Economics HL

• Green = new unit, Yellow = new topic, Underline = new section

• Real world examples at the end → demand + supply side policies (WIP)

Unit 1: What is economics?

Factors of Production

• Land

  • natural resources

• Labour

  • human resources

• Capital

  • production of goods

• Entrepreneurship

  • management, ideas

Scarcity - limited availability of economic resources relative to society’s unlimited demand for goods and services

Efficiency - maximized production using supply and based off of individual choices (demand) or making the best possible use of scarce resources

Choice - not all needs and wants can be satisfied, so choices have to be made → opp. cost

Oppurtunity cost - what you give up to have something else

Economic cost - accounting/financial cost + oppurtunity cost

Sustainability - ability of the present generation to meet its needs without compromising the ability of the future generation(s) to meet their own needs

Margin - theory of how prices are derived, derived from consuming something, not total utility but extra utility of consuming

Production Possibilities Curve (PPC)

• a graph which indicates the different possible choices a firm can make to maximize profit while maintaining maximum efficiency

• difference between Price 1 and Price 2 is not the same as the difference between Price 2 and Price 3 (opp. cost is not equal in all scenarios)

• curve is named PPF (production possibility frontier)

• assumptions

  • technology, time and FOP are constant

  • only two goods are produced in this market

  • all of society’s income goes toward these two goods

Circular Flow Diagram

• GDP = C + I + G + (X-M)

  • Consumption, Investment, Government, eXports, iMports

• simplification of reality that takes out certain factors and makes them constant

Methodology

• Positive

  • scientific perspective on economics (hypothesis + data/evidence)

  • verifiable in principle

  • all other things remain equal (ceteris paribus)

• Normative

  • subjective value judgement

  • cannot be objectively verified/measured

  • nonquantifiable adjectives (important, ought to, must, etc.)

Economists

• Adam Smith

  • the “invisible hand” is a metaphor for efficient allocation of resources by society

  • laissaz faire - policy of letting things run their own course

• Karl Marx

  • labour theory of value

  • decreasing rates of profit and increasing concentration of wealth

  • more caring toward the masses

• Keynes

  • counter-cyclical government and multiplier

  • argued that governments had an important management role in macroeconomics

  • provided a foundation for modern macroeconomics

  • full employment is a special case and is not frequently occuring

  • incentive to invest is too weak and the urge to hoard cash is too strong

  • without necessary investment, the economy maximizes the unfull employment which increases productivity

19th Century Classical Economic Ideas

• Bentham

  • utilitarianism - most happiness among greatest number of people

  • utilty - property in any object tends to produce

  • benefits/advantages/pleasure/good/happiness or to prevent the opposite

• Jevon

  • Jevon’s paradox - as technological advancements increase efficiency of labour, demand will increase thus not changing efficiency and waste

• Say

  • Say’s Law - unemployment cannot exist for long periods because production would create its own demand

• Carl Menger

  • subjective theory of value - in an exchange, both parties always profit as they trade something they think is less valuable for something they think is more valuable

• Leon Walras

  • Walras’ Law - the existence of excess supply in one market must be matched by excess demand in another market so that both factors are balanced out

• Milton Friedman

  • economic theory should be subject to empirical corroboration to test its relevance to the real world

  • prediction is a key factor

  • not the realism of the assumptions but the accuracy

• Robert Lucas Jr.

  • individual’s rational expectations of inflation and government policies

• Friedman + Lucas

  • the role of markets is bringing the economy back to a situation where there is full employment without any government intervention

Free Sector Diagram

• Injections - investment (I), government spending (G), exports (X)

• Leakages - savings (S), tax (T), imports (M)

• If injections = leakages, the economy is in equilbrium/static

Behavioural Economics

• Assumptions made in behavioural economic graphs

  • people are rational/consistent

  • utility is maximized

  • people have access to all information at all times

• Thinking Fast/Slow

  • heurisitcs where people use rule of thumb to make quick decisions

• Present Bias

  • people under-invest because the benefits come in the future, and people generally would want benefits in the present

• Representative Individual

  • one person is recorded/measured and “cloned” to create a larger demographic

• Nudging

  • preserving freedom but helping people make decisions when they cannot / don’t (default)

• Hot-hand fallacy

  • belief that a winning streak leads to further success

• Biases

  • overconfidence

    • a belief that one’s skill or judgement is better than they truly are, or that probability of success is higher than it actually is (ex: health club membership)

  • hyperbolic discounting

    • tendency of people to make the present much more important than even the near future while making economic decisions (ex: credit cards)

  • framing effects

    • endowment effect - possessing a good makes it more valuable

    • loss aversion - a framing bias in which consumers choose a reference point around which losses hurt more than gains feel good

    • anchoring - a framing bias in which a person’s decision is influenced by specific pieces of information given

  • sunk cost fallacy

    • the mistake of a sunk cost to affect decisions (ex: Robert Griffin III)

Degrowth communism

• the economy is big enough already, when is the stopping point for growth?

• focus growth on more important aspects such as healthcare and not consumption as it raises healthcare costs

• example of Japan

Interdependence

• a consideration of possible economic consequences of interdependences is essential when conducting economic anaylsis

• nothing in the economy is self-sufficient, so they interact with one another (the greater the scale of interaction, the greater the interdependence)

Linear economy

• take → make → waste

• resource extraction → production → distribution → consumption → disposal

Circular economy

• take → make/remake → distribute → use/repair/reuse → selectively dispose → enrich/recycle → take → …

• aims to minimize waste and promote a sustainable use of natural resources

• problems

  • no clear definition (too vague)

  • ignores scientific principles (matter/energy cannot be created or destroyed)

  • lack of scale (hard to scale up to global level)

Systems perspective

• taking into account all of the behaviours of a system as a whole in the context of its environment

Economic efficiency

• socially constructed concept with its politics and its political implications

• public goal, competing with other public priorities

• to improve the state of one party, you must hurt another

• soceity gets maximum net benefits

Eco-efficiency

• production of goods and services while using fewer resources and creating less waste/pollution

• creating more value through an increase in resource productivity and a decrease in resource intensity

• leads to less resource consumption

Economic Well-Being

• refers to levels of prosperity, economics satisfaction and standards of living among the members of a society

Unit 2: Microeconomics

Marginal rate of substitution

• MRSxy = oppurtunity cost, slope of indifference curve

A series of optimal consumer choices provides the theoretical basis for an individual demand curve

Diminishing marginal utility

• as we consume more of a good, the satisfaction we derive from 1 additional unit decreases

• rate of satisfaction diminishes with every 1 unit

• examples: food, cars

Indifference curves

• IC always has a negative slope if consumer likes both goods

• IC cannot intersect

• Every good can lie on one IC

• ICs are not thick

Demand Theory

• Substitute effect

  • Measures of consumer MRSxy, before and after the price change

  • Amount of additional food the consumer would buy to achieve the same level of utility (assuming a price decrease in one good)

  • Moving from one optimal curve to another

  • Steps:

    • Identify initial optimum basket of goods

    • Identify final optimum basket of goods, after the price change

    • Identify the decomposition optimum basket (DOB), attributed to the substitution effect

      • DOB must be on a BL that is parallel to BL2 following the price change

      • Assume that consumer retains same level of utility after the price change

• Income effect

  • Accounts for price change by holding the consumer’s purchasing power (following price change) constant and finding an optimum bundle on a new (higher/lower) utility function

    • Purchasing power - number of goods/services that can be purchased with a unit of currency (falls when price increases)

  • Measured from the DOB (B and Xb) to the final optimum bundle, following price change (C and Xc)

  • Both effects move in the same direction

• Law of Demand

  • At a higher price, consumers will demand a lower quantity of a good (vice versa)

  • Relates to diminishing marginal utility by compensating (off-set) DMU must be negatively related to quantity

  • Inverse relationship of price and quantity

  • Given the presence of diminishing marginal utility, in order to promote increased consumption, prices must fall

  • For a “normal good,” the increase in consumption results from a fall in price - this is driven by:

    • a lower MRSxy, while remaining on the same IC generates increased consumption of good X (substitute effect)

    • the theoretical increase in income necessary to lift the consumer to the higher IC, while keeping the ratio of prices at the new level (income effect)

  • Economic theory of demand always starts at the individual level. A horizontal summation of many individual demand curves provides a market demand curve. Market demand curves are always less steep than individual demand curves

Determinants of Demand

• Income

• Price of substitutes/complements

• Number of consumers

• Preference or tastes

  • These factors cause a market demand curve to shift (change in demand)

Individual Demand Curve

• a series of optimal choice bundles across different price levels (shown on price-quantity graphs)

Inferior Good

• whether the substitution effect or income effect dominates in an empirical not theoretical question

• Opposite of a normal good, demand falls when income rises

Non-price determinants of demand

• income (normal good)

• income (inferior good)

• preferences/tastes

• price of substitute/complement goods

• number of consumers

Perfect Competition

• Economic profit maximization is the assumed goal of private firms

  

• Total cost represents the most efficient combination of inputs for a given level of output

• The rate at which total revenue (TR) changes with respect to change in output (Q) is marginal revenue (MR)

• MR = TR/Q = (Q*P)/Q = P

  

• Profits are maximized when marginal revenue = marginal cost

  • After the point where MR=MC, your profits will be negative

• Supply = MC, total cost optimized

Market Equilibrium

• the intersection of the demand and supply curves

• total cost is important as it is the basis of an individual firm’s supply curve

  • upward sloping section of the marginal cost curve is the supply curve

Efficiency of demand/supply curves

• Supply curves

  • Optimal combination of cost-minimizing inputs for each level of output

• Demand curves

  • Optimal combination of utility-maximizing goods for a given level of income

• Market supply curve

  • Horizontal summation of a series of individual supply curves

Supply Theory

• Supply - total amount of goods and services that producers are willing and able to purchase at a given price in a given time period

• Law of Supply

  • as the price of a product rises, the quantity supplied of the product will usually increase (ceteris paribus)

  • firms attempt to maximize product by increasing quantity supplied when the price is higher (and vice versa)

Non-price determinants of supply

• Changes in costs of factors of production

• Prices of related goods

• Indirect taxes and subsidies

• Future price expectations (producer)

• Changes in technology

• Number of firms

• Shocks

  • Markets only work when there is strong competition

Market Equilibrium Graphs (supply + demand)

Consumer Surplus (C.S.) - willingness to pay and what they did pay

Producer Surplus (P.S.) - difference between market price and lowest price a producer uses to produce

Assumptions of perfectly competitive markets

• all actions (consumers/producers) have access and fully process all relevant information

• there are many small buyers and producers - all with equally negligible market power

• all actors are rationally self-interested

Welfare - theoretical surplus value left with different economic agents (consumers, firms, governments)

Production - market clearings

Optimal Allocation

• MR = MB (marginal benefit)

• Social surplus = consumer + producer surplus

• In a perfectly competitive market, social surplus is at its largest

• Analysis of surpluses are called “welfare analysis”

Price Mechanism Functions

A - allocation (resources are allocated to those who need it most)

R - rationing (not everyone in the market gets what they want, only those who have the same valuation of the product as the firms)

S - signaling (communication of information that drives other factors)

I - incentive (capitalist system is driven by incentives)

2 Demand Curves

2 Supply Curves

• Moving from point 1 to point 3 on both graphs

• Point 2 has excess supply/demand

• ARSI to move to the new equilibrium point

• At both equilibriums, there is optimal allocation

Structure of Microeconomics

• How do consumers and producers make choices in trying to meet their economic objectives?

  • Demand

  • Supply

  • Competitive market equilibrium

  • Elasticities of Demand

  • Elasticities of Supply

  • Critique of the maximizing behavior of consumers and producers

  • interaction between consumers and producers determine where resources are directed

  • welfare is maximized if allocative efficiency is achieved

  • constant change produces dynamic markets

  • consumer and producer choices are the outcome of complex decision making

• When are markets unable to satisfy important economic objectives - and does government interaction help?

  • Role of government in microeconomics

  • Market failure

    • externalities and common pool or common access resources

    • public good

    • asymmetric information (imbalanced information held by consumers and/or consumers)

    • market power (single/small number of suppliers)

Price Elasticity of Demand (PED)

• measure of the responsiveness of the quantity demanded of a good subject to the change in price

  • Percentage change and differentiation to calculate

• the greater the PED, the more sensitive the quantity demanded is to changes in price

• PED = percentage change in quantity demanded / percentage change in price

  

• |PED| > 1 demand is relatively elastic

• |PED| < 1 demand is relatively inelastic

• |PED| = 0 demand is unitary

• PED = ∞ perfectly elastic (horizontal demand curve)

  • quantity demanded responds infinitely to changes price

• PED = 0 perfectly inelastic (vertical demand curve)

  • fixed price: quantity demanded does not change at all when price changes

How can PED change along a straight line?

• as you move along the x-axis, it gets less elastic

  • as quantity increases, elasticity decreases

Determinants of Price Elasticity of Demand (PED)

• number of close substitutes

  • more subtitutes = increased price sensitivity

    • substitution effect

• luxuries VS staples

  • higher proportion of income spent on the good = increased price sensitivity

    • expensive good alerts the consumer more when price changes

• necessity

  • if consumers really need the product (ex: food), then they will not change their quantity demanded when price changes therefore inelastic

• time

  • purchases made with longer time periods are generally more elastic

    • short-run → less elastic, long-run → more elastic

How does PED change across income levels?

• more elastic for lower income groups

  • increased necessity and proportion of income for each good

• elasticity depends on the good (price-quantity relationship)

• quantity demanded changes, but not the demand curve

• “staples” are essential, less elastic

  • necessity, not many close substitutes, cheap

Applications of PED

• pricing decisions by firms regarding price changes and effects of a change of price on total revenue (TR) → price * quantity

  • inelastic → % change in Q < % change in P

    • when TR rises, P rises and vice versa

• government decisions regarding indirect taxes

  • elastic → % Q > % P

    • if an indirect tax is applied, unemployment could increase due to the decreased revenue for firms when they change the price with the tax

Income Elasticity of Demand (YED)

• measure of how much demand for a product changes when there is a change in the consumer’s income

• YED = percentage change in quantity demanded / percentage change in income

  

• |YED| > 1

  • income-elastic

  • luxury goods

  • % change in D > % change in income

• |YED| < 1

  • income-inelastic

  • necessity goods

  • % change in D < % change in income

• YED to categorize inferior and normal goods

  • normal good → when income increases, demand increases

    • positive YED value

  • inferior goods → when income increases, demand decreases

    • negative YED value

Engel Curve

• axes → income and quantity

• |YED| > 1 luxury/service, |YED| < 1 necessity

  • YED > 0 normal good

  • YED < 0 inferior good

• quantity demanded when income increases also increases then diminishes and goes backwards

• if you continue a segment AB with the same slope and that line cuts the y-axis, then it is a luxury

  • if it cuts the x-axis, it is a necessity

  • only works on income = y and quantity = x

Primary Commodities

• raw materials (cotton, coffee)

• inelastic demand (they are necessities)

• consumers are not everyday households, but manufacturers

Manufactured Goods

• made from primary commodities

• more elastic, as there are more substitutes

Why is YED important?

