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MACMILLAN
WORKOUT
SERIES

R. Young
and
S. Grant

M
MACMILLAN
© R. Young and S. Grant 1989

All rights reserved . No reproduction, copy or transmission

of this publication may be made without written permission.

No paragraph of this publication may be reproduced, copied

or transmitted save with written permission or in accordance
with the provisions of the Copyright Act 1956 (as amended),
or under the terms of any licence permitting limited copying
issued by the Copyright Licensing Agency, 33-4 Alfred Place,
London WC1E 7DP .

Any person who does any unauthorised act in relation to

this publication may be liable to criminal prosecution and
civil claims for damages .

First published 1989

Published by
THE MACMILLAN PRESS LTD
Houndmills, Basingstoke, Hampshire RG21 2XS
and London
Companies and representatives
throughout the world

British Library Cataloguing-in-Publication Data

Young, Richard, 1955-
Work out economics 'A' level.
1. Economics. Questions and answers - For schools.
I. Title . II. Grant, S. III. Series.
330' .076
ISBN 978-0-333-45873-0 ISBN 978-1-349-10010-1 (eBook)
DOI 10.1007/978-1-349-10010-1

To our families
Preface vii

Acknowledgements viii

Introduction 1

1 The Economic Problem 7

2 Demand 20

3 Supply and Prices 34

4 Elasticity 49

5 Costs of Production 65

6 Markets 80

7 Regional Economics 100

8 Income and Wealth 110

9 Labour Economics 130

10 Welfare Economics 144

11 National Income Accounting 160

12 Income Determination 175

13 Money and Banking 195

14 Monetary Economics 210

15 Unemployment 221

16 Inflation 231

17 International Trade 245

18 Balance of Payments 258

v
19 Exchange Rates 276

20 Managing the Economy 292

Index 304

vi
This book has been primarily designed to prepare students for the 'A' level
examination in economics. In addition, it should also provide a useful reference
for Scottish Higher Certificate examinations; for the first year of undergraduate
studies; and for professional papers which contain economics. We hope that
students revising or following self-study, distance learning courses will find
benefit in following through a series of structured worked examples.
Work Out Economics 'A' Level is based on a thorough analysis of all the
syllabuses set by the examining groups listed in the Acknowledgements. It has
been structured to enable effective revision. Each chapter begins by setting out a
summary of the essential economics that students need to know. Students are
then presented with examples of past data response and essay questions set by
examining groups, together with complete solutions. Where appropriate, new
questions reflecting recent developments in the subject have also been included.
All multiple-choice questions have been set by the authors, and solutions explain
not only why a particular answer is correct, but also why other options are
wrong.
All answer guidelines are our sole responsibility and have not been provided
or approved by any examining group .

Witney, Oxfordshire, 1989 R. Y.

S. G.

vii
 Acknowledgements

The authors and publisher would like to thank the following boards who have
given permission for the use of copyright material:

Associated Examining Board

Joint Matriculation Board
Northern Ireland Schools Examination Council
Scottish Examinations Board
Southern Universities' Joint Board
University of Cambridge Local Examinations Syndicate
University of London School Examinations Board
University of Oxford Delegacy of Local Examinations
Welsh Joint Education Committee

All examining groups would wish to point out that worked examples included
in the text are entirely the responsibility of the authors and have neither been
provided nor approved by the board. They may not constitute the only possible
solutions.
The University of London School Examinations Board accepts no
responsibility whatsoever for the accuracy or method of working in the answers
given .
The authors and publisher would also like to thank the following, who have
also given permission for the use of copyright material:

The Guardian
The Independent
Times Newspapers Ltd

Every effort has been made to trace all copyright holders but if any have
inadvertently been overlooked , the publishers will be pleased to make the
necessary arrangements at the first opportunity.
We are most grateful to the following Heads of Economics for their careful
reading and correction of some or all of the original typescript:

Clarrie Haynes , Marlborough School, Woodstock, Oxfordshire

Danny Myers, New College , Swindon, Wiltshire
Brian Sangster, Burford School, Oxfordshire
Jonathan Townsend, Abingdon School, Oxfordshire
Laurence Whitehouse, Farnborough Sixth Form College, Hampshire

A particular thanks to Robert Ackrill for the long hours of invaluable

assistance given freely in shaping the initial stages of the book. Past students of

viii
 West Oxfordshire Technical College, Corrina Boreham, Angela Frost, Clare
Guy and Robert Prior-Wandesforde, and Sally Trego, formerly of Matthew
Arnold School, corrected many early errors. We also owe a huge debt to the
many other students who have painstakingly worked through the examples.
Robert Sulley of Macmillans has given the most helpful support.
Since this is a joint venture , both authors thank the ir families for their
sacrifices , patience and understanding throughout.
Any failings which remain are entirely our own.
The cover illustration is courtesy of Camera Press London and Benoit
Gysembergh.

Examination Boards for Advanced Level

Syllabuses and past examination papers can be obtained from:

The Associated Examining Board (AEB)

Stag Hill House
Guildford
Surrey GU2 5XJ

University of Cambridge Local Examinations Syndicate (UCLES)

Syndicate Buildings
Hills Road
Cambridge CB1 2EU

Joint Matriculation Board (JMB)

78 Park Road
Altrincham
Cheshire WA14 5QQ

University of London School Examinations Board (L)

University of London Publications Office
52 Gordon Square
London WC1E 6EE

University of Oxford (OLE)

Delegacy of Local Examinations
Ewert Place
Summertown
Oxford OX2 7BZ

Oxford and Cambridge Schools Examination Board (O&C)

10 Trumpington Street
Cambridge CB2 1QB

Scottish Examination Board (SEB)

Robert Gibson & Sons (Glasgow) Ltd
17 Fitzroy Place
Glasgow G3 7SF

Southern Universities' Joint Board (SUJB)

Cotham Road
Bristol BS6 6DD

ix
 Welsh Joint Education Committee (WJEC)
245 Western Avenue
Cardiff CF5 2YX

Northern Ireland Schools Examination Council (NISEC)

Examinations Office
Beechill House
Beechill Road
Belfast BT8 4RS

x
How to Use This Book
This book has been designed to help you prepare for your 'A' Level examination
in economics. Simply buying a revision text does not guarantee examination
success . However, by working from this book over the months leading up to the
final examination, you will improve your ability to understand and apply key
economic concepts.
Work Out Economics 'A' Level is not intended as a textbook but as a
comprehensive revision manual. If there are topics which you have not covered
in class , refer to a good textbook and make notes from the relevant chapter. Key
economic terms are in italic type for emphasis and are clearly defined in the text.
The book is divided into self-contained chapters each covering a major topic.
At the beginning of a chapter you will find a summary of the essential economics
you need to know. Make sure you become thoroughly familiar with the material
in these summaries.
Each chapter contains a number of worked examples of the type of question
you can expect in the final examination. For data response and essay -type
questions , suggested solutions are given. It is absolutely essential that you do not
treat solutions given as 'model' answers to be memorised and then copied out in
the examination. In economics there is almost always more than one 'correct'
solution to a given problem. This is particularly true in macroeconomics , where
professional economists are divided as to the causes and cures for problems such
as inflation and unemployment. Use the solution given as an indication of the
sort of analytical skills of evaluation and judgement that you should be using
yourself.
The section on objective questions gives you a chance to test your own
knowledge and understanding of a topic. Do these questions without looking at
the answers provided. If you give an incorrect solution to one of the questions,
refer back to the relevant section in the fact sheets.

Revision
Most courses in 'A' Level economics are over two years . Ideally, preparation
begins six months before the final examination! You cannot hope or expect to
sustain intensive concentration for twenty-six weeks. Start by obtaining a copy of
the syllabus from the appropriate examining group listed in the acknowledge-
ments. Use the syllabus to write out a study plan , listing the topics you are going
to revise each week.. Spend most time studying those concepts and issues central
to the subject. For instance , you may find that some topics such as indifference
curves or welfare economics are covered in more depth in Work Out Economics
'A ' Level than is required by your syllabus.
Build up to a period of intensive revision during the last four weeks before the
exam. Many people find it helpful to write as they revise. Make notes on one side

1
 of loose-leaf paper. Leave generous margins in case you want to add new ideas.
In particular, make sure that when you have finished a topic , you can:

(a) define economic terms ;

(b) list key points;
(c) apply important concepts;
(d) draw relevant graphs .

It is important to be able to draw graphs quickly and accurately, and a little

practice will be needed .
The number of hours you put in is far less important than what you put into
those hours . Most students find that they can concentrate better and learn faster
if they work in bursts of thirty minutes with regular breaks. Avoid uninterrupted
three-hour slogs. Promise yourself a special 'treat' at the end of a successful
revision session .
Try to review material covered shortly after you have studied it and again a
few days later. At the beginning of the revision programme have a look at past
questions and write down the main points you would make in an answer. Draw
and label relevant graphs . Make sure you can explain in your own words
important concepts such as crowding out and inferior goods. It may help to draw
up your own glossary of key economic words. Find time to familiarise yourself
with current economic trends in the UK by reading economic articles in the
quality newspapers and journals. For instance, do you know the present rate of
inflation or the balance of payments trend? Similarly, you should be aware of the
current government's policy. Are you aware of the Chancellor's strategy for
demand management of the economy?
As the final exam approaches, practise answering questions in full and under
examination conditions. You will soon find that your ability to apply economics
has improved beyond all measure .
Make sure your study programme is balanced and allows time for enjoyment
and relaxation . Work hard! do your best and look forward to the long summer
holiday when you can take a well-earned break.

The Examination
You are bound to be slightly nervous on the day of the exam. So is everyone else.
Remember, with careful revision and good examination technique picked up by
reading this book , you should do well. Arrive in good time. Do not forget to take
the appropriate equipment for each paper. There are three main types of
question in the final examination.

(a) Essay Questions

For this paper you are going to need two pens, a ruler, a pencil, a rubber and a
watch . Correcting fluids such as Tipp-Ex are not allowed! Essay questions test
the ability to evaluate arguments and express viewpoints . Most students find this
type of question the hardest to tackle and , on average , marks earned in the essay
paper are generally lower than those for data response and objective test papers.
Start by reading through the paper and decide the topic covered by each
question. Check the phrasing, noting particularly the key words. These will
indicate what the examiner is looking for. For instance, 'compare and contrast'
means discuss similarities and differences , while 'elucidate' means explain . Only

2
answer questions on topics you have revised. Only attempt questions where you
can answer each part. Once you have decided to attempt a question, briefly plan
your answer. Many candidates like to gain confidence by tackling their best
question first. Remember , there are two main reasons why capable students
underachieve when writing essays:

(i) Candidates decide a question is about one topic (e.g. inflation) and then
write all they know about that topic .
(ii) Candidates copy out a memorised answer to a similar past question .

You will do much better if you make an answer a well-reasoned explanation

which is relevant to the set question . Develop a line of argument which has a
beginning, a middle and an end . Try starting an essay by defining important
economic terms given in the question. Then make clear any assumptions you are
going to make. For example, suppose a question asked' "In the long run, all
firms earn normal profits, only ." Discuss.' You might begin by defining firms and
normal profits and then continue by initially assuming a perfectly competitive
market structure. After establishing that the ability of firms to leave or enter the
industry ensures that only normal profits are earned in perfectly competitive
markets, in the long run, end the essay by evaluating an industry assuming
imperfect competition .
Some questions , such as the one just discussed , lend themselves to a graphical
analysis. Clear, neat and labelled graphs which are relevant to the set question
can save a hundred words of explanation. It is always better to draw a series of
graphs to advance an argument than to use one diagram for all stages of an
argument. Avoid simply drawing diagrams and then ignoring them in your
answer. Any graph should be an integral part of the essay. Draw the examiners'
attention to a diagram by, say , stating 'in Figure 1 the firm sets output at Qt
Write in clear, simple, short sentences. Often arguments are best developed
by stating a point, explaining that point and then giving a real-world example.
For instance, suppose part of a question asked, ' Explain the meaning of ad
valorem taxes'. You might write:

An ad valorem tax means value added tax [statement]. A given percentage is

added to the selling price of a good and the resulting tax is passed on to the
government by the seller [explanation] . For example , 15% VAT on the sale of
a £200 camera would increase its market price to £230 and raise £30 of tax for
the government [example] .

Once a point has been fully developed , start a new paragraph. Try to relate your
theory to the real world . Examiners are always impressed if a candidate can
display an understanding of how economics influences the world around us.
Remember, too , that good candidates avoid narrow interpretations and re-
cognise that there is more than one approach which is valid.
Do not use unacceptable abbreviations - for example , 'gov ' instead of
government. When using acceptable abbreviations , first write out the word or
phrase in full with the abbreviation following in brackets. For instance,
'International Monetary Fund (IMF)'. Thereafter, you may use the abbrevia-
tion .
It is absolutely essential that you complete the required number of questions.
If you are running out of time and cannot complete an answer, do a full essay
plan, including graphs where appropriate.
Be careful to avoid irrelevant answers , which not only earn no marks, but also
waste valuable time which could have been used to earn marks from another

3
 question . No marks are earned by waffle or by repeating points made earlier in
the essay . Do not spend too much time on one particular question. Set out your
work clearly and neatly . Use your economics. Above all, make sure that what
you are writing is relevant and answers the set question .

(b) Data Response Questions

For this paper you are going to need two pens, a ruler, a pencil , a rubber and a
watch. Bring a calculator along. Remember to check that the batteries are not on
the verge of running out.
Data response questions are especially good at testing the ability to apply
economics and to quantify. There are two types of data response questions:
statistical data, displayed as graphs, tables , charts or diagrams , and literary prose
extracts from newspapers, journals, etc.
Each examining board tends to have its own 'house' style of data response
question. Make sure you have familiarised yourself with examples drawn from
previous papers. In the actual exam, allocate sufficient time for a careful study of
the entire question . Here is a check-list of points to consider when tackling
statistical data response questions :

(a) Ask yourself what key economic concepts are being tested by the
question .
(b) Look at how the data have been obtained:
(i) Are there any hidden assumptions or unsupported statements?
(ii) Is the evidence used selective or biased?
(iii) Is the survey complete (all the appropriate population have been
included) or a sample (only some of the population have been
included)?
(c) Identify major variables in the data:
(i) Are the figures shown as absolute values ; percentages ; index
numbers; billions of Is; thousands of people; etc?
(ii) Which is the largest item ?
(iii) How do other items compare?
(iv) Which variables are stock values (i.e. an amount at a given moment in
time) or flow values (i.e . an amount per time period)?
(d) Observe any trends (patterns) in the data:
(i) Which variables are rising , falling or stable?
(ii) What is the percentage change in a variable? Use the equation
(present value - previous value)
percentage change = . x 100
previous value

(iii) Are any variables cyclical?

(e) Is there a direct relationship between any variables in the data? Look out
for:
(i) Causal relationships , where the value of one variable determines the
value of a second variable . However, remember that unrelated
variables sometimes move closely together.
(ii) Lagged relationships, where the current value of one variable is
related to the previous value of a second variable .
(f) Relate your knowledge of theory to the data. Can you give reasons for
relationships, trends or cycles observed?
(g) Always look for relevant data to explain your assertions.

4
 Gain confidence in handling and interpreting statistical data by fam iliarising
yourself with typical examples. Much of the data used by economists is presented
as time series which show the value of a particular variable such as national
income at different points in time . Gr eat use is made of official statistics issued
by the Central Statistical Office (CSO). Try to find time to look at CSO
publications such as the ' Blue Book' (UK National Accounts) or the 'Pink Book'
(Balance of Payments Statistics), held in the reference section of most public
libraries.
Literary data response questions set a passage and sometimes supporting
tables for analysis . Spend time reading the section of prose carefully. Many of
the check-list of points given for use with statistical data can equally be applied to
prose .
You are almost certainly going to be asked to identify and express in your own
words the main features of the data . Try to avoid making sweeping or vague
statements which are unsupported by evidence . Instead , explain essential
features of the passage, quoting relevant phrases from the text only to support a
point made in your own words. Always indicate such phrases by 'quotation
marks'.
Many literary data response questions ask candidates to apply economic
concepts. You are expected to relate relevant theories such as supply-and-
demand or theory of the firm to the passage given. Remember that a variety of
approaches may be required. Diagrams should be used if appropriate.
You may be asked to evaluate the data and then predict future trends or
outcomes. Look back at the passage and identify key variables, relationships and
economic concepts. Use these as the basis of your predictions. A void making a
series of random predictions unsupported by information contained in the data
provided.

(c) Objective Questions

For this paper you are going to need a pencil, rubber, ruler, watch and
calculator.
Objective questions are well suited to testing knowledge and understanding of
theories , and deal with 'certainty' areas of economics. Hence, objective ques-
tions are set on topics where economists are agreed that there is a single correct
answer. There are four types of objective question used in 'A ' Level economics.

(i) Multiple-choice questions

Multiple-choice que stions contain a stem and a number of possible answers of
which only one is correct.

Example 1

STEM Industrial inertia occurs when :

labour is geographically immobile

DISTRACTORS ~~ the share of manufacturing in national output declines
firms fail to exploit economies of scale OPTIONS
industry gains no cost advantage from anyone site
KEY E the initial reasons for location have disappeared

5
 The stem sets the question and then candidates have to choose between a
number of incorrect distractors and the correct option , called the key. Some
questions can be answered quickly. Look at the options and see whether there
are any which can be immediately eliminated or accepted. If not, it is important
not to be delayed by those questions requiring deep thought or lengthy
calculations. Remember: each que stion, whether easy or difficult , carries the
same number of marks . Make a note of such questions for later consideration
and carryon working through the paper.

(ii) Multiple-completion Questions

MUltiple-completion questions are similar to multiple-choice except that one or
more of the options may be correct. The need to sort out which options, rather
than which single option , may be correct means that multiple-completion take
more time than multiple-choice. Each board has its own option code. If you can
establish that one option is definitely a distractor , this reduces the number of
answers possibl e from the option code.

(iii) Matching-pairs Questions

Matching-pairs questions are another variation on multiple-choice questions ,
where the same set of options are used for several questions. It is important to
remember that the same option can be the correct answer for more than one
question.

(iv) Assertion-Reason Questions

Candidates are given an assertion (first statement) followed by a reason (second
statement). Consider the assertion and decide whether it is a true statemen.t.
Consider the reason and decide whether it is a true statement. If both the
assertion and the reason are true , consider whether the reason is a correct
explanation of the assertion. Each board then supplies its own option key.
Start by studying each statement separately. Mistakes usually follow from
looking at both statements at the same time . Remember: it is quite possible for
both statements to be correct and yet unrelated .

A range of strategies can be used when tackling the objective question paper.
Only one rule must be followed : answer all the questions . Some candidates
prefer to work through the paper , answering each question in turn, irrespective
of the amount of time or degree of difficulty involved . However , we have already
suggested that it may be better to hold over time-consuming questions until you
have worked through all other questions. Be sure to treat each question carefully
and not to give a wrong answer through carelessly misreading the stem or
options. Questions with 'not' in the stem are particularly dangerous! For this
type of que stion , the option to which you can answer 'no' is the correct solution .
If you begin to run out of time , work through the remaining questions allowing
yourself a maximum of , say, 20 seconds per question . If time is about to run out
completely, make sure you scribble down some answer and hope that at least one
or two will be right.
In any case , DON'T PANIC. Both the authors wish you all the best and good
luck in the final exams!

6
 1 The Economic Problem
1.1 Fact Sheet

(a) The Economic Problem

(i) Wants and needs are satisfied through the consumption (use) of goods
and services.
(ii) Outputs (goods and services) are produced from inputs (resources)
sometimes called factors of production. The four factors are land , labour,
capital and entrepreneurs.
(iii) The economic problem arises because, while our resources are finite, our
wants and needs are infinite.
(iv) All societies have to decide: what goods and services to produce ; how to
produce them; and who is to receive them.

• Resource allocation refers to a particular use of land , labour, capital and

entrepreneurs.
• Economics studies the allocation of scarce re sources between alternative
uses.

(b) Economic Methodology

Economics is a social science and uses scientific methods:

(i) A hypothesis (prediction) is constructed about economic behaviour which

may be right or wrong.
(ii) A model is built describing the behaviour of economic variables (influen-
cing factors) involved in the initial hypothesis .
(iii) The hypothesis is tested against empirical (real-world) evidence by use of
the model.
(iv) If the hypothesis cannot be disproved, it becomes an accepted theory .

• Economists isolate the relationship between two variables by assuming

ceteris paribus - i.e . that all other influencing factors are held constant.
• Positive economics deal s with statements of fact which can be proved or
disproved , and shows how the economy actually works .
• Normative economics deals with statements of opinion which cannot be
proved or disproved, and suggest s what should be done to solve economic
problems.
• Microeconomics considers the behaviour of an individual consumer, firm
and industry, and is mainly interested in resource allocation and relative
prices.

7
 • Macroeconomics considers the behaviour of the economy as a whole , and is
mainly interested in national output , employment , the balance of payments
and general prices.

(c) Opportunity Cost

The decision to produce or consume one product involves the sacrifice of

another product. The real or opportunity cost of an action is the next best
foregone alternative .

• An economic good IS In limited supply and possesses an opportunity

cost - e.g. a car.
• However, a free good is not scarce and has no opportunity cost - e.g.
sunshine .

(d) Production Possibility Curves

A production possibility curve (PPC) is sometimes called an opportunity cost or

transformation curve , and shows the combination of two goods a country can
make in a given time period with resources fully employed (Figure 1.1). A PPC is
drawn assuming a country has a fixed amount of resources and a constant state of
technology .

Good Y
c
•

I
A I
H - - - - - - . - - 1- -
I
I
I

E G M
Good X

Figure 1.1 A production possibility curve

(i)LM is a rrc.
(ii)Points under the PPC (e .g . A) imply resource underutilisation .
(iii)Points along the PPC (e.g. B) indicate a full employment of resources.
(iv) Points outside the PPC (e .g. C) are beyond the current productive
capacity of the economy.
(v) The opportunity cost of producing E amount of good X is LF of good Y.
(vi) The opportunity cost of reallocating resources from B to D is FH of good
Y.

8
(e) Economic Growth

Economic growth typically refers to an increase in a country's output of goods

and services , and occurs following:
(i) an increase in resources through:
(1) net investment;
(2) the discovery of natural resources;
(3) an increase in the labour force.
(ii) a better use of existing resources through:
(1) using previously unemployed factors ;
(2) training of the labour force;
(3) innovations which increase productivity ;
(4) a reallocation of factors from low-productivity (e .g. agricultural) to
high-productivity (e .g. manufacturing) sectors.

Table 1.1 The benefits and costs of economic growth

Potential benefits of economic growth Potential costs of economic growth

Improved standard of living The opportunity cost of additional investment
Poverty can be reduced Resulting externalities, including pollution
Opportunities for more leisure time The depletion of non-renewable resources
A rise in people's expected life-spans Alienation and stress on the labour force

(0 Types of Economic Systems

An economic system is the network of organisations used by a society to resolve

the economic problem . There are three categories of economic system.

(i) Free market economy

• Resources are owned by households .
• Markets allocate resources through the price mechanism. An increase in
price encourages firms to switch additional resources into the production of
that good.
• Income depends on the market value of a resource. Factors in scarce supply
and high demand are best rewarded.

(ii) Planned or command economy

• Resources are owned by the state.
• The state allocates resources, and sets production targets and growth rates
according to its own view of peoples' wants.
• Income distribution is decided by the state , and ignores the scarcity value of
a particular factor.

(iii) Mixed economy

In practice all economies are mixed where :
• Some resources are owned by the public sector (i.e. the government).
• Some resources are owned by the private sector (i.e . households).

9
 Table 1.2 Problems of different economic systems
Market economy can result in Planned economy can result in
The non-production of public goods Production not satisfying consumers' real
Monopolies reducing competition wants
Production ignoring externalities Reduced consumer sovereignty
An unequal distribution of income Shortages and surpluses of products
and wealth The forgone output of administrators
High unemployment Reduced incentives lowering individual effort

See also Section 10.1 (d) on market failure .

1.2 Data Response

Worked Example 1.1

One of the most fateful errors of our time is the belief that 'the problem of
production' has been solved. Not only is this belief firmly held by people
remote from production and therefore professionally unacquainted with the
facts - it is held by virtually all the experts, the captains of industry, the
economic managers in the governments of the world, the academic and
not-so-academic economists, not to mention the economic journalists. For the
rich countries, they say, the most important task now is 'education for leisure'
and, for poor countries, the 'transfer of technology'.
Modern man does not experience himself as part of nature but as an outside
force destined to dominate and conquer it. He even talks of battle with nature,
forgetting that, if he won the battle, he would find himself on the losing side.
The illusion of power is based on the failure to distinguish between income
and capital where this distinction matters most. Every economist and business-
man is familiar with the distinction and applies it conscientiously and with
considerable subtlety to all economic affairs - except where it really matters:
namely the irreplaceable capital which man has not made, but simply found,
and without which he can do nothing.
A businessman would not consider a firm to have solved its problems of
production if he saw it was rapidly consuming its capital. How, then, could we
overlook this vital fact when it comes to that very big firm, the economy of
Spaceship Earth and, in particular, the economies of its rich passengers?
Source: E. F. Schumacher, Small is Beautiful- A Study of Economics As If
People Mattered (London: Abacus, 1974), pp. 10-11

(a) From the passage distinguish between income and capital. (4 marks)
(b) Explain the major problems which the author identifies nations are facing.
(8 marks)
(c) What are the implications of the passage for government policies promoting
economic growth? (8 marks)

Solution 1.1

(a) Income is a flow value, and is the amount of money, goods or services
received by an individual, firm or economy in a given time period, usually
one year. Capital is a stock value; is one of the four factors of production
and refers to producer goods used to manufacture other goods . However,
the author is using a broader definition of capital than is generally
employed by economists to include the Earth's natural resources. Tra-
ditional economists count gifts of nature as land.

10
(b) The passage advances two points of view concerning the problems facing
rich nations. Most traditional economists argue th at great advances in
technology have allowed rich countries to produce such a surplus of goods
and services that the bulk of human wants and needs can now be satisfied.
The problem is not so much one of scarcity as of knowing what to do with
the large number of work ers now no longer needed in the manufacturing
process and who require training in the use of free time. Schumacher
argues that the major problem facing rich nations is the over-rapid
consumption of irreplaceable natural resources such as metals and
minerals . Hence , economic growth is only achieved by running down our
'capital' - that is, our stock of finite natural resources.
Poor countries , it is argued , do not have a sufficient infrastructure to
allow for capital accumul ation through net investment , either because
th ere is no surplus after output has been used to satisfy basic needs or
because the nation lacks the technology to generate such surpluses. A
transfer of 'production know-how ' from rich to poor nations would
overcome this last problem.
(c) Economic growth is typically taken to mean an increase in a country's
output of goods and services, and occurs through either an increase in the
amount of resources available or the better use of existing resources.
Measures which encoura ge increases in production have been advanced
by successive government s becau se output increases allow more want s and
needs to be satisfied. Measures to encourage economic growth through
net investment include subsidies to firms building new factories, par-
ticularl y in depressed are as, and tax incenti ves to firms buying new
machinery.
The pa ssage highlights the concern of some economists for what they
see as an unpleasant side-effect of economic growth: the unacceptably
high level of consumption of resources which are gifts of nature and which
once used cannot be replaced. Sustained economic growth implies an
accelerating rate of consumption for non-renewable natural resources.
Governments may be concerned to ensure that the system of resource
allocation used takes full account of such negative externalities , as well as
any pollution generated by high growth .
For instance, the price mechanism does not immediately take account
of the depletion of finite resourc es such as oil. As the world 's resources
begin to reach exhaustion , restricted suppl y would th en result in higher
prices. But , in the immediate term , governments might want consumers
and producers to pay some penalty for using irreplaceable resources , by
imposing an indirect tax on their consumption. For example, substantial
taxes on petrol reduces consumption but encourages conservation.
Alternatively, th e government might want to encoura ge conservation of
scarce gifts of nature by offering subsidies to firms which recycle waste
products. For example, some local au thorities convert refuse collected
from households into electricity by burning waste at plants.
Finall y, government energy policy can be adjusted. On e man-made
source of energy is nuclear power, the use of which avoids the depletion of
finite resources such as oil , coal and gas. The government might want to
achieve economic growth in the energy sector by building more nuclear
power stations. However , this in itself creates more problems because of
the high long-term economic and social costs of disposing of radioactive
waste.

11
1.3 Objective Questions

Example 1.2

A worker is currently earning £200 for a 40 hour week . The management offer a 12%
wage increase or a basic wage of £205 and a reduction in the working week to 38
hours. What is the opportunity cost if the worker opts for a 38 hour week ?
A 2 hours B 38 hours C £5 D £19 E £24

Example 1.3

The production possibility frontier for a market economy will necessarily shift
immediately following a change in:
A income distribution B wealth distribution C the stock of capital
D population size E resource allocation

Examples 1.4-1.6 refer to the following diagram, which shows a range of

production possibilities for a country.

N
Consumer R r-_ _
goods

o '--------'-----------'--- Capital goods

T 5

Example 1.4

An economy operating at point K can eventually reach point L:

A by moving to point M B by moving to point N
C by improving its standard of living D by employing idle resources
E never

Example I.S

A movement from point K to point N result s in:

A constant returns in the production of both goods
B decreasing returns in the production of consumer goods
C constant scale economies in the production of both goods
D decreasing scale economies in the production of consumer goods
E an improvement in social welfare

Example 1.6

If the economy is currently producing OV consumer goods, the opportunity cost

involved is:
A OR consumer goods B OS capital goods C VR consumer goods
D TS capital goods E OT capital goods

12
Example 1.7

The production possibility boundary for a country producing only two goods, X and
Y, is given by the formula Y = 100 - 20X, where 100 is the maximum amount of Y
that a country can make . Assuming the full employment of resources, the opportunity
cost of producing one extra unit of X is:
A 1I100Y B 1I20Y C 1/SY D SY E 20Y

Example 1.8

The essential characteristic of a market economy is:

A consumer sovereignty B consumer surplus C producer surplus
D marginal cost pricing E public corporations

Example 1.9

Only in a pure command economy does production :

A reflect the preferences of households
B reflect the preferences of firms
C experience diminishing returns
D respond to directives
E respond to prices

Example 1.10

Which of the following measures is most likely to encourage economic growth,

directly?
A redistributing income B increasing taxation
C increasing consumption D improving the state of technology
E reducing the rate of inflation

Select your answers to Examples 1.11-1 .13 by means of the following code :
A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 1.11

Normative statements in economics:

1 can be tested empirically 2 make policy recommendations
3 depend on value judgements

Example 1.12

Economics studies the allocation of :

1 economic goods only 2 consumer goods only 3 free goods

Example 1.13

Economic growth usually results in:

1 an increase in living standards 2 a depletion of natural resources
3 positive externalities

13
1.4 Essays
Example 1.14

Explain the basis on which economists in classifying economic systems distinguish

between 'market' and 'command' economies. On what basis, if any, is it possible to
say which type of economy is superior?
(1MB 1987)

• Establish criteria such as resource ownership, for comparing market and

command economies.
• Explain how welfare criteria can be used to judge the success of an
individual economic system .
• One economic system is superior to another only if it is better able to satisfy
welfare criteria. Discuss the evidence.
• Avoid making subjective, political statements of opinion.

Solution 1.14

A market economy is an economic system where resources are owned by

individuals and allocated by the price mechanism without government interven-
tion. In a command economy, the government owns resources and decides on
the type and quantity to be made. A study of comparative economic systems will
try to identify and contrast characteristics common to both types of economy.
For instance, property rights are the rules that define the use to which resources
may be put. In market economies, individuals are free to buy and sell land,
labour and capital, provided that they do not infringe the legal property rights of
others. In a command economy , individuals can own consumer goods but they
are not allowed to own industrial plant or machinery. All non-labour resources
are owned by the state.
Different economic systems have different methods of resolving the problem
of scarcity. Market economies use the price mechanism to allocate resources . All
goods, services and resources have a market price. An increase in consumer
demand raises price and encourages a firm to increase production of that good by
transferring resources out of the manufacture of less profitable products. In
command economies, the state allocates resources according to its own view of
what people want. A body of central planners decide what proportion of
resources to devote to consumer and producer goods. They then set production
targets and arrange for the supply of necessary inputs . Firms aim not to make a
profit but to meet production targets .
It can be seen that the decision-making process in command economies is
collectivist and centralised. The government is the single most important
economic institution. On the other hand, decision-making in market economies
is highly individualistic and decentralised . The role of the state is limited to
collecting taxes to pay for public goods such as defence, and enforcing property
rights .
The method of motivating economic agents varies between the two systems. In
market economies, jobs in high demand but short supply command high wages.
Successful entrepreneurs receive profits for taking on the risk and responsibility
of organising production. Hence, income and wealth distributions are unequal.
In command economies, limited wage differentials do exist to reward extra
effort. However, it is the sense of 'shared purpose' springing from the common
ownership of resources that is meant to act as the prime 'moral' incentive to
work.

14
 The success of an economic system lies in its ability to use resources to satisfy
as many wants as possible. Welfare economics supplies a number of tests which
can be used to judge the absolute efficiency of an economic system . There are
two main tests:

(a) is it possible to reallocate resources and increase output?

(b) is it possible to reallocate resources and make a consumer better off
without making anyone else worse off?

The system which best meets those conditions will be superior. Before con-
sidering empirical evidence, it is important to note that real-world examples such
as the USA and the USSR only approximate to theoretical market and command
models .
Economic theory suggests that a competitive market economy automatically
brings about an optimal resource allocation. However, market failure occurs
when some private-sector firms in the USA do not take full account of the
spill-over effects of production such as pollution. Frictions in factor markets have
resulted in mass unemployment and a general depression. Moreover, efficiency
criteria make no statement about the 'fairness' of an uneven distribution of
income and wealth in the USA.
Data suggest that there is hardly any unemployment in the USSR . However,
critics argue that this has only been achieved by massive overmanning. Produc-
tivity and standards of living could be raised following a reallocation of
resources. Modern economies are highly specialised , interdependent and com-
plex. In the absence of market prices, planners have insufficient information on
which to make welfare-maximising decisions . Distorted information stops
planners taking full account of production and consumption externalities.
In conclusion, it can be seen that comparison of market and command
economies is difficult and complex. Final judgement depends on the importance
placed on a particular measure . For example, in terms of productivity, evidence
suggests that market economies are superior to command economies; in terms of
unemployment levels, evidence suggests that command economies are superior
to market economies.

Example 1.15

What do you understand by 'opportunity cost'? Why is this concept relevant to the
allocation of resources of a market economy? (NISEC 1987)

• This question tests your understanding of the relationship between oppor-

tunity cost and the economic problem.
• Use examples to explain the link between opportunity cost and resource
allocation.
• Production possibility curves can be used to illustrate the opportunity cost
of resource allocation at a macroeconomic level.

Solution 1.15

Humans have material wants and needs which are satisfied by consuming goods
and services. At any moment in time, a country has a fixed amount of resources
available for the creation of goods and services. Scarcity exists because a nation
cannot produce sufficient products to satisfy every want and need. Therefore,
society has to decide which wants and needs will be met.

15
 In short, the 'economic problem' hinge s on the concept of scarcity and choice .
Society must choose what is to be produced, but the decision to make one good
necessarily results in the loss of an alternative product. This is the concept of
opportunity cost, which states the cost of obtaining one product in terms of the
forgone quantity of another product that could have been made instead .
In a market economy, resource allocation is based on the free movement of
prices. Comparing the prices of two products allows consumers and producers to
calculate the opportunity cost of different goods. For example , it follows that if
the price of apples is 20p and of pears lOp, the opportunity cost of one apple is
two pears. A change in relative price affects the opportunity cost of a product.
Opportunity cost , then , is a key economic concept which focuses the attention
of producers and consumers on the consequences of decision-making. The
particular relevance of opportunity cost to resource allocation in a market
economy at a macro level can be illustrated by using production possibility
curves.

Consumer L
goods
J

G K M

The production possibility curve , JK in the diagram , shows the combinations

of consumer goods and capital goods that a country can produce in one year with
resources fully employed. The shape of the curve is due to the existence of
decreasing returns in production. Points under the curve, such as A, imply an
underutilisation of resources. Points above the curve are beyond the current
productive capacity of the economy. Assume that the country is at point B . The
opportunity cost of producing F consumer goods is the extra amount of producer
goods , K - E , that could be made instead.
Consider now the opportunity cost of a reallocation of resources which results
in economic growth. It is not possible to increase the output of producer goods
without reducing the manufacture of consumer goods . The expansion along the
production possibility curve from B to 0 increases the amount of producer goods
by G - E at an opportunity cost of F - H fewer consumer goods.
In the next time period , the extra plant and machinery now available increases
the ability of the economy to manufacture both consumer and capital goods.
Economic growth shifts the production possibility curve to the right, to LM.
However, the production and consumption of extra goods and services may
cause negative externalities such as pollution and congestion. These should also
be included when calculating the true opportunity cost of economic growth .
Opportunity cost is a key economic concept which reminds us that , for any
given resource allocation in a market economy, there is an alternative forgone.
This essay has considered the particular example of the opportunity cost
involved in economic growth .

16
1.5 Solutions to Objective Questions
Solution 1.2 Answer: D

A 12% wage increase on a 40 hour week results in a pay increase of

£200 x 12/100 = £24. A worker opting for a 40 hour week now earns
£200 + £24 = £224. Therefore, if the worker elects to work 38 hours and earn
£205, he will be forgoing £19.

Solution 1.3 Answer: C

A production possibility curve (PPC) is sometimes called a production possibility

frontier. A PPC is drawn, assuming that a nation's stock of resources , including
capital, is fixed. A change in the stock of capital affects the ability of a country to
produce goods and services and so shifts the Pl'C,
A and B ~ Changes in income and wealth distribution may affect patterns of
consumption and production, which may eventually affect the Pl'C.
D ~ The increase in population size could be the result of an increase in
dependants, such as children, which does not immediately increase the country's
ability to produce goods.
E ~ A change in resource allocation, where factors are moved out of the
production of one type of consumer good and into another, will not affect the
position of the Pl'C,

Solutions 1.4-1 .6 refer to the following diagram :

Consumer
goods
U
R
X
-- ......
N ............
......
<,
V 1 K <, "-

I I "-
I I ~ .. L
I I "-
I I "-,,-
I I "-
I I \
I I \
I I \
I I \
'-_-=-_-":- .1---'--_ Capita l goods
o z T s w

Solution 1.4 Answer: A

The movement from point K to point L can only come about if the production
possibility curve (PPC) shifts to the right, to UW . This requires an increase in the
productive capacity of the economy. Moving along the PPC from K to M shifts
resources out of the production of consumer goods and into the production of
capital goods. Additional capital goods can be used to make more consumer and
producer goods and the economy can now be at point L. Other options are
wrong because:
B ~ reduces the productive capacity of the economy;
C ~ is the effect of moving to L and not the cause;
D ~ point K lies on the PPC, so that there are no idle resources available .

17
 Solution 1.5 Answer: B

Because the PPC is non-linear , resources moved out of the production of capital
goods produce fewer and fewer additional consumer goods - i.e. decreasing
returns in the production of consumer goods . For instance, the movement from
point K to point N along the initial PPC reduces capital goods by TZ and
increases consumer goods by VX. A similar movement from N to R reduces
capital goods by the same amount as when moving from K to N , but , because of
decreasing returns, there is a much smaller increase in consumer goods of XR.
Other options are wrong because:
A =? is true only if the PPC is linear ;
C and D =? scale economies are a long-run concept (see Table 5.4) ;
E =? there is insufficient information to deduce whether or not society prefers N
to K .

Solution 1.6 Answer: D

If the economy devotes all of its resources to producing capital goods , then it
could produce OS. Similarly, if it devotes all of its resources to producing
consumer goods , then it could produce OR.
If the country produces OV consumer goods , then it is also producing OT
capital goods and forgoing TS capital goods. Since opportunity cost is measured
in terms of the forgone alternative , TS capital goods is the opportunity cost of OV
consumer goods.

Solution 1.7 Answer: E

The opportunity cost of producing an extra unit of X is found by dividing the

maximum amount of Y a country can make, by the total amount of X.
If the economy were to make only good Y , it would make zero amount of good
X. The equation becomes:
Y = 100 - OX = 100
100 units of Y could be made . If the economy were to make only good X, it
would not make any Y. The equation becomes:
OY = 100 - 20X
Rearranged ,
20X = 100
Therefore ,
X = 5
The opportunity cost of producing an extra unit of X is 100Y/5X - i.e. 20 units
of Y . (Note that the opportunity cost of additional Y can be calculated by
dividing total X by total Y.)

Solution 1.8 Answer: A

In a market economy , households have consumer sovereignty and determine

what is produced, by 'voting' with their purchases. For instance, if consumers
demand more of a product , price rises and more is supplied. Other options are
wrong because :
B =? consumers do not necessarily enjoy consumer surplus;

18
C ::;. firms do not necessarily enjoy producer surplus;
D ::;. some firms will not use a marginal cost pricing policy;
E ::;. public corporations are nationalised industries and a feature of mixed
economies.

Solution 1.9 Answer: D

A planned economy is run by the state and directives (instructions) are used to
organise production. Other options are wrong because :
C ::;. all types of economic system experience diminishing returns ;
E ::;. prices are not used as a method of regulating production in a pure
command economy .

Solution 1.10 Answer: D

Economic growth occurs following an increase in, or better use of, resources. An
increase in technology improves a country's ability to produce goods and
therefore results in economic growth.
A ::;. An income redistribution from poor to rich would tend to reduce
demand and so hinder economic growth .

Solution 1.11 Answer: C

Normative economics involves statements of opinion which cannot be proved or

disproved against real-world (empirical) evidence . Therefore, option 1 is
incorrect.

Solution 1.12 Answer: D

Economics studies the allocation of scarce resources between alternative uses.

Economic goods are scarce , while free goods are not scarce and are therefore not
usually studied by economists.
2 ::;. Is incorrect because it implies that other types of scarce goods such as
producer goods are not studied.

Solution 1.13 Answer: B

Externalities are the spill-over effects of consumption or production. Economic

growth involves additional production, which usually causes negative external-
ities such as pollution . Option 3 is incorrect.

19
 2 Demand
2.1 Fact Sheet

(a) Definition of Demand

• Demand is the amount of a good consumers are both willing and able to buy
at a given price .
• Consumer surplus is the difference between the maximum a consumer
would pa y for the good and the price actually paid .
• A demand curve shows th e amount of a good consumers are willing and able
to bu y at different prices.
• The a mount of a good dem anded depends on :
(i) price ;
(ii) the conditions of dem and .

(b) Movements along a Demand Curve

• A change in price results in a movement along a demand curve , resulting in

a change in quantity demanded.
• A change in the price of a good NEVER shifts the demand curve for that
good .
• In Figure 2.1 an increase in price causes a contraction in demand, and a
decrease in price results in an expansion in demand.

0,
Price per

C'~
unit (PI
P
2
I qC'fl
o
PI
r- - - - - 1I - - - - 'I}

PJ
!-
:
-----t - - -
:
-r- - - -
I I
I
I. I
1 _
Quantity demanded
'-- '---_ _....L..-_ _--L per time period (Qo I

Figure 2.1 Movements along a demand curve

20
(c) Increases and Decreases in Demand

• A demand curve is drawn assuming ceteris paribus - i.e . that all factors
influencing demand are being held constant except price . The conditions of
demand refer to those factors held constant , and include :
(i) the real income of consumers;
(ii) the price of other goods:
(1) in competitive demand (substitutes);
(2) in joint demand (complements);
(iii) consumer taste ;
(iv) advertising;
(v) expectations about the economy ;
(vi) the population size and structure.
• A change in one of these conditions affects the level of demand at all prices
and results in a shift in the demand curve.
• Figure 2.2 illustrates the effect of a decrease in demand .

~---------------- 00

Figure 2.2 A decrease in demand

Cause:
a decrease in real income ;
or an increase in the price of a complement;
or a decrease in the price of a substitute;
or an adverse movement in consumer taste;
or a reduction in advertising for this good;
or reduced expectations about the economy;
or a decrease in the population .

Effect:
the demand curve shifts to the left.

(d) Income and Substitution Effects

• The income effect occurs when the price of a good falls and the consumer
can maintain current consumption for less expenditure . Provided that the
good is normal, some of the resulting increase in real income is used to buy
more of this product. If the good is inferior , an increase in income is used to
buy more of a superior substitute and less of this product.

21
 • The sub stitution effec t occurs when the price of a good falls and the
consumer substitutes more of this product for others .
• The demand curve of a giffen good (a good whose demand falls as its price
falls) such as potatoes slopes upwards from left to right because the income
and substitution effects work in opposite directions and the income effect
outweighs the substitution effect.

(e) Utility

• Utils are used to measure satisfaction.

• Total utility is the amount of satisfaction obtained by consuming units of a
good.
• Marginal utility (MU) is the extra satisfaction obtained from consuming one
more unit of a good.
• The law of diminishing marginal utility states that the more a consumer has
of a given commodity the smaller the satisfaction gained from consuming
each extra unit.
• A rational consumer spends his income in order to maximise satisfaction.
The consumer compares:
(i) the utils per extra £ spent on X, using the equation MUxIP x , with
(ii) the utils per extra £ spent on Y , using the equation MUyl P».
• If the number of utils per £ spent on X is greater than the number of utils
per £ spent on Y, the consumer can increase his satisfaction by increasing
his consumption of X.
• Satisfaction is maximised by arranging expenditure among commodities so
as to achieve equi-marginal returns. This occurs when:
marginal utility of X marginal utility of Y
price of X price of Y
• Utility theory requires consumers to be able to measure satisfaction.

(0 Indifference Curves

• An indifference curve shows the combinations of two goods whose con-

sumption yields equal total satisfaction to the consumer .
• A budget line or income line shows all the combinations of two goods the
consumer can buy , given a fixed income and constant prices.
• A rational consumer maximises satisfaction by adjusting his expenditure
between two goods so as to be at the point on the budget line tangential
Gust touching) to an indifference curve furthest from the origin - i.e. point
A in Figure 2.3.
In Figure 2.3, JK is the budget line of the consumer, and II and Iz are
indifference curves. 12 is further from the origin and yields a higher level of
satisfaction than does It. To maximise satisfaction , the consumer will select
point A and buy B amount of good X, and C amount of good Y .
• An increase in income would result in a parallel shift to the right in the
budget line JK.
• An increase in price of good X would pivot the budget line around point J
towards the origin.
• Indifference curves can be used to isolate the income effect and substitution
effect of a change in price. See Example 2.11.

22
 Goo d Y
J

c - -- - - - --
"""': -- - - 12
~--~~- 1 1
L.- -'- ---=:>~ _ _ Good X

B K

Figure 2.3 Con sumer equilibrium

2.2 Data Response

Worked Example 2.1

AVERAGE
HOU E PRICES

Change in Annual
Quarter Change
UNITED KINGDOM £59,480 £39,300 £31,380 +4% +12%
NORTHERN IRELAND - £41,320 £~~,5~0 £18,100---+2%--+S~
NORTH WEST £47,990 £29,020 £19,730 +2% +6%-
WALES - £44,640 £28,120 £22,310 +3"k ';8"4-
SCOTLAND £47,490 d~,540 £31,490 +2% +5"4 -
WEST MIDLANDS - £45,430 £211,130 £21,070 +2% -; 4"4 ' -
SOUTH WEST - £57,53 0- - - - £38,560 £i2,870- - - -+4"k- -+1304-
NORTHERN - W :260 £27:J10-~--£20]90 -- --.1"4 - . j "4 -
~11~"~J;j~3:~:J:~II~;ljli
·I~U~lh~~I·g
·'4~;~;i~l.~ij £43,510 [26,420 £18]50--- - .1-4 - ;60;. --
EAST MIDLANDS £43,450 £27,630 £22,270 .2% +11 ~"-
OUTER SOUTH EAST -r£67,820- - - - £46,110 . £37,890 - - ;504- -+16°,0-
EAST ANG LIA - £52,860 -~-,~ £35,520-- -- - - £30,860- ' - - +1~~ - -+10%-
GREATER LONDON - £100,820 - - - £71;630· - - - - £58,80-0---- +7%- -+21"4 -
OUTER MEt AREA - £88,160 £58,210 - - - , £4i,290----+6~ 6%-

House prices increased by 4% in the third quarter of the year, the same rise as
in the previous quarter, and giving an annual increase of 12% to the end of
September, according to the latest house price survey by the Nationwide
Building Society. The society says the 4% increase for the UK showed that rises
were not abating. The annual rate of house price increase, 12%, was 2% higher
than in the second quarter, and if the present high level of housing activity
continued it was likely that the annual rates of rises would be close to 15% by
the end of the year. As the rate of increase continues well in excess of the
increase in average earnings (7.5%), the Nationwide points out that the house
price/earnings ratio has increased to 3.54, compared with the long-term
average of 3.25.
Source: 'House prices', by Christopher Warman, The Times, 13 October 1986

(a) What evidence is there for believing that the real price of housing is rising?
(b) Describe the regional variations in house prices .
(c) Suggest causes for the regional variations you have described.
(d) What are the economic implications of the regional variations you have
described?

23
 Solution 2.1

(a) (i) The annual rate of house price increases (12%) is greater than
increase in average earnings (7.5%) .
(ii) The price of an average house has risen from 3.25 times average
yearly income to 3.54 times annual earnings.
(b) Taking semi-detached as an example, the average UK house costs
£39000.
(i) Only house prices in the outer south-east, outer metropolitan and
Greater London areas exceed the national average . In general, the
further an area from London the lower the price of housing.
(ii) The rate of change in house prices conforms to the same pattern,
except that the annual change in the south-west (13%) also exceeds
the average (12%).
(c) The price of houses is determined by the local conditions of supply and
demand.
(i) For instance, house prices in the south-east are highest because:
(1) the 'green belt ' (planning restrictions) around London means
that the supply of land for housing is limited and expensive;
(2) average earnings are higher than elsewhere;
(3) a larger percentage of the working population is in work than
elsewhere.
(ii) Low average earnings and high unemployment in the midlands , the
north, Northern Ireland and Wales means that house prices are
below the national average in these areas.
(d) (i) The geographical mobility of labour from north to south may be
reduced if workers are unable to afford higher house prices.
(ii) Moreover , since the annual rate of change in house prices is higher in
the south than in the north, this barrier to labour immobility will
increase over time .
(iii) Houseowners who have paid off their mortgage will have a more
valuable asset if their house is in the south-east than elsewhere . The
distribution of wealth becomes more regionally uneven.
(iv) First-time buyers in the south-east are likely to have a larger
mortgage than are those in other areas.

2.3 Objective Questions

Example 2.2

Which one of the following is not held constant when a demand curve is drawn?
A households' real income B households' taste
C the prices of competing goods D the price of the good itself
E the prices of complementary goods

Example 2.3

The demand curve for a normal good shifts to the left when:
A prices of complementary goods rise B the price of this good rises
C prices of substitutes rise D unit cost rises
E the tax on this product is decreased

24
Example 2.4

A basic assumption of all demand theories is that consumers allocate their incomes so
as to maximise:
A their wealth B total utility C their savings
D marginal utility E current consumption

Example 2.5

The table shows the total utility gained from consuming each of three goods:

Units of good X y Z
1 40 16 10
2 48 30 20
3 52 42 30
4 54 52 40
5 52 60 50

The consumer experiences diminishing marginal utility in the consumption of:

A X alone B Y alone C Y and Z alone
D Z and X alone E Y and X alone

Example 2.6

Good Price Quantity Marginal utility

A 20p 6 10
B 30p 2 ?

If a consumer buys the quantities of A and B shown above and is maximising his
satisfaction, what is the marginal utility derived from good B?
A 3.33 B 5 C 6 D 10 E 15

Example 2.7

A consumer has the following demand schedule for chocolate:

Number of bars 1 2 3 4 5
Price 60p SOp 40p 30p 20p

If the price of chocolate is 40p and the consumer buys three bars, what is his consumer
surplus?
A 30p B 40p C SOp D 60p E 70p

Example 2.8

The diagram shows a demand curve for journeys over a toll bridge .

Toll (£)

6 I
5 ------i------
I D
4 I
I
3
I
2 I
I
L...-
I
--'- L...- Journeys
1000 2000
25
 A reduction in the toll from £6 to £5 increases consumer surplus by:
A £500 B £1000 C £1500 D £6000 E £7500

Example 2.9

Following a fall in the price of an inferior good :

A the substitution and income effects are both positive
B the substitution and income effects are both negative
C the substitution effect is zero
D only the income effect is positive
E only the income effect is negative

Example 2.10

The diagram below shows a consumer's indifference map. RS is the consumer's

budget line, and points J, K, L, M and N show different combinations of goods Y and
x.

Good Y

' - - - - - - - - - - - - - - - - " " - - _ Good X

s

It can be seen that the consumer would prefer:

A no one combination to all others B combination M to combination N
C combination N to combination J D combination L to all others
E combination K to all others

Example 2.11

The indifference curves I) and /2 are part of a consumers' indifference map for
two goods X and Y. JK is the individual's initial budget line, and JL is his new
budget line following a rise in the price of good X. Which distance shows the
decrease in the quantity demanded of good X which is the result of the income
effect of the price increase?
A TL B ST C TV D RT E RS

26
 Good Y

~::-- _ _ Il

o '---------:--:---,L-----'>.1----'--"--------':::...-- Good X
u K

Select your answers to Examples 2.12-2.15 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 2.12

The demand for apples is likely to increase following:

1 a fall in the price of apples
2 a rise in the price of pears
3 an increase in income

Example 2.13

A good in composite demand has:

1 many uses
2 many substitutes
3 a high price elasticity of demand

Example 2.14

The law of diminishing marginal utility states that the more a consumer has of a given
commodity the :
1 lower the satisfaction from each extra unit consumed
2 lower the price of each extra unit consumed
3 lower the total level of satisfaction enjoyed

Example 2.15

A fall in the price of a giffen good results in:

1 a negative income effect
2 a positive substitution effect
3 a negative price effect

27
2.4 Essays

Example 2.16

'An increase in demand raises the price of a particular good . An increase in price cuts
demand for that good' . Discuss.

• The question tests candidates' ability to distinguish between movements

and shifts in demand curves.
• Make a careful distinction between the cause and effect of an increase in (i)
demand and (ii) price.
• Include demand and supply graphs.

Solution 2.16

Demand refers to the amount of a good con sumers are willing and able to buy at
a given price. The amount of a good consumers are initially willing and able to
buy at different market prices is shown by the demand curve D, in Figure 1.

P,

P,
r--------- i

1
1
I
1

_ I 0,
L - - - - - - - . JL-_--L o
0,

Figure 1

Assume that the good in question is apples . The demand curve D, is drawn ,
assuming that all factors influencing the demand for apples are held constant,
except price. A change in a condition of demand invalidates this ceteris paribus
assumption . For example , a rise in the price of a substitute good , such as
oranges, encourages consumers to switch to alternative commodities, such as
apples. Hence, the demand for apples increases at all prices. The increase in
demand has the effect of shifting the demand curve D 1 to the right, to Dz. The
price of apples rises from P, to Pz, causing an expansion along the supply (S)
curve from A to B. Initial analysis suggests that ' an increase in demand raises the
price of a particular good' .
An increase in the price of a good also affects the amount demanded by
consumers. However, unlike an increase in demand, an increase in price does
not shift the demand curve for the good. Again using apples as an example , an
increase in price results in a fall in the quantity demanded , causing a contraction
along the demand curve from A to B in Figure 2.
In fact, the fall in the quantity demanded in Figure 2 can only have been
caused by a decrease in supply causing the supply curve to shift to the left and the
price to rise. In these circumstances, 'an increase in price cuts demand for that
good' .
28
 P

P,

L - - - - - -- L -_ _...l.- O

Figure 2

Analysis has so far supported both statements given in the question . By itself,
an increase in demand does raise the price of a good . However, the price
increase is the effect and not the cause of the increase in demand. By itself, an
increase in price does cut demand . However, the price increase is now the cause
and not the effect of the fall in demand.
In conclusion , it can be seen that the two statements in the question are correct
if considered separately but are incorrect if linked together.

Example 2.17

How does a rational consumer allocate a fixed income between the purchase of two
commodities? Would the consumer always use an increase in income to buy more of
both goods?

• The question can be answered, using one of three consumer demand

theories: marginal utility; revealed preference ; or indifference curves. Use
only one.
• Establish an initial position of consumer equil ibrium .
• Illustrate the effect of an increase in income.
• Distinguish between normal and inferior goods .

Solution 2.17

A rational consumer is one who attempts to maximise satisfaction . A number of

consumer demand theories, including marginal utility and revealed preference
theory, explain how the consumer allocates income . This answer uses indif-
ference curves.
An indifference curve (Ie) shows combinations of two goods whose consump-
tion yields equal total utility to the consumer. Figure 1 shows an indifference
map - i.e. a large number of ICs . ICs further from the origin involve larger
quantities of goods and give more satisfaction than do ICs close to the origin. In
Figure 1, the budget line (lK) shows combinations of goods A and B the
consumer can buy, given a fixed income and constant prices. The consumer can
select any combination of A and B lying on or below the budget line. A
consumer selecting point L is irrational, because by buying more of good Band
less of good A the consumer can move to point M, which is on a higher IC,
offering a greater level of satisfaction.
While the consumer would prefer to be on an even higher IC at point N, he

29
 Good A

-----1 2

---~---1l
L...--------------:>.---_Good B
K
Figure 1

cannot afford to buy this combination. Therefore, satisfaction is maximised at

point M, where the budget line is just touching the highest attainable LC.
An increase in income does not affect the position of the ICs . An increase in
income means that the consumer is able to buy more of both goods , and so the
budget line shifts to the right. In Figures 2 and 3, the new budget line is RS.
If A and B are normal goods, the consumer will use the extra income to buy
more of both. In Figure 2, the new position of equilibrium is point N, where the
budget line, RS, touches the highest attainable K'.

Good A Good A

'----'----'----"'----=---"---Good B '--_-'-_---l.._--"'- ..3.-----l_ Good B

K 5

Figure 2 Figure 3

However, some goods are inferior, and an increase in income results in a fall in
the amount of the good bought. Assume that good B is inferior. Initially the
consumer buys good B only, because the superior substitute, good A , is beyond
his means. The increase in income means that he can now afford to reduce his
consumption of B and buy more of A. The new position of equilibrium is shown
by point P in Figure 3.
It has been shown that a consumer will not always use an increase in income to
buy more of both goods if one product is an inferior good.

2.5 Solutions to Objective Questions

Solution 2.2 Answer: D

When drawing a demand curve, all the factors influencing demand are held
constant except price. Options A, B, C and E are incorrect, because they are all
examples of conditions of demand held fixed when a demand curve is drawn .

30
Solution 2.3 Answer: A

If prices of complementary goods increase, the demand for this good decreases,
resulting in the demand curve shifting to the left. Other options are incorrect
because:
B ~ causes a movement (contraction) along the demand curve;
C ~ increases demand for the product;
D ~ shifts the supply curve to the left;
E ~ results in the price of the good falling and demand extending.

Solution 2.4 Answer: B

While consumers are interested in all the options stated, rational consumers seek
to maximise their total utility or satisfaction.
D ~ Is incorrect because consumers maximise their total utility by ensuring
that the marginal utility per penny or pound spent for each good is equal.

Solution 2.5 Answer: E

This question requires students to calculate the marginal utility (MU) for each
product. Marginal utility is the change (~) in total utility (TU) resulting from
consuming one extra unit (Q) and is found, using the equation MU = ~TU/~Q .

Units of good X Y Z

TU MU TU MU TU MU
1 40 40 16 16 10 10
2 48 8 30 14 20 10
3 52 4 42 12 30 10
4 54 2 52 10 40 10
5 52 -2 60 8 50 10

The calculations show that while the marginal utility of Z is constant, the
marginal utilities of X and Y decline as consumption increases. Indeed, in the
case of X disutility occurs - i.e. the consumption of the fifth unit causes total
utility to decline.

Solution 2.6 Answer: E

A consumer will not change his pattern of expenditure if he is at present enjoying

maximum total satisfaction. This occurs when the marginal utility (MU) of each
good divided by its price (P) is equal so that in each case:
MU of A MU of B 10?
P of A = P of B so that 20 = -30
Therefore ,
10 15
20 = 30 so that 0.5 = 0.5

31
 Solution 2.7 Answer: A

Consumer surplus occurs when people are able to buy a good for less than they
were willing to pay. The price of a chocolate bar is 40p, so:

consumer surplus on first bar = 60p - 40p = 20p

consumer surplus on second bar = SOp - 40p = lOp
consumer surplus on third bar = 40p - 40p = Op
Total consumer surplus is: 20p + lOp = 30p

Toll (£)

'--------'----------L.---Journeys
1000 2000

Solution 2.8 Answer: C

In the diagram, consumer surplus is shown by areas a + b. Those consumers

who previously paid £6 now only have to pay £5. 1000 journeys are made at £1
less than people would have paid, so the increase in surplus is area a - i.e.
£1000.
In addition, a further 1000 journeys are undertaken. The resulting increase in
consumer surplus equals area b. Area b is given by the equation
i (PI - P z) X (Qz - QI)
= i (£6 - £5) x (2000 - 1000)

= i (£1) x (1000) = £0.5 x 1000 = £500

Therefore , the total increase in consumer surplus is area a + area b = £1000 + £500
= £1500.

Solution 2.9 Answer: E

A fall in the price of an inferior good results in two effects:

(a) a positive substitution effect - i.e. the consumer buys more of this good,
because it has become relatively cheaper;
(b) a negative income effect - i.e. the consumer uses the increase in
purchasing power brought about by the fall in price to buy less of the
good.

Solution 2.10 Answer: E

Consumers will always prefer the point furthest away from the origin - i.e. K.
Other options are incorrect because:
A ~ point K is furthest away;
B ~ the consumer is indifferent between point M and point N, because the two
are on the same indifference curve;

32
C :::} point J is further from the origin than is point N ;
D :::} while combination L is the consumer's point of equilibrium, the question
asks which combination the consumer prefers.

Solution 2.11 Answer: B

The income effect arising from a price change can be found on an indifference
map by drawing a budget line parallel with the new budget line. The gap between
where this new budget line just touches the original indifference curve (at T) and
the new quantity demanded (S) represents the income effect.

Solution 2.12 Answer: C

The demand for apples will increase following a rise in the price of a substitute
(pears) and an increase in income.
1 :::} Option 1 is incorrect. A fall in the price of a good never increases the
demand for the good. Provided that the good is normal , there would be an
extension in quantity demanded.

Solution 2.13 Answer: D

A good in composite demand has many uses - e.g. apples can be demanded for
cider or juice. Other options are incorrect because:
2 :::} a good in composite demand mayor may not have many substitutes;
3 :::} goods with many uses tend to be price-inelastic and have low elasticity of
demand.

Solution 2.14 Answer D

Diminishing marginal utilit y means that the satisfaction gained from consuming
extra units declines as con sumption increases . Other options are incorrect
because:
2 :::} the individual consumer is actually unable to influence the price at which
the product is bought;
3 :::} given overconsumption , marginal utility can be negative, so that additional
consumption decreases total satisfaction . However, this possibility is not a
necessary feature of the law of diminishing marginal returns.

Solution 2.15 Answer A

All options are correct. A fall in price allows an individual to buy a superior
substitute and reduce consumption of the giffen good , so that the income effect is
negative . The substitution effect is still positive. However, for giffen goods the
negative income effect is always greater than the substitution effect , so that the
overall price effect is negative .

33
 3 Supply and Prices
3.1 Fact Sheet

(a) Definition of Supply

• Supply is the amount of a good which producers are both willing and able to
sell at a given price.
• Producer surp lus is the difference between the minimum price a producer
would accept to supply a given quantity of a good and the price actually
received.
• A supply curve shows the amount of a good which producers are willing and
able to sell at different prices.
• The amount of a good supplied depends on :
(i) price;
(ii) the conditions of supply.

(b) Movements along a Supply Curve

• A change in price results in a movement along a supply curve , resulting in a

change in the quantity supplied.
• A change in the price of a good NEVER shifts the supply curve for that
good.
• In Figure 3.1 an increase in price causes an expansion in supply and a
decrease in price results in a contraction in supply.

Price
SI
P3 - - - - - - - - - - - - -

PI
t
- - - - - - - -

I C - - - - - - = - -----L- --L--_Quantity

Figure 3.1 Movements along a supply curve

34
(c) Increases and Decreases in Supply

• A supply curve is drawn assuming ceteris paribus - i.e. that all factors
influencing supply are being held constant except price . The conditions of
supply refer to those factors held constant and include:
(i) average (or unit) costs of production;
(ii) the current state of technology;
(iii) the price of other goods:
(1) in competitive supply (i.e. alternative products which the firm
could make);
(2) in joint supply (i.e. by-products from manufacture);
(iv) unforeseen circumstances (e.g. a drought ruining a wine crop) ;
(v) the number of firms in the industry;
(vi) the goals of producers.
• A change in one of these conditions affects the level of supply at all prices
and results in a shift in the supply curve .
• Figure 3.2 illustrates the effect of an increase in supply.

Price

L...-------------Quantity

Figure 3.2 An increase in supply

Cause:
a decrease in unit costs of production;
or improved technology ;
or a fall in the price of a good in competitive supply ;
or a rise in the price of a good in joint supply ;
or beneficial unforeseen circumstances;
or new firms entering the industry;

Effect:
the supply curve shifts to the right.

(d) Price Determination

• In Figure 3.3, excess supply occurs at prices above P I> because producers
are prepared to sell more than consumers are willing to buy. Attempts to
maintain a minimum price above the market price (e.g . Common Agricul-
tural Policy) results in structural surpluses.
• Excess demand occurs at prices below PI> because consumers want to buy
more than producers are prepared to sell. Attempts to maintain a maximum
price below the market price (e.g . rationing) results in artificial shortages .

35
 Price 0, 5,
Excess supply
P3 --------
I
I
I
I
I
I
I
I
I I
--- -t-----
I• I • I
I Excess demand I

Q,

Figure 3.3 Equilibrium and non-equilibrium prices

• Equilibrium is a state of balance - i.e . a situation where there is no

tendency for change. There is only one market price where the amount that
producers want to sell equals the amount that consumers want to buy . The
forces of supply and demand ensure that PI is the equilibrium market price.

(e) Price Instability

• Products with stable conditions of supply and demand will have stable prices
from year to year.
• Products with unstable conditions of supply or demand will experience price
fluctuations from year to year.
• Products with seasonal variations in demand, such as hotel accommodation,
tend to be price-unstable .
• Agricultural prices tend to be unstable because:
(i) supply changes from one time period to the next because of variable
weather conditions;
(ii) the effect of changes in supply is amplified by price-inelastic demand
(see Chapter 4) ;
(iii) the effect of changes in demand is amplified by price-inelastic supply;
(iv) supply lags (delays) between decisions to produce and the product
coming onto the market. The resulting cobweb model is explained in
Example 3.18.

(f) Indirect Taxation

An indirect tax (Tj ) is a surcharge on price imposed on the sale of goods and
services by the government and can be:
(i) specific - i.e. a fixed amount per unit;
(ii) ad valorem - i.e . a percentage of the selling price.

• The effect of an indirect tax is shown by adding the amount of the tax to the
supply curve.
• Tax incidence refers to the burden of a tax . The more price-inelastic the
demand for a good the greater the incidence falling on the consumer.

