if desired, are provided by governments and paid for collectively through taxes. The free-rider problem is one example of market failure, a reason why the market requires government intervention to change what would otherwise be produced. Unemployment that arises because of changes or friction in particular markets. These are: medium of exchange; unit of account; store of value. Markets in which agreements are made relating to a payment that will be made for delivery of goods in the future.

Fisher equation Fixed costs Fixed exchange rate Floating exchange rate Fractional reserve system Free-rider problem

Frictional unemployment Functions of money

Futures markets

GLOSSARY

371

Game theory

A microeconomic approach or tool of analysis applied to understand the behaviour of individuals and rms. Pay-offs generated by following different strategies can be compared. A location-based measure of economic activity which measures the value of real output produced in an economy. The value of new capital created by investment plus depreciation. See net investment. GNP is also called gross national income (GNI), since national economic activity is the same whether measured in terms of output (the product in GNP) or income that is generated by citizens providing their factor resources to markets for payment. The value of real output that is retained by the citizens in a country after all inows and outows are allowed for. A method of identifying the proximate causes of changes in output and its rate of growth. Measures the market share of all rms in an industry by summing the squares of each individual rms market share:
N

Gross domestic product (GDP) Gross investment Gross national income (GNI)

Gross national product (GNP) Growth accounting Herndahl Index

H =
1

Si2

where Si denotes each rms market share and summation is from rm 1 to N , the total number of rms in the market. The squared term indicates that industries consisting of rms with large market shares will have high indices. See market concentration. Horizontal equity Treating identical people in an identical manner (i.e. not discriminating based on gender or race between individuals who are economically identical and can perform similar tasks). See also vertical equity.

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THE ECONOMIC SYSTEM

Human capital

Includes all the skills, knowledge and expertise that people accumulate over time that allow them to increase their productive capacity as individuals, members of rms and within society more broadly. Rates imposed by governments on imported goods, which raise the price paid by consumers, thereby making the goods less attractive to buy. The adjustment in quantity demanded due to the change in real income alone caused by a price change. Measures the responsiveness of the quantity demanded of a good to changes in consumers income (Y ). It is computed as % Qd/% Y. Arises when the strategic choice of one rm affects the performance of another due to strategic reaction by a third rm. Indirect taxes are paid on expenditure whereas direct taxes are paid on income. See price elasticity of demand. A good for which demand rises if real income falls or for which demand falls if real income rises. A rise in the average price level. Ination = rate of money supply growth rate of real output growth See also deation. The difference between equilibrium output and actual output when an economy is producing above its potential long-run level. Exist when one party has more information than another party in an exchange agreement. Injections into the circular ow of income include: investment expenditure by rms; government expenditure; income earned as payment for exports. See also leakages.

Import tariffs

Income effect Income elasticity of demand Indirect competition Indirect taxes Inelastic PED Inferior good Ination

Inationary gap

Information asymmetries Injections

GLOSSARY

373

Intermediate goods Investment function Labour Labour market exibility Labour productivity

Goods sold by rms to other rms and used in making nal goods. This describes the macroeconomic or aggregate investment behaviour in an economy. All human resources used in production. The ability of the labour market to adjust to economic shocks. The average output of each worker in the economy. It is generally measured as the value of a countrys production per worker, e.g. UK national output divided by the employed workforce of the UK for a particular period of time. All natural resources including minerals and other raw materials. When a rm adds workers to a given amount of capital machinery, equipment, etc. it eventually leads to a less efcient match between labour and capital to the extent that, if all capital is used by workers, hiring an additional worker will only lead to workers getting in each others way and the marginal product of labour declining. Leakages of income out of the circular ow include: savings; taxes; income paid for imported goods. See also injections. The level of material well-being of a citizen. It is generally measured as the value of a countrys production per person, e.g. UK national output divided by the population of the UK for a particular period of time. A vertical line drawn at potential output.

Land Law of diminishing marginal returns

Leakages

Living standards

Long-run aggregate supply (LRAS) curve

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THE ECONOMIC SYSTEM

Macroeconomics

The study of: The relationships between aggregate or combined elements in the economic system such as national production and employment. Causes of changes in aggregate economic performance including economic structure and economic institutions. The process of considering the effect of small changes in one factor relevant to an economic decision (e.g. on output levels or pricing) and identifying whether an economic objective will be met. The objective may relate to prot maximization, benet maximization, cost minimization or revenue maximization as examples. The logic of marginal analysis is that a small incremental change should be made once an economic objective is met there is economic rationale to increasing price only if prots rise, if that is the economic objective. If no change enhances the economic objective (if it is already maximized/minimized) the decision variable should be changed no further. It is a method for optimizing decision-making within a reasonably well-dened setting. The change in total costs as output changes ( TC / Q ). The change in the quantity of output produced by each additional worker: Q / L .

Marginal analysis

Marginal cost (MC) Marginal physical product of labour (MPPL) Marginal propensity to consume (MPC) Marginal rate of substitution

The relationship between a change in income and the resulting change in aggregate consumption expenditure. At different points on the indifference curve, the consumer is willing to trade different amounts of one good for another good. This is also reected in the slope of the indifference curve at any point. The change in total revenue associated with a change in quantity demanded.

Marginal revenue

GLOSSARY

375

Marginal revenue function

Shows the amount of additional revenue generated for a rm at different levels of quantity demanded. It is computed as the change in total revenue divided by the change in output: TR / Q . The change in total revenue (price of output number of units sold) generated by each additional worker. It is computed by multiplying the product price by the marginal physical product of labour. The change in total utility for each additional good/service consumed. It is estimated as TU / Q . The number of rms in a specic market and their relative market share. See also Herndahl Index. Occurs when economic resources are not allocated efciently caused by the price system working imperfectly. The reduction of barriers to the free movement of goods and services to encourage entry by new competitors. Exists when rms in a market hold a sufciently large market share that their actions can change the price of their product producing more results in a falling equilibrium price, producing less leads to a rise in equilibrium price, ceteris paribus. This describes the main characteristics of an industry, such as the level of concentration, the extent of entry barriers and the extent of product differentiation. Examples of market structures are monopoly, perfect competition, monopolistic competition and oligopoly. Situations where exchange occurs between buyers and sellers or where a potential for exchange exists. Markets cover the full spectrum from physical locations where buyers and sellers meet to electronic markets (such as auction websites) facilitated by the Internet. A cost of ination to rms and shops, which have to reprint price lists during periods of ination because of frequent price changes.

