• 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 acess 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 PES

• 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