36
 Price incidence falling on
the consumer
s 1'::::::::::::1 incidence falling on
.. ..... the producer

L..- ...I......L.- ---1. . 0uantity

Figure 3.4 An ad valorem indirect tax. Are a P3P2AB equ als the total amount of tax revenue
raised

(g) Subsidies

• A subsidy (Su) is a discount on price given by the government.

• A subsidy can be specific or ad valorem.
• The effect on a supply curve is shown by deducting the amount of the
subsidy from the supply curve.
• The more price-inelastic the demand for a good the greater the share of the
subsidy going to the consumer.

Price
Subsidy received by
the consumer
S -Su
V:::::::::'='I Subsidy received by
............:.: the producer

L . . - - - - - - L - . . . L - - - - - - - - 1.. 0uantity

Figure 3.5 A specific subsidy. Area P2P3JK equals the total amount of subsidy paid

3.2 Data Response

Worked Example 3.1

The following information refers to an imaginary market for corn. Farmers are
assumed to plan next year's production on the basis of last year's price .

Year Price per tonne (£) Amount bought and sold (tonnes)

1900 150 3000

1991 200 1000
1992 125 4000
1993 162.5 2500
1994 145 3250
1995 150 3000
1996 150 3000

37
 (a) Describe the annual variations in the price of corn shown in the table .
(4 marks)
(b) Given that demand conditions are unchanged , how would you explain the annual
variations in the price of corn shown in the table? (8 marks)
(c) What pricing policies for corn might a government adopt for the period shown?
(8 marks)

Solution 3.1

(a) Figure 1 indicates that the price of corn moves between £150 per tonne in
years 1990 and 1996. The highest price of £200 is achieved in 1991, and the
lowest of £125 in the following year. Note that the severity of the
oscillation diminishes.
(b) Market prices are determined by the interaction of supply and demand .
Market equilibrium occurs when there is a stable long-run market price
from which there is no tendency to move. A change in any of the
conditions of supply or demand would affect equilibrium by causing a shift
in a supply or demand curve and, hence , a change in price.
Agricultural goods such as corn are particularly prone to unforeseen
weather cond itions which affect supply from one year to another. The fact
that the price of corn is £150 for three separate years would tend to suggest
that this is the long-run equilibrium price for corn . The initial change in

Price of
corn 175
per
tonne (£)

150

125

100

75

25

1990 1991 1992 1993 1994 1995

Year
Figure 1

38
 price in 1991 is likely to be the result of an unexpectedly poor harvest
brought about by, say, frost damage. The resultant fall in supply shown in
Figure 3 raises price to £200, with only 1000 tonnes bought and sold.
Figure 2 shows the path the market might follow in moving back to
equilibrium. Long-run disequilibrium occurs between 1991 and 1995,
because farmers are unable to accurately predict next year's price . In
1992, they make too much, and price falls to remove excess supply. In
1993, farmers make too little, and price rises to remove excess demand.
By 1995, the amount producers want to sell at £150 equals the amount
consumers want to buy , and price remains stable into 1996.

Price
per
tonne (£)

Quantity
Figure 2

(c) Pricing policy refers to the government's ability to leave markets free to
set their own price or to intervene to stabilise price . Price intervention in
the corn market requires the government to keep a buffer stock . For
instance, Figure 3 shows that the effect of the poor harvest of 1991 on
price could be overcome by the government selling 2000 tonnes from stock
at the prevailing price of £150. Such price intervention would avoid the
subsequent 'cobweb' shown in Figure 2.

200

150

1000 3000

Figure 3

39
3.3 Objective Questions

Example 3.2

Other things being equal , a normal supply curve for corn slopes upwards from left to
right because :
A farmers charge more to cover a rise in the price of seed
B farmers increase supply following increases in demand
C farmers' profits increase as price increases
D farmers are willing to produce more corn as price increases
E farmers are given government subsidies to encourage production

Example 3.3

The supply of a good is represented by the equation P = 10 + 0.8Qs' where Prefers

to the price in pounds (£) and Qs is the quantity of the good sold. At what price will
the producer sell 20 units?
A £10 B £16 C £20 D £26 E £30

Example 3.4

A supply curve shifts to downwards to the right following:

A an increase in customs duties B a decrease in specific subsidies
C a decrease in VAT D an increase in production costs
E a decrease in the number of firms in the industry

Examples 3.5-3. 7 refer to the following diagram, which shows the supply of and
demand for British-made lawnmowers. The market is initially in equilibrium at
point A. After each question , indicate the new equilibrium position A, B, C, D or
E.

Price

L...--------------_Quantity

Example 3.5

What will be the new market price following the introduction of labour-saving
technology?

Example 3.6

What will be the new market price if the price of imported mowers falls considerably?

40
Example 3.7

What will be the new market price if there is a successful advertising campaign for
lawnmowers, while at the same time the government introduces an indirect tax on the
sale of lawnmowers?

Example 3.8

The market demand for a good Y is given by the equation Y = 80 - lOP and the
market supply for good Y is given by the equation Y = -40 + 20P, where P denotes
the price of good Y . The equilibrium price for the good is
A 2P B 4P C lOP D 20P E 40P

Example 3.9

The burden of an expenditure tax falls entirely on the producer if the elasticity of
demand is:
A lower than the elasticity of supply B higher than the elasticity of supply
C less than unity D greater than unity
E infinite

Example 3.10

If a subsidy is given to a product whose demand is price-elastic but whose supply is

price-inelastic:
A producers keep the entire subsidy
B consumers keep the entire subsidy
C the subsidy is shared equally between consumers and producers
D the bulk of the subsidy is kept by producers
E the bulk of the subsidy is kept by consumers

Select your answers to Examples 3.11-3.14 by means of the following code:

A if 1 , 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 3.11

Which of the following will cause the supply curve for apples to shift to the left?
1 a successful advertising campaign for pears
2 a reduction in EC subsidies to fruit growers
3 an increase in the total population consuming apples

Example 3.12

Good X and good Yare in competitive supply. Other things being equal , a decrease in
the demand for good Y will:
1 increase the price of good X 2 increase the supply of good X
3 decrease the price of good X

41
 Example 3.13

The government imposition of a maximum price below the equilibrium price in a

competitive market will, in the short run, result in:
1 the development of a black market 2 excess demand
3 a decrease in quantity supplied

Example 3.14

The diagram indicates the conditions of demand and supply of wheat. If the
government set a minimum price of Pz, this will:
1 cause an excess supply of wheat
2 make the market demand curve JKL
3 require the intervention buying of QI - Q3 wheat

Price
J s

_ _ _ _----=:!~---- _ ~--- L

P,

L-- --l-_ _...l...-_ _.L- Quantity

0,

3.4 Essays

Example 3.15

Analyse the effect, in the short run only, on the price of coffee of (i) a severe frost; (ii)
a fall in the rate of VAT; (iii) the introduction of rationing.

• You are not expected to have a detailed knowledge of the coffee industry.
• Apply your understanding of general supply and demand analysis.
• Make assumptions about the price elasticity of supply and demand for
coffee and then draw flat or steep curves to match.

Solution 3.15

In a market economy the price of coffee is determined by the interaction of

supply (the amount of a good which producers are willing and able to sell) and
demand (the amount of a good which consumers are willing and able to buy) .
(i) In Figure 1, S shows supply and D demand at different prices. PI is the
initial equilibrium market price (EMP) and QI the initial amount of coffee
bought and sold . The long time taken to grow coffee plants means that
supply is price-inelastic. Demand is price-inelastic, because analysis has
assumed that there are few substitutes for coffee. Sand D are drawn
assuming ceteris paribus (all other things being equal). A severe frost
invalidates this assumption and I predict that there will be a decrease in the

42
 P
Price per S
jar (PI

D No . of jars ' - -_ _:1-.L......- D Q

'--------J'-----each month (Q)
Q1

Figure 1 Figure 2

quantity of coffee supplied at all market prices , causing the supply curve in
Figure 2 to shift to the left , to 5 z. The decrease in supply causes a rise in
price to Pz and a contraction in demand.
The more severe the frost the greater the decrease in supply, and the
greater the resulting incre ase in price. The more price-inelastic demand the
greater the increase in price for a given fall in supply .
(ii) Vat is an ad valorem (according to value) indirect tax on the sale of goods
and services. In Figure 3, the effect of VAT on coffee is found by adding the
amount of the tax to the original supply curve , at each level of output. A fall
in VAT rates reduces the amount of tax received at each level of output and
the 51 + T l curve shifts downwards to 51 + T z. The assumption of inelastic
demand means a significant fall in price , to Pz.
(iii) Rationing usually occurs in respon se to a crisis such as war and is when the
government intervenes in a market to fix the price and output of a good. In
Figure 4, the government fixes the output of coffee at Qz. Given that supply
is now totally unresponsive to changes in price , 5z is perfectly price -inelastic
and price rises to Pz. Often rationing authorities consider high free market
prices to be unfair to those on low incomes and unable to buy coffee.
Instead , Qz coupons are issued to consumers, allowing them to buy a fixed
amount of the good each month at , say, price Pl'

P P
S+ T1

P1

Figure 3 Figure 4

The final effect on the legal price is indeterminate. The government

may decide to offer the good above , at or below the price prevailing
before the introduction of rationing . However, the existence of excess
demand at prices below Pz encourages the development of an illegal
black market , where price is likely to be higher than that set by the
government.

Example 3.16

Why do the prices of some commodities fluctuate more th an those of others?

(L 1987)

43
 • Explain why unstable conditions of supply and demand result in price
changes.
• Explain why price inelasticity amplifies the effect on price of changes in
supply and demand.
• Introduce time lags and apply the cobweb theory.
• Make use of graphs and relevant examples.

Solution 3.16

Equilibrium is a situation of balance from which there is no tendency to change .

Equilibrium prices change only if there has been a change in a condition of
supply or demand . It follows that products where the conditions of supply and
demand are inherently unstable are subject to greater price fluctuations than are
those with constant supply and demand conditions.
For instance, goods where demand varies according to the time of year will
display price instability. For example , the price of coal falls during the summer
but rises in the winter. Similarly , a rise in income increases the demand for all
normal goods . Ceteris paribus , the greater the increase in demand the greater the
rise in price. Therefore , goods with a low income elasticity of demand usually
possess great price stability. Goods with a low cross elasticity of demand with
respect to all other goods have few substitutes or complements and are likely to
show price stability. Similarly , products with few goods in joint or competitive
supply are less likely to be subject to price changes.
Empirical (real-world) evidence suggests that agricultural goods have oscillat-
ing prices. Farm products are particularly prone to unforeseen events such as
weather and disease. Figure 1 shows that as the weather changes , so does supply.
The effect on price of each change in supply is exaggerated by inelastic demand .
Agricultural products have a low price elasticity of demand (PED) , because they
are inexpensive , and consumers tend to buy much the same amount regardless of
price .

Price Supply given

poor Sl
weather ---"~--I
I ---+--Supply given
normal
weather
Range of price _--+_ 1
fluctuat ions - Supply given
good
weather

'--_.1.-_-1...._----''-- Quantity

Figure 1

The cobweb theory explains why the price of some goods oscillates more than
others. Assume that farmers expect to sell their next crop at the same market
price as in the previous season. This means that this year's price has no effect on
current production but instead determines next year 's supply. In Figure 2, the
initial price is PI ' A 'shock' to the system (e .g. an unexpected poor harvest)
causes price to rise to P2 . Farmers expect price P2 in the next time period and
produce Q2' However, consumers are only prepared to pay P3 to buy up Q2'
Farmers then expect the next market price to be P 3 and so produce Q3' Because
supply is more inelastic than demand, the cobweb is converging and the long-run
equilibrium price of PI is eventually restored. Had demand been more inelastic

44
 Price s

01 O2
Figure 2

than supply, the resulting divergent cobweb would have caused even greater
price variations over time .
In conclusion, it can be seen that the prices of some commodities fluctuate
more than those of others, because of differences in the stability of the
underlying conditions of supply and demand.

3.5 Solutions to Objective Questions

Solution 3.2 Answer: D

A supply curve slopes upwards from left to right, since higher prices induce
producers to extend their supply . Other options are incorrect because:
A ~ when drawing a supply curve all variables are held constant except price . A
rise in the price of seed shifts the supply curve to the left;
B ~ an increase in the demand for corn causes a rise in price and an extens ion in
supply and not an increase in supply ;
C ~ profitability cannot be assessed without further information about revenue ;
E ~ a subsidy shifts the supply curve to the left.

Solution 3.3 Answer: D

The equation P = 10 + 0.8Qs simply means 'price equals 10 plus whatever

quantity is being supplied multiplied by 0.8' . Therefore,
P = 10 + [0.8 x 20] = 10 + 16 = 26

Solution 3.4 Answer: C

A decrease in VAT increases supply and shifts the supply curve to the right. All
other options result in an increase in supply , which shifts the supply curve to the
left.

Solution 3.5 Answer: C

The introduction of labour-saving technology reduces unit costs, increases

supply and shifts the supply curve to the right, to S3' The new equilibrium
position is given by the intersection of S3 and D 1 - i.e . point C.

45
 Solution 3.6 Answer: B

A fall in the price of a substitute good for home-produced lawnmowers reduces

demand and shifts the demand curve to D 3 • The new equilibrium position is
given by the intersection of D3 and SI - i.e. point B.

Solution 3.7 Answer: E

A successful advertising campaign shifts the demand curve for lawnmowers to

the right, to Dz. A tax on the sale of lawnmowers shifts the supply curve to the
left , to Sz. The equilibrium position is point E.

Solution 3.8 Answer: B

In equilibrium, the two equations given in the question must equal each other.
Remember when manipulating equations that whatever is done to one side must
also be done to the other side of the equation. The market price is found by:

quantity demanded = quantity supplied

substituting 80 - lOP = -40 + 20P
adding lOP 80 = -40 + 30P
adding 40 120 = 30P
dividing by 30 4=P

Solution 3.9 Answer: E

s
P1

01

In general, price elasticity determines the slope of supply and demand curves
(see Figures 4.2 and 4.3). The diagram shows that a demand curve of infinite
price elasticity is horizontal. The shaded area is the amount of tax raised, and the
incidence falls entirely on the producer.

Solution 3.10 Answer: D

It almost always helps to draw a diagram to illustrate details given in a question.

D 1 represents a price-elastic demand curve and SI represents a price-inelastic
supply curve. To show the effect of a subsidy, deduct an amount (say, P3 - Pz)
from the supply curve at all output levels and label the new curve Sz. The initial
market price is PI> with QI bought and sold. The subsidy has increased supply
and reduced the equilibrium price to P z. While consumers pay only P z,
producers receive P3 per unit sold. Because demand is price-elastic and supply is
price-inelastic, the bulk of the subsidy (area A) goes to the producer.

46
 P
SI

01

'------'L---~--..l..------1- Q

Solution 3.11 Answer: B

The following options are correct.

1 => A successful advertising campaign for pears increases demand , raises the
price of pears and increases the quantity of pears supplied. Some apple
producers are now encouraged to replant their orchards with pears. The supply
of apples falls, shifting the supply curve to the left.
2 => Reduced subsidies cause a decrease in supply .
3 => Is incorrect because, in the short run , an increase in population increases
demand and not supply .

Solution 3.12 Answer: C

Py Px
Good Y Good X

PI

01

The left-hand diagram shows that a decrease in the demand for good Y reduces
its price . Since good Y and good X are in competitive supply , a fall in the price of
Y encourages producers to increase their supply of X. Option 2 is correct.
The right-hand diagram shows that the increase in the supply of X reduces its
price . Therefore , option 3 is correct and option 1 is incorrect.

Solution 3.13 Answer: A

All options are correct.

2 => In the diagram, the amount that consumers are willing to buy at the
maximum price is found by projecting across to the demand curve and down, i.e .
Q2' A similar operation reveals that quantity supplied at the maximum price is
only Q3' There is an excess demand of '02 - Q3'
1 => Intervention which results in excess demand tends to encourage the
development of a black market.

47
 P
SI

PI

L-_-L-_----l._L-----I ...30..._ _ Q

3 ~ At the initial market price , QI is demanded. Price maintenance means

that only Q3 can be bought, and there has been a contraction in demand .

Solution 3.14 Answer: B

The following options are correct.

1 ~ At the minimum price producers want to sell more ( Qz) than consumers
want to buy (Q 3)'
2 ~ Above point K , the market demand curve is unaffected by government
action. Beyond point K, the government is prepared to intervene and buy up any
amount of wheat necessary to maintain the market price at P z. The demand
curve becomes perfectly elastic at K and extends to point L.
Option 3 is incorrect because the amount of unsold wheat to be bought and
added to intervention stocks equals Qz - Q3 and not QI - Q3'

48
 4 Elasticity
4.1 Fact Sheet

(a) Price Elasticity of Demand

Price elasticity of demand (P.E .D .) measures the responsiveness of demand to a

given change in price. The P.E.D . coefficient (value) is calculated by use of
either of the following equations :
percentage change in quantity demanded P ilQo
PED = =-x--
. . . percentage change in price Qo ilP
where P is the initial price, Qo is the initial quantity demanded and il (delta)
means 'the change in'.

Price
D
P -+
I
1

2 t>.P I
I
1
1
1 - - -1- - - - - - - - - - - -
D
1 t>.Q
Q"-.... I -.- - - - - - --
1 2 3 4 5

Figure 4.1 Calculating P.E .D .:

P.E.D . between points A and B = ;D x ~~~D

3 4
=-x-=6
1 1

• The P.E.D. coefficient can be between zero and infinity (00) .

• If P.E.D . is less than 1, demand is inelastic.
• If P.E.D. is greater than 1, demand is elastic .
• P.E .D. is usually treated as a positive number and any minus signs are
ignored.

Figure 4.2 shows that the gradient (slope) of a demand curve generally reflects
its P.E .D. However, great care should be taken when interpreting the gradient
of a demand curve.

49
 p p p

0,
(a)
L-------_O
(b)
~D'
L-------_O
(e)

p p

------0
L-------_O
4
1 - - - - - - - 05

'----------<- 0
(dl (e)

Figure 4.2 Demand curves with different price elasticities . In (a) the demar.d curve is a
vertical line ; demand is perfectly inelastic ; the P.E .D . coefficient is equal to 0; and
a price rise means no decrease in Qo . In (b) the demand curve is a steep line;
demand is relatively inelastic; the P.E.D . coefficient is greater than 0 but less than
I ; and a price rise means a smaller percentage decrease in Qo . In (c) the demand
curve is a rectangular hyperbola; demand is unitary elastic ; the P.E .D . coefficient
is equal to 1; and a price rise means an equal percentage decrease in Qo . In (d)
the demand curve is a shallow line; demand is relatively elastic ; the P.E .D .
coefficient is greater than 1 but less than 00 ; and a price rise means a greater
percentage decrease in Qo. In (e) the demand curve is a horizontal line; demand is
perfectly elastic; the P.E.D. coefficient is equal to 00 ; and a price rise means
consumers buying perfect substitutes

(i) The slope of a demand curve is not necessarily a guide to price elasticity.
The scale of each axis affects P.E .D .
(ii) On a steep demand curve, P .E.D. at points near the y-axis can be elastic .
(iii) On a flat demand curve , P .E.D . at points near the x-axis can be inelastic.
(iv) P.E.D. falls as you move down a linear demand curve .
(v) A demand curve shifting to the left becomes more elastic.

Table 4.1 Factors influencing price elasticity of demand

Factor The demand for a good is relatively price-inelastic because:

Number of substitutes if there are few substitutes for a good, consumers are
unlikely to switch products
Consumer loyalty if consumers are in the habit of buying a good, they are
unwilling to use substitutes
Absolute price of the good if a good is inexpensive, a large percentage change in
price represents only a few pence
Proportion of income if the good takes up only a small proportion of income,
consumers will not react significantly
Number of complements if the good has many complements, the product is
needed if the other items are used
Consumer adjustment if consumers are slow to react to a change in price, the
amount bought is largely unaffected

50
(b) Price Elasticity of Supply

Price elasticity of supply (P.E .S.) measures the responsiveness of supply to a

given change in price :
percentage change in quantity supplied P AQs
PES = =- x -
. . . percentage change in price Qs AP

• The P.E.S. coefficient can be between zero and infinity (00) .

• If P.E.S. is less than 1, supply is inelastic.
• If P.E. S. is greater than 1, supply is elastic.

Figure 4.3 shows that the gradient of a supply curve generally reflects its
P.E.S.

p p p

L . . - _.......... Q L..---''--- Q M!::=-- Q

(a) (b) (e)

p p

55 1-
56

L..- ~ Q L.-- ~ Q

(d) (e)

Figure 4.3 Supply curves with different price elasticities. In (a) supply is perfectly inelastic;
the P.E .D . coefficient is equal to 0; and a price fall means no decrease in Qs. In
(b) supply is relatively inelastic; the P.E.D. coefficient is greater than 0 but less
than 1; and a price fall means a smaller percentage decrease in Qs. In (c) supply is
unitary elastic; the P.E.D. coefficient is equal to 1; and a price falI means an equal
percentage decrease in Qs. In (d) supply is relatively elastic; the P.E.D . coefficient
is greater than 1 but less than 00 ; and a price fall means a greater percentage
decrease in Qs. In (e) supply is perfectly elastic; the P.E .D . coefficient is equal to
00 ; and a price fall means that suppliers halt production

It is important to remember that for linear supply curves:

• P.E.S. is inelastic at all points when the supply curve intersects the x-axis
first.
• P.E.S. is elastic at all points when the supply curve intersects the y-axis first.
• P.E.S. is unitary at all points when the supply curve intersects the origin.

51
 Table 4.2 Factors influencing price elasticity of supply

Factor The supply for a good is relatively price-elastic because:

Time in the long run , firms can adjust all factor inputs to change supply
easily
Production time if a good is manufactured quickly, supplies can be changed easily
Stocks if a firm has a large amount of stocks, supplies can be changed
easily
Capacity if labour and capital are underused, supplies can be changed easily
Factor mobility if resources can move in and out of the industry, supplies can be
changed easily

(c) Income Elasticity of Demand

Income elasticity of demand (Y.E.D.) measures the responsiveness of demand to

a given change in income :
percentage change in quantity demanded y aQo
Y.E .D . = percentage change in price = Qo x ay

• Since Y.E .D. can be negative, it is important to include minus signs.

• If Y.E.D . is negative, the product is an inferior good.
• If Y.E .D . is positive, the product is a normal good.
• If Y.E .D. is positive and greater than 1, the product is a superior good.

An Engel curve shows the amount of a good demanded at different levels of

income. Figure 4.4 shows that the slope of an Engel curve reflects its Y.E .D .

Quantity
demanded (Do )
Y.E.D. = 0

L- -'-- ..l- Income (Yl

Normal good Inferior good

Figure 4.4 An Engel curve with different income elasticities

(d) Cross Elasticity of Demand

• Cross elasticity of demand (X.E.D.) measures the responsiveness of

demand for good A to a given change in the price of good B:
percentage change in the quantity of A demanded PB aQoA
XED = =-x--
. . . percentage change in the price of B QOA aPB

52
 • Since X.E .D. can be negative, it is important to include minus signs .
• If X.E.D. is positive, the two goods are in competitive demand - i.e.
substitutes.
• If X.E .D. is negative, the two goods are in joint demand - i.e. comple-
ments.
• If X.E .D. is zero, the two products are unrelated - i.e. independent goods .

(e) Price Elasticity of Demand and Revenue

The effect of a price change on revenue depends on the elasticity of demand.

Figure 4.5 shows how a change in price can increase revenue .

• If P.E.D. is elastic, a fall in price increases revenue.

• If P.E.D . is inelastic, a rise in price increases revenue.
• If P.E.D . is unitary, a price change leaves revenue unchanged .

The relationship between P.E .D. and marginal revenue is analysed in Figure
6.5

Revenue gained Cilll

P P
Revenue lost

PI

(a)

Figure 4.5 (a) Elastic demand and revenue . Since the price decrease results in a
proportionately larger increase in quantity demanded , revenue rises. (b) Inelastic
demand and revenue . Since the price increase results in a proportionately smaller
decrease in quantity demanded , revenue rises

4.2 Data Response

Worked Example 4.1

Products X and Yare both produced in perfectly competitive product markets using
unskilled labour obtained from a perfectly competitive labour market.

X has an income elasticity of demand = -0.5

Y has an income elasticity of demand of 0.5

Firms produce either X or Y, and initially all firms within each industry are at a
long-run equilibrium .. Over the next year there occurs an increase of 20% in the
average consumer disposable income .
(a) What term would you use to describe good X? (1 mark)
(b) Calculate how the change in income will affect the demand for each good.
(2 marks)

53
 (c) Describe, with the help of relevant diagrams , the changes which will occur over
time in the above product and factor markets. (14 marks)
(d) Why might a problem occur if labour were occupationally immobile? (3 marks)
(SUJB June 1987)

Solution 4.1

(a) A good with a negative income elasticity of demand is known as an

inferior good. An increase in income results in a fall in demand for this
type of good .
(b) Income elasticity of demand (Y.E .D.) is calculated from the equation
Y.E.D . = percentage change in quantity demanded
percentage change in income
For good X, -0.5 = ?/20 = -10%. Demand for X falls by 10%.
For good Y, 0.5 = ?/20 = + 10%. Demand for Y rises by 10%.
(c) Answer (b) indicates that the demand for good X falls by 10% over one
year. The effect on the product market for X is shown in Figure 1 and the
effect on the labour market is given in Figure 2.
In Figure 1 the increase in income is used to buy less of the inferior good
X. The demand curve shifts to the right. Note that the fall in quantity
supplied is achieved by releasing resources such as labour to contract
production. The demand for labour used in the production of X is derived
from the demand for the final product. A fall in the demand for product X
means a fall in the demand for labour. This is shown in Figure 3.

Price Price

P,

L...-_ _-..L_----I Quantity

' - - - - - - - - - ' - - - - - ' - - - _ Quant ity
O2 0, 0, O2
Figure 1: Good X Figure 2: Good Y

Wage Wage

D,

Labour

Figure 3 : Labour used in X Figure 4 : Labour used in Y

54
 Figure 2 shows the increase in the demand for product Y following an
increase in income . The demand curve for Y has shifted to the right. The
resultant increase in quantity supplied is achieved by attracting additional
resources such as labour into the industry. The increase in the demand for
the final product raises the demand for labour used in the manufacture of
Y, causing the demand curve for labour in Figure 4 to shift to the right.
Figure 3 shows a fall in wages in industry X. The increase in wages
occurring in industry Y will attract redundant labour from X. The
reallocation of resources has been achieved through a change in the
relative price of products and labour between the two product and factor
markets.
(d) The occupational immobility of labour refers to the inability of workers to
move between jobs requiring different skills. For instance, a teacher does
not necessarily possess the skills which would allow him to transfer to a
plumbing occupation .
If labour is occupationally immobile between industries X and Y,
workers no longer required in industry X will be unable to move across to
industry Y, even though there has been an increase in relative pay . In the
long run, workers once employed in making X may retrain for Y, thereby
overcoming occupational immobility .

4.3 Objective Questions

Example 4.2

The following table shows a demand schedule for a particular good :

Price (£) 1 2 3 4 5
Quantity demanded (lb) 40 35 30 25 20

In which range does the price elasticity of demand (expressed as a positive number) lie
for a rise in price from £3 to £4?
A o.o-o.i B 0.2-0 .3 C 0.3-0.4 D 0.5-0.8
E greater than or equal to 0.9

Example 4.3

If the demand curve for a normal good is linear, the price elasticity of demand for the
good:
A decreases as the amount bought increases
B increases as the amount bought increases
C is always less than 1
D is always more than 1
E is unity

Example 4.4

From the following diagram it can be inferred that the price elasticity of demand is:
A the same at point A and point B
B the same at point C and point B
C more inelastic at point C than at point B
D more inelastic at point A than at point B
E the same for both demand curves at point B

55
 p

'---- ..30... ~ __ Q

Example 4.5

If market price falls by 5% following a rise in supply, and there is no change in the
quantity bought, the demand curve is:
A kinked B relatively elastic C relatively inelastic
D completely elastic E completely inelastic

Example 4.6

Which one of the following graphs refers to a good which exhibits a negative income
elasticity of demand at all levels of income?

A B C D E

Q)

E
..
E
..
E
0 0 0

.= .=
()

.=
() ()

Quantity Quantity Quantity Quantity Quantity

Example 4.7

The following table gives an individual's demand for three goods at two different
income levels :

Income (£ 000) 5 6
Units of A 10 15
Units of B 8 10
Units of C 10 11

It follows that the proportionate rise in income leads to:

A a proportionately equal increase in the quantity of A demanded
B a proportionately greater increase in the amount of A demanded
C a proportionately greater increase in the amount of C demanded
D a proportionately greater increase in the demand for good B than for good A
E a proportionately greater increase in the demand for good C than for good B

Example 4.8

Which one of the following diagrams represents the relationship between two normal
goods which are in joint demand?

56
 -,
A B C D E
Price Price Price Price Price
of X of X of X of X of X

Quantity of Y
/
Quantity of Y Quant ity of Y Quantity of Y Quantity of Y

Example 4.9

If the price elasticity of demand for a good is 2, a decrease in price:

A increases consumers' expenditure on the good
B decreases consumers' expenditure on the good
C does not change consumers' expenditure on the good
D increases the profits of the firm
E decreases the profits of the firm

Example 4.10

A cinema discontinues offering half-price mid-week tickets and instead charges full
price . As a result , the cinema finds that its total revenue from mid-week sales falls.
This shows that:
A if weekend prices were reduced , total revenue would fall
B the demand for mid-week tickets is more elastic than the demand for weekend
tickets
C the demand for mid-week tickets is more inelastic than the demand for weekend
tickets
D at these prices the demand for mid-week tickets is elastic
E at these prices the demand for mid-week tickets is inelastic

Select your answers to Examples 4.11-4.15 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 4.11

If elasticity of demand is unitary :

1 the demand curve is a rectangular hyperbola
2 revenue remains unchanged as price changes
3 the good is a manufactured product

Example 4.12

The demand for a product is elastic with respect to price if:

1 it has several substitutes
2 its price is high in relation to income
3 it has few complements

57
 Example 4.13

Price elasticity of supply will be smaller:

1 the longer the time period under consideration
2 the smaller the amount of stocks held by firms
3 the more immobile the factors of production used

Example 4.14

The diagram below shows the supply of beer. Elasticity of supply is:
1 greatest at L 2 equal at all points 3 unitary at point L

""---------- Q

Example 4.15

If the cross elasticity of demand for good X with respect to good Y is zero, then X and
Yare:
1 independent goods 2 substitute goods 3 in competitive demand

4.4 Essays

Example 4.16

Of what relevance is an understanding of each one of the three measures of elasticity

of demand to the sales director of a firm of travel agents?
(C 1987)

• A detailed knowledge of the travel and tourism industry is not expected.

• Apply your general understanding of demand elasticity.
• Be careful to ensure that arguments are supported with worked examples
relevant to a travel firm.
• Analyse each type of demand elasticity in separate paragraphs.

Solution 4.16

Elasticity of demand measures the responsiveness of demand to changes in other

variables. There are three types of elasticity of demand. Price elasticity of
demand (P.E.D .) measures the responsiveness of quantity demanded to a given
change in price . The P.E .D . of a product will be of relevance to the sales director
if he is contemplating a price change and needs to know the probable effect on
revenue .

58
 Figure 1 shows two possible demand curves for day coach trips . D, is relatively
price-inelastic and D z is relatively price-elastic. At the initial price of £10, 100
trips are sold and the firm's total revenue (price x quantity) is
£10 x 100 = £1000. A 'special offer' campaign where price is reduced by 20%
affects revenue according to the P.E.D. for trips. Given Db total revenue
becomes £8 x 110 = £880. Given D z, total revenue is £8 x 150 = £1200.
Therefore, the special offer only increases the revenue of the firm if P.E.D. is
elastic.

Price (£)

10 - - - - - - - -
I
I
I
I
8 --------T
I
I
I
I
I
I
I
I 01
100 110 150 200

Income elasticity of demand (Y.E.D .) measures the responsiveness of demand

to a given change in income. A knowledge ofY.E.D. allows the sales director to
predict the likely pattern of future demand for travel as consumers' real income
rises. For example, assume that the firm has to decide between increasing the
number of day coach trips or introducing a new luxury tour service. If market
research reveals that the Y.E.D . for day trips is negative, then demand will fall
over time and the firm is operating in a declining market. If the survey finds that
the Y.E .D . for luxury tours is positive and greater than 1, then demand will rise
proportionately faster over time than income and the market is expanding.
Cross elasticity of demand (X.E.D .) measures the responsiveness of demand
for one good to a given change in price of a second good. The X.E.D . value tells
the firm which pair of products are substitutes (+ X.E.D. coefficient), comple-
ments (-X.E.D. coefficient) or independent goods (X.E.D . = 0). The director
can estimate the wider effects of discounting one holiday. Assume that the
X.E .D. coefficient between holidays A and B is 2. The effect of a 10% reduction
in the price of holiday A is calculated from the equation
% change in quantity demanded of B
X.E.D. = 01 h . .
10 C ange III pnce 0
fA

The 20% fall in the quantity of B demanded may discourage the director from
discounting the price of A.
X.E .D. also permits the firm to assess the effect of a loss-leader strategy,
where the price of one good is heavily reduced in the hope that additional
purchases of other products will compensate. Loss-leader campaigns are most
effective when the X.E.D. of the product with respect to a large number of other
goods sold by the firm is negative and less than 1, e.g. -4. The loss made on one
item is made up by the profit from the sale of complements.

59
 Example 4.17

What factors determine the elasticity of supply of any product (a) in the short run (8),
(b) in the long run ? (12)
(SUl1987)

• Select a good whose elasticity of supply is affected by time.

• Avoid simply listing factors affecting elasticity of supply.
• Use your named product to illustrate why elasticity of supply varies between
time periods.

Solution 4.17

Price elasticity of supply (P.E .S.) measures the responsiveness of quantity

supplied to a given change in price. P.E.S . is calculated by comparing the
proportionate change in price and quantity supplied by use of the equation
percentage change in quantity supplied
P.E.S . = percentage chanze i pnce
ange III .

The short run is defined as the period of time in which a firm is unable to alter
the amount of fixed factors such as capital used in production. Within a given
time period, the elasticity of supply depends largely on the ability of a firm to
vary output in response to price changes. If output is adjusted easily in response
to price changes, then P.E.S. is elastic . Products whose output cannot be varied
possess low P.E .S.
Therefore, analysis of the factors determining elasticity of supply requires a
careful analysis of the factors determining the ability of a firm to vary output.
Consider the production of margarine. There are a number of reasons for
believing that, in the short run, margarine output can be readily adjusted and the
P.E.S. of margarine is elastic . For instance, margarine is a relatively simple
manufactured good which requires little time for mass production. Output can
be expanded rapidly by operating overtime or by working night shifts. Margarine
can be refrigerated and stored for long periods. Stocks can then be used to effect
changes in quantity supplied.
On the other hand, there are several factors which would make the short-run
P.E.S. of margarine inelastic . The impact of diminishing returns and the
difficulty of substituting one factor of production for another raises short-run
unit costs and makes supply inelastic. If margarine factories are operating at or
near full capacity, output cannot be expanded rapidly in response to a price rise.
Again , if the labour used to operate machinery requires specialist training, it is
also difficult to expand production rapidly.
The long run is defined as the period of time when the firm is able to vary the
amount of any factor used in production. In the long run, P.E.S. is more-elastic
than in the short run, for a variety of reasons. In the long run , firms have an
opportunity to overcome diminishing returns by adjusting the mix of labour and
capital. The difficulties of factor immobility can be overcome through training.
Supply is elastic in the long run because firms have longer to plan their
production decisions and more time to actually manufacture the good. For
example , machinery used to produce similar products such as cheese spreads can
be switched into or out of the production of margarine. The industry can adjust
production capacity by installing or removing machines. If the firm decides on a
very large adjustment in capacity, a new factory can be built or an existing plant
can be closed down. Moreover, provided that there are no barriers to entry, new
firms can enter the industry. Alternatively, existing firms can switch into the

60
 production of another good. It is also likely that supply will be affected by the
development of new technologies which improve production techniques and
increase P.E.S.

4.5 Solutions to Objective Questions

Solution 4.2 Answer: D

Price elasticity of demand (P.E .D .) is calculated here by using the equation

p tlQ
P.E.D. = Qx tlP

where P is the initial price, Q is the original quantity demanded, tlQ is the
change in quantity demanded and tlP is the change in price. Substituting,

= l.- x [30 - 25] = l.- x ~ = ~ = 5

P .E.D. 30 [3 - 4] 30 1 30 O.

Note that the question states P.E .D. 'expressed as a positive number' . By
convention, all negative signs are ignored when calculating P .E.D. The negative
value from the rise in price (-1) is treated as a positive.

Solution 4.3 Answer: A

A 'linear' demand curve is a straight line. The phrase 'a normal good' simply tells
you that the demand curve in question slopes downwards from left to right.
Consider the following diagram:

Price (£)
5

IA~
I
3 - - -+--
I
I
I I
2 --;----t--
I I
I I I
1 - --!.---+-- --+--
i I I
I I I
'----'------'-_----''---_...I..-_-3L_ _ Quantity
o 2 4 6 8 10

As you move down a demand curve , you are dividing a smaller percentage
change in quantity demanded (%tlQo) by a larger percentage change in price
(%tlP) . For example :

A to B %tlQo = change in Qo x 100 = ~ x 100 = 100%

original Qo 2

%tlP = cha.nge in P x 100 = 1 x 100 = 33.3%

onginal P 3

61
 : . P.E.D . A to B - = 3 (il.e . P .ED
= %.:lQD = -100 ' e Iasnc
. . IS .)
%.:lP 33.3

2
J to K %.:lQo = "6 x 100 = 33.3%

1
% .:lP = - x 100 = 50%
2
33.3
: . P.E.D . J to K = 50= 0.67

Solution 4.4 Answer: C

In general, the flatter a demand curve the more price-elastic is demand . Points B
and C correspond to the same level of output. Since D I is flatter than D 2 , C is
more inelastic than B.

Price D

PI
5% Fall P
2

' - - - - - - - - - - - - - Quantity

Solution 4.5 Answer: E

A completely inelastic demand curve is a vertical straight line . The 5% decrease

in price results in no change in the quantity bought.

Solution 4.6 Answer: D

A good with a negative income elasticity of demand (Y .E.D .) is an inferior

- i.e . as income rises, quantity demanded falls . Option D is correct. As you
move up the y-axis, income rises but the quantity demanded continues to
decline .
Other options are incorrect because:
A ~ shows a positive Y .E.D . up to a certain level of income, then Y.E.D.
becomes zero and finally negative ;
B ~ the same amount is demanded no matter what the level of income - i.e.
there is zero Y.E.D .;
C ~ shows a negative Y.E.D. up to a certain level of income, then Y.E .D .
becomes zero and finally positive;
E ~ Y .E.D. is positive throughout.

Solution 4.7 Answer: B

The question requires the calculation of:

(a) the percentage change in income;
(b) the resulting percentage change in the amount of each good demanded.

62
The percentage (%) change (~) in income (Y) is calculated by using the equation
~y £5000 - £6000 £1000
%~y =- x 100 = x 100 =-- x 100 = 20%
Y £5000 £5000
The percentage change in demand for each good equals the change in demand ,
divided by the original demand , times 100:
5 2 1
%~A = -x 100 = 50%' % ~ B = - x 100 = 25% ' % ~ C = - x 100 = 10%
10 ' 8 ' 10
The 20% increase in income results in a proportionately greater increase in the
quantity of A demanded of 50% .

Solution 4.8 Answer: A

Two goods in joint demand are complements. Complements have a negative

cross elasticity of demand (X.E.D.). If the price of one good (e.g. electricity)
rises, the demand for a complement (e.g. electric fires) falls. This type of
relationship between price and demand is only shown in option A. Other options
are incorrect because:
B ~ shows positive X.E .D. , which is possessed by substitutes ;
C ~ shows zero X.E.D. , which occurs when goods are independent ;
D and E ~ do not represent any possible relationship .

Solution 4.9 Answer: A

If price elasticity of demand is 2, the good is relatively elastic. While consumers

are now paying less for each unit bought, they are in fact buying proportionately
more than before the price decrease. Other options are incorrect because:
D and E ~ require information about revenue which is not supplied.

Solution 4.10 Answer: D

The effect of discontinuing half-price mid-week tickets is to increase price . If

elasticity of demand for mid-week tickets is greater than 1 but less than infinity
(i.e. elastic), then the increase in price brings about a greater percentage fall in
sales. Total revenue falls.

Solution 4.11 Answer: B

The following options are correct:

1 ~ rectangular hyperbola demand curves possess unitary P.E.D. at all points ;
2 ~ where P.E.D. is unitary , a given percentage change in price is followed by
an equal but opposite percentage change in quantity demanded .
Option 3 is incorrect, because manufactured goods do not necessarily possess
unitary P.E.D.

Solution 4.12 Answer: A

All options are correct.

1 ~ Demand is elastic if consumers can switch easily to substitutes following a
price increase.
2 ~ Consumers notice small percentage changes in the price of expensive
goods. For instance , a 4% increase adds £400 to the price of an £8000 car.

63
 3 => A product with few complements will not be needed for joint use with
other goods.

Solution 4.13 Answer: C

1 => 'Price elasticity of supply will be smaller' means 'supply becomes more
inelastic'. Option 1 is incorrect because firms can use more fixed factors in the long
run to increase supply. The following options are correct :
2 => firms with few stocks are unable to increase quantity supplied, quickly ;
3 => firms cannot increase quantity supplied , quickly , if they are unable to
employ additional factors of production.

Solution 4.14 Answer: C

The following options are correct:

2 => a feature of any linear supply curve passing through the origin is that it
possesses unitary price elasticity of supply (P .E .S.) at all points;
3 => P.E.S. equals 1 at point L (and points K and J).

Solution 4.15 Answer: D

The type of relationship between two goods is indicated by the cross elasticity of
demand (X.E.D.) value. If X.E .D. equals zero, a change in the price of good X
has no effect on the quantity of good Y demanded and the two goods are said to
be independent of each other. Other options are incorrect because:
2 and 3 => substitute goods are in competitive demand and have a positive
X.E.D.

64
 5 Costs of Production
5.1 Fact Sheet

(a) Short-run Product Curves

In the short run , firms can increase output by adding extra units of labour to a
fixed amount of capital.

• The addition to output made by each extra worker is called marginal

product of labour (MP L ) .
• Output per worker is called average product of labour (APd.
• The concept of returns compares the percentage change in labour (%aL)
with the resulting percentage change in output (%aQ).

Table 5.1 Types of return

Type of return Description Marginal product

Increasing returns %I::iL is smaller than the resulting %I::iQ is rising

Constant returns %I::iL is equal to the resulting %I::iQ is constant
Decreasing returns %I::iL is greater than the resulting %I::iQ is falling

• The law of diminishing returns states that, as extra units of a variable factor
are combined with a given amount of a fixed factor , the marginal product of
the variable factor will eventually fall.
• If only diminishing returns are referred to, this is taken to mean diminishing
marginal returns .

Output (0)
A

E..- Labour (L)

Figure 5.1 Product curves: AP = elL; MP = t1Qlt1L. A is the point of diminishing returns; B is
the point of diminishing average returns

65
 (b) Costs of Production

Table 5.2 Types of cost

Term Symbol Definition Equation

Total cost TC The amount spent on producing TC = FC + VC

a given output
Variable costs VC Production expenses dependent VC = TC - FC
on the level of output
Fixed costs FC Production expenses independent FC = TC - VC
of the level of output
Average cost AC The amount spent on producing AC = TC -;- Q
each unit
Average variable cost AVC Unit variable costs dependent on AVC = VC -;- Q
the level of output
Average fixed cost AFC Unit fixed costs independent of AFC = FC -;- Q
the level of output
Marginal cost MC The amount spent on producing MC = dTC -;- dQ
one extra unit

• Accountancy and economic definitions of costs are different.

• Economists use the concept of opportunity cost when calculating production
costs.
• If resources are owned by the firm, the imputed (estimated) transfer
earnings of the factor is included as a cost.

(c) Short-run Cost Curves

There are two methods of illustrating short-run cost curves.

In Figure 5.2:
• MC curve rises given diminishing returns.
• AC curve rises if MC is greater than AC.
• MC is made up entirely of changes in YC.
• Optimum output is where AC is lowest (point A).

In Figure 5.3:
• TC curve rises if output increases.
• YC curve rises if output increases.
• FC stay constant as output increases.

£ £
TC

AC VC

AVC

~-""""':lI,,&-----------FC

----;_ 0
L..----------------__ O a.c...

Figure 5.2 Unit cost curves Figure 5.3 Total cost curves

66
(d) Economies of Scale

In the long run, the firm can increase output by varying all factors of production.
Economies of scale (EOS) are reductions in long-run costs which occur from an
increase in production.

• Internal EOS occur within the firm as output rises.

• External EOS occur outside the firm and are independent of the size of the
individual firm.

Table 5.3 Types of internal economy of scale

Types of internal EOS Description

Specialisation Large firms have more scope for the division of labour
than have small firms
Indivisibilities Some machines are of a minimum size which can only
be kept fully occupied by large firms
Increased dimension The cost of capital does not increase in proportion to
the output of each machine
Principle of multiples Large firms use a machine combination which eliminates
bottlenecks caused by different machines working at
different speeds
Linked processes Bringing together different stages of production in one
factory reduces costs
Managerial Big firms can spread the cost of employing the best
managers over a large level of output. Managerial costs
do not increase in proportion with output
Financial Large firms offer more security and pay a lower rate of
interest on loans than do small firms. Large firms can
raise capital cheaply through a rights issue
Commercial Large firms buy raw materials and components in bulk
and are therefore given a discount
Marketing Transportation and advertising costs do not increase in
proportion with output
Research and development Large firms can spread the cost of improving products
over a large level of output

Table 5.4 Types of external economy of scale

Types of external EOS Description

Infrastructure Proximity to a good transport and communications net-

work
Ancillary firms Local back-up firms supply specialist support services or
components
Skilled local labour An area may have trained workers looking for jobs
Education An area may have colleges providing specialist training

(e) Diseconomies of Scale

Diseconomies ofscale (DOS) are increases in long-run costs which occur from an
increase in production.

67
 (i) Internal DOS occur within the firm when increases in output raise
long-run costs. They occur mainly because of managerial difficulties in
oversized firms:
(1) managers are unable to exercise effective control or co-ordination;
(2) internal communications within the company are difficult;
(3) workers feel isolated and out of touch with managers , and industrial
relations decline.
(ii) External DOS occur outside the firm when the long-run costs of all local
firms rise when:
(1) local road congestion causes transportation delays ;
(2) local land and factories become scarce and rents rise;
(3) labour shortages develop within the area and wages rise.

(f) Long-run Cost Curves

• A short-run average cost curve (SAC) shows the unit cost associated with a
given size of plant.
• A long-run average cost curve (LAC) shows the minimum unit cost of
producing each level of output, allowing the size of plant to vary.
• A LAC curve is found by drawing a line tangential to each SAC curve.
• Each SAC curve shows the unit cost from plants of different size.
• The size of plant associated with SAC z is the smallest needed to minimise
unit cost - i.e. minimum efficient plant size (MEPS).
• The slope of the LAC curve is determined by internal EOS .
• The position of the LAC curve is determined by external EOS.

LAC
SAC,

Economies of Constant-scale Diseconomies

scale economies of scale

Figure 5.4 Long-run average cost curve

The concept of returns to scale compares the percentage change in labour and
capital (%I1L&K) with the resulting percentage change in output (%I1Q). Table
5.4 explains the relationship between returns to scale and economies of scale .

Table 5.5 Returns to scale and scale economies

Returns to scale Description Scale economies Slope of LA C curve

Increasing returns %6.L&K is smaller than Economies of Falling

to scale the resulting % 6.Q scale
Constant returns %6.L&K is equal to the Constant Horizontal
to scale resulting %6.Q
Decreasing returns %6.L&K is greater than Diseconomies of Rising
to scale the resulting % 6.Q scale

68
 g) Integration

ntegration occurs when two firms combine. The new firm will probably enjoy
ignificant economies of scale, and require fewer managers and workers.

• A merger is when the two firms agree to form a new company.

• A takeover is when one company buys a controlling interest in a second
against the wishes of that company's directors .

There are three types of integration.

(i) Horizontal, between two companies at the same stage of production.

(ii) Vertical, between two companies at different stages of production, either:
(1) forwards, with a firm further up the chain of production; or
(2) backwards, with a firm lower down the chain of production.
(iii) Lateral (i.e . diversification), between companies making unrelated goods
but with common inputs.
(iv) Conglomerate between companies making unrelated goods.

5.2 Data Response

Worked Example 5.1

A profitable airline is consideringthe introduction of a new trans-Atlantic flight and is

faced with the following costs per flight:

Fuel charges 10 000

Depreciation 700
Insurance 300
Landing charges 500
Interest 500
Labour 5000
Other fixed costs 5 000

(a) From the above table distinguish between fixed and variable costs. Give reasons
for your choice. (4 marks)
(b) (i) Given a maximum seating capacity of 300 persons per aircraft, what is the
minimum price per seat that the airline must charge on this flight to avoid
making a loss? (5 marks)
(ii) If the above costs were representative of all flights , what price must the
airline charge to remain in business in the long run? (5 marks)
(c) Discuss the factors that are likely to determine the actual price charged.
(6 marks)
(L Jan. 1987)

Solution 5.1

(a) Fixed costs are those costs of production independent of the level of
number of flights undertaken . An allowance for depreciation has to be
made whether or not an aeroplane flies. In a given time period, the amount
of insurance paid, or interest owed on loans, does not change with the
number of flights made . Variable costs are those costs dependent on the
number of flights undertaken. Fuel charges, landing charges and labour
costs are incurred after each flight. This assumes that labour is paid per
flight and can be laid off at zero cost if no flights are made.

69
 (b) (i) In the short run , a firm will continue to operate at a loss, provided
that variable costs are covered. From the table , the total variable cost
of each flight is £10 000 fuel charges , £500 landing charges and £5000
labour costs, making a total of £15 500. Assuming that all 300 seats
are sold at £15 500 +- 300 = £51.67, then the operating loss is less
than the total of fixed costs which would have to be met if the flight
were cancelled. To avoid making a loss, all costs must be met. From
the table, the total cost of each flight is £22 000. Dividing by seating
capacity gives loss-avoiding price of £73.34.
(ii) A price of £73.34 would be sufficient to cover the costs specified in
the table . However, this price may not be sufficient to reward the
owners for the risk and responsibility of running the airline. Normal
profit is considered to be a cost of production and may well have been
included in the 'other fixed costs' category. If not, the airline may
operate a 'cost-plus' pricing policy and add , say , 20% onto costs
(£14.67) , giving a flight price of £88.01.
It is also highly unlikely that the airline will be able to sell all 300
seats for every flight. The minimum price which must be charged is
average cost +- average seating. For example , assume that 250 seats
on average are sold for each flight. Minimum price becomes
£22 000 +- 250 = £88.
(c) Airline flights are subject to international agreements between countries.
These agreements are highly restrictive, and can specify the number of
flights each week, the timing of flights and the prices which can be
charged. Hence, the market for international flights is highly imperfect
and essentially oligopolistic in nature. Evidence suggests that even where
more than one transatlantic airline flies between two cities , companies
operate as a cartel with price fixed above the likely market price. With
each airline charging the same price , non-price competition and branding
is used to differentiate products.
The actual price charged , then , is likely to be affected by the cost
structure of each flight; the number of seats sold on average ; and the
degree of competition between airlines on the transatlantic route.

5.3 Objective Questions

Example 5.2

The addition to total output from the use of an extra unit of one factor is:
A marginal cost B marginal product C average cost
D average product E marginal product of labour

Example 5.3

In the following diagram, MP shows the marginal product of labour and AP shows the
average product of labour, at each level of output. The law of diminishing returns
begins to operate beyond output level:
ABC D E

70
 Output

AP

IIL-_---'_ _--L.._ _- I -_ _...J-. Labour

A B C D E

Examples 5.4-5.7 refer to the following table. Each question has a response A,
B, C, D and E. Each letter may be used once, more than once or not at all.
The table shows the weekly output of a perfectly competitive firm .
Average revenue is £5.

Output (tonnes) o 10 20 30 40
Total cost (£) 120 180 200 210 225

A 0 B 10 C 20 D 30 E 40
From the alternatives A-E above, select that which shows:

Example 5.4

The level of output where average cost is highest.

Example 5.5

The level of output where marginal cost is lowest.

Example 5.6

The level of output where average variable costs are £4.

Example 5.7

The level of output produced by the firm.

Example 5.8
The diagram shows short-run per-unit cost curves for a firm:

ATC
AVC

L..- --L. O

71
 Total fixed cost is given by:
A A-B B A-C C (A - B) X QI
D (B - c) X QI E (A - C) X QI

Example 5.9

The short-run total costs (TC) of an imperfectly competitive firm are given by the
equation TC := £3000 + 5Q2, where Q is the level of output. The fixed costs of the
firm are :
A 0 B 5Q2 C £3000
D £3000 X Q2 E £3000 + 5Q 2

Example 5.10

If a firm 's average variable cost curve is U-shaped, then, as output increases from
zero, marginal cost must:
A always increase
B always decrease
C be constant
D initially decrease and then increase
E initially increase and then decrease

Example 5.11

The diagram shows the total cost curve of a firm. It follows from the diagram that , as
the level of output increases, marginal cost must:

Costs (£) TC

"'"-- - - - - - - - - - - Output (0)

A always increase
B always decrease
C remain constant
D initially decrease and then increase
E initially increase and then decrease

Example 5.12

The long-run average cost curve of a firm:

A is tangential to the lowest points of short-run average cost curves
B decreases continuously because of increasing returns to scale
C shifts upwards following the opening of a local motorway
D shows the unit cost of operating a given size of plant
E shows the unit cost of operating different plant

72
 Example 5.13

A firm increases the amount of labour, raw materials and capital used in production
by 25% . If output increases by 15%, the firm is subject to :
A the law of diminishing returns
B decreasing returns to capital
C decreasing returns to labour
D diseconomies of scale
E decreasing marginal efficiency of capital

Example 5.14

Horizontal integration occurs when a car manufacturer:

A merges with a second car manufacturer
B buys a chain of garages
C merges with a steel firm
D merges its accounts and sales departments
E sells part of the company to a competitor

Select your answers to Examples 5.15-5.17 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 5.15

Theory of the firm usually assumes that in the short run :

1 at least one factor is fixed
2 firms eventually experience diminishing returns
3 firms are perfectly competitive

Example 5.16

In the short run, the variable cost of producing one extra unit is £220. Therefore:
1 marginal cost is £220
2 marginal fixed costs are zero
3 marginal variable costs are £220

Example 5.17

An oil company acquires a chain of petrol stations. This is an example of :

1 external growth
2 forward vertical integration
3 a holding company

5.4 Essays

Example 5.18

Explain the determination of the firm 's average cost curve in (a) the short run and (b)
the long run .
(AEB Nov . 1985)

73
 • The question tests your understanding of returns and returns to scale.
• Make good use of accurate graphs.
• Use examples to develop important points.

Solution 5.18

A firm is that unit which organises the production of goods and services .
Traditional neoclassical theory assumes that firms use only two factors to
produce output: labour and capital. Furthermore , it assumes that firms can only
increase output in the short run by adding extra units of labour to a fixed number
of machines.
Marginal cost (MC) refers to the cost of producing an extra unit . Extra units
are manufactured by employing additional workers. Assume that each worker
receives the same wage . Initially, each extra worker is able to produce more than
the previous worker, because, at first, marginal workers have easy access to a
fixed number of machines and the division of labour principle can be applied .
Since the firm is initially obtaining an increasing return for a constant outlay on
wages, marginal costs are falling and the MC curve in Figure 1 slopes down-
wards . Beyond Ql> the law of diminishing returns operates and the firm receives
back a decreasing return for a constant outlay on wages. Workers experience
delayed access to machines and the opportunities for the division of labour have
been fully exploited.

Costs
MC
SAC

0,

Figure 1

Average cost is the unit cost of producing a given level of output. The shape of
the short-run average cost curve (SAC) in Figure 1 depends critically on the
behaviour of marginal costs. SAC slopes downwards up to Q2 because marginal
cost is less than unit cost . Beyond Q2, marginal cost exceeds average cost and the
SAC curve begins to rise.
It has been established that the shape of the short-run average cost curve is
determined by the shape of the marginal cost curve, which, in turn, is
determined by the law of diminishing returns . The type of return experienced
depends on the degree of access workers have to machines and on the scope for
the division of labour.
In the short run, the firm is constrained to its current SAC curve . In the long
run, the firm can increase plant (production unit) size and move to a new SAC
curve. Increasing the amount of capital employed shifts the SAC curve to the
right. The type of scale economy then experienced determines whether or not
the new SAC curve also shifts upwards or downwards . SAC shifts downwards if
the firm experiences economies of scale (Figure 2), upwards if diseconomies of
scale begin to come into effect (Figure 3) and horizontally given constant scale
economies (Figure 4).

74
Cost Cost Cost

SAC,

V
LAC,
'--------- 0 '--------- 0 '---------0
Figure 2 Figure 3 Figure 4

A long-run average cost curve (LAC) is the envelope of the firm's SAC
curves. The shape of the LAC curve is determined by the type of internal scale
economies experienced by the firm.
For example, the manufacture of cars offers significant potential technical
economies of scale . Highly automated production lines populated with robot
arms reduce LAC. As more cars are produced , the firm 's greater requirement
for raw materials such as steel allows it to negotiate substantial discounts with
suppliers. Initially, the LAC curve of a car manufacturer slopes downwards as in
Figure 2. However, beyond a certain level of output , LAC begins to rise as in
Figure 3. Management becomes more difficult when the activities of the firm
become more complex. Additional strata of middle managers (e .g. foremen)
increase wages with no corresponding increase in output. Productivity may fall if
workers feel alienated by impersonal mass production techniques.
In conclusion , it has been demonstrated that the firm's average cost curve is
determined by the type of return experienced in the short run and the type of
scale economy enjoyed in the long run.

Example 5.19

'Large firms have such overwhelming technical and financial advantages that the
survival of the small business is surprising. ' Discuss.
(SUJB 1986)

• The question tests your understanding of technical and financial economies

of scale open to large firms.
• Describe the circumstances in which small firms thrive .
• Where possible, use real-world examples.

Solution 5.19

It is important to distinguish between large and small firms. The Bolton

Committee Report (1971) suggests that small businesses are firms managed by
the owner(s) and with a relatively small share of the market. Small manufactur-
ing firms employ fewer than 200 people. Large firms are typically incorporated
(limited companies) , where ownership and management are separated. Large
companies which exploit economies of scale enjoy a cost advantage over small
firms in the same industry. In particular, large firms have access to the following
technical and financial economies.
Technical economies occur in the production of a good. As the firm expands,
there is greater scope for specialisation and the division of labour. For example,
large factories can employ specialist skilled workers to do the same job all day
with no time lost in changing tools or doing unfamiliar tasks. The indivisibility of
certain types of capital means that many production processes including chern-

75
 icals are impossible on a small scale. Mass production allows large firms to keep
specialist capital fully utilised . Large firms can benefit by linking production
processes that would otherwise be carried out in separate factories. For example,
a large shift manufacturer can reduce transport costs by combining the weaving
and cutting of cotton under the same roof. Economies of increased dimensions
mean that doubling the size of the machine results in more than double an
increase in output. The principle of multiples suggests that large firms can avoid
the bottlenecks that occur when machines operate at different speeds, by
installing a ratio of machines which keeps each fully utilised.
Financial economies allow large enterprises to raise capital on advantageous
terms. Large firms are considered to be reliable and are therefore charged a low
rate of interest. In particular, large firms have access to capital markets such as
the Stock Exchange . Selling shares is a relatively inexpensive method of raising
large sums of capital.
Despite the cost advantage to large firms of producing in bulk, small
businesses continue to survive for a variety of reasons . Limited opportunities for
economies of scale allow them to find niches in providing specialised products for
small markets . For instance , in design where the product is specialised, is
non-uniform and cannot be manufactured in bulk. Service industries such as
hairdressing cannot easily achieve a large scale of operation, and therefore tend
to be dominated by small firms . An irregular or limited demand for a product
prevents mass production .
Small firms have the flexibility and low overheads needed to undertake
'one-off' projects - e .g. building construction. Often small firms survive by
accepting subcontracted work from large companies. In industries such as
printing, where fixed costs form only a small percentage of total costs, low set-up
costs encourage the development of small firms . Where the market for a good is
restricted and highly localised, small firms survive . For example, village shops.
In an attempt to stimulate the supply side of the economy, the government has
introduced a number of schemes which help the survival of the small firm . For
instance, the Enterprise Allowance pays a weekly sum to the unemployed while
they are setting up their own firm. The Business Expansion Scheme gives relief
against income tax to investors in unquoted companies.

5.5 Solutions to Objective Questions

Solution 5.2 Answer: B

Marginal product refers to the addition to total product following the employ-
ment of an extra unit of a variable factor.
E ~ Economists usually assume that capital is the fixed factor while labour is
variable . However, since there is no reason why labour could not be the fixed
factor instead of capital, option E is incorrect.

Solution 5.3 Answer: C

Unless otherwise stated , the law of diminishing returns refers to diminishing

marginal returns. In the diagram the apex (top) of the marginal product curve
shows the point of diminishing returns and this corresponds to output level C.
Output beyond this point results in diminishing returns.

76
 Solutions 5.4-5.7 make use of the following table.

Output (tonnes) 0 10 20 30 40
Total cost (l) 120 180 200 210 225
A verage cost 18 10 7 5.6
Marginal cost 6 2 1 1.5
Abnormal loss -120 -130 -100 -60 -25

Solution 5.4 Answer: B

Dividing total cost by each level of output gives average cost. From the table,
average cost is highest at output level 10.
A =;> Note that there are no average costs involved in producing zero output.

Solution 5.5 Answer: D

Marginal cost is calculated by dividing the change in total cost involved in

increasing output by the resulting change in output. For instance, the marginal
cost of the thirtieth unit is the cost of making 30 tonnes (£210), less the cost of
making 20 tonnes (£200), i.e. £10, divided by the increase in output of 10 tonnes
(30 - 20). Marginal cost here is £1.

Solution 5.6 Answer: C

Fixed costs have to be paid out by the firm even if it produces zero output. There
are no variable costs involved in producing nothing. However, the table indicates
that the total cost of zero production is £120. Therefore, the firm's fixed costs
must be £120.
Total cost minus fixed cost gives variable cost. The variable cost of producing
20 tonnes is £200 - £120 = £80.
Variable cost divided by the level of output gives average variable cost. The
average variable cost of producing 20 tonnes is £80/20 = £4.

Solution 5.7 Answer: E

Figures 6.3 and 6.4 show how loss-making firms decide whether or not to carry
on production . Multiplying each output level by average revenue (£5) gives total
revenue. The abnormal loss column is found by subtracting total cost from total
revenue, at each level of output.
A =;> The loss of £25 from producing 40 tonnes is less than the fixed costs of
£120 which would have had to be met even if the firm stopped production
altogether.

Solution 5.8 Answer: -D

Total fixed cost is found by multiplying average fixed cost by the level of output
(Ql)' Average fixed cost is the difference between average total cost and average
variable cost (B - C).

77
 Solution 5.9 Answer: C

The equation TC = £3000 X 5Q2 means 'total cost is found by multiplying a

fixed sum of £3000 by 5 times the particular level of output, squared'. Fixed costs
are £3000. Variable costs are 5 times the particular level of output, squared.

Solution 5.10 Answer: D

Fixed costs are not affected by changes in output. Therefore , marginal cost (MC)
determines changes in variable costs. Figure 5.2 shows a U-shaped average
variable cost (AVC) curve. Note that the AVC curve slopes downwards,
provided that MC is less than AVC. The MC curve intersects AVC at its lowest
point. Once MC is above AVC , the AVC curve begins to rise.

Solution 5.11 Answer: C

A linear total cost curve means the cost of making each extra unit , marginal cost,
remains the same .

Solution 5.12 Answer: E

LAC

Other options are incorrect because:

A ~ while the long-run average cost (LAC) curve is tangential to each SAC, the
point of tangency does not always occur at the lowest point of each SAC curve
(for example, on SACs, A is the lowest point on the curve but B is the point of
tangency);
B ~ the LAC curve of some firms slopes upwards because of decreasing returns
to scale;
C ~ is an external economy of scale which would shift the LAC upwards;
D ~ each individual SAC shows the unit cost of operating a given size of plant.

Solution 5.13 Answer: D

Returns to scale compares the percentage change in all factors with the resulting
change in output. Since a 25% increase in production results in a smaller
percentage increase of only 15%, the firm is experiencing decreasing returns to
scale. Decreasing returns to scale are the result of diseconomies of scale.
A ~ The law of diminishing returns is a short-run concept where only one
factor is varied, usually labour. The question specifies changes in more than one
factor.

78
Solution 5.14 Answer: A

Horizontal integration occurs when two firms at the same stage of production
merge . Other options are incorrect because:
Band C ~ are examples of vertical integration ;
D ~ is an example of management reorganisation ;
E ~ has nothing to do with integration .

Solution 5.15 Answer: B

Option 3 is incorrect because theory of the firm considers several types of

market structure apart from perfect competition.

Solution 5.16 Answer: A

There are no fixed costs involved in increasing output. Therefore, in the short
run, marginal cost and marginal variable costs are identical.

Solution 5.17 Answer: B

1 ~ External growth occurs when a firm becomes larger through merger or

takeover.
3 ~ A holding company owns a subsidiary. Holding companies are not a
necessary consequence of vertical integration.

79
 6 Markets
6.1 Fact Sheet

(a) Market Structure

• A market exists where buyers and sellers negotiate the exchange of a

product.
• An industry is made up of firms producing similar products.
• Market structure refers to the number and type of firms in a particular
industry .
• Concentration ratios measure the proportion of an industry's output or
employment accounted for by, say, the five largest firms.

Table 6.1 Market structure

Market structure No. of firms Substitutes Price Barriers Abnormal profit

Taker! to entry (-IT)
Maker

Perfect competition Many small Many perfect Taker None Only in the
short run
Monopolistic Many small Many close Maker None Only in the
competition short run
Oligopoly Several large Few Maker Some Possible in the
long run
Pure monopoly One large None Maker Complete Possible in the
long run

(b) Revenue

• The money received from the sale of output is called revenue.

Table 6.2 Types of revenue

Term Symbol Definition Equation

Total revenue TR The income received from the sale TR = AR X Q

of a given output
Average revenue AR The amount received from the sale AR =TR Q
of each unit
Marginal revenue MR The amount received from selling MR = ATR -+- AQ
one extra unit

80
(c) Profit

Table 6.3 Types of profit

Term Symbol Definition TR - TC is

Normal profit 'IT=O The minimum amount of profit the firm Zero
must receive to carryon producing (i.e.
transfer income)
Abnormal profit 'IT Profits exceed the amount the firm must Positive
receive to carryon producing (i.e. economic
rent)
Abnormal loss -'IT Profits are below the amount the firm must Negative
receive to carryon producing (i.e.
subnormal profit)

• Accountancy and economic definitions of profit are different.

• Economists regard normal profit as a cost of production.
• Revenue minus production costs equals abnormal profit (1T) :
1T = TR - TC = (AR - AC) X Q
• Neoclassical theory assumes that firms aim to maximise profits . However,
where ownership and control of a company are in separate hands , managers
may have a different aim, such as sales maximisation.

