AS Markets & Market Systems

Economic Resources

Microeconomics is the study of the behaviour and decisions of individuals and businesses
in markets across the economy. We start our study of microeconomics by looking at the
resources which an economy may have available to supply and produce goods and
services to meet the ever-changing needs and wants of individuals and society as a
whole.

In economics we classify goods as “tangible” products, example might include food and
drink, cars, digital televisions, flat-screen televisions, energy products and cricket bats!
Services are sometimes known as intangibles, education and health-care are two
important services and tourism, business consultancy, cleaning and home insurance are
all examples of services.

Finite resources

There are only a finite (or limited) number of workers, machines, acres of land and
reserves of oil and other natural resources on the earth. Because most of our resources
are finite, we cannot produce an unlimited number of different goods and services and by
producing more for an ever-increasing population we are in real danger of destroying the
natural resources of the planet. This has important consequences for the long-term
sustainability of economies throughout the world and potentially huge implications for
our living standards and the quality of life.

1
1
Tuna reaches the quayside and will soon be supplied to the market – but over-fishing may
have destroyed fish stocks and risks the whole future of the tuna fishing industry in the
European Union

Tuna at risk of extinction

Bluefin tuna are at risk of extinction in the Mediterranean and eastern Atlantic according
to a report from the Worldwide Fund for Nature. They lay the blame on fishermen who
have caught more than the quotas allowed under current European Union rules. Over-
fishing has led to a reduction in stocks of tuna and average catch sizes are declining. The
WWF has called for an immediate halt to bluefin tuna fishing arguing that failure to act
now will lead to the complete destruction of what should be a renewable resource.

Source: Worldwide Fund for Nature and BBC news reports

Environmental pressure groups such as Friends of the Earth and Greenpeace seek to
highlight the permanent damage to the stock of natural resources available throughout the
world and the dangers from economic development and global warming. One such issue
is the huge threat posed by the global shortage of water as the world’s demand for water
for household and commercial use continues to grow each year. At the heart of
improving resource sustainability is the idea of de-coupling – a process of trying to
increase the efficiency with which resources are used in producing goods and services
and breaking the link between ever-increasing output and resource depletion.

Factors of production

Factors of production refer to the resources we have available to produce goods and
services. We make a distinction between physical and human resources.

Land

Land includes all of the natural physical resources – for example the ability to exploit
fertile farm land, the benefits from a temperate climate or the ability to harness wind and
solar power and other forms of renewable energy. Some nations are richly endowed with
natural resources and then specialise in the extraction and production of these resources –
for example – the development of the North Sea oil and gas in Britain and Norway or
the high productivity of the vast expanse of farm land in Canada and the United States
and the oil sands in Alberta, Canada. Other countries have a smaller natural factor
endowment and may be more reliant on importing these resources. Japan for example is
the world’s second largest economy but remains heavily dependent on imported oil.

Labour

Labour is the human input into the production process. It is inevitable that some
workers are more productive than others because of the education, training and work
experience they have received.

2
1
What matters is the size and quality of the workforce. An increase in the size and the
quality of the labour force is vital if a country wants to achieve economic growth. In
recent years the issue of the migration of labour has become important, can migrant
workers help to solve some of the labour shortages that many countries experience? And
what of the long-term effects on the countries who suffer a drain or loss of workers
through migration?

Labour is the human input into the production process. It is inevitable that some
workers are more productive than others because of the education, training and work
experience they have received.
What matters is the size and quality of the workforce. An increase in the size and the
quality of the labour force is vital if a country wants to achieve economic growth. In
recent years the issue of the migration of labour has become important, can migrant
workers help to solve some of the labour shortages that many countries experience? And
what of the long-term effects on the countries who suffer a drain or loss of workers
through migration?

Capital

To an economist, investment is not the money that people put into the stock market or
into bank and building society accounts. Instead, in economics the term capital means
investment in capital goods that can then be used to produce other consumer goods and
services in the future.

 Fixed capital includes machinery, plant and equipment, new technology,

factories and other buildings.

 Working capital refers to stocks of finished and semi-finished goods (or

components) that will be either consumed in the near future or will be made into
finished consumer goods.

3
1
 The global oil and gas industry uses a huge amount of capital equipment to get the
product – crude oil – to the refineries and processing stages.

Capital inputs and productivity

New items of capital machinery, buildings or technology are generally used to enhance
the productivity of labour. For example, improved technology in farming has vastly
increased the productivity of our agricultural sector and allowed people to move out of
working on the land into more valuable jobs in other parts of the economy. And,
investment in information and communication technology can increase the efficiency of
workers across many industries.

Infrastructure

Infrastructure is the stock of capital used to support the entire economic system.
Examples of infrastructure include road & rail networks; airports & docks;
telecommunications eg cables and satellites to enable web access. The World Bank
regards infrastructure as an essential pillar for economic growth in developing countries.

4
1
 The Gatwick Express – the railway infrastructure is an essential part of our transport
network

Entrepreneurship

An entrepreneur is an individual who seeks to supply products to a market for a rate of

return (i.e. to make a profit).

Entrepreneurs will usually invest their own financial capital in a business (for example
their savings) and take on the risks associated with a business investment. The reward to
this risk-taking is the profit made from running the business.

Many economists agree that entrepreneurs are in fact a specialised part of the factor input
'labour'.

Renewable resources

Renewable resources are commodities such as solar energy, oxygen, biomass, fish
stocks or forestry that is inexhaustible or replaceable by new growth providing that the
rate of extraction of the resource is less than the natural rate at which the resource renews
itself. This is becoming an enormously important issue in environmental economics, for
example the issue of the over-extraction of fish stocks, and the global risks of permanent
water shortages resulting from rising use of ground water stocks. Finite resources cannot
be renewed. For example with plastics, crude oil, coal, natural gas and other items
produced from fossil fuels, no mechanisms exist replenish them.

Factor Rewards

Factors of production are used to create output to be sold in markets. Each factor used in
production can expect some reward.

5
1
High oil prices help Shell to record profits

Soaring crude oil prices are boosting oil companies' profits around the world. Royal
Dutch Shell has announced record annual profit for a UK stockmarket listed company.
Shell generated profits of £13.12bn in 2005 – up nearly a third on the 2004 level. Most of
Shell’s profits come from finding and extracting oil, and then selling it on to the world’s
oil markets.

Source: Adapted from news articles, February 2006

Income

Income represents a flow of earnings from using factors of production to produce an

output of goods and services which are then sold in markets. The main sources of income
for individuals and households are:

1. Wages and salaries from work often supplemented by overtime and productivity
bonuses.
2. Interest from savings held in banks, building societies and other accounts.
3. Dividends from share ownership.
4. Rent income from the ownership of property.

For the majority of people, most of their weekly or monthly income comes from their job.
The government can also affect people’s disposable (or “post-tax”) income by taxing
incomes and by giving welfare benefits to households on low incomes or to people who
are out of work.

Wealth

Wealth is defined as a stock of assets that creates a flow of income and it can be held in a
variety of forms by individuals, firms and also the nation as a whole:

o Financial wealth - stocks and shares, bonds, savings in bank and building society
accounts and contributions to pension schemes.
o Marketable wealth - consumer durables that can be sold for a price e.g. rare
antiques.
o Social capital – including social infrastructure such as transport systems, schools
and hospitals.

It is important to distinguish between income and wealth. For example, if you receive a
higher wage or salary from your job then this adds to your monthly income and if this is
saved in a bank, or by making contributions to a pension fund then you are adding to your
financial wealth.

Being wealthy can also generate income for if you own shares in companies listed on the
stock market then you expect to receive dividend income once or twice a year. And if

6
1
you have money in a savings account, you will be paid interest on your savings balances.
Likewise, if you own properties, then you can earn some income from renting it out to
tenants. There has been a huge expansion in recent years in the buy-to-let sector of the
housing market with hundreds of thousands of people buying properties and then letting
them out. By the summer of 2006 in the UK there were over 700,000 people who had
bought property and then let it out to tenants as part of the buy-to-let sector of the
housing market.

Of course the value of financial wealth can fluctuate over time. In the UK in recent years
we have seen a boom in the UK housing market leading to sharp rises in average house
prices, particularly in London and the South East. The result has been a jump in housing
wealth for people with mortgages, but a growing problem of affordability for people
looking to enter the housing market for the first time on relatively low incomes. Share
prices have also been volatile with a collapse in prices from 2000-2003 and then a
recovery in the stock market over the last three years.

Inequality in the distribution of income and wealth

Factor incomes or factor rewards are rarely if ever distributed equitably in any country.
Indeed it is a fact of life that the distribution of income and wealth in the UK is highly
unequal there is a huge gap between the richest and poorest households in our society.
For example, the latest available data shows that 94% of the total wealth in this country is
held by 50% of the population. Put another way, the other half of our population can lay
claim to only 6% of total wealth. Millions of people must rely on relatively low incomes
with little opportunity to accumulate wealth. Is this fair? What are the consequences of a
high level of inequality? Should the government intervene to change the distribution of
income? And what might be some of the effects of such policies? These are important
questions and we will return to them when we consider the issue of market failure.

Income of the richest UK families is sixteen times that of the poorest

In 2004-05, the average gross (pre-tax) income of the richest 20% of families in Britain
was £66,300, more than 16 times that of the poorest 20% who earned £4,300 on average.
After adjusting for taxes and welfare benefits such as income support and the state
pension, however, this ratio fell to four-to-one. For direct taxes, the top fifth of
households pay 25% of their gross income in direct taxes such as income tax while for
the poorest households the figure is 10%. Levels of inequality are little changed from that
seen during the years of the Thatcher government.
Adapted from the ONS and the Guardian, June 2006

Labour and Wages

Most people have the ability to do some form of work. If they are of working age and
actively seeking a job then they are included in the working population. In industries
and jobs where labour is not particularly scarce, wages tend to be lower. Millions of
workers in the UK are paid hourly wages well below the national average. The minimum

7
1
wage (currently £5.05 for all adult workers – it rises to £5.35 in October 2006) seeks to
address some of the problems associated with low pay. On the other hand, some people
have skills that are quite rare, and these people will command high salaries in the labour
market.

Capital and Interest

Businesses often need to borrow money to fund capital investment. The reward for
investing money is called interest. Interest rates can of course go up or down. If the
interest rate is high, it becomes less worthwhile to borrow money because any project
will have to make more money than before to be profitable since more interest is now
being paid.

Enterprise and Profit

In return for having innovative business ideas and taking the risk in putting funds into a
business the entrepreneur takes any money that the business has left after the other factors
of production have received their rewards. This is called gross profit. Taxes then have to
be paid to the government, and the entrepreneur takes what is left. This after-tax profit is
called net profit.

Profits flow from increased passenger numbers

The low-cost airline EasyJet is reaping the benefits of higher sales and it is forecasting
that pre-tax profits in 2006 will be up by as much as 50 per cent. The business is creating
higher profits by increasing passenger revenue per seat and achieving extra sales and
income from ancillary revenues. EasyJet has managed to overcome the challenge of
higher oil prices partly by making cost savings in other parts of their business. EasyJet
said it carried 2.6 million passengers in June 2006, up 15.6 percent from a year earlier,
while its load factor, a measure of how efficiently it is filling seats on each flight, was
87.6 percent, 2 per cent higher than at the same time in 2005. EasyJet is part of the Easy
Group of companies.

Source: EasyGroup web site, Adapted from news reports, June 2006

Passenger data and passenger revenue for EasyJet

12 months to 12 months to Change over

June 2006 June 2005 the year

Passengers 32,122,137 28,291,843 +13.5%

Load Factor 84.4% 85.1% -0.7%

8
1
Total Revenue £1,535m £1,261m +21.8%

Source: EasyJet Investor Relations web site, accessed July 2006

Economists often assume that one of the main objectives of a business is to achieve
maximum profits. But this is not always the case! Some businesses are looking to achieve
a rising market share and increasing market share might mean having to sacrifice some
profits in the short run by cutting prices and under-cutting rival suppliers in the market.

There is also a growing interest in the concept of ethical businesses and corporate social
responsibility where the traditional assumption of businesses driven solely by the profit
motive is being challenged and where businesses are encouraged to take account of their
economic, social and environmental impacts.

Factor Description Reward

Land all natural resources (gifts of nature) The reward for landlords for allowing
including fields, mineral wealth, and firms to use their property is rent
fishing stocks

Labour The physical and mental work of The reward for workers giving up time
people whether by hand, by brain, to help create products is wages or
skilled or unskilled salaries

Capital Man made goods used to produce The reward for creditors lending money
more goods including factories to firms to invest in buildings and
(plant), machines and roads. capital equipment is interest

Enterprise An entrepreneur risks financial The reward for individuals risking funds
capital and organises land labour & and offering products for sale is profit.
capital to produce output in the hope Unsuccessful firms make losses.
of profit

Source: Richard Young, Markets Question and Answer, Tutor2u

AS Markets & Market Systems

Production Possibility Frontier

In this chapter we will consider the nature of the production possibility frontier and its
relationships with the fundamental economic problem.
9
1
A production possibility frontier (PPF) is a curve or a boundary which shows the
combinations of two or more goods and services that can be produced whilst using all of
the available factor resources efficiently.

We normally draw a PPF on a diagram as concave to the origin. This is because the extra
output resulting from allocating more resources to one particular good may fall. I.e. as we
move down the PPF, as more resources are allocated towards Good Y, the extra output
gets smaller – and more of Good X has to be given up in order to produce the extra
output of Good Y. This is known as the principle of diminishing returns. Diminishing
returns occurs because not all factor inputs are equally suited to producing different
goods and services.

Combinations of output of goods X and Y lying inside the PPF occur when there are
unemployed resources or when the economy uses resources inefficiently. In the
diagram above, point X is an example of this. We could increase total output by moving
towards the production possibility frontier and reaching any of points C, A or B.

Point D is unattainable at the moment because it lies beyond the PPF. A country would
require an increase in factor resources, or an increase in the efficiency (or
productivity) of factor resources or an improvement in technology to reach this
combination of Good X and Good Y. If we achieve this then output combination D may
become attainable.

10
1
Producing more of both goods would represent an improvement in our economic welfare
providing that the products are giving consumers a positive satisfaction and therefore an
improvement in what is called allocative efficiency

Reallocating scarce resources from one product to another involves an opportunity

cost. If we go back to the previous PPF diagram, if we increase our output of Good X
(i.e. a movement along the PPF from point A to point B) then fewer resources are
available to produce good Y. Because of the shape of the PPF the opportunity cost of
switching resources increases – i.e. we have to give up more of Good Y to achieve gains
in the output of good X.

The PPF does not always have to be drawn as a curve. If the opportunity cost for
producing two products is constant, then we draw the PPF as a straight line. The gradient
of that line is a way of measuring the opportunity cost between two goods.

11
1
Explaining Shifts in the Production Possibility Frontier

The production possibility frontier will shift when:

o There are improvements in productivity and efficiency perhaps because of the

introduction of new technology or advances in the techniques of production)
o More factor resources are exploited perhaps due to an increase in the size of the
workforce or a rise in the amount of capital equipment available for businesses

In the diagram below, there is an improvement in technology which shifts the PPF
outwards. As a result of this, output possibilities have increased and we can conclude
(providing the good provides positive satisfaction to consumers) that there is an
improvement in economic welfare.

12
1
Technology, prices and consumer welfare

Improved technology should bring market prices down and make products more
affordable to the consumer. This has been the case in the market for personal computers
and digital products. The exploitation of economies of scale and improvements in
production technology has brought prices down for consumers and businesses.

External Costs

In the case of air pollution there is an external cost to society arising from the
contamination of our air supplies. External costs are those costs faced by a third party
for which no compensation is forthcoming. Identifying and then estimating a monetary
value for air pollution can be a very difficult exercise – but one that is important for
economists concerned with the impact of economic activity on our environment. We will
consider this issue in more detail when we study externalities and market failure.

Free Goods

Not all goods have an opportunity cost. Free goods are not scarce and no cost is
involved when consuming them.

13
1
 Air conditioning uses up scarce resources especially during hot weather

Is fresh air an example of a free good? Usually the answer is yes – yet we know that air
can become contaminated by pollutants. And, in thousands of offices, shops and schools,
air-conditioning systems cool the air before it is “consumed”. With air conditioning,
scarce resources are used up in providing the “product” – for example the capital
machinery and technology that goes into manufacturing the air conditioning equipment;
the labour involved in its design, production, distribution and maintenance and the energy
used up in powering the system.

Cool air might appear to be free – but in fact it is often an expensive product to supply!

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Positive and Normative Statements

In this brief note we introduce you to the idea of positive and normative statements and
the idea of value judgements contained in statements and articles.

Detecting bias in arguments

Whenever you are reading articles on current affairs it is important to be able to

distinguish where possible between objective and subjective statements. Very often the
person writing an article has a particular argument to make and will include in their piece
subjective statements about what ought to be or what should be happening. Their
articles are said to carry value judgements, they are trying to persuade you of the

14
1
particular merits or demerits of a particular policy decision or issues. These articles may
be lacking in objectivity.

Positive Statements

Positive statements are objective statements that can be tested or rejected by referring to
the available evidence. Positive economics deals with objective explanation and the
testing and rejection of theories. For example:

 A rise in consumer incomes will lead to a rise in the demand for new cars.
 A fall in the exchange rate will lead to an increase in exports overseas.
 More competition in markets can lead to lower prices for consumers.
 If the government raises the tax on beer, this will lead to a fall in profits of the
brewers.
 A reduction in income tax will improve the incentives of the unemployed to
search for work.
 A rise in average temperatures will increase the demand for chicken.
 Poverty in the UK has increased because of the fast growth of executive pay.

Normative Statements

Normative statements express an opinion about what ought to be. They are subjective
statements rather than objective statements – i.e. they carry value judgments. For
example:

 The level of duty on petrol is too unfair and unfairly penalizes motorists.
 The London congestion charge for drivers of petrol-guzzling cars should increase
to £25 - three times the current charge.
 The government should increase the national minimum wage to £6 per hour in
order to reduce relative poverty.
 The government is right to introduce a ban on smoking in public places.
 The retirement age should be raised to 75 to combat the effects of our ageing
population.
 The government ought to provide financial subsidies to companies manufacturing
and developing wind farm technology.

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Theory of Supply

In this chapter we turn our attention to the decisions that producers make about how
much of a product to supply to a market at any given price. Once we have understood the

15
1
basics of supply, we can they put supply and demand together to consider the
determination of equilibrium prices in a market.

Definition of Supply

Supply is defined as the quantity of a product that a producer is willing and able to
supply onto the market at a given price in a given time period.

Note: Throughout this study companion, the terms firm, business, producer and seller
have the same meaning.

The basic law of supply is that as the price of a commodity rises, so producers expand
their supply onto the market. A supply curve shows a relationship between price and
quantity a firm is willing and able to sell.

A supply curve is drawn assuming ceteris paribus - ie that all factors influencing supply
are being held constant except price. If the price of the good varies, we move along a
supply curve. In the diagram above, as the price rises from P1 to P2 there is an expansion
of supply. If the market price falls from P1 to P3 there would be a contraction of supply
in the market. Businesses are responding to price signals when making their output
decisions.

16
1
Explaining the Law of Supply

There are three main reasons why supply curves for most products are drawn as sloping
upwards from left to right giving a positive relationship between the market price and
quantity supplied:

1. The profit motive: When the market price rises (for example after an increase in
consumer demand), it becomes more profitable for businesses to increase their
output. Higher prices send signals to firms that they can increase their profits by
satisfying demand in the market.
2. Production and costs: When output expands, a firm’s production costs rise,
therefore a higher price is needed to justify the extra output and cover these extra
costs of production.
3. New entrants coming into the market: Higher prices may create an incentive
for other businesses to enter the market leading to an increase in supply.

Shifts in the Supply Curve

The supply curve can shift position. If the supply curve shifts to the right (from S1 to S2)
this is an increase in supply; more is provided for sale at each price. If the supply curve
moves inwards from S1 to S3, there is a decrease in supply meaning that less will be
supplied at each price.

17
1
Changes in the costs of production

Lower costs of production mean that a business can supply more at each price. For
example a magazine publishing company might see a reduction in the cost of its imported
paper and inks. A car manufacturer might benefit from a stronger exchange rate because
the cost of components and new technology bought from overseas becomes lower. These
cost savings can then be passed through the supply chain to wholesalers and retailers and
may result in lower market prices for consumers.

Conversely, if the costs of production increase, for example following a rise in the price
of raw materials or a firm having to pay higher wages to its workers, then businesses
cannot supply as much at the same price and this will cause an inward shift of the supply
curve.

A fall in the exchange rate causes an increase in the prices of imported components and
raw materials and will (other factors remaining constant) lead to a decrease in supply in a
number of different markets and industries. For example if the pounds falls by 10%
against the Euro, then it becomes more expensive for British car manufacturers to import

18
1
their rubber and glass from Western European suppliers, and higher prices for paints
imported from Eastern Europe.

Changes in production technology

Production technologies can change quickly and in industries where technological change
is rapid we see increases in supply and lower prices for the consumer.

Government taxes and subsidies

19
1
Changes in climate

For commodities such as coffee, oranges and wheat, the effect of climatic conditions can
exert a great influence on market supply. Favourable weather will produce a bumper
harvest and will increase supply. Unfavourable weather conditions will lead to a poorer
harvest, lower yields and therefore a decrease in supply.

Changes in climate can therefore have an effect on prices for agricultural goods such as
coffee, tea and cocoa. Because these commodities are often used as ingredients in the
production of other products, a change in the supply of one can affect the supply and
price of another product. Higher coffee prices for example can lead to an increase in the
price of coffee-flavoured cakes. And higher banana prices as we see in the article below,
will feed through to increased prices for banana smoothies in shops and cafes.

Cyclone destroys the Australian banana crop and sends prices soaring

Cyclone Larry has devastated Australia's banana industry, destroying fruit worth $300
million and leaving up to 4,000 people out of work. Australians now face a shortage of
bananas and likely price rises after the cyclone tore through the heart of the nation's
biggest growing region. Queensland produces about 95 per cent of Australia's bananas.

20
1
The storm ruined 200,000 tonnes of fruit and market supply shortages will be severe
because Australia does not allow banana imports because of the bio-security risks in
doing so. Bananas are grown throughout the year in north Queensland, with the fruit
having a growing cycle of around two months.

Source: Adapted from news reports, April 2006

Change in the prices of a substitute in production

A substitute in production is a product that could have been produced using the same
resources. Take the example of barley. An increase in the price of wheat makes wheat
growing more financially attractive. The profit motive may cause farmers to grow more
wheat rather than barley.

The number of producers in the market and their objectives

The number of sellers (businesses) in an industry affects market supply. When new
businesses enter a market, supply increases causing downward pressure on price.

Competitive Supply

Goods and services in competitive supply are alternative products that a business could
make with its factor resources of land, labour and capital. For example a farmer can plant
potatoes or maize.

Farmers can change their crops if there are sizeable changes in market prices and if
expectations of future price movements also change.

Author: Geoff Riley, Eton College, September 2006

21
1
AS Markets & Market Systems
Price Elasticity of Demand

In this chapter we look at the idea of elasticity of demand, in other words, how sensitive
is the demand for a product to a change in the product’s own price. You will find that
elasticity of demand is perhaps one of the most important concepts to understand in your
AS economics course

Defining elasticity of demand

Ped measures the responsiveness of demand for a product following a change in its
own price.

The formula for calculating the co-efficient of elasticity of demand is:

Percentage change in quantity demanded divided by the percentage change in price

Since changes in price and quantity nearly always move in opposite directions,
economists usually do not bother to put in the minus sign. We are concerned with the co-
efficient of elasticity of demand.

Understanding values for price elasticity of demand

 If Ped = 0 then demand is said to be perfectly inelastic. This means that demand
does not change at all when the price changes – the demand curve will be vertical
 If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is
smaller than the percentage change in price), then demand is inelastic. Producers
know that the change in demand will be proportionately smaller than the
percentage change in price
 If Ped = 1 (i.e. the percentage change in demand is exactly the same as the
percentage change in price), then demand is said to unit elastic. A 15% rise in
price would lead to a 15% contraction in demand leaving total spending by the
same at each price level.
 If Ped > 1, then demand responds more than proportionately to a change in price
i.e. demand is elastic. For example, a 20% increase in the price of a good might
lead to a 30% drop in demand. The price elasticity of demand for this price
change is –1.5

What Determines Price Elasticity of Demand?

Demand for rail services

At peak times, the demand for rail transport becomes inelastic – and higher prices are
charged by rail companies who can then achieve higher revenues and profits

22
1
  The number of close substitutes for a good / uniqueness of the product – the
more close substitutes in the market, the more elastic is the demand for a product
because consumers can more easily switch their demand if the price of one
product changes relative to others in the market. The huge range of package
holiday tours and destinations make this a highly competitive market in terms of
pricing – many holiday makers are price sensitive
 The cost of switching between different products – there may be significant
transactions costs involved in switching between different goods and services. In
this case, demand tends to be relatively inelastic. For example, mobile phone
service providers may include penalty clauses in contracts or insist on 12-month
contracts being taken out
 The degree of necessity or whether the good is a luxury – goods and services
deemed by consumers to be necessities tend to have an inelastic demand whereas
luxuries will tend to have a more elastic demand because consumers can make do
without luxuries when their budgets are stretched. I.e. in an economic recession
we can cut back on discretionary items of spending
 The % of a consumer’s income allocated to spending on the good – goods and
services that take up a high proportion of a household’s income will tend to have
a more elastic demand than products where large price changes makes little or no
difference to someone’s ability to purchase the product.
 The time period allowed following a price change – demand tends to be more
price elastic, the longer that we allow consumers to respond to a price change by
varying their purchasing decisions. In the short run, the demand may be inelastic,
because it takes time for consumers both to notice and then to respond to price
fluctuations
 Whether the good is subject to habitual consumption – when this occurs, the
consumer becomes much less sensitive to the price of the good in question.
Examples such as cigarettes and alcohol and other drugs come into this category
 Peak and off-peak demand - demand tends to be price inelastic at peak times – a
feature that suppliers can take advantage of when setting higher prices. Demand is
more elastic at off-peak times, leading to lower prices for consumers. Consider for
example the charges made by car rental firms during the course of a week, or the
cheaper deals available at hotels at weekends and away from the high-season.
Train fares are also higher on Fridays (a peak day for travelling between cities)
and also at peak times during the day
23
1
  The breadth of definition of a good or service – if a good is broadly defined,
i.e. the demand for petrol or meat, demand is often fairly inelastic. But specific
brands of petrol or beef are likely to be more elastic following a price change

Wi-fi prices and price elasticity of demand

From airports to hotels to conference centres. From inter-city rail services to sports
stadiums and libraries, more and more people are demanding wireless internet
connections for personal and business use. But demand is being constrained by the
limited availability of services and, in places, high user charges. However the price of
connecting to the internet through wi-fi services is set to fall as competition in the sector
heats up. Nearly 90 per cent of laptops now come with wi-fi connections as standard and
many public areas are being equipped with hotspots, but users often complain about the
high price of accessing the internet. At present airports and hotels can charge high prices
because in many cases a wi-fi service provider has exclusivity on the area. However the
supply of wi-fi services is more competitive on the high street and prices are falling
rapidly as restaurants and coffee shops are using low-priced wi-fi access as a means of
attracting customers. The more wi-fi providers there are in the market-place, the higher is
the price elasticity of demand for wi-fi connections.

Wireless usage is growing across the UK with sales of 3G cards growing by 475%; these
are mostly through business channels. In the consumer market, sales of Wi-Fi routers for
the home have grown by 77% many broadband providers are now providing free wireless
routers with each new broadband subscription.

Note: WiFi stands for Wireless Fidelity

Source: The Cloud and GFK UK Technology Barometer, 2006

24
1
Demand curves with different price elasticity of demand

Elasticity of demand and total revenue for a producer

The relationship between price elasticity of demand and a firm’s total revenue is a very
important one. The diagrams below show demand curves with different price elasticity
and the effect of a change in the market price.

25
1
When demand is inelastic – a rise in price leads to a rise in total revenue – for example a
20% rise in price might cause demand to contract by only 5% (Ped = -0.25)
When demand is elastic – a fall in price leads to a rise in total revenue - for example a
10% fall in price might cause demand to expand by only 25% (Ped = +2.5)

The table below gives a simple example of the relationships between market prices;
quantity demanded and total revenue for a supplier. As price falls, the total revenue
initially increases, in our example the maximum revenue occurs at a price of £12 per unit
when 520 units are sold giving total revenue of £6240.

Price Quantity Total Revenue Marginal Revenue

£ per unit Units £s £s

20 200 4000

18 280 5040 13

16 360 5760 9

14 440 6160 5

12 520 6240 1

26
1
 10 600 6000 -3

8 680 5440 -7

6 760 4560 -11

Consider the price elasticity of demand of a price change from £20 per unit to £18 per
unit. The % change in demand is 40% following a 10% change in price – giving an
elasticity of demand of -4 (i.e. highly elastic). In this situation when demand is price
elastic, a fall in price leads to higher total consumer spending / producer revenue

Consider a price change further down the estimated demand curve – from £10 per unit to
£8 per unit. The % change in demand = 13.3% following a 20% fall in price – giving a
co-efficient of elasticity of – 0.665 (i.e. inelastic). A fall in price when demand is price
inelastic leads to a reduction in total revenue.

Change in the market What happens to total revenue?

Ped is inelastic and a firm raises its price. Total revenue increases

Ped is elastic and a firm lowers its price. Total revenue increases

Ped is elastic and a firm raises price. Total revenue decreases

Ped is -1.5 and the firm raises price by 4% Total revenue decreases

Ped is -0.4 and the firm raises price by 30% Total revenue increases

Ped is -0.2 and the firm lowers price by 20% Total revenue decreases

27
1
Ped is -4.0 and the firm lowers price by 15% Total revenue increases

Elasticity of demand and indirect taxation

Many products are subject to indirect taxation imposed by the government. Good
examples include the excise duty on cigarettes (cigarette taxes in the UK are among the
highest in Europe) alcohol and fuels. Here we consider the effects of indirect taxes on a
producers costs and the importance of price elasticity of demand in determining the
effects of a tax on market price and quantity.

AS Markets & Market Systems

Income Elasticity of Demand

How sensitive is the demand for a product to a change in the real incomes of consumers?
We use income elasticity of demand to measure this. The results are important since the
values of income elasticity tell us something about the nature of a product and how it is
perceived by consumers. It also affects the extent to which changes in economic growth
affect the level and pattern of demand for goods and services.

Definition of income elasticity of demand

Income elasticity of demand measures the relationship between a change in quantity

demanded for good X and a change in real income.

The formula for calculating income elasticity: % change in demand divided by the %
change in income

Normal Goods

Normal goods have a positive income elasticity of demand so as consumers’ income

rises, so more is demanded at each price level i.e. there is an outward shift of the demand
curve

 Normal necessities have an income elasticity of demand of between 0 and +1 for

example, if income increases by 10% and the demand for fresh fruit increases by
4% then the income elasticity is +0.4. Demand is rising less than proportionately
to income.
 Luxuries have an income elasticity of demand > +1 i.e. the demand rises more
than proportionate to a change in income – for example a 8% increase in income
might lead to a 16% rise in the demand for restaurant meals. The income elasticity

28
1
 of demand in this example is +2.0. Demand is highly sensitive to (increases or
decreases in) income.

Inferior Goods

Inferior goods have a negative income elasticity of demand. Demand falls as income
rises. Typically inferior goods or services tend to be products where there are superior
goods available if the consumer has the money to be able to buy it. Examples include the
demand for cigarettes, low-priced own label foods in supermarkets and the demand for
council-owned properties.

The income elasticity of demand is usually strongly positive for

Fine wines and spirits, high quality chocolates (e.g. Lindt) and luxury holidays overseas.
Consumer durables - audio visual equipment, 3G mobile phones and designer kitchens.
Sports and leisure facilities (including gym membership and sports clubs).

In contrast, income elasticity of demand is lower for

Staple food products such as bread, vegetables and frozen foods.
Mass transport (bus and rail).
Beer and takeaway pizza!
Income elasticity of demand is negative (inferior) for cigarettes and urban bus services.

Product ranges: However the income elasticity of demand varies within a product range.
For example the Yed for own-label foods in supermarkets is probably less for the high-
value “finest” food ranges that most major supermarkets now offer. You would also
expect income elasticity of demand to vary across the vast range of vehicles for sale in
the car industry and also in the holiday industry.

Long-term changes: There is a general downward trend in the income elasticity of

demand for many products, particularly foodstuffs. One reason for this is that as a society
becomes richer, there are changes in consumer perceptions about different goods and
services together with changes in consumer tastes and preferences. What might have been
considered a luxury good several years ago might now be regarded as a necessity (with a
lower income elasticity of demand).

Consider the market for foreign travel. A few decades ago, long-distance foreign travel
was regarded as a luxury. Now as real price levels have come down and incomes have
grown, so millions of consumers are able to fly overseas on short and longer breaks. For
many an annual holiday overseas has become a necessity and not a discretionary item of
spending!

Estimates for income elasticity of demand

How high is the income elasticity for fine Income elasticity for baked beans? Likely to
wines? be low but positive as beans are a staple

29
1
 food

Income elasticity for cigarettes? According What of the income elasticity of demand for
to some estimates, cigarettes are inferior private executive air travel?
goods

Product Share of budget Price elasticity of Income elasticity of

(% of household demand (Ped) demand (Yed)
income)

All Foods 15.1 n/a 0.2

Fruit juices 0.19 -0.55 0.45

Tea 0.19 -0.37 -0.02

Instant coffee 0.17 -0.45 0.16

Margarine 0.03 n/a -0.37

Source: DEFRA www.defra.gov.uk

The income elasticity of demand for most types of food is pretty low – occasionally
negative (e.g. for margarine) and likewise the own price elasticity of demand for most
foodstuffs is also inelastic. In other words, the demand for these products among

30
1
consumers is not sensitive to changes in the product’s price or changes in consumer
income.

How do businesses make use of estimates of income elasticity of demand?

Knowledge of income elasticity of demand for different products helps firms predict the
effect of a business cycle on sales. All countries experience a business cycle where actual
GDP moves up and down in a regular pattern causing booms and slowdowns or perhaps a
recession. The business cycle means incomes rise and fall.

Luxury products with high income elasticity see greater sales volatility over the
business cycle than necessities where demand from consumers is less sensitive to
changes in the economic cycle

The UK economy has enjoyed a period of economic growth over the last twelve years. So
average real incomes have increased, but because of differences in income elasticity of
demand, consumer demand for products will have varied greatly over this period.

Income elasticity and the pattern of consumer demand

Over time we expect to see our real incomes rise. And as we become better off, we can
afford to increase our spending on different goods and services. Clearly what is
happening to the relative prices of these products will play a key role in shaping our
consumption decisions. But the income elasticity of demand will also affect the pattern of
demand over time. For normal luxury goods, whose income elasticity of demand
exceeds +1, as incomes rise, the proportion of a consumer’s income spent on that product
will go up. For normal necessities (income elasticity of demand is positive but less than
1) and for inferior goods (where the income elasticity of demand is negative) – then as
income rises, the share or proportion of their budget on these products will fall

UK Consumer Spending Shares by Volume

(%) 1980 1990 2003

Food 14.5 11.5 9.6

Alcohol & tobacco 7.8 5.0 3.5

Of whichAlcohol 2.1 1.8 1.8

Tobacco 6.0 3.3 1.7

31
1
Clothing & footwear 4.8 5.2 8.1

Household goods, etc 5.4 5.4 6.0

Health 1.5 1.6 1.3

Transport 13.9 15.3 14.0

Of whichCars 4.1 5.8 6.5

Travel 3.6 3.4 3.1

Of whichAir 1.0 1.2 1.3

Communications 1.4 1.6 3.1

Recreation & culture 7.8 10.0 15.5

Travel Other, including package holidays 2.0 2.7 4.5

Education 1.4 1.1 1.2

Restaurants & hotels 12.7 12.6 9.3

Source: Family Expenditure Survey

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Price Mechanism

The invisible hand – the workings of the price mechanism

32
1
 Adam Smith, one of the Founding Fathers of economics
famously wrote of the “invisible hand of the price
mechanism”. He described how the invisible or hidden
hand of the market operated in a competitive market
through the pursuit of self-interest to allocate resources in
society’s best interest. This remains the central view of
all free-market economists, i.e. those who believe in the
virtues of a free-market economy with minimal
government intervention.

The price mechanism is a term used to describe the

means by which the many millions of decisions taken
each day by consumers and businesses interact to
determine the allocation of scarce resources between
competing uses. This is the essence of economics!
Adam Smith

The price mechanism plays three important functions in any market-based economic
system:

The signalling function

The price of digital printing is coming

down – this will have an effect on the
demand for substitute forms of image
printing. How will traditional photo
imaging retailers respond?

Firstly, prices perform a signalling function. This means that market prices will adjust to
demonstrate where resources are required, and where they are not.

Prices rise and fall to reflect scarcities and surpluses. So, for example, if market prices are
rising because of high and rising demand from consumers, this is a signal to suppliers to
expand their production to meet the higher demand.

33
1
Consider the left hand diagram on the next page. The demand for computer games
increases and as a result, producers stand to earn higher revenues and profits from selling
more games at a higher price per unit. So an outward shift of demand ought to lead to an
expansion along the market supply curve.

In the second example on the right, an increase in market supply causes a fall in the
relative prices of digital cameras and prompts an expansion along the market demand
curve

Conversely, a rise in the costs of production will induce suppliers to decrease supply,
while consumers will react to the resulting higher price by reducing demand for the good
or services.

The transmission of preferences

Through the signalling function, consumers are able through their expression of
preferences to send important information to producers about the changing nature of
our needs and wants. When demand is strong, higher market prices act as an incentive
to raise output (production) because the supplier stands to make a higher profit. When

34
1
demand is weak, then the market supply contracts. We are assuming here that producers
do actually respond to these price signals!

One of the features of a free market economy is that decision-making in the market is
decentralised in other words, the market responds to the individual decisions of millions
of consumers and producers, i.e. there is no single body responsible for deciding what is
to be produced and in what quantities. This is a remarkable feature of an organic market
system.

The rationing function

Prices serve to ration scarce resources when demand in a market outstrips supply. When
there is a shortage of a product, the price is bid up – leaving only those with sufficient
willingness and ability to pay with the effective demand necessary to purchase the
product. Be it the demand for tickets among England supporters for the 2006 World Cup
or the demand for a rare antique, the market price acts a rationing device to equate
demand with supply.

The prices for using the M6 Toll Road are a good example of the rationing function of
the price mechanism. A toll road can exclude those drivers and vehicles that are not
willing or able to pay the current toll charge. In this sense, motorists and road haulage
businesses and other road users are paying for the right to use the road, road space has a
market price instead of being regarded as something of a free good. The current charges
are below:

Prices on the M6 Toll Road Day Night

June 2006 (06:00 - 23:00) (23:00 - 06:00)

Class 1 (e.g. motorbike) £2.50 £1.50

Class 2 (e.g. car) £3.50 £2.50

Class 3 (e.g. car & trailer) £7 £6

Class 4 (e.g. van/coach) £7 £6

Class 5 (e.g. HGV) £7 £6

What would happen if the day-time charges increased to £5 for cars?

The growing popularity of auctions as a means of allocating resources is worth

considering as a means of allocating resources and clearing a market. The phenomenal

35
1
success of EBAY is testimony to the power of the auction process as a rationing and
market clearing mechanism as internet usage has grown.

The price mechanism is the only allocative mechanism solving the economic problem in
a free market economy. However, most modern economies are mixed economies,
comprising not only a market sector, but also a non-market sector, where the
government (or state) uses the planning mechanism to provide public goods and
services such as police, roads and merit goods such as education, libraries and health.

In a state run command economy, the price mechanism plays little or no active role in
the allocation of resources. Instead government planning directs resources to where the
state thinks there is greatest need. The reality is that state planning has more or less failed
as a means of deciding what to produce, how much to produce, how to produce and for
whom. Following the collapse of communism in the late 1980s and early 1990s, the
market-based economy is now the dominant economic system – even though we are
increasingly aware of imperfections in the operation of the market – i.e. the causes and
consequences of market failure.

Prices and incentives

 Incentives matter enormously in our study of microeconomics, markets and

instances of market failure. For competitive markets to work efficiently all
economic agents (i.e. consumers and producers) must respond to appropriate
price signals in the market.

 Market failure occurs when the signalling and incentive function of the price
mechanism fails to operate optimally leading to a loss of economic and social
welfare. For example, the market may fail to take into account the external costs
and benefits arising from production and consumption. Consumer preferences
for goods and services may be based on imperfect information on the costs and
benefits of a particular decision to buy and consume a product. Our individual
preferences may also be distorted and shaped by the effects of persuasive
advertising and marketing to create artificial wants and needs.

Government intervention in the market

Often the incentives that consumers and producers have can be changed by government
intervention in markets. For example a change in relative prices brought about by the
introduction of government subsidies and taxation.

Suppose for example that the government decides to introduce a new tax on aviation fuel
in a bid to reduce some of the negative externalities created by the air transport industry.

 How will airlines respond?

a. Will they pass on the tax to consumers?

36
1
 b. Can they absorb the tax and seek cost-savings elsewhere in their
operations?

 If the tax raises price for air travellers, will they change their behaviour in the
market?
 Is an aviation tax the most effective way of controlling pollution? Or could
incentives for producers and behaviour by consumers wanting to travel by air be
changed through other more effective and efficient means?

Agents may not always respond to incentives in the manner in which textbook economics
suggests.
The “law of unintended consequences” encapsulates the idea that government policy
interventions can often be misguided of have unintended consequences! See the revision
focus article on government failure.

37
1
 Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Inter-relationships Between Markets

Supply and demand analysis can be used to explain and inter-relationships between
different markets and industries. For example, fluctuations in supply and demand
conditions in one market change the incentives and the decisions made by producers and
consumers in other markets.

A change in market supply and demand in two markets

In the first example we consider the huge increase in the market supply of low-cost
flights available from airports across the United Kingdom. The market supply of flights
has shifted out to the right, probably by far more than the increase in market demand.
(New lost cost airlines have entered the market and existing airlines have expanded their
route network and fleet capacity). The net result is a reduction in the average real price of
flights to short-haul destinations in Europe.

38
1
Consider the possible effect on the UK tourist industry. Assuming other factors remain
constant (for example the exchange rate and the growth of incomes in other countries
whose tourists might choose the UK as a venue for a holiday). A fall in the relative price
of airline flights increases the market demand for overseas holidays (short city breaks,
package holidays for example). Assuming that British tourists can choose to holiday at
home or overseas and regard the two products as substitutes, then the effect is to reduce
the demand for holidays in the UK – putting downward pressure on prices, profit margins
and leading to the risk of excess capacity in the UK tourist industry.

Example: the growth of market demand for digital cameras

Global demand for digital cameras continues to be strong. Industry analysts IDC forecast
that 110 million digital cameras will be shipped in 2008, but a slowdown in market
demand is on the horizon. The industry is already worth $33 billion in annual sales. The
Asian/Pacific region is emerging as the powerhouse for rising demand as incomes
continue to rise in emerging market economies. By 2010, these two regions will account
for over 40% of total global shipments of digital cameras. The major suppliers are Canon,
Fuji, HP, Kodak, Konica Minolta, Nikon, Olympus, Pentax Technologies, Samsung and
Sony.

What are the inter-relationships between markets in this example?

1. Substitute products: The growing demand for digital cameras is causing a fall in
demand for analogue cameras that rely on taking film to developers – some
producers including Eastman Kodak have stopped producing traditional film
cameras due to falling demand. If others follow suit, then market supply will also
shift inwards
2. Complementary products: As demand for digital cameras increases, so too does
demand for printing paper, inks and other accessories used by people who want to
print out their favourite images from their desktop or notebook PC
3. Demand-side threat to other markets: The change in consumer demand
represents a competitive threat to mobile phone manufacturers – they are having
to respond by becoming more innovative in terms of what their mobile phone
handsets can do

Example - High gas prices cause shut-downs in UK brick production

Steep rises in the price of oil and gas is causing problems for the British brick-producing
industry and is likely to lead to a fall in output and loss of jobs. It is a stark example of
how the changing prices of essential inputs into the production process can filter through
to affect many related industries.

39
1
Baggeridge Brick, the fourth-biggest brick maker in the UK has announced that it plans
to shut down two of its seven factories over Christmas and extend the closedown
throughout January. The business has been hit by a double-whammy. Firstly the
slowdown in the housing market and a trend towards building smaller properties has
prompted a decline of 200 million in the market demand for bricks. Demand has also
declined because of a reduction in spending on housing repairs, maintenance and
improvement. Output in the industry has fallen by around ten per cent in 2005.

Secondly the rise in the market price of gas has meant that the brick-producer is now
paying double for its gas compared with this time last year. Gas is a major input into
production because brick manufacturing is a very energy-intensive business.

Higher brick prices will cause an increase in the cost of building new properties and in
renovating existing buildings. Industry analysts forecast that planned price increases by
the major brick suppliers will add around £150 - £200 to the cost of each new residential
property depending on its size. Because all of the brick producers in the UK have
experienced much the same rise in their energy costs, they are all expected to try to pass
on these costs to final customers through higher prices. This is not collusion, merely an
inevitable response to an industry-wide rise in production costs.

Macroeconomics and market effects

Another good example of inter-relationships is how macroeconomic developments in one

country affect the prices of goods and services that we consume in our own economy.
Consider the recent phenomenal growth of the Chinese economy and the impact that it
has had on demand for and prices of many important internationally-traded raw materials
and commodities

Chinese growth drives up world commodity prices

China’s explosive economic growth voracious appetite for raw materials and energy has
driven up prices worldwide and created shortages. In 2005, China consumed over 50
percent of the world's cement, 40 percent of its steel and 25 percent of its aluminium.
China's growing demand for oil has been one reason crude prices are so high. Talk of an
economic slowdown engineered by the Chinese government is pricking up ears from
Chilean copper mines to Minnesota soybean fields. China has 4,813 cement plants - more
than the rest of the world combined - and they still aren't enough to supply the cement for
projects such as the Three Gorges Dam or the stadiums and housing for the 2008 Beijing
Olympic Games.

Consider how rising oil prices can feed through to related markets:

40
1
Derived demand

The demand for a product X might be strongly linked to the demand for a related
product Y. For example, the demand for steel is strongly linked to the market demand
for new cars, the construction of new buildings and many manufactured products. The
demand for labour is derived from the final demand for the goods and services that we
employ labour to produce.

So when the economy is enjoying a strong upturn in aggregate demand, so too the
demand for labour increases. Conversely in a recession, as real national output declines,
so we see a fall in the demand for labour at each prevailing wage rate.

Composite demand

Composite demand exists where goods or services have more than one use so that an
increase in the demand for one product leads to a fall in supply of the other. The most
commonly quoted example is that of milk which can be used for cheese, yoghurts, cream,
butter and other products. If more milk is used for manufacturing cheese, other things

41
1
remaining the same, there is less available for butter. Another good example is land –
land can be developed in many different ways – for commercial property, residential
properties, leisure facilities, farming, common land and so forth. Likewise oil has
numerous alternative uses – for heating oil, petrol fuel, use in petrochemicals etc.

Joint supply

Joint supply describes a situation where an increase or decrease in the supply of one good
leads to an increase or decrease in supply of another. For example an expansion in the
volume of beef production will lead to a rising market supply of beef hides. A contraction
in supply of lamb will reduce the supply of wool.

Orange Juice Squeezed by Nature

42
1
Britain's daily dose of Vitamin C may be about to get a lot more expensive. The price of
frozen orange juice hit a 14-year high last week, pushed up by speculators betting that
market supply would remain tight this year after hurricanes and dry weather had reduced
growing in the world's leading orange-producing countries.

"Mother Nature has certainly done a job on the Florida citrus industry," said a spokesman
for Tropicana, the world's biggest orange juice seller. Florida is the world's number-two
orange producer behind Brazil, where total juice production was also down last year.
43
1
The price for orange juice futures - the price of frozen juice to be delivered at a date in
the future - has nearly trebled since the beginning of 2005 partly because of predictions
of another heavy hurricane season in Florida. Florida will produce 153 million boxes of
juice this year, one-fifth less than earlier predicted.

Consumption, meanwhile, is on the rise. According to the British Soft Drinks

Association, Britons guzzled 1.4 billion litres of fruit juice in 2005, an increase of 6.8 per
cent over the year before. Orange juice accounts for about 70 per cent of fruit juices
consumed in the UK. Tropicana has already passed some of the higher cost along to
customers, hiking its juice prices by 7 per cent last year. Where the cost crunch will be
most acute, however, is in "ambient" juice - the cheap supermarket branded juices stored
at room-temperature, said a BSDA spokesman. "The profit margins [for ambient juices]
are razor thin, so any squeeze has got to happen there," he said.

Sources: Adapted from the Independent, 14 May 2006 and data from EcoWin

AS Markets & Market Systems

Producer Surplus

Producer surplus relates to the welfare that businesses can achieve by supplying
products to the market.

Defining producer surplus

Producer surplus is a measure of producer welfare. It is measured as the difference

between what producers are willing and able to supply a good for and the price they
actually receive. The level of producer surplus is shown by the area above the supply
curve and below the market price and is illustrated in this diagram.

44
1
Producer surplus and changes in demand and supply

We first consider the effects of a change in market supply – for example caused by an
improvement in production technology or a fall in the cost of raw materials and
components used in the production of a good or service.

45
1
We now consider the effects on producer surplus of a rise in market demand:

46
1
 Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Market for Copper

The market for copper has hit the headlines in the last two years as a price boom has
occurred.

The world price of copper nearly trebled between the start of 2005 and the summer of
2006, one of the most remarkable booms in commodity markets in many years. Much of
the steep rise in price has been due to demand-side factors. World demand for copper
has been rising much faster than the growth in market supply that result from new
discoveries of copper and increased extraction rates of known reserves. In 2004, world
copper consumption exceeded production by 843,000 tons and a similar demand-supply
imbalance occurred in 2005 and the early months of 2006.

47
1
According to a recent study from geologists at Yale University, new discoveries of
copper have raised global reserves by just 0.63 per cent a year since 1925 but usage (final
demand) has risen at 3.3 per cent per annum. And now demand is growing strongly on
the back of phenomenal growth in China, India and other emerging market economies.
Stocks of copper have been in sharp decline in the last few years and it is this scarcity
that has driven prices higher as commodities traders out-bid each other as they scramble
for available supplies. Supply has fallen behind the growth of demand and prices can
move in only one direction when this happens!

The world supply of and demand for copper

Most copper ore is mined or extracted as copper sulfides from large open pit mines in
copper porphyry deposits that contain 0.4 to 1.0 percent copper. Over 40 per cent of
world copper supply comes from North and South America; 31 per cent from Asia and 21
per cent from Europe. Chile is the world’s biggest supplier of copper (it provided 35 per
cent of the total in 2003 with Indonesia and the USA each contributing 8 per cent).

Copper – an example of derived demand

Because copper is malleable and ductile, there is a huge industrial demand for copper.
Like most metals the demand for it is derived in part from the final demand for products
that use copper as an important component or raw material. Nearly 50 per cent of the
demand for copper comes from the construction industry, and 17 per cent is from the

48
1
electrical sector. Copper is also used extensively in heavy and light engineering and in
transport industries. From copper wire to copper plumbing, from the use of copper in
integrated circuits to its value as a corrosive resistant material in shipbuilding and as a
component of coins, cutlery and to colour glass, copper has a huge array of possible
industrial uses.

A good example of where demand for copper comes from is the automobile industry.
The average new car contains 27.6kg of copper. And hybrid cars which incorporate
electric motors in conjunction with combustion engines could lead to further rises in
copper demand. A typical electric hybrid car might use around 2 times the current usage
of copper in extra cabling and windings for electric motors."

Higher copper prices should encourage an expansion of supply

Incremental demand – the China and India effect

Recent data suggests that the incremental growth in world demand for copper has come
almost exclusively from China and other Asian economies. HSBC analysts calculate that
between the years 2000-04, the compound annual growth in copper consumption from
North America has fallen by 3 per cent and by 1.8 per cent from Western Europe and 2
per cent from Japan. In contrast, demand from Asian countries other than Japan has
increased by 8.6 per cent each year whilst in China the growth has been a staggering 15
per cent per year.

There has also been a noticeable speculative demand for copper as investment funds
around the world have started to track commodity prices. In the case of copper, thus far,
the market has been a one way street for financial investors, although you may have
heard about the rogue copper trader from China who a fortune betting that the market
price of copper would fall back in November 2005!

The volatility of commodity prices

49
1
As we have seen, price volatility stems from a lack of responsiveness of both demand and
supply in the short term, i.e. both demand and supply are assumed to be inelastic in
response to price movements.

The low price elasticity of demand for copper usually stems from a lack of close
substitutes in the market. For some products and processes, aluminium or plastic may act
as a substitute to copper for some uses, but there are costs and delays involved in
switching between them.

The elasticity of supply is also low. Supply is usually unresponsive to price movements
in the short term because of the high fixed costs of developing new extraction plants
which also involve lengthy lead-times. If existing copper mining businesses are working
close to their current capacity then a rise in world demand will simple lead to a
reduction in available stocks. And as stocks fall, so buyers in the market will bid up the
price either to finance immediate delivery (the spot price) or to guarantee delivery of
copper in the future (reflected in the futures price). It can take huge price swings in the
market for supply and demand to respond sufficient to bring the market back to some sort
of equilibrium.

The effects of rising copper prices

The demand for copper will continue to remain strong provided that the global industrial
sectors continue to expand production. But if price remain high then we can expect to see

50
1
some shifts occurring. For a start, copper can be recycled although the costs of doing so
are often high and there are fears concerning the negative externalities arising from the
pollution created by trying to recycle used copper. These external costs include
atmospheric emissions from recycling plants and waste products dumped into rivers.
Nonetheless price theory would predict an increase in demand for scrapped copper and
perhaps a substitution effect away from copper towards aluminium. And in the medium
term high prices and emerging new technologies may cause an even bigger shift in
demand away from copper based products. Plastics provide lower material and
installation costs for businesses. And the take off in wireless technology and fibre
optics will also have an impact.

And higher prices might also be the stimulus required for an expansion of copper ore
production as supply responds to the incentives of increased potential revenues and
profits. In recent years, copper mining production has fallen short of expectations. But as
with any market, if the price is high enough suppliers will eventually respond!

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Market for Coffee

Each day nearly 2.5 billion cups of coffee are consumed. It is the 5th most widely traded
commodity in the world and millions of people depend directly or indirectly on the
production and sale of coffee for their livelihoods. The global market for coffee is
characterised by volatile prices and production levels which impacts directly on the
incomes of producers and prices facing consumers.

The World Coffee Market

Experts on the world coffee market often make reference to the “coffee paradox”.
A coffee crisis in producing countries with a trend towards lower prices, declining
producer incomes and profits with important consequences for the export revenues of
leading coffee exporting countries and the living standards of millions of people in
developing nations
A coffee ‘boom’ in consuming countries with rising retail sales and profits for coffee
retailers
A widening gap between producer and consumer prices

Coffee production and developing countries

The World Bank estimates that out of the total 141 developing countries, 95 depend on
exports of commodities for at least 50 percent of their total export earnings. Coffee is a

51
1
very good example of such “commodity-dependency” representing, for example, 75% of
the total exports of Burundi and 54% in Uganda, and about 22% in the case of Honduras.
About 20 to 25 million families produce and sell coffee for their livelihood and most of
them are small-scale farmers with limited financial resources and scope to diversify out
of coffee production.

Globally, coffee sales each year exceed $70 billion, but coffee producing countries only
capture $5 billion of this value, with the bulk of revenues from the coffee trade retained
by developed countries. Coffee farmers in producing countries only obtain a fraction of
the final retail price of coffee. A recent Oxfam research report showed that Ugandan
coffee farmers only get about 2.5 percent of the final retail price of their coffee in the UK
market. One strongly positive sign has been the surge in demand for FairTrade coffee in
the UK and other countries. The FairTrade organisation claimed in July 2006 that one in
five cups of filter coffee drunk in the UK are now being supplied from a "fair" source.
Sales of Fairtrade coffee in the UK totalled £65.8m on 2005, up from £34.3m in 2003 (5
% of the UK market) although FairTrade coffee sales account for only 0.5% of the global
market

Coffee prices

There have been no price controls in the global coffee trade since 1989, when the buffer-
stock system run by the International Coffee Agreement broke down.

The main reason for the decline in prices in the early years of the current decade was a
gradual and continuous increase in coffee production throughout the world, particularly
the new coffee exporting countries entering the international market, a good example
being Vietnam. Global coffee production grew faster than demand leading to large
surpluses of production. Our chart below shows the average monthly price for coffee in
the world markets. The price chart shows a composite price for the different grades of
coffee such as Robusta and Arabica beans. From the second half of 1997 through to the
trough of prices in 2001, the average price of coffee collapsed from $180 per lb to less
than $40 per lb. Prices remained very low until 2004 since when there has been some
recovery in prices, but they remain well below the levels witnessed in the mid 1990s.

52
1
 Consumption of coffee and price elasticity of demand

World coffee consumption is estimated at 114.7 million bags in 2005. Domestic

consumption in exporting countries in 2005 was just over 30 million bags and in
importing countries consumption was estimated at just fewer than 85 million bags. The
main buyers of raw coffee beans are the largest multinational buyers, dominated by four
firms: Nestlé, Kraft, Procter & Gamble and Sara Lee.

53
1
 A coffee roasting plant

According to recent Cecafé estimates, the value of retail sales of processed coffee
(roasted and soluble) is in the order of US$35 billion, while the retail value of coffee
sold by the cup in places such as Costa Coffee and Starbucks (accounting for 20% to 30%
of world coffee consumption outside the home) is estimated at over US$120 billion.

Coffee consumption has been growing at a steady rate of between 1 and 1.5 % per year;
a growth rate is well below that for food products as a whole which is closer to 4% per
annum. Changes in eating habits and increased demand for alternative drinks to coffee
are largely behind this relatively slow growth of global market demand. Even the sharp
fall in coffee prices during 2000 - 2004 seemed to have little impact on world demand,
suggesting that coffee has a very low price elasticity of demand.

Employment in coffee producing countries

Coffee production employs a labour force estimated at around 25 million families by the
ICO and accounts for more than 50% of export earnings in many countries, an increase in
consumption favouring a gradual rise in world prices would be a positive factor for
economic growth and increased per capita incomes in these countries. In Brazil alone
more than a million jobs are generated by the coffee industry.

The International Coffee Organisation (ICO)

The International Coffee Organization (ICO) is the main intergovernmental organization

for coffee, bringing together 74 producing and consuming countries to tackle the
challenges facing the world coffee sector through international cooperation. It makes a
practical contribution to the world coffee economy and to improving standards of living
in developing countries by helping to increase world coffee consumption through
innovative market development activities and improving coffee quality through the
Coffee Quality-Improvement Programme.

Leading coffee producers and exporters in 2005

The main coffee producers and exporters are shown in the table below. The data comes
from the annual reports on the world coffee industry produced by the International Coffee
Organisation. Brazil is far and away the biggest supplier of coffee beans in the global
economy although nations such as Vietnam, India and Mexico have been gaining ground
in recent years.

Production of 60kg bags per year 2004 2005 % change 2004-05

54
1
Brazil 39272000 32944000 -16

Colombia 11405000 11550000 1

Vietnam 13844000 11000000 -21

Indonesia 7386000 6750000 -9

India 3844000 4630000 20

Ethiopia 5000000 4500000 -10

Mexico 3407000 4200000 23

Guatemala 3703000 3675000 -1

Honduras 2575000 2990000 16

Peru 3355000 2750000 -18

Uganda 2750000 2750000 0

Cote d'Ivoire 1750000 2500000 43

Costa Rica 1720000 2157404 25

Nicaragua 1127000 1400000 24

El Salvador 1447000 1371700 -5

Papua New Guinea 1002000 1232000 23

Kenya 709000 1002000 41

Cameroon 727000 1000000 38

Brazil is effectively the “swing producer” for the global coffee markets, in other words,
since Brazil is the largest coffee producer, changes in Brazil's supplies of coffee account
for a large portion of the change in the world total supplies of coffee which then directly

55
1
affects the prevailing international price. Brazilian coffee production peaked at 3.75
million tons in the year 2000 but fell into a steep recession from 2001 onwards as
producers cut back supply in the wake of the collapse in coffee prices. Supply has
stabilised in 2004 and 2005 with prices recovering ground.

As we can see there is a direct relationship between the current world price and the value
of exports of coffee from nations such as Brazil. Factors such as changes in the exchange
rate can influence the income that coffee exporting countries will generate from their
overseas sales. But for Brazil, the recovery in prices since 2004 has been important in
boosting for their export incomes.

56
1
 Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Scarcity and Choice in Resource Allocation

In this chapter we consider the nature of economics and the choices that all economic
agents, be they consumers, businesses and different levels of government must make
every day.

What is Economics?

The Economist's Dictionary of Economics defines economics as

"The study of the production, distribution and consumption of wealth in human society"

Another definition of the subject comes from the economist Lionel Robbins, who said in
1935 that

57
1
"Economics is a social science that studies human behaviour as a relationship between
ends and scarce means which have alternative uses. That is, economics is the study of the
trade-offs involved when choosing between alternate sets of decisions."

The purpose of economic activity

Road space throughout the world is becoming increasingly scarce as the demand for
motor transport increases each year – what do you think are some of the best solutions to
reducing the problem of congestion on our roads?

It is often said that the central purpose of economic activity is the production of goods
and services to satisfy consumer’s needs and wants i.e. to meet people’s need for
consumption both as a means of survival but also to meet their ever-growing demand for
an improved lifestyle or standard of living.

The basic economic problem is about scarcity and choice since there are only a limited
amount of resources available to produce the unlimited amount of goods and services we
desire.

All societies face the problem of having to decide:

 What goods and services to produce: Does the economy uses its resources to
operate more hospitals or hotels? Do we make iPod Nanos or produce more
coffee? Does the National Health Service provide free IVF treatment for
thousands of childless couples? Or, do we choose instead to allocate millions of
pounds each year to providing beta-interferon to sufferers of multiple sclerosis?
 How best to produce goods and services: What is the best use of our scarce
resources of land labour and capital? Should school playing fields be sold off to
provide more land for affordable housing? Or are we contributing to the problem
of obesity by selling off these playing fields?
 Who is to receive goods and services: What is the best method of distributing
products to ensure the highest level of wants and needs are met? Who will get
expensive hospital treatment - and who not? Should there be a minimum wage? If
so, at what level should it be set?

58
1
Scarcity

Water, water everywhere

We use an average of 158 litres of water a day in Britain, for which we pay a price of 28p
per litre — but much of it is just cash down the drain, according to water companies.
Most are campaigning to cut the amount we use. And the front-line weapon in their
campaign is the water meter. They want us all to have one and one company is seeking
powers to make them compulsory. When a meter is installed, in most homes,
consumption drops by 20 per cent and, in some, it goes down by a third. According to
Ofwat, the water industry regulator, the average water and sewerage bill for homes with a
meter is £248 compared with £289 for those with flat-rate bills. At present only 25 per
cent of households have meters and most of those are in East Anglia. They are installed
free by water companies but households then have about £43 added to each bill to cover
the cost of installing and reading the meter. Unsurprisingly, we use more water in
summer. Peak demand on hot days can be 50 to 70 per cent above average. Most of this is
for lawns, flowers, paddling pools and extra showers and baths.
Source: Adapted from an article by Valerie Elliott, the Times, 9 July 2005

If something is scarce - it will have a market value.

If the supply of a good or service is low, the market price will rise, providing there is
sufficient demand from consumers. Goods and services that are in plentiful supply will
have a lower market value because supply can easily meet the demand from consumers.
Whenever there is excess supply in a market, we expect to see prices falling. For
example, the prices of new cars in the UK have been falling for several years and there
have been huge falls in the prices of clothing as supply from countries such as China and
Vietnam has surged.

Insatiable human wants and needs

The Swedish furniture giant IKEA sells to millions of consumers throughout the world

59
1
Human beings want better food; housing; transport, education and health services. They
demand the latest digital technology, more meals out at restaurants, more frequent
overseas travel, more leisure time, better cars, cheaper food and a wider range of
cosmetic health care treatments.

Opinion polls consistently show that the majority of the electorate expect government
policies to deliver improvements in the standard of education, the National Health
Service and our transport system. (Whether voters are really prepared to pay for these
services through higher taxes is of course another question!)

Economic resources are limited, but human needs and wants are infinite. Indeed the
development of society can be described as the uncovering of new wants and needs -
which producers attempt to supply by using the available factors of production. For a
perspective on the achievements of countries in meeting people’s basic needs, the
Human Development Index produced annually by the United Nations is worth reading.
Data for each country can be accessed and cross-country comparisons can be made.

Making choices

Because of scarcity, choices have to be made on a daily basis by all consumers, firms and
governments. For a moment, just have a think about the hundreds of millions of decisions
that are made by people in your own country every single day.

Take for example the choices that people make in the city of London about how to get to
work. Over six million people travel into London each day, they have to make choices
about when to travel, whether to use the bus, the tube, to walk or cycle – or indeed
whether to work from home. Millions of decisions are being taken, many of them are
habitual (we choose the same path each time) – but somehow on most days, people get to
work on time and they get home too! This is a remarkable achievement, and for it to
happen, our economy must provide the resources and the options for it to happen.

Trade-offs when making choices

Making a choice made normally involves a trade-off - in simple terms, choosing more of
one thing means giving up something else in exchange. Because wants are unlimited but
resources are finite, choice is an unavoidable issue in economics. For example:

1. Housing: Choices about whether to rent or buy a home – a huge decision to make
and one full of uncertainty given the recent volatility in the British housing
market! There are costs and benefits to renting a property or choosing to buy a
home with a mortgage. Both decisions involve a degree of risk.

2. Working: Choosing between full-time or part-time work, or to take a course in

higher education lasting three years – how have these choices and commitments
been affected by the introduction of university tuition fees?

60
1
 3. Transport and travel: The choice between using Euro-Tunnel, a speedy low-
cost ferry or an airline when travelling to Western Europe. Your choices about
which modes of transport to use to get to and from work or school each day.

Consumer welfare and rationality

What makes people happy? Why despite several decades of rising living standards do
surveys of happiness suggest that people are not noticeably happier than previous
generations? When we study the decisions of consumers in different markets, we can start
to consider and explore what their aims are. Our working assumption for the moment is
that consumers make choices about what to consume based on the aim of maximising
their own welfare. They have a limited income (i.e. a limited budget) and they seek to
allocate their funds in a way that improves their standard of living.

Of course in reality consumers rarely behave in a perfectly informed and rational way.
We will see later that often decisions by people are based on imperfect or incomplete
information which can lead to a loss of satisfaction and welfare not only for people
themselves but which affect other and our society as a whole. As consumers we have all
made poor choices about which products to buy. Do we always learn from our mistakes?
To what extent are our individual choices influenced and distorted by the effects of
persuasive advertising? Multinational companies have advertising and marketing
budgets that often run into hundreds of millions of pounds. We are all influenced by them
to a lesser or greater degree and there is always the risk that advertising can be
misleading.

Economic Systems

An economic system is best described as a network of organisations used by a society

to resolve the basic problem of what, how and for whom to produce.

There are four categories of economic system.

 Traditional economy: Where decisions about what, how and for whom to
produce are based on custom and tradition. Land is typically held in common ie
private property is not well defined.
 Free market economy: Where households own resources and free markets
allocate resources through the workings of the price mechanism. An increase in
demand raises price and encourages firms to switch additional resources into the
production of that good or service. The amount of products consumed by
households depends on their income and household income depends on the
market value of an individual’s work. In a free market economy there is a limited
role for the government. Indeed in a highly free market system, the government
limits itself to protecting the property rights of people and businesses using the
legal system, and it also seeks to protect the value of money or the value of a
currency.

61
1
  Planned or command economy: In a planned or command system typically
associated with a socialist or communist economic system, scarce resources are
owned by the state (i.e. the government). The state allocates resources, and sets
production targets and growth rates according to its own view of people's wants.
The final income and wealth distribution is decided by the state. In such a system,
market prices play little or no part in informing resource allocation decisions and
queuing rations scarce goods.
 Mixed economy: In a mixed economy, some resources are owned by the public
sector (government) and some resources are owned by the private sector. The
public sector typically supplies public, quasi-public and merit goods and
intervenes in markets to correct perceived market failure. We will come back to
all of these concepts later on in our study of microeconomics.

Opportunity Cost

There is a well known saying in economics that “there is no such thing as a free lunch!”
Even if we are not asked to pay a price for consuming a good or a service, scarce
resources are used up in the production of it and there must be an opportunity cost
involved.

Opportunity cost measures the cost of any choice in terms of the next best alternative
foregone. Many examples exist for individuals, firms and the government.
Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a
week is the lost wages foregone. If you are being paid £6 per hour to work at the local
supermarket, if you choose to take a day off from work you might lose £48 from having
sacrificed eight hours of paid work.
Government spending priorities: The opportunity cost of the government spending
nearly £10 billion on investment in National Health Service might be that £10 billion less
is available for spending on education or the transport network.
Investing today for consumption tomorrow: The opportunity cost of an economy
investing resources in new capital goods is the current production of consumer goods
given up. We may have to accept lower living standards now, to accumulate increased
capital equipment so that long run living standards can improve.
Making use of scarce farming land: The opportunity cost of using arable farmland to
produce wheat is that the land cannot be used in that production period to harvest
potatoes.

Sectors of production in the economy

 Primary sector: This involves extraction of natural resources e.g. agriculture,

forestry, fishing, quarrying, and mining

 Secondary sector: This involves the production of goods in the economy, i.e.
transforming materials produced by the primary sector e.g. manufacturing and the
construction industry

62
1
  Tertiary sector: the tertiary sector provided services such as banking, finance,
insurance, retail, education and travel and tourism
 Quaternary sector: The quaternary sector is involved with information
processing e.g. education, research and development

Manufacturing industry in the United Kingdom only accounts for 18 per cent of national
output. The bulk of our income and employment comes from the service sector.

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Specialisation & Trade

One feature of nearly every aspect of economic life is that individuals, businesses and
countries engage in specialization.

Specialization is when we concentrate on a particular product or task. Surplus products

can then be exchanged and traded with the potential for gains in welfare for all parties.

The potential benefits from specialisation

By concentrating on what people and businesses do best rather than relying on self
sufficiency:
Higher output: Total output of goods and services is raised and quality can be improved.

63
1
A higher output at lower costs means more wants and needs might be satisfied with a
given amount of scarce resources.
Variety; Consumers have improved access to a greater variety of higher quality products
i.e. they have more and better choice both from their own economy and from the
production of other countries
A bigger market: specialisation and international trade increase the size of the market
offering opportunities for economies of scale (a fall in long run costs per unit of output)
Competition and lower prices: Increased competition for domestic producers acts as an
incentive to minimise costs and innovate to remain competitive. Competition helps to
keep prices down and maintains low inflation

The division of labour

Specialisation occurs in nearly every business – from manufacturing to restaurants

The division of labour is a particular type of specialisation where the production of a

good is broken up into many separate tasks each performed by one person or by a small
group of people. The division of labour raises output per person, thereby reducing costs
per unit because lower skilled workers are easily trained and quickly become proficient
through constant repetition of a task – ‘practice makes perfect’ – or “learning by doing”.
Low unit costs allow firms to remain competitive in the markets in which they operate.
Traditionally the division of labour and high level of specialisation in manufacturing
industries is associated with the concept of scientific management or Taylorism.

Limitations of division of labour

There are limits and downsides to the breaking down of production into many small
tasks. Perhaps the greatest downside is that the division of labour may eventually reduce
efficiency and increase unit costs because unrewarding, repetitive work lowers worker

64
1
motivation and productivity. Workers begin to take less pride in their work and quality
suffers, the result may be a problem of diseconomies of scale.

The division of labour also runs the risk that if one machine breaks down then the entire
factory stops. Some workers receive a narrow training and may not be able to find
alternative jobs if they find themselves out of work (they may suffer structural
unemployment). Another disadvantage is that mass-produced standardized goods tend to
lack variety.

The concept of comparative advantage

First introduced by David Ricardo in 1817, comparative advantage exists when a

country has a ‘margin of superiority’ in the production of a good or service i.e. where
the marginal cost of production is lower.

Countries will usually specialise in and then export products, which use intensively the
factors inputs, which they are most abundantly endowed. If each country specializes in
those goods and services where they have an advantage, then total output can be
increased leading to an improvement in allocative efficiency and economic welfare. Put
another way, trade allows each country to specialise in the production of those products
that it can produce most efficiently (i.e. those where it has a comparative advantage).

This is true even if one nation has an absolute advantage over another country. So for
example the Canadian economy which is rich in low cost land is able to exploit this by
specializing in agricultural production. The dynamic Asian economies including China
have focused their resources in exporting low-cost manufactured goods which take
advantage of much lower unit labour costs.

In highly developed countries, the comparative advantage is shifting towards specializing

in producing and exporting high-value and high-technology manufactured goods and
high-knowledge services.

Production advantage, the PPF and specialisation

Two countries are producing two products (X and Y). With a given amount of resources,

Output of X Output of Y

Country A 180 90

Country B 200 150

65
1
In this example, country B has an absolute advantage in both products. Absolute
advantage occurs when a country or region can create more of a product with the same
factor inputs.

But although country A has an absolute disadvantage, in fact it has a comparative

advantage in the production of good X. It is 9/10ths as efficient at producing good X but
it is only 3/5ths as efficient at producing good Y.

Comparative advantage exists when a country has lower opportunity cost, ie, it gives up
less of one product to obtain more of another product. Economists argue countries benefit
if they specialise in a product in which they have a comparative advantage and trade.
In our example above, for country A, every extra unit of good Y produced involves an
opportunity cost of 2 unit of good X. Whereas for country B, an additional unit of good Y
involves a sacrifice of only 4.3 units of good X.

There are gains to be had from country A specializing in the supply of good X and
country B allocating more of their resources into the production of good Y.

Another worked example of comparative advantage

In this second example, we will work through an example of comparative advantage and
also show some of the possible benefits that might flow from specialisation and trade
between two countries.
Consider two countries producing two products – digital cameras and vacuum cleaners.

66
1
With the same factor resources evenly allocated by each country to the production of both
goods, the production possibilities are as shown in the table below.

Pre-specialisation Digital Cameras Vacuum Cleaners

UK 600 600

United States 2400 1000

Total 3000 1600

Working out the comparative advantage

To identify which country should specialise in a particular product we need to analyse the
internal opportunity costs for each country. For example, were the UK to shift more
resources into higher output of vacuum cleaners, the opportunity cost of each vacuum
cleaner is one digital television. For the United States the same decision has an
opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage
in vacuum cleaners.
If the UK chose to reallocate resources to digital cameras the opportunity cost of one
extra camera is still one vacuum cleaner. But for the United States the opportunity cost is
only 5/12ths of a vacuum cleaner. Thus the United States has a comparative advantage in
producing digital cameras because its opportunity cost is lowest.

Output after Specialization

Digital Cameras Vacuum Cleaners

UK 0 (-600) 1200 (+600)

United States 3360 (+960) 600 (-400)

Total 3000 1600

3360 1800
o The UK specializes totally in producing vacuum cleaners – doubling its output to
1200
o The United States partly specializes in digital cameras increasing output by 960
having given up 400 units of vacuum cleaners
o As a result of specialisation according to the principle of comparative advantage,
output of both products has increased - representing a gain in economic welfare.

67
1
For mutually beneficial trade to take place, the two nations have to agree an acceptable
rate of exchange of one product for another.
There are gains from trade between the two countries. If the two countries trade at a rate
of exchange of 2 digital cameras for one vacuum cleaner, the post-trade position will be
as follows:

o The UK exports 420 vacuum cleaners to the USA and receives 840 digital
cameras
o The USA exports 840 digital cameras and imports 420 vacuum cleaners

Post trade output / consumption

Digital Cameras Vacuum Cleaners

UK 840 780

United States 2520 1020

Total 3360 1800

Compared with the pre-specialisation output levels, consumers in both countries now
have an increased supply of both goods to choose from.

We have seen in this chapter how specialisation and trade based on the idea of
comparative advantage can lead to an improvement in economic welfare.

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Theory of Demand

We now consider the basic theories of how the market mechanism works. In this chapter
we consider the economics of the law of demand. This is important background to
understanding the determination of prices in competitive markets.

Demand

Demand is defined as the quantity of a good or service that consumers are willing and
able to buy at a given price in a given time period. Each of us has an individual

68
1
demand for particular goods and services and the level of demand at each market price
reflects the value that consumers place on a product and their expected satisfaction
gained from purchase and consumption.

Market demand

Market demand is the sum of the individual demand for a product from each
consumer in the market. If more people enter the market and they have the ability to
pay for items on sale, then demand at each price level will rise.

Effective demand and willingness to pay

Demand in economics must be effective which means that only when a consumers' desire
to buy a product is backed up by an ability to pay for it does demand actually have an
effect on the market. Consumers must have sufficient purchasing power to have any
effect on the allocation of scarce resources. For example, what price are you willing to
pay to view a world championship boxing event and how much are you prepared to spend
to watch Premiership soccer on a pay-per-view basis? Would you be willing and able to
pay to watch Elton John perform live through a subscription channel?

Auctions of film posters

Classic film posters are fetching thousands of pounds as more and more private collectors
vie for a piece of cinema history. The prices that collectors are prepared to pay for film
posters continues to rise, some of the buyers are hoping for a financial return whereas
others are just willing and able to pay for the satisfaction that comes from owning a small
slice of cinema memorabilia.

Rockonomics – rising ticket prices for pop concerts

Tickets for the most popular rock and pop concerts keep getting more expensive but
consumers seem happy and able to pay for them judging from the number of sell-out gigs
in London this spring. The price of a seat for to see Madonna's "Confessions on a
Dancefloor" tour ranges from £80 to £160, with an additional £13 booking fee. A ticket
to see Red Hot Chili Peppers will set you back £40 and the chance to see Bruce
Springsteen at the Hammersmith Apollo is priced at just under £50 for a standard ticket.
Ticket prices have been rising much faster than the overall rate of inflation which has led
to a large rise in the real price of seeing your favourite pop star on stage.

Latent Demand

Latent demand is probably best described as the potential demand for a product. It exists
when there is willingness to buy among people for a good or service, but where
consumers lack the purchasing power to be able to afford the product. Latent demand is
affected by advertising – where the producer is seeking to influence consumer tastes and
preferences.

69
1
The concept of derived demand

The demand for a product X might be strongly linked to the demand for a related product
Y – giving rise to the idea of a derived demand.

For example, the demand for steel is strongly linked to the demand for new vehicles and
other manufactured products, so that when an economy goes into a downturn or
recession, so we would expect the demand for steel to decline likewise. The major
producer of steel in the UK is Corus. They produce for a wide range of different
industries; from agriculture, aerospace and construction industries to consumer goods
producers, packing and the transport sector. Steel is a cyclical industry which means that
the total market demand for steel is affected by changes in the economic cycle and also
by fluctuations in the exchange rate.

The demand for new bricks is derived from the demand for the final output of the
construction industry- when there is a boom in the building industry, so the market
demand for bricks will increase

The Law of Demand

Other factors remaining constant (ceteris paribus) there is an inverse relationship

between the price of a good and demand.

 As prices fall, we see an expansion of demand

 If price rises, there will be a contraction of demand.

The ceteris paribus assumption

Understanding ceteris paribus is the key to understanding much of microeconomics.

Many factors can be said to affect demand. Economists assume all factors are held

70
1
constant (ie do not change) except one – the price of the product itself. A change in a
factor being held constant invalidates the ceteris paribus assumption

The Demand Curve

A demand curve shows the relationship between the price of an item and the quantity
demanded over a period of time. There are two reasons why more is demanded as price
falls:

 The Income Effect: There is an income effect when the price of a good falls
because 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 by consumers to buy more of this product.
 The Substitution Effect: There is also a substitution effect when the price of a
good falls because the product is now relatively cheaper than an alternative item
and so some consumers switch their spending from the good in competitive
demand to this product.

The demand curve is normally drawn in textbooks as a straight line suggesting a linear
relationship between price and demand but in reality, the demand curve will be non-
linear! No business has a perfect idea of what the demand curve for a particular product

71
1
looks like, they use real-time evidence from markets to estimate the demand conditions
and they accumulated experience of market conditions gives them an advantage in
constructing demand-price relationships.

A change in the price of a good or service causes a movement along the demand curve.
A fall in the price of a good causes an expansion of demand; a rise in price causes a
contraction of demand. Many other factors can affect total demand - when these change,
the demand curve can shift. This is explained below.

Shifts in the Demand Curve Caused by Changes in the Conditions of Demand

There are two possibilities: either the demand curve shifts to the right or it shifts to the
left.
In the diagram below we see two shifts in the demand curve:

 D1 – D3 would be an example of an outward shift of the demand curve (or an

increase in demand). When this happens, more is demanded at each price.
 A movement from D1 – D2 would be termed an inward shift of the demand curve
(or decrease in demand). When this happens, less is demanded at each price.

The conditions of demand

72
1
The conditions of demand for a product in a market can be summarised as follows:

D = f (Pn, Pn…Pn-1, Y, T, P, E)

Where:
Pn = Price of the good itself
Pn…Pn-1 = Prices of other goods – e.g. prices of Substitutes and Complements
Y = Consumer incomes – including both the level and distribution of income
T = Tastes and preferences of consumers
P = The level and age-structure of the population
E = Price expectations of consumers for future time periods

Changing prices of a substitute good

Substitutes are goods in competitive demand and act as replacements for another
product.

For example, a rise in the price of Esso petrol should cause a substitution effect away
from Esso towards competing brands. A fall in the monthly rental charges of cable
companies or Vodafone mobile phones might cause a decrease in the demand for British
Telecom services. Consumers will tend over time to switch to the cheaper brand or
service provider. When it is easy and cheap to switch, then consumer demand will be
sensitive to price changes.

Much depends on whether consumers have sufficient information about prices for
different goods and services. One might expect that a fall in the charges from one car
rental firm such as Budget might affect the demand for car rentals from Avis Hertz or
Easycar. But searching for price information to get the best deal in the market can be time
consuming and always involves an opportunity cost. The development of the internet has
helped to increase price transparency thereby making it easier for consumers to
compare relative prices in markets.

Changing price of a complement

Two complements are said to be in joint demand. Examples include: fish and chips,
DVD players and DVDs, iron ore and steel.
A rise in the price of a complement to Good X should cause a fall in demand for X. For
example an increase in the cost of flights from London Heathrow to New York would
cause a decrease in the demand for hotel rooms in New York and also a fall in the
demand for taxi services both in London and New York.
A fall in the price of a complement to Good Y should cause an increase in demand for
Good Y. For example a reduction in the market price of computers should lead to an
increase in the demand for printers, scanners and software applications.

Change in the income of consumers

73
1
Most of the things we buy are normal goods. When an individual’s income goes up, their
ability to purchase goods and services increases, and this causes an outward shift in the
demand curve. When incomes fall there will be a decrease in the demand for most
goods.

Change in tastes and preferences

Changing tastes and preferences can have a huge effect on demand. Persuasive
advertising is designed to cause a change in tastes and preferences and thereby create an
outward shift in demand. A good example of this is the recent surge in sales of smoothies
and other fruit juice drinks.

The market for health fruit and vegetable drinks has grown rapidly in recent years
following a change in consumer preferences. How much are we influenced by the effects
of advertising?

The market demand for smoothies

The UK’s growing thirst for healthy eating and fears about the longer term health effects
of the consumption of fast food has meant that the demand for smoothies and other fresh
fruit drinks has expanded rapidly in recent years. Innocent, the leading brand in
supermarkets, estimates that the market could be worth £170m in 2007. More and more
retail outlets such as Crussh are appearing on the high streets, and demand is rising in
school canteens and workplaces. Innocent has seen its turnover expand to £37m in the
past six years and has over 50 per cent of the UK market. It sells 1m smoothies a week,
compared with 20 on its first day of operation in 1999. Some stockmarket experts are
forecasting that a fruit juice manufacturer could eventually enter the FTSE-100 list of top
stockmarket businesses.
Source: Adapted from news reports, June 2006 and the Innocent web site

74
1
Discretionary income

Discretionary income is disposable income less essential payments like electricity & gas
and, especially, mortgage repayments. An increase in interest rates often means an
increase in monthly mortgage payments reducing demand. And during 2005 and 2006 we
have seen a sharp rise in the cost of utility bills with a series of hikes in the prices of gas
and electricity. This has eaten into the discretionary incomes of millions of households
across the UK. The discretionary incomes of people suffering from fuel poverty have
become a major current issue.

Interest rates and demand

Many products are bought on credit using borrowed money, thus the demand for them
may be sensitive to the rate of interest charged by the lender. Therefore if the Bank of
England decides to raise interest rates – the demand for many goods and services may
fall. Examples of “interest sensitive” products include household appliances, electronic
goods, new furniture and motor vehicles. The demand for housing is affected by changes
in mortgage interest rates.

Exceptions to the law of demand

Does the demand for a product always vary inversely with the price? There are two
possible reasons why more might be demanded even when the price of a good or service
is increasing. We consider these briefly – ostentatious consumption and the effects of
speculative demand.

(a) Ostentatious consumption

Some goods are luxurious items where satisfaction comes from knowing both the price
of the good and being able to flaunt consumption of it to other people! The demand for
the product is a direct function of its price.

A higher price may also be regarded as a reflection of product quality and some
consumers are prepared to pay this for the “snob value effect”.

Examples might include perfumes, designer clothes, and top of the range cars. Consider
the case of VI which is considered to be the most exclusive perfume in the world. Only
475 bottles have been produced and bottles have been selling for £47,500 each – a classic
case of paying through the nose for an exclusive good.

Goods of ostentatious consumption are known as Veblen Goods and they have a high-
income elasticity of demand. That is, demand rises more than proportionately to an
increase in income.

(b) Speculative Demand

75
1
The demand for a product can also be affected by speculative demand. Here, potential
buyers are interested not just in the satisfaction they may get from consuming the
product, but also the potential rise in market price leading to a capital gain or profit.
When prices are rising, speculative demand may grow, adding to the upward pressure on
prices. The speculative demand for housing and for shares might come into this category
and we have also seen, in the last few years, strong speculative demand for many of the
world’s essential commodities.

Speculation drives the prices of commodities to fresh highs

World commodity prices have reached new highs this year helped by an increase in the
rate of economic growth in the global economy. Among the metals that have achieved
record price levels are copper, zinc, gold and platinum; prompting sceptics to question
how much longer prices can continue rising. Many market experts believe that the
demand for commodities has been spurred by heavy speculator activity. For example,
pension funds and hedge funds have been investing in commodity mutual funds over
recent years leading to increased demand for precious metals. Prices have risen quickly
because commodity producers are unable to raise output sufficiently to meet
unexpectedly strong demand.
Source: Adapted from news reports, July 2006

The non-linear demand curve and the idea of price points

So far in our introductory theory of demand, we have drawn the demand curve for a
product to be linear (a straight line). In many real world markets this assumption of a
linear relationship between price and quantity demanded is not realistic. Many price-
demand relationships are non-linear and an example of this is provided in the chart
above, used to illustrate the idea of price-points.

Price points are points on the demand curve where demand is relatively high, but where a
small change in price may cause a sizeable contraction in demand leading to a loss of
total revenue for the producer.

Price points can be justified in a number of ways:

 A price rise at the price point may make the product more expensive than a close
substitute causing consumers to change their preferences
 Customers may have become used to paying a certain price for a type of product
and if they see a further price rise, this may cause them to revalue how much
satisfaction they get from buying and consuming something, leading to a decline
in demand
 There may be psychological effects at work, supermarkets for example know the
importance of avoiding price points - £2.99 somehow seems cheaper than £3.00
despite the tiny price difference

76
1
For AS level economics, you will be expected to draw and use linear demand curves in
your basic analysis. But it is important to realise that in the real world of business, price-
demand relationships can be complex and often a business does not have enough
information about the behaviour of consumers for them to actually construct an accurate
demand curve. As with many aspects of economic theory, we are constructing curves to
illustrate economic relationships. They are simplifications of reality.

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Market Equilibrium Price

In this note we bring the forces of supply and demand together to consider the
determination of equilibrium prices.

The Concept of Market Equilibrium

77
1
Equilibrium means a state of equality or a state of balance between market demand
and supply. Without a shift in demand and/or supply there will be no change in market
price. In the diagram above, the quantity demanded and supplied at price P1 are equal. At
any price above P1, supply exceeds demand and at a price below P1, demand exceeds
supply. In other words, prices where demand and supply are out of balance are termed
points of disequilibrium.

Changes in the conditions of demand or supply will shift the demand or supply curves.
This will cause changes in the equilibrium price and quantity in the market.

Demand and supply schedules can be represented in a table. The example below provides
an illustration of the concept of equilibrium. The weekly demand and supply schedules
for T-shirts (in thousands) in a city are shown in the next table:

Price per unit (£) 8 7 6 5 4 3 2 1

78
1
Demand (000s) 6 8 10 12 14 16 18 20

Supply (000s) 18 16 14 12 10 8 6 4

New Demand 10 12 14 16 18 20 22 24
(000s)

New Supply (000s)26 24 22 20 18 16 14 12

1. The equilibrium price is £5 where demand and supply are equal at 12,000 units
2. If the current market price was £3 – there would be excess demand for 8,000 units
3. If the current market price was £8 – there would be excess supply of 12,000 units
4. A change in fashion causes the demand for T-shirts to rise by 4,000 at each price.
The next row of the table shows the higher level of demand. Assuming that the
supply schedule remains unchanged, the new equilibrium price is £6 per tee shirt
with an equilibrium quantity of 14,000 units
5. The entry of new producers into the market causes a rise in supply of 8,000 T-
shirts at each price. The new equilibrium price becomes £4 with 18,000 units
bought and sold

Changes in Market Demand and Equilibrium Price

The demand curve may shift to the right (increase) for several reasons:

79
1
 1. A rise in the price of a substitute or a fall in the price of a complement
2. An increase in consumers’ income or their wealth
3. Changing consumer tastes and preferences in favour of the product
4. A fall in interest rates (i.e. borrowing rates on bank loans or mortgage interest
rates)
5. A general rise in consumer confidence and optimism

The outward shift in the demand curve causes a movement (expansion) along the supply
curve and a rise in the equilibrium price and quantity. Firms in the market will sell more
at a higher price and therefore receive more in total revenue.

The reverse effects will occur when there is an inward shift of demand. A shift in the
demand curve does not cause a shift in the supply curve! Demand and supply factors are
assumed to be independent of each other although some economists claim this
assumption is no longer valid!

Changes in Market Supply and Equilibrium Price

The supply curve may shift outwards if there is

1. A fall in the costs of production (e.g. a fall in labour or raw material costs)
2. A government subsidy to producers that reduces their costs for each unit supplied
3. Favourable climatic conditions causing higher than expected yields for
agricultural commodities

80
1
 4. A fall in the price of a substitute in production
5. An improvement in production technology leading to higher productivity and
efficiency in the production process and lower costs for businesses
6. The entry of new suppliers (firms) into the market which leads to an increase in
total market supply available to consumers

The outward shift of the supply curve increases the supply available in the market at each
price and with a given demand curve, there is a fall in the market equilibrium price from
P1 to P3 and a rise in the quantity of output bought and sold from Q1 to Q3. The shift in
supply causes an expansion along the demand curve.

Important note for the exams:

A shift in the supply curve does not cause a shift in the demand curve. Instead we move
along (up or down) the demand curve to the new equilibrium position.

A fall in supply might also be caused by the exit of firms from an industry perhaps
because they are not making a sufficiently high rate of return by operating in a particular
market.

The equilibrium price and quantity in a market will change when there shifts in both
market supply and demand. Two examples of this are shown in the next diagram:

81
1
In the left-hand diagram above, we see an inward shift of supply (caused perhaps by
rising costs or a decision by producers to cut back on output at each price level) together
with a fall (inward shift) in demand (perhaps the result of a decline in consumer
confidence and incomes). Both factors lead to a fall in quantity traded, but the rise in
costs forces up the market price.

The second example on the right shows a rise in demand from D1 to D3 but a much
bigger increase in supply from S1 to S2. The net result is a fall in equilibrium price (from
P1 to P3) and an increase in the equilibrium quantity traded in the market.

Moving from one market equilibrium to another

Changes in equilibrium prices and quantities do not happen instantaneously! The shifts
in supply and demand outlined in the diagrams in previous pages are reflective of
changes in conditions in the market. So an outward shift of demand (depending upon
supply conditions) leads to a short term rise in price and a fall in available stocks. The
higher price then acts as an incentive for suppliers to raise their output (termed as an
expansion of supply) causing a movement up the short term supply curve towards the
new equilibrium point.

We tend to use these diagrams to illustrate movements in market prices and quantities –
this is known as comparative static analysis. The reality in most markets and industries
is much more complex. For a start, many firms have imperfect knowledge about their

82
1
demand curves – they do not know precisely how demand reacts to changes in price or
the true level of demand at each and every price level. Likewise, constructing accurate
supply curves requires detailed information on production costs and these may not be
available.

The importance of price elasticity of demand

The price elasticity of demand will influence the effects of shifts in supply on the
equilibrium price and quantity in a market. This is illustrated in the next two diagrams. In
the left hand diagram below we have drawn a highly elastic demand curve. We see an
outward shift of supply – which leads to a large rise in equilibrium price and quantity and
only a relatively small change in the market price. In the right hand diagram, a similar
increase in supply is drawn together with an inelastic demand curve. Here the effect is
more on the price. There is a sharp fall in the price and only a relatively small expansion
in the equilibrium quantity.

Author: Geoff Riley, Eton College, September 2006

83
1
AS Markets & Market Systems
Price Elasticity of Supply

In this chapter we consider elasticity of supply. Students should understand how to

calculate elasticity of supply and understand some of the factors that influence the
elasticity of supply for different products.

Definition of price elasticity of supply

Price elasticity of supply measures the relationship between change in quantity supplied
and a change in price.
If supply is elastic, producers can increase output without a rise in cost or a time delay
If supply is inelastic, firms find it hard to change production in a given time period.

The formula for price elasticity of supply is:

Percentage change in quantity supplied divided by the percentage change in price

 When Pes > 1, then supply is price elastic

 When Pes < 1, then supply is price inelastic
 When Pes = 0, supply is perfectly inelastic
 When Pes = infinity, supply is perfectly elastic following a change in demand

Factors that Affect Price Elasticity of Supply

(1) Spare production capacity

If there is plenty of spare capacity then a business should be able to increase its output
without a rise in costs and therefore supply will be elastic in response to a change in
demand. The supply of goods and services is often most elastic in a recession, when there
is plenty of spare labour and capital resources available to step up output as the economy
recovers.

(2) Stocks of finished products and components

If stocks of raw materials and finished products are at a high level then a firm is able to
respond to a change in demand quickly by supplying these stocks onto the market -
supply will be elastic. Conversely when stocks are low, dwindling supplies force prices
higher and unless stocks can be replenished, supply will be inelastic in response to a
change in demand.

(3) The ease and cost of factor substitution

84
1
If both capital and labour resources are occupationally mobile then the elasticity of
supply for a product is higher than if capital and labour cannot easily and quickly be
switched

(4) Time period involved in the production process

Supply is more price elastic the longer the time period that a firm is allowed to adjust its
production levels. In some agricultural markets for example, the momentary supply is
fixed and is determined mainly by planting decisions made months before, and also
climatic conditions, which affect the overall production yield.

An empty restaurant – plenty of spare When telecommunications networks get

capacity to meet any rise in demand! congested at peak times, the elasticity of
supply to meet rising demand may be low

Stocks in a warehouse – businesses with For many agricultural products there are
plentiful stocks can supply quickly and easily time lags in the production process which
onto the market when demand changes means that elasticity of supply is very low
in the immediate or momentary time period

85
1
Supply curves with different price elasticity of supply

86
1
The non-linear supply curve

A non linear supply curve has a changing price elasticity of supply throughout its length.
This is illustrated in the diagram below.