• For firms:

  • products with a high YED will see a demand increase when income increases (used to see maximum profit based off changes in income)

    • allocation of resources to fit income groups in products

    • if income falls, production of inferior goods increase because of YED rules

• Sectoral changes

  • primary sector: agriculture, fishing, extraction (forestry, mining)

  • secondary sector: manufacturing, takes primary products and uses them to manufacture producer goods (machinery, consumer goods) also includes construction

  • tertiary sector: service, produces services or intangible products (financial, education, information, technology)

  • shifts in the relative share of national output and employment

  • as countries grow and living standards improve, there is a change in proportion of the economy that is produced

  • extra income is spent on manufactured goods as the demand is more elastic than the primary products (using YED to measure/verify) ← same goes for the service sector

    

Price Elasticity of Supply (PES)

• sensitivity/responsiveness of quantity supplied to changes in price

• PES = percentage change in quantity supplied / percentage change in price

• PES > 1 relatively elastic

• PES < 1 relatively inelastic

• same rules as per PED except no absolute value because of positive relationship between price and quantity supplied

Determinants of F

• time

  • producers cannot adjust quantity supplied quickly

    • short-run → inelastic, long-run → elastic

• mobility of factors of production

  • easy to swich between production → more elastic and vice versa

• unused capacity

  • if there is a sudden increase in quantity demanded, then firms can use unused capacity to increase production

    • more unused capacity → more elastic

• inventory/ability to store stocks

  • the more there is in stock, the easier it is to distribute a product if demand increases

    • more inventory → more elastic

Primary commodities → relatively inelastic

• takes time to grow/extract which makes it more difficult to increase production

• not always easy to store → time

Manufacture products → relatively elastic

• easier to increase production and/or keep inventory

2.4 - Behavioural Economics

Assumptions of Rational Consumer Choice

• free markets are built on the assumptions of rational decision making

• in classical economic theory, rational means economics agents are able to consider the outcome of their choices and recognise the net benefits of each one

  • rational agents - will select the choice that reaps highest benefit/utility

• Rational choice theory - individuals use logic and sensible reasons to determine the correct choice (connected to an individual’s self-interest)

• Consumer Rationality

  • assumption that individuals use rational calculations to make choices which are within their own best interest (using all information available to them)

• Utility Maximization

  • economic agents select choices that maximize their utility to the highest level

• Perfect Information

  • information is easily accessible about all goods/services on the market

  • individuals have access to all information available at all times in order to make the best possible decision

Limitations of Assumptions of Rational Consumer Choice

• behavioural economics recognizes that human decision-making is influenced by cognitive biases, emotions, social, and other psychological factors that can lead to deviations from rational behaviour

• individuals are unlikely to always make rational decisions

• 5 limitations are shown below:

1. Biases

• biases influence how we process information when making decisions = influence the process of rational decision making

  • example: common sense, intuition, emotions, personal/social norms

• Types of Bias

  • Rule of Thumb - individuals make choices based on their default choice gained from experience (ex: same product from same company, but not the best possible choice)

  • Anchoring and Framing - individuals rely too heavily on an initial piece of information (anchor) when making subsequent judgements or decisions (ex: car dealer says car is worth $10,000 and you know it’s worth less, but this anchor of information causes you to purchase the car for a higher price)

  • Availability - individuals rely on immediate examples of information that come to mind easily when making judgements/decisions (causes individuals to overestimate the likelihood/importance of events/situations based on how readily available they are in their memory)

2. Bounded Rationality

• people make decisions without gathering all necessary information to make a rational decision within a given time period

• rational decision making is limited because of

  • thinking capacity

  • availability of information

  • lack of time available to gather information

• too many choices also cause people to make irrational decisions

  • example: in a supermarket, there are too many choices of products of the same good, making it difficult to reach a decision

3. Bounded Self-Control

• individuals have a limited capcity to regulate their behaviour and make decisions in the face of conflicting desires or impulses

  • self-control is not an unlimited resource

• because humans are influenced by family, friends, or social settings, it causes social norms to interfere in decision making (does not result in the maximization of consumer utility)

• decision making based on emotions → does not yield the best outcome

• businesses capitalize on the lack of bounded self-control of individuals when appealing to their target audience to maximize sales

4. Bounded Selfishness

• economics agents do not always act within their own self interest

• individuals do things for others without a direct reward

  • ex: altruism - selflessness without expecting anything in return

5. Imperfect Information

• information is not perfectly accessible due to:

  • intelluctual property rights

  • cost of accessing information

  • amount of information and options available

• people make decisions based on limited information

• asymmetric information may also lead to decisions based on limited information

  • when one party has more information than another

Choice Architecture

• intentional design of how choices are presented so as to influence decision making

• simplifies the decision making process

• 3 types, as shown below:

1. Default Choice

• individual is automatically signed up to a particular choice

• decision is already made even when no action has been taken

• individuals rarely change from the default change

2. Restricted Choice

• choices available to individuals are limited which helps individuals make more rational decisions

3. Mandated Choices

• requires individuals to make a specific decision or take a particular action by imposing a requirement or obligation

• mandated choices can be used to ensure compliance with regulations or societal norms, making it necessary for individuals to make certain decisions

Nudge Theory

• practice of influencing choices that economic agents make, using small prompts to influence their behaviour

• firms should use nudges in a responsible way to guide and influence decision making

• designed to guide people toward certain decisions or actions while still allowing them to have freedom of choice

• consumer nudges should be designed with transparancy, respect for individual autonomy, and clear societal benefits in mind

Profit Maximization

• most firms have the rational business objectiveof profit maximization

  • profits benefit shareholders as they receive dividends and also increase the underlying share price

    • an increase in the underlying share price increases the wealth of the shareholder

• profit maximization rule

  • when MC=MR, then no additional profit can be extracted from producing another unit of output

  • when MC<MR, additional profit can still be extracted by producing another unit of output

  • when MC>MR, the firm has gone beyond the profit maximization level of output and starts making a marginal loss on each unit produced (beyond MR=MC)

• in reality, firms find it difficult to produce at the profit maximization level of output

  • the level may be unknown

  • in the short term, they may not adjust their prices if the marginal cost changes

    • MC changes regularly and regular price changes would be disruptive

  • in the long-term, firms will seek to adjust prices to the profit maximization level of output

  • firms may be forced to change prices by the competition regulators in their country

    • profit maximization level of output often results in high prices for consumers

    • changing prices changes the marginal revenue

Growth

• increasing sales revenue/market share

• maximize revenue to increase output and benefit from economies of scale

  • a growing firms is less likely to fail

1. Revenue Maximization as a Sign of Growth

• in the short-term, firms may use this strategy to eliminate the competition as the price is lower than when focusing on profit maximization

• firms produce up to the level of output where MR=0

  • when MR>0, producing another unit of output will increase total revenue

2. Market Share as a Sign of Growth

• sales maximzation which further lowers prices and has the potential to increase market share

  • occurs at the level of output where AC=AR (normal profit/breakeven)

• firms may use this strategy to clear stock during a sale to increase market share

  • firms sell remaining stock without making a loss per unit

Satisficing

• pursuit of satisfactory/acceptable outcomes rather than profit maximization

  • decision-making approaach where businesses aim to meet a minimum threshold or standard of performance rather than striving for the absolute best outcome

• small firms may satisfice around the desires of the business owner

• many large firms often end up satisficing as a result of the principal agent problem

  • when one group (the agent) makes decisions on behalf of another group (the Principal), often placing their priorities above the Principal’s

Corporate Social Responsibility (CSR)

• conducting business activity in an ethical way and balancing the interests of shareholders with those of the wider community

• extra costs are involved in operating in a socially responsible way and these costs must be passed on to consumers

2.7 - Government Intervention

Why do governments intervene in markets?

• Influence (increase/decrease) household consumption

  • decrease consumption of demerit goods

• provide support to firms

• earn revenue

• influence the level of production of firms

• provide support to low-income households

• correct market failure

• promote equity

Microeconomic forms of government intervention

• price controls

• indirect taxes

• subsidies

• direct provision of services

• command and control regulation and legislation

• consumer nudges

Price controls

• price ceiling + price floor

• Price Ceiling

  • maximum price

  • below equilibrium point

  • the point where the price ceiling is set is Pmax

    • at Pmax, firms are willing to supply Qmax but the consumers demand a quantity above Q*

  • shaded area - 2 triangles, a and b

    • a = amount by which consumer surplus is reduced

    • b = amount by which produer surplus is reduced

  • excess demand shown by the values Qmax - Q1

    • managed through subsidies and tax breaks → costs

• Price Floor

  • minimum price

  • above equilibrium point (Pmin)

  • common in agriculture

  • areas c, e, f, g, h are government expenditure → excess supply

  • producer surplus is increased (d+e → b, c, d, e, f)

    • f = directly from the government to the producers

  • a price floor creates welfare loss, indicating allocative inefficiency due to an overallocation of resources to the production of goods

  • society is getting too much of the good

Indirect taxes

• imposed on spending to buy goods and services

  • both consumers and producers pay a share of the tax

  • firms practically pay the tax

• excise taxes - imposed on particular goods/services (ex: imports)

• taxes on spending - value added tax (VAT) or goods/services tax (GST)

• direct taxes are those directly paid to the government by taxpayers

• an indirect tax creates a tax wedge

  • consumers face a higher price, while producers receive a lower price

• Qt - Q* → lost sales (potential sales but they are lost/didn’t happen because of the tax)

  • Pp - price for producers, marginal cost

  • area of rectangle = government revenue

  • Pc - price for consumers

  • Pc>Pp, so demand decreases

• shifts from S → S1

  • new equilibrium point formed at (Qt, Pc)

  • 2 triangles, a and b

    • a + b - welfare loss, Dead Weight Loss (DWL)

      • both disappear, allocative inefficiency

      • a - consumer surplus loss

      • b - producer surplus loss

  • 2 prices, C.S. and P.S. at different equilibriums

Subsidies

• assistance by the government to individuals (firms, consumers, industries)

• results in greater consumer and producer surplus

  • society loss as government spending on subsidy

• loss from government spending is greater than the gain in surplus

  • welfare loss (allocative inefficiency) due to overallocation of resources to the production of goods (overproduction)

• Pp and Pc switched (from indirect taxes), as consumers pay less and producers receive more

• a = dead weight loss (DWL) due to overproduction

  • supply curve shifts (S → S1) because of one of the non-price determinants of supply (subsidies)

    • S1 = S + subsidy

2.8 - Market Failures

• externalities are market failures, both positive and negative

  • also known as spillover effects

• positive externalities: MS > MP at all levels of output up to the socially optimal level

• negative externalities: MS < MP at al levels of output up to the socially optimal level

Merit Goods

• goods that are beneficial to consumers but people do not consume enough

  • people underestimate/ignore potential benefits, caused by imperfect access to information

• causes the demand to be lower than it should be

• rivalrous and excludable

  • rivalrous → consumption of a merit good reduces amount available to others

  • excludable → possible for suppliers to prevent non-payers from benefitting from them

• examples: healthcare, education

Positive externality of consumption

• goods that when consumed, both the consumer and third parties benefit from it (external benefits)

  • ex: healthcare

• MSC - marginal social cost

  • MPB - marginal private benefit

  • MSB - marginal social benefit

  • in a free market, people would consume where MPB=MSC (Q1, P1)

  • (Q*, P*) where MSB=MSC is the socially optimal level (potential welfare gain) because from Q1-Q*, MSB>MSC

  • if MPB shifts from Q1-Q* (toward MSB), then the welfare loss is gained (potential welfare gain = welfare loss)

  • MPB<MSB because there is an underconsumption of the merit good, and therrefore the shaded area above (potential welfare gain) is not gained by the society indicating a market failure

    • can be regarded as a welfare loss

• underallocation of resources to this market (underproduction)

Government “fix”to positive externality of consumption

• increasing consumption of merit goods

• subsidies/direct provision

  • shifts the MSC curve rightwards

  • new socially efficient level at Q* but at a lower price (P2)

  • P2 < P1 < P*

• improving information (merit goods)

• legislation: government passing laws that force citizens to consume the good

Positive externality of production

• production of a good creates external benefits for third parties

  • ex: human capital: training employees

• MPC - marginal private cost

  • produces where MPC=MSB, where Q1 is located (Q1 < Q*)

  • if production increases to Q*, there is a welfare gain (welfare loss turned into welfare gain)

  • since MSC>MPC, there is an underconsumption of the merit good

• underallocation of resources → market failure, allocative inefficiency

Government “fix” to positive externality of production

• subsidies

  • causes MPC to be shifted downwards

  • full subsidy causes MPC=MSC when shifted

• direct provision

  • high cost

  • offering training through the state for firms causes MPC=MSC

Demerit Goods

• goods that are harmful to the consumer but people still consume either because they are unaware of or ignore the potential harm

  • caused by imperfect information

  • demand is higher than it should be

  • creates negative externalities when consumed

• example: cigarettes, alcohol, gambling, junk food, drugs, prostitution

Negative externality of consumption

• consumption of a demerit good causes adverse effects to third parties

  • ex: second hand smoking

• in a free market, people maximize their private utility so they consume at MPB=MSC

  • there is a welfare loss as MSC>MSB from Q*-Q1

  • overconsumption of demerit goods

  • too many resources allocated to this market (demerit)

Government “fix” to negative externality of consumption

• indirect taxes

  • taxes reduce consumption (DIAGRAM INCORRECT, CHECK TEXTBOOK)

• legislation/regulation

  • making laws against the overconsumption of demerit goods

• education/raising awareness

Negative externality of production

• production of a good negatively impacts third parties

  • example: fumes from a factory

• MSC<MPC so MPC=MSC+costs

  • MPC is below MSC, because there is an external cost added to society

  • producers produce at Q1

  • from Q1-Q*, MSC>MSB

  • welfare loss → market failure

Government “fix” to negative externality of production

• indirect taxes

  • closes gap between MSC and MPC (MPC shifts leftward toward MSC to reduce level of consumption of demerit good)

Common Pool Resources

• rivalrous and non-excludable (linked to negative externalities)

  • rivalrous: if one person uses, others cannot at the same level of utility

  • non-excluable: very difficult to exclude people/groups of people from using

• typically natural resources

  • examples: fishing grounds, forests, atmosphere, etc.