Marginal revenue product of labour (MRPL) Marginal utility Market concentration Market failure Market liberalization Market power

Market structure

Markets

Menu costs

376

THE ECONOMIC SYSTEM

Microeconomics

The study of the causes and effects of the behaviour of individual economic units within the economic system (or groups with broadly similar interests and goals) such as consumers, producers, trades unions, rms and their impact on the markets in which they interact. The size/scale of plant required if a rm wishes to produce sufcient output to allow it to produce at its minimum long-run average cost. Wage rate set by the government below which employers are not legally permitted to pay workers. Employers are free to pay workers above this wage rate if they choose. The means by which the supply of money is regulated in an economy, including how ination is controlled and how the stability of the currency is maintained. How a change in money supply leads to an ultimate change in money supply by a multiple of the initial change. The size of the money multiplier depends on the required reserve ratio according to the formula: Money Multiplier = 1 required reserve ratio

Minimum efcient scale (MES) Minimum wage

Monetary policy

Money multiplier

Monopolistic competition

A market structure where there are many rms, each with some power to set the price of their product because they supply a particular brand of product they differentiate their product but where many imperfect substitutes are available. A market structure where there is just one prot-maximizing rm in a market. We hold money or demand money (in more liquid forms) for different purposes for transactions, as a precautionary measure and for speculative purposes. These are known as the motives for holding money. Indicates how much income/output changes after a change in autonomous expenditure. It is calculated

Monopoly Motives for holding money

Multiplier

GLOSSARY

377

according to the following formula: 1 (1 MPC ) Nash equilibrium National economic activity Exists when each player in a game chooses their best strategy given the strategies followed by other players. National economic activity is the sum of activity by all of the economic decision-makers including households, producers and government. For this reason it is also called aggregate economic activity. National output or income, denoted Y, is calculated as the value of all the goods bought for consumption purposes; C plus all the investment expenditures by rms; I plus all government expenditures; G plus the net value of all goods traded by the economy, exports minus imports: X M. Where scale economies imply that only one rm could supply efciently, i.e. at low cost to the market. The rate of unemployment that would prevail when the labour market is in long-run equilibrium some people choose to change jobs and even in boom periods it can take a worker time to nd a job best suited to their skills. Investment which creates new capital assets, whereas gross investment includes the value of capital depreciation plus new capital investment. The difference between GDP and GNP.

National output or income

Natural monopoly Natural rate of unemployment

Net investment

Net property income from abroad Normal (economic) prot Normal good

The minimum prot a rm is willing to make rather than go out of business. Any level of prot beyond this is called supernormal prot. A good for which demand falls if real income falls or for which demand rises if income rises.

378

THE ECONOMIC SYSTEM

Offshore outsourcing

Offshore outsourcing (known as offshoring in the United States) involves relocation of elements of the supply chain to a foreign location for more efcient production. Both production and services may be outsourced. See offshore outsourcing. A market structure where there are a few rms of large size relative to the total market, so each rm has some degree of market power. When the central bank buys or sells government bonds. The cost of what is given up in following one course of action such that other choices are no longer possible. It is subjective and can be estimated in terms of the cost of the next-best preferred alternative but only when the choice made cannot be reversed. This identies the factors that determine whether a single currency maximizes single-currency benets for members given the costs generated. The difference between potential output (also known as full employment output) and actual output. A market structure where there are many rms, each small relative to the overall size of the market. The relationship between unemployment and ination, which is negative, meaning that high unemployment is associated with low ination and vice versa. See also expectations-augmented Phillips curve. The term given to the study of how the rules, regulations, laws, institutions and practices of a country (or a state, region, province) have an inuence on the economic system and its features. A countrys output level if all resources were fully employed.

Offshoring Oligopoly

Open-market operation Opportunity cost

Optimal currency area (OCA) theory

Output gap

Perfect competition

Phillips curve

Political economy

Potential output

GLOSSARY

379

Poverty trap

A poverty trap (also sometimes known as an unemployment trap) exists when the opportunity cost of moving from unemployment benets to paid employment is too high. Unemployed workers are often entitled to various benets in addition to unemployment payments. These may include housing or rent allowances, reduced medical costs, food vouchers, etc. On taking up paid employment, especially of a low-paid nature, the benets foregone may be less than the wages earned. A vicious circle of poverty can be created which is difcult to break. A method for comparing benets in different time periods in order to compare the future receipt with a current receipt of the same value. The standard formula used to determine present value is PV = X (1 + r )T

Present value (PV) determination

Price cap Price ceiling Price elasticity of demand (PED)

where PV denotes present value; X is the amount to be received in the future; r is the market interest rate; T is the number of years before the investment is repaid. See price ceiling. A price that puts an upper limit on the price that suppliers can charge. The responsiveness of quantity demanded to a change in price. It is calculated as: PED = % Qd /% P PED differs at different points on the demand curve. In absolute terms (ignoring the minus sign) PED is greater than one when the percentage change in quantity demanded is greater than the percentage change in price. This is elastic PED. PED is less than one when the percentage change in quantity demanded is less than the percentage change in price. This is inelastic PED.