Useful applications of price elasticity of demand and supply

Elasticity of demand and supply is tested in virtually every area of the AS economics
syllabus. The key is to understand the various factors that determine the responsiveness
of consumers and producers to changes in price. The elasticity will affect the ways in
which price and output will change in a market. And elasticity is also significant in

87
1
determining some of the effects of changes in government policy when the state chooses
to intervene in the price mechanism.

Some relevant issues that directly use elasticity of demand and supply include:

 Taxation: The effects of indirect taxes and subsidies on the level of demand and
output in a market e.g. the effectiveness of the congestion charge in reducing road
congestion; or the impact of higher duties on cigarettes on the demand for tobacco
and associated externality effects
 Changes in the exchange rate: The impact of changes in the exchange rate on
the demand for exports and imports
 Exploiting monopoly power in a market: The extent to which a firm or firms
with monopoly power can raise prices in markets to extract consumer surplus and
turn it into extra profit (producer surplus)
 Government intervention in the market: The effects of the government
introducing a minimum price (price floor) or maximum price (price ceiling) into a
market

Elasticity of demand and supply also affects the operation of the price mechanism as a
means of rationing scarce goods and services among competing uses and in
determining how producers respond to the incentive of a higher market price.

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Cross Price Elasticity of Demand

Very often, a change in the price of one product leads to a change in the demand for
another, economists call this the cross-price effect and this is the focus of this chapter.

Cross price elasticity (CPed) measures the responsiveness of demand for good X
following a change in the price of good Y (a related good). We are mainly concerned
here with the effect that changes in relative prices within a market have on the pattern
of demand.

With cross price elasticity we make an important distinction between substitute

products and complementary goods and services

Substitutes: With substitute goods such as brands of cereal or washing powder, an

increase in the price of one good will lead to an increase in demand for the rival product.
Cross price elasticity for two substitutes will be positive. For example, in recent years,
the prices of new cars have been either falling or relatively flat. Data on price indices for

88
1
new cars and second hand cars is shown in the chart below. As the price of new cars
relative to people’s incomes has declined, this should increase the market demand for
new cars and (ceteris paribus) reduce the demand for second hand cars. We can see that
there has been a very marked fall in the prices of second hand cars.

Complements: With goods that are in complementary demand, such as the demand for
DVD players and DVD videos, when there is a fall in the price of DVD players we
expect to see more DVD players bought, leading to an expansion in market demand for
DVD videos. The cross price elasticity of demand for two complements is negative

The stronger the relationship between two products, the higher is the co-efficient of
cross-price elasticity of demand. For example with two close substitutes, the cross-price
elasticity will be strongly positive. Likewise when there is a strong complementary
relationship between two products, the cross-price elasticity will be highly negative.
Unrelated products have a zero cross elasticity.

Complementary goods - the UK IT market

The value of the UK IT market was estimated to be worth £3.9 billion in the first six
months of 2006. It provides a good example of complementary products since a rise in
the demand for one product such as a new personal computer will frequently be
associated with an increase in demand for related goods and services. The IT market is
usually split into seven sectors and their estimated value measured by the level of total
sales revenue in the first half of 2006 is shown below

89
1
Personal Computers (desktops and laptops) (£1,443m)
Printing devices (£303m)
Monitors (£343m)
Consumables such as ink cartridges (£813m)
Hard disk drives (£130m)
Communication devices (£122m)
Computer software (£239m)

Source: GFK report on Consumer Spending Trends, July 2006

How can businesses make use of the concept of cross price elasticity of demand?

Pricing strategies for substitutes: If a competitor cuts the price of a rival product, firms
use estimates of cross-price elasticity to predict the effect on the quantity demanded and
total revenue of their own product. For example, two or more airlines competing with
each other on a given route will have to consider how one airline might react to its
competitor’s price change. Will many consumers switch? Will they have the capacity to
meet an expected rise in demand? Will the other firm match a price rise? Will it follow a
price fall?

Consider for example the cross-price effect that has occurred with the rapid expansion of
low-cost airlines in the European airline industry. This has been a major challenge to the
existing and well-established national air carriers, many of whom have made adjustments
to their business model and pricing strategies to cope with the increased competition.

Pricing strategies for complementary goods: For example, popcorn, soft drinks and
cinema tickets have a high negative value for cross elasticity– they are strong
complements. Popcorn has a high mark up i.e. pop corn costs pennies to make but sells
for more than a pound. If firms have a reliable estimate for Cped they can estimate the
effect, say, of a two-for-one cinema ticket offer on the demand for popcorn. The
additional profit from extra popcorn sales may more than compensate for the lower cost
of entry into the cinema.

Advertising and marketing: In highly competitive markets where brand names carry
substantial value, many businesses spend huge amounts of money every year on
persuasive advertising and marketing. There are many aims behind this, including
attempting to shift out the demand curve for a product (or product range) and also build
consumer loyalty to a brand. When consumers become habitual purchasers of a product,
the cross price elasticity of demand against rival products will decrease. This reduces the
size of the substitution effect following a price change and makes demand less sensitive
to price. The result is that firms may be able to charge a higher price, increase their total
revenue and turn consumer surplus into higher profit.

90
1
 Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Price Volatility in Markets

We often find that prices in markets rise and fall by large amounts over a short time
period. They display a high level of volatility which directly affects both consumers and
producers. In this chapter we look at some of the reasons for fluctuating prices and
consider some real-world examples.

Price stability

Not all markets experience volatile prices. They tend to be markets with products where
the conditions of supply and demand are relatively stable from year to year and where the
91
1
elasticity of demand and the elasticity of supply are both high. We can see this in the
diagram below.

92
1
 The price of milk is pretty stable over time. Partly this is due to intense competition
between the leading supermarkets but the conditions of market demand and supply are
also relatively stable and predictable.

Price volatility

Products with unstable conditions of supply and demand will experience price
fluctuations from year to year. For example, for many products there are large seasonal
variations in market demand which cause prices to rise sharply at peak times and then fall
back during the off-peak periods. Seasonal demand is particularly strong in the tourism
and leisure industries. The cost of hotel rooms and the prices of package holidays are
always higher during the school holidays because hoteliers and travel businesses know
that, at times of peak demand, the demand for holidays is price inelastic and that families
will have to pay higher prices because they are limited to when they can take their
holidays.

Agricultural prices and prices of other traded commodities

Agricultural prices tend to be volatile (unstable) because:

Supply changes from one time period to the next because of variable weather conditions
which affect the size of the harvest

93
1
 o When actual output falls short of planned output, for a given level of
demand, price will rise
o When actual output is in excess of planned output, for a given level of
demand, market price will fall

The effects of changes in supply can be amplified by a price-inelastic demand, for

example in markets for raw materials and components where the buyer regards them as
essential to their production processes, they must buy at whatever the prevailing market
price is.

Price volatility can be magnified because of the activity of speculators in markets who
are betting on future price changes. We have noticed this in many of the world’s
commodity markets during the recent boom in international commodity prices. Hedge
funds and pension funds together with other speculators have been buying into “hard
commodities” such as copper, nickel, tin and also “softs” such as rubber and coffee
because they expect market prices to remain high. Their demand has the effect of driving
prices higher at times when stocks of these commodities are low.

94
1
Example of price volatility – the market for nickel

In July 2006 nickel prices climbed to a record high capping a near 50 per cent rise in less
than a month and a 90 per cent rise within the space of nine months!. The price increases
were down to two fundamental market forces - demand is strong but stocks or inventories
of the metal are low. If there isn’t enough nickel in the market, the price can only head in
one direction!

By the middle of July, stockpiles of Nickel held at London Metal Exchange registered
warehouses were the equivalent to just two days’ worth of demand. Only about 1.3
million tonnes of Nickel is produced each year. But industrial demand from countries
such as China has been rising strongly, especially because many industrial users are
demanding nickel for stainless steel production having switched from alternative metals

95
1
such as manganese. China has been responsible for nearly half the increase in global
demand for nickel this year.

96
1
 97
1
 Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Consumer Surplus

In this note we look at the importance of willingness to pay for different goods and
services. When there is a difference between the price that you actually pay in the market
and the price or value that you place on the product, then the concept of consumer
surplus becomes a useful one to look at.

Defining consumer surplus

Consumer surplus is a measure of the welfare that people gain from the consumption of
goods and services, or a measure of the benefits they derive from the exchange of goods.

98
1
Consumer surplus is the difference between the total amount that consumers are willing
and able to pay for a good or service (indicated by the demand curve) and the total
amount that they actually do pay (i.e. the market price for the product). The level of
consumer surplus is shown by the area under the demand curve and above the ruling
market price as illustrated in the diagram below:

Consumer surplus and price elasticity of demand

When the demand for a good or service is perfectly elastic, consumer surplus is zero
because the price that people pay matches precisely the price they are willing to pay. This
is most likely to happen in highly competitive markets where each individual firm is
assumed to be a ‘price taker’ in their chosen market and must sell as much as it can at
the ruling market price.

In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand is

totally invariant to a price change. Whatever the price, the quantity demanded remains
the same. Are there any examples of products that have such a low price elasticity of
demand?

99
1
The majority of demand curves are downward sloping. When demand is inelastic, there is
a greater potential consumer surplus because there are some buyers willing to pay a high

price to continue consuming the product. This is shown in the diagram below:

Changes in demand and consumer surplus

100
1
When there is a shift in the demand curve leading to a change in the equilibrium market
price and quantity, then the level of consumer surplus will alter. This is shown in the
diagrams above. In the left hand diagram, following an increase in demand from D1 to
D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands.
There is a higher level of consumer surplus because more is being bought at a higher

price than before.

In the diagram on the right we see the effects of a cost reducing innovation which
causes an outward shift of market supply, a lower price and an increase in the quantity
traded in the market. As a result, there is an increase in consumer welfare shown by a rise
in consumer surplus.
Consumer surplus can be used frequently when analysing the impact of government
intervention in any market – for example the effects of indirect taxation on cigarettes
consumers or the introducing of road pricing schemes such as the London congestion
charge.

Applications of consumer surplus

Paying for the right to drive into the centre of London

101
1
 In July 2005, the congestion charge was raised to £8 per day. How has the London
congestion charge affected the consumer surplus of drivers?

Transport for London has details on the impact of the congestion charge

Consider the entry of Internet retailers such as Last Minute and Amazon into the markets
for travel and books respectively. What impact has their entry into the market had on
consumer surplus? Have you benefited from you perceive to be lower prices and better
deals as a result of using e-commerce sites offering large discounts compared to high
street retailers?

Price discrimination and consumer surplus

Producers often take advantage of consumer surplus when setting prices. If a business can
identify groups of consumers within their market who are willing and able to pay
different prices for the same products, then sellers may engage in price discrimination –
the aim of which is to extract from the purchaser, the price they are willing to pay,
thereby turning consumer surplus into extra revenue.

Airlines are expert at practising this form of yield management, extracting from
consumers the price they are willing and able to pay for flying to different destinations
are various times of the day, and exploiting variations in elasticity of demand for
different types of passenger service. You will always get a better deal / price with airlines
such as EasyJet and RyanAir if you are prepared to book weeks or months in advance.
The airlines are prepared to sell tickets more cheaply then because they get the benefit of
cash-flow together with the guarantee of a seat being filled. The nearer the time to take-
off, the higher the price. If a businessman is desperate to fly from Newcastle to Paris in
24 hours time, his or her demand is said to be price inelastic and the corresponding price
for the ticket will be much higher.

One of the main arguments against firms with monopoly power is that they exploit their
monopoly position by raising prices in markets where demand is inelastic, extracting
consumer surplus from buyers and increasing profit margins at the same time. We shall

102
1
consider the issue of monopoly in more detail when we come on to our study of markets
and industries.

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Market for Oil

The effects of changes in the price of crude oil traded on the international petroleum
exchanges can be far-reaching, not just for the British economy but for the global
economy too. A basic study of the oil market is a useful application of the principles of
supply and demand analysis and a way of understanding the interconnections between
the microeconomics of the oil market and their macroeconomic consequences.

Market theory in action - what determines crude oil prices?

Oil is one of the most heavily traded commodities in the world. Fluctuating prices have
important effects for oil producers/exporters and the many countries that remain
dependent on oil as a key input in their energy, manufacturing and service industries.

The demand for oil

1. Cyclical demand: There is a strong link between the demand for oil and the rate
of global economic growth because oil is an essential input into many industries –
when the economy is expanding, the demand for oil rises. The best recent
example of this is the growth of the Chinese economy. Fast growth of national
output in energy-intensive sectors has led to a surge in demand for crude oil into
the Chinese economy.
2. Prices of substitutes: Demand for crude oil affected by the relative prices of oil
substitutes (e.g. the market price of gas). If, in the longer term, reliable and
relatively cheaper substitutes for oil can be developed, then we might expect to
see a shift in demand away from crude oil towards the emerging substitutes. The
high price of oil during 2004-2006 seems to have led to a rise in research and
development into non-oil substitutes. These can take several years to come
through to affect the market for energy.
3. Changes in climate – e.g. affecting the demand for heating oil. It is often said
that if the winter in North America is fierce, then the price of crude rises as the
USA and Canadian economies raise their demand for oil to fuel household heating
systems and workplaces
4. Market speculation: There is always a speculative demand for oil (i.e.
purchasers hoping for a rise in prices on world markets). Indeed one of the
features of the most recent spike in oil prices has been the high level of demand
by hedge funds and other investors pouring into the international petroleum
exchanges to buy up any surplus oil futures contracts. They hope that by the time

103
1
 the contracts are ready to be fulfilled, they will have made a large profit.
Speculation involves risk, prices can do down as well as up.

Who are the main consumers of oil? Nearly two thirds of global crude oil production is
consumed by the leading industrialised nations – i.e. the nations that make up the
Organisation of Economic Cooperation and Development. But a rising share of oil
demand is coming from the emerging market economies including China, Brazil, Russia
and India.

The world's largest consumers of oil

Consumption of oil in 2005 Share of total

Thousand barrels daily consumption %

USA 20655 24.6%

China 6988 8.5%

Japan 5360 6.4%

Russian Federation 2753 3.4%

Germany 2586 3.2%

India 2485 3.0%

South Korea 2308 2.7%

Canada 2241 2.6%

France 1961 2.4%

Mexico 1978 2.3%

Saudi Arabia 1891 2.3%

Italy 1809 2.2%

Brazil 1819 2.2%

United Kingdom 1790 2.2%

104
1
Spain 1618 2.1%

The supply of oil

When we consider the global supply of oil we need to make a distinction between short-
term and longer-term supply to the international markets. The short run supply curve is
normally drawn on the basis of a given state of production technology and fixed use of
capital inputs (i.e. the oil industry is supplying from a known level of oil reserves and a
given stock of capital machinery used to extract that oil). There is inevitably a short-run
limit on daily oil supply and, as production gets close to capacity limits, so the short run
supply of oil becomes more inelastic.

One possible way of modelling this is to assume the market supply curve for oil is non-
linear (shown in the left hand diagram below). An alternative is to suggest that more oil
can be supplied elastically at a fairly constant price until the capacity limit is reached,
when the short run supply curve becomes vertical.

In short, the short-run supply of crude oil is affected by a series of different factors

1. Profit motive: The production decisions of OPEC and Non-OPEC countries (see
revision notes on OPEC below)

105
1
 2. Spare capacity: The level of spare production capacity in the oil sector
3. Stocks: The current level of crude oil stocks (inventories) available for immediate
supply from the major oil refineries – i.e. a high level of stocks means that extra
oil supplies can be released onto the market quickly when demand fluctuates
4. External shocks: The effects of production shocks (e.g. loss of output from rig
closures or disruption of oil supplies due to war and terrorist attacks)

Taking a longer-term perspective, the long run world oil supply is linked to

1. Reserves: Depletion of proven oil reserves – the faster that demand grows, the
quicker the expected rate of depletion
2. Exploration: Investment spending on exploring, identifying and then exploiting
new oil reserves. When oil prices are rising and are expected to stay strong for the
foreseeable future, it makes financial sense to invest more resources in exploring
for new reserves, even though these may not come on stream for some years.
3. Technology: Technological change in oil extraction (which affects the costs of
extraction and the profitability of extracting and then refining the oil)

The interaction between oil demand and supply in the short run

Higher oil demand matched against an inelastic short run supply of oil invariably drives
market prices higher – this is shown in the diagram below. An increase in demand causes
a fall in oil stocks at the major international refineries and pushes prices higher. This acts
as a signal to suppliers to expand production. However there are time lags between a
change in price and extra supplies coming on stream.

The demand for oil is also price inelastic. This combination of an inelastic demand and
supply helps to explain some of the volatility in world oil prices.

106
1
The role and impact of the OPEC cartel

The Organization of Petroleum Exporting Countries (OPEC) accounts for around

40% of current world supply. This gives OPEC a pivotal influence in shaping the
direction of oil prices – but only when the cartel acts together to control production and
balance supply and demand in the international market. Non-OPEC countries account for
the largest portion of total supply. Oil is produced in nearly every corner of the world,
and nearly every region has been expanding oil production in the last decade. This
includes Europe, where Norwegian oil companies are achieving a rapid increase in oil
extraction and also Russia now one of the world’s largest oil suppliers.

107
1
World Oil Production

Production on oil Output as a share

Thousand barrels daily of world total

Saudi Arabia 11035 13.5%

Russian Federation 9551 12.1%

USA 6830 8.0%

Iran 4049 5.1%

Mexico 3759 4.8%

China 3627 4.6%

Venezuela 3007 4.0%

108
1
Canada 3047 3.7%

Norway 2969 3.5%

Kuwait 2643 3.3%

United Arab Emirates 2751 3.3%

Nigeria 2580 3.2%

Iraq 1820 2.3%

Algeria 2015 2.2%

Brazil 1718 2.2%

United Kingdom 1808 2.2%

Total production Output as a percentage

000 barrels daily of total world output

Total World Oil Production in 2005 81088 100.0%

Of which
OPEC countries 33836 41.7%

Non-OPEC 35408 43.4%

Former Soviet Union 11844 14.8%

OPEC sets quotas for how much crude oil they want to produce with the aim of
stabilising the price at a target level. There are always major doubts about OPEC’s ability
to keep to output limits. Basically, OPEC acts as the swing producer in the world oil
market. It controls that part of the world supply curve which is easiest to change and if it
wants to keep oil prices high, then it can keep tight control on short run production so that
supply does not run too far ahead of demand. OPEC has to tread a fine line, because if
prices remain too high for a long period, then oil consumers have a clear incentive to look
for alternative sources of energy or other non-oil substitutes in production.

109
1
 The microeconomic consequences of higher oil prices

Crude oil has many uses in many different markets and industries. So changes in the
global price of oil inevitably have an effect on the microeconomics of particular sectors
of the economy. The main uses for crude oil are as follows:

1. Gasoline: motor spirit/petrol

2. Middle Distillates:
1. Diesel - vehicles and other motors/engines
2. Jet fuel
3. Kerosene – cooking/heating
4. Heating Oil
5. Fuel Oil: boiler fuel for industry, power and shipping
6. Other: lubricants, bitumen etc

The economic effects of high oil prices

110
1
After a long period of relatively low oil prices, in the last few years, the world economy
has had to come to terms with the prospect that the era of cheap oil is now over. This
affects many industries in the UK economy and has direct and indirect effects on
consumers.

For those industries that use oil as a key input into their production process, then a rising
price acts as a supply-side shock – leading to higher input costs i.e. a rise in their
variable costs of production. The more an industry relies on oil, the bigger will be the
impact of a rise in oil prices on its costs and profitability, and hence the bigger the fall in
its production is likely to be in the long run.

The increase in costs causes a profit maximising firm to increase price and reduce the
equilibrium level of output. The extent to which a business is able to pass on an increase
in costs depends on the price elasticity of demand for their products. If demand is price
inelastic, then the supplier may choose to pass on some or all of any rise in variable costs
to the consumer of the final product. For example, a controversial issue has been the
decision by many (although not all) of the airlines to increase their fuel surcharges to
customers.

For consumers, higher oil prices has led directly to more expensive fuel at the pumps,
higher gas and electricity bills and a reduction in their real incomes.

Although oil and gas prices have been very high, so far we have not seen a dramatic rise
in inflation – other factors have helped to keep inflation under control.

Author: Geoff Riley, Eton College, September 2006

AS Markets & Market Systems

Market for Rhodium

111
1
The Market for Rhodium

Something rather exceptional has been happening in the international markets for niche
rare metals. Take the little known metal rhodium as an example. As the chart
demonstrates, the world price measured in US dollars per ounce has climbed to
unprecedented heights during the first half of 2006, indeed by the end of May this year
the spot price had reached nearly $6,300 per ounce, more than seven times the average
price at the start of 2004 before falling back from these high levels. Commodity markets
around the world have seen super-spikes in prices and they provide economists with a
terrific window on what can happen to the prices of commodities when the conditions of
demand and supply move in particular directions.

Consumers who have bought a new LCD flat-screen television or a fibre glass yacht will
have indirectly contributed to the boom in rhodium prices over the last couple of years.
Rhodium is a silvery-white hard transition metal and it has a solid claim to be among
the world’s most expensive precious metals. The primary use of rhodium is as an
alloying agent for hardening platinum and palladium and these alloys are used in
electrodes for items such as aircraft spark plugs, precision optical instruments and in
jewellery. Missile technology, LCD television screens and catalytic converters all make
use of rhodium as a key component. Purchases worldwide of rhodium expanded by 11
per cent to 812,000 oz in 2005, equalling the previous high recorded in 2000.

112
1
On the supply side, South Africa accounts for the majority of the world's rhodium supply,
in fact in 2005, the South Africans contributed over 83% of total output. Russia is the
second largest producer although its output, subject to the vagaries of political control,
tends to be more volatile, production in Russia dipped by ten per cent last year.

The market for rhodium really is small, to put it into perspective, the value of the
commodity bought and sold is around a tenth of the size of platinum and palladium. But
limited supply and strong market demand means that the world price of rhodium can
move in only one direction. Although there has been some speculative element to the
recent price surge, the fundamental reasons lie firmly in the changing balance between
demand and supply. After several years of surplus with short run supply exceeding
demand, the rhodium market moved into heavy deficit in 2005 and in the early months of
2006.

Prices are starting to fall back from their stratospheric highs as speculators take profits,
and some car producers start to look at ways of taking rhodium out of the production of
catalytic converters. But such changes in production techniques can take years to show
through and, for the moment, the world price of one of our scarcest precious metals looks
set to remain as hard and durable as the commodity itself.

A simple question of market supply and demand

Rhodium Supply and 2004 2005 % change on the year

Demand
000 ounces

Supply

South Africa 587 627 6.8

Russia 100 90 -10

North America 17 20 15

Others 16 17 6.25

Total Supply 720 754 4.7

Demand

Auto-industry 618 684 10.7

113
1
Chemical 43 47 9.3

Electrical 8 9 12.5

Glass 46 55 19.6

Other 14 17 21.4

Total Demand 729 812 11.4

Supply versus Demand Supply deficit of 9 Supply deficit of

58

Author: Geoff Riley, Eton College, September 2006

114
1
A tax increases the costs of a business causing an inward shift in the supply curve. The
vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit.
With an indirect tax, the supplier may be able to pass on some or all of this tax onto the
consumer through a higher price. This is known as shifting the burden of the tax and
the ability of businesses to do this depends on the price elasticity of demand and supply.

Consider the two charts above. In the left hand diagram, the demand curve is drawn as
price elastic. The producer must absorb the majority of the tax itself (i.e. accept a lower
profit margin on each unit sold). When demand is elastic, the effect of a tax is still to
raise the price – but we see a bigger fall in equilibrium quantity. Output has fallen from Q
to Q1 due to a contraction in demand. In the right hand diagram, demand is drawn as
price inelastic (i.e. Ped <1 over most of the range of this demand curve) and therefore the
producer is able to pass on most of the tax to the consumer through a higher price without
losing too much in the way of sales. The price rises from P1 to P2 – but a large rise in
price leads only to a small contraction in demand from Q1 to Q2.

The usefulness of price elasticity for producers

Firms can use price elasticity of demand (PED) estimates to predict:

The effect of a change in price on the total revenue & expenditure on a product.
The likely price volatility in a market following unexpected changes in supply – this is
important for commodity producers who may suffer big price movements from time to

115
1
time.
The effect of a change in a government indirect tax on price and quantity demanded
and also whether the business is able to pass on some or all of the tax onto the consumer.
Information on the price elasticity of demand can be used by a business as part of a
policy of price discrimination (also known as yield management). This is where a
monopoly supplier decides to charge different prices for the same product to different
segments of the market e.g. peak and off peak rail travel or yield management by many of
our domestic and international airlines.

Habitual spending on cigarettes remains high but sales are falling

Sales of cigarettes are falling by the impact of higher taxes mean that smokers must
spend more to finance their habits according to new research from the market analyst
Mintel. Total sales of individual sticks for the UK in 2006 are forecast to be 68 billion,
eleven billion lower than in 2001. Over a quarter of cigarettes are brought into the UK
either duty free or through the black market. Total consumer spending on duty-paid
cigarettes is likely to exceed £13 billion, 13% higher than in 2001. In the past, increases
in the real value of duty (taxation) on cigarettes has had had little effect on demand
from smokers because demand has been inelastic. But there are signs that a tipping point
may have been reached. Sales of nicotine replacement therapies such as patches, lozenges
and gums have boomed by nearly 50% over the past five years to around £97 million. But
for every £1 spent on nicotine replacement, over £130 is spent on cigarette sticks.

Nearly half of smokers tried to kick the habit last year. According to the Mintel research,
smokers under the age of 34 are the most likely to stop smoking, with people aged 65 and
over the least likely to try quitting. A ban on smoking in public places comes into force in
England, Northern Ireland and Wales in the spring of 2007, the same ban became law in
Scotland in March 2006.

Sources: Adapted from Mintel Research, the Guardian and the Press Association

116
1
 Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Introduction to the UK Economy

What is macroeconomics?

Macroeconomics considers the economy as a whole and relationships between one

country and others for example we focus on changes in economic growth; inflation;
unemployment and our trade performance with other countries (i.e. the balance of
payments). The scope of macroeconomics also includes looking at the relative success or
failure of government policies.

Introduction to the UK economy

117
1
 The City of London, an important centre The individual spending decisions of millions
for international finance and a major of consumers add up to affect the
source of income for our balance of performance of the whole economy
payments

Searching for work – unemployment has

Anticipating demand – stocks of products in a
been low in the UK for over ten years – but
warehouse. Businesses need to anticipate
it is now starting to rise again
demand changes when setting production
levels
 The United Kingdom is one of the world’s leading advanced economies. It has the
second largest economy in the European Union (EU) behind Germany and just
ahead of France and it is the second biggest exporter of services in the global
economy and ranked eighth in global exports of goods. In 2006 the UK will
contribute 3 per cent to global output.
 In terms of per capita national income, the UK is ranked in the top fifteen nations
of the world and in 2006 it is forecast that the UK will have a per capita income
(PPP adjusted) of $31,529 some distance behind that of the United States and also
Norway and Ireland, two of Europe’s richest countries.
 Britain has enjoyed a period of continuous growth that stretches back to 1992, the
longest sustained expansion for over forty years. However, in 2005, real GDP
grew by 1.8%, the slowest pace of growth for twelve years.
 Over 27 per cent of the UK’s GDP in 2005 came from exports of goods and
services. Imports amounted to 31.5 per cent of national income leading to a large
trade deficit in goods and services with other countries.

118
1
  The UK joined the European Economic Community (now known as the EU) in
January 1973 and it is a founder member of the World Trade Organisation. The
UK retains its own currency having decided for the time being not to consider
entry to the EU single currency area, the Euro Zone.

The main sectors of the economy

 Households: receive income for their services and then buy the output of firms
(consumption)
 Firms: hire land labour and capital to produce goods and services for which they
pay wages rent etc (income). Firms receive payment. Firms invest (I) in new
producer goods
 Government: collect taxes (T) to fund spending on public services (G)
 International: The UK buy overseas products, imports, (M)) and overseas
economic agents buy UK products, exports (X)

Targets and objectives of macroeconomic policy

Government management of the economy is a key political issue and each government
sets targets and objectives when it assumes power – and often, economic objectives and
priorities lie right at the heart of a government’s overall political strategy.

We focus on large number when we undertake the study of macroeconomics. For

example, the value of national output in the UK, expressed at constant prices so that we
eliminate the effects of inflation on the value of what we produce and consume, edged
above £1 trillion in 2003. But we still stand well below the United States, whose national
output (GDP) accounts for over a quarter of world output each year. No wonder that
people often say “when the United States catches sneezes, the rest of the world catches a
cold!”

What are the main indicators we use when making cross-country comparisons of
economic performance? Traditionally we have tended to focus on four key indicators of
achievement. They are

 Growth: The rate of growth of real national output (i.e. real GDP)
 Inflation: The rate of price inflation (i.e. the annual percentage change in the
price level)
 Unemployment: The rate of unemployment in the labour market
 Trade: The balance of payments in trade in goods and services and net flows of
investment income – representing the effects of trade and investment between
countries

Author: Geoff Riley, Eton College, September 2006

119
1
AS Macroeconomics / International Economy
Measuring National Income

We need information on how much spending, income and output is being created in an
economy over a period of time. National income data gives us this information as we see
in this chapter.

Measuring national income

To measure how much output, spending and income has been generated in a given time
period we use national income accounts. These accounts measure three things:

1. Output: i.e. the total value of the output of goods and services produced in the UK.

2. Spending: i.e. the total amount of expenditure taking place in the economy.

3. Incomes: i.e. the total income generated through production of goods and services.

What is National Income?

National income measures the money value of the flow of output of goods and
services produced within an economy over a period of time. Measuring the level and rate
of growth of national income (Y) is important to economists when they are considering:
The rate of economic growth
Changes over time to the average living standards of the population
Changes over time to the distribution of income between different groups within the
population (i.e. measuring the scale of income and wealth inequalities within society)

120
1
 Consumer spending accounts for over two thirds of total spending. Consumer spending
has been strong in recent years, a reflection of rising living standards and low
unemployment, but this may now be coming to an end because of the mountain of
household debt

Gross Domestic Product

Gross Domestic Product (GDP) measures the value of output produced within the
domestic boundaries of the UK over a given time period. An important point is that our
GDP includes the output of foreign owned businesses that are located in the UK
following foreign direct investment in the UK economy. The output of motor vehicles
produced at the giant Nissan car plant on Tyne and Wear and by the many foreign owned
restaurants and banks all contribute to the UK’s GDP.

There are three ways of calculating GDP - all of which should sum to the same amount
since the following identity must hold true:

National Output = National Expenditure (Aggregate Demand) = National Income

Firstly we consider total spending on goods and services produced within the economy:

Nissan at Sunderland – Celebrating 20 years of production

The Nissan plant at Washington, Tyne and Wear is celebrating its 20th anniversary in
July 2006, the first car having rolled off the line on July 8th, 1986. In that first year of
production 470 staff had a production target of 24,000 Bluebirds. Twenty years on, more
than 4,200 employees produce around 310,000 Micras, C+Cs, NOTEs, Almeras and
Primeras each year. That car has been followed by 4.3 million others thanks to a total
investment of £2.3 billion. Production is set to rise from 310,000 per year last year to
400,000 in 2007 with the introduction of a new small 4x4, and Sunderland has been rated
as Europe's most productive car factory for the last eight years.
Sources: Reuters News, Sunderland Echo, July 2006

(i) The Expenditure Method of calculating GDP (aggregate demand)

This is the sum of spending on UK produced goods and services measured at current
market prices. The full equation for GDP using this approach is GDP = C + I + G + (X-
M) where

C: Household spending
I: Capital Investment spending
G: Government spending
X: Exports of Goods and Services
M: Imports of Goods and Services

The Income Method of calculating GDP (the Sum of Factor Incomes)

121
1
Here GDP is the sum of the incomes earned through the production of goods and
services. The main factor incomes are as follows:

Income from people employment and in self-employment

+
Profits of private sector companies
+
Rent income from land
=
Gross Domestic product (by factor income)

It is important to recognise that only those incomes that are actually generated through
the production of output of goods and services are included in the calculation of GDP by
the income approach.

We exclude from the accounts the following items:

 Transfer payments e.g. the state pension paid to retired people; income support
paid to families on low incomes; the Jobseekers’ Allowance given to the
unemployed and other forms of welfare assistance including child benefit and
housing benefit.
 Private transfers of money from one individual to another.
 Income that is not registered with the Inland Revenue or Customs and
Excise. Every year, billions of pounds worth of economic activity is not declared
to the tax authorities. This is known as the shadow economy where goods and
services are exchanged but the value of these transactions is hidden from the
authorities and therefore does not show up in the official statistics!). It is
impossible to be precise about the size of the shadow economy but some
economists believe that between 8 – 15 per cent of national output and spending
goes unrecorded by the official figures.

Output Method of calculating GDP – using the concept of value added

This measure of GDP adds together the value of output produced by each of the
productive sectors in the economy using the concept of value added.

Value added is the increase in the value of a product at each successive stage of the
production process. We use this approach to avoid the problems of double-counting the
value of intermediate inputs.

The table below shows indices of value added from various sectors of the economy in
recent years. We can see from the data that manufacturing industry has seen barely any
growth at all over the period from 2001-2004 whereas distribution, hotels and catering
together with business services and finance have been sectors enjoying strong increases
in the volume of output. These figures illustrate a process of structural change, with a

122
1
continued decline in manufacturing output and jobs relative to the rest of the economy.
By far the largest share of total national output (GDP) comes from our service industries.

Index of Gross Value Added by selected industry for the UK

Mining and Manufacturing Construction Distribution, Business

quarrying, hotels, and services
inc oil & catering; and
gas repairs finance
extraction

2001 weights in total GDP 28 172 57 159 249

(out of 1000)

2001 100 100 100 100 100

2002 100 97 104 105 102

2003 94 97 109 108 106

2004 87 98 113 113 111

We can see from the following chart how there have been divergences in the growth
achieved by the manufacturing and the service sectors of the British economy. Indeed by
the middle of 2006, the index of manufacturing output was below the level achieved at
the start of 2000.

In contrast the service industries have enjoyed strong growth, leading to a continued
process of structural change in the economy – away from traditional heavy industries
towards service businesses.

123
1
GDP and GNP (Gross National Product)

Gross National Product (GNP) measures the final value of output or expenditure by UK
owned factors of production whether they are located in the UK or overseas.

In contrast, Gross Domestic Product (GDP) is concerned only with the factor incomes
generated within the geographical boundaries of the country. So, for example, the value
of the output produced by Toyota and Deutsche Telecom in the UK counts towards our
GDP but some of the profits made by overseas companies with production plants here in
the UK are sent back to their country of origin – adding to their GNP.

GNP = GDP + Net property income from abroad (NPIA)

NPIA is the net balance of interest, profits and dividends (IPD) coming into the UK from
our assets owned overseas matched against the flow of profits and other income from
foreign owned assets located within the UK. In recent years there has been an increasing
flow of direct investment into and out of the UK. Many foreign firms have set up
production plants here whilst UK firms have expanded their operations overseas and
become multinational organisations.

The figure for net property income for the UK is strongly positive meaning that our GNP
is substantially above the figure for GDP in a normal year. For other countries who have
been net recipients of overseas investment (a good example is Ireland) their GDP is
higher than their GNP.

124
1
Measuring Real National Income

When we want to measure growth in the economy we have to adjust for the effects of
inflation.
Real GDP measures the volume of output produced within the economy. An increase in
real output means that AD has risen faster than the rate of inflation and therefore the
economy is experiencing positive growth.

Income per capita

Income per capita is a basic way of measuring the average standard of living for the
inhabitants of a country. The table below is taken from the latest edition of the OECD
World Factbook and measures income per head in a common currency for the year 2005,
the data is adjusted for the effects of variations in living costs between countries.

GDP per capita $s GDP per capita $s

Luxembourg 57 704 EU (established 15 countries) 28 741

United States 39 732 Germany 28 605

Norway 38 765 Italy 27 699

Ireland 35 767 Spain 25 582

Switzerland 33 678 Korea 20 907

United Kingdom 31 436 Czech Republic 18 467

Canada 31 395 Hungary 15 946

Australia 31 231 Slovak Republic 14 309

Sweden 30 361 Poland 12 647

Japan 29 664 Mexico 10 059

France 29 554 Turkey 7 687

Source: OECD World Economic Factbook, 2006 edition

125
1
By international standards, the UK is a high-income country although we are not in the
very top of the league tables for per capita incomes. We do have an income per head that
is about ten per cent higher than the average for the 15 established EU countries. But we
are some distance behind countries such as the United States (where productivity is much
higher). And Ireland’s super-charged growth over the last twenty years means that she
has now overtaken us in terms of income-based measures of standards of living.

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Using Index Numbers

Index numbers are a useful way of expressing pieces of information and collections of
data. This brief chapter shows you how to express data in index number format and some
examples of data which is commonly presented as an index number

Converting data in index number format: Measuring the level of real national
output

When we are measuring the level of national income we often make use of index
numbers to track what is happening to real GDP. In the table below we see the value of
consumer spending and also real GDP expressed in £ billion. I have chosen 1995 as the
base year for our index of spending and output. So the data for consumer spending and
real GDP has an index value of 100.0 in 1995.

To calculate the index number for consumer spending in 1996 we use the following
formula

Index (1996) = (consumer spending (1996) / base year consumer spending) x 100

Consumer Index of consumer Real GDP Index of real GDP

spending spending

£ billion 1995 = 100 £ billion 1995 = 100

1995 (Base) 512.6 100.0 857.5 100.0

1996 531.9 103.8 880.9 102.7

126
1
 1997 551.1 107.5 908.7 106.0

1998 572.3 111.6 938.1 109.4

1999 598.8 116.8 966.6 112.7

2000 625.1 121.9 1005.5 117.3

2001 644.9 125.8 1027.9 119.9

2002 667.4 130.2 1048.5 122.3

2003 684.8 133.6 1074.9 125.3

2004 710.2 138.5 1108.9 129.3

One of the advantages of index numbers is that it allows us to compare and contrast more
easily different sets of economic data. Consider the information in the table above.
Using 1995 as our base year for the index, we can see that consumer spending has grown
more quickly than real national income over the period 1995-2003.

Of course the two sets of data are closely linked because consumption accounts for more
than 60% of GDP. But the data indicates that consumer demand has been a key factor
behind the continuing growth of the economy, indeed consumption as a share of GDP has
grown from 60% in 1995 to nearly 65% in 2003 – a record level. Can this consumer
boom continue? Much of it has been financed by high rates of borrowing linked to low
interest rates and the recent UK housing boom.

Calculating a price index

We will now see how information on prices can be used to create a weighted price index
for the economy – this is the sort of data which is then used to calculate the rate of
inflation

Category Price Index Weighting Price x Weight

Food 106 18 1908

Alcohol & Tobacco 110 6 660

127
1
Clothing 97 12 1164

Transport 103 15 1545

Housing 106 22 2332

Leisure Services 112 9 1008

Household Goods 95 7 665

Other Items 105 11 1155

100 10437

A weighted price index calculates changes in the average level of prices in the economy.
In the hypothetical data shown in the table above we have split consumer spending into
eight categories and given each a “weighting” based on the share of total consumer
spending given over to each category. So for example, housing and food costs are
assumed in our example to take up 40% of total consumer spending. These two items will
have a heavy influence on the overall price index.

The price index for each category shows what has happened to the price level since a
base year value. To generate a weighted price index we multiply the price index for each
category by its weight and then sum these. We then divide by the sum of the weights
(100) to find an overall price index (104.37) or 104.4 rounded to one decimal place.

Here is some real world data on a selected of price indices for goods and services in the
UK.

All items Health Transport Communication Tobacco Clothing New Cars Second Hand Cars

1996 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

2000 105.6 111.6 112.7 89.3 141.2 82.2 99.8 91.2

2003 109.8 124.2 116.9 84.5 158.8 66.8 95.7 85.1

128
1
Over the period 1996-2003 there has been a 10% rise in the general price level. But this
hides major changes in average prices for different products. The average cost of
purchasing tobacco products has jumped by nearly sixty per cent whereas the prices of
clothing, second hand cars and communication have been falling.

Author: Geoff Riley, Eton College, September 2006

129
1
AS Macroeconomics / International Economy

130
1
Consumer Spending and Saving

Consumption accounts for 65% of aggregate demand. There are many factors that affect
how much people are willing and able to spend. It is important to understand these
factors because changes in consumer spending have an important effect on path of the
economic cycle.

131
1
 132
1
John Maynard Keynes developed a theory of consumption that focused primarily on the
level of people’s disposable income in determining their spending. The rate at which
consumers increase demand as income rises is called the marginal propensity to
consume. For example if someone receives an increase in income of £2000 and they
spend £1500 of this, the marginal propensity to spend is £1500 / £2000 = 0.75. The
remainder is saved – so the propensity to save would be 0.25.

The marginal propensity to spend and to save differs from person to person. Generally,
people on lower incomes tend to have a higher propensity to spend. This has important
implications when the government announces changes in direct taxation and the level of
welfare benefits.

Incomes matter in determining spending

The Bank of England has an economic model that seeks to predict what will happen to
consumer spending after various shocks. In the long term, the thing that matters most is
people's real incomes. Changes in the amount we earn are by far the most important
feature determining how much we spend. Other features, such as the value of our homes
or our financial savings, matter a bit but their effect is dwarfed by changes in our
earnings. Source: Hamish McRae, the Independent, 8th August 2004

133
1
The key factors that determine consumer spending in the economy can be summarized as
follows:

 The level of real disposable household income

 Interest rates and the availability of credit
 Consumer confidence
 Changes in household financial wealth
 Changes in employment and unemployment

The strength of consumer spending has been one of the main reasons why Britain has
avoided a recession in recent years – but at the same time, there are fears that household
spending has been too high, and that much of it has been financed by a surge in
borrowing leading to record levels of household debt. One key reason for this has been
the strength of the housing market which has allowed millions of home-owners to borrow
extra money secured on the value of their property. This is known as mortgage equity
withdrawal. A large percentage of this demand has also fed into demand for imported
goods and services, causing a sharp increase in the UK’s trade deficit with other
countries.

Spending on consumer durables

Consumer durables are items that provide a flow of services to a consumer over a
period of time. Examples include new cars, household appliances, audio-visual

134
1
equipment, furniture etc. The real level of spending on durables has surged in the last
eight years.

Among the explanations are

 Falling prices for many durable products – arising from rapid advances in
production technology and the effects of globalization which means that we can
now import many of these durables more cheaply from overseas
 Low interest rates which have encouraged people to spend more on “big ticket
items” – there has been a surge in demand for consumer credit
 Strong consumer confidence and borrowing levels. The demand for consumer
durables is more income elastic than for non-durables which are usually staple
items in people’s monthly budget.

The Wealth Effect

Wealth represents the value of a stock of assets owned by people. For most people the
majority of their wealth is held in the form of property, shares in quoted companies on
the stock market, savings in banks, building societies and money accumulating in
occupational pension schemes.

There is a positive wealth effect between changes in financial wealth and total consumer
demand for goods and services. For example when house prices are rising strongly,

135
1
 consumer confidence grows and home-owners can also borrow some of the equity in
their homes to finance major items of spending.

The Savings Ratio

Saving represents a decision to postpone consumption by saving money out of

disposable income. Why do people choose to save their incomes? There are many
motivations for saving:

 Precautionary saving: People might save more because of a fear of being made
unemployed. A nest egg of savings allows people to smooth their spending even
when incomes are fluctuating.
 Building up potential spending power: Saving more now is a choice to defer
spending today to finance major spending commitments in the future (e.g. saving
for the deposit on a mortgage, a new car or a wedding). People are also becoming
increasingly aware of the need to save in order to build up assets in occupational
pension schemes because of fears that the relative value of the state retirement
pension will fall in the years ahead.
 Interest rates and saving: There might be a greater willingness to save because
of the incentives of high interest rates from banks, building societies and other
financial institutions.
 Inheritance: Many people have a desire to pass on bequests of wealth to future
generations.
 Saving and the life-cycle of consumers: Younger people are often net borrowers
of money because they need to fund their degrees, purchase a property and
expensive consumer durables. As people grow older, their incomes from work

136
1
 tend to rise and their spending commitments decline leading to an increase in net
saving ahead of retirement.

The savings ratio

The household savings ratio is the level of people’s savings as a percentage of their
disposable income. The savings ratio was high during the early 1990s as a result of the
high levels of unemployment and also high interest rates. In recent years there has been a
fall in the savings ratio in part because consumer borrowing has reached record levels,
fuelled in part by the rapid acceleration in house prices. At some point the savings ratio
will need to rise again as people rein back on their spending in order to repay debts on
credit cards and other forms of secured and unsecured borrowing. We have started to see
a gradual rise in the savings ratio during 2005 and the first half of 2006.

The importance of consumer confidence

The willingness of people to make major spending commitments depends on how

confident they are about both their own financial circumstances, and also the general state
of the economy. Consumer confidence is quite volatile from month to month. Some of
the fluctuations are seasonal – but the underlying trend is what really matters. One
interesting aspect of recent data is that people have remained more optimistic about their
own financial situation than they have about prospects for the UK economy as a whole.
This perhaps helps to explain why people have continued to be prepared to make big-
ticket purchases on new consumer durables (many of which have been imported).

The main factors affecting consumer confidence are summarised as follows:

 Expectations of future income and employment

 The current level of interest rates and expectations of future interest rate
movements
 Trends in unemployment and changes in perceived job security
 Anticipated changes in government taxation
 Changes in household wealth including movements in house and share prices

The consumer borrowing boom of recent years

137
1
The British economy has seen high consumer borrowing in recent years. This has been
the result of a number of factors summarised below:

 Low unemployment – has led to rising consumer confidence.

 Strong growth of house prices – has encouraged mortgage equity withdrawal.
 Expectations of rising real incomes – people have expected their incomes to rise
each year as pay levels have grown more quickly than inflation.
 Low interest rates – reducing the opportunity cost of borrowing money.
 Falling prices of consumer durables – many of which are bought using credit.

Strong demand for loans has boosted consumer spending and helped to keep the UK
economy growing at a time of global uncertainty. Borrowing has also contributed to the
rising trade deficit in goods and services. By the summer of 2006, the consumer
borrowing boom appeared to be coming to an end. The slowdown in credit demand has
been the result of a number of factors:

 Rising interest rates – the Bank of England has been raising interest rates from
3.5% to 4.75% – this has helped to curb demand for new loans (interest rates
currently at 4.5%).
 Weakness in the housing market and fears of a possible fall in average house
prices which may expose homeowners to a high level of mortgage debt.

138
1
  Unemployment has started to edge higher and more people now expect rising
unemployment, expectations of what might happen tomorrow affects our
behaviour today!
 The consumer debt mountain has reached high levels – well over £1 trillion –
and many people are now scaling back their borrowing and saving more as a
precaution against a future downturn.
 Possible consumer satiation – how many plasma TV screens or digital cameras
do you need? There are limits to how many consumer durables people need to
buy!

Consumer spending and the UK balance of payments

Consumers in Britain have a high marginal propensity to import goods and services so
that, when their real incomes are rising and their spending increases, so too does the
demand for imports. Unless there is a corresponding increase in UK exports overseas,
then the balance of trade in goods and services will move towards heavier deficit. This
has been the case in the UK over the last five or six years. In the medium term if demand
for imports rises and the level of import penetration into the domestic economy
continues to rise, then national output and employment will weaken and this will work its
way through the circular flow to reduce real incomes. Living standards are reduced in the
long run if our export industries are unable to compete with output produced in other
countries.

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Aggregate Supply

Having looked at the components of aggregate demand, we now turn to the supply-side of
the economy. Aggregate supply tells us something about whether producers across the
economy can supply us with the goods and services that we need.

A definition of aggregate supply

Aggregate supply (AS) measures the volume of goods and services produced within the
economy at a given price level. In simple terms, aggregate supply represents the ability of
an economy to produce goods and services either in the short-term or in the long-term. It
tells us the quantity of real GDP that will be supplied at various price levels. The nature
of this relationship will differ between the long run and the short run

 In the long run, the aggregate-supply curve is assumed to be vertical

139
1
  In the short run, the aggregate-supply curve is assumed to be upward sloping

Short run aggregate supply (SRAS) shows total planned output when prices in the
economy can change but the prices and productivity of all factor inputs e.g. wage rates
and the state of technology are assumed to be held constant.

Long run aggregate supply (LRAS): LRAS shows total planned output when both
prices and average wage rates can change – it is a measure of a country’s potential output
and the concept is linked strongly to that of the production possibility frontier

The short run aggregate supply curve

A change in the price level (for example brought about by a shift in AD) results in a
movement along the short run aggregate supply curve. The slope of SRAS curve depends
on the degree of spare (under-utilised) capacity within the economy.

 Negative output gap: At low levels of real national income where actual GDP <
potential GDP, firms have a large amount of spare capacity and can expand their
output without paying their workers overtime. The SRAS curve is therefore drawn
as elastic

140
1
  Positive output gap: As national output expands and the economy heads towards
full capacity, so “supply bottlenecks and shortages” may start to appear in some
sectors and industries. Workers receive the same wage rate but require payment of
overtime and bonuses to work longer hours and increase GDP – SRAS is
becoming more inelastic
 Diminishing returns? As national output expands, older less productive
machinery may be used and less efficient workers hired. This means that while
wage rates remain constant, unit costs of production may rise and thus the SRAS
slopes upwards
 Full-capacity output at LRAS. Eventually the economy cannot increase the
volume of output further in the short-term no matter what bonus or overtime
payments on offer, at this point SRAS is perfectly inelastic – the economy has
reached full-capacity (the LRAS curve)

Shifts in short run aggregate supply (SRAS)

Shifts in the SRAS curve can be caused by the following factors

 Changes in unit labour costs: Unit labour costs are defined as wage costs
adjusted for the level of productivity. For example a rise in unit labour costs
might be brought about by firms agreeing to pay higher wages or a fall in the level
141
1
 of worker productivity. If unit wage costs rise, this will eventually feed through
into higher prices (this is known as an example of “cost-push inflation”)

 Commodity prices: Changes to raw material costs and other components e.g. the
world price of oil, copper, aluminium and other inputs in many production
processes will affect a firm’s costs. These costs might be affected by a change in
the exchange rate which causes fluctuations in the prices of imported products. A
fall (depreciation) in the exchange rate increases the costs of importing raw
materials and component supplies from overseas
 Government taxation and subsidy: Changes to producer taxes and subsidies
levied by the government as part of their fiscal policy have effects on the costs of
nearly every producer – for example an increase in taxes designed to meet the
government’s environmental objectives will cause higher costs and an inward
shift in the short run aggregate supply curve. A rise in VAT on raw materials will
have the same effect.

The short run aggregate supply curve is upward sloping because higher prices for goods
and services make output more profitable and enable businesses to expand their
production by hiring less productive labour and other resources

Shifts in aggregate supply in the short run

Shifts in the short run aggregate supply curve are illustrated in the diagram below

142
1
The most important single cause of a shift in the short run aggregate supply curve is a
change in wage rates. Higher wage rates without any compensating increase in labour
productivity cause a rise in production costs, leading businesses to produce less and the
aggregate supply curve will shift to the left (i.e. SRAS1 shifts to SRAS2). Conversely a
fall in raw material prices or component costs will reduce production costs, encouraging
firms to produce more and the short run aggregate supply curve moves to the right (i.e.
SRAS1 shifts to SRAS3).

Long run aggregate supply (LRAS)

In the long run, the ability of an economy to produce goods and services to meet demand
is based on the state of production technology and the availability and quality of
factor inputs.

A long run production function for a country is often written as follows:

Y*t = f (Lt, Kt, Mt)

143
1
  Y* is an aggregate measure of potential output in an economy
 T is the time period under consideration
 L represents the quantity and ability of labour input available to the production
process
 K represents the available capital stock, i.e. machinery, buildings and
infrastructure
 M represents the availability of natural resources and materials for production
i.e. land

LRAS is determined by the stock of a country’s productive resources and also by the
productivity of factor inputs (labour, land and capital). Changes in the state of
technology also affect the potential level of real national output.

The vertical long run aggregate supply curve

In the long run we assume that aggregate supply is independent of the price level. As a
result we draw the long run aggregate supply curve as vertical. In drawing the LRAS as
vertical, we are saying that there is a maximum level of physical output that the economy
can produce. Neo-classical economists view the LRAS curve as being perfectly inelastic
at a level of output where actual GDP has achieved its potential. There will be no unused
labour in that all those who are available for employment at the prevailing wage rate will
be in employment – in other words, a full-employment level of national income has
been reached. There will remain the problem of voluntary unemployment.

According to the neo-classical school of economics, real GDP will in the long run
always return to the level at which all available labour resources have found employment.

Causes of shifts in the long run aggregate supply curve

Any change in the economy that alters the natural rate of growth of output (i.e. trend
growth) shifts the long-run aggregate-supply curve.

Improvements in productivity and efficiency or an increase in the stock of capital and

labour resources cause the LRAS curve to shift out. This is shown in the diagram below.
The result is that a great volume of national output can be produced at any given price
level.

144
1
The fundamentals of increasing long run aggregate supply

These all relate to the supply-side of the economy

 Expanding the labour supply - e.g. by improving incentives for people to

search for and then accept new jobs as they become available. Government
policies seek to expand the available labour supply by encouraging more people
to join the labour force and become economically active. The UK government has
also been encouraging an influx of migrant labour which has added to the supply
of labour although it is also causing concern about some of the social and political
effects.
 Increase the productivity of labour and capital – e.g. by investment in training
of the labour force and improvements in the quality of management and human
resource management
 Increase the occupational and geographical mobility of labour to reduce
certain types of unemployment for example the level of structural unemployment
which is caused by occupational immobility of labour. A reduction in structural
unemployment will reduce the scale of unemployment and provide the economy
with a great supply of available labour.
 Expand the capital stock – i.e. increase the level of capital investment and
research and development spending by firms
 Increase business efficiency by promoting greater competition within and
between markets

145
1
  Stimulate a faster pace of invention and innovation – this will hopefully in the
long term promote lower production costs and also improvements in the dynamic
efficiency of markets

Aggregate supply shocks

Aggregate supply shocks might occur when there is

 A sudden rise in oil prices or other essential inputs

 The invention and diffusion of a new production technology

The effects of supply-side shocks are normally to cause a shift in the short run aggregate
supply curve. But there are also occasions when significant changes in production
technologies or step-changes in the productivity of factors of production that were not
expected, feed through into a shift in the long run aggregate supply curve.

In the long-run

In the long run we are all dead. Economists set themselves too easy, too useless a task if
in tempestuous seasons they can only tell us that when the storm is long past the ocean is
flat again.”

John Maynard Keynes, 1936

146
1
 Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

UK Economic Cycle

The economic cycle is also known as the business cycle. The chart above shows the
annual rate of growth of national output for the UK economy since 1980. There have
been two recessions in the last twenty-five years. The early 1980s downturn was a deep
recession – the worst downturn in the UK’s post-war history. We can see the descent into
recession in 1990 and 1991 and then a recovery which was maintained throughout the
remainder of the 1990s. Further positive rates of growth have been sustained in the first
six years of the current decade, allowing the UK economy to claim one of the longest
periods of expansion in our modern history. After a slowdown in 2005 the British
economy looked to be enjoying stronger growth in the first half of 2006.

As we shall see later, all countries go through a business or economic cycle leading to
fluctuations in national output and unemployment. The chart below shows what has
happened to the US economy over recent years.

The United States enjoyed a period of fast growth during the second half of the 1990s.
But a combination of rising interest rates (the US central bank raised the cost of
borrowing to curb the growth of consumption) and of course the fallout from the events
147
1
of 9-11 which severely affected consumer and business confidence brought about a sharp
slowdown in their growth rate. The USA economy went into a steep slowdown – but
although, for a short period, national output did fall, the annual growth rate stayed
positive before a recovery emerged in 2002 and 2003. In 2003, the US economy grew by
3% and growth climbed above 4% in 2004 before edging lower in 2005. The United
States has been running a policy of low interest rates for most of the current decade. But
between 2004 and 2006, they have been gradually increasing interest rates in a bid to
control demand and inflationary pressures. As a result, the speed of growth in the USA is
now starting to slowdown.

We can compare and contrast the relative performance of different countries by making
use of the economic data published for each nation. The main source of data for the UK is
via the Office for National Statistics where there is a wealth of information not just on
Britain but also for each of our regions and for other countries as well.

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Economic Growth

148
1
Growing economies provide the means for people to enjoy better living standards and for
more of us to find work. But what is economic growth and how best can a country
achieve it?

Defining economic growth

Economic growth is best defined as a long-term expansion of the productive potential

of the economy. Sustained economic growth should lead higher real living standards and
rising employment. Short term growth is measured by the annual % change in real GDP.

Growth and the Production Possibility Frontier

An increase in long run aggregate supply is illustrated by an outward shift in the PPF.

Advantages of Economic Growth

Sustained economic growth is a major objective of government policy – not least because
of the benefits that flow from a growing economy.

 Higher Living Standards – for example measured by an increase in real national

income per head of population – see the evidence shown in the chart below
 Employment effects: Growth stimulates higher employment. The British
economy has been growing since autumn 1992 and we have seen a large fall in
unemployment and a rise in the number of people employed.
149
1
  Fiscal Dividend: Growth has a positive effect on government finances - boosting
tax revenues and providing the government with extra money to finance spending
projects
 The Investment Accelerator Effect: Rising demand and output encourages
investment in new capital machinery – this helps to sustain the growth in the
economy by increasing long run aggregate supply.
 Growth and Business Confidence: Economic growth normally has a positive
impact on company profits & business confidence – good news for the stock
market and also for the growth of small and large businesses alike

Rising national income boosts living standards

And an expanding economy provides the impetus for a rising level of employment and a
falling rate of unemployment. This has certainly been the case for the British economy
over the last decade.

Disadvantages of economic growth

There are some economic costs of a fast-growing economy. The two main concerns are
firstly that growth can lead to a pick up in inflation and secondly, that growth can have
damaging effects on our environment, with potentially long-lasting consequences for
future generations.

150
1
  Inflation risk: If the economy grows too quickly there is the danger of inflation
as demand races ahead of aggregate supply. Producer then take advantage of this
by raising prices for consumers
 Environmental concerns: Growth cannot be separated from its environmental
impact. Fast growth of production and consumption can create negative
externalities (for example, increased noise and lower air quality arising from air
pollution and road congestion, increased consumption of de-merit goods, the rapid
growth of household and industrial waste and the pollution that comes from
increased output in the energy sector) These externalities reduce social welfare
and can lead to market failure. Growth that leads to environmental damage can
have a negative effect on people’s quality of life and may also impede a country’s
sustainable rate of growth. Examples include the destruction of rain forests, the
over-exploitation of fish stocks and loss of natural habitat created through the
construction of new roads, hotels, retail malls and industrial estates.

Many economists and environmentalists are concerned about the impact that rapid
economic growth can have on our limited scarce resources and our environment.

The trend rate of economic growth

Another way of thinking about the trend growth rate is to view it as a safe speed limit for
the economy. In other words, an estimate of how fast the economy can reasonably be
expected to grow over a number of years without creating an increase in inflationary
pressure.

 Above trend growth – positive output gap: If the economy grows too quickly
(much faster than the trend) – then aggregate demand will eventually exceed long-
run aggregate supply and lead to a positive output gap emerging (excess demand
in the economy). This can lead to demand-pull and cost-push inflation.

151
1
  Below trend growth – negative output gap: If the economy experiences a
sustained slowdown or recession (i.e. growth is well below the trend rate) then
output will fall short of potential GDP leading to a negative output gap. The result
is downward pressure on prices and rising unemployment because of a lack of
aggregate demand.

Demand and supply factors influence growth of GDP

Many factors influence the rate of economic growth. Some factors, such as changes in
consumer and business confidence, aggregate demand conditions in the UK’s trading
partners, and monetary and fiscal policy, tend to have a mainly temporary effect on
growth. Other factors, such as the rates of population and productivity growth, have more
enduring effects, and help to determine the economy’s average growth rate over long
periods of time.

Adapted from a Treasury paper www.hm-treasury.gov.uk

The importance of the supply-side of the economy

The trend rate of growth is determined mainly by the supply-side capacity of a country –
i.e. the extent to which LRAS increases year-on-year to meet a higher level of demand
for goods and services. Potential output in the long run depends on the following factors

 The trend growth of the working population i.e. the size of the active labour
supply (e.g. those people able available and willing to find paid employment)
 The growth of the nation’s stock of capital – driven by the level of capital
investment in new buildings, machinery, plant and technology
 The trend rate of growth of factor productivity (including labour productivity) –
a measure of gains in factor efficiency
 Technological improvements driven by innovation and invention which reduce
the costs of supplying goods and services and which lead to an outward shift in a
country’s production possibility frontier

Long Run Aggregate Supply and the Trend Rate of Growth

The effects of an increase in long run aggregate supply are traced in the diagram below.
An increase in LRAS allows the economy to operate at a higher level of aggregate
demand – leading to sustained increases in real national output.

152
1
Potential output in the long run depends on the following factors

(1) The growth of the labour force e.g. those people able available and willing to find
employment

If the government can increase the number of people willing and able to actively seek
paid employment, then the employment rate increases leading to a higher output of goods
and services. The Government has invested heavily in a number of employment schemes
designed to raise employment including New Deal and reforms to the tax and benefit
system. Changes in the age structure of the population also affect the total number of
people seeking work. And we might also consider the effects that migration of workers
into the UK from overseas, including the newly enlarged European Union, can have on
our total labour supply

(2) The growth of the nation’s stock of capital – driven by the level of fixed capital
investment.

A rise in capital investment adds directly to GDP in the sense that capital goods have to
be designed, produced, marketed and delivered. Higher investment also provides workers
with more capital to work with. New capital also tends to embody technological
improvements which providing workers have sufficient skills and training to make full
and efficient use of their new capital inputs, should lead to a higher level of productivity
after a time lag.

(3) The trend rate of growth of productivity of labour and capital. For most countries
it is the growth of productivity that drives the long-term growth. The root causes of

153
1
improved efficiency come from making markets more competitive and achieving better
productivity within individual plants and factories. Increased investment in the human
capital of the workforce is widely seen as essential if the UK is to improve its long run
productivity performance – for example – increased spending on work-related training
and improvement in the UK education system at all levels.

(4) Technological improvements are important because they reduce the real costs of
supplying goods and services which leads to an outward shift in a country’s production
possibility frontier

The current growth phase for the UK is the longest period of continuous growth for over
forty years.

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Employment and Unemployment

We now turn our attention to the labour market and consider why people find themselves
out of work and cannot find a paid job. Unemployment imposes heavy economic and
social costs; we look at which policies are likely to be most effective in keeping
unemployment as low as possible.

Defining and measuring unemployment

Officially, the unemployed are people who are registered as able, available and willing to
work at the going wage rate but who cannot find work despite an active search for
work. This last point is important for to be classified as unemployed, one must show
evidence of being active in the labour market.

There are two main measures of unemployment in the UK:

1. The Claimant Count measure of unemployment includes those unemployed

people who are eligible to claim the Job Seeker's Allowance (JSA) or who have
enough National Insurance Credits. People who satisfy the criteria receive the
JSA for six months before moving onto special employment measures including
the New Deal Programme. The Claimant Count is a “head-count” of people
claiming unemployment benefit.
2. The Labour Force Survey covers those who are without any kind of job
including part time work but who have looked for work in the past month and are
able to start work in the next two weeks. The figure also includes those people
who have found a job and are waiting to start in the next two weeks.

154
1
On average, the labour force survey measure has exceeded the claimant count by about
400,000 in recent years. Because it is a survey (albeit a large one and one that provides a
rich source of data on the employment status of thousands of households across the UK),
we must remember that there will always be a sampling error in the data. The Labour
Force Survey measure is the internationally agreed definition of unemployment and
therefore the measure that best allows cross-country comparisons of unemployment
levels.

Under-counting the true level of unemployment

Britain may be twice as high as official statistics show. Research on the UK labour
market by economists at HSBC bank takes into account anybody who is 'economically
inactive', but looking for a job, not just those who are eligible for unemployment benefits.
The report estimates that there are 3.4m Britons who are unemployed, as opposed to the
International Labour Organisation's estimate of 1.4m people. Britain's official
unemployment rate is 4.8% - one of the lowest rates of unemployment in the European
Union

Adapted from newspaper reports, July 2004

The most recent changes in claimant count and labour force survey measures of
unemployment are summarised in the chart above and the table below.

155
1
 Labour Force Survey Unemployment Claimant Count

Unemployment
(seasonally adjusted)

Level Annual change Rate Level Annual change Rate

000s 000s % 000s 000s %

1990 2,004 -102 6.9 1,648 -120 5.5

1993 2,953 157 10.5 2,877 135 9.7

1997 2,045 -299 7.2 1,585 -503 5.3

1998 1,783 -262 6.3 1,348 -237 4.5

1999 1,759 -24 6.1 1,248 -100 4.1

2000 1,638 -121 5.6 1,088 -160 3.6

2001 1,431 -207 4.9 970 -119 3.2

2002 1,533 102 5.2 947 -23 3.1

2003 1,476 -57 5.0 933 -14 3.0

2004 1,426 -50 4.8 854 -80 2.7

2005 1,425 -1 4.7 862 8 2.7

In 2005, the UK had one of the lowest rates of unemployment among the major
developed nations. Although the Netherlands and Ireland both have unemployment rates
below that of the UK, we have one of the lowest rates in the European Union. Indeed for
the Euro Zone as a whole the rate of unemployment has been persistently high in recent
years – never lower than eight per cent and now rising to nearly nine per cent.
Unemployment is a major economic, social and political problem in countries such as
Poland, Germany, Spain and France – although the Spanish have succeeded in bringing
their unemployment down from high levels over the last few years.

156
1
Main causess of unemployment

We now consider some of the main underlying causes of people being out of work

Frictional Unemployment

Frictional unemployment is transitional unemployment due to people moving between

jobs:
For example, redundant workers or workers entering the labour market for the first time
(such as university graduates) may take time to find appropriate jobs at wage rates they
are prepared to accept. Many are unemployed for a short time whilst involved in job
search. Imperfect information in the labour market may make frictional unemployment
worse if the jobless are unaware of the available jobs. Incentives problems can also
cause some frictional unemployment as some people actively looking for a new job may
opt not to accept paid employment if they believe the tax and benefit system will reduce
the net increase in income from taking work. When this happens there are disincentives
for the unemployed to accept work.

Structural Unemployment

Structural unemployment occurs when there is a long run decline in demand in an

industry leading to a reduction in employment perhaps because of increasing
international competition. Globalisation is a fact of life – and inevitably it leads to
changes in the patterns of trade between countries over time. Britain for example has

157
1
probably now lost for good, its cost advantage in manufacturing goods such as motor
cars, household goods and audio-visual equipment. Manufacturing industry has lost over
400,000 jobs in the last five years alone. Many of these workers may suffer from a period
of structural unemployment, particularly if they are in regions of above-average
unemployment rates where job opportunities are scarce. The decline in manufacturing
industry jobs is shown in the next chart.

There is often a mismatch between the skills required for job vacancies and the skills and
experience that unemployed workers have – this is a problem associated with structural
unemployment

158
1
Structural unemployment exists where there is a mismatch between their skills and the
requirements of the new job opportunities. Many of the unemployed from manufacturing
industry (e.g. in coal, steel and engineering) have found it difficult to find new work
without an investment in re-training. This problem is one of occupational immobility of
labour

Cyclical Unemployment:

Cyclical unemployment is involuntary unemployment due to a lack of demand for

goods and services. This is also known as Keynesian "demand deficient"
unemployment. When there is a recession or a severe slowdown in economic growth, we
see a rising unemployment because of plant closures, business failures and an increase in
worker lay-offs and redundancies. This is due to a fall in demand leading to a contraction
in output across many industries. A downturn in demand is often the stimulus for
businesses to rationalise their operations by cutting employment in order to control costs
and restore some of their lost profitability.

Cyclical unemployment and the output gap

159
1
Real wage unemployment:

This is considered to be the result of real wages being above their market clearing level
leading to an excess supply of labour. Some economists believe that the minimum wage
risks creating unemployment in industries where international competition from low-
labour cost producers is severe. As yet, there is relatively little evidence that the
minimum wage has created rising unemployment on the scale that was feared.

Hidden unemployment

Undoubtedly there are thousands of people who by any reasonable definition are
unemployed, but who are not picked up by the official unemployment statistics. Many
have become discouraged workers and have stopped actively searching for work.

Unemployment and the production possibility frontier

160
1
The economic and social costs of unemployment

High unemployment is widely recognised to create substantial costs for individuals and
for the economy as a whole. Some of these costs are difficult to measure, especially the
longer-term social costs of a high level of unemployment. Some of the costs are
summarised below:

1. Loss of income: Unemployment normally results in a loss of income. The

majority of the unemployed experience a decline in their living standards and
are worse off out of work
2. Loss of national output: Unemployment involves a loss of potential national
output (i.e. GDP operating below potential) and represents an inefficient use of
scarce resources. If some people choose to leave the labour market permanently
because they have lost the motivation to search for work, this can have a negative
effect on long run aggregate supply (LRAS) and thereby damage the economy’s
growth potential
3. Fiscal costs: The government loses out because of a fall in tax revenues and
higher spending on welfare payments for families with people out of work. The
result can be an increase in the budget deficit which then increases the risk that
the government will have to raise taxation or scale back plans for public spending
on public and merit goods

161
1
 4. Social costs: Rising unemployment is linked to social deprivation. There is a
relationship with crime, and social dislocation (increased divorce rates, worsening
health and lower life expectancy). Areas of high unemployment see falling real
incomes and a worsening in inequalities of income and wealth

Gtytylovernment policies to reduce unemployment

Some countries are more successful than others in reducing the scale of unemployment.
In the long term, effective policies are required for both the demand and the supply side
of the economy so that enough new jobs are created and that people possess the skills and
incentives to take those jobs.

In general the most effective policies are those that:

1. Stimulate an improvement in the human capital of the workforce – so that

more of the unemployed have the skills to take up the available jobs. Policies
normally concentrate on improving the occupational mobility of labour. The
pattern of employment in any modern economy is always changing, so people
need to have sufficient flexibility to adapt to structural changes in industries over
the years
2. Improve incentives for people to search and then accept paid work – this may
require reforms of the tax and benefits system for example a reduction in the
starting rate of income tax (an incentive for people in lower paid jobs). Or perhaps
a change in welfare benefits such that people who find work do not experience a
sharp withdrawal of benefits because they are now earning more. The reality is
that simply cutting welfare benefits across the board makes little difference to the
unemployment figures – because of the complex nature of most unemployment.
But targeted measures to improve incentives, including the linking of welfare
benefits to participation in work experience programmes which is part of the New
Deal programme or lower tax rates for people on low incomes might have an
impact.
3. Employment subsidies: Government subsidies for those firms that take on the
long-term unemployed will create an incentive for businesses to increase the size
of their workforce. Employment subsidies may also be available for overseas
firms locating in the UK as part of the government’s regional policy. Labour’s
New Deal programme works by offering subsidised jobs and training to the long-
term unemployed. It differs from previous job creation schemes, in that people
who refuse to comply can have their benefits stopped. According to the
government's own figures, more than 40% of the jobs gained through the New
Deal are short-term.
4. Achieve a sustained period of economic growth – this requires that aggregate
demand is sufficiently high for businesses to be looking to expand their
workforce. The Keynesian theory of unemployment emphasises the argument
that if monetary and fiscal policy does not keep demand at a high enough level,
then the economy is less likely to be able to sustain a high rate of employment.

162
1
 However, not every increase in aggregate demand and production has to be met
by employing more labour. Each year we expect to see a rise in labour
productivity (more output per worker employed). And, businesses may decide to
increase production by making greater use of capital inputs such as extra units of
machinery. A growing economy creates jobs for people entering the labour
market for the first time. And, it provides employment opportunities for people
unemployed and looking for work.

Policies used in the UK to reduce unemployment

Demand side policies Supply-side policies

Employment subsidies for employers who Welfare reforms – including lower starting
take on the long-term unemployed (New rates of income tax and the introduction of
Deal) tax credits

Financial assistance for inward investment Policies to promote entrepreneurship and the
from overseas growth of small-medium size enterprises

Monetary policy – low interest rates has Increased spending on education and
allowed aggregate demand to grow despite a attempts to increase private sector spending
global economic slowdown. Fiscal policy is on training
also boosting AD as the budget deficit
increases

Evaluation points on unemployment policies

1. There are always cyclical fluctuations in employment. If growth can be

sustained and monetary and fiscal policy can avoid a large negative output gap
then it should be possible to create a steady flow of new jobs
2. Demand and supply-side policies need to work in tandem for unemployment to
fall in the long term. Simply boosting demand if the root cause of unemployment
is structural is an ineffective way of tackling the problem. If demand is stimulated
too much, the main risk becomes one of rising inflation (i.e. the trade-off between
these two objectives may worsen)
3. Full-employment does not mean zero unemployment! There will always be some
frictional unemployment – it may be useful to have a small surplus pool of labour
available
4. There are still large regional differences in unemployment levels and pockets of
deep-rooted long-term unemployment in many areas, which causes significant
economic and external costs

Recent trends in UK unemployment

163
1
The main explanation behind the decline in unemployment has been economic growth.
Labour as a factor input has a derived demand - so rising production generates a higher
demand for labour. These employment-creation effects have not been uniform throughout
regions and industries.

Other factors that have helped bring down the unemployment rate include:

1. Demographic factors – there has been a slower growth of the population of

working age than at a similar stage of the last economic cycle in the early 1980s.
This has lead to a slowdown in the numbers of people of working age entering the
UK labour market.
2. Expansion of further and higher education - there is a trend for more young
people choosing to delay their entry into the labour market and remain in full-time
post-16 further and higher education to boost their qualifications. Government
policies have an explicit aim of increasing the participation rate of 18 year-olds in
higher education. This puts less pressure on the number of new entrants into the
labour force looking for work.
3. "Discouraged worker effects" due to structural unemployment: Some
workers have given up active job search, in the process become economically
inactive and moved onto permanent sickness and invalidity benefits or early
retirement. The precise number of people involved is difficult to calculate with
accuracy – it probably affects several thousand people.
4. Employment creation from foreign investment: The British economy has been
successful in attracting billions of pounds worth of inward investment from
overseas companies. A high proportion of this has gone into building new plants
in the UK and this has created thousands of new jobs helping to offset some of the
regional disparities in unemployment.
5. Increased investment in worker training: This seems to have reduced structural
unemployment. Labour shortages are problematic in some industries, notably in
areas where house prices are high and unemployment rates have fallen below 2%.
But taking the economy as a whole, it seems that shortages of labour have not
proved to be as difficult as in previous phases of economic expansion. The main
shortages are in highly skilled jobs and in areas where living costs are well above
the national average. The government has suffered from a shortage of workers in
key public sector jobs.
6. Increased flexibility in the labour market: This has made it easier for
businesses to hire workers and match their desired labour input to planned
production. The number of part-time workers on short-term contracts has grown
by many thousands. There has also been greater functional flexibility with
workers expected to perform a number of tasks within the business.

Can the UK achieve full-employment?

The British labour market has performed well in the last decade raising hopes that low
unemployment be maintained for the foreseeable future. There is still much to be done to
reduce unemployment in economically depressed areas. Although the average rate of

164
1
unemployment has come down, jobless rates in excess of 10% are a feature of many
towns and cities. And youth unemployment remains a serious problem. The sustained
fall in unemployment has encouraged optimism that Britain can reach full-employment
in the near future. Indeed, in some regions and towns and cities, full-employment is
already a reality. The UK unemployment rate started to rise again in 2005 and 2006 albeit
at a gentle rate.

Economists agree that unemployment cannot fall to zero since there will always be
frictional unemployment caused by people moving into the labour market and others
switching between jobs. Full-employment might be defined as when the labour market
has reached a state of equilibrium - i.e. when those who are willing and able to work at
going wage rates are able to find work.

Another interpretation of full-employment is when the total of people out of work

matches the number of unfilled job vacancies. The problem with this is that estimates of
the scale of job vacancies vary considerably. The true number of jobs available is
probably three times the official published figure.

Skills Shortages

The prospect of reaching full-employment is diminished by the continuing problem of

skills shortages. Skills shortages have been a recurrent problem in manufacturing jobs,
but the problem has widened to new economy businesses and also the public services
(including education and the NHS)

Closing the skills gap

Literacy, numeracy and skills levels in the UK are so poor that a quarter of employers
struggle to fill job vacancies. A study by the national Skills Task Force backs up previous
research by suggesting that nearly one in five adults - about seven million - have a lower
level of literacy than the average 11 year old. Because of skills shortages, employers are
lowering their expectations when recruiting people and cutting back on capacity and
quality level. The report finds that a quarter of adults are "functionally innumerate", and
that one in three have less than five GCSE exam-passes. And it says employers believe
almost two million of their staff is not fully proficient at their jobs

Adapted from news reports on the Skills Gap

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Balance of Payments

165
1
The balance of payments provides us with important information about whether or not a
country is “paying its way” in the international economy.

What is the Balance of Payments?

The balance of payments (BOP) records all of the many financial transactions that are
made between consumers, businesses and the government in the UK with people across
the rest of the World. The BOP figures tell us about how much is being spent by British
consumers and firms on imported goods and services, and how successful UK firms have
been in exporting to other countries and markets. It is an important measure of the
relative performance of the UK in the global economy. At AS level we focus only on one
part of the balance of payments accounts. This section is known as the current account.
We will go through the make-up of this account in a later section.

Why is the export sector of the economy vital for the UK?

 Aggregate demand and the multiplier: An increasing share of Britain’s national

output is exported overseas as the nation becomes ever more integrated into the
global economy. Export earnings are an injection of AD into the circular flow. If
British companies can successfully sell more goods and services overseas, the rise
in exports boosts national income and should have a positive multiplier effect on
the national income, output and employment.
 Manufacturing industry: Export sales are particularly important for
manufacturing industry where exports are a high % of total production.
Thousands of jobs depend directly on the performance of the export sector and
even more are affected in supply industries. Select this link for more articles on
British manufacturing industry
 Regional economic health: The relative success of failure of export industries is
important for certain regions of the UK. When export sales dip (for example as a
result of a global downturn or the impact of the strong exchange rate), output,
employment and living standards come under threat and threaten to widen the
existing north-south divide.

Trade in goods includes items such as: Trade in services includes:

Manufactured goods Banking, insurance and consultancy
Semi-finished goods and components services
Energy products Other financial services including
Raw Materials foreign exchange and derivatives
Consumer goods trading
(i) Durable goods e.g. DVD recorder and Tourism industry
new cars Transport and shipping
(ii) Non-durable goods e.g. foods and Education and health services
beverages Services associated with research and

166
1
Capital goods (e.g. new plant and development
equipment) Cultural arts

Trade in goods

Trade in goods includes exports and imports of oil and other energy products,
manufactured goods, foodstuffs, raw materials and components. Until recently this was
known as visible trade – i.e. exporting and importing of tangible products. Since 1986 the
net balance of trade in goods for the UK has been in deficit. And as the following chart
shows, the trade deficit in goods has increased enormously in the last few years. In 2005
there was a record trade deficit of £66 billion, over three times the deficit seen in 1998.

Trade in services

Overseas trade in services includes the exporting and importing of intangible products –
for example, Banking and Finance, Insurance, Shipping, Air Travel, Tourism and
Consultancy. Britain has a strong trade base in services with over thirty per cent of total
export earnings come from services.

167
1
The balance of trade in services has been positive for many years. In 1999 the UK
became the second largest exporters of services in the world and in 2004 the UK
achieved its highest ever annual trade surplus in services although there was a smaller
surplus in 2005 partly because of higher insurance payouts arising from the effects of
Hurricane Katrina in the United States. Strong surpluses are especially common in
financial and business services and hi-tech knowledge services.

But the UK runs a deficit in international travel and transportation in part because of the
growth of demand for overseas holidays as living standards have improved. Once again,
rising incomes have caused a large rise in the demand for overseas leisure and business
travel and the sustained strength of the exchange rate against most European currencies
and the rapid expansion of low cost airlines offering short haul overseas breaks has also
played its part.

Britain has a comparative advantage in selling financial services to the rest of the
world. London is one of the three main financial centres in the world and has the largest
share of trading in many international financial markets. Many overseas banks have
established themselves in London’s money and capital markets. And numerous British
financial businesses have world class status in their areas of expertise. Our UK based
commercial banks, fund managers, securities dealers, futures and options traders,
insurance companies and money market brokerage businesses are part of a complex
network of financial and business services that represent a huge asset for the UK balance
of payments accounts.

168
1
Measuring the current account

The current account balance comprises the balance of trade in goods and services plus
net investment incomes from overseas assets. Net investment income arises from interest
payments, profits and dividends from external assets located outside the UK. We also add
in the net balance of private transfers between countries and government transfers (e.g.
UK government payments to help fund the various spending programmes of the
European Union).

The net investment income flow for the UK is positive – a reflection of the heavy
investment overseas in recent years by British businesses and individuals. The transfer
balance is negative – one reason is that the British government is a net contributor to the
EU budget.

The current account of the balance of payments

The current account balance is essentially a reflection of whether the British economy is
paying its way with other countries. The annual balance is volatile from year to year,
because each of the four component parts is subject to wide fluctuations.

Balance of Balance of Net Investment Current Current account

trade in goods trade in Income transfers balance
services

£ billion £ billion £ billion £ billion £ billion

1996 -13.7 11.2 0.6 -4.8 -6.7

1997 -12.3 14.1 3.3 -5.9 -0.8

1998 -21.8 14.7 12.3 -8.4 -3.2

1999 -29.1 13.6 1.3 -7.5 -21.7

2000 -33.0 13.6 4.5 -10.0 -24.8

2001 -41.2 14.4 11.7 -6.8 -21.9

2002 -47.7 16.8 23.4 -9.1 -16.5

2003 -48.6 19.2 24.6 -10.1 -14.9

169
1
2004 -60.9 25.9 26.6 -10.9 -19.3

2005 -67.3 17.9 29.9 -12.2 -26.6

Source: Office of National Statistics

What are the main questions that concern economists regarding these figures?

 Causation: Why does the UK now run such large trade deficits in goods?
 Consequences: Does it really matter if the British economy is running persistent
current account deficits?
 Correction: Which demand and supply-side economic policies are likely to be
most effective in improving our trade balances in the years ahead?

The underlying causes of the UK trade deficit

It is useful to group the explanations for the record trade deficit in goods into short-term,
medium-term and long-term factors. Some relate to the demand-side of the economy,
others to supply-side economic influences

Short-term factors

 Strong consumer demand: Real household spending has grown more quickly
than the supply-side of the economy can deliver, leading to a very high level of
demand for imported goods and services
 High income elasticity of demand for imports: Evidence suggests that UK
consumers have a high income elasticity of demand for overseas-produced goods
– demand for imports grows quickly when consumer demand is robust. Nicholas
Fawcett and Michael Kitson in a recent article in the Guardian estimated that the
income elasticity is around +2.3 suggesting that a 2% increase in real incomes
boosts demand for imports by 4.6%. Because the overseas demand for UK exports
rarely keeps pace with the surging demand for imported products, so the trade
deficit widens when the economy enjoys a period of consumption-led growth.
 The strong exchange rate has helped to reduce the UK price of imports causing
an expenditure-switching effect away from domestically produced output.
 The weakness of the global economy and in particular the slow growth in the
Euro Zone has damaged UK export growth. Nearly 60% of UK manufactured
goods exports and over 50% of our exports of services are to fellow members of
the European Union.

Medium-term factors

170
1
  UK trade balances have been affected by shifts in comparative advantage in the
international economy – for example the rapid growth of China as a source of
exports of household goods and other countries in South-east Asia who have a
cost advantage in exporting manufactured products
 The availability of imports from other countries at a relatively lower price
inevitably causes a substitution effect from British consumers.

Longer-term factors

 Much of our trade deficit is due to structural rather than cyclical factors
 Our trade performance has been hindered by supply-side deficiencies which
impact on the price and non-price competitiveness of British products in global
markets - non-price competitiveness factors such as design and product quality
are now more important for trade than merely price alone.
o A relatively low rate of capital investment compared to other countries
o The persistence of a productivity gap with our major competitors –
measured by differences in GDP per person employed or per hour worked
– this is linked to low investment and also to the existence of a skills-gap
between UK workers and employees in many other countries
o A relatively weak performance in terms of product innovation – linked
to a low rate of business sector spending on research and development
 The UK manufacturing sector has been in long-term decline for more than
twenty years. This is known as a process of deindustrialisation. Although we still
have some world class manufacturing companies, the size of our manufacturing
sector is not large enough both to meet consumer demand in the UK and also to
export sufficient volumes of products to pay for a growing demand for imports

What does a current account deficit mean?

Running a sizeable deficit on the current account basically means that the UK economy is
not paying its way in the global economy. There is a net outflow of demand and income
from the circular flow of income and spending. The current account does not have to
balance because the balance of payments also includes the capital account. The capital
account tracks capital flows in and out of the UK. This includes portfolio capital flows
(e.g. share transactions and the buying and selling of Government debt) and direct capital
flows arising from foreign investment.

The Effects of Changes in the Balance of Payments on the UK Economy

Consider the effects of a slowdown in exports and a faster growth in imports of goods
and services caused by a rise in the value of sterling against other currencies that leads to
a worsening of the balance of payments. This has further effects on the economy as a
whole:

 Reductions in demand in the circular flow: There will be a net fall in AD

because more money is leaving the circular flow of income (through imports) than

171
1
 is coming in from exports. An inward shift of AD would lead to a contraction
along the SRAS curve.
 Lost jobs: There will be a loss of employment if exporting industries require less
labour and if UK businesses lose market share and output to cheaper imports from
overseas.
 Dip in business confidence and investment: A fall in business confidence and a
decline in capital investment spending by UK exporting firms whose order books
are less full and whose profits take a hit from a fall in demand from overseas.
 Reductions in inflationary pressure: Lower inflation because imports coming
into the UK are cheaper and a fall in AD takes the economy further away from
full capacity. Reduced inflationary pressure might then persuade the Bank of
England to reduce interest rates to provide a boost to macroeconomic activity.

The exchange rate and the balance of payments

Changes in the exchange rate can have a big effect on the balance of payments although
these effects are subject to uncertain time lags. When sterling is strong then UK exporters
found it harder to sell their products overseas and it is cheaper for UK consumers to buy
imported goods and services because the pound buys more foreign currency than it did
before.

The Balance of Payments and the Standard of Living

A common misconception is that balance of payments deficits are always bad for the
economy. This is not necessarily true. In the short term if a country is importing a high
volume of goods and services this is a boost to living standards because it allows
consumers to buy more consumer durables. However, in the long term if the trade deficit
is a symptom of a weak economy and a lack of competitiveness then living standards
may decline.

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Monetary Policy

Monetary policy influences the decisions that we make about how much we save, borrow
and spend.

What is Money?

172
1
Money is defined as any asset that is acceptable as a medium of exchange in payment for
goods and services. The main functions of money are as follows:

1. A medium of exchange used in payment for goods and services

2. A unit of account used to relative measure prices and draw up accounts
3. A standard of deferred payment – for example when using credit to purchase
goods and services now but pay for them later
4. A store of value - money holds its value fairly well unless there is a situation of
accelerating inflation. As the general price level in the economy rises, so the
internal value of a unit of currency decreases.

Interest Rates

There is no unique rate of interest in the economy. For example we distinguish between
savings rates and borrowing rates. However interest rates tend to move in the same
direction. For example if the Bank of England cuts the base rate of interest then we
expect to see lower mortgage rates and lower rates on savings accounts with Banks and
Building Societies.

The Real Rate of Interest

The real rate of interest is often important to businesses and consumers when making
spending and saving decisions. The real rate of return on savings, for example, is the
money rate of interest minus the rate of inflation. So if a saver is receiving a money rate
of interest of 6% on his savings, but price inflation is running at 3% per year, the real rate
of return on these savings is only + 3%.

The Job of Monetary Policy

“…to deliver price stability (as defined by the Gove

rnment’s inflation target) and, subject to this objective, to support the Government’s
economic policy, including its objectives for economic growth and employment…”

The Bank of England has been independent since 1997. In that time there has been a
cycle of small changes in interest rates. They have varied from 3.75% (in the late autumn
of 2003) to 7.5% in the autumn of 1997. Generally though, the UK economy has
experienced a sustained period of low interest rates over recent years. And, this has had
important effects on the wider economy.

The Bank of England prefers a gradualist approach to monetary policy – believing that
a series of small movements in interest rates is a more effective strategy rather than sharp
jumps in the cost of borrowing money. Their aim is not to shock consumers and
businesses to control their spending, but to gradually increase the cost of borrowing
money and increase the incentive to save, so that the pace of growth moderates and the
economy can continue to grow without causing rising inflation.

173
1
Factors considered when setting interest rates

1. The State of Demand: Is aggregate demand too strong – for example is

household spending booming at an unsustainable rate?
2. The Housing Market: What are the economic signals coming from the housing
market? If house prices rising too strongly, this might feed through into increased
consumer demand and the risk of a surge in demand-pull inflation.
3. The Labour Market: Are their inflationary signals coming from the labour
market in the form of acceleration in wages and average earnings well above the
growth of labour productivity?
4. Inflation from overseas: Is there a risk from import costs such as a rise in oil
prices?
5. Trends in the Exchange Rate: What is happening and what is projected to
happen to the sterling exchange rate?

It is important to note that monetary policy in Britain is designed to be pro-active and

forward-looking. This means that the MPC is aware that changes in interest rates take
time to work through the economic system. Making decisions on interest rates on the
basis of today’s inflation data simply does not make sense. The teams of economists at
the Bank must make regular forecasts of inflation and consider whether the current level
of UK interest rates is appropriate in order to meet the inflation target.

Interest rate changes since 1997

174
1
Effects of Changes in Interest Rates

There are several ways in which changes in interest rates influence aggregate demand.
These are collectively known as the transmission mechanism of monetary policy.

One of the principal channels that the MPC can use to influence aggregate demand, and
therefore inflation, is via the lending and borrowing rates charged by the market.

When the Bank’s base interest rate rises, banks will typically increase both the rates that
they charge on loans, and the interest that they offer on savings. This tends to discourage
businesses from taking out loans to finance investment and encourages the consumer to
save rather than spend — and so depresses aggregate demand. Conversely, when the base
rate falls, banks tend to cut the market rates offered on loans and savings. This will tend
to stimulate aggregate demand.

Changes to the level of interest rates take time to have an impact on overall economic
activity - i.e. there is a time lag involved. A change in interest rates can have wide-
ranging effects on the economy.

The Bank’s view of the transmission mechanism resulting from a change in official
base interest rates is shown in the flow chart above – the key to it is that short-term

175
1
changes in interest rates feed through fairly quickly to the rest of the UK financial system
(e.g. resulting in changes in mortgage interest rates, rates of interest on savings accounts
and also credit card rates) and then start to influence the spending and savings decisions
of millions of households and businesses.

A key influence played by rate changes is the effect on confidence – in particular

household’s confidence about their own personal financial circumstances.

1. Housing market & house prices: Higher interest rates increase the cost of
mortgages and eventually reduce the demand for most types of housing. This will
slow down the growth of household wealth and put a squeeze on equity
withdrawal (consumers borrowing off the back of rising house prices) which adds
directly to consumer spending and can fuel inflation
2. Effective disposable incomes of mortgage payers: If interest rates increase, the
income of homeowners who have variable-rate mortgages will fall – leading to a
decline in their effective purchasing power. The effects of a rate change are
greater when the level of existing mortgage debt is high, leading to a rise in debt-
servicing burdens for home-owners. On the other hand, a rise in interest rates
boosts the disposable income of people who have paid off their mortgage and who
have positive net savings in bank and building society accounts.
3. Consumer demand for credit: Higher interest rates increase the cost of servicing
debt on credit cards and should lead to a deceleration in the growth of retail sales
and spending on consumer durables. Much depends on the impact of a rate change
on consumer confidence.
4. Business capital investment: Firms often take the actual and expected level of
interest rates into account when deciding whether or not to proceed with new
capital investment spending. A rise in short term rates may dampen business
confidence and lead to a reduction in planned capital investment. However, many
factors influence investment decisions other than rate changes.
5. Consumer and business confidence: The relationship between interest rates and
business and consumer confidence is complex, and depends crucially on
prevailing economic conditions. For example, when businesses and consumers are
worried about the risk of a recession, an interest rate cut can boost confidence
(and therefore aggregate demand) because it reassures the public that the Bank is
alert to the dangers of an economic slump. There are circumstances, however,
where a cut in rates could undermine confidence. For example, were the Bank of
England to cut interest rates too quickly, the fear might be that the Bank is
particularly worried about the prospects of a recession. The setting of interest
rates nearly always calls for a finely balanced judgement, particularly when the
effects on consumer and business confidence are concerned.
6. Interest rates and the exchange rate: Higher UK interest rates might lead to an
appreciation of the sterling exchange rate particularly if UK interest rates rise
relative to those in the Euro Zone and the United States attracting inflows of “hot
money” into the British financial system. A stronger exchange rate reduces the
competitiveness of UK exports in overseas markets because it makes our exports
appear more expensive when priced in a foreign currency (leading to a decline in

176
1
 export volumes and market share). It also reduces the sterling price of imported
goods and services leading to lower prices and rising import penetration. If the
trade deficit in goods and services widens, this is a net withdrawal of demand
from the circular flow and acts to reduce excess demand in the economy.

Usually a UK interest rate cut will tend to weaken the pound as it makes it less attractive
for foreign investors to hold their money in Britain.

When the pound rises, British exports become more expensive, while imported goods
from abroad become cheaper. So a rising pound leads to a fall in demand for UK exports
and a fall in demand for domestically produced goods that compete with imports from
overseas. A rising pound therefore reduces aggregate demand, and so can dampen down
the rate of inflation. An increase in the pound also affects the inflation rate directly by
bringing down the price of imported goods.

Monetary Policy Asymmetry

Fluctuations in interest rates do not have a uniform impact on the economy. Some
industries are more affected by interest rate changes than others (for example exporters
and industries connected to the housing market). And, some regions of the British
economy are also more exposed (sensitive) to a change in the direction of interest rates.

The markets that are most affected by changes in interest rates are those where demand
is interest elastic in other words, market demand responds elastically to a change in
interest rates (or indirectly through changes in the exchange rate).

Good examples of interest-sensitive industries include those directly linked to demand

conditions in the housing market¸ exporters of manufactured goods, the construction
industry and leisure services. In contrast, the demand for basic foods and utilities is less
affected by short term fluctuations in interest rates.

The rate of interest is under the control of the Bank of England, but most other economic
variables are not! The MPC’s decisions can influence consumer and business behaviour
but it cannot determine directly the rate of inflation.

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Fiscal Policy

Fiscal policy involves the use of government spending, taxation and borrowing to
influence both the pattern of economic activity and also the level and growth of

177
1
aggregate demand, output and employment. It is important to realise that changes in
fiscal policy affect both aggregate demand (AD) and aggregate supply (AS).

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as an instrument of demand management.

This means that changes in government spending, direct and indirect taxation and the
budget balance can be used to help smooth out some of the volatility of real national
output particularly when the economy has experienced an external shock. For example,
from 2001-2005 there has been a fiscal stimulus to the UK economy through substantial
increases in government spending on transport, and in particular heavier spending in the
twin areas of health and education. This fiscal stimulus will come to an end in the next
couple of years as the government slows down the rate of which its own spending is
increasing.

 The Keynesian school argues that fiscal policy can have powerful effects on
aggregate demand, output and employment when the economy is operating well
below full capacity national output, and where there is a need to provide a
demand-stimulus to the economy. Keynesians believe that there is a clear and
justified role for the government to make active use of fiscal policy measures to
manage the level of aggregate demand.