Government “fix” to negative externality of production

• international agreements

• tradable permits

• carbon taxes

• legislations/regulations

• subsidies

Consequences for Stakeholders

• Ronald Coase → transaction costs are a way of attempting to measure the impossible, to measure the charges for externalities

• externality = transaction cost; there is a threshold where the transaction cost is too high so it is considered an externality

• sometimes when transaction cost is low, government intervention is not needed

Collective self-governance

• a solution to the over-use of common pool resources

• users take control of the resource and use them in a sustainable way

• applies at a local level (small communities)

• pressure in small communities to operate within social norms

• Ostom’s theories → no authority needed

Carbon Tax VS Tradable Permits

• carbon taxes are easier than tradable permits (design + implementation)

• carbon taxes are more difficult to manipulate for/against certain groups

• carbon taxes do not require as much monitoring

• carbon taxes are regressive

  • affects low-income groups more than high-income groups

• tradable permits more easily control the level of carbon reduction

• carbon taxes are easier to predict

  • businesses need certainty to plan for the future

• rivalrous → one person consuming the good prevents another from consuming it

• excludable → able to stop other people from consuming it once it has been provided

• Common Pool Resource - rivalrous and non-excludable

  • no price signals

  • Tragedy of the Commons

    • overuse/over-consumption of the resource which may lead to depletion

• Private Good - rivalrous and excludable

• Public Good - non-rivalrous and non-excludable

  • free-rider problem → other people benefit from the good without paying for it

• Quasi-public Good - non-rivalrous and excludable

Asymmetric information

• when one party has more information than the other

• buyers and sellers do not have equal access to information

  • either the buyer or seller has more information

Adverse Selection

• when one party in a transaction has more information on the quality of the good than the other party

Moral Hazard

• one party takes risks but does not face the full costs of these risks because the full costs of the risks are borne by another party

Perfect Competition / Rational Producer Behaviour

1. Suppliers and consumers are made up of equally small individuals

2. No barriers to market entry or exit

3. Firms are profit maximizing

4. Consumers are fully rational and consistent

5. Products sold are homogenous

6. Full information throughout the market

• cannot set the price:

Imperfect competition - monopolies

• monopoly market - where only one supply operates

  • the assumption of many small suppliers does not hold

  • 1 supplier with absolute control over the market price

• monopolist sets price at maximum total revenue

• as quantity increases, total cost increases, total revenue increases then decreases

Monopoly

• single seller facing many buyers

  • profit maximization condition: ΔTR(Q)/ΔQ = ΔTC(Q)/ΔQ

    • MR(Q) = MC(Q)

• MR>MC → firm increases Q

• MR<MC → firm decreases Q

• MR=MC → maximizes profit, cannot increase

• to sell more units, a monopolist lowers price

  • increase in profit = III while revenue sacrificed = I

  • change in TR = III-I

  • Area III = P * ΔQ

  • Area I = -Q * ΔP

  • change in monopolist profit: P(ΔQ) + Q(ΔP)

  • MR = ΔTR/ΔQ = (PΔQ + QΔP)/ΔQ = P+Q(ΔP/ΔQ)

    • MR → P=increase in revenue due to higher volume - marginal units = Q(ΔP/ΔQ): decrease in revenue due to reduced price

  • AR = TR/Q = PQ/Q = P

  • price a monopolist can change to sell quantity Q is determined by the market demand curve (the AR curve = market demand curve)

    • AR(Q) = P(Q)

  • if Q>0, MR<P and MR<AC (MR lies below demand curve)

  • firms produce at MR=MC to maximize profits

• TR = B+E+F

  • Profit = B + E

  • L.S. = A

  • PED impacts the revenue

    • inelastic = more revenue

  • margin drives the average

• P=a-bQ TR=P*Q
  TR=(a-bQ)Q=aQ-bQ²
  dTR/dQ = a-2bQ

• Characteristics of a monopoly market

  • single firm in the market

  • no close substitutes - monopolist’s good or service is unique

  • high barriers to entry

• Long Run - factors of production are constant

• Short Run - only labour can change (not land or capital)

• Economies of Scale

  • LRAC = Long Run Average Cost

    • considered a barrier to entry

    • as the monopolist increases production, their costs go down as output goes up

    • if new firms try to compete, they are unable to keep up with the costs of the large firm

Profits

• normal (π=0) → 0 profit

  • entrepreneurship is factored into the costs, so the wages are added into TC

• abnormal (π>0)

• loss (π<0)

• π = TR-TC = (PQ) - (CQ)
  π/Q = AR-AC = PQ/Q - CQ/Q = P-C
  AR = P, AC = C

  • normal profits are defined by the minimum revenue a firm must make to keep the business from shutting down (covers implicit and explicit costs)

• in a perfectly competitive market:

  • there are no profits in the long run

    • due to free entry + full information

    • there are economic profits in the short run

  • P*=AR=MR, all horizontal lines

• in a monopoly market:

  • can change the price but are still bounded by the demand, so AR and MR are no longer horizontal lines as they are in perfectly competitive markets

Perfectly Competitive Profits

• for a single firm

  • normal profits (P*=AC)

  • MC cuts AC at its minimum

  • P* = AR = AC (when AR=AC, π=0)

• abnormal profits (P*>AC)

  • AR>AC, so profits are positive (π>0)

  • sells at Q*

  • shaded area = profit

• loss (P*<AC)

  • AR<AC, so profits are negative (π<0), so there is a loss

  • shaded area = loss

• Rules for a single firm in a perfectly competitive market

  • cannot determine price, so they determine the quantity at MR=MC due to the profit maximizing rule

  • they also determine profit when AR=AC (AR=AC=π=0)

Monopolist Profits

• normal profit (π=0)

  • higher price, lower quantity

  • profit = difference between AR and AC

  • Q*=P*=AR=AC, so there is no profits

• abnormal profit (π>0)

  • AR>AC

  • shaded area = profit

  • Q* determined where MR=MC, then find AR/D when it is equal to Q*

  • AC1 determined where AC is when it is at Q*

• loss (π<0)

  • same as abnormal profit, Q*, MR=MC, but AC>AR

  • shaded area = negative profit = loss because cost > revenue

Unit 3: Macroeconomics

Equality and Equity

• Equity → income inequalities are needed to create incentive

• Equality → equal distribution of income (minimizing income gap)

• Market is unable to achieve equity

  • Equity → concept/idea of fairness; normative, means different things to different people

  • inequity is not inequality → distribution of wealth, income, or human opportunity

National Income Accounting

• used to measure amount of economic activity in a country

  • money value of all goods and services produced in a year

  • can be measured through things like GDP

1. output method

   • actual value of all finished goods and services produced each year

   • prevents double counting

   • measures level of economic activity

2. income method

   • calculates the value of all factor incomes earned in the economy

     • sum of wages and salaries (labour), rent (land), interest (capital), profits (enterprise) → factors of production

   • national income (Y) → households receive factor incomes for output produced

3. expenditure method

   • total value of all spending

     • total spending on all newly produced goods and services

   • comprising C, I, G, and (X-M)

     • C → spending by individuals and households (largest component)

     • I → spending by all firms (gross fixed capital formation)

     • G → spending of the public sector

     • (X-M) → import expenditure

Circular flow of income

• injections → add money to increase size (inc. in G, I, X)

• leakages → remove money to reduce size (inc. in savings, tax, import)

Gross National Income (GNI)

• GNI = GDP + (income earned abroad) - (income sent abroad)

Aggregate Demand (AD)

• AD is the total demand for all goods and services in an economy at any given average price level

• value often calculated using expenditure approach

  • AD = C+I+G+(X-M)

• if AD has increased, economic growth has occured (and vice versa)

• a 1% increase in C or G is much more significant than a 1% increase in (X-M)

• AD curve is downward sloping

• whenever there is a change in average price level, there is movement along the AD curve

• if there is a change in any non-price determinants of AD, the AD curve shifts

• increase in the non-price determinants results in a rightward shift

  • at every price level, real GDP has increased

Factors of Aggregate Demand

• consumption (C)

  • consumer confidence →

  • interest rates ←

  • wealth →

  • income taxes ←

  • level of household debt ←

  • expectations of future price levels →

• investment (I)

  • interest rates ←

  • business confidence →

  • technology →

  • business taxes ←

  • level of corporate debt ←

• government spending (G)

  • political priorities

  • economic priorities

• net exports (X-M)

  • income of trading partners →

  • exchange rates ←

  • trade policies

Real GDP and GNI

• adjusted for inflation

  • calculated using a price deflator (GDP deflator)

• converts current prices to constant prices

• Real GDP = (nominal GDP / GDP deflator) * 100

• Real GNI = Real GDP + net income earned abroad

• Real GDP per capita = Real GDP / population

• Real GNI per capita = Real GNI / population

• purchasing power parity (ppp)

  • used to calculate relative purchasing power of different currencies

  • shows number of units of a country’s currency that are required to buy a product in the local economy, as $1 would buy the same product in the USA

Business Cycle

• Recession

  • two or more consecutive quarters (6 months) of negative economic growth

  • increasing/high unemployment

  • increasing negative output gap and spare production capacity

  • low confidence for firms and households

  • low inflation

  • increase in government expenditure (great budget deficit)

• Boom

  • increasing/high rates of economic growth

  • decreasing unemployment, increasing job vacancies

  • reduction of negative output gap or creation of positive output gap

  • spare capacity reduced/eliminated

  • high confidence = riskier decisions

  • increasing rates of inflation → usually demand-pull

Alternative Measures of Well-being

• OECD Better Life Index → 11 factors

  • Housing

  • Jobs

  • Income

  • community

  • education

  • environment

  • civil engagement

  • health

  • life satisfaction

  • safety

  • work-life balance

• The Happiness Index → 14 factors (scale from 0-10)

  • business and economic

  • citizen engagement

  • communications and technology

  • diversity (social issues)

  • education and families

  • emotional well-being

  • environment and energy

  • food and shelter

  • government and politics

  • law and order (safety)

  • health

  • religion and ethics

  • transportation

  • work (employment)

• The Happy Planet Index → 4 factors

  • well-being → how citizens feel about their life overall (0-10)

  • life-expectancy → number of years a person is expected to live

  • inequality of outcomes → inequalities of people in a country (well-being, etc.)

  • ecological footprint → impact a person has on an environment

Aggregate Demand (AD) Curve

• negative relationship between price levels and real GDP

1. wealth effect

   • when price levels increase, real value of wealth decreases, decreasing consumer confidence thus reducing demand/output

2. interest rate effect

   • increase in price levels leads to a fall in output demanded due to interest rates increasing because of an increased need for money

3. international trade effect

   • rising price level causes a fall in exports and a rise in imports due to domestic price increasing but others stay the same

Short Run (SR) and Long Run (LR)

• SR in macroeconomics in the period of time when prices of resources are rougly constant/inflexible, in spite of changes in the price level

• LR in macroeconomics is the period of time where prices of all resources (labour/wages) are flexible and change with changes in the price level

  • wages account for the largest part of the firm’s costs of production

• SRAS - short run aggregate supply

  • profitability causes positive relationship between price levels and real GDP (increase in price = increase in output) and with unchanging resource prices, profits increase

  • Determinants of SRAS:

    • costs of factors of production

    • indirect taxes/potential subsidies/supply shocks

• LRAS - long run aggregate supply

  • Monetarist/Neoclassical model

    • price mechanism

    • competitive market equilibrium

    • economy as a harmonious system (automatically tends to full employment)

  • LRAS is vertical due to changing resource prices

  • located at Yp (potential GDP) at the full employment level of real GDP

  • in the LR, economy produces potential GDP, which is independant of the price level

• inflationary/deflationary gap - difference between SR and LR equilibrium

  • inflationary → SR>LR

  • deflationary → SR<LR

• market corrections → either SRAS or AD curve shifts (different price levels, same GDP)

  • inflationary gap:

  • deflationary gap:

Keynesian model

• equilibrium at different sections means different things (where AD=AS)

• Ymax is where there is full employment

• economy can be below full employment level, even in the long run

• section 1 → AS is perfectly elastic as there is spare capacity (any increase in demand has no direct impact on general price levels)

• section 2 → AS is relatively price elastic (upward sloping) as there is pressure of scarce resources as the economy grows

• section 3 → AS is perfectly inelastic as there is no longer any spare capacity (all factor resources are fully employed)

  • any increase in AD beyond full employment level is inflationary

Shifts of the AS curve

• Short run

  • costs of factors of production / indirect taxes

  • labour costs - wages/salaries account for a significant portion

  • raw material costs - increase means increase in costs of production

  • exchange rate - rise means domestic firms can buy imports at a lower price

  • interest rates - borrowing

  • bureaucracy and administration - legal procedures and policies

• Long run

  • changes in economy’s quantity of factors of production

  • improvements in technology

  • increases in efficiency

  • changes in institutions

  • reductions in natural rate of employment

Long Run Equilibria

• full employment is not zero unemployment (unemployment always exists)

  • frictional → certain number of people are in between jobs

  • seasonal → redundancies are caused by cyclical factors in the year

  • structural → skills mismatch in certain industries

• Monetarist/Neoclassical model

  • occurs at full employment level of output (potential output)

• Keynesian model

  • increase in AD increases national output without changing the general price level

  • increased demand for scarce resources and labour shortages cause general price levels to rise as national output increases

  • full employment level of output

  • firms compete for highly limited resources

  • general price increases but GDP is at its max

Macroeconomic objectives

• economic growth

• low unemployment

• inflation

Economic Growth

• maximization of the factors of production → quality + quantity

• long-term economic growth

  • above potential level → something is wrong

  • short-term economic growth

• actual output → current level fo real GDP

  • represented by any point on PPF diagram

• actual growth → rate at which actual moves towards potential

  • short-term → below full level of unemployment

  • annual percentage change of a country’s output

• short-run economic growth

  • increase in AD (rightrward shift) → Keynesian + Monetarist

  • increase in SRAS (rightward shift) → Monetarist

• long-run economic growth

  • increase in potential output

    • achieves both economic growth and full employment

  • shift of the AS → monetarist + Keynesian

• measurements of economic growth

  • nominal: rate of change in monetary value of GDP

  • real: accounts for inflation

Consequences of economic growth

• living standards

  • generally leads to higher living standards

    • higher real income per capita

  • reduction/elimination of absolute poverty (not able to purchase essential goods)

  • raises consumption → encourages investment in capital → sustains growth

  • increased tax revenues (for taxes on expenditure/income) enable government to fund more merit goods

  • increased consumer spending → higher sales revenue (firms) → greater profits

  • spending on demerit goods increase → in long run, causes social welfare loss

  • risk of inflation increases → excessive aggregate demand → negative consequences

• environment

  • creates negative externalities that cause problems to the environment

  • creates market failures caused by resource depletion

    • damages social and economic well-being in the long run

  • resource depletion not always sustainable → intergenerational equities

  • green GDP → adjustment of a country’s GDP to take into account environment degradation

• income distribution

  • often generates greater disparities in distribution of income/wealth

    • not everyone benefits from economic growth

      • example: rich get richer, poor get relatively poorer

  • greater tax revenues = government redistribution of income/wealth in the economy

Low Unemployment

• employment - use of factors of production in the production process

  • use of labour resources

  • governments want all available and willing to be employed

• formal sector employment → officially recorded employment → workers paying income taxes and contributing to the country’s official GDP

• unemployment → exists when forces of demand and supply are in disequilibrium

  • people are available and willing, seeking work but cannot find a job

  • inefficiency, non-use of scarce resources in the production process

• ADL → aggregate demand for labour

  • ASL → aggregate supply for labour

  • those who are able and willing to work at the prevailing market equilibrium wage rate (Wc)

  • A = employer surplus, B+C = employee surplus, D+E = welfare loss, F = welfare supply

• complements economic growth → higher employment = greater national expenditure

  • raises economic well-being and living standards

• increases tax revenues for government expenditure on education/healthcare/infrastructure

• prevents workers from leaving the country to find better opportunities (brain drain)

Measuring unemployment and unemployment rate

• using number of people officialy unemployed as a percentage of the workforce per time period

• unemployment rate = (number of employed / labour force) * 100

  • labour force - employed + self-employed + unemployed

• difficulties of measuring unemployment

  • hidden unemployment / disguised unemployment → not included in the calculation

  • discouraged workers → unwilling to work but able to

  • voluntarily unemployed → not actively searching for work

Underemployment

• people are inadequately employed → underutilization of labour force

  • although technically employed, the underemployed are not at their most efficient

    • cannot fully use their skills/abilities

Disparities

• measure of unemployment ignores disparities such as:

  • regional → different regions have different rates of unemployment

  • ethnic → ethnic minority groups struggle more to find a job (higher unemployment)

  • age → unemployment rates are higher for the young/old

  • gender → females face a higher rate of unemployment

Cyclical Unemployment

• unemployment derived from a downturn in the business cycle (recession)

  • lack of aggregate demand → fall in national real output → job losses

  • also referred to as demand deficient unemployment

  • most severe type of unemployment

• results in mass job losses

  • firms try to control costs, protect profitability, and prevent business failure

• represented through a deflationary gap / recessionary gap / negative output gap

  • difference between full employment and actual level of output (short-run)