380

THE ECONOMIC SYSTEM

Price elasticity of supply (PES)

The responsiveness of quantity supplied to changes in price. It may be elastic, inelastic or unit elastic. It is computed as the proportional change in quantity supplied divided by the proportional change in price: % QS /% P

Price oor

A price that suppliers can be sure to receive for their output. Where either a dominant rm in the industry sets price and all others follow or a well-established rm becomes the leader and is trusted with setting the price that all rms will charge. See prot margin. Exists when the equilibrium from a game generates a sub-optimal outcome for all parties involved. With commitment (or a binding contract) between the rms, higher pay-offs could be achieved to the benet of all players. The sale of government-owned businesses (and associated assets) in whole or in part to the private sector. Examples include electricity, gas and telecommunications industries. The benet to producers due to the difference between the price suppliers are willing to receive for their output and what they actually receive. The features or attributes that explain consumers decisions to buy one variety or brand instead of another are the basis for product differentiation. A relationship describing how economic activity, specically output, depends on the factors of production

Price leadership

Price-cost margin Prisoners Dilemma

Privatization

Producer surplus

Product differentiation

Production function

GLOSSARY

381

and technology. It describes a technically efcient use of the factors of production and technology necessary to produce output, i.e. no resources are unemployed. Prot margin The mark-up over costs that a rm makes or wishes to make. Some rms will be happy to earn low mark-ups, other rms wish to earn high mark-ups. Also called the price-cost margin. A tax system in which individuals pay a higher percentage of their income in tax, the more they earn. Goods that would not be provided in a free-market system. They are goods that

Progressive income tax system Public goods

if consumed by one person can still be consumed by others; non-rival in consumption. Private goods once consumed are not available to others. if provided, cannot be excluded from the consumption of anyone who desires the good, even if they do not wish to pay for it. Public goods are non-excludable in consumption.

Purchasing power parity (PPP)

A measure of the relative purchasing power of different currencies. PPP is the exchange rate that equates the price of a basket of identical traded goods and services in two countries. It is often very different from the market exchange rate. M V =P Y where M denotes the nominal money supply in an economy, V denotes velocity of money, P denotes the average price level, Y denotes the level of real economic activity and hence P Y is the nominal value of economic activity (i.e. income or output).

Quantity equation

Quotas

Quantitative restrictions set by governments on the amount of imports permitted from another customs area. Because quotas limit the supply of a good, they drive the price of the good up.

382

THE ECONOMIC SYSTEM

Real business cycle (RBC) theory Real interest rate (r)

This theory is based on the view that changes in technology explain business cycles. This is computed as the difference between the nominal interest rate and the rate of ination. r =i where i denotes the nominal rate and is the rate of ination.

Realignments Recessionary gap Regulatory capture

Simultaneous and coordinated devaluation or revaluation of currencies. In a recession, the difference between the level of potential output and the lower actual output. Where regulations set up to protect consumers to lead to greater competition and lower prices become captured by the industry for the benet of producers in that industry. This happens where producers can convince the regulator to introduce rules favouring producers. The percentage of all deposits received by banks that must be held in the bank and not used for loans or other purposes. The lowest wage a worker will accept to take a job. Goods where their quality attributes can be assessed before purchase. See also experience goods. Non-material or intangible items of consumption that are consumed as they are created. The effect of people holding less currency during periods of ination, thereby needing to make more trips to the bank to withdraw cash. The period of time it takes for a rm to change its scale of production and this depends on its xed factor of production usually capital.

Required reserve ratio Reservation wage Search goods Services Shoe-leather costs

Short run

GLOSSARY

383

Speculative demand for money Spot or cash markets Standardized products Standardized unemployment rate

See demand for idle balances. Markets where money changes hands today for goods or services received today. Products for which many substitutes are available and which use readily available technology in their production. See also differentiated products. The standardized unemployment rate measures those unemployed as people of working age without work who are available to start work within two weeks and who are actively seeking employment. The term used by Solow to describe the equilibrium state of output and capital stock in the long run. (The term is also used in physics.) An economy that reaches a steady-state level of capital stock and level of output has no tendency to change from these levels, ceteris paribus. Unemployment arising from a permanent decline in employment in industries located in a particular region or area. A payment or a tax concession from the government that reduces producers average production costs. The adjustment in quantity demanded due to the change in relative prices alone, i.e as the price of one good increases, people buy less of it preferring its relatively cheaper substitutes. See normal prot. The activities of rms that organize the factors of production to produce output and make it available to buyers. The resources and processes that are involved in acquiring components and raw materials and includes delivery of end products to nal consumers. It includes

Steady state

Structural unemployment Subsidy Substitution effect

Supernormal prot Supply

Supply chain

384

THE ECONOMIC SYSTEM

the activities of sellers, distributors, manufacturers, wholesalers and any other service providers and contributors to the buyers decision to buy. Tacit knowledge Knowledge that is highly personal, not easily visible or expressible and cannot easily be copied. It usually requires joint, shared activities in order to transmit it. Examples of tacit knowledge include subjective insights, intuitions and hunches. See import tariffs. The difference between the real wage paid by an employee and the real wage received by an employee. Differences are accounted for by payroll taxes (usually related to social insurance/security contributions), income taxes, consumer price taxes. The sum of variable costs and xed costs incurred by a rm. A measure of the efciency with which inputs are employed to produce output. TFP is a catch-all term that measures the effect on output not only of any changes in technology, but also in the social and political systems that affect the quantity and quality of output that an economy can produce from its labour and capital resources. TFP is effectively that portion of output change that cannot be accounted for by changes in the quantity and quality of labour and capital. Price times the quantity of goods sold: TR = P Q . The total benet perceived by the consumer from consumption of a good/service. Policies or practices that reduce the amount of imports into a country. Examples include import tariffs and quotas. The complete price plus non-price costs of a transaction, including search, information, bargaining and policing costs.

Tariffs Tax wedge

Total costs (TC) Total factor productivity (TFP)

Total revenue (TR) Total utility (TU) Trade barriers

Transactions costs

GLOSSARY

385

Unanticipated ination Unemployment trap Variable costs (VC)

Ination that takes people by surprise and therefore has not been taken into account in economic decision-making. See also anticipated ination. See poverty trap. Costs that depend directly on the amount of output a rm produces, such as the costs for production inputs and workers. The higher the quantity produced the higher the variable costs. See also xed costs. Treating people with intrinsically different characteristics (education, experience, abilities) differently in order to reduce the income disparity resulting from their differences. See also horizontal equity.