 Monetarist economists on the other hand believe that government spending and
tax changes can only have a temporary effect on aggregate demand, output and
jobs and that monetary policy is a more effective instrument for controlling
demand and inflationary pressure. They are much more sceptical about the
wisdom of relying on fiscal policy as a means of demand management.

The fiscal policy transmission mechanism

178
1
How does a change in fiscal policy feed through the economy to affect variables such as
aggregate demand, national output, prices and employment? This simple flow-chart
above identifies some of the possible channels involved with the fiscal policy
transmission mechanism.

The multiplier effects of an expansionary fiscal policy depend on how much spare
productive capacity the economy has; how much of any increase in disposable income is
spent rather than saved or spent on imports. And also the effects of fiscal policy on
variables such as interest rates

Government spending

Government (or public) spending each year takes up over 40% of gross domestic product.
Spending by the public sector can be broken down into three main areas:

 Transfer Payments: Transfer payments are government welfare payments

made available through the social security system including the Jobseekers’
Allowance, Child Benefit, the basic State Pension, Housing Benefit, Income
Support and the Working Families Tax Credit. These transfer payments are not
included in the national income accounts because they are not a payment for
output produced directly by a factor of production. Neither are they included in
general government spending on goods and services. The main aim of transfer
payments is to provide a basic floor of income or minimum standard of living for
low income households in our society. And they also provide a means by which
the government can change the overall distribution of income in a country.
 Current Government Spending: i.e. spending on state-provided goods &
services that are provided on a recurrent basis every week, month and year, for
example salaries paid to people working in the NHS and resources used in
179
1
 providing state education and defence. Current spending is recurring because
these services have to be provided day to day throughout the country. The NHS
claims a sizeable proportion of total current spending – hardly surprising as it is
the country’s biggest employer with over one million people working within the
system!
 Capital Spending: Capital spending would include infrastructural spending such
as spending on new motorways and roads, hospitals, schools and prisons. This
investment spending by the government adds to the economy’s capital stock and
clearly can have important demand and supply side effects in the medium to long
term.

Government spending is justified on economic and social grounds including the desire to
correct for perceived market failure when the market mechanism might fail to provide
sufficient public and merit goods for social welfare to be maximized.

Therefore, we justify government spending on these grounds:

 To provide a socially efficient level of public goods and merit goods

 To provide a safety-net system of welfare benefits to supplement the incomes of
the poorest in society – this is also part of the process of redistributing income
and wealth
 To provide necessary infrastructure via capital spending on transport, education
and health facilities – an important component of a country’s long run aggregate
supply
 As a means of managing the level and growth of AD to meet the government’s
main macroeconomic policy objectives such as low inflation and high levels of
employment

The Private Finance Initiative (PFI)

180
1
The Private Finance Initiative is a way of funding expensive infrastructure
developments without running up debts. Rather than borrowing to fund new projects,
John Major's government entered into a long-term leasing agreement with private
contractors. Under a PFI, companies borrow the cash to build and run new hospitals,
schools and prisons for a period of up to 60 years. So far, about 150 PFI contracts have
been signed, worth more than £40bn, with more in the pipeline. PFI is often portrayed as
using private money to pay for improvements in public services. But, critics argue, it is
still paid for through the public purse. It is not new money. Furthermore, the critics say,
private finance is, by its nature, more expensive than public capital. The government of
the day may feel it is getting a hospital or school at a bargain price but the country will
pay more in the long run.

Automatic stabilisers and discretionary changes in fiscal policy

Discretionary fiscal changes are deliberate changes in direct and indirect taxation and
govt spending – for example a decision by the government to increase total capital
spending on the road building budget or increase the allocation of resources going direct
into the NHS.

Automatic stabilisers include those changes in tax revenues and government spending
that come about automatically as the economy moves through different stages of the
business cycle

 Tax revenues: When the economy is expanding rapidly the amount of tax
revenue increases which takes money out of the circular flow of income and
spending
 Welfare spending: A growing economy means that the government does not
have to spend as much on means-tested welfare benefits such as income support
and unemployment benefits
 Budget balance and the circular flow: A fast-growing economy tends to lead to
a net outflow of money from the circular flow. Conversely during a slowdown or
a recession, the government normally ends up running a larger budget deficit.

Taxation

We now turn to the revenue that flows into the government’s accounts from taxation.
There are so many different kinds of taxation and the tax system itself often appears to be
horrendously complex! But one important distinction to make is between direct and
indirect taxes.

 Direct taxation is levied on income, wealth and profit. Direct taxes include
income tax, national insurance contributions, capital gains tax, and corporation
tax.

 Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes
and alcohol and Value Added Tax (VAT) on many different goods and services

181
1
By far the biggest source of income for the government is income tax. In the last tax year
the state received over £127 billion in income tax receipts, nearly fifty billion pounds
higher than the income from national insurance contributions.

Income from selected range of taxes for the UK government 1999-00 2004-05

£ billion £ billion

Income tax 95.7 127.2

National Insurance contributions 56.1 78.1

VAT 56.4 73.0

Corporation tax 34.3 34.1

Fuel duties 22.5 23.3

Council Tax 13.1 20.1

Business rates 15.4 18.7

Other taxes 8.1 11.7

Stamp duties 6.9 9.0

Tobacco duty 5.7 8.1

Vehicle excise duty 4.9 4.7

Beer & cider duties 3.0 3.3

Inheritance tax 2.1 2.9

Spirits duties 1.8 2.4

Capital gains tax 2.1 2.3

Wine duties 1.7 2.2

Customs Duties & levies 2.0 2.2

182
1
Betting & Gaming duties 1.5 1.4

Petroleum revenue tax 0.9 1.3

Air Passenger duty 0.9 0.9

Source: HM Treasury Public Finance Statistics

Progressive, proportional and regressive taxes

 With a progressive tax, the marginal rate of tax rises as income rises. I.e. as
people earn more income, the rate of tax on each extra pound earned goes up.
This causes a rise in the average rate of tax (the percentage of income paid in tax).
The UK income tax system is progressive. Everyone is entitled to a tax-free
income. Thereafter, as income grows, people pay the starting rate of tax (10%)
before moving onto the basic tax rate (22%). Higher income earners pay the top
rate of tax (40%) on each additional pound of income over the top rate tax limit.
This is the highest rate of income tax applied.

183
1
  With a proportional tax, the marginal rate of tax is constant. For example, we
might have an income tax system that applied a standard rate of tax of 25% across
all income levels. If the marginal rate of tax is constant, the average rate of tax
will also be constant. National insurance contributions are the closest example in
the UK of a proportional tax, although low-income earners do not pay NICs
below an income threshold, and NICs also do not rise for income earned above a
top threshold.

 With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate
of tax is lower for people of higher incomes. In the UK, most examples of
regressive taxes come from excise duties of items of spending such as cigarettes
and alcohol. There is well-documented evidence that the heavy excise duty
applied on tobacco has quite a regressive impact on the distribution of income in
the UK.

Fiscal Policy and Aggregate Supply

Changes to fiscal policy can affect the supply-side capacity of the economy and therefore
contribute to long term economic growth. The effects tend to be longer term in nature.

 Labour market incentives: Cuts in income tax might be used to improve

incentives for people to actively seek work and also as a strategy to boost labour
productivity. Some economists argue that welfare benefit reforms are more
important than tax cuts in improving incentives – in particular to create a “wedge”
or gap between the incomes of those people in work and those who are in
voluntary unemployment.

 Capital spending. Government capital spending on the national infrastructure

(e.g. improvements to our motorway network or an increase in the building
programme for new schools and hospitals) contributes to an increase in
investment across the whole economy. Lower rates of corporation tax and other
business taxes might also be used as a policy to stimulate a higher level of
business investment and attract inward investment from overseas
 Entrepreneurship and new business creation: Government spending might be
used to fund an expansion in the rate of new small business start-ups
 Research and development and innovation: Government spending, tax credits
and other tax allowances could be used to encourage an increase in private
business sector research and development – designed to improve the international
competitiveness of domestic businesses and contribute to a faster pace of
innovation and invention
 Human capital of the workforce: Higher government spending on education and
training (designed to boost the human capital of the workforce) and increased
investment in health and transport can also have important supply-side economic
effects in the long run. An enhanced transport infrastructure is seen by many
business organisations as absolutely essential if the UK is to remain competitive
within the European and global economy

184
1
Free market economists are normally sceptical of the effects of government spending in
improving the supply-side of the economy. They argue that lower taxation and tight
control of government spending and borrowing is required to allow the private sector of
the economy to flourish. They believe in a smaller sized state sector so that in the long
run, the overall burden of taxation can come down and thus allow the private sector of the
economy to grow and flourish.

However targeted government spending and tax decisions can have a positive impact
even though fiscal policy reforms take a long time to feed through. The key is to help
provide the right incentives for individuals and businesses – for example the incentives to
find work and incentives for businesses to increase employment and investment.

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Supply-side Policies

In this chapter we take a walk on the supply-side of the economy. The “supply side”
refers to factors affecting the quantity or quality of goods and services produced by an
economy such as the level of productivity or investment in research and development.

What are supply-side policies?

Supply-side economic policies are mainly micro-economic policies designed to improve

the supply-side potential of an economy, make markets and industries operate more
efficiently and thereby contribute to a faster rate of growth of real national output

Most governments now accept that an improved supply-side performance is the key to
achieving sustained economic growth without a rise in inflation. But supply-side
reform on its own is not enough to achieve this growth. There must also be a high
enough level of aggregate demand so that the productive capacity of an economy is
actually brought into play.

There are two broad approaches to the supply-side. Firstly policies focused on product
markets where goods and services are produced and sold to consumers and secondly the
labour market – a factor market where labour is bought and sold.

Supply Side Policies for Product Markets

Product markets refer to markets in which all kinds of commodities are traded, for
example the market for airline travel; for mobile phones, for new cars; for pharmaceutical
products and the markets for financial services such as banking and occupational
pensions.

185
1
Supply-side policies in product markets are designed to increase competition and
efficiency. If the productivity of an industry improves, then it will be able to produce
more with a given amount of resources, shifting the LRAS curve to the right.

Privatisation

Over the last twenty-five years, many former state-owned businesses have been
privatised – i.e. they have transferred from the public sector into the private sector.
Examples in Britain include British Gas, British Telecom, British Airways, British Steel,
British Aerospace, the regional water companies, the main electricity generators and
distributors, and the Railways.

British Rail was privatised in 1994 but the failure of Railtrack led to the creation of
Network Rail, a ‘not for profit’ company in 2002. The Labour Government has continued
to privatise or part-privatise other parts of the UK public sector since it came to power in
1997.

Privatization is designed to break up state monopolies and create more competition. The
government also created utility regulators who have imposed price controls on many of
these industries and who are now over-seeing the move towards competitive markets in
areas such as gas and electricity supply and telecommunications.

Deregulation of Markets

De-regulation or liberalisation means the opening up of markets to greater

competition. The aim of this is to increase market supply (driving prices down) and
widen the range of choice available to consumers. The discipline of competition should
also lead to greater cost efficiency from producers – who are keen to hold onto their
existing market share. Good examples of deregulation to use include: urban bus transport,
parcel delivery services, mortgage lending, telecommunications, and gas and electricity
supply.

Toughening up of Competition Policy

Most supply-side economists believe in the dynamic effects of greater competition and
that competition forces business to become more efficient in the way in which they use
scarce resources. This reduces costs which can be passed down to consumers in the form
of lower prices. A tougher competition policy regime includes policies designed to curb
anti-competitive practices such as price-fixing cartels and other abuses of a dominant
market position – in other words – intervention to curb some of the market failure that
can come from monopoly power

A commitment to free international trade

Trade between nations creates competition and should be a catalyst for improvements in
costs and lower prices for consumers. The UK government is committed to an expansion

186
1
of free trade within the European Single Market and also to negotiating a liberalisation
of trade in the global economy as part of its membership of the World Trade
Organisation. For example, it wants to see further reforms of the Common Agricultural
Policy as a stepping-stone to global trade agreements between Europe, the United States
and developing countries.

Measures to encourage small business start-ups / entrepreneurship

The small businesses of today can often become the larger businesses of tomorrow,
adding to national output, employing more workers and contributing to innovative
behaviour that can have positive spill-over effects in other industries. Governments of all
political persuasion argue that they want to promote an entrepreneurial culture and to
increase the rate of new business start-ups. Supply side policies include loan
guarantees for new businesses; regional policy assistance for entrepreneurs in depressed
areas of the country; advice for new firms

Capital investment and innovation:

Capital spending by firms adds to aggregate demand (C+I+G+(X-M)) but also has an
important effect on long run aggregate supply. Supply side policies would include tax
relief on research and development and reductions in the rate of corporation tax. Ireland
is a good example of a country inside the EU that has benefited hugely from cutting
company taxes which has led to a large rise in foreign direct investment. One of the new
countries joining the EU in 2004, Estonia, has cut its corporation tax rate to zero per cent
(0%) in a deliberate attempt to attract new investment and stimulate economic growth
and employment. There are now big differences in corporation tax rates among the
twenty five nations of the European Union.

Corporate Tax Rates in the European Union in 2004

Estonia 0.0% Luxembourg 30.0%

Ireland 12.5% Denmark 30.0%

Lithuania 15.0% Czech Rep. 31.0%

Cyprus 15.0% Portugal 33.0%

Latvia 19.0% Austria 34.0%

Slovakia 19.0% Belgium 34.0%

Poland 19.0% Italy 34.0%

187
1
Hungary 20.0% Netherlands 34.5%

Slovenia 25.0% Spain 35.0%

Sweden 28.0% Greece 35.0%

Finland 29.0% France 35.4%

UK 30.0% Germany 38.7%

The issue of incentives is crucial for if inventions and innovations can be widely and
easily copied and implemented, then the rewards to those engaged in cutting-edge
research might be diluted leading to a decrease in the willingness of entrepreneurs to take
risks.

Innovation and Economic Growth

‘A dynamic environment with opportunities for enterprise and innovation is vital to

improving economic performance. New businesses entering the marketplace increase
competitive pressures facilitating the introduction of new ideas and technologies. The
Government is therefore committed to supporting enterprise and innovation throughout
the economy, including in Britain’s most disadvantaged areas.’
Source: Government Spending Review Statement, July 2002

Supply side policies for the Labour Market

These policies are designed to improve the quality and quantity of the supply of labour
available to the economy. They seek to make the British labour market more flexible so
that it is better able to match the labour force to the demands placed upon it by employers
in expanding sectors thereby reducing the risk of structural unemployment. An expansion
in the UK’s total labour supply increases the productive potential of an economy. That
expansion in the supply of people willing and able to work can come from several
sources for example: encouraging older people to stay in the workforce; a relaxed
approach to labour migration and measures to get non-working parents to actively look
for work.

Trade Union Reforms

Many of the traditional legal protections enjoyed by the trade unions have been taken
away – including restrictions on their ability to take industrial action and enter into
restrictive practices agreements with employers. The result has been a decrease in strike
action in virtually every industry and a significant improvement in industrial relations in
the UK.

188
1
Increased Spending on Education and Training

Economists disagree about the scale of the likely economic and social returns to be
earned from higher spending on education – but few of them deny that “investment in
education” has the potential to raise the skills within the work force and improve the
employment prospects of thousands of unemployed workers. The economic returns from
extra education spending can vary according to the stage of development that a country
has achieved.

Government spending on education and training improves workers’ human capital.

Economies that have invested heavily in education are those that are well set for the
future. Most economists agree, with the move away from industries that required manual
skills to those that need mental skills, that investment in education, and the retraining of
previously manual workers, is absolutely vital.

It should also be noted that improved training, especially for those who lose their job in
an old industry should improve the occupational mobility of workers in the economy.
This should help reduce the problem of structural unemployment. A well-educated
workforce acts as a magnet for foreign investment in the economy.

Income Tax Reforms and the Incentive to Work

Economists who support supply-side policies believe that lower rates of income tax
provide a short-term boost to demand, and they improve incentives for people to work
longer hours or take a new job – because they get to keep a higher percentage of the
money they earn.

Attention has focused in recent years on lower income households. In the mid 1990s, a
lower starting rate of tax of 10% was introduced and the band of income on which this is
paid has been widened in recent Budgets. Cutting tax rates for lower paid workers may
help to reduce the extent of the ‘unemployment trap’ – where people calculate that they
may be no better off from working than if they stay outside the labour force.

Do lower taxes really help to increase the active labour supply in the economy? It seems
obvious that lower taxes should boost the incentive to work because tax cuts increase the
reward from a job. But some people may choose to work the same number of hours and
simply take a rise in their post-tax income! Millions of other workers have little choice
over the hours that they work.

Showing the effects of supply-side improvements in the economy

Supply-side factors often help to explain why it is that some countries grow faster than
others. In a world of globalisation, it is becoming clearer that maintaining and improving
competitiveness is vital in achieving success in international markets. A rising share of
GDP in most countries is devoted to international trade. Markets are becoming more
competitive and those countries whose supply-side lets those down can find a rising level

189
1
of import penetration into their domestic markets and a weak export performance in
goods and services.

Supply side improvements can also be shown using a production possibility frontier

Supply side policies and productivity

It is important to recognise that the supply-side does not operate in isolation from
changes in aggregate demand. If there is insufficient AD, it is unlikely that better
supply-side performance can be achieved over a number of years. Equally, if aggregate
demand grows too quickly, acceleration in wage and price inflation might require
deflationary policies that ultimately harm a country’s productive potential.

Evaluating the UK’s supply-side performance

On the right tracks

“There has been a remarkable structural improvement in the British economy. This began
under Margaret Thatcher and has largely been maintained under Tony Blair.

190
1
Deregulation, privatisation, reductions in trade union power and reform of unemployment
benefits have transformed the business environment.”
Source: Ed Crooks, Economics editor of the Financial Times. June 2004

Improvements in the Supply Side Supply-Side Weaknesses

Sustained economic growth. The UK hasThere remains a large productivity

maintained its position as the 4th largest between the UK and other leading
economy in the world and has weathered economies – this is now a major focus of
the global economic downturn well supply side policies

There has been a large fall in Sharp rise in the balance of payments
unemployment and a record level of deficit in goods and services – suggesting
employment. The UK currently has the continued problems of international
highest employment ratio in the EU competitiveness

Falling unemployment and continued Few signs that the underlying rate of
low inflation – suggesting an economic growth has improved above
improvement in the trade-off between 2.5% per year – other countries have a
these two important macroeconomic faster rate of growth of potential output
objectives

Service sector has been strong but

manufacturing industry has suffered three
recessions in the last ten years

The UK labour market is seen as one of Still an investment gap (including under-
the most flexible among leading investment in public sector services such
economies, with a rising level of as education, health and transport) and
occupational flexibility of labour the UK devotes a falling share of GDP to
business research and development

There is a general consensus that the supply-side of the British economy has improved
over the last twenty years even though there are still weaknesses in several sectors and
the UK must face up to increasingly fierce competition from other countries as the effects
of globalisation take hold. Our product and labour markets are more flexible than they
were a decade ago but many businesses complain that government intervention places too
heavy a cost of administration and other forms of red-tape and that this acts as a barrier to
future investment and growth. Increasing amounts of regulation both from the UK and
the European Union can add to business costs and reduce competitiveness.

Author: Geoff Riley, Eton College, September 2006

191
1
AS Macroeconomics / International Economy
Macroeconomic Objectives

All governments have targets and aims for the economy – in this chapter we consider the
main objectives of macroeconomic policy.

Objectives are the aims or goals of government policy whereas instruments are the
means by which these aims might be achieved and targets are often thought to be
intermediate aims – linked closely in a theoretical way to the final policy objective.

So for example, the government might want to achieve low inflation. The main
instrument to achieve this might be the use of interest rates (now set by the Bank of
England) and a target might be the growth of consumer credit or perhaps the exchange
rate.

Only a limited number of policies can be used to achieve the government’s objectives.
There is a huge amount of research conducted in trying to determine the effectiveness of
different policies in meeting key objectives. Indeed, the debates about which policies are
most suitable lie at the heart of differences between economic schools of thought.

The main policy instruments available to meet the objectives are

Monetary policy –changes to interest rates, the supply of money and credit and changes
to the exchange rate
Fiscal policy – changes to government taxation, government spending and borrowing
Supply-side policies designed to make markets work more efficiently
Direct controls or regulation of particular markets

Find out more about schools of thought

If you want to delve a little deeper into the differences between schools of thought in
Economics here are a few links to resources available on the Wikipedia web site:

 Keynes and Keynesian Economists: http://en.wikipedia.org/wiki/Keynes

 Monetarists: http://en.wikipedia.org/wiki/Monetarist

 Classical economists: http://en.wikipedia.org/wiki/Classical_economics

The Objectives of UK Economic Policy

The Labour Government has several current macroeconomic objectives:

192
1
  Stable low inflation - the Government’s inflation target is 2.0% for the
consumer price index. The Monetary Policy Committee sets interest rates at a
level it thinks will meet the inflation target over a two year forecasting horizon.
The Bank of England has been independent since May 1997 but inflation targets
pre-date the decision to hand over control of monetary policy to the BoE. Inflation
targets were first introduced into the UK in October 1992 and have played a role
in keeping inflation expectations under control.
 Sustainable economic growth – as measured by the rate of growth of real gross
domestic product – sustainable both in terms of maintaining low inflation and
also in terms of the environmental impact of growth (for example the impact of
growth on levels of pollution, household and industrial waste and the use and
depletion of our scarce resources).
 Higher levels of capital investment and labour productivity – this is designed
to improve the UK’s international competitiveness and boost our trade
performance in goods and services. The pressures of globalisation and the
increasing competition within the European Single Market make this one of the
most important long-term objectives of the government. Britain needs to be
competitive in an increasingly globalized world.
 High employment - the government wants to achieve full-employment – a
situation where all those able and available to find work have the opportunity to
work. But unemployment can never fall to zero since there will always be a
degree of frictional and structural unemployment in the labour market. At the
time of writing, unemployment in the UK is at low levels, with less than three per
cent of the labour force out of work and claiming the Jobseeker’s Allowance.
 Rising living standards and a fall in relative poverty – for example the
objective of cutting child poverty and reducing pensioner poverty over the next
few years – this will require a continuation of economic growth together with
taxation and benefit changes to make the distribution of income more equal
 Sound government finances - including control over the size of government
borrowing and the total national debt.

193
1
 The Bank of England was made independent in May 1997 and has the job of setting
interest rates as part of monetary policy. Interest rates are viewed as a key weapon in
keeping control of demand and inflationary pressures in the economy. Most economists
are in favour of Bank of England independence because economists are likely to make
better judgements on interest rates than politicians seeking re-election!

The government always emphasizes macroeconomic stability as one of its main aims –
it believes that the stability of the economy is a pre-condition for improvements in
capital investment, productivity, company profits and employment.

Of course the vagaries of and uncertainties in developments in the global economy make
this a difficult objective to pursue. A dose of good luck as well as sound judgement is
required given the domestic and external shocks that can affect the British economy at
any time!

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Aggregate Demand

This section gives you a platform for understanding issues such as inflation, economic
growth and unemployment. Aggregate demand (AD) and aggregate supply (AS) analysis

194
1
provides a way of illustrating macroeconomic relationships and the effects of government
policy changes.

Aggregate Demand

The identity for calculating aggregate demand (AD) is as follows:

AD = C + I + G + (X-M)
Where

C: Consumers' expenditure on goods and services: This includes demand for

consumer durables (e.g. washing machines, audio-visual equipment and motor vehicles &
non-durable goods such as food and drinks which are “consumed” and must be re-
purchased). Household spending accounts for over sixty five per cent of aggregate
demand in the UK.

I: Capital Investment – This is investment spending by companies on capital goods

such as new plant and equipment and buildings. Investment also includes spending on
working capital such as stocks of finished goods and work in progress.

Capital investment spending in the UK typically accounts for between 15-20% of GDP in
any given year. Of this investment, 75% comes from private sector businesses such as
Tesco, British Airways and British Petroleum and the remainder is spent by the public
(government) sector – for example investment by the government in building new
schools or investment in improving the railway or road networks. So a mobile phone
company such as O2 spending £100 million on extending its network capacity and the
government allocating £15 million of funds to build a new hospital are both counted as
part of capital investment. Investment has important long-term effects on the s supply-
side of the economy as well as being an important although volatile component of
aggregate demand.

G: Government Spending – This is government spending on state-provided goods and

services including public and merit goods. Decisions on how much the government will
spend each year are affected by developments in the economy and also the changing
political priorities of the government. In a normal year, government purchases of goods
and services accounts for around twenty per cent of aggregate demand. We will return to
this again when we look at how the government runs its fiscal policy.

Transfer payments in the form of welfare benefits (e.g. state pensions and the job-seekers
allowance) are not included in general government spending because they are not a
payment to a factor of production for any output produced. They are simply a transfer
from one group within the economy (i.e. people in work paying income taxes) to another
group (i.e. pensioners drawing their state pension having retired from the labour force, or
families on low incomes).

The next two components of aggregate demand relate to international trade in goods

195
1
and services between the UK economy and the rest of the world.

X: Exports of goods and services - Exports sold overseas are an inflow of demand (an
injection) into our circular flow of income and therefore add to the demand for UK
produced output.

M: Imports of goods and services. Imports are a withdrawal of demand (a leakage)

from the circular flow of income and spending. Goods and services come into the
economy for us to consume and enjoy - but there is a flow of money out of the economy
to pay for them.

Net exports (X-M) reflect the net effect of international trade on the level of aggregate
demand. When net exports are positive, there is a trade surplus (adding to AD); when
net exports are negative, there is a trade deficit (reducing AD). The UK economy has
been running a large trade deficit for several years now as has the United States.

Aggregate demand shocks

Economic events such as changes in interest rates and economic growth in the United
States can have a powerful effect on other countries including the UK. This is because the
USA is the world’s largest economy. 15 per cent of our exports go to the USA.

Lots of unexpected events can happen which cause changes in the level of demand,
output and employment in the economy. These unplanned events are called “shocks” One
of the causes of fluctuations in the level of economic activity is the presence of demand-
side shocks.

196
1
Some of the main causes of demand-side shocks are as follows:

 A capital investment boom e.g. a construction boom to increase the supply of

new houses or to build new commercial and industrial buildings.
 A rise or fall in the exchange rate – affecting net export demand and having
follow-on effects on output, employment, incomes and profits of businesses
linked to export industries.
 A consumer boom abroad in the country of one of our major trading
partners which affects the demand for our exports of goods and services.
 A large boom in the housing market or a slump in share prices.
 An unexpected cut or an unexpected rise in interest rates.

The Aggregate Demand Curve

The AD curve shows the relationship between the general price level and real GDP.

Why does the AD curve slope downwards?

197
1
There are several explanations for an inverse relationship between aggregate demand and
the price level in an economy. These are summarised below:

 Falling real incomes: As the price level rises, so the real value of people’s
incomes fall and consumers are then less able to afford UK produced goods and
services.
 The balance of trade: As the price level rises, foreign-produced goods and
services become more attractive (cheaper) in price terms, causing a fall in exports
and a rise in imports. This will lead to a reduction in trade (X-M) and a
contraction in aggregate demand.
 Interest rate effect: if in the UK the price level rises, this causes an increase in
the demand for money and a consequential rise in interest rates with a
deflationary effect on the entire economy. This assumes that the central bank (in
our case the Bank of England) is setting interest rates in order to meet a specified
inflation target.

Shifts in the AD curve

A change in factors affecting any one or more components of aggregate demand,

households (C), firms (I), the government (G) or overseas consumers and business (X)
changes planned aggregate demand and results in a shift in the AD curve.

Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and
an outward shift of AD from AD1 to AD2. The increase in AD might have been caused
for example by a fall in interest rates or an increase in consumers’ wealth because of
rising house prices.

198
1
Factors causing a shift in
AD

Changes in Expectations The expectations of consumers and businesses can have a

Current spending is powerful effect on planned spending in the economy E.g.
affected by anticipated expected increases in consumer incomes, wealth or
future income, profit, and company profits encourage households and firms to spend
inflation more – boosting AD. Similarly, higher expected inflation
encourages spending now before price increases come into
effect - a short term boost to AD.
When confidence turns lower, we expect to see an increase
in saving and some companies deciding to postpone capital
investment projects because of worries over a lack of
demand and a fall in the expected rate of profit on
investments.

Changes in Monetary An expansionary monetary policy will cause an outward

Policy – i.e. a change in shift of the AD curve. If interest rates fall – this lowers the
interest rates cost of borrowing and the incentive to save, thereby
(Note there is more than encouraging consumption. Lower interest rates encourage
one interest rate in the firms to borrow and invest.
economy, although There are time lags between changes in interest rates and
borrowing and savings the changes on the components of aggregate demand.

199
1
rates tend to move in the
same direction)

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Capital Investment and Spending

Investment is spending by UK firms on capital goods such as new factories, plant or

buildings, machinery & vehicles. It is an important component of demand, but as we shall
see, it also has an impact on the supply-side of the economy.

Definition of Capital Investment

 Capital investment is defined as spending on capital goods such as new

machinery, buildings and technology so that the economy can produce more
consumer goods in the future.
 A broader definition of investment would encompass spending on improving the
human capital of the workforce - for example extra investment in training and
education to improve the skills and competences of workers.
 Most economists agree that investment is vital to promoting long-run economic
growth through improvements in productivity and a country’s productive
capacity.

Gross and Net Investment

Gross investment spending includes an estimate for capital depreciation since some
investment is needed to replace technologically obsolete plant and machinery. Providing
that net investment is positive, businesses are expanding their capital stock giving them
a higher productive capacity and therefore meet a higher level of demand in the future.

The Economic Importance of Capital Investment

200
1
Firms often invest in new capital goods to exploit internal economies of scale. This,
together with technological advances that are often built into new machinery, is vital to
improving the UK's competitiveness and to causing an outward shift in the country’s
production possibility frontier.

The amount of capital equipment available for each worker to use and whether this
capital is up to date has a bearing on the productivity of the labour force. The quality of
business training also matters to make the most of investment in new capital and
technology

201
1
In the short run, devoting more a country’s scarce resources to the production of
investment goods (a process known as capital accumulation) might require a reduction
in today’s output of consumer goods and services (lower consumption would be
accompanied by a rise in saving). The re-allocation of resources towards capital goods
would be shown by a movement from point A to B on the production possibility frontier.

But if the extra investment is successful and leads to an increase in a country’s productive
capacity then the PPF can shift out and open up the potential for an increased output of
consumption goods to meet people’s needs and wants. This is shown by a movement
from point B on the PPF to point C which lies on the new PPF after the effects of an
increase in investment.

Investment affects AD as well as Aggregate Supply (AS)

It should be remembered that investment is also a component of AD. Businesses involved

in developing, manufacturing, testing, distributing and marketing the capital goods
themselves stand to benefit from increased orders for new plant and machinery.

A rise in capital investment will therefore have important effects on both the demand and
supply-side of the economy – including a positive multiplier effect on national income.

202
1
  Demand side effects: Increase spending on capital goods – affects industries that
manufacture the technology / hardware / construction sector
 Supply side effects: Investment is linked to higher productivity, an expansion of
a country’s productive capacity, a reduction in unit costs (e.g. through the
exploitation of economies of scale) – and therefore a source of an increase in
LRAS (trend growth)

It is not just the level of capital investment which is important but also the quality of the
increase in the capital stock. A high level of investment on its own may not be sufficient
to create an increase in LRAS – workers need to be trained to work the new machinery
and there may be time lags between new capital spending and the knock-on effects on
output and productivity in particular. Also, if there is insufficient demand in a market, a
high level of capital investment may lead to excess capacity emerging in industries –
putting downward pressure on prices and profits

203
1
 One way to remember the importance of investment is to consider the 3 Cs - capacity,
costs and competitiveness. Higher investment should allow British businesses to lower
their production costs per unit, increase their supply capacity and become more
competitive in overseas markets.

Key Factors Determining Capital Investment Spending

Several factors influence how much businesses are prepared to commit to investment
projects:

 Real interest rates: Interest rates affect the cost of borrowing money to finance
investment. If the rate of interest increases, the cost of funding investment
increases, reducing the expected rate of return on capital projects. A second factor
is that higher interest rates raise the opportunity cost of using profits to finance
investment – i.e. a business might decide that the cost of financing new capital is
too high and that it could earn a higher rate of return by simply investing the cash.
Low interest rates are not always good news for business investment. Recently
economists have become concerned that low interest rates has reduced the cost of
capital for businesses to such an extent that some low quality capital investment
projects have been given the go ahead and much of this investment has proved to
be disappointing.
 The rate of growth of demand: Investment tends to be stronger when consumer
demand is rising, giving businesses an extra incentive to invest to expand their
capacity to meet this demand. Higher expected sales also increase potential profits
– in other words, the price mechanism should allocate extra funds and factor
204
1
 inputs towards investment goods into those markets where consumer demand is
rising.
 Corporate taxes: Corporation tax is paid on profits. If the government reduces
the rate of corporation tax (or increases investment tax-allowances) there is a
greater incentive to invest. Britain has relatively low rates of company taxation
compared to other countries inside the EU. This is a factor that helps to explain
why Britain has been a favoured venue for inward investment from overseas
during the last decade.

 Technological change and degree of market competition: In markets where

technological change is rapid, companies may have to commit themselves to
higher levels of investment to keep pace with the shifting frontier of technology
and remain competitive. In markets where there is a premium on a business
keeping costs down but at the same time, achieving year on year gains in
efficiency and quality of service, there is also an incentive to keep capital
investment spending high.
 Business confidence: Business confidence can be vital in determining whether to
go ahead with an investment project. When confidence is strong then planned
investment will rise. The Confederation of British Industry (www.cbi.org.uk)
publishes a quarterly survey of confidence that gives economists an insight into
likely trends in investment from manufacturing industry – although it must be
remembered that over 70% of total GDP now comes from the service sector. In
recent years, capital spending by service businesses has grown strongly – but
manufacturing investment has weakened.

Business investment and the economic cycle

Investment depends critically on the health of the economy. When GDP growth is strong
and inflation is under control, then business investment invariably picks up. There is
often a time lag involved – it takes time for businesses to reach capacity constraints and
give the go ahead for new projects. And the completion of new investment schemes
inevitably is subject to the risk of delay.

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Macroeconomic Equilibrium

We now put aggregate demand and supply to together to consider the idea of equilibrium
for the economy.

205
1
In this chapter, we will be using the neo-Keynesian version of the long run aggregate
supply curve – which is drawn as a non-linear curve. This shape of the LRAS curve
shows that increases in aggregate demand may increase real output and employment in
the short term though when SRAS is upward sloping, this may be at the expense of
higher inflation.

Macro-economic equilibrium is established when AD intersects with SRAS. This is

shown in the diagram below. At price level P1, AD is equal to SRAS – i.e. at this price
level, the value of output produced within the economy equates with the level of demand
for goods and services. The output and the general price level in the economy will tend
to adjust towards this equilibrium position. If the general price level is too high for
example, there will be an excess supply of output and producers will experience an
increase in unsold stocks. This is a signal to cut back on production to avoid an excessive
level of inventories. If the price level is below equilibrium, there will be excess demand
in the short run leading to a run down of stocks – a signal for producers to expand output.

206
1
Changes in short-run aggregate supply (SRAS)

Suppose that higher productivity of labour and capital inputs together with lower raw
material costs such as cheaper oil and steel causes the short run aggregate supply curve to
shift outwards. (Assume that there is no shift in AD). The next diagram shows what is
likely to happen. SRAS1 shifts outwards to SRAS3 and a new macroeconomic
equilibrium will be established at Y3.

207
1
Equilibrium using a linear aggregate supply curve

In the next diagram we see the effects of two inward shifts in AD. This might be caused
for example by a decline in business confidence (reducing planned investment demand)
and a fall in exports following a global downturn. It might also be caused by a cut in
government spending or a rise in interest rates (announced by the Bank of England).

The result of the inward shift of AD is a contraction along the short run aggregate supply
curve and a fall in national output (i.e. a recession). This causes downward pressure on
the general price level and takes the equilibrium level of national output further away
from the full capacity level of national income as indicated by the LRAS curve. We
would expect to see a rise in unemployment.

208
1
The Output Gap

The output gap (or GDP gap ) is an important concept in macroeconomics. It is defined
as the difference between the actual level of national output and its potential level and is
usually expressed as a percentage of the level of potential output.

209
1
Negative output gap – downward pressure on inflation

The actual level of real GDP is given by the intersection of AD & SRAS – the short run
equilibrium. If actual GDP is less than potential GDP (e.g. real output level Y1) then
there is a negative output gap. Some factor resources including labour are under-utilised
and the main economic problem is likely to be higher than average unemployment. High
unemployment indicates an excess supply of labour in the factor market which means
there is downward pressure on real wage rates. In the next time period, a fall in wage
rates shifts SRAS downwards until actual and potential GDP are identical – assuming
labour markets are flexible.

Positive output gap – upward pressure on inflation

If actual GDP is greater than potential GDP i.e. a level of real GDP of Y2 then there is a
positive output gap. Some resources including labour are working beyond normal
capacity e.g. shift work and overtime. The main economic problem is likely to be demand
pull and cost-push inflation. The shortage of labour puts upward pressure on wage rates.
In the next time period, a rise in wage rates shifts SRAS upwards until actual and
potential GDP are identical – assuming labour markets are flexible.

210
1
The last boom in the late 1980s left the UK with a large positive output gap, one of the
reasons why we say a sharp acceleration in inflation before the recession of the early
1990s (high inflation required very high interest rates to control it and this squeezed
business and consumer confidence and spending). At the end of the recession in 1992 the
output gap was negative – allowing the economy to grow for several years without the
fear of demand-pull inflationary pressure.

Over the last six or seven years, the output gap has remained close to zero. The Bank of
England has managed quite successfully through its interest rate strategy to keep
aggregate demand growing more or less in line with the economy’s productive potential.
The recent global economic slowdown has hit GDP growth in the UK (leading to weak
exports and falling investment) – but the economy continues to operate fairly close to its
potential.

Author: Geoff Riley, Eton College, September 2006

211
1
AS Macroeconomics / International Economy
Multiplier and Accelerator Effects

In this chapter we look at two ideas, the multiplier and the accelerator, both of which
help to explain how we move from one stage of an economic cycle to another

The multiplier process

An initial change in aggregate demand can have a much greater final impact on the level
of equilibrium national income. This is commonly known as the multiplier effect and it
comes about because injections of demand into the circular flow of income stimulate
further rounds of spending – in other words “one person’s spending is another’s income”
– and this can lead to a much bigger effect on equilibrium output and employment.

Consider a £300 million increase in business capital investment – for example created
when an overseas company decides to build a new production plant in the UK. This will
set off a chain reaction of increases in expenditures. Firms who produce the capital goods
that are purchased will experience an increase in their incomes and profits. If they in turn,
collectively spend about 3/5 of that additional income, then £180m will be added to the
incomes of others.

At this point, total income has grown by (£300m + (0.6 x £300m).

The sum will continue to increase as the producers of the additional goods and services
realize an increase in their incomes, of which they in turn spend 60% on even more goods
and services.

The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).

The process can continue indefinitely. But each time, the additional rise in spending and
income is a fraction of the previous addition to the circular flow.

Multiplier effects can be seen when new investment and jobs are attracted into a
particular town, city or region. The final increase in output and employment can be far
greater than the initial injection of demand because of the inter-relationships within the
circular flow.

The Multiplier and Keynesian Economics

212
1
The concept of the multiplier process became important in the 1930s when John
Maynard Keynes suggested it as a tool to help governments to achieve full employment.
This macroeconomic “demand-management approach”, designed to help overcome a
shortage of business capital investment, measured the amount of government spending
needed to reach a level of national income that would prevent unemployment.

The higher is the propensity to consume domestically produced goods and services, the
greater is the multiplier effect. The government can influence the size of the multiplier
through changes in direct taxes. For example, a cut in the basic rate of income tax will
increase the amount of extra income that can be spent on further goods and services.

Another factor affecting the size of the multiplier effect is the propensity to purchase
imports. If, out of extra income, people spend money on imports, this demand is not
passed on in the form of extra spending on domestically produced output. It leaks away
from the circular flow of income and spending.

213
1
The multiplier process also requires that there is sufficient spare capacity in the
economy for extra output to be produced. If short-run aggregate supply is inelastic, the
full multiplier effect is unlikely to occur, because increases in AD will lead to higher
prices rather than a full increase in real national output. In contrast, when SRAS is
perfectly elastic a rise in aggregate demand causes a large increase in national output.

The construction boom and multiplier effects

214
1
A study has found that the British construction sector alone has driven a fifth of UK GDP
growth in the past year and 34% of net job creation in the past two years. The
construction boom has been caused by the combination of large projects like Terminal 5,
the Channel Tunnel Rail Link, Wembley Stadium and the Scottish Parliament with a
revival in house building, heavy expenditure by the public sector on new schools and
hospitals and a surge in home improvement expenditure.

The study provides compelling evidence on the multiplier effects of major capital
investment projects. 'One characteristic of construction activity is that it feeds through to
many other related businesses. It has "backward linkages" into the likes of building
materials; steel, architectural services, legal services and insurance, and most of these
linkages tend to result in jobs close to home. This makes a boom in construction
peculiarly powerful in fuelling expansion in the economy - for a given lift in building
orders, the multiplier effect may be well over two. This means that every building job
created will generate at least two others in related areas and in downstream activities such
as retailing, which benefits when building workers spend their wages. Other industries,
particularly those where much of the output value comes in the form of imported
components, might have a multiplier of less than 1.5 for new projects'.

Adapted from a report from the Centre for Economics and Business Research

The accelerator effect

Planned capital investment by private sector businesses is linked to the growth of demand
for goods and services. When consumer or export demand is rising strongly, businesses
may increase investment to expand their production capacity and meet the extra demand.
This process is known as the accelerator effect. But the accelerator effect can work in the
other direction! A slowdown in consumer demand can create excess capacity and may
lead to a fall in planned investment demand.

A good example of this in recent years is the telecommunications industry. Capital

investment in this sector surged to record highs in the second half of the 1990s, driven by
a fast pace of technological advance and huge increases in the ICT budgets of
corporations, small-to-medium sized businesses, and extra capital investment by the
public sector (including education and health).

The telecommunications industry invested giant sums in building bigger and faster
networks, but demand has slowed in the first three of the decade, leaving the industry
with a vast amount of spare capacity (an under-utilisation of resources). Capital
investment spending in the telecommunications industry has fallen sharply in the last
three years – the accelerator mechanism working in reverse.

215
1
Demand for capital investment (I)

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Inflation

216
1
What causes rising prices in an economy? And what tools are available to keep inflation
under control? This chapter focuses on the causes of inflation and some of the
consequences.

What is inflation?

Inflation is best defined as a sustained increase in the general price level leading to a
fall in the purchasing power or value of money. The greatest falls in the value of money
came during the mid-late 1970s and again in the late 1980s when there was acceleration
in the rate of inflation in the UK. In contrast, the last fifteen years have seen much lower
rates of inflation – and as a result, money has held value better. The next chart shows the
UK consumer price index since 1970.

The value of money refers to the amount of goods and services £1 can buy and is
inversely proportionate to the rate of inflation. Inflation reduces the value of money.
When prices are increasing, then the value of money falls.

The rate of inflation is measured by the annual percentage change in the level of
consumer prices. The British Government has set an inflation target of 2% using the
consumer price index (CPI). It is the job of the Bank of England to set interest rates so
that AD is controlled and the inflation target is reached. Since the Bank of England was
made independent, inflation has stayed comfortably within target range. Indeed Britain
has one of the lowest rates of inflation inside the EU.

217
1
There has been a fall in average inflation rates in most of the world’s developed countries
including the UK over the last fifteen years. Indeed lower inflation seems to have
become a global phenomenon. Japan has experienced negative inflation (i.e. price
deflation) over recent years (although in 2006, this period of price deflation came to an
end) and the German economy has also come close to experiencing deflation with
inflation of less than one per cent.

Deflation

Price deflation is when the rate of inflation becomes negative. I.e. the general price
level is falling and the value of money is increasing. Some countries have experienced
deflation in recent years – good examples include Japan and China. In Japan, the root
cause of deflation was slow economic growth and a high level of spare capacity in many
industries that was driving prices lower. In China, economic growth has been rapid – but
the huge amount of capital investment and rising productivity has led to economies of
scale being exploited and a fall in production costs.

There has been some price deflation in the UK economy – not for the whole economy –
but for items such as clothing (where many prices of clothing on the high street have been
driven lower by cheaper imports); audio-visual equipment, computers and many other
household goods. The effects of technological change in increasing supply are important
when explaining deflation in some UK markets. Rapid advances in technology help to
explain for example the sharp fall in the prices of state of art digital cameras and
televisions, which has made the digital age accessible to millions of consumers.

218
1
Hyperinflation

A 500 billions bill with most zeros in the economy history. The product of hyperinflation
in Yugoslavia 1993

Hyperinflation is extremely rare. Recent examples include Yugoslavia Argentina , Brazil

, Georgia and Turkey (where inflation reached 70% in 1999). The classic example of
hyperinflation was of course the rampant inflation in Weimar Germany between 1921

219
1
and 1923 . When hyperinflation occurs, the value of money becomes worthless and
people lose all confidence in money both as a store of value and also as a medium of
exchange. The current hyperinflation in Zimbabwe is a good example of the havoc that
can be caused when price inflation spirals out of control.

Often drastic action is required to stabilize an economy suffering from high and volatile
inflation – and this leads to political and social instability. The International Monetary
Fund is often brought into the process of implementing economic reforms to reduce
inflation and achieve greater financial stability.

The main causes of inflation

Inflation can come from several sources: Some come direct from the domestic economy,
for example the decisions of the major utility companies providing electricity or gas or
water on their prices for the year ahead, or the pricing strategies of the leading food
retailers based on the strength of demand and competitive pressure in their markets. A
rise in government VAT would also be a cause of increased domestic inflation because it
increases a firm’s production costs.

Inflation can also come from external sources, for example an unexpected rise in the
price of crude oil or other imported commodities, foodstuffs and beverages. Fluctuations
in the exchange rate can also affect inflation – for example a fall in the value of sterling
might cause higher import prices – which feeds through directly into the consumer price
index.

We make a simple distinction between demand pull and cost push inflation.

Demand-pull inflation

Demand-pull inflation is likely when there is full employment of resources and

aggregate demand is increasing at a time when SRAS is inelastic. This is shown in the
next diagram:

220
1
In the diagram above we see a large outward shift in AD. This takes the equilibrium level
of national output beyond full-capacity national income (Yfc) creating a positive output
gap. This would then put upward pressure on wage and raw material costs – leading the
SRAS curve to shift inward and causing real output and incomes to contract back towards
Yfc (the long run equilibrium for the economy) but now with a higher general price level
(i.e. there has been some inflation).

The main causes of demand-pull inflation

Demand pull inflation is largely the result of the level of AD being allowed to grow too
fast compared to what the supply-side capacity can meet. The result is excess demand
for goods and services and pressure on businesses to raise prices in order to increase
their profit margins.

Possible causes of demand-pull inflation include:

1. A depreciation of the exchange rate which increases the price of imports and
reduces the foreign price of UK exports. If consumers buy fewer imports, while
exports grow, AD in will rise – and there may be a multiplier effect on the level of
demand and output
2. Higher demand from a fiscal stimulus e.g. via a reduction in direct or indirect
taxation or higher government spending. If direct taxes are reduced, consumers
will have more disposable income causing demand to rise. Higher government

221
1
 spending and increased government borrowing feeds through directly into extra
demand in the circular flow
3. Monetary stimulus to the economy: A fall in interest rates may stimulate too
much demand – for example in raising demand for loans or in causing a sharp rise
in house price inflation
4. Faster economic growth in other countries – providing a boost to UK exports
overseas. Export sales provide an extra flow of income and spending into the UK
circular flow – so what is happening to the economic cycles of other countries
definitely affects the UK

Cost-push inflation

Cost-push inflation occurs when firms respond to rising costs, by increasing prices to
protect their profit margins. There are many reasons why costs might rise:

1. Component costs: e.g. an increase in the prices of raw materials and other
components used in the production processes of different industries. This might
be because of a rise in world commodity prices such as oil, copper and
agricultural products used in food processing
2. Rising labour costs - caused by wage increases, which are greater than
improvements in productivity. Wage costs often rise when unemployment is low
(skilled workers become scarce and this can drive pay levels higher) and also
when people expect higher inflation so they bid for higher pay claims in order to
protect their real incomes. Expectations of inflation are important in shaping
what actually happens to inflation!
3. Higher indirect taxes imposed by the government – for example a rise in the
specific duty on alcohol and cigarettes, an increase in fuel duties or a rise in the
standard rate of Value Added Tax. Depending on the price elasticity of demand
and supply for their products, suppliers may choose to pass on the burden of the
tax onto consumers

Cost-push inflation can be illustrated by an inward shift of the short run aggregate
supply curve. The fall in SRAS causes a contraction of national output together with a
rise in the level of prices.

222
1
Which government policies are most effective in reducing inflation?

Most governments now give a high priority to keeping control of inflation. It has become
one of the dominant objectives of macroeconomic policy.

Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the
rate of growth of aggregate supply (AS). The main anti-inflation controls available to a
government are:

1. Fiscal Policy: If the government believes that AD is too high, it may reduce its
own spending on public and merit goods or welfare payments. Or it can choose to
raise direct taxes, leading to a reduction in disposable income. Normally when the
government wants to “tighten fiscal policy” to control inflation, it will seek to
cut spending or raise tax revenues so that government borrowing (the budget
deficit) is reduced. This helps to take money out of the circular flow of income
and spending
2. Monetary Policy:A tightening of monetary policy involves higher interest rates
to reduce consumer and investment spending. Monetary policy is now in the hand
of the Bank of England –it decides on interest rates each month.
3. Supply side economic policies: Supply side policies include those that seek to
increase productivity, competition and innovation – all of which can maintain
lower prices.

223
1
The most appropriate way to control inflation in the short term is for the British
government and the Bank of England to keep control of aggregate demand to a level
consistent with our productive capacity. The consensus among economists is that AD is
probably better controlled through the use of monetary policy rather than an over-reliance
on using fiscal policy as an instrument of demand-management. But in the long run, it is
the growth of a country’s supply-side productive potential that gives an economy the
flexibility to grow without suffering from acceleration in cost and price inflation.

Why has inflation remained low in the UK over recent years?

The last twelve years has been a period of very low and stable inflation. No one factor
explains this – but among them we can highlight the following:

1. Low wage inflation from the labour market: Wages have been growing at a
fairly modest rate in recent years despite a large fall in unemployment. This has
been helped by a fall in expectations of inflation
2. Low global inflation and deflation in some countries: There has been a clear
fall in the average rate of consumer prices inflation among leading economies,
and this decline in global inflation has filtered through to the UK. World inflation
has stayed low despite the recent increases in the prices of many of the world’s
globally traded commodities.
3. The effectiveness of monetary policy in the UK: The success of the Bank of
England through monetary policy in keeping aggregate demand under control
through interest rate changes
4. Increased competition: Many markets have become more contestable in the last
decade and this extra competition has placed a discipline on businesses to control
their costs, reduce profit margins and seek improvements in efficiency. Many UK
businesses face severe pressure from foreign competition as the process of
globalisation continues
5. The strength of the exchange rate: The recent strength of the pound has lowered
the cost of imported products and also squeezes demand for UK exporters
6. Information technology effects: The rapid expansion of information and
communication technology has helped to reduce costs and has made prices more
transparent for consumers – e-commerce has contributed to falling prices in many
markets

In short, low inflation is the result of a combination of demand and supply-side

factors.

224
1
 Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

International Trade

We now turn our attention to the labour market and consider why people find themselves
out of work and cannot find a paid job. Unemployment imposes heavy economic and
social costs; we look at which policies are likely to be most effective in keeping
unemployment as low as possible.

Defining and measuring unemployment

Officially, the unemployed are people who are registered as able, available and willing to
work at the going wage rate but who cannot find work despite an active search for
work. This last point is important for to be classified as unemployed, one must show
evidence of being active in the labour market.

There are two main measures of unemployment in the UK:

225
1
 1. The Claimant Count measure of unemployment includes those unemployed
people who are eligible to claim the Job Seeker's Allowance (JSA) or who have
enough National Insurance Credits. People who satisfy the criteria receive the
JSA for six months before moving onto special employment measures including
the New Deal Programme. The Claimant Count is a “head-count” of people
claiming unemployment benefit.
2. The Labour Force Survey covers those who are without any kind of job
including part time work but who have looked for work in the past month and are
able to start work in the next two weeks. The figure also includes those people
who have found a job and are waiting to start in the next two weeks.

On average, the labour force survey measure has exceeded the claimant count by about
400,000 in recent years. Because it is a survey (albeit a large one and one that provides a
rich source of data on the employment status of thousands of households across the UK),
we must remember that there will always be a sampling error in the data. The Labour
Force Survey measure is the internationally agreed definition of unemployment and
therefore the measure that best allows cross-country comparisons of unemployment
levels.

Under-counting the true level of unemployment

Britain may be twice as high as official statistics show. Research on the UK labour
market by economists at HSBC bank takes into account anybody who is 'economically
inactive', but looking for a job, not just those who are eligible for unemployment benefits.
The report estimates that there are 3.4m Britons who are unemployed, as opposed to the
International Labour Organisation's estimate of 1.4m people. Britain's official
unemployment rate is 4.8% - one of the lowest rates of unemployment in the European
Union

Adapted from newspaper reports, July 2004

226
1
The most recent changes in claimant count and labour force survey measures of
unemployment are summarised in the chart above and the table below.

Labour Force Survey Unemployment Claimant Count

Unemployment
(seasonally adjusted)

Level Annual change Rate Level Annual change Rate

000s 000s % 000s 000s %

1990 2,004 -102 6.9 1,648 -120 5.5

1993 2,953 157 10.5 2,877 135 9.7

1997 2,045 -299 7.2 1,585 -503 5.3

1998 1,783 -262 6.3 1,348 -237 4.5

1999 1,759 -24 6.1 1,248 -100 4.1

227
1
2000 1,638 -121 5.6 1,088 -160 3.6

2001 1,431 -207 4.9 970 -119 3.2

2002 1,533 102 5.2 947 -23 3.1

2003 1,476 -57 5.0 933 -14 3.0

2004 1,426 -50 4.8 854 -80 2.7

2005 1,425 -1 4.7 862 8 2.7

In 2005, the UK had one of the lowest rates of unemployment among the major
developed nations. Although the Netherlands and Ireland both have unemployment rates
below that of the UK, we have one of the lowest rates in the European Union. Indeed for
the Euro Zone as a whole the rate of unemployment has been persistently high in recent
years – never lower than eight per cent and now rising to nearly nine per cent.
Unemployment is a major economic, social and political problem in countries such as
Poland, Germany, Spain and France – although the Spanish have succeeded in bringing
their unemployment down from high levels over the last few years.

Main causess of unemployment

228
1
We now consider some of the main underlying causes of people being out of work

Frictional Unemployment

Frictional unemployment is transitional unemployment due to people moving between

jobs:
For example, redundant workers or workers entering the labour market for the first time
(such as university graduates) may take time to find appropriate jobs at wage rates they
are prepared to accept. Many are unemployed for a short time whilst involved in job
search. Imperfect information in the labour market may make frictional unemployment
worse if the jobless are unaware of the available jobs. Incentives problems can also
cause some frictional unemployment as some people actively looking for a new job may
opt not to accept paid employment if they believe the tax and benefit system will reduce
the net increase in income from taking work. When this happens there are disincentives
for the unemployed to accept work.

Structural Unemployment

Structural unemployment occurs when there is a long run decline in demand in an

industry leading to a reduction in employment perhaps because of increasing
international competition. Globalisation is a fact of life – and inevitably it leads to
changes in the patterns of trade between countries over time. Britain for example has
probably now lost for good, its cost advantage in manufacturing goods such as motor
cars, household goods and audio-visual equipment. Manufacturing industry has lost over
400,000 jobs in the last five years alone. Many of these workers may suffer from a period
of structural unemployment, particularly if they are in regions of above-average
unemployment rates where job opportunities are scarce. The decline in manufacturing
industry jobs is shown in the next chart.

229
1
There is often a mismatch between the skills required for job vacancies and the skills and
experience that unemployed workers have – this is a problem associated with structural
unemployment

Structural unemployment exists where there is a mismatch between their skills and the
requirements of the new job opportunities. Many of the unemployed from manufacturing
industry (e.g. in coal, steel and engineering) have found it difficult to find new work
without an investment in re-training. This problem is one of occupational immobility of
labour

Cyclical Unemployment:

Cyclical unemployment is involuntary unemployment due to a lack of demand for

goods and services. This is also known as Keynesian "demand deficient"
unemployment. When there is a recession or a severe slowdown in economic growth, we
see a rising unemployment because of plant closures, business failures and an increase in
worker lay-offs and redundancies. This is due to a fall in demand leading to a contraction
in output across many industries. A downturn in demand is often the stimulus for
businesses to rationalise their operations by cutting employment in order to control costs
and restore some of their lost profitability.

230
1
Cyclical unemployment and the output gap

Real wage unemployment:

This is considered to be the result of real wages being above their market clearing level
leading to an excess supply of labour. Some economists believe that the minimum wage
risks creating unemployment in industries where international competition from low-
labour cost producers is severe. As yet, there is relatively little evidence that the
minimum wage has created rising unemployment on the scale that was feared.

Hidden unemployment

Undoubtedly there are thousands of people who by any reasonable definition are
unemployed, but who are not picked up by the official unemployment statistics. Many
have become discouraged workers and have stopped actively searching for work.

Unemployment and the production possibility frontier

231
1
The economic and social costs of unemployment

High unemployment is widely recognised to create substantial costs for individuals and
for the economy as a whole. Some of these costs are difficult to measure, especially the
longer-term social costs of a high level of unemployment. Some of the costs are
summarised below:

1. Loss of income: Unemployment normally results in a loss of income. The

majority of the unemployed experience a decline in their living standards and
are worse off out of work
2. Loss of national output: Unemployment involves a loss of potential national
output (i.e. GDP operating below potential) and represents an inefficient use of
scarce resources. If some people choose to leave the labour market permanently
because they have lost the motivation to search for work, this can have a negative
effect on long run aggregate supply (LRAS) and thereby damage the economy’s
growth potential
3. Fiscal costs: The government loses out because of a fall in tax revenues and
higher spending on welfare payments for families with people out of work. The
result can be an increase in the budget deficit which then increases the risk that
the government will have to raise taxation or scale back plans for public spending
on public and merit goods

232
1
 4. Social costs: Rising unemployment is linked to social deprivation. There is a
relationship with crime, and social dislocation (increased divorce rates, worsening
health and lower life expectancy). Areas of high unemployment see falling real
incomes and a worsening in inequalities of income and wealth

Government policies to reduce unemployment

Some countries are more successful than others in reducing the scale of unemployment.
In the long term, effective policies are required for both the demand and the supply side
of the economy so that enough new jobs are created and that people possess the skills and
incentives to take those jobs.

In general the most effective policies are those that:

1. Stimulate an improvement in the human capital of the workforce – so that

more of the unemployed have the skills to take up the available jobs. Policies
normally concentrate on improving the occupational mobility of labour. The
pattern of employment in any modern economy is always changing, so people
need to have sufficient flexibility to adapt to structural changes in industries over
the years
2. Improve incentives for people to search and then accept paid work – this may
require reforms of the tax and benefits system for example a reduction in the
starting rate of income tax (an incentive for people in lower paid jobs). Or perhaps
a change in welfare benefits such that people who find work do not experience a
sharp withdrawal of benefits because they are now earning more. The reality is
that simply cutting welfare benefits across the board makes little difference to the
unemployment figures – because of the complex nature of most unemployment.
But targeted measures to improve incentives, including the linking of welfare
benefits to participation in work experience programmes which is part of the New
Deal programme or lower tax rates for people on low incomes might have an
impact.
3. Employment subsidies: Government subsidies for those firms that take on the
long-term unemployed will create an incentive for businesses to increase the size
of their workforce. Employment subsidies may also be available for overseas
firms locating in the UK as part of the government’s regional policy. Labour’s
New Deal programme works by offering subsidised jobs and training to the long-
term unemployed. It differs from previous job creation schemes, in that people
who refuse to comply can have their benefits stopped. According to the
government's own figures, more than 40% of the jobs gained through the New
Deal are short-term.
4. Achieve a sustained period of economic growth – this requires that aggregate
demand is sufficiently high for businesses to be looking to expand their
workforce. The Keynesian theory of unemployment emphasises the argument
that if monetary and fiscal policy does not keep demand at a high enough level,
then the economy is less likely to be able to sustain a high rate of employment.

233
1
 However, not every increase in aggregate demand and production has to be met
by employing more labour. Each year we expect to see a rise in labour
productivity (more output per worker employed). And, businesses may decide to
increase production by making greater use of capital inputs such as extra units of
machinery. A growing economy creates jobs for people entering the labour
market for the first time. And, it provides employment opportunities for people
unemployed and looking for work.

Policies used in the UK to reduce unemployment

Demand side policies Supply-side policies

Employment subsidies for employers who Welfare reforms – including lower starting
take on the long-term unemployed (New rates of income tax and the introduction of
Deal) tax credits

Financial assistance for inward investment Policies to promote entrepreneurship and the
from overseas growth of small-medium size enterprises

Monetary policy – low interest rates has Increased spending on education and
allowed aggregate demand to grow despite a attempts to increase private sector spending
global economic slowdown. Fiscal policy is on training
also boosting AD as the budget deficit
increases

Evaluation points on unemployment policies

1. There are always cyclical fluctuations in employment. If growth can be

sustained and monetary and fiscal policy can avoid a large negative output gap
then it should be possible to create a steady flow of new jobs
2. Demand and supply-side policies need to work in tandem for unemployment to
fall in the long term. Simply boosting demand if the root cause of unemployment
is structural is an ineffective way of tackling the problem. If demand is stimulated
too much, the main risk becomes one of rising inflation (i.e. the trade-off between
these two objectives may worsen)
3. Full-employment does not mean zero unemployment! There will always be some
frictional unemployment – it may be useful to have a small surplus pool of labour
available
4. There are still large regional differences in unemployment levels and pockets of
deep-rooted long-term unemployment in many areas, which causes significant
economic and external costs

Recent trends in UK unemployment

234
1
The main explanation behind the decline in unemployment has been economic growth.
Labour as a factor input has a derived demand - so rising production generates a higher
demand for labour. These employment-creation effects have not been uniform throughout
regions and industries.

Other factors that have helped bring down the unemployment rate include:

1. Demographic factors – there has been a slower growth of the population of

working age than at a similar stage of the last economic cycle in the early 1980s.
This has lead to a slowdown in the numbers of people of working age entering the
UK labour market.
2. Expansion of further and higher education - there is a trend for more young
people choosing to delay their entry into the labour market and remain in full-time
post-16 further and higher education to boost their qualifications. Government
policies have an explicit aim of increasing the participation rate of 18 year-olds in
higher education. This puts less pressure on the number of new entrants into the
labour force looking for work.
3. "Discouraged worker effects" due to structural unemployment: Some
workers have given up active job search, in the process become economically
inactive and moved onto permanent sickness and invalidity benefits or early
retirement. The precise number of people involved is difficult to calculate with
accuracy – it probably affects several thousand people.
4. Employment creation from foreign investment: The British economy has been
successful in attracting billions of pounds worth of inward investment from
overseas companies. A high proportion of this has gone into building new plants
in the UK and this has created thousands of new jobs helping to offset some of the
regional disparities in unemployment.
5. Increased investment in worker training: This seems to have reduced structural
unemployment. Labour shortages are problematic in some industries, notably in
areas where house prices are high and unemployment rates have fallen below 2%.
But taking the economy as a whole, it seems that shortages of labour have not
proved to be as difficult as in previous phases of economic expansion. The main
shortages are in highly skilled jobs and in areas where living costs are well above
the national average. The government has suffered from a shortage of workers in
key public sector jobs.
6. Increased flexibility in the labour market: This has made it easier for
businesses to hire workers and match their desired labour input to planned
production. The number of part-time workers on short-term contracts has grown
by many thousands. There has also been greater functional flexibility with
workers expected to perform a number of tasks within the business.

Can the UK achieve full-employment?

The British labour market has performed well in the last decade raising hopes that low
unemployment be maintained for the foreseeable future. There is still much to be done to
reduce unemployment in economically depressed areas. Although the average rate of

235
1
unemployment has come down, jobless rates in excess of 10% are a feature of many
towns and cities. And youth unemployment remains a serious problem. The sustained
fall in unemployment has encouraged optimism that Britain can reach full-employment
in the near future. Indeed, in some regions and towns and cities, full-employment is
already a reality. The UK unemployment rate started to rise again in 2005 and 2006 albeit
at a gentle rate.

Economists agree that unemployment cannot fall to zero since there will always be
frictional unemployment caused by people moving into the labour market and others
switching between jobs. Full-employment might be defined as when the labour market
has reached a state of equilibrium - i.e. when those who are willing and able to work at
going wage rates are able to find work.

Another interpretation of full-employment is when the total of people out of work

matches the number of unfilled job vacancies. The problem with this is that estimates of
the scale of job vacancies vary considerably. The true number of jobs available is
probably three times the official published figure.

Skills Shortages

The prospect of reaching full-employment is diminished by the continuing problem of

skills shortages. Skills shortages have been a recurrent problem in manufacturing jobs,
but the problem has widened to new economy businesses and also the public services
(including education and the NHS)

Closing the skills gap

Literacy, numeracy and skills levels in the UK are so poor that a quarter of employers
struggle to fill job vacancies. A study by the national Skills Task Force backs up previous
research by suggesting that nearly one in five adults - about seven million - have a lower
level of literacy than the average 11 year old. Because of skills shortages, employers are
lowering their expectations when recruiting people and cutting back on capacity and
quality level. The report finds that a quarter of adults are "functionally innumerate", and
that one in three have less than five GCSE exam-passes. And it says employers believe
almost two million of their staff is not fully proficient at their jobs

Adapted from news reports on the Skills Gap

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Government Macroeconomic Policy

236
1
In this chapter we consider the ways in which government economic policies can be used
to achieve aims such as low inflation, stable growth and high levels of employment.

Is there a need for macroeconomic policy?

A central issue in macroeconomics is whether or not markets, left alone, automatically

bring about long run economic equilibrium. If the free operation of market forces
eventually resulted in a full employment level of national income with stable prices and
economic growth, there would be no need for government intervention in the macro
economy - no need for fiscal monetary exchange rate and supply side policies. The reality
is that all governments intervene through their macroeconomic policies in a bid to
achieve certain policy objectives and improve the overall performance of the economy.

Main Objectives of Government Economic Policy

 Sustained economic growth

 Stable prices (low inflation)
 A high level of employment
 A rise in average living standards
 Sustainable position on the balance of payments
 Sound government finances

Demand Management

Demand management occurs when the government attempts to influence the level and
growth of AD hence the levels of national income, employment, rate of inflation, growth
and the balance of payments position

 Reflationary policies seek to increase AD and raise the level of planned

expenditure at or near the level of potential GDP
 Deflationary policies decrease AD in the event of aggregate demand running
ahead of AS and posing inflationary risks or leading to an unsustainable deficit on
the balance of payments

We will focus on fiscal and monetary policies as the main instruments of demand
management

The Main Problems of Managing the Macroeconomy

The government’s task of managing the economy is made difficult by several factors
some of which are discussed below:

 Inaccurate economic data: All of the main macroeconomic indicators are subject
to a margin of error. They rely on statistical data collected from tax returns and
surveys and data is often revised many months after its first release

237
1
  Conflicting policy objectives: A policy of stimulating aggregate demand may
reduce unemployment in the short term but initiate a period of higher inflation
and exacerbate the current account of the balance of payments. Choices have to be
made between objectives i.e. there exist trade-offs between them
 Selecting the right policy instrument: Each macroeconomic objective requires a
separate policy instrument: The usual ‘rule of thumb’ is that one main policy
instrument should be assigned to one policy objective. So, for example, interest
rates might be assigned as the main instrument for keeping control of inflation,
whilst fiscal policy instruments such as changes to the tax system might be
allocated to achieving some supply-side objectives such as increasing the labour
supply, boosting incentives, raising investment and increasing productivity. There
are quite deep-rooted disagreements between some economists (who belong to
different ‘schools of thought’) as to which policies are most effective to meet a
certain objective
 Uncertain time lags when running a policy: Changes in economic policies are
subject to uncertain time lags e.g. a change in interest rates is estimated to take
some 18-24 months to work its way fully through the whole economy to filter
through to a change in prices. The length of the time lags can change over the
years as the reactions of consumers and businesses to policy measures alters
 External shocks: Unexpected external shocks to economy such as the events
surrounding Sept 11th 2001 or unexpected volatility in exchange rates and
commodity prices can upset economic forecasts and take the economy some
distance from the expected path. The Government might under-estimate or
exaggerate the potential impact of an economic shock to either the demand or
supply-side of the economy and therefore apply too little or too much of a policy
response.

Changes in direct and indirect taxes have an impact on people’s disposable incomes –
this feeds through to the wider economy and affects demand, growth and employment

The main policies of economic management

238
1
  Fiscal Policy

o Fiscal policy involves the use of government spending, taxation and

borrowing to influence both the pattern of economic activity and also the
level and growth of aggregate demand, output and employment.

 Monetary Policy

o Monetary policy involves the use of interest rates to control the level and
rate of growth of aggregate demand in the economy.

The Bank of England is charged with the task of 'maintaining the integrity and value of
the currency'. The Bank pursues this objective through the use of monetary policy.
Above all, this involves maintaining price stability, as defined by the inflation target set
by the Government, as a precondition for achieving a wider goal of sustainable economic
growth and high employment. Since 1997, the BoE has had operational independence
in the setting of interest rates. The Bank aims to meet the Government's inflation target
- currently 2.0 per cent for the consumer price index- by setting short-term interest rates.
Interest rate decisions are taken by the Monetary Policy Committee (MPC) at their
monthly meetings.

Monetary policy also involves the effects of changes in the exchange rate – the external
value of one currency against another – on the wider economy

Supply-side Policies

Supply-side economic policies are mainly micro-economic policies designed to improve

the supply-side potential of an economy, make markets and industries operate more
efficiently and thereby contribute to a faster rate of growth of real national output. Most
governments now accept that an improved supply-side performance is the key to
achieving sustained economic growth without a rise in inflation. But supply-side reform
on its own is not enough to achieve this growth. There must also be a high enough level
of aggregate demand so that the productive capacity of an economy is actually brought
into play.

There are two broad approaches to the supply-side. Firstly policies focused on product
markets where goods and services are produced and sold to consumers and secondly
supply-side policies applied to the labour market – a factor market where labour is
bought and sold.

The effects of Monetary and Fiscal Policy on the economy

There are some differences in the economic effects of monetary and fiscal policy, on the
composition of output, the effectiveness of the two kinds of policy in meeting the
government’s macroeconomic objectives, and also the time lags involved for fiscal and
monetary policy changes to take effect. We will consider each of these in turn:

239
1
Effects of Policy on the Composition of National Output

Monetary policy is often seen as something of a blunt policy instrument – affecting all
sectors of the economy although in different ways and with a variable impact.

In contrast, fiscal policy can be targeted to affect certain groups (e.g. increases in means-
tested benefits for low income households, reductions in the rate of corporation tax for
small-medium sized enterprises, investment allowances for businesses in certain regions)

Consider as an example the effects of using either monetary or fiscal policy to achieve a
given increase in national income because actual GDP lies below potential GDP (i.e.
there is a negative output gap)

(i) Monetary policy expansion

Lower interest rates will lead to an increase in consumer and business capital spending
both of which increases national income. Since investment spending results in a larger
capital stock, then incomes in the future will also be higher through the impact on LRAS.

(ii) Fiscal policy expansion

An expansion in fiscal policy (i.e. an increase in government spending) adds directly to

AD but if financed by higher government borrowing, this may result in higher interest
rates and lower investment. The net result (by adjusting the increase in G) is the same
increase in current income. However, since investment spending is lower, the capital
stock is lower than it would have been, so that future incomes are lower.

Time Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect

Monetary policy in the UK is flexible (interest rates can be changed each month) and
emergency rate changes can be made in between meetings of the MPC, whereas changes
in taxation take longer to organize and implement. Because capital investment requires
planning for the future, it may take some time before decreases in interest rates are
translated into increased investment spending. Typically it takes six months – twelve
months or more before the effects of changes in UK monetary policy are felt.

The impact of increased government spending is felt as soon as the spending takes place
and cuts in direct and indirect taxation feed through into the economy pretty quickly.
However, considerable time may pass between the decision to adopt a government
spending programme and its implementation. In recent years, the government has
undershot on its planned spending, partly because of problems in attracting sufficient
extra staff into key public services such as transport, education and health.

Author: Geoff Riley, Eton College, September 2006

240
1
AS Macroeconomics / International Economy
Exchange Rates

This chapter looks at the currency markets where the value of one currency against another is
determined on a daily basis

 The exchange rate measures the external value of sterling in terms of how much of another
currency it can buy. For example - how many dollars or Euros you can buy with £5000.

 The daily value of the currency is determined in the foreign exchange markets (FOREX)
where billions of $s of currencies are traded every hour.

 The global currency markets are open 24 hours a day allowing businesses, banks, individuals
to trade in the currencies that they need.

Recent trends in the exchange rate

The UK operates with a floating exchange rate system where the forces of market demand and
supply for a currency determine the daily value of one currency against another. If, for example,
overseas investors want to buy into sterling to take advantage of higher interest rates on offer in UK

241
1
bank accounts, they will swap their own currencies for pounds. This causes an increase in the demand
for sterling in the foreign exchange markets, and in the absence of other offsetting factors, this will
force sterling higher against other currencies.

How does a change in the exchange rate influence the economy?

Changes in the exchange rate can have a powerful effect on the macro-economy affecting variables
such as the demand for exports and imports; real GDP growth, inflation and unemployment – but as
with most variables in economics, there are time lags involved.

 The scale of any change in the exchange rate.

 Whether the change in the currency is short term or long term.
 How businesses and consumers respond to exchange rate fluctuations – the concept of price
elasticity of demand is important here.

Advantages of an appreciation in the currency

 Cheaper imports for consumers: A high pound leads to lower import prices – this boosts
the real living standards of consumers at least in the short run – for example an increase in the
real purchasing power of UK residents when travelling overseas or the chance to buy cheaper
computers or motor vehicles from the United States or Europe.
 Lower costs for producers: When the sterling exchange rate is high, it is cheaper to import
raw materials, component parts and capital inputs such as plant and equipment – this is good
242
1
 news for businesses that rely on imported components or who are wishing to increase their
investment of new technology from overseas countries. A fall in import prices has the effect
of causing an outward shift in the short run aggregate supply curve. And if a country can now
import more productive technology, the LRAS curve may shift out.
 Lower inflation: A strong exchange rate helps to control the rate inflation because domestic
suppliers now face stiffer international competition from cheaper imports and will look to cut
their costs and prices accordingly in order not to suffer from a loss of international
competitiveness. Cheaper prices of imported foodstuffs and beverages will also have a
negative effect on the rate of consumer price inflation.
 If inflation is lower, then interest rates will be lower than if the exchange rate was weaker
– and cheaper money will eventually stimulate higher consumer spending and capital
spending in the circular flow

Disadvantages of a Strong Pound

 Increase in the trade deficit: The lower price of imports leads to consumers increasing their
demand and this can cause a large trade deficit. Exporters lose price competitiveness because
they will find it more expensive to sell in foreign markets and face losing market share – this
can damage profits and employment in some sectors and industries.
 Slower economic growth: If exports fall, this causes a reduction in aggregate demand and
reduces the short-term rate economic growth as measured by the % change in real GDP. Some
regions of the economy are affected by this more than others. In the North east for example,
manufacturing industry accounts for over 28% of regional GDP whereas the percentage for
the UK as a whole is just 19%.
 If exports fall, then so will business confidence and capital investment – because
investment is partly dependent on the strength of demand

243
1
Showing the effects of currency movements using AD-AS analysis

Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume
ceteris paribus – all other factors held constant – which of course is highly unlikely to be the case

 Counter-balancing use of fiscal and monetary policy: For example the government can
alter fiscal policy to manage the level of AD and the Bank of England has the flexibility to
change interest rates (e.g. lower interest rates if they felt that a high exchange rate was
damaging export sectors and causing much lower inflation)
 Low elasticity of demand: In the short term, the effects of exchange rates on export and
import demand tends to be low because of low price elasticity of demand
 Business response to the challenge of a high exchange rate: Businesses can and do adapt to
a high exchange rate. There are several ways in which industries can adjust to the competitive
pressures that a strong pound imposes. Some of the options include:
 Cutting their export prices when selling in overseas markets and therefore accepting lower
profit margins to maintain competitiveness and market share
 Out-sourcing components from overseas to keep production costs down
 Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps
trying to negotiate a reduction in pay levels
 Investing extra resources in new product lines where demand is price inelastic and less

244
1
 sensitive to exchange rate fluctuations. This involves producing products with a higher
income elasticity of demand, where non-price factors such as product quality, design and
effective marketing are as important in securing orders as the actual price

London is the major centre for foreign exchange trading in the world economy – the market is nearly
wholly screen based and billions of dollars worth of currencies is traded every hour

Author: Geoff Riley, Eton College, September 2006

AS Macroeconomics / International Economy

Government Borrowing & the Budget Deficit

In this chapter we consider the effects that government borrowing to finance their
spending can have on the wider performance of the economy.

The level of government borrowing is an important part of fiscal policy and management
of aggregate demand in any economy. When the government is running a budget deficit,
it mean’s that in a given year, total government expenditure exceeds total tax revenue.

245
1
If the government is running a budget deficit, it has to borrow this money through the
issue of government debt such as Treasury Bills and long-term government bonds. The
issue of debt is done by the central bank and involves selling debt to the bond and bill
markets. Most of the government debt is bought up by financial institutions but
individuals can buy bonds, premium bonds and buy national savings certificates.

Government finances have moved from surplus in the late 1990s to a deficit of over 2%
of GDP in 2006. The emergence of a rising budget deficit has been due to a weaker
economy and the effects of increases in government spending on priority areas such as
health, education, transport and defence. Critics of Gordon Brown argue that he risks
losing control of the budget deficit if tax revenues continue to come in below forecast
whilst public sector spending remains high. Gordon Brown’s reputation of fiscal
prudence has come under pressure over the last few years. He is forecast to be running a
budget deficit of over 3% of GDP (in excess of £32 billion) in 2006.

Does a budget deficit matter?

There is a consensus that a persistently large budget deficit can turn out to be a major
problem for the government and the economy. Three of the reasons for this are as
follows:

1. Financing a deficit: A budget deficit has to be financed and day-today, the issue
of new government debt to domestic or overseas investors can do this. But it may
be that if the budget deficit rises to a high level, the government may have to offer
higher interest rates to attract buyers of government debt. In the long run, higher

246
1
 government borrowing today may mean that taxes will have to rise in the future
and this would put a squeeze on spending by private sector businesses and
millions of households.
2. A government debt mountain? In the long run, a high level of government
borrowing adds to the accumulated National Debt. This means that the
Government has to spend more each year in debt-interest payments to holders of
government bonds and other securities. There is an opportunity cost involved
here because interest payments might be used in more productive ways, for
example an increase in spending on health services. It also represents a transfer
of income from people and businesses that pay taxes to those who hold
government debt and cause a redistribution of income and wealth in the economy
3. Wasteful public spending: Neo-liberal economists are naturally opposed to a
high level of government spending. They believe that a rising share of GDP taken
by the state sector has a negative effect on the growth of the private sector of the
economy. They are sceptical about the benefits of higher spending believing that
the scale of waste in the public sector is high – money that would be better off
being used by the private sector.

Potential benefits of a budget deficit

What are the main economic and social justifications for a higher level of government
spending and borrowing? Two main arguments stand out

1. Government borrowing can benefit economic growth: A budget deficit can

have positive macroeconomic effects in the long run if it is used to finance extra
capital spending that leads to an increase in the stock of national assets. For
example, higher spending on the transport infrastructure improves the supply-
side capacity of the economy promoting long-run growth. And increased public-
sector investment in health and education can bring positive effects on labour
productivity and employment. The social benefits of increased capital spending
can be estimated through use of cost-benefit analysis.

2. The budget deficit as a tool of demand management: Keynesian economists

would support the use of changing the level of borrowing as a way of fine-tuning
or managing the level of aggregate demand. An increase in borrowing can be a
stimulus to demand when other sectors of the economy are suffering from weak
spending. The fiscal stimulus given to the British economy during 2002-2005 has
been important in stabilizing demand and output at a time of global uncertainty.
The argument is that the government can and should use fiscal policy to keep real
national output closer to potential GDP so that we avoid a large negative output
gap. Maintaining a high level of demand helps to sustain growth and keep
unemployment low.

Author: Geoff Riley, Eton College, September 2006

247
1
AS Macroeconomics / International Economy
Macroeconomic Objectives and Policy Trade-offs

It is rare for any government to be able to meet all its objectives at the same time. The
complexity of the economy and the limitations of economic policies make this a really
tough task! In this chapter we consider possible trade-offs between the key policy
objectives.

There are potential trade-offs between objectives imply that choices between different
goals may have to be made in the short and medium run.

1. Should the highest priority be given to keeping inflation firmly under

control?
2. Or can the British economy now operate at a higher level of GDP growth
and lower unemployment without worrying too much about the
inflationary consequences?
3. Should the government be concerned about a large and rising trade deficit
with other countries? Or can the trade deficit be ignored because it is the
result of a high level of short term growth and strong consumer spending?

248
1
Unemployment and Inflation – the Phillips Curve

Is there a trade-off between unemployment and inflation?

Arguments for a trade-off:

When unemployment falls to low levels, there is a risk that wage and price inflation will
pick up. The demand for labour is increasing and labour shortages in many industries and
occupations may arise. This puts upward pressure on pay as employers offer higher pay
both to recruit and retain their key workers.

Falling unemployment leads to an increase in AD which can lead to demand pull inflation
if SRAS is inelastic and the output gap has become positive. As the economy heads
towards full-employment, there is a danger than inflation will accelerate and that
economic policy will have to be tightened (for example a rise in taxation or an increase in
interest rates). The diagrams below illustrate an outward shift of the demand for labour
during an economic boom and an increase in AD from AD1 to AD2 when SRAS is
inelastic.

249
1
Counter-arguments
Unemployment has many causes and there is no automatic rule that falling
unemployment must lead to rising inflation. It is widely acknowledged that the
relationship between unemployment and inflation in the UK (and some other countries)
has altered over the last fifteen years. As a consequence, the British economy has enjoyed
a very long period of falling unemployment without any significant acceleration in
inflation. This is shown in the data chart on the next page.

250
1
Why has the “trade-off” between unemployment and inflation changed?

Some economists point to the effect of supply side improvements in the British
economy such as higher capital investment; increases in productivity, lower labour costs
and the benefits of rapid innovation. All of these factors have helped to increase the
supply-side potential of the economy which has contributed to a period of non-
inflationary growth.

But it would be wrong to automatically assume that inflation is now dead! There are
plenty of possible causes of a return to higher inflation. For example, the UK is not
immune to fluctuations in global commodity prices, or the effects of a sharp fall in the
exchange rate. And too much domestic demand for goods and services, perhaps driven by
the continued boom in house prices and consumer borrowing, might also bring about a
return of demand-pull inflationary pressure.

Is there a trade-off between economic growth and inflation?

Arguments for the trade-off

Sustained growth caused by rising aggregate demand can lead to acceleration in inflation
as the economy uses up scarce resources and short run aggregate supply becomes
inelastic. When SRAS is elastic, an outward shift of aggregate demand can easily be met

251
1
by a rise in real GDP (there is plenty of spare capacity and supply responds elastically to
the higher level of AD). But when SRAS becomes inelastic, the trade-off between growth
and inflation worsens – an increase in AD tends to lead to higher prices rather than
increased output and employment.

Counter-arguments

The trade off between growth and inflation can be avoided if an economy is able to
increase potential output by improving their supply-side performance. For example,
LRAS can be increased by achieving sustained improvements in productivity, advances
in technology and the benefits that come from product and process innovations. Potential
output is also increased by expanding the stock of capital goods (via higher investment)
and through an increase in the available labour supply.

An outward shift in LRAS means that the economy can meet a higher level of aggregate
demand without putting upward pressure on the general price level. This is shown in the
diagram below. LRAS has moved to the right (an increase in potential GDP). Aggregate
demand has also shifted out (perhaps due to lower interest rates or higher real incomes
for consumers). Equilibrium national output increases from Y1 to Y2 – the level of
output Y2 would not have been feasible without a shift in LRAS.

252
1
Clearly those countries that grow very quickly are at risk of rising inflation. The key is to
keep control of aggregate demand (using monetary and fiscal policy) whilst at the same
time seeking to increase aggregate supply through improvements in efficiency and the
stock of available resources.

If we look at the data for economic growth and inflation in the UK over the last fifteen
years, we see that there has indeed been an improvement in the trade-off between these
two objectives. In the late 1980s, an economic boom got out of control and excess
demand led to a sudden and sharp rise in cost and price inflation. The rate of inflation
peaked at over 10% in 1990 and interest rates were increased up to a maximum of 15% in
order to bring aggregate demand under control. The result of this was a deep recession
lasting for nearly two years – the effect of which was to reduce inflation but which also
caused a huge rise in unemployment.

Since the early 1990s the British economy has enjoyed a period of relative
macroeconomic stability, with a sustained phase of economic growth allied to continued
low inflation. There have been some years of very strong growth (for example in 1997
when real GDP increased by 3.4% and also in 2000 when the economy expanded by 3%).
But on the whole the economy has avoided excessive growth of demand which can cause
inflation.

Part of the reason for this has been the management of aggregate demand using monetary
policy by the independent Bank of England. They have kept the output gap to very low
levels (indicating an economy close to macroeconomic equilibrium) whilst a combination
of other favourable factors on the demand and supply side of the economy has
contributed to low inflation. In the absence of a major external inflationary shock from
the global economy, there is every reason to believe that the British economy can
continue to enjoy a combination of steady growth and low inflation. But this requires the
supply-side of the economy to continue to deliver higher levels of productivity and
investment to give the economy the productive capacity to meet demand and to maintain
the competitiveness of UK producers in global markets.

253
1
Economic Growth and the Balance of Payments

Is there a trade off between fast economic growth and a worsening of the balance of trade
in goods and services?

Arguments for the trade-off

When aggregate demand is high and domestic producers are unable to meet all of this
demand, so the demand for imported goods and services will increase leading to an
increase in the trade deficit. This trade-off is evident when the main source of rising AD
is a high level of consumer spending. British consumers have a high propensity to import
goods and services. As their incomes increase, so too does their demand for imports. The
trade-off is worsened by the lack of international competitiveness of many UK industries
compared to other leading countries.

The experience of the UK in recent years shows that the size of the trade deficit is largely
cyclical. The strong growth of GDP and consumer demand has led to a large increase in
the trade deficit in goods and services. This suggests that if the government wants to
reduce the trade deficit, then it must accept that consumer demand (and GDP) must
eventually grow at a slower rate in order to reduce the imbalance between exports and
imports.

254
1
Counter-arguments

Economic growth can be achieved without a worsening of the balance of payments in

goods and services. The causes of a trade deficit are not solely cyclical – there are
structural explanations too – indeed in the long run, the main causes of imports out-
pacing exports relate to the competitiveness of UK producers in their own domestic
markets and when trying to export overseas.

Much depends on the strength of the exchange rate. When sterling is strong, the relative
prices of imports coming into the UK falls, and British exports because more expensive
in international markets – these causes a slowdown in export sales and a rise in the
demand for imports. Depreciation in the exchange rate would provide a competitive boost
to UK producers and might lead to an improvement in our balance of payments.
However, a low exchange rate would also lead to an increase in the costs of imported
goods and services risking higher “cost-push” inflation.

Exports can also be increased if our domestic industries increase their competitiveness in
other ways: higher productivity helps to reduce unit costs; greater investment in new
capital and research and development can lead to a faster pace of innovation and the
development of new products in export sectors. Non-price competitiveness can also be
improved by better design, after sales service, guaranteed delivery dates and more
effective marketing.

Export-led growth (i.e. increases in aggregate demand brought about by an increase in the
value of exported goods and services) can bring about economic growth without
deterioration in a country’s trade balance.

A worsening of the trade balance in goods and services acts as a drag on short term
economic growth for a country because imports are counted as a withdrawal from the
circular flow of income and spending – so a surge in demand for overseas-produced
goods and services leads to a flow of income and demand out of the economy.

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Production and Costs

In this note we consider some of the background to the theory of supply in markets by
considering the concepts of production and productivity and how they relate to the costs
that all businesses must face.

Production

255
1
Production refers to the output of goods and services produced by businesses within a
market. This production creates the supply that allows our needs and wants to be
satisfied. To simplify the idea of the production function, economists create a number of
time periods for analysis.

1. Short run production

The short run is a period of time when there is at least one fixed factor input. This is
usually the capital input such as plant and machinery and the stock of buildings and
technology. In the short run, the output of a business expands when more variable factors
of production (e.g. labour, raw materials and components) are employed.

1. Long run production

In the long run, all of the factors of production can change giving a business the
opportunity to increase the scale of its operations. For example a business may grow by
adding extra labour and capital to the production process and introducing new technology
into their operations.

The long run for a business such as Pret a Manger will be different from the long run for the
power generation industry. The long run is when all factors of production are variable – there
are no fixed factors!

The length of time between the short and the long run will vary from industry to industry.
For example, how long would it take a newly created business delivering sandwiches
around a local town to move from the short to the long run? Let us assume that the
business starts off with leased premises to make the sandwiches; two leased vehicles for
deliveries and five full-time and part-time staff. In the short run, they can increase
production by using more raw materials and by bringing in extra staff as required. But if
demand grows, it wont take the business long to perhaps lease another larger building,

256
1
buy in some more capital equipment and also lease some extra delivery vans – by the
time it has done this, it has already moved into the long run.

The point is that for some businesses the long run can be a matter of weeks! Whereas for
industries that requires very expensive capital equipment which may take several months
or perhaps years to become available, then the long run can be a sizeable period of time.

The meaning of productivity

When economists and government ministers talk about productivity they are referring to
how productive labour is. But productivity is also about other inputs. So, for example, a
company could increase productivity by investing in new machinery which embodies the
latest technological progress, and which reduces the number of workers required to
produce the same amount of output. The government’s objective is to improve labour and
capital productivity in the British economy in order to improve the supply-side potential
of the country.

Productivity of the variable factor labour and the law of diminishing returns

In the example of productivity given below, the labour input is assumed to be the only
variable factor by a firm. Other factor inputs such as capital are assumed to be fixed in
supply. The “returns” to adding more labour to the production process are measured in
two ways:

Marginal product (MP) = Change in total output from adding one extra
unit of labour

Average product (AP) = Total Output divided by the total units of labour
employed

In the example below, a business hires extra units of labour to produce a higher quantity
of wheat. The table below tracks the output that results from each level of employment.

Units of Labour Total Physical Product (tonnes of Marginal Product (tonnes of Average Product
Employed wheat) wheat) (tonnes of wheat)

0 0

1 3 3 3

2 10 7 5

3 24 14 8

257
1
 4 36 12 9

5 40 4 8

6 42 2 7

7 42 0 6

Diminishing returns is said to occur when the marginal product of labour starts to
fall. In the example above, extra labour is added to a fixed supply of land when a farming
business is harvesting wheat. The marginal product of extra workers is maximized when
the 4th worker is employed. Thereafter the output from new workers is falling although
total output continues to rise until the seventh worker is employed.

Notice that once marginal product falls below average product we have reached the point
where average product is maximized – i.e. we have reached the point of productive
efficiency.

Explaining the law of diminishing returns

The law of diminishing returns occurs because factors of production such as labour and
capital inputs are not perfect substitutes for each other. This means that resources used
in producing one type of product are not necessarily as efficient (or productive) when
switched to the production of another good or service. For example, workers employed in
producing glass for use in the construction industry may not be as efficient if they have to
be re-employed in producing cement or kitchen units. Likewise many items of capital
equipment are specific to one type of production. They would be much less efficient in
generating output if they were to be switched to other uses. We say that factors of
production such as labour and capital can be “occupationally immobile”; they can be
switched from one use to another, but with a consequent loss of productivity.

There is normally an inverse relationship between the productivity of the factors of

production and the unit costs of production for a business. When productivity is low, the
unit costs of supplying a good or service will be higher. It follows that if a business can
achieve higher levels of efficiency among its workforce, there may well be a benefit from
lower costs and higher profits.

Costs of production

Costs are defined as those expenses faced by a business when producing a good or
service for a market. Every business faces costs and these must be recouped from selling
goods and services at different prices if a business is to make a profit from its activities.
In the short run a firm will have fixed and variable costs of production. Total cost is
made up of fixed costs and variable costs

258
1
Fixed Costs

These costs relate do not vary directly with the level of output. Examples of fixed costs
include:

1. Rent paid on buildings and business rates charged by local authorities.

2. The depreciation in the value of capital equipment due to age.
3. Insurance charges.
4. The costs of staff salaries e.g. for people employed on permanent contracts.
5. Interest charges on borrowed money.
6. The costs of purchasing new capital equipment.
7. Marketing and advertising costs.

Variable Costs

Variable costs vary directly with output. I.e. as production rises, a firm will face higher
total variable costs because it needs to purchase extra resources to achieve an expansion
of supply. Examples of variable costs for a business include the costs of raw materials,
labour costs and other consumables and components used directly in the production
process.

We can illustrate the concept of fixed cost curves using the table below. The greater the
total volume of units produced, the lower will be the fixed cost per unit as the fixed costs
are spread over a higher number of units. This is one reason why mass-production can
bring down significantly the unit costs for consumers – because the fixed costs are being
reduced continuously as output expands.

In our example below, a business is assumed to have fixed costs of £30,000 per month
regardless of the level of output produced. The table shows total fixed costs and average
fixed costs (calculated by dividing total fixed costs by output).

Output (000s) Total Fixed Costs (£000s) Average Fixed Cost (AFC)

0 30

1 30 30

2 30 15

3 30 10

4 30 7.5

5 30 6

259
1
 6 30 5

7 30 4.3

When we add variable costs into the equation we can see the total costs of a business.

The table below gives an example of the short run costs of a firm

Output Total Fixed Cost Total Variable Cost Total Cost Average Total Cost Marginal Cost
Units TFC (£s) TVC (£s) TC (£s) ATC (£ per unit) MC (£)

0 100 0 100

20 100 40 140 7.0 2.0

40 100 60 160 4.0 1.0

60 100 74 174 2.9 0.7

80 100 84 184 2.3 0.5

100 100 90 190 1.9 0.3

120 100 104 204 1.7 0.7

140 100 138 238 1.7 1.7

160 100 188 288 1.8 2.5

180 100 260 360 2.0 3.6

200 100 360 460 2.3 5.0

Average Total Cost (ATC) is the cost per unit of output produced. ATC = TC divided
by output

Marginal cost (MC) is defined as the change in total costs resulting from the production
of one extra unit of output. In other words, it is the cost of expanding production by a
very small amount.

Long run costs of production

260
1
The long run is a period of time in which all factor inputs can be changed. The firm can
therefore alter the scale of production. If as a result of such an expansion, the firm
experiences a fall in long run average total cost, it is experiencing economies of scale.
Conversely, if average total cost rises as the firm expands, diseconomies of scale are
happening.

The table below shows a simple example of the long run average cost of a business in the
long run when average costs are falling, then economies of scale are being exploited by
the business.