  • closing the gap reduces cyclical unemployment

Natural Rate of Unemployment

• equilibrium rate of unemployment

  • calculating level of unemployment when labour market is in equilibrium

• NRU: no involuntary unemployment

  • some voluntary → some poeple remain out of a job

  • NRU = structural + seasonal + frictional

Costs of unemployment

• personal costs

  • stress (depression, suicide)

  • low self-esteem

  • poverty

  • family breakdowns

• social costs

  • crime / anti-social behaviour

  • indebtedness

  • social deprivation

• economic costs

  • loss of GDP → negative economic growth

  • loss of tax revenues

  • increased cost of unemployment benefits

  • loss of income for individuals

  • greater disparities in distribution of income and wealth

Low and Stable rate of Inflation

• inflation → sustained rise in general price level over time

  • people spend more to get the same amount

  • reduces purchasing power and country’s international competitiveness

• price stability → general price levels remain broadly constant

  • net zero inflation, but a low and stable rate

Measuring rate of inflation

• consumer price index (CPI) - change in average consumer prices over time

  • measured on a monthly basis but reported for a twelve month period

    • collects price data from a range of retail locations

    • assigns statistical weights (volume + value of quantities purchased)

    • (total cost of year T / total cost of base year) * 100

Limitations of the CPI

• atypical households → CPI measures the ‘average’ household

• regional/international disparities → prices vary between countries + average household

• different income earners → CPI measures average; high income less affected by inflation

• changes in product quality → CPI ignores quality

• different patterns of consumption → difficult to apply statistical weights in historical data

• time lags → due to huge amount of data needed to construct the CPI

• volume / value of quantities purchased → uses quantities purchased instead of percentage of income

Causes of inflation

• Keynesian - increase in aggregate demand

• Monetarist - money supply

• demand-pull → AD must be controlled

  • example: deflationary fiscal policy → prevents rise in consumption and investment

• higher levels of AD

  • drives up general price levels

  • excessive aggregate demand (AD increases faster than AS)

  • might be due to higher GDP per capita, lower unemployment, increase in exports, lower interest rates, cuts in income tax

  • shown by AD1 → AD2

• cost-push → rise in general price level

• higher costs of production

  • shift from SRAS1 → SRAS2

  • increase in general price levels

  • reduces national output

  • higher production costs = raised prices

Costs of a high inflation rate

• diminishes ability of money to function as a medium of exchange

• uncertainty → reducing consumer and business confidence levels (lowers long run economic growth)

• redistributive effects → costs are not equally distributed (ex: people with fixed income)

• savings → real value of savings decrease over time (borrowers, lenders)

• export competitiveness → exports become more expensive

• economic growth → lowers expected real rates of return on capital investments

• inefficient resource allocation → higher costs of production

• shoe leather costs → customers spend more time looking for the best deals

• REUSER → redistributive effects, export competitiveness, uncertainty, savings, economic growth, resource allocation

Causes of deflation

• deflation → persistent fall in general price levels over time (inflation rate is negative)

  • either continual decline in AD or increase in SRAS

• Benign deflation → positive effect as economy can produce more (rightwards shift of the SRAS curve) → boosts rational output + employment without raising general price level

• deflation can be caused by lower production costs, higher productivity, or higher efficiency

• Benign deflation - SRAS1 → SRAS2

  • also called non-threatening deflation

  • greater number and variety of goods and services

• malign deflation → negative effect (leftwards shift of AD)

  • AD1 → AD2

  • associated with recessions and unemployment

  • harmful to the economy as there is a fall in real GDP

Disinflation

• fall in the rate of inflation but prices are still rising

  • occurs when inflation rate is negative

  • leads to deflation if not controlled

• shown by smaller proportional increase in average prices

Costs of deflation (malign)

• uncertainty → increase in value of debts reduces confidence levels

• redistributive effects → fall in value of assets and wealth

• deferred consumption → postpones consumption (deflationary spiral)

• cyclical unemployment / bankruptedness → falling prices/wages = falling AD/confidence

• increase in real value of debt

• inefficient resource allocation

• policy ineffectiveness

Sustainable level of government (national) debt

• budget deficit → value of government spending exceeds its revenue (G>T) per time period

  • government debt = accumulated budget deficits over the years

• sustainable level - debt is affordable → paid in the long term

Measurement of government debt

• uses percentage of GDP (debt to GDP ratio)

• different from nominal/absolute value of debt

Costs of government debt

• debt servicing costs - loan repayment plus interest rates incurred in the debt

• credit ratings - measure of borrower’s ability to repay a loan

• future taxation / government spending - austerity measures

• budget deficits are not sustainable in the long run, there must be budget surpluses (G<T) to balance it out

Potential conflict between macroeconomic objectives

• low unemployment and low inflatioon

• high economic growth and low inflation

• high economic growth and environmental sustainability

• high economic growth and equity in income distribution

Low unemployment and low inflation

• more employment = inflationary pressures

  • low unemployment creates demand-pull inflation due to increase in AD

  • full employment creates cost-push inflation due to wage inflation

• short run Philips curve (SRPC) shows relationship between inflation and unemployment

• demonstrates opportunity cost, either low unemployment or low inflation

  • trade-off only exists in the short run

• stagflation → employment / GDP falls as there is inflation

  • stagflation and short run Philips curve

• increased natural rate of unemployment

  • stagflation creates a worse trade-off between low unemployment and low inflation

• long-run Philips curve (LRPC) is vertical at the natural rate of unemployment (NRU) → no trade-off

  • attempts to reduce NRU will be inflationary in the long run ((A→B) will cause (B→C))

  • the increase in costs of production shifts SRPC reverting the unemployment rate back to NRU

High economic growth and low inflation

• economic growth → increase in AD in a country

  • if AD rises faster than AS, there is demand-pull inflation

• increase in price levels caused by increase in AD

  • graph also represents trade-off between low unemployment and low inflation

• cost-push inflation can also occur due to the full employment level being reached

  • firms try to attract the more scarce skilled labour, leading to wage inflation

• monetary policy → reduces inflation by raising interest rates or increasing economic growth by cutting interest rates

  • conflict in use of interest rates, therefore conflict in objectives

• sustainable economic growth can exist with low/stable rate of inflation

  • AS increases with AD

  • when inflation rises too quickly, it harms consumption and investment

• controlled inflation can be helpful for economic growth (increases certainty)

• high economic growth leads to an inflationary gap

High economic growth and environmental sustainability

• as an economy grows, increased levels of production and consumption can create negative externalities that harm the environment

• increased consumption of demerit goods (ex: cigarettes)

• increased carbon footprint from increased income because of economic growth

• environmentally sustainable economic growth is possible

  • use of green technologies and renewable energy sources

High economic growth and equity in income distribution

• rapid economic growth leads to greater disparities in the distribution of the wealth/income in a country

  • widening the gap between the rich and the poor

• although everyone in the country benefits from economic growth, not everyone benefits in the same way

  • minimum wage builds less wealth than billionaires

• economic growth increases tax revenues, allowing the government to use the revenues to re-distribute income

  • so long as the tax system is progressive and equitable, there is not necessarily a conflict between economic growth and distribution of wealth

Unequal distribution of income/wealth

• income

  • imbalances of income distributions → very few members of the society enjoying a high concentration of the nation’s income

  • to compare nations → GDP per capita or GDP in terms of purchasing power parity

• wealth

  • imbalances in the spread of a country’s wealth → very few members account for a disproportionately large proportion of the wealth in a society

  • wealth → accumulation of assets with a monetary value

Factors that influence difference in wealth

• economic factors → high national debt

• natural resources → increases GDP per capita

• environment → reduces wealth (ex: floods, droughts, etc.)

• physical factors → reduces wealth (ex: hot/dry climates)

• social factors → limits ability to produce wealth (ex: education)

• political factors → determines economic prosperity (ex: war)

Measuring economic inequality

• income inequality → relative share of national income earned by given percentages of a population (deciles / quintiles)

• uses Lorenz curve and Gini coefficient

Lorenz curve

• graphical representation of income/wealth distribution in a country

• shows proportion of overall income/wealth accounted by each quintile or decile

• this example shows that the bottom 60% of the population holds 20% of the wealth (B)

  • means the top 40% holds 80% of the wealth

  • data is cumulative → adds up to 1/100%

Gini coefficient

• measures income/wealth inequality by calculating a numerical value of the Lorenz curve

• G is between 0 and 1

  • the higher the value, the greater inequality

• A = shaded area, B = area under Lorenz curve

  • Gini coefficient = A/(A+B)

  • line of equality has a 45° angle

Poverty

• condition of an individual, household, or community/country being extremely poor

  • not having money to meet basic human needs

    • food, clothing, shelter, healthcare, education

• absolute poverty → unable to afford basic needs for survival

• relative poverty → income/consumption level below social norm within a country

  • differs from country to country

Measuring poverty

• international poverty lines (poverty threshold) → minimum level of income to afford basic needs for human survival (below $1.90 a day)

  • does not take into account access to sanitation/water/electricity

• a more accurate measure would be a national poverty line

  • line value depends on the country (higher national income = higher poverty line)

• multidimensional poverty index (MPI)

  • uses health, education, adn standards of living

  • considers multiple factors that reduce quality of life

    • ex: sanitation, child mortality rate, average years of school

Minimum Income Standards (MIS)

• lowest amount of income needed for an acceptable standard of living

  • varies by a country’s people’s standards and economic state

  • helps people live in a socially acceptable way

• in the UK, MIS is used for:

  • calculating the living wage (minimum wage)

  • quantitative benchmark for NGO/charities to determine who is in need

  • calculating costs of bearing/raising a child

  • helps governments determine level of social security and transfer payments

Difficulties in measuring poverty

• how would the national poverty line of very poor countries translate to the IPL?

• relative poverty is highly subjective

• a permanently low income creates a poverty trap

• PPP highly differs with location

Causes of economic inequality and poverty

1. inequality of opportunity

2. different levels of resource ownership

3. different levels of human capital

4. discrimination (gender, race, etc.)

5. unequal status and power

6. government tax and benefit policies

7. globalization and technological change

8. market-based supply-side policies

Impact of high income/wealth inequality

• brings possibility of higher income for those who work hard which creates incentives for people to work harder → improving labour effort

• prospect of earning higher incomes encourages people to invest in education and skill development → imporves labour productivity

• entrepreneurial instincts are encouraged as a result of potential to earn higher profits

• greater incentives and wealth creation can lead to a higher savings ratio

  • can be used to fund investments which creates an increase in the economy’s long-term growth and development

• creates more social tensions in the form of demonstrations, protests, political unrest, and crime which leads to less investment and labour participation rates

• more government spending on transfer payments to sustain the economy

  • adds to government debt, not directly to the national income

• discourages workers from joining labour foce and entrepreneurs from investing

  • increases voluntary unemployment

• affects standard of living

• affects social stability

Taxation

• progressive tax → higher incomes = higher percentage of tax paid

  • tax threshold → workers earn a certain amount of income per year before they can be taxed

• proportional taxes → percentage of tax paid stays the same irrespective of taxpayer’s income

  • also called flat rate taxes

• regressive taxes → those with a higher ability to pay are charged a lower rate of tax

• used to combat inequality in wealth and income

Monetary policy

• control and use of interest rates and money supply to influence level of AD and economic activity

  • overseen by the central bank or designated money authority

  • interest rates → price of money

Functions of a central bank

• executor of monetary policy

• government’s bank

• banker’s bank

• sole issue of legal tender (bank notes or coins)

• lender of last resort

• credit control

Goals of monetary policy

• low and stable rate of inflation (inflation targeting)

  • inflation target rate → transparent goal to help control inflation

• low unemployment

  • lower interest rates = economic activity increases = increase in AD

    • reduces borrowing costs so consumer confidence increases

• reduce business cycle fluctuations

  • lower interest rates in a downturn and higher interest rates in booms

• promote a stable economic environment for long-term growth

  • greater degree of certainty and confidence

• external balance (imports = exports)

  • influence the exchange rate

    • lower interest rates = reducing exchange rate

Money creation

• credit creation → banks create money from deposits of savers and borrowers

• minimum reserve ratio → limit on amount commercial banks can lend

  • to limit growth in money supply

  • money multiplier = 1/reserve ratio (how much deposit increases money supply)

• if the central bank wants to limit economic activity and suppress inflationary pressures, the minimum reserve ratio is increased to limit growth in money supply

Tools of monetary policy

• Open Market Operations (OMO)

  • buying/selling of government securities by a country’s central bank

    • government securities - type of public sector debt to finance government

    • sale of bonds with promise to repay borrowed money with fixed rate of interest

  • government securities sold when money supply needs to fall

    • increased interest (return) rate attracts buyers/investors

    • contractionary monetary policy → withdraws money from economy

  • opposite is true (not sold but purchased by central banks)

• Minimum Reserve Requirements (MRR)

  • commerical banks generally want to lend more to profit more, but the central banks require them to keep a certain percentage of their deposits at the central bank

    • called the minimum reserve ratio or minimum reserve requirement (MRR)

  • ensures the commercial banks have enough cash for their daily transactions

    • bank run → most customers withdraw all their cash deposits on any given day

  • raising MRR limits growth → 1/MRR = money multiplier

• Changes in central bank Minimum Lending Rate (MLR)

  • official rate of interest charged by central bank or loans to commercial banks

    • also known as base rate, discount rate, and refinancing rate

    • influences interest rates from commerical banks for lending

  • if MLR increases, the lending rates increase too → contractionary

• Quantitative Easing (QE)

  • central banks purchase corporate bonds to directly inject money into the economy

    • the institutions have “new” money and see an increase in liquidity

  • boosts money supply and promotes lending (increase in AD)

  1. central bank creates money

  2. central bank buys bonds from financial institutions

  3. interest rates reduced

  4. businesses/people borrow more money

  5. businesses/people spend more and create jobs

  6. boosts the eocnomy

Demand and Supply of money

• interest rate → return for lenders or price for borrowing (price of money)

• Dm → desire to hold money rather than saving it

  • Sm → total amount of money in the economy

• supply is vertical because supply of money is fixed at any given time by central banks

• opportunity cost of holding money varies directly with interest rate → fall in interest rates = reduction in opportunity cost of holding money

• central banks consider these when deciding supply of money:

  • state of economy (ex: deflationary gap = reduction in interest rates)

  • rate of growth of nominal wages (ex: higher labour cost = higher prices = inflation)

  • business confidence levels (lower interest rates = more incentive for investment)

  • house prices (most valuable asset)

  • exchange rate

Real VS Nominal interest rates

• interest rate → price of money (cost of credit or return on savings)

• nominal interest rate → actual rate agreed on between bank and customer

• real interest rate → accounts for inflation

  • real IR = nominal IR - inflation rate

    • IR = interest rate

Expansionary monetary policy (loose/easy)

• lower interest rates → shifts AD rightwards to close a deflationary gap

  • AD = C+I+G+(X-M)

    • C, I, G rise due to cheaper borrowing cost

    • (X-M) rise due to fall in exchange rate

Contractionary monetary policy (tight)

• closes an inflationary gap by increasing interest rates

  • opposite of expansionary

Effectiveness of monetary policy

• limited scope of reducing interest rates when close to zero

• low consumer and business confidence

• incremental + flexible + easily revertible

• short time lags

Fiscal policy

• use of taxation and government expenditure strategies to influence level of economic activity

  • to achieve low unemployment, sustainable economic growth, and low inflation

• promotes long-term economic growth and low unemployment through:

  • government spending on physical capital goods (ex: machinery, buildings, vehicles)

  • government spending on human capital formation (ex: education, training)

  • provision of incentives for firms to invest (ex: tax breaks, tax incentives)