Vertical equity

INDEX
absolute advantage 378, 135 AC see average costs ACEA see European Automobile Manufacturers Association acquisition 234 active labour market policies 315 advantages of single European currency 277 advertising 215, 226 Aer Lingus 235 AFC see average xed costs aggregate consumer behaviour 1037 aggregate demand 1725 aggregate economic activity 17071 aggregate expenditure 1723 aggregate supply 171, 1757, 269 Airbus 2056, 233 alliance of economic perspectives 279 allocation of resources 187 ALPS see active labour market policies alternative targets for monetary policy 27072 xed and oating exchange rates 27072 Taylor rules and economic judgement 272 analysis of unemployment 2913 classical approach 2912 Keynesian approach 2923 analytical tools 138 anti-competitive practices 17, 226, 315 anti-pollution systems 52 anticipated ination 3045 antitrust 231 applications of elasticity analysis 989 appreciation 255, 258 arbitrage 25960, 277 arc price elasticity 96 articial scarcity 17 Asian Tiger 330, 337 assembled knowledge 589 assumption of rationality in economics 834 ATC see average total cost attribute combination 102 attribute model 1013 Austrian perspectives on competition 2213 Austrian School of Economics 200, 204 automatic stabilizers 188 autonomous consumption 104, 1789 autonomous investment 143 average costs 12531 explaining U-shaped cost curves 12631 and prot maximization 133 average xed costs 1234 average output 12023 average product of labour 121 average relationships 1223 average total cost 125

BA see British Airways backward bending 71 balance of payments 275, 305 Bank of England 266 Bank for International Settlements 259 banking system 244 bankruptcy 202, 235, 264 banning smoking 109 bargaining power 309, 313 barriers to entry 135, 199, 315 basket of goods 172 benchmark 209 benets of competition 232 benets of international trade 1846 benets of monopoly 213 best practice 314, 325 beyond demand 77112 aggregate consumer behaviour 1037

388

THE ECONOMIC SYSTEM

beyond demand (continued ) consumer choice and product attributes 1013 consumer satisfaction utility 814 consumers response to price changes 93100 demand, consumers and consumer surplus 9092 demand and the importance of consumers 7881 government policies consumer focus 1079 introduction 778 marginal utility, prices and law of demand 8490 see also consumers; demand beyond supply 11354 rms in economic action 11415 rms investment behaviour 1424 government inuence on supply and production 14450 introduction 11314 maximizing prots in the long run 1318 organizing economic system around rms 11531 producers response to price changes 14042 supply, producers and producer supply 139 see also rms; supply bid down price 212 Big Mac Index 4 black market 152 BMW 49 Boeing 2056, 233 bond rankings 265 bonds 2638, 304 ination and interest rates 2668 boom 160, 273, 298, 306 borrowing 1056 bounded rationality 84 brand loyalty 212, 21415 breakfast cereals 1013

bringing AD and AS together 1778 British Airways 235 broadband 3489 budget decit 189, 276 budget line 87, 89 business cycle 15865 explanations/causes of business cycles 1614 implications for business and government 165 and real output 15865 business uncertainty 305 buyers income 434

Cambridge School of Economics 14 capital 23, 303, 3345, 3445 capital deepening 342 capital goods 234 capital intensity 191 capital requirement 212 capital resources 27 capital stock investment 3356 capital widening 342 cartel 216, 301 cash market 261 caste system 5 Caterpillar tractors 185 causes of business cycles 1614 causes of change in exchange rates 25860 causes of differences in natural unemployment rate 31214 Celtic Tiger 330 central bank independence 255, 268 central banks 162, 2425 money multiplier 2445 central planning 61 centralized decision-making 2022 ceteris paribus assumption 89, 13, 424, 160, 331 CFC gases 147 challenges for car producers 130

INDEX

389

challenges for the economic system 283320 cross-country differences 31417 ination 296305 introduction 2834 linking unemployment and ination 306314 unemployment 28496 Chamberlin, Edward 213 change 223 changes in equilibrium 55 changes in inuences on demand 456 changes in labour input 3413 changes in technology 3434 chlorouorocarbons 147 Chrysler 130 circular ow 1568 classical approach to unemployment analysis 2912 classication of dangerous substances 52 Clayton Act 1914 231 co-operative equilibrium 221 Coca-Cola 90, 234 Coke see Coca-Cola collective wage-bargaining 29091, 315 collusion 21619, 301 comfort products 45 commodity 1823 Common Agricultural Policy 57 comparative advantage 39 comparative measures of economic activity 168 competition 134, 197238 alternative models of competition and market structure 204221 Austrian and traditional perspectives: a comparison 2213 benets of 232 in the economic system 198204 government regulation of competition 22635 introduction 1978 when markets fail 2236

competition policy 23035 implementation of 2325 principles 2312 competition spectrum 229 competitiveness 28, 276 complements 423, 51 components of real output 16570 other measures of economic activity 1678 computation of multiplier 179 concentration ratio 205 conclusions from the Solow model 3457 congestion charge 43 consideration of the euro 2748 constant returns to scale 129 constraints 116 consumer choice 1013 consumer condence 17, 445 consumer focus 1079 consumer preferences 90 consumer price index 299300 consumer response to price changes 93100 applications of elasticity analysis 989 other elasticity examples 99100 price elasticity of demand 948 consumer satisfaction 814 assumption of rationality in economics 834 consumer surplus 9092, 289 consumer theory 15 consumer welfare 92 consumers 77112 aggregate consumer behaviour 1037 choice and product attributes 1013 consumer surplus and consumer welfare 92 demand and consumer surplus 9092 demand and importance of 7881 as focus of government policies 1079 marginal utility 8490 response to price changes 93100 and utility 814 consumption function 104, 107, 108

390

THE ECONOMIC SYSTEM

consumption goods 77, 7981 consumption smoothing 2612 containerization 183 contestable market 202 contracting out 49 convergence 337, 354, 355 convertible bond 264 copyright 153 cost disadvantage 212 cost-push ination 2967, 308 costs of rm 1235 costs of ination 3045 costs of international trade 1846 costs of unemployment 28596 countercyclical scal policy 188 CPI see consumer price index CR see concentration ratio creative destruction 164, 236 credit cards 24042 cross-country differences: unemployment and ination 31417 employment legislation 31617 cross-price elasticity 100 currency stability 273, 276 cyclical unemployment 287 cyclically adjusted budget 189