Long Run Output (units per month) Total Costs (£s) Long Run Average Cost (£s per unit)

1,000 8,500 8.5

2,000 15,000 7.5

5,000 36,000 7.2

10,000 65,000 6.5

20,000 120,000 6.0

50,000 280,000 5.6

100,000 490,000 4.9

500,000 2,300,000 4.6

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Productivity

The American economist Paul Krugman once said that “productivity isn’t everything, but
in the long run it is almost everything.” We take a look at productivity in this chapter.

The advantages of higher productivity for a business and for the economy

Higher productivity can provide the economy with a number of advantages over time

261
1
 1. Lower average costs: Improvements in labour and capital productivity allow
businesses to produce output at a lower average cost. These cost savings might be
passed onto consumers in the form of lower prices, encouraging an expansion of
demand, higher output and possibly an increase in employment.
2. Improved competitiveness in international markets: Productivity growth and
lower unit costs are key determinants of the competitiveness of British firms in
domestic and overseas markets. From improved productivity, businesses can
develop a competitive advantage in markets where there is intense price and non-
price competition from overseas suppliers.
3. Higher profits: Efficiency gains resulting in rising productivity are a source of
larger profits for companies which might be re-invested to support the long term
growth of the business
4. Higher real wages: In the long run there is a positive relationship between
improvements in labour productivity and the real wages paid to labour as a factor
of production. Put simply, businesses are better able to afford higher wages when
their labour force is more efficient
5. Economic growth: Our capacity to produce goods and services depends on the
stock of factor resources available plus the productivity of those factors. If the
British economy can raise the rate of growth of productivity then the trend growth
of national output can pick up. This has implications for living standards,
unemployment and tax revenues and government spending in future years

The productivity gap

262
1
The level of GDP per worker and GDP per hour worked in the UK is well below that of
the United States, France and Germany. Evidence on the productivity gap is shown in the
previous chart and in the table below. Some progress has been made in closing the gap
but there is still much work to do.

Output per worker employed - international comparisons

UK productivity index = 100 Source ONS

France

Germany

UK

US

Factors explaining the productivity gap

Report into low UK productivity by economists at the London School of Economics

The persistent productivity gap between the UK and the two big continental European
economies can mainly be 'explained' by the fact that they have more capital invested per
worker and their workers are more skilled. Productivity growth is highest in industries
with greater product market competition - where less productive firms contract and close
while new more productive ones open and grow; and where competitive pressures force
existing firms to improve.

Capital investment plays an important role in productivity growth. But the UK has less
physical capital per worker than the United States and considerably less than France and
Germany. Many explanations have been offered for these shortfalls, including
macroeconomic instability and business uncertainty.

No one factor on its own is sufficient to explain the differences in efficiency. Some of the
more widely quoted reasons are summarized below:

263
1
 1. Relatively low rates of capital investment – the government believes that the
productivity gap is partly the result of a long-term investment gap, i.e. the failure
of the economy to invest and thereby to raise the stock of physical capital
available to the workforce
2. Low rates of spending on research and development – The percentage of GDP
allocated to R&D spending has been on a downward trend for some years. The
UK now devotes much less of GDP to research spending than other nations and
this impacts on the pace of innovation and the speed with which new technology
is incorporated into production
3. Skills of the labour force – there are long-standing concerns about the
educational skills of the UK labour force including basic literacy and the quality
of job specific training. Although governments have made numerous attempts to
reform the education system over the last two decades, and have pumped
increasing resources into improved vocational and academic education, Britain
still has one of the highest rates of functional illiteracy among adults, together
with fewer workers with higher skills (at degree level or above) compared to the
United States and fewer workers with intermediate and vocational skills compared
to Germany and Japan.
4. Over-regulation of industry and commerce and a lack of competition – the
1999 McKinsey Report highlighted a lack of competitive pressures in some
industries (notably retailing) as a source of inefficiency and low productivity
growth. Opening up markets to the discipline of competition was seen by the
McKinsey study as a necessary supply-side economic strategy to bring new
businesses into markets and weed out inefficiencies.

Skills gap and low profits contribute to poor productivity

A recent study from the Engineering Employers Federation finds that fewer firms in
Britain take on apprentices, investment projects are often ditched by managers and skilled
workers are in short supply. The EEF argues that UK firms need to invest in capital
equipment and skills and innovation, as well as making the best of modern working
practices such as lean manufacturing and high performance working. Part of the problem
for manufacturers has been a lack of profits to invest.

Adapted from research published by the Engineering Employers Federation

www.eef.org.uk

Productivity in the UK Car Industry

A good example of the differences in productivity between the UK and our European
competitors is shown by the annual assessment of productivity in the automotive
industry.

Nissan leads productivity in the European Car Manufacturing Sector

264
1
A British car plant was today named as the most productive in Europe for the seventh
year running. Bosses praised the efforts of workers at the Nissan factory in Sunderland.
Productivity at the Nissan plant was 99 units per employee, followed by Renault’s plant
in Spain at 89 and Toyota Motor Corp's plant in France at 88. The UK's biggest car plant,
Nissan in Sunderland, is also more than five per cent more productive than the most
efficient car plant in North America according to a major international study. The
Harbour Report measures the productivity of car plants on a labour hours/vehicle basis. It
showed that in 2004 the average combined time it took Sunderland to build its three
models (Micra, Almera and Primera) was a fraction over 15 hours per car. This is 5.1 per
cent better than the top-ranked plant in North America, which averaged 15.85 hours per
car.

Source: Adapted from news reports in 2005

Britain has some of the most efficient car plants in the EU – but also some of the worst.
This two speed car industry suggests that there are structural reasons behind
productivity differences. Nissan has remained at the top of the European productivity
league for each of the last seven years.

Those industries with the most up-to-date capital machinery, together with advanced
managerial skills and highly qualified and well-trained workforces tend to achieve
much higher levels of productivity. The availability of large-scale green-field, full-
integrated production plants and good industrial relations are also at the heart of
achieving year on year improvements in output per person employed.

The strength of demand also affects productivity. When demand is high and
production plants are running close to full capacity, then output per worker employed is
likely to be rising because factor resources including labour and capital are being used to
their full extent. In contrast, during a recession or a slowdown in demand, the utilisation

265
1
of labour and capital falls. Productivity growth often slows down during a period of weak
demand and falling output.

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Market Failure

When markets do not provide us with the best outcome in terms of efficiency and fairness,
then we say that there exists market failure. This brief chapter introduces us to some of
the main causes of market failure; we will explore them in more detail in succeeding
chapters.

What is market failure?

Market failure occurs whenever freely-functioning markets operating without

government intervention, fail to deliver an efficient allocation of resources and the
result is a loss of economic and social welfare. Market failure exists when the
competitive outcome of markets is not satisfactory from the point of view of society. This
is usually because the benefits that the free-market confers on individuals or businesses
carrying out an activity diverge from the benefits to society as a whole.

One useful distinction is between complete market failure when the market simply does
not exist to supply products at all (i.e. we see “missing markets”), and partial market

266
1
failure, when the market does actually function but it produces the wrong quantity of a
good or service at the wrong price.

Markets can fail for lots of reasons and the main causes of market failure are summarized
below:

1. Negative externalities (e.g. the effects of environmental pollution) causing the

social cost of production to exceed the private cost
2. Positive externalities (e.g. the provision of education and health care) causing the
social benefit of consumption to exceed the private benefit
3. Imperfect information means merit goods are under-produced while demerit
goods are over-produced or over-consumed
4. The private sector in a free-markets cannot profitably supply to consumers pure
public goods and quasi-public goods that are needed to meet people’s needs and
wants
5. Market dominance by monopolies can lead to under-production and higher
prices than would exist under conditions of competition
6. Factor immobility causes unemployment hence productive inefficiency
7. Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of
income and consequent social exclusion which the government may choose to
change

Market failure and economic efficiency

When markets function well we experience an efficient and fair (equitable) allocation of
resources
Market failure results in

 Productive inefficiency: Businesses are not maximising output from given factor
inputs. This is a problem because the lost output from inefficient production could
have been used to satisfy more wants and needs. Costs are higher and productivity
is lower than it might have been.
 Allocative inefficiency: Resources are misallocated and the economy is
producing goods and services that are not wanted or not valued by consumers.
This is a problem because resources might be put to a better use making products
that we value more highly. Allocative efficiency is the most relevant concept that
you can use at AS level to analyse and evaluate market failure.

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Negative Externalities

267
1
In this note we consider some of the external costs that can result from people consuming
goods and services and businesses supplying products. Externalities are common
everywhere in everyday life and the key issue is whether the market, left to its own
devices, will take these externalities into account. If not, then market failure can occur
and there is a justification for some form of government intervention.

What are externalities?

Externalities are third party effects arising from production and consumption of goods
and services for which no appropriate compensation is paid. Externalities cause market
failure if the price mechanism does not take account of the social costs and benefits of
production and consumption.

Many types of economic activity give rise to the creation of externalities. And these
externalities can be positive and negative.

Externalities can and do result in the market mechanism producing the wrong quantity of
goods and services so that there is a loss of social welfare

Externalities occur outside of the market i.e. they affect economic agents not directly
involved in the production and/or consumption of a particular good or service. They are
also known as spin-over or spill-over effects.

Externalities and the importance of property rights

External costs and benefits are around us every day – the key point is that the market may
fail to take them into account when pricing goods and services. Often this is because of
the absence of clearly defined property rights – for example, who owns the air we
breathe, or the natural resources available for extraction from seas and oceans around the
world?

A question of property rights

268
1
I paint a picture on the side of your house – who owns the picture?

Property rights confer legal control or ownership of a good. For markets to operate
efficiently, property rights must be clearly defined and protected – perhaps through
government legislation and regulation. If an asset is un-owned no one has an economic
incentive to protect it from abuse.

This can lead to what is known as the Tragedy of the Commons i.e. the over use of
common land, fish stocks etc which leads to long term permanent damage to the stock of
natural resources.

Negative Externalities

Negative externalities occur when production and/or consumption impose external costs
on third parties outside of the market for which no appropriate compensation is paid.
Some examples are given below, many of them are environmental.

1. Smokers ignore the unintended but harmful impact of toxic ‘passive smoking’ on
non-smokers
2. Acid rain from power stations in the UK can damage the forests of Norway
3. Air pollution from road use and traffic congestion
4. The social costs of drug and alcohol abuse
5. External costs of scraping the seabed for supplies of gravel
6. External costs of travelling by taxi
7. The environment damage caused by the intensive use of fertilisers in agriculture
8. The external costs of cleaning up from litter and the dropping of chewing gum
9. The external costs of the miles that food travels from producer to the final
consumer

US pollution may damage UK health

Pollution created by consumers and producers in one country can often cause external
costs in other countries. The classic example of this is the effects of the nuclear fall-out
from the Chernobyl disaster in 1986. Recent news reports have claimed that polluted air
from America could be damaging the health of people in Britain. A study from the
Intercontinental Transport of Ozone and Precursors programme has found that airborne
chemicals from 8,000km away are being dumped in the UK and Western Europe and
may be to blame for a rise in lung disease. They claim that "It is highly likely that air
leaving the States contains a cocktail of nitrogen oxides and hydrocarbons, which are
emitted from vehicle exhausts and power stations."
Adapted from news reports, June 2004

Private Costs and Social Costs

269
1
The existence of production and consumption externalities creates a divergence between
private and social costs of production and also the private and social benefits of
consumption.

Social Cost = Private Cost + External Cost

Social Benefit = Private Benefit + External Benefit

When negative production externalities exist, social costs exceed private cost. This leads
to the private optimum level of output being greater than the social optimum level of
production. The individual consumer or producer does not take the effects of externalities
into their calculations.

External costs from production

Production externalities are generated and received in production - examples include

noise pollution and atmospheric pollution from factories and the long-term environmental
damage caused by depletion of our stock of natural resources

External costs from consumption

Consumption externalities are generated and received in consumption - examples

include pollution from cars and motorbikes and externalities created by smoking and
alcohol abuse and also the noise pollution created by loud music being played in built-up
areas.

Negative consumption externalities lead to a situation where the social benefit of

consumption is less than the private benefit. Positive consumption externalities lead to a
situation where the social benefit of consumption is greater than the private benefit. In
both cases externalities can lead to market failure.

Consider this example of the estimated social costs arising from drug addiction in the
UK.

External Costs of Drug Dependency

Heroin and crack cocaine addicts are costing the country up to £19 billion a year,
according to a study from experts at York University. A hard core of problem drug
abusers is running up a bill of £600 a week each in crime, police and court time, health
care and unemployment benefits. Last year, the NHS spent about £235 million on GP
services, accident and emergency admissions and treatment linked to drug abuse. When
social costs are added, the bill rises to between £10.9 billion and £18.8 billion. There are
at least 1.5 million recreational and regular users of Class A drugs. The average cost to
society of all Class A drug users is £2,030 each a year, says the study.

Externalities from alcohol use and misuse

270
1
For most adults drinking alcohol is part of a pleasurable social experience, which causes
no harm to themselves or others. For some people though, alcohol misuse is responsible
for causing serious damage to themselves, their family and friends and to the community
as a whole. In this context, alcohol has significant costs not only for the individual but
also for the whole economy. Per capita alcohol consumption in the UK has risen by more
than half in the part thirty years to 8.5 litres of pure alcohol in 2001. However obtaining
reliable information about drinking behaviour is difficult and social surveys consistently
under-record consumption of alcohol for two reasons.In 2001, over nine million people
were estimated to be drinking above government weekly guidelines. Around eight
percent of the English population or around 2.8 million people in England aged 16 and
over are estimated by government figures to have some form of alcohol dependency.

Britons are paying the penalty for the soaring rate of alcohol consumption, a report by
doctors shows. According to the report, deaths from liver cirrhosis are rising faster in
Britain than anywhere else in Europe. The rise has been especially sharp in men and
women aged fewer than 45, where death rates now exceed the European average.

Sources: Adapted from government reports and newspaper reports, November 2005

Private and external costs and benefits of alcohol

Private costs:

Expenditure on alcohol
Financial costs of consequences of alcohol misuse (e.g. medical treatment, higher health
premiums or lawyer’s fees)
Pain and suffering for the alcohol abuser
Loss of quality of life / quality life years lost

Private benefits:

Pleasure / satisfaction from consumption

Some health benefits e.g. from moderate alcohol consumption
Consumer surplus (e.g. from drinking at a price lower than a consumer’s willingness to
pay)

External costs:

Injuries / damage done to 3rd parties

Alcohol related crime – according to the British crime survey of 2002, 47 percent of all
violent crime is alcohol related
Alcohol related motor accidents / victim’s lost production and quality of life / damaged
property
Costs of law enforcement / crime prevention
Pain and suffering of family and friends / unwanted pregnancies / partner assaults /
education outcomes

271
1
Lost output from premature death / illness – some illnesses are 100 % attributable to
alcohol use, others are only partly attributable - Alcohol is responsible for nearly 100
conditions, including impotence, psoriasis and heart disease. The present value of lost
output in the economy due to premature deaths among employees who misuse alcohol is
between £ 2.3 billion and £ 2.5 billion
Excess use of health services (in patient and out patient services)
Specialist alcohol treatment services (e.g. detoxification, rehabilitation, dependency-
prescribed drugs) – total healthcare costs for England and Wales in 2001 related to
alcohol misuse range between £1.4 and £1.7 billion with a middle estimate of about £1.6
billion.
Lower productivity in the workplace / absenteeism / loss of productive efficiency

External benefits:

Alcohol as a social lubricant

Building of business networks / social capital effects

Death rates from alcohol-related causes

England & Wales Rates per 100,000 population

Males Females

1980 5.9 4.1

1990 8.4 5.2

2000 13.3 7.1

2003 15.8 7.6

Source: Office for National Statistics

Government policy on alcohol – is this an example of government failure?

A leading alcohol campaigning charity has heavily criticised the Government after a
major new report revealed Britons are drinking themselves to death at a faster rate than
people anywhere else in Western Europe.

A new study published in The Lancet medical journal shows liver cirrhosis deaths are
soaring in the UK while falling in other European countries. National charity Alcohol

272
1
Concern today said the trend is an indictment of Britain's drinking culture and accused
the Government of failing to tackle alcohol abuse and binge drinking. According to the
pressure group, excessive drinking kills around 22,000 people every year.
Source: Alcohol Concern

The Wanless Report on Health (2004)

The value of some externalities can vary depending on the situation in which a good is
consumed. For example, the externality of alcohol consumption depends critically on the
amount consumed – small amounts of alcohol can be beneficial, while large amounts
damage health. Ideally when introducing a tax, it should be set at the value of the last unit
of the good consumed – called the marginal cost. Therefore, for example, the tax on a
heavy drinker could be greater than someone only having a glass of wine during a meal.

Source Wanless Report

The private costs of dumping waste are close to zero – but the external costs are often
very high

Illustrating the market failure from negative externalities

The diagram below provides a way of illustrating the effects of negative externalities
arising from production on the private and social costs and benefits to producers and
consumers. The key is to understand the difference between private and social costs.

273
1
In the absence of externalities, the private costs of the supplier are the same as the costs
for society. But if there are negative externalities, we must add the external costs to the
firm’s supply curve to find the social cost curve. This is shown in the diagram above.

If the market fails to include these external costs, then the equilibrium output will be Q2
and the price P2. From a social welfare viewpoint, we want less output from production
activities that create an “economic-bad” such as pollution and other forms of
environmental damage. A socially-efficient output would be Q1 with a higher price P1.
At this price level, the external costs have been taken into account. We have not
eliminated the pollution (we cannot do this) – but at least the market has recognised them
and priced them into the price of the product.

Author: Geoff Riley, Eton College, September 2006

274
1
AS Market Failure
Government Intervention & Externalities

How can we take into account some of the third party effects that arise? Is there anything
that the government can do? To many economists interested in environmental problems
and who believe that that the government can successfully intervene in the price
mechanism, the key is to internalise some or all of the external costs and benefits to
ensure that the businesses and consumers who create the externalities include them when
making decisions.

Taxes

One common approach to adjust for externalities is to tax those who create negative
externalities. This is sometimes known as “making the polluter pay”. Introducing a tax
increases the private cost of consumption or production and ought to reduce demand and
output for the good that is creating the externality. According to the Department of the
Environment, “Taxes send a signal to polluters that our environment is valuable and is
worth protecting.”

Some economists argue that the revenue from pollution taxes should be ring-fenced and
allocated to projects that protect or enhance our environment. For example, the money
raised from a congestion charge on vehicles entering busy urban roads, might be
allocated towards improving mass transport services; or the revenue from higher taxes on
cigarettes might be used to fund better health care programmes. Usually in the UK,
revenue from environmental taxation simply goes into the general pot of taxation which
is then used to finance all types of government spending.

Examples of Environmental Taxes

1. The Landfill Tax - this tax aims to encourage producers to produce less waste
and to recover more value from waste, for example through recycling or
composting and to use more environmentally friendly methods of waste disposal.
The tax applies to active and inert waste, disposed of at a licensed landfill site.
2. The Congestion Charge: -this is a very high profile environmental charge
introduced in February 2003 by the Mayor of London Ken Livingstone. It is
designed to cut traffic congestion in inner-London by charging motorists £5 per
day to enter the central charging zone – for more information go to the Transport
for London web site
3. Plastic Bag Tax: In Ireland a pioneering new 15 cent levy on plastic shopping
bags was launched in 2002. The tax is designed to encourage people to use
reusable bags and has stimulated an increase in the availability of biodegradable
bags. Payable in all sales outlets 15 cents are charged for each bag issued and
itemized separately on receipts. Proceeds from the tax go to the Environment

275
1
 Fund and are used to fund various waste management and other environmental
initiatives.

Would a tax on aviation fuel be an effective and appropriate way to reduce carbon
emissions from the airline industry?

Problems with Taxes to Curb Pollution

Many economists argue that pollution taxes can create further problems which lead to
government failure and little sustainable improvement in environmental conditions. The
main problems are as thought to be as follows:

(1) Assigning the right level of taxation:

There are problems in setting tax so that private cost will exactly equate with the social
cost. The government cannot accurately value the private benefits and cost of firms let
alone put a monetary value on externalities such as the cost to natural habitat, the long-
term effects if resource depletion and the value of human life

(2) Imperfect information:

Without accurate information setting the tax at the correct level is impossible. In reality,
therefore, all that governments and regulatory agencies can hope to achieve is a
movement towards the optimum level of output.

(3) Consumer welfare effects

1. Taxes reduce output and raise prices, and this might have an adverse effect on
consumer welfare. Producers may be able to pass on the tax to the consumers if
the demand for the good is inelastic and, as result, the tax may only have a small
effect in reducing demand

276
1
 2. Taxes on some de-merit goods (for example cigarettes) may have a regressive
effect on lower-income consumers and leader to a widening of inequalities in the
distribution of income.

(4) Employment and investment consequences:

If pollution taxes are raised in one country, producers may shift production to countries
with lower taxes. This will not reduce global pollution, and may create problems such as
structural unemployment and a loss of international competitiveness. Similarly higher
taxation might lead to a decline in profits and a fall in the volume of investment projects
that in the long term might have beneficial spill-over effects in reducing the energy
intensity of an industry or might lead to innovation which enhance the environment.

Dumped rubbish on the streets of the UK – the landfill tax is widely regarded as having
encouraged fly-tipping

Command and Control Techniques – Regulation

Instead of trying to change market prices and therefore affect the behaviour of consumers
and producers, the government may choose to intervene directly in a market through the
use of regulations and laws.

For example, the Health and Safety at Work Act covers all public and private sector
businesses. Local Councils can take action against noisy, unruly neighbours and can pass
by-laws preventing the public consumption of alcohol. Cigarette smoking can be banned
in public places – such as the ban on smoking in workplaces and bars and restaurants
introduced in Ireland in 2004. The British government is currently consulting about a ban
on smoking in public places from 2006. However the government has also introduced a
more liberal licensing law for the sale of alcohol, although this has met fierce resistance
from come critics.

277
1
 The European Union has also introduced a wide range of directives on how consumer
durables such as cars, batteries, fridges freezers and other products should be disposed of.
The onus is now on producers to provide facilities for consumers to bring back their
unwanted products – but the costs of disposal eventually get past onto consumers.

Can the market mechanism find the right incentives for consumers to recycle – or is there
a need for government intervention and regulation to make us recycle more of what we
consume?

Carbon Emissions Trading – Marketable Pollution Permits

Some countries have moved toward market-based incentives to achieve pollution

reduction. This new approach involves the creation of a limited volume of pollution
rights, distributed among firms that pollute, and allows them to be traded in a secondary
market. The intent is to encourage lowest-cost pollution reduction measures to be
utilized, in exchange for revenues from selling surplus pollution rights. Companies that
are efficient at cutting pollution will have spare permits that they can then sell to other
businesses. As long as the total bank (or stock) of permits is reduced year by year by the
government or an agency, cuts in total pollution can be achieved most efficiently.

Quite simply, limiting emissions makes polluting a scarce resource, and scarcity brings
economic value. Emissions’ trading is a central feature of the Kyoto Protocol and the
European Carbon Emissions Trading Scheme started in full in January 2005.

278
1
 Is carbon trading the best market-based solution to the threats from global warming?

In short, carbon trading is designed to reduce the cost of achieving sustainable cuts in
greenhouse gas emissions and secondly to extend the principle of property rights as a
means of meeting environmental objectives.

Subsidising positive externalities

An alternative to taxing activities that create negative externalities is to subsidise

activities that lead to positive externalities. This reduces the costs of production for
suppliers and encourages a higher output. For example the Government may subsidise
state health care; public transport or investment in new technology for schools and
colleges to help spread knowledge and understanding. There is also a case for subsidies
to encourage higher levels of training as a means to raise labour productivity and improve
our international competitiveness.

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Merit Goods

Merit goods create a divergence between the private and social costs and benefits of
production and consumption leading to the risk of market failure.

Risk of under-consumption:

279
1
Merit goods are those goods and services that the government feels that people will
under-consume, and which ought to be subsidised or perhaps provided free at the point
of use so that consumption does not depend primarily on the ability to pay for the good or
service.

Who provides merit goods?

It is important to realise that it is not simply the government (or public sector) that
supplies merit goods. Both the state and private sector provide merit goods & services.
We have an independent education system and people can buy private health care
insurance.

Externality issues:

Consumption of merit goods is believed to generate positive externalities- where the

social benefit from consumption exceeds the private benefit.

Merit goods – museums and libraries

What are the external benefits that might flow from more people having access to our
major museums and other heritage sites?

Merit goods can be defined in terms of their externality effects and also in terms of
informational problems facing the consumer

A merit good is a product that society values and judges that everyone should have
regardless of whether an individual wants them. In this sense, the government (or state) is
acting paternally in providing merit goods and services. They believe that individuals
may not act in their own best interest in part because of imperfect information about the
benefits that can be derived. Good examples of merit goods include health services,
education, work training programmes, public libraries, Citizen's Advice Bureaux and
inoculations for children and students.

280
1
Notice here that we are talking about the sorts of goods and services that society judges
to be in our best welfare. Judgements involve subjective opinions – and we cannot escape
from making some valued judgements when we are analysing and discussing merit
goods.

 Do you believe that most National Health Services and dental services should be
made available free at the point of need?
 Should the state continue to provide free and compulsory education up to the age
of 16?
 Should people be forced to make compulsory savings for their retirement?

Education as a merit good

Exclusive schooling

Education is provided by the state and the private sector – but if it was left only to be fee-
paying sector, education would be heavily under-consumed

281
1
The argument concerning imperfect information is an important one. Parents with
relatively poor educational qualifications may be unaware of the full longer-term benefits
that their children might derive from a proper education. Because the knowledge of these
private benefits is an ongoing learning process, children themselves will tend to
underestimate the long term gains from a proper education.

Education is a long-term investment decision. The private costs must be paid now but
the private benefits (including higher earnings potential over one’s working life) take
time to emerge.

Education should provide a number of external benefits that might not be taken into
account by the free market. These include rising incomes and productivity for current
and future generations; an increase in the occupational mobility of the labour force
which should help to reduce unemployment and therefore reduce welfare spending.

Increased spending on education should also provide a stimulus for higher-level

research which can add to the long run trend rate of growth. Other external benefits
might include the encouragement of a more enlightened and cultured society, less prone
to political instabilities and one which manages to achieve a greater degree of social
cohesion. Providing that the education system provides a sufficiently good education
across all regions and sections of society, increased education and training spending
should also open up a higher level of equality of opportunity. The reality is of course
that there are very deep and wide variations in educational performance and opportunities
across the country.

School milk – should it be subsidised?

Economists working as consultants for London Economics have written a paper arguing
that the Government should consider ending the current milk subsidy scheme for 1.2
million primary school children in England as they cost too much to administer and do
little to improve health. They found that administration costs took up 70 per cent of the
total cost of running the milk scheme and that the money could be better spent on
alternative projects. The subsidy payable on whole milk is about 19p per litre or 11p per

282
1
pint and the subsidy payable on semi-skimmed milk is about 15p per litre or 9p per pint.
Abandoning the payments to 15,000 schools and local education authorities in England
would save £1.5 million a year. The subsidy is already set to be cut by 16 per cent up to
July 2007 as part of Common Agricultural Policy reform.

In their report the London Economics consultants argue that "The private sector already
offers milk at a low price, so it is not clear why schools should offer it also. While many
products are helpful for children - such as toothpaste and toothbrushes - schools do not
typically offer them for sale to pupils."

But Milk for Schools, a campaign funded by the dairy industry, says the subsidy should
be extended, not dropped. A spokesman said that "School milk schemes are essential to
ensure access to nutrition for all and that the scheme was important as a way of
alleviating child poverty."

Jim Begg, Director General of Dairy UK, said: “This subsidy is highly valued by parents,
teachers and schools as a method of delivering the nutritional benefits of milk to children.
If the Government chose to reduce or scrap this subsidy the effect will be most acutely
felt by the neediest and it is highly unlikely that the money would be re-directed to other
nutritional programmes.”

Source: Dairy UK, Milk for Schools

Brain food – is it a new merit good?

Tucking into an oily fish as such sardine, salmon or mackerel may be the way that people
can consumer sufficient fatty acids. But should the government provide a subsidy for
schools to give their students multivitamin pills and omega-3 supplements in a bid to
improve educational performance? The use of supplements as brain food is an interesting
example of a paternalistic approach to improving education results. Some trials have
found that omega-3 supplements can enhance learning abilities and relieve depression.
Omega-3 is termed an "essential fat", found in oily fish. The claim is that such foods are
under-consumed by children (and adults) in a world dominated by convenience foods
with many of the important minerals and vitamins stripped away by the food processing
industry. Naturally there are plenty of skeptics ready to line up and question not only the
benefits of such supplements but also the cost. The retail price is estimated to be 40p to
£1.20 a day per student for the recommended dose of half a gram. Might that money be
better spent elsewhere for example in increased funding for school libraries or ICT
equipment?

Source: Adapted from news reports, June 2006

So why does the government provide merit goods and services?

 To encourage consumption so that some of the positive externalities associated

with merit goods can be achieved

283
1
  To overcome the information failures linked to merit goods, not least when the
longer-term private benefit of consumption is greater than the shorter-term benefit
of consumption
 On grounds of equity – because the government believes that consumption should
not be based solely on the grounds of ability to pay for a good or service

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Factor Immobility

One cause of market failure is the immobility of factors of production. There are two
main types of factor immobility, occupational and geographical immobility.

Immobility of labour – a cause of unemployment and market failure

One of the main causes of long term unemployment is that workers lack the skills
required by expanding industries in the economy.

Occupational Immobility

Occupational immobility occurs when there are barriers to the mobility of factors of
production between different sectors of the economy which leads to these factors
remaining unemployed, or being used in ways that are not economically efficient.

Some capital inputs are occupationally mobile – a computer can be put to use in many
different industries. Commercial buildings can be altered to provide a base for many
businesses. However some units of capital are specific to the industry they have been
designed for.

284
1
Labour often experiences occupational immobility. For example, workers made
redundant in the sheet metal industry or in heavy engineering may find it difficult to gain
re-employment. They may have job-specific skills that are not necessarily needed in
growing industries. This implies that there is a mismatch between the skills on offer from
the unemployed and those required by employers looking for extra workers. This is also
called structural unemployment and explains why there is a core of workers in the UK
who find it difficult to find paid work. Clearly this leads to a waste of scarce resources
and represents market failure.

Geographical Immobility

People may also experience geographical immobility – meaning that there are barriers to
them moving from one area to another to find work. There are good reasons why
geographical immobility might exist:

1. Family and other social ties.

2. The financial costs involved in moving home including the costs of selling a
house, removal expenses and other associated expenditure.
3. Huge regional variations in house prices.
4. Differences in the general cost of living between regions.

The regional divide in house prices is a major contributor to geographical immobility.

The widening gap in average prices and associated problems of housing affordability can
make it virtually impossible for people from the North to consider moving south because
they cannot afford to maintain their standard of living in the South East.

Policies to Improve the Mobility of Labour

To reduce occupational immobility the government might:

1. Invest in increased provision of training schemes for the unemployed –

particularly those workers experiencing structural unemployment. Investment in
the training of the labour force is designed to boost the human capital of
employees to give them new skills and skills that can be transferred from one
occupation to another. If such training is successful, then the labour market can
become more flexible in response to changes in labour demand and labour supply
2. Subsidise the provision of industrial training by private sector firms to raise the
skills level
3. Raise total spending on education and move towards increased investment in
vocational training for students

To reduce geographical immobility:

 Reforms to the housing market designed to improve the supply and reduce the
cost of rented properties and to increase the supply of affordable properties

285
1
  Specific subsidies for people moving into areas where there are shortages of
labour – for example teachers and workers in the National Health Services

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Poverty & Inequality in Resource Allocation

In this chapter we consider some of the causes of the huge gap between rich and poor in
the UK, something that is visible in nearly every country regardless of their stage of
economic development.

Poverty, Inequality and Market Failure

In a market economy an individual’s ability to consume goods & services depends upon
his/her income. An unequal distribution of income and wealth may result in an
unsatisfactory allocation of resources. The relatively poor do not have access to the range
of goods and service consumed by ‘average’ citizens. High inequality may also lead to
alienation and encourage crime with negative consequences for all. The market system
will not respond to the needs and wants of those with insufficient economic votes to have
any impact on market demand because what matters in a market based system is your
effective demand for goods and services.

Top of the income ladder

“The richest have continued to get richer. The richest one per cent of the population has
increased their share of income from around six per cent in 1980 to 13 per cent in 1999.
Inequality in disposable income (after taxes and benefits) appears to have slightly
increased since 1997 after significant increases in the 1980s.”

“The State of the Nation” IPPR report, www.ippr.org.uk August 2004

When we are discussing inequality and poverty, we cannot escape having to make value
judgements. Ultimately, what is an ‘unacceptable’ distribution of income and what if
anything the government should do about this is a value judgement and is a political issue
beyond the remit of economics as a subject? That said there is plenty of evidence that
high and rising levels of inequality of income and wealth can lead to negative social
consequences.

Absolute poverty

286
1
Absolute poverty measures the number of people living below a certain income threshold
or the number of households unable to afford certain basic goods and services. What we
choose to include in a basic acceptable standard of living is naturally open to discussion.

Relative poverty

Relative poverty measures the extent to which a household’s financial resources falls
below an average income threshold for the economy. Although living standards and real
incomes have grown because of higher employment and sustained economic growth over
recent years, the gains in income and wealth have been unevenly distributed across the
population.

There is little doubt that Britain has become a more unequal society over the last 20-25
years.

Poorer families have a lower life expectancy

People from poorer backgrounds are unhealthier and die earlier than the rich, according a
study measuring the link between health and wealth. Poorer people in their fifties were
10 times more likely to die earlier than those who are richer, according to a report from
the Institute of Fiscal Studies (IFS). That was despite an "even distribution in the quality
of healthcare between different wealth groups", the IFS said. The poor often have to stop
work early due to ill health, the group added and this increases the risk of these groups
suffering income poverty during their retirement years.
Source: BBC news and Institute for Fiscal Studies

How many people live below the poverty line?

The most commonly used threshold of low income in Britain is 60% of median
household income after deducting housing costs. This is a relative measure of poverty,
which rises each year as average income rises and it is the measure now used to measure
the number of households in a country living below the poverty line.

 Around two-thirds of individuals live in households that have incomes below the
mean
 In contrast, just 2% of individuals have incomes above three times the national
average
 Nearly 13 million people live in poor households whose income is less than sixty
per cent of median income
 In 2003 3.6 million children were living in poor households – 28 per cent of all
children. This compares with 1.9 million children in 1979

Proportion of people whose income is below various fractions of median household

disposable income

287
1
UK

Below

60 per cent Below half

of median of median

income income

1961 12.8 7.4

1971 13.6 6.3

1981 12.1 4.5

1991 20.1 11.7

2001 17.0 9.7

2004 16.8 9.4

Source: Social Trends 36

Going without

“In the UK people can become poor as a result of social and economic processes, such as
unemployment and changing family structures. Poverty is not simply about being on a
low income and going without – it is also to do with being denied hood health, education,
good housing and social activities, as well as basic self-esteem”
Source: Child Poverty Action Group fact sheet

The Poverty Trap

The poverty trap affects people living in households on low incomes. The poverty trap
creates a disincentive to look for work or work longer hours because of the combined

288
1
effects of the income tax and welfare benefits system. For example, a worker might be
given the opportunity to earn an extra £50 a week by working ten additional hours. This
boost to his/her gross income is reduced by an increase in income tax and national
insurance contributions. The individual may also lose some income-related welfare
benefits. The combined effects of this might be to take away over 70% of a rise in
income, leaving little in the way of extra net or disposable income.

When one adds in the possible extra costs of more expensive transport charges and the
costs of arranging child care, then the disincentive to work may be quite strong.

Government Policies to Reduce Poverty

The Labour government has said on many occasions that it wants to reduce relative
poverty in the UK. It has set ambitious targets for reducing the level of child poverty and
it also wants to reduce the problem of poverty among older households.

Policies to reduce relative poverty normally focus on (a) changes to the tax and benefits
system and (b) policies designed to increase employment and reduce unemployment.

When evaluating different policies to reduce poverty consider some of these related
issues:

 Cost: The cost of schemes such as an increase in welfare benefits or the New
Deal
 Effectiveness: The effectiveness of policies – e.g. the possible low “take-up” of
means tested benefits by the poorest households
 Impact on others in the economy: Whether introducing a more progressive
welfare system might damages towards wealth creation in other parts of the
economy

Some of the main policy measures are summarised below:

1. Changes to the tax and benefits system

To many economists, the tax system is the most obvious place to start if the government
wants to make a serious effect on the scale of relative poverty. For example, increases in
higher rates of income tax would make the British tax system more progressive and
reduce the post-tax incomes of people at the top of the income scale. The risk is that
higher rates of direct taxation may act as a disincentive for people to earn extra income
and might damage enterprise and productivity.

Lower "starting rates" of income tax would help to reduce the poverty trap and encourage
people to look for a job. One of the problems with this is that all taxpayers would benefit
from lower starting rates of tax and increased tax allowances whether or not they are
poor. Therefore it is an expensive way of alleviating relative poverty.

289
1
 2. A switch towards greater means-tested benefits

Means testing allows welfare benefits to go to those people and families in greatest need.
A means-test involves a check on the financial circumstances of the benefit claimant
before paying any benefit out. This would help the welfare system to target help for
those households on the lowest incomes. However means tested benefits are often
unpopular with the recipients.

3. Linking the state retirement pension to average earnings rather than prices

This policy would help to relieve relative poverty among low-income pensioner
households. Their pension would rise in line with the growth of average earnings each
year. However given the demographic pressures on the welfare state (not least the long
run increase in the number of people of pension age) such a strategy would be extremely
expensive and put great pressure on total government spending. Other areas of spending
might suffer a reduction in funding. Or the burden of taxation might have to increase to
fund a substantial increase in spending on state pensions.

4. Special employment measures (including New Deal)

Government employment schemes seek to raise employment levels and improve the
employment prospects of the long-term unemployed. Many schemes have been tried in
the past - the latest of which is Labour's New Deal strategy that focuses on reducing long-
term unemployment among youth and older workers. The New Deal includes
employment subsidies and employment training for participants on the scheme.

5. Regional Policy Assistance

Relative poverty is often worse in areas where unemployment is well above the national
average. The government may allocate increase funds for regional policy initiatives to
attract new businesses into depressed areas and to improve the infrastructure of these
regions. There are doubts though about the cost-effectiveness of regional policy funding.
The European Union provides regional “structural” funds for areas where GDP is less
than seventy-five per cent of the European Union average. Regions such as Cornwall,
Wales, Scotland, Northern Ireland and the North East and North West of England have
been in receipt of these funds over recent years.

6. Increased spending on education and training

Unemployment is a cause of poverty and structural unemployment makes the problem

worse. There are millions of households in the UK where no one in the family is in any
kind of work and this increases the risk of poverty. There are substantial long term
benefits from improving the educational attainment of families on low incomes and
improving their prospects in the labour market.

7. The National Minimum Wage

290
1
The National Minimum Wage (NMW) was introduced in April 1999. It is a statutory pay
floor - employers cannot legally undercut the NMW.

A minimum wage will help to reduce relative poverty for people who earn very low
wages. But only a small percentage of the employed labour force is directly affected by
the minimum wage.
Since 1999, the beneficial impact of the minimum wage has been concentrated on the
lowest paid workers in service sector jobs where there is little or no trade union
protection. Female workers have been affected more than males – thus the NMW is
making some contribution to closing the long-term gender pay gap in the British
economy. There is an argument that workers in all jobs deserve a fair rate of pay for the
job they do and that a minimum wage should reduce exploitation of lower-paid workers
by some employers.

However a minimum wage may cost jobs in some industries. To the extent that this
worsens the living standards of those affected it has a negative impact on poverty.

Further background reading on poverty and inequality in the UK

o Breadline Britain (BBC)

http://news.bbc.co.uk/1/hi/in_depth/business/2005/breadline_britain/
default.stm
o Child Poverty Action Group (CPAG) www.cpag.org.uk/
o Institute of Public Policy Research www.ippr.org.uk
o Joseph Rowntree Foundation www.jrf.org.uk/
o The changing face of poverty (BBC)
http://news.bbc.co.uk/1/hi/business/4070112.stm

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Indirect Taxation

What are indirect taxes?

An indirect tax is imposed on producers (suppliers) by the government. Examples

include excise duties on cigarettes, alcohol and fuel and also value added tax. Taxes are
levied by the government for a number of reasons – among them as part of a strategy to
curb pollution and improve the environment.

291
1
A tax increases the costs of a business causing an inward shift in the supply curve. The
vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit.
With an indirect tax, the supplier may be able to pass on some or all of this tax onto the
consumer through a higher price. This is known as shifting the burden of the tax and the
ability of businesses to do this depends on the price elasticity of demand and supply.

In the left hand diagram, demand is elastic meaning that demand is responsive to a
change in price. The producer must absorb most of the tax itself (i.e. accept a lower
profit margin on each unit sold). When demand is elastic, the effect of a tax is to raise the
price – but we see a bigger fall in equilibrium quantity. Output has fallen from Q to Q1
due to a contraction in demand.

In the right hand diagram above demand for the product is inelastic and therefore the
producer is able to pass on most of the tax to the consumer through a higher price without
losing too much in the way of sales.

292
1
Who pays the tax? The burden of taxation

Taxation, elasticity of demand and government revenue

The Government would rather place indirect taxes on commodities where demand is
inelastic because the tax causes only a small fall in the quantity consumed and as a result
the total revenue from taxes will be greater. An example of this is the high level of duty
on cigarettes and petrol.

The table below shows the demand and supply schedules for a good

Price (£) Quantity Demanded Quantity Supplied Quantity supplied

293
1
 (Pre-tax) (Post-tax)

10 20 1280 600

9 60 1000 400

8 150 850 150

7 260 600 50

6 400 400

5 600 150

4 900 50

1 What is the initial equilibrium price and quantity? Price = £6

Quantity = 400

2 The government imposes a tax of £3 per unit. The new supply schedule is shown in
the right hand column of the table – less is now supplied at each and every market
price

3 Find the new equilibrium price after the tax has been New price =£8
imposed

4 Calculate the total tax revenue going to the government Tax revenue = £450

5 How have consumers been affected by this tax?

There has been a fall in quantity traded and a rise in the price paid by consumers – this
leads to a fall in economic welfare as measured by consumer surplus

Specific taxes

A specific tax is where the tax per unit is a fixed amount – for example the duty on a pint
of beer or the tax per packet of twenty cigarettes. Another example is the air passenger
duty which imposes a standard tax of £10 for flights within the European Economic Area
(EEA) and £40 for flights outside of the EEA

Ad valorem taxes

294
1
Where the tax is a percentage of the cost of supply – the best example of this is value
added tax currently levied at the standard rate of 17.5% or Insurance Premium Tax
which is taxed at 5%.
In the diagram below, an ad valorem tax has been imposed on producers. The market
equilibrium price rises from P1 to P2 whilst quantity traded falls from Q1 to Q2.

Note that the effect of an ad valorem tax is to cause a pivotal shift in the supply curve.
This is because the tax is a percentage of the unit cost of supplying the product. So a
good that could be supplied for a cost of £50 will now cost £58.75 when VAT of 17.5%
is applied whereas a different good that costs £400 to supply will now cost £470 when the
same rate of VAT is applied. The absolute amount of the tax will go up as the market
price increases.

Tobacco taxation is a good example of a product on which both specific and ad valorem
taxes are applied. The data below is taken from information produced by the UK
Customs and Excise and breaks down the taxation of cigarettes for a typical brand in the
mid-price category. Over the last ten years, the specific duty on cigarettes has nearly
doubled from 105 pence in 1994 to 200 pence after the March 2004 Budget. When we
add value added tax to the equation, the total tax on a standard packet of twenty cigarettes
has grown from 186 pence in 1994 to 365 pence in 2004. Cigarette taxation in the UK is
the highest among European Union nations. Total taxation as a percentage of the price
has remained fairly stable over the last decade at 80 – 81 per cent.
295
1
Taxation on Cigarettes
Typical Brand In Mid Price Category

(for a pack of 20 cigarettes)

Typical Pre-tax Specific Ad VAT Total Tax as % Specific

Price Price Duty Valorem Tax of Price Duty as % of

Duty Total Tax

1994 232 46.4 104.7 46.4 34.6 185.6 80.0 56.4

2000 367 66.4 165.2 80.7 54.7 300.6 81.9 55.0

2004 449 83.7 199.6 98.8 66.9 365.3 81.3 54.6

In recent years the government has encouraged a switch away from direct taxation on
income towards indirect taxes on the goods and services that we buy and then consume.
A wider range of indirect taxes has been introduced including the Insurance Premium
Tax, the Air Passenger Duty and the Landfill Tax.

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Maximum Prices

In this chapter we consider what might happen in markets if the government or an agency
of the government decides to introduce price ceilings, price-caps or maximum prices.

The Government can set a legally imposed maximum price in a market that suppliers
cannot exceed – in an attempt to prevent the market price from rising above a certain
level. To be effective a maximum price has to be set below the free market price.

296
1
One example of a maximum price might when shortage of essential foodstuffs threatens
large rises in the free market price. Other examples include rent controls on properties –
for example the system of rent controls still in place in Manhattan in the United States.

A maximum price seeks to control the price – but also involves a normative judgement
on behalf of the government about what that price should be. An example of a maximum
price is shown in the next diagram. The normal free market equilibrium price is shown at
Pe – but the government decides to introduce a maximum price of Pmax. This price
ceiling creates excess demand for the product equal to quantity Q2-Q2 because the price
has been held below the normal equilibrium.

It is worth noting that a price ceiling set above the free market equilibrium price would
have no effect whatsoever on the market – because for a price floor to be effective, it
must be set below the normal market-clearing price.

Maximum prices and consumer and producer welfare

How does the introduction of a price ceiling affect consumer and producer surplus. This
is shown in the next diagram. At the original equilibrium price consumer surplus =
triangle ABPe and producer surplus equals the triangle PeBC.

297
1
Because of the maximum price ceiling, the quantity supplied contracts to output Q2.
Consumers gain from the price being set artificially lower than the equilibrium, but there
is a loss of consumer welfare because of the reduction in the quantity traded. At P max
the new level of consumer surplus = the trapezium ADEPmax. Producer surplus is
reduced to a lower level Pmax EC. There has been a net reduction in economic welfare
shown by the triangle DBE.

Black Markets

A black market (or shadow market) is an illegal market in which the normal market
price is higher than a legally imposed price ceiling (or maximum price). Black markets
develop where there is excess demand (or a shortage) for a commodity. Some consumers
are prepared to pay higher prices in black markets in order to get the goods or services
they want.

When there is a shortage, higher prices act as a rationing device.

 Good examples of black markets include tickets for major sporting events, rock
concerts and black markets for children’s toys and designer products that are in
scarce supply.

298
1
  Another example is the black market for the anti-impotence drug Viagra and its
new rival products now coming onto the market
 There is also evidence of black markets in the illegal distribution and sale of
computer software products where pirated copies can often dwarf sales of legally
produced software.

Rationing when there is a market shortage

Rationing when there is a maximum price might also be achieved by allocating the good
on a ‘first come, first served’ basis – e.g. queues of consumers. Suppliers might also
allocate the scarce goods by distributing only to preferred customers. Both of these ways
of rationing goods might be considered as inequitable (unfair) – because it is likely that
eventually those who might have the greatest need for a commodity are unlikely to have
their needs met.

Another problem arising from the maintenance of a maximum price is that in the long
run, suppliers might respond to a maximum price by reducing their supply – the supply
curve becomes more elastic in the long term. This is illustrated in the next diagram

If landlords decide that they cannot make a satisfactory rate of return by selling rented
properties in the market because of the maximum price, they might decide to withdraw
some properties from the market. At the prevailing maximum rent, the long run supply

299
1
curve shows a smaller quantity of rented properties available for tenants – which with a
given level of market demand cause the excess demand (shortage) in the market to
increase.

The quality of rented properties might also deteriorate over time because landlords decide
to cut spending on routine maintenance and property improvements. The end result
would be a loss of allocative efficiency because there are fewer properties on the market
and the quality of accommodation is getting worse – fewer people’s needs and wants are
being met at the prevailing market price.

Although maximum prices such as rent controls are still in place in many countries, in the
UK, rent controls were essentially abolished in the late 1980s. And, over the last fifteen
years the government has actively sought to encourage an expansion in the total supply of
rented properties provided by both private sector landlords and also registered social
landlords such as housing associations. The rapid growth in the buy-to-let property
market has also contributed to a huge increase in the supply of properties available for
letting in the majority of towns and cities in the UK.

European Union proposes a maximum price for mobile phone call charges

The European Union telecommunications commissioner has proposed imposing a

maximum price for the mobile phone operators. The EU is proposing to introduce a
price-cap (i.e. a maximum price) on the so-called “roaming charges” imposed by
companies such as Vodafone and T-Mobile. The roaming charges are imposed when
customers on one mobile phone network access the network infrastructure of other
providers when they are making calls to subscribers to competing networks and the
charges are estimated to be worth nearly £6 billion per year to the European mobile
telecommunications industry. But these roaming charges make the cost of using a mobile
phone abroad way higher than the prices charged for national calls. The EU believes that
there is market failure here with prices of Euro1.15 per minute leading to a loss of
allocative efficiency and consumer welfare.

Many of the mobile phone operators make high profits from roaming charges which, in
some cases, can generate over 5 per cent of their total revenues. Under the plans, the EU
has set a maximum price of 11 pence a minute for receiving calls, 35 pence a minute for
calling home and 23 pence a minute for calls within a country. At present, consumers in
Britain pay an average of 42 pence a minute to receive calls while on the Continent and
up to 1.20 pounds a minute to make calls, depending on the service providers. A four-
minute call home on a UK phone used in France typically costs £2.38. The same call
from Malta costs £4.83, according to EU commission statistics.

Adapted from BBC news online and the EU internal market commission website

Author: Geoff Riley, Eton College, September 2006

300
1
AS Market Failure
Buffer Stocks

The prices of agricultural products such as wheat, tea and coffee tend to fluctuate more
than the prices of manufactured products and services. This is largely due to the volatility
in the market supply of agricultural products coupled with the fact that demand and
supply are price inelastic. One way to smooth out the fluctuations in prices is for the
government to operate price support schemes through the use of buffer stocks. But many
of them have had a chequered history.

Buffer stock schemes seek to stabilize the market price of agricultural products by
buying up supplies of the product when harvests are plentiful and selling stocks of the
product onto the market when supplies are low.

The diagram below illustrates the operation of a buffer stock scheme. The government
offers a guaranteed minimum price (P min) to farmers of wheat. The price floor is set
above the normal free market equilibrium price. Notice that the price elasticity of supply
for wheat in the short term is very low because of the length of time it takes for producers
to supply new quantities of wheat to the market. (Indeed in the momentary period, we
would draw the supply curve as vertical indicating a fixed supply).

301
1
If the government is to maintain the guaranteed price at P min, then it must buy up the
excess supply (Q3-Q1) and put these purchases into intervention storage. Should there be
a large rise in supply due to better than expected yields of wheat at harvest time, the
market supply of wheat will shift out (see the diagram on the next page) – putting
downward pressure on the free market equilibrium price. In this situation, the government
will have to intervene once more in the market and buy up the surplus stock of wheat to
prevent the price from falling.

It is easy to see how if the market supply rises faster than demand then the amount of
wheat bought into storage will grow.

The problems with buffer stock schemes

In theory buffer stock schemes should be profit making, since they buy up stocks of the
product when the price is low and sell them onto the market when the price is high.
However, they do not often work well in practice. Clearly, perishable items cannot be
stored for long periods of time and can therefore be immediately ruled out of buffer stock
schemes.

Setting up a buffer stock scheme also requires a significant amount of start up capital,
since money is needed to buy up the product when prices are low. There are also high
administrative and storage costs to be considered.

The success of a buffer stock scheme however ultimately depends on the ability of those
managing a scheme to correctly estimate the average price of the product over a period of
time. This estimate is the scheme’s target price and obviously determines the maximum
and minimum price boundaries.
But if the target price is significantly above the correct average price then the
organization will find itself buying more produce than it is selling and it will eventually
run out of money. The price of the product will then crash as the excess stocks built up by
the organization are dumped onto the market.
Conversely if the target price is too low then the organization will often find the price
rising above the boundary, it will end up selling more than it is buying and will
eventually run out of stocks

The European Union Common Agricultural Policy has come under sustained attack for
many years and there have been several attempts to reform the system.

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Government Failure

302
1
A failure of the free market and the price mechanism to deliver an allocatively efficient
allocation of scarce resources is normally regarded as justification for some form of
government intervention in the economy. This intervention is designed to correct for
instances of market failure and achieve an improvement in economic and social welfare.
But what if intervention leads to further inefficiencies? What if government policies prove
to be costly to implement but ineffective in achieving their desired outcomes? What
happens if intervention distorts markets still further leading to a further loss of allocative
efficiency?

What is Government Failure?

Even with good intentions governments seldom get their policy application correct. They
can tax, control and regulate but the eventual outcome may be a deepening of the
market failure or even worse a new failure may arise. Government failure may range
from the trivial, when intervention is merely ineffective, but where harm is restricted to
the cost of resources used up and wasted by the intervention, to cases where intervention
produces new and more serious problems that did not exist before. The consequences of
this can take many years to reverse.

Government failure in a non-market economy

The collapse of the Soviet Union in the late 1980s marked the failure of command or
state-run economies as a means of allocating resources among competing uses. The
essence of a command economy was that the state planning mechanism would decide
what to produce and how to produce it and for whom to produce.

Government failure occurred when the central planners produced products that were not
wanted by consumers – a loss of allocative efficiency, since there was no price
mechanism to signal changes in consumer preferences and demand. Another fundamental
failing of the pure command economy was that there was little incentive for workers to
raise productivity; poor quality control; and little innovation by firms as no profit motive
existed. Command economies also suffered massive environmental de-gradation because
they did not posses structures for valuing the environment and giving consumers and
producers the right incentives to protect their environmental heritage.

All of these economies are now moving towards the western mixed economy, though at
varying speeds and with varying success. Ten countries became new members of the
European Union in May 2004, some of them former state-run economies in the Eastern
Block. Countries such as Hungary, the Czech Republic and Poland are all moving
towards a market based system for the allocation of resources through privatisation and
market liberalisation.

Causes of Government Failure

Government intervention can prove to be ineffective, inequitable and misplaced.

303
1
(a) Political self-interest

The pursuit of self-interest amongst politicians and civil servants can often lead to a
misallocation of resources. For example decisions about where to build new roads, by-
passes, schools and hospitals may be decided with at least one eye to the political
consequences.

The pressures of a looming election or the influence exerted by special interest groups
can foster an environment in which inappropriate spending and tax decisions are made. -
e.g. boosting welfare spending in the run up to an election, or bringing forward major
items of capital spending on infrastructural projects without the projects being subjected
to a full and proper cost-benefit analysis to determine the likely social costs and
benefits. Critics of current government policy towards tobacco taxation and advertising,
and the controversial issue of genetically modified foods argue that government
departments are too sensitive to political lobbying from the major corporations.

(b) Policy myopia

Critics of government intervention in the economy argue that politicians have a tendency
to look for short term solutions or “quick fixes” to difficult economic problems rather
than making considered analysis of long term considerations.

Two recent examples come to mind. Firstly, the view that building more roads and
widening existing roads and motorways is the most effective strategy to combat the
worsening problem of traffic congestion.

A decision to build more roads and by-passes might simply add to the problems of traffic
congestion in the long run encouraging an increase in the total number of cars on the
roads. The Commission for Integrated Transport (www.cfit.gov.uk) has criticised the
Government for a failure to develop a properly integrated transport policy. They clearly
believe that government failure is endemic in our transport industry – although we should
remember that their view is normative, based on value judgements!

Secondly criticisms of the huge increases in state spending on the National Health
Service. Government critics argue that much of the extra spending is being “lost” in
higher pay and administration rather than finding its way into improving front-line health
services.

The risk is that myopic decision-making will only provide short term relief to particular
problems but does little to address structural economic problems.

Critics of government subsidies to particular industries also claim that they distort the
proper functioning of markets and lead to inefficiencies in the economy. For example
short term financial support to coal producers to keep open loss-making coal pits might
prove to be a waste of scarce resources if the industry concerned has little realistic

304
1
prospect of achieving a viable economic rate of return in the long run given the strength
of global competition.

(c) Regulatory capture.

This is when the industries under the control of a regulatory body (i.e. a government
agency) appear to operate in favour of the vested interest of producers rather can
consumers. Some economists argue that regulators can prevent the ability of the market
to operate freely. We might find examples of this in agriculture, telecommunications, the
main household utilities and in transport regulation.

For example, to what extent has the system of agricultural support known as the
Common Agricultural Policy operated too much in the interests of farmers and the
farming industry in general? And as a result, has the CAP worked against the long-term
interest of consumers, the environment and developing countries who claim that they
are being unfairly treated in world markets by the effects of import tariffs on food and
export subsidies to loss-making European farmers?

(d) Government intervention and disincentive effects

Free market economists who fear government failure at every turn argue that attempts to
reduce income and wealth inequalities can worsen incentives and productivity. They
would argue against the National Minimum Wage because they believe that it
artificially raises wages above their true free-market level and can lead to real-wage
unemployment. They would argue against raising the higher rates of income tax
because it is deemed to have a negative effect on the incentives of wealth-creators in the
economy and generally acts as a disincentive to work longer hours or take a better paid
job.

(e) Government intervention and evasion

A decision by the government to raise taxes on de-merit goods such as cigarettes might
lead to an increase in attempted tax avoidance, tax evasion, smuggling and the
development of grey markets where trade takes place between consumers and suppliers
without paying tax. Equally a decision to legalize and then tax some drugs might lead to a
rapid expansion of the supply of drugs and a substantial loss of social welfare arising
from over consumption.

(f) Policy decisions based on imperfect information

How does the government establish what citizens want it to do in their name? Can the
government ever really know the true revealed preferences of so many people? Our
current electoral system is not an ideal way to discover this! Turnout in every type of
election, (local, national, European etc) is falling, there is general disinterest in the
political process. Furthermore, people rarely vote purely out of their own self-interest or

305
1
on the basis of a well informed and rational assessment of the costs and benefits of
different government policies.

Proponents of government failure argue that the free market mechanism is, in the long-
run, the best way of finding out
(a) What consumer preferences are and
(b) Aggregating these preferences based on the number of people that are willing and
able to pay for particular goods and services.

Often a government will choose to go ahead with a project or policy without having the
full amount of information required for a proper cost-benefit analysis. The result can be
misguided policies and damaging long-term consequences.

How does the government know how many extra houses need to be built in the UK over
the next twenty years? Is building thousands of extra homes in an already congested
South-east the right option? Are there better solutions? But ones that politically may not
be feasible. There have been plenty of instances of government housing policy having
failed in previous decades!

(g) The Law of Unintended Consequences!

The law of unintended consequences is that actions of consumer and producers — and
especially of government—always have effects that are unanticipated or
"unintended." Particularly when people do not always act in the way that the economics
textbooks would predict – this is of course the essence of a social, behaviour science – we
do not live our lives in sanitised laboratories where all of the conditions can be
controlled.

The law of unintended consequences is often used to criticise the effects of government
legislation, taxation and regulation. People find ways to circumvent laws; shadow
markets develop to undermine an official policy; people act in unexpected ways because
or ignorance and / or error. Unintended consequences can add hugely to the financial
costs of some government programmes so that they make them extremely expensive
when set against their original goals and objectives.

Steel tariffs – a self-inflicted wound for the USA?

A report from the US International Trade Commission found that the 30% steel tariffs
imposed by the US in an attempt to save jobs merely increased unemployment among car
workers. The ITC's report found that although there have been some gains for steel
producing areas, overall the effect on the US economy had been a loss to GDP of $30m
(£18m). And steel tariffs failed to prevent further reductions in employment in the steel
industry. The number of U.S. workers employed by manufacturers of basic steel products
and in blast furnaces and steel mills declined by 17 percent and 19 percent, respectively,
from 1999 through 2002 and again in 2003. Car manufacturers in the USA were opposed
to the increased costs of their steel inputs which led them to have to source their steel

306
1
from more expensive domestic (US) suppliers. 20,000 and 40,000 car job losses were
attributed to the steel tariff.

The World Trade Organisation (WTC) ruled in July 2003 that the US steel tariffs broke
international trade rules – eventually the Bush administration backed down and repealed
them.

(h) Costs of administration and enforcement

Government intervention can prove costly to administer and enforce. The estimated
social benefits of a particular policy might be largely swamped by the administrative
costs of introducing it.

Key points about government failure

1. Free market economists are naturally distrustful of government intervention in

the economy. They believe that the signalling, incentive and rationing functions
of the price mechanism should be given more freedom to operate
2. When government failure exists, the result can be a deepening of an existing
market failure. The result is a further loss of allocative and productive
efficiency because of the waste of scarce resources – leading to a reduction in
consumer and producer welfare
3. Often we can accuse the government of policy failure only with the benefit of
hindsight
4. Limited information - no government has the resources and information
available to it to make fully-informed, objective judgements. That is the nature of
politics.
5. Government failure is most likely to occur when decisions are made in the vested
interest of special interest groups, at the expense of other groups (the result is a
loss of equity)

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Economies and Diseconomies of Scale

This notefocuses on long run costs, the effect of economies of scale on unit costs and the
effects of economies of scale on prices and competition in markets.

What are economies of scale?

Economies of scale are the cost advantages that a business can exploit by expanding
their scale of production in the long run. The effect is to reduce the long run average

307
1
(unit) costs of production over a range of output. These lower costs are an improvement
in productive efficiency and can feed through to consumers in the form of lower market
prices. But they can also give a business a competitive advantage in the market. They
lead to lower prices but also higher profits, consumers and producers will both benefit.

There are many different types of economy of scale and depending on the particular
characteristics of an industry, some are more important than others. They are the result of
a complex series of factors which together form the benefits of operating on a bigger
scale of production in the long run.

 Why can you now buy high-performance personal computers for just a few
hundred pounds when a similar computer might have cost you over £2000 just a
few years ago?
 Why is it that the average market price of digital cameras is falling all the time?

The answer is that scale economies have been exploited bringing down the unit costs of
production and gradually feeding through to lower prices for consumers.

Internal economies of scale (IEoS)

Internal economies of scale arise from the growth of the firm itself. Examples include:

 Technical economies of scale:

a. Large-scale businesses can afford to invest in expensive and specialist

capital machinery. For example, a national chain supermarket can invest
in technology that improves stock control and helps to control costs. It
would not, however, be viable or cost-efficient for a small corner shop to
buy this technology.
b. Specialisation of the workforce: Within larger firms they split complex
production processes into separate tasks to boost productivity. The
division of labour in mass production of motor vehicles and in
manufacturing electronic products is an example
c. The law of increased dimensions. This is linked to the cubic law where
doubling the height and width of a tanker or building leads to a more than
proportionate increase in the cubic capacity – an important scale economy
in distribution and transport industries and also in travel and leisure
sectors

 Marketing economies of scale and monopsony power: A large firm can spread
its advertising and marketing budget over a large output and it can purchase its
factor inputs in bulk at negotiated discounted prices if it has monopsony (buying)
power in the market. A good example would be the ability of the electricity
generators to negotiate lower prices when negotiating coal and gas supply
contracts. The major food retailers also have monopsony power when purchasing
supplies from farmers and wine growers.

308
1
  Managerial economies of scale: This is a form of division of labour. Large-scale
manufacturers employ specialists to supervise production systems. Better
management; investment in human resources and the use of specialist equipment,
such as networked computers that improve communication raise productivity and
reduce unit costs.
 Financial economies of scale: Larger firms are usually rated by the financial
markets to be more ‘credit worthy’ and have access to credit facilities, with
favourable rates of borrowing. In contrast, smaller firms often face higher rates of
interest on their overdrafts and loans. Businesses quoted on the stock market can
normally raise fresh money (i.e. extra financial capital) more cheaply through the
issue of equities. They are also likely to pay a lower rate of interest on new
company bonds issued through the capital markets.
 Network economies of scale: There is growing interest in the concept of a
network economy of scale. Some networks and services have huge potential for
economies of scale. That is, as they are more widely used (or adopted), they
become more valuable to the business that provides them. The classic examples
are the expansion of a common language and a common currency. We can
identify networks economies in areas such as online auctions, air transport
networks. Network economies are best explained by saying that the marginal
cost of adding one more user to the network is close to zero, but the resulting
benefits may be huge because each new user to the network can then interact,
trade with all of the existing members or parts of the network. The rapid
expansion of e-commerce is a great example of the exploitation of network
economies of scale – how many of you are devotees of the EBay web site?

Two good examples of economies of scale – huge freight tankers and large-scale storage
facilities

309
1
Illustrating economies of scale – the long run average cost curve

The diagram below shows what might happen to the average costs of production as a
business expands from one scale of production to another. Each short run average cost
curve assumes a given quantity of capital inputs. As we move from SRAC1 to SRAC2 to
SRAC3, so the scale of production is increasing. The long run average cost curve (drawn
as the dotted line below) is derived from the path of these short run average cost curves.

Exploiting economies of scale – TNT

In January 2006, the market for postal services was opened up to competition thus ending
the monopoly of the Royal Mail in the delivery of letters to households and businesses.
Attention is now focusing on some of the likely rivals to the Royal Mail in the newly
competitive market. One such business is TNT logistics. TNT Express Services was
established in the UK in 1978, the company has developed its dominant position in the
time-sensitive express delivery market through organic growth and, with an annual
turnover in excess of £750 million. TNT employs 10,600 people in the UK & Ireland and
operates more than 3,500 vehicles from over 70 locations. TNT Express Services delivers
hundreds of thousands of consignments every week - in excess of 50 million items per
year.

Source: TNT investor relations web site

310
1
 Why are economies of scale important for a business such as TNT?
What types of economies of scale might the business be able to exploit in the long run?

External economies of scale (EEoS)

External economies of scale occur outside of a firm, within an industry. Thus, when an
industry's scope of operations expand due to for example the creation of a better
transportation network, resulting in a subsequent decrease in cost for a company
working within that industry, external economies of scale are said to have been achieved.

Another good example of external economies of scale is the development of research

and development facilities in local universities that several businesses in an area can
benefit from. Likewise, the relocation of component suppliers and other support
businesses close to the main centre of manufacturing are also an external cost saving.

Diseconomies of scale

A firm may eventually experience a rise in long run average costs caused by
diseconomies of scale. Diseconomies of scale a firm may experience relate to:

1. Control – monitoring the productivity and the quality of output from thousands of
employees in big corporations is imperfect and costly – this links to the concept of
the principal-agent problem – how best can managers assess the performance of
their workforce when each of the stakeholders may have a different objective or
motivation?
2. Co-operation - workers in large firms may feel a sense of alienation and
subsequent loss of morale. If they do not consider themselves to be an integral
part of the business, their productivity may fall leading to wastage of factor inputs
and higher costs

311
1
Do economies of scale always improve the welfare of consumers?

There are some disadvantages and limitations of the drive to exploit economies of scale.

 Standardization of products: Mass production might lead to a standardization

of products – limiting the amount of effective consumer choice in the market
 Lack of market demand: Market demand may be insufficient for economies of
scale to be fully exploited. Some businesses may be left with a substantial amount
of excess capacity if they over-invest in new capital
 Developing monopoly power: Businesses may use economies of scale to build
up monopoly power in their own industry and this might lead to a reduction in
consumer welfare and higher prices in the long run – leading to a loss of
allocative inefficiency
 Protecting monopoly power: Economies of scale might be used as a form of
barrier to entry – whereby existing firms have sufficient spare capacity to force
prices down in the short run if there is a threat of the entry of new suppliers

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Economic Efficiency

This chapter introduces you to the idea of efficiency, perhaps one of the most important
in economics! Efficiency is really about a society making the best or optimal use of our
scarce resources to satisfy most wants & needs.

Defining efficiency

Confusingly, there are several meanings of the term economic efficiency but they
generally relate to how well a market or the economy allocates our scarce resources to
satisfy consumers. Normally the market mechanism is a pretty efficient at allocating
these resources, but there are occasions when the market can fail leading to a reduction in
efficiency and a subsequent loss of economic welfare. We will return to this when we
study market failure in more detail.

Allocative efficiency

Allocative efficiency is concerned with whether the resources we have available are
actually used to produce the goods and services that we want and which we place the
greatest value on. In other words, are businesses in the economy and also the government
(or public) sector supplying the products that are required to meet needs and wants?

312
1
Allocative efficiency is reached when no one can be made better off without making
someone else worse off.

Allocative efficiency and the prices charged for different products

Allocative efficiency occurs when the value that consumers place on a good or service
(reflected in the price they are willing and able to pay) equals the cost of the resources
used up in production. The technical condition required for allocative efficiency is that
price = marginal cost i.e. When this happens, total economic welfare is maximised.

In the diagram above, the market is in equilibrium at price P1 and output Q1. At this
point, the total area of consumer and producer surplus is maximised. If for example,
suppliers were able to restrict output to Q2 and hike the market price up to P2, sellers
would gain extra producer surplus by widening their profit margins, but there also would
be an even greater loss of consumer surplus. Thus P2 is not an allocative efficient
allocation of resources for this market whereas P1, the market equilibrium price is
deemed to be allocative efficient.

We will see when we study the economics of monopoly that when businesses have
significant pricing power in their own particular markets, they may opt to increase their
profit margins to squeeze some extra profit from consumers (in economics-speak, they
are turning consumer surplus into producer surplus). This has an effect on allocative
efficiency in a market for if a monopoly supplier is able to price well above the costs of
supply, the likelihood is that consumers will suffer a reduction in their welfare. The
producer has become better off but someone else (aka the consumer) has become worse
off.

313
1
Using the Production Possibility Frontier to show allocative efficiency

Vilfredo Pareto defined allocative efficiency as a position where no one could be made
better off without making someone else at least as worth off. This can be illustrated using
a production possibility frontier – all points that lie on the PPF can be said to be
allocatively efficient because we cannot produce more of one product without affecting
the amount of all other products available. In the diagram below, the combination of
output shown by Point A is allocatively efficient as is the combination shown at point B –
but at the output combination denoted by the point X we can increase production of both
goods by making fuller use of existing resources or increasing the efficiency of
production.

An allocation is Pareto-efficient for a given set of consumer tastes, resources and

technology, if it is impossible to move to another allocation which would make some
people better off and nobody worse off. If every market in the economy is a competitive
free market, the resulting equilibrium throughout the economy will be Pareto-efficient.

Productive Efficiency

Productive efficiency refers to a firm's costs of production and can be applied both to the
short and long run production time-span. It is achieved when the output is produced at
minimum average total cost (ATC) i.e. when a firm is exploiting most of the available
economies of scale. Productive efficiency exists when producers minimise the wastage of
resources in their production processes.

Dynamic Efficiency

314
1
Dynamic efficiency occurs over time and it focuses on changes in the amount of
consumer choice available in markets together with the quality of goods and services
available.

At a macroeconomic level, a dynamically efficient economy is increasingly successful in

improving existing products and also at developing new products.

A faster pace of invention, innovation and research and development can lead to
improvements in dynamic efficiency and this might translate into higher sales in key
export markets.

Innovation as a source of dynamic efficiency

Dynamic efficiency is improved when businesses bring to the market goods and services
that are innovative and high quality and which offer consumers greater choice.

Social Efficiency

The socially efficient level of output and or consumption occurs when social benefit =
social cost. At this point we maximise social welfare. The existence of negative and
positive externalities means that the private optimum level of consumption or production
often differs from the social optimum leading to some form of market failure and a loss
of social welfare.

In the diagram below the socially optimum level of output occurs where the social cost of
production (i.e. the private cost of the producer plus the external costs arising from
externality effects) equals demand (a reflection of private benefit from consumption.

A private producer who opts to ignore the negative production externalities might choose
to maximise their own profits at point A. This divergence between private and social
costs of production can lead to market failure.

315
1
 Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Competition, Monopoly & Allocation of Resources

In this note we consider the nature of competition within different industries. You will
find during your study of economics that no two markets are ever the same because they
all have different market structures. The market for airline travel is very different from
the market for coal or the market for clothing on the high street. At AS level you need to
understand what is meant by monopoly power in a market and also consider some of the
costs and benefits of markets and industries where one or more firms have market power.

An introduction to market structures

A market structure is the characteristics of a market which can affect the behaviour of
businesses within the market and also influence the outcome of a market in terms of
economic efficiency and the welfare of consumers.

Some of the main aspects of market structure are listed below:

 The number of firms in the market and extent of overseas competition

 The market share of the largest firms
 The nature of production costs in the short and long run e.g. the ability of
businesses to exploit economies of scale

316
1
  The extent of product differentiation i.e. to what extent do the businesses in the
market try to make their products different from those of competing firms?
 The price and cross price elasticity of demand for different products within the
market
 The number and the power of buyers of the industry’s main products
 The turnover of customers (also known as “market churn”) – this is a measure of
the percentage of consumers who switch suppliers each year and it is affected by
the degree of brand loyalty and the effects of advertising and marketing.

The market for detergents

The market for detergents and fabric conditioners is dominated by two producers, Proctor
& Gamble and Unilever. The total value of the market for clothes-washing detergents and
laundry aids was worth around £1.42 billion in 2005 with 75 per cent of this market being
taken up by sales of detergents. Proctor & Gamble and Unilever account for 84 per cent
of the market with the remaining market share being taken mainly by the own-label sales
of the major supermarkets.

Market share in 2005 (per cent)

Proctor & Gamble 54

Of which

Ariel 20

Bold 16

Daz 9

Unilever 30

Of which

Persil 24

Surf 6

Others / supermarket own-label 16

Source: Mintel Research

317
1
Some of the features of this market are as follows:

 Demand for liquid detergents has a low income elasticity of demand but the
demand for ancillary products such as fabric conditioners is more income elastic
 Heavy spending on advertising and marketing by each of the two major players
 Investment in research and development to change the formulations in the
detergents and to expand the number of brands available. Investment has also
focused on creating new products such as stain removers, fresheners and creation
of more environmentally-friendly products
 Many consumers in the market are brand-loyal, especially older people

The market for gas and electricity supplies

The market for gas supply in the UK was privatised in 1986 with the market for
electricity generation and distribution also transferred to the private sector of the
economy a few years later. Over the years the years there have been important changes in
the market share of the leading electricity distribution companies and domestic gas
suppliers with the former state monopolies losing much of their dominance over this
time. The most recently available market share data is shown in the table below.

Supplier Market Shares in Electricity Market Shares in Gas

December 2002 March 2006 December 2002 March 2006

British Gas 22 22 63 52

Powergen 22 20 12 13

SSE 13 16 6 10

Npower 16 15 9 10

Scottish Power 10 13 5 9

EDF Energy 15 13 5 6

Source: OFGEM

The UK energy market is split into three elements. Suppliers sell electricity and gas to
final commercial, industrial and household consumers. Distributors are companies
responsible for getting energy to users e.g. by building and maintaining the infrastructure
of pipes and cables in the road and in installing meters. Thirdly, the generators are
responsible for generating the energy used in homes, offices, shops and factories.

318
1
The retail market for energy is competitive because all users are now able to change their
gas or electricity supplier. That said, although suppliers are competing with each other for
customers, many people do not switch their suppliers even when they might be able to
make savings on their gas or electricity bill. One reason is that people do not find it easy
to get accurate information about what the differences are between these competing
suppliers.

The industry regulator OFGEM believes that the opening up of the market to competition
(and subsequent changes to market structure) has worked well over the last fifteen years.
They claim for example that in March 2006, 900,000 customers responded to a series of
gas and electricity price rises by switching their energy supplier. Their energy-watch web
site is designed to improve flows of information for consumers so that more of them can
switch supplier.

The gas and electricity supply industry is best described as an oligopoly since virtually
the whole market is taken by the six leading businesses. But the market is competitive
because consumers have a real choice about who will sell them their energy. The market
share of new entrants into the industry since privatisation is now above 40 per cent for
both gas and electricity. British Gas has seen a steady and persistent decline in its share
of the gas market and by March 2006 this was down to 52 per cent compared to 63 per
cent in the winter of 2002.

What is a monopoly?

There are several meanings of the term monopoly:

 A pure monopolist in an industry is a single seller. It is quite rare for a firm to

have a pure monopoly – except when the industry is state owned and has a legally
protected monopoly position. The Royal Mail used to have a statutory monopoly
on delivering household mail. But this is now changing as the industry is being
opened up to fresh competition.
 A working monopoly: A working monopoly is any firm with greater than 25% of
the industries' total sales. In practice, there are many markets where businesses
enjoy some degree of monopoly power even if they do not have a twenty-five per
cent market share. In the UK market for breakfast cereals for example, Kellogg’s
had a 39 per cent share of a market where total sales were 31.2 billion in 2005.
Cereal Partners (Nestle) took 17 per cent of the market and Weetabix secured 15
per cent.
 An oligopolistic industry is characterised by the existence of a few dominant
firms, each has market power and which seeks to protect and improves its market
position over time.
 In a duopoly, the majority of market sales are taken by two dominant firms. A
good example of this is the market for razors in the UK – one dominated by
Gillette and also is Schick (the manufacturers of the Wilkinson Sword brand).
Gillette has approximately 70% of the global shaving market.

319
1
How monopolies can develop

Monopoly power can come from the successful organic (internal) growth of a business
or through mergers and acquisitions (also known as the integration of firms).

Horizontal Integration
This is where two firms join at the same stage of production in one industry. For example
two car manufacturers merge, or a bank successfully takes-over another bank. A good
recent example in the UK is the merger between Safeway and Morrisons to create the
UK’s fourth largest national food retailer. Another example came in July 2004 with the
merger between Travel Inn and Premier Lodges to form Premier Travel Inn. And in
August 2005, German sports goods firm Adidas announced an agreement to buy US rival
Reebok for £2.1bn.

Vertical Integration
This is where a firm develops market dominance by integrating with different stages of
production in the industry e.g. by buying its suppliers or controlling the main retail
outlets. A good example is the oil industry where many of the leading companies are
explorers, producers and refiners of crude oil and have their own retail networks for the
sale of petrol and diesel and other products.

 Forward vertical integration occurs when a business merges with another

business further forward in the supply chain
 Backward vertical integration occurs when a firm merges with another business
at a previous stage of the supply chain

Case Study: Building a Monopoly Position

Tesco has built a monopoly position in the UK food retailing industry and is now
increasing its share of the non-food retail sector. What are the costs and benefits of
Tesco’s dominance?

Market share in the UK retail grocery industry for the 12 Weeks to 18 June 2006

320
1
Retailer % Share

Tesco 31.4

Asda 16.5

Sainsbury's 16.0

Morrisons 11.3

Somerfield 4.2

Waitrose 3.8

Aldi 2.5

Lidl 2.0

Iceland 1.6

Netto 0.7

Farmfoods 0.5

The Internal Expansion of a Business

Firms can generate higher sales and increased market share by expanding their operations
and exploiting possible economies of scale. This is internal rather than external growth
and therefore tends to be a slower means of expansion contrasted to mergers and
acquisitions. To go back to our previous example, US computer giant Dell succeeded in
raising total sales revenue by 58 per cent over the last five years.

Preventing competition - barriers to entry

Barriers to entry are the means by which potential competitors are blocked. Monopolies
can then enjoy higher profits in the long run as rivals have not diluted market share.
There are several different types of entry barrier – these are summarised below:

 Patents: Patents are legal property rights to prevent the entry of rivals. They are
generally valid for 17-20 years and give the owner an exclusive right to prevent

321
1
 others from using patented products, inventions, or processes. The owners of
patents can sell licences to other businesses.

 Advertising and marketing: Developing consumer loyalty by establishing

branded products can make successful entry into the market by new firms more
expensive and less successful. Advertising can also cause an outward shift of
demand and also make demand less sensitive to price

 Brand proliferation: In many industries multi-product firms engaging in brand

proliferation can give a false appearance of competition to the consumer. This is
common in markets such as detergents, confectionery and household goods – it is
non-price competition.

Monopoly, market failure and government intervention

Should the government intervene to break up or control the monopoly power of firms in
markets? This debate about the benefits and costs of government intervention revolves
around the advantages and disadvantages of businesses holding monopoly power.

A monopolist is able to enjoy and exploit some power over the setting of prices or output.
But be careful of stating that monopolists can “charge any price that they like”! A
monopolist cannot, charge a price that the consumers in the market will not bear! In this
sense, the price elasticity of the demand curve acts as a constraint on the pricing power
of the monopolist.

The economic and social costs of monopoly

The main case against a monopoly is that these businesses can earn higher profits at the
expense of allocative efficiency. The monopolist will seek to extract a price from
consumers that is above the cost of resources used in making the product. And higher
prices mean that consumers’ needs and wants are not being satisfied, as the product is
being under-consumed. Under conditions of monopoly, consumer sovereignty has been
partially replaced by producer sovereignty.

322
1
In the diagrams above we contrast a market where demand is price inelastic (i.e. Ped <1)
with one where demand is more sensitive to price changes (i.e. Ped>1). The former is
associated with a monopoly where consumers have few close substitutes to choose from.
When demand is inelastic, the level of consumer surplus is high, raising the possibility
that the monopolist can reduce output and raise price above cost thereby operating with a
higher profit margin (measured as the difference between price and average cost per
unit).

323
1
One way of showing the loss of economic welfare that comes from monopolistic firms
exploiting their power is to use supply and demand analysis and the concepts of
consumer and producer surplus. If a monopoly reduces output from the equilibrium at
Q1 to Q2 then it can sell this at a higher price P2. This results in a transfer of consumer
surplus into extra producer surplus. But because price is now about the cost of
supplying extra units, there is a loss of allocative efficiency. This is shown in the
diagram by the shaded area which is not transferred to the producer, merely lost
completely because output is lower than it would otherwise be in a competitive market.

Higher costs – loss of productive efficiency:

Another possible cost of monopoly power is that businesses may allow the lack of real
competition to cause a rise in production costs and a loss of productive efficiency.
When competition is tough, businesses must keep firm control of their costs because
otherwise, they risk losing market share. Some economists go further and say that
monopolists may be even less efficient because, if they believe that they have a protected
market, they may be less inclined to spend money on research and improved
management. These inefficiencies can lead to a waste of scarce resources.

The potential benefits of monopoly

The possible economic benefits of monopoly power suggest that the government and the
competition authorities should be careful about intervening directly in markets and try to
break up a monopoly.

324
1
Market power can bring advantages both to the firms themselves and also to consumers
and these should be included in any evaluation of a particular market or industry.

1. Research and Development Spending

Huge corporations enjoying a high level of profits are well placed to allocate some of
their profits to fund capital investment spending and research and development projects.
The positive spill-over effects of research can be seen in a faster pace of innovation
and the development of improved products for consumers. This is particularly the case in
industries such as telecommunications and pharmaceuticals. This can lead to gains in
dynamic efficiency and social benefits (i.e. positive externalities). The table below
provides data from the 2005 UK research and development survey. The top firms are all
household names, large scale businesses, and operating in industries and sectors where
research spending is hugely important in being competitive against global competition.

Top 15 UK companies by size of R&D investment

Company Position in R&D Growth of R&D Sector

2000 (1 year)

1. GlaxoSmithKline 2 £2839m +2% Pharmaceuticals

2. AstraZeneca 1 £1981m +10% Pharmaceuticals

3. BAe Systems 4 £1110m +1% Aerospace

4. Ford 8 £763m -12% Automotive

5. Unilever 5 £736m -2% Food Producers

6. Pfizer 10 £598m +8% Pharmaceuticals

7. Airbus -* £345m -1% Aerospace

8. Shell 11 £288m -5% Oil & Gas

9. Rolls-Royce 12 £282m 0 Aerospace

10. BT 9 £257m -23% Telecoms

11. BP 14 £229m +26% Oil & Gas

325
1
 12. Land Rover -* £227m -7% Automotive

13. Vodafone 37 £219m +28% Telecoms

2. Exploitation of Economies of Scale

Because monopoly producers often supply goods and services on a large scale, they may
achieve economies of scale – leading to a fall in average costs. Lower costs will lead to
an increase in profits but the gains in productive efficiency might be passed onto
consumers through lower prices.

3. Monopolies and International Competitiveness

One argument in support of businesses with monopoly power is that the British economy
needs multinational companies operating on a scale large enough to compete in global
markets. A firm may enjoy domestic monopoly power, but still face competition in
overseas markets. Two good examples of these are UK Coal and Corus, the UK-Dutch
owned steel manufacturer.

Government intervention in markets – an introduction to UK competition policy

Competition policy involves the regulation of markets so that consumer welfare is

protected and improved. It operates in different ways – three of the main competition
bodies are the Competition Commission, the Office of Fair Trading and the European
Union Competition Authority.

 The Competition Commission carries out inquiries into matters referred to it by

the other UK competition authorities. Their main concern is to investigate
mergers and takeovers to examine if these mergers will have a negative effect on
overall competition. For more details go to their web site:
www.competition.gov.uk

 The Office of Fair Trading reports on allegations of anti-competitive practices

including claims of collusive behaviour where businesses are thought to be
engaging in price-fixing. Their web site is at www.oft.gov.uk

 The European Competition Authority monitors competition in the European

single market. They examine anti-competitive behaviour, mergers and takeovers
between European businesses and investigate state aid to struggling businesses to
make sure that subsidies do not reduce or distort competition. Their web site is at
http://europa.eu.int/comm/competition/index_en.html

 Utility regulators monitor the industries that were privatised during the 1980s
and 1990s. The regulators have used the power to introduce and review price
capping and they have also have sought to bring fresh competition into markets.

326
1
 Competition was introduced into the telecommunications in 1984; in Gas from
1996-98 and in Electricity from 1998.

Another key role for the regulatory agencies is to monitor the quality of service provision
and improve standards for consumers. Examples of utility regulator web sites can be
found by using the following links:

OFGEM: www.ofgem.gov.uk/ofgem/index.jsp
OFWAT: www.ofwat.gov.uk/
OFCOM: www.ofcom.org.uk/

Many markets have firms with monopoly power but they seem to work perfectly well
from the point of view of the consumer. Although there is a consensus among many
economists that competition is a force for good in the long-run, we should be careful not
simply to assume that monopoly power is bad and competition is good. There are
persuasive arguments on both sides.

In recent years many markets have become more competitive with the entry of new
suppliers and much greater choice for consumers. Many factors have contributed to this
including:

 Technological change – e.g. the rise of e-commerce and the internet

 Globalisation – e.g. fresh low-cost competition from emerging market economies
such as China and India
 Deliberate government policies (in the UK and the European Union) to open up
markets and give new businesses the right to compete (e.g. in the markets for
postal services, car retailing and telecommunications)

Deregulation of monopoly
An important government policy towards markets where monopoly power exists is to
open up markets and encourage the entry of new suppliers into a market where there was
monopoly power in the past – a process called de-regulation.
Examples of this in the UK include the opening up of markets for household energy and
the introduction of competition into Postal Services.
The expansion of the European Union Single Market has accelerated the process of
market liberalisation. The Single Market seeks to promote four freedoms – namely the
free movement of goods, services, financial capital and labour. In the long term we can
expect to see the microeconomic effects of the EU Single Market working their way
through many British markets and industries and the general expectation is that
competitive pressures for all businesses working inside the European Union will continue
to intensify.

Author: Geoff Riley, Eton College, September 2006

327
1
AS Market Failure
Positive Externalities

There are many occasions when the production and/or consumption of a good or a
service creates external benefits which boost social welfare. In this note we consider the
idea of positive externalities and the market failure that can result if the market under-
consumes or under-provides these sorts of products.

Examples of positive externalities

 Social benefits from providing milk to young schoolchildren

 External benefits from vaccination / immunisation programmes
 Social benefits from restoration and use of historic buildings
 External benefits from improved training and education
 External benefits from development of renewable energy sources
 External benefits from other new production technologies

Positive externalities and market failure

328
1
Where positive externalities exist, the good or service may be under consumed or under
provided since the free market may fail to value them correctly or take them into account
when pricing the product. In the diagram above, the normal market equilibrium is at P1
and Q1 – but if there are external benefits, the Q1 is an output below the level that
maximises social welfare.

There is a case for some form of government intervention in the market designed to
increase consumption towards output level Q2 so as to increase economic welfare.

329
1
 Bird flu vaccine being prepared

The economics of vaccination

What good is a vaccination? Obviously there are benefits for the person receiving the
vaccine, they are less susceptible to disease and children in particular are more likely to
attend school and earn more income over their lifetime. A new study on the economic
effects of vaccinations from the World Bank finds that well designed and comprehensive
vaccination programmes have a positive effect on savings and wealth and encourage
families to have fewer children which lead to less demographic pressures on scarce
resources. More subtly, it can be good for an entire population since, if enough of its
members are vaccinated, even those who are not will receive a measure of protection.
That is because, with only a few susceptible individuals, the transmission of the infection
cannot be maintained and the disease spread.

In the case of many vaccines, there are non-medical benefits, too, in the form of costs
avoided and the generation of income that would otherwise have been lost. These goods
are economic. The dispassionate economic case for vaccination, therefore, looks at least
as strong as the compassionate medical one. Spending on vaccination programmes
appears to be a sound social investment for the future.

Source: Adapted from the Economist, October 2005

Vocational training – externalities and market failure

There is growing evidence that skilled workforces have positive impacts on high-level
economic aims, such as raising productivity and enhancing a country's GDP growth.

At the same time, there is evidence of a major skills deficiency in the UK, which is
reflected in the low numbers of people holding intermediate level vocational

330
1
qualifications, compared to Germany and other European Union countries. There is
further evidence that there are three forms of market failure that continue to cause this
skills gap:

1. Externalities leading to under-investment in training by employers. Firms are

concerned that once trained, an employee will leave the firm before the firm has recouped
its investment. Unless training pays off very quickly, firms are therefore reluctant to
provide training to their workers. This is an example of the free-rider problem - where
one firm can take advantage of the money invested in training by another firm. Fewer
than four in ten employers in the UK provide some off-the-job training each year.

2. Imperfect information leading to employees (workers) being unable to judge the

quality of their training or appreciate the benefits to themselves. This reduces their
willingness for example to accept lower wages during the training period or to receive
any training at all.

3. Credit market imperfections. Training is a costly business, but individuals expect to

obtain higher wages from training in the long-term (i.e. their wages are likely to be higher
in jobs that require a greater degree of training and specific skills). Some individuals may
wish to borrow money to fund training in the expectation that they will be able to pay
back the loan through higher future wages. However, low-paid employees in particular
are likely to be "credit constrained" and unable to obtain loans to pay for training.

These market failures mean that the level of training provided by the market is likely to
be inefficiently low from society’s point of view. Well-designed government intervention
may help to bridge the gap

How can government intervention help to resolve the “training gap?”

The aims of government intervention might be to

 Move towards a socially optimal level of training

 Achieve higher productivity among those who take training programmes
 Build the economy’s human capital
 Increase the proportion of the employed workforce that has a recognised
vocational training qualification

Options for government intervention

 Increased funding for education and training programmes within the public sector
 State funded and operated vocational training e.g. modern apprenticeships and
expansion of vocational exams
 Tax credits for businesses that invest in vocational training programmes
 Regulation
 The Industrial Training Levy (2002)

331
1
 Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Public and Private Goods

Public goods provide an example of market failure resulting from missing markets. To
understand this it is helpful first to discuss what is meant by a private good or service.

Private Goods

A private good or service has three main characteristics:

1. Excludability: Consumers of private goods can be excluded from consuming

the product by the seller if they are not willing or able to pay for it. For example
a ticket to the theatre or a meal in a restaurant is clearly a private good. Another
example is the increasing use of “pay-per-view” as a means of extracting
payment from people wanting to watch exclusive coverage of sporting events on
television or the payment required to travel on a toll-road or toll-bridge. Another
example of a private good is the use of subscription-based services on the
internet. Some newspapers provide the bulk of their news stories on the internet as
a “quasi public good” such as The Guardian www.guardian.co.uk. Others are
developing an alternative business model where users can only access premium
services through password-protected parts of a web site that require payment from
consumers – examples include The Economist www.economist.com and the
Financial Times www.ft.com. Excludability gives the service provider (the seller)
the chance to make a profit from producing and selling the product. As we shall
see, with public goods, such excludability does not exist. When goods are
excludable, the owners can exercise property rights.
2. Rivalry: With a private good, one person's consumption of a product reduces the
amount left for others to consume and benefit from - because scarce resources are
used up in producing and supplying the good or service. If you order and then
enjoy a pizza from Pizza Hut, that pizza is no longer available to someone else.
Likewise driving your car on a road uses up road space that is no longer available
at that time to another motorist. The greater the volume of traffic on the roads, the
higher the likelihood of traffic congestion which has the effect of reducing the
average speed and increasing the average journey time for each road user.
3. Rejectability: Private goods and services can be rejected - if you don't like the
soup on the college or school menu, you can use your money to buy something
else! You can choose not to travel on Virgin Rail on a journey to the North West
and go instead by coach, or you can choose not to buy a season ticket for your
local soccer club and instead use the money to finance a subscription to a local
health club. All private goods and services can be rejected by the final consumer
should their tastes and preferences change.

332
1
Private and Public Goods – a question of exclusion

Le Shuttle is a private good – the service is excludable, rival in consumption and

rejectable. But not all providers of public goods make a profit. EuroTunnel is facing large
losses and even bigger debts!

Characteristics of Public Goods

As one might expect, the characteristics of pure public goods are the opposite of private
goods:

 Non-excludability: The benefits derived from the provision of pure public goods
cannot be confined to only those who have actually paid for it. In this sense, non-
payers can enjoy the benefits of consumption at no financial cost to themselves –
this is known as the “free-rider” problem and it means that people have a
temptation to consume without paying!
 Non-rival consumption: Consumption of a public good by one person does not
reduce the availability of a good to everyone else – therefore we all consume the
same amount of public goods even though our tastes and preferences for these
goods (and therefore our valuation of the benefit we derive from them) might
differ

Examples of Public Goods

There are relatively few examples of pure public goods. Examples of public goods
include flood control systems, some of the broadcasting services provided by the BBC,
public water supplies, street lighting for roads and motorways, lighthouse protection
for ships and also national defence services.

Policing – a public good?

333
1
To what extent is our current system of policing an example of a public good? Some (but
not all) aspects of policing might qualify as public goods. The general protection that the
police services provide in deterring crime and investigating criminal acts serves as a
public good. But resources used up in providing specific police services mean that fewer
resources are available elsewhere. For example the use of police at sporting events or
demonstrations and protests means that police resources have to be diverted from other
policing duties. The police services must make important decisions about how best to
allocate their manpower in order to provide the most effective policing service for the
whole community.

Private protection services (including private security guards, privately bought security
systems and detectives) are private goods because the service is excludable, rejectable
and rival in consumption and people and businesses are often prepared to pay a high price
for exclusive services. A good recent example of this has been the use of private security
firms in post-war Iraq where up to 15,000 workers are said to have been working for
private businesses protecting installations, coalition buildings and convoy protection.

Public goods and market failure

Pure public goods are not normally provided at all by the private sector because they
would be unable to supply them for a profit. Thus the free market may fail totally to
provide important pure public goods and under-provide quasi public goods (see below).

It is therefore up to the Government to decide what output of public goods is appropriate

for society. To do this, it must estimate the social benefit from the consumption of
public goods. Putting a monetary value on the benefit derived from street lighting and
defence systems is problematic. The electoral system provides an opportunity to see the
public choices of voters but elections are rarely won and lost purely on the grounds of
government spending plans and the turnout at elections continues to fall.

The air waves – a public good or a quasi public good?

334
1
The airwaves used by mobile phone companies, radio stations and television companies
are essentially owned by the government of a particular country.

Do they count as a pure public good? Normally the answer would be yes. One person’s
use of the airwaves rarely reduces the extent to which other people can benefit from
utilising them. But when demand for mobile phone services is high at peak times, the
airwaves become crowded and as a result access to the networks can become slow. In
this sense the airwaves can be treated a crowded non-pure public good.

The government also controls the issue of licences needed to operate mobile phone
services using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd
generation mobile phone services and raised £22 billion in doing so.