Sources of government revenue

• taxation → direct and indirect

• sale of goods/services from state-owned enterprises

• privitization proceeds from sale of government assets

Taxation

• government levy on income or expenditure

• direct → imposed on income, wealth, or pfoits of individuals/firms

  • ex: on wages/salaries, inheritance, and company profits

• indirect → expenditure taxes on spending of goods/serivces in economy

  • ex: GST/VAT

Sale of goods and services from state-owned enterprises

• state-owned enterprises/nationalized industries → postal, airports, broadcasting

• government odes not aim to earn profits so revenue sources go toward paying the costs of providing the good or service

Sale of government assets

• selling government-owned assets/enterprises to shareholders in the private sector

  • hence the alternate name privitization

• short-lived policy → limited amount of assets to be sold

Government expenditures

• current → spending on goods and services consumed within the current year

  • also called consumption expenditure

  • for immediate operations and benefits

    • ex: wages/salaries, healthcare/education, subsidies, interest repayments

• capital → long-term items of spending (public sector investments) that boosts eocnomy’s productivity

  • spending large amount of money to increase nation’s capital stock

  • also called fixed capital formation

  • intended to create future benefits for all members of society

    • ex: physical infrastructure: roads, tunnels, harbours, airports, schools, hospitals

  • ideally, the government would borrow money only to fund capital expenditure

    • fund investment expenditure in the economy

• transfer payments → welfare expenses from government to redistribute income

  • done through funding essential public services

    • ex: state education, housing, healthcare, social housing, postal services

  • no corresponding exchange of goods and services (unlike current/capital)

    • ex: unemployment benefits, state pensions, housing benefits, disability allowances

Goals of fiscal policy

• low and stable rate of inflation

  • using taxation policies to promote price stability

    • ex: higher tax rates + running a budget surplus = reduction in C+I+G

• low unemployment

  • prevents cyclical unemployment during recessions

    • reduction in tax rates and/or increasing government expenditure (G)

• promote a stable economic environment for long-term growth

  • promotes long-term economic growth by enabling low taxation

• reduce business cycle fluctuations

  • to reduce impacts of a recession, a budget deficit can be run (expenditure > revenue)

  • opposite is true with a budget surplus and higher tax rates for a boom

• equitable income distribution

  • done by using high marginal tax rates in a progressive tax system

  • also can use transfer payments

• external balance

  • X=M

    • ex: indirect taxers imposed on imports and/or government subsidies for domestic exporters will generally increase external balance: (X-M) → positive, increases GDP

      • opposite is true creating less external balance

Expansionary/reflationary fiscal policy

• used to stimulate economy during a recession

  • by increasing government expenditure and/or lowering taxes

    • boosts consumption and investment → rightward shift in AD

• Keynesian → no LRAS, believes government intervention is effective and needed

• Monetarist → LRAS shows no change in real GDP but increase in price levels (vertical)

Contractionary fiscal policy

• reduces economic activity by decreasing government spending and/or raising taxes

  • limits consumption (C) and investment (I)

• used to reduce inflationary pressures during a boom → closes inflationary gap

• austerity measures

  • used to reduce a government’s budget deficit

    • reductions in government spending and increased taxes

Keynesian multiplier

• shows any increase in value of injections results in proportionally larger increase in AD

  • any increase in any of the injections will increase value of the Keynesian multiplier

• injections → stimulates further rounds of spending (spending → income for another person)

  • ex: government spends money on social housing, leads to many other industries benefitting

    • the initial money generates a far greater value of final output

• leakages → reduce value of Keynesian multiplier: takes money out of the economy

  • negative multiplier effect → initial leakage leads to greater than proportionate fall in GDP

• derterminants of Keynesian multiplier: MPC, MPM, MPS, MPT

  • marginal propensity to consume (MPC) → proportion of increase in household income that is spent on goods and services rather than saved (MPC = ∆C + ∆Y)

  • marginal propensity to import (MPM) → proportion of increase in household income that is spent on imports rather than on domestically produced goods/services (MPM = ∆M + ∆Y)

  • marginal propensity to save (MPS) → proportion of increase in household income saved rather than spent on consumption or imports (MPS = ∆S + ∆Y)

  • marginal propensity to tax (MPT) → proportion of each extra dollar of income earned that is taxed by the government (MPT = ∆T + ∆Y)

• Keynesian multiplier = 1/(1-MPC)

• Keynesian multiplier = 1/(MPS+MPT+MPM)

  • MPC + MPS + MPT + MPM = 1

Effectiveness of fiscal policy

• constriants on fiscal policy

  • political pressures

  • time lags

  • sustainable debt

  • crowding out

    • when increased government borrowing increases interest rates and creates a reduction in the private sector investment expenditure

      • G increases but I decreases

• strengths of fiscal policy

  • targeting of specific economic sectors

  • government spending effective in deep recession

  • automatic stabilizers

    • progressive taxes and unemployment benefits

Supply-side policies

• long-term government

REAL WORLD EXAMPLES

Policies

Monetary

• Expansionary

  • 1990s-2024 Japan implements negative interest rates (near-zero) in response to stagflation and deflation partly due to the aging of the population

• Contractionary

  • 1970 United States' Federal Reserve (central bank) and the Great Inflation -> raised inflation rates to 20% to control demand-pull inflation

Fiscal

• Expansionary

  • 2009 American Recovery and Reinvestment Act (ARRA) -> during a large demand-deficient recession (The Financial Crisis of 2008), government expenditure was boosted $831 billion dollars to boost aggregate demand which increased employment and the economic growth rate but also increased level of government debt

• Contractionary

  • 2008 United Kingdom using austerity measures to combat a budget deficit and stabilize public finances -> cutting public spending (G) and increasing taxes

Supply-side

• Market-side

  • Competition

    • Deregulation

      • 1978 United States airline industry -> increased competition and boosted market's growth but caused the quality of airlines to deteriorate decreasing safety

    • Privatization

      • 1972 Singapore Airlines was privatized from the government-owned Malayan Airways and is now one of the world's top airlines

    • Trade liberalization

      • NOW Japan imposes up to 778% import taxes on rice to protect agriculture in the country

    • Anti-monopoly regulation

      • 2019 UK's Competition and Markets Authority (CMA) blocked merging of Sainsbury's and Asda (two largest supermarkets) to prevent forming a monopoly / collusive oligopoly

  • Labor-side

    • Reducing the power of labor unions

    • Reducing unemployment benefits

    • Abolishment of minimum wages

      • 2024 Turkey increases minimum wage by 49% to reduce inflation rates of 51%

  • Incentive-related

    • Personal income tax cuts

      • NOW Hong Kong personal income tax rates range from 2-17% which provide greater incentives for people to work

    • Cuts in business tax and capital gains tax (CGT)

      • NOW Hong Kong business tax rates range from 7-16.5% and there is no CGT which makes Hong Kong attractive to businesses

• Interventionist

  • 1960-1980 South Korea's government implemented plans focusing on education, infrastructure, and technological advancements and now they are a leading industrial power

The Global Economy

Gains from trade (5/8/24)

• international trade → buying and selling goods/services across international borders

  • impacts GDP calculations (exports → X, imports → M)

    • GDP=C+I+G+X-M

• countries export products when the domestic price is lower than the world price (Pd<Pw)

  

  • 30 = quantity demanded domestically

  • 50 = quantity supplied domestically

    • there is a surplus as quantity supplied exceeds quantity demanded (at the world price) which causes the country to export the surplus (20)

• countries import products when the domestic price is higher than the world price (Pd>Pw)

• 

  • 90 = quantity demanded domestically

  • 20 = quantity supplied domestically

    • there is a shortage as quantity demanded exceeds quantity supplied (at the world price) which causes the country to import the shortage (70)

• free international trade (free trade) → trade without any restrictions

  • no government intervention

    • effects:

      • maximizes competition

      • provides most benefits

• benefits from international trade

  • producers

    • greater efficiency

    • access to capital

    • access to more/better resources

    • access to larger markets

    • economies of scale

  • consumers

    • lower prices

      • competition increases supply and incentivizes efficiency

    • greater choice

      • access to more/better products (not always better)

  • countries

    • foreign exchange

    • efficiency in resource allocation

    • specialization

      • do what you do best and trade for the rest

    • increased economic growth

    • access to technology, skills, ideas

    • peace

Absolute and Comparative advantage (6/8/24)

• absolute advantage → ability of one country to produce a good using fewer resources than another country

  • that country can produce more of a good than another country when given the same resources

• theory of absolute advantage (Adam Smith) → specialization and trade make countries better off

  • allows for increased competition in both countries

    

• point E and point F → with trade

  • both countries consume more than they would have been able to produce

• comparative advantage → ability of one country to produce a good at a lower opportunity cost than another country

  • lower relative cost

• theory of comparative advantage (David Ricardo) → all countries can benefit from specialization and trade

  • allows for increased consumption in both countries

  • applicable even when one country has absolute advantage in both goods

  • limitations: (7/8/24)

    • interferes with necessary structural changes over time

      • developing countries need to transition out of the primary sector

        • primary sector → low value added so low income (ex: agriculture)

    • excessive specialization is risky

      • overspecialized countries are vulnerable to unforeseen changes

    • depends upon unrealistic assumptions

      • factors of production are assumed to be fixed

        • labour and capital are mobile

        • education and training affects quality

      • technology is assumed to be fixed

      • employment of resources is assumed to be full

      • free trade is assumed

      • products are assumed to be homogenous

      • transportation costs are ignored

• law of comparative advantage → results in greater global output and consumption beyond the PPC

  • only works when either one country has one absolute advantage and/or countries face different opportunity costs

    

    • both countries consume more than they could have produced (cottonia at B, microchippia at A)

  • case of parallel PPCs

    • one country has absolute advantage in the production of both goods

    • both countries face equal opportunity costs in the production of both goods

      • comparative advantage does not exist → no benefit to specialization and trade

    • very unusual

      

• sources of comparative advantage (7/8/24)

  • differences in factor endowments (factors of production)

    • used in manufacturing

    • helps determine what a country should specialize in

  • differences in levels of technology

    • impacts efficiency and productivity

Tariffs (12/8/24)

• trade protection → government intervention in international trade

  • use of trade restrictions (trade barriers)

  • prevention of imports (despite comparative disadvantage)

• tariff → tax on imported goods (customs duties)

  • most common form of trade restriction

    • protects domestic industries from foreign competition → inefficiency

    • generates tax revenue (government)

    • 

  winners → less efficient domestic producers, efficient domestic producers, domestic employment, foreign producers, domestic income

• losers → domestic consumers, foreign producers, domestic income distribution (regressive tax), global efficiency, resource allocation

  • regressive tax → same % tax but greater % of income depending on income level

    • ex: $100 tax is different %income for different people

• welfare effects (economic well-being)

  • consumer surplus (CS) → reduced

    • transferred to government, producers, or just lost due to inefficiency and reduced consumption

  • producer surplus (PS) → increased

    • taken from consumers

  • social surplus is reduced (total)

    

    • was → CS=a+b+c+d+e+f, PS=g

    • now → CS=a+b, PS=c+g. DWL (deadweight loss)=d+f, government revenue=e

Import Quotas (13/8/24)

• legal limit on imports

  • limits quantity of a certain good over a particular period of time (ex: 1 year)

  • limits foreign competition for domestic industries

    • government issues a limited amount of “import licenses”

      • not license like driving license, more like tickets

      • recipients gain quota revenues (quota rents)

    • importers buy at Pw and sell at Pd (Pd>Pw) OR were selling at Pw and are now selling at Pd (foreign producers)

• 

  • winners → efficient domestic producers, less efficient domestic producers, domestic employment, holders of licenses

  • losers → domestic consumers, domestic income distribution, global efficiency, resource allocation

  • neutral → government

    • no revenue generated, unlike tariffs

  • uncertain: foreign producers

    • might balance out (wins and losses)

    • Pd>Pw, but less quantity can be imported → depends if they have a license

• 

  • welfare effects (economic well-being)

    • CS is reduced

    • PS increases

      • was → CS=a+b+c+d+e+f, PS=g

      • now → CS=a+b, PS=c+g, DWL=d+e+f

    • DWL comes from inefficiency and reduced consumption

    • social surplus is reduced

Tariffs and Quotas (14/8/24)

• tariff VS quota

  • same but tariffs generate tax revenues (less DWL)

    • therefore tariff > quota

• tariffs

  • domestic consumers: higher price, lower quantity (-)

  • domestic producers: higher price, increased quantity (+)

  • government: increased revenue (+)

  • foreign producers: decreased quantity sold (-)

  • welfare loss: inefficiency and reduced consumption (-)

• import quotas

  • domestic consumers: higher price, lower quantity (-)

  • domestic producers: higher price, increased quantity (+)

  • government: no impact (…)

  • foreign producers: higher price (?), decreased quantity (?)

  • welfare loss: inefficiency and reduced consumption and reduced CS (-)

    • same as tariff but it moves the supply curve, not the price (price moves with supply)

Production Subsidies (15/8/24)

• subsidy → payment by the government to a firm for each unit of output produced

  • production subsidy → protects domestic firms from foreign competition

  • export subsidy → protects domestic firms that export to foreign countries

• subsidy is the effect of production, not the cause (incentivizes)

• production subsidy → protectionist measure that pays domestic firms for each unit of output produced

  • allows firms to remain competitive against imports

• 

  • domestic consumers pay Pw, domestic firms receive Pw+s

  • shifts the product supply curve

    • by the amount per unit subsidy

  • all output for domestic market only

  • winners: efficient domestic producers, less efficient domestic producers, domestic employment

  • losers: foreign producers, government budget, taxpayers, global efficiency, resource allocation

  • neutral: domestic consumers

    • face the same price regardless

• 

  • welfare effects

    • CS is not affected

    • PS increases at the expense of the government

    • DWL from inefficient production

Export Subsidies (19/8/24)

• protectionist measure that pays domestic firms for each unit of output produced and exported

  • allows exporting firms to compete in foreign markets (Pw>Pd)

  • the world price stays the same, domestic supply curve shifts

    • increases domestic price to Pw+s

• 

  • winners: efficient domestic producers, less efficient domestic producers, domestic employment

  • losers; domestic consumers, government budget, taxpayers, domestic income distribution, foreign producers, global efficiency, resource allocation

  • domestic producers face two prices when the export subsidy is implemented

    • foreign market → Pw + subsidy (Pw+s)

    • domestic market → Pw

      • domestic < foreign, so they choose the foreign market

        • forces domestic producers to match the foreign price, which increases price (Pw → Pw+s)

• 

  • welfare effects

    • CS is reduced

      • higher price lower quantity

      • all transferred to firms (domestic producers)

    • PS is increased

      • at the expense of domestic consumers and government

    • social surplus is reduced

      • DWL → b+d

Exchange Rates (20/8/24)

• the rate at which one currency can be exchanged for another (price of a currency)

  • number of units of a foreign currency that correspond to the domestic currency

  • necessary mechanism for international trade to exist

• foreign exchange market (FOREX) → global marketplace that allows for the trading of one currency for another

  • necessary for international transactions

    • supports the continuous flow of money in and out of countries

    • individuals, firms, banks, governments, etc.

  • demand creates supply (only in FOREX)

    • foreign demand = domestic supply since it is exchanging, not buying

      • if I buy 10 USD for 150k IDR, the demand for USD increases as I am requesting USD in exchange for 150K IDR. at the same time, the supply for IDR increases as I am supplying IDR into the market in exchange for USD.