Daimler 130 deadweight loss 211, 225 dealing with AS and AD shocks 187 debt 303 debt nancing 264 decentralized decision-making 612 decision-making 1622, 612, 7071, 11617, 2535 decisions of rms 11617 decline in trade barriers 182 deation 171, 299 demand 3576, 7881, 9092 consumers and consumer surplus 9092 in the foreign exchange market 256 and importance of consumers 7881

non-price determinants of demand 426 see also beyond demand; law of demand demand for balances 2467 demand for bonds 265 demand for credit 304 demand curve 4041, 46 demand for money 2467 demand schedule 41, 46 demand shock 188 demand-decient unemployment 292 demand-pull ination 2967 demography 339 dependency ratio 32731 depreciation 1423, 169, 255, 271, 3356 depression 80 description of economic relationships 914 determinants of demand non-price 426 determination of exchange rate 2578 devaluation 271, 276 development of the economic system 32160 economic growth over time 3312 income distribution 34956 introduction 322 living standards and labour productivity relationships 32231 modelling economic growth: Solow growth model 33349 differentiated product 199 diminishing returns 127, 215, 348 direct competition 233 direct taxes 169 dis-saving 1056 discouraged workers 284 discovery 2014 diseconomies of scale 127, 130 disequilibrium 72, 311 disposable income 43, 44 distortion 146 dominant strategy 21718 domino effect 178

INDEX

391

Dr Pepper 234 durable consumption goods dynamic efciency 267

43, 79

easyJet 130, 233 ECB see European Central Bank economic action 11415 economic activity 15596 another perspective on 19092 and the circular ow 1568 equilibrium economic activity 17078 equilibrium economic activity and the multiplier 17881 government activity 18792 international integration 1817 real output and the business cycle 15865 real output and its components 16570 see also macroeconomy economic analysis 7, 138 economic approach 69 economic efciency 3 economic fundamentals 26061 economic growth 3, 330 economic growth over time 3312 economic judgement 272 economic and monetary union 275 economic perspectives 279 economic prot 468 see also normal prot economic relationships 914 economic resources and markets 26 economic shock 161, 270, 273, 316 economic system 134 alliance of economic perspectives 279 competition in 197238 describing and interpreting economic relationships 914 economic resources and markets 26 economics approach: theory-based analysis 69 introducing the economic system 12 microeconomics and macroeconomics 1418

positive/normative economics 2930 resource scarcity and prices in the economic system 1822 resource use, opportunity costs and efciency 227 economic theory 7 economies of scale 127, 210213 economies of scope 215 economy as a production function 19092 effects of ination on income distribution 305 effects on production of environmental taxes 1478 efciency 23, 227, 1336, 198 efciency wage 290 efcient production 24 elastic PED 967 elasticity see price elasticity of demand elasticity analysis 989 elderly dependency ratios 329 employment legislation 31617 EMU see economic and monetary union End of Life Vehicles EU directive 50, 52, 74 endogenous growth 3479 Enron 17 entrepreneurship 23, 2014, 350 environmental taxes 1478 equilibrium 55, 63, 712 in the labour market 712 equilibrium economic activity 17081 aggregate demand 1725 aggregate supply 1757 bringing AD and AS together: the short run 1778 and the multiplier 17881 price level 1712 equilibrium price 535, 91 equity nancing 264 ERM see exchange rate mechanism euro 2559, 2748 how it scores under the four OCA factors 2778

392

THE ECONOMIC SYSTEM

European Automobile Manufacturers Association 74 European car industry 11112 European Central Bank 179, 242, 25051, 258, 271, 277 European Monetary Union 189 evidence on convergence 354 ex-ante real interest rate 2534 ex-post real interest rate 2534 exchange 3640, 24041 and money 24041 exchange rate 25560, 27072 causes of changes in 25860 determination 2578 exchange rate mechanism 275 expansionary scal policy 188 expectations of ination 2535 expectations-augmented Phillips curve 3067 expectations-generated ination 308 expected future prices 44, 51 expenditure approach 165 expenditure categories 156 experience curve effect 212 experience goods 225 explaining U-shaped cost curves 12631 explanation of business cycles 1614 explanation of growth 3445 explanation of international productivity differences 346 explanation of international trade growth 1824 extent of competition in the economy 198204 competition as a process 199201 entrepreneurship, discovery and market process 2014 externalities 147, 224 factor earnings 169 factors of production 2, 4850 fallacy of composition 106, 186 Federal Reserve 242, 250, 258, 272 female participation in the workforce

316

fertility rate 329 at money 241 nal goods 168 Finance Act 2001 108 nancial markets 23982 foreign exchange market 25560 international monetary integration 2728 introduction 23940 liquidity, central banks and money supply 2425 monetary policy 26872 money demand 2467 money and exchange 24041 money market: demand and supply 24751 quantity theory of money and explaining ination 2515 speculation in markets 26068 rm output 12023 see also product rms 11354 in economic action 11415 government inuence on supply and production 14450 investment behaviour 1424 maximizing prots in the long run 1318 organizing economic system around 11531 producers response to price changes 14042 supply, producers and producer surplus 139 rst-mover advantage 136 scal drag 305 scal policy 188, 298 Fisher equation 254 xed costs 1234 xed exchange rates 27072 xed factors of production 116 oating exchange rates 27072 oor prices 141 food labelling 52, 226