(d) Perfect Competition

• A perfectly competitive industry is made up of a large number of small firms,

each selling homogeneous (identical) products to a large number of buyers .
• No individual customer receives preferential treatment.
• Each firm is a price taker; therefore, MR = P.
• There are no barriers to entry .
• Consumers and producers have perfect market knowledge .
• The profit-maximising level of output occurs where marginal cost (MC) rises
to equal marginal revenue (MR) - i.e. where MR = Me.

In Figure 6.1 , the representative firm has to decide whether or not to produce
extra units. The firm compares the cost of the marginal unit (i.e. MC) with the
revenue received from its sale (i.e. MR) . An extra unit is only worth producing if
MR exceeds Me. Since MC includes an amount of normal profit, the firm
maximises its profits by increasing production up to and including Qt .

p p
Industry A typical firm

0, o (m i llions) 0, o (tens)

Figure 6.1 Profit maximisation in perfect competition

81
 (e) Supply Curves in Perfect Competition

In Figure 6.2, an increase in demand raises market price to P2 • In the short run ,
the firm earns an abnormal profit of (P 2 - P3 ) X Q2. In the long run, the entry
of new firms increases supply and the supply curve shifts to the right. Assuming
constant scale economies, price falls back to PI> where normal profits are
restored.

p Industry p A typical firm

MC

0, = AR, = MR,

o (millions) 0, o (tens)
Figure 6.2 Long-run supply curve of a perfectly competitive firm

• The MC curve shows combinations of price and quantity supplied by a firm.

Therefore, the MC curve is the supply curve of the firm.
• The addition of each firm's MC curve gives the industry's short-run supply
curve.
• The long-run supply curve (LS) shows the amount of a good supplied by the
industry at different prices, allowing the number of firms and size of plant to
vary.

(0 Abnormal Losses in Perfect Competition

£ TC

TR,

-=:;...--------------'-------0
Figure 6.3 Revenue covers variable costs: losses are minimised by carrying on production
because total revenue covers all variable costs and some (Be) of the fixed costs

82
 £ TC

1oII!::. -L. 0

Figure 6.4 Variable costs exceed revenue : losses are minimised by ceasing production because
total revenue fails to cover any variable costs and none of the fixed costs

• A loss-making firm carries on production in the short run, provided that

variable costs are met.
• In the long run, some firms making abnormal losses leave the industry,
supply decreases and price rises. The total revenue curve in Figures 6.3 and
6.4 would shift upwards until normal profits are restored.

(g) Imperfect Competition

• An imperfectly competitive industry is made up of a firm or firms selling a

differentiated (non-identical) product.
• The most extreme form of imperfect competition is pure monopoly.
• Monopolists are price makers and can set price or output for their own
product.
• The more price-inelastic the firm's demand curve the greater its market
power.

c.

D= AR
a
£

1<-- ---''-- ----30'--_ _ 0

01

Figure 6.5 Revenue curves and price elasticity of demand (PoEoD o)

83
 • The MR curve bisects the origin and the AR curve.
• To sell more output, the firm has to reduce price on the extra unit and all
preceding units. Therefore, MR is always less than price .
• Up to Q], MR is positive, TR is rising and P.E.D is elastic.
• Beyond Q], MR is negative, TR is falling and P.E.D is inelastic.
• At A, P.E.D is unitary.
• Total revenue is maximised at QI'

(h) Profit Maximisation in Imperfect Competition

• Monopolists do not automatically earn abnormal profits.

• The ability of monopolists to exclude competition allows them to earn
abnormal profits in the long run.
• The intersection of the MC and MR curves give the profit-maximising level
of output.
• In Figure 6.6, abnormal profits equals the area (PI - P z) X Q!.
• In Figure 6.7, normal profits only are being earned.

p p

'-------'--~-------""-----Q
'---------:---~---------'''''-----Q

Figure 6.6 Abnormal profits in imperfect competition Figure 6.7 Normal profit in imperfect competition

(i) Alternative Pricing Strategies

(i) Cost-plus pricing occurs when a firm adds a given percentage mark-up to
average cost. A loss can be made if sales fall short of estimates.
(ii) Price discrimination occurs when the same product is sold in different
markets for different prices. A discriminating monopoly is only able to
practise price discrimination if it:
(1) has some monopoly power and is able to exclude competitors;
(2) is able to prevent the resale of the product;
(3) has markets with different price elasticity of demand for the product.
The monopolist adds together MR], from market A and MR z from
market B to find the MR curve for both markets (MR I + MR z). Output
is fixed where the MR I + MRz curve intersects the MC curve at QI' Qt is
then divided between the two markets by setting output where
MC = MR in each market. Note that QA + QB = Qt. Price is P, in
market A and ' P z in market B. Price is higher in the market where
demand is less elastic.
(iii) Market penetration pricing occurs when a firm reduces price to increase
market share (the percentage of an industry's sales accounted for by one
firm).

84
 P P P

P,

Market A Market B Market A + market B

Figure 6.8 Price discrimination in two markets

(iv) Limit pricing occurs when a firm sets price just low enough to discourage
possible new entrants.
(v) Predatory pricing occurs when a firm reduces price in the short run so as
to force competitors out of the industry .
(vi) Skimming pricing occurs when a firm charges a high initial price where
some consumers are prepared to pay more for a new product. Eventually
price is lowered to extend demand .

(j) Non-price Competition

Oligopolies tend to avoid price competition because competitors will match any
price cuts. Firms wishing to increase sales are more likely to use non-price
competition such as:
(i) Advertising, where firms promote information about the company or a
product. Advertising aims to:
(1) increase demand for a product;
(2) improve brand image and encourage consumer loyalty, thereby
making demand more price-inelastic;
(3) create separate markets for the same product so that price discrimina-
tion can take place - e .g. soap powders.
(ii) Organising promotion campaigns (e.g. free offers).
(iii) Providing improved after-sales service.

6.2 Data Response

Worked Example 6.1

A publishing firm has decided to publish a new hard-cover Economics textbook . The
publisher incurs substantial fixed costs in the form of editing, type setting, proof
reading and advertising. After these initial expenses there is additionally the costs of
paper, printing, binding, etc ., such costs being a constant amount per book produced.
The author of the book negotiates a contract with the publishing firm whereby he is
paid a percentage of the publisher's gross profits from the sale of the book. The
publisher has exclusive rights to publish the book as enforced through copyright law.
The relevant average revenue and marginal revenue curves as estimated by the
publisher are indicated in the diagram on the next page.

85
 Price per
copy (f)
20

1..- ----"'-- ......... • Number of copies (0005)

o 2

(a) Why are the average revenue and marginal revenue curves downward-sloping as
indicated in the diagram?
(4 marks)
(b) Reproduce the diagram and draw in the general form of the publisher's marg inal
cost curve , average fixed cost curve and average total cost curve .
(4 marks)
(c) With reference to your diagram , explain in general terms the price the publisher
will set for the book if he seeks to maximise profits.
(4 marks)
(d) Suppose the publisher is considering increasing his expenditure on advertising the
book by a certain amount. Would this necessarily increase his profits?
(4 marks)
(e) Suppose that instead of a profit-sharing agreement the author had negotiated to
receive royalty payments calculated as a percentage of the publisher's sales
revenue. Explain why in this case there is likely to be a conflict of interest between
the publisher, who is seeking to maximise profits, and the author as to the
appropriate price for the book.
(5 marks)
(f) Why might it be profitable for the publisher, after a lapse of time, to publish a
paperback edition at a lower price?
(4 marks)
(WJEC 1987)

Solution 6.1

(a) The average revenue curve is the consumers' demand curve for the book.
The downward-sloping curve indicates that consumers are prepared to
buy more copies of the book as price falls because of the substitution
effect (the book is now relatively cheaper than substitutes) and the income
effect (consumers can now afford to buy more copies of the text).
The marginal revenue curve slopes downwards because the publisher is
a price maker. In order to sell more copies , price must fall not only for
extra copies sold, but also on all preceding books. Hence, marginal
revenue is always less than price.

86
 (b)

Pr ice per
copy (£)
20

o ' - - - - - - ' - - - - 1 - -_ _....:...._---''''--_---1_ Number of copies (ODDs)

2

(c) The publisher will continue to print books up to the point where the cost
of the extra unit (Me) equals revenue from the sale of the extra text
(MR). This suggests a price of £15. (Note that the actual price charged
depends on where the candidate draws the actual Me curve .)
(d) Advertising would increase cost of production and so diminish profits.
However, successful advertising would increase demand and shift the
dem and curve to the right. thereby increasing sales . Hence, profits only
increase if the net revenue from extra sales more than pays for the cost of
the initial advertising.
(e) The profit-maximising publisher would set output where Me = MR and
charge the corresponding price. In the diagram this is £15. However, the
point of sales revenue maximisation occurs where MR intersects the
x-axis , at 1000 copies. Up to this point, marginal revenue has been
positive and revenue has increased with sales . The author would want to
increase sales to 1000 by reducing price to £10.
(f) Publishing a paperback edit ion creates a second market for the same good
and allows the publisher to act as a discriminating monopolist. The price
elasticity of demand for the paperback edition is more elastic . However,
by equalising the marginal revenue generated by each edition, the
publisher earns a higher level of profit than would be the case if uniform
prices were charged.

6.3 Objective Questions

Example 6.2

Which of the following is the most likely characteristic of a perfectly competitive

industry?
A some firms offer discounts to important customers
B firms are price takers
C price competition between firms
D some differentiation of products
E the presence of barriers to entry

87
 Example 6.3

One difference between a firm operating in a perfectly competitive market and one
operating in a monopolistically competitive market is that, for the latter only:
A all firms produce an identical product
B some producers have imperfect market knowledge
C average revenue equals price
D the number of producers is small
E some producers advertise

Example 6.4

A tailor charges £100 per suit up to and including the fifth suit made. If more than 5
suits are ordered, the price charged for all suits falls to £80 per suit. What will be the
marginal revenue to the tailor for the sixth suit?
A £100 B £80 C £0 D -£20 E -£80

Example 6.5

The diagram shows a marginal revenue curve (MR). From the diagram it can be seen
that as output increases from 0 to Q, total revenue is:
A increasing B decreasing C at a maximum
D at a minimum E zero

01

Example 6.6

The following table shows the cost and revenue conditions facing a firm . At what level
of output would the firm be making maximum profit?

Weekly output Total cost Total revenue

A 1 £60 £24
B 2 £110 £56
C 3 £150 £94
D 4 £180 £154
E 5 £200 £274

88
 Examples 6.7-6.11 are based on the diagram below, which shows the total
revenue (TR) and total cost (TC) curves of a firm.

TR

R
011:...---:-----:1........------..1------1.-----__ 0
0,

Which level of output A0 B OQl C OQz D OQ3 E OQ4 shows:

Example 6.7

Where profits are maximised?

Example 6.8

Where break-even occurs?

Example 6.9

Where losses are maximised?

Example 6.10

The firm 's fixed costs :

A are equal to OR B are equal to WS C are equal to XT
D are equal to YU E cannot be calculated from the diagram

Example 6.11

Which market form is implied by the diagram?

A perfect competition B monopolistic competition
C oligopoly D monopsony
E monopoly

89
 Examples 6.12-6.14 are based on the diagram below, which shows the cost
curves of a perfectly competitive firm .

Cost and
price

ATC
AVC
E

~---_AFC

Output

For each of Examples 6.12-6.14, select from the prices A to E:

Example 6.12

The price which gives the firm the largest amount of profit.

Example 6.13

The price at which the firm will earn normal profits.

Example 6.14

The price below which the firm will cease production in the short run .

Examples 6.15-6.17 are based on the following diagram, which illustrates the
cost and revenue situation of a firm.

Price and cost

per unit

T t----T-----'~...:.

Sr--~~~~
R f--- - ---K

AR
o y Output

A ORXY B RSWX C STVW D UTV E OTVY

For each of Examples 6.15-6.17, select the appropriate area which shows:

90
Example 6.15

Abnormal profit.

Example 6.16

Consumer surplus.

Example 6.17

Total revenue .

Example 6.18

A profit maximising monopolist will increase output if:

A marginal revenue is less than marginal cost
B marginal revenue is positive
C average costs fall
D advertising costs rise
E a profits tax is imposed

Example 6.19

A firm will continue production in the short term, provided that revenue covers:
A indirect cost B total cost C average cost
D fixed cost E variable cost

Example 6.20

Which of the following is a necessary condition for a monopolist to practise price

discrimination?
A different cost structures in each market
B different price elasticities of demand in each market
C consumers can buy in one market and resell in another
D consumers can choose which market to buy in
E consumers in each market have perfect market knowledge

Select your answers to Examples 6.21-6.23 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 6.21

In the long run, for each firm under conditions of perfect competition price equals:
1 average revenue 2 marginal revenue 3 marginal cost

91
 Example 6.22

Oligopolistic industries are usually characterised by:

1 price stability 2 non-price competition 3 price takers

Example 6.23

For a profit-maximising monopolist earning normal profit , price is equal to :

1 marginal revenue 2 average revenue 3 average cost

6.4 Essays

Example 6.24

Why are a firm's profits maximised when marginal cost equals marginal revenue? In
what circumstances might a firm use criteria other than profit maximisation for
determining the price of its products?
(AEB Nov. 1986)

• Demonstrate profit maximisation , assummg either perfect or imperfect

competition .
• The second part of the question asks you why firms use non-profit
maximising pricing strategies.

Solution 6.24

There are two types of profit in economics. Normal profit is the return sufficient
to keep the firm in the industry. Normal profit is seen as a cost of production and
is therefore included in the firm 's cost curves . Any return above normal profit is
called abnormal profit.

Price

'--_ _- ' - _ - ' - _ ' - ' . - - AR _

---::!lo.....-_ Output

The diagram shows the short-run unit cost and revenue curves of an
imperfectly competitive firm. Assume that the firm can produce any level of
output between 0 and Qmax' The marginal cost curve, Me, tells the firm the cost
of making the extra unit. The marginal revenue curve, MR, tells the firm the

92
revenue received from the sale of the extra unit. At Qb the difference between
MR and Me (1 - K) is greatest. However, there is an incentive for the
profit-maximising firm to increase output beyond this point. The revenue
received from the sale of every additional unit up to Q2 is greater than the cost of
making that extra unit. Any firm which fixed output at Q! would be forgoing a
profit on each of Q2 - Q!. A normal profit is made on the sale of the Q2 unit.
Above output level Q2' a loss is made on the sale of each extra unit, because
marginal cost exceeds marginal revenue . For example , at Q3 a loss of L - Mis
made on the sale of that unit alone. Profits are therefore maximised when
marginal cost equals marginal revenue .
Economic theory assumes that individuals and firms are 'rational', acting in a
manner which maximises their own satisfaction . In the case of the firm, the
maximisation of profits guarantees the largest possible income for the owners of
a company. A profit-maximising pricing policy is likely to be used by sole traders
and partnerships.
However, the emergence of limited companies means that ownership and
control of the most important firms are now separated. In general , shareholders
expect the firm to maximise profits and therefore set output where marginal cost
equals marginal revenue. Managers may have different objectives.
New 'managerial' theories of the firm suggest that companies use pricing
criteria which improve the welfare of managers . For example, salaries and
'fringe benefits' are more likely to be linked to sales than to profits . Bonuses may
be paid for achieving sales targets . It follows that manager-controlled firms will
try to maximise sales revenue rather than profit and fix output where average
cost equals average revenue .
Managers may decide that setting a price which maximises the firm's rate of
growth is in their own best interest. An expanding company increases managers'
salary and status. Moreover , the resulting increase in the value of the company's
shares is in the interest of the owners .
Large businesses are highly complex, with different departments responsible
for specialised functions such as production, sales and finance. Each department
has a different objective, so that the maximisation of one goal, profits, is
inappropriate. Instead, satisficing occurs where each department is set minimum
acceptable levels of performance - for example, asking the sales department to
achieve a given market share .
The firm may feel that the cost of collecting information about marginal cost
and revenue is too high and therefore managers use a cost-plus pricing strategy.
The firm fixes output and then estimates unit cost. Adding a profit margin to
average cost gives the final selling price.
Nationalised industries aim to operate in the public interest. Profit maximisa-
tion results in an inefficient allocation of resources . Instead, state-owned firms
adopt a marginal cost pricing strategy and increase output to the point where ,
including externalities, marginal cost equals price .

Example 6.25

Explain the differences between oligopoly and monopolistic competition. Why do

some firms tend towards oligopoly and some towards monopolistic competition?
(NISEC 1987)

Solution 6.25

Monopolistic competition and oligopoly are types of market structure and differ
in the following respects .

93
 (a) Type of product Monopolistically competinve firms produce a good
which is only slightly different from that of all other sellers. Buyers can therefore
tell the difference between the output of different firms. The output of
oligopolies can be homogeneous (identical) or differentiated.
(b) Number and size of sellers In monopolistic competition , there are a large
number of small producers selling to a large number of bu yers. In oligopolistic
industries , there are a small number of large producers also selling to a large
number of buyers.
(c) Barriers to entry In monopolistic competition, new firms are free to start
up in the industry. In oligopoly industries , entry is more restricted.
(d) Interdependence The large number of firms in monopolistic competition
means that the actions of one firm have little effect on competitors. In oligopoly,
there are only a few sellers and the actions of one firm have a significant effect on
competitors.
(e) Price and output decisions The independence of monopolistically com-
petitive firms means that pricing policy is influenced only by cost and revenue
considerations. Interdependence means that oligopoly pricing strategies take
into account the likely response of other firms. For instance, the Sweezey model
argues that if an oligopolistic firm increases its price , other firms will not raise
theirs and customers are lost. Reducing price has no effect on market share ,
because other firms will follow suit. Oligopolies therefore exhibit price rigidity.
(f) Profits Figure 1 shows a representative firm in monopolistic competition.
Abnormal profits attract new firms into the industry, reducing market share and
thereby reducing demand for the individual firm. In Figure 2, the demand curve
shifts to the left until price equals average cost. Monopolistically competitive
firms only earn normal profits in the long run. The ability of oligopolies to
exclude competition allows them to continue earning abnormal profits in the
long run.

Me

MRI

01
Figure 1 Figure 2

There are two main reasons why some firms are oligopolies and some are in
monopolistic competition.
Economies of scale (EOS) influence market structure . Where EOS are
available , those firms which are able to increase their plant size acquire a cost
advantage over smaller competitors. Small firms are uncompetitive, and the
industry becomes oligopolistic or monopolistic. In industries offering no scope
for scale economies, firms are unable to reduce unit costs by increasing their size.
Such industries tend to be monopolistically or perfectly competitive.
Brand image influences market structure. Industries where the consumer can
be convinced that the products of a few large companies are superior to the
output of smaller firms will tend to be oligopolistic. Advertising is used to
increase demand , and to create the impression of differences between the firm's

94
 product and those of its competitors. Consequently, UK advertising is domi-
nated by oligopolies trying to increase consumer loyalty to their product.
Industries where the consumer cannot be easily persuaded that the output of one
firm is distinctly different from the product of others will tend to be monopol-
istically competitive.

6.5 Solutions to Objective Questions

Solution 6.2 Answer: B

A price taker is a firm which is unable to change market price by varying its own
output. For instance, if a small perfectly competitive firm were to ask more for
its produce than the current market price, consumers would buy a perfect
substitute from a competitor. Since the firm is able to sell all its output at the
going market price, there is no reason why it should sell any of its output for less .
A ~ In perfect competition , no one buyer is sufficiently large to be able to
negotiate a discount on purchases.
C ~ The firm can sell all its output at the equilibrium market price and does
not need to cut its prices to increase market share .
D ~ Differentiated products means that consumers are able to tell the
difference between the output of one firm and another. A condition of perfect
competition is that the produce of each firm is identical.
E ~ A condition of perfect competition is that firms are free to leave or enter
the industry at will.

Solution 6.3 Answer: E

Unlike a firm in perfect competition, monopolistically competitive firms produce

a slightly different product from others in the industry. Therefore, firms benefit
from advertising because: (i) it increases demand for the product and (ii) it
improves the brand image of the good so that demand becomes more price-
inelastic.
B ~ The amount of information which firms have about the market does not
explain the difference between perfect and monopolistic competition.
C ~ Average revenue equals price in all market structures.
D ~ There are a large number of producers in both perfect and monopolistic
competition .

Solution 6.4 Answer: D

The marginal revenue (MR) of the sixth suit is found by dividing the change in
(d) total revenue (TR) by the change in output (Q) - that is, MR = dTR
-;- dQ. Total revenue is calculated by multiplying price (P) by output - that is,
TR = P x Q.

TR from the sale of 5 units = £100 x 5 = £500

TR from the sale of 6 units = £ 80 x 6 = £480
:. MR = (£500 - £480) -;- (5 - 6) = -£20

95
 Solution 6.5 Answer: A

The relationship between total revenue and marginal revenue is explained in

Figure 6.5 . Since QI is to the left of the point where the marginal revenue curve
intersects the x-axis, total revenue is rising.

Solution 6.6 Answer: E

The firm will maximise profits by fixing output at the level where the difference
between total revenue and total cost is greatest and positive - i.e. at output
levelS.

Weekly output Total cost Total revenue Profit

A 1 £60 £24 -£36

B 2 £110 £56 -£54
C 3 £150 £94 £56
D 4 £180 £154 £26
E 5 £200 £274 £74

Solution 6.7 Answer: E

Profits will be maximised at the output level where the vertical distance between
the total revenue and total cost curves is greatest and positive.
D :::} By producing Q3' the firm is making a profit of XT but this is not as much
as the profit of YU gained from producing Q4'

Solution 6.8 Answer: C

Break-even refers to the situation where total revenue equals total cost.

Solution 6.9 Answer: B

Losses will be maximised at the output level where the vertical distance between
the total revenue and total cost curves is greatest and negative.

Solution 6.10 Answer: A

Even when output is zero , the firm still incurs fixed costs for such items as rent
and insurance. The amount of fixed costs is given by the intersection of the total
cost curve with the y-axis.

Solution 6.11 Answer: A

A linear total revenue curve implies that price remains constant as output
increases. Perfectly competitive firms are price takers and sell extra units at a
constant market price . Firms in imperfect competition are price makers and are
able to change market price. However, in order to increase output, price must be
reduced not only for the extra unit, but also on all preceding units as well.
Eventually, marginal revenue becomes negative and the total revenue curve
begins to slope downwards . See Figure 6.5 .

96
Solution 6.12 Answer: E

The answers to Examples 6.12-6.14 depend on your ability to derive revenue

curves from the information given . Remember that since the firm is in a perfectly
competitive market, marginal revenue will be constant and equal to price.
Hence, projecting a horizontal line across from a given price gives the firm's
demand (D), average revenue (AR) and marginal revenue (MR) curves at that
price. For example , at price E (assuming profit maximisation) the firm produces
QI and makes an abnormal profit equal to the shaded area in the following
diagram:

Cost and
pr ice

0,

Solution 6.13 Answer: D

Normal profits occur when average revenue equals average total cost (ATC).
Note that ATC and average cost (AC) mean the same thing. Only at price D
does ATC = AR.

Solution 6.14 Answer: C

A loss-making firm has two choices: (i) cease production and incur fixed costs;
(ii) carryon production and incur abnormal losses . At prices below C, the firm
p

G "T....,..,....' .T7 / / 7 71':

Loss from
carry ing on ---l"7~~/.
production

Loss f rom
halting
product ion .........>..>..;u..>."'-"'-'>.-"'-"-'-:- _
o 0

minimises losses by stopping production for the current time period and paying
out fixed costs . For example , at price B in the diagram, the loss the firm makes
from halting production equals AFC x Q = J X Q 2 - that is, area OBJQ2' The
abnormal loss from production (A TC - AR) x Q = (H - I) x Q2 - that is,
area FGHI .

97
 Solution 6.15 Answer: C

When using per unit cost and revenue curves, abnormal profit ('IT) is the
difference between average revenue (AR) and average cost (AC) , multiplied by
the level of output (Q) . In the diagram for Examples 6.15-6.17 , AR = V ,
AC = Wand Q = Y. (V - W) x Q equals area STVW.

Solution 6.16 Answer: D

Consumer surplus is the difference between the maximum price consumers are
willing to pay and the price actually paid.

Solution 6.17 Answer: E

Total revenue equals the price paid (T) multiplied by the quantity sold (Y).
T x Y equals area OTVY.

Solution 6.18 Answer: C

A fall in average costs causes a monopolist's average cost and marginal cost
curves to shift to the right. The diagram shows the effect of a fall in costs on
output.

Price

'----~---'----"'-------"""'---_ Quantity

Solution 6.19 Answer: E

If variable costs are covered , the abnormal loss from continuing manufacture is
less than the total of fixed costs that would have to be paid out if the firm halted
production.

Solution 6.20 Answer: B

Look up Figure 6.8. If the price elasticity of demand in each market is identical,
then the gradient of each demand curve is the same and the monopolist is unable
to charge different prices for the same product.

Solution 6.21 Answer: A

Referring back to Figure 6.2, the perfectly competitive firm and industry are in
long-run equilibrium at price Pt. At PI> price equals average revenue, marginal
revenue and marginal cost.

98
Solution 6.22 Answer: B

An oligopolistic industry is dominated by a few large firms , and where there are
some barriers to entry. For example, the car industry. The following options are
correct.
t and 2 ~ Oligopolistic firms are interdependent. For example, if one firm
reduces prices to increase market share , other firms follow, thereby undermining
the effectiveness of price competition . Hence , oligopoly industries tend to show
stable prices. Non-price competition such as special offers is used to increase
sales.
3 ~ is incorrect because oligopolies are large enough to influence the price at
which their product is sold .

Solution 6.23 Answer: C

Looking back at Figure 6.7 , the monopolist produces Ql and sells each unit for
r..
I ~ is incorrect because marginal revenue is always less than price in
imperfect competition.
2 ~ is correct because average revenue and price are always the same.
3 ~ is correct because normal profit requires that average cost and average
revenue - hence, price - are the same.

99
 7 Regional Economics
7.1 Fact Sheet
(a) Influences on Industrial Location

A profit-maximising firm expands on the location which minimises unit costs .

The firm takes account of:
(i) Natural advantages, including:
(1) an area's proximity to raw materials;
(2) the physical features of the area;
(3) the climate of an area.
(ii) Acquired advantages from other firms having located in the area . The
resulting external economies of scale are described in Table 5.4.
(iii) Government regulations and financial incentives.

• Weight-losing industries use bulky raw materials to produce a compact

finished product, and tend to locate near the major source of raw materials.
• Weight-gaining industries use compact raw materials to produce a bulky
finished product , and tend to locate near the major market for the good .
• A footloose industry gains no cost advantage from anyone site.
• Improved transport and power networks (e.g. motorways and the national
grid) have made many industries footloose .
• Industrial inertia occurs when external economies of scale cause a firm
to remain in its original location even after natural advantages have
disappeared.

(b) Localisation of Industry in the UK

Table 7.1 Structure of UK industry by region

Standard regions Major indu stries

North Traditional heavy industry concentrated around Tyneside and

Teeside
North-west Heavy engineering; cotton; clothing; glass; chemicals; vehicles
Yorkshire and Iron and steel; textiles and clothing; coal; fishing
Humberside
East Midlands Diverse industry, but specialises in hosiery, footwear and clothing
West Midlands Mechanical and electrical engineering; vehicles; iron and steel ;
Potteries
South-west Agriculture and food processing; tourism; aerospace; tobacco
East Anglia Agriculture and food processing; footwear; tourism
South-east Financial and commercial centre; technological and light
engineering
Wales Coal, iron and steel in South Wales; agriculture; light engineering
Scotland North Sea oil; agriculture; coal; shipbuilding; tourism
Northern Shipbuilding; textiles
Ireland

100
(c) Deindustrialisation

Deindustrialisation refers to a continuing reduction in the share of manufacturing

in national output. Deindustrialisation may cause:
(i) unemployment if there is no corresponding increase in service industry
employment;
(ii) economic decline in regions with a high concentration of manufacturing
industries;
(iii) a reduction in the rate of economic growth;
(iv) a deterioration in the balance of payments if the import of manufactures
increases , while the export of goods falls.

(d) Regional Problem

The regional problem refers to an uneven spread of living standards and

employment levels between different areas of the UK. A region may be in
relative decline because:
(i) factory closures result in a regional multiplier effect;
(ii) net migration from the area reduces:
(1) the local demand for products;
(2) the local supply of skilled labour;
(iii) local authorities have insufficient income to provide an adequate infra-
structure and services;
(iv) a contracting industrial base reduces the external economies of scale of an
area.

(e) Regional Policy

• Sufficiently low wages and rents attract the movement of new firms to
declining regions. However, market forces are unable to remove the
regional problem if labour and capital are immobile, or if firms prefer to
locate in prosperous areas.
• Government regional policy aims to reduce high levels of regional
unemployment and to reduce congestion in prosperous areas.
• Regional policy instruments include:
(i) offering financial incentives to firms locating in:
(1) Development Areas,
(2) Intermediate Areas
(note that Regional Development Grants were abandoned as a policy
instrument in 1988);
(ii) issuing only a limited number of Industrial Development Certificates
(IDCs) to firms wanting to expand in non-development areas (note
that IDCs were abandoned as a policy instrument in 1981);
(iii) increasing public spending in declining regions.
• Government measures have been mainly geared to moving jobs to workers
rather than workers to jobs.
• The European Regional Development Fund is used to give financial
assistance to declining regions.

101
 (f) Urban Problem

Since 1945, there has been a significant movement in employment and popula-
tion from conurbations to rural areas because :
(i) there is little urban land for expansion;
(ii) urban rents, rates and wages are high ;
(iii) more industries have become footloose .

• The most serious decline has occurred in inner-city areas . The population
has a high proportion of semi-skilled, low-income and ethnic minorities who
cannot afford to move elsewhere.

(g) Urban Policy

Government urban policy instruments include :

(i) restricting the growth of urban areas through green-belt legislation ;
(ii) encouraging firms to locate in derelict inner-city enterprise zones by
offering rate and tax rebates, and exemption from many planning
restrictions;
(iii) encouraging investment in declining areas by allow ing Freeports, where
goods can be processed for re-exportation without incurring customs
duties ;
(iv) establishing Urban Development Corporations (UDCs) to buy up and
improve derelict land with the involvement of local private sector firms .

(h) Multinationals

A multinational corporation (MNC) is a company which produces over 25% of

its product outside its parent country (country of origin).

• The largest MNCs have turnovers in excess of the GNP of most countries,
and account for the bulk of world trade in manufactures.
• MNCs reduce unit costs by locating different production processes in
different countries.

Table 7.2 Multinationals

Advantages of MNCs for the host Disadvantages of MNCs for the host
country country

MNCs provide domestic employment MNCs may force local firms in

opportunities competition out of business
Investment improves the current Returned profits worsens future balance
balance of payments of payments
Investment increases the domestic MNCs may exploit monopsony (sole
growth rate buyer) power in wage negotiations
Imports replaced by home-produced MNCs may deplete local natural
MNC-made goods resources too quickly
Technology and production techniques Transfer pricing may be used to
are transferred minimise tax payments

102
7.2 Data Response

Worked Example 7.1

'What has emerged is that until the mid-1960s concentrations of declining

industries, including coal, textiles and shipbuilding, were chiefly to blame for
job losses in depressed areas. But since then the causes of decline have been
very different.
The main problem, it now seems, is that regions such as Scotland and the
North are being dragged down by their big cities. In other parts of these regions
employment trends are not nearly as bad. Throughout Britain a massive shift of
jobs from cities to smaller towns and rural areas is occurring on a scale which
swamps most other trends in industrial location.'
Source: S. Fothergill and G. Gudgin, The Guardian, 1982

(a) Explain how the changed pattern of industrial location may have been the result
of:
(i) more capital intensive production methods (4 marks)
(ii) market forces affecting industrial location (8 marks)
(b) What are the implications of the described change for government investment in
social capital? (4 marks)
(c) Discuss the use of Enterprise Zones as a response to the observed trend .
(4 marks)

Solution 7.1

(a) The changed pattern of industrial location specified in the passage is the
'massive shift of jobs from cities to smaller towns and rural areas' - that
is, the switch of production and employment from cities to small town/
country locations.
(i) Capital-intensive production processes such as chemical manufacture
involve the extensive use of large plant and machinery. Capital-
intensive processes are likely to occupy large sites which may either
be too expensive or simply not available in city areas. It is cheaper to
locate at green-field sites in a rural area or on the outskirts of an
urban area.
One reason for locating in a city is to utilise the large supply of local
labour. Capital-intensive processes place less emphasis on the need
for large amounts of labour, and can therefore consider rural or town
locations.
(ii) In a market economy each good has its own product and factor
market where the interaction of supply and demand set price.
Changes in relative price between two markets act as an incentive to
producers and consumers to adjust their behaviour. As city areas
become relatively more expensive, firms are increasingly attracted to
smaller town and rural areas . For example, if the percentage increase
in inner-city rent and rates exceeds that of rural areas, firms will tend
to move out of cities. Labour costs may be relatively cheaper in rural
as opposed to city areas. Increased traffic congestion in city areas
causes external diseconomies of scale, and the resulting increase in
costs encourages firms to relocate close to efficient transport net-
works offered by motorways such as the M25 .
(b) Social capital refers to infrastructure usually provided by the state for use
by the general community. Examples of social capital include schools and
hospitals . The observed trend for employment to move out of city to small

103
 town/rural areas poses a number of problems . Schools and hospitals in
urban areas will be faced with falling demand , while the growing rural
population require additional facilities. Hence , the government is unlikely
to invest in new social capital in city areas in decline but will instead locate
new schools and hospitals in new towns. At the same time , the decline of
inner-city areas increases the need of local residents for improved social
capital.
(c) Enterprise zones are located in the more derelict parts of inner-city areas
and offer firms a number of privileges. Companies setting up in enterprise
zones are exempt from local authority rates and development land tax;
receive substantial tax allowances ; and are free from a number of planning
regulations. Such financial incentives will attract firms. However, it is
likely that such firms would probably have located in an urban area in any
case. Companies whose prime requirement is for access to motorways or
proximity to ancillary firms, or who need large amounts of land, usually
find the financial incentives offered insufficient.

7.3 Objective Questions

Example 7.2

Industrial inertia occurs when:

A labour is geographically immobile
B the share of manufacturing in national output declines
C firms fail to exploit economies of scale
D industry gains no cost advantage from anyone site
E the initial reasons for location have disappeared

Example 7.3

Weight-gaining industries tend to locate :

A close to the source of raw materials
B close to major markets
C close to important transport networks
D in development areas
E in relatively prosperous areas

Example 7.4

Which one of the following industries is least dispersed throughout the UK?
A wholesaling B agriculture C tourism
D car manufacturing E construction

Example 7.5

Multinational corporations are firms which:

A export and import goods
B form cartels to set minimum prices
C have shareholders in many countries
D produce goods in more than one country
E invest overseas

104
 Select your answers to Examples 7.6-7.8 by means of the following code:
A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 7.6

External economics of scale are available :

I to new firms locating in an area
2 where firms are geographically close to each other
3 only to firms large enough to manufacture in bulk

Example 7.7

The regional problem occur s:

1 following net migration between geographical areas of a country
2 if resources are geographically immobile
3 if living standards vary between geographical areas of a country

Example 7.8

A host country which allows a multinational to undertake direct foreign investment

generally benefits from :
1 a technology transfer
2 increased exports of manufactured goods
3 an increase in gross national product at factor cost

7.4 Essays

Example 7.9

Consider the view that , since 1945, the location of industry has been largely
determined by regional policy.
(NISEC 1986)

• Avoid simply describing the theory of location and the regional problem.
• Explain how post-war government industrial policy has affected industrial
location decisions.
• Consider the likely impact of other factors on location .

Solution 7.9

The UK is divided into eleven standard economic regions . The 'co re ' area of the
South-east has experienced far greater growth than the other 'pe rip he ry' regions .
Governments consider the resultant income and e mp lo ym e nt disparities so great
that they constitute a regional problem requiring a regional policy . In theory ,
market forces should eliminate regional disparities over time. The low wages and
rents of depressed areas influence location decisions and attract new firms .
However, capital and labour can be geographically immobile .

105
 To offset these market imperfections, a number of controls and incentives
have operated since 1945 to influence the location decisions of firms . Industrial
Development Certificates (IDCs) were only granted to firms expanding in
specified regions until 1988. Regional Development Grants offered assistance to
firms locating in designated Development Areas.
Firms, then, have to compare the cost advantage of sites in development and
non-development areas . Companies take into account the natural advantages of
an area, including the physical features and climate of a region. The acquired
advantages of an area , such as the transport network, labour force and proximity
to markets, are also important factors .
However, it is difficult to isolate the impact of government regional policy on
location decisions since 1945. Detailed regional statistics have only recently
become available, and the areas actually qualifying for assistance have been
changed frequently . Let us consider the evidence.
New firms may ignore offers of assistance and be reluctant to locate in
declining regions because the younger members of the local workforce have
moved to areas of high employment. The negative regional multiplier reduces
the size of the market, thereby reducing the area's external economies of scale .
Firms which suffer industrial inertia expand on their current site, and their
location decision is unaffected by regional policy.
The effect of IDCs is uncertain . There is no guarantee that a firm denied an
IDC to expand in a prosperous area will automatically locate in a Development
Area . Multinationals could simply build their new factory overseas. In terms of
general depression, no region is willing to accept restrictions on development,
and for this reason IDCs have been suspended since 1981.
Firms where government financial incentives make up a large proportion of
location costs are most likely to take account of regional policy. For example,
capital-intensive firms such as ICI have been attracted into assisted areas .
Multinational enterprises considering direct foreign investment in UK green-
field sites have accepted grants and located in Development Areas . The Nissan
plant at Washington , Tyne and Wear, is an example . However, other multi-
nationals have emphasised different location factors, such as proximity to
markets and transport networks, in their location decision . Honda have sited
their engine plant in Swindon without any government assistance.
Microtechnology is a footloose industry where no one site offers a cost
advantage. Transport costs are only a small proportion of total costs. Despite the
allowances on offer elsewhere, many 'sunrise' information technology firms
decide to locate along the M4 corridor between London and Bristol. However,
government assistance has helped to create in Scotland's Glens a high concentra-
tion of silicon chip firms .
In conclusion, it has been demonstrated that the financial assistance given by
post-war regional policy is an important but not overriding consideration in the
location decision of the firm . Direct controls such as IDCs have had no impact
since 1981.

Example 7.10

How would you explain the economic decline of inner-city areas in the United
Kingdom? Suggest possible remedies and discuss their economic implications.
(AEB June 1987)

• Inner-city decline has been targeted as a key economic issue by the third
Thatcher administration . Make sure you include examples of recent govern-
ment policies and their effects.

106
Solution 7.10

The decline in inner-city areas can be measured in terms of falling output ,

increased unemployment and below-average income levels. Two major factors
have contributed to this trend: (a) the movement of labour-intensive firms away
from inner areas and (b) the flight of well-paid employees to outer-urban and
rural areas.
One reason for the migration of inner-urban firms is the introduction of
modern production techniques, which have increased the demand for floor
space. Green-belt restrictions and the active use of Industrial Development
Certificates in the 1960s and 1970s made it difficult for firms seeking expansion
to locate in inner-city areas. Footloose firms faced with high rents and the
availability of Regional Development Grants in Development Areas have left
some inner-city areas. In the service sector , many companies have relocated
their offices, with a subsequent loss of inner-city office jobs. The continuous
flight of firms generates a negative inner-city multiplier effect , causing even
further decline . The negative multiplier effect is shown in the diagram.

- : Local demand \

I Local incomes I Local output

~I Local employment J
The type of external economy of scale available in inner-city areas has
changed. Transport economies from locating weight-gaining industries close to
the market have been eroded by diseconomies caused by traffic congestion .
Inner-city decline leaves local authorities with insufficient income to maintain an
adequate social infrastructure.
Demographic trends are also to account for the decline of inner-city areas.
Many workers have used increased real incomes to move to suburban and rural
areas where improved communications allow them to commute to work . Many
of the jobs left to inner-city residents are low-skilled low-income ones. As a
result, average earnings in outer areas rise while inner-city earnings decline . The
resultant negative local multiplier effect further reduces income output and
employment in inner cities.
Inner-city decline can only be arrested by government intervention . One
possible remedy is to offer firms incentives to locate in inner cities . Since 1981, a
number of Enterprise Zones in the most derelict inner-urban areas have been
established, which give firms tax allowances and exemption from rates and
certain planning regulations. Special agencies for urban renewal (Urban Devel-
opment Corporations) have been given resources to acquire land , improve social
and industrial infrastructure, and involve private-sector firms. Urban Develop-
ment Grants are available which encourage investment in inner-city areas which
would not otherwise have taken place .
Incentive schemes which are successful in generating new investment have a
spin-Off multiplier effect. Local businesses experience an increase in the demand
for their products. Yet there is no guarantee that the employment created by
new investment will automatically reduce unemployment in inner-city areas .
New jobs may be filled by workers from other areas . Moreover, incentives can
have the effect of simply diverting investment from one region to another.
Increased employment in inner-urban areas would have taken place elsewhere.

107
 Government int ervention can lead to a misall oc ation of resources. Siting
production in inappropri at e inn er-urban a reas is ju stifi ed o n th e basis of the
resulting so cial benefits. Ho we ver , th ese must be weighed aga ins t the cost s o f
not producing a t th e least-cost site.

7.5 Solutions to Objective Questions

So lution 7.2 A nswer: E

Once th e natural ad vant ages o f a site have di sappe ared , th e firm m ay still find it
cheape r to ex pa nd at its curre nt lo cati on . This is bec au se it is ex pe ns ive to move
plant to a ne w site. H en ce , stee l plants a re found in a reas wh ere th e local sup ply
of coal ha s long been ex ha usted.
B ~ Refers to deindustrialisation .
D ~ R efers to fo otl oo se industries.

So lution 7.3 A nswer: B

See Section 7. 1(a).

Solution 7.4 A nswe r: D

So me industries are footloose a nd wid el y di sp ersed throughout th e UK bec au se

th ere is no cos t advant age from one site. Other industrie s a re co nce ntra te d in
particular regions of th e UK . Se e T abl e 7 .1.
Each region o f th e U K has diffe rent fac tor endow me nts - th at is, different
natural resources , la bour fo rce, tr an sp ort net wo rk , e tc . R egion al specialisatio n
occurs wh en each a rea uses its pa rti cul ar fac tor e ndow men t to concentrat e in the
manufacture o f ce rtain goods and services.
A , B , C , E ~ a re exa mples of di sp e rsed indust ries.

Solution 7.5 A nswer: D

A multinati onal is a compan y whi ch p roduces over 25% of its p roduct ove rseas.
A ~ An y firm ma y im port a nd ex po rt go ods .
B ~ A cartel is a group of producers wh o ac t to gether to fix price o r o utpu t.
C ~ Co mpa nies whi ch produce in o nly o ne country ma y have share holde rs
from man y different countries.
E ~ Wh ile multin ati on als ofte n undertak e forei gn in vestment , so d o pri vat e
ind ivid ua ls , gove rn me nts , etc .

So lution 7.6 Answer: B

1 ~ Is correct because exte rna l eco no m ies of sca le (EO S) are reductions in unit
cos t as a result o f a n in cr ease in th e size o f th e e n tire industry. These are eq ua lly
availa ble to ex isting firms and ne w firms in th e a rea.
3 ~ Re fers to internal E OS and is the re fo re incorrect.

Solution 7.7 A nswer: C

1 ~ Is not correct, becau se net migr ati on may occur as a result of uneven living
sta nd ards between re gions but it do es not cau se th e regional problem. The othe r
o p tio ns are correct.

108
 2 :::} If resources were geographically mobile, lower rents, wages, etc ., in
depressed areas would attract an inflow of resources from prosperous areas until
living standards between different regions were equal.
3 :::} Defines the regional problem.

Solution 7.8 Answer: B

1 :::} Multinationals based in developed countries can introduce modern produc-

tion techniques and technologies to less-developed host countries.
2 :::} Once the multinational is established , goods produced in the host country
can be exported.
3 :::} Is not correct, because profits made by the overseas branch of the
multinational company will be returned to the parent country. The resultant
negative property income from abroad reduces the gross national product of the
host country.

109
 8 Income and Wealth
8.1 Fact Sheet

(a) Factor Incomes

The demand for all factors of production (inputs) is a derived demand - i.e . the
demand for factors of production depends on the demand for the products they
produce . In return for providing their services, land, labour, capital and
entrepreneurs receive factor incomes.

(b) Profit

• Profit is the reward for bearing uninsurable risks associated with produc-
tion. The types of profit are explained in Table 6.3. Note that profit is
uncertain and may even be negative. Profit has the following functions :
(i) rewards those who bear uncertain risks;
(ii) encourages invention and innovation;
(iii) indicates efficiency ;
(iv) encourages firms to switch resources from loss-making to profit-
making operations ;
(v) provides a source for the purchase of investment goods.

(c) Economic Rent

• Rent is the payment for the use of all natural resources .

• Economic rent has a wider meaning - i.e. a surplus paid to any factor of
production over its supply price .
• Transfer earnings is the minimum payment needed to keep the factor in its
present occupation . This can also be defined as the payment which can be
earned in the factor's next-best-paid occupation:

present earnings less transfer earnings = economic rent.

(lawyer's pay £20 000) less (teacher's pay £15 000) = £5000

• Quasi-rent is short-term economic rent arising from a temporary inelasticity

of supply.
• Pure economic rent is the reward to any factor that is in completely inelastic
supply.
• The proportion of a factor's earnings made up of economic rent increases as
supply becomes more inelastic.

110
 Factor s Factor
income income

Transfer
Transfer earnings D
earnings

o Q Quantity o Q Quantity o Q Quantity

(a) (b) (c)

Figure 8.1 Economic rent and elasticity of supply : (a) perfectly inelastic supply ; (b) elastic
supply; (c) perfectly elastic supply

(d) Interest

• Interest is the reward for forgoing liquidity, and is an amount paid to a

lender over and above the original sum borrowed.
• The Loanable Funds (Classical) Theory states that the rate of interest is
determined by the demand for loanable funds (investment) and the supply
of loanable funds (savings) .
• Keynesian theory states that the rate of interest is determined by the
demand for and supply of money . For simplification, the supply of money is
presumed to be largely government-determined and to be perfectly interest-
inelastic. Keynes identified three motives for demanding money (liquidity
preference) - that is, for holding wealth in the form of money:
(i) The transactions motive is the desire to keep money to make everyday
purchases.
(ii) The precautionary motive is the desire to hold money to meet
unexpected expenses.
(iii) The speculative motive is the desire to hold idle balances to take
advantage of changes in the price of bonds .
• In Figure 8.2, the liquidity trap occurs after point A, when the rate of
interest is so low (and the price of bonds is so high) that everyone
anticipates a future fall in the price of bonds. If the money supply increases,
people will hold all the extra money for fear of making a capital loss from
holding bonds . Hence, the demand for money becomes perfectly interest-
elastic.
Rate of
interest L

R 1 - - - - - - - - - '....

A
~-----L

o Q Quantity of money

Figure 8.2 Determination of the rate of interest

111
 (e) Wages

Wages ar e a pa yment mad e to labour. A number of factors help determine wage

rates:
(i) The marginal productivity theory sugges ts th at any factor of production
will receive a payment equal to th e value of its marg inal product :
wage rate = marginal ph ysical product x marginal revenue
(ii) Government action in th e form of incomes policies, arbitration and
conciliation , and as an employer.
(iii) Trad e unions (see Section 9.1) .

(D Wage Differentials

Wage differentials are th e differ ences in wages between workers in different

occupations , age groups, etc. Wage differ entials arise through:
(i) occupational imm obility du e to non-monetary advantages and disadvant-
ages of jobs;
(ii) occupatio nal imm obility because of age , phy sical factors, mechanical
skills and qualificat ion s;
(iii) geographical imm obility du e to famil y ties, hou sing shortages , etc. ;
(iv) econo mic rent ari sing from high demand for spec ial talents;
(v) differ ences in th e stre ngths of tr ade unions and professional organisa-
tion s;
(vi) social con vention and public opinion influ encing wages claims and
sett leme nts.

Workers will be in a stro nge r position to gain wage rises if dem and for labour
is inel astic . The ela sticit y of demand for a factor will dep end on:
• the degree of sub stitution betw een factors;
• th e elasticity of demand for the product produced ;
• the proportion of th e factor's costs in total costs.

(g) Income Distribution

• Income is a flow of ea rn ings. Th e fun ctional distribution of income is th e

distribution of incom e between factors of pr oduction .

Table 8.1 Th e functional distribution of income in th e UK , 1986

Source (factor of pr oduction ) Share of total earnings

(Em) %

Income from employme nt 209445 63.8

Incom e from self-employme nt 34 340 10.5
Profit 59 072 18.0
Rent 24 497 6.8
Other 3026 0.9
Total dom estic income 328380 100.0

Source : Adapted from CSO Annual A bstract of Statistics (19HH)

112
 • The size distribution of income is concerned with the proportion of income
received by different proportions of the population. The degree of income
inequality can be represented by Lorenz curves and Gini coefficients.
In the case of a Lorenz curve, the degree of inequality can be assessed by
the extent to which the curve showing a country's distribution deviates from
the 45° line.

r - - - -- - - --------", y
% of income

a x
% of popu lat ion

Figure 8.3 The Lorenz curve . OY = complete equality ; OXY = complete inequality. with the
last person having all the income ; OZY = degree of inequality

The Gini coefficient is the ratio between the area between a Lorenz curve
and the 45° line and the area below the 45° line :
area a 100
----x-
area a + b 1
The Gini coefficient has a range from 0 (complete equality) to 1 (complete
inequality) .

(h) Wealth Distribution

• Wealth is a stock of all those assets capable of earning an income .

• Wealth can be human (e .g . skills, qualifications) or material (e .g. time
deposits , shares , property) .
• Inheritances, capital gains, pensions and savings are the major sources of
wealth .

Table 8.2 Distribution of wealth in the UK in 1985

% of wealth owned by Marketable Marketable wealth plus occupational

wealth (%) and state pension rights (%)

Most wealthy 1% 20 11
Most wealthy 5% 40 25
Most wealthy 10% 54 36
Most wealthy 25'10 76 57-60
Most wealthy 50% 93 81-85
Source : Social Trends 1988 (CSO)

113
 • Note that wealth is more unequally distributed than income in the UK .
• The 1988 UK budget reduced the highest rate of income tax to 40 %. This is
likely to make the distribution of income and wealth more uneven over
time.

8.2 Data Response

Worked Example 8.1

1971 1985

52%
Pensioners 27%

Single people
of work ing age

One -parent
fam ilies
Work ing-age
couple w ithout
ch ildren
17% Work ing-age
couple w ith 22%
7% 5% chi ldr en 9%

Lowest quintile group of income by famil y type. Source: Social Trends 1988

The lowest quintile group is the 20% of families receiving the lowest net income in the
country. The figures are adjusted for differences in the size and composition of the
families. During the period shown , there was an increase in the actual number of
pensioners and the proportion of pensioners in the total population . There was also a
significant rise in unemployment and an increase in the number and proportion of
one-parent families in th e population . Most of the poor in th e UK are either
unemployed, retired or single parents, with the main cau ses of poverty being old age ,
sickness, unemployment (and in relation to these the level of benefits) , failure to
claim benefits and low wages.
(a) What is meant by the highest quintile group of income? (1 mark)
(b) Describe the changes in the lowest quintile group between 1971 and 1985.
(4 marks)
(c) If during the period 'there was an increase in the actual number of pensioners and
the proportion of pensioners in the total population' , why did the proportion of
pensioners in the lowest quintile group fall? (4 marks)
(d) In what sense is the lowest quintile group of income a measure of relative rather
than absolute poverty? (3 marks)
(e) One solution some economists advance to reduce poverty is the introduction of a
national minimum wage . Which of the categories shown in the lowest quintile
group might this benefit? (4 marks)
(f) What other measures could be taken to reduce poverty? (3 marks)

Solution 8.1

(a) The highest quintile group is the 20 % of families receiving the highest net
income in the country .
(b) The most significant changes were a fall in the proportion of pensioners in
the lowest quintile from just over a half (52 %) in 1971 to just over a
quarter in 1985 (27 %) and a rise in the proportion of single people from
19% to 34% . There were also increases in the proportion of working-age
couples with children (17% to 22%), working-age couples without chil-
dren (7 % to 9%) and one-parent families (5 % to 8 %). So, while the

114
 proportion of the pensioners category fell, the proportion of all the other
categories rose .
(c) A fall in the number of pensioners can be rejected as a possible
explanation. The change in the proportion of pensioners in the lowest
20% of income receivers must have been the result of other categories
becoming worse off in relation to them and thereby moving down into the
lowest quintile . One main cause of the relative decline in the position of
the other categories identified in the information provided is a rise in
unemployment in the period shown. There were also more single parents
in the total population.
(d) The lowest quintile group of income compares the income of one group of
the population with other groups and not against an absolute standard.
The lowest quintile group are poorer than other members of the commun-
ity. However, to determine whether they are experiencing absolute
poverty, it would be necessary to identify what is a level of living standards
necessary for human health and existence. Those living below this level
could be said to be experiencing absolute poverty.
(e) Single people of working age, one-parent families, and working-age
couples with and without children would benefit if they are in employment
initially receiving less than the national minimum wage and if they remain
in employment after its introduction. Pensioners and the unemployed
would not benefit directly.
(f) Among other suggested measures to reduce poverty are:
(1) increasing benefits and pensions;
(2) increasing tax thresholds and lowering the standard rate of taxation;
(3) retraining, training and education;
(4) increasing employment by increasing demand and/or incentives.

8.3 Objective Questions

Example 8.2
Which of the following does not describe the economist's definition of profit?
A a reward which may be positive or negative
B a reward for bearing uninsurable risks
C a return to enterprise
D a contractual payment fixed in advance
E a return which is uncertain in amount

Example 8.3
Normal profit is:
A the level of profit made by the average firm in the industry
B the positive difference between total revenue and total cost
C the level of profit necessary to keep the firm in the industry
D quasi-economic rent earned under conditions of perfect competition
E the level of profit earned when Me = MR

115
 Example 8.4

The diagram below shows a firm producing under conditions of monopoly .

OYBZ contains:
A abnormal profit? B abnormal loss? C normal profit?
D economic rent? E qu asi-economic rent?

Costs/revenue

Y~--~-~I.:"

Example 8.5

An acre of land in a Development Area could receive a yearly rental of £5000 in its
least remunerative occupation. It is currently earning £7600 in its present use. Which
of the following statements is correct?
A economic rent is £5000 B transfer earnings are £2600
C economic rent is £7600 D economic rent is £2600
E economic rent cannot be determined from the information given

Example 8.6

A factor of production's earnings will con sist entirely of economic rent if:
A supply is perfectly inelastic and demand is ela stic
B supply is perfectly elastic and demand is elastic
C demand is perfectly inelastic and supply is elastic
D demand is perfectly elastic and supply is elastic
E demand is perfectly inelastic and supply is perfectly clastic

Examples 8.7 and 8.8 are based on the diagram opposite, which shows the
demand for and supply of word processors.

116
 Wage rate

W f----------~....

C f--- - -- --:.r

B f - -- - . . . " r o

o Q, Number of workers

Example 8.7

If OQ3 workers are employed , what are the total transfer earnings received by
the labour force ?
A OAXQ 3 B A WX C BWX D OWXQ1 E CWXY

Example 8.8

The economic rent earn ed by word proc essor op erator Q2 is shown by the distance:
A BC B BW C CW D ZY E YX

Example 8.9

Th e table shows how man y people would be willing to work for a firm at different
weekly wage rates.

Wage rate (£s per week) Number of people

11 5 20
120 45
125 70
130 120
135 240
140 320

If the firm pays a wage of £ 135 and employs 240 pe opl e . what is the total economic
rent ea rne d by the workers?
A £330 B £600 C £1275 D £1600 E £4800

117
 Example 8.10

Which of the following is an example of quasi-rent?

A normal profits earned under conditions of perfect competition
B abnormal profits earned under conditions of perfect competition
C abnormal losses earned under conditions of perfect competition
D abnormal profits earned under conditions of oligopoly
E monopoly profits

Example 8.11

A bond is issued for £970 for which the government will pay £1200 in one year's time .
If the market rate of interest is 20%, what will be the market price of this bond?
A £818 B £960 C £1000 D £1012 E £1149

Example 8.12

If the market rate of interest is 12%, what will a bond paying £18 interest sell for now?
A £82 B £88 C £112 D £150 E £168

Example 8.13

According to Keynesian analysis, interest rates are likely to rise when there is:
A an increase in liquidity preference
B an increase in the money supply
C an increase in the price of bonds
D a decrease in national income
E a decrease in the price level

Example 8.14

The liquidity trap is said to occur when:

A a change in the rate of interest has no effect on the price of bonds
B a change in the price of bonds has no effect on the rate of interest
C increases in public-sector borrowing crowd out private investment
D demand for money becomes perfectly inelastic at high rates of interest as people
expect the rate of interest to fall in the future
E demand for money becomes perfectly elastic as people expect the rate of interest
to rise in the future

Example 8.15

Year 1 Year 2

Hourly wage rate £3 £5.50

Price index 120 150

The table above shows that between years 1 and 2 the hourly wage rate in real terms
changed by approximately:
A 126% B 83% C 47% E 17%

118
Example 8.16

Which of the following would result in an increase in demand for bank clerks?
A the widespread introduction of an electronic funds transfer point of sales system
(EITPOS)
B the reduction in the cost of automated teller machines
C an increase in bank clerks' wages
D an increase in building society deposits
E an increase in the number of cheques bank customers write

Example 8.17

A firm operating under conditions of perfect competition in both the labour and
product markets is faced with the following output schedule:

Number of workers Total output

I 500
2 560
3 640
4 740
5 810
6 850

The price of the product is £4 and the wage rate is £280. How many workers should
the firm employ to maximise profits?
A 2 B 3 C 4 D 5 E 6

Example 8.18

Demand for a factor of production will be more elastic:

A the greater the ease with which the factor input can be substituted by other inputs
B the greater the level of employment of factors in the economy
C the less elastic the demand for the final product
D the lower the proportion of the cost of the factor in the total cost of production

Select your answers to Examples 8.19-8.23 by means of the following code:

A if 1, 2 and 3 are all correct

B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 8.19

Which of the following is/are a tax on wealth ?

1 capital transfer tax
2 capital gains tax
3 corporation tax

119
 Example 8.20

Economic rent can be described as:

1 a surplus earned by a factor of production in excess of its supply price
2 the difference between a factor's present earnings and its transfer earnings
3 equivalent to the factor's opportunity cost

Example 8.21

A first division football player earns £2000 per week . His next best paid occupation
would be as an economics teacher earning £205 per week. From this information it can
be concluded that:
1 his economic rent is £2000 per week
2 his transfer earnings are £205 per week
3 his economic rent exceeds his transfer earnings

Example 8.22

Which of the following would cause the liquidity preference curve to shift to the left?
1 a rise in interest rates
2 a fall in the general price level
3 a fall in national income

Example 8.23

Wage drift can arise due to:

1 wage negotiations at the factory level
2 occupational wage differentials increasing
3 wages rising more rapidly than prices

8.4 Essays

Example 8.24

Discuss the arguments for and against the establishment of a national minimum wage.
(AEB June 1986)

• Explain how minimum wage legislation works .

• Concentrate on a minimum wage set above the existing level.
• Discuss the impact on wages and poverty.
• Discuss the impact on employment.

Solution 8.24

The effects of introducing a national minimum wage will depend mainly on the
level at which it is set and how workers and employers respond . The main motive
is likely to be to reduce poverty, while the main argument against the
introduction of a minimum wage is that it may result in a rise in unemployment.
If a minimum wage is set below the existing level, then there will be little or no
effect. For instance, if an employer is paying a wage rate of £110 and legislation
is introduced stating that workers have to be paid at least £100, it is unlikely that

120
there will be a change in the wage paid to existing workers. However, there is a
possibility, particularly during times of high unemployment, that new workers
may be recruited at lower wages, although existing workers are likely to resist
any cut in money wages .
However, it is more likely that the minimum wage will be set above the
existing wage level in some industries. The introduction of a national minimum
wage is sometimes urged as a measure to reduce income inequality and, in
particular, poverty. A national minimum wage can be imposed to raise the wage
level of the lowest-paid and possibly reduce the number of people who decide
not to work, although there are vacancies, because the wages they would receive
are below the benefits they are currently receiving.
Another argument for setting a minimum wage is to protect workers in
industries dominated by monopsonists . In the case of a monopsonist , the
marginal cost of hiring additional (labour (MeL) will be greater than the average
cost of labour (wage per employee). Figure 1 shows that the employer initially
equates the marginal cost of labour with his/her demand for labour (Dd and
employs OLI amount of labour at a wage of WI . The establishment of a
government minimum wage of W z (where D L equals the average cost of labour)
raises both the wage rate and employment.

Wage rate
Mel

W1 ~~-J'-------..r
Dl

o L, l abour services

Figure 1

However, in most industries a minimum wage set above the equilibrium level,
while raising wages , is likely to result, at least in the short term , in the supply of
workers exceeding the demand for workers and a fall in employment. Figure 2

Wage rate

w ~~~-j~~~(..

o 01 o l abour services
Figure 2

121
 shows the minimum wage (W2 ) being set above the equilibrium wage (Wd . This
cau ses a fall in employment from OL1 to OL2 •
The groups of workers who are most likely to be made redundant or who are
less likely to be taken on include the elderly, the disabled and the less skilled
workers. These may be the very groups that the implementation of a national
minimum wage may be designed to help. Raising the wage rate will also increase
the cost of training workers, which may result in higher unemployment among
school leavers and in the longer term may lead to a shortage of skilled workers.
The ext ent to which unemployment will occur in different industries will
depend on a number of factors. These include the profitability of the industry ,
the proportion of total costs accounted for by wages , the type of market structure
and the elasticity of demand for the product.
Another influence will be the extent to which labour can be substituted . As
labour becomes more expensive, there may be some substitution of capital for
labour. The extent to which this occurs will depend on the nature of the product
being produced, the relative productivities and prices of the factors.
Monetarists beli eve that a government-imposed national minimum wage will
interfere with free market forces and thereby reduce the efficiency of the labour
market. This could result in a decrease in aggregate supply and a fall in output
and employment.
However , some Keynesians argue that if a national minimum wage is imposed,
then demand for most industries' products will rise. So, although costs will rise ,
the level of employment may remain constant or possibly rise .
Nevertheless,the response of workers to the policy may result in a further rise
in production costs, inflation and unemployment. Workers may press for wage
rises to restore their wage differentials . If successful and if productivity does not
rise , this will increase costs of production and possibly cost push inflation. Rising
prices may reduce domestic competitiveness and, hence, domestic employment.
If unsuccessful , the narrowing of wage differentials may reduce labour mobility
and result in a shortage of skilled workers .
The effectiveness of a national minimum wage in reducing poverty may be
offset by a number of factors. Employers may try to circumvent the legislation by
reclassifying jobs (e.g . from full-time to part-time and taking on more part-time
workers and fewer full-time workers). Also, there may be a large number of
poor people who will not be helped by the legislation, including those past
retirement age, the unemployed and some single parents .

Example 8.25

What is economic rent and why do some economists argue that taxes sho uld be
imposed on economic rent?

• Define economic rent and give examples.

• Explain the main determinants of economic rent.
• Discuss the effect on resource allocation of a tax on economic rent.

Solution 8.25

Economic rent can be earned by any factor of production. It is a surplus paid

above the income needed to keep that factor in its present occupation.
For instance, a football player earning £2500 a week may have as his next best
paid occupation bricklaying, for a wage of £150 a week. So the football player
will be receiving an economic rent of £2350 and the opportunity cost of his

122
present job will be the £150 (transfer earnings) he is forgoing as a result of being
a professional sportsman . Similarly, an area of land which is used for industrial
purposes may receive a rent of £1000 per week , whereas , if it were to be used for
residential purposes , it might receive a rent of £800. So the land will be receiving
an economic rent of £200. If a piece of machinery has no alternative use , then all
of its earnings will be economic rent.
Indeed, one of the main determinants of the economic rent a factor receives is
that factor's elasticity of supply. If supply is perfectly inelastic, then all of the
factor's earnings will constitute economic rent , whereas, if the supply is perfectly
elastic, no economic rent will be received and all of the earnings will represent
transfer earnings. In practice , for most factors supply will be neither perfectly
elastic nor perfectly inelastic. Figure 1 shows that in a case where supply is
relatively elastic some of the payment received will represent economic rent,
while the rest will represent transfer earnings.

Factor
income

Transfer
earn ings

o Q Quantity

Figure 1

It is sometimes suggested that a tax should be placed on economic rent , as it is

a surplus. If some but not all of this surplus is taken by the government in tax,
then the factors are unlikely to transfer to other uses. For instance , if a model is
being paid £4000 per week when her next best paid occupation is as a shop
assistant earning £110 per week, then taxing her economic rent of £3880 at 90%
is unlikely to result in her giving up her modelling job .
Monopoly profits are a form of economic rent, and a tax on monopoly profits
(provided that it is less than 100%) will not result in a change in the output or
pricing policy of the monopolist. Figure 2 shows the total revenue and total cost
curves of a monopolist. Prior to the imposition of a tax, maximum profits are
earned at OQ output. The imposition of a tax causes the total cost curve to shift
from TC I to TC 2 , but the maximum profit output remains at OQ . Some
economists argue that at least part of monopoly profits should be taxed away on
grounds of equity.
The economic rent on land can also be taxed without affecting the allocation of
resources . If all land, irrespective of use, is taxed at the same rate , the relative
profitability of different uses will be unaffected . As supply will be unaffected,
prices will not change and the burden of the tax will fall entirely on landlords. In
addition, some economists argue that the economic rent earned on land should

123
 Costs / revenu e

L_- --tL - -j- - "\:- - TC 2

1_- --,l-- - -t- - \ -TC 1

o Q Ou tput

Figure 2

be taxed, because a high return from land may result partially from public
spending on the infrastructure .
However, in practice it is not always easy to identify economic rent,
particularly as it may be difficult to ascertain what a factor's transfer earnings
are. For instance, few workers , at any particular time , will know with certainty
what employment they would be able to gain if they left their present jobs.
So economic rent is a payment in excess of transfer earnings which may be
earned by any factor of production which is not in perfectly elastic supply. It has
been suggested that economic rent could be taxed without affecting the
allocation of resources , but in practice it can be difficult to isolate that part of a
factor 's payment which represents economic rent.

8.5 Solutions to Objective Questions

Solution 8.2 Answer: D

When an entrepreneur undertakes production , he will not know in advance how

much profit will be earned, since he will not be certain what demand and costs
will be in the future. Whereas workers will usually know what wages they will be
paid before they start working, lenders what interest they will be paid and
owners of land what rent they will receive , an entrepreneur will not have a
contract setting out what profit will be earned.
A, B, C , E ::} All apply to profit.

Solution 8.3 Answer: C

Normal profit is the supply price of entrepreneurship - i.e . the minimum which
needs to be paid to the entrepreneur for him to supply his services and keep his
firm in the industry. This can also be referred to as transfer earnings .
B, D ::} Refer to abnormal profits .
E ::} A firm which produces where Me = MR is producing at the equilibrium
output, and this may be where normal profits are earned . However, it may also
be where abnormal profits or abnormal losses are earned.