• consequences of currency appreciation (increasing value of particular currency)

  • imports become cheaper and exports more expensive (decreased net exports)

  • worsening trade balance (increasing trade deficit)

  • decreasing cost-push and demand-pull inflationary pressure

  • cyclical unemployment

  • indeterminate impact on economic growth

  • indeterminate impact on living standards

• consequences of currency depreciation (decreasing value of particular currency)

  • imports become more expensive and exports cheaper (increased net expors)

  • improving trade balance (decreasing trade deficit)

  • increasing cost-push and demand-pull inflationary pressure (factors of production)

  • job growth

  • indeterminate impact on economic growth

  • indeterminate impact on living standards

The Trade Protection Debate (22/8/24)

• arguments for trade protection (trade restrictions) → despite known inefficiencies / misallocation of resources

  • infant industries → new domestic industry that is without economies of scale (in a developing country)

    • ex: pharmaceuticals

    • may disincentivize efficiency (-)

  • national security → some industries are essential for national defense

    • not an economic argument, but political/military

    • ex: aircraft, weapons

      • may be overextended (ex: steel) (-)

  • health and safety standards

    • imported goods might fall short (ex: food, medicine, etc.)

    • may actually be an administrative barrier (-)

  • LEDC (least economically developed country) diversification

    • opposite of specialization

    • LEDCs are often dependent on a limited number of commodities

    • difficult to identify (-)

  • anti-dumping

    • dumping: selling a good in an international market below the cost of production

      • due to export subsidies

    • difficult to justify → may actually be administrative barriers (-)

  • balance of payments correction

    • outflow of money > inflow of money

      • imports > exports

    • risk of retalliation (-)

• arguments against trade protection

  • misallocation of resources

    • less efficient markets

  • retalliation

    • potential for trade war

  • increased costs

    • raw materials and capital are more costly

  • higher prices

    • true for tariffs, quotas, and administrative barriers

    • less Qd

  • less choice

    • fewer options to satisfy needs/wants

    • result of decreased competition

  • domestic firms lack incentive to become more efficient

    • lack of competition permits inefficiencies

  • reduced export competitiveness

    • inefficient firms must charge more than foreign competition

    • foreign demand for products is typically greater than domestic

Preferential Trade Agreements (PTA) (26/8/24)

• form of economic integration (trade policies that increase interdependence)

• agreement to lower/remove trade barriers

  • ensures easier access to specific markets in 2+ member countries

  • may include cooperation on additional issues (ex: labor/environmental standards)

• promotes trade liberalization

  • bilateral trade agreement (mutual agreement between 2 countries)

  • regional trade agreement (according to geographic region)

  • multilateral trade agreement (legally binding agreement between 3+ countries)

    • accomplished through the World Trade Organization (WTO)

Administrative Barriers (27/8/24)

• protectionist measures that impose bureaucratic standards and regulations on foreign firms

• ‘red tape’ checks and procedures that create obstacles for imports

  • overly concerned with procedure at the cost of efficiency/common sense

  • costly → both time and money

    • ex: customs inspections/valuations, packaging requirements, strict health/safety/environmental

• winners: efficient domestic producers, less efficient domestic producers, domestic employment

• losers: domestic consumers, foreign producers, global efficiency, resource allocation

Trading Blocs (2/9/24)

• group of countries that have agreed to reduce barriers to trade to encourage free/freer trade

  • amongst those in the bloc

  • includes free trade areas, customs unions, and common markets

• free trade area (FTA)

  • group of countries agree to eliminate trade barriers among members

    • most common intergration → relatively low degree

    • members can pursue their own policies with non-member countries

    • creates dependence upon the country with the lowest non-member barriers to trade (-)

      • I don’t like country O but country A does and I’m in a FTA with A so I’ll get O’s products from A

    • ex: USMCA, CAFTA, ANZFTA, EFTA

• customs union

  • group of countries agree to eliminate trade barriers among members AND adopt a common policy towards all non-member countries (FTA+)

    • members act together in all negotiations with non-members

    • no need for ‘rules of origin’

    • more complicated (-)

    • ex: Mercosur, GCC, ECOWAS

• common market

  • group of countries agree to eliminate trade barriers among members AND adopt a common policy towards all non-member countries AND agree to eliminate all restrictions on movement of the factors of production (FTA++)

    • labour and capital can move freely across borders

    • most efficient allocation of factors of production

    • extremely complicated → countries lose autonomy (-)

    • ex: EU, SACU

• possible advantages

  • increased competition

  • expansion into larger markets

  • economies of scale

  • lower prices and greater choice

  • increased investment

  • improved resource allocation

  • productive efficiency and economic growth

  • stronger bargaining power (with non-member countries)

  • peace and political stability

• possible limitations

  • inferior to WTO’s multilateral approach

    • aims for free trade for all

  • unequal distribution of gains and some losses

  • loss of sovereignty

Trade Creation and Trade Diversion (2/9/24)

• trading blocs change patterns of trade → through reduced trade barriers

• trade between non-member nations is discouraged → through trade barriers

• trade creation → higher cost products are replaced low cost imports through a customs union

  • original products may have imported or domestically produced

  • combines comparative advantage and trade liberalization

  • increases consumption, greater productive efficiency, greater allocative efficiency, increases social welfare

• trade diversion → lower cost imports (from non-member countries) are replaced by higher cost imports (from member countries) through a customs union

  • is an argument against trading blocs and for multilateral trade liberalizations (WTO)

  • decreases consumption, productive inefficiency, allocative inefficiency, decreases social welfare

    • long-term benefits still (likely) outweigh the costs

      • political relationships

      • economic integration

      • if I trade within my trading bloc, member countries will buy my products too

Monetary Union (3/9/24)

• a common market that requires market countries to adopt a single common currency and a common central bank (FTA+++)

  • responsible for one monetary policy

  • has strict membership requirements

    • ex: rate of inflation, interest rate, debt to GDP ratio

  • many similarities to a fixed exchange system

• RWE → EU (eurozone countries)

Evaluation of monetary union (5/9/24)

• advantages

  • single currency encourages price transparency

    • allows consumers and firms to easily compare prices

    • promotes competition and efficiency

  • single currency eliminates transaction costs

    • conversion fees are always paid → not anymore

    • encourages trade and investment → supports allocative efficiency

  • single currency eliminates exchange rate risk and uncertainty

    • exchange rates typically fluctuate

    • benefits importers, exporters, consumers, and investors

    • encourages trade and investment → supports allocative efficiency

  • single currency promotes inward investment

    • encourages investment from outsiders → appeal of expanded market and single currency → supports economic growth

  • low rate of inflation give rise to low interest rates

    • member countries are deeply concerned with inflation (single monetary policy)

      • to remain competitive

    • encourages investment → supports economic growth

    • encourages consumption spending → increases output

• disadvantages

  • loss of sovereignty

  • loss of domestic monetary policy

  • each member country is affected differently by shared monetary policy

    • varying positions in the business cycle

    • varying levels of inflation/unemployment

  • loss of exchange rates as a mechanism for adjustment

    • unable to depreciate/devalue

      • when seeking balance of trade / trying to counter inflation

  • convergence requirements constrain fiscal policy

    • economic/financial requirements

      • potentially limiting expansionary fiscal policy

      • ex: debt deficit limits

The World Trade Organization (WTO) (9/9/24)

• the only global international organization dealing with the rules of trade between countries

  • responsible for WTO agreements

    • help producers, exporters, and importers conduct their business

    • negotiated and signed by the bulk of the world’s trading countries and ratified in their parliaments

• objectives → lengthy and complex legal trade documents that encourage:

  • non-discrimination, open trade, predictability + transparency, fair competition, support for LDCs, protection of the environment, inclusion

• six functions:

  1. administrating WTO agreements

  2. forum for trade negotiations

  3. handling trade disputes

  4. monitoring national trade policies

  5. cooperation with other international organizations

  6. technical assistance and training for developing countries

• criticisms

  • WTO allows unfavourable treatment of LDCs

    • MDCs continue to subsidize agricultural products

      • MDC → more developed countries

    • MDCs receive greater tariff reductions

    • exposed to non-tariff barriers

    • protection of intellectual property increases costs of technology

    • MNCs not required to purchase supplies locally

      • MNC → multinational company

  • WTO fails to distinguish between developed and developing economies

    • only recognize/protect LDCS → LEAST

    • developing countries _> infant industry ptoection

    • developing countries may need to diversify

      • reduce reliance on primary commodities

  • WTO ignores environmental issues

    • encourages removal of trade barriers against countries with low standards

    • permits subsidies on harmful products (ex: agriculture, coal, transporation)

  • WTO ignores labour issues

    • ex: child labour

  • WTO members have unequal bargaining power

    • LDCs often silent in fear of retalliation

    • includes agenda setting

Floating exchange rates (18/9/24)

• an exchange rate determined entirely by market forces

  • supply and demand determine equilibrium (Qd=Qs)

  • no government intervention

  • no central bank interaction

  • free float / flexible exchange rate

• downward sloping demand curve

  • currency demand occurs when there are inflows of foreign currencies into a country

• upward sloping supply curve

  • currency supply occurs when there are outflows of domestic currency out of a country

• 

  • prices are reciprocals of one another

  • the quantity on the x axis will always be the denominator on the y axis

• currency appreciation → increase in currency’s value (in relation to another)

  • caused by increased demand or decreased supply

  • increase in price (value)

• 

• currency depreciation → decrease in currency’s value (in relation with another)

  • caused by decreased demand or increased supply

• 

• causes of change in demand and supply for a currency

  • foreign demand for exports

    • goods and services

  • domestic demand for imports

    • goods and services

  • inward/outward foreign direct investment

    • expanding operations of MNCs

  • inward/outward portfolio investment

    • financial instruments

  • remittances

    • overseas nationals send money back

  • speculation

    • currency as a financial asset

    • saving in hopes of appreciation

  • relative inflation rates

    • general price levels

  • relative interest rates

    • price of money

  • relative growth rates

    • increased wages and consumption

  • central bank intervention

    • reserves of FOREX currencies

• strengths

  • policy makers have great flexibility → no need for central banks to hold foreign reserves

    • balance of payments is achieved automatically

  • automatic adjustments to excess demand or supply

  • naturally provides downward pressure on high inflation

• limitations

  • uncertainty for stakeholders

  • currency speculation can be destabilizing

Fixed exchange rates (19/9/24)

• an exchange rate that is fixed by a country’s central bank and not permitted to change freely

  • “pegging” → verb for definition above (relative to another country’s currency)

  • requires constant central bank intervention

    • manipulating demand/supply of currencies → mostly buying/selling reserve currencies

• 

  1. fall in demand for exports reduce demand (D1→D2)

  2. central bank buys excess of the country’s currency, increasing demand (D2→D1)

  

  1. fall in demand for exports reduce demand (D1→D2)

  2. imports are reduced, so supply of the currency falls (S1→S2)

• central bank must respond to excess demand for currency

  • caused by increased demand or decreased supply

    • ex: increasing exports or decreasing imports

    • can buy foreign currency (domestic supply)

• central bank must respond to excess supply of currency

  • caused by increased supply or decreased demand

    • ex: increasing imports or decreasing exports

    • can buy domestic currency (using foreign reserve supply)

      • until they run out of foreign currencies

• additional measures to maintain a fixed rate

  • response to excess supply of domestic currency:

    • increase interest rates

      • attracts inflow of foreign currency

      • (-) contractionary monetary policy may cause recession

    • borrow from abroad

      • access to foreign currency

      • (-) increasing foreign debt

    • efforts to limit imports

      • decreases excess domestic supply

      • contractionary policy to decrease spending → (-) potential recession

      • trade protection policies → (-) potential retalliation by trade partners

• devaluation of a currency

  • officially and deliberately decreasing the value of a pegged currency

  • looks similar to depreciation of a floating currency

    • results in cheaper exports and more expensive imports

• revaluation of a currency

  • officially and deliberately increasing the value of a pegged currency

  • looks similar to appreciation of a floating currency

    • results in cheaper imports and more expensive exports

• strengths

  • high degree of certainty for stakeholders

  • very little speculation activity

• limitations

  • requires constant monitoring to eliminate disequilibrium

  • requires central banks to hold sufficient FOREX reserves

  • policy makers have little flexibility → most maintain fixed exchange rate

  • requires contractionary fiscal policies to keep exports competitive during inflation

  • imbalance of payments is not easily corrected

Managed exchange rates (26/9/24)

• an exchange rate determined by market forces but periodically influenced by a country’s central bank

  • “managed float”

  • combines floating and fixed systems

    • closer to floating

• intervention aims for short term stability

  • prevention of large and abrupt fluctuations

    • fluctuations discourage investment and spending

  • typically buying/selling currencies

    • generally done within upper and lower ‘bands’

      • freedom to float within a determined range

• consequences of overvalued currencies (greater than equilibrium free market value)

  • cheaper imports → cheaper capital and raw materials

    • helpful for LDCs to grow manufacturing

  • (-) expensive exports, worsening trade balance, increased competition for domestic firms, domestic unemployment

    • may need to be devalued

• consequences of undervalued currencies (lower than equilibrium free market value)

  • considered cheating (unfair competitive advantage) → “dirty float”

  • cheaper exports, growth of export industries, job creation

  • (-) expensive imports, cost-push inflation

    • may need to be revalued

• both overvalued and undervalued currencies only occur in fixed and managed systems, not free floats

BOP accounts (14/10/24)

• BOP → balance of payments

• record of all transactions between a country’s residents and the rest of the world

  • over a defined period (ex: one quarter)

  • households, firms, and government

  • ex: imports/exports, travel, financial investments, foreign direct investment, etc.

• “balance of international payments”

• credits = debits

  • credit → inflow, debit → outflow

  • inflow of payments received (credits) create foreign demand for country’s currency which is the supply for foreign currency

  • outlfow of payments made (debits) create domestic supply of nation’s currency which is the demand for foreign currency

• BOP consists of three accounts

  • current account (4)

    • balance of trade in goods (X-M)

    • balance of trade in services (X-M)

    • income (inflows - outflows)

    • current transfers (inflows - outflows)

  • capital account (2)

    • capital transfers (inflows - outflows)

    • transactions in non-produced, non-financial assets (inflows - outflows)

      • capital account is relatively small and unimportant

  • financial account (4)

    • (foreign) direct investment (inflows - outflows)

    • portfolio investment (inflows - outflows)

    • reserve assets (inflows - outflows)

    • official borrowing (inflows - outflows)

The balance of payments (15/10/24)

• there is interdependence between the three accounts

  • a deficit in one account will be offset by a surplus in another

  • sum of the three accounts will always be zero (“zero balance”)

    • credits match the debits; surpluses match the deficits

  • current account = -(capital account + financial account)

    • current = -(capital + financial + errors and omissions)

• if a country has a current account deficit (exports < imports)

  • inflows (credits) < outflows (debits)

  • financial (and capital) accounts surplus provides foreign exchange to pay for deficit

    • zero balance is achieved

  • country consumes beyond PPC (more than they can produce)

• if a country has a current account surplus (exports > imports)

  • inflows (credits) > outflows (debits)

  • surplus provides foreign exchange used to pay for financial (and capital) deficit/spending

    • zero balance is achieved

  • country consumes beyond PPC

The BOP and exchange rates (17/10/24)

• relationship between current account and exchange rate

  • floating exchange rate system

    • current account deficit causes downward pressure on the exchange rate

      • increasing debits require outflows of domestic currency (increased supply = decreased value)

    • current account surplus causes upward pressure on the exchange rate

      • inflows of foreign currency must be exchanged (increased demand = increased value)

  • managed exchange rate system

    • central bank responds to current account surplus by buying foreign currency

      • done to avoid appreciation

    • central bank responds to current account deficit by selling foreign currency

      • done to avoid depreciation

  • fixed exchange rate system

    • central bank responds to current account surplus by increasing debits

      • ex: buy foreign currency, decrease interest rates, lend abroad

      • done to avoid revaluation

    • central bank responds to current account deficit by increasing credits

      • ex: sell foreign currency, increase interest rates, borrow from abroad

      • also can increase debits by limiting imports

      • done to avoid devaluation

• relationship between financial account and exchange rate

  • financial account surplus is typically caused by investment in domestic economy from outside

    • foreign direct investment or response to high interest rates

    • increased demand for currency increases its value

  • financial account deficit is typically caused by investment in foreign economies

    • foreign direct investment or response to high interest rates

    • increased supply for currency decreases its value

Current account deficits and surpluses (29/10/24)

• consequences of persistent current account surpluses (extended trade surplus, balanced with financial account)

  • low domestic consumption

    • production > consumption → lower standard of living

  • upward pressure on exchange rate

    • damage on domestic economy

  • insufficient domestic investment

    • caused by financial account deficit

  • reduced export competitiveness

    • due to currency appreciation

  • unemployment

    • workers begin to lose jobs

  • (+) downward pressure on price levels

    • demand-pull and cost-push

• consequences of current account deficits (extended trade deficit, balanced with financial account)

  • downward pressure on exchange rate

    • imported inflation (from countries with higher prices)

  • need for high interest rates to attract inflows

    • contractionary monetary policy → discourages investment

  • foreign ownership of domestic assets (ex: U.S.)

