4.

Content guidance

Theme 3: Business behaviour and the labour market

This section provides ideas and suggestions for teaching approaches for Theme 3
and is not intended to be prescriptive. The specification must be referred to as the
authoritative source of information.

3.1 Business growth

In this topic students will explore business size, why some remain small and why
others might grow, and how they do this. When looking at how businesses grow
students will consider the advantages and disadvantages of each method.
Students will also explore reasons for, and the impact of, demergers.

3.1.1 Sizes and types of firm

a A starting point could be to explore why firms grow and how the following
might make a firm seek growth:
• Profits – to generate more profits to give shareholders a better return.
• Costs – to benefit from economies of scale, resulting in lower unit costs of
production.
• Market power – to become a more dominant force in their market; if a firm
dominates the market it can increase its prices.
• Reducing risk – firms might want to diversify so that if sales drop in one
market they have another market to generate sales.
• Managerial motives – senior managers may wish to grow in order to control
a larger business.
This can be contrasted with why some firms remain small. Possible reasons
include: lack of finance for expansion; avoiding diseconomies of scale;
providing niche products which have a low PED or high YED; offering a more
personal service as they get to know customers and their needs; acting as
suppliers; and acting as local monopolies at specific times.
b Students need to consider the significance of the divorce of ownership from
control. Shareholders own the business and appoint directors and managers to
run it on their behalf. Shareholders want to maximise profits to maximise their
dividends, whereas managers might have different motives, such as wanting to
increase sales and revenue at the expense of profits. This divorce of ownership
creates the principal-agent problem. The principal is the shareholder and the
agent is the manager and their divergent aims. This may lead to the business
growing larger than a firm aiming to maximise profit.
c Students are required to know and understand the difference between public
and private sector organisations.
d Students are required to know and understand the difference between profit
and not-for-profit organisations.

3.1.2 Business growth

a Examples should be used to support understanding of how businesses grow:
• Organic growth is where a business grows internally by reinvesting profits or
borrowing from banks. Reasons for internal growth include: to increase
market share; the development of new innovative products, finding new
markets to sell its existing products, getting existing customers to buy more
products through advertising or investing in new capital or technologies to
expand production. Examples include Subway, Wasabi, Poundland and Hotel
Chocolat.

48 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

• Forward and backward vertical integration is where two businesses at

different stages of production, but in the same industry, join together.
Forward vertical is where one firm integrates with a firm in a stage of
production closer to the customer, such as a brewer buying pub chain.
Backwards vertical is where a firm integrates with another in the stage of
production further away from the customer, such as a car manufacturer
buying a tyre manufacturer.
• Horizontal integration is where two businesses at the same stage of
production in the same industry join together, such as a merger between
two banks or two chocolate manufacturers. Examples include Virgin Money
and Northern Rock, and Amazon and LoveFilm.
• Conglomerate integration is where two businesses in different industries
merge. For example, Tata’s acquisitions in different sectors including Jaguar
Land Rover, Corus, Ritz-Carlton hotels, British Salt, Citigroup and Tetley.
b Students should consider the advantages and disadvantages of each. Examples
include the following:
• Vertical integration – advantages include greater control over the supply
chain resulting in reducing costs and improving quality, and better access to
raw materials; disadvantages include different cultures in businesses and
diseconomies of scale.
• Horizontal integration – advantages include economies of scale, spreading
risk, allowing rationalisation and reducing competition; disadvantages
include different cultures in businesses and diseconomies of scale.
• Conglomerate integration – advantages include reducing risk by operating in
different markets and benefiting from knowledge from the other market;
disadvantages include the requirement for different skills, not necessarily
benefiting from economies of scale and cultural difference.
c Students need to consider constraints on business growth, including the size of
the market, limited access to finance, owner objectives and regulation.

3.1.3 Demergers
a A demerger is when a business sells off one or more of the businesses that it
owns into a separate company. Reasons for demergers include: cultural
differences, creating more focused firms, protecting the value of the firm,
reducing the risk of diseconomies of scale, raising money from asset sales and
return to shareholders to meet requirements of competition authority
regulators. Examples include the Foster’s Group demerging its wine and beer
divisions and Lloyds TSB Banking Group demerging to create two separate
banks – TSB and Lloyds Bank.
b Students should be able to consider the impact of demergers on businesses,
workers and consumers, such as:
• businesses – allowing focus on the core business, raising funds from selling
part of the business, removing loss-making parts of the business
• workers – increased job security if loss-making parts of the business are
demerged, reduced conflict between cultures, increased focus on the
business to enable it to be more profitable
• consumers – greater competition leads to lower prices, more focused
businesses are able to better meet consumer needs.

© Pearson Education Ltd 2014. This material is not copyright free. 49

 4. Content guidance

3.2 Business objectives

This section introduces students to the key goals of businesses. Profit
maximisation can be connected with rational decision making and the assumption
of profit maximising should be challenged. Students should consider that people
running businesses are likely to have different goals and therefore may revenue
and sales maximise. Understanding what satisficing is and why it is likely to occur
is useful here. This topic requires diagrams and students should be able to
produce diagrams and use formulae to illustrate different business objectives.

3.2.1 Business objectives

a Students should consider what motivates a firm and the main participants and
influencers of firms, including owners, directors and managers, workers and
consumers.
The assumption of rationality means that shareholders will seek to maximise
their utility by maximising profits. Profit maximisation occurs where Marginal
Revenue is equal to Marginal Costs (MR=MC).
As shareholders will be motivated by maximising their dividend to maximise
their profits from the company, it is assumed that the firm will want to
maximise its profits. However, when pricing according to MR=MC firms may
find they are loss-making.
Keynesian economists believe that firms will try to maximise their long-run
rather than short-run profits. This is based on firms using cost-plus pricing
where firms calculate the average cost and add a mark-up. Firms will adjust
price and output in response to changes in market conditions. However, rapid
price changes may affect a firm’s position in the market. Consumers dislike
rapid price changes, and may see price reductions as signs of a firm’s
desperation and distress. So rather than adjusting prices rapidly they will
continue to charge the current price and may make a loss in the short term but
will adjust the price to the profit maximising point in the long term.
Like shareholders, managers will also seek to maximise their utility. Managers
are often paid a salary that is linked to the amount of sales they achieve. So to
maximise their own utility they will seek to maximise sales so they achieve a
higher salary. Sales maximisation is where the business makes the maximum
sales possible while still breaking even. This occurs where Average Revenue =
Average Cost (AR=AC).
Similarly, some managers will want to maximise their utility by making as much
revenue as possible. Revenue maximisation is where the business makes the
maximum revenue and occurs where Marginal Revenue = 0 (zero).
Managers may be motivated by high salaries, the number of people under their
control and the availability of fringe benefits. They may, therefore, pursue
policies other than profit maximisation. However, if they ignore profit
shareholders can revolt, and may vote out the managers. So often managers
will profit satisfice where they satisfy the demands of shareholders. Once those
demands have been met, managers would be free to maximise their own
rewards from the company – they will do just enough to satisfy the
shareholders and avoid being dismissed. This means they are likely to give an
outcome somewhere between profit maximisation and sales maximisation.
b Students are required to show diagrammatically the positions of profit, revenue
and sales maximisation. The monopoly diagram below illustrates the three
positions. Students are required to identify the condition for each; for example,
MR=MC, MR=0 and AR=AC.

50 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

3.3 Revenues, costs and profits

This section will support students in exploring theories of the firm. Students are
required to understand the relationships between total, average and marginal
revenue. They should understand how PED relates to revenues. Similarly
students will need to calculate and understand the relationships between different
costs. An appreciation of the short and long run is essential here. Economies and
diseconomies of scale should be covered. When looking at profit, students should
explore supernormal and normal profit, and understand the short- and long-run
shut-down points.

3.3.1 Revenue
a Students are required to know the formulae for each of the following:
Total revenue = price x quantity
Average revenue = total revenue ÷ quantity
Marginal revenue = change in revenue ÷ change in quantity
Students will need to understand the relationship between the revenues.
It would be useful for them to see the relationships numerically and
diagrammatically. Students could also consider what happens if a business
cannot adjust the price and the relationship between the different revenues.
This will support the study of perfect competition.
b Students should consider PED along a demand/average revenue curve and how
this relates to total revenue. Students might find it useful to show the
relationship diagrammatically and should remember that:
• when demand is elastic, increasing price will reduce total revenue and
decreasing price will increase total revenue
• when demand is inelastic, increasing price will increase total revenue and
decreasing price will decrease total revenue.

© Pearson Education Ltd 2014. This material is not copyright free. 51

 4. Content guidance

3.3.2 Costs
a Students are required to know the formulae for each of the following:
Total cost = total fixed cost x total variable cost
Total variable costs = variable cost x quantity
Average (total) cost = total cost ÷ quantity
Average fixed cost = total fixed cost ÷ quantity
Average variable cost = total variable cost ÷ quantity
Marginal cost = change in cost ÷ change in quantity
Students should understand the relationship between the different costs.
It would be useful for them to see the relationships numerically and
diagrammatically. You could provide students with price and quantity data and
ask them to calculate the revenue curves. Students could construct graphs
based on the information provided.
b Students should understand that, in the short run, some factors of production
are fixed. From this, they need to understand the assumption of diminishing
marginal productivity. Cost curves are needed here.
c Students should also appreciate the relationship between short-run and long-
run average cost curves.