Quasi-Public Goods

Most public goods are non-pure public goods – these are also known as quasi-public
goods. The main reason is that we can find ways and means of excluding some groups
from consuming them!

335
1
A quasi-public good is a near-public good i.e. it has many but not all the characteristics
of a public good. Quasi public goods are:

 Semi-non-rival: up to a point, extra consumers using a park, beach or road do not

reduce the amount of the product available to other consumers. Eventually
additional consumers reduce the benefits to other users. Beaches become crowded
as do parks and other leisure facilities.
 Semi-non-excludable: it is possible but often difficult or expensive to exclude
non-paying consumers. E.g. fencing a park or beach and charging an entrance fee;
building toll booths to charge for road usage on congested routes

336
1
The diagram below is one way of illustrating the different characteristics of public and
private goods.

The BBC as a public good

Broadcasting is a good example of a public good. Let us remind ourselves of the three
main characteristics of a public good.

Firstly it is non-rival, meaning that the consumption of a public good or service by one
individual does not preclude consumption by another individual. Secondly, consumption
is non-excludable. This means that consumption by one individual makes it impossible
to exclude any other individual from having the opportunity to consume. Effectively the
cost of providing a pure public good to an extra user is zero, and this implies that, in
order to achieve allocative efficiency, the charge for the product should be zero. Of
course, in this situation, private sector businesses are unlikely to consider providing pure
public goods because they will not be able to make any profit at a zero price, and many
consumers can take a free ride on such goods because of non-excludability.

The provision of pure public goods is therefore a cause of market failure. Left to the
free market, public goods are under-provided and under-consumed leading to a loss of
social welfare.

337
1
At the moment, around 23 million households in Britain pay an annual licence fee. All of
these people are stakeholders in the debate about the future funding of the BBC and the
vast majority use one or more BBC services at least once a week. The fee is a means of
providing collective payment for a public good. We know that there are fee-dodgers
who try to take a free-ride by avoiding payment, but there are well established although
costly means to enforce the licence fee and take non-payers to court.

Of course the BBC is now facing huge competition from broadcasters such as Sky who
are able to exclude people from their services through the use of subscription-based
services. Sky’s financial muscle continues to grow.

The case for government intervention in the case of public goods

 The non-rival nature of consumption provides a strong case for the government
rather than the market to provide and pay for public goods.
 Many public goods are provided more or less free at the point of use and then paid
for out of general taxation or another general form of charge such as a licence fee.
 State provision may help to prevent the under-provision and under-
consumption of public goods so that social welfare is improved.

Public bads

A public bad is the opposite of a public good – it provides disutility or dis-satisfaction

to people when consumed and therefore reduces our economic welfare. A good example
to look at would be the disposal of household and commercial waste.

People are normally prepared to pay a price for their household waste to be collected and
disposed of in a safe and non-polluting way. But if waste was changed for according to
how much had been generated, then some people would find an incentive to dump their
waste on other people’s property and thereby avoid direct charges.

The economics of waste – is it a public bad?

Waste is now a major economic problem. As a nation, the UK generates over 430 million
tonnes of waste each year, the majority coming from municipal, industrial and
commercial sources. Each household is estimated to produce over 500 kg of waste per
person each year and we throw away nearly a tonne of waste each over the course of
twelve months! Waste is a nuisance good that has a negative effect on our welfare. From
unsightly waste products to the costs of clearing up and disposing of waste, there are
many private and external costs arising from the mountain of detritus that comes from our
homes every day.

But how much are we prepared to pay for waste collection and disposal? The current
situation is that local authorities have a legal responsibility to collect household waste
once per week, the private sector “market” does not provide the bulk of waste collection

338
1
services for households although they have a role to play in providing waste services for
businesses and other larger organisations.

Household waste collection is nearly always done “free at the point of collection”. This
raises questions of equity and efficiency and also the issue of whether there are better
ways of providing incentives for us to create less waste as our living standards improve.
Why should a large family that fills many wheelie bins every week pay the same as a
single householder who creates just one or two bags worth of rubbish?

Can economists come up with good ideas to reduce waste and to give people the right
incentives to dispose of their waste in an environmentally friendly way?

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Demerit Goods

Basically, de-merit goods are the opposite of merit goods. They can cause market failure too!

Externalities and information failure with de-merit goods

De-merit goods are thought to be ‘bad’ for you. Examples include the costs arising from
consumption of alcohol, cigarettes and drugs together with the social effects of addiction to
gambling. The consumption of de-merit goods can lead to negative externalities.

The government seeks to reduce consumption of de-merit goods. Consumers may be unaware of
the negative externalities that these goods create – they have imperfect information about long-
term damage to their own health.

The government may decide to intervene in the market for de-merit goods and impose taxes on
producers and / or consumers.

Higher taxes cause prices to rise and should lead to a fall in demand. But many economists argue
that taxation is an ineffective and inequitable way of curbing the consumption of drugs and
gambling particularly for those affected by addiction.

Banning consumption through regulation may reduce demand, but risks creating secondary (illegal)
or underground markets in the product.

Obesity – is it a case of market failure?

Healthcare costs related to obesity-linked illnesses such as diabetes, heart disease and high
cholesterol are soaring. Should the government intervene in the market in order to combat the

339
1
growing costs of obesity?

The City of Detroit in the USA has considered a fast-food tax to combat some of the external costs
of obesity

Obesity – a time bomb?

There is a huge debate at the moment about the root causes of obesity and the social costs that arise
from increasing levels of obesity. This is an international problem.

Proportion of children in England who are obese: by sex

Percentages

1995 Boys Girls

2003 9.6 10.3

Children aged two to ten years. 14.9 12.5

Source: Health Survey for England

340
1
What of harder drugs?

Should hard drugs be prohibited at all costs by the government in a bid to control demand by
restricting supply? Regulation has been the route chosen by most governments in developed
countries over recent years – but economists are once again divided on the issue. Some believe that
legalisation and taxation of harder class drugs is a more appropriate policy to pursue, arguing that
regulation is both ineffective and also costly. Another approach would be to divert resources away
from regulation towards giving better information to drug users about the longer term health
implications of their consumption decisions.

Gambling – economic and social effects

“Gambling has gained more widespread acceptance as a mainstream leisure activity and new forms
of gambling have emerged, most notably via the internet.”

341
1
 Source: UK Gambling Commission, Problem Gambling Issues Paper, March 2006

We have never had so many opportunities to place bets and engage in gambling on and offline. Our
nation has over 130 small casinos and will soon have a raft of large super casinos. Add to that over
8,500 betting shops and an almost unlimited potential number of people willing and able to gamble
online on poker websites and the betting platforms of the major bookmakers. From betting on the
results of general elections, the Grand National, the number of corners that England win in one of
their World Cup matches or the temperature in London on Christmas Day, we seem to have an
almost insatiable desire for gambling on the outcomes of virtually every sporting, political,
meteorological event.

Segments of the gambling industry in the UK

 Online gaming (including internet poker)

 Casinos
 Dog races
 Football pools
 Other lotteries
 Private bets
 Fruit machines
 Bingo
 Horse racing
 Scratch-cards
 National Lottery

Since Chancellor Gordon Brown cut betting tax in 2001 (replacing betting duty with a tax on the
profits of gaming companies), the amount the nation spends on betting has increased sevenfold with
£50bn spent last year alone. £50bn is a truly huge sum, representing just fewer than 5% of national
income and more than the government spent on defence and transport combined in 2005. Expressed
another way, our gambling spending last year came to more than £800 for every man, woman and
child. Gambling is now a truly lucrative business, online poker companies have floated on the stock
exchange and the industry is making huge profits. The 2004 Gambling Bill has now come into force
and we are soon to find out the sites for the first tranche of super-casinos.

Inevitably the rapid expansion of this industry raises important questions about the external costs
and benefits of gambling. Some researchers point to the employment and tourism benefits that
flow from the strong growth in demand for gambling services especially if businesses are
established in some of the UK's poorest towns and cities. There is also a fiscal dividend from this
booming industry with a predicted £3bn per year of extra tax revenues flowing into the Treasury's
coffers.

The government has defended its decision to reform the gambling laws. The Secretary of State
Tessa Jowell was quoted in the Guardian in April 2006.

“All British casinos must enforce high standards of social responsibility, and the Gambling

342
1
Commission can ban free alcohol as an inducement to gambling. In some places a new casino will
leverage much needed investment to transform sporting, leisure and tourist facilities.”

The hidden external costs

But gambling also creates external costs. Over 350,000 people in the UK are thought to be addicted
to betting and their problem gambling can contribute to crises including personal debt or
bankruptcy, loss of employment and the breakdown of families. The dangers of addiction are
greatest for the young and the vulnerable, especially those susceptible to advertising and marketing
strategies.

Polly Toynbee writing in the Guardian in April 2006

“Really destructive gambling, often hidden in lace-curtain secrecy, creates harm that the state
should try to limit, not encourage. The children who fall furthest below the poverty line are those
whose plight does not get recorded in the statistics because their parents' income is devastated by
gambling mania, which crosses every class line and is often unseen outside the family."

Source: Guardian special report on gambling

To what extent can gambling be regarded as a de-merit good?

De-merit goods are thought to be ‘bad’ for you although remember that holding such a view implies
that a normative value judgement is being made. The consumption of de-merit goods can lead to
negative externalities so that the social costs of consumption are greater than the private costs to the
individual concerned.

De-merit goods and information failure

The government may seek to reduce consumption of de-merit goods. Consumers may be unaware of
the negative externalities that these goods create – they have imperfect information about long-
term damage to their own health, their finances and the stability and health of their own families.

The usual approach to de-merit goods is to tax consumption, so that the private cost of consumption
is increased and demand contracts. But the government has actually got rid of betting & gaming
duty (it was abolished in 2001) to be replaced with a tax on the profits of gaming companies. The
Gambling Act of 2005 deregulates the industry and allows the creation of more casinos in the UK.

Background on gambling in the UK

The estimated annual turnover of gambling activities in the UK is about £53 billion, according to
2005 figures from the National Audit Office. The most popular gambling activity in Britain is
lotteries, especially the National Lottery, with some two thirds of the population having bought a
lottery ticket in the past year. The second most popular gambling activity is the purchase of scratch-
cards, with one in five (22%) people purchasing scratch-cards in the past year. This is followed by

343
1
fruit machines (14%) and betting on horseracing (13%).

UK Gambling Commission: http://www.gamblingcommission.gov.uk/Client/index.asp

Gamblers Anonymous: http://www.gamblersanonymous.org.uk/

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Imperfect Information

Both consumers and producers require complete information if they are to make efficient
choices and decisions about what to buy and what to supply to the market. What happens
when this information is missing or incomplete?

Missing information in the market

In the standard textbook theory of competitive markets we assume that all “agents” in the
market enjoy perfect information about the availability of goods and services and also
complete information about prices charged by suppliers. Consumers can make purchasing
decisions on the basis of full and free information on the products that they are buying.

The reality of course is different! All of us experience information deficits which can
often lead to a misallocation of resources and hence the possibility of market failure.
Information failure occurs when people have inaccurate, incomplete, uncertain or
misunderstood data and so make potentially ‘wrong’ choices.

For example, you and I might under or over-estimate the private benefit from consuming
a particular good or service. The classic case of this is the demand for health or education
services– where consumers may well underestimate the long term private benefits from
investing time and money into extra education or buying a specific form of health
treatment. There may well be a case for the government to intervene in the market in
some way if information failures become serious.

Examples of information failure

Imperfect information can be caused by

344
1
  Misunderstanding the true costs or benefits of a product: E.g. the social costs
and benefits of different classes of drugs and the private and social benefits from
higher education when there are so many universities and courses to choose from
 Uncertainty about costs and benefits e.g. should younger workers be buying
into pension schemes when we can only guess at economic conditions in 40 years
time?
 Complex information e.g. choosing between makes of computers requires
specialist knowledge of hardware. Do I buy an Apple or PC computer? The
problems of choosing a quality second hand car or when deciding whether or not
to buy a property
 Inaccurate or misleading information e.g. persuasive advertising may ‘oversell’
the benefits of a product leading to a higher demand and consumption than is
optimal
 Addiction e.g. drug addicts may be unable to stop consumption of harmful
substances

Imperfect information – are equity release schemes being mis-sold?

The consumer watchdog group Which? has criticized the advertising of housing equity
release schemes which they claim can be very expensive and inflexible leaving
homeowners, and especially older property owners, with virtually no equity in their
properties later on in their life.

Which? claims that, for example, borrowing £80,000 through a lump sum equity release
scheme on a £350,000 property could end up costing £256,570 after 20 years or £343,350
after 25 years. Although the equity release schemes give property-owners the cash (or
liquidity) that might be needed to meet short term spending needs, Which claims that
such schemes are incredible expensive and that downsizing your property or even
borrowing money from family is a much better option.

Which? believe some suppliers of equity release schemes have engaged in irresponsible
advertising which can lead to a miss-selling of the product. Norwich Union, for example,
suggests its scheme could pay for a trip to New York or 'something for the family'.

Source: Adapted from the Which? Website

Health warnings for snacks in bid to improve consumer information

The food industry has made its first move towards issuing health warnings for snack
foods. The decision comes as food companies come under in-creasing pressure to provide
more information about the nutritional value of their products amid concern about rising
levels of obesity. It marks a shift in the food industry’s attitude towards consumers. Food
companies have argued that consumer education is not their job. However, the threat of
legislation to regulate the promotion of food to children has prompted the food and drink
industry to become more proactive. The European Commission released a green paper in
December questioning whether companies’ self-regulation for the marketing of sugary

345
1
snacks and soft drinks was “adequate”. Last month, soft drink producers agreed to a
voluntary ban on advertising to children in Europe. They also said they would provide
better nutritional information on beverages and public education campaigns to promote
healthy lifestyles.

Food and drink manufacturers have already made efforts to cut down on fats, salts and
sugars, and provide more nutritional information. This week, Walkers crisps said it had
made a multimillion pound investment in sun seed oil to reduce levels of saturated fats.
Last month, Nestlé said it would put calorie information on the front of confectionery
packets.

Source: Adapted from news reports, February 2006

The effects of asymmetric information

Asymmetric information occurs when somebody knows more than somebody else in
the market. Such asymmetric information can make it difficult for the two people to do
business together

Examples include the following:

 A government selling mobile phone or broadcasting licences does not know what
buyers are prepared to pay for them (an auction is usually the preferred solution to
this).
 A lender does not know how likely a borrower is to repay their loan in future
years.
 A used-car seller knows more about the quality of the car being sold than do
buyers.

Asymmetric information can distort people's incentives to buy and sell goods and
services at the right prices and as a result can lead to inefficiencies and market failure.
One of the classic examples of asymmetric information comes from research on the used
car market by the Nobel Prize winning economist George Akerlof – in his theory of the
market for lemons!

The Market for Lemons

Take problem of buying a used car. Assume that used cars come in two types: those that
are in good repair, and duds (or “lemons” as Americans and most economists call them).
Suppose further that used-car shoppers would be prepared to pay $20,000 for a good one
and $10,000 for a lemon. As for the sellers, lemon-owners require $8,000 to part with
their old banger, while the one-owner, careful-driver old lady with the well-maintained
estate won't part with hers for less than $17,000. If buyers had the information to tell
wheat from chaff, they could strike fair trades with the sellers, the old lady getting a high
price and the lemon-owner rather less.

346
1
If buyers cannot spot the quality difference, though, as is often the case in the real world,
there will be only one market for all used cars, and buyers will be ready to pay only the
average price of a good car and a lemon, or $15,000. This is below the $17,000 that
good-car owners require; so they will exit the market, leaving only bad cars. This result,
when bad quality pushes good quality from the market because of an information gap, is
known as “adverse selection”. This was the simple but powerful insight of George
Akerlof, now a professor at the University of Berkeley in California, in a seminal 1970
paper. A great many markets, including those for shares, labour, insurance and banking,
often resemble a used-car sale more closely than a McDonald's restaurant.

Adapted from the Economist, October 2001

Try to avoid choosing a lemon (a bad car) when you use the second hand car market!

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Government Intervention in the Market

In a free market economic system, scarce resources are allocated through the price
mechanism where the preferences and spending decisions of consumers and the supply
decisions of businesses come together to determine equilibrium prices. The free market
works through price signals. When demand is high, the potential profit from supplying to
a market rises, leading to an expansion in supply (output) to meet rising demand from

347
1
consumers. Day to day, the free market mechanism remains a tremendously powerful
device for determining how resources are allocated among competing ends.

Intervention in the market

The government may choose to intervene in the price mechanism largely on the grounds
of wanting to change the allocation of resources and achieve what they perceive to be an
improvement in economic and social welfare. All governments of every political
persuasion intervene in the economy to influence the allocation of scarce resources
among competing uses

What are the main reasons for government intervention?

The main reasons for policy intervention are:

 To correct for market failure

 To achieve a more equitable distribution of income and wealth
 To improve the performance of the economy

Options for government intervention in markets

There are many ways in which intervention can take place – some examples are given
below

Government Legislation and Regulation

Parliament can pass laws that for example prohibit the sale of cigarettes to children, or
ban smoking in the workplace. The laws of competition policy act against examples of
price-fixing cartels or other forms of anti-competitive behaviour by firms within markets.
Employment laws may offer some legal protection for workers by setting maximum
working hours or by providing a price-floor in the labour market through the setting of a
minimum wage.

The economy operates with a huge and growing amount of regulation. The government
appointed regulators who can impose price controls in most of the main utilities such as
telecommunications, electricity, gas and rail transport. Free market economists criticise
the scale of regulation in the economy arguing that it creates an unnecessary burden of
costs for businesses – with a huge amount of “red tape” damaging the competitiveness of
businesses.

Regulation may be used to introduce fresh competition into a market – for example
breaking up the existing monopoly power of a service provider. A good example of this is
the attempt to introduce more competition for British Telecom. This is known as market
liberalisation.

Direct State Provision of Goods and Services

348
1
Because of privatization, the state-owned sector of the economy is much smaller than it
was twenty years ago. The main state-owned businesses in the UK are the Royal Mail
and Network Rail.

State funding can also be used to provide merit goods and services and public goods
directly to the population e.g. the government pays private sector firms to carry out
operations for NHS patients to reduce waiting lists or it pays private businesses to operate
prisons and maintain our road network.

Fiscal Policy Intervention

Fiscal policy can be used to alter the level of demand for different products and also the
pattern of demand within the economy.
(a) Indirect taxes can be used to raise the price of de-merit goods and products with
negative externalities designed to increase the opportunity cost of consumption and
thereby reduce consumer demand towards a socially optimal level
(b) Subsidies to consumers will lower the price of merit goods. They are designed to
boost consumption and output of products with positive externalities – remember that a
subsidy causes an increase in market supply and leads to a lower equilibrium price
(c) Tax relief: The government may offer financial assistance such as tax credits for
business investment in research and development. Or a reduction in corporation tax (a
tax on company profits) designed to promote new capital investment and extra
employment
(d) Changes to taxation and welfare payments can be used to influence the overall
distribution of income and wealth – for example higher direct tax rates on rich
households or an increase in the value of welfare benefits for the poor to make the tax
and benefit system more progressive

Intervention designed to close the information gap

Often market failure results from consumers suffering from a lack of information about
the costs and benefits of the products available in the market place. Government action
can have a role in improving information to help consumers and producers value the
‘true’ cost and/or benefit of a good or service. Examples might include:

 Compulsory labelling on cigarette packages with health warnings to reduce

smoking
 Improved nutritional information on foods to counter the risks of growing obesity
 Anti speeding television advertising to reduce road accidents and advertising
campaigns to raise awareness of the risks of drink-driving
 Advertising health screening programmes / information campaigns on the dangers
of addiction

These programmes are really designed to change the “perceived” costs and benefits of
consumption for the consumer. They don’t have any direct effect on market prices, but
they seek to influence “demand” and therefore output and consumption in the long run.

349
1
Of course it is difficult to identify accurately the effects of any single government
information campaign, be it the campaign to raise awareness on the Aids issue or to
encourage people to give up smoking. Increasingly adverts are becoming more hard-
hitting in a bid to have an effect on consumers.

The effects of government intervention

One important point to bear in mind is that the effects of different forms of government
intervention in markets are never neutral – financial support given by the government to
one set of producers rather than another will always create “winners and losers”. Taxing
one product more than another will similarly have different effects on different groups of
consumers.

The law of unintended consequences

Government intervention does not always work in the way in which it was intended or
the way in which economic theory predicts it should. Part of the fascination of studying
Economics is that the “law of unintended consequences” often comes into play – events
can affect a particular policy, and consumers and businesses rarely behave precisely in
the way in which the government might want! We will consider this in more detail when
we consider government failure.

Judging the effects of intervention – a useful check list

To help your evaluation of government intervention – it may be helpful to consider these

questions:

Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarce
resources among competing ends? E.g. does it improve allocative, productive and
dynamic efficiency? For example - would introducing indirect taxes on high fat foods be
an efficient way of reducing some of the external costs linked to the growing problem of
obesity?

Effectiveness of a policy: i.e. which government policy is most likely to meet a specific
economic or social objective? For example which policies are likely to be most effective
in reducing road congestion? Which policies are more effective in preventing firms from
exploiting their monopoly power and damaging consumer welfare? Evaluation can also
consider which policies are likely to have an impact in the short term when a quick
response from consumers and producers is desired. And which policies will be most cost-
effective in the longer term?

Equity effects of intervention: i.e. is a policy thought of as fair or does one group in
society gain more than another? For example it is equitable for the government to offer

350
1
educational maintenance allowances (payments) for 16-18 year olds in low income
households to stay on in education after GCSEs? Would it be equitable for the
government to increase the top rate of income tax to 50 per cent in a bid to make the
distribution of income more equal?

Sustainability of a policy: i.e. does a policy reduce the ability of future generations to
engage in economic activity? Inter-generational equity is an important issue in many
current policy topics for example decisions on which sources of energy we rely on in
future years.

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Producer Subsidies

Should government money be used in subsidies to help businesses in financial trouble?

The age-old issue of the arguments for and against subsidy has resurfaced in recent years
as several sectors of the economy have experienced difficulties. They range from farming
to coal mining to steel production and the aviation industry.

Government Subsidy

A subsidy is a payment by the government to suppliers that reduce their costs of

production and encourages them to increase output. The effect of a government subsidy is
to increase supply and (ceteris paribus) reduce the market equilibrium price. The subsidy
causes the firm's supply curve to shift to the right. The amount spent on the subsidy is
equal to the subsidy per unit multiplied by total output. Occasionally the government can
offer a direct subsidy to the consumer – which has the effect of boosting demand in a
market
Different Types of Producer Subsidy

1. A guaranteed payment on the factor cost of a product – e.g. a guaranteed

minimum price offered to farmers
2. An input subsidy which subsidises the cost of certain inputs used in production –
e.g. an employment subsidy for taking on more employees
3. Government grants to cover losses made by a business – e.g. a grant given to
cover losses in the railway industry
4. Financial assistance (loans and grants) for businesses setting up in areas of high
unemployment – e.g. as part of a regional policy designed to boost employment

Showing the effect of a subsidy to producers

351
1
To what extent will a subsidy feed through to lower prices for consumers? This depends
on the price elasticity of demand for the product. The more inelastic the demand curve
the greater the consumer's gain from a subsidy. Indeed when demand is perfectly inelastic
the consumer gains most of the benefit from the subsidy since all the subsidy is passed
onto the consumer through a lower price. When demand is relatively elastic, the main
effect of the subsidy is to increase the equilibrium quantity traded rather than lead to a
much lower market price.

352
1
The Economic and Social Justifications for Subsidies

Why might the government be justified in providing financial assistance to producers in

certain markets and industries? How valid are the arguments for government subsidies?

1. To control the rate of inflation and boost the real living standards of some
groups of consumers – for example lower income households.
2. To encourage the provision and consumption of merit goods and services which
are said to generate positive externalities (increased social benefits). Under-
consumption or provision of merit goods can lead to market failure causing a loss
of social welfare
3. Maintain or increase the revenues (incomes) of producers during times of
special difficulties in markets (consider some of the examples mentioned below)
4. Reduce the cost of capital investment projects – which might help to stimulate
economic growth by increasing long-run aggregate supply
5. Subsidies to smooth or slow-down the process of long term structural
change/decline in an industry (for example in farming, coal, fishing and steel)
6. Boost employment for certain groups of workers e.g. the long term
unemployed

Economic Arguments against Subsidies

The economic and social case for a subsidy should be judged carefully on the grounds of
economic efficiency and also fairness (or equity). We need to be careful to measure and

353
1
evaluate who gains from any particular subsidy and who pays. Might the money used up
in subsidy payments be better spent elsewhere? Government subsidies inevitably carry an
opportunity cost and in the long run there might be better ways of providing financial
support to producers and employees in specific industries.

Free market economists argue that government subsidies distort the workings of the free
market mechanism and can eventually lead to government failure where government
intervention actually leads to a worse distribution of resources.

1. Distortion of the Market: Subsidies distort market prices - this can lead to a
misallocation of resources – many economists believe that the free-market
mechanism works best. Export subsidies distort the free trade in goods and
services and can severely curtail the ability of ELDCs to compete in the markets
of industrialised countries
2. Arbitrary Assistance: Decisions about which groups or industries receive a
subsidy can be arbitrary – if tourism is supported, why not the British steel
industry?
3. Financial Cost: Subsidies can become expensive – note the opportunity cost!
4. Who pays and who benefits?: The final cost of a subsidy usually falls on
consumers (tax-payers) who themselves may have derived no benefit from the
subsidy
5. Encouraging inefficiency: Subsidy can artificially protect inefficient firms who
need to restructure – i.e. it delays much needed economic reforms
6. Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments
7. There are alternatives: It may be possible to achieve the objectives of subsidies
by alternative means which have less distorting effects, for example by direct
income support through the tax and benefit system

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Minimum Prices

In the last chapter we focused on maximum prices, we now look at the economics of price
floors where the government intervenes in the market so that prices cannot fall below a
certain level.

Definition of a minimum price

A minimum price is a legally imposed price floor below which the normal market price
cannot fall. To be effective the minimum price has to be set above the normal equilibrium

354
1
price. Perhaps the best example of a minimum price is the minimum wage. The national
minimum wage was introduced into the UK in 1999. It is an intervention in the labour
market designed to increase the pay of lower-paid workers and thereby influence the
distribution of income in society. In October 2005, the value of the minimum wage for
adults was £5.05 – following a series of small increases over recent years.

The main aims of the minimum wage

1. The equity justification: That every job should offer a fair rate of pay
commensurate with the skills and experience of an employee
2. Labour market incentives: The NMW is designed to improve the incentives for
people to start looking for work – thereby boosting the economy’s available
labour supply
3. Labour market discrimination: The NMW is a tool designed to offset some of
the effects of persistent discrimination of many low-paid female workers and
younger employees

Adult Rate Development Rate 16-17 Year Olds Rate

(for workers aged 22+) (for workers aged 18-21)

1 Apr 1999 £3.60 1 Apr 1999 £3.00 - -

1 Oct 2000 £3.70 1 Oct 2000 £3.20 - -

1 Oct 2001 £4.10 1 Oct 2001 £3.50 - -

1 Oct 2002 £4.20 1 Oct 2002 £3.60 - -

1 Oct 2003 £4.50 1 Oct 2003 £3.80 - -

1 Oct 2004 £4.85 1 Oct 2004 £4.10 1 Oct 2004 £3.00

1 Oct 2005 £5.05 1 Oct 2005 £4.25 1 Oct 2005 £3.00

1 Oct 2006 £5.35 1 Oct 2006 £4.45 1 Oct 2006 To be

announced

How does a minimum wage work?

355
1
The minimum wage is a price floor – employers cannot legally undercut the current
minimum wage rate per hour. This applies both to full-time and part-time workers.
Labour supply and demand curve analysis can be used to show the effects.

A diagram showing the possible effects of a minimum wage is shown above. The market
equilibrium wage for this particular labour market is at W1 (where demand = supply). If
the minimum wage is set at Wmin, there will be an excess supply of labour equal to E3 –
E2 because the supply of labour will expand (more workers will be willing and able to
offer themselves for work at the higher wage than before) but there is a risk that the
demand for workers from employers (businesses) will contract if the minimum wage is
introduced.

Possible disadvantages of a minimum wage

Although all political parties are now committed to keeping the minimum wage, there are
still plenty of economists who believe that setting a pay floor represents a distortion to
the way the labour market works because it reduces the flexibility of the labour market

1. Competitiveness and Jobs: Firstly a minimum wage may cost jobs because a rise
in labour costs makes it more expensive to employ people and higher labour costs
might damage the international competitiveness of British producers. To the

356
1
 extent that rising unemployment worsens the living standards of those affected it
has a negative impact on poverty.
2. Effect on relative poverty: Is the minimum wage the most effective policy to
reduce relative poverty? There is evidence that it tends to boost the incomes of
middle-income households where more than one household member is already in
work whereas the greatest risk of relative poverty is among the unemployed,
elderly and single parent families where the parent is not employed.

Can a minimum wage actually increase employment?

The answer is yes – depending on the circumstances in the labour market when a pay
floor is introduced and also on what happens to the productivity of labour when a high
(statutory) rate of pay is introduced. There are two main explanations for the possibility
of higher employment

1. The Keynesian argument that higher wage rates will increase the real disposable
incomes of lower-paid workers many of whom have a high marginal propensity
to consume. Thus they will increase their own spending and this will feed
through the circular flow of income and spending
2. The efficiency wage argument that raising pay levels for low-paid employees
may have a positive effect on their productivity and efficiency. In addition to the
psychological benefits of being paid more, businesses may take steps to improve
production processes, workplace training etc if they know that they must pay at
least the statutory pay floor.

The importance of elasticity of demand and supply of labour

The impact of a minimum wage on employment levels depends in part on the elasticity of
demand and elasticity of supply of labour in different industries. If labour demand is
relatively inelastic then the contraction in employment is likely to be less severe than if
employers’ demand for labour is elastic with respect to changes in the wage level.

In the next diagram we see the possible effects of a minimum wage when both labour
demand and labour supply are elastic in response to a change in the market wage rate.
The excess supply created is much higher than in the previous diagram.

357
1
Evidence on the minimum wage – has it worked?

1. Employment: Since the minimum wage was introduced, unemployment in

Britain has continued to fall and the level of employment in the British economy
is now at a record high. It should be remembered that the National Minimum
Wage was introduced in a tight labour market, with employment rising and
unemployment falling. The true test of a pay floor is probably when the economy
experiences recession.
a. The sectors most directly affected by the minimum wage are in hospitality,
leisure, textiles and social care. Even here, the employment effects are
small – and they might easily be explained by changes in competition (e.g.
from overseas) and from the effects of technological change on labour
demand
2. Inflation: There have been negligible adverse effects on wage and price inflation.
Other factors affecting inflationary pressure have been broadly favourable for the
UK in recent years. In many sectors firms find it hard to pass on higher wage
costs to final consumers – again limiting the inflationary effect of the minimum
wage
3. Wage costs: The minimum wage affects only a small proportion of workers and
the effects on the wage bills of most businesses is not a significant factor in their
employment decisions. In the short term, the demand for labour tends to be
inelastic with respect to changes in wages
4. Discrimination: The minimum wage has had a significant impact on the earnings
of part-time female workers.
358
1
 5. Productivity: It is hard to identify any strong positive effect on labour
productivity - but productivity gains have been made in most low-paying
industries, a trend which started before the minimum wage was introduced.

Suggestions for further research and reading on the Minimum Wage

Although all of Britain’s major political parties now support the idea of a national
minimum wage, the issue remains a controversial one for economists.

You can find out more about the minimum wage in Britain by visiting the Department for
Trade and Industry, The Trades Union Congress, the Confederation of British Industry,
the Federation of Small Businesses and the Low Pay Commission.

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Farm Support - the CAP

All governments intervene in their farming markets to one degree or another. But farm
subsidies are controversial – indeed many economists regard them as a prime source of
government failure, acting to deepen existing market failures and cause a further loss of
economic and social welfare.

Distorting the global market

The CAP is hugely unpopular around the world. It subsidizes European farmers to such
an extent that they can undercut farmers from poor countries, who also face trade barriers
that largely exclude them from the potentially lucrative European market
(Adapted from the Economist, June 2003)

The Common Agricultural Policy has come under sustained criticism from many
quarters including the British Government which has been a supporter of the reform
process.

UK Government Policy on the CAP

The current CAP is not delivering what farmers, the rural economy or the environment
need. It is an expensive policy and is insufficient to meet the challenges posed by the
enlargement of the EU. Reform is also vital to improve the position of developing
countries, who find it harder to access our markets when the EU subsidises its own
production. The UK Government’s goal is to reduce the overall burden of the CAP,
delivering better value for money to taxpayers

359
1
 Source: Adapted from the DEFRA web site www.defra.gov.uk

The main criticisms of the CAP are as follows

1. Productive inefficiency: Generous CAP intervention prices have encouraged

excess production of many farm products and permitted production inefficiencies
and dependency on farm subsidies - all of which leads to a mis-allocation of
scarce resources. Much of the price support goes to farmers who need it least.
Because most support is production-based, the bulk of it goes to the larger, often
richer, farms able to exploit economies of scale
2. Loss of allocative efficiency and consumer welfare: The CAP is seen by much
of the public as failing to deliver what society wants and needs from agriculture in
terms of food safety, animal health and rural environment. It is neither consistent
with policies on sustainable development, nor with consumer demands for high
quality, local and regional foods. And consumers have ended up paying twice for
their food!– once in higher taxes to fund farm support and secondly in higher
prices of imported foods because of the tariff levied by the EU on many
foodstuffs entering the European Union
3. Fiscal costs: The financial cost of EU farm support policies has been huge and
involves a large opportunity cost – that money might well have been spent on
more socially useful programmes over the years
4. Loss of equity: Farm support imposes higher food prices for EU consumers and
the cost hits poorer families most because they spend a higher proportion of their
income on food implying a regressive effect on the distribution of income
5. Environmental concerns: The CAP has encouraged intensive farming which is
prompting concern about the environmental impact of CAP. One recent study of
olive growers showed they used more than 400 times the recommended level of
pesticides – and more generally the trend towards intensive farming is seen as
imposing significant external costs on the European economy
6. Global market distortions – a barrier to international trade: The CAP is seen
by many critics as anti-competitive and distorts international markets threatening
the development of many lower-income countries. The EU spent £2.14 billion on
export subsidies in 2001. The CAP is a cause of tension between the EU and the
rest of the world in global trade negotiations

The costs of the CAP – a UK government perspective

“The CAP is expensive, inefficient and ineffective. Because three quarters of the world's
poor live in rural areas, because 96 per cent of the world's farmers live in developing
countries, our agricultural protectionism costs developing countries 20 billion dollars a
year directly, up to 100 billion dollars indirectly -- twice the amount of development aid
they receive."

Source Speech by Gordon Brown, March 2004

Reforming the Common Agricultural Policy

360
1
For several years now farm ministers have been negotiating reforms of the Common
Agricultural Policy. The main elements of the reforms are as follows:

1. Replacing price support with a single annual income payment for farmers:
farm payments will no longer be linked to the amount produced (this is known as
“de-coupling”). Initially the new system will apply mainly to arable farm
production and will be extended to beef and sheep sectors from 2008. If the
reforms are implemented in full – 90% of CAP payments will no longer be linked
to production
2. Linking farm incomes to protection and improvement of the environment:
Farmers must meet clear rules on the environmental impact of their farming, food
safety and animal welfare and plant health to qualify for the annual income
payments. In this sense the CAP will reward farmers who treat their environment
as a public good with positive externalities for those people who enjoy our rural
heritage
3. Cutting payments to the largest farms: CAP aid payments to larger farms of
more than euro 5,000 per year will be cut and the proceeds used to encourage
rural development
4. Reductions in guaranteed minimum prices: The intervention price for butter is
being cut by 25% over 4 years. There is a 15% cut in intervention prices for
skimmed milk powder and a freeze on prices for cereals. You can easily show the
effects of a reduction in guaranteed prices using supply and demand diagrams
5. Extra funds for rural development to promote new employment in farming
areas: The EU rural development fund currently worth around euros 5 billion per
year will be given an extra euro 1.2 billion a year – partly this is to improve
employment opportunities for young people living in farming areas and to reduce
the risk of increased structural unemployment

Will these reforms work?

Some of the main issues to consider are as follows:

 The future of smaller-scale farming: Will reductions in direct payments for

production stimulate increases in farm productivity due to a switch to larger-scale
production? Trends in the Danish pig industry which is now a sector free of all
farm support are illustrative of what is likely to happen. In 1991 only 9.5% of pigs
were reared from suppliers with pig herds of 5,000 or more. By 2001 that
percentage had grown to 34.1%
 Dynamic efficiency gains? Will reforms to the CAP stimulate improvements in
the dynamic efficiency of the UK and European farming industry? Supporters of
reform believe that cutting dependency on financial support will encourage
farmers to diversify the use of their land including breaking into rural tourism and
focusing resources on supplying niche products to local markets / farmers’
markets
 Risks of unemployment: Will there be sufficient geographical and occupational
mobility in the farming industry to cope with falling price support? The main risk

361
1
 is a sharp rise in structural unemployment and associated problems of rural
poverty arising from occupational immobility of labour
 Will food prices fall? Textbook analysis would suggest that reducing import
tariffs for food coming into the UK and reducing farm support prices should lead
to an increase in non-EU food supplies into the EU and lower food prices in real
terms. Will food manufacturers pass cost savings onto retailers who then pass
them on to consumers?

Author: Geoff Riley, Eton College, September 2006

AS Market Failure
Health Care

Providing health care – the state or the free market?

The costs of providing health care

The costs of running the National Health Service run into many billions of pounds per
year. The main costs are the labour costs together with the money spent on drugs and
specialist equipment.

The issue of health provision in the UK is nearly always at the top of the political agenda.
Millions of people buy health-care products every week – most of them including over-
the-counter pharmaceutical products such as painkillers and first aid equipment are
bought and sold freely through the market mechanism. Likewise a sizeable and growing
percentage of nursing care is provided by the private sector. But the bulk of major health
services, including primary and secondary care are provided through the National Health
Service (NHS) and the NHS receive a huge amount of government spending funded
through general taxation every year.

Are we getting good value for money from our state provided health service? Is the NHS
offering enough proper choice for patients? How best can the NHS or the private sector
meet our changing health needs and wants in the coming years? These are hugely
important economic as well as political questions.

362
1
Equity and Efficiency in Health Care

The issue of health care in the UK and other countries can be linked strongly to the twin
concepts of economic efficiency and equity.

(1) Economic Efficiency

Consider first the two main types of efficiency – allocative and productive:

1. Does the health care provided in Britain meet people’s changing needs and wants
(i.e. do we achieve allocative efficiency?)
2. Is health care provided at the lowest possible cost per treatment (i.e. do we
achieve productive efficiency?) or could improvements be made in the efficiency
with which health services are provided for millions of people?

(2) Equity

Are people’s health needs met by health treatments on the basis mainly of clinical need
or alternatively based on an ability to pay for health services? Are health outcomes in
the UK reasonably equal across localities, regions, ethnic groups, age groups and by
gender? Or are there unacceptable inequalities in the provision of health care across
different sections of the population? The issue of equitable provision of health is an
important ongoing issue.

Market Failure in Health Care

What might cause market failure in the provision of health services?

1. Imperfect information among health care providers and consumers -

Consumers may under-value the longer term private benefits of consuming health
care – due to information failure (or ‘patient ignorance’). Health providers such as
doctors and consultants have more specialised information than consumers – an
example here of asymmetric information.
2. Lack of adequate health insurance: A second cause of information failure is
that it is virtually impossible for people to predict their future health needs.
Sudden illness or injury may require extensive and expensive medical care for
which most people are unlikely to have adequate health care insurance. Indeed the
private health insurance market will not provide cover for all groups of people.
High-risk individuals may find it impossible or extremely expensive to get
appropriate medical insurance if the market was the only provider of health care.
The ‘failure’ of health insurance companies to provide cover for high risk groups
is an example of ‘missing markets’ – another cause of market failure
3. Externalities arising from health care provision: Health services are normally
assumed to be merit goods providing a private benefit for people who consume
them and additional external benefits for society as a whole.

363
1
 4. Inequalities in access to basic health care: There are regional and local
differences in the quality and quantity of health care available (media stories are
fond of discussing so-called “postcode prescribing”). Millions of people are
wholly dependent on the NHS for health care– they have no hope of being able to
fund private health insurance. If people were required to pay for more treatments
they would often be unable to afford them
5. Monopoly power among health care suppliers: if there was a wholly free
market in providing health care, it is likely that in the long run, several dominant
health care providers would emerge raising concerns about increasing market
concentration and the opportunities for these firms to exploit their monopoly
power.

The fundamental policy question regarding health care in the UK is this: Should it remain
essentially funded by the tax system and provided mainly free at the point of need?

In the United States, which remains the world’s largest spender on health care, state
provided and state-financed health care goes mainly to the old and families on low
incomes. Most American workers are insured privately through the health insurance
schemes run by their employers. But this does not stop many millions of Americans
being unable to afford their own health care insurance – this has become a huge political
issue in the United States. There are also huge worries among US companies about the
soaring cost of employer-funded health benefit schemes.

In rich developed countries, health care spending on average takes up nearly ten per cent
of national income (GDP) and the projections for the years ahead see that figure
continuing to rise.

The NHS will always face the problem of resource scarcity because our ever-growing
demand for different types of health care exceeds the available supply. The Labour
government is committed to significant increases in real spending on health + share of
health in total GDP.

NHS Spending

Until recently, the UK has been one of the lowest spenders on health care among the
major industrialised countries. But the Labour government’s spending programme has
catapulted health care spending to new levels. Spending on the NHS is forecast to rise by
seven per cent per year in real terms until 2008. At which point, health care spending will
have risen to 9.4% of GDP compared with 6.9% in 1998.

Fundamental Principles of the National Health Service

The main aim of the NHS is to provide a comprehensive, high quality service available
on the basis of clinical need and not ability to pay. The Fundamental building blocks of
the NHS are as follows:

364
1
Providing a national universal (comprehensive) service
Health care free at the point of use
Medical care is not based on ability to pay but rather on the basis of clinical need

Who should pay for the drugs dispensed by the National Health Service?

The Economic and Social Importance of Health Care

Quality of Life and Poverty: Health and well-being in childhood affect educational
attainment with consequences for people throughout their lives. Ill health in adulthood is
associated with poverty and long periods out of work. There is now solid evidence that
improvements in medical care pay off in the long term in terms of healthier and longer
lives. There are welfare gains from improvements both in life expectancy and also the
quality of life that comes from a better overall standard of public health.
Employment: The NHS is the largest employer in UK with over 1.3 million people
employed in the NHS in England alone. After social security payments, health is the
biggest single component of government expenditure. 15 per cent of tax and National
Insurance Contributions (NICs) go to pay for the health service.
Productivity: The health service also affects the productivity of business with almost
half of all NHS spending allocated to people of working age. Ill health imposes a
restriction on the productive potential of the economy. Around 2 per cent of working
days each year are lost due to short-term sickness, while more than 7 per cent of the
working age population is unable to work due to long-term sickness or disability costing
over £12 billion a year in welfare benefits. Workplace absence is estimated to have cost
British business over £10 billion in 1999 and this figure has surely risen in the years since
Higher GDP/Economic Growth and Standard of Living: If average life expectancy
could be increased by five years (i.e. to Japanese levels) then UK real GDP could be
between £3 billion and £5 billion a year higher.

Fundamental Problems Facing the NHS

Rarely a day goes by without a health story featuring in the newspapers. The NHS faces
many challenges – these are four of the main ones:

365
1
 1. Persistent resource crises: Resource problems are the inevitable consequence of
under-funding and under-investment in the health service over many years –
affecting the quality and quantity of the capital stock available to health providers
2. Hospital waiting lists: There are persistent delays in people receiving
appointments to see consultants and delays in receiving emergency treatment
3. Problems in recruiting sufficient well qualified staff which leads to long hours
for NHS staff and contributes to wide disparities in the quality of care and range
of care from region to region and between local health authorities.
4. Meeting the growing demand for health care: There are growing doubts as to
whether the NHS is meeting changing consumer preferences and growing health
needs

Health Care Rationing – An Inevitable Process

Health rationing occurs because demand for health care always outweighs supply. In
a free market, markets match supply and demand by altering price. This form of rationing
relies on the simply fact that post-tax incomes are unequal and that those households on
relatively low incomes will be the first to be priced out of the market. Rationing in the
NHS is inevitable - no amount of resources from the Government funded by taxation
could possibly meet all of our demands for health care when the NHS system remains
based on the fundamental principle of most health services being free at the point of need.

In the diagram below, even if the government invests higher levels of money into the
NHS system permitting an outward shift in the PPF for health care services, there is still
an issue of scarcity to resolve even though the total “output” of the NHS can rise as a
result.

366
1
The NHS currently rations health resources in a variety of ways

1. Government rationing: Ministers and Parliament decide on the overall size of

the NHS budget thus dictating the type and volume of care the NHS can provide
2. The National Institute for Clinical Excellence (NICE) contributes to rationing
decisions by advising the NHS on clinical and economic benefits and costs of
certain health care interventions
3. Health authorities and primary care groups allocate money to particular
disease/treatment areas. Treatment decisions for individuals are made at the
clinical level by health care professionals

Key Factors Putting Increased Financial Pressures on the NHS

1. Developments in medical technology and new treatments: The fruits of

research and development in health sciences has brought us many new medical
procedures (such as transplants); new treatments and new products (e.g. magnetic-
resonance imaging scanners)
2. New drugs including drugs that reduce the “risk” of disease rather than the
symptoms of illness – e.g. statins to lower cholesterol or anti-hypertensives to
reduce the likelihood of strokes. Pharmaceutical spending is now 13% of total
spending on health care in the UK. The costs of bringing a new drug to market are
truly enormous. One study has found that, taking into account failed products, it
now costs up to $900 million to develop a new prescription drug. The costs of
drugs tends to fall in the long term as expensive new drugs protected by patent
property rights are replaced by the emergence of generic drugs once this
protection is lifted. But this process can take many years.
3. The increased costs of staffing in the NHS -the NHS is a highly labour intensive
industry. The costs of pay and other employment costs can take up to sixty per
cent of the operating expenses of a hospital.
4. Growing health problems including increased incidence of diseases associated
with affluence and the health issues following an increase in relative poverty – for
example the costs of treating smoking related diseases and the costs of treating
illness associated with rising levels of obesity
5. Long term change in age structure of the population - The cost of health care
rises dramatically for older patients and the UK population along with that of
many other countries is becoming older as average life expectancy continues to
grow
6. Increasing expectations of patients and their families – in part the result of
politicians promising to achieve improved health outcomes from extra funding

Demographic Change and the NHS

The UK population is ageing. The medical conditions that account for the majority of the
burden of disease in the UK are primarily related to old age – e.g. cancer and coronary
heart disease. Spending on health varies significantly with age. The beginning and end of
life are the most expensive. On average, around a quarter of all the health care someone

367
1
consumes in their lifetime is consumed in the last year of their life. Just over a third of all
spending on hospital and community health services is for people who are over the age of
65. Over the next 20 years, the UK population is projected to increase by around 5
million.

Main Funding Options for Health Care

On average across the leading rich developed countries, the government accounts for
nearly three-quarters of health care expenditure. The lowest share is in the United States
where state funding represents less than fifty per cent of total health spending. In
Canada, Britain and Sweden, the health service is funded mainly through general
taxation. In Germany and France the system is funded largely from compulsory
contributions made by employers and workers and from voluntary private insurance. In
most countries, health care is provided by the mixed economy. Doctors are usually self
employed or in private practice. The government sector is most heavily involved in
operating hospitals. Although in Britain, the government is now committed to giving
hospitals much greater autonomy in running their own affairs and in contracting out some
health care to the private sector through its foundation hospital system

The Case for Maintaining a Tax Funded Health Care System

The Government is committed to maintaining a National Health Service funded mainly

through general taxation. In the March 2002 Budget, Chancellor Brown announced huge
increases in real spending on health financed in part by a rise in National Insurance
Contributions from 10% to 11% (effectively an increase in direct taxation).

Justifications for having a state funded National health Service

1. The NHS can exploit huge economies of scale and therefore provide health
services for millions of people at an efficient cost – these scale economies include
the benefits of specialization and significant buying power in the purchasing of
drugs from pharmaceutical companies
2. Revenue to fund the NHS is drawn from a millions of taxpayers who pay mainly
through a progressive system of direct taxation- satisfying the principle of
vertical equity. Higher income taxpayers are therefore paying more towards the
general provision of health care – the NHS is a means towards greater equality of
opportunity within society
3. Basing health care treatments on being able to pay might discourage people from
seeking important treatments

Case for using the market mechanism / charging for some forms of health care

What are the arguments for extending the market mechanism to providing health care in
the UK?

368
1
  With user charges, households would freely choose their own pattern of
consumption and the supply of health care would then adjust to the pattern of
preferences and level of demand for different treatments
 Some economists believe that the price mechanism is a better way of rationing
health care than the current arbitrary system of queuing / waiting lists
 The demand for health treatments would be linked to the private benefit to the
patient – so a wider system of charging / private sector provision would lead to a
lower demand for non-essential treatments and free up resources for more urgent
treatments
 Some user charges already exist within the NHS such as those for dental
treatment, eye examinations and prescriptions – the principle of user charges
could be extended without challenging the fundamental principles upon which the
NHS is based


Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Short Run and Long Run Production

As part of our introduction to the theory of the firm, we first consider the nature of
production of different goods and services in the short and long run.

The concept of a production function

The production function is a mathematical expression which relates the quantity of

factor inputs to the quantity of outputs that result. We make use of three measures of
production / productivity.

 Total product is simply the total output that is generated from the factors of
production employed by a business. In most manufacturing industries such as
motor vehicles, freezers and DVD players, it is straightforward to measure the
volume of production from labour and capital inputs that are used. But in many
service or knowledge-based industries, where much of the output is “intangible”
or perhaps weightless we find it harder to measure productivity
 Average product is the total output divided by the number of units of the variable
factor of production employed (e.g. output per worker employed or output per
unit of capital employed)
 Marginal product is the change in total product when an additional unit of the
variable factor of production is employed. For example marginal product would
measure the change in output that comes from increasing the employment of
labour by one person, or by adding one more machine to the production process in
the short run.

369
1
The Short Run Production Function

The short run is defined in economics as a period of time where at least one factor of
production is assumed to be in fixed supply i.e. it cannot be changed. We normally
assume that the quantity of capital inputs (e.g. plant and machinery) is fixed and that
production can be altered by suppliers through changing the demand for variable inputs
such as labour, components, raw materials and energy inputs. Often the amount of land
available for production is also fixed.

The time periods used in textbook economics are somewhat arbitrary because they differ
from industry to industry. The short run for the electricity generation industry or the
telecommunications sector varies from that appropriate for newspaper and magazine
publishing and small-scale production of foodstuffs and beverages. Much depends on the
time scale that permits a business to alter all of the inputs that it can bring to production.

In the short run, the law of diminishing returns states that as we add more units of a
variable input (i.e. labour or raw materials) to fixed amounts of land and capital, the
change in total output will at first rise and then fall. Diminishing returns to labour
occurs when marginal product of labour starts to fall. This means that total output will
still be rising – but increasing at a decreasing rate as more workers are employed. As we
shall see in the following numerical example, eventually a decline in marginal product
leads to a fall in average product.

What happens to marginal product is linked directly to the productivity of each extra
worker employed. At low levels of labour input, the fixed factors of production - land and
capital, tend to be under-utilised which means that each additional worker will have
plenty of capital to use and, as a result, marginal product may rise. Beyond a certain point
however, the fixed factors of production become scarcer and new workers will not have
as much capital to work with so that the capital input becomes diluted among a larger
workforce.
As a result, the marginal productivity of each worker tends to fall – this is known as the
principle of diminishing returns.

An example of the concept of diminishing returns is shown below. We assume that there
is a fixed supply of capital (e.g. 20 units) available in the production process to which

Initially the marginal product of labour is rising.

 It peaks when the sixth worked is employed when the marginal product is 29.
 Marginal product then starts to fall. Total output is still increasing as we add more
labour, but at a slower rate. At this point the short run production demonstrates
diminishing returns.

370
1
The Law of Diminishing Returns

Capital Input Labour Input Total Output Marginal Product Average Product of Labour

20 1 5 5

20 2 16 11 8

20 3 30 14 10

20 4 56 26 14

20 5 85 28 17

20 6 114 29 19

20 7 140 26 20

20 8 160 20 20

20 9 171 11 19

20 10 180 9 18

20 11 187 7 17

Average product will continue to rise as long as the marginal product is greater than the
average – for example when the seventh worker is added the marginal gain in output is 26
and this drags the average up from 19 to 20 units. Once marginal product is below the
average as it is with the ninth worker employed (where marginal product is only 11) then
the average will decline.

371
1
This marginal-average relationship is important to understanding the nature of short
run cost curves. It is worth going through this again to make sure that you understand it.

Criticisms of the Law of Diminishing Returns

How realistic is this notion of diminishing returns? Surely ambitious and successful
businesses do what they can to avoid such a problem emerging.

It is now widely recognised that the effects of globalisation, and in particular the ability
of trans-national corporations to source their factor inputs from more than one country
and engage in rapid transfers of business technology and other information, makes the
concept of diminishing returns less relevant in the real world of business. You may have
read about the expansion of “out-sourcing” as a means for a business to cut their costs
and make their production processes as flexible as possible.
In many industries as a business expands, it is more likely to experience increasing
returns. After all, why should a multinational business spend huge sums on expensive
research and development and investment in capital machinery if a business cannot
extract increasing returns and lower unit costs of production from these extra inputs?

Long run production - returns to scale

In the long run, all factors of production are variable. How the output of a business
responds to a change in factor inputs is called returns to scale.

372
1
  Increasing returns to scale occur when the % change in output > % change in
inputs
 Decreasing returns to scale occur when the % change in output < % change in
inputs
 Constant returns to scale occur when the % change in output = % change in
inputs


A numerical example of long run returns to scale

Units of Units of Total % Change in % Change in Returns to Scale

Capital Labour Output Inputs Output

20 150 3000

40 300 7500 100 150 Increasing

60 450 12000 50 60 Increasing

80 600 16000 33 33 Constant

100 750 18000 25 13 Decreasing

In the example above, we increase the inputs of capital and labour by the same proportion
each time. We then compare the % change in output that comes from a given % change in
inputs.

 In our example when we double the factor inputs from (150L + 20K) to (300L +
40K) then the percentage change in output is 150% - there are increasing returns
to scale.
 In contrast, when the scale of production is changed from (600L + 80K0 to (750L
+ 100K) then the percentage change in output (13%) is less than the change in
inputs (25%) implying a situation of decreasing returns to scale.

As we shall see a later, the nature of the returns to scale affects the shape of a business’s
long run average cost curve.

The effect of an increase in labour productivity at all levels of employment

Productivity may have been increased through the effects of technological change;
improved incentives; better management or the effects of work-related training which
boosts the skills of the employed labour force.
373
1
 The length of time required for the long run varies from sector to sector. In the nuclear
power industry for example, it can take many years to commission new nuclear power
plant and capacity. This is something the UK government has to consider as it reviews
our future sources of energy.

374
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Economies and Diseconomies of Scale

In the long run all factors of production are variable; the whole scale of production can
change. In this note we look at economies and diseconomies of large scale production.

Economies of scale

Economies of scale are the cost advantages exploited by expanding the scale of
production in the long run. The effect is to reduce long run average costs over a range
of output.

These lower costs represent an improvement in productive efficiency and can feed
through to consumers in lower prices. But economies of scale also give a business a
competitive advantage in the market-place. They lead to lower prices and higher profits!

The table below shows a simple representation of economies of scale. We make no

distinction between fixed and variable costs in the long run because all factors of
production can be varied. As long as the long run average total cost (LRAC) is
declining, economies of scale are being exploited.

Long Run Output (Units) Total Costs (£s) Long Run Average Cost (£ per unit)

1000 12000 12

2000 20000 10

5000 45000 9

10000 80000 8

20000 144000 7.2

50000 330000 6.6

100000 640000 6.4

500000 3000000 6

375
1
Returns to scale and costs in the long run

The table below shows a numerical example of how changes in the scale of production
can, if increasing returns to scale are exploited, lead to lower long run average costs.

Factor Inputs Production Costs

(K) (La) (L) (Q) (TC) (TC/Q)

Capital Land Labour Output Total Cost Average

Cost

Scale A 5 3 4 100 3256 32.6

Scale B 10 6 8 300 6512 21.7

Scale C 15 9 12 500 9768 19.5

Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

Because the % change in output exceeds the % change in factor inputs used, then,
although total costs rise, the average cost per unit falls as the business expands from scale
A to B to C.

Increasing Returns to Scale

Much of the new thinking in economics focuses on the increasing returns to scale
available to a company growing in size in the long run. If a business can sell more output,
it may become progressively easier to sell even more output and reap the benefits of
large-scale production.

An example of this is the computer software business. The overhead costs of developing
new software programs are huge - often running into hundreds of millions of dollars or
pounds - but the marginal cost of producing additional copies of the product for sale in
the market is close to zero. If a company can establish itself in the market in providing a
piece of software, positive feedback from consumers will expand the customer base,
raise demand and encourage the firm to increase production. Because the marginal cost of
production is so low, the extra output reduces average costs, giving the business the scope
to exploit economies of size. Lower costs normally mean higher profits and increasing
financial returns for the shareholders of a business.

The long run average cost curve

376
1
The LRAC curve or ‘envelope curve’ is drawn on the assumption of their being an
infinite number of plant sizes – hence its smooth appearance. The points of tangency
between LRAC and SRAC curves do not occur at the minimum points of the SRAC
curves except at the point where the minimum efficient scale (MES) is achieved.

If LRAC is falling when output is increasing then the firm is experiencing economies of
scale. For example a doubling of factor inputs in the production process might lead to a
more than doubling of output leading to increasing returns to scale.

Conversely, When LRAC rises, the firm experiences diseconomies of scale, and, If
LRAC is constant, then the firm is experiencing constant returns to scale.

There are many different types of economy of scale. Depending on the characteristics of
an industry or market, some are more important than others.

Internal economies of scale (IEoS)

Internal economies of scale arise from the long term growth of the firm itself.
Examples include:

1. Technical economies of scale: (these relate to aspects of the production process

itself):

a. Expensive capital inputs: Large-scale businesses can afford to invest in

expensive and specialist machinery. For example, a supermarket might
invest in new database technology that improves stock control and reduces
transportation and distribution costs. It may not be cost-efficient for a
small corner shop to buy this technology. We find that highly expensive
fixed units of capital are common in nearly every mass manufacturing
production process – a good example is investment in robotic technology
in producing motor vehicles or in assembling audio-visual equipment.
b. Specialization of the workforce: Within larger firms the production
process can be split into separate tasks to boost productivity.
c. The law of increased dimensions or the “container principle”. This is
linked to the cubic law where doubling the height and width of a tanker or
building leads to a more than proportionate increase in the cubic capacity
– the application of this law opens up the possibility of scale economies in
distribution and transport/freight industries and also in travel and leisure
sectors. Consider the new generation of super-tankers and the
development of enormous passenger aircraft capable of carrying well over
500 passengers on long haul flights. The law of increased dimensions is
also important in the energy sectors and in industries such as office rental
and warehousing.

377
1
 d. Learning by doing: There is growing evidence that industries learn-by-
doing! The average costs of production decline in real terms as a result of
production experience as businesses cut waste and find the most
productive means of producing output on a bigger scale. Evidence across a
wide range of industries into so-called “progress ratios”, or “experience
curves” or “learning curve effects”, indicate that unit manufacturing
costs typically fall by between 70% and 90% with each doubling of
cumulative output. Businesses that expand their scale can achieve
significant learning economies of scale.

1. Marketing economies of scale and monopsony power: A large firm can spread
its advertising and marketing budget over a much greater output and it can also
purchase its factor inputs in bulk at discounted prices if it has monopsony
(buying) power in the market. A good example would be the ability of the
electricity generators to negotiate lower prices when finalizing coal and gas
supply contracts. The national food retailers also have significant monopsony
power when purchasing supplies from farmers and wine growers and in
completing supply contracts from food processing businesses
2. Managerial economies of scale: This is a form of division of labour. For
example, large-scale manufacturers employ specialists to supervise production
systems. And better management; increased investment in human resources and
the use of specialist equipment, such as networked computers can improve
communication, raise productivity and thereby reduce unit costs.
3. Financial economies of scale: Larger firms are usually rated by the financial
markets to be more ‘credit worthy’ and have access to credit facilities with
favourable rates of borrowing. In contrast, smaller firms often face higher rates of
interest on overdrafts and loans. Businesses quoted on the stock market can

378
1
 normally raise fresh money (extra financial capital) more cheaply through the sale
(issue) of equities to the capital market. They are also likely to pay a lower rate of
interest on new company bonds because of a better credit rating.
4. Network economies of scale: (Please note: This type of economy of scale is
linked more to the growth of demand for a product – but it is still worth
understanding and applying.) There is growing interest in the concept of a
network economy of scale. Some networks and services have huge potential for
economies of scale. That is, as they are more widely used (or adopted), they
become more valuable to the business that provides them. We can identify
networks economies in areas such as online auctions and air transport
networks. The marginal cost of adding one more user to the network is close to
zero, but the resulting financial benefits may be huge because each new user to
the network can then interact, trade with all of the existing members or parts of
the network. The rapid expansion of e-commerce is a great example of the
exploitation of network economies of scale. EBay is a classic example of
exploiting network economies of scale as part of its operations.

The container principle at work- an example of an internal economy of scale

Economies of scale – the effects on price, output and profits for a profit maximizing
firm
The next diagram illustrates the effects of economies of scale using cost and revenue
curve analysis.
Note: To understand the following diagram you will need to have covered the profit

379
1
maximising rule for a business where marginal revenue = marginal cost.

External economies of scale (EEoS)

External economies of scale occur outside of a firm but within an industry. Thus, when
an industry's scope of operations expand due to for example the creation of a better
transportation network, resulting in a decrease in cost for a company working within
that industry, external economies of scale have been achieved.

Another example is the development of research and development facilities in local

universities that several businesses in an area can benefit from. Likewise, the relocation
of component suppliers and other support businesses close to the centre of
manufacturing are also an external cost saving.
Agglomeration economies may also result resulting from the clustering of similar
businesses in a distinct geographical location.

Economies of Scale – The Importance of Market Demand

380
1
The market structure of an industry is affected in the long term by the nature and
extent of the economies of scale available to individual suppliers and also by the size of
market demand. In many industries, it is possible for small firms to operate profitably
because the cost disadvantage of them doing so is small. Or because product
differentiation allows a business to charge a price premium to consumers which more
than covers their higher costs.

A good example is the retail market for furniture. The industry has some major players in
each of its different segments (e.g. flat-pack and designer furniture) including the
Swedish giant IKEA and a number of other mass-volume producers. However, much of
the home furniture market remains with smaller-scale suppliers with consumers willing to
pay higher prices for bespoke furniture. One reason is that the price elasticity of demand
for furniture products is more inelastic than at the volume end of the market. Small-scale
furniture manufacturers can exploit the higher level of consumer surplus that is present
when demand is estimated to have a low elasticity.

Economies of scope

Economies of scope occur where it is cheaper to produce a range of products rather

than specialize in just a handful of products. A company’s management structure,
administration systems and marketing departments are capable of carrying out these
functions for more than one product. In the publishing industry for example, there might
be cost savings to a business from using a team of journalists to produce more than one
magazine.

Expanding the product range to exploit the value of existing brands is a good way of
exploiting economies of scope. There are many good examples of this – consider the way
in which Cadbury has rapidly widened the product range associated with Dairy Milk
chocolate bars in recent years.

The minimum efficient scale (MES)

The minimum efficient scale (MES) is best defined as the scale of production where the
internal economies of scale have been fully exploited. The MES corresponds to the
lowest point on the long run average cost curve and is also known as an output range
over which a business achieves productive efficiency. The MES is not a single output
level – more likely we describe the minimum efficient scale as comprising a range of
output levels where the firm achieves constant returns to scale and has reached the
lowest feasible cost per unit in the long run.

381
1
The MES must depend on the nature of costs of production in a particular industry.

1. In industries where the ratio of fixed to variable costs is high, there is scope for
reducing average cost by increasing the scale of output. This is likely to result in a
concentrated market structure (e.g. an oligopoly, or perhaps a monopoly) – indeed
economies of scale may act as an effective barrier to the entry of new firms
because existing firms have achieved cost advantages and they then can force
prices down in the event of new firms coming in!
2. In contrast, there might be only limited opportunities for scale economies such
that the MES turns out to be just a small percentage of market demand. It is likely
that the market will be competitive with many suppliers able to achieve the MES.
3. With a natural monopoly, the long run average cost curve falls over a huge range
of output, there may be room for perhaps only one or two suppliers to fully
exploit the available economies of scale.

Diseconomies of scale

Diseconomies are the result of decreasing returns to scale. The potential diseconomies
of scale a firm may experience relate to:

1. Control – monitoring the productivity and the quality of output from thousands of
employees in big corporations is imperfect and costly – this links to the concept of
the principal-agent problem – how best can managers assess the performance of
their workforce when each of the stakeholders may have a different objective or
motivation which can lead to stakeholder conflict?
2. Co-ordination - it can be difficult to co-ordinate complicated production
processes across several plants in different locations and countries. Achieving
efficient flows of information in large businesses is expensive as is the cost of

382
1
 managing supply contracts with hundreds of suppliers at different points of an
industry’s supply chain.
3. Co-operation - workers in large firms may feel a sense of alienation and
subsequent loss of morale. If they do not consider themselves to be an integral
part of the business, their productivity may fall leading to wastage of factor inputs
and higher costs. Traditionally this has been seen as a problem experienced by
large state sector businesses, examples being the Royal Mail and the Firefighters,
the result being a poor and costly industrial relations performance. However, the
problem is not concentrated solely in such industries. A good recent example of a
bitter dispute was between Gate Gourmet and its workers.

Avoiding diseconomies of scale

A number of economists are skeptical about diseconomies of scale. They believe that
effective management techniques and the appropriate incentives can do much to reduce
the risk of rising long run average costs. Here are three reasons to doubt the persistence
of diseconomies of scale:

1. Developments in human resource management (HRM) are an attempt to avoid

the risks and costs of diseconomies of scale. HRM is a horrible phrase to describe
improvements that a business might make to any of its core procedures involving
worker recruitment, training, promotion, retention and support of faculty and
staff. This becomes critical to a business when the skilled workers it needs are in
short supply. Recruitment and retention of the most productive and effective
employees makes a sizeable difference to corporate performance in the long run
(as does the flexibility to fire those at the opposite extreme!)
2. Likewise, performance-related pay schemes (PRP) can provide appropriate
financial incentives for the workforce leading to an improvement in industrial
relations and higher productivity. Another aim of PRP is for businesses to reward
and hang onto their most efficient workers.
3. Increasingly companies are engaging in out-sourcing of manufacturing and
distribution as they seek to supply to ever-distant markets. Out-sourcing is a tried
and tested way of reducing costs whilst retaining control over production.

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Profits

383
1
We now put costs and revenues together and look at profits. Economists have different
interpretations of what profit is, we look at this together with the roles that profit plays in
a market-based economy.

The meaning of profit and different profit concepts

Profit measures the return to risk when committing scarce resources to a market or
industry. Entrepreneurs take risks for which they require an adequate expected rate of
return. The higher the market risk and the longer they expect to have to wait to earn a
positive return, the greater will be the minimum required return that an entrepreneur is
likely to demand.

1. Normal profit - is defined as the minimum level of profit required to keep the
factors of production in their current use in the long run. Normal profits
reflect the opportunity cost of using funds to finance a business. If you decide to
put £200,000 of your personal savings into a new business, then those funds could
easily have earned a fairly risk-free rate of return by being saved in a bank or
building society deposit account. You might therefore use the rate of interest on
that £200,000 as the minimum rate of return that you need to make from your
business investment in order to keep going in the long run!

Of course we are ignoring here differences in risk and also the non-financial (or non-
pecuniary) benefits of running and building your own business or investing funds in
someone else’s project.
Because we treat normal profit as an opportunity cost of investing financial capital in a
business, we normally include an estimate for normal profit in the average total cost
curve, thus, if the firm covers its ATC (where AR meets AC) then it is making normal
profits.

2. Sub-normal profit - is any profit less than normal profit (where price < average
total cost)
3. Abnormal profit - is any profit achieved in excess of normal profit - also
known as supernormal profit. When firms are making abnormal profits, there is
an incentive for other producers to enter the market to try to acquire some of this
profit. Abnormal profit persists in the long run in imperfectly competitive markets
such as oligopoly and monopoly where firms can successfully block the entry of
new firms. We will come to this later when we consider barriers to entry in
monopoly.

Profits are maximised when marginal revenue = marginal cost

Price Per Unit Demand / Total Marginal Total Marginal Profit

(£) Output Revenue Revenue Cost Cost (£)
(units) (£) (£) (£) (£)

384
1
 50 33 1650 2000 -350

48 39 1872 37 2120 20 -248

46 45 2070 33 2222 17 -152

44 51 2244 29 2312 15 -68

42 57 2394 25 2384 12 10

40 63 2520 21 2444 10 76

38 69 2622 17 2480 6 142

36 75 2700 13 2534 9 166

34 81 2754 9 2612 13 142

Consider the example in the table above. As price per unit (average revenue) declines, so
demand expands. Total revenue rises but at a decreasing rate (as shown by column 4 –
marginal revenue). Initially the firm is making a loss because total cost exceeds total
revenue. The firm moves into profit at an output level of 57 units. Thereafter profit is
increasing because the marginal revenue from selling units is greater than the marginal
cost of producing them. Consider the rise in output from 69 to 75 units. The MR is £13
per unit, whereas the marginal cost is £9 per unit. Profits increase from £142 to £166.

But once marginal cost is greater than marginal revenue, total profits are falling.
Indeed the firm makes a loss if it increases output to 93 units.

385
1
As long as marginal revenue is greater than marginal cost, then total profits will be
increasing (or losses decreasing). The profit maximisation output occurs when marginal
revenue = marginal cost.

In the next diagram we introduce average revenue and average cost curves into the
diagram so that, having found the profit maximising output (where MR=MC) we can then
find (i) the profit maximising price (using the demand curve) and then (ii) the cost per
unit. The difference between price and average cost marks the profit margin per unit of
output.

386
1
Total profit is shown by the shaded area and equals the profit margin multiplied by output

Changes in demand and the profit maximising price and output

A change in demand and/or production costs (supply) will lead to a change in the profit
maximising price and output. In exams you may often be asked to analyse how changes
in demand and costs affect the equilibrium output for a business. Make sure that you are
confident in drawing these diagrams and you can produce them quickly and accurately
under exam conditions.

In the diagram below we see the effects of an outward shift of demand from AR1 to AR2
(assuming that short run costs of production remain unchanged). The increase in demand
causes a rise in the market price from P1 to P2 (consumers are now willing and able to
buy more at a given price perhaps because of a rise in their real incomes or a fall in
interest rates which has increased their purchasing power) and an expansion of supply
(the shift in AR and MR is a signal to firms to move along their marginal cost curve and
raise output). Total profits have increased.

387
1
Roles of profit in a market economy

Profits serve a variety of purposes to businesses in a market-based economic system

 Finance for investment Retained profits remain the most important source of
finance for companies undertaking new capital investment projects. The
alternatives such as issuing new shares (equity) or bonds may not be attractive
depending on the state of the financial markets. It is easier for companies to raise
fresh capital when stock markets are performing strongly or when the demand for
corporate bonds is high (reflected in a high price) and correspondingly, bond
interest rates are low.
 Market entry: Rising profits send signals to other producers within a market.
When the existing firms are earning supernormal profits, this sends a signal that
profitable entry may be possible. In contestable markets, we would see a rise in
market supply and downward pressure on prices. But in a monopoly, the existing
dominant firm(s) may be able to protect their market position in the long run.
 Demand for factor resources: Scarce factor resources tend to flow where the
expected rate of return or profit is highest. In an industry where demand is strong
more land, labour and capital are then committed to that sector. Equally in a
recession, national output, employment, incomes and investment all fall leading to
a squeeze on profit margins and attempts by businesses large and small to cut
costs and preserve their market position. In a flexible labour market, a fall in

388
1
 demand can quickly lead to a reduction in planned investment and cut-backs in
labour demand

Two steps to higher profits!

In an ideal world, running a business would be easy! You come up with an innovative
idea, create a new product or service so popular you can’t stop people from buying it.
Word spreads and, before you know it, sales and profits are growing rapidly. If only. In
reality, few businesses are able to sit back and watch the profits roll in. Creating and
subsequently increasing profitability depends on doing a hundred little things better than
the existing competition. So what are the best ways for a business to increase its
profitability?

Method 1: Grow the “Top Line”

Every business and every market is different. But for most businesses, the best long-term
way to improve profitability is to increase sales (also known as “turnover”). This is for
four main reasons:

o If a business has a high gross profit margin, every extra sale is highly
profitable. Once your turnover reaches the break-even level (i.e. where
price = average cost) then each additional sale adds to profits. Cutting
your prices may reduce profit margins, but the extra sales should still add
to total profits.
o Acquiring new customers is made easier by greater market presence and
reputation. As you grow, unit costs are reduced through economies of
scale.
o If your customers tend to be loyal, the value of each new customer lays
not just in the immediate sale, but in future sales as well. The cost of
selling to existing customers is almost always lower than the cost of
acquiring new customers. Loyal customers also tend to be your best
promotional tool, because they recommend the business via “word-of
mouth”. Behavioural economists have lots to say about this aspect of
business growth. From popular restaurants to emerging technologies, there
is often a tipping point in a market where sales surge partly on the back of
recommendations from satisfied customers.
o Defending a high market share against competitors is easier than
defending high profit margins. Businesses can happily depart from a
narrow profit maximization objective in order to protect their existing
demand.

However, not every business can increase their turnover easily. Many businesses operate
in what are called “low growth” markets - where expansion only comes by taking a
bigger share of the available demand. That usually requires investment in marketing and
possibly increased production capacity. Low growth markets tend to be where the

389
1
income elasticity of demand is low, so that as the real incomes of consumers increase,
there is little positive effect on total market demand.

Method 2: Keep Costs under Control

If a business has a low gross profit margin, reducing direct costs dramatically increases
the profit on each sale. Eliminating unnecessary overheads has an immediate impact on
profit. Every business can increase profitability by reducing hidden costs. Hidden costs
include the costs of employing inappropriate people since poor recruitment can lead to
lower quality, increased training costs and ultimately redundancy costs.

For wider reading on businesses announcements, see BBC news search articles on profits
warnings and BBC news search articles on businesses reporting higher profits.

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Divorce between Ownership & Control

In this chapter we look at the possible divorce between ownership of businesses and those
who make most of the day to day decisions on how that business operates in one or more
markets.

Ownership and control

The owners of a private sector company normally elect a board of directors to control
the business’s resources for them. However, when the owner of a company sells shares,
or takes out a loan or bond to raise finance, they may sacrifice some of their control.
Other shareholders can exercise their voting rights, and providers of loans often have
some control (security) over the assets of the business. This may lead to conflict between
them as these different stakeholders may have different objectives. The flow chart
below attempts to show the possible divorce between ownership and control.

390
1
The Principal Agent Problem

How do the owners of a large business know that the managers they have employed and
who are making the key day-to-day decisions operate with the aim of maximising
shareholder value in both the short term and the long run?

This lack of information is known as the principal-agent problem. In other words, one
person, the principal, employs an agent (e.g. a sales or finance manager) to perform tasks
on his behalf but he or she cannot ensure that the agent always performs them in precisely
the way the principal would like. The decisions and the performance of the agent are both
impossible and expensive to monitor and the incentives of the agent may differ from
those of the principal. The principal agent problem is illustrated in the flow chart above.

Examples of the principal-agent problem that have hit the headlines recently in the UK
include the mis-management of financial assets on behalf of investors (e.g. the case
surrounding Equitable Life) and the management of companies on behalf of shareholders
(e.g. during the turbulent years experienced by Marks and Spencer and Shell). The classic
case in the United States is of course the Enron fraud and debacle. Follow this BBC news
link for more background on the Enron case.

Incentives Matter! - Employee Share Ownership Schemes

There are various strategies available for coping with the principle- agent problem. One is
the rapid expansion of employee share-ownership schemes and share-options

391
1
programmes. The government has encouraged the wider use of share-ownership
schemes through a series of tax incentives. But the use and occasional misuse of share
options schemes has been controversial for several years. A recent example involved the
US computer giant Apple.

The growth of "shareholder activism"

Many commentators are now questioning the assumption that shareholders play little
direct role in influencing corporate strategy in modern corporations. There are plenty of
examples in recent times when both institutional and individual shareholders have
exercised their voting rights to express views on the direction that a company is taking or
its performance. Typically they are critical of a perceived failure of a business to
maximise shareholder value measured in terms of share price, the flow of dividend
incomes etc.

An activist shareholder uses an equity stake in a business to put public pressure on its
management. The rapid expansion of hedge funds who take equity stakes in many
businesses has cemented the idea of shareholder activism. Many hedge funds take
minority equity stakes and then try to get the existing management to divest poorly
performing or unprofitable parts of a business and focus instead on core activities.

That said it remains the case that the general pattern of ownership and control within
British industry is relatively dispersed. Typically the largest shareholder in any large
business listed on the stock market is likely to own a voting minority of the shares.
Majority ownership by a single shareholder is unusual. The usual presumption from this
is that only the very largest shareholders have any incentive to participate in corporate
decision making and few shareholders have any real voting power.

Examples of recent shareholder activism

Sainsbury's: In 2004, a third of J Sainsbury's shareholders voted against the
supermarket's pay policy, objecting to its decision to give a £2.3m bonus to ousted
chairman Sir Peter Davis. Sainsbury's subsequently decided to cancel the controversial
pay award. Sir Peter Davis quit Sainsbury's after a group of major institutional
shareholders demanded management changes. He was replaced by Justin King.
Disney: In 2004, Michael Eisner, the chairman and chief executive of Disney, resigned
after 43% of Disney shareholders voted against his re-election.
Euro Tunnel: In 2004, the management board of EuroTunnel was ousted at the
company's AGM. Private French shareholders were encouraged to protest by share tipster
Nicolas Miguet and French campaign group, ADACTE because of the huge loss of share
value and the assertion that the company could be turned around by a new board.
EuroTunnel has continued to experience heavy losses and in July 2006 it filed for
bankruptcy protection.
Vodafone: In May of 2006, Vodafone announced the biggest loss in British corporate
history (£14.9 billion). Vodafone reported one-off costs of £23.5 billion due to the
revaluation of their Mannesmann subsidiary. In July 2006, the CEO of Vodafone Arun

392
1
Sarin came under huge pressure from a group of shareholders unhappy about the
performance of the struggling telecoms company.

Corporate Social Responsibility and Business Ethics

Business ethics is concerned with the social responsibility of management towards the
firm’s major stakeholders, the environment and society in general. There is a growing
belief that ethical and ‘green’ business are linked to improved business performance over
time because of increased public concern for human rights and the world environment.
Many businesses are now trumpeting their progress in making their activities carbon
neutral for example by offsetting the impact of their production activities on their
environment through offset activities. Businesses such as Carbon Clear provide a means
by which organisations can find ways to offset their carbon emissions.

Business ethics extends to treating all stakeholders ‘fairly’; hence the growing emphasis
on health and safety issues, good working practices and the like in business decision-
making.

For more reading on this try this link to the Institute for Business Ethics. The Times 100
Case Studies includes one on Cadbury’s and corporate social responsibility. Click here
for BBC news articles on carbon neutrality.

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Growth of Firms

In this note we consider the different ways in which businesses can grow. We consider in
particular the difference between organic and external growth.

Motivations for the growth of businesses

The following factors are commonly associated with the desire of firms to grow:

1. The profit motive: Larger scale enterprises grow to expand output and achieve a
higher level of profit. The stimulus to achieve year-on-year growth is often
provided by the demands and expectations placed on a business by the capital
(stock) markets. The stock market valuation of a firm is heavily influenced by
expectations of future sales and profit streams so if a company achieves
disappointing growth figures, this might be reflected in a fall in a company’s

393
1
 market capitalisation. Falling share prices increases the risk of a hostile take-
over and also makes it harder and more expensive for a quoted company to raise
fresh financial capital by issuing new shares onto the market.
2. The cost motive: Economies of scale have the effect of increasing the productive
capacity of the business and they help to raise profit margins. They also give a
business a competitive edge in domestic and international markets.

1. The market power motive: Firms may wish to grow to increase their market
dominance thereby giving them increased pricing power in specific markets.
Monopolies for example can engage in price discrimination.
2. The risk motive: The expansion of a business might be motivated by a desire to
diversify production and sales so that falling sales in one market might be
compensated by healthier demand and output in another market.
3. Managerial motives: Behavioural theories of the firm predict that the growth of a
business is often spurred on by the decisions and strategies of managers employed
by a firm whose objectives might be different from those with an equity stake in
the business.

Organic and external growth of a business

Organic growth

Case Study: Growing a business organically – Caffe Nero

Caffe Nero, which began with five stores in 1997, is the third-largest coffee bar chain in
the country behind Whitbread-owned Costa Coffee and Starbucks. The business has
based its strategy on a programme of opening new stores on a regular basis. Each year a
number of new stores are opened and some are closed, but the net number of new stores
is positive. Caffe Nero now generates sufficient cash to fund an opening programme of
40 - 50 stores without recourse to external funding such as fresh bank loans or the issue
of corporate bonds. Caffe Nero is the third-largest UK branded coffee bar chain, as
measured by outlet numbers. It now trades from 230 bars and is expanding at a rate of
close to 40 new bars a year. The performance of the business is impressive: Turnover has
risen from £26.6m in 2002 to £70.1m in 2005. The business generates a strong cash flow
and high operating profit which in turn allows it to finance the opening of new stores
without having to borrow money. Caffe Nero is achieving like for like sales growth faster
than its major competitors in the market and it serves over 750,000 ABC1 customers
every week, and has a strong brand reputation in highly competitive market place.

Allegra Consumer Report 2005 - Major Coffee Brands

Service
Rank Coffee QualityAtmosphere Food Quality Price/Value
Quality

1. Caffe Nero Caffe Nero Caffe Nero Caffe Nero Caffe Nero

394
1
2. Costa Coffee Starbucks Starbucks Starbucks Costa Coffee

3. Starbucks Costa Coffee Costa Coffee Costa Coffee Starbucks

External growth of a business

How does a firm establish and then protect a monopoly position? The fastest route to take
an increasing share of a market is through integration i.e. through mergers or contested
take-overs.

o Horizontal integration: Horizontal integration occurs when two businesses in

the same industry at the same stage of production become one – for example a
merger between two car manufacturers or drinks suppliers. The contested bid for
Safeway by Morrisons and other leading retailers is another example of the
process of horizontal integration.
o Vertical integration: Vertical Integration involves acquiring a business in the
same industry but at different stages of the supply chain – for example an oil
company that owns drilling and extraction businesses together with refining,
distribution and retail subsidiaries.

Monopoly power also comes from owning patents and copyright protection or the
exclusive ownership of productive assets (e.g. De Beers – diamonds). Monopoly power
can also come from winning bidding races for exclusive agreements – the best example
of which is probably the monopoly on broadcasting live soccer games on TV owned by
BSkyB as a result of winning auctions organised by the Premier League.

The government and its agencies may also give legal monopoly power to some business
through franchises and licences. Monopoly power can of course come organically
through internal growth where a firm takes advantage of economies of scale.

External growth – joint ventures

Tesco expands into China

Tesco plans to become the first British supermarket group to enter the booming Chinese
food retail market. It has announced a £140 million deal that could transform the
company into the world’s biggest grocer. Tesco is buying a 50 per cent stake in the 25-
strong Hymall hypermarket chain from Ting Hsing, the biggest food producer in China.
The deal gives Tesco the opportunity to take on the likes of Wal-Mart and Carrefour, the
world’s two biggest retailers, which already have a presence in the communist state. The
deal makes Tesco the latest in a long line of British companies — including Emap,
Kingfisher, Prudential and WPP — to seek business opportunities in China where
economic growth has averaged nearly ten per cent per annum in recent years. According

395
1
to Tesco, “China is one of the largest economies in the world with tremendous forecast
growth"
Suggestions for further reading:
Tesco investor relations
Articles on Tesco on BBC news online

Outsourcing

The tendency of companies to outsource some of their production operations overseas has
become an important issue in recent years. Over 30% of UK companies now do some of
their production work abroad, whilst 10% have over half of their manufacturing offshore
in lower cost locations. Dyson is a high profile example of a company that has relocated
production abroad to Malaysia, whilst keeping their research and design operations in the
UK. Most recently we are witnessing an accelerated trend for service sector businesses to
follow suit. In recent times we have seen Norwich Union, Abbey National, Tesco, British
Airways and National Rail Enquiries all transfer significant parts of their operation
overseas.

There are three main drivers promoting outsourcing as a business strategy:

1. Technological change – Information, communication and telecommunication

costs are falling - this makes it much easier to outsource both service and
manufacturing operations to sub-contractors in other countries. Technological
advances now promote "Just in time delivery" inventory strategies for the
delivery of components and finished products and encourage the development of
"virtual manufacturing". Communication costs are dropping sharply - the average
price of a one minute international call was 74% lower in 2003 than in 1993
2. Increased competition in a low-inflation environment - which increases the
pressure on businesses to achieve lower unit costs as a means of maintaining
market share
3. Pressure from the financial markets for businesses to improve their profitability

For many large businesses, there are clear cost advantages to be gained through doing
business via a call centre located overseas. Call centre staff in India can expect an
equivalent salary of around £1200 and with that comes the status of a junior doctor or a
lawyer. Services are increasingly footloose. The Sunday Times has recently speculated
that up to 200,000 UK service sector jobs could be lost within the next five years. First
mover advantages are being recognised (i.e. there are advantages in re-locating first) and
a snowballing effect is now in evidence.

Offshore relocation makes sense when it is part of a strategy for growth that protects the
long term interests of the business. If it is merely a cost cutting reaction to competition
then it is a survival strategy.

Outsourcing is not simply confined to service sector industries. Many manufacturing

businesses are using outsourcing as a means of reducing their costs, providing greater

396
1
flexibility of production levels at times of volatile demand and also in speeding up the
time it takes to get their goods to market, especially new products. The Dutch telecoms
business Philips has outsourced much of its handset production to a joint venture which
the Dutch electronics company has in China. Finland’s Nokia, the world’s largest cell
phone maker now outsources 20% of its handset production. And its Swedish rival,
Ericsson, has transferred all of its mobile-phone production to a contractor in Singapore.
Many of the major personal computer businesses such as HP-Compaq, Dell and IBM
outsource PC production.

One of the longer term benefits of sub-contracting manufacturing to other companies is

that a business can then concentrate on marketing their products and investing in
research and development to develop new products through product innovation. The
contractors engaged in manufacturing can also gear themselves up to exploit much
greater technical economies of scale because they make similar products for other
customers, and can order components in larger numbers to achieve some financial scale
economies. There are though some risks involved. Businesses need to be confident that
their contractors can guarantee to meet required production levels.

The survival of smaller businesses in the economy

Over time there is a clear trend towards larger scale business operations partly because of
the pressures of competition; the need to achieve economies of scale and the effects of
mergers and takeovers across many industries. However the process towards big business
size is not purely a one-way street. There are plenty of examples where businesses are de-
merging and divesting themselves of some of their existing assets. And even in industries
where giant businesses dominate the market place, there is frequently room for smaller
firms to compete and survive profitably.

Why do small businesses continue to thrive despite the prevalence of economies of scale
and multinational businesses in many markets and industries?
It is incontestable that nowadays, firms that operate on a large scale and can thereby
maximise the potential of economies of scale and scope. However, economic realities
also mean that amidst the big firms there are small businesses competing in the same
markets and industries. The most striking evidence of this is the fact that there are no
pure monopolies in the world today. This is mainly due to do with the fact that there is
no market where a firm can achieve a minimum efficient scale that meets 100% of its
demands. Therefore, firms that are profit or revenue maximising, or even “satisficing”,
would not even consider trying to create a monopoly position for themselves: it would
simply be too expensive when one considers the diseconomies of scale that would result.

Take the petroleum industry: even if Royal Dutch-Shell or Chevron or BP were operating
at maximum efficiency, with the lowest possible long run average costs, that output
would only meet 15% of the market’s demand for petrol. If any one of these companies
tried to expand output to try and take a greater market share, costs would begin to
increase as the firm encounters diseconomies of scale. This would be unacceptable to

397
1
shareholders as they began to see profits, and perhaps even revenues begin to drop as
collateral of an attempt to dominate the market.

The most striking was to illustrate this point is to look at Japan. Businesses in Japan
focus on market share rather than revenues or profits. They are willing to sustain huge
losses in the short term in order to gain a market share that will create greater profits in
the long run. It is no coincidence that Japanese business is dominated by six or seven
keiretsu, super-corporations like Mitsubishi that have dealings in almost every industry.
This status quo seems bizarre to those of us from Western economies focussed on the
bottom line. I believe that the reason that small firms can survive in even the most
competitive markets because they are allowed to. While it is nigh on impossible to
compete with the keiretsu in Japan, even the biggest US corporations are limited by our
business mentality, and while some lambaste the mercantile attitude of these firms, it is
what makes a diverse market possible.

It is worth further analysing exactly why it would be prohibitively expensive for larger
corporations to squeeze smaller businesses out of the market in an effort to dominate it.
Take the supermarket sector: in Britain at the moment there exists an oligopoly
dominated by Tesco. Indeed there are worries that Tesco is on the road to having an
unfair handle on the market. However, as well as intervention by the government, the
market will not allow Tesco to become the only retailer of food (and certainly not the
only retailer of insurance or financial services). Despite its attempts to become all things
to all people (“Waitrose quality at Asda prices” as one advertising campaign puts it), it
will simply not be able to corner every market: the cost of establishing a Tesco store
wherever there are customers is not feasible.

One cannot ignore the impact of specialisation and quality. While firms that exploit
economies of scale and can become major players in an industry as a whole, there is
always room for countless small firms to find a niche in which they can perform better
than any other firm, including the biggest ones. A great example of this is in the financial
services industry. There are several large players – Citigroup, AIG, Bank of America,
HSBC, Merrill Lynch and JP Morgan to name a few) – however there also exist myriad
small businesses that have a niche (often very obscure) in which they can perform better
than anyone else. Two examples would be a political risk insurance broker for
investments in emerging markets or a hedge fund specialising in increasing shareholder
value through managerial restructuring. Both of these are highly specialised fields, where
it just isn’t worth it for the larger firms to establish themselves.

The continued survival of small firms in markets where large firms might dominate is
caused by the structure of the market itself (i.e. the fall in performance associated with
expanding production due to economies of scale) and factors such as such as demand for
specialised or high-quality product, that can not necessarily be answered by large firms
capable of exploiting economies of scale.

Source: Max Dewez, November 2005

398
1
The growth of firms – the importance of the brand
Google is challenging Coca-Cola and Microsoft for global fame after becoming the
fastest growing brand in the world, only eight years after it was set up in a California
garage Google now outranks Sony, MTV and Reuters in terms of worldwide renown,
according to Interbrand, the brand consultancy. The $117bn (£63bn) business is ranked
24th by Interbrand, one year after it first entered the top 100 of the annual brand survey.
According to the survey, Google's brand is worth $12.4bn to the company - a
considerable achievement for a business that rarely advertises on TV, radio or billboards.
Conventional brand-building wisdom states that selling a product to an entire country, let
alone the world, requires considerable investment in advertising campaigns, sponsorship
and public relations. Google appears to have dodged the old axiom about advertising -
50% of it is wasted, but no one knows which 50% - by not bothering to advertise at all
and relying on the global span of the internet to spread the Google word. Coca-Cola holds
on to number one with a brand value five times larger than Google's and its closest rival,
Pepsi
Adapted from the Guardian, July 2006 and from the Inter-Brand web site

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Dynamics of Competition and Competitive Market Processes

It is wrong to assume that competition is good and monopoly power is bad. The reality is
much more complex than this as we shall see when we analyse and evaluate imperfectly
competitive markets where existing firms have genuine market power in setting prices for
consumers.
However there does appear to be a consensus that increasing the amount of competition
in a market can bring about positive side-effects not only for consumers but also for
society as a whole. In this section we consider briefly some of the effects of competition
within a market – and we return to it when we consider the nature and consequences of
contestable markets.

Adam Smith on Competition

“The natural price or the price of free competition ... is the lowest which can be taken. [It]
is the lowest which the sellers can commonly afford to take, and at the same time
continue their business.”
Adam Smith, the Wealth of Nations (1776), Book I, Note VII

The common characteristics of markets that are considered to be “competitive” are:

399
1
  Lower prices because of the large number of competing firms. Suppliers face
elastic demand curves and any rise in price will lead to a fall in demand and in
total revenue. The cross-price elasticity of demand for one product with respect to
a change in the price of another will be high suggesting that consumers are
prepared to switch their demand to the most competitively priced products in the
market-place.
 Low barriers to entry – new firms will find it relatively easy to enter markets if
they feel there is abnormal profit to be made. The entry of new firms provides
competition and ensures prices are kept low in the long run.
 Lower total profits and lower profit margins than in markets which dominated
by a few firms.
 Greater entrepreneurial activity – the Austrian school of economics argues that
true competition is a process rather than a static condition. For competition to be
improved and sustained there needs to be a genuine desire on behalf of
entrepreneurs to engage in competitive behaviour, to innovate and to invent to
drive markets forward and create what Joseph Schumpeter famously called the
“gales of creative destruction”.
 Economic efficiency – competition will ensure that firms attempt to minimise
their costs and move towards productive efficiency. The threat of competition
should lead to a faster rate of technological diffusion, as firms have to be
particularly responsive to the changing needs of consumers. This is known as
dynamic efficiency.

The UK government has a firm commitment to competition as part of its competition

policy agenda. In a detailed research document on the static and dynamic gains from
increasing the contestability of UK markets publishes in 2004, the Department for Trade
and Industry came out firmly in favour of a pro-competition policy regime. This short
quote provides a flavour of their arguments.

The gains from greater competition

“Competition is a process, in which the long-run and short-run may look very different,
and in which firms use a variety of weapons – not just price – with which to compete.
Innovation, product design and variety are often important parts of the competitive game
between firms”
Source: DTI report on competition in UK markets, July 2004

The importance of non-price competition

In competitive markets which are not perfectly competitive, frequently it is the

effectiveness of non-price competition which is crucial in winning sales and protecting or
enhancing market share.

Panini Peddlers, Baps, Baguettes and Bagels - Product Differentiation in the

Sandwich Market
According to the British sandwich industry, approximately 1.8 billion sandwiches are
purchased outside the home each year and the retail sandwich market is worth

400
1
approximately £3.5 billion, over three times the value of the pizza market for example.
About a million consumers buy sandwiches five days a week. The industry employs over
300,000 people and if the latest consumer profiles are to be believed, the most likely
person in front of you in the queue for a bap, wrap or baguette is likely to be male,
between 25-44 years old and also in a rush – our average lunch break is now less than
thirty minutes! From our largest supermarkets to the smallest corner shop; from dedicated
sandwich makers who deliver direct to offices to coffee shops and independent sandwich
bars, from petrol stations to pubs and local and national chains of bakers, the many
competing suppliers in the industry are fighting a daily battle for sales, revenue and
market share.
Differentiating the product
Here are some of the ways in which the humble sandwich can be made distinct against its
competitors in the market-place:

 Hot and cold sandwiches

 Different styles – e.g. a bap, baguette, wraps and filled bagels
 Speciality breads such as focaccia and ciabatta
 Product range - including
 Organic ingredients
 Healthy options (e.g. non-mayo)
 Packaging and branding
 Quality of ingredients
 Different fillings
 Made to order in the store / off the shelf / home or work delivery of sandwiches
 Finest range / value sandwiches

Price matters in the market but not perhaps to the degree that people expect. According to
research from food analysts Winship, “UK sandwich consumers are not always driven by
price and they are more concerned with perceived value for money and will pay more for
a product they believe delivers that rather than shop around for cheaper offerings.”