    • satisfies need for credits in financial account

  • increasing levels of debt

    • risk of default → cannot pay the debt

  • poor international credit rating

    • considered less credit-worthy

  • cost of paying interest on loans (debt servicing)

    • opportunity cost

  • painful demand management policies

    • contractionary policies to limit imports (debits)

  • lower economic growth

    • result of contractionary policies and government paying interest on loans

• policies to correct persistent current account deficits

  • expenditure reducing policies (aims to limit AD)

    • contractionary policies → reduces output, income, consumption, imports

      • (+) lower rate of inflation → more competitive exports

      • (-) likely recession → higher interest rates put upward pressure on exchange rates

  • expenditure switching policies (from imported to domestic goods)

    • trade protection

      • (-) retalliation, higher domestic prices, lower domestic consumption, misallocation of resources

    • depreciation

      • (+) benefits export industries

      • (-) demand-pull, cost-push inflation

  • supply-side policies (increase competitiveness)

    • ex: limit power of trade unions, reduce minimum wage/corporate taxes, deregulation

      • (+) greater potential output, downward pressure on inflation

      • (-) requires a lot of time

  • Marshall-Lerner condition → measure of effectiveness of devaluation/depreciation to reduce a trade deficit

    • if sum of the PEDs of imports and exports is greater than 1, devaluation/depreciation will improve trade balance

    • if sum of the PEDs of imports and exports is less than 1, devaluation/depreciation will reduce trade balance

    • if sum of the PEDs of imports and exports is equal to 1, devaluation/depreciation will not affect trade balance

  • 

  • 

    • suggests that a devaluing/depreciating country may initially experience a worsening trade balance, followed by a shrinking deficit, then a trade surplus

      • “J-curve” effect

    • result of initially low PED (due to time lags) that increases with time

Sustainable Development

• sustainable development → development that uses resources to meet present needs without compromising future needs

  • concerned with both depletion and degradation

  • both growth and development

  • shared concern for economy and environment

    • increasing production and consumption while still preserving natural world

    • typically in conflict (questions true needs/wants)

• sustainable development goals (SDGs)

  • 17 “universal goals that meet the urgent environmental, political, and economic challenges facing our world”

  • intended to be met between 2015-2030

    • used by international organizations and national governments

    • fights poverty and develops sustainably

  • 

• sustainability and poverty

  • pollution of affulence → high income production and consumption resulting from economic growth

    • rising real output

    • requires use of fossil fuels

    • uses up common pool resources

    • results in climate change

    • 

  • pollution of poverty → economic activity pursued by very poor people in an effort to survive

    • overexploitation of scarce environmental resources

      • overuse of common pool resources

    • overuse of land depletes soil’s natural minerals

    • overgrazing depletes pastures of nutrients

    • deforestation in search of farmland

    • higher birth rates = greater demand for resources

Economic Growth and Development

• economic growth

  • increases in real output and income over time

    • allows societies to better satisfy needs/wants

    • potentially increases living standards

  • typically measured as real GDP per capita

• economic development

  • increases in real output and income over time + improvement in living standards

    • + reduced poverty, increased access to goods/services that satisfy needs/wants (healthcare, education, sanitation), improved gender equality, improved employment opportunities, reduced income/wealth inequalities

  • not so easily measured

• growth VS development

  • growth can occur without development

  • development unlikely without growth (but possible)

    • reallocation of resources

  • development will eventually require growth (+)

    • reallocation will eventually be exhausted

  • 

    • development without growth: A→B

    • growth without development: B→C

    • growth with development: A→E

Measuring Economic Development

• requires economic indicators

  • data that describes performance

  • captures attributes (specific + measurable)

  • captures characteristics (general + descriptive)

• purpose:

  • monitoring development

  • comparing countries

  • assessing progress

  • devising policies

• single indicators

  • GDP per capita

    • output per person, regardless of who produces

  • GNI per capita (GDP + net income from abroad)

    • income per person, regardless of where it is earned

  • trends in GDP/GNI per capita

    • similar if inflows and outflows are similar

    • similar if factors of production are owned by its residents

    • GNI per capita better reveals living standards

    • GDP per capita better reveals output

  • purchasing power parities (PPP)

    • the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods/services in each country

    • ‘buying power equivalence’

    • eliminates the influence of price differences on values of output/income

      • typically applied to GDP/GNI

  • trends in PPPs

    • in poorest countries, PPP conversions are greater than exchange rate conversions

      • money in low-price countries has greater purchasing power

• single health indicators

  • life expectancy at birth

    • average number of years of life

  • infant mortality

    • average number of deaths before age one per 1000 live births

  • maternal mortaility

    • average number of pregnancy related deaths per 100,000 live births

  • trends in health indicators

    • strong health indicators are linked with high GDP per capita

      • adequate health services with broad access

      • healthy environment → safe drinking water, sewage and sanitation, low levels of pollution

      • adequate diet

      • high levels of education

      • no serious income inequalities/poverty

    • exceptions:

      • some countries have greater inequalities in income

      • some countries have greater public health policies

      • each country allocates its resources differently

• single education indicators

  • adult literacy rate

    • percent of people aged 15+ who can read + write

  • primary (or secondary) school enrollment

    • percent of school aged children enrolled in school

  • trends in education indicators

    • less developed countries typically devote more resources to primary education

    • strong education indicators are linked with high GDP per capita

      • exceptions → due to different prioritization of education amongst countries

• single economic inequality indicators

  • Lorenz curve

    • diagram of cumulative % of income received by cumulative shares of population

  • Gini coefficient

    • summary measure of Lorenz curve (A/A+B)

  • poverty line

    • income level that is just enough to ensure a family of minimum necessities

• single social inequality indicators (condition where people have unequal access to valued resources, services, and positions in society)

  • crime and homicide rates

  • adolescent fertility rates

  • infants lacking immunization

  • old-age pension recipients

  • degree of trust metrics

• single energy indicators

  • access to electricity

  • share of household income spent on fuel/electricity

  • energy use per capita

• single environmental indicators

  • CO2 emissions per capita

  • bird or fish species threatened

  • measures of ozone depletion

• composite indicators

  • summary measures of multiple dimensions of development

  • necessary because economic development is multidimensional

  • produces more meaningful results

  • Human Development Index (HDI)

    • average of 3 dimensions scored from 0 (low) to 1 (high)

      • life expectancy at birth (long, healthy life)

      • mean years of schooling / expected years of schooling (access to knowledge)

      • GNI per capita US$ PPP (decent standard of living)

    • observations:

      • similar development can be achieved in very different ways

      • GNI/GDP per capita ranking may greatly differ from HDI ranking

      • development depends upon how countries choose to allocate their resources

      • has flaws → says nothing about income distribution, malnutrition, gender inequalities, etc.

  • Inequality-adjusted Human Development Index (IHDI)

    • adjusts the three HDI values for inequality

      • attempts to account for losses in development caused by inequality

      • if there were perfect equality in income, health, and education, IHDI = HDI

    • observations:

      • IHDI < HDI of all countries examined by the UN Development Programme

      • countries that lost the least HDI values have high HDI scores

        • countries that lost the greatest HDI values have relatively low HDI scores

      • countries that lost the least HDI values have more equal distribution of income (GINI)

  • Gender Inequality Index (GII)

    • combines 3 indicators to measure gender inequality

      • maternal mortality rate and adolescent birth rate (reproductive health)

      • share of parliamentary seats held by women and proportion of women in population with secondary education (empowerment)

      • proportion of women in the labour force (labour force participation)

  • Happy Planet Index (HPI)

    • combines 4 indicators to measure sustainable human well-being

      • life expectancy

      • well-being

      • inequality of outcomes

      • ecological footprint

        • HPI = (well-being x life expectancy x inequality) / ecological footprint

      • observations:

        • little correspondance between GNI per capita, HDI, and HPI

          • high income countries often have high ecological footprint

• limitations of economic development indicators

  • provide limited information

    • improves with addition of more indicators

  • sometimes present conflicting perspectives

  • based on statistical information

    • some countries have limited capacity for collection

    • collection methods differ from country to country

    • data are not fully available in some countries

    • new data is not produced at the same time

The Poverty Cycle

• poverty

  • the inability to afford basic needs

    • individual, household, community, or country

• absolute poverty

  • occurs when an individual/household lacks the income to meet basic needs

  • exists when income level is below the ‘poverty line’

    • unable to sustain a family in terms of food, housing, clothing, medical needs, etc.

    • determined by individual countries

  • international poverty line: $1.90 a day

    • identified by World Bank as ‘extreme poverty’

      • extreme version is concentrated in developing countries

  • lower-middle-income countries poverty line: $3.20 a day

  • upper-middle-income countries: $5.50 a day

• relative poverty

  • occurs when an individual/household earns less than a determined percentage of a society’s median income

    • may be able to afford basic necessities, but unable to achieve typical lifestyle (according to society)

  • would not exist if income were equally distributed

    • low equity in income distribution → increased relative poverty

• characteristics of those in poverty

  • tend to spend entire income acquiring needs

    • possibly not enough for survival

  • low levels of physical capital

    • tools, roads, water supplies, sanitation

  • low levels of human capital

    • education, skills, knowledge, healthcare

  • low levels of natural capital

    • soil, lakes, forests, etc.

• the poverty cycle

  • ‘the poverty trap’

  • low income = low (or zero) savings = low (or zero) investments in capital = low productivity = low income = … and so on and so forth

    • requires intervention

• generational poverty

  • transmitted from one generation to the next

    • unable to afford quality education/healthcare

    • typically have large families

    • forced to overuse their land

    • unable to secure bank loans (low credit)

  • children are almost destined for low productivity/income

• breaking the poverty cycle

  • requires government intervention through investment in capital

    • physical capital → infrastructure (sanitation, water supplies, roads, power supplies, irrigation, etc.)

    • human capital → health services, education, nutrition

    • natural capital → conservation and regulation of the environment

    • requires government expenditure 😭😭😭😭😭

International Trade Strategies

• limited access to international markets (PROBLEM)

  • developed countries protect domestic producers with subsidies

  • developed countries impose higher tariffs on imports from developing countries

  • developed countries impose higher tariffs on manufactured goods (disincentivizing value added production)

  • developing countries impose higher tariffs on imports from other developing countries

• limited access to appropriate technology (potential to increase quality of physical quality) (PROBLEM)

  • must be well-suited to specific conditions

    • economic, geographical, ecological, climate

    • different for developed and developing countries

      • (-) most technolgical advances take place in and for developed countries

  • labour-intensive technologies

    • use more labour than capital

    • create jobs → increased incomes, decreased poverty

    • increased need for local skills and inputs

  • capital-intensive technologies

    • use more capital than labour

    • creates unemployment → decreased incomes, increased poverty

    • increased need for outside skills and capital

• import substitution (SOLUTION)

  • use of protectionist measures to promote a country’s domestic industry

    • manufacture of simple consumer goods orientated towards the domestic market

      • shoes, textiles, beverages, appliances, etc.

    • tarrifs and quotas discourage imports

    • inward looking

  • (+) decreased need for specific imports; development of specific manufacturing

  • (-) requires heavy government intervention (likely including public ownership of firms); resource misallocation; high product prices; risks growth of capital-intensive rather than labour-intensive production

• export promotion (SOLUTION)

  • use of strong government intervention to expand exports

    • typically an extension of import substitution

    • aims for export revenues to expand GDP

    • transformative for China, Hong Kong, Indonesia, Malaysia, Singapore, South Korea, Taiwan, and Thailand

    • outward looking

  • (+) new markets; diversification; investments in human capital; appropriate technologies; increased employment; gives rise to secondary sector shift

  • (-) dependent upon healthy foreign economies; hindered by increased protectionism

• economic integration (SOLUTION)

  • the process of being more interdependent and economically unified

    • requires free trade agreements

    • growth and development best achieved when member nations are geographically close, at similar levels of development, have similar market sizes, and committed to cooperation (regional)

  • (+) new markets; economies of scale; diversification; increased investment (domestic + foreign)

  • (-) developed countries often exploit developing country (bilateral); trade deficits and balance of payments problems for LEDCs (bilateral)

Diversification and Social Enterprise

• dependence on primary sector production (PROBLEM)

  • ex: agriculture, fishing, mining, forestry, etc.

  • unsustainable

    • extraction of finite resources

  • overspecialization of few commodity exports (basic goods that are interchangeable with other goods of the same type)

    • vulnerable to unforeseen changes

    • little opportunity for value-added production

  • price volatility of primary products

    • instability impacts farmers’ incomes, agricultural investment, employment, and wages

    • instability impacts export earnings and balance of payments

    • instability impacts government revenues and development planning

• diversification (SOLUTION)

  • reallocation of resources into new activities

    • ex: manufacturing

      • typically for export

    • broadens the range of products

      • relative share of primary sector in GDP declines

        • shifts to secondary then tertiary (value-added production)

  • challenges the theory of comparative advantage

  • (+) sustained increases in exports; development of technology; increases in human and physical capital; reduced vulnerability; potential use of domestic primary commodities

  • (-) increases in domestic prices (reduced supply); high risk of failure (lack of expertise); requires time (development of skills/knowledge)

• social enterprise (SOLUTION)

  • ‘social business’

    • nonprofit or for-profit (profit is not the goal)

  • organization that focuses on meeting specific social objectives

    • effort to promote social change + improve people’s well-being

    • becoming increasingly popular in LEDCs

      • poverty alleviation and other social issues

  • (+) encourages civic engagement; creates awareness (attracts media attention); often ecological/environmental benefits

  • (-) lacks funding/people to create significant change; government assistance has opportunity cost

Market-Based Policies

• policies that aim to achieve economic growth and development via free market forces

  • focus on increasing productive capacity through the supply-side of an economy

    • liberate industries from rules/regulations

    • allow market incentives to raise productivity

    • incentivize investment in the economy

  • founded on the assumption that market forces allocate resources efficiently, leading to growth/development

• trade liberalization (SOLUTION)

  • the reduction/removal of trade barriers

    • tariffs, quotas, subsidies, administrative barriers

    • encourages competition and efficiency in export and import markets

    • requires trade relationships for both trade and investment

  • (+) encourages free and fair trade; increases competition; increases productivity + efficiency; improves global resource allocation; FDI creates employment opportunities

  • (-) intense competition from larger overseas firms; closure of local businesses causes unemployment; domestic firms harmed by dumping; profit maximizing firms may compromise on ethical/environmental matters

• deregulation (SOLUTION)

  • reduction/removal of government rules/regulations in an industry

    • aims to encourage competition and efficiency

    • product markets and labour markets

      • ex: financial institutions given autonomy to decide what types of products to offer

      • ex: reduction of labour union power, elimination of minimum wage

  • (+) increases efficiency in targeted markets

  • (-) increases deception + corruption (particularly in LEDCs)

• privitization (SOLUTION)

  • transfer of ownership from public sector to private sector

    • aims to improve competition, efficiency, and productivity in economy

      • motivated by profit rather than survival

      • public sector is known for inefficiences + corruption

    • ex: transport oil, gas, communication, etc.