3.3.3 Economies and diseconomies of scale

a Students are required to understand types of economies and diseconomies of
scale – for example, financial, technical, managerial, marketing, purchasing and
risk-bearing – and be able to explain these using examples. Students should be
able to understand these as a long-run concept.
b An understanding of the minimum efficient scale is also required. Students
should draw long-run average cost curves to show economies and diseconomies
of scale as well as being able to identify the minimum efficient scale.
c Students should consider the distinction between internal and external
economies of scale. Students could consider examples of where businesses
benefit from economies of scale; for example, explaining the possible external
economies of scale AstraZeneca would benefit from in its move to Cambridge.

3.3.4 Normal profits, supernormal profits and losses

a Profit maximisation occurs where MR=MC.
b Students need to know what is meant by normal profits. Fundamental here is
the idea of opportunity costs. It is useful to explain that this forms part of the
costs. Students should also make the distinction between normal and
supernormal profits. Being able to identify profits and losses will be useful when
considering market structures in 3.4.
c The short-run shut-down point occurs when average variable costs equal
average revenue (AVC=AR). If AR>AVC then each additional unit sold will
reduce the size of any losses and go towards covering fixed costs. The firm will
be better off continuing to operate as they will be reducing the size of their
losses. Firms will shut down when AVC>AR because every additional unit sold
will add to losses.
The long-run shut-down point occurs when average (total) costs equal average
revenue (ATC=AR). If AR>ATC then each additional unit sold will add to profits.
The firm will be better off continuing to operate. Firms will shut down when
ATC>AR because every additional unit sold will add to losses.
In this diagram the firm will profit maximise where MR=MC and the price
charged is P and quantity Q. In the short run they will continue to operate as
AR>AVC. In the long run ATC>AR so this firm will shut down.

52 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

When profit maximising the price charged is P and quantity Q. In the short run
AR=AVC, so the firm is at the shut-down point. In the long run ATC>AR so this
firm will shut down.

3.4 Market structures

This topic was introduced in 3.3. Students will consider efficiency and the
following market structures: perfect competition, monopoly, monopolistic
competition and oligopoly. Students will also explore monopsonists and
contestability. It is useful to look at real world examples to support
understanding of market structures.

3.4.1 Efficiency
a Students need to understand that allocative efficiency is where price equals
marginal costs.
b Productive efficiency is where average costs are at their lowest point.
c Allocative and productive efficiencies are static in the short term. Dynamic
efficiency looks at how, over the long term, new technology and productive
techniques can increase the productive potential of firms.

© Pearson Education Ltd 2014. This material is not copyright free. 53

 4. Content guidance

d X-inefficiency is where firms find themselves with average costs that are higher
than they could be. Students should be able to identify causes of such
efficiencies.
e Students should consider the efficiencies and inefficiencies in the different
market structures they explore in this section.

3.4.2 Perfect competition

a Perfect competition exists in a market where there is a high degree of
competition. A perfectly competitive market must possess four characteristics:
there are many buyers and sellers, none of whom is large enough to influence
price; there are no barriers to entry and exit from the industry; buyers and
sellers possess perfect knowledge of prices; the products are homogenous.
There are few industries that meet all of these characteristics – an example is
the foreign exchange market.
b (b and c) Perfect competition has a large number of suppliers in the market. A
firm can expand or reduce output without influencing price. The price is
determined by the market because the individual firm is too small to influence
price and is a price-taker. Students need to explain and show diagrammatically
the relationship between the market and the firm. The horizontal demand curve
is also the firm’s average and marginal revenue curves. If a firm sells all its
output at the market price, then this price must be the average price or
revenue. In addition, each extra item sold will receive the same price for each
additional unit and, therefore, marginal revenue will be the same as average
revenue. The perfectly competitive firm’s demand curve:

In a perfectly competitive market, the supply curve for a firm is the marginal
cost curve above the average variable cost in the short run, and the average
total cost in the long run. The marginal cost of production – the change in total
cost resulting from the sale of one more unit – represents the additional cost of
supplying one more unit of output.
In perfect competition, we assume firms are profit maximisers and produce
where marginal cost is equal to marginal revenue (MC=MR). Perfectly
competitive firms can make supernormal profits in the short run. In this
diagram the horizontal demand/average revenue curve is shown to be above
the average total cost at the point where MC=MR (point A). At Q1 the firm
charges P1, but faces only average costs of P2. The firm will make supernormal
profits shown by the shaded area (P1P2AB).

54 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

The diagram below shows short-run firm-making losses. The firm is profit
maximising where MR=MC. The price charged is P2 and average costs P1. This
brings about losses equal to P1P2CD.

If a firm makes supernormal profits in the short run, other firms would have the
incentive to enter the market (and could do so owing to lack of barriers to entry
in perfect competition). The entry of new firms stimulates an increase in supply
from S1 to S2, with the demand curve for the firm shifting down and the price
shifting down to PE. The firm is now making normal (not supernormal) profit.

© Pearson Education Ltd 2014. This material is not copyright free. 55

 4. Content guidance

If a firm is making losses in the long run, some firms would leave the industry
as there are no barriers to exit. As a result, total supply falls from S1 to S2. At
S1, the firm makes a loss. At S2, the demand shifts upwards as firms leave the
markets leading to normal profits.

In the long run, competition ensures that equilibrium occurs where firms make
neither supernormal profits nor losses. Average costs will equal average
revenue and the firms make normal profit.

3.4.3 Monopolistic competition

a The assumptions for monopolistic competition are that: there are a large
number of small firms; there are low barriers to entry and exit; and firms
produce similar but differentiated products.
b (b and c) Product differentiation means there is a downward sloping curve
because firms have some market power. They can change price and will not
lose all customers. The firm will profit maximise and produce where MC=MR so
will produce at an output level of Q1 and charge price P1.

56 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

In the long run, supernormal profits will be eroded because new firms will enter
the market owing to lack of barriers to entry. The entry of new firms will
increase supply, shifting the average revenue curve downwards to the point
where AR=AC, as in the diagram. If the firm was making a loss, it would leave
the industry, reducing supply and shifting the AR curve upwards again to a
point where AR=AC. Therefore, in the long run, a monopolistically competitive
firm can make neither supernormal profits nor losses.

3.4.4 Oligopoly
a Firms operating in oligopolistic markets tend to keep prices stable. The actions
of one firm will impact on other firms in the industry – they are interdependent.
b Students should be able to calculate concentration ratios and be able to identify
the likely market structure and the significance.
c Oligopoly firms have an incentive to work together through collusive
agreements.
d Students should consider why firms might collude tacitly or overtly, or engage
in non-price competition.
e Game theory can be used to predict how firms might behave. It is used to
explain why firms may collude and why collusive agreements may break down.
The prisoner’s dilemma can explain the way that game theory can be used by
firms.
f Students should explore types of price competition. If one firm increases its
price, competitors will not follow as they can attract the firm’s customers by
having a lower price. If a firm lowered their prices, then other firms would
follow suit, resulting in a price war with lower prices – no firm would gain from
this. Other types of price competition should be considered; for example,
predatory pricing and limit pricing.
g Non-price competition can take the form of advertising, issuing of loyalty cards,
branding, packaging and other measures to reduce the closeness of substitutes.

3.4.5 Monopoly
a A monopoly is assumed to: be the only firm in the industry; have high barriers
to entry, preventing new firms from entering the market; and be a short-run
profit maximiser.
b (b and c) A monopoly firm is the same as the industry as it is the only firm in
the market. Monopolies have a downward sloping demand curve and can set
the level of price or output.

© Pearson Education Ltd 2014. This material is not copyright free. 57

 4. Content guidance

A monopolist profit maximises where MC=MR. The diagram shows the

equilibrium profit maximising level of output at Q1, with a price of P1.
Supernormal profits are equal to P1C1BA.

d Third degree price discrimination is when a business charges different groups of

customer different prices for the same product. For example, discounted rail
fares for students. For price discrimination to be possible 3 conditions apply:
• market power – price discrimination can only take place when the firm has
the ability to vary the price (such as a monopoly)
• information – it must be possible to distinguish between different customers’
willingness to pay
• limited ability to resell – consumers cannot resell the product
The assumption is that there are two markets – one with inelastic demand and
the other with elastic demand. The ‘total firm’ diagram on page 59 shows that a
profit maximising firm will have price Pt and earn supernormal profit equal to
the area old profit. Where MR=MC in the inelastic demand market this is profit
maximising and gives price Pa and profit marked by the blue shaded area.
The elastic demand market sees price Pb and profit marked by the blue area.

58 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

Combining these two profits should generate more profit for the firm than profit
maximising without price discriminating.

Pt

e Students should explore the costs and benefits of monopoly to firms,

consumers, employees and suppliers. For example:

Advantages of monopoly Disadvantages of monopoly

power power
Abnormal profit means: Abnormal profit means:
● finance for investment to ● less incentive to be efficient and
maintain competitive edge to develop new products
● reserves to overcome short- ● efforts are directed to protect
term difficulties and provide market dominance.
funds for research and
development.
Monopoly power means powers to Monopoly power means higher
match global companies. prices and lower output for
domestic consumers.
Cross-subsidisation may lead to an Monopolies may waste resources by
increased range of goods or undertaking cross-subsidisation,
services available to the consumer. using profits from one sector to
finance losses in another sector.