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Price Discrimination

Most businesses charge different prices to different groups of consumers for what is more
or less the same good or service! This is price discrimination and it has become
widespread in nearly every market. This note looks at variations of price discrimination
and evaluates who gains and who loses?

401
1
What is price discrimination?

Price discrimination or yield management occurs when a firm charges a different

price to different groups of consumers for an identical good or service, for reasons not
associated with costs.

It is important to stress that charging different prices for similar goods is not pure price
discrimination.

We must be careful to distinguish between price discrimination and product

differentiation – differentiation of the product gives the supplier greater control over
price and the potential to charge consumers a premium price because of actual or
perceived differences in the quality / performance of a good or service.

Conditions necessary for price discrimination to work

Essentially there are two main conditions required for discriminatory pricing

o Differences in price elasticity of demand between markets: There must be a

different price elasticity of demand from each group of consumers. The firm is
then able to charge a higher price to the group with a more price inelastic demand
and a relatively lower price to the group with a more elastic demand. By adopting
such a strategy, the firm can increase its total revenue and profits (i.e. achieve a
higher level of producer surplus). To profit maximise, the firm will seek to set
marginal revenue = to marginal cost in each separate (segmented) market.
o Barriers to prevent consumers switching from one supplier to another: The
firm must be able to prevent “market seepage” or “consumer switching” –
defined as a process whereby consumers who have purchased a good or service at
a lower price are able to re-sell it to those consumers who would have normally
paid the expensive price. This can be done in a number of ways, – and is probably
easier to achieve with the provision of a unique service such as a haircut rather
than with the exchange of tangible goods. Seepage might be prevented by selling
a product to consumers at unique and different points in time – for example with
the use of time specific airline tickets that cannot be resold under any
circumstances.

Examples of price discrimination

Price discrimination is an extremely common type of pricing strategy operated by

virtually every business with some discretionary pricing power. It is a classic part of price
competition between firms seeking a market advantage or to protect an established
market position.

(a) Perfect Price Discrimination – charging whatever the market will bear
Sometimes known as optimal pricing, with perfect price discrimination, the firm
separates the whole market into each individual consumer and charges them the price

402
1
they are willing and able to pay. If successful, the firm can extract all consumer surplus
that lies beneath the demand curve and turn it into extra producer revenue (or producer
surplus). This is impossible to achieve unless the firm knows every consumer’s
preferences and, as a result, is unlikely to occur in the real world. The transactions costs
involved in finding out through market research what each buyer is prepared to pay is the
main block or barrier to a businesses engaging in this form of price discrimination.

If the monopolist is able to perfectly segment the market, then the average revenue
curve effectively becomes the marginal revenue curve for the firm. The monopolist will
continue to see extra units as long as the extra revenue exceeds the marginal cost of
production.

The reality is that, although optimal pricing can and does take place in the real world,
most suppliers and consumers prefer to work with price lists and price menus from
which trade can take place rather than having to negotiate a price for each unit of a
product bought and sold.

Second Degree Price Discrimination

This type of price discrimination involves businesses selling off packages of a product
deemed to be surplus capacity at lower prices than the previously published/advertised
price.

Examples of this can often be found in the hotel and airline industries where spare rooms
and seats are sold on a last minute standby basis. In these types of industry, the fixed
costs of production are high. At the same time the marginal or variable costs are small
and predictable. If there are unsold airline tickets or hotel rooms, it is often in the
businesses best interest to offload any spare capacity at a discount prices, always
providing that the cheaper price that adds to revenue at least covers the marginal cost of
each unit.

There is nearly always some supplementary profit to be made from this strategy. And, it
can also be an effective way of securing additional market share within an oligopoly as
the main suppliers’ battle for market dominance. Firms may be quite happy to accept a
smaller profit margin if it means that they manage to steal an advantage on their rival
firms.

The expansion of e-commerce by both well established businesses and new entrants to
online retailing has seen a further growth in second degree price discrimination.

Early-bird discounts – extra cash-flow

The low cost airlines follow a different pricing strategy to the one outlined above.
Customers booking early with carriers such as EasyJet will normally find lower prices if
they are prepared to commit themselves to a flight by booking early. This gives the
airline the advantage of knowing how full their flights are likely to be and a source of

403
1
cash-flow in the weeks and months prior to the service being provided. Closer to the date
and time of the scheduled service, the price rises, on the simple justification that
consumer’s demand for a flight becomes more inelastic the nearer to the time of the
service. People who book late often regard travel to their intended destination as a
necessity and they are therefore likely to be willing and able to pay a much higher price
very close to departure.

Airlines call this price discrimination yield management – but despite the fancy name, at
the heart of this pricing strategy is the simple but important concept – price elasticity of
demand!

The airlines have become masters at price discrimination as a means of maximising

revenue from passengers travelling on the flight networks. Other transport businesses do
the same!

Peak and Off-Peak Pricing

Peak and off-peak pricing and is common in the telecommunications industry, leisure
retailing and in the travel sector. Telephone and electricity companies separate markets
by time: There are three rates for telephone calls: a daytime peak rate, and an off peak
evening rate and a cheaper weekend rate. Electricity suppliers also offer cheaper off-peak
electricity during the night.

At off-peak times, there is plenty of spare capacity and marginal costs of production
are low (the supply curve is elastic) whereas at peak times when demand is high, we
expect that short run supply becomes relatively inelastic as the supplier reaches capacity
constraints. A combination of higher demand and rising costs forces up the profit
maximising price.

404
1
Third Degree (Multi-Market) Price Discrimination

This is the most frequently found form of price discrimination and involves charging
different prices for the same product in different segments of the market. The key is
that third degree discrimination is linked directly to consumers’ willingness and ability
to pay for a good or service. It means that the prices charged may bear little or no
relation to the cost of production.

The market is usually separated in two ways: by time or by geography. For example,
exporters may charge a higher price in overseas markets if demand is estimated to be
more inelastic than it is in home markets.

MC=AC

405
1
Suppose that a firm has separated a market by time into a peak market with inelastic
demand, and an off-peak market with elastic demand. The demand and marginal revenue
curves for the peak market and off peak markets are labelled A and B respectively. This
is illustrated in the diagram above. Assuming a constant marginal cost for supplying to
each group of consumers, the firm aims to charge a profit maximising price to each
group.

In the peak market the firm will produce where MRa = MC and charge price Pa, and in
the off-peak market the firm will produce where MRb = MC and charge price Pb.
Consumers with an inelastic demand for the product will pay a higher price (Pa) than
those with an elastic demand who will be charged Pb.

The internet and price discrimination

A number of recent research papers have argued that the rapid expansion of e-commerce
using the internet is giving manufacturers unprecedented opportunities to experiment
with different forms of price discrimination. Consumers on the net often provide
suppliers with a huge amount of information about themselves and their buying habits
that then give sellers scope for discriminatory pricing. For example Dell Computer
charges different prices for the same computer on its web pages, depending on whether
the buyer is a state or local government, or a small business.

Two Part Pricing Tariffs

406
1
Another pricing policy common to industries with pricing power is to set a two-part tariff
for consumers. A fixed fee is charged (often with the justification of it contributing to the
fixed costs of supply) and then a supplementary “variable” charge based on the
number of units consumed. There are plenty of examples of this including taxi fares,
amusement park entrance charges and the fixed charges set by the utilities (gas, water
and electricity). Price discrimination can come from varying the fixed charge to different
segments of the market and in varying the charges on marginal units consumed (e.g.
discrimination by time).

Peak time pricing – a common feature of many local transport markets

Product-line pricing

Product line pricing is also becoming an increasingly common feature of many markets,
particularly manufactured products where there are many closely connected
complementary products that consumers may be enticed to buy. It is frequently
observed that a producer may manufacture many related products. They may choose to
charge one low price for the core product (accepting a lower mark-up or profit on cost) as
a means of attracting customers to the components / accessories that have a much higher
mark-up or profit margin.

407
1
 Manufacturers charge low prices for the razors but high prices for the razor blades – a
good example of product line pricing

Good examples include manufacturers of cars, cameras, razors and games consoles.
Indeed discriminatory pricing techniques may take the form of offering the core product
as a “loss-leader” (i.e. priced below average cost) to induce consumers to then buy the
complementary products once they have been “captured”. Consider the cost of computer
games consoles or Mach3 Razors contrasted with the prices of the games software and
the replacement blades!

The Consequences of Price Discrimination - Welfare and Efficiency Arguments

To what extent does price discrimination help to achieve a more efficient allocation of
resources? There are arguments on both sides of the coin – indeed the impact of price
discrimination on welfare seems bound to be ambiguous.

The impact on consumer welfare

Consumer surplus is reduced in most cases - representing a loss of consumer welfare.

For the majority of consumers, the price charged is significantly above marginal cost of
production. Those consumers in segments of the market where demand is inelastic
would probably prefer a return to uniform pricing by firms with monopoly power! Their
welfare is reduced and monopoly pricing power is being exploited.

However some consumers who can buy the product at a lower price may benefit.
Previously they may have been excluded from consuming it. Low-income consumers
may be “priced into the market” if the supplier is willing and able to charge them a
lower price. Good examples to use here might include legal and medical services where
charges are dependent on income levels. Greater access to these services may yield
external benefits (positive externalities) which then have implications for the overall
level of social welfare and the equity with which scarce resources are allocated.

408
1
Producer surplus and the use of profit

Price discrimination is clearly in the interests of businesses who achieve higher profits. A
discriminating monopoly is extracting consumer surplus and turning it into extra
supernormal profit. Of course businesses may not be driven solely by the aim of
maximising profit. A company will maximise its revenues if it can extract from each
customer the maximum amount that person is willing to pay.

Price discrimination also might be used as a predatory pricing tactic – i.e. setting prices
below cost to certain customers in order to harm competition at the supplier’s level and
thereby increase a firm’s market power. This type of anti-competitive practice is
difficult to prove, but would certainly come under the scrutiny of the UK and European
Union competition authorities.

A converse argument to this is that price discrimination may be a way of making a

market more contestable in the long run. The low cost airlines have been hugely
successful partly on the back of extensive use of price discrimination among consumers.

The profits made in one market may allow firms to cross-subsidise loss-making
activities/services that have important social benefits. For example profits made on
commuter rail or bus services may allow transport companies to support loss making
rural or night-time services. Without the ability to price discriminate these services may
have to be with drawn and employment might suffer. In many cases, aggressive price
discrimination is seen as inimical to business survival during a recession or sudden
market downturn.

An increase in total output resulting from selling extra units at a lower price might help a
monopoly supplier to exploit economies of scale thereby reducing long run average
costs.

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Oligopoly - Overview

We now move away from the fairly straightforward world of perfect competition and
monopoly into the complex and uncertain world of oligopoly and duopoly. We find that
many market structures tend towards being an oligopoly as time progresses. They are
frequently fascinating markets to look at!

409
1
An oligopoly is a market dominated by a few producers, each of which has control over
the market. It is an industry where there is a high level of market concentration.
However, oligopoly is best defined by the conduct (or behaviour) of firms within a
market rather than its market structure.

The concentration ratio measures the extent to which a market or industry is dominated
by a few leading firms. Normally an oligopoly exists when the top five firms in the
market account for more than 60% of total market demand/sales.

Characteristics of an oligopoly

There is no single theory of how firms determine price and output under conditions of
oligopoly. If a price war breaks out, oligopolists will produce and price much as a
perfectly competitive industry would; at other times they act like a pure monopoly. But
an oligopoly usually exhibits the following features:

1. Product branding: Each firm in the market is selling a branded (differentiated)

product
2. Entry barriers: Significant entry barriers into the market prevent the dilution of
competition in the long run which maintains supernormal profits for the dominant
firms. It is perfectly possible for many smaller firms to operate on the periphery
of an oligopolistic market, but none of them is large enough to have any
significant effect on market prices and output
3. Interdependent decision-making: Interdependence means that firms must take
into account likely reactions of their rivals to any change in price, output or forms
of non-price competition. In perfect competition and monopoly, the producers did
not have to consider a rival’s response when choosing output and price.
4. Non-price competition: Non-price competition s a consistent feature of the
competitive strategies of oligopolistic firms. Examples of non-price competition
includes:

a. Free deliveries and installation

b. Extended warranties for consumers and credit facilities
c. Longer opening hours (e.g. supermarkets and petrol stations)
d. Branding of products and heavy spending on advertising and marketing
e. Extensive after-sales service
f. Expanding into new markets + diversification of the product range

The kinked demand curve model of oligopoly

The kinked demand curve model developed first by the economist Paul Sweezy assumes
that a business might face a dual demand curve for its product based on the likely
reactions of other firms in the market to a change in its price or another variable. The
common assumption of the theory is that firms in an oligopoly are looking to protect and
maintain their market share and that rival firms are unlikely to match another’s

410
1
price increase but may match a price fall. I.e. rival firms within an oligopoly react
asymmetrically to a change in the price of another firm.

If a business raises price and others leave their prices constant, then we can expect quite a
large substitution effect away from this firm making demand relatively price elastic.
The business would then lose market share and expect to see a fall in its total revenue.

If a business reduces price but other firms follow suit, the relative price change is much
smaller and demand would be inelastic in respect of the price change. Cutting prices
when demand is inelastic also leads to a fall in total revenue with little or no effect on
market share.

The kinked demand curve model therefore makes a prediction that a business might
reach a stable profit-maximising equilibrium at price P1 and output Q1 and have
little incentive to alter prices.

The kinked demand curve model predicts periods of relative price stability under an
oligopoly with businesses focusing on non-price competition as a means of reinforcing
their market position and increasing their supernormal profits.

Short-lived price wars between rival firms can still happen under the kinked demand
curve model. During a price war, firms in the market are seeking to snatch a short term
advantage and win over some extra market share.

411
1
There is limited evidence for the kinked demand curve model. The theory can be
criticised for not explaining why firms start out at the equilibrium price and quantity. But
it is one model of how firms in an oligopoly might behave if they have to consider the
likely responses of their rivals.

The importance of non-price competition under oligopoly

Non-price competition assumes increased importance in oligopolistic markets. Non-price

competition involves advertising and marketing strategies to increase demand and
develop brand loyalty among consumers. Businesses will use other policies to increase
market share:

1. Better quality of service including guaranteed delivery times for consumers and
low-cost servicing agreements
2. Longer opening hours for retailers, 24 hour telephone and online customer
support
3. Extended warranties on new products
4. Discounts on product upgrades when they become available in the market
5. Contractual relationships with suppliers - for example the system of tied
houses for pubs and contractual agreements with franchises (exclusive
distribution agreements)

412
1
Advertising spending runs in millions of pounds for many firms. Some simply apply a
profit maximising rule to their marketing strategies. A promotional campaign is profitable
if the marginal benefit (or revenue) from any extra sales exceeds the cost of the
advertising campaign and marginal costs of producing an increase in output. However, it
is not always easy to measure accurately the incremental sales arising from a specific
advertising campaign. Other businesses see advertising simply as a way of increasing
sales revenue. If persuasive advertising leads to an outward shift in demand, consumers
are willing to pay more for each unit consumed. This increases the potential consumer
surplus that a business might extract.

Relatively high spending on marketing is important for new business start-ups (consider
the huge and often extravagant sums spent on marketing by the emerging dot-coms
during the internet mania of the late 1990s and into 2000) and also by firms trying to
break into an existing market where there is consumer or brand loyalty to the existing
products in the market.

Price leadership – tacit collusion

Another type of oligopolistic behaviour is price leadership. This is when one firm has a
clear dominant position in the market and the firms with lower market shares follow
the pricing changes prompted by the dominant firm. We see examples of this with the
major mortgage lenders and petrol retailers where most suppliers follow the pricing
strategies of leading firms. If most of the leading firms in a market are moving prices in
the same direction, it can take some time for relative price differences to emerge which
might cause consumers to switch their demand.

Firms who market to consumers that they are “never knowingly undersold” or who claim
to be monitoring and matching the cheapest price in a given geographical area are
essentially engaged in tacit collusion. Does the consumer really benefit from this?

Tacit collusion occurs where firms undertake actions that are likely to minimise a
competitive response, e.g. avoiding price cutting or not attacking each other’s market

Explicit collusion under oligopoly

It is often observed that when a market is dominated by a few large firms, there is always
the potential for businesses to seek to reduce market uncertainty and engage in some
form of collusive behaviour. When this happens the existing firms decide to engage in
price fixing agreements or cartels. The aim of this is to maximise joint profits and act
as if the market was a pure monopoly. This behaviour is deemed illegal by the UK and
European competition authorities. But it is hard to prove that a group of firms have
deliberately joined together to raise prices.

413
1
Price fixing

Collusion is often explained by a desire to achieve joint-profit maximisation within a

market or prevent price and revenue instability in an industry. Price fixing represents an
attempt by suppliers to control supply and fix price at a level close to the level we would
expect from a monopoly.

To fix prices, the producers in the market must be able to exert control over market
supply. In the diagram below a producer cartel is assumed to fix the cartel price at output
Qm and price Pm. The distribution of the cartel output may be allocated on the basis of
an output quota system or another process of negotiation.

Although the cartel as a whole is maximising profits, the individual firm’s output quota is
unlikely to be at their profit maximising point. For any one firm, within the cartel,
expanding output and selling at a price that slightly undercuts the cartel price can achieve
extra profits. Unfortunately if one firm does this, it is in each firm’s interests to do
exactly the same. If all firms break the terms of their cartel agreement, the result will be
an excess supply in the market and a sharp fall in the price. Under these circumstances, a
cartel agreement might break down.

Collusion in a market or industry is easier to achieve when:

1. There are only a small number of firms in the industry and barriers to entry
protect the monopoly power of existing firms in the long run.
2. Market demand is not too variable

414
1
 3. Demand is fairly inelastic with respect to price so that a higher cartel price
increases the total revenue to suppliers in the market
4. Each firm’s output can be easily monitored – this enables the cartel more easily
to control total supply and identify firms who are cheating on output quotas.

Possible break-downs of cartels

Most cartel arrangements experience difficulties and tensions and some producer cartels
collapse completely. Several factors can create problems within a collusive agreement
between suppliers:

 Enforcement problems: The cartel aims to restrict total production to maximize

total profits of members. But each individual member of the cartel finds it
profitable to raise its own production. It may become difficult for the cartel to
enforce its output quotas. There may be disputes about how to share out the
profits. Other firms – not members of the cartel – may opt to take a free ride by
producing close to but just under the cartel price.
 Falling market demand during a slowdown or recession creates excess capacity
in the industry and puts pressure on individual firms to cut prices to maintain their
revenue. There are good recent examples of this in international commodity
markets including the collapse of the coffee export cartel and some of the
problems that have faced OPEC in recent years
 The successful entry of non-cartel firms into the industry undermines a
cartel’s control of the market – e.g. the emergence of online retailers in the book
industry in the mid 1990s
 The exposure of illegal price fixing by market regulators – e.g. the severe fines
imposed on vitamin producers by the European Commission in the autumn of
2001 and recent investigations of price-fixing by the UK Office of Fair Trading.

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Consumer & Producer Surplus

In this note we recap the concepts of consumer and producer surplus that were covered
as part of the AS economics course and we then use them to help analyse some of the
welfare effects of the market structures visited in previous notes.

Recap on the ideas

415
1
  Consumer surplus is the difference between the total amount that consumers are
willing and able to pay for a good or service (indicated by the demand curve) and
the total amount that they actually pay (the market price).
 Producer surplus is the difference between what producers are willing and able
to supply a good for and the price they actually receive. The level of producer
surplus is shown by the area above the supply curve and below the market price.

Economic efficiency

Economic efficiency is achieved when an output of goods and services is produced

making the most efficient use of our scarce resources and when that output best meets the
needs and wants and consumers and is priced at a price that fairly reflects the value of
resources used up in production. There are two main types of efficiency - static and
dynamic.

416
1
Price Discrimination and consumer & producer surplus

Price discrimination occurs when a firm charges a different price to different groups of
consumers for an identical good or service, for reasons not associated with the costs of
supply. Price discrimination is common in any market where firms have a degree of
pricing power over different groups of consumers. But what are the possible implications
for consumers and producers in terms of consumer and producer surplus? Is price
discrimination something that economists should be supporting in terms of the behaviour
of businesses and final outcomes in different markets?

Pure (1st degree) discrimination

With 1st degree price discrimination the firm is able to perfectly segment the market so
that the consumer surplus is removed and turned into producer surplus. Thus there is a
clear transfer of welfare from consumers to producers. This is shown in the next diagram.

417
1
Third degree (or multi-market) price discrimination is the most frequently found form of
price discrimination and involves charging different prices for the same product in
different segments of the market. The key is that third degree discrimination is linked
directly to consumers’ willingness and ability to pay for a good or service. It means that
the prices charged may bear little or no relation to the cost of production. Clearly the
price elasticity of demand is the key factor determining the pricing decision for producers
for each segment of the market.

The market is usually separated in two ways: by time or by geography. For example,
exporters may charge a higher price in overseas markets if demand is estimated to be
more inelastic than it is in home markets. There is more consumer surplus to be exploited
when demand is insensitive to price changes. This is demonstrated in the following

418
1
diagram:

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Contestable Markets

affect the behaviour of businesses in the market-place.

What is a contestable market?

William Baumol defined contestable markets as existing where “an entrant has access to
all production techniques available to the incumbents, is not prohibited from wooing the
incumbent’s customers, and entry decisions can be reversed without cost.”

419
1
For a contestable market to exist there must be low barriers to entry and exit so that
there is always the potential for new suppliers to come into a market to provide fresh
competition to existing suppliers. For a perfectly contestable market, entry into and exit
out of the market must be costless

The reality is that no market is perfectly contestable (there are always some “barriers
to contestability” – see your revision notes on barriers to entry). That said it is also
true that virtually every market is contestable to some degree even when it appears
that the monopoly position of a dominant seller is unassailable. This can have important
implications for the competitive behaviour (conduct) of existing firms and clearly then
affects the performance of a market from an economic efficiency viewpoint (e.g.
allocative, productive and dynamic efficiency)

Contestable markets and perfect competition - the differences

Contestable markets are different from perfect competitive markets. For example, it is
feasible in a contestable market for one firm to dominate the industry, have price-setting
power and also for firms in a market to produce a differentiated product both of which
run counter to the assumptions behind the traditional model of perfect competition.

There are three main conditions for pure market contestability:

1. Perfect information and the ability and/or the right of all suppliers to make use
of the best available production technology in the market
2. The freedom to market / advertise and enter a market with a competing product
3. The absence of sunk costs – this reduces the risks of coming into a market

Sunk costs – a barrier to contestability

Barriers to market contestability exist when there are sunk costs. These are costs that
have been committed by a business cannot be recovered once a firm has entered the
industry. It might be easier to think of sunk costs as costs that are unavoidable once they
have been committed at a particular moment in time – a classic example being the money
that the telecoms firms committed to winning the 3rd generation mobile phone licences at
auction in 2000. When sunk costs are high, a market is more likely to produce a price and
output similar to monopoly (with the risk of allocative inefficiency / market failure that
follows on from this).

The Increasing Contestability of Markets

One feature of the British and European economy in recent years has been an increase in
the number of markets and industries that are genuinely contestable. Several factors
explain this development:

Entrepreneurial Zeal

420
1
It is often the case that markets become more competitive because of the persistence of
entrepreneurs who simply do not accept that the existing market structure is a given.
Decisions to enter markets where there are already dominant businesses with significant
industry experience involve taking risks – but a new supplier may have the advantage of
product innovation or a more competitive business model based on different pricing
strategies.

Blueback Taxis
The London taxi-cab market has just been shaken up by the arrival of a new, heavily
branded competitor. Blueback aims to become the “Starbucks” of the taxi market. What
strategy is it using to enter the market?
The London taxi market is highly fragmented - i.e. supplied by numerous small operators
and is largely unbranded. The objective of Blueback is to rapidly grow market share by
launching a clearly branded service that will encourage taxi drivers to switch to the
company.
Blueback has taken a leaf out of low-cost airline Easyjet’s strategy book with the way it
has developed its new service. Blueback has one, up-front pricing policy and runs only
one type of vehicle, the Fiat Multipla. Each vehicle carries the same, distinctive blue and
silver livery. The drivers wear the same uniform and offer customers newspapers and
mobile phone chargers as part of the onboard service. All drivers go through Blueback’s
driver training programme and are licensed by the PCO. The Blueback service was
developed from marketing research that asked people what they wanted from taxi hire.
This covered areas such as ordering, pricing and experience of the service. The long-term
objective of the company is to have a fleet of 1000 vehicles within the next few years and
to be the market-leading taxi operator in London
Adapted from Business Café, Tutor2u (February 2004)

De-regulation of markets – Also known as market liberalisation, de-regulation

involves the opening up of markets to competition by reducing some of the statutory
barriers to entry that exist. Good examples of recent deregulation include the main
utilities such as gas and electricity and also the liberalisation of telecommunications and
postal services as part of the European Union competition initiatives.

In postal services, all EU countries must open up business and household mail delivery
services so that there is at least one competing supplier to the dominant national postal
service provider. The liberalisation is scheduled to be completed by 2007. Already the
Royal Mail is negotiating agreements with other postal service companies to deliver their
pre-sorted mail “the final mile” to consumers. The UK postal services market was opened
up to full competition in January 2006. The latest UK market review is available here.

In telecommunications, the advent of pre-carrier selection means that there is now

increasing competition for land-line telephone services. British Telecom (BT Group) is
now facing much greater competitive pressure from Just Talk, Talk-2, Talk-Talk
(Carphone Warehouse) and other providers.

421
1
The retail clothing market in the UK has also undergone rapid change not least with the
arrival of a group of western European retailers such as Primark who have taken market
share from the established businesses together with the rapid entry of the supermarkets
into discount clothing. Likewise, new technology has been at the forefront of a much
more competitive and contestable market in DVD rentals.

Competition Policy

Tougher competition laws acting against predatory behaviour by existing firms are
designed to make markets more contestable. In both the UK and the EU this has included
tougher rules against price fixing cartels. When market contestability is weak, there is
nearly always greater scope for cartel-type behaviour by the existing firms, particularly if
the market structure in which they operate comes close to an oligopoly.

The European Single Market

The development of the Single European Market has opened up the markets for member
nations. A good example of this is home and car insurance and also the entry of Western
European clothes retailers onto the UK high streets and shopping malls. The abolition of
block-exemption for car dealerships within the EU should also help to make the retail car
market more contestable in the UK in particular and may help to bring down further the
prices of new cars.

Technological Change (including the e-mergence of e-commerce)

The impact of new technology is having a huge effect, not least because it have brought
down some of the entry costs in some markets (leading to an increase in capital mobility).
The rapid expansion of e-commerce for example has lead to the emergence of new
players in the travel sector and online bookselling, insurance and many other markets.

Technological spill-over can lead to the development of rival products that copy or
imitate the characteristics of the products of the incumbent firms. Just a few years after
the launch of Viagra, the anti-impotence drug, Levitra, the first market rival to the hugely
profitable Viagra, is now being manufactured by the German firm, Bayer AG, and
marketed by the British firm GlaxoSmithKline.

Contestable market case study – the market for broadband in the UK

2005 was the year when finally the market demand for broadband services took off!
Having lagged well behind most other western European countries in our use of
broadband, the UK witnessed a huge boom in take-up for broadband technology. The
telecommunications industry is an excellent one to study, not least because of the
important role played by the industry regulator, OFCOM in opening up the market to
fresh competition and acting as a catalyst for the successful entry of new firms into the
broadband market.
OFCOM believes that the retail market for broadband is now sufficiently competitive
market so that it can operate without price regulation. In the past, industry regulators in

422
1
recently privatized industries where monopoly power remained have used their powers to
impose price regimes on the major utilities. But as competitive forces have strengthened,
so the role of the regulator has moved away from direct price controls, towards a broader
role of monitoring the scale and quality of competition within a market.
As part of the current legal arrangements in the UK telecoms sector, BT is required to
provide regulated wholesale access to broadband products so that other service providers
can sell broadband to households and business customers. OFCOM has intervened to
reduce the access charges that BT can make to these other suppliers, and this too has been
important in reducing barriers to entry in the market and thereby making the industry
more contestable. For example, just over a year ago, Ofcom announced proposals set a
maximum price of £81.85 that BT can charge its competitors to rent a fully unbundled
local loop. The ceiling is designed to promote competition in the broadband market by
ensuring that BT's charge is fair, reasonable and cost-oriented.
The importance of local loop unbundling
Unbundling the local loop has been of pivotal importance in creating a contestable
market for broadband services. Local Loop Unbundling (LLU) enables telecoms
operators to connect directly to the consumer via BT's own copper local loops and then
add their own equipment to offer broadband and other services. This process involves
operators accessing BT’s local exchange buildings to connect to BT’s network of copper
lines which connect them to homes and businesses. Most homes in the UK are within one
mile of a local telephone exchange.
Main service providers in the UK broadband market
We can see the contestable nature of the broadband market by looking at a growing list of
main service providers and also the changing balance of market share by total sales.
Britain has more than 100 suppliers of broadband although aggressive price discounting
is likely to see this number fall as some businesses drop out of the market because they
cannot make a profit.
The effects of increased contestability on the market for broadband
Demand and “take-up”: Broadband penetration among household consumers has
increased significantly.
Falling prices: Average UK residential subscription prices have fallen sharply with some
service providers claiming to offer “free broadband” as part of a package of
telecommunications services. It has become clear though that there is no such thing as a
free lunch – broadband services are rarely if ever free!
Speeds: Broadband speeds are increasing as the broadband suppliers roll out the effects
of increased investment in high speed cables and servers.
Evolving market shares: The market shares of the broadband providers continue to
change. In the year 2000, the market share of the top three providers (BT, NTL and
Telewest) was 87%. By 2002 this had declined to 79% and in 2004 OFCOM reports that
the concentration ratio of the leading three firms had declined further to just 55%.
Suggestions for more reading on the battle for market share in broadband
BBC news articles on broadband
Ofcom on the UK broadband market
The broadband boom and you (BBC)

423
1
Contestable Markets and the Performance and Conduct of Businesses

How might the contestability of a market affect the conduct and performance of
businesses? It is worth emphasising in essays and data questions that it is the actual
behaviour of agents in the market that is more important that a simple picture of market
share.

In the diagram above a pure monopoly might price at P1 and reach a profit maximising
equilibrium. If a market is contestable, there is downward pressure on price, because
the existence of supernormal profits provides a signal for new firms to enter the market
and if the existing monopolist is producing at too high a price or has allowed their
average total costs to drift higher, then entrants can undercut the monopolist and some of
the monopoly profit will be competed away. Normal profit equilibrium occurs when
average revenue equals average total cost (at output Q2 and price P2).

From an economic welfare point of view, a lower price and higher output implies an
improvement in consumer welfare (which could be illustrated by an increase in consumer
surplus).

When markets are genuinely contestable – we expect to see lower profit margins (i.e.
lower “mark-ups”) than when a monopoly operates without competition. Indeed the
threat of competition may be just as powerful an influence on the behaviour of the
existing firms in a market than the actual entry of new businesses. If a dominant firm in a
contestable market knows that new suppliers may come in – this may be sufficient for
them to charge a price closer to the level we might expect from a competitive market
structure.

424
1
If a market is contestable, industry structure and firm behaviour is determined by the
threat of competition - 'hit-and-run' entry. The market will resemble perfect competition,
regardless of the number of firms, since incumbents behave as if there were intense
competition.

Key revision points for contestable markets:

o Be familiar with the barriers to entry and exit that might exist in any given
industry
o Understand how the threat of competition can affect current price and output
decisions of firms within a contestable market
o Understand that market share is not a reliable guide to market contestability. We
need much more detail on aspects such as price elasticity of demand, the costs of
suppliers etc
o Be aware that the UK and Competition Authorities are increasingly turning their
attention to the determinants of market contestability rather than a narrow focus
on market share and the profitability of businesses. The emphasis of government
competition policy is mainly towards opening-up markets and encouraging the
entry of new suppliers (both domestic and international)

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Market Structures - Summary

Another summary note on the key characteristics of market structure.

Market structure is best defined as the organisational and other characteristics of a

market. We focus on those characteristics which affect the nature of competition and
pricing – but it is important not to place too much emphasis simply on the market share
of the existing firms in an industry.

Traditionally, the most important features of market structure are:

 The number of firms (including the scale and extent of foreign competition)
 The market share of the largest firms (measured by the concentration ratio –
see below)

425
1
  The nature of costs (including the potential for firms to exploit economies of
scale and also the presence of sunk costs which affects market contestability in
the long term)
 The degree to which the industry is vertically integrated - vertical integration
explains the process by which different stages in production and distribution of a
product are under the ownership and control of a single enterprise. A good
example of vertical integration is the oil industry, where the major oil companies
own the rights to extract from oilfields, they run a fleet of tankers, operate
refineries and have control of sales at their own filling stations.
 The extent of product differentiation (which affects cross-price elasticity of
demand)
 The structure of buyers in the industry (including the possibility of monopsony
power)
 The turnover of customers (sometimes known as “market churn”) – i.e. how
many customers are prepared to switch their supplier over a given time period
when market conditions change. The rate of customer churn is affected by the
degree of consumer or brand loyalty and the influence of persuasive advertising
and marketing

Summary of market structures

Characteristic Perfect Competition Oligopoly Monopoly

Number of firms Many Few One

Type of product Homogenous Differentiated Limited

Barriers to entry None High High

Supernormal short run ü ü ü

profit

Supernormal long run û ü ü

profit

Pricing Price taker Price maker Price maker

Profit maximization? ü Not always Usually, but not

always

Non price competition û ü ü

Economic efficiency High Low Low

426
1
Innovative behaviour Weak Very Strong Potentially strong

Market structure and innovation

Which market conditions are optimal for effective and sustained innovation to occur?
This is a question that has vexed economists and business academics for many years.

High levels of research and development spending are frequently observed in

oligopolistic markets, although this does not always translate itself into a fast pace of
innovation.

The recent work of William Baumol (2002) provides support for oligopoly as market
structure best suited for innovative behaviour. Innovation is perceived as being
“mandatory” for businesses that need to establish a cost-advantage or a significant lead
in product quality over their rivals.

“As soon as quality competition and sales effort are admitted into the sacred precincts of
theory, the price variable is ousted from its dominant position…..But in capitalist reality
as distinguished from its textbook picture, it is not that kind of competition which counts
but the competition which commands a decisive cost or quality advantage and which
strikes not at the margins of profits and the outputs of the existing firms but at their
foundations and their very lives. This kind of competition is as much more effective than
the other as a bombardment is in comparison with forcing a door”

Supernormal profits persist in the long-run in an oligopoly and these can be used to
finance R&D

Government policy and innovation in the economy

The current government places a huge emphasis on the potential value from more
innovation across all sectors of the British economy. This is because of the economic
gains that follow:
For example:

 Improvements in the competitiveness of UK producers in home and overseas

markets.
 Innovation helps to protect and develop comparative advantage.
 Higher productivity will keep down unit labour costs against the challenge of low-
cost competition from emerging market economies.
 Innovation is a potential source of higher long-term trend growth – indeed supply
creates its own demand (“Say’s Law”) and can give businesses much higher rates
of return on their investment than an expansion of their existing capacity and
product range.

427
1
  Innovation can also create many thousands of new jobs even though some jobs
may be lost because of the adoption of labour-saving technology. The new jobs
emerge in training & other services together with the demand for labour that
comes from expanding output to supply an expansion to new markets.
 There might also be significant social benefits (positive externalities) from
innovative behaviour – for example the delivery of new health treatments or
innovations that provide safer forms of transport.

Government policy and innovation

Supply-side strategies are usually linked directly with attempts to promote more
innovative behaviour. Indeed the focus of government policy is firmly focused on
improvements in the microeconomics of markets. Consider this extract from a recent
speech by Gordon Brown

“If the past century of economic policymaking has taught us anything, it is that achieving
strong long term growth often has less to do with macroeconomic policies that with good
microeconomics, including fostering competitive markets that reward innovation and
restricting government to only a limited role.”

Which policies might encourage more innovation?

 Tax credits / investment allowances

 Policies to encouragement small business creation and entrepreneurship
 Toughening up of competition policy to expose cartel behaviour, but to allow and
promote joint ventures to fund research and development
 Lower corporation taxes to encourage innovative foreign companies to establish
in Britain
 Increased funding for research in our universities

Important developments:

1. Increasingly most innovation is done by smaller firms – indeed multinational

corporations are now out-sourcing their research and development spending to
small businesses at home and overseas – much is being shifted to cheaper
locations “offshore”—in India and Russia
2. Innovation is now a continuous process – in part because the length of the
product cycle is getting shorter as innovations are rapidly copied by competitors,
pushing down profit margins and (according to a recent article in the economist)
“transforming today's consumer sensation into tomorrow's commonplace
commodity” – a good example of this is the introduction of two major
competitors to the anti-impotence drug Viagra
3. Innovation is not something left to chance – the most successful firms are those
that pursue innovation in a systematic fashion
4. Demand innovation is becoming more important: In many markets, demand is
either stable or in long-run decline. The response is to go for “demand

428
1
 innovation” - discovering new forms of demand from consumers and adapting an
existing product to meet them – the toy industry is a classic example of this
5. Globalisation is driving innovation and not just in manufactured goods but across
a vast range of household and business services and in particular in high-value
knowledge industries

Classic examples of innovation first achieved by smaller firms:

o Air-conditioning
o Hydraulic brakes
o Digital X-Rays
o Soft contact lenses
o Quick frozen food
o Zip fastener

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Government Failure

Government intervention can sometimes fail to meet the desired outcomes, or can make
existing policy problems worse. In this note we look at the idea of government failure.

The idea of government failure

Even with the best of intentions governments seldom get their policy application correct.
They can tax, control and regulate but the eventual outcome may actually be a deepening
of the market failure or even worse a new failure may arise which requires corrective
action. Government failure may range from the trivial, when intervention is merely
ineffective, but where harm is restricted to the cost of resources used up and wasted by
the intervention, to cases where intervention produces new and more serious problems
that did not exist before. The consequences of this can take many years to reverse.

Over the last fifty or sixty years, Western governments have intervened to try to improve
the social and economic life of their countries on a scale unimaginable to previous
generations. Yet social and economic problems persist. Policies fail.
Adapted from “Why Most Things Fail”, Paul Ormerod

Government failure in a non-market economy

429
1
The collapse of the Soviet Union in the late 1980s and early 1990s marked, for many
people, the final failure of command or planned economies as a means of allocating
resources among competing uses. The essence of a command economy was that the state-
operated planning mechanism would decide what to produce and how to produce it and
for whom to produce.

Government failure occurred when the central planners supplied products that were
simply not wanted by consumers – showing a loss of allocative efficiency, since there
was no price mechanism to signal changes in consumer preferences and demand. John
Kay’s book “The Truth about Markets” has excellent sections on the basic fault-lines in
the planning process. Another fundamental failing of the pure command economy was
that there was little incentive for workers to raise productivity; few incentives to prevent
poor quality control; and little innovation by firms as no profit motive existed.

Command economies also suffered environmental de-gradation because they did not
posses structures for valuing the environment and giving consumers and producers the
right incentives to protect their environmental heritage.

All of these economies are now moving towards the western mixed economy, though at
varying speeds and with varying success. Eight former eastern Bloc countries joined the
European Union in May 2004, some of them former state-run economies in the Eastern
Bloc. Countries such as Hungary, the Czech Republic and Poland are all moving towards
a market based system for the allocation of resources for example through programmes of
privatisation and market liberalisation. Many of them have enjoyed fast rates of economic
growth and a rise in relative living standards both before and since their accession to
become members of the European Union.

Possible Causes of Government Failure

Government intervention can prove to be ineffective, inequitable and misplaced. There

is a growing body of research in the economics literature on this topic – some of which
uses highly mathematical techniques to analyse public policy-making. We will focus
instead on the underlying reasons and consider some topical examples along the way.

(a) Political self-interest

The pursuit of self-interest amongst politicians and civil servants can often lead to a
misallocation of scarce resources. For example decisions about where to build new roads,
by-passes, schools and hospitals may be decided with at least one eye to the political
consequences.

The pressures of a looming election or the influence exerted by special interest groups
can create an environment in which inappropriate government spending and tax decisions
are made. - e.g. boosting the level of welfare spending in the run up to an election, or
bringing forward major items of capital spending on infrastructural projects without the
projects being subjected to a full and proper cost-benefit analysis to determine the likely

430
1
social costs and benefits. Critics of current government policy towards tobacco taxation
and advertising, and the controversial issue of genetically modified foods argue that
government departments are too sensitive to political lobbying from the major
corporations.

(b) Policy myopia

Critics of government intervention in the economy argue that politicians have an in-built
tendency to look for short term solutions or “quick fixes” to difficult economic
problems rather than making considered analysis of long term considerations. The risk is
that myopic decision-making will only provide short term relief to particular problems
but does little to address structural economic difficulties. Consider for example the long
term problems facing the UK’s transport network. To what extent has transport suffered
from a lack of long-term planning and joined up thinking about how to create a properly
integrated transport network which can provide proper solutions to the issues of traffic
congestion and the environmental consequences of rising transport use.

Critics of government subsidies to particular industries also claim that they distort the
proper functioning of markets and lead to deeper inefficiencies in the economy.

(c) Regulatory capture.

This is when the industries under the control of a regulatory body (i.e. a government
agency) appear to operate in favour of the “vested interests” of producers rather than
consumers. Some economists argue that regulators can prevent the ability of the market
to operate freely.

Olive growing in Spain – has the CAP encouraged over-production, a waste of resources
and caused damage to the economies of many developing countries?

431
1
For example, to what extent has the European Union’s Common Agricultural Policy
operated mainly in the interests of farmers? Has the CAP worked against the long-term
interest of consumers, the environment and developing countries who claim that they
are being unfairly treated in world markets by the effects of import tariffs on food and
export subsidies to loss-making European farmers? The CAP is widely criticised as a
classic example of government failure and there are many who claim that the current
reform process does not go far enough.

(d) Government intervention and disincentive effects

Free market economists who fear government failure at every turn argue that attempts by
the government to reduce income and wealth inequalities can actually worsen incentives
and productivity in the economy. They would argue against the National Minimum
Wage because they believe that it can lead to real-wage unemployment. They would also
argue against raising the higher rates of income tax because it is deemed to have a
negative effect on the incentives of wealth-creators in the economy and generally acts as
a disincentive to work longer hours or take a better paid job. They are critical of the
government focusing welfare benefits on the poorest using means-tested benefits
because they might damage the incentive to find work.

The opposite point of view is that a lack of effective government policies to reduce the
scale of income and wealth inequality is also a cause of government failure since
inequality can, over the longer term; create many deep-rooted problems for society once
social cohesion starts to break down.

(e) Government intervention and evasion

A decision by the government to raise taxes on de-merit goods (such as cigarettes) might
lead to an increase in attempted tax avoidance, tax evasion, smuggling and the
development of grey markets where trade takes place between consumers and suppliers
without paying tax. Equally a decision to legalize and then tax some drugs might lead to a
rapid expansion of the supply of drugs and a substantial loss of social welfare arising
from over consumption.

(f) Policy decisions based on imperfect information

How does the government establish what citizens want it to do in their name? Can the
government ever really know the true revealed preferences of so many people? Our
current electoral system is not an ideal way to discover this! Turnout in every type of
election, (local, national, European etc) is falling, there is general disinterest in the
political process. Furthermore, people rarely vote purely out of their own self-interest or
on the basis of a well informed and rational assessment of the costs and benefits of
different government policies.

Proponents of government failure argue that the free market mechanism is, in the long-
run, the best way of finding out

432
1
(a) What consumer preferences are and
(b) Aggregating these preferences based on the number of people that are willing and
able to pay for particular goods and services.

Often a government will choose to go ahead with a project or policy without having the
full amount of information required for a proper cost-benefit analysis. The result can be
misguided policies and damaging long-term consequences.

How does the government know how many extra houses need to be built in the UK over
the next twenty years? Is building thousands of extra homes in an already congested
South-east the right option? Are there better solutions? There have been plenty of
instances of government housing policy having failed in previous decades!

(g) The Law of Unintended Consequences!

This law lies at the heart of many of the possible causes of government failure in markets!

The law of unintended consequences says that a government policy will always lead to at
least one reaction from either consumers or producers that are unanticipated or
unintended. Economic agents do not always act in the way that the economics textbooks
would predict – this is of course the essence of a social, behavioural science – we do not
live our lives in sanitised laboratories where all of the conditions can be controlled. The
law of unintended consequences is often used to criticise the effects of government
legislation, taxation and regulation. People find ways to circumvent laws; shadow
markets develop to undermine an official policy; people act in unexpected ways either
because or ignorance and / or error.
Unintended consequences can add hugely to the financial costs of some government
programmes so that they make them extremely expensive when set against their original
goals and objectives.

(h) Costs of administration and enforcement

Government intervention can prove costly to administer and enforce. The estimated
social benefits of a particular policy might be largely swamped by the administrative
costs of introducing it.

A summary of the arguments

 Free market economists are naturally distrustful of government intervention in

the economy
 They believe that the signalling, incentive and rationing functions of the price
mechanism should be given more freedom to operate
 They believe that government failure can occur at a microeconomic level (e.g.
introducing minimum prices in markets, rent controls, producer subsidies etc) and
at a macroeconomic level (pursuing inappropriate exchange rate, tax or interest
rate policies etc)

433
1
  When government failure exists, the result can be a deepening of an existing
market failure
 The result is a further loss of allocative and productive efficiency because of the
waste of scarce resources – leading to a reduction in consumer and producer
welfare
 Often we can accuse the government of policy failure only with the benefit of
hindsight
 Limited information - no government has the resources and information
available to it to make fully-informed, objective judgements. That is the nature of
politics.
 Government failure is most likely to occur when decisions are made in the vested
interest of special interest groups, at the expense of other groups (the result is a
loss of equity)
 But government failure is rarely total. Policies may be ineffective, expensive
and inefficient – but providing that policies are flexible and adaptable, (i.e.
lessons are learned) then intervention can often work in the interests of the
majority
 Advances in our understanding of how consumers and businesses behave and
respond to changing incentives are helping government policies to evolve. For
example the growing interest in auctions and traded permits as a means of
controlling pollution and other forms of environmental damage

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Externalities - Government Policy Options

Government intervention to reduce market failure from negative externalities

Traditionally, government policy towards the environment has concentrated in two main
areas

 Intervention in the price mechanism – for example through environmental taxes

 Command and control measures – for example direct regulation and legislation

These policies are designed to:

o Achieve a more efficient use of resources

o Promote substitution between resources (e.g. abundant for scarce, renewable for
non-renewable)

434
1
 o Provide incentives for a reduction of pollution emissions or change from
harmful to benign

Environmental taxation

An environmental tax is a tax on a good or service which is judged to be detrimental to

the environment. It may also be a tax on a factor input used to produce (supply) that final
product. The main aim of environmental taxation is to:

 Increase the private cost of producing goods and services so that the producer /
consumer is paying for some of the negative externalities that their actions are
creating (i.e. the externality is internalised) – this promotes allocative
efficiency
 In this way, the government is providing a continuous incentive for the
producer / consumer to take the externalities into account, thereby correcting a
failure of the signalling function of the price mechanism
 Raise the price of the product so that the level of demand contracts (there is
normally a direct link between the level of output / consumption and the total
pollution created)
 Reduce output levels towards the estimated social optimum level of production
– which contributes to a more sustainable economy in the long term
 Well designed environmental taxes may encourage innovation and the
development of new technology which reduces the dependency of an economy
on pollution inefficient forms of energy. This can help to promote dynamic
efficiency
 Revenue derived from these taxes can be earmarked for lower taxes elsewhere in
the economy (e.g. a reduction in employers’ national insurance contributions) or
to fund increased government spending on environmental projects / an expansion
of provision of public and merit goods. Well designed environmental taxes can
provide a source of revenue while correcting an economic distortion
 Inter-generational equity justification: Consider what might happen if the
government refuses to introduce some environmental taxes so that current
producers and consumers do not pay directly for some of the external costs they
create. A refusal to impose tax displaces the environmental costs to future
generations (implying a lack of intergenerational equity)

435
1
 The Durham congestion charge – a means of reducing traffic congestion

Examples of environmental taxes include: petrol duty, vehicle excise duty, the landfill
tax, the new carbon tax and the London Congestion Charge. The Irish Government also
introduced a tax on plastic bags in a bid to reduce consumption and encourage recycling.
The main aim of an environmental tax is to increase the firm’s private marginal cost
(PMC) until it equates with the social marginal cost curve (SMC).

Evaluation – problems with environmental taxation

There is a growing body of economists who argue that reliance on environmental taxation
is an ineffective way of promoting environmental improvement, indeed that some taxes
are prone to government failure. And, that the focus should now switch to alternatives
ways of changing the incentives of producers and consumers through the market
mechanism. The main criticisms of environmental taxes are discussed below:

 Valuing the environment: There are fundamental problems in setting taxes so

that marginal private costs will equate with the marginal social costs. The
government cannot accurately value the private benefits and cost of firms let
alone put a monetary value on externalities such as the cost to natural habitat, the
long-term effects of resource depletion and the value of human life. Frequent
adjustments of tax levels may be required and this involves substantial
organisational costs
 Consumer welfare effects: Taxes reduce output and raise prices, and this might
have an adverse effect on consumer welfare. Producers may be able to pass on the
tax to the consumers if the demand for the good is inelastic and, as result, the tax
may only have a marginal effect in reducing demand and final output
 Achieving a target quantity of pollution reduction: Taxes do not lend
themselves to the government achieving an accurate reduction in total pollution.

436
1
 This is because no government can ever predict how consumers and or producers
will respond to higher costs and prices. The elasticity of demand may vary over
time.
 Income distribution: Taxes on some de-merit goods (for example cigarettes)
may have a regressive effect on low-income consumers and lead to greater
inequalities in the distribution of income. Having said this, it should be possible
for authorities to develop “smart tariffs or taxes” where account is taken of the
impact of pollution taxes on vulnerable households such as low low-income
consumers. The current Labour government has reduced the rate of VAT on
domestic fuel to the EU minimum rate of 5%, but the government has no plans to
introduce a domestic energy tax (which would be an explicit environmental tax)
because of the huge numbers of low-income households that currently live in fuel
poverty. In the UK, the poorest 10% of households spends 13.2% of income on
energy whereas the richest spends 3.5%.
 Employment and investment consequences: If pollution taxes are raised in one
country, producers may shift production to countries with lower taxes. This will
not reduce global pollution, and may create problems such as structural
unemployment and a loss of international competitiveness. Similarly, higher
taxation might lead to a decline in profits and a fall in the volume of investment
projects that in the long term might have beneficial spill-over effects in reducing
the energy intensity of an industry or might lead to innovation which enhance the
environment
 More efficient alternatives? It might be more cost effective for governments to
switch away from pollution taxation to direct subsidies to encourage greater
innovation in designing cleaner production technologies. ‘Eco-tax’ reformers
often argue that pollution taxes should be revenue neutral – so for example, an
increase in environmental taxation might be accompanied by reductions in
employment taxes such as National Insurance Contributions so that the
employment consequences of higher taxation are minimised. The impact of green
taxes depends crucially on what is done with the revenues. If they are balanced by
reducing other taxes through ‘revenue re-cycling’, research suggests that green
taxes could result in an overall economic improvement

Alternatives to environmental taxes

An effective use of environmental taxation

Most power stations are surrounded by coal tips or pipes carrying gas. But round the
plant that powers the Swedish town of Enköping, some 70 kilometres west of Stockholm,
there is willow coppice stretching as far as the eye can see. Enköping is probably the only
town in Europe that is powered by bio-fuels. The plant's director, Eddie Johansson, says
willow is as economic as coal or gas because Sweden levies a tax on carbon emissions
from most power plants. Under the government's rules, he does not have to pay the tax
because for every tonne of carbon dioxide that disappears up the stack, the plant's willow
trees soak up a tonne from the air as they grow. Hundreds of willow-powered plants
could operate across Europe, he says if power companies had similar incentives to cut

437
1
carbon emissions.
Source: Business Week, September 2005

Carbon Emissions Trading

Emission trading is regarded by many as the future of environmental protection and

improvement in the UK, European and international economy. Carbon trading is another
form of pollution control that uses the market mechanism to change relative prices and
the incentives of producers and consumers. There is also growing interest in the idea of
personal carbon trading, the UK government is currently looking at the issue .

Carbon allowances for consumers!

The environment minister, David Milliband has unveiled a radical plan to cut greenhouse
gas emissions by charging individuals for the amount of carbon they use. Under the
proposals, consumers would carry bank cards that record their personal carbon usage.
Those who use more energy - with big cars and foreign holidays - would have to buy
more carbon points, while those who consume less - those without cars, or people with
solar power - would be able to sell their carbon points. Under the scheme, all UK citizens
would be allocated an identical annual carbon allowance, stored as points on an electronic
card similar to Air Miles or supermarket loyalty cards. Points would be deducted at point
of sale for every purchase of non-renewable energy. People who did not use their full
allocation, such as families who do not own a car, would be able to sell their surplus
carbon points into a central bank. High energy users could then buy them - motorists who
had used their allocation would still be able to buy petrol, with the carbon points drawn
from the bank and the cost added to their fuel bills. To reduce total UK emissions, the
overall number of points would shrink each year.
Source: Adapted from the Guardian, July 2006

The basics of cap and trade - emissions trading

 A fixed number of emission permits is allocated each year to polluting factories

 Usual denomination: 1 permit = 1 tonne (e.g. of CO2 emissions)
 Total number of permits is the limit on pollution “the cap”
 Annual emissions of each factory must be less than or equal to permit holdings
 Permits can be traded – i.e. “cap and trade”
 Factories which can reduce (abate) pollution for less than the price of a permit can
sell spare ones for a profit
 Factories which find it more expensive to reduce pollution can buy extra permits
instead
 Gradually the supply of permits is reduced – the market price rises. This gives
firms who find it expensive to cut pollution, more of an incentive to seek new
technologies / process that will reduce their pollution emissions

A marketable pollution permit gives a business the right to emit a given volume of
waste or pollution into the environment. Ideally, the number of permits that are issued
corresponds with the total level of pollution that is admissible at the social optimum level

438
1
of output i.e. where the MSB = MSC. Once this has been determined the permits are
issued by auction and firms that pollute the environment can bid for them and then buy
and sell them amongst themselves.

Pollution permits should, in theory, give firms an incentive to control pollution emissions
for less than it would cost to buy permits, and there is evidence from “cap and trade”
pollution permit schemes in the UK and the United States that the costs of monitoring
pollution reduction and administration of the permits system is smaller than when an
industry is subject to direct regulation. In the United States cap and trade scheme, it was
found that many high-polluting businesses invested in fitting new pollution control
equipment (e.g. Flue Gas Desulphurisation) and other polluters switched from high to
low sulphur coal.

Consequently the use of marketable permits allows the cost of pollution control to be
minimised. Another advantage is that the revenue from a traded pollution permits scheme
can be re-cycled into other schemes for environmental improvement.

Incentives matter – create a market in the “right to pollute” - The basic idea behind
traded pollution permits is to through the incentive to cut pollution directly to the
producers themselves. Companies can then make their own decisions about the costs and
benefits to them of particular routes to emission reductions. In other words, market forces
are brought to bear on the issue of pollution and potential market failure.

Emission trading is likely to be most effective when:

 There is an easily measurable pollutant

 The government sets a clearly defined and stable emissions target
 There are a large number of participant firms, with companies sufficiently
sophisticated to deal with the technicalities of trading at auction
 Wide variation in costs of reducing pollution so that trading of surplus permits
can take place
 The transactions costs of trading permits are low and there is clear pollution data
availability at the start and during trading
 Strict enforcement of permits (i.e. a high compliance rate among participating
businesses)

Kyoto

Emission trading was a key feature of the Kyoto Protocol as a strategy to address some
of the threats posed by climate change in 1997. Kyoto allows trading of permits for
carbon dioxide between industrialised countries but the United States withdrew from the
agreement in 2001 and since the USA represents 32% of emissions amongst developed
countries with emission targets, the absence of the USA from an embryonic trading
system will seriously reduce demand for permits and therefore drive down their price and
effectiveness.

439
1
Pollution regulation

Instead of relying on intervention in the market mechanism by using taxation, subsidies

or pollution permits, the government and its appointed agencies can regulate the level of
output and pollution in a market. In theory, the government could set a quota so that
output is set at the social optimum. More frequently, minimum or environmental /
emission standards are widespread in many industries. This requires regulatory bodies
to monitor (inspect) and fine firms that do not meet the standards set for water and air
quality.

The 1989 Environmental Protection Act for example set standards on emissions for firms
that carried out chemical processes, waste incineration and oil refining. There will be a
ban on smoking on public places in England from the summer of 2007. A ban came into
force in Scotland in March 2006.

Compliance with environmental regulations can be very costly to enforce and it may be
impossible to monitor all firms accurately because of imperfect information. Regulation
also does not bring in any direct tax revenue flows that can be used to fund environmental
improvement schemes or compensate those who have been negatively affected by
pollution.

Suggestions for further reading on carbon emissions trading

o Carbon trading, what price a pollution solution? (Green Biz)

o Carbon trading’s real colours (BBC)
o Power tool (Guardian)
o Questions are raised over carbon trading (Guardian)
o Scale of industry’s impact on the environment (Guardian)

Airlines and environmental policy

Over the past 20 years, there has been huge growth in the airline industry. The number of
passenger kilometres has risen from 125 billion worldwide in 1990 to 260 billion in 2000,
while air freight grew even faster, at 9% per year. In 1970, British airports were used by
32 million people. In 2004, the figure was 216 million. In 2030, according to government
forecasts, it will be around 500 million.

Several factors have contributed to rising demand for airline travel

The emergence of low-cost flying, such as EasyJet and Ryanair which have brought
prices down allowing lower-income families to fly and creating a new effective demand
for flying
New technologies have also made long-haul flights with flagship-carriers, such as BA,
cheaper and more enjoyable
Increased demand for business air travel

440
1
Aviation creates external costs. The main external cost of flying is the damage to the
environment. It is estimated that one return flight to Florida produces as much carbon
dioxide as a year’s motoring, while a return flight to Australia the same amount as 3 cars
in one year. And flying from London to Edinburgh produces 8 times as much carbon
dioxide as taking the train. Aviation currently contributes 5% to the UK’s carbon dioxide
emissions. With air travel growing at 3-5%, it is expected that planes will contribute 15%
to the UK’s carbon dioxide emissions in the next ten years

For some time, there has been a debate over the merits and de-merits of introducing an
aviation tax on airlines. Is this the best way of controlling the environmental damage
created by the rapid expansion of the UK and European airline industry? Or will it simply
create more problems and damage the competitiveness of the European airline sector?
Are there better more effective ways of reducing pollution? For example bringing the
airlines into the newly established EU carbon emissions trading scheme?

Suggestions for wider reading and research

Airlines sport their green colours
Aviation Environmental Federation
Aviation 'huge threat to CO2 aim' (BBC):
Blair says cutting air travel is unrealistic:
Calls to control low cost flights
Department for Transport
Easy Jet’s environmental policy
EU plans airline CO2 reductions (BBC):
Friends of the Earth:

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Public Goods

When the market fails to provide certain goods and services, there is a clear case for
government intervention.

The nature of public goods

Public goods are services which must be provided collectively for two main reasons:

 Non-excludability - the goods cannot be confined to those who have paid for it
 Non-rivalry in consumption - the consumption of one individual does not reduce
the availability of goods to others

441
1
Examples of pure public goods include flood control systems, street lighting and national
defence. A flood control system, such as the Thames Barrier, cannot be confined to those
who have paid for the service. Also, the consumption of the service by one household
will not reduce its availability to others. If left to the free market mechanism, no public
goods would be provided and, as a result, there would be a clear market failure. No
individual consumer would pay for a product that could be consumed for free if another
household decided to purchase it.

The benefits of the Thames Barrier cannot be confined only to those people who have
paid for it

Quasi-public goods: These are products that are essentially public in nature, but do not
exhibit fully the features of non-excludability and non-rivalry. The road network in the
UK is currently available to all, but could be made excludable via a system of electronic
road pricing. There is also non-rivalry in consumption, but only up to an extent. Once the
road becomes congested there is rivalry in consumption.

Environmental public goods: An example of an environmental public good is public

open space, which nobody would provide on their own, even though everybody benefits
from it being available. Street lighting is another example of a public good.

The Air-Waves – a Quasi Public Good

The airwaves are essentially owned by the government of a particular country. Do they
count as a pure public good? Normally the answer would be yes. One person’s use of the
airwaves rarely reduces the extent to which other people can benefit from utilising them.
But when demand for mobile phone services is high at peak times, the airwaves become
crowded and access to the networks provided by the main mobile phone companies can
become slow. In this sense the airwaves can be treated a crowded non-pure public good.

442
1
The government controls the issue of licences needed to operate mobile phone services
using the airwaves in the UK. In 2000, they auctioned off five licences for 3rd generation
mobile phone services and raised £22 billion in doing so. The government was using the
auction process to ration the airwaves through a licence system. Although the
government has monopoly control in the sense that it controls the issue of licences, it did
not set the market price. This was determined by the auction process, and the fact that at
the end of a bidding war, the major mobile phone companies were prepared to pay such a
high price for a licence to allow them to operate in the market, is evidence of the private
benefit (or anticipated future profit) that the companies expected to make from selling 3rd
generation contracts to customers.
The fact that these telecoms companies may have greatly misjudged the actual market
demand for third generation mobile phone services is not the result of the auction process
itself. The government decided that the income from the sale of these licences would be
used to repay a slice of the national debt, providing a bonus for current and future
generations in terms of reducing the annual interest payments on government debt.

An example of a quasi public good - the air-waves can become congested

Finding an Equilibrium Allocation of Public Goods that Maximises Social Welfare

Finding the socially efficient level provision of public goods is a hugely difficult process.
First we must seek a valuation of the willingness and ability of consumers to pay for
public goods which involves estimating the individual demand curves for each consumer
and then aggregating to find the “market demand curve” – a reflection of the social
marginal benefit (or valuation) that consumers place on each extra unit of a public good
that is made available.
In the diagram below we consider a non-pure public good whose marginal cost of supply
does rise gently as output is increased. If the market fails to provide a sufficient quantity
of a public good, then there is a loss of economic (social) welfare.

443
1
Case Study: The BBC as a public good

Broadcasting is a good example of a public good. Let us remind ourselves of the three
main characteristics of a public good.

Firstly it is non-rival, meaning that the consumption of a public good or service by one
individual does not preclude consumption by another individual. Secondly, consumption
is non-excludable. This means that consumption by one individual makes it impossible to
exclude any other individual from having the opportunity to consume. Effectively the
marginal cost of providing a pure public good to an extra user is zero, and this implies
that, in order to achieve allocative efficiency, the charge for the product should be zero.
Of course, in this situation, private sector businesses are unlikely to consider providing
pure public goods because they will not be able to make any profit at a zero price, and
many consumers can take a free ride on such goods because of non-excludability. The
provision of pure public goods is therefore a cause of market failure. Left to the free
market, public goods are under-provided and under-consumed leading to a loss of social
welfare.

444
1
Traditional analogue broadcasting differs from encrypted digital broadcasting in the sense
that digital broadcasters can now exclude non-payers using set-top boxes. But even when
Britain moves fully to digital when the analogue signal is turned off in a few years, the
broadcasting services will continue to be completely non-rival and it is this that really
matters in the context of the services that the BBC provides. One extra person consuming
programmes on BBC1 or BBC2 has no effect at all on the ability of people to consume
other services provided by the BBC.

Paying for a public good - the licence fee debate

At the moment, around 23 million households in Britain pay an annual licence fee. All of
these people are stakeholders in the debate about the future funding of the BBC and the
vast majority use one or more BBC services at least once a week. The fee is a means of
providing collective payment for a public good. We know that there are fee-dodgers who
try to take a free-ride by avoiding payment, but there are well established although costly
means to enforce the licence fee and take non-payers to court.

According to research undertaken by the BBC as part of the Charter Review, on rough
estimates, about 17 million households value BBC television, radio and internet services
at more than the current licence fee of £122. These are gainers from the existence of the
BBC. In contrast, the study finds that 6 million people value the BBC at less than the
current licence fee. These are losers – they are paying more than the utility that they get
and many such people may resent having to pay the licence fee when they have paid for
their BSkyB subscription and have already deserted the BBC for other digital or
commercial channels. The BBC study estimates that the net consumer surplus created by
the BBC is well over £2bn/year, or ¼% of GDP.

The most likely groups to think the licence fee represents good value for money for their
household are those aged over 60 and those in the higher AB social groups. Groups more
likely to think the fee represents poor value for money are those with multi-channel
television access, people aged 31-45, people in the C2DEs social groups and younger
people of Black or Asian origin. People in C2DE social groups are far more likely to
have an income below the median, and therefore the question of raising the licence fee
becomes important because a sharp rise in its level would affect people’s ability to pay.

Television Radio Other

BBC 1 Radio 1 BBC Online

BBC 2 Radio 2 World Service

BBC 3 Radio 3 BBC Scotland

BBC 4 Radio 4 BBC Northern Ireland

445
1
 Cbeebies Radio Five Live BBC Wales

CBBC Five Live Extra BBC English Regions

BBC News 24 1Xtra

BBC Parliament 6 Music

BBC 7

Asian Network

6 Nations services

40 local and regional services

For millions of people, the value that they derive from the BBC’s output does exceed the
price they currently have to pay via the licence fee. Would they be happy to pay a
significantly higher fee in the future? Much would depend on the quality and range of
broadcasting that the BBC is able to deliver. Assuming a constant range, reliability and
quality of services, a large rise in the BBC licence fee would reduce total consumer
surplus. The BBC study estimates that if the fee was raised by forty per cent from £122 to
£170, up to four million people would no longer value BBC services as much as the
higher compulsory fee, consumer surplus would be reduced and the BBC’s services
might end up being under-consumed.

This, in a nutshell, is the argument against the introduction of a subscription-based

system for funding the BBC. It would exclude several million people from consuming
their services and would probably result in a net loss of social welfare.

446
1
What is the best way to finance broadcasting? Should the licence fee remain compulsory?

Criticisms of the licence fee

Opponents of the licence fee argue that

1. It is a regressive form of taxation – everyone pays the same flat charge,

regardless of their disposable income, the number of televisions they own or the
extent to which they watch television in general and BBC services in particular
2. As fewer people watch the BBC, the case for a licence fee diminishes. Indeed as
technology develops, it become even harder to sustain a compulsory licence fee
when people have moved predominantly to alternative sources of information
through the internet, digital channels, broadband and their mobile phones
3. The costs of collection and evasion are high including £150 million per year
chasing licence-fee evaders

What are the alternatives for funding the BBC?

 Moving to a subscription base system (technology may allow this in the future).
 Allowing advertising and sponsorship of programmes similar to the ITV model.
 Greater emphasis on selling BBC programmes overseas through BBC
Worldwide and sales of DVDs to generate increased revenue for the BBC.
 Funding the BBC entirely through direct taxation and scrapping the licence fee.
 A tax on the revenues of other commercial broadcasters to part-fund the BBC’s
services – reflecting the public service nature of much of the BBC’s output.

Of these alternatives, introducing advertising is least preferred among people surveyed. A

sizeable majority of viewers (over sixty per cent according to a recent MORI poll) regard

447
1
advertising as an intrusion to their enjoyment of programmes, and few think that the BBC
should move to this form of finance. And there are worries that the total size of the TV
advertising market is not large enough to absorb the entry of the BBC as a supplier of
advertising slots. It might well damage the financial viability of ITV for example. In any
case, advancing technology now allows viewers to skip advertising when they have pre-
recorded programmes.

On the whole, there is a preference for keeping the licence fee (a system of funding used
in many other countries) although there are concerns among older groups about their
ability to pay for it. But without a sizeable increase in its value, there is little doubt that
BBC revenues will soon be overtaken permanently by Sky and this will damage the
BBC’s ability to bid for live television events including the rights for sports such as
soccer, cricket and golf.

Public Goods and the Free Rider Problem

Consumers have an incentive to not reveal their willingness and ability to pay for public
goods if they believe that they will be expected or required to contribute to financing the
public good accordingly by the government. After all, if the public good is supplied, it
will be available to them just as it would be to anyone else because pure public goods are
non-excludable. This is the essence of the “free rider problem”: the incentive which
consumers have to avoid contributing to financing public goods in proportion to their
valuation of such good.

Good examples to use include TV licence dodgers and people who choose to evade the
Council Tax but who still receive local authority services. Another example might be a
group of residents in a block of flats who all stand to benefit from the refurbishment of an
adjacent playground or better lighting and security systems, but who individually might
try to avoid payment and benefit once the improved amenities are in place.

Given the nature of the free rider problem, public goods are often financed through some
form of enforcement, notably the compulsory nature of the TV licence fee, management
fees for residents living in blocks of accommodation or the signing of international
treaties on the environment. .

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Competitition Policy

Competition policy covers the different ways in which the competition authorities of
national governments and also the European Union seeks to make markets work better
and achieve a higher level of economic efficiency and economic welfare.

448
1
The Main Aims of Competition Policy

The aim of competition policy is promote competition; make markets work better and
contribute towards increased efficiency and competitiveness of the UK economy within
the European Union single market. Competition policy aims to ensure:

 Wider consumer choice in markets for goods and services.

 Technological innovation which promotes gains in dynamic efficiency.
 Effective price competition between suppliers.
 Investigating allegations of anti-competitive behaviour within markets which
might have a negative effect on consumer welfare.

There are four pillars of competition policy in the UK and in the European Union:

 Antitrust & cartels: This involves the elimination of agreements which seek to
restrict competition (e.g. price-fixing agreements, or cartels) and of abuses by
firms who hold a dominant position in a market.
 Market liberalisation: Liberalisation involves introducing fresh competition in
previously monopolistic sectors e.g. energy supply, telecommunications, air
transport and postal services together with new arrangements for car retailers
inside the single market.
 State aid control: Competition policy analyses examples of state aid measures by
Member State governments to ensure that such measures do not artificially distort
competition in the Single Market (e.g. the prohibition of a state grant designed to
keep a loss-making firm in business even though it has no prospect of long-term
recovery).
 Merger control: This involves the investigation of mergers and take-overs
between firms (e.g. a merger between two large groups which would result in
their dominating the market).

"Ronald Coase said he had gotten tired of anti-trust because when the prices went up the
judges said it was monopoly, when the prices went down they said it was predatory
pricing, and when they stayed the same they said it was tacit collusion."
Source: William Landes, "The Fire of Truth: A Remembrance of Law and Econ at
Chicago", JLE (1981)

Anti-Trust Policy - Abuses of a Dominant Market Position

A firm holds a dominant position if its economic power enables it to operate within the
market without taking account of the reaction of its competitors or of intermediate
or final consumers.

In appraising a firm's economic power in the marketplace, the EU Commission considers

its market share and other factors such as whether there are credible competitors,
whether the firm has ownership and control of its own distribution network and

449
1
whether it has favourable access to raw materials. Note here that market share is not the
sole determinant of economic power in an industry

Holding a dominant position is not wrong in itself if it is the result of the firm's own
effectiveness and competitiveness against other businesses. But if the firm exploits this
power to stifle competition, this is deemed to be an anti-competitive practice.

A recent example of this has been the long investigation and legal battle by the EU
Commission into the alleged abuse of market power by Microsoft. Microsoft was
accused of continuing to abuse its monopoly in the software market. The investigators
alleged that Microsoft bundled Media Player with Windows, unfairly damaging rival
programs such as Real Networks’ RealPlayer and Apple Computer’s QuickTime. The
investigation and fall-out has now lasted more than eight years. In March 2004 the EU
fine Microsoft €497m levied in March 2004 for its alleged abuse of its dominant position
in the operating software and server software market. In July 2006, a Guardian Unlimited
Business | | EU fines Microsoft €280mfurther fine of £194m was imposed.

Anti-Competitive Practices:

Anti-competitive practices are best defined as strategies designed deliberately to limit the
degree of competition inside a market. Such actions can be taken by one firm in
isolation or a number of firms engaged in explicit or implicit collusion. Since 1998 there
have been numerous investigations in industries such as chemicals, banks,
pharmaceuticals, airlines, beer, and paper, plasterboard, food preservatives and computer
games!

Examples of anti-competitive practices

 Predatory pricing financed through cross-subsidization (not all price

discrimination is anti competitive though – much of it is simply a genuine attempt
to remain competitive in a market). An example of an allegation of predatory
pricing came in 2005 when Wal-Mart was accused of using this strategy as it tried
to break into the German food retail market. Wal-Mart faced accusations that it
was using short-term predatory pricing to put small shopkeepers out of business.
In July 2006, it was announced that Wal-Mart was pulling out of Germany having
sold its stores to another business.
 Vertical restraint in the market:
o Exclusive dealing: This occurs when a retailer undertakes to sell only one
manufacturer's product and not the output of a rival firm. These may be
supported with long-term contracts that bind or “lock-in” a retailer to a
supplier and can only be terminated by the retailer at high financial cost.
Distribution agreements may seek to prevent instances of parallel trade
between EU countries (e.g. from lower-priced to higher priced countries)
o Territorial exclusivity: This exists when a particular retailer is given the
sole rights to sell the products of a manufacturer in a specified area

450
1
 o Quantity discounts: Where retailers receive progressively larger price
discounts the more of a given manufacturer's product they sell - this gives
them an incentive to push one manufacturer's products at the expense of
another's in order to widen their own profit margins
o A refusal to supply: Where a retailer is forced to stock the complete
range of a manufacturer's products or else he receives none at all, or where
supply may be delayed to the disadvantage of a retailer
 Creation of artificial barriers to entry: Through advertising and marketing and
brand proliferation which increase the costs of a new firm successfully entering a
market
 Collusive practices: These might include agreements on market sharing, price
fixing and agreements on the types of goods to be produced.

Price Fixing – The Office of Fair Trading

UK competition law now explicitly prohibits almost any attempt to fix prices - for
example, you cannot:

 Agree prices with your competitors, e.g. you can't agree to work from a shared
minimum price list
 Share markets or limit production to raise prices
 Impose minimum prices on different distributors such as shops
 Agree with your competitors what purchase price you will offer your suppliers
 Cut prices below cost in order to force a smaller or weaker competitor out of the
market
 The law doesn't just cover formal agreements. It also includes other activities with
a price-fixing effect. For example, you shouldn't discuss your pricing plans with
your competitors. If you then all "happen" to raise your prices, you are fixing
prices.

Cartels and the law in the UK

Cartels are a particularly damaging form of anti-competitive behaviour - taking action
against them is one of the OFT's priorities. Under the Competition Act 1998 and Article
81 of the EC Treaty, cartels are prohibited. Any business found to be a member of a
cartel could be fined up to 10 per cent of its worldwide turnover. In addition, the
Enterprise Act 2002 makes it a criminal offence for individuals to dishonestly take part in
the most serious types of cartels. Anyone convicted of the offence could receive a
maximum of five years imprisonment and/or an unlimited fine.
Source: OFT web site

There have been many examples of allegations of and investigations in price fixing and
other forms of collusive behaviour in UK and European markets in recent years. They all
provide interesting evidence of how the competition authorities both in the UK and in the
European Union are using their enhanced powers under new competition laws to
investigate possible instances of price fixing or anti-competitive behaviour.

451
1
House of Fraser and Oakley – price fixing for sunglasses
The House of Fraser department store group is facing accusations that it colluded with
Oakley to fix the price of its sunglasses, which sell for between £50 and £200 a pair.
Following a two year investigation, the Office of Fair Trading (OFT) has published a
provisional report claiming that both House of Fraser and Oakley have breached the 2002
Competition Act. Both companies now have the opportunity to make submissions to the
OFT in defence of their position.
The OFT believes that between November 2001 and March 2004, Oakley supplied House
of Fraser with sunglasses on the condition that the department store sold them at no lower
than the Oakley suggested minimum selling price. The investigation was instigated after
complaints from rival retailers and complaints from some customers. If the findings are
confirmed, the OFT has the power to fine a firm up to ten per cent of its turnover.
Dual pricing – Sony versus the internet retailers
The UK Office of Fair Trading is investigating accusations of possible illegal price
discrimination by the global electronics giant Sony. Some online retailers have
complained that Sony is discriminating against them by offering cheaper (discounted)
prices to established high street retailers and making the online retailers pay more for
their supplies of many of Sony's top selling products.
The complaint came from the Interactive Media in Retail Group (IMRG) and their claim
was that dual pricing acts as an anti-competitive strategy which is damaging to
consumer welfare. Dual Pricing is a mechanism recently introduced by electrical
consumer goods manufacturers whereby their dealers pay more for goods if sold online.
The IMRG claimed that there is no economic justification for dual pricing and that the
defence that it costs more to run a "bricks and mortar" retail business compared to an
online business is both irrelevant and open to dispute. In a press release they claim that
Sony have been exposed in the newspapers as one of the manufacturers being looked at
but others including Panasonic, Sharp, Phillips and Hitachi may also have their dual-
pricing tactics considered.
Price fixing in the dairy industry
The Office of Fair Trading is investigating claims that some of the UK's top dairy
processing businesses have been involved in a price fixing agreement. Dairy Crest and
Robert Wiseman, two of the UK's top three dairy processors are under the microscope
and Arla Foods may also be part of the broader scope of the investigation which centers
on a decision by the dairy processors to jointly increase the price paid to milk farmers in
the UK. But this investigation is coming under quite fierce criticism from supporters of
the farming industry who believe that unless effective steps are taken to raise the prices
and incomes flowing to milk producers, the industry itself may collapse with the loss of
thousands of jobs.

Suggestions for wider reading on price fixing and cartels

Breach of competition law by 50 independent schools (November 2005)
Chemical firms face price fixing probe:
Competition Commission of the European Union
Enquiry begins into the price of school uniforms (July 2006)
EU smashes acrylic glass cartel (March 2006)
Fine for European chemical companies involved in price fixing cartel (2006)

452
1
OFT to refer grocery market to Competition Commission (June 2006) see also Inquiry
spells trouble for the Big 4 retailers (Guardian) and “Supermarkets in competition probe”
(BBC)
OFT to study market structure of UK airports (June 2006)
Samsung in price fixing admission
Scottish roofing contractors fined for collusive bidding (June 2005)
Wikipedia: http://en.wikipedia.org/wiki/Price_fixing

Some collusive behaviour is tolerated / encouraged

Not all instances of collusive behaviour are deemed to be illegal by the European Union
Competition Authorities. Practices are not prohibited if the respective agreements
"contribute to improving the production or distribution of goods or to promoting
technical progress in a market. Examples include:

 Development of improved industry standards /technical standards of production

and safety which eventually benefit the consumer.
 Research joint-ventures and know-how agreements which seek to promote
innovative and inventive behaviour in a market.

Market Liberalization

The main principle of EU Competition Policy is that consumer welfare is best served by
introducing competition in markets where monopoly power exists. Frequently, these
monopolies have been in network industries for example transport, energy and
telecommunications. In these sectors, a distinction must be made between the
infrastructure and the services provided directly to consumers using this
infrastructure.

While it is often difficult to establish a second, competing infrastructure, for reasons

linked to investment costs and economic efficiency (i.e. the natural monopoly
arguments linked to economies of scale and a high minimum efficient scale) it is
possible and desirable to create competitive conditions in respect of the services
provided.

The European Commission has developed the concept of separating infrastructure

from commercial activities. The infrastructure is thus the vehicle of competition. While
the right to exclusive ownership may persist as regards the infrastructure (the telephone
or electricity network for example or the supply of gas and electricity to the individual
household and business), monopolists must grant access to companies wishing to
compete with them as regards the services offered on their networks (good examples
include the markets for telephone communications or electricity and gas supply).

State Aid in Markets

453
1
The argument for monitoring state aid given to private and state businesses by member
Government is that by giving certain firms or products favoured treatment to the
detriment of other firms or products, state aid disrupts normal competitive forces.
According to the EU Competition Commission, neither the beneficiaries of state aid nor
their competitors prosper in the long term. Often, all government subsidies achieve is to
delay inevitable restructuring operations without helping the recipient actually to return
to cost and non-price competitiveness. Unsubsidised firms who must compete with those
receiving public support may ultimately run into difficulties, causing loss of
competitiveness and endangering the jobs of their employees.

Under the current European state aid rules, a company can be rescued once. However,
any restructuring aid offered by a national government must be approved as being part of
a feasible and coherent plan to restore the firm’s long-term viability. Government aid
designed to boost research and development, regional economic development and the
promotion of small businesses is normally permitted.

Merger Policy in the UK and the European Union

Corporate restructuring is a fact of life. There is a natural tendency for markets to

consolidate over take through a process of horizontal and vertical integration. The
main issue for competition policy is whether a proposed merger or takeover between two
businesses is thought to lead to a substantial lessening of competitive pressures in the
market and risks leading to a level of market concentration when collusive behaviour
might become a reality.

When companies combine via a merger, an acquisition or the creation of a joint venture,
this generally has a positive impact on markets: firms usually become more efficient,
competition intensifies and the final consumer will benefit from higher-quality goods at
fairer prices.

UK Competition Commission gives the green light for the takeover of Ottakar’s by
HMV
After an investigation into the possible effects on competition in the UK retail book
market, the Competition Commission has announced that a takeover of the bookseller
Ottakar's by HMV, which owns the larger Waterstone's book chain, would not harm the
public interest and that the takeover has been given the green light. The takeover bid was
launched in September 2005 and valued Ottakar's at £96.4 million. But at a time of
weakening demand for book sales in a faltering economy, HMV may be able to complete
a successful takeover with a bid of perhaps one third less than its opening gambit.
The decision goes against a wave of opinion in the book industry among authors and
publishers that the creation of a much larger book retailing business could limit consumer
choice and have a damaging effect on smaller independent booksellers. The book
industry is growing, but there are enormous competitive pressures for smaller booksellers
not least from the supermarkets and online retailers. The Competition Commission has
concluded that the takeover will be unlikely to affect book prices, the range of titles
offered or the quality of service. They believe that there will be sufficient competition

454
1
between existing bricks and mortar retailers and the new entrants to the market so that
HMV will not have any extra power to raise prices on top-selling books.
The combined UK market share of Waterstone’s and Ottakar’s in 2005 were around 24
per cent of all books but overall market concentration has changed little during the past
five years. The Commission estimates that the four largest retailers (WH Smith,
Waterstone’s, Ottakar’s and Borders) have 45 per cent of the market.

Waterstones (HMV) Ottakar’s

Number of stores 194 131

Square footage (m) 1.3 0.6

Sales (£m) year to April 05 £440.0 £173.2

Operating profit (£m) £26.1 £8.2

Employees 4,231 2,023

There is intensive price and non-price competition especially at local level. Non-price
competition tends to focus on the range of titles in stock and quality of in-store service
including author book signings, book ordering facilities, opening hours and
complementary facilities such as areas to browse books and the quality of advice from
bookstore staff.

However, mergers which create or strengthen a dominant market position can, after
investigation, be prohibited in order to prevent ensuing abuses. Acquiring a dominant
position by buying out competitors is in contravention of EU competition law.
Companies are usually able to address the competition problems, normally by offering to
divest (sell or off-load) part of their businesses.

Evaluating the factors behind approving or rejecting a merger within the EU

Often a merger is allowed to progress without any intervention by the competition

authorities when the economic benefits of allowing the integration to take place are
significantly greater than the potential costs. Here are some of the justifications for
approving a merger between two businesses:

(1) Efficiency arguments

 Static efficiency: Mergers may result in the exploitation of further internal

economies of scale and therefore improved productive efficiency (cost savings)

455
1
  Dynamic efficiency: Increased profits can be used for R&D into new products
and new production processes (innovation) creating long term dynamic
efficiency; provides funds for capital investment

(2) The role of the capital markets:

Some economists argue that capital markets (stock markets) will sort out mergers which
eventually fail to deliver the promised financial benefits. If unsuccessful mergers occur,
corporate raiders are always ready to kick out the unsuccessful management who are not
making enough profit for shareholders. The survival of the fittest ensures efficiency by
keeping management on their toes (reducing X-inefficiencies). It is argued that this is a
more effective mechanism than government intervention which will only make matters
worse because of the potential for government failure.
(3) Market contestability arguments:
There has been a huge growth of interest in the concept of contestable markets and this
tends to complement the free market approach to mergers. By concentrating on
removing entry barriers to a marker, monopolies and mergers can only remain
dominant by producing good products efficiently
(4) The capital investment argument:
Lower costs and a bigger combined business may prompt higher levels of capital
investment which is good news for the productive capacity of the EU economy
(5) The globalisation argument
Mergers and takeovers can reinforce and improve the competitive position of EU
companies relative to non EU companies (a countervailing power to dominance of giant
US firms) – this is important in industries that are becoming truly globalized and where
increasing returns to scale (falling LRAC) is an important ingredient of competitive
advantage
(6) Mergers and takeovers as a means of enhancing economic integration within the
EU:
Mergers and takeovers are an inevitable consequence of the creation of a single market –
perhaps the EU competition authorities should continue take a benign view of mergers if
they have at their core, the aim of creating businesses large enough to provide goods and
services to a community of nearly 500 million people.
Economic arguments for not approving a merger:
Under what circumstances might the EU Competition Authorities block a
merger/takeover or insist on some form of redress before permitting it to proceed?
(1) Monopoly power:
Mergers and takeovers create market dominance; consumers are exploited and resources
misallocated if there are entry barriers inhibiting competition leading to market failure
and loss of economic welfare. In practice, there are always barriers to market
contestability especially in industries where sunk costs are high.
(2) Mixed evidence on benefits of mergers:
The evidence is mixed as to whether mergers improve companies' performance, either in
terms of profitability, or cost savings – indeed many of the claims for increased
efficiency and economies of scale made prior to a merger or a takeover prove to be
exaggerated with the benefit of hindsight.
(3) Imperfections in the capital markets:

456
1
The market for corporate control does not work optimally. Unsuccessful managements in
poorly performing businesses may remain in place for a long time. Shares are mainly
held by financial institutions but whilst they are the owners, they do not run the
companies on a day to day basis. This means there is a divorce of ownership and control
with managers pursuing their own interests (salary and welfare) rather than maximising
profits for the shareholders.
(4) Employment effects
Mergers and takeovers nearly always lead to rationalisation as part of a process of cost
cutting but may be at the expense of jobs (possibility of structural unemployment) and
fewer outlets / choice for consumers (an issue of equity)
The vast majority of cases referred to the EU competition authorities are cleared.

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Cost Benefit Analysis

In a world of finite public and private resources, we need a standard for evaluating
trade-offs, setting priorities, and finally making choices about how to allocate scarce
resources among competing uses. Cost benefit analysis provides a way of doing this.

What is cost benefit analysis?

Cost benefit analysis (COBA) is a technique for assessing the monetary social costs
and benefits of a capital investment project over a given time period. The principles of
cost-benefit analysis (CBA) are simple:

1. Appraisal of a project: It is an economic technique for project appraisal, widely

used in business as well as government spending projects (for example should a
business invest in a new information system)
2. Incorporates externalities into the equation: It can, if required, include wider
social/environmental impacts as well as ‘private’ economic costs and benefits so
that externalities are incorporated into the decision process. In this way, COBA
can be used to estimate the social welfare effects of an investment
3. Time matters! COBA can take account of the economics of time – known as
discounting. This is important when looking at environmental impacts of a
project in the years ahead

Uses of COBA

COBA has traditionally been applied to big public sector projects such as new
motorways, by-passes, dams, tunnels, bridges, flood relief schemes and new power

457
1
stations. Our example later considers some of the social costs and benefits of the new
Terminal 5 for Heathrow airport.

The basic principles of COBA can be applied to many other projects or programmes. For
example, - public health programmes (e.g. the mass immunization of children using
new drugs), an investment in a new rail safety systems, or opening a new railway line.
Another example might be to use COBA in assessing the costs and benefits of
introducing congestion charges for motorists in London. Or the costs and benefits of the
New Deal programme designed to reduce long-term unemployment. Cost benefit
analysis was also used during the recent inquiry into genetically modified foods.
Increasingly the principles of cost benefit analysis are being used to evaluate the returns
from investment in environmental projects such as wind farms and the development of
other sources of renewable energy, an area where the UK continues to lag behind.

Because financial resources are scarce, COBA allows different projects to be ranked
according to those that provide the highest expected net gains in social welfare - this is
particularly important given the limitations of government spending.

The Main Stages in the Cost Benefit Analysis Approach

At the heart of any investment appraisal decision is this basic question – does a planned
project lead to a net increase in social welfare?

o Stage 1(a) Calculation of social costs & social benefits. This would include
calculation of:
o Tangible Benefits and Costs (i.e. direct costs and benefits)
o Intangible Benefits and Costs (i.e. indirect costs and benefits –
externalities)
o This process is very important – it involves trying to identify all of the significant
costs & benefits
o Stage 1(b) - Sensitivity analysis of events occurring – this relates to an
important question - If you estimate that a possible benefit (or cost) is £x million,
how likely is that outcome? If you are reasonably sure that a benefit or cost will
‘occur’ – what is the scale of uncertainty about the actual values of the costs and
benefits?
o Stage 2: - Discounting the future value of benefits - costs and benefits accrue
over time. Individuals normally prefer to enjoy the benefits now rather than later –
so the value of future benefits has to be discounted
o Stage 3: - Comparing the costs and benefits to determine the net social rate of
return
o Stage 4: - Comparing net rate of return from different projects – the
government may have limited funds at its disposal and therefore faces a choice
about which projects should be given the go-ahead

Evaluation: Criticisms of COBA

458
1
There are several objections to the use of CBA for environmental impact assessment:

1. Problems in attaching valuations to costs and benefits: Some costs are easy to
value such as the running costs (e.g. staff costs) + capital costs (new equipment).
Other costs are more difficult – not least when a project has a significant impact
on the environment. The value attached to the destruction of a habitat is to some
“priceless” and to others “worthless”. Costs are also subject to change over time –
I.e. the construction costs of a new bridge over a river or the introduction of
electronic road pricing
2. The CBA may not cover everyone affected (i.e. all third parties) – inevitably
with major construction projects such as a new airport or a new road, there are a
huge number of potential “stakeholders” who stand to be affected (positively or
negatively) by the decision. COBA cannot hope to include all stakeholders – there
is a risk that some groups might be left out of the decision process

a. Future generations – are they included in the analysis?

b. What of “non-human” stakeholders?

1. Distributional consequences: Costs and benefits mean different things to

different income groups - benefits to the poor are usually worth more (or are
they?). Those receiving benefits and those burdened with the costs of a project
may not be the same. Are the losers to be compensated? To many economists, the
equity issue is as important as the efficiency argument.
2. Social welfare is not the same as individual welfare - What we want
individually may not be what we want collectively. Do we attach a different value
to those who feel “passionately” about something (for example the building of
new housing on greenfield sites) contrasted with those who are more ambivalent?
3. Valuing the environment: How are we to place a value on public goods such as
the environment where there is no market established for the valuation of
“property rights” over environmental resources? How does one value “nuisance”
and “aesthetic values”?
4. Valuing human life: Some measurements of benefits require the valuation of
human life – many people are intrinsically opposed to any attempt to do this. This
objection can be partly overcome if we focus instead on the probability of a
project “reducing the risk of death” – and there are insurance markets in existence
which tell us something about how much people value their health and life when
they take out insurance policies.
5. Attitudes to risk – e.g. a cost benefit analysis of the effects of genetically
modified foods

a. Precautionary Principle: Assume toxicity until proven safe

1. If in doubt, then regulate

b. Free Market Principle: Assume it is safe until a hazard is identified

459
1
 1. If in doubt, do not regulate.

Despite these problems, most economists argue that CBA is better than other ways of
including the environment in project appraisal.

Discounting the future

Would you rather have £1000 of income today or £1000 of income in the future (say in 3
years?). The answer is probably now, because £1000 in three years time is unlikely to
buy as many goods and services as it does now (because of inflation). And also because
£1000 put into a savings account today will yield interest.
Discounting is a widely used technique as part of cost benefit analysis. The technique of
discounting reflects the following:

The value of a cost or benefit now > the value of a cost or benefit in future years

Discounting reflects this by reducing all future costs and benefits to express them as
today’s values. The key question is: How do you choose an ‘interest rate’ for reducing
future costs to give them a present value today?

Setting a general discount rate for new projects has important implications for the
environment:

1. A low discount rate is often favoured by economists since they argue that
investing a high proportion of current income is a good way of providing for the
future
2. A high discount rate may also be favoured since it discourages investment (and by
implication environmental damage) in the present

Most projects have lifetimes of 20-30 years – with many of the big costs arising early in a
project e.g. from construction whereas the stream of benefits from a project occur over a
much longer period of time. But for many huge construction projects, some of the costs
only become apparent in the long run. Consider the building of a new nuclear power
station. Environmentalists would argue that there is a long list of costs from waste
management and decommissioning which stretch over 100 years into the future whereas
no social benefits exist to offset these costs beyond year 30 or 40 (where the nuclear
power station might reasonably be expected to be ready for closure).

The value of decommissioning costs over 100 years away is almost negligible no matter
what discount rate we use. This makes discounting difficult to justify

Revealed Preference – Valuing the Benefits from a Project

According to some economists, the valuation of benefits and costs used in COBA should
reflect the preferences revealed by choices which have actually been made by
individuals and businesses in different markets.

460
1
Consider this example:
20 employees are given the chance of using a new car park close to work for £5 per day
or parking further away from work for free – but involving an extra 10 minutes walk.
Their decisions reveal how much they value time. If they all choose to spend the £5 per
day on car parking, this reveals that time is more important to them than 50p per minute.
If only half take up the car parking option, this reveals that average value of time to them
was 50p per minute. Hard choices made in markets are the best guide to private benefit.

Information contained in the demand curve tells us much about how much people are
willing and able to pay for something. This is important in revealed preference theory.
When consumers make purchases at market prices they reveal that the things they buy are
at least as beneficial to them as the money they relinquish.

Cost benefit analysis in practice – Heathrow Terminal 5

The debate over whether there should be a fifth terminal at Heathrow airport has fierce
and long-lasting! The official planning enquiry reported after 5 years and having cost
many millions of pounds. The rival arguments at the inquiry highlighted many examples
of environmental impact (externalities) - noise, air quality, rivers etc. - but concluded that
these were not enough to refuse planning permission and that the new terminal project
should go ahead.