124
Solution 8.4 Answer: C

OYBZ represents the cost of producing OZ quantity. Normal profits are included
in costs of production. So costs of production include the return to all the factors
of production - i.e. wages , interest, rent and normal profit. In this case, the
firm is producing where total revenue is greater than total cost and, hence, it is
earning more than normal profits. The area of abnormal profits is shown by
YXAB .

Solution 8.5 Answer: E

If an acre of land can earn £5000 in its least remunerative occupation, the word
'least' implies that the land has more than two uses. Economic rent is a surplus
above what can be earned in its next best paid occupation - i.e. above transfer
earnings. In this case , it is not known what can be earned in the next best paid
occupation - just what can be earned in the least most profitable use. So it is
not possible to calculate economic rent or transfer earnings .

Solution 8.6 Answer: A

If supply is perfectly inelastic , then the factor would continue to supply the same
quantity of its service irrespective of the financial reward received. So, even if no
reward was paid, the factor would continue to provide the service . Hence, any
money paid is a surplus above what is needed to keep the factor in its present
use .

Solution 8.7 Answer: A

Transfer earnings is the minimum which must be paid to keep a factor in its
present occupation. It is shown by the area below the supply curve .
B =? A WX represents economic rent.
D =:;> OWXQ3 represents total earnings, consisting of both economic rent and
transfer earnings.

Solution 8.8 Answer: C

Economic rent is a surplus paid to a factor above that needed to keep it in its
present occupation . The diagram shows that word processor operator Q2 would
have been prepared to work for a wage of Oc. In fact, he is paid OW.
So his economic rent is the wage rate paid - transfer earnings - i.e.
OW - OC = CWo

Solution 8.9 Answer: C

Some of the 240 people employed at a wage of £135 would have been willing to
work for less. It is important to remember that, e.g., when 70 people are
employed, this number includes 20 people who would have worked for £115 (and
so are enjoying £20 economic rent each) , 25 who would have worked for £120
(£15 economic rent each) and 25 who would have worked for £125 (£10 economic
rent each) . When 240 people are employed at a wage rate of £135, the total
economic rent earned is:

125
 Number of people x Economic rent == Total economic
per worker (£) rent (£)

20 20 400
25 15 375
25 10 250
50 5 250
120 o o
1275

Solution 8.10 Answer: B

Quasi-rent is short-term economic rent. In the long term, it is usually competed

away by an increase in the supply of the factor concerned.
Abnormal profits are a surplus over what is necessary to keep the firm in the
industry. In perfect competition , these would last only in the short term, since, in
the longer term, new firms will be attracted into the industry, which will lower
price and return output to the normal profit level.
A ~ Normal profits represent transfer earnings.
D, E ~ Firms under conditions of oligopoly and monopoly may produce
where AR > AC in the long term, and so, in these cases, abnormal (monopoly)
profits may be regarded as economic rent.

Solution 8.11 Answer: C

The price of a bond will usually move to the point where the interest paid on it is
equivalent to the market rate of interest. In this case, if the price of the bond was
initially £970 and the bond is to be redeemed at £1200, £230 interest will be
earned - i.e.

230 x 100 = 23.7%

970 1
As this is above the market rate of interest, the price of the bond will be bid up
until the interest paid is 20% of £1200:
1200 100
- x - = £1000
1 120
Thus, someone who pays £1000 for the bond now will receive 20% interest on it.

Solution 8.12 Answer: D

If the market rate of interest is 12%, a bond paying £18 interest will sell for a
figure which will mean that £18 is 12% of it:
18 100
- x- = 12% = 18 x 100 = 12 x ?
? 1

18 x 100 = ? = 150
12 .

The bond will sell for £150, earning £18 interest - i.e . 12% interest.

126
Solution 8.13 Answer: A

An increase in liquidity preference will mean a shift of the liquidity preference

curve to the right. As people want more money, they will sell bonds, causing the
price of bonds to fall and the rate of interest to rise.

Rate of
interest L, s

R, I---~---'L.

Rf-------~
L,

o Q Quantity of money

B ~ An increase in the money supply means that people are going to have
higher money balances, so they are likely to buy bonds, causing the price of
bonds to rise and the rate of interest to fall.
C ~ The price of bonds and the rate of interest move in an inverse direction.
D, E ~ A decrease in NY and a decrease in the price level would both tend to
cause a decrease in the transactions demand for money. This would cause the
liquidity preference curve to shift to the left and the rate of interest to fall.

Solution 8.14 Answer: E

Keynes believed that, at a low interest rate, demand for money could become
perfectly elastic . If the rate of interest is very low (and, hence, the price of bonds
is very high), everyone might expect that the price of bonds will fall and the rate
of interest will rise in the future . They will hold any increase in the money
supply , since they will not want to buy bonds now for fear of making a capital
loss if and when their price falls .

Solution 8.15 Answer: C

To calculate rises in real income, it is first necessary to remove the effects of

price changes by use of a price deflator. In this case, money wages have risen to
£5.50 when the price index has increased from 120 to 150. Thus, in year 2 the real
wage has changed to :
5.50 price index in base year 5.50 120
- x =- x- = £4.40
1 price index in current year I 150
So, in real terms, the wage has risen by £1.40, which, in percentage terms, is

1.40 x 100 = 47%

3.00 1

127
 Solution 8.16 Answer: E

One of the main functions of bank clerks is processing cheques. If there is an

increase in the use of cheques , then more bank clerks may be employed to deal
with these.
A =:> EFfPOS is a system whereby money can be transferred from one
account to another electronically and without the use of cheques. EFTPOS is likely
to result in a fall in banks' demand for labour and a rise in their demand for
capital.
B =:> A reduction in the cost of automated teller machines is likely to result in
a spread of their use and a reduction in demand for bank clerks .
C =:> Ceteris paribus an increase in wages is likely to cause a fall in demand for
the factor .
D =:> An increase in building society deposits will tend to be accompanied by a
fall in bank deposits as customers switch from one institution to another. If this is
the case, demand for bank clerks will fall.

Solution 8.17 Answer: D

In theory, a firm will employ the number of workers where the wage rate equals
the marginal revenue product of labour. To calculate MRP , it is necessary to
work out marginal product (change in total output as a result of employing one
more worker) and multiply it by MR (which , under conditions of perfect
competition, equals price). So, in this case:

Number of Total Marginal Marginal MRP

x
workers output product revenue (£) (£)

1 500
2 560 60 4 240
3 640 80 4 320
4 740 100 4 400
5 810 70 4 280
6 850 40 4 160

Thus, the wage rate of £280 equals MRP when 5 workers are employed .

Solution 8.18 Answer: A

Demand for a factor of production will be elastic when a rise in the price of the
factor causes a greater percentage fall in demand for the factor. If a factor can be
easily substituted by another factor, then, if it rises in cost, the employer will
switch to using more of the other factors.
B, C, D =:> In each case, demand will be inelastic and a rise in price of the
factor would cause a smaller percentage fall in demand for the factor.

Solution 8.19 Answer: D

Capital transfer tax is a tax on gifts made during a person 's life and on his or her
death (inheritance) . It is currently the only form of wealth tax in the UK.
2 =:> Capital gains tax is a tax on the income received when certain capital
assets are sold at a higher price than their purchase price.
3 =:> Corporation tax is a tax on company profits, which are a form of income .

128
Solution 8.20 Answer: B

Economic rent is a surplus earned over and above the factor's transfer earnings.
3 =? A factor's opportunity cost is equivalent to transfer earnings.

Solution 8.21 Answer: C

The first division football player's present wage is £2000 a week and the wage of
his next best paid occupation is £205 per week. Thus, his economic rent is
present earnings - transfer earnings - i.e. £2000 - £205 = £1795. His transfer
earnings are £205, since, if he was paid less than this as a football player, he
would switch to being a teacher. Thus, his economic rent of £1795 does exceed
his transfer earnings of £205.

Solution 8.22 Answer: C

A shift to the left of the liquidity preference curve would be caused by a decrease
in demand for money. A fall in the general price level and a fall in NY would
result in a decrease in the transactions demand for money.
1 =? A rise in interest rates will cause a contraction in demand for
money - i.e. a movement along the same liquidity curve .

Solution 8.23 Answer: D

Wage drift arises when the wages workers actually receive exceed the nationally
agreed rates . This can occur as a result of local agreements made at the factory
level.

129
 9 Labour Economics
9.1 Fact Sheet

(a) Population Structure

Demography is the study of population statistics. Population size is a stock value

(an amount at a given moment in time). Population size is affected by inflows
(births and immigration) and outflows (deaths and emigration) over time.

• The birth rate is the number of live births per thousand of the population in
a year.
• The death rate is the number of deaths per thousand of the population in a
year.
• The natural change in population is the difference between the number of
births and deaths in a year.
• Net migration is the difference between immigration and emigration in a
year.

Figure 9.1 divides the population into two sections.

Economically active Economically inactive

~ ~
labour force or working population dependent population

~ ~
(people willing and able to work) (people unwilling or unable to work)

.mPI:v::!.JoY~\~mPIOY'd ,hUt.: /~'~Y~ ,,~'"\ h':;"POOO

registered unemployed people on training schemes voluntarily unemployed ret ired

Figure 9.1 Economic act ivity and inactivit y

• The activity (or participation) rate is the percentage of the population of

working age in the labour force.
• An ageing population occurs when the average age per person is rising.
• Malthus argued that since population has a tendency to grow geometrically
(i.e . as the series 1, 2, 4, 8, 16), while the good supply rises arithmetically
(i.e . as the series 1, 2, 3, 4, 5), economies may eventually operate at a
subsistence level. Unless people raise small families, famine, war and
disease would be the only checks on population growth.
• Agricultural innovations, international trade and a low birth rate have
enabled the UK to avoid Malthus's prediction .

130
 • Optimum population occurs when productivity (output per person) is
highest.
• Population pyramids show the age and sex distribution of a country at a
particular moment in time

(b) Supply of Labour

The total supply of labour depends on:

(i) the size and age of the population ;
(ii) the activity rate;
(iii) social acceptance of women working;
(iv) wage level s;
(v) the level of income tax and of unemployment benefit;
(vi) the length of the working week and of holidays .
(vii) industrial relations record

(c) Offer Curve of Labour

• The work indifference curves in Figure 9.2(a) show combinations of hours

worked and income received which yield equal total satisfaction to the
worker. They slope upwards because work is usually a disutility (i.e. gives
negative satisfaction).
• As the worker moves to an indifference curve further to the left, a higher
level of satisfaction is enjoyed.

Total
income

w,

Hours worked
(a)
Wage rate

B'

w,

Hours worked

Figure 9.2 (a) Income-leisure trade-off; (b) offer curve of labour

131
 • The wage rate line WI corresponds to a given hourly rate of pay.
Multiplying the wage rate by the number of hours worked gives total wages.
An increase in the hourly rates of pay pivots the wage rate line upwards,
about the origin .
• Figure 9.2(b) shows that workers may eventually work fewer hours follow-
ing an increase in wage rates , and the offer curve of labour, S, begins to
slope backwards.

(d) Occupational Distribution of Labour

Table 9.1 suggests that there has been a relative decline in the share of
agricultural and manufacturing employment in total employment. The service
sector of the economy has expanded .

Table 9.1 Distribution of employment in the UK

1964 1984

Primary sector 5% 3%
Secondary sector 47% 32%
Tertiary sector 48% 65%

(e) Labour Mobility

There are three types of labour mobility:

(i) Workers moving between jobs requiring different skills have occupational
mobility, and this depends on:
(1) the willingness and ability of an individual to retrain;
(2) employment barriers to entry (e.g. closed shops).
(ii) Workers moving between jobs requiring the same skills have industrial
mobility. Workers in declining industries tend to be industrially immobile .
(iii) Workers moving between different regions have geographical mobility,
and this depends on:
(1) regional variations in house prices;
(2) the availability of rented accommodation ;
(3) existing family and social ties .

(f) Trade Unions

A trade union is an organisation which represents groups of employees.

• Collective bargaining occurs when the union discusses pay and working
conditions on behalf of its members with groups of employers . Figures 9.3
and 9.4 show how a trade union can increase wage rates.

132
 Wages

5,

w,
o

L..-_ _- L . ....L.l._ _- - ' - --o_ Labour

Figure 9.3 Dec reasi ng the supp ly of labour . Unio ns restrict the supply of labour by impos ing a
closed shop; insisting on long appre ntices hip pe riods ; insisting on high
qu alificat ion s. T herefore , the num ber of work ers employed falls

Wages

w,

Figure 9.4 Increasing the demand for labo ur. Unions increase the dem and for labo ur by
ove rmanning agree me nts; increasing productivity; suppo rting an adve rtising
campaign. Th erefore . the num ber of work ers employed rises

9.2 Data Response

Worked Ex a m ple 9.1

One of the most likely changes in the budget is a cut in the top rate of income
tax from 60 pence in the pound which Mr Lawson wi ll justify on the grounds of
incentives, There are two economic effects when tax rates are cut. The first, the
so-called 'income effect'. You feel richer. You do not need to wo rk so hard in
order to earn what you need to buy your food , clothes and holiday on the
beach . Tax cuts allow you to earn more for the same effort as befo re, so they
make you lazier . They are a disincen tive to effort.
The second opposite effect is the 'incentive' effect. Your top rate of tax comes
down from 60 pence to, say, 45 pence . You w ill in future keep 55 pence of every
pound you earn instead of 40 pence. You have a greater incen tive than before to
earn more money if you can.
How important is the laziness -inducing effect compared with the effort-
inducing incent ive effect? Economic research suggests that for most people
one effect just about cancels out the other, so that on balance tax cuts have no
effect on effort. A study commissioned by the Treasury at great expense from

133
 Professor C. V. Brown of Sterling University even discovered that most people
cannot increase their earnings. Their jobs are such that they are not paid more
for extra work.
However, most economists think that the argument is more finely balanced
for higher rate payers. In the main they can work harder. Because rates are so
much higher - 60 per cent against 36 per cent for the basic rate payer (once
National Insurance contributions are included) - the disincentive effect is
likely to be more powerful than the income effect. The rate of tax on each extra
pound is what economists call the marginal rate. It is not the same as the
average rate of income tax, yet average rate is what determines your income.
You can face a marginal rate of 40% but because a long band of your income is
taxed at the base rate with a further slice tax free in the form of personal
allowances, and a further slice tax free because of mortgage tax relief, your
average rate may only be a quarter. The marginal rate determines incentives
but the average rate determines income.
Source: 'Lawson Can Soak the Prosperous by Bringing Down Their Taxes',
C Huhne, The Guardian, 24 February 1988

(a) What is the difference betw een marginal and average rates of taxation?
(2 marks)
(b) What evidence is there in the passage for believing that the current system of
income tax is progressive? (4 marks)
(c) Give three rea sons why so me workers will not work longer hours following a cut
in the top rate of taxation . (6 marks)
(d) Use the passage to ad vise the Cha ncellor on how a future budget might cut ta x
rates but increase overall tax revenues. (13 marks)

Solution 9.1

(a) The marginal rate of taxation refers to the amount of each extra pound of
income paid in tax. The average rate of tax refers to the proportion of
total income paid in tax.
(b) A progressive system of taxation is where the proportion of income taken
by the government in tax rises, as income rises. The passage notes that
low-income earners pay no tax because of tax-free personal allowances. It
also observes that at the time there were two different rates of taxation: a
standard rate of 36%, including the effect of National Insurance contribu-
tions, and a higher rate of 60p in the pound paid only by top earners. It
follows that high earners pay a greater proportion of their income in tax
than do low earners .
(c) A large number of people are unaffected by changes in the top rate of tax
because their pay doe s not bring them into the highest tax bracket. Others
are unable to vary the amount of work done for more pay, because they
are salaried and take-home pay is independent of the number of hours
worked each individual month . Some workers may decide to work fewer
hours and take home the same amount of pay following a cut in the top
rate of tax .
(c) A cut in marginal rates of tax has two opposite effects. On the one hand, it
act s as an incentive to work , because households are able to retain a
greater proportion of their earnings to spend on goods and services of
their own choice . They may be encouraged to work harder and earn more ,
with the effect that the absolute amount paid to the government actually
rises. For example, a higher-rate payer earning £2000 in the highest tax
bracket of 60p in the pound, pays £1200 in tax . A cut in the top rate to,
say , 40p may encourage him to work extra hours, so that earnings eligible
for tax at the highest rate rise to, say, £5000, and £2000 is now paid in tax.
The Exchequer receives an additional £SOO.

134
 This argument overlooks the possibility that there may be an opposite
income effect whereby workers use the increase in take-home pay brought
about by tax cuts to buy more leisure time. Tax receipts from workers who
maintain a constant income by adjusting the number of hours worked falls
following a cut in marginal rates of taxation . Using the above example, the
higher-rate payer earning £2000 takes home £800 at the 60% rate. Once
the rate falls to 40% , he need only work long enough to earn £1335 to
maintain a disposable income of £800. Treasury receipts fall to £534.
Moreover, the passage indicates that salaried workers have no choice as
to the number of hours worked. Tax receipts from those salaried workers
earning sufficient to fall into the highest-rate group would fall.

9.3 Objective Questions

Example 9.2

An increase in population at the same time as a decrease in the birth rate can occur
following:
A positive net migration and a fall in the fertility rate
B positive net migration and a rise in the fertility rate
C positive net migration and a fall in the death rate
D zero net migration and a rise in the fertility rate
E zero net migration and a fall in infant mortality

Example 9.3

Optimum population occurs when . with current resources:

A productivity is rising
B productivity is constant
C productivity is highest
D labour is fully utilised
E the largest population possible is supported

Example 9.4

An ageing population will be most likely to result in:

A an increase in the dependent population
B an increase in labour mobility
C a reduction in unemployment
D a reduction in transfer payments
E a constant pattern of consumption

Examples 9.5-9.8 refer to the following diagrams , which show the age
distribution of the population in four countries.

135
 A B C D
Age Age Age Age

Male Male Female Male Female

Which diagram (A, B, C or D) mo st accurately depicts:

Example 9.5

A developing economy?

Example 9.6

A developed economy with a constant birth rate?

Example 9.7

An economy with a migrant population?

Example 9.8

An economy with an increasing birth rate ?

Example 9.9

Wage rate

~-------------I- Hours worked

The diagram shows the offer curve (5) for labour. The offer curve shows that the
number of hours worked eventually:
A increases as wage rates rise
B decreases as wage rates rise
C increases as the demand for labour increases
D decreases as the demand for labour increases
E is unresponsive to changes in wage rates

136
Example 9.10

In the short run , a trade union is most likely to increase wage rate s in an industry
without reducing the number employed by:
A imposing a closed shop
B insisting on long apprenticeship periods
C negotiating overmanning agr eements
D imposing an overtime ban
E insisting that only their members do certain jobs

For Examples 9.11-9.13, use the diagram below, where DID( is the original
demand curve for bricklayers and SIS, is the original supply curve .

Wage rate

Hours worked

After each question indicate the new equilibrium position A, B, C, D or E following:

Example 9.11

An increase in the productivity of bricklayers, ceteris paribus .

Example 9.12

A reduction in the apprenticeship period for bricklayers from 4 years to 3.

Example 9.13

The introduction of a closed shop and a large fall in interest rates.

Select your answers to Examples 9.14-9.16 by means of the following code :

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

137
 Example 9.14

The work ing population includ es:

1 the self-employed
2 employers
3 reg istered unemployed

Example 9.15

The immobility of labour is likely to be reduced by:

1 legislation restricting closed shops
2 the abolition of rent controls
3 compulsory retraining schemes for the unemployed

Example 9.16

If the supply of labour incre ases following an decrease in marginal rates of income tax:
1 workers value incom e more than leisure
2 the supply curve of labour does not slop e backwards or vertically
3 the supply curve of labour has shifted to the right

9.4 Essays

Example 9.17

'The size of a nation 's population is not as important as its age, sex and geographical
distribution' . Discuss .
(AEB June 1986)

• This is an open question, with a number of possible answers .

• Establish criteria for judging the relative importance of population size and
population characteristics.
• Discuss the relative economic importance of the stated population features.

Solution 9.17

Economists can compare the importance of population size and population

characteristics in terms of their relative contribution to the production of goods
and services.
In theory , population size is a major determinant of total product. Output
depends on the quantity of inputs. All other things being equal , a larger
population allows a country to produce more goods and services. The United
States of America is able to use a large population to produce the highest GDP
of any nation in the world . Yet countries with larger populations exist. Surely
India should produce more than the USA? One reason why it doe s not lies in the
different age distribution of the populations. Developing countries such as India
tend to have a larger proportion of unproductive young people in the population
than do developed nations such as the USA . Here size of population is not as
important as the age composition of that population.
Population size must be assessed in relation to the quantity and quality of a
country's resources .

138
 Standard
of living

L-... .l...-_---l ...l..- Population

The diagram illustrates the relationship between the size of population and
standards of living. India has over 140 times the population of Denmark but a far
lower standard of living. This is because the population of Denmark combines
with available resources to achieve almost the greatest output per person
possible. Denmark is close to its optimum population. On the other hand, India
is overpopulated in the sense that a reduction in population size would probably
increase output per head and raise living standards. It follows that population
size alone is relatively unimportant in determining a country's average living
standard . A small population has not hindered the economic development of
New Zealand or Austria. More important are the abilities and characteristics of
all resources , including population.
For instance, less developed countries (LDCs) have a low average age , with
50% of the population under the age of 15. The rapid increase in the size of the
population means that, even when output is rising , output per person can be
falling. On the other hand , developed countries (DCs) have a high average age ,
with less than 25% of the population under 15. A relatively stable population
means that increases in output usually cause productivity to increase as well.
The age structure of a population also affects the pattern of production.
Countries with a high proportion of young dependants (e .g. Kenya) need to
concentrate production on youth-related products such as education. Countries
with an ageing population (e .g. France) have different considerations. An
increasing proportion of old people requires the increased production of related
products such as hospitals. Also, there is no direct relationship between the
population size of a country and the mobility of labour . Mobility depends on age
structure. Countries where average age is rising experience increasing labour
immobility. Hence , it is age distribution and not the size of population which
determines the pattern of employment and output.
Sex distribution has a similar effect in helping to determine the nature of
economic activity. Developing countries such as Brazil have a larger number of
men of working age than women. Nations with large numbers of migrant males
aged 20-45 are likely to have a dynamic and flexible workforce. High rates of
economic growth are probable.
In part, the uneven geographical distribution of population is caused by the
inhospitable physical features and climate of some regions. However, geo-
graphical distribution affects and reflects the pattern of a nation's production.
Less-developed economies with a large labour-intensive agricultural sector have
an even geographical distribution of people . The industrialisation of developed
countries has led to a concentration of populations in urban areas. For example ,
80% of the UK population live in urban areas, and conurbations house a third of
the population in only 3% of the land area.
In conclusion, it has been shown that the qualitative factors of age, sex and
geographical distribution of a nation's population have a greater impact on
economic systems than the actual size of that country's population .

139
 Example 9.18

It has been suggested that the incentive to work in the UK will be increased by (a) a
reduction in social security payments and (b) a reduction in the higher rates of
taxation . Explain and evaluate the reasoning underlying these views.
(JMB 1986)

• Reductions in social security benefits increase net wage rates and are
therefore an incentive to work .
• However, workers can use wage increases to 'buy' more leisure.
• The income-leisure trade-off depends on the income and substitution
effects of wage increases.
• Indifference curves can be used to illustrate this trade-off.

Solution 9.18

Workers on low incomes are eligible to receive social security benefits, such as
income support. The 'poverty trap' occurs when a low-paid worker gains little or
nothing by working overtime once tax and lost benefits have been taken into
account. A reduction in social security payments reduces the income of low-paid
workers, who may then decide to make up lost benefits by working longer hours.
The 'unemployment trap' occurs when there is no substantial difference
between income in or out of work. Studies suggest that low-paid workers with
families of two earn only 15% more by working than when receiving unemploy-
ment benefit. Another indicator of the unemployment trap is the replacement
ratio (RR), which measures the ratio between income in and out of work. The
RR for a long-term unemployed family of two adults and two children is below
75% . Reducing unemployment benefit reduces the RR and so acts as an
incentive to look for work .
A reduction in the higher rates of income tax makes overtime more attractive
to high-income workers. Labour still has to decide between working extra hours
for more money or enjoying more leisure time. The income-leisure trade-off can
be analysed by using indifference curves. Look at Figure 1.
The work indifference curves 1), 12 and 13 show combinations of hours worked
and income received which yield equal total satisfaction to the worker. They
slope upwards because work is usually a disutility and gives negative satisfaction.

Income
received

w,

140
 As the worker moves to an indifference curve further to the left, the higher the
level of satisfaction enjoyed. The line WI shows the amount of income earned
from working various hours at a given wage rate .
Assume that the worker is at point A. A reduction in benefits or tax rates
increases net wage rates and pivots the wage rate line upwards, to W z. The
resultant 'income effect' means that a worker can use an increase in wages to buy
more leisure time. The 'substitution effect' means that leisure is now relatively
dearer, since more income is now sacrificed for each extra hour of leisure .
Benefit or tax cuts which increase wage rates from WI to W z increase the
incentive to work, because the substitution effect is stronger than the income
effect. The worker moves from point A to point B. However , an increase from
W z to W3 reduces the incentive to work, because the income effect outweighs the
substitution effect and extra income is used to buy more leisure time . The worker
moves from point B to point C.
In conclusion, a reduction in social security benefits and rates of taxation acts
as an incentive to work only if the substitution effect of the resultant increase in
net wages is stronger than the income effect.

9.5 Solutions to Objective Questions

Solution 9.2 Answer: A

Positive net migration occurs when the number of people permanently entering a
country is greater than the number leaving . Fertility rates affect birth rates.
C ~ Positive net migration increases the size of the population , but the fall in
the death rate has no direct effect upon the birth rate .

Solution 9.3 Answer: C

Optimum population occurs when productivity (output per person) from a given
amount of resources is highest.

Solution 9.4 Answer: A

An ageing population is likely to cause an increase in the number of retired

people. People who have retired are economically inactive and are classified as
dependants .

Solution 9.5 Answer: B

Developing countries tend to have a high birth rate and a high death rate. As a
result, the base of a population pyramid is broad, while the top is narrow .

Solution 9.6 Answer: A

Developed countries tend to have both a low birth rate and a low death rate .
Consequently, the upper regions of a population pyramid are almost as broad as
the base. The vertical slope of the pyramid indicates a constant birth rate.
C and D ~ Also show developed countries, but the V-shaped base of the
pyramid suggests that the birth rate is falling.

141
 Solution 9.7 Answer: D

A migrant population consists of people, mainly of working age , who have

settled in a country . As a result, there is a bulge in the mid-range of a population
pyramid .

Solution 9.8 Answer: B

B is the only diagram where the base is the broadest part of the population
pyramid. With an increasing birth rate, the sides of a population pyramid slope
outwards as in Figure B in Example 9.5. It follows that there are more births now
than there have been in the past.

Solution 9.9 Answer: B

Refer back to Figure 9.2. An increase in the wage rate results in a movement up
the offer curve of labour. Eventually, the curve slopes backwards and the
number of hours worked falls .

Solution 9.10 Answer: C

An overmanning agreement results in more workers being used for a job than is
necessary . In the short run, employers are forced to increase their demand for
labour. The wage rate of all workers in the industry rises. See Figure 9.4 . In the
long run, a loss of competitiveness may cause the firm to close down, with a
resulting increase in unemployment.

Solution 9.11 Answer: C

An increase in productivity raises the marginal revenue product of bricklayers,

which, in turn, increases the demand for their labour. The demand curve for
bricklayers shifts to the right.

Solution 9.12 Answer: D

A reduction in the apprenticeship period means that all those bricklayers in their
fourth year of training are now available for work, thus increasing supply.

Solution 9.13 Answer: B

The introduction of a closed shop means that all bricklayers must now belong to
a recognised union. The resultant fall in supply shifts the supply curve to the left.
The large fall in interest rates increases aggregate demand, and reduces the cost
of mortgages . A consequent increase in the demand for houses increases the
derived demand for workers, such as bricklayers, involved in construction.

Solution 9.14 Answer: A

See Figure 9.1.

142
Solution 9.15 Answer: A

1 ::;> The industrial mobility of non-union workers is improved.

2 ::;> The resultant increase in the supply of rented accommodation increases the
geographical mobility of labour.
3 ::;> Retraining increases the occupational mobility of labour.

Solution 9.16 Answer: B

A fall in the marginal rate of income tax increases wage rates . If the supply of
labour increases following an increase in wages , workers value income more than
forgone leisure , and the supply curve for labour slopes upwards.
3 ::;> Is incorrect because an increase in wage rates results in a movement along
the supply curve.

143
 10 Welfare Economics
10.1 Fact Sheet

(a) Optimal Resource Allocation

Economic systems have to choose between alternative allocations (uses) of land,

labour and capital. Welfare economics provides a framework for deciding on the
optimal (best) use of scarce resources . A particular resource allocation is
assessed by using:
(i) Efficiency criteria (rules) first developed by Pareto, whereby the economy
should have :
(1) Technical or productive efficiency . This occurs when resources are
fully employed and all firms are producing at minimum average cost.
It is then impossible to increase the output of anyone good without
reducing the output of some other good.
(2) Consumption or allocative efficiency . This occurs when it is imposs-
ible to redistribute products to increase the welfare of anyone
consumer without reducing the welfare of some other consumer.
(ii) Equity (fairness) criteria, which judge the 'desirability' of a particular
resource allocation.

• Using Pareto criteria , a reallocation of resources is desirable only if

someone gains and no one loses.
• A Pareto optimal allocation of resources exists when no one can be made
better off without someone else being made worse off, following a
reorganisation of production or distribution.
• Pareto efficiency criteria cannot be used in resource decisions where
someone gains and someone loses, as this requires the use of equity criteria.
• Equity judgements can be made by using the Kaldor-Hicks test. A change
in production or distribution is desirable only if those who gain can
compensate those who lose, and still be better off. Note that compensation
does not necessarily take place .

(b) Social Costs and Social Benefits

Analysis of a resource allocation requires an accurate valuation of the true costs

and benefits involved in economic activity, including externalities. Externalities
are the spill-over effects of production or consumption , for which no compensa-
tion is paid .
(i) Externalities can be positive (e.g. beekeepers indirectly provide a source
of pollination to market gardeners).

. 1b fi _ private benefit positive externalities

Socra ene It - (b i divid + (b ene fiIts to t hirr d parties
ene fiIt to t hee In IVI ua 1) ies)

144
 (ii) Externalities can be negative (e.g. pollution from a power station may
damage the health of local residents) .
. I _ private cost negative externalities
Socia cost - ( + (costs
cost to t he In
. divid
IVI ua I) to t hiir d parties
ies)

Figures to.1 and to.2 show the effect of externalities on social cost and social
benefits.
Private marginal cost (PMC) is the cost incurred by the firm in producing each
extra unit of good X .
External marginal cost (EMC) is the amount that consumers are prepared to
pay to avoid the negative externalities associated with extra units of X.
Social marginal cost (SMC) is the full opportunity cost of producing each extra
unit of X .
Private marginal benefit (PMB) is the utility gained by the individual from the
consumption of each extra unit of good X.
External marginal benefit (EMB) is the benefit to third parties from the
consumption of each extra unit of X .
Social marginal benefit (5MB) is the full value placed by society on the
consumption of each extra unit of X.

Price

' - - -- - - - - - -- -- - - - Output

Figure 10.1 Social marginal cost

Price

5MB

l...- O ut put

Figure 10.2 Social marginal benefit

145
 (c) Market Failure through Externalities

• An efficient allocation of resources occurs in a market where the opportunity

cost of the extra unit (SMC) equals the value placed by society on its
consumption (SMB) - i.e . where SMC = 5MB.
• Market failure occurs when the price mechanism results in an inefficient
allocation of resources .

Figures 10.3 and lOA show market failure caused by negative and positive
externalities.
In Figure 10.3, QI is the socially efficient level of output where SMC = 5MB.
Q2 is supplied by the industry. The resulting overproduction results in a welfare
loss triangle of ABC.
In Figure lOA, QI is the socially efficient level of output where SMC = 5MB.
Only Q2 is supplied by the industry. The resulting underproduction results in a
welfare loss triangle of JKL.

p p

5MB

L-------'------I...----_O
0,

Figure 10.3 Negative externalities Figure 10.4 Positive externalities

(d) Market Failure through Public Goods

A public good is a product such as defence which is:

(i) non-rival- i.e . an individual's consumption of a public good does not
reduce its benefit to others;
(ii) non-excludable - i.e . once a public good is provided, others cannot be
stopped from consuming it.

• The non-excludability of a public good encourages some consumers to avoid

payment and become free riders.
• A merit good is a product, such as education , which consumers may
undervalue but which the government believes is 'good' for consumers .
Unlike public goods , merit goods can be bought and sold .
• Market failure occurs because profit-maximising firms underproduce public
and merit goods.

(e) Market Failure through Imperfect Competition

Assuming no externalities, marginal cost (Me) equals social marginal cost

(SMC), and price (P) accurately measures social marginal benefit (SMB). Figure

146
 Price

L-- -'-_~.:..:...:...J ____::!l"___ _ Ou tput

Figure 10.5 Alternative pricing policies in imperfect competition

10.5 and Table 10.1 indicate that , unless a firm sets output where the cost of
making the last unit equals its price (marginal cost pricing), market failure
results .

• Nationalised industries generally use a marginal cost pricing policy . Follow-

ing privatisation the same firm will underproduce if it uses a profit-
maximisation pricing policy .

Table 10.1 Consequences of pricing policies

Pricing policy Condition Price Output Result Welfare loss

Average cost P = AC PI QI Overproduction Triangle AJK

Profit maximisation MC=MR P3 Q3 Underproduction Triangle ABC
Marginal cost P = MC Pz Qz Efficient production None

(0 Cost-Benefit Analysis

Cost-benefit analysis (CBA) is a method of assessing the social costs and benefits
of an investment project. This involves comparing the private costs and negative
externalities of a scheme with its private benefits and positive externalities, using
money as a measure of value. Problems involved in CBA occur because:
(i) Externalities are difficult to measure:
(1) negative externalities are valued by calculating how much consumers
would pay to avoid any inconvenience caused by the scheme;
(2) positive externalities are valued by estimating the change in con-
sumer surplus of individuals affected by the project.
(ii) Future costs and benefits are difficult to measure . The present value (PY)
of future net social benefits (social benefits less social costs) is found by
discounting . For example, £500 lent for 2 years earning 10% interest per
annum is worth:
£500 (loan) + £50 interest (in year 1) + £55 interest (in year 2) = £605 (total)
Therefore, the PY of £605 in 2 years' time , discounted at 10% per annum,
is £500.

147
 • The PV of an investment project is calculated by using the equation :

where NSB is net social benefit , r is the rate of social discount and n is the
life of the project.
• A scheme is worth undertaking only if the present value of net social
benefits is positive.

10.2 Data Response

Worked Example 10.1

The firm represented in the diagram below is nationalised and follows a marginal cost
pricing policy.

Costs and
revenue

o R Output per period

(a) With specific reference to the above diagram comment on the relationship
between price elasticity of demand and marginal revenue . (3 marks)
(b) What price would a nationalised industry charge and what output would it
produce if pursuing a marginal cost pricing policy? (1 mark)
(c) State the change in price that would occur if the firm were to adopt an average
cost pricing policy. (2 marks)

148
 (d) (i) What is meant by 'consumer surplus'? (2 marks)
(ii) Assume: (1) the firm is now privatised and, instead of following a policy of
marginal cost pricing, it follows a policy of profit maximisa-
tion ;
(2) cost conditions are unchanged and the firm charges the same
price to all consumers .
What is the change in con sumer surplus? (3 marks)
(e) Subsequently, if this firm were to pursue a policy of price discrimination, explain
with the aid of a diagram how profits could be increased. (4 marks)
(f) Examine the circumstances in which a nationalised firm following a marginal cost
pricing policy would incur a loss. Use a diagram to illustrate your answer.
(S marks)
(L June 1987)

Solution 10.1

(a) Up to output level U, marginal revenue is positive; therefore, the sale of

extra units increases total revenue . Yet , as the firm moves down the
demand (AR) curve, more is being sold but at a lower price . Since
marginal revenue is positive , the given fall in price must give rise to a
proportionately greater increase in quantity demanded . It follows that, up
to output level U, demand is price-elastic. Beyond U, marginal revenue is
negative and demand is price-inelastic.
(b) A firm following a marginal cost pricing policy sets output where
MC = P. Output is T and price is D.
(c) A firm following an average cost pricing policy sets output where
AC = P . Output is X and price is B . Price falls from D to B.
(d) (i) Consumer surplus is the difference between the price consumers pay
and the price they would be prepared to pay rather than go without
the product.
(ii) The initial area of consumer surplus lies below the demand (AR)
curve but above the line DI. The new area of consumer surplus is
PBK. Therefore, the change in consumer surplus is DBKI.
(e) Price discrimination occurs when a firm charges different prices in
different markets for the same product. See Figure 6.8.
(f) A nationalised firm following a marginal cost pricing policy always incurs
a loss if, at the corresponding level of output, costs are greater than
revenue. In the diagram below the total cost of producing Qj, A x QJ, is
greater than the revenue of B x Ql received from its sale .

Cost and
revenue

Q, Output per period

149
10.3 Objective Questions

Example 10.2

Productive efficiency in an economy is achieved in the long run when:

A all resources are fully employed
B the rate of economic growth is maximised
C all firms are producing goods at minimum unit cost
D firms can only supply more of one good by making less of another
E all firms are maximising profits

Example 10.3

Demerit goods are products that:

A are supplied by the government
B create positive externalities
C involve no external costs in production or consumption
D can only be bought in a black market
E are likely to be overconsumed in a market economy

Example 10.4

According to the Pareto criterion, a reallocation of resources that increases almost

everyone's welfare:
A represents an increase in social welfare
B represents a decrease in social welfare
C represents no change in social welfare
D requires an accurate valuation of spillover effects
E cannot be assessed

Example 10.5

Market failure occurs when there is an imperfectly competitive market because:

A all firms are profit maximisers
B marginal cost exceeds marginal revenue
C price exceeds marginal cost
D firms overproduce merit goods
E firms underproduce demerit goods

Example 10.6

The following data refer to a cost-benefit analysis of three possible investment

projects.

Project J Project K Project L

Private benefits (£) 125 140 50

Private costs (£) 115 150 90
External benefits (£) 75 50 200
External costs (£) 100 10 150

150
 It can be deduced that economic welfare would be improved by undertaking:
A project J only B project K only C project L only
D both projects J and K E both projects K and L

Example 10.7

The government decides to fit filters which reduce the amount of sulphur dioxide
discharged into the atmosphere by power stations. To maximise net social benefit, the
government should fit extra filters up to the point where:
A total social benefit is maximised
B marginal social benefit is maximised
C total social benefit minus total social cost is zero
D marginal social benefit minus marginal social cost is zero
E marginal social benefit is zero

Example 10.8

The private costs of a firm do not equal its social costs . All other things being equal,
which one of the following government actions improves welfare?
A tax the firm if social costs are more than its private costs
B tax the firm if social costs are less than its private costs
C subsidise the firm if social costs are more than its private costs
D close the firm down if social benefits minus social costs are positive
E do nothing

Example 10.9

The data below refer to a chemical factory which creates a spill-over effect in the form
of river pollution .

Output (units) 1 2 3 4 5 6 7
Average revenue (£) 14 12 10 8 6 4 2
Marginal private cost (£) 2 4 6 810 12 14
Marginal external cost (£) 2 3 4 5 6 7 8

Assuming no external benefits, the socially efficient level of output is:

A 2 B 3 C 4 D 5 E 6

Example 10.10

Which one of the following comes closest to being a public good?

A council houses B medical care C education
D flood control E postal services

Example 10.11

Cost-benefit analysis does not allow the economist to :

A calculate the national budget
B calculate the full opportunity costs of spending
C calculate the social effects of investment decisions
D evaluate private-sector investment schemes
E assess the purchase of new factory equipment

151
 Examples 10.12-10.15 are based on the following diagram, which shows the
cost and revenue curves of a nationalised industry.

Cost and
revenu e

L--_...1..-_--'--'_.L----L -"""_ _ Output

A BCD

For each of Examples 10.12-10.15 select from the range of output A-E the level which
is the result of:

Example 10.12

A marginal cost pricing policy

Example 10.13

A break-even pricing policy

Example 10.14

A policy to maximise the difference between revenue and cost

Example 10.15

A policy to maximise economic welfare

Select your answers to Examples 10.16-10.19 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 10.16

A positive externality likely to result from the introduction of subsidised inter-city

train service is (are):
1 reduced traffic congestion on inter-city motorways
2 reduced traffic congestion on city ring roads
3 a fall in the number of road accidents

152
 Example 10.17

The following diagram illustrates the cost and revenue curves of a firm:

0,

It can be deduced that the firm :

1 is imperfectly competitive
2 is using marginal cost pricing
3 has taken full account of externalities

Example 10.18

A pure public good is a product :

1 for which it is impossible to charge consumers directly
2 which is not available in a free market economy
3 which has zero opportunity cost in consumption

Example 10.19

Which of the following may prevent a market economy from establishing an optimal
allocation of resources?
1 third party costs or benefits
2 the existence of monopolies
3 the price mechanism

10.4 Essays

Example 10.20

Suppose certain chemical firms discharge waste products into rivers and lakes.
(a) Explain why such discharges may constitute what is termed an 'externality' .
(5)
(b) Explain the argument which asserts that , from a social point of view, the level of
chemical production may be excessive . (10)
(c) Consider whether government policy could lead to a socially more efficient level
of chemical production. (10)
(WJEC 1987)

• This question focuses on a particular example of market failure through

negative externalities.

153
 • Use social cost and benefit curves to illustrate the welfare loss of over-
producing chemicals which cause negative externalities.
• Be careful to concentrate analysis on the specific example of a chemical
firm .

Solution 10.20

(a) An externality occurs whenever the production or consumption decision

of an individual or firm directly affects others other than through market
prices. That is, an externality is a spill-over effect from economic activity
which affects third parties but for which no compensation is paid . The
discharge of waste products into rivers and lakes is an example of a
negative externality. The private cost to the firm of waste disposal is the
cost of transportation . Society at large has to bear, without compensation
by the firm, the external costs which arise from the resulting destruction of
the environment, reduced leisure facilities and other inconveniences.
(b) The diagram illustrates the amount of welfare loss from the over-
production of chemicals.

Price

PMC ; S

l-- =-
---::'-_ _ --"'~ Quantity

Assuming no positive externalities, the demand curve, D, shows the

money value placed by society on the consumption of each extra unit of
chemicals - that is, social marginal benefit (SMB).
Assuming perfect competition, the industry's supply curve, S, is the
addition of each firm's marginal cost curve. The private costs of producing
each extra unit of chemicals is given by the private marginal cost curve
(PMC). In a market economy, profit-maximising chemical firms ignore
the wider social costs of their activity. Anyone company which incurred
the cost of treating its waste product would become uncompetitive and
unable to match the price of rivals . The interaction of supply and demand
results in quantity Ql being produced.
In the diagram, external marginal cost, EMC, is the amount consumers
would be prepared to pay to avoid the pollution associated with the
manufacture of extra units of chemicals. Adding EMC to PMC gives the
social marginal cost, SMC, of producing extra units of chemicals. The
socially efficient level of output occurs at Q2' Profit-maximising firms
produce Ql' Chemical production at levels above Q2 is excessive, because
social cost exceeds social benefit. Total loss from overproduction is given
by the triangle ABC.

154
 (c) The government can achiev e a socially more efficient level of chemical
production by imposing a specific tax equal to EMC at each level of
output. Firms include the amount of the tax as a private cost and reduce
their level of activity to the desired level of Q2' However , a socially
efficient level of output is achieved only if the government is accurate in
calculating the monetary cost to society of pollution .
Alternatively , the government could introduce legislation banning the
disch arge of waste products into the environment. Firms would then have
to include waste tr eatment as a private cost. However , the PMC of
chemicals, including treatment , may now exceed SMC, excluding treat-
ment. Legislation would onl y then achieve a socially efficient level of
production if combined with a subsidy to chemical firm s.
Finally , the government may consider a policy of banning chemical
production altogether. This would result in a loss of welfare equal to
triangle AJK. Even after taking into account the pollution chemicals
caus e , consumers still value extra units up to Q2' more than the social cost
of manufacture . G overnment policy would be more successful if a quota
restricting output to Q2 were introduced.

Example 10.21

'Public sector investment decisions present greater difficulties than do private sector
investment decisions.' Discuss.
(L Jan. 1987)

• Use either the discounted cash flow or int ernal rate of return method to
explain investment deci sion s.
• Private firm s onl y calculate private costs and benefits. Public bodies include
private and social costs and ben efits in a cost-benefit an alysis of investm ent
deci sion s.
• Th e bulk of the essay should consider the difficulties invol ved in such a
cost-benefit analysis.

Solution 10.21

Profit-maximising private firm s onl y tak e into account the effect on their own
costs and revenues of buying capital. Th e spill-ove r effects of investment ar e of
no concern. Social-welfare-maximising public agencies, on the other hand , take
full account of the social implications of buying capital. Public bodies hav e to
include any indirect effects on third parti es in their investment calculations.
The calcul ation of priv ate cost s is a relatively simple matter for the private
firm. The cost of the machine can be found in a catalogue. There may be an
element of uncertainty in estimating the probable net yield from the project in
times of inflation or changing market conditions, but usuall y the firm can predict
future pr ivat e benefits. Th e business then buys new plant or machinery,
provided that the return on the investm ent exceeds its cost.
Public bodies have to undertake a more detailed and involv ed cost-benefit
analysis. For instance, a local authority considering building a by-pas s around a
town has first to identify and then value the likel y social costs and benefits that
arise in each year of the project. Private costs and benefits from building the
by-pass are included at their market price. However , if market prices are
distorted and do not accurately reflect true opportunity cost, alternative
'shadow' prices will have to be calcul ated .

155
 Money is also used as a unit of account for valuing external costs and benefits.
For instance, the by-pass is likely to benefit motorists by reducing travel time .
Multiplying the number of minutes saved by the average wage rate gives an
estimated value of the resulting social benefit. If the scheme reduces the number
of road accidents, reduced expenditure on medical treatment is included in the
calculations. The benefit the by-pass brings to new travellers is another positive
externality, which is included by estimating the increase in consumer surplus.
The wages of anyone unemployed before working on the bridge should not be
included as a social cost, because they would not otherwise have produced
anything. On the other hand, a monetary value is placed on the loss of
landscape . If noise from the by-pass affects local residents , a sum is deducted in
the cost-benefit analysis which represents that damage .
The authority must be particularly careful not to include irrelevant changes.
For example, reduced travel time may increase the value of local houses but this
is not a true benefit of the scheme.
All investment decisions have to calculate the present value of future net
benefits. Benefits received in the future are worth less than the same benefit
received now . Firms resolve this problem by discounting future benefits at a
given rate of interest. For example, at an interest rate of 10% per annum, £550 in
1 year's time is worth only £500 now . Private firms use the current market rate of
interest in their calculations. Public bodies have to calculate a social rate of
discount which states the true opportunity cost of future benefits.
Finally, private investment decisions typically involve schemes with only a
short life. Machines are expected to last only a few years before being replaced
by an improved model. Public projects have a life-span measured in decades .
Estimates of future supply and demand patterns , and demographic trends over a
period of 20 years , make public sector investment decision peculiarly difficult
and complex.

10.5 Solutions to Objective Questions

Solution 10.2 Answer: D

The conditions neces sary for productive efficiency are explained in Section
10.1(a)(i).
A and C =? Are necessary but not sufficient conditions for productive
efficiency. That is, by themselves A and C do not guarantee technical efficiency
in an economy.

Solution 10.3 Answer: E

Demerit goods , such as cigarettes, harm consumers and impose costs on society
in general. For example, the cost of treating lung cancer caused by smoking.
Demerit goods are consumed in quantities above that which is socially desirable.
D :::} Some demerit goods , such as alcohol , are not illegal and are readily
available in the market.

Solution 10.4 Answer: E

Pareto criteria cannot be used to compare a change in resource use which makes
some people better off but others worse off. Here equity criteria such as the
Kaldor-Hicks test are used.

156
 D ~ Is true but does not explain why Pareto criteria cannot be used in
declining resource changes resulting in both gainers and losers.

Solution 10.5 Answer: C

Market failure occurs when a free market economy fails to reach a Pareto
optimal allocation of resources. If the price of a good exceeds its marginal cost ,
underproduction occurs. In Figure 10.5, the area BAC illustrates market failure
from setting output below the point where marginal cost equals price.

Solution J 0.6 Answer: E

Adding together private and external benefits gives social benefits. Adding
together private and external costs gives social costs . Subtracting social costs
from social benefits gives net social benefits. If net social benefits are positive,
general welfare can be increased by undertaking the project.

Project J Project K Project L

Social benefit (£) 200 190 250

Social cost (£) 215 160 240

Net social benefit (£) -15 30 10

Solution 10.7 Answer: D

Welfare is improved by fitting an extra filter, provided that the social benefit
from the extra filter is greater than or equal to the social cost of installation.
A, B, E ~ Ignore the social costs of installation.
C ~ The decision to install extra filters requires a marginal and not total
method of analysis.

Solution 10.8 Answer: A

If a firm has social costs which do not pass through the market (e .g. pollution),
then the government should tax the enterprise so that the firm internalises the
externality and incurs its true total costs .
C ~ A study would only encourage the firm to produce more and, hence ,
increase negative externalities.
D ~ Net social benefits are positive and therefore the firm should be allowed
to carryon production.

Solution 10.9 Answer: B

Adding together private marginal cost (PMC) and external marginal cost (EMC)
gives social marginal cost (SMC). The price consumers are willing to pay for an
extra unit of a good is given by average revenue (AR) - remember that average
revenue always equals price . The socially efficient level of output occurs when
SMC = AR.
At output level 3, SMC = PMC + EMC = 6 + 4 = 10 = AR .

157
 Solution 10.10 Answer: D

The characteristics of a public good are explained in Section 1O.1(d). It is

difficult, if not impossible , to make consumption of flood control dependent on
prior payment.
A and C are examples of merit goods which are rival and excludable products .

Solution 10.11 Answer: A

Cost-benefit analysis (CBA) is a method of evaluating investment projects to

include all gains and benefits. The budget is a statement of how the government
intends to raise money to finance its expenditure.
D =? Although CBA is usually used in the evaluation of public-sector invest-
ment projects , there is no reason why it could not be applied to private-sector
schemes.

Solution 10.12 Answer: D

Marginal cost pricing occurs when a firm makes price equal to marginal cost and
fixes output where the MC curve intersects the demand curve.

Solution 10.13 Answer: E

Break-even pricing occurs when a firm makes price equal to average cost and
fixes output where the average cost (AC) curve intersects the demand curve.

Solution 10.14 Answer: B

Maximising the (positive) difference between revenue and cost will result in
maximum profit. The condition for profit maximisation is that the firm makes
marginal cost equal to marginal revenue and fixes output where the MC and MR
curves intersect.

Solution 10.15 Answer: D

A marginal cost pricing policy where output is increased up to the point where
social marginal benefit equals social marginal cost maximises welfare.

Solution 10.16 Answer: A

A positive externality is a benefit from economic activity, accruing to a third

party, for which no compensation is paid. Subsidising inter-city rail journeys is
likely to reduce the volume of cars on motorways and city roads, thereby
reducing the number of accidents.

Solution 10.17 Answer: B

I =? A downward sloping demand curve indicates imperfect competition.

2 =? The firm has made price equal to marginal cost when fixing the level of
output.
3 =? Is incorrect because no information is given as to whether or not the cost
and revenue curves include externalities.

158
Solution 10.18 Answer: A

1 ~ The non-excludability of public goods such as defence makes it impossible

to link consumption with payment.
2 ~ Since it is impossible to exclude free riders from consuming public goods, a
private firm cannot produce such goods and make a profit.
3 ~ Public goods are non-rival. For instance, once defence has been provided
for one consumer, the cost of providing security for additional consumers is zero.

Solution 10.19 Answer: B

1 ~ An optimal allocation of resources only takes place if firms take full account
of the effect of externalities on third parties.
2 ~ Monopolies may not produce where price equals marginal cost, or at
minimum average cost.
3 ~ In conditions of perfect competition where the government provides public
goods and there are no externalities, the price mechanism ensures a Pareto
optimal resource allocation.

159
 11 National Income
Accounting
11.1 Fact Sheet

(a) Ca lcula ting Nationa l Income

National inco me is the mon ey value of the good s and services produced by a
country in one yea r. Th er e are three method s of calcul ating national income.

(i) The Income Method

First calculate total dom estic inco me by adding up all the money earned by
peopl e and firms in producing this yea r's output. Include :

(1) income from employme nt;

(2) incom e from self-employme nt;
(3) rent ;
(4) gro ss trading profits of companies;
(5) gro ss tr ading surpluses of nationalised industries;
(6) an imputed charge for the con sumption of non-trad ed capital.

Th en proceed as in Figure 11 .1

Stock Net Capital

appreciation property consumption =
+ income
Residual from
error abroad

Figure 11.1 The income meth od

• GDP refers to Gross Domestic Product and is a mea sure of economic

activity within the UK.
• GNP refers to Gross National Product and is a measure of UK citizens'
activity all over th e world.
• NNP refers to Net National Product and is the technical term for national
Income.
• Sto ck appreciation is the increase in the valu e of inventories brought about
by inflation .

160
 • Residual error occurs because income and expenditure data are collected
from different sources. An amount is included to balance up the difference
between these estimates.
• Net property from abroad is the difference between income received from
UK ownership of overseas assets and income paid out to overseas owners of
UK assets.

(ii) The Expenditure Method

First calculate total domestic expenditure by adding up all the money spent
buying up this year's output. Include:
(1) consumers' expenditure (C);
(2) general government final consumption (G);
(3) investment expenditure (I) on :
(a) gross domestic fixed capital formation (e.g. machinery, vehicles);
(b) physical increases in stocks and work in progress.
Then proceed as in Figure 11.2 .

.'
Total GOP at Taxes on GOP at Then proceed
+ Exports expend itu re =
dorrfestic market factor as for the
- Imports
expenditure prices cost income method
+ Subsidies

Figure 11.2 The expenditure method

(iii) The Output Method

The economy is divided into industrial sectors (e.g. construction). The value of
inputs (purchases) is then deducted from the value of outputs (sales) to find each
industrial sector's value added. For example:
sales - purchases = value added
£60b - £50b = £10b
• Adding up each sector's value added, and including a imputed (estimated)
value for the ownership of dwellings, gives GDP at factor cost .

It is important to understand the relationships shown in Table 11.1.

Table 11.1 National Income accounting equations

National Income - National Expenditure == National Output

GNP = GDP + Net property income from abroad
NNP = GNP - Capital consumption
Gross investment Net investment + Capital consumption
Factor cost Market prices - Expenditure taxes + Subsidies

161
 (b) Problems in Calculating National Income Accounts

Difficulties arise in the calculation of national income accounts (N .Y.A.)

because of:
(i) double counting if transfer payments (e .g. pensions), intermediate ex-
penditures or outputs (e .g. components) , and stock appreciation are
included;
(ii) unrecorded production in the black economy;
(iii) arbitrary definitions:
(1) the imputed value of services from owner occupied houses is included
in N.Y. A ., while the imputed value of services of consumer durables
(e.g. cars) is not;
(2) paid production (e.g. decorator) is included in N.Y.A., while unpaid
production (e .g. DIY) is not.

(c) Importance of National Income Accounts

National Income Accounts provide data for:

(i) showing the current allocation of resources;
(ii) government economic planning;
(iii) calculating trends within the economy;
(iv) measuring a country's standard of living;
(v) comparing standards of living between different countries.

(d) Real and Money National Income

• Money (or nominal) national income (M .N .Y .) is the value of this year's

output at current prices.
• A price deflator is an index used to eliminate the effect of inflation. There
are two main price indices in the UK:
(i) the Retail Price Index (RPI), covering only consumer goods and
services;
(ii) the GDP deflator, covering both consumer and capital goods.
• Real national income (R .N .Y .) is the value of this year's output at constant
prices and is calculated by using either of the following equations:
M.N.Y.
R.N.Y. = G DP de flator x 100

price index of base year

R.N.Y. = M.N .Y. x ----:...-------~­
price index of current year

(e) Measuring a Country's Standard of Living

National income measures the value of goods and services produced by a country
in a year. An increase in the value of national income implies an increase in
economic welfare, unless:
(i) the increase has been brought about by inflation;
(ii) there is a corresponding increase in population;
(iii) only a small fraction of the population receive the benefits because of an
unequal distribution of income ;

162
 (iv) additional output results in negative externalities such as pollution ;
(v) additional output is on non-consumer items such as defence;
(vi) increased output is the result of harder conditions of work or reduced
leisure time.

The standard of living (SOL) refers to real national income per capita
(person), and is calculated by using the equation:

SOL = R .N.Y.
population
Table 11.2 gives examples of calculating changes in a country's standard of
living, over time .

Table 11.2 Calculating the standard of living

Year M .N.Y. RPI R.N.y. Population SOL

(£m) (deflator) (£m) (m) (£)

1989 £20000 100 £20000 5 £4000

1990 £22000 105 £20952 5 £4 190
1991 £24000 110 £21 818 5.5 £4970

• An increase in per capita R.N.Y. is one indicator of improved economic

welfare.
• An increase in the percentage of the population owning consumer durables
such as cars indicates a rise in overall living standards.
• A reduction in the amount of time taken by the average worker to earn
sufficient money to buy given products indicates improved living standards.
• Measurable Economic Welfare (devised by Nordhaus and Tobin) adjusts
national income figures for leisure, working conditions, unpaid housework
and externalities, and excludes defence and police work .

(f) Comparing Living Standards in Different Countries

Using per capita R.N .Y . to compare standards of living between countries is

difficult, because:
(i) changes in the exchange rate affect the relative value of each country's
national income;
(ii) different statistical procedures are used to calculate national income in
different countries;
(iii) the extent of the black economy varies between nations ;
(iv) the distribution of income varies between countries.

International comparisons can be made by contrasting the percentage of the

population in each country owning particular consumer durables ; by contrasting
the amount of time taken in each country to earn sufficient money to buy given
products; by contrasting mortality rate s; or by contrasting measurable economic
welfare .

163
11.2 Data Response

Worked Example 11.1

Table 1 Average weekly household income in the United Kingdom

1970 1975 1980 1983

Gross weekly income £35.40 £72.87 £147.18 £187.86

Weekly disposable income £29.54 £58.16 £121.50 £152.58

Source : Famil y Expenditure Survey

Table 2 The rental price index (1975 = 100)

1970 1975 1980 1983

54.2 100.0 195.6 248.6

Source: Economic Trends

Table 3 Selected commodities or services as a percentage of total household

expenditures in the United Kingdom

1970 1975 1980 1983

Housing 12.6 13.1 15.0 16.8

Fuel , light , and power 6.3 5.5 5.6 6.4
Food 25.7 24.8 22.7 20 .8
Alcoholic drink 4.5 5.1 4.8 4.8
Tobacco 4.8 3.6 3.0 2.9
Clothing and footwear 9.2 8.7 8.1 7.0
Durable household goods 6.5 7.4 7.0 7.2
Transport and vehicles 13.7 13.8 14.6 14.7
Services 9.0 9.9 10.8 11.3

Source: Family Expenditure Survey

(a) Explain the terms 'gross weekly income' and 'weekly disposable income'.
(2 marks)
(b) Discuss whether the average household in the United Kingdom is better or worse
off over the period shown in the data . (6 marks)
(c) (i) Summarise the significant features of the data in Table 3 (4 marks)
(ii) Suggest the possible reasons which might explain the changes or the lack of
change in the pattern of hou sehold expenditure shown in the data .
(8 marks)
(AEB June 1986)

Solution 11.1

(a) Gross weekly income refers to the amount of money received by

households before deductions for tax and national insurance . Weekly
disposable income is the amount of 'take home' pay after deductions have
been made and any benefits have been included from gross pay for income
tax and national insurance.
(b) The data in Table 1 would seem to indicate a clear improvement in money
income over the period specified . However, these raw data fail to take
account of the effect of inflation on the purchasing power of weekly pay.

164
 Real income is found by using the equation
. money income x 100
real Income = . ..
retail pnce index
Using the data in Tables 1 and 2 gives the following information:

Table 4 Real weekly income

1970 1975 1980 1983

Real gross weekly income (£) 65.31 72.87 75.25 75.57

Real weekly disposable income (£) 54.50 58.16 62.12 61.38

Real gross weekly income has risen throughout the period . However,
disposable income rises between 1970 and 1980 but falls between 1980 and
1983. In this period, households are able to buy fewer goods and services.
(c) (i) The three items of household expenditure which absorb the largest
proportion of household spending are: food, transport and vehicles,
and housing. These three items have maintained their relative posi-
tion throughout the period covered . However, while the percentage
spent on housing (up [16.8 - 12.6]/12.6 = 33%) and transport (up
[14.7 - 13.7]/13.7 = 7%) has risen consistently , the proportion spent
on food has fallen continually and by 19%. Spending on tobacco
(down 40%) and clothing (down 24%) has fallen , while spending on
services has risen by 26% .
Spending on fuel , alcohol, durable household goods and transport
is relatively stable , with a less than 1% change in the absolute
proportion of each item .
(ii) A large increase in the proportion of the population owning their own
homes has increased the demand for houses. Escalating house prices
have forced would-be householders to take larger mortgages, with
repayments accounting for a growing percentage of overall spending.
Food has a low income elasticity of demand coefficient. As incomes
rise, a smaller proportion has been devoted to expenditure on food
between 1970 and 1983. Services, on the other hand, have a high
income elasticity of demand and now account for a higher percentage
of spending. Items where the percentage spent has remained virtually
static throughout the period are likely to have income elasticity of
demand coefficients close to unity.
A movement in consumer taste away from tobacco smoking has
caused a decline in relative spending.

11.3 Objective Questions

Example 11.2

Which one of the following is not a reason for a country collecting national income
statistics:
A to calculate changes in the standard of living
B to calculate changes in the cost of living
C to compare standards of living between countries
D to provide data for private-sector firms
E to estimate the rate of economic growth

165
 Example 11.3

Which one of the following is included in UK national income accounts:

A the imputed value of direct production
B the market value of the output of housewives
C a charge for the depletion of non-renewable resources
D an imputed rent from owner occupation of houses
E the imputed value of undeclared economic activity

Example 11.4

The national income accounts exclude all the following except:

A intermediate expenditures B transfer payments
C transfer earnings D residual error
E balancing item

Example 11.5

On reaching 65, a builder earning £10 000 per year sells his firm for £10 000 but stays
on as consultant for a fee of £5000 per year. He receives an annual occupational
pension of £5000 . One of two assistants, each earning £5000, loses his job and is not
eligible for state social security benefits. As a result , national income :
A falls by more than £5000 B falls by £5000
C is unchanged D rises by £5000
E rises by more than £5000

Example 11.6

Gross national product exceeds gross domestic product by the amount of :

A subsidies less expenditure taxes B transfer payments
C income from abroad D imports
E capital consumption

Example 11.7

Which one of the following is the most accurate measure of a country's standard of
living?
A real national income B nominal national income
C per capita real national income D per capita nominal national income
E the domestic product deflator

Examples 11.8-11.10 are based on the following table, which shows the value of
inputs and outputs at different stages in the production of wooden tables.

Stage Cost Revenue

Plantation 0 10
Mill 10 25
Factory 25 50
Retailer 50 70

166
 A 20 B 25 C 50 D 70 E 85

On the basis of the above information, select from the options A-E above, the figure
which corresponds to:

Example 11.8

The value added by the retailer.

Example 11.9

The value of final output.

Example 11.10

The value of intermediate expenditures .

Examples 11.11-11 .14 make use of the following information concerning the
national income accounts of an imaginary country.

feb)
Total final expenditure at market prices 22
Gross domestic product at market prices 20
Subsidies 1
Gross domestic product at factor cost 18
Gross national product at factor cost 18
Net national product at factor cost 17

A fOb B £1b C £2b D f3b E f4b

On the basis of the above information, select from the options A-E the figure which
corresponds to :

Example 11.11

Taxes on expenditure.

Example 11.12

Imports.

Example 11.13

Depreciation .

Example 11.14

Net property income from abroad .

167
 Examples 11.15-11.17 are based on the following national income statistics of a
hypothetical country .

feb)
Consumption 195
Investment 55
Government spending 70
Exports 68
Imports 66
Capital consumption 38
Indirect taxes 44
Income from abroad 3

A £454b B £388b C £322b D £278b E £243b

Use the above data to select from options A-E the figure which measures:

Example 11.15

Total final expenditure at market prices .

Example 11.16

Gross domestic product at market prices.

Example 11.17

Net national product at factor cost.

Example 11.18

If, over the last twelve months, prices have gone up by 6%, population has increased
by 2% and nominal national income has risen by 6%, then :
A real national income has increased B real national income has decreased
C real income per head has increased D real income per head has decreased
E real income per head is unchanged

Example 11.19

The table below gives information about a country in 1989, 1990 and 1991. In 1988
real GDP per head was £8200.

GDP G D P deflator Population

(£ millions) index (1987 =100) (millions)
1989 440000 110 50
1990 450000 120 50
1991 480000 120 51

168
 From the data, it can be deduced that real GDP per head:
A has increased in all three years
B has decreased in all three years
C has increased in 1989 and 1990 only
D has decreased in 1989 and 1990 only
E has remained constant

Select your answers to Examples 11.20-11.23 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 11.20

Which of the following is (are) not necessarily equal to national income?

1 national wealth 2 national product 3 national output

Example 11.21

Which of the following is (are) not included in national income calculated by the
income method?
1 interest received by holders of government stocks
2 the prize received by a football pools winner
3 final consumption

Example 11.22

All other things being equal, which of the following would increase the average
standard of living of a country?
1 a rise in population and a proportionately greater increase in national product
2 no change in population and an increase in national product
3 a fall in population and no change in national product

Example 11.23

When calculating final national income, it is necessary to exclude:

1 the purchase of a second-hand car
2 intermediate outputs
3 stock appreciation

11.4 Essays
Example 11.24

Distinguish between wealth and welfare. Discuss whether increases in national

income provide a suitable indication of improvements in welfare .
(AEB June 1987)

• Material welfare is the satisfaction derived from the consumption of wealth .

• National income is a narrow measure of a nation's wealth creation in a given
time period.
169
 • Include a discussion of the circumstances in which an increase in national
income does and does not improve welfare .
• A detailed discussion of how national income accounts are calculated is not
required.