Price discrimination may raise total Monopolists may undertake price

revenue to a point that allows discrimination to raise producer
survival of a product or service. It surplus and reduce consumer
is often said that economy-class surplus.
flights are funded by those flying
business and first class.
Monopolists do not produce at the
most efficient point of output (i.e.
at the lowest point of the average
cost curve).

© Pearson Education Ltd 2014. This material is not copyright free. 59

 4. Content guidance

Monopolists can take advantage of There are few permanent

economies of scale, which means monopolies. Supernormal profits
that average costs may still be act as an incentive to break down
lower than the most efficient the monopoly through a process of
average of a small competitive firm. creative destruction, i.e.
undermining the monopoly through
product development and
innovation. Monopolists can be
complacent and develop
inefficiencies.
Monopolists avoid undesirable Monopolies lead to a misallocation
duplication of services and therefore of resources by setting prices
a misallocation of resources. above marginal cost, so that price
is above the opportunity cost of
providing the good.

f In the UK, water supply and the railway track are all monopolies. These
industries are often referred to as natural monopolies because economies of
scale are so large, new entrants would find it impossible to match the costs and
prices of the established firm. Some monopolies, such as the water companies,
have considerable monopoly power because there are no good substitutes for
their product. A local monopoly describes the only supplier in an area; for
example, the only village shop or petrol station. A monopoly maintains its
position as the sole supplier because of barriers to entry, including: legal
barriers such as patents; marketing barriers such as advertising; restrictive
practices; and access to specific technology or raw materials.

3.4.6 Monopsony
a A monopsony exists when there is one buyer in the market. There are few pure
monopsonists; for example, the government dominates the market for hiring
teachers. Monopsonists are profit maximisers – they aim to minimise costs by
paying suppliers the lowest possible price. Monopsonists will pay lower prices to
suppliers than if the market was competitive but suppliers will also supply less
to the market.

60 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

b Students should consider costs and benefits of a monopsony to firms,

consumers, employees and suppliers. For example:

Benefits Costs
Firms Lower costs – cost The relationship with the
minimisation supports supplier may worsen, the
firms in making more monopsonist may drive
profits. their supplier out of
business.
Consumers Lower prices – the The supplier may have to
monopsonist pays the cut corners or lower
minimum it can. quality to lower its costs
to remain profitable.
Employees In minimising costs of raw May question the ethics
materials it leaves more of the way their firm is
funds to pay its staff. acting.
Suppliers When the supplier has The buyer minimises
market power as a costs leading to a
monopolist it can reduced price paid to the
counteract the supplier. The
monopsonist. monopsonist may exploit
its market power by
paying less or later.
Suppliers may be driven
out of the market due to
lower profitability.

3.4.7 Contestability
a Contestable markets:
• must have no barriers to entry or exit
• have no sunk costs – a firm’s start-up costs that they cannot recover if they
exit the market
• new firms must have no competitive disadvantage compared to the
incumbent
• must have access to the same technology.
Incumbents cannot set a price above AC – if they do and earn supernormal
profits others will enter and compete the profits away.
b If businesses make supernormal profits:
• this would make them vulnerable to a ‘hit and run’ entry by a new firm
• they would come into the market, take some profits and then exit again.
To avoid this, the incumbent firm may charge where P=AC where there are no
supernormal profits and no incentive for entry to the market. Alternatively the
incumbent firm(s) may charge a limit price, i.e. one below the profit
maximising price and low enough to deter new entrants.
c Barriers to entry are obstacles that limit a firm’s ability to enter, set up or
extend into new markets. Barriers to exit are factors that prevent firms leaving
a market or, when a firm is making a loss, make it more unprofitable to leave.
Examples of this include sunk costs – costs that are irretrievable – such as
advertising.

© Pearson Education Ltd 2014. This material is not copyright free. 61

 4. Content guidance

Barriers include:
• illegal anti-competitive practices by incumbents, including predatory and
limit pricing
• the nature of the business causing barriers to exist, such as economies of
scale
• legally imposed barriers –patents, state-owned franchises such as train
operating companies and legislation that allows firms to operate such as
postal services and 4G licenses.
d Sunk costs are costs that are irretrievable; for example, advertising costs.
When sunk costs are high in a market it will make entry to and exist from that
market less attractive and therefore make the market less contestable.

3.5 Labour market

This topic gives students the opportunity to explore a specific type of market in
detail by focusing on the labour market. It is important to emphasise that when
looking at the labour market, students are exploring specific markets: for
example, the labour market for Maths teachers or unskilled agricultural workers.
Students should explore labour demand and labour supply, appreciating factors
influencing each of these. Students should also consider occupational and
geographical immobility and how they affect the labour market, and policies that
can be used to reduce immobility. Minimum and maximum wages should also be
explored.

3.5.1 Demand for labour

a (a and b) In a particular labour market, the supply of labour comes from people
in households and the demand for labour comes from businesses. The demand
for labour is known as a derived demand, which means the demand for labour
is dependent on demand for the final goods and services that they produce. If
there is a high demand for the final goods and services they produce
businesses will demand more labour; for example, in times of economic boom.
When demand for a final good falls the demand for labour will fall.
Demand for labour also increases when workers become more productive; for
example, because they have better skills. Firms can choose to use capital or
labour so if capital becomes more expensive then firms will demand more
labour.

3.5.2 Supply of labour

a The supply of labour is dependent on a number of factors, including: changes in
migration, income tax, benefits, presence of trade unions, social trends, and
required skills and qualifications.
b Market failure can result from the inability of workers to easily move between
jobs. There are a number of reasons for this:
• Geographical immobility refers to workers being unable to move to different
places to seek and find work. This may be due to social reasons, such as not
wanting to move away from family. It may also be due to the cost of travel
or cost of accommodation.
• Occupational immobility refers to workers being unable to move between
jobs as they lack the appropriate skills or training. As an economy shifts
from having a manufacturing base to a service-sector base, many
manufacturing workers find it difficult to transfer to jobs in the service
sector as they lack the required skills.

62 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

3.5.3 Wage determination in competitive and non-competitive

markets
a The price of labour is the wage rate. If wages are too high, labour supply will be
high but labour demand will be low – there is excess supply leading to
unemployment. In a competitive market, workers will have to accept lower
wages or go without a job, meaning the wage rate will tend to fall to the
market clearing wage rate.
If wages are too low, labour demand will be high but supply will be low – there
is excess demand and therefore there will be a labour shortage. Workers will
not work if they are not paid enough to do so. Firms will have to pay workers
more to convince them to work, and so the wage rate will rise towards the
market clearing wage.
Students are required to draw, annotate and interpret labour market diagrams.

Students should also consider the importance of the participation rate in the
labour force, and recognise the concepts of unemployment and under-
employment.
b Students should have an understanding of current labour market issues. These
might include: skills shortages; young people in the labour market – such as
problems accessing the labour market and youth unemployment; changes to
retirement ages; schooling ages; and temporary, flexible and zero-hour
contracts/working.
c The minimum wage is the minimum firms are legally allowed to pay their
workers. Students should consider the impact of an introduction or change in
minimum wages.
The minimum wage, set at W1, will result in a wage above the market
equilibrium wage, We. The higher wage will result in an extension of the supply
of labour to Q but firms will contract demand to Q1. This leads to excess supply
and Q-Q1 will be unemployed.

© Pearson Education Ltd 2014. This material is not copyright free. 63

 4. Content guidance

Students should consider the impact (benefits and drawbacks) of the

introduction or increase in both a minimum and maximum wage.
Students should also explore how, through public sector wage setting, the
government can impact the labour market, as well as the policies to tackle
labour market immobility. These include training programmes and relocation
subsidies.
d Elasticity of demand for labour refers to how responsive the demand for labour
will be to changes in wages. If demand for labour is elastic, businesses cut back
aggressively on employment if wage rates increase and will expand rapidly
when labour becomes cheaper relative to other factor inputs. When the
elasticity of demand for labour is inelastic the response to changes in wages will
be smaller.
The wage elasticity of demand for labour depends on a number of factors: the
proportion of labour costs in the total costs of a business, the ease and cost of
factor substitution, the price elasticity of demand for the final output produced
by a business and the time period under consideration.
The elasticity of labour supply to an occupation measures the responsiveness of
labour supply to a change in the wage rate. In low-skilled occupations, labour
supply is elastic because a pool of labour is available to take the job. Where
jobs require specific skills, training or qualifications, the labour supply will be
more inelastic because it is hard to expand the workforce in a short period of
time when demand for workers has increased.

3.6 Government intervention

Throughout this theme, areas have been identified where there is a role for the
government to bring about better outcomes; for example, in limiting mergers
that would create firms with market power, limiting exploitation by monopolies
and promoting competition, and protecting suppliers against monopsonists. In
this topic students will explore the impact and limits of government intervention.