The case for terminal 5

1. Economic growth: Demand for air travel in south-east England is forecast to

double in the next 20 years, making expansion vital – many thousands of jobs and
businesses depend on Heathrow airport expanding to provide sufficient supply
capacity to meet this growing demand. An increase in the capacity of Heathrow
will make best use of airport's existing infrastructure and land (nearly 3,000
acres).
2. The economy and trade: The UK will lose airlines and foreign investment to
European rivals if it does not meet demand. The benefits of a world-beating
industry would be diminished – many sectors of our aviation industry have a
comparative advantage and add huge sums to our balance of payments
3. Jobs: The terminal 5 project will create or safeguard an estimated 16,500 jobs, as
well as creating 6,000 construction jobs during the building phase – this will have
multiplier effects on the local / regional and national economy
4. Transport: The terminal will be the centre of a world-class transport interchange,
with new Tube and rail links. Car traffic would rise only slightly – the social costs
of increased traffic congestion have been exaggerated by the environmentalists
5. Environment: The site earmarked for terminal 5 is currently a disused sludge
works, and any displaced wildlife and plant life will be carefully relocated. The
noise climate around Heathrow Airport has been improving for many years, even
though the number of aircraft movements has increased considerably – partly due
to the phasing out of older, nosier aircraft

461
1
 6. Noise and night flights: BAA promises no increase in overall noise levels or in
night flying. The number of flights would rise only 8%

Objections to Terminal 5

1. Growth: BAA forecasts are misleading and will lead to uncontrolled expansion,
rather than targeting better solutions such as using existing space at other airports.
2. The economy: Heathrow already has the biggest capacity in Europe, and
ambitions to extend its lead are merely "commercial prestige" rather than having
long term macroeconomic benefits
3. Jobs: Only 6,000 jobs will be created - a tiny fraction of all the new jobs in the
South East. Local studies say jobs will increase anyway even without a fifth
terminal
4. Transport: There will be a significant increase in road-widening and car parks to
cater for the tens of thousands of extra car journeys to the airport every year
5. Environment: Air pollution will increase significantly, and hundreds of acres of
wildlife and Green Belt land will be lost forever. Plus the environmental costs of
increased traffic congestion
6. Noise and night flights: More flights will mean more noise under the flight paths,
and the pressure for controversial night flights and a third runway will increase –
the regulators will be captured by the airlines and airport authorities and will
eventually be pressurized into giving way on allowing more night time flights

These are just a few of the arguments raised for and against the Terminal 5 project. For
more news on the project consult
www.baa.com/main/airports/heathrow/terminal_5_frame.html

Case study - A national smoking ban

According to a cost benefit analysis performed for the Chief Medical officer's Annual
Review of Public Health published in July 2004, a ban on smoking in public places
would benefit the economy by between £2.3bn and £2.7bn a year. The COBA argued that
a ban on smoking in pubs, restaurants and cafes would not reduce profits in the leisure,
catering and hospitality industry. However critics of the new study responded by saying
that the assumptions behind the economic model, remained unpublished.

Annual Benefits £ million

Health benefits (reduced absenteeism) 70 – 140

Health benefits (reduced costs of healthcare) 4

Health benefits (averted deaths from second-hand smoke 21

amongst employees)

462
1
Health benefits (reduced uptake, particularly new young 550
employees)

Health benefits (smoking cessation) 1600

Safety benefits (damage, deaths, injuries) 57

Safety benefits (cost to fire services) 0.2

Safety benefits (administration costs) 6.3

Cost savings to NHS from smoking cessation Not estimated

Cleaning costs and damage to equipment avoided 100

Production gains 340 – 680

Total 2700 - 3100

Annual Costs £ million

Production losses (smoking breaks) 430

Losses to continuing smokers (loss of satisfaction) 155

Losses to quitters (loss of satisfaction) 550

Losses to the Treasury 1145

Total

To recap, cost benefit analysis is basically an appraisal technique that tries to place
monetary values on all benefits arising from a project and then compares the total value
with the project's total cost. It has numerous potential applications although there are
inherent difficulties with the issue of valuation. Essentially the process of COBA is a
comparative one, so that we can perhaps make judgements about which projects from a
limited choice should be given the go ahead.

463
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Labour Market - Demand for Labour

The labour market

Although over three million people in the UK are classified as self-employed, the vast
majority of people in work in the UK are employed by private sector businesses, the
government and a range of unincorporated businesses. The working of the labour market
affects us all because the vast majority of people at some point during their working lives
will be active participants in the labour market.

The demand for labour comes from the employer. We shall start with this side of the
market. Then we move onto the issue of labour supply before analysing the determination
of wage rates in competitive and imperfectly competitive labour markets.

Product and labour markets

We often make a distinction between product and labour markets.

Product markets are where businesses and consumers meet to buy and sell the output of
goods and services produced by an economy.

The labour market provides a means by which employers find the labour they need,
whilst millions of individuals offer their labour services in different occupations. A
simplified set of relationships is shown in the flow chart below.

464
1
The demand for labour

There is normally an inverse relationship between the demand for labour and the wage
rate that a business needs to pay for each additional worker employed. If the wage rate is
high, it is more costly to hire extra employees. When wages are lower, labour becomes
relatively cheaper than for example using capital equipment and it becomes more
profitable for the business to take on more employees.

Standard “neo-classical” labour market theory assumes that businesses seek to maximise
profits. They will therefore search in the long run for the mix of factors of production
(labour and capital) that produces the required level of output as efficiently as possible
for the lowest possible total cost. Of course we can drop the assumption of profit
maximisation and this has implications for employment and equilibrium wages in
particular industries or occupations. But for the moment we will assume that businesses
are profit-maximisers when deciding on their desired demand for labour.

465
1
 The demand for labour is derived from the demand for the goods and services that
workers are asked to produce

Marginal revenue product of labour

Marginal revenue productivity of labour (MRPL) is a theory of the demand for labour
and market wage determination where workers are assumed to be paid the value of their
marginal revenue product to the business

Marginal Revenue Product (MRPL) measures the change in total revenue for a firm
from selling the output produced by additional workers employed.

MRPL = Marginal Physical Product x Price of Output per unit

o Marginal physical product is the change in output resulting from employing one
extra worker
o The price of output is determined in the product market – in other words, the price
that the firm can get in the market for the output that they have produced

A simple numerical example of marginal revenue product is shown in the next table:

Labour Capital (K) Output (Q) MPP price (£) MRP = MPP x P (£)

0 5 0 5

1 5 30 30 5 150

2 5 70 40 5 200

466
1
 3 5 120 50 5 250

4 5 180 60 5 300

5 5 270 90 5 450

6 5 330 60 5 300

7 5 370 40 5 200

8 5 400 30 5 150

9 5 420 20 5 100

10 5 430 10 5 50

We are assuming in this example that the firm is operating in a perfectly competitive
market such that the demand curve for its output is perfectly elastic at £5 per unit.
Marginal revenue product follows directly the behaviour of marginal physical product.
Initially as more workers are added to a fixed amount of capital, the marginal product is
assumed to rise. However beyond the 5th worker employed, extra units of labour lead to
diminishing returns. As marginal physical product falls, so too does marginal revenue
product. The story is different is the firm is operating in an imperfectly competitive
market where the demand curve for its product is downward sloping. In the next
numerical example we see that as output increases, the firm may have to accept a lower
price. This has an impact on the marginal revenue product of employing extra units of
labour.

Labour Capital (K) Output (Q) MPP price (£) MRP = MPP x P (£)

0 5 0 10.0

1 5 25 25 9.60 240

2 5 60 35 9.00 315

3 5 100 40 8.70 348

4 5 150 50 8.20 410

5 5 210 60 7.90 474

467
1
 6 5 280 70 7.70 539

7 5 360 80 7.00 560

8 5 430 70 6.80 476

9 5 450 20 6.50 130

10 5 460 10 6.00 60

MRP theory suggests that wage differentials result from differences in labour
productivity and the value of the output that the labour input produces. The MRP theory
outlined below is based on the assumption of a perfectly competitive labour market and
rests on a number of key assumptions that realistically are unlikely to exist in the real
world. Most of our labour markets are imperfect – this is one of the many reasons for the
existence and persistence of large earnings differentials between occupations which we
explore a little later on.

The main assumptions of the marginal revenue productivity theory of the demand for
labour are:

o Workers are homogeneous in terms of their ability and productivity

o Firms have no buying power when demanding workers (i.e. they have no
monopsony power)
o Trade unions have no impact on the available labour supply (the possible impact
on unions on wage determination is considered later)
o
o The physical productivity of each worker can be accurately and objectively
measured and the market value of the output produced by the labour force can be
calculated
o The industry supply of labour is assumed to be perfectly elastic. Workers are
occupationally and geographically mobile and can be hired at a constant wage rate

The profit maximising level of employment

The profit maximising level of employment occurs when a firm hires workers up to the
point where the marginal cost of employing an extra worker equals the marginal revenue
product of labour. This is shown in the labour demand diagram shown below.

468
1
Shifts in the labour demand curve

Marginal revenue productivity of labour will increase when there is

o An increase in labour productivity (MPP) e.g. arising from improvements in the

quality of the labour force through training, better capital inputs, or better
management.
o A higher demand for the final product which increases the price of output so
firms hire extra workers and thus demand for labour increases, shifting the labour
demand curve to the right.
o The price of a substitute input e.g. capital rises – this makes employing labour
more attractive to the employer assuming that there has been no change in the
relative productivity of labour over capital

The next diagram shows how this causes an outward shift in the labour demand curve.
For a given wage rate W1, a profit maximising firm will employ more workers. Total
employment in the market will rise.

469
1
Limitations of MRPL theory of labour demand

Although marginal revenue product theory is a useful aspect of labour market analysis it
is important to be aware of some of its limitations:

1. Measuring productivity: In many cases it is hard to objectively measure

productivity because no physical output is produced or the output produced may
not be sold at a market price. This makes it hard to place an exact valuation on the
output of each extra worker. How does one go about measuring the final output of
people employed in teaching or the health service? It is easier to measure physical
output in industries where a tangible product is produced each day. It is also
costly to measure people’s productivity.
2. Pay Award Bodies: In some jobs wages and salaries are set independently of the
state of labour demand and supply. Public sector workers for example fire-
fighters, council workers, nurses and teachers may have their pay set according to
decisions of independent pay review bodies with “market forces” having only an
indirect role in setting pay-rates
3. Self employment and Directors’ Pay: There are over three million people
classified as self-employed in the UK. How many of these people set their wages
according to the marginal revenue product of what they produce? What too of
those people who have the ability to set their own pay rates as directors or owners
of companies?

470
1
 Workers employed on a construction site. In some industries it is easier than others to
measure the physical productivity of workers

Elasticity of labour demand

Elasticity of labour demand measures the responsiveness of demand for labour when
there is a change in the ruling market wage rate. The elasticity of demand for labour
depends:

1. Labour costs as a % of total costs: When labour expenses are a high proportion
of total costs, then labour demand is more elastic than a business where fixed
costs of capital are the dominant business expense.
2. The ease and cost of factor substitution: Labour demand will be more elastic
when a firm can substitute quickly and easily between labour and capital inputs
when the relative prices of each change over time. When the two inputs cannot
easily be changed in the production process (e.g. when specialised labour or
capital is needed), then the demand for labour will be more inelastic with respect
to the wage rate
3. The price elasticity of demand for the final output produced by a business: If
a firm is operating in a highly competitive market where final demand for the
product is price elastic, they may have little market power to pass on higher wage
costs to consumers through a higher price. The demand for labour may therefore
471
1
 be more elastic as a consequence. In contrast, a firm that sells a product where
final demand is inelastic will be better placed to pass on higher costs to
consumers.

The diagram below shows two labour demand curves with different elasticity

Labour as a Derived Demand

The demand for all factors of production (inputs), including labour, is a derived demand
ie the demand for factors of production depends on the demand for the products they
produce. When the economy is expanding, we expect to see a rise in the aggregate
demand for labour providing that the rise in output is greater than the increase in labour
productivity. In contrast, during an economic recession or a slowdown, the aggregate
demand for labour will decline as businesses look to cut their operations costs and scale
back on production. In a recession, business failures, plant shut-downs and short term
redundancies lead to a reduction in the derived demand for labour.

Employment change in the UK economy 1990 2005% change

Data is for December each year

472
1
 000s 000s 1990-2005

Banking, finance and insurance 4442 6097 27.1

Total services 20501 24711 17.0

Education and health 6470 7790 16.9

Distribution, hotels & restaurants 6463 7078 8.7

Transport & communication 1680 1839 8.6

Construction 2357 2099 -12.3

Agriculture & fishing 641 446 -43.7

Manufacturing 5203 3383 -53.8

Mining, electricity, gas & water 398 171 -132.7

Source: UK Labour Market Statistics

473
1
 474
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Supply of Labour to Markets

How many people are willing and able to work in different industries and occupations?
This question refers to the supply of labour.

The labour supply curve

The labour supply curve for any industry or occupation will be upward sloping. This is
because, as wages rise, other workers enter this industry attracted by the incentive of
higher rewards. They may have moved from other industries or they may not have
previously held a job, such as housewives or the unemployed. The extent to which a rise
in the prevailing wage or salary in an occupation leads to an expansion in the supply of

475
1
labour depends on the elasticity of labour supply.

Key factors affecting labour supply

The supply of labour to a particular occupation is influenced by a range of monetary and

non-monetary considerations.

1. The real wage rate on offer in the industry itself – higher wages raise the
prospect of increased factor rewards and should boost the number of people
willing and able to work
2. Overtime: Opportunities to boost earnings come through overtime payments,
productivity-related pay schemes, and share option schemes and financial
discounts for employees in a certain job.
3. Substitute occupations: The real wage rate on offer in competing jobs is another
factor because this affects the wage and earnings differential that exists between
two or more occupations. So for example an increase in the relative earnings
available to trained plumbers and electricians may cause some people to switch
their jobs. In recent times, the British media has been fond of stories of people

476
1
 leaving jobs in academia (including high level university research) and moving in
household services because the basic rates of pay and potential earnings are so
much greater.
4. Barriers to entry: Artificial limits to an industry’s labour supply (e.g. through
the introduction of minimum entry requirements or other legal barriers to entry)
can restrict labour supply and force average pay and salary levels higher – this is
particularly the case in professions such as legal services and medicine where
there are strict “entry criteria” to the professions. Indeed these labour market
barriers are partly designed to keep pay levels high as well as being methods of
maintaining the quality of people entering these professions

The length of time it takes to qualify as an architect restricts the labour supply and keeps
salaries high

1. Improvements in the occupational mobility of labour: For example if more

people are trained with the necessary skills required to work in a particular
occupation
2. Non-monetary characteristics of specific jobs – these can be important – they
include factors such as the level of risk associated with different jobs, the
requirement to work anti-social hours or the non-pecuniary benefits that certain
jobs provide including job security, opportunities for promotion and the chance
to live and work overseas, employer-provided in-work training, employer-
provided or subsidised health and leisure facilities and other in-work benefits
including occupational pension schemes
3. Net migration of labour – the UK is a member of the European Union single
market that enshrines free movement of labour as one of its guiding principles. A
rising flow of people seeking work in the UK is making labour migration an
important factor in determining the supply of labour available to many industries

477
1
 – be it to relieve shortages of skilled labour in the NHS or education, or to meet
the seasonal demand for workers in agriculture and the construction industry

Compensating wage (pay) differentials

Wage differentials in part act as a compensation for people who have to work unsocial
hours or who are exposed to different degrees of risk at work, both in the short term and
long run. Some jobs require a wage-rate that encompasses this risk premium – so
workers in the North Sea Oil industry expect a higher return to adjust for the inherent
dangers of their work.

Elasticity of labour supply

The elasticity of labour supply to an occupation measures the extent to which labour
supply responds to a change in the wage rate in a given time period. In low-skilled
occupations we expect labour supply to be elastic. This means that a pool of readily
available labour is employable at a fairly low market wage rate. Where jobs require
specific skills and lengthy periods of training, the labour supply will be more inelastic. It
is hard to expand the workforce in a short period of time when demand for workers has
increased.

In many professions there are artificial barriers to the entry of workers. Examples
include Law, Accountancy and Medicine. The need for high level educational
qualifications makes the supply of newly qualified entrants to these occupations quite
inelastic in the short run and is one reason why these workers may earn a higher real

wage than average salaries.

478
1
The work-leisure trade off

Once somebody has entered the labour force how many hours will they choose to work?
For many people, the hours they work are fixed by their employers and they have little or
no flexibility in the total number of hours they supply. But the majority of workers have
an opportunity at some point to work additional hours, or perhaps switch from a full-time
job to a part-time position, a. And the official data probably understates the true number
of people who are “moonlighting” and working in a second or third job because of the
rapid expansion of the shadow economy which had encouraged the expansion of a
shadow labour force.

Often employers adjust the number of hours of work available to meet their employees’
preferences. Over seven million people are now in part-time employment and much of

479
1
this growth in part-time jobs has been sustained because it meets the preferences of
people looking for greater flexibility in their working arrangements.

Economic theory would suggest that the real wage is a key determinant of the number of
hours. The real wage is the money wage rate adjusted for changes in the price level and it
measures the quantity of goods and services that can be bought from each hour worked.
An increase in the real wage on offer in a job should lead to someone supplying more
hours of work over a given period of time, although there is the possibility that further
increases in the going wage rate might have little effect on an individual’s labour supply.
Indeed, there is the possibility of a backward-bending individual labour supply curve.
This is illustrated in the next diagram.

Two distinct individual labour supply curves are shown. In the first curve, higher real
wages do lead to an increase in the number of extra hours supplied, although the rate at
which the individual is prepared to give up their leisure time and work longer hours
diminishes as the real wage rises. But the labour supply curve meets the standard
prediction that higher wages attract people to work longer hours. In the second curve, for
most of the range of real wages, the same prediction holds true, but when as real wages
step upwards, eventually an individual may choose to actually work fewer hours (ceteris

480
1
paribus) giving us what is sometimes termed a “backward bending” labour supply
curve.

Income and substitution effects

To understand why this might happen we consider the income and substitution effects
that arise from a change in the real wage being paid to an individual worker. We start
with the income effect.

o The income effect: Higher real wages increase the income that someone can earn
from a job, but they also mean that the time that must be spent at work to earn
sufficient to pay for a particular product declines. Put briefly, higher pay levels
mean that a target real wage can be achieved with fewer hours of labour supply.
So this income effect might persuade people to work less hours and enjoy
extended leisure time.
o The substitution effect: The substitution effect of a higher wage rate should
unambiguously give people an incentive to work extra hours because the financial
rewards of working are raised, and the opportunity cost of not working (measured
by the wages given up when people opt for leisure instead) has increased.

With the income and substitution effects working in opposite directions, there is no hard
and fast prediction about whether people will choose to increase their labour supply as
real wages increase. Are the income and substitution effects different for male compared
to female workers? What about younger workers entering the labour market for the first

time who are looking to save to finance a deposit on a house or to fund other major items
of spending? How might people closer to retirement age respond to changes in real
wages? What of workers in households where at least someone else is in paid
employment compared to a household where there is only one main “breadwinner”?

The available empirical evidence for the UK labour market is mixed, indeed some
analysts believe that in aggregate, the income and substitution effects effectively cancel
each other out so that real wages have no impact on the individual labour supply!

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Trade Unions and Monopsony Employers

481
1
Trade Unions
Trade unions are organisations of workers that seek through collective bargaining with
employers to protect and improve the real incomes of their members, provide job
security, protect workers against unfair dismissal and provide a range of other work-
related services including support for people claiming compensation for injuries sustained
in a job.

Union Membership Trends in the UK

 There has been a large decline in union membership over the last twenty-five
years
 Membership: In autumn 2005 an estimated 6.39 million employees in the United
Kingdom were members of a trade union. This was a fall of approximately
119,000 or 1.9 per cent, compared with levels recorded in autumn 2004.
 Union density: The proportion of employees who were trade union members in
the UK in autumn 2005 was 26.2 per cent
 Collective bargaining: The number of employees covered by a collective pay
agreement was 8.75 million in autumn 2003, 35.8 per cent of all employees
 Full-time, part-time: 32% of full-time workers are members of a trade union
whereas only 21% of part-time workers are unionised
 Union density is highest in the North east and Northern Ireland (both at 43%) in
contrast to the South East where only 23% of full-time workers are union
members
 Union membership is very low among people working for small businesses.
Where less than 25 people are in a place of work, union membership is only 15%
 Union membership is high in the public sector (59%) but only 18% in the private
sector

Trade union membership

Percentages

Men Women

16–24 25–34 35–49 50 and over 16–24 25–34 35–49 50 and over

1995 14.9 31.4 43.1 40.7 14.0 31.1 35.3 31.5

2000 11.9 24.5 37.4 36.8 10.0 27.3 35.4 33.5

2004 10.6 22.9 34.2 35.0 8.9 27.1 34.9 34.5

Union membership (including staff associations) as a proportion of all employees

482
1
 Source: Labour Force Survey, Office for National Statistics

Examples of trade unions in the UK

 Most trade unions belong to the Trades Union Congress (TUC) - The Trade
Unions Congress (TUC) is a federation of unions in the United Kingdom. There
are seventy one affiliated unions with a total of about seven million members
 Amicus
 Association of University Teachers
 Communication Workers Union
 Fire Brigades Union
 National Union of Teachers
 Professional Footballers Association (PFA)
 Rail Maritime and Transport Union
 Transport and General Workers Union
 Union of Shop, Distributive and Allied Workers (USDAW)
 Unison

Trade union power

Unions have less power and influence in the labour market than they did two decades ago
although in several big industries they can still exert their “industrial muscle”. Power has
gradually ebbed away for a variety of reasons:

 Employment legislation which has outlawed illegal strikes, given employers the
right to seek compensation for the effects of certain forms of industrial action and
requires all unions to hold secret ballots of their members before any strike action
is permitted
 The effects of increased competition in product markets – in nearly every
domestic market for goods and services, there is greater competition than there
was a few years ago. Be it the intensity of global competition from lower-cost
producers or the deregulation of markets that has increased market contestability,
trade unions have had to adjust to a world where the pricing power of
manufacturers and service industries has been severely curtailed. Hence the
increasing demands from businesses to link pay and conditions to worker
productivity. There are still some fairly militant trade unions around – notably in
the public sector services including transport. The train drivers’ union, ASLEF,
has been one of the more militant unions in recent years, conducting strikes on the
rail network and London Underground.
 Patterns of employment: There has been a long term change in the structure of
employment in the British economy away from traditionally strong union sectors
such as heavy engineering, coal-mining, steel and textiles, towards service sector
jobs in the private sector where union density is much lower

Unions and wage negotiations – labour market theory

483
1
Unions might seek to exercise their collective bargaining power with employers to
achieve a mark-up on wages compared to those on offer to non-union members. For this
to happen, a union must have some control over the total labour supply available to an
industry. In the past this was possible if a union operated a closed shop agreement with
an employer – i.e. where the employer and union agreed that all workers would be a
member of a particular union. However in most sectors, the closed shop is now history.

More frequently, a union may simply bid through bi-lateral negotiations with employers
to achieve an increase in wages ahead of the rate of inflation so that real wages rise, and
other improvements to working hours and conditions.

The balance of power between employers and a trade union in their periodic wage
negotiations depends on a range of factors:

 Unemployment: when labour is scarce and there are shortages of skilled workers,
then the balance of power tilts towards unions. Unions are always less powerful
when the demand for labour is falling and labour is less scarce.
 Competitive pressures in product markets – when a firm is enjoying a
dominant monopoly position and high levels of abnormal profit, the unions will
know that the employer has the financial resources to meet a more generous wage
settlement

484
1
Monopsony in the labour

market

A monopsony producer has significant buying power in the labour market when
seeking to employ extra workers. A monopsony employer may use their buying-power to
drive down wage rates. The monopsonist knows that they face an upward sloping labour
supply curve, in other words, to attract more workers in their industry, they must pay a
higher wage rate – so the average cost of employing labour rises with the number of
people taken on. Because the average cost of labour is increasing, the marginal cost of
extra workers will be even higher, since we assume that an increase in the wage rate
paid to attract one extra worker must also be paid to existing workers.

485
1
The profit maximising level of employment is where the marginal cost of labour
equates with the marginal revenue product of employing extra workers. In the
diagram, Eq workers are taken on, but the monopsonist can employ these workers at an
average wage rate of Wq – a pay level below the marginal revenue product of the last
worker. In this sense the monopsonist is exploiting labour by not paying them the full
value of their marginal revenue product.

Trade unions may seek to counterbalance the monopsony power of an employer by

controlling aspects of the labour supply and by using whatever collective bargaining
power they possess to negotiate wages higher without being at the expense of
employment levels.

Examples of monopsony employers

Good examples might be the major employer in a small town (e.g. a car plant, a major
supermarket or the head office of a bank); nursing homes as employers of care assistants,
the government can also have monopsony power as the major employer in the teaching
profession or the NHS (the third largest employer in the world behind the Indian
Railways and the Chinese Red Army!
486
1
How might a minimum wage impact on employment and wage decisions of a
monopsony?

Because the minimum wage is a pay floor, the monopsonist cannot pay a wage below it,
so the NMW effectively becomes the marginal and average cost curve for hiring workers
up to employment level Emin. Thereafter to hire additional staff, the wage rate must be
bid up, again creating a divergence between the average and marginal cost of labour. The
effect on the diagram is that with an appropriately set rate, the profit maximising level of
employment after a minimum wage is higher (E2) and the wage rate paid to labour has
also increased (W2). So in this particular example, making certain assumptions, a
minimum wage might actually boost total employment and secure higher factor rewards
for workers in occupations and industries where there is some monopsonistic power
among the buyers of labour.

There are some doubts as to how many workers are actually in this position, reme

mber that the UK minimum wage at its current rate affects directly less than one worker
in ten so we cannot expect the monopsony justification to be a significant one when
putting the argument for keeping a national minimum wage.

Author: Geoff Riley, Eton College, September 2006

487
1
A2 Markets & Market Systems
Labour Market - Migration

The costs and benefits of labour migration has become a highly topical issue among
economists and policy-makers over recent years. Foreign workers now account for over
5 per cent of the UK labour force. This note considers some of the economic and social
costs and benefits from the rising scale of labour migration.

An increase in the rate of net migration can have significant effects on the labour markets
of individual countries and wider macroeconomic effects on variables such as economic
growth, unemployment and inflation.

Economic factors influencing migration decisions

Context:
- Global Population: 6.5 billion
- Global labour force 3.2 billion of whom 85% live in less developed countries
- Global Migrants: estimated at 190 million, of whom 90 million are in the labour force
95 million and sixty per cent are in developed countries
- Global labour force: 40% agriculture, 20% industry, 40% services
- Developed country labour force: 3% agriculture, 25% industry, 72 % services
- Migrants in developed countries (60 million out of a total of 500 million): 10%
agriculture, 40% industry, 50% services
Source: Phil Martin, Agricultural and resource economics, UC Davis, US, July 2006

There are many reasons why people choose to migrate:

Financial incentives: Individuals may estimate the private costs and private benefits of
moving from one country to another. The incentive to migrate is strongest when the
expected increase in earnings exceeds the cost of relocation. In some countries there are
significant differences in average wage levels that more than compensate for variations in
the cost of living. In a world of rising economic inequalities, the motivation to move to
search for better paid word can be extremely powerful.

Estimates of purchasing power parity can be useful in establishing the real income
gains from working in one country rather than another.

Financial incentives are also affected by the tax and welfare systems of different
countries. Just as capital can move from one country to another seeking the highest post-
tax expected rate of return, so workers may be induced to move because of variations in
the generosity of the welfare system and differences in the rates of direct income tax.

488
1
Non-financial reasons: Other reasons for migrating, such as the opportunity to study in a
foreign country, learn a new language, joining family members, or more generally
improving living standards and seeking a better quality of life. Revolutions in
communication and transport have also encouraged higher levels of cross country
migration.

The economic costs and benefits of migration

“The economic effects of immigration depend not on population growth or density but on
the characteristics of the immigrants themselves. While every mouth brings a pair of
hands, these hands sometimes make more than they eat and sometimes less.”
“On balance, immigration usually produces economic benefits for the receiving country.
Immigrants are more economically active than the native population; are paid less than
natives with similar skills; are more energetic than natives; and more willing to take
undesirable jobs, such as those with unsocial hours.”
Adapted from an article by Professor John Kay in the Financial Times

Does labour market migration create more of an economic burden for the host country?
Or can it provide a valuable contribution to raising productivity, entrepreneurship and
economic growth in the long term? There can be no definitive answer of course. What is
certain is that migration will remain an important issue for the UK and for the European
Union over the coming years. In our discussion below of the costs and benefits of
migration we focus on legal immigration rather than the concerns that arise from the
illegal movement and trafficking of workers from country to country.

Migration policies in the European Union

 1 May 2004: UK, Ireland, Sweden allow in workers from eight new member
states, but other 12 older EU states maintain restrictions. Workers from new
members Cyprus and Malta do not face restrictions
 1 May 2006: Finland, Greece, Spain and Portugal lift curbs on workers from the
eight new member states in Central and Eastern Europe
 2011: Deadline for all EU members to remove labour restrictions.

The benefits of migration:

Case study: Economic migrants from Poland

They are caterers, builders, stockbrokers, shelf-stackers, plumbers, nurses, dishwashers
and dentists, but, most importantly, they are no longer here. Since Poland joined the EU a
year ago on 1 May 2004, industrious, ambitious Poles have become an integral part of the
British employment landscape, arriving in their thousands to fill jobs.
Adapted from the Independent, April 28th 2005

What are some of the macroeconomic benefits from an influx of workers into the
economy?

489
1
 1. An expansion of the labour supply – migration can extend the pool of available
labour for firms: for example, skilled migrants may alleviate shortages in sectors
such as the NHS, agriculture, construction, computing industries and state
education - allowing the government to meet targets for improving public
services. Migrants tend to be young adults – so a rising trend of migration can
help to increase the population of working age and also the flexibility of the
labour market. Many migrants into the UK are highly skilled people, drawn
particularly to the quaternary service sector, especially in finance, in London and
South-east England.

 Reduced pressure on wage inflation - an increase in labour supply from

migration is likely to restrain wage growth in the short term, given the amount of
labour that firms demand. This is shown in the diagram below. A slower rate of
increase in wages has the effect of easing cost-push inflationary pressure which
might then give the Bank of England more leeway to keep interest rates low.
Immigrants are usually prepared to work for lower wages than domestic workers.
This can mean lower costs of production for suppliers which can then feed
through into lower retail prices for consumers.
 A fall in the NAIRU - If migration effects are strong, then it is plausible to argue
that the non-accelerating inflation rate of unemployment might fall. Because
when labour demand is very strong, whereas normally this could put upward
pressure on wages, if labour supply can adjust flexibly to rising demand, then
there is less risk of acceleration in wage and price inflation. However, we should
be cautious about this idea – for there are always natural and institutional barriers
to the geographical mobility of labour. And the levels of migration we are seeing
in the UK are not particularly large at the current time
 Aggregate demand effects- economic migrants are likely to earn more than they
spend contributing to the growth of the local or regional economy
 Entrepreneurship – supporters of a more relaxed approach to migration claim
that many of the migrants are younger and have the potential to be entrepreneurial
in their approach – another potential supply-side gain for the economy
 Higher trend growth - taken as a whole, a positive rate of migration can add
both to short-term economic growth (via a rise in aggregate demand) and also a
slightly faster trend rate of growth (which brings economic benefits in the long
run). The UK Treasury has estimated that the economy might grow each year by
an additional quarter of a percentage point—worth £2.5 billion —until 2006. That
handy annual addition to GDP should also boost government tax revenues by
about £1 billion every year. This assumes a net migration of between 160,000 –
180,000 per year

Case study -Migration expands the UK workforce

The number of people in the UK of working age (16 to 59 for women, 16 to 64 for men)
has risen by 274,000 over the last year and by over 450,000 since unemployment reached
a low in September 2004. The total number of people aged 16 or above has risen by
637,000 over the same period. Part of this increase no doubt reflects the effects of
immigration flows into the UK following the expansion of the European Union. It is

490
1
estimated that net migration totalled 300,000 or so in 2004, before rising to around
470,000 in 2005. Of course, these totals are unlikely to have shown up in full in the
official data on the working age population, not least because some of the migrants will
presumably have been children. Nonetheless, they suggest that much of the recent pick-
up in the growth of the work-force has been down to the effect of increased immigration.
Source: Adapted from the Deloitte UK Economic Review, 3rd Quarter 2006

The costs of migration

We cannot rely on mass immigration to solve the problems arising from ageing of the
population and alleged labour shortages. Mass immigration is not an effective solution to
these problems. To the extent that they are real, such problems can only be effectively
tackled by mobilizing the under-utilized talents and energies of the existing population.
This does not mean that there is no economic benefit at all from immigration. It will
always be in our collective interest to admit skilled and talented people. But this is

491
1
happening already
Adapted from a speech by Professor Bob Rowthorn, April 2004

Opponents of labour migration including pressure groups such as Migration Watch

highlight the potential costs of a growing inflow of new workers.

 Depressing the real wages of domestic workers – e.g. an inflow of new workers
will lead to an increased supply of low skilled workers and therefore drive down
the equilibrium wage for domestic low-skilled employees
 Doubts about productivity effect: Many immigrants, especially those from
poorer countries, have a low educational level and are more likely to be
unemployed or economically inactive than the domestic population.
 Increased pressure on the welfare state (benefits, education, housing and
health) – the taxpayer may eventually have to pay for the increased level of
government spending needed to extend the economy’s infrastructure
 Unemployment concerns: There is a risk of higher unemployment if the skills
profile of migrants does not match the demands of the growing industries in the
economy
 Increased pressure on scarce resources: The inflow of immigrants into an area
may increase the demand for housing and push up the cost of living. To
compensate their workforce many employers are likely to raise money wages

The longer term benefits and costs of increased labour migration are very hard to quantify
and estimate. Much depends on:

 The types of people who choose to migrate from one country to another
 The ease with which they assimilate into a new country and whether they find
full-time employment
 The extent to which a rise in labour migration stimulates an increase in capital
expenditure by firms and by government.
 Whether workers who come to the UK decide to stay in the longer term (this may
involve members of their extended family joining them) or whether they regard
migration as essentially a temporary exercise (e.g. to gain qualifications, learn
some English) before moving back to their country of origin.

Suggestions for wider reading

o Barriers to labour migration still exist in an enlarged EU (BBC)

o Britain’s employment puzzle (The Times)
o Centre on Migration Policy and Society
o Destination UK (Special report on migration and immigration - BBC)
o Eastern European migration figures higher than expected (BBC)
o EU migrants erode old divisions (BBC)
o Immigration (The Economist)
o Migrant workers boost business and growth (BBC)
o Migration and the Irish economy (The Times)

492
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Distribution of Income & Wealth

In this note we consider the scale of income and wealth inequalities in the UK. Why does
inequality happen? And what government policies have been applied to affect the final
distribution of income?

Income and Wealth

It is important to make a clear distinction between income and wealth:

o Income is a flow of factor incomes such as wages and earnings from work; rent
from the ownership of land and interest & dividends from savings and the
ownership of shares
o Wealth is a stock of financial and real assets such as property, savings in bank
and building society accounts, ownership of land and rights to private pensions,
equities, bonds etc

Sources of income

Sources of gross income by quintile groups of disposable income, 2005

Values (£ per year) Bottom 2nd 3rd 4th Top Overa

Cash benefits 6 409 6 213 4 773 2 799 1 381 4 31

Investment income 1 132 2 185 3 074 3 860 6 221 3 29

Earned income 3 144 9 011 18 501 30 604 60 111 24 27

493
1
Earned income includes wages and salaries, income from self-employment and income from "fringe benefits"
Investment income includes occupational pension income

For the poorest households in the UK, cash benefits from the state are more than twice as
important as a source of income as income earned from working. Poorer families have
little access to investment income. Income from assets earns five times as much income
for the richest 20 per cent of households than it does for those at the bottom of the income
ladder.

Measuring inequality – the Lorenz Curve and the Gini Coefficient

We can measure the distribution of income and wealth by using concepts such as the
Lorenz Curve and the Gini Coefficient. A diagram showing the Lorenz Curve is given
below.

The further the Lorenz curve lies below the line of equality, the more unequal is the
distribution of income. There are problems with the Lorenz curve – particular if we are
inaccurate in our measure of incomes across the distribution of households in a country

The Gini Coefficient is derived from the same information used to create a Lorenz Curve.
The Gini Coefficient can take values from 0 to 100 per cent where a value of zero would
indicate that each household had an equal share of income, while higher values indicate
greater inequality.

The chart below shows the trend in the Gini Coefficient for original and disposable
incomes of UK households since the late 1970s. Inequality of disposable income was

494
1
fairly stable in the first half of the 1980s then increased during the second half of the
1980s. Inequality was relatively flat in the 1990s but with some indications of a slight fall
in the first half of the 1990s. The Gini-coefficient for all types of income including
original income and post-tax income has indeed fallen since 1998 providing evidence of a
reduction in the overall inequality of incomes in the UK

Gini-coefficients for UK households 1993 1998 2005

Original income 53.5 52.7 50.6

Gross income 37.5 37.5 36.1

Disposable income 34.5 34.1 32.3

Post-tax income 38.5 38.0 36.1

Source: Office for National Statistics

The distribution of wealth

The distribution of wealth is more unequal than the distribution of income. This is shown
in the chart below. In 2001, over 90% of marketable wealth was in the hands of just half
the population and over a fifth of wealth was highly concentrated among the richest one
per cent of households.

Distribution of marketable wealth in the UK

Percentages

1991 1996 2001 2002

Percentage of wealth owned by:

Most wealthy 1% 17 20 22 23

Most wealthy 25% 71 74 72 74

Most wealthy 50% 92 93 94 94

495
1
Total marketable wealth (£ billion) 1,711 2,092 3,477 3,464

Source: HM Revenue and Customs

Distribution of real disposable household income

£ per week at 2003/04 prices

10th 90thRatio of 90th to 10th

percentile

percentile Median percentile

1971 103.4 188.0 328.0 3.2

1979 124.7 217.2 372.8 3.0

1989 130.7 268.9 526.9 4.0

1999 147.1 292.5 604.6 4.1

2004 171.1 335.7 673.9 3.9

The Gap gets Wider

The most visible evidence of excessive inequality is boardroom pay, which long ago
severed its links with economic fundamentals. In the US, annual pay packages of $15m-
$45m (£8.5m-£25.5m) reflect top executives' greed rather than their productivity or
scarcity value. But the problem is much broader: on both sides of the Atlantic, the top 10
per cent is pulling away from the bottom 90 per cent. And the real elite - the top 1 to 2
per cent - is pulling away even from the favoured top tenth.
Source: Michael Prowse, Financial Times, 22nd April 2005

Proportion of people whose income is below various fractions of median household

disposable income

Below

496
1
 60 per cent Below half

of median of median

income income

1961 12.8 7.4

1971 13.6 6.3

1981 12.1 4.5

1991 20.1 11.7

2001 17.0 9.7

2004 16.8 9.4

Source: Social Trends 36

Another way of measuring relative poverty and inequality is the proportion of the
population whose income falls below some pre-defined threshold. In the table above we
see two measures of relative poverty. If income falls below 60 per cent of median
income, this takes a family below the European Union’s official “poverty line” or
“poverty threshold”. There was a huge rise in inequality between 1981 and 1991 but
since then the figure has fallen from 20% of the population to just under 17 per cent
(although this figure is still much higher than that seen in the 1960s and 1970s). Nearly
ten per cent of households live on an income of less than half median income.

Explaining the scale of income and wealth inequality in the UK

There are numerous explanations both for the existence and persistence of a huge divide
in incomes and wealth within the UK. Most of them are directly economic in origin, but
some are linked to social change. A summary is provided below:

(1) Differences in pay in different jobs and industries

High growth industries have enjoyed above average increases in pay and earnings. These
include financial and business services and information technology. Jobs where labour
demand is high and there are persistent shortages of skilled labour tend to offer more
generous pay packages for employees. In contrast, public sector service jobs have seen a
decline in relative pay levels because pay in private sector jobs has tended to out-strip
earnings growth.

497
1
Many of the worst paid jobs are still found in low-skill service sector industries – often
there is little trade union protection and job insecurity is endemic. Income inequality
tends to rise during periods of rapid wage growth because the poorest households are the
most likely to contain non-working individuals.

(2) Falling relative incomes of people dependent on state benefits

State welfare benefits normally rise in line with prices (they are index-linked) rather than
with earnings. Therefore, households dependent on welfare assistance see their relative
incomes fall over time. This is a particular problem for many thousands of pensioner
households – the issue of pension poverty has become a major political challenge for the
government.

(3) The effects of unemployment

Unemployment is a key cause of relative poverty (i.e. an increase in income inequality).

For example, a serious problem is the increase in the number of households where no one
is in paid employment and where a family is dependent on state welfare aid.

(4) Changes to the tax and benefit system

Changes to direct and indirect taxes have contributed to an increase in relative poverty.
Income tax rates have fallen over the last two decades. The top marginal rate of tax fell
from 83% in 1979 to 40% in 1988 where it has remained. The basic rate has come down
from 33% in 1979 to 22% today. These tax reductions allow people in work to keep a
higher proportion of their earned income. The benefits from lower taxes have flowed
disproportionately to people on above-average incomes because of a fall in the
progressive nature of the UK’s direct tax system.

There has been a switch towards indirect taxes in recent years including higher rates of
value added tax and higher excise duties on petrol, alcohol and cigarettes. Some of these
indirect taxes have a regressive effect on the distribution of income.

Suggestions for wider reading and research

o Child Poverty Action Group

o Fuel poverty
o Institute for Fiscal Studies see also IFS Background
o Joseph Rowntree Foundation – see also background on Joseph Rowntree
Trusts
o Oxfam - UK campaign on child poverty
o Poverty rate may have risen under Labour (BBC news – March 2006)
o Voices from the poverty front line (BBC)
o Where do you fit into the UK income distribution? (IFS interactive web
site)

498
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Short Run Costs

In this note we consider production costs in the short run, in particular the difference
between fixed and variable costs and the relationships between marginal and average
costs.

In the short run, because at least one factor of production is fixed, output can be
increased only by adding more variable factors. Hence we consider both fixed and
variable costs

Fixed costs

Fixed costs are business expenses that do not vary directly with the level of output i.e.
they are treated as independent of the level of production.

Examples of fixed costs include the rental costs of buildings; the costs of leasing or
purchasing capital equipment such as plant and machinery; the annual business rate
charged by local authorities; the costs of full-time contracted salaried staff; the costs of
meeting interest payments on loans; the depreciation of fixed capital (due solely to age)
and also the costs of business insurance.

499
1
Fixed costs are the overhead costs of a business. They are important in markets where
the fixed costs are high but the variable costs associated with making a small increase in
output are relatively low. We will come back to this when we consider economies of
scale.

 Total fixed costs (TFC) remain constant as output increases

 Average fixed cost (AFC) = total fixed costs divided by output

Average fixed costs must fall continuously as output increases because total fixed
costs are being spread over a higher level of production. In industries where the ratio of
fixed to variable costs is extremely high, there is great scope for a business to exploit
lower fixed costs per unit if it can produce at a big enough size. Consider the new Sony
portable play station. The fixed costs of developing the product are enormous, but these
costs can be divided by millions of individual units sold across the world.

A change in fixed costs has no effect on marginal costs. Marginal costs relate only to
variable costs!

500
1
Variable Costs

Variable costs are costs that vary directly with output. Examples of variable costs
include the costs of intermediate raw materials and other components, the wages of
part-time staff or employees paid by the hour, the costs of electricity and gas and the
depreciation of capital inputs due to wear and tear. Average variable cost (AVC) = total
variable costs (TVC) /output (Q)

Variable costs are those associated with changes in short run production – what are the
variable costs associated with an increase in the production of Californian wine shown in
the picture above?

Average Total Cost (ATC or AC)

Average total cost is simply the cost per unit produced
Average total cost (ATC) = total cost (TC) / output (Q)

Marginal Cost

Marginal cost is the change in total costs from increasing output by one extra unit.

The marginal cost of supplying an extra unit of output is linked with the marginal
productivity of labour. The law of diminishing returns implies that the marginal cost
of production will rise as output increases. Eventually, rising marginal cost will lead to a
rise in average total cost. This happens when the rise in AVC is greater than the fall in
AFC as output (Q) increases.

Worked example of short run production costs

501
1
A simple numerical example of short run costs is shown in the table below. Fixed costs
are assumed to be constant at £200. Variable costs increase as more output is produced.

Output Total Fixed Total Variable Total Cost Average Cost Marginal Cost
(Q) Costs (TFC) Costs (TVC) Per Unit (the change in total
cost from a one unit
(TC= TFC + (AC = TC/Q) change in output)
TVC)

0 200 0 200

50 200 100 300 6 2

100 200 180 400 4 2

150 200 230 450 3 1

200 200 260 460 2.3 0.2

250 200 280 465 1.86 0.1

300 200 290 480 1.6 0.3

350 200 325 525 1.5 0.9

400 200 400 600 1.5 1.5

450 200 610 810 1.8 4.2

500 200 750 1050 2.1 4.8

In our example, average cost per unit is minimised at a range of output between 350 and
400 units. Thereafter, because the marginal cost of production exceeds the previous
average, so the average cost rises (for example the marginal cost of each extra unit
between 450 and 500 is 4.8 and this increase in output has the effect of raising the cost
per unit from 1.8 to 2.1).

Short Run Cost Curves

When diminishing returns set in (beyond output Q1) the marginal cost curve starts to rise.
Average total cost continues to fall until output Q2 where the rise in average variable cost
equates with the fall in average fixed cost. Output Q2 is the lowest point of the ATC

502
1
curve for this business in the short run. This is known as the output of productive
efficiency.

A change in variable costs

A rise in the variable costs of production leads to an upward shift both in marginal and
average total cost. The firm is not able to supply as much output at the same price. The

503
1
effect is that of an inward shift in the supply curve of a business in a competitive market.

An increase in fixed costs has no effect at all on variable costs of production. This means
that only the average total cost curve shifts. There is no change at all on the marginal cost
curve leading to no change in the profit maximising price and output of a business. The
effects of an increase in the fixed or overhead costs of a business are shown in the
diagram below.

504
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Business Revenues

Having studied costs we now turn to the income that businesses generate from selling
their output of goods and services in markets – business revenues.

The meaning of revenue

Revenue (or turnover) is the income generated from the sale of output in product
markets. There are two main revenue concepts to grasp at this stage:

 Average Revenue (AR) = Price per unit = total revenue / output

 Marginal Revenue (MR) = the change in revenue from selling one extra unit of
output

505
1
The table below shows the demand for a product where demand varies inversely with the
price.

Price per unit Quantity Demanded Total Revenue Marginal Revenue

(average revenue) (Qd) (TR) (MR)

£s units £s £s

400 220 88000

370 340 125800 315

340 460 156400 255

310 580 179800 195

280 700 196000 135

250 820 205000 75

220 940 206800 15

190 1060 201400 -45

Average and marginal revenue – the important relationships

In our example in the table above, as price per unit falls, demand expands and so too does
total revenue, although because the demand curve is downward sloping, the average
revenue falls as more units are sold. This causes marginal revenue to decline. Eventually
once marginal revenue becomes negative, a further fall in price (e.g. from £220 to £190)
causes total revenue to fall.

Because the price per unit is declining, total revenue is rising at a decreasing rate and will
eventually reach a maximum (see the next paragraph).

Elasticity of demand and total revenue

When a firm faces a perfectly elastic demand curve, then average revenue = marginal
revenue (i.e. extra units of output can all be sold at the ruling market price). However,
most businesses face a downward sloping demand curve! And because the price per unit
must be cut to sell extra units, therefore MR lies below AR. In fact he MR curve will fall
at twice the rate of the AR curve. You don’t have to prove this for the exams – but it is
worth remembering that the marginal revenue curve has twice the slope of the AR curve!

506
1
The total revenue for any business is maximised when marginal revenue (MR) = zero.
Once MR becomes negative, total revenue falls if extra units are sold. This is shown in
the next diagram.

Total revenue is shown by the area underneath the firm’s demand curve (average revenue
curve).

507
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Business Objectives

We now turn to the aims and objectives of businesses. This is a complex and interesting
area of the subject since changes in business objectives can have quite powerful effects
on the decisions that businesses take day-to-day regarding pricing, output levels and
spending on advertising, market and capital investment. Often the objectives and targets
of a corporation or small enterprise will evolve to meet changing economic conditions.

Profit maximisation

508
1
The traditional theory of the firm tends to make a standard assumption that businesses
possess the information, market power and motivation to set a price and output that
maximises profits in the short or long run. This assumption is now criticised by
economists who have studied the organisation and objectives of modern-day corporations
and in particular the existence of a ‘divorce of ownership and control’ that is common
to most large scale corporations.

Why might a business depart from profit maximisation?

There are numerous possible explanations. Some relation to the lack of accurate and
detailed information required to undertake optimal maximising behaviour. Others
concentrate on the alternative objectives of modern businesses. We start first with the
effects of imperfect information.

Imperfect information about Demand and Cost Conditions

One reason why firms might depart from profit maximisation is that it is difficult for
them to identify their profit maximising output, as they cannot accurately calculate
marginal revenue and marginal costs. Often the day-to-day pricing decisions of
businesses are taken on the basis of “estimated demand conditions” rather than a
systematic calculation of a demand curve. Most modern businesses are multi-product
firms operating in a range of separate markets. The amount of information that they have
to handle can be vast. And they must keep track of the changing preferences of
consumers and ever-evolving market conditions. The idea that there is a neat and single
profit maximising price is really redundant.

Behavioural Theories of the Firm

Behavioural economists believe that modern corporations are complex organizations

made up of various groups or stakeholders. Stakeholders are defined as any identifiable
groups who have a vested interest in the activity of a business. Examples of relevant
stakeholders might include:

 Employees within a business

 Managers employed by the firm
 Shareholders – people who have an equity stake in a business
 Customers in the market
 The local community
 The government and it’s agencies including local government

Each of these groups is likely to have different objectives or goals at different points in
time. The dominant group at any moment in time can give greater emphasis to their own
objectives – for example price and output decisions may be taken at local level by
managers – with shareholders taking only a distant and imperfectly informed view of the
company’s performance and strategy.

509
1
Behavioural Economics
Behavioural economics is a relatively new field of economics which looks directly at the
way human behaviour and decision-making is modelled. By integrating economics with
psychology, economists can benefit from the experience psychology has in examining
our behaviour. Indeed many psychologists are teaming up with economists in an attempt
to study human beings in the economic forum, the most recent team being the 2002
Nobel Prize winners Daniel Kahneman (a cognitive psychologist) and Vernon Smith (an
experimental economist).
For the first time, laboratory experiments are being used to provide serious empirical data
for economists to study. These experimental economists use techniques borrowed from
psychology to test human subjects in a controlled experiment. As methodology
improves, such experiments are slowly gaining more credibility within the economic
academia.
Source: Jack Wills, Behavioural Economics and Rational Behaviour, 2003

If firms are likely to move away from pure profit maximising behaviour, what are the
alternatives? The reality is that there are numerous different strategies that can be
employed. Although a business might have profitability as an important medium-term
aim, it might depart from this in the short term.

Here are some alternatives to pure profit maximisation strategies:

1. Satisficing behaviour involves the owners setting minimum acceptable levels

of achievement in terms of business revenue and profit.
2. Sales Revenue Maximisation

The objective of maximising sales revenue rather than profits was initially developed by
the work of William Baumol (1959). His research focused on the behaviour of manager-
controlled businesses – price and output decisions taken by managers are divorced from
the shareholders (the owners of the business). Baumol argued that annual salaries and
other perks might be more closely correlated with total sales revenue rather than profits.
Companies geared towards maximising revenue are likely to make frequent and extensive
use of price discrimination (or yield management) as a means of extracting extra revenue
from consumers.

3. Managerial Satisfaction model

An alternative view was put forward by Oliver Williamson (1981), who developed the
concept of managerial satisfaction (or utility). This can be enhanced by success in
raising sales revenue.

4. Constrained Sales Revenue Maximisation

Shareholders of a business may introduce a constraint on the decisions of managers –

known as constrained sales revenue maximisation. For example hey may introduce a

510
1
minimum profit constraint designed to underpin the valuation of their shares and
maintain a dividend.

The diagram below shows how price and output differs if the firm changes its objective
from profit to revenue maximisation. Assuming that the firm’s costs remain the same, a
firm will price lower and produce a higher output when sales revenue maximisation is the
main objective.

The profit maximising price is P2 at output Q2 whilst the revenue maximising price is P1
at output Q1. A change in the objectives of the business has an effect on economic
welfare and in particular the balance between consumer and producer surplus. Consumer
surplus is higher with sales revenue maximisation because output is higher and price is
lower.

Price and Output under Constrained Profit Maximisation

Shareholders might attempt to “constrain” the price and output decisions of managers by
introducing a minimum profit constraint.

Consider the following diagram on the next page:

 The normal profit maximising output is at Q2 (where the vertical distance

between the total revenue and total cost curve is at its greatest)

511
1
  Revenue is maximised at output Q1 where the total revenue curve reaches a
maximum (i.e. marginal revenue is zero)
 If shareholders insist on the business achieving a minimum profit as shown, then
the managers of a business have the discretion to vary price and output anywhere
between Q2 and Q4
 At any output beyond Q3 (where total revenue and total cost intersect) losses are
made

The short run supply decision - the shut-down price

The theory of the firm assumes that a business needs to make at least normal profit in the
long run to justify remaining in an industry but this is not a strict requirement in the short
term. In the short run the firm will continue to produce as long as total revenue covers
total variable costs or put another way, so long as price per unit > or equal to average
variable cost (AR = AVC).

The reason for this is as follows. A business’s fixed costs must be paid regardless of the
level of output. If we make an assumption that these costs are sunk costs (i.e. they cannot
be covered if the firm shuts down) then the loss per unit would be greater if the firm were
to shut down, provided variable costs are covered.

512
1
ATC

Consider the cost and revenue curves facing a business in the short run in the diagram
above.

 Average revenue (AR) and marginal revenue curves (MR) lies below average cost
across the full range of output, so whatever output produced, the business faces
making a loss
 At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut
down as price is less than AVC. The loss per unit of producing is vertical distance
AC
 If the firm shuts down production the loss per unit will equal the fixed cost per
unit AB.

Deriving the Competitive Firm’s Supply Curve in the Short Run

In the short run, the supply curve is the marginal cost curve above average variable
cost.

In the long run, a firm must make a normal profit. When price = average total cost, this is
the break-even point. It will therefore shut down at any price below this in the long run.
As a result the long run supply curve will be the marginal cost curve above average
total cost.

513
1
A supply curve can only be derived from the marginal cost curve for firms operating in
perfectly competitive markets. The concept of a ‘supply curve’ is inappropriate when
dealing with monopoly situations because a monopoly is a price-maker, not a “passive”
price-taker, and can thus select the price and output combination on the demand curve so
as to maximise profits where marginal revenue = marginal cost.

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Technological Change, Costs & Supply in Long-run

We turn now to the effects that innovation and technological change can have on
individual markets and industries.

Innovation
The Oxford English Dictionary defines innovation as “making changes to something
established”. Invention, by contrast, is the act of “coming upon or finding: discovery”.
Innovations frequently disrupt the way that businesses do things (and may have been
doing them for years). See this BBC report on how the internet has transformed business.

Product innovation

Product innovation is a driving dynamic in most markets – be they markets for goods or
services – consider for example how important innovation is perceived to be in these
markets:

 Telecommunications
 Pharmaceuticals
 Transport
 Audio-visual products
 Knowledge industries

Differentiation of products:

Product innovation is often associated with many small-scale and subtle changes to the
characteristics and performance of a particular product. Ground-breaking product
innovation appears to becoming rarer despite for example the billions of dollars spent
each year by the global pharmaceutical companies and household goods manufacturers.

New markets and “synergy demand”:

514
1
Product innovation creates new markets, especially when the emergence and exploitation
of technology creates radically different products for consumers. Innovation is also a
source of synergy demand. Gillette (a business unit of Proctor and Gamble) launched in
2004 the successor to its top branded product the Mach3 and Mach3 “turbo” razor. The
new “wet-shave” razor is battery powered – handy given that Gillette also owns the
Duracell battery brand! (Think back to the idea of cross-price elasticity of demand at AS
level!).

Sustaining and disruptive innovations

Many new products are similar to existing ones on the market – companies are often
satisfied with “sustaining innovations” rather than “disruptive innovations” which have
the power to upset the status quo and make serious inroads into the market shares of well-
established businesses. Schumpeter famously made reference to innovation creating
“gales of creative destruction”.

Examples of disruptive innovations:

 Emergence of the low-cost airlines following a radically different business model

– this has had a huge effect on national scheduled airline carriers such as British
Airways
 The expansion of the internet and e-commerce challenging the economics and the
business models of existing bricks and mortar retailers who have limited shelf
space.
 Consider the impact of online music download businesses such as iTunes and peer
to peer file sharing. This is having a huge effect on the online and traditional
music industry.
 Voice over Internet Protocol VoIP such as Skype versus traditional telephone and
mobile phone service providers.

Gains in dynamic efficiency:

Dynamic efficiency occurs over time. It focuses on changes in the consumer choice
available in a market together with the quality/performance of goods and services that
we buy. Innovation can stimulate improvements in dynamic efficiency in the long-term,
always providing that the innovations that come to market are appropriate in satisfying
our changing needs and wants

Innovation as a barrier to entry

Innovative behaviour can be an important barrier to entry in markets. Firstly because

some the property rights embedded in product innovations might be protected by patent
laws. There is nearly always a “first mover advantage” for successful innovators that
gives them scope to exploit some monopoly power in a market.

515
1
Set against this argument is that view that high rates of product and process innovation
actually have the effect of reducing barriers to entry because they can strike right at the
heart of the existing market power enjoyed by well-established businesses.

Process innovation

Process innovations involve changes to the way in which production takes place, be it
on the factory floor, in backroom administration, business logistics or innovative
behaviour in managing employees in the workplace. The effects can be both on a firm’s
cost structure (i.e. the ratio of fixed to variable costs) as well as the balance of factor
inputs used in production (i.e. labour and capital).

Cost reducing innovations have the effect of causing an outward shift in market supply
and they also provide the scope for businesses to enjoy higher profit margins with a
given level of demand. Process innovation should lead to a more efficient use of scarce
resources reflected in gains in productive efficiency / productivity.

The diagram above uses standard cost and revenue curves to show the effect of driving
down production costs from SRAC1 to SRAC2 – leading to lower prices and a higher
level of output. You could also use this diagram to show the gains in producer and
consumer surplus that come from cost-reducing innovation and technological change.

Consumers also stand to gain from such innovation in that they should be able to expect
lower prices. This increases their real incomes, allows for a higher level of consumer
surplus and means that there is less pressure for increases in wages in order to boost real
living standards.

516
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Perfect Competition

We now move on to study the economics of different market structures. The spectrum of
competition ranges from perfectly competitive markets where there are many sellers who
are price takers to a pure monopoly where one single supplier dominates an industry and
sets price. We start our analysis of market structures by looking at perfect competition.

Perfect competition – a pure market

Perfect competition describes a market structure whose assumptions are extremely

strong and highly unlikely to exist in most real-time and real-world markets. The reality
is that most markets are imperfectly competitive. Nonetheless, there is some value in
understanding how price, output and equilibrium is established in both the short and the
long run in a market that holds true to the tough assumptions of a world of perfect
competition.

Economists have become more interested in pure competition partly because of the rapid
growth of e-commerce in domestic and international markets as a means of buying and
selling goods and services. And also because of the popularity of auctions as a rationing
device for allocating scarce resources among competing ends.

Basic assumptions required for conditions of pure competition to exist

 Many small firms, each of whom produces an insignificant percentage of total

market output and thus exercises no control over the ruling market price.
 Many individual buyers, none of whom has any control over the market price –
i.e. there is no monopsony power
 Perfect freedom of entry and exit from the industry. Firms face no sunk costs -
entry and exit from the market is feasible in the long run. This assumption ensures
all firms make normal profits in the long run
 Homogeneous products are supplied to the markets that are perfect substitutes.
This leads to each firms being passive “price takers” and facing a perfectly elastic
demand curve for their product
 Perfect knowledge – consumers have readily available information about prices
and products from competing suppliers and can access this at zero cost – in other
words, there are few transactions costs involved in searching for the required
information about prices

517
1
  No externalities arising from production and/or consumption which lie outside
the market

The real world of imperfect competition!

Clearly the assumptions of pure competition do not hold in the vast majority of markets.
Some suppliers may exert some control over market supply and seek to exploit their
monopoly power. On the demand-side, some consumers may have monopsony power
against suppliers because they purchase a high percentage of total demand. There are
nearly always some barriers to the contestability of the market (see revision notes on
barriers to entry) and far from being homogeneous, most markets are full of
heterogeneous products due to product differentiation.

Consumers nearly always have imperfect information (for example information gaps)
and their preferences and choices can be influenced by the effects of persuasive
marketing and advertising. In every industry there is always asymmetric information
where the seller knows more about quality of good than buyer. The real world is one in
which negative and positive externalities from both production and consumption are
numerous – both of which can lead to a divergence between private and social costs and
benefits. Finally there may be imperfect competition in related markets such as the
market for essential raw materials, labour and capital goods.

We can come fairly close to a world of perfect competition but in practice there are
nearly always barriers to pure competition.

Currency markets - taking us closer to perfect competition

518
1
 “As perfect competition is a theoretical absolute, there are no pure examples of a
perfectly competitive market.” (Source: Wikipedia)

It is often said that the most competitive market possible is at best rare and probably does
not exist at all in its purest form. Perhaps the vast market in global currencies takes us as
close as we might reasonably get to a world of perfect competition?

Brief background on currency dealing

The foreign exchange market is where all buying and selling of world currencies takes
place.
There is 24-hour trading, 5 days a week (about 9pm London Sunday to 10pm London
Friday.
Trade volume in the Forex market is around $1.2 trillion per day. This compares with to
the New York Stock Exchange which trades ‘only’ $25 billion per day. 31% of global
currency trading takes place in London.
Well over ninety per cent of trading in currencies around the world is speculative rather
than the buying and selling of currencies to enable people and firms to conduct business
in the real economy.

The main players in the currency markets are as follows:

Banks both as “market makers” dealing in currencies and also as end users demanding
currency for their own operations). These banks include investment banks and
commercial “high street” banks
Hedge funds and other institutions (e.g. funds invested by asset managers, pension funds)

519
1
Central Banks (including occasional currency intervention in the market)
Corporations (mostly defensive hedging of exposures to risk)
Private investors / market speculators / tourists

Why does a currency market come close to perfect competition?

Homogenous output: The "goods" traded in the foreign exchange markets are
homogenous - a US dollar is a dollar whether someone is trading it in London, New York
or Tokyo.

Many buyers and sellers meet openly to determine prices: There are large numbers of
buyers and sellers - each of the major banks has a foreign exchange trading floor which
helps to "make the market". Indeed there are so many sellers operating around the world
that the global currency exchanges are open for business twenty-four hours a day. No one
agent in the currency market can influence the price on a persistent basis - all are ‘price
takers’.

Currency values are determined solely by demand and supply factors.

High quality information: Most participants in the market - be they buyers or sellers - are
well informed, in most cases with access to real time information and also plenty of
background analysis on the factors driving the prices of each individual national
currency. Technological progress has made much more information more immediately
available at a fraction of the cost of just a few years ago. This is not to say that
information is cheap - an annual subscription to a Bloomberg or a Reuter’s news terminal
will normally cost several thousand dollars. But the market is rich with information and
transactions costs for each batch of currency bought and sold have come down.

Seeking the best price: The buyers and sellers in foreign exchange only deal with those
who offer the best prices.

What are the limitations of currency trading as an example of a near-perfectly

competitive market?

Firstly the market can be influenced by official intervention via buying and selling of
currencies by governments or central banks operating on their behalf. There is a huge
debate about the actual impact of intervention by policy-makers in the currency markets.

Those who are sceptical about the effects of intervention buying and selling to move
currencies in anything other than the short term talk of governments not being able to
"buck the market". Others conceded that intervention does change the ruling price for a
currency especially if there is concerted and coordinated intervention by a number of
countries acting in unison.

520
1
Secondly there are costs involved in a bank or other financial institution when
establishing a new trading platform for currencies. They need the capital equipment to
trade effectively; the skilled labour to employ as currency traders and researchers.

Despite these limitations, the foreign currency markets take us close to a world of perfect
competition. Much the same can be said for trading in the equities and bond markets and
also the ever expanding range of future markets for financial investments and
internationally traded commodities.

Establishing price and output in the short run under perfect competition

The previous diagram shows the short run equilibrium for perfect competition. In the
short run, the twin forces of market demand and market supply determine the equilibrium
“market-clearing” price for the industry. In the diagram below, a market price P1 is
established and output Q1 is produced. This price is taken by each of the firms. The
average revenue curve (AR) is their individual demand curve. Since the market price is
constant for each unit sold, the AR curve also becomes the Marginal Revenue curve
(MR).

521
1
For the firm, the profit maximising output is at Q2 where MC=MR. This output generates
a total revenue (P1 x Q2). The total cost of producing this output can be calculated by
multiplying the average cost of a unit of output (AC1) and the output produced. Since
total revenue exceeds total cost, the firm in this example is making abnormal (economic)
profits. This is not necessarily the case for all firms. It depends on their short run cost
curves. Some firms may be experiencing sub-normal profits if average costs exceed the
market price. For these firms, total costs will be greater than total revenue.

Short run losses

The adjustment to the long-run equilibrium

If most firms are making abnormal (or supernormal) profits, this encourages the entry
of new firms into the industry, which if it happens will cause an outward shift in market
supply forcing down the ruling market price.

522
1
The increase in supply will eventually reduce the market price until price = long run
average cost. At this point, each firm in the industry is making normal profit. Other
things remaining the same, there is no further incentive for movement of firms in and out
of the industry and a long-run equilibrium has been established. This is shown in the next
diagram.

We are assuming in the diagram above that there has been no shift in market demand, i.e.
we are considering an outward shift in market supply brought about by the entry of new
competing firms each of whom is supplying a homogeneous product to the market. The
effect of increased supply is to force down the market price and cause an expansion along
the market demand curve. But for each supplier, the price they “take” is now lower and it
is this that drives down the level of profit made towards the normal profit equilibrium.

In an exam you may be asked to trace and analyse what might happen if

 There was a change in market demand (e.g. arising from changes in the relative
prices of substitute products or complements)
 There was a cost-reducing innovation affecting all firms in the market or an
external shock that increases the variable costs of all producers.

Effects of a change in market demand

523
1
We now consider how a competitive market adjusts to a change in market demand in
both the short and the long run. In the short run, businesses are operating with at least one
fixed factor. Therefore the elasticity of the supply curve depends on the amount of spare
capacity, the level of existing stocks and also the time scale of the production process – in
other words how fast and at what cost the industry can expand supply when demand
changes.

In the long run, because of freedom of entry and exit into and out of the industry, we
expect the market supply curve to be more elastic in response to a change in demand. The
diagram below shows an outward shift of demand with short run market supply deemed
to be relatively inelastic (in which case the short run adjustment in the market drives
prices higher) but where long run market supply is elastic, putting downward pressure on
price as market output increases.

524
1
Pure competition and economic efficiency

Perfect competition can be used as a yardstick to compare with other market structures
because it displays high levels of economic efficiency.

1. Allocative efficiency: In both the short and long run in perfect competition we
find that price is equal to marginal cost (P=MC) and thus allocative efficiency is
achieved. At the ruling market price, consumer and producer surplus are
maximised. No one can be made better off without making some other agent at
least as worse off – i.e. the conditions are in place for a Pareto optimum allocation
of resources.
2. Productive efficiency: Productive efficiency occurs when the equilibrium output
is produced with average cost at a minimum. This is not achieved in the short run,
but is attained in the long run equilibrium for a perfectly competitive market.
3. Dynamic efficiency: We assume that a perfectly competitive market produces
homogeneous products – in other words, there is little scope for innovation
designed purely to make products differentiated from each other and thereby
allow a supplier to develop and then exploit a competitive advantage in the
market to establish some monopoly power.

Some economists claim that perfect competition is not an optimal market structure for
high levels of research and development spending and the resulting product and process
innovations. Indeed it may be the case that monopolistic or oligopolistic markets are
more effective in creating the environment for research and innovation to flourish. A
cost-reducing innovation from one producer will, under the assumption of perfect
information, be immediately and without cost transferred to all of the other suppliers.

That said, a “competitive market” (i.e. a contestable market) provides the discipline on
firms to keep their costs under control, to seek to minimise wastage of scarce resources
and to refrain from exploiting the consumer by setting high prices and enjoying high
profit margins. In this sense, a more competitive market can stimulate improvements in
both static and dynamic efficiency over time. It is certainly one of the main themes
running through the recent toughening-up of UK and European competition policy as this
introductory passage to a competition white paper demonstrates:

525
1
Gains from competition
Competitive markets provide the best means of ensuring that the economy's resources are
put to their best use by encouraging enterprise and efficiency, and widening choice.
Where markets work well, they provide strong incentives for good performance -
encouraging firms to improve productivity, to reduce prices and to innovate; whilst
rewarding consumers with lower prices, higher quality, and wider choice. By
encouraging efficiency, competition in the domestic market - whether between domestic
firms alone or between those and overseas firms - also contributes to our international
competitiveness.
Source: www.dti.gov.uk

The long run of perfect competition, therefore, exhibits optimal levels of economic
efficiency. But for this to be achieved all of the conditions of perfect competition must
hold – including in related markets. When the assumptions are dropped, we move into a
world of imperfect competition with all of the potential that exists for various forms of
market failure.

The next diagram shows how when price and output is not at the competitive equilibrium,
the result is a deadweight loss of economic welfare. The competitive price and output is
P1 and Q1 respectively.

Author: Geoff Riley, Eton College, September 2006

526
1
A2 Markets & Market Systems
Monopoly

You will have covered the basics of monopoly in your AS course. At A2 you are expected
to use a full diagrammatic treatment of price and output determination in markets where
businesses have some monopoly power. Textbooks tend to consider pure monopolies, but
the reality is that most firms have some pricing power in any imperfectly competitive
market.

Price and output under a pure monopoly

A pure monopolist can take market demand as its own demand curve. The firm is a
price maker but a monopoly cannot charge a price that the consumers in the market will
not bear. In this sense, the price elasticity of the demand curve acts as a constraint on the
pricing-power of the monopolist.

The profit-maximising level of output is at Q1 at a price P1. This will generate total
revenue equal to OP1aQ1, but the total cost will be OAC1aQ. As total revenue exceeds
total costs the firm makes abnormal (supernormal) profits equal to P1baAC1.

527
1
The effect of a rise in costs on monopoly price and profits

The rise in price from P1 to P2 helps in part the monopolist to offset some of the rise in
costs, but the net effect is still a reduction in total profits and a contraction in output. The
extent to which a business with monopoly power can pass on a rise in costs depends in
part on the price elasticity of demand – pricing power is greatest when demand is price
inelastic.

Barriers to entry – protecting monopoly power in the long run

Barriers to entry are designed to block potential entrants from entering a market
profitably. They seek to protect the power of existing firms and maintain
supernormal profits / increase producer surplus. These barriers have the effect of
making a market less contestable - they are also important because they determine the
extent to which established firms can price above marginal and average cost in the long
run.

The 1982 Nobel Prize winning economist George Stigler defined an entry barrier as “A
cost of producing which must be borne by a firm which seeks to enter an industry but is
not borne by firms already in the industry”.

528
1
Another Economist, George Bain defined entry barriers in a slightly different way “The
extent to which established firms can elevate their selling prices above the minimal
average costs of production without inducing potential entrants to enter an industry”.

This emphasises the asymmetry in costs that often exists between the incumbent firm
(i.e. the business with market power already inside the market) and the potential entrant.
If the existing businesses have managed to exploit economies of scale and therefore
developed a cost advantage over potential entrants, this advantage might be used to cut
prices if and when new suppliers enter the market. This involves a decision to move away
from short run profit maximisation objectives – but it is designed to inflict losses on new
firms and thereby protect a dominant market position in the long run. The monopolist
might then revert back to profit maximization once a new entrant has been rebuffed!

Different types of entry barriers exist:

o Structural barriers (innocent entry barriers) – arising from differences in

production costs
o Strategic barriers (see the notes below on strategic entry deterrence)
o Statutory barriers - entry barriers given force of law (e.g. patent protection of
franchises such as the National Lottery or television and radio broadcasting
licences)

Entry barriers exist when costs are higher for an entrant than for the incumbent firms.
This is shown in the next diagram:

529
1
In the previous diagram we assume that the incumbent monopolist has achieved
economies of scale so that that its own LRAC and LRMC are lower than that of a
potential entrant. If the monopolist maintains a profit maximising price of P1, a market
entrant could achieve economic profits since its costs are lower than the prevailing price.
At any price below Pe the potential entrant will make a loss – and entry can be
blockaded.

Barriers to Exit - Sunk Costs

Sunk costs cannot be recovered if a business decides to leave an industry. Examples

include:

 Capital inputs that are specific to an industry and which have little or no resale
value.
 Money spent on advertising, marketing and research and development
projects which cannot be carried forward into another market or industry.

When sunk costs are high, a market becomes less contestable. High sunk costs act as a
barrier to entry of new firms (they risk making huge losses if they decide to leave a
market). In contrast, markets such as fast-food restaurants, sandwich bars, hairdressing
salons and local antiques markets have low sunk costs so the barriers to exit are low.

The frequent market entry and failure of firms in many service and retail trade industries
is evidence of insubstantial entry barriers.

Exit costs – Coca Cola withdraws Dasani from the UK market

March 2004 was a bad month for Coca-Cola - the world’s largest soft-drinks maker. It
had to withdraw its Dasani bottled water from retail shelves in the UK just two months
after it launched because the product did not meet safety standards. This was a damaging
and costly blow for Coca-Cola as it attempts to diversify away from its traditional
products into the faster-growing bottled water market. It demonstrates the financial costs
incurred when a business is either forced or chooses to withdraw a product from a
market. The product withdrawal was required because of strict consumer safety
regulation in Britain. Under UK law, bottled or tap water should contain no more than 10
micograms per litre of bromate, a chemical that has the potential to increase the risk of
cancer. Coca-Cola’s analysis revealed levels in some samples of the bottled water of up
to 25 micrograms per litre.
So the Dasani bottles had to be withdrawn from sale as quickly as possible. There were
over 500,000 bottles on sale when the decision was taken. Coca-Cola was left pondering
the effectiveness of the £2 million it had already spent launching the product - part of a
total promotional campaign worth £7 million which it had budgeted to make the launch
of Dasani the same kind of success in the UK as it has enjoyed in Europe.
Coca-Cola, which gets more than two-thirds of its revenue from outside the U.S., is now
relying more on sales of water and juices to counter slower demand for soft drinks in
North America. The Dasani recall’s negative publicity may make it more difficult for
Coca-Cola to compete against bottled water makers such as Nestle SA in other parts of

530
1
Europe as well.
Further reading:
BBC news: Coca Cola recalls bottles of Dasani – see also Coca Cola’s bomb! (2004) and
Money Programme Report on Coca Cola (2004)

Strategic Entry Deterrence

Strategic entry deterrence involves any move by existing firms to reinforce their position
against other firms of potential rivals. This might involve:

o Hostile takeovers and acquisitions

 Product differentiation through brand proliferation (i.e. investment in

developing new products and heavy spending on marketing and advertising)
 Capacity expansion to achieve lower unit costs from exploiting economies of
scale
 Predatory pricing: Incumbent businesses may offer price cuts to customers who
identify lower price entrants.

Strategic barriers may be deemed anti-competitive by the British and EU competition

authorities - The EU Competition Commission has been active in recent years in
building cases against European businesses that have engaged in anti-competitive
practices including price fixing cartels. Nonetheless we often do witness the entry of new
suppliers into markets and industries where one or more firms have a clear position of
market power. Entry can occur in a variety of ways:

 A takeover from outside the industry (sometimes known as the “Trojan-horse

route” to by-pass any structural entry barriers that might exist within an industry)
 The widening of a product range from a firm outside a specific market but
with a state of technology sufficient to challenge existing firms
 A transfer of brand names from one sector of the economy to another (for
example the diversification practiced by both EasyGroup and Virgin in recent
years)
 Increasing competition from overseas - perhaps stimulated by fluctuations in
the exchange rate of the development of a competitive advantage by foreign
businesses
 Growing markets – if demand is increasing, market prices might be expected to
rise and through the working of the price mechanism, higher prices offer
increased potential profits for new entrants even if their initial production costs
are higher than the incumbent firms
 Existing firms may be content to control the flow of new firms coming into a
market rather than engaging in strategies designed to block the entry of any new
firm outright.

Barriers to Exit

531
1
For many businesses, there are also barriers to exit which increase the intensity of
competition in an industry because existing firms have little choice but to “stay and fight”
when market conditions have deteriorated. There are several costs associated with exiting
an industry.

 Asset-write-offs – e.g. the expense associated with writing-off items of plant and
machinery, stocks and the goodwill of a brand
 Closure costs including redundancy costs, contract contingencies with suppliers
and the penalty costs from ending leasing arrangements for property
 The loss of business reputation and consumer goodwill - a decision to leave a
market can seriously affect goodwill among previous customers, not least those
who have bought a product which is then withdrawn and for which replacement
parts become difficult or impossible to obtain.
 A market downturn may be perceived as temporary and could be overcome
when the economic or business cycle turns and conditions become more
favourable

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Monopoly & Economic Efficiency

In this note we evaluate the costs and benefits of businesses with industry muscle,
monopoly pricing power in markets. The standard economic and social case against
monopolistic businesses is no longer straightforward. Markets are changing all of the
time and so are the conditions in which businesses must operate regardless of whether
they have any noticeable market power.

The economic case against monopoly

The usual textbook argument against monopoly power in markets is that existing
monopolists can continue to earn abnormal (supernormal) profits at the expense of
economic efficiency and the welfare of consumers and society.

The standard case against monopoly is that the monopoly price is higher than both
marginal and average costs leading to a loss of allocative efficiency and a failure of the
market mechanism. The monopolist is extracting a price from consumers that is above the
cost of resources used in making the product and, consumers’ needs and wants are not
being satisfied, as the product is being under-consumed.

532
1
The higher average cost of production if there are inefficiencies in production also means
that the firm is not making optimum use of its scarce resources. Under these conditions,
there may be an economic case for some form of government intervention to limit or
reduce the scale of monopoly power, for example through the rigorous application of
competition policy or by a process of market deregulation (liberalisation).

X Inefficiencies under Monopoly

X inefficiency is a term first coined by Harvey Libenstein. The lack of real competition
may give a monopolist less of an incentive to invest in new ideas or consider consumer
welfare. It can also be argued that even if the monopolist benefits from economies of
scale, they will have little incentive to control production costs and 'X' inefficiencies will
mean that there will be no real cost savings.

Comparison between Monopoly and Perfect Competition

A competitive industry will produce in the long run where market demand = market
supply. Consider the diagrams below. Equilibrium output and price is at Q1 and Pcomp
on the left hand diagram and Pcomp and Q1 on the right hand diagram. At this point,
Price = MC and the industry meets the conditions for allocative efficiency.

If the industry is taken over by a monopolist the profit-maximising point (MC=MR) is at

price Pmon and output Q2. The monopolist is able to charge a higher price restrict total
output and thereby reduce economic welfare. The rise in price to Pmon reduces consumer
surplus. Some of this reduction in consumer welfare is a pure transfer to the producer
through higher profits, but some of the loss is not reassigned to any other economic
agent. This is known as the deadweight welfare loss and is equal to the area ABC.

533
1
A similar result is seen in the next diagram which makes the working assumption of
constant long run average and marginal costs under both competition and monopoly. The
deadweight loss of economic welfare under monopoly (whose profit maximising price
is P1 and Q1) is shown by the triangle ABC. The competitive price and output is Pc and
Qc respectively.

534
1
Potential Benefits from Monopoly

A high market concentration (fewness of sellers) does not always signal the absence of
competition; sometimes it can reflect the success of leading firms in providing better
quality products, more efficiently, than their smaller rivals

It is important in essays and data questions when you are analyzing imperfectly
competitive markets where the concentration ratio is high to mention some of the
potential advantages of suppliers having monopoly power.

One difficulty in assessing the welfare consequences of monopoly, duopoly or oligopoly

lies in defining precisely what a market actually constitutes! In nearly every industry the
market is segmented into different products, and the impact of globalisation makes it
difficult to gauge the true degree of monopoly power that might exist in an industry at
any moment in time. Increasingly markets where a monopoly appears to exist are actually
becoming more contestable because of the effects of growing international competition.

So what are the main advantages of a market dominated by a few sellers?

Economies of Scale

A monopolist might be better positioned to exploit economies of scale leasing to an

equilibrium which gives a higher output and a lower price than under competitive
conditions. This is illustrated in the next diagram, where we assume that the monopolist
is able to drive marginal costs lower in the long run, finding an equilibrium output of Q2
and pricing below the competitive price.

535
1
Monopoly Profits, Research and Development and Dynamic Efficiency

As firms are able to earn abnormal profits in the long run there may be a faster rate of
technological development that will reduce costs and produce better quality products for
consumers. This is because the monopolist will invest profits into research and
development to promote dynamic efficiency.

Monopoly power can be good for innovation, according to research by Professor

Federico Etro, published in the April 2004 edition of the Economic Journal. Despite the
fact that the market leadership of firms like Microsoft is often criticised, their investments
in research and development (R&D) can be beneficial to society because they expand
the technological frontier and open new ways to prosperity. Many technological
innovations are developed by firms with patents on the leading-edge technologies. These
firms perpetuate their leadership and their market power through innovations. Etro's
research argues that providing that a market is characterised by free entry, then the
market leader will actually have more incentives than any other firm to invest in R&D.

Baumol – Oligopoly and Innovation

William Baumol an economist from Princeton University in the USA published a book in
2002 “The Free Market Innovation Machine” in which he analysed the conditions best
suited for markets and countries to achieve a faster pace of innovation. Baumol argues
that the structure that fosters productive innovation best is oligopoly. The Baumol
hypothesis is that oligopolists compete by making their products differ slightly from their
rivals. Highly innovative firms are often quick to license new technology or to become
members of technology-sharing consortia.

536
1
Natural Monopoly

A natural monopoly occurs in an industry where LRAC falls over a wide range of
output levels such that there may be room only for one supplier to fully exploit all of the
internal economies of scale, reach the minimum efficient scale and therefore achieve
productive efficiency.

The major utilities such as gas, electricity and water are often put forward as examples of
industries with strong "natural tendencies" towards being a natural monopoly in part
because of the huge fixed costs of building and maintaining nationwide networks of
cables and pipes. In fact we can make an important distinction between the supply and
distribution of services such as gas and electricity. The retail market for the supply of gas
and electricity to homes and businesses is also fully competitive. However, the businesses
which transport gas and electricity to the final consumer are closer to being natural
monopolies. The industry regulator Ofgem regulates these companies through price
controls and monitoring of quality of service.

The natural monopoly through the exploitation of economies of scale can in theory
undercut any actual or potential rivals purely on the grounds of cost. If the monopolist
loses market share (for example by the competition authorities acting to split up an
existing monopoly) there is the risk that smaller-scale suppliers will produce at higher
average total cost which would represent a waste of scarce resources. Forcing such a
company to price at marginal cost would also inflict inevitable losses and threaten the
long term financial viability of the supplier.

537
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Oligopoly - Game Theory

“When I am getting ready to reason with a man I spend one-third of my time thinking
about myself and what I am going to say, and two-thirds thinking about him and what he
is going to say.”
Abraham Lincoln

A game occurs when there are two or more interacting decision-takers (players) and each
decision or combination of decisions involves a particular outcome (pay-off.) The fate (or
the payoff) of a player in a game depends not only on the actions of that player but also
on the other players!

The Monty Hall problem!

Suppose you’re on a game show, and you’re given the choice of three doors. Behind one
door is a car, behind the others, goats. You pick a door, say number 1, and the host, who
knows what’s behind the doors, opens another door, say number 3, which has a goat. He
says to you, “Do you want to pick door number 2?” Is it to your advantage to switch your
choice of doors?
Possible answer to the Monty Hall problem

Game theory is mainly concerned with predicting the outcome of games of strategy in
which the participants (for example two or more businesses competing in a market) have
incomplete information about the others' intentions.

The Prisoners’ Dilemma

The classic example of game theory is the Prisoners’ Dilemma, a situation where two
prisoners are being questioned over their guilt or innocence of a crime. They have a
simple choice, either to confess to the crime (thereby implicating their accomplice) and
accept the consequences, or to deny all involvement and hope that their partner does
likewise.

538
1
 Confess or keep quiet? The Prisoner’s Dilemma is a classic example of basic game
theory in action!

The “pay-off” is measured in terms of years in prison arising from each of their choices
and this is summarised in the table below. No communication is permitted between the
two suspects – in other words, each must make an independent decision, but clearly they
will take into account the likely behaviour of the other when under interrogation.

Two prisoners are held in a separate room Prisoner A

and cannot communicate
They are both suspected of a crime Confess Deny
They can either confess or they can deny
the crime
Payoffs shown in the matrix are years in
prison from their chosen course of action
Decisions made under uncertainty

Confess (3 years, 3 years) (1 year, 10 years)

Prisoner B
Deny (10 years, 1 year) (2 years, 2 years)

What is the optimal strategy for each prisoner? Equilibrium occurs when each player
takes decisions which maximise the outcome for them given the actions of the other
player in the game. In our example of the Prisoners’ Dilemma, the dominant strategy for
each player is to confess since this is a course of action likely to minimise the average
number of years they might expect to remain in prison. But if both prisoners choose to

539
1
confess, their “pay-off” i.e. 3 years each in prison is higher than if they both choose to
deny any involvement in the crime.

However, even if both prisoners chose to deny the crime (and indeed could communicate
with each other to agree this course of action), then each prisoner has an incentive to
cheat on any agreement and confess, thereby reducing their own spell in custody.

The equilibrium in the Prisoners’

Dilemma occurs when each player takes
the best possible action for themselves Prisoner A
given the action of the other player.

The dominant strategy is each prisoners’

unique best strategy regardless of the
other players’ action Confess Deny
Best strategy? Confess?

A bad outcome – prisoners could do

better by both denying – but once
collusion sets in, each prisoner has an
incentive to cheat!

Confess (3 years, 3 years) (1 year, 10 years)

Prisoner B
Deny (10 years, 1 year) (2 years, 2 years)

Real world applications of game theory

Game theory analysis has direct relevance to our study of the behaviour of businesses in
oligopolistic markets – for example the decisions that firms must take over pricing of
products, and also how much money to invest in research and development spending.
Costly research projects represent a risk for any business – but if one firm invests in
R&D, can another rival firm decide not to follow? They might lose the competitive edge
in the market and suffer a long term decline in market share and profitability.

The dominant strategy for both firms is probably to go ahead with R&D spending. If they
do not and the other firm does, then their profits fall and they lose market share.
However, there are only a limited number of patents available to be won and if all of the
leading firms in a market spend heavily on R&D, this may ultimately yield a lower total
rate of return than if only one firm opts to proceed.

In game theory, nothing is fixed!

Conventional economics takes the structure of markets as fixed. People are thought of as

540
1
simple stimulus-response machines. Sellers and buyers assume that products and prices
are fixed, and they optimize production and consumption accordingly. Conventional
economics has its place in describing the operation of established, mature markets, but it
doesn’t capture people’s creativity in finding new ways of interacting with one another.
Game theory is a different way of looking at the world. In game theory, nothing is fixed.
The economy is dynamic and evolving. The players create new markets and take on
multiple roles. They innovate. No one takes products or prices as given. If this sounds
like the free-form and rapidly transforming marketplace, that’s why game theory may be
the kernel of a new economics for the new economy.”
Source: Brandenburger & Nalebuff- Foreword to Co-opetition

The Prisoners’ Dilemma can help to explain the break down of price fixing agreements
between producers which can lead to the out-break of price wars among suppliers, the
break-down of other joint ventures between producers and also the collapse of free-trade
agreements between countries when one or more countries decides that protectionist
strategies are in their own best interest.

The key point is that game theory provides an insight into the interdependent decision-
making that lies at the heart of the interaction between businesses in a competitive
market – particularly those dominated by a few leading players!

John Maynard Keynes’ “The Beauty Contest”:

“...professional investment may be likened to those newspaper competitions in which the
competitors have to pick out the six prettiest faces from a hundred photographs, the prize
being awarded to the competitor whose choice most nearly corresponds to the average
preferences of the competitors as a whole; so that each competitor has to pick, not those
faces which he himself finds prettiest, but those which he thinks likeliest to catch the
fancy of the other competitors, all of whom are looking at the problem from the same
point of view. It is not a case of choosing those which, to the best of one’s judgment, are
really the prettiest, nor even those which average opinion genuinely thinks the prettiest.
We have reached the third degree where we devote our intelligences to anticipating what
average opinion expects the average opinion to be.”
J.M. Keynes; General Theory, p.156, 1936

Suggestions for further background reading on game theory

Game theory resources (US based site) www.gametheory.net/
Game theory society (US based site) www.gametheorysociety.org/
Prisoners Dilemma and a Big Brother Housemates Game!
http://www.paulspages.co.uk/hmd/

Author: Geoff Riley, Eton College, September 2006

541
1
A2 Markets & Market Systems
Contestable Markets

affect the behaviour of businesses in the market-place.

What is a contestable market?

William Baumol defined contestable markets as existing where “an entrant has access to
all production techniques available to the incumbents, is not prohibited from wooing the
incumbent’s customers, and entry decisions can be reversed without cost.”

For a contestable market to exist there must be low barriers to entry and exit so that
there is always the potential for new suppliers to come into a market to provide fresh
competition to existing suppliers. For a perfectly contestable market, entry into and exit
out of the market must be costless

The reality is that no market is perfectly contestable (there are always some “barriers
to contestability” – see your revision notes on barriers to entry). That said it is also
true that virtually every market is contestable to some degree even when it appears
that the monopoly position of a dominant seller is unassailable. This can have important
implications for the competitive behaviour (conduct) of existing firms and clearly then
affects the performance of a market from an economic efficiency viewpoint (e.g.
allocative, productive and dynamic efficiency)

Contestable markets and perfect competition - the differences

Contestable markets are different from perfect competitive markets. For example, it is
feasible in a contestable market for one firm to dominate the industry, have price-setting
power and also for firms in a market to produce a differentiated product both of which
run counter to the assumptions behind the traditional model of perfect competition.

There are three main conditions for pure market contestability:

1. Perfect information and the ability and/or the right of all suppliers to make use
of the best available production technology in the market
2. The freedom to market / advertise and enter a market with a competing product
3. The absence of sunk costs – this reduces the risks of coming into a market

Sunk costs – a barrier to contestability

Barriers to market contestability exist when there are sunk costs. These are costs that
have been committed by a business cannot be recovered once a firm has entered the
industry. It might be easier to think of sunk costs as costs that are unavoidable once they
have been committed at a particular moment in time – a classic example being the money

542
1
that the telecoms firms committed to winning the 3rd generation mobile phone licences at
auction in 2000. When sunk costs are high, a market is more likely to produce a price and
output similar to monopoly (with the risk of allocative inefficiency / market failure that
follows on from this).

The Increasing Contestability of Markets

One feature of the British and European economy in recent years has been an increase in
the number of markets and industries that are genuinely contestable. Several factors
explain this development:

Entrepreneurial Zeal

It is often the case that markets become more competitive because of the persistence of
entrepreneurs who simply do not accept that the existing market structure is a given.
Decisions to enter markets where there are already dominant businesses with significant
industry experience involve taking risks – but a new supplier may have the advantage of
product innovation or a more competitive business model based on different pricing
strategies.

Blueback Taxis
The London taxi-cab market has just been shaken up by the arrival of a new, heavily
branded competitor. Blueback aims to become the “Starbucks” of the taxi market. What
strategy is it using to enter the market?
The London taxi market is highly fragmented - i.e. supplied by numerous small operators
and is largely unbranded. The objective of Blueback is to rapidly grow market share by
launching a clearly branded service that will encourage taxi drivers to switch to the
company.
Blueback has taken a leaf out of low-cost airline Easyjet’s strategy book with the way it
has developed its new service. Blueback has one, up-front pricing policy and runs only
one type of vehicle, the Fiat Multipla. Each vehicle carries the same, distinctive blue and
silver livery. The drivers wear the same uniform and offer customers newspapers and
mobile phone chargers as part of the onboard service. All drivers go through Blueback’s
driver training programme and are licensed by the PCO. The Blueback service was
developed from marketing research that asked people what they wanted from taxi hire.
This covered areas such as ordering, pricing and experience of the service. The long-term
objective of the company is to have a fleet of 1000 vehicles within the next few years and
to be the market-leading taxi operator in London
Adapted from Business Café, Tutor2u (February 2004)

De-regulation of markets – Also known as market liberalisation, de-regulation

involves the opening up of markets to competition by reducing some of the statutory
barriers to entry that exist. Good examples of recent deregulation include the main
utilities such as gas and electricity and also the liberalisation of telecommunications and
postal services as part of the European Union competition initiatives.

543
1
In postal services, all EU countries must open up business and household mail delivery
services so that there is at least one competing supplier to the dominant national postal
service provider. The liberalisation is scheduled to be completed by 2007. Already the
Royal Mail is negotiating agreements with other postal service companies to deliver their
pre-sorted mail “the final mile” to consumers. The UK postal services market was opened
up to full competition in January 2006. The latest UK market review is available here.

In telecommunications, the advent of pre-carrier selection means that there is now

increasing competition for land-line telephone services. British Telecom (BT Group) is
now facing much greater competitive pressure from Just Talk, Talk-2, Talk-Talk
(Carphone Warehouse) and other providers.

The retail clothing market in the UK has also undergone rapid change not least with the
arrival of a group of western European retailers such as Primark who have taken market
share from the established businesses together with the rapid entry of the supermarkets
into discount clothing. Likewise, new technology has been at the forefront of a much
more competitive and contestable market in DVD rentals.

Competition Policy

Tougher competition laws acting against predatory behaviour by existing firms are
designed to make markets more contestable. In both the UK and the EU this has included
tougher rules against price fixing cartels. When market contestability is weak, there is
nearly always greater scope for cartel-type behaviour by the existing firms, particularly if
the market structure in which they operate comes close to an oligopoly.

The European Single Market

The development of the Single European Market has opened up the markets for member
nations. A good example of this is home and car insurance and also the entry of Western
European clothes retailers onto the UK high streets and shopping malls. The abolition of
block-exemption for car dealerships within the EU should also help to make the retail car
market more contestable in the UK in particular and may help to bring down further the
prices of new cars.

Technological Change (including the e-mergence of e-commerce)

The impact of new technology is having a huge effect, not least because it have brought
down some of the entry costs in some markets (leading to an increase in capital mobility).
The rapid expansion of e-commerce for example has lead to the emergence of new
players in the travel sector and online bookselling, insurance and many other markets.

Technological spill-over can lead to the development of rival products that copy or
imitate the characteristics of the products of the incumbent firms. Just a few years after
the launch of Viagra, the anti-impotence drug, Levitra, the first market rival to the hugely

544
1
profitable Viagra, is now being manufactured by the German firm, Bayer AG, and
marketed by the British firm GlaxoSmithKline.

Contestable market case study – the market for broadband in the UK

2005 was the year when finally the market demand for broadband services took off!
Having lagged well behind most other western European countries in our use of
broadband, the UK witnessed a huge boom in take-up for broadband technology. The
telecommunications industry is an excellent one to study, not least because of the
important role played by the industry regulator, OFCOM in opening up the market to
fresh competition and acting as a catalyst for the successful entry of new firms into the
broadband market.
OFCOM believes that the retail market for broadband is now sufficiently competitive
market so that it can operate without price regulation. In the past, industry regulators in
recently privatized industries where monopoly power remained have used their powers to
impose price regimes on the major utilities. But as competitive forces have strengthened,
so the role of the regulator has moved away from direct price controls, towards a broader
role of monitoring the scale and quality of competition within a market.
As part of the current legal arrangements in the UK telecoms sector, BT is required to
provide regulated wholesale access to broadband products so that other service providers
can sell broadband to households and business customers. OFCOM has intervened to
reduce the access charges that BT can make to these other suppliers, and this too has been
important in reducing barriers to entry in the market and thereby making the industry
more contestable. For example, just over a year ago, Ofcom announced proposals set a
maximum price of £81.85 that BT can charge its competitors to rent a fully unbundled
local loop. The ceiling is designed to promote competition in the broadband market by
ensuring that BT's charge is fair, reasonable and cost-oriented.
The importance of local loop unbundling
Unbundling the local loop has been of pivotal importance in creating a contestable
market for broadband services. Local Loop Unbundling (LLU) enables telecoms
operators to connect directly to the consumer via BT's own copper local loops and then
add their own equipment to offer broadband and other services. This process involves
operators accessing BT’s local exchange buildings to connect to BT’s network of copper
lines which connect them to homes and businesses. Most homes in the UK are within one
mile of a local telephone exchange.
Main service providers in the UK broadband market
We can see the contestable nature of the broadband market by looking at a growing list of
main service providers and also the changing balance of market share by total sales.
Britain has more than 100 suppliers of broadband although aggressive price discounting
is likely to see this number fall as some businesses drop out of the market because they
cannot make a profit.
The effects of increased contestability on the market for broadband
Demand and “take-up”: Broadband penetration among household consumers has
increased significantly.
Falling prices: Average UK residential subscription prices have fallen sharply with some
service providers claiming to offer “free broadband” as part of a package of
telecommunications services. It has become clear though that there is no such thing as a

545
1
free lunch – broadband services are rarely if ever free!
Speeds: Broadband speeds are increasing as the broadband suppliers roll out the effects
of increased investment in high speed cables and servers.
Evolving market shares: The market shares of the broadband providers continue to
change. In the year 2000, the market share of the top three providers (BT, NTL and
Telewest) was 87%. By 2002 this had declined to 79% and in 2004 OFCOM reports that
the concentration ratio of the leading three firms had declined further to just 55%.
Suggestions for more reading on the battle for market share in broadband
BBC news articles on broadband
Ofcom on the UK broadband market
The broadband boom and you (BBC)

Contestable Markets and the Performance and Conduct of Businesses

How might the contestability of a market affect the conduct and performance of
businesses? It is worth emphasising in essays and data questions that it is the actual
behaviour of agents in the market that is more important that a simple picture of market
share.