Solution 11.24

Any asset which can be exchanged for money can be regarded as an item of
wealth. There are two main types:
(a) Material wealth consists of financial assets such as shares , and real assets
such as property and consumer durables .
(b) Human wealth con sists of the skills, training and education of individuals.
The consumption of material wealth satisfies the wants and needs of individuals.
The higher an individual's rate of consumption the higher his material welfare .
Hence, wealth and material welfare are interlinked .
A nation's stock of wealth allows it to produce an enormous variety of goods
and services which can then be used to satisfy material wants and needs. National
income is simply the money value of all final products provided during a year
which flow through the markets . Hence, national income is a indicator of
economic welfare.
However, an increase in national income does not automatically raise living
standards. For instance , an increase in national income may be the result of an
increase in the price level with output held constant, or an increase in output
with prices held constant. Only the latter suggests an increase in material
well-being. To measure changes in real as opposed to money national income ,
output is valued at constant prices by dividing current money national income by
a general index of all prices , called the GDP deflator.
Yet an increase in real national income is still no guarantee that average living
standards have improved. Any improvement in material standards could be
negated by a proportionately larger increase in population. The actual standard
of living of a nation is found by dividing real national income by the total
population. Material well-being, then, increases only if per capita real national
income increases.
It can be argued that per capita real national income is a restrictive, narrow
welfare indicator. Official statistics only count final products sold in markets and
ignore the value of non-market activities such as the output of unpaid house-
keepers . The value of leisure time finds no place in national income accounts .
Official statistics fail to take into account the impact of intangibles such as the
quality of the environment on overall social welfare . The presence of negative
externalities may cause the material and social welfare of a nation to diverge .
Nordhaus and Tobin have devised an alternative measure of social welfare:
measurable economic welfare. Here real national income is adjusted to include
an allowance for non-marketed output and leisure time, while expenditure on
'regrettable necessities' including defence, and the effects of negative external-
ities such as pollution, are deducted . An improvement in measurable economic
welfare indicates an improvement in social welfare .
There are a series of other non-economic measures which can also be used to
indicate improvements in welfare over time . The United Nations publishes data
on the infant mortality rates, suicides and road accidents of various countries. A
fall in these figures implies an improvement in a nation's quality of life.
Similarly, an increase in the proportion of the population owning various types
of consumer durable such as video recorders, or a reduction in the time taken to
earn sufficient money to buy given products, implies improved social welfare .

170
 In co nclusio n, it has been sho wn tha t a co untry's stock of wealth helps
det ermine th e qu antity of goods ava ilab le fo r th e sa tisfac tio n of mat erial wa nts
a nd needs . In cr eases in real pe r ca pita nat ion al income are a suitable indicat ion
of impro vements in material we lfa re . A sim ulta neous and lar ger increase in
negat ive exte rna lities o r re d uced le isure wo uld lo wer overall so cia l we lfa re .

Example 11.25

D iscuss th e problems which might ar ise in atte mp ting to co mpare th e sta nda rd of
livin g in th e U nite d Kin gd om wit h th at in (a) Br azil a nd (b) th e Sov iet Un ion .
(O LE 1986)

• Discu ss va rious methods of measuring living sta nda rds .

• D etail ed knowledge of th e econo mic syste ms of Brazil and the Soviet Uni on
is not expecte d .
• The UK is an ex ample of a mixed eco no my ; Brazil , a dev eloping eco no my;
a nd th e Soviet Union , a planned ec o no my .
• Place th e em phasis of th e essay o n th e probl em s of comparing livin g
sta nda rds between countries.

Solution 11.25

The sta ndard of living can be defined as real per capita income. H en ce ,
inte rnatio nal compari son s of living sta ndards are usu all y made by re fe rring to
nation al income sta tist ics. H owever , great care sho uld be tak en in usin g raw
nati on al income figures. Mon ey nati on al income sta tes th e va lue of thi s year's
final mark et ed output at curre nt pri ces . An incr ease in o ne co untry's nominal
nation al income may be th e result of infl ati on rather th an an increase in total
o utput. Therefore , nati on al income divid ed by an index of a ll prices - for
examp le , th e GDP defl at or - pro vides a better basis for co m pariso n . E ven
th en , real GNP alo ne is not an accurate guide to a country's sta ndard of livin g.
R eal GNP is twic e as high in th e UK as in Brazil. Brazil has more th an twic e th e
populati on of th e UK . Di vidin g real GNP by total populati on means that th e
average sta ndard of livin g is four tim es high er in th e UK th an in Brazil.
A furt he r adjustment is necessary to co nve rt th e figures of each country to th e
sa me cur re ncy . This ca n ca use problem s if th e market rat e of ex change of o ne
country does not refl ect different cos ts of living . For exa mple , th e am ount of
roubles excha nged fo r £ 1 at th e officia l ra te may buy fewer goods in th e USSR
th at ca n be bought with £1 in the U K. Conve rting So viet nati on al income int o
ste rling at th e official ra te of exc ha nge wo uld result in an overvalua tio n .
Moreo ver , Brazil and th e U K have floating exc ha nge ra tes , and th e resulting
con tinual cha nges in th e rel at ive va lue of th e two cur re nc ies mak e a direct
co mpariso n d ifficult.
Bec au se Brazil has not yet reach ed th e sa me stage of econo mic development
as th e UK , a ran ge of activities included in the U K accounts go unrecorded in
Brazil. Inten se spe cia lisa tio n mean s th at most UK citize ns use markets to bu y
goods and se rv ices th ey have not had tim e to mak e th emsel ves. H ence , UK
nati onal inc ome figures include most of th e eco no mic ac tivity which has tak en
place in th e last ye ar. Unmarket ed and undecl ar ed activity is o nly likel y to
acco unt fo r a small percentage of total output. For exa mple , th e tax returns of a
UK fa rmer are usuall y an accurate indicator for nati on al inc ome accountants of
th e valu e adde d by a farmer in a nyo ne ye ar. By way of co ntrast, markets are less
developed in Brazil bec au se co mm unities are more se lf-sufficie nt and practise

171
 less specialisation and exchange. The output of a Brazilian farmer will not be
officially recorded if a crop is either consumed by the farmer or exchanged for
other goods, or if income is not declared to the authorities .
Problems arise when different countries use different statistical procedures in
calculating national income figures . For instance, the Soviet Union is a planned
economy where resources are allocated by the state . Official prices are used to
value output , but these may not reflect the relative value of goods and services
consumed in the Soviet Union . Activities considered economic in the UK and
included in national accounts are considered unproductive and excluded from
USSR statistics. For instance, the output of entertainers is excluded for Soviet
statistics but included in UK national accounts .
Different countries draw different boundaries between intermediate and final
output. Most people travel to work . A large number of commuters in the UK use
British Rail, and the value of their expenditure on travel, less the cost of inputs,
is added to national income. In the USSR, public transport is considered an
intermediate output - that is, a type of input - and is therefore not included in
the accounts .
Physical conditions vary widely between Brazil , the UK and the USSR. The
climate of the USSR is severe in winter; the climate of Brazil is not. Yet the
national income of the USSR includes expenditure on heating, which Brazil does
not have to undertake, and the value of the resources used to heat buildings is
included in Soviet national income .
The extent of negative externalities and the proportion of national product
spent on 'regrettable necessities' vary between countries. For example, defence
spending in the USSR accounts for a larger percentage of GDP than in either
Brazil or the UK .
International comparisons of standards of living may overcome the problems
discussed by adopting alternative measures of welfare. The country where least
time is taken by a worker to earn sufficient income to buy a given basket of goods
is likely to enjoy the highest standard of living. Low suicide rates and low infant
mortality rates also indicate a good quality of life.

11.5 Solutions to Objective Questions

Solution 1.2 Answer: B

Changes in the cost of living are calculated by using the retail price index. The
uses of national income accounts are explained in Section 11.1 (c).

Solution 11.3 Answer: D

A decrease in the number of people renting accommodation reduces the income

of landlords, and national income falls. An imputed (estimated) figure for the
amount of income home owners could obtain by renting out their homes is
included in the accounts .

Solution 11.4 Answer: D

By definition, the value of national income using the income or expenditure

methods is the same. However, the sources of information used to collect income
and expenditure figures are different. Income is adjusted to equal expenditure
by the inclusion of a ' residual error'.
E => Is an error term used in the balance of payments.

172
Solution 11.5 Answer: A

The pension of the builder (a transfer payment) and the money received from
the sale of the firm (a transfer of ownership) are not included in national income.
The fall in national income is: £5000 (the builder's reductions in earnings) +
£5000 (the loss of the assistant's salary) = £10 000.

Solution 11.6 Answer: C

Solution 11.7 Answer: C

Solution 11.8 Answer: A

Value added is the difference between the value of inputs (costs) and outputs
(revenue) .

Solution 11.9 Answer: D

The value of final output can be calculated either by adding together the value
added by each stage of production or by only counting the final output of the
retailer.

Solution 11.10 Answer: E

The total amount of money spent on buying inputs gives the value of inter-
mediate expenditures.

Solution 11.11 Answer: D

GDP at market prices - indirect taxes + subsidies = GDP at factor cost

(£20b) - (£3b) + (£1b) = (£18b)

Solution 11.12 Answer: C

Total final expenditure at market prices (£22b) less imports (£2b) gives GDP at
market prices.

Solution 11.13 Answer: B

GNP at factor cost (£18b) minus depreciation (El b) gives NNP at factor cost
(£17b).

Solution 11.14 Answer: A

GNP at factor cost (£18b) less GDP at factor cost (£18b) gives net property
income from abroad (£Ob) .

Solution 11.15 Answer: B

Consumption (£195b) + investment (£55b) + government spending (£70b) +
exports (£68b) gives a total final expenditure at market prices of £388b.

173
 Solution 11.16 Answer: C

Consumption (£195b) + investment (£55b) + government spending (£70b) +

exports (£68b) - imports (£66b) gives a GOP at market prices of £322b .

Solution 11.17 Answer: E

GDP at market prices (£322b) - indirect taxes (£44b) + income from abroad
(£3b) - capital consumption (£38b) gives a net national product of £243b.

Solution 11.18 Answer: D

A and B :::} Equal percentage increases in nominal (money) national income and
prices means real national income is unchanged.
C and E :::} A 2% population increase with constant real national income means
real income per head has decreased .

Solution 11.19 Answer: D

There are two stages in calculating real GOP per head:

(i) divide GDP by the GDP deflator to find real GOP;
(ii) divide real GDP by population.
In 1989: real GDP = (£440 000 -7- 110) x 100 = £400 000
real per head GOP = £400 000 -7- 50 = £8000
In 1990: real GDP = (£450 000 -7- 120) x 100 = £375 000
real per head GOP = £375 000 -7- 50 = £7500
In 1991: real GOP = (£480 000 -7- 120) x 100 = £400 000
real per head GOP = £400 000 -7- 51 = £7843

Solution I I .20 Answer: D

Wealth is the current market value of all assets, including those created III
previous years .

Solution 11.21 Answer: B

1 :::} The interest received by the holders of government stocks is not included,
as it is a payment on debt created in the past and is not related to current output.
2 :::} Prizes from gambling are a type of transfer payment.
3 :::} Final consumption is included in the expenditure method .

Solution 11.22 Answer: A

Solution 11.23 Answer: A

1 :::} The car has already been included in previous accounts .

2 :::} Intermediate outputs are the raw materials and components used in produc-
tion . Only the value of final output is counted.
3 :::} Stock appreciation is the increase in the value of stocks brought about by
inflation and is therefore not included .

174
 12 Income Determination
12.1 Fact Sheet

(a) The Circular Flow of Income

The economy can be divided into a number of spending sectors:

(i) households (H) , whose expenditure is called consumption (C);
(ii) firms (F) , who se expenditure is called investment (I) ;
(iii) government (G);
(iv) international, referring to the difference between exports (X) and imports
(M).

• A closed economy has no international trade (i.e . no X - M) .

• An open economy takes account of international trade (i.e. includes
X - M).
• The circular flow of income shows the flow of income and payments
between domestic households and firms .

w-M <T< S ' / ~

.~ /.
J =X +G +I ..

Figure 12.1 The circul ar flow of incom e in a four- sect or economy

• Injections (1) are additions to the income of firms which do not normally
arise from the expenditure of households. There are three types : invest-
ment, government and exports . Injections cause a rise in spending in the
economy .
• Leakages or withdrawals (W) is any income not passed on in the circular
flow. There are three types: savings, taxation and imports. Withdrawals
reduce spending in the economy .

(b) Consumption

Consumption is expenditure by households on goods and services which satisfy

current wants.

175
 • The consumption function in Figure 12.2 shows how much will be spent at
different income levels , and is given by the equation:
C = a + bY
where C = consumption, a = autonomous consumption (what is spent
when income is 0 and does not vary with income) , b = the marginal
propensity to consume and Y = National Income. bY is income-induced
consumption.
• As income rises, the amount spent rises depending on the value of the
marginal propensity to consume. As national income rises, so the propor-
tion spent begins to decline .
• The average propensity to consume (ape) is the proportion of total income
spent: ape = ClY.
• The marginal propensity to consume (b or mpc) is the proportion of each
extra pound spent by households, and is the change in consumption
resulting from a change in income : b = !:1C1!:1Y.

NEx NEx = N.Y.

o H N.Y.

Figure 12.2 Autonomous and induced consumption: OA or HF = autonomous

consumption = a ; DH/BH = ape

NEx

c
0
I
I
--- - El
I
I
I
I
LlY I
I
I
I
0 G H N.Y.

Figure 12.3 The marginal propensity to consume: DE/GH = b

176
 Influences on consumption include the level of income; credit facilities;
distribution of income; the population's age structure; the quality and availabil-
ity of consumer goods; the amount and distribution of wealth ; expectations of
inflation.
It is important to remember that there is more than one theory of consump-
tion. Most economists agree that the main influence on consumption is income.
However:
(i) Keynesians believe that consumption is a function of current income.
Therefore, the value of the marginal propensity to consume is high.
(ii) Friedman's Permanent Income Hypothesis and Modigliani's Life Cycle
Hypothesis argue that consumption is a function of estimated lifetime
income. Therefore , the value of the marginal propensity to consume is
low.

(c) Savings

Savings is that part of disposable income (income less taxes) not spent on goods
and services.

• The savings function shows how much will be saved at different income
levels and is given by the equation
S= - a + sY
where S = savings; - a = autonomous dissaving (the amount of s when
Y = 0); s = the marginal propensity to save; Y = National Income;
s Y = induced saving. As income rises, both the amount saved and the
proportion saved usually increase.
• The average propensity to save (aps) is the proportion of total income saved:
aps = SlY.
• The marginal propensity to save (s or mps) is the proportion of each extra
pound of disposable income not spent and is the change in saving resulting
from a change in income: s = aSlay.

Savings

s
+

} Savinq

N.Y.
_~.-r:::--- Dissavings

Figure 12.4 The savings function

177
 Influences on savings include the level of income ; the rate of interest ; the rate
of inflation; the quality of financial institutions ; general attitudes to the virtue of
saving; government policies (e.g. tax concessions) ; expectations of inflation ;
advertising.

(d) Investment

• Investment is expenditure on capital goods and changes in stocks.

• The marginal efficiency of capital is the expected rate of return on
investment.
• The accelerator theory states that a given change in demand for consumer
goods will cause a greater percentage change in demand for capital goods .
So the level of planned investment is a function of changes in income:
1= (f) ~Y.

The level of investment is also influenced by:

(i) the rate of interest;
(ii) the relative prices of capital and labour ;
(iii) corporation tax ;
(iv) technological change and innovation;
(v) business expectations ;
(vi) profits/company liquidity.

(e) Income Determination

Assuming a two-sector closed economy of households and firms , aggregate

demand is made up of consumption and investment. There are two conditions
necessary for equilibrium:
(i) aggregate demand (C+/) must equal national income (N .Y.);
(ii) planned withdrawals (savings) must equal planned injections (invest-
ment).

NEx

NEx = N.Y .

o N .Y .

Figure 12.5 Equilibrium in a two-sector closed economy

178
 (f) Disequilibrium Levels of National Income

Disequilibrium occurs when planned injections are not equal to planned

withdrawals or when aggregate demand does not equal national income. For
instance, at Y 2 in Figure 12.5 , national output (1) is greater than aggregate
demand (K) . Firms are left with]- K unsold goods which are added to stocks. In
the next time period, these stocks are run down by laying off workers and income
falls back towards YI .

(g) The Multiplier

The multiplier (k) shows by how much income changes as a result of a change in
an injection . The value of the multiplier is given by any of the following
equations:
~Y 1 1
k -- - - - -- -
s: I-b w
where b is the marginal propensity to consume, and w is the marginal propensity
to withdraw - that is, the proportion of each extra pound withdrawn from the
circular flow.
To calculate the effect of changes in an injection on national income, use the
equation:
~Y = k x ~]

For example, assume a three-sector closed economy where b = 0.8 . An increase

of £50m in government spending results in an increase in national income of
1/1 - 0.8 x 50 = 5 x 50 = 250.
Note that:
(i) w = s in a two-sector closed economy ;
(ii) w = s + t in a three-sector economy , where t is the marginal propensity
to tax;
(iii) w = s + t + m in a four-sector economy, where m is the marginal
propensity to import.

• The multiplier effect is the series of consumer incomes and expenditures

generated by an initial change in an injection .

(h) The Government Sector

Government spending (G) is an injection and taxation (T) is a leakage .

• The marginal propensity to tax (t or mpt) is the proportion of each extra

pound of income taken by the government, and is the change in tax
resulting from a change in income: ~TI~Y.
• A three-sector closed economy is in equilibrium when :
(i) N.Y . = C + I + G;
(ii) 5 + T = I + G .

(i) The International Sector

Exports (X) add to income in the home economy and, hence, are an injection,
whereas imports (M) result in income leaving the domestic circular flow of
income and represent a leakage.

179
 • The marginal propensity to import (m or mpm) is the proportion of each
extra pound of disposable income spent on foreign-made goods, and is the
change in expenditure on imports resulting from a change in income:
;).M/;).Y.
• A three-sector open or four-sector economy is in equilibrium when :
(i) N.Y. = C + 1+ G + (X-M);
(ii) S + T + M = I + G + X.

(j) Aggregate Supply

Aggregate supply is the total of all planned production in a period at each level
of prices. The aggregate supply (AS) curve in Figure 12.6 shows:
(i) AS is horizontal if the economy is operating well below full employment
and national income rises through an increase in output with constant
prices;
(ii) AS is upward-sloping if there are bottlenecks in some but not all markets
and national income rises through an increase in both prices and output;
(iii) AS is vertical if the economy is at full employment and national income
rises through an increase in prices with constant output.

Price level

ADI-AD2 = o»
AD2-AD3 = alPI
AD 3-AD 4 = lIP,

o Real N.Y.

Figure 12.6 Aggregate supply and demand

(k) Aggregate Demand

Aggregate demand is the total of all planned expenditure at each level of prices.
The aggregate demand (AD) curves in Figure 12.6 are downward-sloping
because:
(i) The lower the rate of inflation the lower the rate of interest and, hence,
the greater the demand for interest-sensitive investment and consumer
goods.
(ii) As prices fall, people's wealth buys more products.
(iii) As UK prices fall, consumers substitute domestically made goods for
imports.

180
 (I) Changes in Aggregate Supply and Demand

• Supporters of supply-side economics argue that output is largely supply

determined. The AS curve can be shifted to the right by:
(i) removing market distortions ;
(ii) increasing incentives by reducing taxes on income .
• The AD curve shifts to the right if there is an increase in aggregate demand
at each price level. This may be the result of more desired consumption,
investment, government spending or international demand for UK products.

12.2 Data Response

Worked Example ]2.1

Year 1: In a closed economy there is initially no government spending or taxation and

the only injection is investment. National Income is £600m and mpc is 0.75 of
disposable income .
Year 2: A government sector is introduced with a tax rate of 20% of N.Y . and
government spending of £80m. Investment remains at the level prevailing in year 1
and mpc remains at 0.75 of disposable income.
Year 3: The country engages in international trade . Export earnings are £110m and ~
of consumption is spent on imports. Government spending remains at £80m but
investment rises by nOm . The tax rate stays at 20% of N. Y. and mpc at 0.75 of
disposable income .

(a) Calculate the level of investment in Year 1. (2 marks)

(b) Calculate the level of N. Y. and the budget deficit or surplus in Year 2.
(6 marks)
(c) Calculate the level of N.Y. , the budget deficit or surplus and the balance of trade
position in Year 3. (8 marks)
(d) Is the government's fiscal policy reflationary or deflationary? (2 marks)
(e) Would you expect the mpc to remain constant as income changes? (2 marks)

Solution 12.1

(a) In year 1, mpc is 0.75, so mps is 1 - 0.75 = 0.25 and the multiplier is
1/0.25 = 4. Investment is the only injection. N.Y . = injections x the
multiplier. So investment = £600m/4 = £150m.
(b) In year 2, mpt is 0.2 and mps is ~ of 0.8 (disposable income) - i.e. 0.2.
So the multiplier is
1 1
----= =2!
mpt + mps 0.2 + 0.2 2

Injections are £150m (investment) + £80m (government spend-

ing) = £230m. So N.Y . = £230m x 2~ = £575m.
The budget position is tax revenue - government spending. Tax revenue
is 0.2 x £575m = £115m. So the budget position is £115m - £80m = a
budget surplus of £35m.
(c) In year 3, mpt is 0.2, mps is 0.2 and mpm is ~ of consumption - i.e . ~ of
0.6 = 0.1. So the multiplier is:
1 1
-------= =2
mpt + mps + mpm 0.2 + 0.2 + 0.1

181
 Injections are £llOm (exports) + £80m (government spending) +
£170m (investment) = £360m. N.Y. is £360m x 2 = £720m.
The budget position is 0.2 x £720m - £80m = £144m - £80m = a
surplus of £64m .
The balance of trade is exports - imports = £llOm - 0.1 x £720m
= £110m - £72m = £38m surplus .
(d) The government's fiscal policy is deflationary. Tax revenue exceeds
government expenditure, so the government will be reducing demand by
taking more spending out of the economy than it is injecting.
(e) As income rises , mpc usually declines. People will spend a larger total
amount but a smaller proportion of extra income, as the higher income
enables them to save more .

12.3 Objective Questions

Example 12.2

A man has a rise in income from £15000 to £17000 . As a result, his saving rises
from - £100 to £300 . His mpc is :
A 0 .2 B 0 .3 C 0.4 D 0 .6 E 0 .8

Example 12.3

The following table shows a country's consumption schedule :

Income (Em) Consumption (Em}

o 60
100 130
200 200
300 270
400 340

C is consumption and Y is national income . Which of the following represents the

consumption function ?
A C = -60m + 0 .3Y B C = 60m + 0 .3Y C C = 60m + 0.7Y
D C = -60m + 0 .7Y E C = 60m - 0 .7Y

Example 12.4

A closed economy has a National Income of £65m , a marginal propensity to save of

0 .3 and a marginal propensity to tax of 0 .1 . If the government wishes to achieve the
full employment level of N .Y . of £75m , it will have to increase government
expenditure by:
A £40m B £lOm C £4m D £3 .3m E £1m

182
Example 12.5

An economy has a saving function (5) which is given by the equation 5 =

-£500m + 0.2Y (where Y is National Income) . If the level of National Income is
£5000m, what is the average propensity to save ?
A 0.1 B 0.2 C 0.6 D 0.8 E 0.9

Example 12.6

If, in an economy, out of every additional £100 of National Income, £20 is taxed, £20
is saved and £10 is spent on imports, the value of the multiplier is:
A 2 B 2.5 C 3.3 D 5 E 6

Example 12.7

In the diagram below, as income increases from £15000 to £17000, what is the
marginal propensity to consume?
A 0.8 B 0.6 C 0.4 D 0.2 E 0.1

S +1

s
5800 f-------------..,~---
I,

5000 I-----------..,.or::;...--+----

N.Y.

Example 12.8

Which of the following represents a leakage from the circular flow?

A distributed profits B interest paid on bank loans
C national insurance contributions D investment
E exports

Example 12.9

The diagram on page 184 shows the relationship between planned saving and planned
investment.
If income is OY, which distance represents actual investment?
A AB B BC C CY D AC E BY

183
 S+I

Planned saving

Planned invest ment

OF---7'''''--------L.-------_
N.Y.

Example 12.10

The table below refers to a closed economy:

Income Investment Savings Government Taxation

(£m) (£m) (Em) spending (£m)
(£m)

100 60 20 40 50
200 70 20 30 60
300 80 20 20 40
400 90 20 10 80
500 100 20 40 90

The equilibrium level of National Income is:

A £100m B £lOOm C BOOm D £400m E £500m

Example 12.11

Y = C + I (National Income = Consumption + Investment) . I = £l500m and C =

£700m + 0.6 Y. If the full employment level of National Income is £10 OOOm, by how
much must investment be increased to achieve it?
A £200m B £500m C £800m D £l000m E £2500m

Example 12.12

A firm makes 10 000 goods, using 20 machines. Each year 2 machines wear out. If
demand for the good rises to 12 000, gross investment will increase by:
A 50% B 100% C 200% D 300% E 600%

Example 12.13

In an economy, Y (National Income) = C (Consumption) + I (Investment). If

Consumption = 50m + 0.75Y, Planned Investment = £80m and National Income =
£800m, Realised Investment will be:
A £50m B £80m C £100m D £150m E £lOOm

184
Example 12.14

An economy with no taxation has a marginal propensity to consume of 0.8. Out of

this, for every £10 spent £2.50 goes on imported goods . The current level of National
Income is £350. The full employment level of National Income is £400m. To achieve
full employment the government should inject spending of:
A £lOrn B £20m C £25m D £40m E £50m

Example 12.15

C = 40 + bY, I = 30, X = 50, M = 60 and b = 0.8 (where C = consumption,

Y = income, I = investment , X = exports and M = imports, and b = the marginal
propensity to consume) . The equilibrium level of Y will be:
A 550 B 400 C 300 D 275 E 250

Example 12.16

If the marginal propensity to consume of all members of a closed economy are equal,
then a rise in taxation of £5000m and of government expenditure of £5000m will cause
National Income to :
A remain constant B rise by more than £5000m
C rise by £5000m D rise by less than £5000m

Example 12.17

The marginal propensity to tax is 0.2 and , out of disposable income, 0.25 is spent on
imports and 0.25 is saved . The multiplier is:
A 1~ B 1~ C 2~ D 3j E 3~

Example 12.18

In a closed economy with no government sector, the consumption function is

C = £l50m + 0.7Y. At which level of N.Y. does the level of savings equal zero?
A £2000m B £1800m C £1200m D £900m E £500m

Example 12.19

An increase in government spending is likely to have a large impact on the level of

employment when there is:
A a high marginal propensity to import
B a high marginal propensity to tax
C a high marginal propensity to consume
D a high level of stocks
E full employment

Example 12.20

Which of the following is concerned with how capital expenditure responds to a

change in consumer expenditure?
A the multiplier B the accelerator
C the consumption function D the savings function

185
 Example 12.21

The paradox of thrift suggests that:

A a decision by people to save more can in the longer term result in a decrease in
savings
B a decision by people to save more will in the short term reduce investment
C while total savings rise with income, the average propensity to save falls
D while total savings rise with income, the marginal propensity to save tends to fall

Example 12.22

According to Keynesian analysis, consumption is a function of:

A permanent income B current income
C estimated lifetime income D previous income

Example 12.23

According to supply-side economics, which of the following could have caused the
short-run aggregate supply curve to shift to the right?
A an increase in demand for consumer goods
B an increase in government spending
C a reduction in the differential between earnings from employment and unemploy-
ment benefit
D a reduction in marginal tax rates

Price level

AD

Pt-------~

PI t-------".,e----I-------:::;)C

AS
AD

o o 01 Real N.Y .

Select your answers to Examples 12.24-12.28 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

186
Example 12.24

NEx
NE x = N.Y .

L_---------;r---- 2
C + I + G + [X - Ml

L_-----/fL.1-1---~ C + 1+ G 1 + IX - M]

o N.Y .

In the diagram above , the economy's initial economy level of National Income is Y1
and Yfe is the full employment level of National Income . If the government raises its
spending from G 1 to G z, which of the following will occur?
1 output will rise 2 employment will rise 3 prices will rise

Example 12.25

A government wishing to reduce an inflationary gap may:

1 reduce government spending 2 reduce direct taxation
3 reduce the exchange rate

Example 12.26

In an economy, the marginal propensity to save is 0.2, the marginal propensity to tax
is 0.16 and the marginal propensity to import is 0.04. National Income is currently
£10 Ooom. The full employment level of N.Y. is £12 389m, and to achieve this level
the government injects extra spending of £860m. Which of the following is/are true in
this situation?
1 the multiplier is 2~
2 at the new equilibrium level of N.Y. imports will be £650m
3 the injection is too expansionary

Example 12.27

According to Keynesian analysis, in a closed economy with no government sector, the

equality of planned savings and planned investment is brought about by changes in:
1 Nat ional Income 2 interest rates 3 prices

Example 12.28

A downward multiplier effect could be caused by:

1 a decrease in government spending
2 a decrease in investment
3 a decrease in savings

187
12.4 Essays

Example 12.29

Are reductions in taxation likely to be less effective than increases in government

expenditure in reducing unemployment in the United Kingdom?
(OLE 1986)

• Discuss both the Keynesian and monetarists' viewpoints.

• Make use of the concept of the multiplier.
• Discuss supply-side economics.

Solution 12.29

A reduction in taxation will reduce a leakage and an increase in government

spending will increase an injection . So both will increase N. Y. Keynesians favour
increases in government expenditure to reduce unemployment, while monetar-
ists advocate reductions in taxation.
Keynesians believe that an increase in government expenditure will have a
larger impact on aggregate demand and, hence, employment. This is because the
recipients of government spending are likely to have a higher marginal propen-
sity to consume than are taxpayers. The recipients of government spending may
include the unemployed, the low-paid and pensioners, all of whom will spend a
high proportion of extra income . In contrast, the main beneficiaries of tax
reductions are likely to be the rich, and they will tend to save rather than spend a
high proportion of extra income. So one leakage , taxation, will in part be offset
by another leakage, savings.
Government spending will enter the circular flow, causing National Income
(N.Y.) to rise by a multiple amount . If, for example, mpc is 0.75, a rise in
government spending of £400m will cause N.Y. to rise by £400m x 4 (the
multiplier) = £1600m. The resulting increase in demand is likely to stimulate
output and employment. The diagram shows that an increase in government
spending causes a rise in N.Y. from Y to Yj •

NEx NEx = N.Y.

-------;71'-----
1_ _
2
C + I + G + [X - M ]

L_- - - -:71C---t----- C + 1+ G, + [X - M ]

Q Y Y, N.Y .

However, unemployment will not fall if there was initially full employment, if
there were already underemployed workers, if existing workers work overtime ,
if there is an increase in productivity or if the rising demand is met from abroad .

188
 Monetarists believe that an increase in government spending can reduce the
rate of unemployment below the natural rate for a short period. However , they
think that , in the longer term , increases in government spending will succeed
only in raising inflation. Indeed , they consider that past attempts to reduce
unemployment through increased government spending financed by borrowing
has resulted in inflation , which , in turn , has cau sed unemployment due to the
resulting reduction in domestic competitiveness.
Monetarists believe that increasing supply will be more effective in increasing
output and employment than increasing demand. They favour microeconomic
policies to improve the efficiency of product , capital and labour markets . One
measure they advocate to create incentives to raise productivity is a reduction in
taxation. They argue that this will cause existing workers to work harder and , by
increasing the gap between paid employment and unemployment benefit , will
also reduce voluntary, frictional and search unemployment.

Example 12.30

Describe the interrelationships between con sumption , investment and income, and
discuss how a change in each on e will affect the other two .

• Stress the interrelationships between the three variables 10 Keynesian

analysi s.
• Make use of the multiplier and accelerator concepts.
• Discuss how an increase in one variable will cause .he other two to increase.

Solution 12.30

Income , consumption and investment are all interrelated and are important
variables in Keynesian analysis .
Income equals consumption plus investment. If investment and/or consump-
tion rise , income will increase. Keynes used Kahn's concept of the multiplier to
show that not only will income increase, but also it will rise by a multiple
amount.
A rise in investment and a rise in autonomous consumption are injections into
the circular flow of income which will result in a multiple rise in N.Y. For
instance , if investment increases by £50m and mpc is 0.8, the final rise in N.Y .
will be £50m x 5 = £250m. The diagram shows that a rise in investment from 1
to II causes N .Y. to increase from Y to Y 1•

S+I

I---------------,f'----- II
1-- ..,,"'- -+ I

N.Y .

189
 Just as a rise in investment will result in a rise in income, so an increase in
income will cause a rise in private-sector investment. The accelerator theory,
incorporated by Keynes into his analysis , states that a given percentage rise in
demand for consumer goods will induce a greater percentage rise in demand for
investment goods. For instance , if 100 goods are usually produced by 10
machines and 1 machine wears out each year, then demand for capital goods will
be 1 per annum. Should consumption rise by 50% to 150 goods, demand for
capital goods would rise by 500% to 6 machines , 1 of which will be to replace a
worn-out machine and 5 will represent net investment. However, if income is
increasing, government investment may be reduced. Part of government invest-
ment may be undertaken to influence the level of aggregate demand in the
economy. When private-sector demand is low, the government may inject
investment into the economy to raise aggregate demand. Conversely, if private-
sector demand is high , a government may reduce investment in order to offset
inflationary pressures .
A rise in income will induce a rise in consumption. Income is the main
influence on consumption. While investment is likely to increase by a greater
percentage than the rise in income which has brought it about, consumption is
likely to rise by a smaller percentage than income . Keynes pointed out that,
when income rises, a person's or a society's spending is also likely to rise.
However, the proportion of total income spent (the average propensity to
consume) and the proportion spent out of extra income (the marginal propensity
to consume) are likely to decline. When a person or a society is poor, the whole
of his or its income is likely to be spent. Indeed, there may be dissaving - that
is, spending more than income by borrowing or drawing on past savings .
However, as income rises, there will be increased opportunities for saving , so,
while both saving and spending will rise, the proportion devoted to consumption
is likely to decline.
Consumption and investment are not only components of national income,
they are also influences on the level of that income and are, in turn, influenced
by income.

12.5 Solutions to Objective Questions

Solution 12.2 Answer: E

The man's savings rise by £400 when his income rises by £2000. So his mps is
400/2000 = 0.2. 1 - mps = mpc . So mpc = 1 - 0.2 = 0.8.

Solution 12.3 . Answer: C

The consumption function shows the relationship between income and consump-
tion - i.e. C = a + bY. In this case, autonomous consumption (a) is £60m and
mpc is 70/100 = 0.7 . So the consumption function is C = £60m + 0.7Y.

Solution 12.4 Answer: C

If mps is 0.3 and mpt is 0.1 the multiplier is: 1/(mps + mpt) = 1/0.4 = 2~. The
gap between present and desired N.Y. is £lOm. To achieve this, the government
will have to increase its spending by £10m/2~ = £4m.

190
Solution 12.5 Answer: A

If the savings function is S = - £500m + 0.2Y, then , when N.Y. is £5000m,

total savings will be - £500m + 0.2 x £5000m = £500m. So aps = £500m/
£5000m = 0.1 .

Solution 12.6 Answer: A

In this case, the multiplier is:

_ _ _1_ _ _ = 1 =_1_ = 2
mpt + mps + mpm 0.2 + 0.2 + 0.1 0.5

Solution 12.7 Answer: B

When income rises by £2000, savings rise by £800, so mps = 800/2000 = 0.4. So
mpc is 1 - 0.4 = 0.6.

Solution 12.8 Answer: C

National Insurance contributions are a tax and so reduce the amount of income
passed round the economy.
A and B =? Distributed profits and interest are incomes earned within the
economy and form part of the circular flow.
D and E =? Investment and exports are injections into the circular flow.

Solution 12.9 Answer: E

Actual investment consists of planned investment plus changes in stocks. As

planned savings exceed planned investment, there are unsold stocks represented
by the distance Be. So actual investment is CY (planned investment) + BC (rise
in stocks) = BY.
The answer could also be derived from the knowledge that actual invest-
ment = actual savings and that actual savings = planned savings. So BY = BY.
A=? AB = consumption.

Solution 12.10 Answer: D

The equilibrium level N.Y. is where planned injections equal planned with-
drawals. In a closed economy this will be where:
investment + government spending = savings + taxation - i.e.
90 + 10 = 20 + 80
which occurs where N.Y . is £400m.

Solution 12.11 Answer: C

There are two ways of working out this answer:

(1) When N.Y . is £10 OOOm , C = £700m + 0.6 x £10 OOOm = £6700m. So
investment needs to be £10000 - £6700m = £3300m. It is currently
£2500m , so there needs to be an increase of £800m.
(2) Initially injections = investment + autonomous consumption - i.e .
£2500m + £700m = £3200m. mps is 1 - 0.6 = 0.4 , so the multiplier is

191
 1/0.4 = 2!. N.Y. is initially £3200m x 2! = £8000m. To raise N .Y . by
nOOOm , it will be necessary to raise investment by nOOOm/2! = £800m .

Solution 12.12 Answer: C

Each machine makes 10 000 -;- 20 = 500 goods , and the firm originally buys two
machines. To produce an extra output of 2000, it will need additional machines
of 2000 -;- 500 = 4. So the firm will purchase a total of 6 machines - 2
replacement and 4 to expand output (net investment). Thus , gross investment
(depreciation + net investment) rises from 2 to 6 - i.e. an increase of 4/2 x
100/1 = 200%.

Solution 12.13 Answer: D

Realised investment is actual investment and includes both planned investment

and changes in stock. C = 0.75 x £800m = £650. So savings = Y - £650m
= £150m. Since actual investment = actual savings , actual investment will be
£I50m . This consists of £80m (planned investment) + £70m unsold stock (£720m
consumer goods made but only £650m sold) .

Solution 12.14 Answer: B

mps is 0.2 , mpm is 0.25 of 0.8 - i.e . 0.2. So the multiplier is: 1/0.4 = 2!. To
raise N .Y . by £50m , the government should inject £50m/2! = nOm.

Solution 12.15 Answer: C

The equilibrium level of Y will be where :

Y = C + I + (X - M)
Y = 40 + 0.8 Y + 30 + (50 - 60)
O.2Y = 40 + 30 - 10
Y = 300

Solution 12.16 Answer: C

According to the balanced budget multiplier theorem, if the mpcs of taxpayers

and recipients of government spending are equal then a rise in government
spending and taxation of equal amounts will cause N .Y. to rise by the amount of
the change . For instance, if mpc is 0.8, a rise in taxation of £5000m will cause
private spending to fall by £5000m x 0.8 = £4000m. Public spending increases
by £5000, so the net injection of spending is £5000m - £4000m = £1000m. mps
is 0.2, so the multiplier is 1/0.2 = 5. Thus , N.Y. will rise by £IOOOm
x 5 = £5000m.

Solution 12.17 Answer: B

mpt is 0.2, disposable income is 0.8. mpm IS 0.25 x 0.8 = 0.2 and mps is
0.25 x 0.8 = 0.2 . Thus, the multiplier is:
1 1
-------=- = 1 ~
mpt + mpm + mps 0.6 }

192
Solution 12.18 Answer: E

When N .Y . is £500m , consumption will be: £150m + 0.7 x £500m = £150m

+ £350m = £500m. Y - C = S. So £500m - £500m = O.

Solution 12.19 Answer: C

A high mpc will mean a high multiplier - i.e . if mpc is 0.9, the multiplier will be
10. Thus, a rise in government spending of £50m will cause N.Y . to rise by
£50m x 10 = £500m . The larger the rise in N.Y. the greater the likely increase
in employment.
A and B ::::} A high mpm and a high mpt will both reduce the size of the
multiplier.
D and E ::::} If there is full employment and a high level of stocks, then a rise in
demand resulting from government spending will not cause a significant increase
in output or employment.

Solution 12.20 Answer: B

The accelerator theory states that a given change in demand for consumer goods
will cause demand for capital goods to change by a greater percentage.
A ::::} The multiplier is concerned with how N.Y. changes as a result of a
change in an injection - e.g. investment.

Solution 12.21 Answer: A

The paradox of thrift suggests that if people save more, planned saving will
exceed planned investment. National Income will decrease as entrepreneurs
experiencing unsold stocks reduce output. As N.Y. falls, savings will fall until
planned savings are again in equilibrium with planned investment.
B ::::} In the short term, a decision by people to save more will increase both
actual savings and actual investment.
C and D ::::} As income rises , total savings, aps and mps all rise.

Solution 12.22 Answer: B

According to Keynesian analysis , the main determinant of consumption is

current income.
A ::::} Milton Friedman and other supporters of the permanent income hypo-
thesis suggest that consumption depends on permanent income . So, if people
experience what they expect to be a short-term change in income, they may not
alter their consumption.
C ::::} Franco Modigliani and Albert Ando developed the Life Cycle Hypo-
thesis , which states that people estimate the income they are likely to earn over
their lifetime and on this base a lifetime consumption plan.

Solution 12.23 Answer: D

The aggregate supply curve will shift to the right if the productivity of the factors
of production increases. Supporters of supply-side economics urge tax cuts to
increase the attractiveness of paid employment and the productivity of workers.
A and B ::::} Would influence demand initially rather than supply.

193
 c ~ Supply-side supporters argue that, if the differential between earnings
from employment and unemployment benefit is narrowed , this will reduce the
incentive for workers to increase productivity.

Solution 12.24 Answer: A

Initially equilibrium income Y\ is below the full employment level of Yf e • When

the government increases its spending to G z, N.Y. rises beyond the FE level to
Y z. As income rises to the FE level, output and employment will rise . When it
passes beyond the FE level , output and employment cannot increase any further
and the rise in demand is likely to result in a rise in prices .

Solution 12.25 Answer: D

An inflationary gap occurs when aggregate demand exceeds the FE level of N.Y.
To remove the gap, it will be necessary to reduce demand and a reduction in
government spending will lower demand.
2 ~ Lower direct taxation will increase disposable income and demand .
3 ~ A lower exchange rate is likely to increase exports , which will result in
higher domestic incomes and demand.

Solution 12.26 Answer: D

The multiplier is:

1 1
- - - - - - - = 21
mps + mpt + mpm 0.2 + 0.16 + 0.04 2

An injection of £860m will cause N. Y. to rise by £860m x 2~ = £2150m. The gap

between present and desired N.Y. is £2389m. So the injection is not sufficiently
expansionary. There is a shortfall of £2389m - £2150m = £239m. At the new
level of N.Y . of £12150m imports will be £12150m x 0.4 = £486m.

Solution 12.27 Answer: D

It is changes in N. Y. which restore equilibrium. If, for instance, planned

investment is greater than planned savings, N.Y. will rise until planned savings
increase to the same amount.

Solution 12.28 Answer: B

A downward multiplier can be caused by either an increase in a leakage or a

reduction in an injection. Government spending and investment are both
injections into the circular flow, and if they decrease, N.Y. will fall.
3 ? A reduction in savings will cause a rise in N.Y.

194
 13 Money and Banking
13.1 Fact Sheet

(a) Barter

• Barter is the direct exchange of goods. Trade was originally carried out by
barter but this posed three main problems:
(i) the need for a double coincidence of wants;
(ii) the difficulty of agreeing on a rate of exchange ;
(iii) the difficulty of storing wealth in the form of goods .
However, there has recently been an increase in international barter
(counter-trade or counter-purchase) because of uncertainty about exchange
rate movements and concern about Third World debt.

(b) Functions and Characteristics of Mone y

• Money is any item which is widely accepted as payment for products.

Money has the following functions:
(i) Medium of exchange Money is used to buy goods.
(ii) Measure of value (unit of account) Money is used to compare the
value of goods , services and factor rewards .
(iii) Store of value Money is used to hold wealth (savings) .
(iv) Standard for deferred payments Money is used to enable people to
borrow and lend agreed amounts.
• The most important characteristic of money is general acceptability. If a
commodity ceases to be acceptable, it will cease to act as money.
• The most widely used types of money in the UK are notes and coins and
bank deposits. The transfer of bank deposits via cheques , etc. , accounts for
approximately 90% by value of all transactions.
• Near money or quasi-money consists of assets which perform some but not
all the functions of money and which can be quickly turned into money .

(c) Measures of the Money Supply

There is some debate as to which items to include in the money supply. The UK
monetary aggregates include:
(i) Narrow measures , which concentrate on money which is used mainly as a
medium of exchange:
(1) Mo, which consists of notes , coins and commercial banks' balances at
the Bank of England ;
(2) MJ, which includes Mo items + sight (current) bank accounts;
(3) M2 , which consists of notes, coins, sight bank accounts, retail deposit
accounts, building society accounts and national savings bank
accounts .

195
 (ii) Broad measures concentrate on money kept as a store of value and on
which interest is paid:
(1) M3 , which consists of M 1 items + time (deposit) accounts and sterling
certificates of deposit ;
(2) M 3e , which includes M 3 measures + foreign currency bank deposits;
(3) M 4 , which is essentially M 3 + building society shares and deposits
and sterling certificates of deposit;
(4) M s, which includes M 4 items + private sector holdings of money
market instruments (e .g. treasury bills), certificates of tax deposits
and national savings instruments .

(d) Financial Intermediaries

• Financial intermediaries are institutions which channel funds from people

and institutions wishing to lend to those wishing to borrow.
• The monetary sector includes authorised institutions, the National Giro-
bank, the Banking department of the Bank of England and some of the
banks of the Channel Islands and the Isle of Man.
• Authorised institutions are banks which meet the Bank of England's (BOE)
statutory prudential requirements , including having adequate capital and
liquidity and conducting their business with integrity and appropriate
professional skills.
• The money market includes institutions concerned with short-term borrow-
ing and lending:
(i) The primary banking system consists of institutions which have the
main function of providing a money transmission service - e.g.
commercial banks and discount houses.
(ii) The secondary banking system includes institutions which accept large
deposits from a relatively small number of depositors and which do not
have a high street branch network - e .g. merchant banks and consor-
tium banks.
• The capital market includes institutions concerned with long-term borrow-
ing and lending.
• The Stock Exchange provides a market for second-hand shares and secur-
ities. Bears sell shares expecting their price to fall, while bulls buy shares
expecting their price to rise. Stags buy newly issued shares expecting their
price to rise .

Table 13.1 Examples of financial intermediaries

Institution Functions

Commercial banks Provide customers with the three traditional services of

accepting deposits , acting as agents for payment , lending,
plus a wide range of other services
Discount houses Borrow from the commercial banks and other institutions at
short notice and use this money to buy treasury bills, com-
mercial bills and other financial assets
Merchant banks Accept bills of exchange, arrange and underwrite the issue of
new shares, provide credit and advice to companies
Building societies Accept deposits, lend to house buyers, and since the 1986
Building Societies Act have offered a wide range of banking
services

196
(e) Investment Finance

Firms wishing to buy capital goods may use:

(i) Internal finance Retained profits account for between 60% and 70% of
all investment finance.
(ii) External finance in the form of:
(1) issuing new shares (e.g. a rights issue);
(2) borrowing from financial institutions or the general public in the form
of debentures.

(f) Commercial Banks' Balance Sheets

Liabilities are the money owed by commercial banks and consist mainly of
deposits (accounts). Assets are the various resources owned by the bank. The
profitability of assets tends to increase as their liquidity is reduced . Banks seek to
maximise the amount of profitable but illiquid assets held , while maintaining
sufficient liquid assets to meet their customers' demand for cash .

Table 13.2 Balance sheet of a commercial bank

Liabilities (D) A ssets (A)

(1) Sight deposits (4) Cash in till

(2) Time depo sits (5) Balances at the BOE
(6) Money at call and short notice
(7) Treasury and other bills
(8) Short-term investments

(9) Investments
(10) Advances
(11) Property

(3) Total liabilities (12) Total assets

(1) Customers' current accounts.

(2) Customers' deposit account s.
(3) Tot al amount of money owed by the bank to customers.
(4) Cash in till held on the premises.
(5) Operational accounts used to settle interbank debt s at clearing and to draw out cash when
necessary.
(6) Money lent at call or short notice (7 days) to the discount houses .
(7) Short-term (91 days) loans to the government or companies.
(8) Government and local authority stocks (securities or bond s) with less than a year to run .
(9) Government securities , etc., with more than 1 year to run .
(10) Loan s to customers.
(11) The value of bank premises , etc .
(12) Total amount of bank claims on other people .

• Items (4)-(8) of the balance sheet are the liquid or reserve assets of the
bank.
• The liquid asset ratio (<I» is the proportion of overall deposits held in liquid
form.

(g) Credit Creation

• Credit creation refers to the commercial banks' ability to create money in the
form of bank accounts. Assume a single-bank system where the only

197
 liability is money held as sight deposits; cash is the only liquid asset. The
bank keeps 10% of its liabilities in cash (<I> = 10%) and lends out the rest.
Any loan is spent only to be redeposited by shopkeepers, etc . Figure 13.1
shows in simplified form the effect on the bank's balance sheet of an initial
deposit of £200 .
Step 1: £200 cash is deposited Step 2: £180 cash is lent out

Balance sheet 1 Balance sheet 2

Liabilities Assets Liabilities Assets

£200 sight deposit £200 cash £200 sight deposit £20 cash

£180 loan

£200 £200 £200 £200

Step 3: £180 cash is redeposited Eventually:

Balance sheet 3 Final balance sheet

Liabilities Assets Liabilities Assets

£380 sight deposit £200 cash £2000 sight deposit £200 cash

£180 loan £1800 loan

£380 £380 £2000 £2000

Figure 13.1 Simple credit creation

• In the final balance sheet , the bank now holds 10% of its overall liabilities
(D) in cash (C): D = 11<1> x c.
• Through a process of deposits, loans , redeposits , loans, etc ., the bank has
created £1800 of credit.
• The bank or credit multiplier (11<1» shows by how much total liabilities
(accounts or low-powered money) can increase as a result of a rise in liquid
assets (high-powered money) deposited in the banking system.
• Using the equation aD = 11<1> x aR , it is possible to calculate the change in
liabilities (aD) following a change in reserve assets (aR) . Assume <I> = 12i%
and that a monopoly bank's liquid assets increase by £2m :
aD = 11<1> x aR = 1112.5/100 x £2m = 11
0.125 x £2m = 8 x 2m = £16m
As loans are redeposited and then lent out, liabilities eventually increase by
£16m - that is, £14m of credit has been created.

(h) Functions of the Bank of England

(i) Issues bank notes . The BOE has sole responsibility in England and
Wales for the printing, issue and distribution of notes .
(ii) Issues and manages the national debt.
(iii) Acts as the government's bank. Tax revenues and current government
expenditure are recorded in the Exchequer Account.

198
 (iv) Acts as banker to the monetary secto r. Authorised institutions keep
0.45% of their eligible liabilities at the BOE and the clearing banks also
maintain operational balances.
(v) Acts as lender of last resort. The BOE will always lend to the discount
houses and thereby ensures sufficient liquidity in the monetary sector to
maintain confidence.
(vi) Supervises the monetary sector, checking that authorised institutions
follow prudent policies and maintain adequate liquidity ratios.
(vii) Carries out government monetary policy - e.g. conducting open
market operations (see Chapter 14, Section (e)).
(viii) Manages the Exchange Equalisation Account, which is a Treasury
account operated by the BOE to buy and sell sterling to influence the
exchange rate .
(ix) Acts as banker to other countries that want to keep their reserves in
sterling on deposit in London .
(x) Meets with other central banks to discuss, e.g ., international liquidity .

13.2 Data Response

Worked Example 13.1

The balance sheet of the Bank of England for 11 August 1983 was as follows :

Liabilities A ssets
£m £m
Issue Department:
Notes in circulation 11436 Government securities 5394
Notes in Banking Dept. 4 Other securities 6046

11 440 11 440
Banking Department:
Capital 15 Government securities 466
Public deposits 42 Advances and other 1 137
accounts
Special deposits o Premises , equipment 983
and other securities
Bankers' deposits 615 Notes and coin 4
Reserves and other accounts 1918

2590 2590

(Source: Bank of England Quarterly Bulletin , December 1983)

With reference to the balance sheet , show how these items reflect the various
functions of a central bank.
(L Jan. 1986)

Solution 13.1

The division of the Bank of England's balance sheet indicates the functions of
the two departments .
The Issue Department has responsibility for the note issue, and the Bank of
England is the only bank in England and Wales with the right to issue notes .
Notes in circulation are ones which have been issued on instructions from the

199
 Treasury, while notes in the Banking Department are those held to meet the
demand for notes from commercial banks.
In the UK , the note issue is entirely fiduciary. It is no longer backed by gold
but by government securities. Government securities consist of gilt-edged
securities and Treasury bills. Other securities include commercial bills. If the
government wishes to increase the notes in circulation, it may instruct the Bank
of England to engage in open market operations, buying securities in exchange
for money.
The Banking Department carries out all the other functions of the Bank of
England. The public deposits reflect the Bank of England's role as the
government's bank . Government revenue is paid into these accounts and
expenditure is paid from these accounts . The inflows and outflows are very large
but the balance is kept small. The Bank of England manages the National Debt,
and the public deposits include the dividend accounts .
The Bank of England is also banker to the banking sector. The banks keep
deposits at the Bank of England . Operational balances are used to settle
interbank debts at clearing and as a source of notes and coins. Non-operational
balances equal to 0.45% of each bank's eligible liabilities are kept to meet Bank
of England requirements.
When the Bank of England engages in open market operations, it influences
the banks' operational balances, and, as these are regarded as liquid assets, their
ability to lend.
The Bank of England may also seek to change the quantity of banks' liquid
assets and their ability to lend by calling for or releasing special deposits. These
are expressed as a percentage of the banks' eligible liabilities and are kept at the
Bank of England. The banks cannot count these as liquid assets. The balance
sheet shows a nil figure for special deposits, so on the day it was drawn up the
Bank was holding no special deposits .
Other accounts include accounts of foreign central banks, international
institutions , staff and a few private customers. The private accounts are a
reminder of the Bank's former role as a commercial bank. The Bank now has
regular contact with other central banks and international organisations.
Reserves are the retained profits of the Bank.
Capital is another item which is a reminder of the Bank's past. It is the share
capital taken over when the Bank was nationalised.
On the assets side of the Banking Department section of the balance sheet, the
government securities are short- and long-term securities, and represent loans to
the government. Advances and other accounts include loans to the discount
houses and other customers of the Bank. As 'lender of last resort' the Bank of
England will always lend to the discount houses. It may do this to influence
interest rates.
Premises, equipment and other securities refer mainly to the Bank's fixed
assets - i.e. those items the Bank owns and will keep for a long period of time.
Notes and coins represent an opposite entry to that in the liability section of
the Issue Department section of the balance sheet. They are issued to the
commercial banks when requested.

200
13.3 Objective Questions

Example 13.2

The essential condition for an item to act as mon ey is that :

A it is portable B it is legal tender
C it is generally acceptable D it is backed by gold
E it is homogeneous

Example 13.3

Debenture holders are:

A part-owners of a public limited company
B creditors of a company
C holders of government long-term stock
D holders of government short-term stock
E shareholders entitled to receive arrears of dividends

Example 13.4

Which financial institution underwrites the weekly treasury bill tender?

A discount houses B merchant banks
C finance houses D commercial banks
E the Bank of England

Examples 13.5-13.7 refer to four assets and one liability of a commercial bank:
A money at call
B operational balances at the Bank of England
C treasury bills
D advances to customers
E customers' current accounts

Example 13.5

Which of the items constitutes the largest figure on the assets side of a commercial
bank's balance sheet?
ABC D E

Example 13.6

Which is a liability of a commercial bank ?

ABC D E

Example 13.7

Which of the assets is the most liquid ?

ABC D E

201
 Example 13.8

A Special Deposit is
A money kept at the Bank of England by a clearing bank to settle debts with other
banks
B money called in from commercial banks which is frozen at the Bank of England
and which cannot count as liquid assets
C money kept at the Bank of England by commercial banks to meet the 0.45 % cash
ratio deposit requirement
D money lent by commercial banks to discount houses
E negotiable bearer securities issued by the commercial banks. usually for large
denominations

Example 13.9

In which of the following ways can a commercial bank add to the money supply?
A cashing cheques for bank customers
B making advances to customers
C responding to a Bank of England call for special deposits
D printing bank notes
E increasing its liquidity ratio

Example 13.10

The bank multiplier would be increased by:

A a reduction in the bank's liquidity ratios
B an increase in the use of cash by the public
C an increase in the demand for loans
D an increase in liquid assets
E an increase in cash deposited in the bank

Example 13.11

A commercial bank which has liquid assets of £400m and which keeps a 20% liquidity
ratio can support maximum deposits of:
A £50m B £80m C £800m D £2000m E £8000m

Example 13.12

A bank keeping a liquidity ratio of 10% receives a cash deposit of £240m. On the basis
of this additional cash, the maximum additional deposits it could create would be:
A £960 B £1200 C £2160 D £2400 E £2640

Example 13.13

A bank which keeps a 12~% liquidity ratio experiences a reduction in liquid

assets of £90. If the bank's holdings of liquid assets was previously Just
meeting its liquidity ratio, the withdrawal of cash will cause a total decrease of
liabilities of:
A £7.2 B £11.25 C £90 D £720 E £1125

202
 Example 13.14

The opportunity cost of holding wealth in the form of cash may include the loss of all
the following except:
A interest B dividends C liquidity D capital gains

Example 13.15

Which type of security's yield is likely to fluctuate the most ?

A a cumulative preference share B a non-cumulative preference share
C a debenture D a gilt-edged security
E an equity

Select your answers to Examples 13.16-13.19 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 13.16

When a commercial bank makes a loan to a customer:

1 its liabilities rise 2 its assets rise
3 the money supply increases

Example 13.17

Which of the following is/are part of the money market?

1 an investment trust 2 a commercial bank 3 a discount house

Example 13.18

Which of the following assets are held by commercial banks at the Bank of England?
1 special deposits 2 balances at Central Bank
3 money at call

Example 13.19

Which of the following are included in the M 4 measure of the money supply?
1 notes and coins 2 current accounts
3 building society deposits

13.4 Essays

Example 13.20

Comment on the structure of the balance sheet of a commercial bank and explain
what factors govern its composition .
(NISEC 1985)

203
 • Define assets and liabilities and give examples.
• Devote most attention to assets .
• Discuss the influence on the composition of the balance sheet of liquidity,
profitability and government action.

Solution 13.20

A bank's balance sheet will show the assets and liabilities. Banks, unlike other
firms, list their assets in order of the most liquid first. Liabilities are divided into
current and long-term items. A bank's assets will be matched by its liabilities.
A bank's liabilities consist of obligations to payout money in the future.
Customers' deposits account for the largest percentage of liabilities. Current
(sight) accounts are used mainly to make payments, while deposit accounts are
used mainly for saving. The customers have effectively lent money to the banks
and are entitled to have this money returned to them on demand in the case of
most current accounts and within 7 days in the case of deposit (time) accounts.
The quantity and value of accounts will be influenced by competition from other
financial institutions, government policy and customers' desire to hold cash.
Other liabilities include capital, which is the money which has been subscribed
by the bank's shareholders, and reserves, which is profit earned in previous years
which has been retained to reinvest in the bank. A bank may also have issued
certificates of deposit to raise money and may, at anyone time, have tax
payments and dividend payments due.
A bank's assets are what the bank owns . Banks have to balance liquidity and
profitability, and the structure of their assets is also influenced by the action and
requirements of the Bank of England, carrying out government policy.
The banks' most liquid asset is cash, whereas its most illiquid asset, excluding
premises, is advances . However, the more liquid an asset is the less profitable it
is. For instance, there is no financial return from holding cash in till. Banks keep
liquid assets in order to meet their customers' demand for cash. Most banks keep
15-18% of their assets in a liquid form. Liquid assets include cash, operational
balances at the Bank of England, money at call, treasury bills, commercial bills,
and local authority and government bonds with less than a year to run.
A bank will wish to lend as much as possible, since it earns most profits from
advances. Indeed, advances account for the greatest percentage of a bank's
assets. How much a bank can lend will be influenced by demand for loans,
suitability of customers, government policy and the liquidity ratio which the
bank decides it should keep. Banks appreciate that, every time they give a loan,
they create a deposit, and, since some of this may be taken out in the form of
cash, they have to ensure that the loans are backed by a sufficient amount of
liquid assets. Banks discuss their liquidity ratios with the Bank of England, which
will approve prudential ratios.
The second most profitable bank asset is investments, which consist mainly of
gilt-edged securities, government bonds and company bonds.
The nature and size of the liabilities and assets may, at anyone time, be
influenced by the Bank of England in furtherance of government policy. The
government may wish to encourage bank lending in order to increase demand,
investment and employment. On the other hand, the government may attempt
to reduce bank lending at a time of inflation.
One method which the BOE may adopt to reduce the money supply by means
of reducing bank lending will actually result in an additional asset, or possibly an
increase in that asset. The asset involved is special deposits, but this is a very
illiquid asset. The BOE can tell the banks to deposit a given percentage - e .g.

204
2% - of their total liabilities in special deposits at the BOE. These are frozen,
in the sense that commercial banks cannot use these deposits or count them in
their liquid assets until they are released by the BOE. If the banks were only just
holding what they regarded as a safe quantity of liquid assets, the call for special
deposits may force them to reduce their loans.
However , the main method which the BOE now employs to influence the
money supply is open market operations. This method will affect initially the
banks' balances at the BOE, and later probably another asset.
Another method which the BOE may employ is funding. This involves selling
fewer short-term government assets and more long-term assets in an attempt to
reduce the banks' liquid assets and , hence, their ability to lend. This method is
likely to result in the quantity of treasury bills held by the banks being reduced ,
and may result in a reduction in banks' advances unless they are able to increase
other liquid assets such as commercial bills.
The BOE requires authorised institutions to keep 0.45% of their eligible
liabilities in non-operational balances at the Bank.
Thus , a bank's balance sheet will contain a range of assets influenced by the
need for liquidity, the desire for profitability and government action. The
quantity and type of liabilities will be influenced by the competitive strength of
banks in relation to other financial institutions and government policy .

Example 13.21

Explain briefly what is meant by the money supply. Why .uight a government seek to
control the rate of growth of the money supply?
(AEB June 1987)

• Very briefly define money.

• Briefly discuss the main but not all measures of the money supply.
• Consider why the government measures the money supply .
• Concentrate on the relationship between changes in the money supply and
inflation, but also consider how the changes in the money supply will affect
other objectives.

Solution 13.21

The money supply is a measure of the items which fulfil the functions of money .
These functions are to act as a medium of exchange , unit of account , store of
value and standard for deferred payments. An item which carries out these
functions will have a number of characteristics, the most important of which is to
be generally acceptable .
The main components of the UK money supply are notes, coins, bank and
building society accounts. There are a number of official measures of the money
supply, which include different items . At anyone time, the government is likely
to concentrate on one or two measures. In recent years, Mo (essentially notes,
coins and banks' operational balances at the Bank of England) , M3 (notes , coins ,
banks' sight and time accounts) and M 4 (notes, coins, banks' sight and time
accounts and building society accounts) have received the greatest attention .
One reason why governments measure the money supply is as an indicator of
economic trends and the state of financial markets. For instance , a rapid growth
of base money (M o) will indicate a future rise in bank accounts .
Another reason is that the government may wish to use changes in the money
supply as a policy instrument or objective , to influence one of its four main

205
 macroeconomic objectives. These are low inflation , a balance of payments
equilibrium, full employment and growth. To achieve the last two objectives, a
government may wish to increase the money supply , perhaps by means of
encouraging bank lending. However, to achieve the first two objectives, it may
seek to reduce the growth of the money supply and the level of demand .
A government whose main objective is to reduce inflation , and which believes
that inflation is caused by the money supply growing too rapidly and at a rate
exceeding the growth of output, will place considerable emphasis on controlling
the growth of the money supply.
Monetarists argue that a rise in the money supply will increase people's money
balances. They will use some of this addition to purchase goods and services. The
rise in demand will, after a period of time , cause producers to raise their prices.
To illustrate this analysis , the monetarists make use of the quantity theory. They
suggest that if V (velocity of circulation) and T (transactions) are presumed to be
constant, then a rise in M (money supply) will cause an percentage rise in P
(prices) .
Monetarists wishing to see a reduction in the growth of the money supply may
urge a decrease in the PSBR (public-sector borrowing requirement) and possibly
control of bank lending.
Some monetarists favour announcing targets for the growth of monetary
aggregates . They argue that this may help to convince people that the govern-
ment is taking steps to control prices and thereby reduce expectations of
inflation, which can affect wage claims and price rises . They also suggest that this
will also impose discipline on a government which will not want to be seen failing
to meet its targets .
If the banks are increasing their lending, this may not only contribute towards
inflation , but also worsen a current account deficit. People borrowing from the
banks may purchase imports, and the rising home demand may cause some
producers to divert goods from the export to the home market.
In contrast, some economists argue that a failure of bank lending to keep pace
with demand for loans can cause problems. During inflation, entrepreneurs will
face rising costs and are likely to try to borrow more from the financial sector. If
they are unable to raise sufficient funds, they may go out of business, thereby
causing unemployment.
The money supply may be regarded as an indicator, target and policy
instrument , and it plays a particularly important role in monetarist analysis and
policy. However, it is difficult to know which measure/measures of the money
supply to use, and economists have found that , once one measure is under
control , others start to move in undesired directions .

13.5 Solutions to Objective Questions

Solution 13.2 Answer: C

An item may possess many of the desirable characteristics of money, but, if it

ceases to be generally acceptable, it will cease to act as money and people will
use another item.
A and E => Are regarded as important qualities for money to possess but they
are not as significant as acceptability.
B => The main form of money in the UK is bank accounts, which are not legal
tender.
D => The vast majority of money - i.e. all bank accounts, building society
accounts and most cash - is not backed by gold and so is fiduciary issue.

206
Solution 13.3 Answer: B

Debenture holders lend money to a company and so are owed money by the
company. They are creditors who receive interest.
A =? Shareholders.
C and D =? Holders of government securities.
E =? Cumulative preference shareholders.

Solution 13.4 Answer: A

A number of financial institutions and individuals buy treasury bills. However, it

is only the discount houses which are committed to purchase any treasury bills
not taken up through the competitive bidding process. In return for carrying out
this function, the discount houses are able to use the Bank of England's 'lender
of last resort' facility.

Solution 13.5 Answer: D

Commercial banks hold a range of current and fixed assets. However , their most
profitable activity is lending , and advances account for the largest single item in
their assets, usually in excess of 60%.

Solution 13.6 Answer: E

Customers' current accounts are liabilities, as a commercial bank has an

obligation to pay these out to the customer on demand.
A, B, C, D =? Are all assets, items that the bank possesses.

Solution 13.7 Answer: B

A commercial bank can draw out money from its operational balances at very
short notice. Operational balances are regarded as very liquid assets, usually the
next most liquid after cash in till.

Solution 13.8 Answer: B

Special deposits represent a proportion of a bank's eligible liabilities which may

be required to be placed with the Bank of England. They earn the going rate of
interest but cannot be counted as liquid assets .
A =? Balances at the Bank of England .
C =? Non-operational balances at the Bank of England .
D =? Money at call.
E =? Certificates of deposit.

Solution 13.9 Answer: B

When a bank makes a loan to a customer, it opens up an account for the

customer and this account will be included in most money supply measures.
A =? Cashing cheques will increase one form of money , cash, and reduce
another, bank accounts. However, if more cash is withdrawn than is deposited in
a period, a bank may have to reduce its loans, which will lower the money
supply.
C =? Responding to a call for special deposits will reduce a commercial bank's
liquid assets and so probably its ability to lend .

207
 D ? Commercial banks do not print notes.
E ? Increasing its liquidity ratio will reduce a bank's ability to lend.

Solution 13.10 Answer: A

The bank multiplier shows by how much a change in liquid assets will affect a
commercial bank's total liabilities and loans. It is found by using the ratio: 100%/
liquid assets ratio . A reduction in the liquidity ratio would increase the bank
multiplier. For example, if the liquidity ratio was originally 25% , the bank
multiplier would be 100%/25 % = 4. If the liquidity ratio was then reduced to
10%, the bank multiplier would increase to 100%/10% = 10.
B ? An increase in the use of cash by the public may cause banks to increase
their liquidity ratios to ensure that they can meet their customers' demand for
cash. This would reduce the bank multiplier.
C, D, E ? Are unlikely to change the bank multiplier - merely bring it into
effect.