64 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

3.6.1 Government intervention

a (a to d) Students should consider competition authorities and the actions the
government takes to control mergers and monopolies, promote competition and
protect suppliers and employees. In each case it is important to consider why
the action is needed. It could be useful to look at the European Competition
Commission and the Competition and Markets Authority (CMA) in the UK (which
took over the powers of the Competition Commission and certain functions of
the OFT in April 2014). Another example is the Antitrust Commission in the US.

3.6.2 The impact of government intervention

a When exploring government intervention it is important to consider what the
government aims to achieve in terms of: prices, profit, efficiency, quality and
choice.
b Government intervention may fail to bring about the social optimal position; for
example, through regulatory capture. It is also important to consider how
asymmetric information could make it difficult for the authorities to investigate
and discover anti-competitive practices.

© Pearson Education Ltd 2014. This material is not copyright free. 65

 4. Content guidance

Theme 4: A global perspective

This section provides ideas and suggestions for teaching approaches for Theme 4
and is not intended to be prescriptive. The specification must be referred to as the
authoritative source of information.

4.1 International economics

This section introduces economics in a global context by considering
globalisation: its causes and consequences; the basis of free trade;
protectionism; the balance of payments; exchange rates; and international
competitiveness.

4.1.1 Globalisation
a According to Peter Jay, globalisation is defined as: ‘The ability to produce any
goods (or service) anywhere in the world, using raw materials, components,
capital and technology from anywhere, sell the resulting output anywhere, and
place the profits anywhere.’
Globalisation refers to the increasing international interdependence of economic
agents (producers, consumers, governments, entrepreneurs). Key phrases
include global branding and global sourcing, although it is not just about the
activity of global (transnational) companies (TNCs). Globalisation is
characterised by increasing foreign ownership of companies, increases in trade
in both goods and services, de-industrialisation in developed countries and
increasing global media presence.
b Factors contributing to globalisation in the last 50 years include:
• improvements in transport infrastructure and operations
• improvements in communications technology and IT (especially the internet,
allowing a global media presence)
• trade liberalisation resulting from agreements reached by the World Trade
Organisation (WTO)
• increasing number and influence of global (transnational) companies
• the end of the Cold War, which led to the opening up of formerly closed
economies in communist countries and a subsequent increase in global
labour supply
• the development of international financial markets.
c The impacts of globalisation and global companies on individual countries,
governments, producers and consumers, workers and the environment include:
• increasing living standards resulting from increased specialisation and trade
(through the law of comparative advantage – see section 4.2.1)
• increased interdependence of economies
• de-industrialisation in developed countries, combined with a global search
for new sources of energy (especially oil/gas reserves) and the growth of
economies such as China and India has left many ‘Western’ countries
concerned about their future and their power in the global economy
• increase in the number of ‘footloose’ companies which can cause
unemployment as they move from country to country; global sourcing
should be considered in the light of activity by TNCs
• greater consumer choice
• lower prices, through specialisation according to comparative advantage
• workers may be exploited by large global (transnational) companies

66 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

• increasing environmental destruction and other negative externalities –

students should be aware of environmental problems caused by
globalisation; for example, rising greenhouse gases from increased
transportation of goods associated with the increase in international trade.
Students should also be introduced to the idea that globalisation is not a new
phenomenon and that there has been a continual process of globalisation since
the time of the first humans.

4.1.2 Specialisation and trade

The primary reason for trade is that countries are not able to produce everything
they want in today’s society. This is associated with economic development and
increases in income. Trade allows countries to specialise in producing the goods/
services that can be produced efficiently. Goods are imported because of their
availability, price and product differentiation.
a Students are required to use numerical and diagrammatic examples to illustrate
absolute and comparative advantage. Assume a world with two countries (A
and B) and two products (oranges and smartphones). Country A has an
absolute advantage because it can produce more of both goods.
To produce one smartphone, Country A must give up production of 2 oranges,
whereas Country B must give up production of 1 orange. Because Country B
gives up fewer oranges to make more smartphones, it has a comparative
advantage in smartphones (similarly Country A for oranges).

Country A’s PPF is shown in blue. Country B’s PPF is shown in red. The
opportunity cost of producing a smartphone in Country A is 2 oranges; the
opportunity cost of producing a smartphone in Country B is 1 orange.
The opportunity cost of producing an orange in Country A is 0.5 of a
smartphone whereas the opportunity cost of producing an orange in Country B
is 1 smartphone Country A should specialise in producing oranges. Country B
should specialise in producing smartphones.
The theory of comparative advantage assumes: constant costs of production
(ignoring economies of scale); that transport cost are zero; there is perfect
knowledge; and that factors of production can easily be switched from
producing one good to producing another. Limitations include that the external
costs of production (such as environmental degradation) are ignored.
b The advantages of specialisation and trade include:
• lower prices and more choice for consumers
• larger markets and economies of scale for firms

© Pearson Education Ltd 2014. This material is not copyright free. 67

 4. Content guidance

• higher economic growth and living standards (based on the law of

comparative advantage).
Disadvantages of specialisation and trade include:
• a deficit on the trade in goods and services balance could arise if a country’s
goods and services are uncompetitive
• danger of dumping by foreign firms, i.e. selling at below average cost
• increased unemployment resulting from the above
• increased economic integration might result in increased exposure to
external shocks
• unbalanced development – international specialisation based on free trade
means that only those industries in which the country has a comparative
advantage will be developed while others remain undeveloped; in other
words there will be a sectoral imbalance which may restrict the overall rate
of economic growth
• global monopolies as global (transnational) companies become larger
• developing and emerging economies may face particular problems; for
example, infant industries may be unable to compete and go out of
business; the monopsony power of global companies may mean that low
prices are paid for commodities from developing countries.

4.1.3 Patterns of trade

a The G7 share of world trade in manufacturing has fallen significantly over the
past century. In global terms, trade flows with emerging economies have
increased significantly. Trade within trading blocs, such as the EU, has also
significantly increased (trade creation), but at the expense of trade with more
traditional trading partners, such as between the UK and the Commonwealth
countries (trade diversion). Students should be encouraged to look at how
patterns of trade have changed and the reasons for these changing patterns,
particularly with reference to the growing importance of trading blocs and the
growth of emerging economies.

4.1.4 Terms of trade

The relative prices of imports and exports may have an important impact on
competitiveness and on a country’s living standards. These are captured in a
country’s terms of trade.
a Students are required to calculate terms of trade:
Terms of trade = Index of export prices x 100
Index of import prices
b Factors influencing a country’s terms of trade include: relative inflation rates,
relative productivity rates and changes in exchange rates.
c Changes in a country’s terms of trade impact on living standards and on the
competitiveness of a country’s goods and services, with implications for the
balance of payments on current account, output and employment. For example,
an improvement (increase in) a country’s terms of trade implies an increase in
its living standards because less has to be exported to buy a given quantity of
imports. However, it could mean that the country’s goods and services are less
competitive and so result in a deterioration in the current account, lower output
and higher unemployment.

68 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

4.1.5 Trading blocs and the World Trade Organisation (WTO)

a Students should consider the characteristics of the various types of trading bloc
and understand the idea of trade creation and trade diversion (which links to
the conflict between blocs and the WTO).
• Free trade areas – these are blocs in which groups of countries agree to
abolish trade restrictions between themselves but maintain their own
restrictions with other countries.
• Customs unions – these have free trade internally and a common set of
protectionist measures. Examples include the EU, the North American Free
Trade Agreement (NAFTA) and the Association of Southeast Asian Nations
(ASEAN).
• Common markets – these have the same characteristics as customs unions
but also allow the free movement of factors of production.
• Monetary unions – these are customs unions which adopt a single currency.
b The costs of regional trade agreements, which are monetary unions, include:
transition costs (costs of changing price lists, slot machines, etc.), loss of
independent monetary policy and loss of exchange rate flexibility. Benefits
include: elimination of transaction costs, price transparency, reduction in
exchange rate uncertainty and increased attractiveness for foreign direct
investment (FDI).
c The WTO promotes free trade between member countries through a series of
trade negotiations. It is also responsible for resolving trade disputes between
member countries.
d Trade within regional trade agreements has also significantly increased (trade
creation) as a result of their emphasis on free trade. However, this is at the
expense of trade with non-members (trade diversion) who may be subject to
trade barriers. This is in conflict with the primary aim of the WTO.

4.1.6 Restrictions on free trade

a Students should consider the reasons for, and types of, restrictions on free
trade as well as their impact on an economy. A country may restrict trade to:
• protect infant industries and sunset industries
• protect employment
• retain self-sufficiency
• correct imbalances on the current account of the balance of payments
• retaliate against restrictions imposed by another country
• prevent dumping
• reduce competition from countries with cheap labour and poor
labour/environmental laws
• protect strategic industries, such as defence, essential foodstuffs
and energy.
Students should be aware of current examples of protectionist measures and
consequent retaliation. Able students could be introduced to the ideas of David
Ricardo regarding the benefits of free trade versus protectionism, as well as
criticisms of these ideas from economists such as Ha-Joon Chang.