INDEX

393

foreign bond 264 foreign exchange market 158, 25560 causes of changes in exchange rates 25860 demand in 256 exchange rate determination 2578 supply in 2567 fractional reserve system 244 Franklin, Benjamin 164 free entry 202 free-market outcome 35 free-market system 612, 204, 289 free-rider problem 22 frictional unemployment 2867, 291, 308 Friedman, Milton 306 full employment output 272 full-time workers 316 functions of money 24041 futures market 261 game of chance 222 game theory 21720 gas emissions 147 GDP deator 300 General Agreement on Tariffs and Trade 186, 354 golden rule level of capital 34041 government activity 18792 economy as a production function 19092 government contribution to ination 3034 see also ination government effect on prices 568 price ceiling 567 price oor 57 problems of price ceilings and oors 578 government expenditure 115 government inuence on supply and production 14450 government policies 1079 government regulation of competition 22635

competition policy 23035 competition spectrum 229 structure, conduct and performance 22930 government regulations 52, 204 Great Depression 8081, 164 Greenspan, Alan 250 grey imports 1523 grey market for cars 1523 Groningen Growth and Development Centre 193 gross domestic product 16670 what it does not measure 16970 gross national income 43, 166 gross national product 16870 what it does not measure 16970 growth accounting 344 growth differential 2589 growth of the economic system 3, 32160 haggling 62 hard investment 336 Harmonized Index of Consumer Prices 193 Hayek, Friedrich August von 6061, 75, 200, 223, 230 hazardous waste 74 HDI see human development index health and safety standards 226 Herndahl Index 205 Hitler, Adolf 81 horizontal equity 351 household saving rates 33840 how euro scores under the four OCA factors 2778 human capital 24, 296, 348 human development index 324 Iberia Airlines 235 IBM 222 idiosyncratic knowledge idle balances 2467

59

394

THE ECONOMIC SYSTEM

illegal accounting methods 17 ILO see International Labour Organization imperfect competition 205 implementation of competition policy 2325 implications of business cycles 165 implications of change in inuence on demand 456 implications of market failure 2256 implicit collusion 21617 importance of consumers 7881 consumption goods 7981 incentive 21, 39, 51, 142, 355 income 16870 income distribution 105, 305, 32160 intra-country 3516 welfare perspective 34951 income effect 42, 8790 income elasticity of demand 99100 income injection 158, 298 income method of measuring economic activity 1678 increased quality of labour 27 increased quantity of labour 26 increasing opportunity costs of production 25 independence of central banks 255, 268 index numbers 10 indifference curve 878 indirect competition 233 indirect taxes 169 individual supply decision 7071 indivisibilities in production 128 industry labour demand curve 64 inelastic PED 96 inelastic PES 140 inferior good 89, 99 ination 171, 2515, 26672, 276, 283320 bonds and interest rates 2668 costs of anticipated and unanticipated ination 3045

cross-country differences: unemployment and 31417 governments contribution to ination 3034 ination expectations, interest rates and decision-making 2535 inationary gap 2979 linking unemployment and 306314 measurement of 2967 trends in international price levels 299303 see also challenges for the economic system ination differential 2589 ination expectations 2535, 304 inationary gap 2979 inuences on demand 456 inuences on supply and production 14450 environmental taxes 1478 international trade 1457 tax incidence 14950 using subsidies 1457 information 5862 decentralized decision-making 612 information asymmetries 2236 innovation 21, 163, 198200 innovation incentives 21 input see labour input insideroutsider model 303 intellectual property 153 intention 40 interest rate differential 258 interest rate effect 1745 interest rates 24851, 2535, 2668, 276, 304 bonds and ination 2668 and decision-making 2535 intermediate goods 168 international business cycle 159 see also business cycle international competitiveness 305 international dependency ratios 328 international ination rates 300

INDEX

395

international integration 1817 benets and costs of international trade 1847 explaining growing international trade 1824 see also international trade International Labour Organization 285 international monetary integration 2728 considering the euro 2748 international price level trends 299303 international trade 1457, 1817 benets and costs 1847 explaining growing international trade 1824 international trade effect 175 interpretation of economic relationships 914 intervention 226 intra-country income distribution 3516 evidence on convergence 354 trade and development 3546 introduction to the economic system 12 inventory 45, 1423, 202 inventory investment 79 investment behaviour of rms 1424 investment in bond markets 2636 investment function 1434 invisible hand concept 60 see also Smith, Adam Iranian Revolution 302 Irish Special Savings Investment Accounts 108 irrational exuberance 250 Keynes, John Maynard 164, 292 Keynesian approach to unemployment analysis 2923, 298 knowledge 5862, 2012, 2213, 230 see also information Kyoto Protocol 147 labour demand 6470 labour input 325, 3415 labour laws 165

labour market 6472, 28990 equilibrium in the labour market 712 labour demand 6470 labour supply 7071 labour market analysis 28691 labour market exibility 316 labour output see output labour productivity 21, 32231, 333, 347 dependency ratio 32731 see also living standards labour supply 7071 lack of stability effects 305 law of demand 8490 income and substitution effects 8790 see also beyond demand; demand law of diminishing returns 667 leakage 158, 180 lean production 144 legal protection 213 liberalization 228 licensing 204 linking unemployment and ination 306314 causes of differences in natural unemployment rates 31214 model explaining natural unemployment rate 309312 liquidity 2427 living standards 31, 32231, 350 denition 3 dependency ratio 32731 see also labour productivity loan term 2489 lobby groups 144, 317 logistics 184 London ForEx 260 long run 11617 long-run aggregate supply 1767 long-run aggregate supply curve 1767 long-run average cost 129 long-run average cost curve 131, 208, 214 long-run equilibrium 2089 loss of purchasing power 305 LRAC see long-run average cost

396

THE ECONOMIC SYSTEM

LRAS see long-run aggregate supply lumpy investment 162 macroeconomic consumption behaviour 1037 macroeconomics 1418 environment for economic decisions 1618 macroeconomy 15596, 310 economic activity and the circular ow 1568 equilibrium economic activity 17078 equilibrium economic activity and the multiplier 17881 government activity 18792 international integration 1817 introduction 1556 real output and the business cycle 15865 real output and its components 16570 see also economic activity maintenance of brand loyalty in monopolistic competition 215 margin-setting curve 310, 312 marginal analysis 117 marginal costs 256, 69, 12531 explaining U-shaped cost curves 12631 marginal output 12023 marginal product of capital 344 marginal product of labour 65, 121, 345 marginal propensity to consume 1045, 108 marginal rate of substitution 88 marginal relationships 1223 marginal revenue 11819 product of labour 67, 69 marginal revenue function 11819 marginal utility 8290 income and substitution effects 8790 mark-up 309 market abuse 235 market analysis 3576 demand 4046 equilibrium 63

exchange 3640 government affecting prices 568 information and knowledge in the market system 5862 introduction 356 market interaction 525 market labour 6472 supply 4652 market clearing price 52 market concentration 204 market economy 62 market failure 22, 2236 implications of market failure 2256 why markets fail 2235 market failure implications 2256 market failure types 2235 externalities 224 information asymmetries 2245 monopoly power 224 natural monopoly 224 public goods 2234 market interaction 525 changes in equilibrium 55 market power 204 market process 2014 market structure 204221 markets 26, 204 Marshall, Alfred 1314 maximization of prots in the long run 1318 maximizing prots over the short run 1378 prot maximization, normal prot and efciency 1336 maximization of prots in the short run 1378 economic analysis 138 MC see marginal costs measures of economic activity 16770 GNP, GDP and income 16870 menu costs 305 MES see minimum efcient scale