Solution 13.11 Answer: D

If a bank has a liquidity ratio of 20%, it has a bank multiplier of 100%/20% = 5.

Thus, liquid assets of £400m will enable the bank to have total deposits of
£400m x 5 =£2000m.

Solution 13.12 Answer: C

A bank with a liquidity ratio of 10% has a bank multiplier of 100%/10% = 10. A
cash deposit of £240m will enable total liabilities to increase by
£240m x 10 = £2400m . This includes the account given to the customer who
deposited the £240m. As a result, additional loans of £2400m minus the initial
deposit could be created - i.e. £2400m - £240m = £2160m.

Solution 13.13 Answer: D

The bank multiplier works in reverse. A liquidity ratio of 12~% will mean a bank
multiplier of 100%/l2~% = 8. Thus, a reduction in liquid assets of £90 will cause
a fall in total liabilities of £90 X 8 = £720 .

Solution 13.14 Answer: C

In choosing to hold wealth in the form of cash, a person forgoes the opportunity
to hold other financial assets which may earn interest or dividends or the
opportunity to hold, e.g., antiques or land, which may appreciate in value .
However, the return which a person does receive from cash is the highest form of
liquidity possible.

Solution 13.15 Answer: E

'Equities' is another term for shares . The dividend paid on ordinary shares may
fluctuate considerably, depending on the profits firms earn and their decisions on
the proportion of profits to distribute to shareholders and the proportion to
plough back into the business. Indeed, a shareholder may receive no dividends .
A and B ? Preference shareholders are paid before ordinary shareholders
and usually receive a fixed dividend out of profits - e.g. 10%.

208
 C and D :::} Debenture holders and gilt-edged security holders receive a fixed
rate of interest.

Solution 13.16 Answer: A

When a commercial bank gives a customer a loan , which is an asset of the bank ,
it opens an account for the person, which is a liability. As bank accounts are
regarded as money , the money supply will increase .

Solution 13.17 Answer: C

The money market consists of institutions which engage in short-term borrowing

and lending. Most of the activities of the discount houses are concentrated in the
money market , and the commercial banks are part of the money and capital
markets.
1 :::} An investment trust is concerned primarily with long-term lending and
borrowing, and is part of the capital market.

Solution 13.18 Answer: B

Special deposits and balances at Central Bank (another term for balances at the
Bank of England) are both held by commercial banks at the Bank of England .
3 :::} Money at call represents money that the commercial banks have lent to
the discount houses and , hence, will be held in the latter institution.

Solution 13.19 Answer: A

All the items are included in the new measure of the money supply , which seeks
to take into account the importance of building societies as financial intermedi-
aries . It includes all the items covered in M 3 plu s building society deposits .

209
 14 Monetary Economics
14.1 Fact Sheet

(a) Changes in the Money Supply

The UK money supply may increase as a result of:

(i) credit creation by the banking sector;
(ii) note issue by the Central Bank;
(iii) a net inflow of sterling from abroad ;
(iv) an increase in the public-sector borrowing requirement.

(b) The Importance of the Money Suppl y

Monetarists believe that change s in the money supply have a direct and
significant impact on the economy. Keynesians believe that the effects are more
complex and difficult to predict.

• The transmission mechanism shows the stages and ways in which a change in
the money supply affects national income , prices and/or employment.
There is still much controversy between Keynesians and monetarists over
the exact working of the transmission mechanism.

(i) Keynesian Transmission Mechanism

Increase in money supply => increase in people's money balances => increase in
demand for bonds => increase in the price of bonds => fall in the rate of
interest => increase in investment => multiplier effect => increase in N.Y. =>
increase in output => increase in employment.

(ii) Monetarist Transmission Mechanism

Increase in money supply => increase in people's money balances => people
using 'surplus' money to demand more goods and services => increase in prices .

(c) Monetary Policy

Monetary policy is a set of measures which seek to control aggregate demand,

mainly by influencing the supply of money or the price of money (the rate of
interest). To achieve a given macro-objective (e .g. stable prices), a government
will use policy instruments , which operate initially on targets .

210
Table 14.1 Examples of monetary policy

Instrument Intermediate target Ultimate target Objective

Funding Banks' liquid assets Volume of bank credit Inflation

Base rate Structure of interest Exchange rate Current account
rates
Special deposits Banks ' liquid assets Interest rates Inflation
Open market Structure of interest Volume of bank credit Employment
operations rates

(d) Monetary Policy Targets

(i) Growth of the money supply. The Medium-term Financial Strategy was
introduced in 1980, setting out plans for monetary growth for several
years ahead, in addition to including targets for public spending,
taxation and the PSBR.
(ii) The level and structure of interest rates.
(iii) The exchange rate . A government may seek to influence exchange rates
by altering interest rates , and buying and selling currencies.
(iv) The total volume of spending which can be influenced by , e.g. , changes
in interest rates .
(v) The volume of bank credit. The commercial banks' ability to create
credit can have a significant impact on the money supply.

(e) Control of Credit Creation

The Bank of England (BOE) is responsible for carrying out the government's
monetary policy. The following measures restrict the ability of banks to create
credit, although some have not been used by recent governments.
(i) Open market operations, where the BOE sells short-term government
securities and bills, thereby reducing commercial banks' liquid assets
and raising interest rates.
(ii) Funding, where the BOE issues more long-term securities and fewer
short-term securities, thereby reducing commercial banks' liquid assets .
(iii) The Minimum Lending Rate (MLR) is the rate , announced in advance ,
at which the BOE will lend to the discount houses. MLR influences
other market interest rates. An increase in MLR discourages borrowing
and so reduces the ability of banks to create credit.
(iv) Interest rate policy The BOE may operate a number of undisclosed
interest rate bands at which it will discount bills, raising or lowering
these bands to influence the structure of interest rates in the money
market.
(v) Special deposits are when the BOE calls for compulsory loans from the
commercial banks, thereby reducing commercial banks' liquid assets.
(vi) An increase in the liquid asset ratio requirement reduces the amount of
liabilities a commercial bank can have from a given volume of liquid
assets .
(vii) Quantitative controls on lending involve the BOE setting an upper limit
on the volume of bank lending.
(viii) Qualitative lending guidelines involve requesting banks to direct lending
to particular groups and/or restrict lending to other groups.

211
 (ix) Moral suasion The BOE can informally try to persuade commercial
banks to change their lending policy.
(x) Monetary base control involves the BOE regulating base money .

• Overfunding occurs when the BOE sells to the non-bank sector more
government securities than is necessary to finance the current PSBR.

(1) Fiscal and Monetary Policy

Fiscal policies have an impact on the money supply and interest rates, and so
have implications for monetary policy. For example, a rise in government
spending may increase the budget deficit, and subsequently may cause a rise in
the money supply and/or interest rates.

(g) The Public-sector Borrowing Requirement

The public-sector borrowing requirement is the difference between the total

income and expenditure of the public sector. This borrowing can be financed by:
(i) Borrowing from the BOE, which is likely to increase the money supply
via a rise in the high-powered monetary base .
(ii) Borrowing from the commercial banks by selling treasury bills, which is
likely to increase the money supply via a rise in commercial banks' liquid
assets .
(iii) Borrowing from the non-bank private sector by selling government
securities, which some argue may crowd out private investment.
(iv) Borrowing from overseas residents will result in a rise in interest
payments on national debt going abroad .

• Other government policies have implications for the PSBR . For instance,
privatisation and setting spending limits for local authority (rate-capping)
both have the effect of reducing the PSBR, thus reducing the rate of growth
of the money supply.

14.2 Data Response

Worked Example 14.1

Study the extract below and then answer questions (a) to (g) .

M3, the most widely used measure of broad money which includes notes, coin
and bank accounts, grew by a seasonally adjusted 0.4 per cent in February but
this still left the rise over the year at 20.4 per cent.
Any encouragement from the drop compared with January's 22.4 per cent
will be shortlived, since it was due more to a sharp rise between January and
February last year than the slowdown this year.
Although bank lending grew by £2.6 billion compared with £4 billion on
average in the past six months, this seemed to be due more to the building
societies' growing share of the mortgage market than any real slowdown in
lending.
The broader money measure M4, which adds in building society accounts,
grew by 16 per cent over the year to February. Total lending was up £4.2 billion
compared with an average of £5.1 billion in the last six months.

212
 The best-behaved money measure is the narrow MO - notes, coin and
bankers' cash at the Bank of England - which fell by a seasonally adjusted 0.1
per cent, although the rise over the year to February still came in at 5.3 per cent
compared with last month's 4.8 per cent.
The reason is the fall in MO at this time last year, which the Treasury expects
to lead to above target growth at the beginning of 1988-9. The present target of
2-6 per cent will come down to 1-5 per cent from April.
(Source: The Guardian, 19 March 1988)

(a) What is the difference between narrow and broad measures of the money supply?
(2 marks)
(b) Why did bank lending grow more slowly than in the previous six months?
(2 marks)
(c) Explain what is meant by the statement: 'The best-behaved money measure is the
narrow MO'? (3 marks)
(d) What does the M4 measure of the money supply include? (1 mark)
(e) Why maya government announce targets for the growth of monetary aggregates?
(4 marks)
(f) Why mayan increase in bank lending cause inflation and why may inflation cause
an increase in bank lending. (4 marks)
(g) Discuss two measures which the Bank of England could employ to reduce bank
lending. (4 marks)

Solution 14.1

(a) Narrow money measures include assets which represent immediate

purchasing power - i.e. assets used mainly as a medium of exchange.
Broad money measures include not only assets used as a medium of
exchange, but also those used as a temporary store of value - i.e .
immediate and potential purchasing power.
(b) The article suggests that the growth in bank lending fell because of the
increase in the building societies' share of the mortgage market. So people
were still borrowing more but the proportion borrowed from different
institutions changed .
(c) MO was the best-behaved money measure in the sense that its growth
stayed within the government-set target. From February 1987 to February
1988 it grew at 5.3% , which was within the 2-6% target.
(d) The M4 measure includes notes, coins , bank accounts and building society
accounts .
(e) Some economists suggest that a government should announce targets for
the growth of monetary aggregates in order to impose discipline on the
government's monetary policy and to reduce expectations of inflation. If a
government announces that it wants M3 to grow at, e.g., 8%, then it will
be possible to assess whether the government has achieved its objective. If
people believe that a government is determined to control the money
supply, it may convince them that the rate of inflation will fall . The
expectation of lower inflation may result in a fall in wage claims and price
increases.
(f) An increase in bank lending will add to the money supply and spending. If
output does not rise in line with spending, then demand will exceed supply
and prices will rise. During periods of inflation, bank lending may
increase . Producers may seek to borrow more to cover increased costs of
production, and consumers may wish to borrow more to buy more
expensive goods. If the rate of inflation exceeds the rate of interest
charged, then debtors will gain by borrowing and buying assets which will
appreciate in value. In real terms, they will pay back less than they

213
 borrowed, while certain assets may rise in price by more than the rate of
inflation.
(g) The Bank of England could engage in open market operations to reduce
the money supply. Selling government securities to the non-bank private
sector will reduce bank customers' accounts, which, in turn, will reduce
commercial banks' operational balances at the Bank of England. The
reduction in the banks' liquid assets may result in a fall in bank lending.
The Bank of England could also lower the banking sector's liquid assets by
funding. This involves selling fewer short-term government securities,
which are liquid assets, and more long-term government securities, which
are not liquid assets .

14.3 Objective Questions

Example 14.2

The money supply can be increased by all the following except:

A commercial banks lending to their customers
B the government borrowing from the Bank of England
C the issue of treasury bills to the banking sector
D the sale of long -term bonds to the general public
E the issue of new notes by the Bank of England

Example 14.3

The Bank of England sells government securities to the public. This will tend to :
A reduce the money supply and have no effect on interest rates
B reduce the money supply and raise interest rates
C reduce the money supply and lower interest rates
D increase the money supply and raise interest rates
E increase the money supply and lower interest rates

Example 14.4

Funding involves:
A buying and selling government securities to influence the money supply
B reducing the size of the national debt
C borrowing from the eurocurrency market
D issuing more long-term and fewer short-term government securities
E financing government expenditure by means of taxation

Example 14.5

If the Bank of England wishes to decrease the commercial banks' ability to lend , it
would not :
A sell government securities
B engage in funding
C release special deposits
D request the banks to reduce their loans
E force up the rate of interest

214
Example 14.6

If the Bank of England calls in special deposits, which one of the following measures is
a commercial bank likely to adopt to maintain its desired liquidity ratio?
A borrow from the Bank of England
B reduce the rate of interest charged to borrowers
C reduce the investments held
D reduce their liabilities
E reduce their capital

Example 14.7

Which of the following measures would be defined as an expansionary monetary

policy?
A the purchase by the Central Bank of government securities from members of the
public
B a reduction in indirect taxation
C the conversion of short-term government debt into long-term government debt
D an increase in special deposits
E an increase in government spending

Example 14.8

A sale of government secun ties to the non-bank private sector by the Bank of
England is likely to be followed by all the following except:
A a fall in the price of government securities
B a fall in the money supply
C a fall in the rate of interest
D a fall in bank lending
E a rise in short-term foreign capital inflows

Example 14.9

Which of the following means of financing government spending is likely to lead to the
greatest increase in the money supply?
A the sale of national savings certificates to the general public
B the sale of government securities to the general public
C the sale of treasury bills to the banking sector
D an increase in direct taxation
E an increase in indirect taxation

Example 14.10

If a government's prime objective is to reduce unemployment by increasing demand ,

the monetary policy it is most likely to adopt is to :
A sell government securities to the non-bank private sector
B call in special deposits
C sell fewer treasury bills and more long-term government securities
D lower the rate of interest

Select your answers to Examples 14.11, 14.12 by means of the following code :
A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

215
 Example 14.11

Which of the following is/are monetary policy measur es ?

1 changes in the deposit on hire purchase payments
2 interest rate changes
3 special deposits

Example 14.12

The public-sector borrowing requirement may be regarded as:

1 a polic y instrument
2 an intermediate policy objective
3 an economic indicator

14.4 Essays

Example 14.13

Wh y does the public-sector borrowing requirement hav e implications for the Bank of
England's ability to control the money supply?
(OLE June 1985)

• Define the PSBR.

• Discuss how the PSBR may be financed .
• Discuss how th e financing of the PSBR can affect the money supply and
interest rates.

Solution J4.13

The public-sector borrowing requirement (PSBR) is the difference between the

public sector's total income and its total expenditure. It consists of borrowing by
the central government and borrowing by local authorities and public corpora-
tions from non-government sources. As the main component is central govern-
ment borrowing , the PSBR is closely related to the budget deficit.
The size of the PSBR and how it is financed will have implications for
monetary policy. There are four main methods of financing the PSBR: borrow-
ing from the BOE ; borrowing from the banking sector; borrowing from the
non-bank private sector; and borrowing from abroad.
The government can always borrow from the BOE. When a government does
this , it actually sells government securities to the BOE in return for an increase
in the note issue. This is sometimes referred to as 'printing money' or resorting to
the printing press. The new currency issue will immediately add to the money
supply, and, when it is deposited into the comm ercial banks, it will enable a
multiple expansion of the money supply to occur.
Similarly, if the government borrows from the commercial banks by selling
them treasury bills, this will add to the money supply by increasing the banks'
liquid assets and, hence, their ability to lend.
The government may also choose to borrow from overseas. The effect on the
money supply will depend on whether foreign currency is borrowed or sterling is
held in the UK or sterling is held abroad. Borrowing sterling initially held abroad
would have the greatest impact on the money supply , increasing the supply of

216
high-powered money . However, all three possibilities represent a 'drain' on
national resources in interest rate payments.
Borrowing from the non-bank private sector by selling government securities
and National Savings Certificates will have a neutral effect on the money supply .
Bank deposits will fall as people write out cheques drawn on the commercial
banks to buy the government securities. However, this may be offset by the
increase in bank deposits arising from the injection of government spending.
Some economists claim that this source of finance can have the disadvantage of
public investment crowding out private-sector investment as a result of interest
rates rising.
In practice, the largest part of the PSBR, usually at least 70%, is financed by
the sale of gilt-edged securities to the non-bank sector - e .g. to pension funds
and insurance companies. Most of the rest is accounted for by borrowing from
the banking sector. The least important source is borrowing from the overseas
sector.
Financing the PSB R may affect the money supply, either directly or indirectly
through the price of money (interest rate). The money supply or the rate of
interest may change in a direction the government does not want. For instance ,
when selling securities to finance the PSBR, the BOE will lose, to a certain
extent, the quantitative control over the money supply and its price. When the
BOE sells government securities, it does not know how much people will be
willing to pay for the securities. So it does not know how many it will have to sell
and, hence, what the price of bonds will be and what the rate of interest will be.
A fall in the price of securities will raise interest rates and increase the cost of
servicing the National Debt. Similarly, increasing the banking sector's liquid
assets may have an uncertain expansionary effect on the money supply ,
depending on the banks' initial holdings of liquid assets and the demand for
loans.
Governments recognise that fiscal policy has implications for the money
supply. A government which believes that inflation is caused by the money
supply increasing more rapidly than output may seek to reduce the PSBR in
order to slow down the rate of growth of the money supply.

Example 14.14

Describe the various methods by which the Government might try to control the
money supply, and comment on their possible success.
(SUJB June 1987)

• Discuss open market operations, special deposits, funding and interest rate
changes.
• Discuss how commercial banks may get round monetary control measures.
• Discuss conflicts of government policies.

Solution 14.14

In attempting to control the money supply, the government may encounter a

number of difficulties , including deciding what to control, conflicts of objectives
and, particularly if trying to reduce the money supply or its growth, a conflict of
interest with commercial banks .
A government can itself add to the money supply by borrowing from the BOE
or the banking sector to finance the PSBR. In seeking to control the money
supply, a government may try to reduce the PSBR or at least reduce its growth.

217
 However , the size of the PSBR may move in a direction not desired by the
government. A recession , for instance, will cause tax revenue to fall and
expenditure on benefits to rise and the PSBR to increase.
Commercial banks can also create money and, indeed, have an incentive to do
this , since lending is their most profitable activity. Thus, if a government
attempts to reduce their lending , they are likely to seek ways round the policy.
One of the most common methods a government can employ to reduce bank
lending is open market operations . This will involve the BOE selling government
securities to the non-banking sector. People will pay for these with cheques
drawn on the commercial banks. When these are settled at clearing, the
commercial banks' balances at the BOE will be reduced . As these balances count
as liquid assets , the commercial banks may be obliged to reduce their loans.
Banks decide what they regard to be a safe liquidity ratio after consulting with
and gaining the approval of the BOE. If open market operations do not result in
the ratio being reduced below their desired rate, the banks may not be obliged to
reduce their loans .
Open market operations may also have some undesirable consequences for a
government. The sale of government securities will reduce their price and raise
th e rate of interest. A higher interest rate will increase the cost of servicing the
National Debt , may raise the exchange rate and may have an adverse effect on
investment, employment and growth .
When the BOE calls for special deposits, banks have to place a percentage of
their total liabilities with the Central Bank. These deposits cannot be counted in
the banks' liquid assets and may oblige them to reduce their loans . However,
again the banks may not have to take any action if their liquid assets are reduced
to a level which they still regard to be adequate.
Funding, which is the issue by the government of more long-term and fewer
short-term government securities , will also not be effective if the commercial
banks can replace treasury bills by other liquid assets - e .g. commercial bills.
The BOE may influence interest rates by using an undisclosed interest rate
band. It may announce that it is prepared to buy bills from the discount houses
but without stating a price. If the money market is short of funds, discount
houses will offer bills to the BOE. These will only be purchased when the BOE is
satisfied with the price (and , hence, the rate of interest). If the BOE wishes to
lower interest rates , it will increase the price it is willing to pay, and when it
wishes to raise interest rat es , it will lower the price . In exceptional cir-
cumstances , it may also reintroduce MLR at a rate lower than the market rate , to
encourage lending , or at a higher rate, to discourage lending. However, a
reduction in interest rates will not succeed in increasing bank lending if people
and firms do not want to borrow. Similarly, a rise in interest rates may not deter
borrowers if there is a consumer boom or if the expected yield from investment is
rising.
In addition to the problems of controlling bank lending, there are problems of
defining what to control. Whenever one form of money is brought under control,
another grows more rapidly than is desired.
A government's success in controlling the money supply will also be affected
by other government policies. For instance, interest rates may be altered to
influence the exchange rate, and the purchase or sale of currencies for this
purpose may also influence the money supply .

218
14.5 Solutions to Objective Questions
Solution 14.2 Answer: D

The public will be likely to pay for government securities by writing cheques
drawn on accounts at the commercial banks. At clearing, this will cause a
transfer of money from the commercial banks' balances to the government's
account at the BGE. The resulting reduction in the commercial banks' balances
at the BGE will reduce their liquid assets , and the money supply .

Solution 14.3 Answer: B

The sale of government securities will reduce the money supply. The increase in
the supply of government securities will also reduce their price. The price of
government securities and interest rates vary inversely. Thus, a fall in the price
of government securities will be accompanied by a rise in interest rates.

Solution 14.4 Answer: D

Funding involves converting short-term into long-term government debt , usually

with the intention of reducing the availability of liquid assets for commercial
banks.

Solution 14.5 Answer: C

If the BGE had been holding special deposits and then released them, this would
cause an increase in the commercial banks' liquid assets. With more liquid assets,
the banks would be able to increase lending.

Solution 14.6 Answer: D

The BGE has the right to tell banks to deposit a percentage of their eligible
liabilities with the Bank. To meet such a call , the commercial banks will have to
transfer money to the BGE. This will be taken out of their liquid assets. To
maintain the proportional relationship between liquid assets and liabilities, the
banks are likely to reduce their liabilities in line with the reduction in liquid
assets. For instance, a call for special deposits reduces liquid assets from £12m to
£lOm, while liabilities are £80m. If a liquidity ratio of 15% is considered to be
desirable, liabilities are likely to be reduced to £67m.

Solution 14.7 Answer: A

An expansionary monetary policy is one which increases the supply of money

and/or reduces the rate of interest and thereby increases demand. The purchase
of government securities by the BGE from members of the public will cause
money to transfer from the government to the commercial banks' balances at the
BGE. This will enable the commercial banks to lend more , which , in turn , will
cause an increase in the money supply.
Band E :::} Are examples of expansionary fiscal policies .
C and D :::} Are examples of restrictionist monetary policies.

219
 Solution 14.8 Answer: C

The sale of government secur ities will increase the supply of bonds , which will
result in a fall in their price and a rise in the rate of int erest. It will also cause a
fall in the money suppl y and bank lending. Foreign capital may be attracted by
the higher domestic interest rat es.

Solution 14.9 Answer: C

The sale of treasury bills to the banking sector will increase th eir supply of liquid
assets , which will enable an increase in bank lending to occur.
A, B, D , E :::} Are likely to have a neutral effect on the money supply. This is
because the increase in bank deposits resulting from th e injection in government
spending is likely to be offset by a fall in bank deposits a rising from increased
taxation or the purchase of government securities.

Solution 14.10 Answer: D

Lowering the rate of interest will be likel y to stimulate borrowing and spe nding.
A, B, C :::} Are all likely to reduce bank lending and demand.

Solution 14.11 Answer: A

HP regulations , interest rates and special deposits all influence the amount of
credit in the economy and are all monetary policy me asures.

Solution 14.12 Answer: A

The PSBR has been used as a policy instrument , an intermediate policy objective
and an economic indicator. For instance , Ke yne sian go vernments have increased
the PSBR to increase demand in the economy , while monetarist governments
have aimed to reduce the PSBR and have interpreted the PSBR as an indicator
of likely monetary expansion and inflation.

220
 15 Unemployment
15.1 Fact Sheet

(a) Definition of Unemployment

Unemployment occurs when people who are willing and able to work are unable
to find suitable paid employment. It is a stock , the size of which is influenced by
inflows and outflows and the duration of unemployment experienced.

• Full employment does not mean that everyone is employed . In a dynamic

economy there will always be some workers changing jobs (frictional
unemployment) , and some people choosing not to take up paid employ-
ment (voluntary unemployment).
• Over-full employment occurs when the number of vacancies exceeds the
number of unemployed.

(b) Measurement of Unemployment

In the UK , official unemployment figure s include those claiming unemployment

benefits.

• Seasonally adjusted unemployment figures take out the effects of seasonal

factors such as weather , which result in unemployment being unusually high
or low in certain months.

Table 15.1 gives examples of adjustments that some suggest should be made to
the official figures .

Table 15.1 Measuring unemployment

Some economists/politicians believe Some economists/politicians believe

the following should be included the following should be omitted

Unemployed over-60s Severely disabled people

Discouraged workers School-Ie avers
Those in government special Claimants working in the 'black' economy
employment measures Claimants who are not looking for work
Unemployed not entitled to benefits Mentally and physically handicapped
Those on short-time working people
Those who choose not to register Those in between jobs
Students on vacation

The unemployment rate is:

registered unemployed
-'''------~---:- x -100
working population 1
221
 (c) Types and Causes of Unemployment

Table 15.2 Types and causes of unemployment

Type of unemployment Description

Frictional Or transitional , occurs when workers are temporarily

unemployed while moving from one job to another
Search A form of frictional unemployment when workers do not
accept the first job offered but remain unemployed while
searching for a better job
Causal Another form of frictional unemployment when workers
are unemployed in between short periods of employment
Seasonal Those who are unemployed as a result of seasonal fluctu-
ations in demand and/or changes in weather conditions
Structural Those out of work because of a permanent decline in the
demand for an industry's products
Regional Those out of work are disproportionately concentrated in
particular regions , largely as a result of these areas being
dependent on declining industries
Technological A form of structural unemployment due to the introduc-
tion of new automated methods of production
International Those out of work due to a fall in demand for domestically
produced goods
Cyclical Or mass or demand-deficient: those out of work because of
a lack of aggregate demand
Involuntary Workers without a job who are willing and able to work at
current wage rates
Voluntary Workers without a job who prefer to live on benefits

Figure 15.1 illustrates Keynes's explanation of unemployment caused by insuf-

ficient aggregate demand. At the full employment level of National Income
(Yfe) , output is J, while aggregate monetary demand is only K. The deflationary
gap of J - K causes cyclical unemployment.

NEx

NEx = N.Y.

o Y, N.Y.

Figure 15.1 A deflationary gap

222
(d) The Natural Rate of Unemployment

A monetarist concept, the natural rate of unemployment (NRU) is the level of

unemployment that is associated with a constant rate of inflation. At the NRU ,
the demand for labour is equal to the number of people prepared to supply their
labour for the prevailing wage rate. Any unemployment is 'voluntary' and arises
from labour market imperfections.

(e) The Costs of Unemployment

These are influenced by the numbers unemployed and the length of time they are
unemployed . They include:
(i) Cost to the economy from lost production which can never be regained .
(ii) Cost to the government in the form of:
(1) lost revenue from, e.g., income tax, National Insurance contribu-
tions, VAT;
(2) increased expenditure on unemployment and other benefits, special
employment schemes, extra retirement redundancy payments in the
public sector.
(iii) Cost to the individual , usually in the form of:
(1) decreased income ;
(2) loss of status, alienation and frustration ;
(3) reduced chance of regaining employment the longer unemployed.

<D Remedies for Unemployment

Table 15.3 Remedies for unemployment

Type Remedy

Frictional and search May be reduced by improved vacancy information services

and retraining
Causal and seasonal Finding other activities during slack periods; employ students,
retired people or work overtime during peak employment
periods
Structural Improve occupational mobility through retraining; import
protection for declining industries
Regional and Regional policies ; retraining and import protection for
technological particular industries
International Lowering the exchange rate ; imposing import controls
Cyclical Increasing aggregate demand by expansionary fiscal and/or
monetary policy. In addition, the Cambridge Economic
Policy Group believe in imposing general import controls to
ensure that rising demand goes on domestic goods and
providing protection while UK industry is restructured
The natural rate of Monetarists suggest supply-side policies widening the gap
unemployment between unemployment and employment income by reducing
direct taxes and unemployment benefits ; reducing trade union
power; and improving the mobility of labour

223
15.2 Data Response

Worked Example 15.1

Seasonally adjusted annual averages

Year % change % UK UK unemployment Unfilled vacancies

in RPI unemployment (thousands) (thousands)

1983 4.9 10.8 2969.7 137.3

1984 5.1 11.1 3046.8 150.2
1985 5.0 11.3 3163.3 162.1
1986 5.5 11.5 3185.1 188.8

Sources: Adapted from the Annual Abstract 1988 and the Employment Gazettefl , January 1988.

It is estimated that only about one-third of all vacancies are notified to job centres and
that approximately one-quarter of all appointments are made through job centres.
In any period , some of the vacancies may be in different areas of the country from
the areas in which the unemployed are, may require different skills and qualifications
from those possessed by the unemployed, or may be for jobs which the unemployed
are unwilling to do .

(a) Do the figures support the relationship between inflation and unemployment
indicated by the Phillips curve? (5 marks)
(b) Explain how a fall in the inflation rate can reduce unemployment. (5 marks)
(c) Discuss the relationship between vacancies and unemployment in the period
1983-6. (4 marks)
(d) Why might the proportion of vacancies notified to job centres (i) increase or (ii)
decrease during times of high unemployment? (4 marks)
(e) ' . . . some of the vacancies .. . may be for jobs which the unemployed are
unwilling to do '. What types of unemployment may this describe ? (2 marks)

Solution 15.1

(a) The Phillips curve suggested that high inflation would be associated with
low unemployment , and vice versa. It implied a trade-off relationship
between inflation and unemployment. Between 1983 and 1984 both
unemployment and inflation increased; between 1984 and 1985 inflation
fell, while unemployment rose; and between 1985 and 1986 both again
showed an increase. So, for most of the period, unemployment and
inflation moved in the same direction, in contradiction of the Phillips
curve.
(b) A fall in the inflation rate could make UK goods more competitive at
home and abroad . If the UK inflation rate falls below that of the UK's
main competitors, then demand for exports should rise, while demand for
imports should fall. The extent to which unemployment will fall will
depend on the original level of unemployment, how much output rises ,
the relative costs of labour and capital, and changes in technology .
(c) Between 1983 and 1986 both unemployment and vacancies rose, and the
number of unemployed considerably exceeded the number of vacancies .
The number of unemployed per vacancy fell throughout the period:

224
 Year No . of unemployed per unfilled vacancy

1983 21.6
1984 20.3
1985 19.5
1986 16.9

(d) During times of high unemployment , employers may be keener to notify

vacancies to job centres, as they believe that people possessing higher
skills and qualifications will be registered there. However, it is possible
that a smaller proportion of vacancies may be notified, since employers
may be able to fill vacancies relatively easily and quickly through, e .g.,
word of mouth, 'in-house' publications and newspaper advertisements .
(e) A situation where there are jobs available which the unemployed do not
take up may describe voluntary or search unemployment. The former
occurs when people are unwilling to work , and the latter occurs when
people do not accept the first job offered but remain unemployed while
seeking a better job.

15.3 Objective Questions

Example 15.2

Which group of workers is most likely to experience causal unemployment?

A accountants B actors C chiropodists
D teachers E undertakers

Example 15.3

As a result of a decrease in demand for blankets, several blanket mills are closed down
and the workers are made redundant. This is a result of :
A demand deficiency unemployment B seasonal unemployment
C causal unemployment D residual unemployment
E structural unemployment

Example 15.4

The natural rate of unemployment is the rate :

A at which unemployment is zero
B at which inflation is zero
C at which inflation is constant
D at which all unemployment is involuntary
E below which it is impossible to lower unemployment, both in the short term and
the long term, by increasing aggregate demand

Example 15.5

The government attempts to reduce cyclical unemployment by means of expansionary

fiscal policy. The impact of the policy in lowering unemployment would be reduced
by :
A a high marginal propensity to consume
B a high marginal propensity to import

225
 C a low marginal propensity to save
D a low exchange rate
E a low rate of real interest

Example 15.6

Which of the following would increase a deflationary gap?

A an increase in government spending
B an increase in export revenue
C an increase in savings
D an increase in investment
E a reduction in taxation

Example 15.7

Which of the following conditions will ensure full employment in an economy?

A a balanced budget
B a balance of payments equilibrium
C planned savings equalling planned investment
D total leakages from the circular flow of income equalling total injections
E none of the above

Select your answers to Examples 15.8-15.10 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 15.8

An increase in which of the following would reduce the natural rate of unemploy-
ment?
1 labour mobility 2 unemployment benefit 3 government expenditure

Example 15.9

Which of the following groups is/are included in the government's official unemploy-
ment figures?
1 unemployed men aged 60-plus
2 people who register for unemployment benefit but who are not actively seeking
employment
3 people who are claiming benefit while working in the 'black economy'

Example 15.10

Immobility of labour will tend to increase the duration of which of the following types
of unemployment?
1 frictional 2 structural 3 regional

226
15.4 Essays

Example 15.11

'Increases in public expenditure lead to lower unemployment and eventually to a

reduction in public expenditure ; public expenditure cuts lead to higher unemployment
and to increased public expenditure.' Critically discuss this statement.
(AEB June 1985)

• Discuss why a rise in public expenditure may be thought to be likely to

increase employment and why some economists would argue that it may
have the opposite effect.
• Discuss the initial and subsequent effects of changes in public expenditure.
• Consider how a rise in public expenditure may be financed.

Solution 15.11

Keynesians argue that a rise in public expenditure will cause N.Y . to rise by a
multiple amount. Draw figure solution 12.29 diagram 1. As demand rises , output
will increase. The initial rise in public expenditure on , e.g. , roads should result in
more people being employed , and the multiple rise in aggregate monetary
demand and output should raise employment by a further and larger amount.
However, unemployment will not fall if there was initially full employment ,
underemployed workers or changes in technology.
Even if an increase in public expenditure is financed by an equal rise in
taxation , this will still cause a rise in N. Y. which should lead to higher
employment. For instance, if the mpc is 0.75, then a rise in government spending
of £100m and a rise in taxation of £lOOm will cause an initial net rise in spending
of £25m (£lOOm government spending - £75m fall in spending resulting from
the rise in taxation). This will cause a multiple rise in N.Y. of £25m x
4 = £lOOm.
As N. Y. increases and employment rises, public expenditure on unemploy-
ment and other benefits should fall. The initial rise in public expenditure will
cause a rise in tax revenue in the longer term and a fall in public expenditure.
Cuts in public expenditure may be expected to have the opposite effects to
those of an increase. The multiplier works in reverse. A fall in public expend-
iture , which is a reduction in an injection , will cause N.Y. to fall by a multiple
amount. As demand decreases, output will be reduced. This is likely to result in
a rise in unemployment , unless entrepreneurs believe that the decrease in
demand is temporary and so hoard labour or employers were initially short of
labour.
The rise in unemployment will reduce tax revenue and , unless the level of
benefits is changed , will increase expenditure on unemployment and other
benefits. Expenditure on special employment schemes may also increase and , if
falling demand encourages students to stay on in education , there will be extra
expenditure on education.
Monetarists would not entirely agree with this analysis . They argue that an
increase in government spending may reduce unemployment in the short term.
However, as entrepreneurs compete for factors of production and less efficient
factors are employed, costs will rise and output will return to, or near, its
previous level but at higher prices. Monetarists believe that a government is
unable to reduce unemployment below the natural rate in the long term by
increasing demand.

227
 Indeed, some argue that increases in government spending may increase
rather than decrease employment. If financed by increased taxation, then there
will be a reduction in incentives for firms and workers . If financed by borrowing
from the Bank of England or the banking sector, the money supply is likely to
increase. Monetarists argue that this will cause a rise in prices, and, if it results in
fewer home-produced goods being sold, unemployment may rise. They also
believe that government borrowing can crowd out private-sector investment by
taking a proportion of what they believe is a limited supply of funds available and
by raising interest rates through the increased sale of government securities. If
private-sector investment falls by more than the amount by which public
expenditure rises, unemployment may rise.
Monetarists urge the reduction in the growth of public expenditure so that
government borrowing and the growth of the money supply can be decreased.
They believe that this will lower inflation , which, in turn, will increase
international competitiveness and result in a rise in output and employment.

Example 15.12

Discuss the view that the official unemployment statistics in the United Kingdom are
not an accurate reflection of the number of people unable to find work.
(L Jan. 1986)

• Discuss the official measures of unemployment.

• Discuss other possible measures.
• Consider why official figures may overstate and why they may understate
the level of unemployment.

Solution 15.12

Unemployment arises when people willing and able to work in paid employment
cannot find employment. In the UK, people are officially classified as
unemployed if they are claiming benefits at unemployment benefit offices. One
total commonly used is the seasonally adjusted total, excluding school-leavers.
This includes registered unemployed , excluding those under 18 who have not
entered employment since leaving school, and is adjusted to take out the effects
of seasonal factors which result in unemployment being unusually high or low in
certain months. Other totals are the unadjusted unemployment figure and the
seasonally adjusted unemployment figure.
There is a debate as to how true a reflection official figures are of the number
of people looking for a job. Until October 1982, the UK unemployment figures
were based on the number of people who registered at job centres. There are a
number of groups of people seeking employment who would have been included
in the former measure but not the current one. These include married women
who are seeking employment but, because they did not pay the full National
Insurance contribution, are not entitled to unemployment benefit; unemployed
men over 60 who are still seeking employment; those who choose not to register;
students on vacation; and school-Ieavers seeking their first job.
Some countries measure unemployment by conducting surveys asking a
sample of households how many of their members are seeking employment. This
method would pick up groups not included in the UK official figures: for
instance, discouraged workers - i.e. those who would like a job but have
dropped cut of the labour market. Some people may stay on in education, and
married women may give up looking for work. Also, people in special employ-

228
 ment schemes would be likely to state that they are seeking employment. There
are a number of people in part-time employment who are seeking full-time
employment, people who have taken early retirement and people past retire-
ment age who would still like to work.
However, some economists argue that the official figures , far from understat-
ing the true level of unemployment , overstate the true level. They argue that
some people who claim benefit are not really looking for work and are content to
live on the benefits they receive. They also suggest that some of the official
unemployed are actually working in the 'black economy' and not declaring their
jobs or earnings. Some also urge that workers who are frictionally unemployed
- that is, between jobs - should also be omitted from the figures .
Most economists believe that the official figures need to be analysed carefully.
In addition to the total figure , consideration should be given to the inflow (those
joining the figures), the outflow (those leaving the figures), the duration of time
people are unemployed and the groups most affected by unemployment.

15.5 Solutions to Objective Questions

Solution 15.2 Answer: B

Causal unemployment occurs when workers who are usually employed on a

short-term basis are laid off. Actors are frequently 'resting' - i.e. unemployed
between roles. Accountants , chiropodists , teachers and undertakers are usually
employed on a more regular and long-term basis than are actors.

Solution 15.3 Answer: E

This is an example of unemployment arising from an industry experiencing a

decline in demand for its products, which is structural unemployment. Demand-
deficiency unemployment arises as a result of a lack of aggregate demand,
seasonal owing to changes in demand occurring at particular times of the year
and when weather conditions prevent production. Causal unemployment occurs
when there are irregular layoffs, and residual unemployment refers to those
people who would be likely to be unemployed even when demand is high.

Solution 15.4 Answer: C

According to monetarists, the natural rate of unemployment is when inflation is

stable but not necessarily zero.
A ~ At the natural rate, there is likely to be some unemployment in the form
of those who are not prepared to work at that wage rate and people in between
jobs.
D ~ Monetarists argue that the unemployment above the natural rate is
voluntary and not involuntary.
E ~ Monetarists believe that , while it is not possible to reduce unemployment
below the natural rate in the long term by increasing demand , it is possible to do
so in the short term but only at the expense of accelerating inflation.

Solution 15.5 Answer: B

Cyclical unemployment arises from a lack of aggregate demand. Expansionary

fiscal policy will increase demand. However, a high mpm will mean that a
significant proportion of the extra demand will create increased employment
abroad rather than at home.
229
 A, e, D, E::} Are all likely to mean that a high proportion of the extra
demand generated will be spent on domestic output. A high mpc means that a
high proportion of extra income will be spent. A low mps means, and a low rate
of interest suggests, that a small proportion of extra income will be saved and,
hence, a high proportion spent. A low exchange rate will mean that the price of
imports is high while the price of exports is low, so not much of the extra demand
will be spent on foreign goods and services .

Solution 15.6 Answer: e

A deflationary gap exists when aggregate monetary demand is below the level
required to ensure full employment - people demand fewer goods and services
than the labour force could produce.
A, B, D, E ::} Would all tend to increase demand for domestic goods and
services and, hence, reduce the gap .
e ::} An increase in savings would reduce demand and increase a deflationary
gap.

Solution 15.7 Answer: E

None of the conditions will ensure full employment.

A, B, e ::} Are each only part of the composition of aggregate demand.
D ::} Will mean that the economy is in equilibrium, but Keynes argued that an
economy can be in equilibrium at any level of employment and not necessarily at
the full-employment level. Indeed, without planning, it would be very unlikely to
be at this level.

Solution 15.8 Answer: D

Monetarists believe that the level of employment and , hence , unemployment is

determined by the demand for and supply of labour. They think that the natural
rate of unemployment would be reduced by anything which increases the supply
of and/or the demand for labour at the equilibrium wage rate. An increase in
labour mobility will result in people moving more quickly from job to job,
increasing the supply of labour and so reducing frictional unemployment.
2 ::} They think that an increase in unemployment benefit would reduce the
supply of labour by increasing voluntary unemployment.
3 ::} Monetarists believe that, although increased government spending may
raise demand for labour in the short term , in the long term it will succeed only in
causing an acceleration in the inflation rate, while unemployment will return to
the natural rate.

Solution 15.9 Answer: e

While many would agree that those who are not actively seeking employment
and those working in the black economy are not really unemployed , if they
register , they will be counted. Indeed, it is difficult to assess which claimants are
looking for work and who may be illegally claiming benefit.

Solution 15.10 Answer: A

Immobility will increase the duration of all the types of unemployment men-
tioned, since, in every case, limits on a person's ability to move to another area
or to another occupation would reduce his/her chances of finding another job
quickly.
230
 16 Inflation
16.1 Fact Sheet

(a) Definition of Inflation

Inflation is a persistent rise in the general price level and , hence , a sustained fall
in the value of money.

• Creeping inflation is a low rate of inflation.

• Hyperinflation is a very high rate of inflation which can cause major
economic problems and politic al instability.
• Stagflation is a situation of high inflation and high unemployment.
• Slumpflation occurs when ther e is high inflation , high unemployment and
negative growth.

(b) Measuring Inflation

(i) The Retail Price Index (RPI) is the most widely used index of general
consumer prices.
(ii) The Tax and Price Index (TPI) measures average household purchasing
power , including the effects of changes in indirect taxes as well as prices .
(iii) Producer Price Indices (PPI) measure changes in material and product
prices, and give an indication of the future trend of retail prices.
(iv) Pensioners' Retail Price Index (PRPI) indicates price changes in goods
and services purchased by the retired.
(v) The GDP deflator is the most widely used index of general prices for both
consumers and producers. .

• These measures are weighted indices , which means that particular import-
ance is attached to items which form a large proportion of expenditure or
output.

(c) Cost Push Inflation

Cost push inflation occurs when a cost of production (e .g. wages) increases and
firms put up prices to maintain profits. Causes of cost push inflation include :
(i) Wage increases which may result from:
(1) a wage-price spiral , when wage increases raise prices, thereby
encouraging further wage demands, etc .;
(2) a wage-wage spiral, when a wage increase in one industry sets off a
series of wage claims in other industries so as to maintain differen-
tials.

231
 (ii) Imported inflation from overseas increases in the prices of goods im-
ported into the UK .
(iii) An increase in the price of imports as a result of a depreciation of sterling.
See Section 19.1(a).

(d) Demand Pull Inflation

Demand pull inflation occurs when aggregate demand exceeds aggregate supply .
In Figure 16.1, an increase in a component of aggregate monetary demand
(AMD) means that total demand (J) exceeds the full employment value of
output (K) . An inflationary gap of J- K results .

NEx
NEx = N.Y.

AMD,

AMD

o N.Y .

Figure 16.1 An inflationary gap

Monetarists argue that, if the growth of the money supply exceeds the growth
of output, prices will eventually rise. Fisher's Quantity Theory of Money states:
MV= PT
where M is the money supply; V is the velocity of circulation (i.e. the number of
times one unit of currency changes hands); P is average prices ; and T is the
number of transactions (goods bought) .

• Monetarists assert that V and T are constant in the short term . Any increase
in M must necessarily increase P.
• However, Keynesians argue that at less than full employment an increase in
M causes an increase in T, as more output is made, leaving prices
unchanged. V rises in times of boom and falls during depressions .

(e) The Effects of Inflation

• Low inflation may stimulate investment if prices are increased before wages
rise .

232
The costs of inflation include:
(i) Shoe Leather costs The high opportunity cost of holding money means
people hold lower money balances and make frequent journeys to
banks, building societies, etc.
(ii) Menu costs, as a result of changing price tags, slot machines, etc .
(iii) FiscaL drag occurs when people's money income rises, dragging them
into higher tax brackets. A higher percentage of real income is paid in
tax.
(iv) Uncertainty may reduce investment and increase the resources devoted
to planning.
(v) The Balance of Payments will be adversely affected if the country's
inflation rate is higher than that of competitors and there are no
offsetting exchange rate changes .
(vi) Labour unrest may occur as workers seek wage rises to maintain real
Income.
(vii) Expectations of inflation may arise, further fuelling inflation.
(viii) Money illusion may occur where people confuse changes in nominal
balances with changes in real balances.
(ix) Arbitrary redistribution of income and wealth may occur, as shown in
Table 16.1.

Table 16.1 Redistribution of income through inflation

Taxpayers The government

Holders of the National Debt The government
Savers Borrowers
Creditors Debtors
Workers in weak trade unions , Those who can raise their incomes by
non-unionised labour and those on fixed more than the rate of inflation
incomes
Domestic producers Foreign producers with lower inflation
rates

(f) Methods of Adapting to Inflation

(i) Firms and households may include indexation in contracts, automatically

adjusting prices and wages to the inflation rate.
(ii) Firms may use infLation accounting and adjust costs, revenue, value of
stock, etc ., in line with inflation.

(g) Remedies for Inflation

The measures taken to cure inflation depend on whether price increases are
caused by demand pull or cost push factors .
(i) Demand pull inflation remedies:
(1) deflationary fiscal policy, where increased taxes and/or reduced
government spending lowers aggregate demand;
(2) deflationary monetary policy, where reducing the growth of the
money supply and/or raising the rate of interest lowers demand ;
(3) stimulating output by improved productivity, labour relations, etc.

233
 (ii) Cost push inflation remedies:
(1) imposing prices and incomes policies to freeze price and income
increases - the wage-price and wage-wage spirals are broken;
(2) subsidising production, to reduce costs;
(3) reducing indirect taxes , to reduce prices;
(4) raising the exchange rate, to reduce the cost of imported materials
and components and to force domestic producers and exporters to
remain competitive with foreign producers.

(h) Inflation and Unemployment

(i) The Phillips curve implies a trade-off relationship between inflation and
unemployment. For instance, in Figure 16.2 the percentage change in
money wages is high when unemployment is low.

% rate of change
of money wages

Wl----+--~

OI-----I.----'---3~----------
% unemployment

Figure 16.2 The Phillips curve

Money wage
LPC
inflation

4%

a % unemployment

Figure 16.3 An expectations-augmented Phillips curve. SPC, and SPC 2 are short-term Phillips
curves . LPC is the long-term Phillips curve at the NRU. Economy initially on
SPC I curve at UN at point A. Government reduces unemployment to UI by
increasing demand. This causes prices and wages to rise . Move to point B. Higher
wages and costs result in a rise in unemployment to UN but at a higher expected
rate of inflation on SPC 2 . Move to point C

234
 (ii) The expectations-augmented Phillips curve reflects the monetarist view
that there is no long-term inflation-unemployment trade-off. Any at-
tempt to reduce unemployment below the natural rate will only succeed
in accelerating the rate of inflation (see Figure 16.3).
(iii) The Rational Expectations Hypothesis suggests that there is no long-term
or short-term trade-off. Supporters argue that people base their actions
on past experiences of inflation and their expectations of current and
future government policies . On average , they correctly forecast the
results of current economic events and policie s, and do not suffer from
money illusion .

16.2 Data Response

Worked Example 16.1

'Unemployment seems to be an unavoidable side effect of curing inflation, just

as going to bed is of an operation, and there are many policies that simulta-
neously add to unemployment and inflation, just as staying in bed may produce
illness (though not appendicitis). I know of no example of a country that has
cured substantial inflation without going through a transitional period of slow
growth and unemployment. I know of no example of a country that has
experienced accelerating inflation without running into serious economic
difficulties. Japan, Great Britain, Chile and Brazil illustrate both propositions. All
got into serious economic difficulties as a side effect of accelerating inflation.
All went through a transitional period of slow growth and unemployment in
curing - or at least reducing - inflation .
Why is unemployment a side effect of curing inflation? Because a cure
changes the economic environment in ways that were not widely anticipated by
the economic actors and that they misinterpret. The only cure for inflation is to
reduce the rate at which total spending is growing:
Source: M. Friedman, condensed from Newsweek, 12 November 1979

(a) How might 'accelerating inflation ' result in 'serious economic difficulties '?
(6 marks)
(b) Why does the author consider that 'slow growth and unemployment' are
necessary in alleviating inflation? (7 marks)
(c) The author states that 'the only cure for inflation is to reduce the rate at which
total spending is growing'. Discuss other policies that might be adopted to cure
inflation . (7 marks)
(L June 1986)

Solution 16.1

(a) Accelerating inflation can result in a number of problems. Rising inflation

will reduce a country's international competitiveness and is likely to result
in a deterioration in its current account position. Output and employment
may fall if more good s are bought from foreign rather than domestic
producers . There may be a reduction in capital inflows if inflation reduces
the real rate of interest below that prevailing in other countries. There will
be an arbitrary redistribution of income, and labour unrest may arise due
to the need to press for wage rises to maintain living standards . Inflation
will impose a number of costs on individuals and firms. People will have to
spend time estimating future inflation, and firms will have to change their
prices and the value of their assets and stocks on a regular basis. If
hyperinflation occurs , confidence in the currency will decrease and there
may be political and economic instability.

235
 (b) Milton Friedman and other monetarists believe that inflation is caused by
an excessive growth of the money supply and expectations of inflation. To
reduce inflation, they urge a reduction in the rate of monetary growth .
There is some dispute among monetarists as to whether the reduction in
the rate of monetary expansion should be gradual or sharp. However , all
accept that the initial effect of reducing the growth of the money supply is
likely to be a sharp rise in the level of unemployment above the natural
rate, as the fall in output precedes the fall in inflation.
When the government reduces the growth of the money supply , prices
will initially rise faster than the nominal money suppl y. This will cause a
fall in aggregate demand , a reduction in output and a rise in involuntary
unemployment. When workers are convinced that the government will
maintain a tight monetary policy and that inflation will fall, they will ask
for lower increases in money wages. The rise in unemployment will also
exert downward pressure on wages. How long and how high unemploy-
ment rises will depend mainly on how fast wages adjust. If workers are
prepared to accept a drop in living standards for a while, then they will
price themselves back into work relatively quickly. However , if workers
are resistant or misinterpret the 'changes in the economic environment' ,
unemployment may continue at a level above the natural rate for some
time .

Rate of change
of money,
wages and prices Long-run
Phill ips
curve

o % unemployment

The diagram shows that initially the economy is experiencing 8%

inflation and unemployment is at the natural rate of V N • To eliminate
inflation and inflationary expectations , unemployment would have to rise
to V\.
(c) The policies which will be adopted to cure inflation will depend on what is
believed to be the cause of inflation and views on the effectiveness of the
policies. Economists who consider that inflation results from increases in
costs of production may urge the implementation of a prices and incomes
policy. They argue that this will reduce price rises while avoiding the
adverse effects of deflationary policies - in particular, rises in unemploy-
ment. Economists who consider that inflation has resulted from demand
exceeding supply may urge a reduction in demand, This could be achieved
by deflationary fiscal and/or monetary policy. The article refers to
reducing the growth of spending. This could be achieved by reducing
government spending, increasing taxation, reducing the growth of the
money supply or raising interest rates. An alternative to reducing demand

236
 is increasing output. This will only be a viable policy if the economy is
below the full-employment level. A rise in the exchange rate may also be
employed to reduce inflationary pressures . The fall in import prices will
lower the cost of finished imported goods , some UK producers' costs of
production and possibly wage claims. The lower import prices may also
increase pressure on domestic producers to keep their prices low in order
to remain competitive at home and abroad.

16.3 Objective Questions

Example 16.2

The weights in the retail price index indicate :

A which goods have risen by more than the average rise in prices
B by how much the prices of goods have changed
C the relative amount spent on each category of good
D that each item has been given an index number of 100 in the base year
E seasonal fluctuations in price

Example 16.3

The following information shows a country's consumer expenditure pattern on four

goods and the price indices of these commodities for two years.

Commodity Index of prices Index of prices Consumers' expenditure

in year I in year 2 (£ million) in year I

W 100 80 300
X 100 110 200
Y 100 120 100
Z 100 150 400

Between years 1 and 2 the general level of prices has:

A remained the same B risen by 4.5% C risen by 12%
D risen by 18% E risen by 60%

Example 16.4

Which of the following groups is most likely to benefit from a period of higher than
anticipated inflation?
A standard-rate taxpayers
B people claiming unemployment benefit
C creditors
D non-un ionised labour
E the government

Example 16.5

Demand pull inflation may initially be caused by:

A an increase in bank credit
B an increase in profit margins

237
 C an increase in wages
D an increase in the price of imported raw materials
E an increase in rent

Example 16.6

An intlationary gap is said to exist when :

A aggregate demand is greater than the full-employment level of National Income
B visible exports exceed visible imports
C leakages exceed injections at the full-employment level of National Income
D government spending exceeds government revenue
E the full-employment level of National Income exceeds the equilibrium level of
National Income

Example 16.7

In conditions of full employment , which of the following would be most likely to lead
to intlation?
A a rise in the expenditure on imports
B an increase in income tax
C a reduction in government expenditure
D an increase in labour productivity
E a rise in demand for exports

Example 16.8

If a government believes that intlation is the result of cost push factors and it wishes to
reduce intlation, which of the following measures is it most likely to adopt?
A an increase in income tax
B a reduction in government expenditure
C a rise in interest rates
D a reduction in the growth of the money supply
E the imposition of a prices and incomes policy

Example 16.9

In year 1, an economy has a money supply of £400 and a velocity of circulation of 6,

and it produces 800 goods. In year 2 the velocity of circulation and the level of output
remain constant, but the money supply increases to £600. According to the quantity
theory, this will cause the price level to rise by:
A £1! B £3 C £4! D £6 E £10

Example 16.10

In the diagram opposite, UN is the natural rate of unemployment, SPCt> SPC 2 , SPC 3
and SPC 4 are short-run Phillips curves associated with successively higher levels of
intlationary expectations, and LPC is the long-run, vertical Phillips curve. If intlation-
ary expectations are at 6% and a government wishes to eliminate wage intlation, it
would have to permit unemployment in the short run to change to:
A ~ B ~ C ~ D ~ E ~

238
 Rate of change
of money wages LPC (NRU)

8%

3%

o VI % unemployment

Select your answers to Examples 16.11, 16.12 by means of the following code:
A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 16.11

Which of the following must occur as a result of inflation?

1 debtors will gain and creditors will lose
2 the volume of exports will decline
3 the domestic purchasing power of the currency will decline

Example 16.12

Which of the following may result in inflationary pressure in an economy with full
employment?
1 an increase in the budget deficit
2 an increase in government spending matched by an equal increase in taxation
3 an increase in the current account deficit

16.4 Essays

Example 16.13

Analyse the proposition that the United Kingdom government cannot avoid even-
tually introducing a formal prices and incomes policy for the whole economy
(OLE 1985)

• Define a prices and incomes policy and consider its main purpose.
• Consider the causes of inflation.
• Discuss different views on the need for a prices and incomes policy.

239
 Solution 16.13

A formal prices and incomes policy is a deliberate government measure to

influence prices and incomes. An incomes policy may be introduced for a
number of purposes , including reducing poverty and establishing equal pay .
However, the most common form of incomes policy, particularly when com-
bined with a prices policy, is to reduce rises in incomes in an attempt to lower
inflation.
Monetarists reject the idea that inflation is caused by cost push factors, and
most dislike prices and incomes policies, not only because they believe they are
an inappropriate solution, but also because they consider that they interfere with
the free market mechanism. Government intervention in pricing and factor
income decisions will, they argue, reduce efficiency and result in a fall in
aggregate supply.
The monetarists believe that rises in money incomes are the result rather than
the cause of inflation. They believe that inflation is of a demand pull nature
resulting from an excessive growth of the money supply. They argue that large
public-sector borrowing requirements have been financed partly by increasing
the money supply , and that this has led to a rise in demand and a rise in prices.
Their solution to inflation is to control the money supply .
However, some monetarists would favour, during times of high inflation,
indexation of wages, and possibly some other incomes and prices , in order to
reduce expectations of inflation. Some would also acknowledge that the govern-
ment may wish to restrict public-sector pay settlements, to avoid a growth of the
PSBR and to encourage low rises in incomes to avoid inflation accelerating.
Most Keynesians believe that inflation is the result of cost push factors,
including wage rises and increases in the cost of raw materials and fuel. Workers
are now concerned with real wages, so that, for instance , a rise in import prices
may provoke wage claims to restore workers' living standards. Workers are also
very concerned about their differentials and there is often a wage-wage spiral.
However, not all economists who believe that inflation is caused by cost push
would advocate a prices and incomes policy. Rises in incomes and prices may be
reduced by other measures, including deflation and raising the value of the
exchange rate. For instance, reducing government expenditure , which causes
unemployment to rise, is likely to result in a reduction in wage claims.
Although one advantage claimed for a prices and incomes policy is that it
enables inflation to be reduced without raising unemployment, there are a
number of problems associated with a prices and incomes policy. As there are
millions of prices , they are difficult to monitor, and new products, seasonal food
and imports may pose problems. Entrepreneurs will probably try to find ways
round controls by, e.g., quality deterioration or by reducing quantity or weight .
They will also probably be asked to be made exceptions because of, e .g., rises in
raw material costs.
Similar problems arise with incomes policies. Exceptions will be claimed on
the grounds of low pay, productivity, labour shortages and comparability. There
will be a conflict of interest between high-paid workers , who will favour
percentage increases, and low-paid workers, who will favour flat-rate pay
increases. Unions and employers will find ways round the policy - e.g. fringe
benefits, upgrading and overtime - and , once an incomes policy is removed,
incomes may rise significantly .
The main motive behind introducing a prices and incomes policy would be to
reduce inflation. A government will not be obliged to introduce such a policy if
inflation is not a problem. A government faced with the problem of inflation will
also not implement a formal prices and incomes policy if it can lower price and

240
income rises by persuasion or other means or if it believes that inflation is caused
by other factors and/or that prices and incomes policies will be ineffective and
will result in market distortions.

Example 16.14

Is inflation only harmful if it is at a rate above that prevailing in other countries?

• Consider the effects of inflation on a country's external position.

• Also consider the effects on a country's internal position.

Solution 16.14

Inflation , which is a persistent rise in the general price level , may have
detrimental effects , not only externally , but also internally. The internal effects
can occur even if the country has a lower inflation rate than that of other
countries.
If the UK's inflation rate is higher than that of other countries , then the UK's
products will become less competitive both at home and abroad . This is likely to
result in a fall in export revenue and a rise in import expenditure. Investment in
the UK may be discouraged . So there is likely to be an adverse effect on the
UK's balance of payments pos ition and employment. It may also result in a fall
in the exchange rate , which will accelerate inflation.
Inflation, especially if it is above a creeping level, will also probably be
undesirable, because of the internal effects. Inflation will affect the distribution
of income, and this can create social tension . For instance, unions will have to
press for wage rises merely to keep pace with inflation - i.e . to maintain real
wages. Members of weak unions - e.g. USDAW - are more likely to suffer a
decline in real wages than are members of strong unions .
The effects of inflation can be alleviated by index linking wages and or
benefits. However, if, e .g., unemployment benefit is not raised in line with
inflation, then the unemployed will experience a fall in their real living
standards. In contrast , house owners may benefit, since the value of their
property is likely to rise by more than the rate of inflation, while the real cost of
their mortgage payments is likely to fall.
Creditors may suffer and debtors may gain if the rate of interest does not rise
in line with inflation. Fiscal drag may occur, although the government could
eliminate this effect by adjusting tax brackets in line with inflation .
There will be costs involved in living with inflation. Firms will incur menu
costs, having to adjust prices regularly , and time and effort may have to be taken
in estimating future inflation. Firms and individuals may also experience shoe
leather costs .
Government measures to reduce inflation may have an adverse effect on other
economic objectives, particularly growth and full employment. Deflationary
monetary policy and fiscal policy will reduce demand and, hence, tend to result
in lower output and employment, at least in the short term .
One possible advantage of inflation may arise if it is at a low level and is of a
demand pull nature . This is because a situation where demand exceeds supply
may make entrepreneurs optimistic about the potential returns which can be
earned from expanding output.
However, inflation , particularly of a high level, will have effects within a
country as well as on its competitive position abroad . While it is possible to
alleviate some of the internal effects, some may cause inconvenience, disruption

241
 and possibly hardships. For a number of countries, including the UK, a
reduction in international competitiveness will be significant, but it is not the
only adverse effect which the country may suffer as a result of inflation .

16.5 Solutions to Objective Questions

Solution 16.2 Answer: C

The index of retail prices is a weighted price index . This means that the price
changes of different categories of goods are multiplied by weights . These weights
indicate what proportion of consumer expenditure is devoted to the different
categories. For instance if, out of a total expenditure of £100m, £30m is spent on
food, then food will receive a weighting of 3/10.

Solution 16.3 Answer: D

To determine the change in the general price level, it is necessary to multiply the
price change of each commodity by its weighting. The total of the weighted price
changes gives the answer.

Commodity Weight Price change Weighted price change

3 20
W - X - =- 6%
10 1
2 10
X - x - = 2%
10 1
1 20
Y - x - = 2%
10 1
4 50
Z - x - = 20%
10 1

18%

Solution 16.4 Answer: E

The government is a net debtor and so is likely to have to pay lower real interest.
The government may also raise more revenue if fiscal drag occurs . Other options
are incorrect.
A and B ~ Standard-rate taxpayers and the unemployed will experience a fall
in living standards if tax rates and benefits are not adjusted in line with inflation
or if there is a lagged response. Even if fiscal drag is avoided and unemployment
benefits are raised in line with inflation, the two groups will not be better off,
merely no worse off.
C ~ Creditors are likely to lose during a period of higher than anticipated
inflation, since the real rate of interest is likely to fall.
D ~ Similarly, non-unionised labour is likely to suffer, since it will be in a
weak position to maintain real wages.

242
Solution 16.5 Answer: A

An increase in bank credit will mean that firms and consumers will have more to
spend and the resulting increase in demand may result in demand pull inflation.
B, C, D, E ::;> Are likely to increase costs of production and so might result in
cost push inflation.

Solution 16.6 Answer: A

An inflationary gap occurs when aggregate demand is greater than the output
which can be produced when there is full employment.
B ::;> Describes a balance of trade gap.
e and E ::;> Describe a deflationary gap.
D ::;> Describes a budget deficit.

Solution 16.7 Answer: E

An increase in demand for exports will mean more money coming into the
country while goods are going out. Thus, there will be more money and fewer
goods to spend it on. With full employment, it will be difficult to produce more
goods and an inflationary gap is likely to develop, with demand exceeding
supply.
A, B, e ::;> Would all reduce demand and, hence, inflationary pressure.
D ::;> Would result in more goods being available and , assuming no increase in
wages, a fall in the inflation rate .

Solution 16.8 Answer: E

Cost push inflation arises when prices are pushed up by increases in the costs of
production, such as wages . One possible solution is a prices and incomes policy
which aims to limit rises in prices and incomes while avoiding deflation.
All the other measures mentioned are designed to reduce demand - A and B by
fiscal measures and e and D by monetary measures - and so would be more
likely to be implemented if it was believed that the inflation was caused by
demand pull.

Solution 16.9 Answer: A

The Quantity Theory is represented by the formula MV = PT or P = MVIT. In

year 1, the price level is:
P = MVIT = 400 x 6/800 = 2400/800 = £3
In year 2, the price level is:
P = MVIT = 600 x 6/800 = 3600/800 = £~

So the price level has risen from £3 to £~ - i.e . by £Ii. The money supply
increases by 50%, causing a 50% rise in the price level.

Solution 16.10 Answer: D

If inflationary expectations are at 6%, the economy is on Phillips curve PC 3 . On

this curve , U4 is the rate of unemployment that will reduce the rate of change of
money wages to zero , since U4 is where PC 3 cuts the zero percentage rate of
change of money wages line. In the long term , when the expected rate of

243
 inflation equals the actual rate of inflation, unemployment will return to the
natural rate of UN '

Solution 16.11 Answer: D

If prices rise, each unit of currency (e .g. each £1) will be able to buy fewer goods
and services.
2 and 3 ~ May occur but will not necessarily occur. Debtors will gain and
creditors will lose if the inflation rate exceeds the rate of interest - i.e. if there
is negative rate of interest. However, the rate of interest may rise in line with
inflation and even possibly above it. Whether the volume of exports decreases or
not will depend on a number of factors , including the inflation rate experienced
in other countries. Indeed , if the home country's inflation rate is below that of
rival countries, her exports will become more and not less competitive .

Solution 16.12 Answer: B

1 ~ An increase in the budget deficit will represent an injection of spending into

the economy, which , if it cannot be matched by a rise in output , may result in a
rise in prices .
2 ~ An increase in government spending matched by an equal increase in
taxation will cause N.Y. to rise, since the recipients of government spending will
be likely to have a higher mpc than taxpayers.
3 ~ An increase in a current account deficit may reduce inflationary pressure,
since it will mean an inflow of goods and services and an outflow of money .

244
 17 International Trade
17.1 Fact Sheet

(a) Problems of International Trade

International trade is the exchange of goods and services between countries.

Problems arise over:
(i) currencies;
(ii) language;
(iii) distance ;
(iv) customs/tastes ;
(v) foreign competition;
(vi) import restrictions ;
(vii) legal and technical regulations;
(viii) possible delays in pa yment.

(b) Benefits of International Trade

(i) A greater variety of goods for consumers.

(ii) A larger market allows domestic producers greater scope for economies
of scale .
(iii) An opportunity to obtain goods which the country cannot produce itself.
This accounts for a very small percentage of the goods the UK imports.
(iv) Consumers' welfare may increase as a result of lower prices resulting
from international competition.
(v) Trade with other countries may lead to the spread of technology.
(vi) International specialisation raises output.

(c) Absolute and Comparative Advantage

The main advantage claimed for international trade is higher world output. The
theories of absolute advantage and comparative advantage explain how output
may be increased by specialisation and trade .

• Absolute advantage exists when a country can produce more of a product

per resource unit than another country .
• Comparative advantage exists when a country can produce a product at a
lower opportunity cost than its trading partners.