© Pearson Education Ltd 2014. This material is not copyright free. 69

 4. Content guidance

b Students should explore types of trade barrier. Tariffs are taxes on imported
goods. They are also known as import or customs duties. Taxes raise prices to
consumers with the aim of restricting imports. The following diagram illustrates
the impact of a tariff:

• Before tariff – domestic suppliers supply 0A, total demand is 0B, so imports
are AB.
• After tariff – domestic suppliers supply 0E, total demand is 0F, so imports
are EF.
• Tariff revenue raised by government is LMWV.
• Additional domestic producer surplus is P1P2LR.
• The deadweight welfare loss areas are RLV and WMT.
Quotas are a physical limit on the quantity of imports. They have a similar
effect to tariffs but no tax revenue is raised and shortages are created.
Subsidies to domestic producers are grants given to domestic producers to
enable them to lower production costs, therefore lowering prices, which should
make the country’s products more competitive internationally. Unlike tariffs and
quotas, subsidies incur a cost to the public finances.
Non-tariff barriers are protectionist measures which might include: product
specifications, health and safety regulations, environmental regulations and
labelling of products.
c Students should consider the impact of protectionist policies on consumers,
producers, governments, living standards and equality.

70 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

4.1.7 Balance of payments

a The balance of payments is a record of all a country’s financial dealings with the
rest of the world over the course of a year. It has four parts: the current
account, the capital account, financial account and the international investment
position. Students should have a clear understanding of these elements and
examine factors which cause current account imbalances and measures which
can reduce such imbalances.
The current account comprises the following:
• Balance of trade – this refers to the difference between the value of goods
and services exported and the value of goods and services imported.
Exports appear as a positive entry into the balance of payments because
they bring money into the country. Imports appear as a negative entry into
the balance of payments because money leaves the country. The balance of
trade itself comprises two elements: the trade in goods balance and the
trade in services balance.
• Income – this comprises income earned by domestic citizens who own
assets overseas minus income earned by foreign citizens who own assets in
this country. It includes profits, dividends on investments abroad and
interest.
• Current transfers – these are usually money transfers between central
governments (who lend and borrow money from each other) or grants, such
as those that the UK receives as part of the CAP from the EU.
If a country has a current account deficit, the value of money leaving the
country exceeds the value of money entering the country. If a country has a
current account surplus, then the value of money entering the country exceeds
the value of money leaving the country.
The capital account refers to transactions in fixed assets and is relatively small.
The financial account comprises transactions associated with changes of
ownership of the UK’s foreign financial assets and liabilities. It includes the
following:
• Direct investment – this relates to capital provided to or received from an
enterprise, by an investor in another country.
• Portfolio investment – this relates to investments in equities and debt
securities.
• Financial derivatives – these include any financial instrument the price of
which is based upon the value of an underlying asset (typically another
financial asset). Financial derivatives include options (on currencies, interest
rates, commodities, indices), traded financial futures, warrants and currency
and interest swaps.
• Reserve assets – these refer to those foreign financial assets that are
available to, and controlled by, the monetary authorities such as the Bank of
England for financing or regulating payments imbalances. Reserve assets
comprise: monetary gold, Special Drawing Rights, reserve position in the
IMF and foreign exchange held by the Bank.
Students should focus especially on flows of FDI between countries.
The international investment position is in the balance sheet of the stock of
external assets and liabilities.

© Pearson Education Ltd 2014. This material is not copyright free. 71

 4. Content guidance

b The balance of payments must always balance. If a country has a current

account deficit, it must have a surplus on the other elements of the balance of
payments. This is because it has to pay for everything it consumes and funds in
some way – to fund a current account deficit, a country must be selling assets
to foreign investors. It is debatable whether this is sustainable in the long run
since, if people invest in a country, at some point they will require a return on
their investment, and this will cause a deficit on the financial account.
In addition, because the data is never completely accurate, the accounts also
incorporate a ‘net errors and omissions’ item, which makes sure that everything
will balance.
Students should understand the components within the current account, and
should be aware of which components record deficits or surpluses. Students
should consider the size of deficits or surpluses on the current account in a
global context, and examine the implications of large imbalances between
countries.
Causes of current account deficits include:
• relatively low productivity
• relatively high value of the country’s currency
• relatively high rate of inflation
• rapid economic growth resulting in increased imports
• non-price factors such as poor quality and design.
Current account surpluses may arise from the reverse of these points.
c Measures to correct a deficit on the current account include expenditure
reducing, expenditure switching and supply-side policies; each of these should
be evaluated, and students should be encouraged to reach their own
conclusions as to the most appropriate measure. Students should consider the
option of doing nothing, in light of theory on floating exchange rates.
Expenditure-reducing policies relate to measures designed to reduce aggregate
demand, such as deflationary fiscal policy. As a result people spend less on
imports. However, a side-effect of this is that spending on domestic goods also
decreases, causing unemployment and a fall in the rate of economic growth.
Expenditure-switching policies involve the use of protectionist measures such as
tariffs or quotas, or a devaluation of the currency under a fixed exchange rate
regime. Such measures encourage people to buy domestic goods rather than
imports. However, they may lead to retaliation, causing exports to also fall so
that the current account deficit may not be corrected.
Supply-side policies, such as spending on education and training in order to
improve the quality and therefore competitiveness of exports, aim to boost
export demand. While they can incur an opportunity cost, they contribute
positively to economic growth and can be anti-inflationary in the long run.
d Some argue that, since a country’s balance of payments must always balance,
any global imbalances are insignificant. However, the Global Financial Crisis of
2008 suggests that persistently large current account deficits may be
unsustainable in the long run. Large and persistent deficits can be a problem
because there is a need to finance the increasing expenditure on imports,
usually through loans from abroad. In contrast, large and persistent surpluses
can be a problem because resources are focused on producing to meet export
demand rather than domestic demand, so consumer choice and resulting living
standards could actually be low. Further, such imbalances may lead to large
currency fluctuations which can have a destabilising impact of world trade.

72 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

4.1.8 Exchange rates

Students should understand the different exchange rate systems, the factors
influencing exchange rates and the impact of changes in exchange rates.
a Exchange rates are the price of one currency in terms of another. Under a
system of floating exchange rates, demand and supply determine the rate at
which one currency exchanges for another.
In a system of fixed exchange rates, the country’s exchange rate is fixed in
relation to, say the US dollar. It can only be changed by the central bank in
agreement with other countries usually mediated through the IMF.
Managed exchange rates imply that the monetary authorities control the
exchange rate through the buying and selling of the country’s currency on the
foreign exchange market and through changes in interest rates.
b (b and c) Appreciation and depreciation are the terms used under a system
floating exchange rates to describe increases and decreases in the value of a
country’s currency in relation to other currencies. Revaluation and devaluation
are the terms used under a system fixed exchange rates to describe increases
and decreases in the value of a country’s currency in relation to other
currencies determined by the country’s central bank.
Appreciation/revaluation means that the value of the pound, in terms of other
currencies, has increased. For example, if the value changes from £1 = $1.50
to £1 = $1.70 then more dollars are required to buy £1. With an
appreciation/revaluation, even though a good may still be priced at £10, it now
costs Americans $17 instead of $15, therefore reducing demand for UK exports.
Depreciation/devaluation means that the value of the pound, in terms of other
currencies, has decreased. For example, if the value changes from £1 = $1.50
to £1 = $1.40 then fewer dollars are required to buy £1. With a
depreciation/devaluation, even though a good may still be priced at £10, it now
costs Americans only $14 instead of $15, therefore increasing demand for UK
exports.
d Essentially, the exchange rate will be determined by the supply of, and demand
for, the currency. In turn, these will depend on factors such as:
• relative interest rates
• relative inflation rates (purchasing power parity theory)
• the current account of the balance of payments – UK exports create a
demand for sterling whereas imports into the UK create a supply of sterling
on the foreign exchange market; therefore, an increasing trade surplus
would cause an increase in the value of sterling
• net investment into the UK – FDI into the UK creates a demand for sterling
whereas UK investment abroad creates a supply of sterling; therefore, an
increase in FDI from abroad would cause the value of sterling to rise
• speculation
• quantitative easing – since QE has the effect of increasing money supply, it
is likely that this will cause a depreciation in the country’s exchange rate.
e Attempts to manage the exchange rate may be achieved by:
• changing interest rates – if the central bank wishes to increase the value of
the country’s currency, it would raise interest rates, so making it more
attractive for foreigners to place cash balances in the country’s banks
• intervention on the foreign exchange market – if the central bank wishes to
increase the value of the country’s currency then it would buy its own
currency.

© Pearson Education Ltd 2014. This material is not copyright free. 73

 4. Content guidance

f Some countries try to gain competitive advantage by taking measures to lower

the value of their currencies. However, if several countries do this then any
advantage would disappear quickly. Consequently, there might be a decline in
world trade if countries pursued such a policy – as happened in the 1930s.
g Impact of changes in exchange rates include:
• The current account of the balance of payments: a depreciation or
devaluation will increase the competitiveness of a country’s goods and
services by causing a fall in the foreign currency price of its exports and an
increase in the domestic price of its imports. However, there will only be an
improvement in the current account of the balance of payments if the sum
of the PEDs for exports and imports is greater than 1. This is called the
Marshall-Lerner condition.
Further, the impact on the current account may be different in the short run
than in the long run. In the short run there might be a deterioration in the
current account of the balance of payments because the demand for imports
might be price inelastic if firms have stocks or if they are tied into contracts;
and the demand for exports might be price inelastic because consumers
take time to adjust to the new, lower, prices. However, in the long run
demand for exports and imports is likely to become more price elastic so the
significance of the above factors disappears. This difference in short-run and
long-run effects is often referred to as the J curve effect.
• Economic growth and employment/unemployment: an increase in the
competitiveness of a country’s goods and services following a
depreciation/devaluation should result in a decrease in unemployment as
demand for the country’s goods and services increases.
• Rate of inflation: the price of imported raw materials and manufactured
goods will increase following a depreciation/devaluation. This could have
inflationary consequences because firms’ costs would increase and a wage-
price spiral could ensue.
• FDI flows: following a depreciation/devaluation it would be cheaper for
global companies to invest in the country so FDI might increase.
An appreciation/revaluation of a country’s currency would have the reverse of
the above effects.