  • (+) reduces government expenditure; increases government revenues (from actual sale); increases competition; increases productivity/efficiency; improves allocation of resources

  • (-) short-term unemployment (privately owned firms will eliminate inefficiences); profit-seeking firms will likely increase prices; some industries lack competition, monopoly power is abused

• better in theory than in practice

  • little or no growth of international trade

    • divergence rather than convergence

  • little/no improvement in diversification

  • increasing income inequality/poverty in LEDCs

    • lower income growth among the poorest

    • creates winners and losers

      • not all have the skills/opportunities to benefit

Interventionist Policies

• policies that aim to achieve economic growth and development via government intervention

  • focus on improving productive capacity through the correction of market deficiencies

    • redistributive policies to reduce inequality within and among countries

• rising economic inequality (PROBLEM)

  • economic growth does not ensure development when the majority remain impoverished

    • insufficient access to education, healthcare, and credit

      • leads to further inequalities

  • corruption

    • rich minority have political influence

  • civil unrest

    • destruction of capital

    • market instability

• tax policies (SOLUTION)

  • progressive taxes charge a higher percentage of tax as an individual’s income increases

    • addresses inequality by redistributing income and wealth from rich to poor

    • economy benefits as those with highest MPC now have more disposable income

  • 

  • indirect taxes tax income through expenditure on goods/services (consumption)

    • redistribute income when applied to luxury products

    • discourage spending on products that generate negative externalities

  • low income tax rates incentivize work

    • encourage labour force participation

  • low corporate tax rates incentivize production

    • encourages investment

  • (-) progressive taxes → disincentivizes work for high income earners; incentivizes tax evasion; less savings/investment

  • (-) indirect taxes → increases inequality (regressive)

  • (-) low taxes → may incentivize rest (income); cannot ensure increased investment (corporate)

• transfer payments (SOLUTION)

  • government payments without an exchange of goods/services

    • redistributive by nature

    • ex: unemployment benefits, pensions, child allowances

  • (+) reduces inequality; improves living standards for disadvantaged/marginalized

  • (-) payments without actual output/gain; opportunity cost for government; LEDCs lack sufficient government budgets

• minimum wage policies (SOLUTION)

  • minimum legal price of labour

    • price floor in labour market

    • aims to protect low-skilled workers

      • sufficient living wage for all

        • ideally allows for savings for all

  • (+) increases living standards for those who benefit

  • (-) requires government resources to ensure compliance; increases costs of production; may increase unemployment

Provision of Merit Goods

• low levels of human capital (PROBLEM)

  • barriers to education

    • school fees; insufficient fundng (insufficient/underqualified teachers/resources); gender discrimination; distance from home; conflict

  • barriers to healthcare

    • doctor’s fees; insufficient funding (insufficient/underqualified teachers/resources); gender discrimination; distance from home; insufficient access to water/sanitation

• limited access to infrastructure (form of physical capital requiring investment) (PROBLEM)

  • ex: electricity, telecommunications, internet access, irrigation, roads, ports, etc.

  • lowers costs of production

  • largely a government responsibility

• merit goods

  • goods which are deemed to be socially desirable → likely to be under-produced and under-consumed through free markets

    • ex: education, healthcare, vaccines, public transit

    • particularly true for poorest members of society

  • products that create positive externalities when consumed

    • MSB > MPB

  • 

• education programs (SOLUTION)

  • allocating a portion of government’s budget for education/training (primary, secondary, adult)

  • social benefits exceed private benefits

    • ex: improvements in capital, increased living standards, lower crime rates, lower birth rates

  • underprovided and underconsumed in LEDCs

    • budget limitations; ‘no free lunch;’ need to work (ex: agriculture)

• health programs (SOLUTION)

  • allocating a portion of government’s budget for investments in health

    • necessary for healthy and productive labourforce

  • social benefits exceed private benefits

    • ex: vaccines and preventative measures against contagious diseases and pandemics; social marketing of preventative measures against malaria/HIV/AIDS

  • underprovided and underconsumed in LEDCs

• infrastructure (SOLUTION)

  • allocating a portion of government’s budget for investments in a country’s basic physical systems

    • decrease costs of production and increase productivity

    • power supports transition from primary to secondary sector

    • roads, rails, ports allow movement of goods

    • telecommunications foster communication + facilitates education

    • clean water + sanitation supports health/safety

  • social benefits exceed private benefits

  • underprovided and underconsumed in LEDCs

Foreign Direct Investment

• investment by a multinational company (MNC) in productive activities in another country

  • based in home country, operating in host country

    • control of 10+% of firm in host country

    • increasingly common to have home in MDC and be hosted in LEDC

  • most important source of foreign finance flows into LEDCs

    • though domestic investment tends to be much greater

• reasons MNCs expand into LEDCs (firms are profit maximizers)

  • increase sales and revenues

  • bypass trade barriers

  • lower costs of production

  • access to locally produced raw materials

  • natural resource extraction

• appealing characteristics of LEDCs

  • stable macroeconomic environment

    • inflation, currency, debt, BOP

  • large markets

  • liberalized economy + trade policy

  • favourable tax rules

  • freedom to repatriate profits

  • well-educated labour force

  • well-functioning infrastructure

  • political stability

• (+) can help offset current account deficit; improved technical/management skills; improved technology; increased savings=increased capital stock; tax revenues; boost to local industry; employment opportunities

• (-) environmental degradation; inappropriate consumption patterns; spending on infrastructure takes priority over spending on merit goods; negative political influence; ‘race to the bottom’

Foreign Aid

• indebtedness (PROBLEM)

  • debt servicing has opportunity cost

    • human capital, infrastructure, etc.

  • may require increasing taxes

  • poor credit ratings + high interest rates

  • discourages FDI

  • potential debt trap

• foreign aid (SOLUTION)

  • financial assistance to developing countries

    • funds, goods, services

    • must be concessional and non-commerical

      • transfers involve more favourable conditions than those found in the market

        • ex: loans have lower interest rates or longer repayment periods

      • must not involve buying/selling

    • goal of improving economic, social, or political conditions

      • military aid, peacekeeping, refugee assistance, and anti-terrorism do NOT meet these conditions

  • types of foreign aid:

    • humanitarian aid

      • food, medical, emergency relief

    • development aid

      • project, programme, technical assistance, debt relief

• humanitarian aid (SOLUTION)

  • aid extended in regions affected by violent conflicts or natural disasters

    • grants (money as a gift) or goods-in-kind (food, medicine, blankets, etc.)

    • intended to save lives, ensure access to basic necessities, and help displaced people

• development aid (SOLUTION)

  • aid intended to help LEDCs achieve development objectives

    • ex: eradicating poverty, improving education/standards of living

    • delivered through grants, concessional loans, and debt forgiveness

      • financial aid counted as inflows in BOP

• debt relief (SOLUTION)

  • forgiveness/restructuring of a portion (or all) of a country’s debt

    • original loans were typically for development projects

    • restructuring is done through new loans on new (improved) terms

    • helps reduce opportunity cost of debt servicing

• official debt assistance ‘ODA’ (SOLUTION)

  • foreign aid from donor governments for development purposes

    • not from NGOs/non-profit organizations

    • can be bilateral → from one country to another

    • can be multilateral → channeled through a development agency like UN/World Bank

    • largely in the form of grants

• non-government organizations ‘NGOs’ (SOLUTION)

  • organizations capable of providing tens of billions of dollars in aid (grants) annually

    • an increasing amount of which was collected as ODA

  • ex: World Vision International, Oxfam International, Save the Children International

  • some of which also help plan, implement, and manage development programs

• (+) increases consumption; increases investment; supports growth of human capital and infrastructure (productivity, potential for some to escape poverty cycle); can improve income distribution; helpful in achieving SDGs; potential to escape debt trap

• (-) tied aid reduces effectiveness (recipients required to use aid to buy products from donor countries); conditional aid reduces effectiveness (recipients required to agree to certain terms); aid is inconsistent and unpredictable; aid may not reach those most in need; potential for corruption; recipient countries may borrow recklessly, assuming future debt forgiveness

Multilateral Development Assistance

• multilateral development assistance (SOLUTION)

  • lending for the purpose of development by intermediary organizations

    • international organizations composed of many countries

      • ex: World Bank, International Monetary Fund

      • large projects funded by pooling money together

      • lending is typically non-concessionary

        • terms determined by market forces

• The World Bank

  • international organization that lends money to LEDCs for economic development and structural change

    • poverty reduction + sustainable development

    • financing for infrastructure, education, health, etc.

      • +technical assistance, policy advice

    • non-concessional loan terms for middle-income countries

    • concessional loan terms for low-income countries

  • (-) governance dominated by rich countries → voting power determined by size of financial contributions

  • (-) excessive interference in domestic policy

    • (-) conditional assistance → loans deprive country of autonomy

  • (-) inadequate attention to poverty alleviation

    • (-) accused of doing very little to help LEDCs

• The International Monetary Fund (IMF)

  • organization that oversees the international financial system + promotes global trade

    • seeks exchange rate stability

    • financial assistance + policy advice to countries facing BOP problems

    • short-term non-concessional loans to countries struggling to make international payments

  • aims to ensure macroeconomic stability

  • (-) governance dominated by rich countries → voting power determined by size of financial contributions

  • (-) excessive interference in domestic policy

    • (-) conditional assistance → loans require extremely conservative macroeconomic policies

  • (-) many countries have experienced increasing rates of poverty and negative growth rates

Institutional Change

• informal economy (PROBLEM)

  • ‘parallel markets’

  • unregistered

    • not recorded for national accounting

    • untaxed

  • unregulated

    • unprotected + vulnerable

  • especially common in LEDCs

    • ex: subsistence farmers, casual jobs paid for in cash

• weak institutional framework (PROBLEM)

  • established systems, structures, and contexts that shape economic behaviour in a country

    • ex: legal system, protection of property rights, taxation structures, banking system

• property rights (SOLUTION)

  • the entitlement to assets owned by an individual, organization, or government

    • tangible + intangible assets

      • physical + intellectual property (particularly land)

    • free to decide how resources are best used

    • rights to use, earn income from, transfer to others

  • necessary for FDI

• land rights (SOLUTION)

  • (+) increased food security; increased access to credit; lower rates of deforestation; biodiversity; protects indigenous peoples and their culture

• improved access to banking (SOLUTION)

  • banks provide link between savers and borrowers

    • not readily available in LEDCs

  • credit is necessary for growth + development

    • investment in human/physical/natural capital

  • mobile banking makes products available to anyone anywhere

• microfinance (SOLUTION)

  • small loans on short repayment plans to those who do not typically qualify

    • including women

    • used for self-employment

  • (+) great success stories; targets women; may require financial literacy course

  • (-) high interest rates; encourages growth of informal economy; possible corruption; tragic stories; very small scale; cannot serve as THE solution

• gender inequality (PROBLEM)

  • ex: health/education, labour market, inheritance/property rights, access to credit

  • limits quantity + quality of labour

  • massive barrier to eliminating poverty

    • contributes to low living standards for women and children

      • repeated across generations

• increasing women’s empowerment (SOLUTION)

  • gender equality helps end social and cultural discrimination against females

  • includes driving, voting, working with men, etc.

    • increased output (and potentially productivity)

  • especially significant in reducing poverty and child mortality

  • educated mothers = educated children = smaller families

• lack of good governance (PROBLEM)

  • the action/manner of governing

    • effectiveness of government

    • those who act on behalf of the people

      • includes policy implementation, spending, taxation, etc.

• corruption (PROBLEM)

  • dishonest/fraudulent conduct

    • ex: bribery, tax evasion

    • typically by government officials, powerful firms/individuals

    • decreases tax revenues + ability to provide merit goods

• reducing corruption (SOLUTION)

  • LEDCs benefit from well-structured and well-enforced legal systems

  • LEDCs benefit from tax system reforms

    • necessary to generate essential revenues without excessive borrowing

Market-Oriented Policies

• LEDCs need a mix of market-oriented and interventionist policies

  • extremes have been ineffective, governments must strike balance

• market-oriented policies (SOLUTION)

  • policies that allow private decision-makers to make economic decisions

    • limited government intervention

    • market determines resource allocation

      • price serves as signals and incentives

        • communicates information, motivates response

      • competition produces lower price and greater quality and choice

  • ex: trade liberalization, freely floating exchange rates, market-based supply-side policies

    • policies that encourage competition (deregulation, privitization, anti-monopoly regulation)

    • labour market reforms (limiting labour union power, eliminating minimum wage)

    • incentive-related policies (incentives to work/innovate/invest)

  • (+) efficient allocation of resources; competitiveness (firms + households benefit); benefits of free trade (firms + households benefit); long-run economic growth (profit motive drives entrepreneurs to innovate and invest)

  • (-) market failures (negative externalities are not corrected, merit goods remain underprovided/underconsumed); income/wealth inequalities (unequal distribution of FOP, benefits do not naturally reach the poorest, insufficient credit opportunities for the poor)

Interventionist Policies

• LEDCs need a mix of market-oriented and interventionist policies

  • extremes have been ineffective, governments must strike balance

• interventionist policies (SOLUTION)

  • policies based on government intervention in the market

    • intended to correct market deficiencies

    • seeks to create more effective markets (at the cost of efficiency)

  • (+) provision of stable macroeconomy

    • price stability, full employment, reasonable budget deficit, reasonable trade balance

    • protects interests of economic decision-makers

    • attracts FDI

  • (+) corrects market failures

    • corrects negative externalities + overuse of common pool resources

    • provides merit goods (products that generate positive externalities)

      • education, healthcare, social safety nets, parks

    • provides public goods (non-excludable, non-rivalrous)

      • natonal defense, basic education/healthcare

  • (+) investment in human capital

    • health/education

    • insufficiently provided by private sector

  • (+) provision of essential infrastructure

    • ports, roads, railways, power, communication, sanitation, sewage, etc.

    • insufficiently provided by private sector

  • (+) provision of social safety net

    • use of transfer payments

    • a certain amount of income is needed to ensure access to basic needs

  • (+) promotion of gender equality

    • empowerment of women

    • access to health/education/credit

    • inheritance + property rights

  • (-) misallocation of resources

    • protects inefficient producers

  • (-) requires significant government spending

    • requires significant taxation

    • opportunity costs

  • (-) poor planning

    • requires technical knowledge + expertise

  • (-) excessive bureaucracy

    • systems, structures, rules, regulations

    • source of inefficiences

  • (-) corruption

    • use of public office for private gain

  • (-) potential influence of elite groups

    • exerting political pressure, self-serving interests