245
 Table 17.1 An example of comparative advantage

Country Monthly output per resource unit

cars boats

A 2 4
B 4 10

While country B has an absolute advantage in the production of both goods, A

has a comparative advantage in the production of cars. A sacrifices only 2 boats
for 1 extra car (4 boats/2 cars), while B has to forgo 2! cars (10 boats/4 cars).

(d) Costs of International Trade

(i) Infant industries may not be able to become established if faced with
competition from foreign companies with lower costs due to greater
economies of scale.
(ii) Declining industries may decline rapidly , causing a significant rise in
unemployment.
(iii) Foreign producers may engage in dumping (i.e. selling surplus output at a
low price , even sometimes below average cost) in the home market.
(iv) A country may become dependent on other nations for products - e.g.
weapons , food - which may be cut off during periods of dispute or war.
(v) A country may experience the disadvantages of overspecialisation,
including diseconomies of scale , vulnerability to sudden changes in
demand and unemployment.

(e) Pattern of UK International Trade

The UK is a major trading country , importing and exporting mainly manufac-

tured goods from and to mainly developed countries.

Table 17.2 The UK's main trading partners in 1986

Most important sources Most important recipients

of UK imports of UK exports

1 West Germany USA

2 USA West Germany
3 France France
4 Netherlands Netherlands
5 Japan Belgium and Luxembourg
6 Italy Irish Republic
7 Belgium and Luxembourg Italy
8 Norway Sweden
9 Irish Republic Spain
10 Switzerland Canada

Source : Monthly Digest of Statistics. January 1988

246
(1) Protectionism

Protectionism protects domestic industries from foreign competition by means of

tariffs and non-tariff barriers. The main forms of restrictions are:
(i) Tariffs (also called customs duties) , which are a tax on imported goods.
This is the most common form of restriction. In addition to protecting
domestic industries, tariffs may be imposed to raise revenue .
(ii) Quotas are limits on the quantity of a commodity which is allowed to
enter the country.
(iii) Exchange control occurs when a government controls the availability of
foreign currency. This often involves a limit on the foreign exchange
available to importers.
(iv) Physical control occurs when a ban is placed on the export or import of a
certain good or on trade with a particular country or countries.
(v) Subsidies act as a form of import restriction by lowering the price of
home-produced goods and, hence, making imports less competitive.

Administrative
restrictions Purchasing
Subsidies f /policies Prices Output
Embargoes Import deposit
.............. Types of ,/" schemes 1 ~ Employment
Exchange _ restrictions _ Voluntary
Effects
control/agreements on - Balance of
payments
Quotas
Tariffs

Further Avoid
political /overspecialisation
objectives ~ A rguments for Arguments for - Promote
Protect _ _ selective controls general controls growth

~~a~~:~s / 1 / \
Correct balance of
payments deficit
Help infant Help Prevent Improve Raise Retaliate
industries declining dumping terms of revenue
industries trade

Figure 17.1 Types of, effects of and reasons for import restrictions

(g) Regional Economic Groupings

There are two main types of groupings:

(i) A free trade area is a group of countries which removes tariff barriers
between member countries but allows each member to decide on its own
tariff policy towards non-members. For instance, the European Free
Trade Area (EFTA) .
(ii) A customs union, which , in addition to removing tariffs between
members, also imposes common external tariffs on non-members. For
instance , the European Economic Community (EEC).

(h) The European Economic Community

The EEC was established in 1957 by France, West Germany, Belgium and The
Netherlands. It currently has 12 members. Its main policies include:

247
 (i) T he Common Agricultural Policy (CAP), which has th e following main
aims:
(1) to increase agr icultural productivity;
(2) to ensure a fair standard of living for the agricultural commun ity;
(3) to stabilise markets through price intervention (see Figure 3.3);
(4) to ensure the availability of supplies to consumers at reasona ble
pnces.
While mos t wo uld agree tha t the EEC has been successful with the first
two aims it has not achieved (3) and (4) . T he high support prices have
resulted in large surpluses and considerable expenditure . CAP usually
tak es up 60% of th e EEC budget.
(ii) Energy policy, which has the following main aims :
(1) to co ntrol th e cons umption of energy resources;
(2) to increase th e Co mmunity's coa l production ;
(3) to increase th e use of solid fue ls and nu clear power.
(iii) Region al policy: th e EEC Region al Developm ent Fun d assists region al
developme nt areas in member countries .
(iv) The E uropean Mo netary Syste m seeks to stabilise excha nge rates be -
tween me mber countries .
(v) The EEC will be a single market after 1992, with no trade barriers.

17.2 Data Response

Exa mple 17.1

T he following table shows imports as a percentage of home demand .

Import Penetrat ion

Imports/home demand 1982 1983 1984 1985 1986

(%) (%) (%) (%) (%)
Manufacturing indust ries 29.0 31.1 33.4 34 .3 34 .3

Class:
Metals 33 36 43 45 48
Chemicals and man -made fibres 34 36 39 41 41
Motor vehicles and thei r parts 47 52 51 50 51
Food , drink and tobacco 16 17 18 18 18
Textile industry 39 41 44 44 45
Pap er , printing and publishing 19 20 21 21 21

Source : Adapted from Annual Abstract of Statistics (HMSO) , 1988

(a) Which ind ustries experienced higher th an average import pe netration and which
o nes experienced lower than ave rage import penetration throughou t the time
period show n? (3 marks)
(b) In which industry was the grow th in impo rt penet ration greates t in percentage
ter ms be twee n 1982 and 1986? (2 marks)

248
 (c) What may have caused the increase in import penetration between 1982 and
1986? (5 marks)
(d) Briefly describe four types of import restrictions which a government could
impose or increase to reduce import penetration . (5 marks)
(e) What other measures, apart from import restrictions, could a government take to
reduce import penetration? (5 marks)

Solution 17.1

(a) Metals, chemicals and man-made fibres, motor vehicles and their parts
and the textile industry all experienced higher import penetration than the
average for manufacturing industries. Food, drink and tobacco, and
paper, printing and publishing experienced lower than the average import
penetration.
(b) The growth of import penetration can be measured by using the equation:

(1986 import penetration - 1982 import penetration) 100

~--~-~---------'-----"--------'-x-
1982 import penetration 1
For metals , this converts to:

(48% - 33%) x 100 =~ x 100 = 45.5%

33% 1 33 1
(c) Reasons include:
(i) lower prices of imports due to high value of the £ during the 1980s;
(ii) the superior quality and better after-sales service of some foreign
producers ;
(iii) foreign subsidies;
(iv) rises in UK prices.
(d) (i) Tariffs (custom duties) may be used to protect home producers
and/or to raise revenue. They may be specific or ad valorem.
Whether the main effect is on the price or the quantity of imports will
depend in part on the elasticity of demand.
(ii) Quotas are physical limits on the quantity of a good that can be
imported. They are usually enforced by licences , and may result in
shortages or higher prices if placed on raw materials.
(iii) Exchange control involves the government controlling the availability
of foreign currency. Importers wanting to pay overseas suppliers have
to apply to obtain foreign currency. The government can thereby
determine the nature and quantity of imports .
(iv) An embargo involves a ban on the import of certain goods (e.g.
drugs) or a boycott of trade with certain countries (e.g. South
Africa) .
(e) A government could introduce deflationary fiscal and/or monetary policy.
A reduction in government spending, an increase in taxation , a rise in
interest rates or a fall in the growth of the money supply will be likely to
result in a reduction in demand for all goods , including imports .
A government could also devalue the currency. This would lower
export prices and raise import prices. The rise in import prices could result
in UK goods becoming more price-competitive.
A government could also encourage consumers and government depart-
ments to buy UK goods by , e .g., an advertising campaign or giving
preference to UK firms when placing orders.

249
17.3 Objective Questions

Example 17.2

A country is said to have a comparative advantage in the production of a good when :

A it can produce more of it than any other country
B it accounts for a gre ater percentage of tot al world sales in the product than in any
other product it produces
C it has captured a larger perc entage share of th e world market than any other
country
D it can produce it at a lower opportunity cost th an its trading partners
E it employs more workers in its production than in any other activity

Example 17.3

With respect to the table below , which of the following stateme nts is correct?

Units of resources required to: Country A Country B

produce o ne TV 30 60
produce one radio 10 40

A country B has an absolute advantage in the production of both products

B country B has an absolute advantage in the production of TVs
C country A has a comparative advantage in the production of TVs
D country B has a comparative advantage in the production of radios
E none of the above statements is correct

Examples 17.4 and 17.5 are based on the following information:

Cuba USA

Output of cigar units per factor input 30 10

Output of sugar units per factor input 90 50

Example 17.4

Which of the following is true of the situation abo ve?

A the USA has an absolute advantage in the production of both sugar and cigars
B Cuba has an absolute advantage in the production of both sugar and cigars
C the USA has an absolute advantage in the production of sugar and Cuba has an
absolute advantage in the production of cigars
D the USA has a comparative advantage in the production of cigars
E Cuba has a comparative advantage in the production of sugar

Example 17.5

Which of the following exchange rates will benefit both Cuba and the USA?
A 1 cigar for 6 sugar B 1 cigar for 5 sugar C 1 cigar for 4 sugar
D 1 sugar for 8 cigar E 1 sugar for 6 cigar

250
Example 17.6

The following table shows the output per factor input in two products :

UK Nigeria

Units of iron 240 48

Units of steel 80 16

If the assumptions are made that there are no trade barriers and no transport costs,
which of the following is most likely to occur?
A the UK will import iron and steel from Nigeria
B Nigeria will import iron and steel from the UK
C the UK will export iron to Nigeria and import steel from Nigeria
D Nigeria will export iron to the UK and import steel from the UK
E there will be no trade between the two countries in the products concerned

Example 17.7

Wheat Wheat

216

54

o 18 Tractors o Tractors

Figure 1 Figure 2

Figure 1 shows the production possibility curve of country A and Figure 2 shows the
production possibility curve of country B.
In this case , which of the following is most likely to occur ?
A no trade , since country B is better at making both products
B no trade, since the opportunity cost ratios are identical
C no trade , since country A is better at making both products
D country A will tend to export wheat to country B
E country B will tend to export wheat to country A

Example 17.8

Which of the following would reduce the level of protection faced by domestic
producers in the home market?
A the introduction of exchange control
B an increase in VAT
C a reduction in the level of import quotas
D a rise in tariffs
E an agreement to implement reciprocal tariff concessions proposed by GATT

251
 Example 17.9

Before the imposition of a tariff, the domestic price of good T is Px and domestic
producers supply SA . Domestic demand is represented by DA. When the country
engages in free international trade , the total world supply is represented by SB and
the price is Pc, The imposition of a tariff on the product causes price to rise to Pz . The
tariff will result in domestic producers increasing their output by:
A OC B CD C DE D EF E FG

Price of
good T

1---"'7l'oe::;..--i----+----+---....;;::a'1'"l::::-- 5B
DA

o c o E F G Output

Example 17.10

Which of the following is the main feature which distinguishes a customs union from a
free-trade area?
A only the free-trade area has no tariff barriers between members
B only the free-trade area requires members to adopt a common external tariff with
non-members
C only the customs union has no tariff barriers between members
D only the customs union requires members to adopt a common external tariff with
non-members
E only the customs union maintains tariffs between member countries

Select your answers to Examples 17.11 and 17.12 by means of the following
code:
A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 17.11

The following table shows the costs of producing a unit of coal and a unit of wheat in
two countries in $s:

Country A Country B

Cost per unit of coal 10 50

Cost per unit of wheat 4 12

252
 Which of the following is/are true?
1 country B has the absolute advantage in producing both coal and wheat
2 country A will specialise in coal
3 country B will export wheat

Example 17.12

The table below shows the output per factor unit in two countries:

Country Y Country Z

Cloth 9 30
Beef 3 6

Which of the following exchange rates would be acceptable to both countries:

1 1 beef for 4 cloth 2 2 beef for 3.3 cloth 3 3 beef for 2 cloth

17.4 Essays

Example 17.13

Discussthe case for and against increased protection for manufacturing industry in the
UK .
(WJEC June 1986)

• Distinguish between arguments for selective and general import controls.

• Concentrate on the arguments rather than detailed descriptions of the
different types of import controls.
• Include a discussion of the CEPG case.

Solution 17.13

Protection limits the entry of goods into a country. It is usually imposed to

protect domestic industries. The main argument against protection is that it
prevents full advantage being taken of the principle of comparative advantage,
which states that world output will be higher when countries specialise and
engage in free trade. Moreover, protection may reduce choice, reduce competi-
tion, create shortages, increase inefficiency and provoke retaliation .
However, some economists argue that selective import controls should be
placed on particular goods or goods from particular countries. These calls for
selective controls are backed by a number of arguments. One reason given is that
protection will be necessary to enable infant industries to grow and take
advantage of economies of scale .
At the other end of the industry age span , protection may be used to help
industries decline gradually . The idea is that this will permit natural wastage to
occur and avoid a sudden increase in unemployment.
Selective import controls may also be used to prevent dumping, when foreign
companies sell products at or below cost price. Predatory pricing benefits
domestic customers in the short term. In the longer term , artificially low prices
may eliminate domestic firms . Foreign producers can then use their monopoly
position to raise prices .

253
 General import controls may improve the terms of trade so that each export
can be exchanged for more imports. This will occur if the imposition of tariffs
forces foreign producers to reduce their prices in order to remain competitive.
Import restrictions may also enable a country to diversify and avoid over-
specialisation. If a country is highly specialised, there is a danger that it will
suffer if there is a fall in world demand or if there are supply problems.
Protection of strategic industries guarantees a domestic supply of essential
goods.
In some developing countries, import controls are used to raise revenue, and
both developing and developed countries may use import controls to gain a
strong bargaining position or to retaliate against other countries' trade restric-
tions . However, the danger is that a trade war may develop .
Countries may also use import controls to correct or prevent a balance of
payments deficit. However, import controls are usually only used as a last resort ,
and are likely to be combined with other measures to reduce the underlying
tendency to purchase a high level of imports.
The Cambridge Economic Policy Group urge the adoption of a system of
general import controls in order to restructure the UK economy. They do not
wish to reduce imports, merely to control their growth and to prevent an
injection of government spending, designed to stimulate the UK economy, being
largely spent on foreign imports. Their main idea is that a protective wall will
enable UK industry to regain its efficiency and growth , creating a situation of full
employment.

Example 17.14

Explain the theory of comparative advantage. To what extent is it a satisfactory

explanation of the basis of international trade?

• Distinguish between absolute and comparative advantage.

• Explain comparative advantage and then consider the assumptions underly-
ing the theory.
• Keep the numerical example simple . It should be designed to illustrate
economic theory and not to prove elaborate mathematical skill.

Solution 17.14

The theory of comparative advantage states that , provided that opportunity cost
ratios differ, even a more and a less efficient country will benefit from
specialisation and trade with each other. However, the simplicity and unreality
of some of the assumptions on which the theory is based have led to a number of
reservations being made about its applicability to the real world .
It is relatively straightforward to ascertain that countries with absolute
advantages in different products will benefit from specialisation and trade .
However, David Ricardo, in developing the theory of comparative advantage,
went further. He stated that both countries will benefit from specialisation and
trade, even if one country is more efficient at making both products concerned,
provided that it is even better at making one of the two. It is relative and not
absolute efficiency which is crucial.

UK USA

Units of output per factor: cars 10 50

Units of output per factor: wheat 20 200
254
 In the example given above , the USA has the absolute advantage in producing
both cars and wheat , since it can produce more of both. However, it has the
comparative advantage in producing wheat , since it is even better at making this
product, being able to produce ten times more of this but only five times more
cars than the UK. In contrast, the UK has the comparative advantage or lesser
disadvantage in making cars , since it is not so bad at making this product,
producing one-fifth of the quantity of cars , but only one-tenth of the quantity of
wheat , of the USA. Another way of determining in which product a country has
a comparative advantage is to examine the internal opportunity cost ratios . A
country has a comparative advantage in a product when producing it involves a
lower opportunity cost than in another country.
Output will be increased by specialisation, and both countries should be able
to enjoy more goods than previously if the exchange rate lies between the
internal opportunity cost ratios - in this case , 1 car : 2-4 wheat.
However, the applicability of the theory to international trade has been
questioned on a number of grounds. It is often stated in terms of a few countries
and a few products , whereas the real world is more complex. It also ignores
transport costs. These will reduce the advantages of specialisation and trade
- particularly in the case of low-price , bulky goods.
The theory assumes constant opportunity cost s as resources are moved from
one industry to another , whereas in practice economies or diseconomies of scale
may arise. The shifting of resources from one use to another also presumes
perfect factor mobility , whereas factors - particularly labour - may be im-
mobile .
Indeed, the theory presumes that perfect competition exists in the interna-
tional and the domestic markets. In practice , completely free trade does not
exist , and the presence of import restrictions reduces specialisation. Also , there
is not perfect knowledge , so it may be difficult to calculate comparative
advantage. There may also be imperfect competition in the domestic markets.
This is likely to mean that at least some prices do not accurately reflect domestic
opportunity cost ratios. Countries also have different degrees of economic power
and , in practice , exchange rates are more likely to favour developed than
developing nations .
The theory concentrates on the supply side. A country may specialise in
making a product and yet still import it if home demand exceeds its output
potential.
A country may also experience significant unemployment , and it may be
considered better to employ factors relatively inefficiently rather than not
employing them at all.
The theory of comparative advantage indicates that output will be increased
by specialisation and trade , but the simplicity and unreality of some of the
assumptions means that it does not fully explain the actual pattern of world
trade.

17.5 Solutions to Objective Questions

Solution 17.2 Answer: D

The law of comparative advantage states that international trade is beneficial to

two or more countries , provided that there are differences in their opportunity
cost ratios. For instance , in the example below the two countries with one
resource unit can produce:

255
 UK France

Cars 20 2
Steel 5 1

France has the comparative advantage , or lesser disadvantage, in producing

steel. In France the opportunity cost of producing one unit of steel is 2 cars,
whereas in the UK it is 4 cars.

Solution 17.3 Answer: E

In this question it is important to remember that the figures given relate not to
the output per resource unit, as is more commonly the case, but to the number of
resource units required to produce 1 TV and to produce 1 radio. Country A can
produce both goods more efficiently (i.e. with fewer resources) and so it has an
absolute advantage in the production of both goods. Options A and B are both
incorrect.
Country A is even better at producing radios, since it requires only one-
quarter of the resources that country B does to produce radios, whereas it
requires one-half of the resources that B does to make one TV. So country A has
the comparative advantage in producing radios and , hence, option C is incorrect.
Country B has the comparative advantage in producing TVs, since it requires
twice the resources to make TVs but four times the resources to make radios.
Thus, option D is also incorrect.

Solution 17.4 Answer: B

Cuba can produce more of both products per factor input and so has an absolute
advantage in the production of both goods . Hence, option B is correct and
options A and C can easily be rejected .
Cuba has the comparative advantage in producing cigars , since it has a lower
opportunity cost in the production of the good than the USA has . In Cuba the
opportunity cost of 1 cigar equals 3 units of sugar, whereas in the USA it is 5
units of sugar. The USA has the comparative advantage in the production of
sugar, as its opportunity cost is ~ cigar whereas the opportunity cost in Cuba is ~
cigar. So, after consideration, options D and E can also be rejected.

Solution 17.5 Answer: C

An exchange rate which will be beneficial to both trading countries must lie
between their internal opportunity cost ratios, as established in Solution 17.4. In
Cuba 1 cigar equals 3 sugar and in the USA 1 cigar equals 5 sugar. So the only
exchange rate which will benefit both countries must lie in the range 1
cigar = 3-5 sugar.

Solution 17.6 Answer: E

The UK has the absolute advantage in both products. However, as the

opportunity costs are the same, a situation of comparative advantage does not
exist and the countries will not benefit from specialisation and trade.

256
Solution 17.7 Answer: E

A production possibility curve shows the potential output of two commodities

which a country can produce with its resources. Country B has the absolute
advantage in producing both tractors and wheat and the comparative advantage
in producing wheat. It can produce 3 times more tractors than country A but 4
times more wheat. So country B will specialise in wheat and export to country A
in exchange for tractors. Country A will concentrate on producing tractors and
will export these to country B. As there are differences in the relative efficiencies
with which the countries can produce the goods , there is the potential for them to
benefit from specialisation and trade .

Solution 17.8 Answer: E

A reduction in the level of protection faced by domestic producers means that

home producers will face more competition from foreign producers.
At first glance the answer may appear to be option C, but a reduction in
import quotas would mean that fewer imported goods would be allowed into the
country and , hence, protection for home producers would be increased. Options
A and D would also increase protection for home producers , whereas an
acceptance of reciprocal tariff concessions proposed by GAIT will mean a
reduction in taxes on imports, which will make foreign goods more competitive
with home products.

Solution 17.9 Answer: B

The pre-trade domestic production of the good is OE. With free trade the
quantity bought is OG , where the domestic demand cuts the world supply (SB).
Of this quantity , OC is supplied by domestic producers and CG by foreign
producers. When the tariff is imposed and price rises to Pz , the new quantity
bought is OF (where DA cuts what is, in effect , a new supply curve running
parallel with P z ). Of this , OD is supplied by domestic producers and DF by
foreign producers. So domestic producers increase their output by CD.

Solution 17.10 Answer: D

Both a customs union and a free-trade area remove tariff barriers between
member countries. However, whereas a customs union also requires member
countries to impose a common external tariff, a free-trade area allows member
countries to decide their own external tariff policies.

Solution 17.11 Answer: C

Country A has the absolute advantage in producing both products, since it can
produce both products more cheaply than country B. Country A is even better at
producing coal than wheat , since it can produce coal five times more cheaply
than country B and wheat three times more cheaply . Thus, country A will
specialise in coal and export coal in exchange for wheat from country B.

Solution 17.12 Answer: D

The exchange rate will lie between the opportunity costs prevailing in the two
countries. In country Y the opportunity cost of 1 beef is 3 cloth and in country Z
it is 1 beef = 5 cloth. Thus, an acceptable exchange rate for both countries will
be 1 beef = more than 3 cloth and less than 5 cloth.

257
 18 Balance of Payments
18.1 Fact Sheet

(a) Definition of the Terms of Trade

The terms of trade (TOT) is the ratio comparing export and import prices:
index of export prices 100
TOT = x-
index of import prices 1
A favourable movement means that the TOT gets larger. Favourable move-
ments are caused by:
(i) rise in export prices ;
(ii) fall in import prices;
(iii) rise in export prices and fall in import prices;
(iv) export prices rising faster than import prices ;
(v) import prices falling faster than export prices .

(b) Causes of Changes in the Terms of Trade

The TOT change in response to:

(i) changes in demand - e.g. rising demand for raw materials during a
boom;
(ii) changes in supply - e.g . a crop failure ;
(iii) changes in the value of the currency - e.g. a depreciation results in a fall
in export prices and a rise in import prices;
(iv) changes in the inflation rate - e.g. an acceleration in the inflation rate
will result in higher export prices.

(c) Results of a Favourable Movement

(i) In the short term , higher export prices and lower import prices are likely
to improve the current account balance before demand has had time to
adjust.
(ii) In the longer term:
(1) if demand for exports is elastic, export revenue will fall;
(2) if demand for imports is elastic , expenditure on imports will rise;
(3) if demand for imports is inelastic , foreigners may experience a fall in
income and reduce demand for UK exports;
(4) UK subsidiaries abroad may suffer a decline in revenue.

258
(d) Composition of the Balance of Payments

The balance ofpayments (BOP) is a record of all economic transactions between

residents in the UK and residents in the rest of the world, over a period of a year.
The BOP has three components:
(i) the current account ;
(ii) UK external assets and liabilities;
(iii) the balancing item

(e) The Current Account

Particular attention is paid to the current account, which is made up of:

(i) The visible balance (also called the balance of trade) shows exports and
imports of tangible goods - e .g. cars , radios. A trade gap occurs when
visible imports exceed visible exports .
(ii) The invisible balance shows the net total of:
(1) services, including sea transport, civil aviation , travel, banking and
insurance , expenditure on embassies abroad and military staff sta-
tioned abroad;
(2) interest , profits and dividends (investment income is included
whether it is remitted or retained for investment);
(3) transfers , including government grants overseas, subscriptions to
international organisations (including the EEC) and private transfers
in the form of payments to overseas dependants and charitable
donations.

Visible balance + Invisible balance = Current account balance

(f) UK External Assets and Liabilities

This is made up of two sections:

(i) Transactions in external assets This comprises:
(1) UK direct and portfolio investment overseas;
(2) lending to overseas residents ;
(3) drawing on (+) and additions to (-) the reserves;
(4) inter-governmental loans made by the UK and subscriptions to
international lending bodies.
(ii) Transactions in external liabilities This comprises:
(1) overseas direct and portfolio investment in the UK;
(2) borrowing from overseas residents by UK residents and banks;
(3) inter-governmental loans to the UK, foreign currency borrowing
from banks overseas and transactions with the IMF.

Transactions in external assets + Transactions in external liabilities = Net

transactions

(g) The Balancing Item

The balancing item represents the net total of errors and omissions in the other
items. The BOP always balances, in the sense that the current account balance
plus net transactions plus the balancing item must equal zero .

259
 Table 18.1 The 1986 UK balance of payments

£ millions

Current Account

visibles 8 254
invisible s + 7154
Current balance 1 100

UK external assets and liabilities

transactions in assets 86964

transactions in liabilities + 81206
Net transactions - 5758

Balancing item + 6858

Source : Monthly Digest of Statistics, 1986

(h) Current Account Surplus

(i) Consequences: A current account surplus may be taken to be a sign of

economic strength , but a large surplus may be considered to be disadvant-
ageous because:
(1) it involves an opportunity cost in terms of forgone higher living
standards ;
(2) it results in an injection of demand into the economy, possibly
contributing to demand pull inflation ;
(3) it is likely to increase the money supply , which may contribute to
inflationary pressures ;
(4) it may make the country unpopular with countries in deficit.
(ii) Measures to disperse a surplus:
(1) Lower interest rates, to encourage a rise in investment abroad and,
hence , an increase in transactions in external assets .
(2) Increase lending abroad , thereby increasing transactions in external
assets.
(iii) Measures to correct a current account surplus:
(1) Revaluation of the currency. This will increase export prices and
lower import prices .
(2) Reflationary fiscal and/or monetary policy , which will increase de-
mand for imports.
(3) Reduce or abolish import controls.

(i) Current Account Deficit

(i) Consequences:
(1) A current account deficit causes a welfare gain, since the country
consumes more than it produces.
(2) A country will eventually be unable to cover a current account deficit
by drawing on reserves.

260
 (3) A leakage in domestic demand.
(4) A decrease in the money supply.
(ii) Measures to cover a current account deficit:
(1) Raise interest rates to increase investment and, hence, transactions in
external liabilities .
(2) Borrow from abroad , again increasing transactions in externalliabil-
ities .
(iii) Measures to correct a current account deficit:
(1) Impose or increase import controls (protectionism) to switch expend-
iture from imports to home-produced goods.
(2) Deflationary fiscal and/or monetary policy to reduce demand for
imports and stimulate exports by lowering domestic demand.
(3) Encourage exports by, say, zero rating VAT on exports.
(4) Devaluation of the currency. This will decrease export prices and
raise import prices .

U) The Marshall Lerner Condition

A depreciation of sterling (£s) results:

(i) in a short-run deterioration in the BOP because of
(1) an immediate rise in the price of imports but a constant quantity of
imports bought;
(2) a fall in the price of exports but a constant quantity of exports bought.
(ii) in a long-run improvement in the BOP because
(1) eventually UK consumers buy fewer imports;
(2) eventually foreign consumers buy more exports.

It is essential to realise that the overall long-run effect of a depreciation of

sterling depends on the Marshal Lerner Condition, which states that a devalua-
tion improves the current account balance if the combined price elasticities of
demand for exports and imports are greater than 1. The] Effect in Figure 18.1
shows that a devaluation initially causes a deterioration in the current account
balance (A to B) before demand and supply adjust to the new prices of exports
and imports (B to C).

Current account
balance (£ millions)

Figure 18.1 The J effect

261
18.2 Data Response
Worked Example 18.1

Singapore : Volume and Price Index of Imports and

Exports 1979 (1972 = 100)

Commodity section Volume Price

Imports

total 185 210

food 128 187

beverages and tobacco 103 160
crude materials 142 265
mineral fuels 111 634
animal and vegetable oils 117 255
chemicals 210 203
manufactured goods 163 178
machinery and equipment 243 156
miscellaneous manufactures 154 199
miscellaneous 167 225

Exports

total 227 217

food 149 190

beverages and tobacco 145 138
crude materials 129 295
mineral fuels 138 452
animal and vegetable oils 165 350
chemicals 200 270
manufactured goods 240 192
machinery and equipment 404 148
miscellaneous manufactures 168 215
miscellaneous 262 186

Source: Singapore Yearbook of Statistics 1979/80

(a) (i) Did Singapore's terms of trade improve or deteriorate between 1972 and
1979? Explain your answer. (2 marks)
(ii) How can the information in the table be used to derive the balance of visible
trade? (2 marks)
(iii) How did the balance of visible trade change between 1972 and 1979?
(1 mark)
(iv) Comment on the relationship between the terms of trade and the balance of
trade in this case. (2 marks)
(b) (i) Which commodity section grew fastest in terms of both imports and exports
between 1972 and 1979? (1 mark)
(ii) How do the data suggest that the relative performance of imports and
exports in this commodity section may be influenced by its price competitive-
ness? (2 marks)
(iii) Singapore has seen a growth in the volume of both imports and exports
traded in the same commodity section . How does this fit in with the theory of
specialisation in international trade? (3 marks)
(Total 13 marks)
(Cambridge Nov.lDec. 1985)

262
 (a) (i) The terms of trade are measured by :
index of export prices 100
- - - - ----'---- -'---- - x -
index of import prices 1
In 1979 the terms of trade were
217 100
- x- = 103.3
210 1
As the terms of trade in 1972 were
100 1
- x - = 100
1 100
there has been an improvement in the terms of trade, caused by
export prices rising by more than import prices.
(ii) The balance of trade compares the value of exports and the value of
imports . Value is found by volume x price.
(iii) The balance of visible trade position improved, because both the
volume and price (and , hence, the value) of exports rose by more
than the volume and price (and, hence, the value) of imports .
(iv) In this case, an improvement in the terms of trade was accompanied
by an improvement in the visible trade position. This may have
occurred because demand for exports was relatively inelastic or
because it was the rise in demand from overseas which caused the rise
in prices.
(b) (i) The commodity section which showed the most rapid increase in
terms of both exports and imports was machinery and equipment. In
volume terms, the imports index rose from 100 to 243 and the exports
index from 100 to 404.
(ii) In the case of imports, machinery and equipment experienced the
biggest increase in volume and the lowest increase in prices. Sim-
ilarly, the volume of machinery and equipment exported experienced
the greatest rise in volume and the second-slowest rise in prices.
Thus, price competitiveness would appear to have been important
in explaining the rise in volume of exports and imports of the
commodity.
(iii) The theory of specialisation in international trade is called the law of
comparative costs. It suggests that countries will benefit from special-
ising in products in which they have a comparative advantage and
then trading. In practice, many countries import and export the same
products. This is because there may be variations in the types of
goods - e.g . the UK imports low-grade oil and exports high-grade
oil - and consumers and producers demand a choice of variety of
products and equipment both at home and abroad .

18.3 Objective Questions

Example 18.2

The terms of trade are:

A the excess of visible exports over visible imports
B the price of the home currency in terms of another currency

263
 C the ratio between the value of exports and the value of imports
D the ratio between the volume of exports and the volume of imports
E the ratio between export prices and import prices

Example 18.3

Afavourable mov ement in the terms of trade occurs when :

A the price of exports rises relative to the price of imports
B the volume of exports rises relative to the volume of imports
C the ratio between export and import earnings increases
D there is an increase in the value of exports relative to the value of imports
E the current account moves into surplus

Example 18.4

The figures below show a country's terms of trade :

1983: 120 1984: 115 1985: 109

1986: 101 1987: 98 1988: 87

Which of the following could account for the movement in the terms of trade from
1983 onwards?
A export pric es rose faster than import price s
B export prices rose while import prices remained constant
C import prices fell faster than export prices
D import prices rose faster than export prices
E import prices fell while export price s remained constant

Example 18.5

Exports Imports

Price per unit Number of units Price per unit Number of units
(£OOOs) (OOOs) (£OOOs) (OOOs)

Year 1 20 20 25 8
Year 2 40 12 40 6

What changes have taken place in the terms of trade and the balance of trade between
years 1 and 2?
Terms of trade Balance of trade
A improved improved
B worsened worsened
C improved worsened
D worsened improved
E unchanged worsened

264
Example 18.6

Which of the following items would appear as a credit item in the invisible balance of
the UK balance of payments?
A the spending of UK tourists in France
B the purchase by a German company of a china factory in Worcester
C the hiring of a UK ship by a Dutch oil company
D profits earned by a Japanese subsidiary located in Sunderland
E the purchase of UK government bonds by French residents

Example 18.7

Which of the following will appear in the UK external assets and liabilities section of
the UK balance of payments?
A support costs of UK embassies abroad
B fees charged by a Welsh insurance company for work carried out in Chile
C profits earned by British subsidiaries in West Germany
D lending to Nigerian companies by British banks
E interest earned on UK funds held in American banks

Examples 18.8-18.11 are based on the information below.

[million

Visible exports 2560

Visible imports 2620
Transfers 50
Interest, profits and dividends 70
Services 90
Net transactions - 200

A -£60m B £50m C £60m D £150m E £21Om

Example 18.8

What is the balance of trade?

Example 18.9

What is the invisible balance?

Example 18.10

What is the current account balance?

Example 18.11

What is the balancing item ?

265
 Example 18.12

The income elasticities of demand for imports and exports in five countries is given
below . Which country's balance of payments position will benefit most from a world
recession?

Country Income elasticity of Income elasticity of

demand for imports demand for exports

A 1.8 0.8
B 1.2 1.2
C 1.0 1.6
D 0.8 2.0
E 0.6 2.5

Example 18.13

The following information shows a country's national income and domestic expend-
iture for 3 years.

Year 1 Year 2 Year 3

National Income 600 660 720

Consumer spending 360 360 390
Government spending 180 180 180
Investment 120 120 120

A balance of trade deficit will be experienced in which year(s)?

A 1 and 3 B 2 and 3 C 1 only D 2 only E 3 only

Example 18.14

A current account deficit, in the absence of government intervention, is likely to result

in:
A an increase in the money supply in the country
B a decrease in the money supply in the country
C an increase in the level of income in the country
D a decrease in unemployment in the country
E an increase in the exchange rate

Example 18.15

A government may reduce a current account surplus to:

A increase the current living standards of its inhabitants
B increase the domestic money supply
C increase domestic employment
D increase exports

266
Example 18.16

Which of the following policies would a government adopt to reduce a current account
surplus and inflation?
A devalue the currency B revalue the currency C deflate the economy
D raise interest rates E impose import controls

Example 18.17

If a UK company keeps the German price of its exports unchanged after a fall in the
value of the £, the result will be :
A a decrease in the demand for its products in Germany
B an increase in the demand for its products in Germany
C an increase in the value of German sales valued in marks
D an increase in the value of German sales valued in £s
E a decrease in the value of German sales valued in £s

Example 18.18

Which one of the following policies would be most effective in correcting a current
account deficit in a country with a high inflation rate?
A revaluing the currency B devaluing the currency
C deflating the economy D imposing import controls
E reflating the economy

Example 18.19

In which of the following circumstances is a devaluation most likely to improve the

visible balance?
Demand for imports Demand for exports
A price-elastic price-inelastic
B price-inelastic price -elastic
C price-inelastic price-inelastic
D price-elastic price-elastic

Example 18.20

Measures designed to improve a country's current account balance may be either

expenditure-reducing or expenditure-switching. Which of the following is an example
of an expenditure-reducing policy?
A the imposition of import controls
B the granting of export subsidies
C the imposition of exchange controls
D a credit squeeze
E devaluation

Select your answers to Examples 18.21-18.24 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

267
 Example 18.21

Which of the following could result in an improvement in the terms of trade of a

country?
1 an increase in foreign costs of production
2 inflationary domestic price rises passed on to overseas customers
3 an increase in overseas demand for the country's products

Example 18.22

Which of the following could appear in the UK 's invisible balance?

1 spending by UK residents in Norway
2 support costs of British armies overseas
3 the carriage of foreign goods in UK ships

Example 18.23

A revaluation of the exchange rate must result in an improvement in a country's:

1 terms of trade 2 visible balance 3 current account balance

Example 18.24

Which of the following are included in the transactions in external assets and liabilities
section of the UK balance of payments?
1 overseas portfolio investment in the UK
2 lending to overseas residents by UK banks
3 additions to reserves

18.4 Essays

Example 18.25

Discuss the advantages and disadvantages of the various means by which the
government might attempt to improve the UK balance of payments position
(SUJB June 1987)

• Briefly explain what is meant by the balance of payments position.

• Concentrate on three main measures of improving the balance of payments.
• Examine both the internal and external effects of the measures.

Solution 18.25

The UK balance of payments is a record of the income and expenditure

transactions between UK residents and people abroad. It has three main
sections: the current account, UK external assets and liabilities and the balancing
item.
A government which is attempting to improve the UK balance of payments
position is likely to be trying to reduce a deficit. Thus, the measures it will adopt
will be aiming to increase income earned and/or reduce expenditure abroad. In
considering which policies to adopt, a government will consider the cause of the
weak position and the advantages and disadvantages of the measures.

268
 One possible policy is devaluation or depreciation of the currency. This will
mean lowering the price of exports , in terms of foreign currencies, and raising
the price of imports, in terms of the home currency. It is essentially an
expenditure-switching measure , changing relative prices.
However, whether the policy will be successful in terms of improving the
balance of payments position will depend on whether there is elastic demand for
imports, elastic demand for exports, elastic supply of exports , lack of import
restrictions abroad and a low domestic marginal propensity to import , among
other factors .
Lowering the value of the currency will affect not only a country's balance of
payments position, but also its internal position. If exports rise and imports
decline, there will be a net injection into the circular flow of income , and
national income should rise by a multiple amount. This should stimulate output
and employment. However , there may be inflationary effects arising from the
increase in import prices and the net injection.
While depreciation is associated with an increase in domestic economy
activity , deflation is associated, in the short term, with a reduction in economic
activity . Deflation involves reducing incomes by restrictive fiscal and/or monet-
ary policy. For instance, a government may increase taxation in the expectation
that, if people's incomes decline, they will buy fewer imports. The higher the
income elasticity of demand for imports the greater the effect will be . It will also
be expected that demand for the home country's products will decline, so home
producers will be forced to try to export more of their output. The rate of
interest may also be forced up, to deflate the economy and to attract foreign
investment. If deflation also reduces inflation , the balance of payments position
will be further improved by the increase in price competitiveness.
However, deflation may , even if only in the short term, have an adverse effect
on employment and growth. There may also be a longer-term decline in
employment if the country is not successful in exporting more and importing less.
The Cambridge Economic Policy Group (CEPG) have been particularly critical
of deflationary measures .
The CEPG instead advocate a general system of import controls, to allow UK
industry to restructure and to ensure that government reflationary policies will
result in a rise in demand for UK rather than foreign products. Other economists
support selective import controls, to prevent dumping, to assist infant industries,
to allow industries to decline gradually, to improve the terms of trade and, of
course, to correct a balance of payments deficit.
Import controls may prove to be inflationary. This is because imports are
included in the retail price index, costs of production will rise if imported raw
materials and components continue to be used and unions press for wage rises to
compensate for higher prices . UK firms may also be able to raise prices and
remain competitive with more expensive imports. Import controls may also
provoke retaliation from other countries.
Among other measures which a country may employ are encouraging exports
by, for instance, giving favourable loans to exporters and encouraging other
countries to remove some of their import restrictions.

Example 18.26

Why might a government eliminate a surplus on its current account balance of

payments? What measures could it use to achieve this end?
(L June 1987)

269
 • Define a surplus on current account.
• Discuss the main motives for eliminating a surplus.
• Discuss revaluation, reflation and other measures to eliminate a surplus.

Solution 18.26

A surplus on its current account means that a country is earning more abroad
than it is spending. This could arise as a result of a surplus on its visible balance
and invisible balance, a visible balance surplus exceeding an invisible deficit or
an invisible surplus exceeding a visible deficit.
A country may wish to eliminate a surplus, to improve the standard of living of
its inhabitants. If a country has been experiencing a large current account surplus
over a number of years, then the opportunity cost involved is the goods and
services which it could have bought with the currency it has been earning.
If a country has been experiencing large current account surpluses, there may
be pressure on it from other countries to reduce or eliminate the surplus.
Measures which a government may take to achieve this may not only restore its
current account equilibrium, but also help deficit countries achieve current
account equilibrium . A country trying to reduce a surplus is likely to buy more
abroad and sell less. Considerable pressure has , in the past, been put on
Germany and Japan to reduce their surpluses.
A country may also eliminate a surplus to reduce inflationary pressures. A
surplus can result in an injection of demand into the domestic economy and an
increase in the money supply.
One possible measure to eliminate a surplus may be implemented with the
prime objective of reducing inflationary pressures. A revaluation of the currency
upwards will mean that more foreign currency will be obtained for the same
value of the home currency. The home country's exports will be more expensive
in terms of foreign currency, while its imports will be cheaper in terms of the
domestic currency. The revaluation is likely to result in an increase in import
expenditure and a fall in export revenue, presuming elastic demand for exports
and elastic demand for imports.
An increase in the value of the currency means that imports are cheaper and
these count in the retail price index. There may also be a reduction in the costs of
production for home producers, as imported raw materials and components will
be cheaper. The rise in the price of exports may force domestic exporters to cut
their costs in order to remain competitive . Domestic producers selling in the
home market will also have to keep their prices low in order to compete with
cheaper imports. However, there is the possibility that foreigners may raise the
price of their goods in the knowledge that they may still be competitive.
Reflationary fiscal and/or monetary measures will increase demand for all
products. For instance , an increase in government spending will result in a
multiple rise in national income and, hence, demand . More imports will be
purchased and the rise in domestic demand for home-produced goods may divert
goods from the export to the home market.
A country may also seek to increase expenditure on imports by removing or
lowering import restrictions. For instance, lowering tariffs will reduce the price
of imports on the home market and will result in an increase in expenditure on
imports. Subsidies on domestic products could also be removed.
In addition, encouragement for exporters could be reduced or removed . For
instance, banks may no longer be directed to give preference to exporters when
lending, and indirect taxation may be imposed or increased on exports.

270
18.5 Solutions to Objective Questions
Solution 18.2 Answer: E

The terms of trade are concerned only with comparing export prices and import
prices and not value or volume.

Solution 18.3 Answer: A

A favourable movement in the terms of trade occurs when the index rises . This
situation arises when the price of exports rises in relation to the price of imports.
This may result from, e .g., a rise in the price of exports and/or a fall in the price
of imports or even export prices falling to a lesser extent than import prices.

Solution 18.4 Answer: D

The figures in the table show an unfavourable movement in the terms of

trade - i.e. the number becoming smaller. An unfavourable movement occurs
when the price of imports rises in relation to the price of exports. This could
result from import prices rising faster than export prices .
A, B, C, E ~ In each case there would be a favourable movement in the terms
of trade .

Solution 18.5 Answer: A

The terms of trade in year 1 were:

index of export prices
----~---''----- x -100 i e. 20 x 100 = 80
index of import prices l' . 25 1

and in year 2:
40 100
-x-=lOO
40 1
Thus, there has been an improvement in the terms of trade in the period shown.
The balance of trade in year 1 was:
value of exports (price x volume) - value of imports (price x volume)
400 (20 x 20) - 200 (25 x 8) = 200 000
and in year 2:
480 (40 x 12) - 240 (40 x 6) = 240000
Thus, the balance of trade has improved with an increase in the surplus of
£40000 .

Solution 18.6 Answer: C

The invisible balance includes services, interest, profits, and dividends and
transfers. A credit item on the invisible balance is one which represents money
being paid to a UK resident or a firm in the UK, whereas a debit item represents
a payment to a foreign resident by a UK resident. If a Dutch oil company hires a
UK ship , money will be paid from Holland to the UK .
A and D ~ Represent debit items in the UK invisible balance, since they
involve money going out of the UK to other countries.
Band E ~ Are credit items in the net transactions section.

271
 Solution 18.7 Answer: D

The external assets and liabilities section of the balance of payments includes
investment into and out of the UK, lending to and borrowing abroad, inter-
governmental lending, and borrowing and drawing on and additions to the
reserves . Lending to Nigerian companies by British banks would appear as a
transaction in external assets.
A, B, C, E ~ Would all appear in the invisible balance section of the balance
of payments.

Solution 18.8 Answer: A

The balance of trade is visible exports - visible imports - i.e . £2560m -

£2620m = - £60m.

Solution 18.9 Answer: E

The invisible balance is net transfers + net interest, profits and dividends + net
services - i.e. £50m + nOm + £90m = £21Om.

Solution 18.10 Answer: D

The current account balance is the visible balance plus the invisible
balance - i.e . - £60m + £21Om = £I50m.

Solution 18.11 Answer: B

The current account balance plus net transactions plus the balancing item equals
zero. In this case £I50m + -£200m + the balancing item = O. So - £50m
+ the balancing item = O. Therefore , the balancing item = £50m.

Solution 18.12 Answer: A

In a world recession , incomes are likely to be falling . To gain the most benefit
from a world recession, a country would want demand for its exports to be
income-inelastic. Thus, a fall in income results in a smaller percentage fall in
demand for its exports. It would, in contrast, want its imports to be income-
elastic, so that a fall in domestic income results in a greater percentage fall in
demand for imports. If income elasticity of demand for imports is 1.8 - i.e.
elastic - and income elasticity of demand for exports is 0.8 - i.e . inelastic - a
fall in income will result in a greater reduction in import expenditure than in
export earnings. Thus a current account deficit would be reduced or a surplus
increased.

Solution 18.13 Answer: C

The country will have a deficit on the current account when its total demand
(consumer spending + .government spending + investment) exceeds its output
(N .Y.)
In year 1 output is 600 but demand is 660, so there will be a deficit of 60.
In year 2 output is 660 and so is demand . Therefore, there will be equilibrium.
In year 3 output is 720 and demand is 690, so there will be a surplus of 30.

272
Solution 18.14 Answer: B

A current account deficit will mean more money leaving the country than
entering it. People and firms buying imports may pay pounds sterling, which will
directly reduce the money supply in the home country. However, it is more likely
that payment will be made in a foreign currency. To obtain the foreign currency ,
pounds sterling will be given in exchange, and this may reduce the quantity of
money in circulation unless the government reintroduces the money into
circulation.

Solution 18.15 Answer: A

A current account surplus has an opportunity cost in forgone consumption.

Thus , a government may reduce a surplus to raise living standards. This could be
achieved by lowering the value of the currency so that more goods and services
can be consumed in the home country.

Solution 18.16 Answer: B

Revaluing the currency is likely to result in expenditure on imports rising and

export revenue falling . This will reduce a current account surplus.
Inflationary pressure is likely to be reduced , since revaluation will reduce
import prices, and imports count in the retail price index . Domestic producers
are also likely to limit price rises in order to remain competitive at home and
abroad .

Solution 18.17 Answer: D

A company can take advantage of a fall in the value of the currency either by
allowing the foreign price of its product to fall and thereby raising demand for it
or by leaving the foreign price constant. This latter option will result in an
increase in its revenue measured in its own currency. For example , if initially
£1 = 10 marks, then a £6 good would sell in Germany for 60 marks. If , when the
exchange rate falls to £1 = 5 marks, the company keeps the price in Germany at
60 marks , it will receive £12 per good when it changes its earnings from marks
into pounds.

Solution 18.18 Answer: C

Deflating the economy will involve reducing demand by means of fiscal and/or
monetary policy. The reduction in demand is likely to reduce demand pull
inflation. It is also likely to improve the current account balance by reducing
spending on imports and possibly by stimulating exports, because of the fall in
domestic demand .
A ::} Revaluing the currency will tend to reduce inflationary pressures but
increase a current account deficit.
B ::} Devaluing the currency is likely to reduce a current account deficit but
increase inflation, because of higher import prices .
D ::} Imposing import controls may assist the current account position, but it
may raise import prices.
E ::} Reflating the economy will involve increasing demand, and this may
increase inflationary pressure and increase a current account deficit.

273
 Solution 18.19 Answer: D

A devaluation is most likely to improve the balance of trade position when

demand for both exports and imports is price-elastic. If this occurs , the rise in the
price of imports will result in a fall in expenditure on imports and the fall in the
price of exports will result in a rise in export revenue.

Solution 18.20 Answer: D

Expenditure-reducing measures seek to improve a country's current account

position by reducing demand for all goods and services, both domestic and
foreign. The fall in demand for imports will reduce import expenditure and the
fall in demand for home-produced goods may encourage firms to switch
production from the home to the foreign market .
In contrast, expenditure-switching measures aim to improve the current
account balance by switching expenditure from foreign to the home country's
goods and services - i.e. from imports to domestic goods and from another
country's exports to the home country's exports.
A credit squeeze is a measure designed to reduce demand for all goods bought
by the home country's residents.
A and C ~ Are expenditure-switching measures encouraging people to switch
from bu ying foreign to buying domestic products.
B ~ Is an expenditure-switching measure encouraging foreigners to buy more
of the export-subsidising country's products and fewer of other countries' and
their own country's products.
E ~ Is an expenditure-switching measure encouraging residents of the coun-
try to switch from buying imports to buying domestically produced goods and
foreigners to switch from buying their own products or other countries' products
to buying the devaluing country's products.

Solution 18.21 Answer: C

1 ~ An increase in foreign costs of production will be likely to increase the price

of imports , which will cause an unfavourable movement in the terms of trade.
2 ~ Inflation will cause a rise in export prices and, hence , in the terms oftrade.
3 ~ An increase in overseas demand for the country's exports is likely to cause a
rise in their price and , hence , an improvement in the terms of trade.

Solut ion 18.22 Answer: A

All the items will appear under services in the invisible balance. Spending by UK
tourists in Norway would be classified as travel , support costs of UK armies
overseas would be UK government current expenditure and carriage of foreign
goods in UK ships would be classified as sea transport.

Solution 18.23 Answer: D

A revaluation of the exchange rate results in a rise in export prices and a fall in
import prices. This must improve the terms of trade.
It is more likely that a revaluation will reduce the visible and current account
balances rather than improve them . However, the outcome will depend on a
number of factors - principally the elasticity of demand for imports and
exports.

274
Solution 18.24 Answer: A

All are included in the UK external assets and liabilities section of the balance of
payments.
1 ~ Overseas portfolio investment in the UK is a transaction in external
liabilities.
2 and 3 ~ Lending to overseas residents by UK banks and additions to
reserves are transactions in external assets.

275
 19 Exchange Rates
19.1 Fact Sheet

(a) The Foreign Exchange Rate

The exchange rate is the price of one currency in terms of another currency. An
exchange rate can be bilateral (e .g. $/£) or multilateral (a basket of currencies
such as the trade weighted sterling index).

• A depreciation of sterling means that one pound now buys fewer units of
another currency. The value of sterling has fallen.
• An appreciation of sterling means that one pound now buys more units of
another currency. The value of sterling has risen .
• A eurocurrency is an y currency deposited in a financial institution outside
its country of origin - e.g. French francs deposited in a bank in Singapore.
• The London Foreign Exchange Market consists of all those who deal in
foreign exchange but has no formal meeting place.
• The spot market is that part of the foreign exchange market concerned with
the buying and selling of currencies for immediate use.
• The forward market is concerned with agreeing the price of currency now to
buy or sell in the future.
• Arbitrage is movements of funds to take advantage of differences in
exchange or interest rates , and this quickly eliminates any such differences.

Table 19.1 The demand for and supply of £s sterling

£s are demanded by £s are supplied by

Foreign re sidents wishing to buy UK UK residents wishing to bu y imports

exports and pay for UK services and pay for foreign se rvices

People wishing to inve st in the UK UK residents wishing to invest abroad

Those wishing to take advantage of a Those wishing to take advantage of a

future rise in the value of the £ future rise in the value of another
currency

Governments wishing to add £s to their Governments wishing to replace £s in

re serves their reserves with other assets

A UK government wishing to raise the A UK government wishing to lower the

value of the £ value of the £

Foreign governments wishing to lower Foreign governments wishing to raise

the value of their currencies the value of their currencies

276
 • The Purchasing Power Parity Theory suggests that the prices of goods in
countries will tend to equate under floating exchange rates .

(b) Exchange Rate Systems

(i) A fixed exchange rate is one which is maintained at a certain level (par) by
the government buying and selling currencies when necessary.
(ii) Adjustable peg is when the exchange rate is maintained within agreed
limits around a par value but with the possibility that the par value may be
changed.
(iii) Crawling peg is a form of adjustable peg where the par value can be
changed regularly on the basis of the previous trend in the exchange rate .
(iv) The European Monetary System, which started in 1979, is a form of
crawling peg . Member currencies are fixed against each other, with a
maximum 2~% divergence permitted . This divergence is calculated
against a weighted basket of EEC currencies (European Currency Unit).
(v) Managed flexibility , sometimes also called dirty floating. The government
may intervene in the exchange market to stabilise the exchange rate or
move it in a desired direction
(vi) Free floating occurs when the exchange rate is determined by demand and
supply, without government intervention.

Value of Value of Value of

currency currency currency

o Time o Time o Time

(a) (b) (c)

Value of Value of
currency currency

o Time
(d) (e)

Figure 19.1 Exchange rate systems: (a) fixed; (b) floating ; (c) managed floating ; (d) crawling
peg; (e) adjustable peg

277
 (c) International Liquidity

International liquidity is any asset which is acceptable in settling international

debts . Internationally acceptable assets are kept in countries' reserves. Forms of
international liquidity are:
(i) Gold .
(ii) Foreign currencies.
(iii) Reserve positions at the IMF - i.e . the ability to borrow from the IMF.
(iv) Special drawing rights (SDRs) are issued by the IMF , and are specifically
created to act as international liquidity assets. They are allocated to
member countries on the basis of their quotas , and their value is
expressed in terms of a weighted basket of five leading currencies.

(d) Problems of International Liquidity

The two current major problems are:

(i) Shortage of international liquidity.
(ii) What form international liquidity should take. Some economists have
suggested:
(1) Increased use of gold. This view overlooks the opportunity cost of
using gold, and its inelastic supply. Some economists suggest demonet-
arisation - i.e . ceasing to use gold as a form of international money .
(2) Increased reliance on foreign currencies. However, this would mean
that the growth of world reserves would depend on national policies.
There may be the risk of destabilisation from movements from
weakening to strengthening currencies.
(3) Adoption of completely freely floating exchange rates . This would
eliminate the need for reserves.
(4) Increased international co-operation between central banks, to make
more effective use of existing reserves through co-ordinated interven-
tion.
(5) Increased use of SDRs.

(e) International Organisations

(i) The International Monetary Fund was set up in 1944, following the
Bretton Woods agreement , and now has more than 140 members. Its
main aims include:
(1) facilitating the expansion and balanced growth of world trade ;
(2) promoting assistance to member countries with balance of payments
difficulties;
(3) promoting exchange rate stability.
Member countries pay a quota based on their National Income and share
of world trade. The purpose of quotas is to make available a pool of
foreign currency which can be borrowed by member countries in
tranches - i.e. percentages of their quotas. The right to the first 25% or
gold tranche is automatic but the right to subsequent tranches is subject
to increasing conditionality.
(ii) The International Bank for Reconstruction and Development, which is
more commonly known as the World Bank. It was established in 1945 to
help member countries recover from World War II. It now gives

278
 long-term loans to member countries for high -priority infrastructure,
agricultural, industrial and educational projects.
(iii) The International Finance Corporation was set up in 1956 to encourage
private-sector development by providing share and loan capital for
companies , encouraging local capital markets and promoting the interna-
tional flow of private capital.
(iv) The International Development Association lends at low, subsidised
interest rates to less developed countries.

• The IFC and the IDA are members of the World Bank group.

(I) Overseas Aid

• Bilateral aid is assistance from one government to another.

• Multilateral aid is channelled through international organisations and
charities to a number of countries.
• Tied aid is given on condition that the assistance is spent buying goods made
in the donor country.

Countries give aid for the following reasons:

(i) Commercial. Tied aid increases the exports of the donor country. As the
assisted country becomes more prosperous , it will tend to buy more goods
from 'friendly' countries.
(ii) Political. Aid is given to win the support and co-operation of strategically
important countries .
(iii) Altruism . Charitable concerns such as Oxfam are motivated by a concern
for others.

(g) Problems of Overseas Aid

Less developed countries argue for trade on more favourable terms than aid,
because:
(i) Aid may involve political interference.
(ii) Aid may be inappropriate if, say , it promotes capital-intensive projects
when labour-intensive activities are better suited to the economy.
(iii) Loans impose future interest and repayment burdens, particularly if debts
must be repaid in foreign currency.
(iv) Tied aid involves a loss of freedom of choice.
(v) Aid in the form of products depresses the price of those goods in aided
countries. Producers are then unable to sell their own output at a profit.

19.2 Data Response

Worked Example 19.1

BANK LETS STERLING BREACH DM3 LEVEL

The Government's policy of keeping the pound as stable as possible on the

foreign exchanges suffered a setback yesterday as the Bank of England finally
abandoned attempts to hold sterling below its unofficial ceiling against the
West German mark.

279
 In the face of continuing upward pressure, which the Bank had been resisting
by selling large amounts of sterling, the decision was taken yesterday morning
to let the pound go above the DM3 level. Sterling immediately rose several
pfennigs and by the close in London stood at DM3.0455 - its highest level
since September 1986, and more than 1~ per cent up on the day.,
The pound also strengthened sharply against a weak American dollar,
gaining 4.4 cents to $1.8185. Later in New York it was trading above 41.82 and
DM3.05 for a while.
The Treasury stressed there had been no change in policy and the Govern-
ment was as committed as ever to stable exchange rates. However, officials
said stability did not mean immobility, and rates may need to be adjusted from
time to time to take account of different circumstances.
Dealers say the upward pressure on the pound is largely due to the high
interest rates in the UK compared with other countries, which has attracted
savings from around the world.
'The feeling is the pound will go higher. It's just a question of how high', one
dealer said.
Although the Government could have eased the pressure on the pound by
reducing interest rates, it is reluctant to do this when the economy is growing
so fast and there are inflationary dangers such as the high level of pay
settlements.
The Bank of England is understood to welcome the decision to allow the
pound to rise, in effect tightening monetary policy, at a time when there is
concern over domestic monetary conditions. The strong demand for credit in
the economy was highlighted again yesterday by the latest figures on con-
sumer credit.
Officials would not want sterling to rise too much, however, and threaten the
competitiveness of British industry.
Source: The Independent, 8 March 1988

(a) What are the advantages of keeping 'the pound as stable as possible on the foreign
exchanges'? (5 marks)
(b) What may have caused the 'continuing upward pressure' on the pound?
(3 marks)
(c) Draw a diagram to illustrate how the sale of sterling can prevent a rise in the value
of the pound against the mark. (3 marks)
(d) What other action does the article suggest a government could take to stop its
currency rising and why may it be reluctant to do this? (3 marks)
(e) What are the advantages and disadvantages of a rise in the value of the pound?
(6 marks)

Solution 19.1

(a) 'Keeping the pound as stable as possible ' will reduce uncertainty for
traders and investors, which may arise if there are frequent and/or large
changes in the exchange rate (although uncertainty can be reduced, even
in these circumstances , by buying and selling currency in the forward
market). Traders , investors and the government can plan more easily on
the basis of a stable exchange rate. A stable exchange rate will avoid the
problem of a rise in prices which can occur when an exchange rate falls
and a reduction in competitiveness when the exchange rate rises. The UK
has also been trying to keep its exchange rate in line with other European
currencies. It is thought that linking sterling to the currencies of low-
inflation countries imposes an external discipline on inflation .
(b) The article refers to one of the causes of upward pressure on the £ - high
domestic interest rates. If UK real interest rates exceed those of other
countries, there will be an increase in demand for sterling from those
wishing to invest in the UK. Upward pressure on the currency can also
arise if UK goods and services become more price-competitive or improve

280
 in quality, if the government buys £s or if it is believed that the price of the
£ will rise in the future .

(c) Price of £5
in marks
01
0

PI
P

01

0 0 01 02 Quantity of £5

The initial equilibrium price is P. A rise in demand for £s would , in a free market ,
cause price to rise to PI ' The government could keep the price at P by increasing
the supply of £s on the market from 55 to 5\5\

(d) The article suggests that the government could reduce upward pressure on
the £ by lowering domestic interest rates. However, it may be reluctant to
do this, since lower interest rates may encourage borrowing and the
resulting rise in spending may accelerate inflation.
(e) The two main advantages of a rise in the exchange rate are a reduction in
inflationary pressures and an increase in the international purchasing
power of the £. A rise in the exchange rate will lower import prices, which
will lower the RPI. The rise in export prices may force UK producers to be
more price-competitive . The higher value of the £ will also mean that
fewer exports will have to be exchanged to obtain the same volume of
imports (an improvement in the terms of trade).
However, a high exchange rate will make exports less competitive
abroad and imports more competitive in the domestic market. This may
result in a reduction in UK output and employment and a worsening of the
current account position .
A fall in the exchange rate will also have disadvantages, including the
possibility of increasing inflationary pressures. Import prices count in the
RPI, and higher import prices may increase some UK producers' costs,
may reduce pressure on domestic producers to keep prices low and may
stimulate unions to press for wage rises to maintain living standards .
The main advantage of a low exchange rate is that UK goods will
become more competitive abroad and at home . This may raise domestic
output and employment, and improve the current account position .

19.3 Objective Questions

Example 19.2

On the foreign exchange market the value of the £ depreciates from £1 = $1.5 to
£1 = $1. If a UK exporter allows the price of his goods to reflect this depreciation, by
what percentage will the price in the USA of his £20 000 good change?
A + 50% B + 33~% C + 10% D - 20% E - 33~%

281
 Example 19.3

The following diagram shows the market for sterling.

Price of
£5 in $5
D

pl-----~--+---"".....-----

o x y z Quantity of £5

If the government wishes to maintain the exchange rate at OP it should:

A buy OX sterling B buy XY sterling C sell OX sterling
D sell XY sterling E sell XZ sterling

Example 19.4

Under a freely floating exchange rate system, which of the following will cause an
appreciation of the £ sterling?
A an increase in the speculative sales of pounds
B a rise in French interest rates
C the purchase by a British company of a controlling interest in a company in
Germany
D an increase in Japanese tourist expenditure in London
E a rise in UK demand for visible imports

Example 19.5

A British shirt manufacturer sells 60 shirts per week in the USA when the price is £10
per shirt and the exchange rate is £1 = $1.5. The American market has a unit
elasticity of demand for these shirts. If the sterling price is unchanged, what is the
maximum number of shirts he can sell in the USA if the exchange rate changes to
£1 = $2?
A 40 B 45 C 60 D 80 E 120

Example 19.6

Which of the following will impose downward pressure on the pound sterling?
A a fall in US interest rates
B a reduction in German import duties
C a reduction in UK investment abroad
D a reduction in foreign tourists coming to the UK
E a reduction in the marginal propensity to import in the UK

282
Example 19.7

Which of the following would be likely to cause a decrease in the UK 's reserves under
a fixed exchange rate?
A the issue of SDRs by the IMF
B a current account surplus
C an increase in the value of gold
D a decrease in overseas investment by UK residents
E support of the pound sterling by the Exchange Equalisation Account

Example 19.8

If the UK demand for German TVs is price-elastic , then a rise in their price, under a
floating exchange rate system, will cause:
A an increase in the demand for sterling
B a decrease in the demand for sterling
C an increase in the supply of sterling
D an increase in the demand for German marks
E a decrease in the demand for German marks

Example 19.9

Which of the following is a possible disadvantage of a fixed exchange rate?

A trade may be diminished because of exchange rat e uncertainty
B there will be an absence of external pressure to control inflationary pressures
C current account deficits will tend to result in an increase in the country's money
supply
D reserves will have to be held
E there will be frequent changes in the value of the currency

Example 19.10

The Exchange Equalisation Account:

A finances UK current account deficits
B assists other countries with current account deficit s
C insures UK exports against currency fluctuations
D regulates the value of the pound sterling
E seeks to improve the UK 's terms of trade

Example 19.11

The exchange rate between country A and country B is £1 = $2.0 . To be as well off in
country B, a citizen of country A earning £12 000 per annum requires to earn $48 000.
What is the purchasing power parity between the $ and £?
A 5:1 B 4:1 C 3:1 D 2 :1 E 1:1

Examples 19.12-19.15 are based on the following diagram, showing the market
for pounds sterling.

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 Price of
£5 in $5

Quantity of £5

The new equilibrium position after each of the changes below, starting each time
from X, would be :

Example 19.12

An increase in spending by foreign tourists in the UK.

Example 19.13

An increase in overseas investment by British companies .

Example 19.14

An increase in demand by UK residents for German goods.

Example 19.15

An increase in the quality and competitiveness of UK cars resulting in a fall in demand

for US cars in the UK .

Select your answers to Examples 19.16-19.19 by means of the following code:

A if 1, 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

Example 19.16

Special drawing rights are :

1 the right of IMF member countries to borrow the first 25% of their quotas
2 a recent form of international liquidity
3 allocated in greater quantities to rich than to poor countries

Example 19.17

Within the European Monetary System:

1 central banks are expected to intervene to ensure that currencies stay within the
permitted limits

284
 2 a depreciat ion of member co unt ries' cur re ncies will result in a fa ll in th e va lue of
th e E uropean C urre ncy Un it
3 the E uro pean Mon etar y Co-o pe ra tio n Fund mak es lo an s to member co unt ries and
holds a proportion of th eir reserves

Example 19.18

Whi ch of th e foll owin g is likely to result in a rise in th e excha nge rat e of th e £ ste rling?
1 a rise in UK inte res t rat es
2 a rise in th e inflation ra te of UK co mpe tito rs
3 an inc rease in th e qu antity of fo reign cur re ncies bought by th e E E A

Example 19.19

Whi ch of th e following measures may be employed by a gove rn me nt wishing to offse t

dow nward pr essure on its cur re ncy?
1 th e sa le of its cur re ncy o n t he fo reign exc ha nge ma rk et
2 th e raisin g of domestic int erest rat es
3 th e re d uctio n o f a b udge t deficit

19.4 Essays

Example 19.20

Di scu ss th e repercussion s for th e U nite d Kingdom econo my of a significa nt deprec ia-

tion in th e ste rling exc ha nge rat e .
(L J an. 1987)

• Expl ain the meaning of depreciation .

• Exam ine the internal and exte rna l effects of a depreciation .
• Mak e use of the con cept of price elasticity of dem and .