4.1.9 International competitiveness

a Competitiveness refers to the ability of a country to sell its goods/services
abroad. Competitiveness is usually determined by the price and/or quality of
the good or service.
b Factors influencing international competitiveness include:
• relative unit labour costs which are heavily dependent on productivity
• wages and non-wage costs relative to those of competitors
• rate of inflation relative to competitors
• regulation relative to that of competitors.
c A country which is internationally competitive is likely to be able to enjoy
export-led growth with positive implications for employment and its balance of
payments on the current account. The reverse would be true for a country
which is internationally uncompetitive. Countries often try to improve their
international competitiveness by adopting supply-side policies.

74 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

4.2 Poverty and inequality

The different causes and consequences of poverty and inequality in both
developed and developing countries should be considered in this section. It
should be noted that, while absolute poverty is decreasing globally, some
countries have experienced increases in inequality over the last 25 years. The
possible reasons for these changes should be explored.

4.2.1 Absolute and relative poverty

a Absolute poverty exists when a person’s continued daily existence is threatened
because they have insufficient resources to meet their basic needs.
Relative poverty exists when a person is poor compared with others in their
society. Most poverty in developed countries tends to be relative poverty.
b Absolute poverty – in 2008, the World Bank set the poverty line at $1.25 a day
at 2005 GDP measured at purchasing power parity. Some economists measure
the poverty line at $2 a day.
Relative poverty – this is measured in comparison with other people in the
country and will vary between countries. People are considered to be in relative
poverty if they are living below a certain income threshold in a particular
country. For example, in the EU, people falling below 60% of median income
are said to be ‘at-risk-of poverty’ and are said to be relatively poor.
c Causes of changes in absolute poverty and relative poverty include: changes in
the rate of economic growth, economic development, FDI, policies which result
in increased trade, government tax and benefits policies, and changes in asset
prices.

4.2.2 Inequality
a Students are required to understand the distinction between wealth and income
inequality. Wealth relates to differences in people’s stock of assets. Income is a
flow concept; therefore, income inequality relates to differences in people’s
income flows from wages, dividends, rents, etc.
b Measures of inequality include the Lorenz curve and the Gini coefficient. Lorenz
curves plot cumulative share of income (or wealth) against the cumulative
share of the population with that income (or wealth). To determine the degree
of inequality, the Gini coefficient may be calculated:
G= A x
A+B
A represents the area between the diagonal line and the Lorenz curve and B
represents the area under the Lorenz curve. The Gini coefficient will have a
value between 0 and 1, with 0 representing absolute equality (the 45º line) and
1 representing absolute inequality (i.e. the Lorenz curve would lie along the
horizontal and vertical axes).

© Pearson Education Ltd 2014. This material is not copyright free. 75

 4. Content guidance

c Causes of income and wealth inequality within and between countries include:
• education, training and skills
• wage rate including minimum wage rates
• strength of trade unions
• degree of employment protection
• social benefits
• the tax system (e.g. how progressive it is)
• pension entitlements
• ownership of assets (e.g. houses and shares) and inheritance.
d It is often observed that, as a country develops and its GDP grows from a
subsistence economy, inequality initially increases and then decreases. This
observation could be analysed by reference to the Kuznet’s curve (although this
is not a requirement). Industrialisation results in increased inequality as
workers move from the lower productivity and lower paid agricultural sector
into the higher productivity manufacturing sector. However, at some point,
inequality starts to decrease. This may be because governments have more
resources to redistribute income through the tax and benefit system.
e Inequality in a free market economy is inevitable, since people with higher skills
and abilities will attract higher wages, whereas those with poor skill levels will
earn nothing. Further, private ownership of resources means that some people
will acquire considerably more assets than others which, in turn, may generate
an income. Some argue that inequality is essential in a capitalist system to
provide an incentive for individuals to take risks in the knowledge that they,
personally, will benefit from any profits made.

76 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

4.3 Emerging and developing economies

Students should understand the ways in which development may be measured,
and the nature and causes of constraints on growth and development. They
should understand the nature of different measures to promote growth and
development, and be able to evaluate them, remembering that the validity of
different measures is dependent on the particular characteristics of the country
undergoing development. For all parts of this section, case studies may be
particularly useful. For example, it might be helpful to consider at least one Asian
country, one African country and one South American country.

4.3.1 Measures of development

a There are three equal weights within the Human Development Index (HDI):
education (the mean years of schooling for an adult aged 25 and expected
years of schooling for a pre-school child), health (life expectancy at birth) and
real GNI per head at PPPs. These are ranked in an index between 0 and 1: the
higher the value, the higher the level of development.
b The advantage of HDI is that it combines the effects of increased growth with
other quality of life indicators and, in that respect, is a useful measure of
development. However, this index does not take account of inequality, poverty
or other measures of deprivation and, in that respect, is regarded by some as
being of limited value.
c Other measures of development include the following:
• The Inequality-adjusted HDI (IHDI) – this was introduced in 2010. The IHDI
is the HDI adjusted for inequalities in the distribution of achievements in
each of the three dimensions of the HDI (health, education and income).
The IHDI will be equal to the HDI value when there is no inequality, but falls
below the HDI value as inequality rises. The difference between the HDI and
the IHDI represents the ‘loss’ in potential human development due to
inequality and can be expressed as a percentage.
• The Multi-dimensional Poverty Index (MPI) – this was published for the first
time in 2010. It reports and complements money-based measures by
considering multiple deprivations and their overlap. The index identifies
deprivations across the same three dimensions as the HDI (in health,
education and standard of living). It shows the number of people who are
multi-dimensionally poor (suffering deprivations in 33% of weighted
indicators) and the number of deprivations with which poor households
typically contend. It can be deconstructed by region, ethnicity and other
groupings as well as by dimension, making it a useful tool for policymakers.
In addition to the above composite measure of development, a variety of other
indicators may be used, including:
• the proportion of the male population engaged in agriculture
• energy consumption per person
• the proportion of the population with access to clean water
• the proportion of the population with internet access
• mobile phones per thousand of population.

© Pearson Education Ltd 2014. This material is not copyright free. 77

 4. Content guidance

4.3.2 Factors influencing growth and development

Economic growth is an increase in real GDP/an increase in the productive potential
of a country. Economic development is an increase in welfare or living standards
over time. Unlike economic growth, economic development is a subjective concept.
a Students should explore the impact of economic factors in different countries:
• Primary product dependency: primary product dependency may be
undesirable for a variety of reasons including: price fluctuations, the low
value added of many commodities and demand for primary products is often
income inelastic. This means that, as world incomes rise, the country’s
terms of trade will fall because prices of manufactured goods, whose
demand is often income elastic will rise, relative to the prices of primary
products. This is referred to as the Prebisch-Singer hypothesis.
• Volatility in commodity prices: the price inelasticity of demand and supply
for commodities will often result in price instability. In turn, this will cause
the revenue of producers and foreign currency earnings of the country to
fluctuate. This uncertainty may deter investment.
• Levels of savings and investment: the Harrod-Domar model suggests that
inadequate savings lead to low investment. In turn, this means that capital
accumulation will be low, resulting in slow economic growth. However, this
model should be evaluated; for example, it focuses on physical investment
only and ignores other sources of investment.
• Foreign currency gap: some developing and emerging economies face a
shortage of foreign currency. This may be because their earnings from
exports are relatively low, or because world oil prices have increased or
because they have large international debts on terms that they cannot
afford to repay; for example, if interest rates increase.
• Capital flight: another problem is capital flight. The owners of any extra
income that could be saved and therefore used for investment often
withdraw their money from the country in search of higher returns abroad.
• Demographic factors: many developing and emerging countries are
characterised by high birth and death rates which can result in high
dependency ratios. A further problem for some countries is that they face
ageing populations, sometimes as a result of policies followed in the past;
for example, China’s one child policy.
• Access to credit and banking: if individuals cannot access credit and banking
services then they may not be able to secure loans to start businesses,
therefore limiting the scope for growth and development.
• Infrastructure: if infrastructure is inadequate then businesses will find it
difficult and costly to trade. Further, poor infrastructure will act as a
deterrent to domestic investment and to FDI.
• Education/skills: countries which place an emphasis on education and
provide some state funding are more likely to grow and develop. This
improves human capital and shifts the PPF outwards.
• Absence of property rights: if property rights are not established then it may
be difficult for individuals to secure loans because they will have no
collateral.
b Non-economic factors in this section include the impact of: corruption, poor
governance, wars, political instability and geography.