INDEX

397

microeconomics 1418, 356 environment for economic decisions 1618 Microsoft 222 millennium development goals (UN) 354 minimum efcient scale 129 minimum wage 28791 mismatch 314 Mitchell, B.R. 299 model explaining natural unemployment rate 309312 modelling economic growth 33349 conclusions from the Solow model 3457 endogenous growth 3479 explaining growth: labour, capital and technology 3445 more on savings 33741 Solow model and changes in labour input 3413 Solow model and changes in technology 3434 models of competition and market structure 204221 monopolistic competition 21315 monopoly 209211 oligopoly 21521 perfect competition 2069 perfect competition vs. monopoly 21113 monetary policy 242, 26872 alternative targets 27072 difculties in targeting money supply 26970 Taylor rules and economic judgement 272 Monetary Policy Committee 271 money 23982 demand 2467 and exchange 24041 international monetary integration 2728

liquidity, central banks and money supply 2425 market: demand and supply 24751 monetary policy 26872 quantity theory of money and explaining ination 2515 see also nancial markets money demand 24651 money market 24751 nominal and real interest rates 24951 which interest rate 2489 money multiplier 2445 money supply 2425, 24751 monopolistic competition 21315 maintaining and enhancing brand loyalty 215 monopoly 209211 benets 213 vs. perfect competition 21113 monopoly power 224 Moodys 265 mortgages 2489 MPC see marginal propensity to consume MPPL see marginal physical product of labour MR see marginal revenue MSC see margin-setting curve multiplier 17881 municipal bond 264 NAIRU see non-accelerating ination rate of unemployment nanny state 109 Nash equilibrium 219, 237 Nash, John 219 National Association of Software and Service Companies 184 national exchange rates 1516 national income 78, 162 national output 78, 299 National Socialist Workers Party 81 national statistics 171 natural monopoly 210, 224

398

THE ECONOMIC SYSTEM

natural rate of unemployment 2867, 306314 causes of differences in 31214 explanatory model 309312 neoclassical growth model 333 see also Solow growth model net exports 115, 175 net investment 143 neuromarketing 90 new growth model 347 NGOs see non-governmental organizations Nissan 130 nominal amounts 11 nominal ination 249 nominal interest rates 24951 non-accelerating ination rate of unemployment 286 non-durable goods 79, 81 non-governmental organizations 350 non-price competition 215 non-price determinants of demand 426 buyers income 434 complements and substitutes 423 consumer condence 445 expected future prices 44 implications of changes in inuences on demand 456 population 44 preferences 44 price of related goods/services 423 non-unionized workers 303, 309 normal good 89, 99 normal prot 48, 1336 see also economic prot normative economics 2930 see also positive economics number of suppliers 51 OCA see optimal currency area OECD see Organization for Economic Cooperation and Development offshore outsourcing 1845 offshoring see offshore outsourcing oil prices 42, 162, 3012, 324

and ination 3012 oligopoly 21521 and game theory 21719 Prisoners Dilemma 21921 OPEC see Organization of Petroleum Exporting Countries open-market operation 243, 247, 3034 opportunity costs 18, 227, 379, 47, 86 opposition 223 optimal currency area 273 optimal form of organization 612 Organization for Economic Cooperation and Development 3, 32, 216, 301, 316, 329, 337 organization of economic system around rms 11531 rm costs 1235 rm output 12023 rm revenue 11720 rms decisions and role of time 11617 marginal and average costs 12531 marginal and average output 12023 product 12023 Organization of Petroleum Exporting Countries 142 output 12023, 15870 output gap 160 outsourcing 49, 314 overproduction 141 overspending 303 ownership rights 2034 paradox of thrift 106 parallel imports 1523 Parmalat 17 part-time workers 316, 343 patents 135, 153, 203 patterns in real output 159 PED see price elasticity of demand Penn World Table 31, 79 Pepsi 90, 234 perfect competition 2049, 222 long-run equilibrium 2089

INDEX

399

short-run equilibrium 2078 vs. monopoly 21113 perfect elasticity 141 perfect inelasticity 141 persistent economic growth 347 perspectives on competition compared 2213 PES see price elasticity of supply Phelps, Edmund 306 Phillips curve 3068 Phillips, William 306 physical capital 348 political economy 5 pollution 52, 147, 170 population 44, 351 positive economics 2930 see also normative economics potential output 160, 1756 poverty trap 326 PPF see production possibility frontier preferences 44, 105 see also consumer preferences present value 2668 price cap see price ceiling price ceiling 567, 142, 289 problems of 578 price changes 93100, 14042 price changes and consumer response 93100 price elasticity of demand 948 cross-price elasticity 100 income elasticity 99100 other examples 99100 some special cases 98 and total revenue 968 price elasticity of supply 140, 142 price xing 17 price oor 578 price leadership 21617 price level 1712 price of production factors 4850 price and quantity effects 11, 14 price ratios 856 price of related goods/services 423, 51

price sensitivity 934, 989, 302 price-cost margin 309 prices 1822, 8490 using resources and centralized decision-making 2022 principles of competition policy 2312 Prisoners Dilemma 21921 private property rights 61 privatization 228 pro-competitive practices 315 problems of price ceilings and oors 578 process of competition 199201 process of economic analysis 7 producer response to price change 14042 producer surplus 139 producers 139 product 12023 see also rm output product attributes 1013 attribute model 1013 product differentiation 101, 135 production function 19092, 334, 348 production possibility frontier 237, 348 productivity advantage 38 prot margin 309 prot maximization in the long run 1318 normal prot and efciency 1336 prot maximization, normal prot and efciency 1336 prot maximization in the short run 1378 economic analysis 138 protability 290 property bubble 250 property rights 349 psychology 45 public debt 276 public goods 212, 187, 2236 public interest 27 public sector employment 1089 purchasing power parity 34, 412 adjustment 3