So lution 19.20

Depreciation me ans a lessenin g of the value of the curren cy in terms of another

cur re ncy or cur re ncies . Under a free ly floatin g excha nge rate , this would result
from dem and and supply factors; under a fixed exchange rate , from delib erate
gove rn me nt action; and und er a mana ged float , fro m mark et forces and
gove rn ment action.
A depreciation will mean that exports , in terms of foreign currenc y, will be
cheap er , while imports, in term s of pounds, will be more expensive . A
depreciation not only mak es exports mor e price-competiti ve , but also incr ea ses
the competitiven ess of UK products sold on the hom e market which compete
against imports.
In the short term, dem and for both imp orts and exports will be inelastic , as
there will not be time for the patt ern of dem and to change . However, if demand
for exports is elastic , then total revenue earned from exports should rise , as the

285
 fall in price will cause a greater percentage rise in demand . Also, expenditure on
imports should decrease, since a rise in their price will cause a greater percentage
fall in demand . The Marshall Lerner condition states that, for depreciation of a
currency to improve the balance of payments position , the elasticity for exports
and imports must be greater than one.
Exporters may take advantage of the fall in the currency either by allowing the
price of their goods to fall in foreign markets or by keeping their prices constant,
raising their sterling profit margins .
If the depreciation results in a rise in export revenue and a fall in expenditure
on imports, there will be a net injection in the circular flow of income. This will
cause National Income to rise by a multiple amount.
If more exports are sold and fewer imports purchased and N.Y . is rising, then
employment will also be likely to rise . This will occur unless there is already full
employment or underemployment or unless a rise in output results entirely from
increased capital or changes in technology . The Cambridge Economic Policy
Group have advocated using the exchange rate to influence the level of
aggregate demand and employment.
While it is believed that demand for UK exports is elastic, it is more doubtful
whether some of the other conditions required for a depreciation to improve the
balance of payments position will be met. If demand for exports and imports is
inelastic, then a fall in the value of the pound will result in more being spent on
imports and less being earned from exports. This will cause a deterioration in the
balance of payments position and will result in a leakage from the circular flow.
Even if demand for exports is elastic, the country may not benefit if the supply
of exports is inelastic. For instance, if there is full employment, then it may be
difficult to meet any extra demand. The beneficial effects of a depreciation may
also be affected by other countries devaluing their currencies.
A depreciation can accelerate inflation both directly and indirectly. Imports
are counted in the retail price index, and a rise in their price will, ceteris paribus,
raise the RPI. Also, home producers may raise their price because of increases in
costs of imported raw materials and components and/or because they can do so
while still remaining competitive against more expensive imports. Trade unions
may be stimulated to press for wage rises , since higher import prices will
probably increase the cost of living.
Investment in the UK may be discouraged, especially if it is thought that there
will be a future fall in the value of the pound. Some countries which have kept
pounds in their reserves may decide to change to other currencies, and this will
put increased pressure on the pound.
The effects of a depreciation are uncertain and may be beneficial or adverse,
depending on a number of factors, including the elasticity of demand for exports
and imports.

Example 19.21

'The problem of international liquidity can be solved by the adoption of floating

exchange rates. '

• Define floating exchange rates and international liquidity.

• Discuss why, in theory , reserves should not be necessary under floating
exchange rates.
• Discuss why, in practice, international liquidity will still be necessary under
conditions of floating exchange rates .
• Discuss the main forms of international liquidity.

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Solution 19.21

One argument in favour of floating exchange rates is that reserves will not be
necessary . This would solve the two main problems of international liquidity ,
which are its inadequate supply and what form that supply should take .
However, as floating exchange rates do not, in practice, guarantee a balance of
payments equilibrium and since most governments engage in dirty floating, the
existence of floating exchange rates , while possibly easing the problems of
international liquidity, does not eliminate them .
A floating exchange rate is one which, if freely floating, is determined entirely
by the demand for, and supply of , the currency. In theory, the exchange rate will
move to a position to ensure a balance of payments equilibrium . For instance , if
a country experienced inflation , demand for its exports would fall and demand
for imports would rise. This would cause a decrease in demand for, and an
increase in the supply of, the currency. The value of the currency would fall,
making exports more, and imports less, price-competitive until export revenue
equals import expenditure . If this also occurred, the need for international
liquidity would be reduced .
International liquidity is international money and is acceptable in settlement
of debts between countries. It is kept by central banks , and is used to cover
deficits in international trade payments and investment movements and to
influence the value of the currency. These reserves come in four main forms:
foreign currency, gold, SD Rs and reserve positions at the IMF .
These reserves are still needed under a floating exchange rate system, since,
while the rate may move to make a balance of payments equilibrium more likely ,
this may not be achieved if demand for imports and exports is inelastic and/or
capital movements work in the opposite direction.
Also, a government may wish to influence the value of the currency to achieve
other economic objectives. For instance, a government may buy pounds in order
to raise the exchange rate and thereby possibly reduce inflationary pressures, or
a government may sell pounds in order to reduce the exchange rate in an attempt
to increase domestic employment.
So, although the problems relating to the provision of international liquidity
may be reduced with floating exchange rates, they still exist. Countries have to
decide what to keep in their reserves and they have to be able to obtain an
adequate supply of reserves . There are a number of problems with all the forms
of international liquidity in existence today.
Gold, which is the oldest form of international liquidity , has an opportunity
cost, and its supply is controlled not by the needs of world trade but by the
decisions mainly of South Africa and the USSR . The problem of supply also
relates to foreign currency, since this is under the control of the countries whose
currencies are kept in the reserves. In addition , there is the problem that , when
the supply of a reserve currency increases, its acceptability is likely to be
reduced, since the higher supply is likely to result in countries fearing that the
value of the currency will fall.
In the case of reserve positions at the IMF, these may not be considered to be
adequate, especially by developing countries, which may have relatively high
balance of payments deficits but low reserve positions. SDRs are also the
responsibility of the IMF, but these represent the first attempt to provide a form
of money for international purposes. All the other forms of international
liquidity have other functions and were originally designed for other purposes.
However , SDRs have not made such a large contribution to solving the problem
of international liquidity as was originally hoped by some economists. This is
because the IMF have not issued SDRs on a large or consistent scale , and, as

287
 they are issued to countries on the basis of their quotas , the y are not always given
to those countries which have the greatest need for them .
Although most countries now have floating exchange rates , the problems of
international liquidity are still regularly discussed in meetings of the IMF and
other forums . In a world of dirty floating and balance of payments difficulties,
the problems of the quantity and form of international liquidity are likely to
remain important until an acceptable solution is found. At present SDRs seem to
be the main hope , but even this latest form of international liquidity has, at the
moment , a number of drawbacks , at least for developing countries.

19.7 Solutions to Objective Questions

Solution 19.2 Answer: E

Originally the £20 000 good would sell in the USA for £20000 x $1.5 =
£30 000. After the depreciation it will sell for £20 000 x £1 = £20 000. This is a
reduction of ($10 000/$30 000) x (100/1) = 33.3 %.

Solution 19.3 Answer: E

At the exchange rate OF, demand for the currency exceeds supply by XZ
amount. To prevent the exchange rate rising, the government would have to sell
XZ amount to ensure that supply matches demand at this artificially low price.

Solution 19.4 Answer: D

An appreciation of the currency will occur if there is an increase in demand for

the currency and/or a decrease in supply of the currency. A rise in Japanese
tourist expenditure in London will mean an increase in demand by the Japanese
for £ sterling.
A :::} Selling £s increases supply and, hence , causes a fall in the price of is.
B :::} A rise in French interest rates may result in a shift in investment finance
from the UK to France. UK residents wishing to invest in France will change £s
into francs , thereby increasing the supply of is. Fewer foreigners will wish to
invest in the UK , and so demand for £s will fall.
C :::} To buy a controlling interest in a German company , a UK firm is likely
to exchange £s for marks and , hence , increase the supply of £s on the world
market.
E :::} If UK residents buy more imports, more £s will be sold to gain foreign
currency , so again the supply of £s will increase.

Solution 19.5 Answer: B

The initial price of a £10 shirt in the USA is £10 x $1.5 = $15. Sixty are sold , so
the total revenue is 60 x $15 = $900. The change in the exchange rate will cause
the USA price to rise to $20. As elasticity of demand for the shirt is unity, a rise
in price will cause an equal percentage change in demand and total revenue will
remain constant. Thus, as total revenue is $900 and each shirt sells for $20, the
number of shirts sold is $900/$20 = 45.

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Solution 19.6 Answer: D

A downward pressure on the £ sterling can arise as a result of an increase in the

supply of £s and/or a decrease in the demand for Is .
A => A fall in UK interest rates will be likely to cause a rise in the value of the
£ sterling, as fewer UK citizens invest in the USA and more foreigners invest in
the UK, as opposed to the USA .
B => If Germany reduces the taxes she places on imports, the UK should be
able to export more to Germany and, hence, demand for £s will increase.
C => A reduction in UK investment abroad should reduce the supply of £s on
the world markets and so increase the price of Is .
E => A reduction in the UK's mpm will cause a decrease in demand for
imports, so fewer £s will be exchanged to gain foreign currency.

Solution 19.7 Answer: E

If the EEA is supporting the £, it will be buying up £s and using some of the
reserves, most probably foreign currencies, to do this.
A => The issue of SDRs by the IMF will increase the reserves of member
countries, including the UK.
B => A current account surplus will mean more money being earned abroad
than is spent abroad and some of this may be added to the reserves.
C => Gold is one of the items held in the reserves. An increase in the value of
gold will not increase the quantity of reserves but will increase their value.
D => A decrease in overseas investment by UK residents may, in the short
term, reduce the amount of money going abroad and, hence, may enable less
money to be drawn from the reserves or more money added to the reserves .

Solution 19.8 Answer: E

If the UK demand for German TVs is price -elastic, then a rise in their price will
result in a greater percentage fall in demand and a decline in the amount spent
on them. Fewer £s will be exchanged for marks to buy German TVs . Hence, the
supply of sterling and demand for German marks will decrease .

Solution 19.9 Answer: D

To maintain a fixed exchange rate, the authorities may have to buy the currency
and to do this it will be necessary to hold reserves. Keeping reserves involves an
opportunity cost.
A, B, E ~ The discouragement of trade, absence of external pressure to
control inflationary pressures and frequent changes in the exchange rate are
claimed by some economists to be disadvantages of a floating exchange rate .
C => A current account deficit will mean more money is spent abroad than is
earned and, unless offset, there will be a reduction in the money supply.

Solution 19.10 Answer: D

The EEA is a department of the Bank of England which operates on behalf of

the Treasury buying and selling £s to influence the exchange rate .

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 Solution 19.11 Answer: B

The purchasing power parity theory states that the exchange rate between
currencies will be such that the purchasing power of the money will be the same
in both countries - i.e . the amount which can be purchased with the money
concerned. If, in order to be as well off in country B, a citizen earning £12 000
needs to earn $48 000, the value of the currencies is $4 to £1 in terms of what the
currencies will buy . Thus, the official exchange rate is not reflecting the
purchasing power of the respective currencies.

Solution 19.12 Answer: A

An increase in spending by foreign tourists in the UK will cause an increase in

demand for is , which, in turn , will result in a rise in price and an extension in
supply. The demand curve shifts to the right, intersecting the original supply
curve at A .

Solution 19.13 Answer: B

An increase in overseas investment by UK companies will mean that more £s will

be exchanged into foreign currencies to invest abroad . The supply of £s will
increase, causing price to fall and demand to expand. The supply curve shifts to
the right, intersecting the original demand curve at B.

Solution 19.14 Answer: B

An increase in demand by UK residents for German goods will cause UK

residents to supply more £s in order to purchase marks. Thus, the supply curve
will shift to the right, intersecting the original demand curve at B.

Solution 19.15 Answer: E

If, because of increasing quality and competitiveness of UK cars, fewer US cars

are demanded by UK citizens , then fewer £s will be exchanged for dollars on the
exchange market. The supply of £s will decrease, causing price to rise and
demand to contract. The supply curve shifts to the left , intersecting the original
demand curve at E.

Solution 19.16 Answer: C

SDRs are a form of international liquidity issued by the IMF to member

countries.
1 ::;> The right of IMF countries to borrow the first 25% of their quotas is
known as the gold tranche and not SDRs.
2 ::;> SDRs are a recent form of international liquidity.
3 ::;> SDRs are issued on the basis of member countries' quotas. Richer
countries pay higher quotas and , hence, are allocated more SDRs.

Solution 19.17 Answer: A

The European Monetary System was implemented in 1979 and includes most
EEC countries.
1 ::;> There is parity grid with a permitted divergence of 2~%. Central Banks
are expected to ensure that currencies stay within this grid .

290
 2 :::} The permitted divergence of exchange rates is based on a weighted
basket called the European Currency Unit rather than against other individual
currencies. The fall in the value of one currency will lower the value of the ECU.
3 :::} The European Monetary Co-operation Fund acts as a European Central
Bank holding member countries' monetary reserves and making loans .

Solution 19.18 Answer: B

The sterling exchange rate will rise as a result of an increase in demand for
sterling and/or a decrease in the supply of sterling.
1 :::} A rise in UK interest rates is likely to cause more foreigners to wish to
invest in the UK. This will result in an increase in demand for is.
2 :::} A rise in the inflation rate of UK competitors will mean that foreign
goods are more expensive in relation to UK goods . This will mean that fewer
foreign goods will be purchased by UK residents and more UK goods by
foreigners . Thus , the demand for £s will increase and the supply of £s will
decrease .
3 :::} To buy foreign currencies, the EEA will use is. This will increase the
supply of £s and, hence, reduce the value of the £.

Solution 19.19 Answer: C

A government wishing to offset the downward pressure on its currency will

increase demand for it and/or reduce its supply.
1 :::} The sale of the currency will increase its supply and lower its price .
2 :::} The raising of domestic interest rates should increase demand for the
currency and its price by making it more attractive for foreigners to invest in the
country.
3 :::} The reduction of a budget deficit should reduce demand in the economy
and, hence, lower expenditure on imports and possibly switch some sales from
the domestic to export markets . This will reduce the supply of £s and increase
demand for them.

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 20 Managing the
Economy
20.1 Fact Sheet

(a) Government Policy

There are three stages of government macro- and microeconomic policy.

(i) Objectives: aims of government policies.

(ii) Targets: variables through which the government attempts to achieve its
objectives.
(iii) Instruments: policy tools over which the government has control and
which are implemented to influence target variables.

(b) Economic Objectives

All governments have four main macroeconomic aims :

(i) Full employment, which does not mean zero unemployment , since even in
a buoyant economy some workers will be between jobs (frictional
unemployment).
(ii) Price stability , which means an acceptable annual inflation rate, since , in
a dynamic economy, relative prices will always be changing in response to
changes in the conditions of demand and supply.
(iii) Current account equilibrium Over a period of time a country will aim to
avoid a deficit, since reserves and willing lenders are finite. It will also
probably try to avoid a long-term surplus , since this involves the
opportunity cost of a higher living standard for its residents.
(iv) Economic growth - i.e. increases in output which should ensure higher
living standards.

• Governments may have a number of other macro-objectives , such as a more

equitable distribution of income . This requires state intervention through
progressive taxation, income-relative benefits, etc .
• Governments may also have a number of micro-objectives , such as protec-
tion of the environment or efficiency in the allocation of resources .

292
(c) Macroeconomic Policies

A central issue in macroeconomics is whether or not markets automatically bring

about equilibrium. If the free operation of market forces automatically resulted
in a full employment level of national income with stable prices and economic
growth , there would be no need for government intervention to achieve
equilibrium. However, if the economy is unstable or slow to reach satisfactory
equilibrium , government economic policies will be required . These include the
following.

(i) Monetary policy The two main instruments are changes in the money
supply and interest rates.
(ii) Fiscal policy or budgetary policy The two main instruments are changes
in government spending and taxation .
(iii) Prices and incomes policy usually involves a limit on price rises and rises
in incomes , particularly wages.
(iv) Regional policy , where government measures help influence the location
of industry and people.
(v) Exchange rate policy, which involves the government managing the
exchange rate to achieve its aims.
(vi) Import controls , where tariffs or quotas are used to reduce or stabilise
imports.

(d) Policy Approaches

(i) Keynes argued that aggregate monetary demand (AMD) is the chief
determinant of output and employment. Therefore, demand management
through macroeconomic policies is the best method of achieving policy
objectives.

• Reflationary policies increase AMD.

• Deflationary policies decrease AMD .

(ii) Monetarists generally argue that supply is the chief determinant of output
and employment. Therefore , micro policies which increase supply are the
best method of achieving policy objectives. Monetarists favour measures
such as reductions in tax rates or policies which reduce market distor-
tions :
(1) increasing the gap between earnings from employment and
unemployment benefit to reduce voluntary and search unemploy-
ment;
(2) increasing, through training, the quality and flexibility of the labour
force;
(3) privatising nationalised industries to make them subject to market
forces;
(4) removing government restrictions to increase the efficiency of
markets;
(5) reducing the monopsony power of unions.

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 Table 20.1 Examples of govern me nt policies

Policy Instrument Target Objective

Monetar y Interest rate Bank lending Price stability

Fiscal Government spending Aggregate demand Employment
Regional Selective grants Location of firms Growth
Exchange rate Exchange rate Price of exports and Current account
imports
Supply-side Privatisation PSBR Price stability
Supply-side Union legislation Labour mobility Growth

(e) Policy Problems

All governments experience problem s in managing th e economy .

(i) Th er e ma y be a conflict bet ween policy objectives . For instanc e ,

increasing gove rnme nt spe nding may increase employme nt and growth
but result in rising pr ices and a cur re nt acco unt deficit. Tinbergen's rule
sta tes th at a government need s to have at least one instrument to achie ve
each objective . Fiscal polic y can be direct ed at un employment ; excha nge
rat e policy can be dir ect ed at th e curre nt acco unt; etc.
(ii) Governments are faced with political con straints. For instance , strict
monetary policy may caus e such high int erest rates th at mortgage payer s
refuse to vote for the government.
(iii) R esistance from trad e uni on s and profession al bodi es ma y act as a
con straint.
(iv) Policy instruments are interdep endent. Fo r exa mple , increa sing govern-
ment spe nding may result in a rise in PSBR and int er est rates.
(v) Policy instruments can also becom e objec tives, th ereb y reducing their
flexibilit y. For exa mple , excha nge rates and th e mon ey supply.
(vi) Th er e may be tim e lags betw een recognising a problem , deciding on th e
policy , and then impl em enting th at policy. In the me antime , economic
rel ati on ship s may change . For example, if a government tackles
un employment by reducing taxation , only to find that dem and is rising
anyway , thi s policy reinforc es th e cycle rather th an acting counte r-
cyclically.
(vii) Th e econo my may not respond in th e way anticipa te d . For example,
entre pre neurs may react to rises in dem and by increasing prices rather
th an output.
(viii) Som e targ et variables are difficult to define. For example, it is difficult
to know which asse ts to include in mea sures of th e money supply.
(ix) External shocks - e .g. a world depression - ma y undermine govern-
ment policie s.

20.2 Data Response

Worked Example 20.1

The Chancellor was positively glowing about the merits of a balanced budget,
telling the House : 'A balanced budget is a valuable discipline for the medium
term . It represents security for the present and an investment for the future.
Having achieved it, I intend to stick to it .'

294
 This represents a considerable shift from his previous commitment to a
Public Sector Borrowing Requirement (PSBR) of 1 per cent of GOP, or some £4
billion as far as the strategy went, set out in the last set of budget documents.
However, his enthusiasm for balanced budgets has been tempered both in
the current financial year and in 1988-9 by his concern that the rapid growth of
the economy might lead to rising pay settlements and other domestic inflation-
ary pressures, and to an unsustainably wide current account deficit.
Mr Lawson has thus made a virtue of a prescription straight out of classical
Keynesian demand management in aiming for a budget surplus at a time of
rapid growth and recovery. The budget surplus, or Public Sector Debt Repay-
ment, as Mr Lawson dubbed it, is estimated at £3 billion this year, or 0.75 per
cent of GOP.
He set the same objective for the coming financial year, and thus substan-
tially limited the tax cuts which he would have been able to give away had he
aimed for his long-term objective of budget balance and was even more
cautious by comparison with last year's £4 billion target for the PSBR in 1988-9.
Mr Lawson has thus achieved once again the triple hat-trick of cutting his
original borrowing target, adding to his original plans for public spending, and
cutting taxation . The detailed arithmetic in the Red Book published yesterday
shows that general government receipts (tax revenues) are expected to be £185
billion compared with a projected £178 billion for 1988-9 in the last budget,
despite the greater than expected tax cuts. At the same time, spending is
forecast to be £183 billion in the next financial year, compared with a forecast of
£180 billion in the last budget. Public corporations are expected to repay £1
billion, leaving a PSBR of minus £3 billion.
Source: The Guardian, 16 March 1988

(a) What is meant by a balanced budget? (2 marks)

(b) What does the article suggest is the opportunity cost of aiming for a budget
surplus for the 1988-9 year rather than a balanced budget? (2 marks)
(c) Why maya rapid growth of the economy result in 'domestic inflationary pressure'
and 'an unsustainably wide current deficit'? (S marks)
(d) Explain what is meant by 'classical Keynesian demand management in aiming for
a budget surplus at a time of rapid growth and recovery' . (S marks)
(e) Why may tax revenues increase despite cuts in tax rates? (3 marks)
(f) Why may government revenue turn out to be lower or higher than originally
forecast? (3 marks)

Solution 20.1

(a) A balanced budget is achieved when government expenditure equals

government revenue .
(b) The article suggests that one opportunity cost of aiming for a budget
surplus for the 1988-9 year was the further tax cuts which could have been
made had a balanced budget been the objective instead.
(c) A rapid growth of the economy will raise incomes. If output does not rise
in line with incomes, prices may increase. Rising employment may
strengthen unions' bargaining power and result in higher wage claims . The
high level of demand may also make entrepreneurs more inclined to raise
prices.
The UK has a relatively high marginal propensity to import, and, when
income rises, expenditure on imports increases and some UK goods are
diverted from the export to the home market. On a number of occasions
in the past when the UK has experienced a rise in the growth rate, current
account deficits have become a problem .
(d) Keynesian demand management is concerned with the government alter-
ing its expenditure and taxation to ensure a full employment level of
aggregate demand . If demand is below the desired level, the government
will inject extra spending to increase income and employment. On the

295
 other hand, if demand is above the full employment level, the government
will reduce demand to eliminate the inflationary gap . If private sector
demand is rising rapidly and at a rate greater than the government desires,
it may seek to reduce aggregate demand by withdrawing more spending
power (in the form of taxation) than it injects (in the form of government
spending).
(e) Total tax revenue may increase when tax cuts are made. Tax cuts will
increase disposable incomes, which may stimulate spending and output.
The rise in output is likely to cause an increase in employment. This will
mean that previously unemployed people will experience a rise in income
as they move into employment. As incomes rise, the total amount of tax
paid will rise.
(f) Governments make their forecasts of government spending and taxation
on the basis of projections of, e .g., output, growth, employment, etc. If
employment rises above the level originally forecast by the government,
then revenue from, e.g., income tax and VAT will be higher than
originally predicted, while expenditure on unemployment and other
benefits will be lower.

20.3 Objective Questions

Example 20.2

Which combination of events might cause a government to lower interest rates and
reduce direct taxation?
A a current account deficit and unemployment
B a current account deficit and inflation
C a current account surplus and inflation
D a current account surplus and unemployment
E unemployment and inflation

Example 20.3

According to a supporter of supply-side economics, which of the following measures is

most likely to reduce unemployment in the UK?
A imposing exchange controls B increasing labour retraining schemes
C increasing unemployment benefit D increasing public-sector investment
E increasing the money supply

Example 20.4

A government is faced with both demand pull inflation and a current account deficit.
Which of the following policy measures might simultaneously reduce both problems?
A devaluation B revaluation
C deflation D reflation
E lowering interest rates

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Example 20.5

An example of a restrictionist monetary policy instrument is:

A a switch of government borrowing from the banking sector to the non-bank
private sector
B an increase in direct taxation
C a tight prices and incomes policy
D a decrease in government spending
E converting long-term government debt into short-term government debt

Example 20.6

Which of the following is an example of an automatic stabiliser?

A defence expenditure B child benefit
C education expenditure D health expenditure
E unemployment benefit

Example 20.7

A government wants to reduce the growth of the money supply and lower direct
taxation. Which policy would be most likely to achieve these two aims?
A the purchase by the Central Bank of government securities from the general
public
B a reduction in interest rates
C a reduction in VAT
D a reduction in government spending
E the release of special deposits

Examples 20.8 and 20.9 are based on the following information. A country has
a progressive income tax system. The first £3000 earned is tax-free. Thereafter the
next £9000 of earned income is taxed at 25% and all taxable income above that is
taxed at 50% .

Example 20.8

A person earns £10 000. What proportion of his income does he pay in tax?
A 50% B 25% C 17.5% D 15.5% E 10.5%

Example 20.9

What is the marginal rate of tax paid when a person's income rises from £12 000 to
£12 001?
A 0.8 B 0.5 C 0.3 D 0.25 E 0.1

Select your answers to Examples 20.10-20.12 by means of the following code:

A if 1 , 2 and 3 are all correct
B if 1 and 2 only are correct
C if 2 and 3 only are correct
D if 1 only is correct

297
 Example 20.10

Which of the tax systems below is/are regressive?

Tax system Income before tax (£) Income after tax (£)

1 20 000 15 000
40 000 24 000

2 20 000 10 000
40 000 28 000

3 20000 8000
40000 25000

Example 20.11

Which of the following is/are examples of fiscal policy instruments?

1 changes in interest rates
2 changes in employees' National Insurance contributions
3 changes in the price of television licences

Example 20.12

In the case of which type of income taxes does/do the amount of tax paid rise with
income?
1 regressive 2 proportionate 3 progressive

20.4 Essays

Example 20.13

Examine the arguments for and against a shift from direct to indirect taxation.
(L Jan. 1987)

• Define direct and indirect taxes.

• Consider the advantages and disadvantages of both indirect and direct
taxation.

Solution 20.13

Direct taxes - e.g. income tax and corporation tax - are levied directly on a
person's or firm's income or wealth. On the other hand, indirect taxes - e.g.
VAT and excise duty - are taxes on goods and services and are paid to the
government through a third party. They are sometimes referred to as expendi-
ture or outlay taxes.
The argument for moving the tax base towards greater reliance on indirect
taxes and less reliance on direct taxation is based on the disadvantages of direct
taxes and the advantages of indirect taxes.

298
 It is claimed by some economists that direct taxation , particularly at a high
level, acts as a disincentive to effort. However, studies have shown that few
people (less than 10%) change the hours they work when income tax rates are
altered and that as many work fewer hours as work more hours.
A high level of corporation tax may discourage risk-taking and may discourage
investment, since most investment is financed by retained profits. Direct
taxation may also reduce savings of individuals, since the rich save more than the
poor and since savings may effectively be taxed twice : once when the income is
earned and then when interest is received on that part of income which is saved .
In addition to reducing the disadvantages arising from direct taxation, a
country would gain more of the advantages of indirect taxation by shifting the tax
base . Indirect taxes are relatively cheap to administer and collect. For instance,
manufacturers and traders do most of the administrative work involved with
VAT.
Indirect taxes can also be adjusted more quickly than direct taxes. While direct
taxes can be changed at budget time and may involve complex revision of, e.g.,
PAYE codings, indirect taxes can be changed relatively quickly .
Indirect taxes are difficult to evade, as they are included in the price of the
good. They may provide more freedom of choice in terms of payment, although,
if a wide range of goods are taxed, this may not be a significant advantage.
Nevertheless, it is thought that many people are unaware of the amount of tax
they are paying when they buy goods, and this may reduce the resentment they
feel in paying taxes.
Some economists argue that indirect taxes do not discourage effort, since the
taxes are linked to spending rather than earning. However, if certain
goods - e .g. cars , colour TVs - are highly taxed, this may place them out of
the reach of people who would have been prepared to work longer hours to buy
them .
Indirect taxation can help to regulate the economy. At times of high demand,
spending on goods will go up, which will cause the revenue from indirect taxation
to go up , which will reduce demand, although , in real terms , the burden of
specific taxes will fall with inflation.
Indirect taxes can also be used for specific aims . Particular goods may be taxed
in order to discourage the consumption of those goods , to protect domestic
industries and even to encourage the production of certain goods by reducing the
amount of tax levied on them . When indirect taxes are placed on goods for which
the private costs of production are below the social costs, resources may be
reallocated in a way which raises total economic welfare .
However, increasing the percentage of tax revenue accounted for by indirect
taxation may give rise to a number of disadvantages. Indirect taxes are
regressive , since they take a higher percentage of the income of the poor than of
that of the rich. This is thought to be one of the main disadvantages of indirect
taxation, and, although certain categories of goods may be zero-rated, the poor
are less well protected than under direct taxation.
Indirect taxes may be inflationary, as a rise in indirect taxes will cause a rise in
prices. They may also distort consumers' patterns of expenditure and the
allocation of resources. If, prior to the imposition of an indirect tax, consumers
were maximising their total utility , then the tax would reduce consumer
satisfaction. Indirect taxes may reduce consumer and producer surplus, as shown
in the diagram .
Some economists would also argue against shifting the tax base, on the
grounds that the advantage of direct taxes are greater than those of indirect
taxes. Direct taxes provide a high yield, and they are certain and convenient,
since most are deducted at source . They also have a stabilising effect, since

299
 Price

o s,
Reduction in
• consumer and
producer surplus

P, I-----~

P l--_~C--_

o 01 0 Quantity

during times of recession tax revenue will fall, while during periods of rising
incomes tax revenue will rise . Direct taxe s also have the advantage of equity , as
most are progressive, so the most able to pay bear the greater burden .
The main arguments advanced for moving towards a greater reliance on
indirect taxation are a reduction in the disincentive effect and economy of
collection. However , because of the relative merits and demerits of each , the
government will continue to rely on both forms of taxation .

Example 20.14

De scribe how the level of aggregate demand can be influenced by fiscal policy.
Discuss the problems that may be encountered by the use of fiscal policy.
(L June 1987)

• Discuss how fiscal policy can increase and reduce demand .

• In the second part of the question , which should be given more attention ,
discuss difficulties of adjusting government spending and taxation , time
lags, conflicts of objectives, difficulties in forecasting, effects of fiscal policy
on other variables and objectives.

Solution 20.14

Discretionary or active fiscal policy is when the government takes a positive

decision to alter government spending or taxation to alter demand. This
contrasts with automatic stabilisers, which come into effect when tax revenue
and government spending change independently of any deliberate government
action.
The level of aggregate demand could be raised by an expansionary policy. This
could involve an increase in government spending and/or a reduction in taxation.
An expansionary or reflationary fiscal policy would represent a net injection into
the circular flow and would cause N.Y. to rise by a mult iple amount. It may be
used to reduce a deflationary gap.
A deflationary or contractionary fiscal policy will result in a multiple fall in
N. Y. and will involve a fall in government expenditure and/or a rise in taxation.
This may be introduced in order to reduce or eliminate an inflationary gap.
However, there are a number of problems which may be encountered with
fiscal policy. Some forms of government spending may not be easy to change. For
instance, a government committed to improving educational standards may find
it difficult to reduce spending on education. Also, it will be difficult to reduce
spending on a long-term investment project once it is under way.
Tax revenues may be difficult to predict. When the government alters indirect

300
 taxation, it has to estimate price elasticity of demand. An even more difficult
calculation may prove to be the multiplier. If the government gets this wrong, it
may inject too much or too little spending into the economy.
There is also likely to be a time lag involved with fiscal policy, which means
that the government has to be able to forecast accurately future changes in
economic variables. For instance , a government may announce in a March
budget a reduction in the standard rate of income tax designed to raise spending.
This may take two to three months to come into effect, by which time gross pay
and demand may be rising anyway. So the policy will be contributing to the cycle
ra ther than acting coun tercyclicall y.
The use of fiscal policy may have different effects on different government
objectives. A contractionary policy may reduce inflation and a current account
deficit but may have an adverse effect on employment and growth.
There is the possibility that the economy may not respond as anticipated to
fine tuning. For instance, a government may raise income tax in order to reduce
spending. However, spending may not fall, or may not fall significantly, if, e.g.,
people choose and are able to work overtime to maintain their current spending
patterns and/or if people choose to reduce saving rather than spending.
A fiscal policy measure may also have undesirable effects on other policy
instruments and variables or may itself be constrained by these . A rise in
government spending, not financed by taxation , may raise the money supply
and/or interest rates. The latter may reduce private-sector investment, which
may , at least in part, offset the expansionary effect of the increase in government
spending. The former may contribute, according to monetarist analysis, to
inflation.
When governments in the past have raised government spending to increase
demand, they have encountered current account difficulties . This resulted in the
'stop-go' cycles - i.e . governments adopting expansionary policies , N.Y. rising,
expenditure on imports rising , governments adopting deflationary fiscal policies
to restore current account equilibrium.
Monetarists claim that expansionary fiscal policy aimed at raising employment
and growth will have a greater impact on prices than on output. They favour a
fixed throttle - i.e. aggregate demand being allowed to grow in line with output.
They also consider that fiscal policy may have very uncertain effects, as it is
difficult to predict future changes in economic variables. They believe that
monetary policy is more important and effective .

20.5 Solutions to Objective Questions

Solution 20.2 Answer: D

Lowering interest rates and reducing direct taxation will increase demand in
the home economy. This is likely to stimulate domestic output and employment.
The increase in demand is also likely to increase imports and possibly reduce
exports (as home producers switch from foreign markets to the home market) .
This will reduce a current account surplus and enable the home country to enjoy
more goods and services .

Solution 20.3 Answer: B

Supporters of supply-side economics urge the use of microeconomic incentives to

raise output and employment. They believe that, if the quantity of factors of
production is improved and markets operate more efficiently, growth and

301
 increases in employment will follow. Retraining schemes should increase the
productivity of labour.
A ~ Exchange controls would interfere with free market forces.
e ~ Increasing unemployment benefit would narrow the gap between
unemployment income and earnings. Supply-side economists favour the oppos-
ite, ensuring that workers are better off in work. They believe that this will make
people seek employment more quickly and settle for lower wages.
D ~ Increasing public-sector investment will increase demand. Supply-side
economists argue that governments should concentrate on increasing aggregate
supply.
E ~ Supply-side economists believe that increases in the money supply, if
greater than increases in output, lead to higher prices but not higher employment
in the long term .

Solution 20.4 Answer: e

Deflation involves reducing demand, usually by means of fiscal and/or monetary
policy. This should reduce demand pull inflation. It should also reduce a current
account deficit by reducing expenditure on imports and possibly stimulating
exports as a result of the fall in domestic demand.
A ~ Devaluation should assist the current account position, but may increase
inflationary pressures as a result of the rise in export earnings and a rise in import
prices.
B ~ Revaluation should reduce inflation by lowering import prices , but it is
likely to have an adverse effect on the current account balance as a result of the
fall in import prices and the rise in export prices .
D ~ Reflation means increasing demand, and this is likely to have an adverse
effect on both the current account position and inflation.
E ~ Lowering interest rates will also be likely to worsen both problems , at
least in the short term . Demand is likely to rise as borrowing becomes cheaper
and less foreign investment is likely to be attracted.

Solution 20.5 Answer: A

When the government borrows from the commercial banks by, e.g., selling
treasury bills, it increases their liquid assets and, hence, their ability to lend. In
contrast , when the government borrows from members of the non-bank private
sector , it merely makes use of existing money. Switching borrowing from the
banking to the non-bank private sector will tend to reduce bank lending and,
hence, reduce monetary expansion.
B, D ~ Increasing taxes and reducing government expenditure are deflation-
ary fiscal policies.
e ~ A prices and incomes policy is a direct government policy.
E ~ Issuing more short-term government debt is an expansionary policy,
since this will increase the supply of liquid assets.

Solution 20.6 Answer: E

Automatic stabilisers are those which offset changes in N. Y. without any direct
government action. If N.Y. is falling, total expenditure on unemployment
benefit will rise . This increase will reduce the fall in demand and, hence, will act
countercyclically.
A, B, C, D ~ will not adjust automatically with changes in N.Y. They are
adjusted as a result of government decision and action.

302
Solution 20.7 Answer: D

A reduction in government spending may enable both taxation to be lowered

and the money supply growth to be reduced. This can occur if government
spending is reduced by more than taxation is lowered, thereby reducing any
budget deficit. This , in turn , will reduce the PSBR and reduce the need to
finance at least part of it by adding to the money supply.
A, B, E::} Are all likely to increase the growth of the money supply.
C ::} A reduction in VAT is likely to reduce government revenue and, hence ,
increase any budget deficit.

Solution 20.8 Answer: C

A person who earns £10000 will have £3000 tax-free income and taxable income
of £7000. The tax he will pay on this will be 25% - i.e . £1750. So the proportion
of his income he pays in tax is
£1750 100
--- X - = 17.5~o
II

£10000 1

Solution 20.9 Answer: B

A person earning £12 000 will have £9000 taxable income and, hence, he will be
in the 25% tax bracket. If his income rises by £1, this extra £1 will be taxed at
50% - i.e. £0.5 will be taken in tax . So the marginal rate of tax is 0.5.

Solution 20.10 Answer: C

A regressive tax is one which takes a higher percentage of the income of the poor
than of the rich. In tax system 2, people earning £20 000 pay £10 000 tax (i.e.
50%), while those earning £40000 pay £12 000 tax (i.e . 30%) . In tax system 3,
people earning £20 000 pay £12000 tax (i.e . 60%), while those earning £40000
pay £15 000 tax (i.e . 37.5%) .
1 ::} Tax system 1 is a progressive tax, with the higher earners (£40 000)
paying 40% of their income in tax , while lower earners (£20 000) pay 25% of
their income in tax.

Solution 20.11 Answer: C

Fiscal policy involves changes in government spending and taxation. Changes in

employees' NI contributions and TV licences are both forms of taxation .
1 ::} Interest rates are a monetary policy instrument.

Solution 20.12 Answer: A

While it is only in the case of progressive income taxes that the percentage of tax
paid rises with income , the actual amount paid will rise in all three cases.

303
 Index
Abnormal losses 77 , 81-82, 97- Balance of payments 101-102, Central banks 278, 290
98 233, 241, 260, 265, Certificates of depos it 204
Abnormal profits 81-82, 84, 268-269 , 272, 286, 288 Ceteris paribus 7, 28, 35, 42,
90, 92, 94, 97-98, 126 composition of 259 44
Absolute advantage 245-246 , measures of improving the Chain of produ ction 69
250 , 255-257 268 Circular flow of income 175,
Absolute poverty 114 Balance of trade 182 , 264, 269
Accelerator 178, 185, 190, 193 266, 272, 274 Closed economy 175
Acquired adv antages 100 , 106 Balanced budget 294-295 Clo sed shop 133, 137, 142
Act ivity r ate 131 Balancing items 166, 259-260, Cobweb Theory 36, 39, 44
Ad valorem 36, 43 268 Collect ive bargaining 132
Ad justable peg 277 Bank cred it, volume of 211 Collusion 99
Advances 204 Bank lending 204 , 294 Command economy 9, 13-14
Advertising 21, 41, 46, 85-87, Bank multipl ier 202 Commerc i al banks 196, 200,
94-95 , 133 Bank of England 198-200, 202, 207 , 209
Ageing population 130, 135, 211, 214-216 , 228, 279-280, balance sheet of 197-198,
139, 141 289 201, 203-204
Aggregate demand 178-181, 190, funct ions of 198 l iability of 201
194 , 229, 243, 294, 296, Banking department 199-200 Common Agricultural Policy 248
300 Barr iers to entry 60 , 81, 87, Comparative advantage 263,
control of 210 9/~ 245-246, 250, 254-257
insufficient 222 Barter 195 Comparat ive Costs, Law of 263
Aggregate monetary demand 222, Base money 205 Competit ive demand 21, 53, 64
227, 230 , 293 Base rate 211 Competitive supply 35, 41, 47
Aggregate supply 180-181 , 193 , Bilateral aid 279 Complementary goods 31
240, 302 Birth rate 130 , 135-136, 142 Complements 21 , 50, 53, 57,
Agricultural goods 38 Black economy 162, 221, 59, 63-64
Agricultural prices 36 229.,.230 Composite demand 33
Aid 279 Black market 42 Concentration ratios 80
Alienation 75 Bolton Committee 75 Conditions of demand 21, 30,
Ancillary firms 67 Bond, market price of 118 42
Ando, Albert 193 Brand image 70, 85, 94-95 Conditions of supply 34-36
Apprec iat ion 276, 288 Break-even 89, 96 Consumer adjustment 50
Arbitrage 276 Break-even pric ing 152, 158 Consumer equiliibrium 29-30
Assertion-reason questions 6 Bretton Woods agreement 278 Consumer goods 16, 18
Assets 170, 197, 204 Broad money, measure of 212 Consumer l oya l t y 50, 85
Authorised i ns t i t ut i ons 196, Budget def icit 244, 291, 303 Con sumer sovereignty 18
205 Budget line 22, 26, 29- 30 Consumer s ur pl us 18, 20,
Automatic stabilisers 297, Budget surplus 295 25-26, 31-32, 90, 98, 147,
302 Budgetary policy 293 149, 156, 299
Autonomous consumption, 176, Budgets 133, 158, 182 Consumer taste 165
189 balanced 294-295 Consumption 7, 170, 175,
Average age 130 Building societies 196 177-178, 184, 189-190
Average cost 66, 71, 74 , 77 Business Expansion Scheme 76 autonomous 190
long run 78 Consumption function 176, 182,
Average cost curve 190
long run 68 , 72, 75 Conurbat ions 139
short run 68 Cambridge Economic Policy Core area 105
Average cost pricing 148-149 Group 223, 254, 269, 286 Corporation tax 128
Average earnings 24 CAP 2/~8 Cost-benefit anal ys i s 147,
Average fixed cost 66, 78 Capacity 52, 60 150-151, 155, 158
Average product of labour 65, Capital 11,17,65,103,110 Cost of l iving 172
70 Capital accumulation 11 Cost-plus pricing 70, 84, 93
Average propensity to consume Capital consumption 174-175 Cost-push inflation 231, 240,
176, 190 Capital gains tax 128 243
Average propensity to save Capital goods 18 remedies for 234
177, 183 Capital inflows 235 Costs of production 35, 65-79
Average revenue 77, 80, 86, Capital intensive 106 Counter-trade 195
88, 95 Capital markets 196, 209 Crawling peg 277
Average revenue curve 86 Cap ital transfer tax 128 Credit creation 197-198
Average variable cost 66, 71- Cartel 70, 108 control of 211
72 , 77-78 Causal unemployment 225 Cred it squeeze 274

304
Cross-elasticity of demand 52, Discretionary 300 Exchange equ alisation account
58-59, 64 Discriminating monopoly 84 199, 283
Crowding out 212, 217 Diseconomies of scale 67 Exchange rates 171, 199, 211,
Current account 211, 235, externa l 103 218, 234, 237 , 241, 255-
259-260, 268, 272, 281, 294 Disequ ilibrium 179 257, 273, 276-277, 280-282,
deterioration in 261 Dispersed i ndus t r i e s 108 285, 287-288 , 291
Current account balance Disposable i ncome 164 fixed 277
272-273 Dissaving 190 floating 278, 286
Current account deficit 260- a ut onomous 177 pol icy on 293-294
261, 266, 273, 289, 302 Distribution of income Expectations 21, 233
Current account equilibrium functional 112 Expenditure method 161
292 size 113 Expenditure reducing methods
Current account (sight) Disutility 31, 140 267
deposit 204 Diversif ication 69 Expenditure switching 267,
Current account surplus 260, Division of labour 74-75 269, 274
266, 273, 289 Double counting 162 Exports 175, 179, 262
Current balance 260 Dumping 246, 253, 269 income elast icity of demand
Customs duties 247 for 272
Customs union 247, 252, 257 pr ice elasticity of demand
Cyclical unemployment 222 Economic goods 8, 19 for 286
Economic growth 9, 11, 13, 16, External assets 260, 265, 275
19, 101, 292 External benefits 150
Data-response questions 4 side-effects of 11 External costs 150
Death rate 130 Economic methodology 7 External diseconomies of scale
Debentures 197, 207 Economic problem 7, 15 67-68
Declining industries 246 Economic rent 110, 112, External growth 73, 80
Declining markets 59 116-117, 120, 122-125, 129 External liabilities 275
Decreasing returns 18, 65 Economic systems 9-10, 14, 19, External marginal benefit 145
Deflation 182, 269, 273, 302 144 External marginal cost 145,
Deflationary gap 222, 226, Economic welfare 151, 162 154
230, 243, 300 Economically inactive 141 Externalities 10, 19, 93, 144,
Deflationary policies 236, 293 Economies of scale 67 , 74-76, 146-147, 153-154, 158-159
Deindustrialisation 101, 108 94
Demand 20, 27, 33, 41-42, 55, external 78, 100-101, 105,
85 107-108
composite 27 EEA 289, 291
contraction in 20, 43 EEC 41, 247, 277 Factor cost 173
decreases in 47 Efficiency criteria 144 Factor endowments 108
excess 35, 1.2 EFTPOS 128 Factor immobil ity 60
expansion in 20 Elasticity of demand 27, 33, Factor incomes 110
increases in 28-29, 45 41, 49-50 , 61, 63, 112, 285 Factor mobility 52, 255
Demand curves 20, 24-25, 30, Elast icity of demand and Factors of product ion 7, 110,
50, 55-56, 61, 86 revenue curves 53, 83 125
movements along 20 Elasticity of supply 41, 51- Fiduciary 200, 206
shifts in 20-21, 28, 31 , 54 52, 60, 64 Final output 167, 173
slopes of 49 Eligible l iabilities 219 Financial assets 170
Demand theories 29 Embargo 249 Financial institutions 207
Demand-pull inflation 232-233, Emigration 130 Financial intermediaries 196
260, 296 Empirical 7, 19 Fine tuning 301
Demerit goods 150, 156 Employment 132, 160, 2v~, 211, Fiscal drag 233
Demography 130 228, 241, 293-294, 296, 302 Fiscal policy 182, 212, 241,
Dependent populations 135, distribution of 132 249, 269-270, 273, 293-294,
139, 141 over full 221 297, 300-303
Deposit (time) accounts 204 Energy pol icy II, 248 deflationary 233, 236
Depreciation 69, 167, 173, Engel curve 52 instruments of 298
175, 258, 261, 269, 276, Enterprise allowance 76 reflationary 260
281, 285-286, 288 Enterprise zones 102-104, 107 Fisher's Quantity Theory of
effects of 285 Entrepreneurs 110, 124 Money 232
Derived demand 142 Environment 154 Fixed costs 66, 69, 72, 77-78,
Devaluation 249, 261, 267, Equilibrium 32, 36, 44 80, 89, 96
269, 273-274, 302 Equilibrium prices 35, 42 , 44 Footloose industries 107-108
Developed countries 136, 139, Equi-marginal returns 22 Foreign exchange market 281
141 Equities 144, 208 Forward market 276
Developing countries 136, 139, Essay quest ions 2 Free goods 8, 19
141, 171, 254, 279, 288 Eurocurrency 276 Free market economy 9
Development areas 101, 106-107 European Currency Unit 277, Free r iders 146, 159
Differentiated products 95 290 Free trade 253
Diminishing Returns, Law of European Economic Community, Free trade area 247, 252, 257
60, 65, 71, 74, 76, 78 see EEC Freeports 102
Direct taxation 296 Eur opea n Monetary System 248, Frictional unemployment 221,
Dirty floating 277, 288 277, 284, 290 292
Discount houses 196, 199-200, European Regional Development Friedman, M. 177, 193, 236
207, 218 Fund 101 Full employment 8, 185, 221,
Discounted cash flow 155 Excess demand 43 226, 238, 292, 296
Discounting 147, 156 Exchange control 247 , 249 Funding 205, 211, 214, 217-219

305
GAll' 257 Income me t hod 160, 169 Internat ional Bank for Recon-
GDP, see Gross domestic product Income tax 143 struction and Development
Gener al government fin al Incomes 9-10 , 50, 56, 112, 278
consumpt ion 161 189-190 Internat ional debt 279
Geogr aphi cal mob ility 132 determinat ion of 178 International Development
Giffen good 22, 27, 33 disposable 177 Associat ion 279
Gini coeffic ients 113 distribution of 112 International Finance
Gold 287, 289 imput ed 66 Corporat ion 279
Government expe ndi t ur e 179, i nequa l i t y of 113 Internat ional liquidity 199,
188-189, 228, 294, 296, 303 r ed istribution of 19, 233, 286, 290-291
Government i nte r vent i on 108 235 Internat ional Monetary Fund
Government pol ic ies 292 Increased d imen sions 67 278 , 284
examples of 294 Increasing r eturns 65 International trade 245-257,
Government s ecur it ies 214-215 Independent goods 53, 59 263
sale of 219 Indifference curves 22, 26 , Investment 9, 161, 175 , 178,
Government s pe ndi ng sector 175 29 , 32, U,O 184, 189-191, 286
Green bel t 24 , 102, 107 and work 131 actual 183 , 191-192
Gross domest i c f ixed capital Ind ifference map 26, 29 gross 184, 192
form at ion, 161 Indirect taxation 36 , 41 , 43, net 9, 11, 190, 192
Gross domestic pr oduc t 160, 301 planned 183, 191
166, 168, 173, 295 Ind ivisibil ities 67 realised 184, 192
Gross domest ic produ ct deflator Induced consumption 176 Invisible balance 259 , 265,
i nde x 162, 168, 170-171, Industrial development cert if- 270- 272, 274
231 icates (IDes) 101, 106-107 Issue Department 199
Gross domestic product per head Indu strial i ne r tia 100, 104,
175 106
Gross nat ional product 160, Ind ustrial location 100 J effect 261
166 Indu strial relat ions 68 Joint demand 21 , 53, 56, 63
Gro ss weekly income 164 I ndus t r ial sectors 161 Joint supply 35
Growth 294-295, 301 Industrialisation 139
Infant i ndus t r i es 246, 249
Inferior good 26, 30 , 32, 52
In flation 171, 189, 204, 206, Kahn, R. 189
Holding company 73, 80 Kaidor-llicks test 14'., 156
Ilor izontal i nt egra tion 69, 73, 211, 228, 231-244, 269- 270 ,
273 , 280-281, 286, 291-292 , Keynes, J . M. 230, 293
79 Keynesians 118, 177, 186, 193,
Household expend itures in the 295
United Kingdom 164 ac celerat ing 235 210, 220 , 227, 232, 240
Housing 165 adv antages of 241
pr ice of 24 causes of 239
Hy per inflation 231 , 235 cost push 231 Labour 60, 65, 110, 132, 302
Hypothes is 7 costs of 233 demand for 132
def inition of 231 mobility of 132, 135, 294
demand pull 232, 237, 273 occupational distribution of
IDA 279 effects of 232 132
IFC 279 expecta t ions of 236, 240 supply of 131-132, 138, 230
Ill iqu i d ass et 204 imported 232 Labour force 9 , 130
IMF 278 , 284, 287, 289-291 measur ing 231 Labour market 53-54
Immigrat ion 130 methods of a da pt i ng to 233 Land 10, 110, 123-125
Immobility 230 remedies for 233 Leakages 175, 179, 183, 188,
geographical 112 unemployment 224, 234 286
of l a bour 55, 226 Inflat ionary expectat ions 243 Leisure 138, 170
occup at ional 112 Inflationary gap 187, 194, Lender of last resort 207
Imperfect competit ion 83, 158 232 , 238, 243, 300 Li ab ilit ies 204
Import controls 223, 253-254 , Infrastructure II , 67, 103, Life Cycle Hypothesis 177, 193
260, 269 , 273, 253-254, 293 107 Limit pricing 85
Import penetrat ion 248-249 Injections 175, 179, 181-182, Limited companies 93
Import prices 269 188, 182, 269 Linked processes 67
Import restrict ions 247, 270 pl a nned 191 Liquid asset ra tio 211
Imports 167, 173, 175, 179, Inner -~ ity areas 102, 107 Liquid assets 198, 200, 204,
262, 288, 302 Inputs 7,110,161,166,173 214, 219
income elasticity of demand Instruments 211, 292, 294, 297 Liquidity
for 272 Insurance 69 international 278
Imputed income 66 Integrat ion 69, 79 problems of 278
Incent ive effect 133 Interdependence 94 Liquidity preference Ill, 120,
In c i dence 36 , 46 Interest 69 , Ill, 118, 178, 127
Income distr ibution 112 212 Liquidity ratio 204, 218
Income e f f ec t 21- 22, 26-27, Interest ra t es 137, 211, 217, Liquid ity trap Ill, 118
32-33, 86, 135, 141 281, 291" 296 Living standards 235
Income elasticity of dema nd policies on 211 i nt e r na t i ona l comparisons of
52, 54, 56, 59 , 62, 266, I nt e r me dia t e areas 101 171
269 Inter mediate expenditures 162, Loanable Funds (Classical)
Income inequality 113 166-167, 173 Theory 111
Income-le isure trade-off 131, Intermediate outputs 169, 175 Local authorities 101
140 Internal rate of return 155 Location of firm 100-109, 294

306
London Foreign Exchange Market Merchant banks 196 effects of 107, 179
276 Mergers 69, 80 regional 101, 106
Long run 60, 67 Merit goods 146, 158 MV = PT 232, 243
Lorenz curve 113 Microeconomic incentives 301
Loss-leader strategy 59 Microeconomic policies 189,
Loss-making firms 70, 77 292 National debt 217
Losses, abnormal 77, 81-82, Microeconomics 7 National income 160-163,
97-98 Microtechnology 106 169-171, 176, 183, 269
Migrant populations 136, 142 equilibrium level of 184
Migration 101, 107 full employment level of 222
MO 205, 213 Minimum efficient plant size money 170-171
M1 195 68 real 170
M2 195 Minimum lending rate 211, 218 National income accounting
M3 212-213 Minimum price 35, 42 equations 161
M4 203, 213 Minimum wage 120 National income accounts
Macroeconomic aims 292 Mixed economies 9, 19, 171
166-167 170
Macroeconomic objectives 206, MLR 211, 218
Mobility, occupational 223 importance of 162
210 problems in calculating 160-
Macroeconomic policies 292-293 Mobility of labour 139
162
Macroeconomics 8 geographical 24
Nationalised industries 19,
Malthus, T. R. 130 Model 7
93, 147-149, 152, 293
Management 75, 79 Modigliano, Franco 177, 193 gross trading surpluses of
Marginal cost 66, 71-72, 74, Monetarists 189, 210, 220,
160
77-78 223, 227, 229, 232, 236, Natural advantages 100, 106,
Marginal cost curve 86, 92 240, 293, 301
Monetary aggregates 195, 213 108
Marginal cost pr1c1ng 19, 93, Natural resources 9, 102
147, 149, 152-153, 158 Monetary base control 212
Monetary policy 199, 210, Negative externalities II,
Marginal efficiency of capital 145-147, 153-151,
178 212-213, 215-216, 220, 236,
Neo-classical Theory 74, 81
Marginal product 76 241, 249, 260, 269-270,
Net investment 175
of labour 65, 70 273, 249, 280, 293-294,
Net migration 130, 141
Marginal Productivity Theory 297, 302
Net national product 160, 168
112 deflationary 233
Net property income from
Marginal propensity to consume examples of 211 abroad 161, 167, 173
176-177,179,183,188,190 reflationary 219 Net social benefit 148
Marginal propensity to import Monetary policy instruments Net transactions 260
180, 295 303 Nominal national income 168
Marginal propensity to save Monetary policy targets 211 Non-excludable 146, 159
177, 183 Monetary sector 196, 199 Non-marketed output 170
Marginal propensity to tax Money 201, 205 Non-operational balances 200
179, 183 at call and short notice 197
Non-price competition 70, 85,
Marginal propensity to characteristics of 195
withdraw 179 functions of 205 99
Marginal revenue 80, 86-88, national income 162 Non-renewable resources 9
Non-rival 146, 159
95, 148-149 near 195
Marginal revenue curve 86, 92 types of 195 Non-traded capital 160
Marginal revenue product 142 Money illusion 233, 235 Nordhaus, R. 163, 170
Marginal utility 22, 25, 29, Money income 164 Normal goods 30, 52, 61
Money markets 196, 203, 209 Normal profits 81, 84, 90, 92,
31, 33
diminishing 22, 25, 27, 33 Money measures 213 97, 99, 115
Money supply 202, 204-206, Normative 13
Mark up 84
209, 212, 214, 216, 218, Normative economics 7, 19
Market economy 13-16, 103, 153
Market failure 10, IS, 146, 232, 236, 238, 260, 273,
ISO, 153, 157 289
through externalities 146 changes in 210, 211, 220, Objective questions 5
through imperfect com- 228 Objectives 211, 292, 294, 301
petition 146 controlling 206, 216-217 conflicts of 217
through public goods 146 importance of 210 Occupational mobility 132
Market imperfections 106 measures of 195, 294 Offer curve of labour 131-132,
Market penetration pricing 84 Monopolies 10, 84, 99, 159 136
Market prices 36, 40, 42, 46, Monopolistic competition 80, Oligopolies 70, 80, 85, 91,
173-174 88, 93-95 93-94
Market share 84 Monopoly profits 123 Open economy 175
Market structure 79-80, 93 Monopsony 102 Open market operations 200,
Marshall Lerner condition 261, Multilateral aid 279 205, 211, 214, 217-218
286 Multinational corporations Operational balances 199-200,
Matching-pairs questions 6 105-108 207, 214
Maximum price 35 Multiple-choice questions 5 Opportunity cost 8-9, 12-13,
Measurable Economic Welfare Multiple-completion questions 15-16, 18, 66, 146, 203,
163, 170 6 245, 255-256, 273, 292, 295
Measure of value 195 Multipliers 179, 181, 185, Optimum output 66
Medium of exchange 195 188-189, 191-193, 227, 301 Optimum population 131, 135,
Medium Term Financial Strategy balanced budget 192, 227 139, 141
211 bank 198, 208 Output method 161
Menu costs 233, 241 credit 198 Output per worker 65

307
Outputs 7, 161, 166, 173 Price effect 27 Public sector investment
efficient levels of 157 Price elasticity of demand 49, decisions 155
intermediate and final 172 55, 57-58, 98, 148 Purchasing Power Parity Theory
Over-full employment 225 factors influencing 50 277, 283, 289
Over funding 212 Price elasticity of demand and Pure monopoly 80
Over-manning 133, 137 revenue 53
Over-manning agreements 142 Price elasticity of supply 42,
51, 58 Qualitative lending guidelines
Over-population 139 211
Over-production 147, 150 factors influencing 52
Price equilibrium 41 Quantitative controls 211
welfare loss from 154 Quantity Theory of Money 232
Overseas aid 279 Price instability 36
Quasi rent 110, 118
problems of 279 Price makers 83, 96
Quotas 247, 249, 278, 290, 293
Overseas investment 289-290 Price mechanisms 9, II, 14,
Overtime 60 146, 153
ban on 137 Price stability 292, 294 Rate of return 178
Ownership 81, 93 Price taker 81, 87, 95-96 Rational consumer 22, 31
Prices 24, 28, 50, 57, 70, 86, Rational Expectations
88, 91, 294 Hypothesis 235
maximum 42 Rationing 35, 43
Paradox of thrift 186, 193 Prices and incomes policies Real assets 170
Pareto, V. 144 234, 236, 239-241, 293 Real income 165
Pareto criteria 144, 150, 156 Pricing policies 39, 84, 94, Real locating resources 8
Pareto optimal 159 147 Real national income 162, 168,
Participation rate 130 Primary banking system 196 174
Pensioners' Retail Price Index Primary sector 132 Rectangular hyperbola 57, 63
231 Principle of multiples 67, 76 Redistribution of income 233
Perfect competition 80-81, Private benefits 144, 150 Reflation 269-270, 302
89-90, 159 Private costs 145, 147, Reflationary policies 293
supply curves in 82 150-151 Regional development grants
Perfectly competitive industry Private marginal benefit 145 106-107
87 Private marginal cost 145, 154 Regional economic groupings
Periphery regions 105 Private sector 9 247
Permanent Income Hypothesis Private sector investment Regional policies 101, 105,
177, 193 decisions 155 223, 293-294
Phillips curve 224, 234, 238 Privatisation 147, 149, 212, Regional problems 101, 105,
expectations augmented 235 293-294 108
Planned economies 10, 19, 171 Producer goods 16 Regressive taxes 298, 303
Planned injections 178 Producer price indices 231 Regrettable necessities 170
Planned investment 178, 193 Producer surpluses 19, 34, 299 Rent controls 138
Planned saving 193 Product curves 65-66 Rent, quasi 126
Planned withdrawals 178-179 Product markets 53 Replacement ratios 140
Planning restrictions 24 Production Research and development 67
Plant 68, 72, 74, 78, 94, 108 automated 75 Reserve assets 198
Plant size, minimum efficient capital intensive 103 Reserve currency 287
68 Production possibility curves Reserves 283, 287, 289
Policy 294 8, 15-19, 251, 257 Residual errors 161, 166, 172
Policy instruments 210, 220, Production targets 14 Resource allocation 7, 14-17,
294 Production time 52 144
Policy problems 294 Productive efficiency 144, 150 Resources 7
Policy variables 301 Productivity 9, 15, 75, 133, misallocation of 108
Pollution 11. 154-155. 157 135. 137. 141-142 optimal allocation of 144,
Population growth 130 Profit maximisation 81, 84, 159
Population pyramid 142 87, 90, 92, 97, 149, 154, reallocation of 16, 55, 150
Population size 17, 21, 130, 158 Retail price index 162, 164,
138 Profits 14, 40, 45, 81, 88- 231, 242, 286
Populations 21, 41, 46, 168, 90, 92, 110, 115 weightings 237
170-171 abnormal 126 Returns 65, 74
age distribution of 136, 138 gross trading 160 Returns to scale 68, 72, 74,
age structure of 139 normal 3, 124-125 78
geographical distribution ot types of 81 Revaluation 260, 268, 270,
139 Progressive income tax 303 273-274, 302
growth in 130 Promotion campaigns 85 Revealed preference 29
natural change in 130 Property rights 14 Revenue 58, 80, 173
Positive economics 7 Protectionism 247, 251, Revision 1-2
Positive externalities 144, 253-254, 257, 261 Ricardo, D. 254
146-147, 152, 158 Prudential ratios 204 Rural areas 103
Poverty 114-115, 240 Public corporations 19
Poverty trap 140 Public expenditure 227
Precautionary motives 111 Public goods 10, 146, 151, Sales revenue, maximisation of
Predatory pricing 85, 253 153, 158-159 93
Present value 147-148, 156 Public sector 9 Satisfaction, maximisation of
Price competition 87 Public sector borrowing 29
Price deflator 162 requirement 210, 216-217, Savings 177-178, 190
Price determination 35 295 actual 191
Price discrimination 84-85, Public sector debt repayment induced 177
90, 149 295 planned 183, 191

308
Savings function 177, 183, 191 Supply-side economics 186, 215, 221, 224-225, 227-230,
Scale economies 18, 74, 82 188, 193, 296, 302 235, 255, 293-294, 296
Scarcity 14-15 Supply-side policies 223, 294 causal 229
Schumacher, E. F. 10 Sweezey model 94 costs of 223
SDRs 278, 287, 289-290 cyclical 229
Second ary banking system 196 def inition of 221
Secondary sector 132 Takeover 69, 80 demand deficiency 229
Self-employment 160 Target variables 294 and inflation 224, 234-235
Sex distribution 139 Targets 210, 290, 292 Keynes's explanation of 222
Shadow prices 155 intermediate 211 measuring 221
Shareholders 93, 207 ultimate 211 natural rate of 189, 223,
Shares 203 Tariffs 247, 249, 252, 254, 225, 229-230
Shoe leather costs 233, 241 257, 270, 293 official measurement of 228
Short run 60, 65 , 73 Tax base 299 remedies for 223
Skimming pricing 85 Tax cuts 296 rise in 227
Slumpflat ion 231 Tax inc idence 36 search 225
Small firms 75 Tax and price index 231 structural 225, 229
Social benefits 144, 157 Taxation 128, 179, 188-189, types and causes 222
Social capital 103-104 218, 294, 296, 298 voluntary 223, 225
Social costs II, 145, 151, 157 average rate of 134 Unemployment figures,
Social discount, rate of 148, direct 298-300 seasonally adjusted 221
156 indirect 298-300 Unemployment rate 221
Social marginal benefit 154 marginal rate of 134, 303 Unemployment trap 140
Social marginal cost 145, 154 progressive 134, 292 Unforeseen circumstances 35
Social security payments 140 Technology II, 35, 40, 45 , 60 Unit cost 45, 74
Social welfare 150 Terms of trade 254, 262-264, Urban areas 103, 139
Special deposits 199-200, 202, 268, 271, 274, 281 Urban development corporations
204-205, 211, 215, 217-219 changes in 258, 271, 274 102, 107
Special drawing rights 278, def inition of 258 Urban policy 102
284 Tertiary sector 132 Utility Theory 22
Specialisation 67, 75, 171 , Theories 7 Utils 22
254, 257, 263 Tied aid 279
Spillover effects 144, 150, Time lags 44, 294
154 Tinbergen's Rule 294
Spot market 276 Tobin, J. 163, 170 Vacancies 224
Stagflation 231 Total cost 66 , 78 Value a dded 161, 167, 173
Standard for deferred payments Total cost curve 72, 89 Variable costs 66, 69, 73, 98
195 Total domestic expenditure 161 Variables 7
Standard regions 100 Total domest ic income 160 VAT 40, 43, 45
Standards of living 9, 163, Total final expend iture 168, Velocity of circulation 232
166, 169, 171 173 Vertical integration 73
betwe en countries 163 Total product 138 Visible balance 259, 270
measurement of 162 Total revenue 57, 63, 77, 80, Visible trade 262-263
Sterling 84, 88-90, 95 , 98 Voluntary unemployment 230
demand for 276, 280, 289-290 Total revenue curve 96
snpply of 276, 289-291 Total revenue and marginal
Stock a ppr eci a t i on 160, 162 , revenue 96
169, 175 Total ut ility 22, 25, 31 Wage differentials 112, 122
Stock Exchange 196 Trade unions 112, 132, 137, Wage drift 120, 129
Stocks 52, 60, 64, 161 286 Wage-price spiral 231, 234
Stop-go cycles 301 Trade war 254 Wage rate 142
Store of value 195 Trad ing partners, UK's main Wages 112, 121
Structural surpluses 35 246 minimum 114, 121-122
Subsidies 37, 40-41, 45-46, Traffic congestion 103 Wage-wage spiral 231, 234
247, 249, 270 Tranches 278, 290 Wants a nd needs 7, 170
Subs istence 130 Transactions 127, 232 Wealth 10, 113, 119, 169-
Substitutes 21, 27-28, 42, 45, motive for III 171, 175, 203
53, 57, 59, 63 Transfer earnings 66, 110, human 170
Subst itution effect 22, 26-27, 116-117, 120, 123-125, 129, material 170
32-33, 86, 141 166 Wealth distribution 24 113
Superior good 52 Transfer payments 135, 162, Weighted price index 231, 242
Supply 34, 40, 42 166, 173, 176 Weight-gaining industries 100,
contraction in 34 Transfer pric ing 102 104, 107
excess 35, 42 Transformation curve 8 Weight-losing industries 100
expansion in 34 Transmissions mechanism 210 Welfare, alternative measures
extension in 45 Treasury bill tender 201 of 172
Supply curves 28, 34, 37, Treasury bills 220 Welfare economics IS, 144
40-41, 45, 51, 64 Withdrawals 175
long run 82 planned 191
movements along a 34-35 Under-production 147, 150 Work, incentive to 141
shift in 35, 40, 45 Unemployment 10, 24, 101, Working populat ion 138
Supply lags 36 121-122, 135, 140, 188-189, World Bank 278, 290

309