78 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

4.3.3 Strategies influencing growth and development

Many of the strategies in this section involve policies which have already been
covered. Consequently, much of this section does not involve teaching of
new material.
a Market-orientated strategies:
• Trade liberalisation – this relates to measures designed to remove trade
barriers. The benefits of free trade are covered in section 4.1.2.
• Promotion of FDI – the impact of increased investment was considered in
Theme 2 and the effect of FDI on the balance of payments was mentioned in
section 4.1.8.
• Removal of government subsidies – the impact of subsidies was covered in
Theme 1. Students should be able to undertake the reverse analysis by
considering the effect of the removal of subsidies.
• Floating exchange rate systems – in many cases developing countries have
tried to maintain an exchange rate at an artificially high rate. Consequently,
floating the exchange rate should result in a depreciation of the currency.
Floating exchange rates were covered in section 4.1.8.
• Microfinance schemes – these relate to providing extremely poor people with
small loans (microcredit) to help them engage in productive activities or to
grow their tiny businesses.
• Privatisation – this was covered in Theme 3.
b Interventionist strategies:
• Development of human capital – this is covered in Theme 2 (section 2.6.3)
on supply-side policies.
• Protectionism – see section 4.1.6.
• Managed exchange rates – see section 4.1.8.
• Infrastructure development – see Theme 2 (section 2.6.3) on supply-side
policies.
• Promoting joint ventures with global companies – see Theme 3 (section
3.1.2) on the growth of companies.
• Buffer stock schemes – these entail a price ceiling and a price floor. If the
price of the commodity drops too low (probably through high supply), then
the government or buffer stock authority purchases large quantities of the
good and stores it (xy in the diagram below). This will reduce supply
sufficiently to ensure that the price does not fall below the floor price. If the
price becomes too high, the government or buffer stock authority release
the good onto the market from storage, thus increasing supply sufficiently to
ensure that the price does not rise above the ceiling price (ab in the diagram
below). The problems with buffer stock schemes are that storage is
expensive, transport to and from storage is expensive, it is very difficult to
equate supply and demand in the long run, and all producers need to be
part of the scheme for it to be effective.

© Pearson Education Ltd 2014. This material is not copyright free. 79

 4. Content guidance

c Other strategies:
• Industrialisation, the Lewis model: this is a structural change model. Lewis
argued that growth would be achieved by the migration of workers from the
rural primary sector to the modern industrial urban sector – this would occur
through higher wage incentives. However, this model may be inappropriate
for some emerging economies, where there are often many unemployed in
urban areas. This theory also assumes that secondary-sector production
would be labour-intensive, whereas it is often capital-intensive.
• Development of tourism: many LDCs are increasingly highly dependent on
tourism from the developed world as incomes rise. They may encourage
tourism because it allows foreign currency to be earned and it is labour-
intensive. However, there may be significant negative externalities resulting
from tourism growth; for example, use of clean water for tourists not locals,
expansion of airports causing pollution and loss of farmland. The Kingdom of
Bhutan, in the Himalayas, aims to tackle this problem by taxing tourists
heavily for every night they spend in the country.
• Development of primary industries: some countries have managed to
develop on the basis of primary products in which they have a comparative
advantage. For example, Chile has benefited from the production of copper
(at least, when the price is high) and also on other primary products with a
high income elasticity of demand, such as blueberries and papaya.
• Fair trade schemes: the WTO works towards reducing protectionist policies.
Many developing and emerging economies are unable to sell their primary-
sector products abroad because of protectionism in the developed world or
can only do so at relatively low prices because of the monopsony power of
large companies in developed countries. The fair trade movement is one way
in which farmers in these countries are supposed to benefit, therefore
improving development. Such schemes guarantee farmers a certain price for
their products, so that they are not subject to monopsony purchasing power
from developed countries. However, there are often a significant number of
‘middle men’ involved, reducing the benefits that fair trade farmers receive.
In addition, it is argued that supermarkets in developed countries are the
main beneficiaries. Further, fair trade schemes can result in a misallocation
of resources: low prices should encourage farmers to reallocate their
resources to the production of more profitable goods.

80 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

• Aid: there are different types of aid, ranging from humanitarian aid (such as
food and shelter in times of emergency), to grants (sums of money that do
not need to be repaid) and soft loans (money that must be repaid but at a
concessionary rate of interest). While many in the developed world see aid
as a positive thing, critics argue that much of the aid is squandered on
projects that will not contribute to development, or diverted into the private
bank accounts of government ministers. Other criticisms suggest that aid is
channelled into projects which have captured the global media interest and
that, in the long run, the provision of aid can reduce the level of
development in a developing country.
• Debt relief: many developing countries hit a ‘debt crisis’ in the 1980s and
1990s, as they could not afford to pay the interest on their large debts to
international financial institutions. This was a combination of interest rates
rising and the value of the dollar rising (and most loans were agreed in
terms of US dollars). Latin American countries and many African countries
were among the worst hit – Mexico defaulted on its loans first, and others
followed suit. This meant that these countries were then unable to borrow.
The massive debts that they had to repay meant that the governments of
these countries were unable to invest in human capital or other
infrastructure necessary for growth and development.
d Students are not expected to study the role of international institutions and
non-government organisations (NGOs) in depth but to have an awareness of
their roles.
The main functions of the World Bank include: granting reconstruction loans to
war devastated countries; granting developmental loans to underdeveloped
countries; providing loans to governments for agriculture, irrigation, power,
transport, water supply, education, health, etc.; and encouraging industrial
development of underdeveloped countries by promoting economic reforms.
The main functions of the International Monetary Fund (IMF) include: to ensure
the stability of the international monetary system – the system of exchange
rates and international payments that enables countries (and their citizens) to
transact with each other; to maintain stability and prevent crises in the
international monetary system by reviewing country policies and national,
regional and global economic and financial developments through a formal
system known as surveillance; and to provide member countries with finance to
correct balance of payments problems.
An NGO is any non-profit, voluntary citizens' group which is organised on a
local, national or international level. The work of NGOs has brought community-
based development to the forefront of strategies to promote growth and
development. The key characteristics of these community-based schemes are:
local control of small scale projects, self-reliance, an emphasis on using the
skills available and environmental sustainability.

4.4 The financial sector

This topic is designed to give students an introduction to the financial sector of
the economy, including the role of financial markets, market failure in the
financial markets and the functions of central banks.

4.4.1 Role of financial markets

a (a to e) Students are required to have a basic understanding of financial
markets in performing various roles: to facilitate saving; to lend to businesses
and individuals; to provide a means by which goods and services can be traded
easily; to reduce risks and provide greater certainty by enabling commodities
and currencies to be traded in futures markets; and to provide a market in
which stocks and shares can be traded.

© Pearson Education Ltd 2014. This material is not copyright free. 81

 4. Content guidance

4.4.2 Market failure in the financial sector

The examples of market failure in this section are covered in Theme 1 but are
related here to the context of the financial sector. For example:
• Asymmetric information – regulators may have insufficient information,
relative to the bankers, to ensure the stability of the banking system.
• Externalities – decisions by the financial sector could cause external costs.
For example, in 2009, the UK government had to spend over $45bn of
taxpayers’ money to prevent the collapse of RBS.
• Moral hazard – by rescuing banks from collapse, there is a danger that they
will follow inappropriate policies in the future because they know that the
government will rescue them.
• Speculation and market bubbles – poor lending decisions by bankers can
lead to market bubbles. For example, excessive lending to home buyers who
have no deposit and/or poor credit records can result in a housing bubble.
• Market rigging – it has been alleged that some bankers have been involved
in rigging key interest rates and exchange rates.

4.4.3 Role of central banks

a The key functions of central banks should be considered:
• Implementation of monetary policy – in a UK context this was covered in
Theme 2 (section 2.6.2).
• Banker to the government – central banks perform various banking services
such as handling accounts of government departments and making short-
term advances to the government.
• Banker to the banks – lender of last resort – if banks run into liquidity
problems they may be able to borrow direct from the central bank.
• Role in regulation of the banking industry – one example is that the central
bank may increase the reserve requirements that the banks need to have at
the central bank and therefore reduce the amount of money in circulation.
Following the financial crisis, regulations are being changed and new ones
introduced. Students will not be expected to know details of regulations but
would be expected to examine the possible consequences of those
mentioned in, for example, a data response question.

4.5 Role of the state in the macroeconomy

This section builds on Theme 2 (section 2.6.2) in which the concepts of fiscal
policy, taxes as a leakage from the circular flow, and direct and indirect taxes
were introduced. Students are now required to consider the macroeconomic
effects of changes in taxation more fully; reasons for changes in the size and
composition of public expenditure and the significance of its level for the
economy; and the significance of the state of public finances.

4.5.1 Public expenditure

This section relates to public (government expenditure), beginning with its different
types. Students should be able to suggest possible reasons for changes in the level
of public expenditure and its composition as well as demonstrating the ability to
analyse and evaluate the impact of changes in these levels.