400

THE ECONOMIC SYSTEM

quantity theory of money 2515, 304 ination expectations, interest rates and decision-making 2535 quasi-xing 271 quota 182, 187 R&D see research and development rankings of bonds 265 rationality in economics 834 real amounts 11 real business cycle 162 see also business cycle real business cycle theory 1623 real economic activity 166 real interest rates 24951 real output 15870 and the business cycle 15865 and its components 16570 patterns in 159 real wage-setting curve 310, 313 real wealth effect 174 realignment 275 the real thing 153 reasons for ination 301 recession 80, 160, 176, 273, 287 recessionary gap 2935 redistribution effect 225 redundancy 316 registered design rights 153 regulation of competition 22635 regulatory capture 227 related goods/services price 423, 51 relative price 86 Renault 130 required reserve ratio 244 research and development 213, 349 reservation wage 70 reserve ratio 244 reskilling 315 resource scarcity 1822 using resources and centralized decision-making 2022 resources 1822, 187, 297 restrictions 199

restructuring 49, 235 returns to large-scale production 128 revenue of rm 11720 revenue maximization 118 risk 249 robotics 49, 124 robustness 236 role of time 11617 Rover 49 RWS curve see real wage-setting curve Ryanair 130, 233 Sabena 235 savings 33741 savings axis 105 savings function 106 scale economies 136 scale of world poverty 354 Schumpeter, Joseph 136, 1634, 200, 203, 213 scientic knowledge 58 SCP paradigm see structure, conduct, performance paradigm SEA see Single European Act seasonal unemployment 287 self-sufciency 38 Sen, Amartya 354 services 79, 81 Sherman Act 1890 231 shoe-leather costs 305 short run 11617 short-run average cost curve 13031 short-run average total costs 1378 short-run equilibrium 2078 short-term uctuation 156, 170 shortage 53 Single European Act 274 Smith, Adam 3, 20, 60, 128, 184, 203 soft investment 336 Solow growth model 33349, 356 and changes in labour input 3413 and changes in technology 3434 conclusions from 3457 endogenous growth 3479

INDEX

401

explaining growth: labour, capital and technology 3445 more on savings 33741 Solow residual 345 Solow, Robert 333 spare capacity 176 special cases of price elasticity of demand 98 special savings accounts 108 specialization 128, 203 spectrum of competition 229 speculation 246, 25868, 277 bonds, ination and interest rates 2668 investment in bond markets 2636 sports utility vehicle 456, 51, 55 spot market 261 SRAC see short-run average cost curve stabilization policy 1878 Standard & Poors 265 standardized product 199 standardized unemployment rate 285 Starbucks 4 start-ups 27 static efciency 26 steady state 3357, 347 sticky wages 292, 294, 298, 302, 308 structural unemployment 2867, 308 structure, conduct, performance paradigm 22930 subsidies 1447, 2345, 355 subsidizing 145, 349, 355 substitutes 413, 51, 175, 233 substitution effect 41, 8790 summary of market characteristics 22021 sunspot theory 164 supernormal prot 48, 1336, 207211, 214 supplier number 51 supply 3576, 139 expected future prices 51 in the foreign exchange market 2567 government regulations 52 number of suppliers 51

prices of factors of production 4850 prices of related goods 51 producers and producer surplus 139 supply chain 183 supply curve 47, 50 supply of money 2425 supply schedule 47, 50 surplus 53, 9092, 139 SUV see sports utility vehicle switching costs 315

tacit knowledge 59, 201 Tall Latte Index 4 targeting monetary supply 26972 alternative targets 27072 difculties in 26970 tariff 182, 184, 187, 355 tax incidence 14950 tax rate 108, 303 tax wedge 31415 see also wedge taxation 187 Taylor rules 272 technology 27, 3435 TFC see total xed costs TFP see total factor productivity theory-based analysis 69 time 11617 time-series data 12 total costs 1235 total factor productivity 345, 347 total xed costs 1234 total output 120 total revenue 967, 118 and price elasticity of demand 968 total utility 823 total variable cost curve 1245 tourism 259, 287 trade barriers 182 trade decit 181, 271 trade and development 3546 trade restrictions 186, 354 trademarks 153

402

THE ECONOMIC SYSTEM

traditional perspectives on competition 2213 transaction costs 62 transactions 246 transfer payment 157, 187 transport deregulation 183 Treaty of Maastricht 2745 Treaty of Rome 229, 232, 274 trend line 14 trends in international price levels 299303 TVC see total variable cost curve types of market failure 2235 types of unemployment 28691 unanticipated ination 3045 unemployment 283320 analysing unemployment 2913 causes of differences in natural rates of 31214 costs of 2956 cross-country differences: ination and 31417 labour market analysis 28691 linking ination and 306314 model explaining natural rate of 309312 rate 2846 and the recessionary gap 2935 types of unemployment 28691 see also challenges for the economic system unemployment benets 292 unemployment trap 326 United Nations 354 unpredictability 2223

unregistered design rights 153 use of resources 2027 opportunity costs and efciency use of subsidy 1457 utility 814 value-added method of measuring economic activity 1678 variable costs 123 velocity 2512 vertical equity 351 Virgin Airlines 235

227

wage rise negotiations 3034, 313 wage-bargaining 29091, 302, 304, 315 Wall Street Crash 80 waste 50, 74 wealth 105 Wealth of Nations 3 wedge 147, 166, 31415 welfare economics 92, 160, 326, 356 what GNP and GDP do not measure 16970 women 316 world poverty 354 World Trade Organization 16, 146, 186, 354 World War Two 81, 301, 324 WorldCom 17 WTO see World Trade Organization Yom Kippur War 302 young dependency ratios zero-coupon bond 264 zero-sum game 200

329