82 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

a Capital expenditure refers to long-term investment expenditure on capital

projects such as Crossrail or new hospitals by the government.
Current expenditure relates to the government’s day-to-day expenditure on
goods and services. Examples include wages and salaries of civil servants, and
drugs used by the NHS.
Transfer payments are those made by the state to individuals without there
being any exchange of goods or services – there is no production in return for
these payments. Typically, transfer payments are used as a means of
redistributing income. UK examples include Employment and Support Allowance
for ill and disabled people and child benefit.
b Key factors in the changing size and composition of public expenditure in a
global context include:
• changing incomes, such as demand for many state-provided services is
income elastic
• changing age distributions – ageing populations in many developed
countries result in increased demands on healthcare
• changing expectations – new technology in services such as health and
education results in increased expectations
• the financial crisis – this has led to an increased proportion of public
expenditure being spent on debt interest in many countries.
c If public expenditure as a proportion of GDP is relatively high then there may
be some undesirable outcomes. For example:
• Crowding out – two types may be identified: resource or financial crowding
out. Resource crowding out occurs when the economy is operating at full
employment and the expansion of the public sector means that there is a
shortage of resources in the private sector. Financial crowding out arises
when the expansion of the state sector is financed by increased government
borrowing. This causes an increased demand for loanable funds which drives
up interest rates and crowds out private sector investment.
• Low productivity and a low rate of economic growth – this occurs because
the state sector is not motivated by the profit motive and so there may be
little incentive to increase efficiency.
• An increase in the national debt – if there were successive years in which
there was a budget deficit, this would increase the size of the national debt.
In turn, this would result in increased interest payments on the national
debt in the future which may mean that less public expenditure is available
for spending on public services such as new schools and hospitals.
On the other hand, if there is increased public expenditure on infrastructure,
transport, the health service and on education and training then this might help
to promote economic growth in the future.

4.5.2 Taxation
This section builds on work covered in Themes 1 and 2. Students should have a
clear understanding of the different categories and types of taxes and the impact of
changes in these taxes.
a Students should understand the distinction between progressive, proportional
and regressive taxes:
• Progressive taxation – as income rises, a larger percentage of income is paid
in tax (e.g. UK income tax).
• Proportional taxation – the percentage of income paid in tax is constant, no
matter what the level of income.

© Pearson Education Ltd 2014. This material is not copyright free. 83

 4. Content guidance

• Regressive taxation – as income rises, a smaller percentage of income is

paid in tax (for example, excise duties on tobacco, alcohol and petrol in the
UK).
b The economic effects of changes in direct and indirect tax rates on other
variables include the following:
• Incentives to work – for example, higher rates of income tax might act as a
disincentive for the unemployed to accept jobs or for those in employment
to work overtime.
• Tax revenues – reference to the Laffer curve, shown below:

When the tax rate is increased to point L, tax revenues increase. However, a
further increase in the tax rate from L to M causes a fall in tax revenue from
J to K. This may be explained by the following factors: increased
disincentives to work; an increase in tax avoidance and evasion; and a rise
in the number of tax exiles.
• Income distribution – a progressive tax, such as income tax, will tend to
redistribute income from those on higher incomes to those on lower incomes
if the tax revenues raised are used for benefits to the poor.
• Real output and employment – an increase in taxes will reduce aggregate
demand because taxes are a leakage from the circular flow of income. In
turn, this might reduce real output and cause an increase in unemployment.
• Rate of inflation – an increase in indirect taxes could be inflationary if it
causes a wage-price spiral; for example, increased indirect tax causes a rise
in prices which, in turn, leads to increased wage demands by workers
causing firms’ costs to rise and a further rise in prices.
• FDI – a higher rate of corporation tax might deter FDI if rates are lower in
other countries.
• The balance of trade – an increase in income tax would reduce disposable
income and consumption. In turn, this would reduce demand for imports
and so result in an improvement in the balance of trade.

84 © Pearson Education Ltd 2014. This material is not copyright free.

4. Content guidance

4.5.3 Public sector finances

a (a to c) A fiscal deficit occurs when government spending exceeds tax revenue,
whereas the national debt is the cumulative total of past government
borrowing.
A cyclical fiscal deficit occurs during a downturn in the economy because tax
revenues will be falling and government expenditure (for example on social
benefits) will be increasing. Such a deficit should disappear when the economy
returns to its trend growth rate. A structural fiscal deficit remains even when
the economy is operating at its full potential. It is, therefore, regarded as a
more serious problem than a cyclical deficit.
d Factors influencing the size of fiscal deficits include: the state of the economy,
the housing market (which influences revenues from stamp duties), political
priorities and unplanned events.
e Factors influencing the size of national debts include the size of fiscal deficits
and government policies.
f The size of fiscal deficits and national debts has an impact on: interest rates,
debt servicing, inter-generational equity, the rate of inflation, the country’s
credit rating and FDI.

4.5.4 Macroeconomic policies in a global context

This sub-topic builds on the work on macro policies covered in Theme 2 – students
should recap this area as a basis for this part of the specification. Students should
be aware of global causes of national macroeconomic problems, and therefore be
aware of the limitations of national macroeconomic policies in correcting these
problems. This would be a good opportunity to discuss the differences between
Keynesian and Monetarist approaches, using LR and SR aggregate supply curves.
a After many years in which fiscal policy was largely passive, the financial crisis of
2008 resulted in the use by many countries of fiscal policy as a Keynesian tool
to stimulate the economy. There is an important distinction between automatic
stabilisers and discretionary fiscal policy:
• Automatic stabilisers: government spending/taxation vary automatically
over the course of the economic cycle (e.g. G rises in a slump owing to
increased benefit payments and T falls as fewer people work and spend).
• Discretionary fiscal policy – deliberate alteration of government expenditure
and taxation designed to achieve its economic objectives.
Similarly, students should consider the use of monetary policy in a global
context and understand the implications of changes in interest rates, inflation
targets, quantitative easing and other monetary tools.
Students should understand that control of the money supply itself is extremely
difficult, as it is nearly impossible to actually measure the amount of money.
Further, control of inflation is becoming more difficult as the influence of
globalisation increases. For example, the growth of China has pushed up prices
of commodities, including food, causing cost-push inflation. This makes the
decisions of policy makers all the more difficult, causing more uncertainty about
the future.
Supply-side policies are designed to increase the productive potential of the
country and, therefore, increase its long-run aggregate supply. Such policies
are often advocated as part of a strategy to increase economic development
because they include: improving education so that people acquire appropriate
skills required in a modern economy; improving healthcare so that life
expectancy increases; teaching entrepreneurship so that more people are able
to start their own businesses; and reducing discrimination to encourage
increased labour force participation.

© Pearson Education Ltd 2014. This material is not copyright free. 85

 4. Content guidance

Direct controls are forms of control which work outside the market system.
They include: maximum price controls (for example, these might be used in
developing countries to control the price of food), minimum guaranteed prices
(including national minimum wages) and wage controls.
These policies should be considered with reference to the impact of:
• measures to reduce fiscal deficits and national debts – for example,
governments might increase taxes and reduce government expenditure
• measures to reduce poverty and inequality – for example, a government
might provide education and healthcare free of charge as means of reducing
poverty; or the tax system may be made more progressive and means-
tested benefits may be increased
• changes in interest rates and the supply of money – reference should be
made to Milton Friedman’s (Monetarist) view of inflation, ‘inflation is always
and everywhere a monetary phenomenon’, in contrast with the Keynesian
view that changes in money supply perform a more passive role by
increasing or decreasing to accommodate changes in the price level
• measures to increase international competitiveness – these may be linked
with policies previously considered, such as supply-side measures aimed at
increasing productivity; devaluation; or measures to engineer a depreciation
of the currency.
b Students could explore the effects of possible external shocks to the global
economy, such as a significant change in oil and/or commodity prices; a major
financial crisis; or a serious political crisis affecting a country or trading bloc.
c Measures to control the operations of global companies might include a
requirement that local factors of production, such as labour and local
component suppliers, are used; or a requirement that the global company
exports a certain proportion of its output; or requirements to set up joint
ventures with technology transfer to the domestic firm.
A particular issue is that of transfer pricing: this refers to the pricing policies
adopted by groups of companies for transactions between companies in the
group, such as the sale of goods or the provision of services. With corporate tax
rates varying considerably from country to country, there is the potential for
global companies to reduce their global tax charge by manipulating the prices
charged on intra-group transactions. Measures to regulate transfer pricing are
more difficult for less powerful countries.
One limit to a government’s ability to control global companies is that many are
‘footloose’, i.e. they may be able to move to another country easily and with
little cost. However, international agreements such as TRIMS (Trade Related
Investment Measures) introduced by the WTO have, for example, banned the
use of local content requirements.
d The problems facing policy makers when applying policies include inaccurate
information, risks and uncertainties and the inability to control external shocks.
• Inaccurate information – inaccurate or out-of-date information could include
on GDP, unemployment or the balance of payments on current account
when setting interest rates.
• Risks and uncertainties – it may be difficult for the authorities to predict the
impact of quantitative easing; or the impact of a country leaving the
Eurozone. Further uncertainties relate to the future behaviour of consumers
or businesses in their spending and investment plans.
• Inability to control external shocks – in an increasingly globalised world in
which countries are more closely integrated economically, it becomes more
and more difficult for an individual country to isolate itself from external
shocks.

86 © Pearson Education Ltd 2014. This material is not copyright free.