In the diagram above a pure monopoly might price at P1 and reach a profit maximising
equilibrium. If a market is contestable, there is downward pressure on price, because
the existence of supernormal profits provides a signal for new firms to enter the market
and if the existing monopolist is producing at too high a price or has allowed their
average total costs to drift higher, then entrants can undercut the monopolist and some of

546
1
the monopoly profit will be competed away. Normal profit equilibrium occurs when
average revenue equals average total cost (at output Q2 and price P2).

From an economic welfare point of view, a lower price and higher output implies an
improvement in consumer welfare (which could be illustrated by an increase in consumer
surplus).

When markets are genuinely contestable – we expect to see lower profit margins (i.e.
lower “mark-ups”) than when a monopoly operates without competition. Indeed the
threat of competition may be just as powerful an influence on the behaviour of the
existing firms in a market than the actual entry of new businesses. If a dominant firm in a
contestable market knows that new suppliers may come in – this may be sufficient for
them to charge a price closer to the level we might expect from a competitive market
structure.

If a market is contestable, industry structure and firm behaviour is determined by the

threat of competition - 'hit-and-run' entry. The market will resemble perfect competition,
regardless of the number of firms, since incumbents behave as if there were intense
competition.

Key revision points for contestable markets:

o Be familiar with the barriers to entry and exit that might exist in any given
industry
o Understand how the threat of competition can affect current price and output
decisions of firms within a contestable market
o Understand that market share is not a reliable guide to market contestability. We
need much more detail on aspects such as price elasticity of demand, the costs of
suppliers etc
o Be aware that the UK and Competition Authorities are increasingly turning their
attention to the determinants of market contestability rather than a narrow focus
on market share and the profitability of businesses. The emphasis of government
competition policy is mainly towards opening-up markets and encouraging the
entry of new suppliers (both domestic and international)

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Externalities Overview

547
1
We now consider in more detail than at AS level, the economics of externalities and
policy approaches to controlling and correcting for market failure caused by the
existence of externalities. Environmental economics is now a huge area of the subject.

The economic importance of the environment

The environment plays an absolutely essential role in shaping our economic and social
welfare. The environment

 Provides services to consumers in the form of living and recreational spaces and
the opportunity to enjoy utility from experiencing natural landscapes and habitats
 It provides us with the natural resources necessary to sustain production and
consumption including the basis for renewable and non-renewable sources of
energy
 It is a dumping ground for the waste products of our society - be it waste
from producers in different industries or from households and consumers

The link between economic activity and our environment is fundamental. We hear
constantly about the need for sustainable economic welfare, for growth to take into
account the direct and indirect effects on our resources. And increasingly we, as
producers and consumers, are affected by many government policies and strategies
designed to promote environmental protection and improvement.

What is the commonly accepted definition of sustainability?

Development which meets the needs of the present without compromising the ability of
future generations to meet their own needs
World Commission on Environment and Development Our Common Future (1987)

Externalities and the environment – the basics

For environmental economics, one of the most important market failures is caused by
negative externalities arising from either production or consumption of goods and
services.

A negative externality occurs where a transaction imposes external costs on a third party
(not the buyer or seller) who is not compensated by the market. The result is a loss of
allocative efficiency and shown by a reduction in economic welfare

Environmental externalities generally arise for three reasons:

 Common resources (not privately owned - e.g. ocean fisheries) – commonly

owned resources may lack the protection of property rights and are susceptible to
over-exploitation because the marginal cost of extracting the resource for a
private economic agent is close to zero. This is known as the “tragedy of the
commons”

548
1
  Public goods (indivisible common resources - e.g. the air)
 Future generations (sources of externality including carbon emissions –
greenhouse effects – contributions to global warming which threatens future
sustainability)

Dead fish on a polluted beach – the external costs of pollution – but who should pay?

In these cases, the private equilibrium of supply and demand is not the same as the
social equilibrium which includes all costs. In a completely free market, a producer will
have no incentive to control pollution because it is external – i.e. the producer only
considers his/her own private costs and benefits. The market failure arising from negative
externalities is shown in the diagram below.

549
1
Economists argue that market failures provide a rationale for policy intervention to
improve economic efficiency. But since market failures are pervasive, intervention is
only justified if the benefits exceed the costs

“The Tragedy of the Commons”

The contribution of each economic agent is minute, but summed over all agents, these
actions degrade the resource and may cause severe long term damage

The “tragedy of the commons” is a metaphor used to illustrate the potential conflict
between individual self-interests of producers and consumers and the common or public
good.

In the original version of the term, the example is used of a stock of common grazing
land used by all livestock farmers in a small village. Each farmer keeps adding more
livestock to graze on the Commons, because the marginal cost of doing so is zero. But
because the commonly-owned resource is then over-exploited, the result is a depletion of
the soil and a fall in the value of the resource for all users. The resource may become
irretrievably damaged, an example of a public bad.

The root cause of any tragedy of the commons is that when individuals use a public
good, they do not bear the entire social cost of their actions. If each seeks to maximize

550
1
individual benefit, he or she ignores the external costs borne by others. The absence of
well defined and legally protected property rights lies at the heart of the problem.

A tragedy of the commons can occur even without complete and permanent destruction
of a resource – the term can be used to describe any situation where what was perceived
as a renewable resource becomes less valuable because of over-exploitation.

Good examples of the tragedy of the commons:

 Burning of fossil fuels – carbon emissions – contributing to global warming

 Pollution of waterways - creating other externalities for users of waterways
further downstream
 Logging of forests – e.g. the long-term impact on the Brazilian rain forest and the
effects of illegal logging see http://news.bbc.co.uk/1/hi/business/4842808.stm
 Over-fishing of the oceans – e.g. the current crisis in the EU fishing industry – see
http://news.bbc.co.uk/1/hi/sci/tech/4996268.stm
 Fly-tipping of waste products on public land – perhaps a response to the landfill
tax?
 E-mail spamming on the internet!

Game theory and the tragedy of the commons

The tragedy of the commons can be linked to the prisoner's dilemma that is a core part
of game theory. Individuals within a group have two options: cooperate with the group
or defect from the group. Cooperation happens when individuals agree to protect a
common resource. Defection happens when an individual decides to use more than his
share of a public resource.

Cooperation has the potential to maximize every individual's benefit in the long run (i.e.
the 'tragedy' does not happen, the commons are preserved and can be used indefinitely),
while defection maximizes an individual's benefit in the short run at the expense of
destroying it in the long run. Thus in the case of fish stocks, suppliers need to cooperate
over a period of time so that fish stocks can start to rise again. This is the essence of
attempts to reform the European Union Common Fisheries Policy.

An alternative to regulation by government is to create a market in property rights in

order to control the impact of economic activity on the environment – for example
establishing a carbon trading emissions scheme or introduction tradable fishing permits
for the EU fishing industry.

The Economics of Waste

The UK government wants more waste being disposed of through incineration rather
than dumped in landfill sites. It has restated its strategy and at the top of the waste
hierarchy is the desire to reduce the amount of waste created in the first place from the
production and consumption of goods and services. The main aim is for the volume of

551
1
waste to grow less quickly than GDP, in other words to achieve a “de-coupling” of waste
generation from rising economic activity. Because waste is normally regarded as a de-
merit good creating external costs, there is justification for some form of government
intervention in the market to change market prices, alter incentives and, hopefully, cause
a change in the behaviour of consumers and producers.

Over two million tonnes of edible food is dumped by retailers in Britain each year,
usually into landfill sites

According to data released by DEFRA, less waste in the UK is being land-filled – down
from 82% to 72% for municipal waste between 1999 and 2004 and from 50% to 44% for
industrial and commercial waste between 1999 and 2003. A successful waste strategy
will bring about sizeable increases in waste recycling and composting. Some local
authorities have a superb record in raising awareness and interest in recycling products.
But in other areas of the UK, recycling rates are abysmally low and well below the levels
needed to meet UK and European Union targets. Government policy needs to be more
effective in enhancing the incentives for individuals and businesses to recycle more of
their waste products.

The vast majority of UK household and industrial waste is disposed of in landfill sites

Hierarchy of principles of waste management:

o Prevention of waste - reduce the amount of waste created in the first place
o Reuse the product
o Recycle or compost the product
o Recover the energy by incinerating
o Disposal of the product using landfill

552
1
What are the best incentives for households and businesses to reduce the amount of waste
created?

Suggestions for further reading and research

Friends of the Earth

Guardian special report on waste and pollution
If the toxic time bomb goes off (BBC)
Norway gets soft drinks eco-tax (BBC)
Recycling around the world (BBC)
Sustainable Development Commission (UK)
Tesco offers carrot to reduce use of plastic bags (Guardian) and “Green grocers favour
reusable bags”
UK 'refuseniks' tackle Big Waste (BBC news Feb 2006)
Waste – facts behind the fiction
Waste incineration set to rise (BBC)
Waste online
Waste problem needs many solutions (BBC)
Wasteful homes threaten eco-targets (BBC)

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Market Failure – Universities and Tuition Fees

553
1
The introduction of tuition fees for students in England and Wales has been
controversial. It raises important issues about the economics of higher education – some
of these issues are raised and evaluated in this note.

Market failure in education

Market failure occurs when markets operating without government intervention, fail to
deliver an efficient or optimal allocation of resources - Therefore - economic and
social welfare may not be maximised – leading to a loss of allocative and productive
efficiency (i.e. welfare losses for society).

Market failure exists when the outcome of markets is not efficient from the point of view
of the economy. This is usually because the benefits that the market confers on
individuals or firms carrying out a particular activity diverge from the benefits to society
as a whole (i.e. there are externalities not taken into account within the market). This is
particularly relevant to the concept of education as a merit good

An aerial view of Oxford – should higher education be regarded as a merit good which
the government should subsidise directly for students?

The idea of positive educational externalities is that the benefits of individually

acquired education may not be restricted to the individual but might spill over to others as
well, meaning that there will be macroeconomic advantages from a higher level of
education spending and attainment.

For example, there is compelling evidence that human capital increases productivity
and thereby increases an economy’s trend rate of growth and international
competitiveness. Education is found to yield additional indirect benefits to growth for

554
1
example by stimulating physical capital investments and technological development and
adoption across many different industries (creating the potential for gains in dynamic
efficiency)

The free “spill-over effects” of improved educational provision can be said to take
education away from being purely as a merit good and more towards meeting the
characteristics of a public good.

The social returns to increasing the average length of time that people spend in
education depend in part on the stage of economic development – recent studies suggest
that an expansion of tertiary/higher education is the most important for growth in
countries such as the UK.

Imperfect information

Markets can also fail when the individual or firm does not have sufficient information to
recognise the future returns from undertaking an action – again this is relevant to
decisions that individuals take as to how much education they should “consume” or
“purchase” at different stages of their life. Many young people are myopic when making
university and degree course decisions. Or they may be averse to taking on debts even
though it might be in their long-term financial interest to do so. In this case, there might
be an economic case for the government to adopt a “paternalistic” view on what is best
or for younger people.

Equity

Markets can generate what is perceived to be an ‘unacceptable’ distribution of income

and too high a level of social exclusion where people on low incomes are denied access
to essential goods and opportunities considered ‘normal’ by a society. Education comes
into this category – not least on the issue of whether students should make a financial
contribution to the cost of their own tuition when they are in higher education.

Merit Goods and Market Failure

A merit good is a product that the government believes consumers undervalue and
under-consume because of imperfect information. A merit good is deemed to be
‘socially desirable’ and also ‘better’ for a consumer than the consumer realises – a value
judgement is involved whenever we talk of merit goods.

555
1
How can a monetary value be placed on the additional social value of education
overlooked by consumers suffering from information failure? Is it simply the present
value of higher income?

How can the value to society of a well educated and more skilled and productive work
force be estimated both in the short term and the long run?

The Private and Social Benefits of Education

Private Benefits of Education Social Benefits of Education

The fun and enjoyment of learning (personal More literate and intelligent society – lower
satisfaction and fulfilment) crime rates?

Accumulation of human capital Contributes to international competitiveness

(qualifications and experience) that will of economy – importance of high-knowledge
reduce the risk of unemployment and allow sectors in international trade continues to
people to hurdle over entry barriers to grow – expansion of scientific research etc
certain occupations

Higher expected earnings in work – a Higher tax revenues in the long run – can be
university degree is a signalling mechanism used to fund other socially beneficial

556
1
for employers – e.g. in promoting fast-track government spending programmes
promotion

Blundell (2000) estimated that the average Social benefits from having more doctors
return to completion of a first degree for a and teachers and scientists – increased
cohort of 33-year-olds in 1991 was around provision of public and merit goods
17% for men and 37% for women compared
with people with A levels as their highest
qualification

There is no such thing as a free lunch. Higher education involves costs – the main issue
is really how best it should be funded. Clearly there are many normative judgements
involved – but we should also try to bring economic arguments into the discussion. A
recent research piece by the Institute for Fiscal Studies made the situation clear:

It is important to be clear that higher education is never free, whether the costs are met
upfront by students, later in life by graduates or in an ongoing way by taxpayers in
general. Altering the system of HE finance changes the incidence and the timing of
payments but does not change the fact that the cost of university education must be paid
for in one way or another.
Adapted from www.ifs.org.uk

Summary of some of the arguments on tuition fees and the funding of universities

Arguments for introducing tuition fees Arguments against tuition fees

The “benefit-pay-principle” A tax on learning? Equity issues

A university education is a valuable and Only 7% of children from families in the
expensive privilege. Why should something lowest social class currently go to
that is so rewarding and costly be free? university – tuition fees will make it
It is equitable for students to make a financial harder for relatively poor families to fund
contribution to their degree teaching – they a degree. This will widen educational
stand to gain financially from a degree – inequality and create a further widening
education is an investment and it is rational for of the two-tier education system
students to borrow at this stage of their life- Top up tuition fees or a graduate tax will
cycle to finance such investment. It is rational raise extra revenue – but they are not an
to forgo current earnings in return for higher alternative for a higher level of
future earnings government funding designed to increase
education spending as a share of GDP

Extra funding for facilities, teaching & Student debt – may deter poorer
research students
Tuition fees will provide extra finance that Tuition fees will lead to a huge surge in

557
1
will allow the government to fund an student debt and hardship which in turn
expansion of the number of students able to will have negative economic and social
enter higher education – promoting wider consequences in the long run
access to HE. Means-testing is costly to monitor and
can create disincentive effects

Means testing to protect access for poorer Social benefits (externalities) argument
students The benefits to participation in higher
Access to higher education to people from less education accrue not only to the individual
privileged backgrounds can be protected. graduate but also to society at large.
Tuition fees can be means-tested to offset the And seeking to expand higher education
danger that fees will hit lower income students too much may work against the best
hardest. Maintenance grants can also be interests of the economy – the graduate
means-tested market may become over-crowded

Improvements in dynamic efficiency Limits to the market – tuition fees no

Fees will encourage students to be more answer
selective in the courses they choose and will A graduate tax exhibits no relationship
stimulate an improvement in teaching quality between the cost of the course attended
if universities are to keep student numbers and the amount repaid by the student. It
high and remain viable - tuition fees make therefore introduces no `market-based'
parents and students ask hard questions about element into the higher education sector in
the purposes of higher education terms of students choosing between
courses and institutions based on the
various prices of attending them

Research and international competitiveness Uncertain flow of tax revenue

Extra funding is needed for universities to The amount that tuition fees will raise is
maintain high levels of research – offering uncertain because it depends on the future
long term macroeconomic benefits for the earnings of graduates once they enter
economy employment – and it will take years for the
extra funding to come through

Progressive system of tuition fee repayment Education as a basic economic and

Repayment through the income tax system social right
introduces a progressivity into the system – Belief that access to university should be
higher income earners will repay their debt available to all people who qualify
more quickly. independent of their ability to pay (a value
Specifying that the loans need only be repaid judgement) – i.e. education as a right not a
when incomes rise above a certain level should commodity
help overcome students’ reluctance to borrow Is education fundamentally different from
when they cannot be confident about their providing health care “free at the point of
future earnings. It is a pay-roll deduction need”?

558
1
scheme rather than a tax

Fees are more equitable than general Impact on demand for certain degrees
taxation It is feared science and engineering -
Funding tuition from general taxation is an among the most expensive courses to run
expensive and poorly targeted way of because of equipment costs and specialist
intervening in the market, because graduates, staff – will see a fall in demand –
who are predominantly found towards the top threatening long term damage to our
of the income distribution, benefit at the manufacturing competitiveness
expense of everyone else i.e. why should non-
graduates pay for the degrees of graduates?
The argument that education should be
provided free is much stronger for the case of
primary and secondary education than for
higher education.
Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Privatisation & de-regulation

Privatisation became one of the most significant microeconomic policies of the 1980s and
1990s. We look briefly at some of the issues involved in transferring assets from the
public to the private sector of the economy.

What is privatisation?
Privatisation means the transfer of assets from the public (government) sector to the
private sector. In the UK the process has led to a sizeable reduction in the size of the
public sector of the economy. State-owned enterprises now contribute less than 2 per cent
of GDP and less than 1.5% of total employment. Privatisation has become a common
feature of microeconomic reforms throughout the world not least in the transition
economies of Eastern Europe as they have made progress towards becoming fully-
fledged market economies.

Major privatisations

The major privatisations in the UK over the last twenty five years have occurred with the
following businesses (the year of privatisation is in parenthesis).

 Associated British Ports (1983)

 British Aerospace (1980) – eventually merged with Marconi Electronic Systems

559
1
  British Airports Authority (1986)
 British Airways (1987)
 British Coal (1994) – in 1994, UK Coal’s assets were merged with RJB Mining to
form UK Coal plc
 British Gas (1986) - In 1997 British Gas plc de-merged Centrica plc and renamed
itself BG plc (later BG Group plc). in Britain it is used by Centrica, while in the
rest of the world it is used by BG Group
 British Petroleum - In August 1998, British Petroleum merged with the Amoco
Corporation (Amoco), forming "BP Amoco."
 British Rail (privatised in stages between 1994 and 1997)
 British Steel (1988) – British Steel merged with the Dutch steel producer
Koninklijke Hoogovens to form Corus Group on 6 October 1999
 British Telecom (1984)
 Cable and Wireless
 National Power and PowerGen (1990) - 1990 the Central Electricity Generating
Board was split into three generating companies (Powergen, National Power and
Nuclear Electric plc.) and electricity transmission company, National Grid
Company.
 Regional water companies

The early examples of privatisation such as the sale of British Telecom to the private
sector in 1984 represented a simple transfer of ownership as shares were offered for
sale via the stockmarket. More recently the privatisation process has become more
complex. The focus has switched to breaking up existing statutory monopoly power
through a process of deregulation and liberalisation of markets – basically designed to
introduce competition where once monopoly power was well established.

Market forces have been introduced in social services, the NHS and in higher education.

What remains of the public sector?

Privatisation has radically reduced the size of the public or government sector of the
economy although since the current Labour government came to power, there has been a
huge rise in total public sector employment, in part the result of a large rise in
government spending on the national health services. The following businesses remain
part of the public sector:

 British Nuclear Fuels plc - an international company, owned by the British

government, concerned with nuclear power. See this company profile.
 Network Rail - Network Rail is a "not for dividend" company that owns the fixed
assets of the UK railway system that formerly belonged to British Rail, the now-
defunct British state-owned railway operator. Network Rail owns the
infrastructure itself, railway tracks, signals, tunnels, bridges, level crossings and
most stations, but not the rolling stock. Network Rail took over ownership by

560
1
 buying Railtrack plc, which was in "Railway Administration", for £500 million
from Railtrack Group plc.
 The Royal Mail - Royal Mail has been a state-owned company since 1969 and
remains a public limited company wholly owned by the UK government. The
Royal Maul is regulated by PostComm which has the power to grant licences to
new competitors entering the deregulated market for household and business mail
services. The market was opened up to full competition in January 2006. The
Royal Mail retains a universal service commitment.

Delivering competition
On 1st January 2006, the mail market opened to full competition. This means that
organisations other than Royal Mail can now - if they have been licensed by Postcomm -
act as postal operators and collect, sort and distribute mail in the UK. Postcomm will
protect the universal service, which is provided by Royal Mail. This means that everyone
- no matter where they live - will continue to enjoy an affordable daily delivery. The
universal service also includes the "one price goes anywhere" stamp, as well as
collections and deliveries for every address in the country, each working day.
Source: Adapted from the PostComm website

The main economic arguments for privatisation and deregulation

Supporters of privatisation believe that the private sector and the discipline of free market
forces are a better incentive for businesses to be run efficiently and thereby achieve
improvements in economic welfare. The argument is that extra competition in markets
will lead to reductions in price levels for consumers and improvements over time in
dynamic efficiency.

Privatisation was also seen as a way of reducing trade union power and encouraging an
increase in capital investment as businesses were now free to raise extra financial capital
through the stock market.

The main economic arguments against privatisation

Opponents of privatisation argued that state owned enterprises had already faced
competition when part of the public sector and that in several instances the transfer of
ownership merely replaced a public sector monopoly with a private sector monopoly.

There were criticisms that state assets were sold off by the government at too low a price
and that the consequences of privatisation has been a decrease in investment and large
scale reductions in employment as privatised businesses have sought to cut their
operating costs.

Deregulation of markets

561
1
Another important policy in industries where welfare and efficiency might be affected by
the dominant market power of some suppliers is to open up markets and encourage the
entry of new suppliers – a process called de-regulation of product markets. Examples
of this in the UK include the opening up of markets for household energy supplies, the
liberalisation of household mail services and financial deregulation affecting both banks
and building societies.

The expansion of the European Single Market has accelerated the process of market
liberalisation. The Single Market seeks to promote four freedoms – namely the free
movement of goods, services, financial capital and labour. In the long term we can expect
to see the microeconomic effects of the EU Single Market working their way through
many British markets and the general expectation is that competitive pressures for all
businesses working inside the European Union will continue to intensify.

Product market liberalisation involves breaking down barriers to entry in industries

and making them more contestable. The aim is to boost market supply, bring down
prices for consumers, and encourage an increase in competition, investment and
productivity leading to a rise in economic efficiency. In the long term, if product markets
become more competitive and investment flows into these industries, there are
macroeconomic implications for example an increase in an economy’s underlying trend
rate of economic growth which might contribute to an improvement in average standards
of living

Has rail privatisation been successful?

Utility regulators

Utility regulators oversee the activities of companies privatised over the last two decades.
These former state-owned utilities are regulated to ensure that they do not exploit their

562
1
monopoly position. The main aims of the regulators have been to create and simulating
the disciplines that companies would experience inside a competitive market. In the long
run, the thrust of regulation has been to encourage competition by easing the entry of new
suppliers and making markets more contestable.

 Ofwat – (water services regulation authority) – Ofwat is the body responsible for
economic regulation of the privatised water and sewerage industry in England and
Wales. Key issues for Ofwat at the moment include the threats of water shortages,
the problems of leaks and rising water bills.
 Ofcom - The Office of Communications is the UK's communications regulator
 Ofgem - The Office of Gas and Electricity Markets is the government regulator
for the electricity and downstream natural gas markets in Great Britain. Its
primary duty is to “promote choice and value for all gas and electricity
customers".
 Office of the Rail Regulator – ORR is the UK government's agency for
regulation of the country's railway network.

The roles of an industry regulator – the case of Ofgem

Ofgem seeks to protect consumers by promoting effective competition, wherever
appropriate, and regulating effectively the monopoly companies which run the gas pipes
and the electricity wires
Ofgem seeks to help secure Britain’s energy supplies by promoting competitive gas and
electricity markets - and regulating so that there is adequate investment in the networks
A further role of Ofgem is to help and encourage the gas and electricity markets and
industry achieve environmental improvements as efficiently as possible take account of
the needs of vulnerable customers, particularly older people, those with disabilities and
on low incomes
Ofgem is funded by the energy companies who are licensed to run the gas and electricity
infrastructure.
Adapted from the Ofgem web site

Price Capping for the Utilities

Price capping has been a dominant feature of regulation in recent years – although this is
now being phased out as most utility markets become more competitive. Inn reality,
setting a price cap, the industry regulator usually has in mind a “satisfactory rate of return
on capital employed” for each business.

Basics of price capping

Price-cap regulation is a form of intervention in the price mechanism which has been
applied at various points in time to all of the privatised utility businesses in the UK.
Price-capping is an alternative to rate-of-return regulation, in which utility businesses are
allowed to achieve a given rate of return (or rate of profit) on capital. In the UK, price
capping has been known as "RPI-X". This takes the rate of inflation, measured by the
Consumer Price Index and subtracts expected efficiency savings X. In the water industry,
the formula is "RPI - X + K", where K is based on capital investment requirements

563
1
designed to improve water quality and meet EU water quality standards. This has meant
increases in the real cost of water bills for millions of households in the UK. In practice,
the distinction between price-cap and rate-of-return regulation may be lost, as regulators
may end up making implicit decisions on the acceptable real rates of return on capital
employed in order to arrive at price limit determinations.
Source: Adapted from the Wikipedia web site

Price capping has meant in most cases that average prices for consumers have fallen in
real terms although this has not been the case for all privatised industries. The assumption
is that productivity growth will help to accommodate the price caps. Profits for utilities
can rise providing that efficiency levels improve (i.e. firms are able to bring down their
unit labour costs)

Arguments for and against price-capping for the utilities

Advantages

 Capping is an appropriate way to curtail the monopoly power of “natural

monopolies”.
 Cuts in the real price levels are good for household and industrial consumers
(leading to an increase in consumer surplus and higher real living standards in the
long run).
 Price capping helps to stimulate improvements in productive efficiency because
lower costs are needed to increase a producer’s total profits.

o The price capping system is a useful tool for controlling consumer price
inflation in the UK.

Disadvantages

 Price caps have led to large numbers of job losses in the utility industries.
 Setting different price capping regimes for each industry distorts the working of
the price mechanism.

Yell and price capping

Price capping is still used in the market for telephone directories where Yell has a
dominant position in the market. In June 2006 it was announced that Yell would still be
subject to a price capping formula because of the relative absence of competition in the
industry. According to the Competition Commission report, "Yell continues to hold a
powerful position in this market and competition is not working effectively. Prices are
capped at the moment and without this price cap, advertisers would pay more than in a
well-functioning market. At present, Yell is subject to a yearly price cap of RPI less 6% -
so at the moment, the real cost of advertising rates are falling year-on-year.
PostComm approves a rise in the price of stamps
Stamp prices rose in April 2006 under a compromise deal between regulator Postcomm
and the Royal Mail. First class stamps would rose 2p to 32p and second class stamps by

564
1
1p to 22p, with the possibility of them rising to 36p and 25p respectively by 2010. The
Royal Mail had wanted to push stamps up to 39p and 27p to help pay for capital
investment and to plug a £4bn hole in its pension fund.
Adapted from the BBC news website, November 2005

The rail industry was privatized between 1994 and 1997 and since then the average price
of a rail fare has risen faster than inflation. Fare changes are announced by the
Association of Train Operating Companies. Despite continuing high levels of
government subsidy, the train operating businesses have increased those fares that are
unregulated by more than inflation, partly because they have to high fees to Network Rail
for access to the track and infrastructure and because they have been making a
contribution towards improvements to rail safety.

Changing Role of the Utility Regulators

Gradually the main utility regulators have withdrawn from price regulation because of
the increased degree of competition in the market. The main focus of the regulatory
authorities is now to provide improved price information for consumers to make prices
of different suppliers more transparent to improve the flow of information in the market.

The authorities also want to encourage free transfer for consumers between suppliers (by
monitoring and enforcing the nature of supply contracts) and keeping a close eye on anti-
competitive behaviour.

565
1
In telecommunications, one key decision made eventually by Ofcom was to enforce
unbundling of the local loop. Local loop unbundling is the process of allowing
telecommunications operators to use the telephone connections from the telephone
exchange's central office or exchange to the customer premises be it a household or a
business location. In the UK this has meant opening up the telephone exchanges owned
by British Telecom and allowing broadband businesses such as AOL-UK and Tiscali to
put in their own equipment and then supply broadband services in direct competition with
BT to households. The vast majority of households are within one mile of their local
telephone exchange.

Although local look unbundling has taken time to become widespread, it has been one
factor behind the rapid expansion of market supply in broadband which is revolutionising
the UK telecommunications market.

Unbundling the local loop allows rivals to take market share

British Telecom has announced that it has lost half a million residential phone lines to
competitors as broadband operators such as Talk Talk, from Carphone Warehouse, and
Orange have increased their investment in local loop unbundling (LLU). LLU allows
rival firms to place equipment in BT's exchanges and transfer customers to their
networks. When 1.5m lines are unbundled, BT's wholesale unit can cut the price of
wholesale broadband and its retail business will be better able to compete for customers.
Source: Adapted from the Guardian web site, July 2006

One of the consequences of the greater level of competition in the telecommunications

industry in the UK is that in July 2006, Ofcom withdrew all price capping controls on
British Telecom. After 22 years of having its prices controlled directly by an industry
regulator, this marked an important milestone in the privatisation and market
liberalisation process.

Summary comments on privatisation

Privatisation has changed the face of the British economy over the last twenty five years.
Over twenty businesses have been transferred from the public sector to the private sector
and many remaining state sector enterprises are now subject to the disciplines of the
market. The transfer of ownership from one part of the economy to another has been, in
many cases, rather a superficial change. The more fundamental changes have occurred
when monopoly powers have been broken down either because of regulators legislating
to open up the market, or because of the effects of wider international changes such as the
process of globalisation.

The performance of the privatised companies has been patchy. Most of them have seen
their monopoly powers eroded as their markets have become more contestable. Some
privatisations have not worked, the most obvious example being the failure of rail
privatization and the eventual collapse of Railtrack when it went into administration.

566
1
There remain controversial issues about the size of the profits that some of the privatised
utilities are making, the water industry is a good example of this. In most utility markets
there is now genuinely more choice for consumers. And real price levels have come
down over the longer term

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Labour Force

The size of the labour force is an important contributor to a country’s potential growth
rate.

The difference between the labour supply and the labour force

The labour supply refers to the total number of hours that labour is willing and able to
supply at a given wage rate. It can also be defined as the number of workers willing and
able to work in a given occupation or industry for a given wage.

The labour force is defined as the number of people either in work or actively seeking
paid employment and available to start work.

The whole economy labour supply measures the total number of people able available
and willing to participate in paid employment. This comprises the employed labour
force plus those registered as unemployed and actively looking for new work.

The total supply of labour available to produce goods and services is a key factor
determining how much output an economy can generate. The government wants to
expand the UK’s active labour supply through its Welfare to Work policies and also
increase the productivity of the work-force to improve international competitiveness. If
successful, an increase in the active labour supply and labour productivity will contribute
to a faster rate of trend growth in the years ahead and will lead to higher long-term
living standards.

567
1
Employment in the British economy

Although the last twelve years has seen a sizeable and important increase in employment
in the British economy, there remain many millions of people of working age who are
deemed to be economically inactive. These people are not actively seeking paid work for
one reason or another, but conceivably they might be encouraged to join the labour force
and therefore add to the potential stock of workers. Government tax and benefit policies
together with other active labour market strategies have the twin aims of firstly providing
the right incentives for people to become economically active, and secondly to possess
the right skills and experience that will allow them to find gainful and fulfilling
employment.

568
1
Reasons for economic inactivity: by sex and age, 2005

Percentages

16–24 25–34 35–49 50–59/64 All aged 16–

59/64

Men

Long-term sick or disabled 5 40 61 52 37

Looking after family or home 1 12 15 4 6

Student 83 24 5 - 30

Retired 0 0 - 30 13

Other 11 24 18 13 14

Women

569
1
Long-term sick or disabled 4 9 25 40 20

Looking after family or home 22 71 60 28 44

Student 66 10 4 1 21

Retired 0 0 - 15 4

Other 8 10 11 16 11

Source: Labour Force Survey, Office for National Statistics

Reasons for economic inactivity

Among males, nearly fifty per cent are inactive in the labour market because of long term
sickness and disability or because they are in full time education. For females, that
percentage falls to less than thirty per cent. The most common reason for inactivity is the
demands of looking after family and or a home.

The main policies designed to increase the supply of labour available to the economy are
as follows:

 Reforms to the system of direct taxation: In the 1980s, Thatcherite economics

focused on cutting income tax rates particularly at the top end and switching away
from direct towards indirect taxation. More recently, successive governments
have tended to focus more on reductions in the lower rates of income tax and tax
allowances for lower-paid workers. The theoretical idea remains broadly the
same, that lower direct taxes increase the post-tax reward to working and act as an
incentive for more people to join the labour supply. As we have seen in our
previous discussion of the income and substitution effects of an increase in the
real wage rate, there is no guarantee that tax cuts by themselves will have much of
an impact on the whole economy labour supply
 Reforms to the benefits system: The emphasis here has changed in recent years,
away from the rather crude idea of cutting the real and relative value of welfare
benefits to encourage people into searching for work, towards a reliance on tax
credits (for example the Working Families Tax Credit) to give parents with
children a greater financial incentives to work.
 Increased investment in education and training: This is designed to boost the
human capital of the labour force and increase the occupational mobility of the
labour force to meet the changing demands of employers across different
industries
 A more relaxed approach to labour immigration: Particularly where there are
shortages of workers with specific skills such as consultants and fully trained
nurses in the NHS, or shortages of teachers in certain subjects.

570
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Wage Determination in Competitive Markets

Explanations for wage differentials in the labour market

There is a very wide gulf in pay and earnings rates between different occupations in the
UK labour market. No one factor explains the gulf in pay that exists and persists between
occupations and within each sector of the economy. Some of the relevant factors are
listed below

571
1
 1. Compensating wage differentials - higher pay can often be some reward for
risk-taking in certain jobs, working in poor conditions and having to work
unsocial hours
2. Equalising difference and human capital - wage differentials compensate
workers for (opportunity and direct) costs of human capital acquisition. There is
an opportunity cost in acquiring qualifications - measured by the current earnings
foregone by staying in full or part-time education.
3. Different skill levels - the gap between poorly skilled and highly skilled workers
gets wider each year. One reason is that the demand for skilled labour grows more
quickly than the demand for semi-skilled workers. This pushes up average pay
levels.
4. Differences in labour productivity and revenue creation - workers whose
efficiency is highest and ability to generate revenue for a firm should be rewarded
with higher pay. Top sports stars can command top wages because of their
potential to generate extra revenue from ticket sales and merchandising
5. Trade unions - unions might exercise their collective bargaining power to
achieve a mark-up on wages compared to those of to non-union members
6. Employer discrimination is a factor that cannot be ignored

Earnings in the Labour Market

572
1
Weekly Pay - Gross (£) - For all employee jobs: UK, 2005

Number

of jobs Percentiles

(thousand) Median Mean 10 90

Health professionals 241 920.0 1,036.4 285.7 1,982.5

Corporate managers 2,943 636.9 774.5 312.5 1,348.3

Business and public service 624 589.1 669.2 307.4 1,076.7

573
1
professionals

All employees 23,606 349.6 423.2 104.6 766.6

Skilled trades occupations 1,903 390.4 412.5 208.4 637.9

Administrative and secretarial 3,323 278.8 291.3 120.0 464.4

occupations

Customer service occupations 340 236.4 231.6 80.8 366.3

Caring personal service occupations 1,527 204.4 215.4 78.3 355.6

Sales and customer service 1,902 160.1 182.7 55.7 329.3

occupations

Source: 2005 Annual Survey of Hours and Earnings

Sticky wages in the labour market

Economists often refer to the existence of “sticky wages” in many labour markets. In a
fully flexible labour market, a decrease in the demand for labour should cause a fall in the
wage level and a fall in employment - just like any demand curve shifting down. (See the
diagram below).

However, sticky wages refers to a situation in which the real wage level doesn't fall
immediately, partly because most employees have wages specified in medium-term
employment contracts that cannot be renegotiated immediately, and partly because
workers (perhaps protected by their trade unions) are resistant to cuts in nominal wages.
If the wage level cannot fall when demand falls, it leads to a much bigger drop in
employment and, more importantly, involuntary unemployment because of a failure of
the labour market to clear.

The empirical evidence for sticky wages is a good counter-argument to neo-classical

models of the labour market that suggest that real wage levels respond flexibly to any
changes in labour demand and supply conditions

574
1
 Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Labour Market - Discrimination

Employers may not treat workers, be they actual or potential employees in the same way
– in which case discrimination is said to occur. It is a possible cause of market failure
and we consider different aspects of labour market discrimination in this note.

What is discrimination?

Nobel-prize winning economist Kenneth Arrow has defined discrimination as “the

valuation in the market place of personal characteristics of the worker that are unrelated

575
1
to worker productivity”. These personal characteristics may be sex, race, age, national
origin or sexual preference.

Discrimination is a cause of labour market failure and a source of inequity in the

distribution of income and wealth and it is usually subject to government intervention
e.g. through regulation and legislation. Discriminatory treatment of minority groups leads
to lower wages and reduced employment opportunities, including less training and
fewer promotions. The result is that groups subject to discrimination earn less than they
would and suffer a fall in relative living standards.

Why does discrimination occur in the labour market?

1. The 'Taste' Model (Gary Becker) - Discrimination arises here because

employers and workers have a distaste for working with people from different
ethnic backgrounds or final customers dislike buying goods from salespeople
from different races i.e. people prefer to associate with others from their own
group. They are willing to pay a price to avoid contact with other groups. With
reference to race, this is equivalent to racial prejudice.
2. Employer ignorance – Discrimination arises because employers are unable to
directly observe the productive ability of individuals and therefore easily
observable characteristics such as gender or race may be used as proxies – the
employer through ignorance or prejudice assumes that certain groups of workers
are less productive than others and is therefore less willing to employ them, or
pay them a wage or salary that fairly reflects their productivity, experience and
applicability for a particular job.
3. Occupational crowding effects – Females and minorities may be crowded into
lower paying occupations

Discrimination against female workers - the “gender pay gap” in the UK

Gross hourly earnings: by sex and whether working full-time or part-time (£ per
hour)

Males Females

part-time full-time part-time full-time

1995 6.83 9.01 5.34 7.16

2003 8.82 12.88 7.78 10.56

Although big changes have occurred in the UK labour market and those of many
countries in terms of the participation rates and employment levels of females, there is
little doubt that a permanent gap exists between average pay rates for females and males

576
1
in the UK labour market. However there is evidence that this gap is closing albeit slowly.
A report by the Women and Work Commission released in February 2006 found that
women in full-time work were earning 17% less than men. The gender pay gap is not
confined to the UK. Average earnings for women in the European Union are 15% less
than men. In America, the difference in median weekly pay is around 20%.

Evidence of the gender pay gap comes each year from the New Earnings Survey.

1. Hourly earnings: Since 1999 women’s hourly earnings have remained at just
over 80 per cent of men’s earnings. The average hourly wage rate for men in 2003
was £12.88 while the rate for women was £10.56.
2. Weekly earnings Average weekly earnings of full-time employees in 2003 for
women (£396.0) were 75.4 per cent of those for men (£525.0). Women's weekly
earnings were lower than men's partly because they worked on average 3.5 fewer
hours per week

Britain's equal pay record is poor when compared to other European countries - tenth out
of fifteen countries surveyed. Over a lifetime, the gender pay gap can cost a childless mid
skilled woman just under £250 000

What factors explain the gender pay gap in the UK?

1. Human capital: i.e. there are differences in educational levels and work
experience between males and females. This is most marked when one compares
married males with married females. Breaks from paid work, including time to
raise a family, also impact on women's level of work experience. It is calculated
that a mid skilled mother of two, loses an additional £140 000 of her potential
earnings after childbirth.
2. Part-time working: a significant proportion of women work part-time and part-
time work typically pays less well than full-time jobs. Nearly 50% of women in
the UK whose youngest child is under 5 are not in employment and of those who
do work, 65% work part-time.
3. Travel patterns: on average, women spend less time commuting than men with
the result that they will have a smaller pool of jobs to choose from. It may also
result in lots of women wanting work in the same location near to where they live
which will result in lower equilibrium wages for those jobs.
4. Occupational segregation: women's employment tends to be concentrated in
certain occupations. Indeed, indeed 60 per cent of working women work in just 10
occupations. Occupations which are female-dominated are often relatively poorly
paid jobs (e.g. Caring, Cashiering, Catering, Cleaning and Clerical jobs) and there
is continued under-representation in higher paid jobs within occupations – the so-
called "glass ceiling" effect.
5. Employer discrimination: Work by the LSE calculates that up to 42% of the
gender pay gap is attributable to direct discrimination against women. Since 1995
the number of equal pay cases registered with employment tribunals has more
than doubled.

577
1
 6. The effects of monopsony power: Females may be relatively geographically
immobile (because they are tied to their husbands' place of employment) and may
be paid less than a competitive wage by a monopsonist employer

A reduction in the demand for female labour relative to male labour will result in a
reduction in the employment of females and a reduction in the relative wages of females
compared to males (assuming that supply of female labour is not perfectly elastic)
Government Intervention to reduce the gender gap

Intervention has taken several forms. The Equal Pay Act introduced in 1970 sought to
provide legal protection for female workers and encouraged employers to bring the pay
for males and females into line. The Sex Discrimination Act of 1975 outlawed unequal
opportunities for employment and promotion in the workplace because of gender and it
set up the Equal Opportunities Commission.

Attention has switched in recent years away from legislation towards encouraging more
women to stay on in further and higher education providing and targeted assistance for
single parents to find work and thereby increase the labour market participation ratio
among female workers.

Earnings Differentials between Ethic Groups

Ethnic minority groups in the UK are more likely to experience unemployment than
White Irish or White British groups. Despite sustained, record low unemployment among
the white population at 4.4 per cent, among black and Asian people unemployment is two
and half times greater at 11.3 per cent.

And in terms of their earnings from the labour market, ethnic minority workers in Britain
are over-represented in low-paying occupations such as service industries, which
employ three-quarters of ethnic minority male employees and self-employed work
compared to around three-fifths of white men. Fifty-two per cent of male Bangladeshi
employees and self-employed work in the restaurant industry, compared to only 1 per
cent of white men. High proportions of Indian and Pakistani women work in the retail
trade, another low-paying sector. Occupational segregation is one reason for persistent
earnings differentials between whites and non-whites in the UK labour market.

Ethnic minorities face two kinds of discrimination in the UK labour market:

1. Less access to higher status occupations than their white counterparts

2. Lower pay for a given job. The latter effect is the more powerful, accounting for a
five percentage point difference between white and ethnic minority wages.

Theory of labour market discrimination

578
1
We can model the effects of discrimination using a simple labour demand and supply
framework

It is difficult to be precise about the effects of discrimination in the labour market.

Employers rarely have full information about the productivity of all of their workers, let
alone prejudiced or ignorant views about the relative merits and de-merits of different
groups. Increasingly employers’ organisations along with trade unions are working hard
to break down barriers to the employment of different minority groups and in
highlighting instances of discriminatory behaviour.

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Labour Market – The Ageing Population

The age structure of the UK population

579
1
“Around the world populations are ageing. The characteristic shape of the human
population since time immemorial—an age pyramid with lots of children at the base—is
inverting into one that will eventually have relatively older people at the top.”
Source: Adapted from the Economist, June 2002

The table below provides a summary of the age structure of the UK population using data
from the 2001 census and estimates for population change published by the Office for
National Statistics.

United Kingdom Percentages

1971 2002 2031

0-15 25.5 19.9 17.2

16-64 61.3 64.2 59.3

65 and over 13.2 15.9 23.5

Source: Population Estimates, Office for National Statistics www.statistics.gov.uk

The % of the UK population aged above 65 is likely to rise from 13% in 1971 to 23.5%
in 2031.

UK Population: by sex and age

Thousands

Under 16 16–24 25–34 35–44 45–54 55–64 65–74 75 and All ages
over

Males

1981 6,439 4,114 4,036 3,409 3,121 2,967 2,264 1,063 27,412

2004 5,970 3,533 3,954 4,553 3,780 3,391 2,374 1,717 29,271

2011 5,744 3,768 4,074 4,293 4,301 3,598 2,652 2,008 30,438

2021 5,821 3,436 4,487 4,133 4,201 4,042 3,158 2,664 31,943

580
1
Females

1981 6,104 3,966 3,975 3,365 3,148 3,240 2,931 2,218 28,946

2004 5,676 3,408 3,983 4,640 3,859 3,509 2,659 2,830 30,564

2011 5,487 3,563 4,050 4,358 4,412 3,755 2,898 2,931 31,454

2021 5,578 3,257 4,347 4,146 4,295 4,244 3,452 3,465 32,784

Source: Office for National Statistics

The changing age structure of the UK population

1. People 60 and over now form a larger part of the population than children under
16. There has been a big increase in the number aged over 85 – to about 1.1
million (1.9% of the population)
2. In 2001 in the UK there were 12.1 million people over the age of 60. Of which 4.4
million were over 75
3. In 2011 in the UK it is projected that 13.9 million people will be over 60. Of
which 4.6 million will be over 75
4. In 2021 in the UK it is projected that 15.9 million people will be over the age of
60. In 2031 the figure is 18.7 million. That’s about 30% of the population. Of
which 5.3 million will be over 75. In 2031 the figure is projected to be 6.6
million.
5. The current shape of the UK age structure is shown in the population pyramid
diagram below
6. Northern Ireland population has the youngest age structure among the constituent
countries of the United Kingdom. Twenty three per cent of the Northern Ireland
population are children (aged under 16), compared to 20 per cent in the United
Kingdom as a whole

581
1
The ageing of the population is a phenomenon common to nearly every developed
country and many developing countries. It is throwing up huge economic, social and
political challenges for the years ahead. Taking the UK's population statistics first, at the
beginning of the 20th century, less than 5 per cent of British people was aged over 65.
That figure has already risen to 15 per cent and will continue to edge higher. This is an
important point to note at the start of the analysis - the process of an "ageing population"
is a gradual one and not something that represents a huge shock to our economic and
political systems.

World demographic indicators, 2004

Population Population Infant Total Life expectancy at

(millions) density mortality Fertility birth (years)
(sq km) rate per Rate
1000 live Males Females
births

Asia 3,860 121 53.7 2.47 65.4 69.2

Africa 887 29 94.2 4.97 48.2 49.9

Europe 729 32 9.2 1.40 69.6 78.0

Latin America & Caribbean 554 27 26.0 2.55 68.3 74.9

582
1
North America 327 15 6.8 1.99 74.8 80.2

Oceania 33 4 28.7 2.32 71.7 76.2

World 6,389 47 57.0 2.65 63.2 67.7

Source: United Nations

What is causing an ageing population?

We are witnessing an increase in the average age of the population. What factors explain
it? Principally there are two main forces at work:

1. Lower mortality: A gradual reduction in age-specific mortality leading to a rise

in average life expectancy. There are many economic and social factors behind
the rise in longevity:
1. Better diet / nutritional standards – despite concerns about the obesity
epidemic
2. Improved housing – although there remain inequalities in the quality of
the housing stock
3. Better working conditions
4. Significant improvements in healthcare
5. Cleaner air
6. Advances in medical technology: The last twenty- thirty years has seen the
eradication of many infectious and contagious diseases. And there have
been major advances in the treatment of degenerative diseases
7. Increases in average living standards
2. Lower fertility: Fertility matters because new births rejuvenate populations.
Many population experts regard declining fertility as the main contributor to
global ageing. Total fertility rates in the EU are the lowest in the world, bar some
countries in Eastern Europe and Japan. Fertility levels in developed countries,
many of which experienced a “baby boom” during the 1950s and 1960s, have
generally declined since 1970. The median reduction in the total fertility of
developed countries was 0.8 children per woman between the 1970s and the
1990s.

Fertility rates in almost all high-income countries are now below the replacement rate of
2.1 births per woman (which takes into account the fact that slightly more boys are born
than girls). Several factors might help to explain the trend decline in fertility rates. Over
the last 35 to 40 years birth rates for women in their 20s have experienced a dramatic fall
as maternity has been delayed whereas fertility rates for women aged 30 and above have
gradually increased over the last 25 years. So the relative number of women in each age
group will have an effect on average fertility rates. Reductions in fertility are the result of
a series of inter-related factors:

583
1
 1. Biological factors: Advances and greater availability of contraceptive
methods and low ability to conceive
2. Economic factors:
1. The rising financial costs and time cost of having children
2. The high costs of other goods and services including housing
3. The expansion of higher education and rising female participation
in the labour market
4. Declines in job stability in Europe which has prompted an increase
in the number of two income families
5. Lack of childcare provision and inflexible working hours
3. Social-Cultural factors
1. The changing role of women in society
2. A rise in divorce and separation rates
3. Growing secularisation of society and rise of individualism
4. Changing social attitudes to marriage and family

Fertility rates in the European Union

The data in the table below is taken from the United Nations World Fertility Report for
2003 and covers a selection of European Union countries.

Country Year Rate Year Rate

Ireland 1970 3.9 2001 2.0

France 1970 2.5 1999 1.8

Denmark 1970 2.0 2001 1.7

Finland 1970 1.8 2001 1.7

Netherlands 1970 2.6 2001 1.7

United Kingdom 1972 2.2 2000 1.6

Sweden 1970 1.9 2001 1.6

Portugal 1970 3.0 2001 1.5

Germany 1978 2.0 2000 1.4

Greece 1970 2.4 1999 1.3

584
1
 Italy 1970 2.4 2000 1.2

Spain 1970 2.9 2000 1.2

In 1960, males could expect to live another 12 years beyond this landmark. By 2002 this
had risen to 16 years. There has been a similar increase in longevity for females.

One notable trend is past and projected ageing within the pensioner population. In 1971,
persons aged 65+ comprised 13.2 per cent of the total UK population, and persons aged
80+ comprised 2.3 per cent of this total. By 2000, the 65+ population had grown to 15.6
per cent of the total, but the 80+ population had almost doubled its proportionate share to
4.0 per cent. Over the 50 years to 2050, the Government Actuary's Department projects
that the 65+ age group will have expanded to 24.4 per cent of the total UK population,
but that the 80+ age group will have more than doubled to reach 9.1 per cent of this total.
[16]

Life expectancy rates for the UK

Years At birth At birth At 50 At 50 At 60 At 60

Males Females Males Females Males Females

1981 70.8 76.8 24.1 29.2 16.3 20.8

1986 71.9 77.7 24.9 29.8 16.8 21.2

1991 73.2 78.7 26.0 30.6 17.7 21.9

2001 75.7 80.4 28.3 32.1 19.8 23.2

Source: www.statistics.gov.uk/statbase/

The possible economic effects

How will an ageing population impact on the macroeconomic performance of countries

such as the United Kingdom?

“In Japan and Europe, populations are ageing from the middle of the age pyramid, which
presents a major challenge for pension and health systems”

According to a recent article by the eminent economist Francis Cairncross, "the rise in the
proportion of the world's old will be the century's defining demographic trend". The

585
1
process will have undeniable economic and social consequences, in particular the
increase in the number of retired people likely to emerge in the next decade or so.
Together with the decline in fertility, this is likely to lead to a significant decline in the
size of the working population. The trend towards early retirement is exaggerating the
effects on the labour supply. Less than 5% of men in Western Europe are still in the
active workforce when they reach their 65th birthday.

So a declining working population will have to create the income, wealth and tax
revenues needed to support the welfare state needs of a rising number of retired people.
Will governments in developed countries be able to continue to offer near-universal
health care coverage and a generous state-funded pension system?

The likely consequences of an ageing population

 Demand for health care will rise - and there will be increasing pressure on state
health care budgets. The likelihood is that in most developed countries there will
be a move to encourage people to make more private provision for their own
health-care needs and wants. In the UK, the ageing population will undoubtedly
be a growing strain on the National Health Service.
 Governments will seek a move away from state funded pension schemes and
will encourage people to work longer and retire later than they do now. This will
mean reversing the trend towards early retirement. State retirement ages in many
countries will rise.
 There will be even greater flexible arrangements in the workplace to attract
the workers that they need - be it women with children or providing the right
incentives for older workers to remain active in the labour market.
 Companies will seek to move away from employer contribution pension
schemes and fewer still will be prepared or able to offer generous in-work health
care schemes to their workers. There is already a drift of businesses deciding to
close their final-salary pension schemes to their employees.
 There is a rising risk of pensioner poverty for millions of people in the UK
especially for those who have been unable to save enough into occupational
pension schemes.

Employment rates of older people in the UK

50–54 55–59 60–64 65 and overAll aged 50

and over

1994 72.6 59.4 34.6 4.9 31.0

2000 76.1 63.2 36.1 5.2 34.6

586
1
 2004 78.8 67.7 41.3 5.9 37.1

Source: Labour Force Survey and ONS

Ageing population and pressures on government spending

Government spending is affected directly in the long term by demographic change.

According to the Department for Work and Pensions, “over half of all benefit spending
depends fairly directly on demographic factors.”

The most transparent effect of population ageing is on the demand for health services,
which is likely to increase as people live longer. It has been estimated that nearly 60 per
cent of a person's health costs occur in the year preceding their death and, as the
population ages, so we expect to see a rising number of deaths and much greater pressure
on health service providers. Health care can be very expensive for older age groups, not
least when intensive health treatments and care is needed for those people suffering from
chronic ailments and diseases.

Is there a European pension time bomb?

The ageing population is putting Europe's traditional state-funded pension system under
great pressure. Most European countries are reliant on 'pay-as-you-go' systems where
people in work fund pension benefits for the retired via a system of social security
contributions. But in the absence of pension reform, or effective measures to boost the
size of the working population, this system of pension entitlements can only be sustained
through raising taxation (which will have negative incentive effects for people in work)
and / or reductions in the real or relative value of state pension benefits

The table below comes from research published in 2001 on the projected levels of
government pension spending as a share of national income for the leading industrialised
countries. At first glance both the UK and the United States face less of a threat than
many of the Western European countries. According to a report published in 2003 by the
Centre for European Reform. Greece, Spain, France and Austria still face a increase in
pension liabilities over the coming years and must urgently reform their systems. The
pensions issue is also becoming one of huge significance in Italy.

Projected state pension spending (% of GDP)

Country 2000 2010 2020 2030

France 9.8 9.7 11.6 13.5

Germany 11.5 11.8 12.3 16.5

587
1
Italy 12.6 13.2 15.3 20.3

Japan 7.5 9.6 12.4 13.4

UK 4.5 5.2 5.1 5.5

USA 4.2 4.5 5.2 6.6

Source: Disney & Johnson (2001)

Pathways for reforming pensions

Reform of pension arrangements in the UK is likely to be based on three main pillars:

 Capping government funded pension entitlements – whereby the state pension

provides something close to a minimum safety net.
 Encouraging people to remain longer in the labour force – i.e. seeking to increase
the participation rates of people aged 50 and over. This may eventually require an
increase in the statutory retirement age perhaps to 68 or more in future years.
 Providing incentives for companies and individuals to provide for their own
retirement.

In May 2006 the UK government unveiled their plans for pension provisions:

 The state pension age will rise to 68 from 2044

 The government will link the state pension to average earnings probably by 2012
 Compulsory occupational savings will be introduced with a minimum
contribution of 3% for employers, 4% for workers, and 1% from the government

More details on the pension issue are available from the BBC news web site. The final
report of the Turner Report for the UK Pensions Commission is available here.

The future for pensions - Choosing between the four options - opinion poll

Percentage of individuals who strongly agree or agree.

To solve the pensions issues in the UK: %

People will have to work longer 56

People will have to save more for their retirement 87

588
1
A greater share of our taxes will have to be spent on pensions 80

Pensioners will have to get poorer compared to the rest of society 12

Source: Turner Report on Pensions, 2006

Pension reform in Sweden

The experiences of other countries can often be instructive in giving us ideas as to how to
approach the pension problem. Sweden recently undertook a fundamental restructuring of
its pension system. Under the new system the new public pension system is made up of
three components:

 The Income Pension: This is run along the lines of a "pay-as-you-go" system.
16% of pensionable income goes into a national account and forms the basis of an
income pension which is paid beyond the age of 61 for those who choose to take
retirement. The pension is paid out of an annuity fund
 The Premium Pension: An extra 2.5% goes into a fully-funded individual
account - individuals can choose to manage this fund themselves e.g. in investing
in the stock market, or place it into a national fund
 The Guaranteed Pension: This provides a minimum pension to those who have
no or small earnings-related pension(s). It is financed through general taxation
and it is means-tested (i.e. designed to provide financial help to those who need it
most)

589
1
The ageing population issue is one that will certainly influence government policy
makers for years to come. But what matters most for businesses are the ways in which the
changing age structure of the population will impact on both the pattern of demand for
goods and services, and also the challenge of finding the workers they need to produce an
output that satisfies these changing needs and wants.

Suggestions for further reading and research

Ageing population – facts behind the fiction

Help the Aged (UK)
Pensions Panic – anyway out? (BBC Money Programme 2005)

Author: Geoff Riley, Eton College, September 2006

A2 Markets & Market Systems

Government Policies towards Poverty

In this note we consider the options available to the government if it wishes to achieve a
greater degree of equity in the distribution of income and wealth.

Policy options to change the distribution of income and wealth

There are many policy options available to a government if it wants to change the final
distribution of income and wealth in a country. The main strategies that the Labour
government has chosen to reduce poverty since it was elected in May 1997.

o The introduction of a National Minimum Wage and a series of increases in its

value
o The launch of the Working Tax Credit and Child Tax Credit – designed to
boost work incentives for low-income households who opt to work full-time or
part-time
o Provision of a Minimum Income Guarantee for Pensioners and increases in the
real value of Winter Fuel Payments – designed to alleviate “fuel poverty”
among old people
o Active employment policies such as the introduction of New Deals for young
people, the long-term unemployed, lone parents and disabled people – a long-term
strategy designed to increase employment opportunities

In addition the government already has in place a progressive system of income tax and
welfare benefits that helps to reduce the huge differences between original and final
disposable incomes between different groups of the population.

590
1
Pensioner Poverty in the UK
A new report has found that the proportion of pensioners in Britain living in relative
poverty has fallen but more needs to be done to boost benefit take-up. Data from the
National Audit Office shows that the percentage of pensioners living in poverty had
fallen from 27% in 1994 to 17% in 2005. Among the government policies introduced in
recent years to alleviate poverty among the elderly, means-tested benefits such as Pension
Credit have played a key role in cutting poverty amongst the elderly but take-up of the
benefit remains below expectations. £6bn was paid out in Pension Credit to 2.7 million
pensioner households in 2004/05. But only less than 70% of those people eligible to
claim pension credit receive it, below the government's target of 73%.
Source: Adapted from news reports, June 2006

Income redistribution through the tax and benefit system

The effects of taxes and benefits by quintile groups on households, 2005

Quintile groups of all households Ratio

Top/Bottom
All quintile

Bottom 2nd 3rd 4th Top households

(£ per year)

Original income 4 280 11 200 21 580 34 460 66 330 27 570 15.5

plus cash benefits 6 410 6 210 4 770 2 800 1 380 4 310

Gross income 10 690 17 410 26 350 37 260 67 710 31 880 6.33

less direct taxes 1 030 2 270 4 650 7 910 16 760 6 520

Disposable income 9 660 15 140 21 690 29 360 50 960 25 360 5.28

less indirect taxes 2 860 3 410 4 570 5 510 7 330 4 730

591
1
Post-tax income 6 800 11 730 17 130 23 850 43 630 20 630 6.4

plus benefits in kind 6 460 5 780 5 420 4 470 3 780 5 180

Final income 13 250 17 520 22 550 28 320 47 410 25 810 3.59

What are the effects of the tax and benefit system on the final distribution of income in
the UK? This summary table is published each year by the Government and gives us an
idea of the progressiveness of the tax and benefits system for households in different
income bands.

Original income comes from wages and salaries in work, self-employment income,
investment incomes et al. To which we add entitlements to welfare benefits in cash – not
that the lowest income households are those most entitled to these benefits, some of
which are means-tested. The ratio of the original income of the richest fifth of
households to the poorest fifth is nearly 16. By the time that government welfare benefits
have been included, that ratio falls to less than 7.1.

Then we include the effects of direct taxation – mainly income tax and national
insurance – which acts as a progressive form of taxation – a higher income group pays a
higher % of their incomes in tax. This gives us disposable income - the ratio of the
disposable income of the richest fifth of households to the poorest fifth is 5.3.

Our final transfer is to include the effects of indirect taxes and estimated benefits in kind
from state provision of education, the NHS and housing subsidies to give a figure for
final income. The final result is that our ratio between richest and poorest quintiles falls
further to 3.6.

Main benefits in kind

 Health services
 Education
 Travel subsidies
 Housing subsidies
 School meals and welfare milk

Indirect taxes fall most heavily on poorest households. In 2001-02, they accounted for
34% of disposable income whereas for the highest income quintile, the percentage was
just 14%. This suggests that indirect taxation overall has a regressive effect on the
distribution of income in the UK.

Percentage shares of household income and Gini coefficients, 2005

592
1
 Percentage shares of equivalised income for all households

Original Gross Disposable Post-tax

income income income income

Quintile group

Bottom 3 7 8 7

2nd 8 11 13 12

3rd 15 16 17 16

4th 24 23 22 22

Top 50 43 41 43

All households 100 100 100 100

Decile group

Bottom 1 3 3 2

Top 32 27 26 27

Gini coefficient for the UK 51 36 32 36

The government has focused its’ policies in the following areas

 Promoting higher levels of employment through increased spending on labour

market training and subsidies for businesses who take on people through the New
Deal programme.

593
1
  Attempting to reduce the skills gap existing in the labour market – workers with
low grade skills are suffering badly in today’s ever-changing labour market.
 Switching towards means-tested benefits rather than universal benefits.
 Offering specific financial help to certain groups.
 Improving work incentives for the low paid.
 Attempts to reduce child poverty e.g. by increasing the value of child benefit.

There has been some limited progress in attacking some of the causes of poverty. For
example the number of children living in poor households fell by 200,000 in 2002-03.
But the latest official figures for the UK show that, for the year 2002-03, income
inequality remains greater under Labour than under the 1979-97 Conservative
governments of Margaret Thatcher and John Major.

The main sources of income for different groups in 2003

Percentage of Gross Income Bottom Second Middle Fourth Top Overall

Quintile Quintile Quintile Quintile Quintile

Source of Income

Earnings from work 35 55 74 84 87 77

Investments 3 2 2 3 6 4

Occupational pensions 4 5 6 5 4 5

Miscellaneous 3 3 2 2 1 2

Welfare Benefits and Tax Credits 55 35 16 7 2 13

The reality is that there are powerful forces at work in the British economy (and
specifically within our labour market) that are increasing the gap between rich and poor.
In particular the incomes of the most affluent households have raced ahead of relatively
poorer families. Thus one can argue that the government has through its redistribution
policies to run simply to stand still. Without Labour’s commitment to redistribution, the
level of income inequality would be even higher than it is now.

Labour fails to stop widening of income gap in the UK

New data on the extent of relative poverty in Britain has found that the Labour
government's main taxation and welfare benefit changes since 1997 have managed to halt
Britain's rising inequality but failed to significantly reverse the growing gap in incomes
between rich and poor that opened up during Margaret Thatcher's time as prime minister

594
1
in the 1980s
A major study from the independent think tank, the Institute for Fiscal Studies found that
income inequality in Britain rose by 40% between 1979 and 2001, a larger increase than
in any other developed country. The richest 1% of individuals (those on at least £82,000 a
year after tax) - took 3% of national income in 1979 but 8% by 2000. And the gap
between rich and poor was greater in 2002-03 than it was in 1996-7, when Labour came
to power.
According to the main report
"Since 1998, New Labour's large, real terms increases in means-tested welfare benefits
and tax credits significantly reduced inequality, but have not so far been sufficient to
offset the effect of two decades during which benefit rates lagged behind earnings
growth."
Source: Institute for Fiscal Studies www.ifs.org.uk

Which policies are most effective in reducing poverty?

A government truly committed to making a serious dent in relative poverty would

 Invest more resources in skills training and life-long education for all
households – particularly those of low income families in a bid to make a real
effect on child poverty
 Making the tax system more progressive – for example raising the higher rate
of tax from 40% for the top-earning households
 Analysing carefully the effects of changes in indirect taxes such as VAT and
excise duty in case they have a regressive effect on the overall distribution of
income
 Focus more on targeting benefits by means-testing them according to financial
need
 Increase the value of welfare benefits / tax credits in line with the annual
percentage growth in median earnings so that the relative value of these benefits
does not decline

Income tax payable: by annual income, in 2005/06

Number Total Average Average

of tax rate of tax
taxpayersliability (percentages) amount
(millions) (£ of tax
million) (£)

£4,895–£4,999 0.1 1 0.1 5

£5,000–£7,499 2.9 369 2.0 126

595
1
£7,500–£9,999 3.5 1,580 5.1 445

£10,000–£14,999 6.1 7,560 9.8 1,220

£15,000–£19,999 5.1 11,500 13.0 2,260

£20,000–£29,999 6.4 24,000 15.4 3,760

£30,000–£49,999 4.3 28,900 17.9 6,690

£50,000–£99,999 1.5 25,900 25.7 17,000

£100,000 and over 0.5 34,200 33.4 71,100

All incomes 30.5 134,000 18.2 4,390

Taking the long view

Percentage shares of original and post tax income in the UK

1993-94 2004-05

Original income

Bottom 2 3

2nd 6 8

3rd 14 15

4th 25 24

Top 52 50

Post-tax income

596
1
Bottom 7 7

2nd 11 12

3rd 16 16

4th 22 22

Top 44 43

No policies to relieve poverty are risk free. Many are highly expensive and their effects
often take many years to show through properly. The consensus among the leading
academic researchers is that high employment, and a commitment to raise the skills and
potential earnings of people towards the bottom of the pay ladder are the most effective
and sustainable policies in the long term.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Nature and Causes of Fluctuations in Economic Activity

The economic cycle

All countries experience business cycles (sometimes known as trade cycles) where the
rate of growth of production, incomes and spending fluctuates over a period of time. The
length and volatility of each of these cycles tends to change over time partly because the
structure of an economy evolves. Often, as economists, we find that previously observed
theoretical relationships between different variables, for example between unemployment
and inflation, appear to have changed. This can make life difficult for policy-makers
when they are trying to manage the economy and meet their objectives. We will tend to
focus on what has been happening to the UK economy over recent years. But bear in
mind that many of the ideas here can be applied and tested with other countries many of
whom will be at different stages of their economic development.

Short term economic growth for the UK

597
1
The annual growth of UK real GDP between 1986 and 2006 is shown in the next chart.
The data shows the annual percentage changes in national output at constant prices, in
other words the figures have been adjusted to take into account changes in the general
level of prices.

The business cycle for the UK over the last twenty-five years

The UK last experienced a recession in 1990-92 during which over three million people
became unemployed. Since 1993, the UK has enjoyed over thirteen years of sustained
growth. The strongest years during the current cycle came in 1997 (3.3%) and in 2000
when real GDP expanded by nearly 4%. Taken as a whole, the UK economy has now
enjoyed its longest period of sustained growth for over forty years whereas other
countries have experienced recessions or very slow growth in the last few years,
including the United States, Germany, France and Japan.

Theories of the Economic Cycle

In this section we consider some theories about the economic cycle and in particular how
a country moves from one stage of a cycle to another. Business cycle models are often
divided into two groups:
598
1
Endogenous models of the cycle try to explain cyclical fluctuations in terms of factors
which lie within the economic system suggesting that, even if there were no shocks to an
economy, there would still be variations in the growth of income, spending and output

Exogenous models of the cycle argue that cycles can be started by demand-side or
supply-side shocks to the economic system. We will return to the idea of shocks a little
later on

Endogenous models of the business cycle

1. The Stock Cycle

The stock cycle helps to explain some of the changes in national output. To see this we
will look at what happened the last time that the economy had a recession. In 1989-90 the
rate of growth in the economy slowed right down at the end of what had been a very
strong consumer boom.

During the recession businesses cut back on production and tried to off-load stocks

599
1
Consider the effects of such a fall in consumer demand which initially (in the first half of
1989) caused an increase in stocks of goods and raw materials held by firms. Because
holding stocks can be a drain on a company’s finances (they must be stored somewhere
and may have a limited product or shelf life), an unexpected rise in unsold stocks acted as
a signal to firms to cut back production - leading to a fall in demand for intermediate
products such as components. This process of de-stocking then worked its way through
the supply-chain. So for example, companies providing raw materials and other supplies
also suffered a downturn in demand. The result was a fall in production and the laying off
of workers. Throughout 1991, 1992 and for most of 1993, businesses in the UK economy
were seeking to reduce their stock levels because of weak demand and low profits. One
way of doing this is to try to sell unsold products at discounted prices; this is indeed what
happened in the UK at the time, the effect being a fall in the rate of inflation.
The British economy started to come out of the recession in 1993 and growth
strengthened considerably in 1994 partly on the back of a boom in exports overseas.
Theory tells us that when AD starts to pick up at the start of a recovery and stock levels
dip, this is a signal for firms to step up production to re-build inventories and meet an
increase in consumer demand. Notice how, in the second half of 1994, stock levels
started to rise quite strongly. The very act of increasing production to rebuild stocks helps
to bring the economy further away from the low point of the recession.

600
1
Is there evidence in this chart for the sort of stock cycle explained in the previous
section?

Is the stock cycle becoming less important in helping us to explain the economic cycle?
Some economists believe that the answer is yes because improvements in information
technology have changed the nature and importance of the stock cycle in most developed
countries. For example, the use of ‘just-in-time’ stock delivery systems common place
in industries such as motor car manufacturing and widespread improvements in stock
control has reduced the need for businesses to hold high levels of stocks of intermediate
products. It is now easier for supply to match changes in demand in the short term.
The stock cycle is not irrelevant, but we need to have other theories to be able to explain
cyclical fluctuations in an economy.

2. Changes in aggregate demand

At AS level, you will have been introduced to the concept of aggregate demand (AD) –
i.e. the total demand for goods and services produced within the domestic economy. The
reality is that changes in the growth of real GDP in the short term are indeed mainly
caused by changes in the components of aggregate demand.

Consumer Government Gross Change Exports Imports Real GDP

spending consumption Investment in stocks of goods of goods
and and
services services

£ billion £ billion £ billion £ billion £ billion £ billion £ billion

1996 562 197 131 1 214 199 909

1997 581 196 139 3 231 219 937

1998 604 199 159 4 238 239 968

1999 632 206 163 6 247 258 997

2000 661 212 167 5 270 281 1035

2001 680 217 172 6 278 294 1060

2002 704 225 178 2 281 309 1081

2003 724 233 179 4 285 315 1110

601
1
2004 749 240 189 5 299 336 1147

2005 759 246 195 3 319 356 1168

Source: Office for National Statistics and HM Treasury

The annual rates of growth of the components of demand are shown in the table below

Consumer Government Gross Change Exports Imports Real GDP

spending consumption Investment in stocks of goods of goods
and and
services services

% change % change % change % change % change % change % change

1996 3.9 0.7 5.3 -0.3 8.9 9.8 2.8

1997 3.5 -0.5 6.5 0.2 8.2 9.8 3.0

1998 3.8 1.1 14.0 0.1 3.0 9.2 3.3

1999 4.7 3.7 2.8 0.2 3.8 7.9 3.0

2000 4.5 3.1 2.7 -0.1 9.1 9.0 3.8

2001 3.1 2.4 2.5 0.1 2.9 4.8 2.4

2002 3.6 3.5 3.7 -0.3 1.0 4.8 2.1

2003 3.0 3.5 0.4 0.2 1.7 2.0 2.7

2004 3.5 3.2 6.0 0.1 4.9 6.6 3.3

2005 1.3 2.6 3.0 -0.1 6.5 5.9 1.9

average 3.5 2.3 4.7 0.0 5.0 7.0 2.8

Source: Office for National Statistics and HM Treasury

602
1
The key features of the above table to consider are:

Strong consumption: Consumer spending has been the driving force behind the growth of
the British economy over recent years. In the short term this has had beneficial effects – it
has helped to absorb some of the weakness of the investment and export sectors. But
there has been a price to pay because the consumer boom has been driven by rising house
prices and an strong level of demand for credit and the risk is that strong consumer
demand has led to an unbalanced economy and an unsustainable “debt mountain”. By the
spring and early summer of 2005 it was becoming clear that the consumer boom was
coming to an end as people started to save more and there was a downturn in retail sales.
Indeed in 2005 the annual growth of consumption was just 1.3%, the weakest growth
since the last recession.

Weak investment: Capital investment on new plant & machinery and buildings has been
relatively weaker although there was a pick up in 2004 with investment rising by six per
cent. Over seventy five per cent of capital spending is done by private sector businesses
and within this total the majority of new investment comes from the service sector which
accounts for nearly seventy per cent of total GDP. Some major infrastructural projects
such as the new Wembley Stadium, Terminal 5 at Heathrow and the National Health
Service building programme have contributed to a faster growth of investment demand.

High demand for imports: Import growth has exceeded exports in Britain in recent times
leading to a further increase in the trade deficit which reached a record level in 2005.
Import demand has been strong because of the high exchange rate and household
spending. 2005 was the first year since 2000 that the volume of exports of goods and
services grew faster than the volume of imported products coming into the country.

Different stages of the economic cycle

Economic Boom

A boom occurs when real GDP grows much faster than the trend growth rate of about
2.5% per year. In a boom phase, AD is high and typically, businesses respond by
increasing production and employment. They may also opt to widen their profit margins
by raising prices and this can lead to cost-push and demand-pull inflation. The main
characteristics of a boom are as follows:

High aggregate demand: A boom in demand in the UK is nearly always driven by

consumer spending. But government spending, an increase in capital investment and a
surge in exports can also add to demand for goods and services. Exports might be boosted
by a rapid growth of world trade or a fall in the exchange rate.

A tightening of the labour market: An expanding economy should lead to higher

employment and an increase in real incomes of people in work. The ‘tightness of the
labour market’ can be measured in various ways for example the rate of unemployment
or the number of unfilled job vacancies. Surveys of labour shortages also provide

603
1
information about the balance of supply and demand in the labour market. If labour
shortages become severe, the risk is that wage inflation will accelerate leading to a rise in
unit labour costs feeding through to higher retail prices. The possible trade-off between
unemployment and inflation is explored in the later chapters on the Phillips Curve and the
NAIRU.

High demand for imports and a wider trade deficit: A common feature of a boom is that
the demand for imports increases because of a high marginal propensity to import among
consumers. Unless the growth of UK exports can match this surge in import demand, the
trade deficit will widen.

Impact on government finances: An economic boom provides a “fiscal dividend” to the

government because tax revenues will be rising quickly as more people are in work and
they are earning and spending more money. An expanding economy also helps to reduce
state spending on welfare payments.

Strong company profits and investment: A cyclical upturn normally leads to a strong
growth in profits and an increase in investment. The link between demand and planned
investment can be explained using the accelerator theory of investment.

Cyclical boost to productivity: An expanding economy is good news for labour

productivity because businesses are stretching to supply the extra demand by using their
existing labour resources more intensively and making more efficient use of existing
capacity. The rise in productivity helps to keep unit labour costs under control. To use the
current jargon – productivity growth tends to be pro-cyclical – i.e. it picks up speed when
the economy is strong, but can falter when demand and production weakens.

A risk of a pick-up in inflation: Both demand-pull and cost-push inflation can occur if
AD exceeds potential GDP over a prolonged period. An excellent example of this was the
boom of the late 1980s that led to rising inflation and several years of very high interest
rates. It is the job of monetary and fiscal policy to make sure that a strong cyclical upturn
does not get out of control.

604
1
Since the early 1990s the UK economy has enjoyed stable inflation and continuous
growth

As the chart above shows, in the late 1980s, there was a sharp rise in inflation as a result
of an overheating economy during the mid-late 1980s. The economy then went into
recession which helped to bring down inflation. Since the early 1990s, we have seen a
favourable combination of steady growth and low, stable inflation. Indeed for nearly all
of period baring a short phase during 2005, the rate of growth of real GDP has exceeded
the rate of growth of consumer prices. In other words, there has been an improvement in
the trade off between economic growth and inflation.

Showing economic growth using an AD-AS framework

In the following diagram we see an outward shift in AD. Equilibrium national income
rises from Y1 to Y2 and takes real national output closer to potential output (shown at
level Yfc). If AD were to rise further beyond AD2, this risks creating excess demand (i.e.
a positive output gap). At this stage of the business cycle, short run aggregate supply is
drawn as inelastic and there is growing pressure on factor resources which might trigger
an increase in commodity prices and wages putting upward pressure on inflation.

605
1
In the diagram below the outward shift of AD had taken the economy beyond potential
GDP leading to a positive output gap measured by the distance AB. This may then cause
higher wages and a rise in labour costs and also the prices of other factor inputs leading
to an inward shift in SRAS. This takes the economy towards full-capacity output but with
a higher price level (P3).

606
1
Economic Slowdown

A slowdown occurs when real GDP continues to expand but at a reduced pace. If a
country can achieve growth without falling into a recession, this is termed a “soft-
landing” whereas (maintaining the aeronautic analogy) a full recession is coined a
“hard-landing”.

Economic Recession

A recession means an actual fall in real national output and a contraction in

employment, incomes and profits. In technical terms a recession is a period of two
quarters (i.e. six months) when real GDP declines. An alternative interpretation of the
term recession is that it occurs when the economy is operating persistently with a level of
real national output below its potential and that the gap between actual and potential GDP
continues to widen.

607
1
The output gap has remained within around 1% or -1% of GDP since 1996

We can see the output gap in the chart above. Can you see the effects of the recession in
1990-92? – this left the economy with a large negative output gap, i.e. national output
was well below its estimated potential. The recovery during the mid 1990s caused the
output gap to narrow and by 1997 the UK had reached potential GDP. Since then,
although there have been cyclical variations, the output gap itself has remained very
small – ranging between +1% and -1% of GDP. This is one of the reasons that the British
economy has managed to continue its current growth phase.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Capital Investment & Spending

608
1
In this note we consider the Keynesian theory of investment and look at some of the
evidence on business investment spending in the UK economy.

The meaning of investment to an economist

Investment to an economist is a precise term which involves the acquisition of capital
goods designed to provide us with consumer goods and services in the future. Investment
spending involves a decision to postpone consumption and to seek to accumulate
capital which can raise the productive potential of an economy. But investment is
similar to consumption as it is an important component of aggregate demand.

It is important to remember that investment has important effects on both the demand-
side and the supply-side of the economy.

Net and gross investment

 Net investment in any given year = gross investment minus an estimate for
replacement investment – i.e. that investment required to replace obsolete
capital. The level of net investment in any one year tells us what is happening to
the final stock of fixed capital available for production.
 Gross fixed investment is spending on fixed assets. The biggest single item of
investment spending is on new buildings, plant and machinery and vehicles. The
real value of business investment in the UK economy over recent years is shown
in the next data chart.

Autonomous and induced investment

 Autonomous investment is capital expenditure on producer goods unrelated to

the level of national income. For example, the cost of purchasing new items of
capital equipment would affect autonomous investment.
 Induced investment is related to levels of national income. An increase in GDP
increases induced investment but leaves autonomous investment unaffected. The
accelerator theory of investment which we will consider shortly is an example of
this.

Factors that affect investment demand

As with consumption and saving, we find that there are plenty of theories as to the main
factors driving investment decisions in the economy. For example, a detailed survey of
these theories published by the UK Treasury in June 2003 argued that:

Expectations – the key to understanding investment decisions

‘The central message of economic theory and the evidence from business surveys is that
capital investment is determined by the relationship between the expected returns from
investment and the expected cost of financing the investment.’
Source: DTI Economics Research Paper on competitiveness and investment

609
1
In other words, profit-seeking businesses operating in the private sector of the economy
will be prepared to go ahead with an investment if they believe that the project will over
its projected lifetime yield a real rate of return greater than if the money tied up in an
investment project had been invested in the next best alternative way.

Efficiency improvements seem to dominate the investment aims of industrial businesses

For government sector investment, the priorities may be a little different. Public sector
investment projects are still subject to tests about their expected rates of return, but the
cost-benefit analysis will normally also include estimates of the social costs and
benefits of the investment rather than a narrow focus on private costs and benefits.

Capital investment spending in the UK economy

Total investment as a share of

national income

Gross Whole Services Manufacturing Government UK USA Japan

610
1
 Investment economy

£ bn % of GDP % of GDP % of GDP % of GDP % of GDP % of GDP % of GDP

2000 167.5 16.9 8.4 1.9 1.5 16.9 17.1 25.3

2001 171.6 16.6 7.9 1.7 1.6 16.6 16.3 24.7

2002 178.1 16.5 7.5 1.3 1.6 16.5 15.0 23.3

2003 178.8 16.1 6.9 1.2 2.0 16.1 15.1 23.0

2004 189.5 16.5 6.9 1.1 2.0 16.5 16.0 22.9

2005 195.1 16.8 6.9 1.1 2.0 16.8 16.7 23.2

Source: Office of National Statistics

Between the years 1997-2005, the real level of gross investment spending in the UK
increased by 40% although, when measured as a share of national income, total
investment remained fairly static at just under 17%. This is similar to that of the United
States but much lower than countries such as Japan and China where investment in recent
years has run at a staggering rate of over 40% of her national income! Indeed the Chinese
government has sought recently to bring this level of investment down because of fears
that the economy is “over-investing”, risking creating too much capacity and also raising
fears that much of the super-charged investment has been of fairly low quality and
financed by risky lending.

The bulk of capital investment in the UK economy is done by service sector businesses,
hardly surprising when services account for over seventy per cent of our GDP.
Worryingly, manufacturing investment as a share of GDP has been falling steadily over
the last decade and reached its lowest ever level in 2004 and 2005. Government
investment has been picking up, but again from low levels.

611
1
Business investment has risen as the economy has expanded – but has it increased
quickly enough?

The majority of capital investment spending is done by the private sector, although there
has been a sizeable increase in government investment in recent years because of
infrastructural projects in transport and the NHS building programme. Because of the
dominance of the private sector, it makes sense to focus on investment decisions made by
UK-based businesses. At the heart of whether or not to go ahead with a project is the
expected return from this investment.

Returns to an investment project

The expected returns from capital investment are determined by the demand for and the
price of the output of goods or services generated by an investment and also by the costs
of production. A rise in demand for the output that capital is purchased to supply will
increase the potential revenue streams that a business can expect from a new project.
Similarly, a change in the costs of purchasing the capital inputs the costs of training
workers to use new capital and in maintaining the capital stock will also affect the
expected rate of return.

612
1
The importance of business expectations and uncertainty

Expectations of demand, prices and costs over the lifetime of the investment are key
determinants of expected returns. There is always uncertainty about the expected rate of
return particularly when demand is volatile and sensitive to changes in interest rates, the
exchange rate and incomes.

The rate of return from an investment is also influenced by the rate at which an
investment project is assumed to depreciate over time and the effects of changes in
corporation tax on company profits.

The cost and availability of internal and external finance is important, as higher costs of
finance (e.g. higher interest rates) require greater returns from the investment to ensure
that it is profitable.

The marginal efficiency of capital (MEC) – the demand curve for investment

Expected rates of return on investment matter when businesses are making investment
decisions and this is where the concept of the marginal efficiency of capital comes in.
The marginal efficiency of capital (MEC) is defined as the rate of interest which makes

613
1
a proposed investment project viable “at the margin”. This is illustrated in the diagram
above. At lower rates of interest (i.e. R2 rather than R1) more capital projects appear
financially viable because the cost of borrowing money to finance the investment is lower
and the opportunity cost of using retained profits as an internal source of investment
finance is also reduced. A fall in interest rates should (ceteris paribus) lead to an
expansion along the investment demand curve. Similarly higher interest rates (R3) may
lead to some projects being postponed or cancelled.

The limited statistical evidence available for the UK is that the demand for new capital
goods tends to be interest inelastic i.e. there is only a weak link between changes in
interest rates and fluctuations in planned capital investment by businesses. Partly this is
because many firms prefer to use the capital market through the issue of new shares and
bonds to raise funds for investment rather than relying on bank loans.

That said, the rate of interest can and does affect capital investment decisions – perhaps
through its effect on business confidence and also expectations of changing demand
and the links between interest rates and the exchange rate. So a period of lower interest
rates might stimulate more investment because of expectations of rising consumer
demand and a lower exchange rate which will boost export demand.

Real Interest Rate

614
1
Changes in business confidence, the costs of capital and demand lead to shifts in the
investment demand curve. For example, an increase in export sales overseas might be an
increase in the expected rates of return on capital investment and thus an outward
shift of the investment demand schedule.

Concerns about demand and profits act as constraint on investment plans

The data shown in the previous chart is taken from the quarterly survey of business
confidence by the Confederation of British Industry. It suggests that uncertainty about
the strength of future demand and the absence of a satisfactory level of profit are
consistently the two biggest factors likely to constrain the level of capital investment by
businesses. Certainly in recent years, the cost of finance – influenced by the level of
interest rates – has come firmly at the bottom of the ranking of key factors, although this
may not be the case for smaller manufacturing businesses that may not have the
opportunity to borrow at the same rate of interest as larger multinational operations.

The Accelerator Model of Investment

This is another theory of investment. Put simply, the accelerator model suggests a
positive relationship between investment and the rate of growth of demand or output.
Accelerator theories of investment assume that there is a desired capital stock for a
given level of output and interest rates. A rise in output or a fall in interest rates may
615
1
prompt increased levels of investment as firms adjust to reach the new optimal capital
stock level.

Planned investment spending

The accelerator model works on the basis of a fixed capital to output ratio which
implies that in order to produce extra goods and services a business needs to adjust its
investment to meet changes in demand. For example if demand in a given year rises by
£4 million and each extra £1 of output requires an average of £3 of capital inputs to
produce this output, then the net level of investment required will be £12 million.

One criticism of this simple accelerator model is that the capital stock of a business can
rarely be adjusted immediately to its desired level because of ‘adjustment costs’ and
‘time lags’ between an investment project being given the go-ahead and it coming ‘on

616
1
stream’ to produce the extra output. The adjustment costs include the cost of lost business
due to installation of new equipment or the financial cost of re-training workers. Firms
will usually make progress towards achieving an optimum capital stock rather than
moving smoothly from one optimal size of plant and machinery to another.

A further criticism of the basic accelerator model is that it ignores the level of spare
capacity that a business might have at their disposal. For example in the latter stages of
an economic recession, most businesses are operating below their capacity limits (i.e.
there is a sizeable negative output gap in the economy). If demand then picks up in the
recovery phase of the cycle, there is little immediate need for businesses to increase their
investment because they can make more intensive use of whatever existing capacity is
available now. Investment is more likely to be strong when businesses are operating close
to their production limits, and when they need to boost their capacity in order to meeting
rising demand from consumers.

If businesses are working below full capacity they may not need to invest in lots of new
capital goods
617
1
The chart above shows the percentage of industrial firms operating below full capacity.
The data series is highly cyclical; notice for example how low the figure was during the
boom of the late 1980s but then shot up to over 70 per cent during the recession of the
early 1990s. There is no automatic link between the level of spare capacity and planned
investment because other factors will come into play when businesses are making
investment decisions.

Summary of the key factors driving capital investment spending

 Interest rates: Interest rates play a role in shaping investment decisions but the
demand for capital goods tends to be inelastic after changes in interest rates – at
least in the short term. In other words, the marginal efficiency of capital curve can
be drawn as inelastic.
 Expectations and confidence: Expectations of demand and expectations of the
costs of buying and running new capital goods are an important factor in the
investment decision. Thus the state of business confidence cannot be ignored in
understanding investment theory. Interest rates do have an effect on these
expectations.
 Profits: The level of business profitability is a major factor driving investment
demand. Higher profits suggest a more favourable business climate which boosts
business confidence. Higher profits also make it easier for firms to reinvest their
“producer surplus” to fund capital projects.
 External economic factors: The health of the global economy is becoming an
important factor influencing capital spending decisions. For example, businesses
will consider where to locate their new investments – focusing on factors such as
relative cost levels, corporate taxation regimes in different countries, expectations
of income and demand growth in different regions and nations and the volatility
of exchange rates

Business profitability
Business profits play an important role in allocating resources – for example, higher
profits provide the funds for capital investment and also for research and development
projects. Profits tend to follow a cyclical pattern – they fall during a recession or an
economic slowdown. And they recover during phases of stronger economic growth

618
1
 Manufacturing industry has suffered a profits squeeze in recent years

The chart above shows the percentage rate of return on capital – a measure of business
profitability. Throughout the period shown, the profit made by service sector businesses
has been higher than for manufacturing industries. Firstly, manufacturing industry in the
UK has been in relative decline for many years because it faces much greater competition
from lower-cost overseas producers – this decline is known as a process of
deindustrialisation. This tough global competition affects the level of demand but it also
means that British manufacturing businesses have less pricing power in their own
markets. UK markets have become more contestable and this has dampened profit
margins.

In the last few years, there has been a downward trend in business profits – the result of

 A strong exchange rate which hits the profit margins of exporters.

 Rising costs e.g. oil prices for firms that use oil as an essential input.
 Higher labour costs – including several rises in the national minimum wage
 Capital investment accounts for just under a fifth of UK national income and it is
a volatile component of aggregate demand that impacts on both the demand &
supply side of the economy
 Net investment = gross investment – replacement investment
619
1
  Positive net investment increases a country’s productive capacity and contributes
to a faster trend rate of growth in the long run
 Firms invest to increase current supply capacity in the expectation that selling
more products increases revenues and profits or leads to lower costs (economies
of scale) and improvements in productivity and efficiency.
 New investment also helps to exploit new technologies and is an important factor
keeping firms competitive in the global economy.
 The Marginal Efficiency of Capital is the rate of return on each extra unit of
capital invested.
 Private sector businesses have an incentive to continue to invest if the returns they
anticipate from each additional capital project exceed the current market rate of
interest rate. Lower interest rates should lead to an expansion along the planned
investment demand curve.
 Improved business confidence increases expected rates of return, shifting the
MEC curve to the right.
 Any anticipated slow down or a possible recession in the economy that lowers
expectations causes an inward shift in the MEC curve.
 The accelerator model predicts a positive relationship between the rate of growth
of demand and planned investment. But much depends on the capital to output
ratio; the amount of spare capacity that a business has, and also the supply-side
capacity of businesses that produce the capital goods.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Theories of Economic Growth

Over the years, economists from different schools of thought have had plenty to say on what really
drives economic growth for an economy. In this chapter we review some of these ideas. In
particular we consider the importance of supply-side factors in determining the trend rate of growth
for countries competing in the global economy.

Trend growth
Economic growth is best defined as a long-term expansion of the productive potential of the
economy.

Trend economic growth refers to the smooth path of long run national output. Measuring the
trend rate of growth requires a long-run series of macroeconomic data (perhaps of 20 years or more)
in order to identify the different stages of the economic cycle and then calculate average growth
rates from peak to peak or trough to trough. Another way of thinking about the trend growth rate is
to view it as an underlying speed limit for the economy. In other words, it is an estimate of how
fast the economy can reasonably be expected to grow over a number of years without creating an
unsustainable increase in inflationary pressure.

620
1
Growth rates for OECD countries 1990-2006

Average annual growth Average annual growth

rate from 1990-2006 (%) rate from 1990-2006 (%)

Ireland 6.7 Mexico 3.0

Korea 5.4 United Kingdom 2.7

Slovak Republic 4.7 Finland 2.7

Poland 4.5 Total OECD 2.7

Turkey 4.3 Sweden 2.4

Luxembourg 4.2 Denmark 2.3

Hungary 3.8 Netherlands 2.2

Australia 3.6 Austria 2.2

Iceland 3.4 Belgium 2.0

New Zealand 3.3 Portugal 1.9

United States 3.3 France 1.9

Canada 3.2 Euro area 1.9

Norway 3.1 Germany 1.4

Czech Republic 3.1 Japan 1.3

Greece 3.0 Italy 1.3

Spain 3.0

Source: OECD World Economic Outlook June 2006, data for 2006 is a forecast

Driving the trend growth rate

Many factors influence the rate of economic growth. Some factors, such as changes in consumer
and business confidence, aggregate demand conditions in the UK’s trading partners, and monetary

621
1
and fiscal policy, tend to have a mainly temporary effect on growth. Other factors, such as the rates
of population and productivity growth, have more enduring effects, and help to determine the
economy's average growth rate over long periods of time.

Source: HM Treasury

A question of potential – the productive capacity of the UK economy grows each year

The chart above shows the estimated level of potential national income for the UK over the last
thirty years. There are two main points to notice from the chart. Firstly, we expect that our real
national income will rise each year. This is because of improvements in productivity; an expanding
labour supply; the effects of capital investment spending and also the effects of technological
change and innovation. Secondly, what matters is the long run average growth of potential national
income. For the UK, we have a trend growth rate of around 2.5% per year. This can fluctuate
depending on the overall strength of the economy and the health (or otherwise) of the supply-side of
the economy. The OECD estimates that during the 1990s and early years of the current decade, our
trend growth rate has been a little higher than 2.5%. But raising it to 3% per year seems to have
been a bridge too far!
For our trend rate of growth to be higher the UK economy needs to do a number of things:

1. Raise capital investment spending as a share of national income.

622
1
 2. Achieve higher productivity from both capital inputs and from our labour supply.
3. Expand the size of the labour supply, perhaps through an increase in the migration of high
productivity workers.
4. Increase the level of research and development and increase the pace and application of
innovation across the economy.

UK productivity growth slumps in 2005

The annual growth of productivity in the British economy increased by only 0.8% in 2005 the
slowest growth since the recession year of 1990. There are many reasons for this sluggish growth of
productivity. Part of the reason was the slowdown in growth in 2005 because output and output per
worker tend to be positively correlated. In an economy where demand and output is weaker, people
in work are not being used as intensively compared to when the economy is stronger. Deeper-rooted
explanations for weak productivity performance focus on supply-side deficiencies. These include
the effects of skills gaps in industry; and the transfer of the economy's resources into the public
sector where productivity is lower. Other factors contributing to sluggish productivity growth
include the effects of business red tape and a persistently low rate of spending on research and
development.Low productivity growth means that little progress has been made in reducing the
productivity gap that exists between the UK and most of her major competitors.

Source: Adapted from news report, June 2006

GDP per worker

UK =100

1992 2004

France 130 111

Germany 115 97

UK 100 100

USA 137 124

GDP per hour worked

623
1
UK = 100

1992 2004

France 142 129

Germany 128 116

UK 100 100

USA 128 116

Many factors explain our productivity gap – among them low capital investment and a skills
shortage

624
1
It is quite interesting to see how the estimated trend growth rates differ from country to country.
The chart above is again drawn from the OECD figures. Notice how a country such as Ireland has a
much faster growth of potential national income. During the mid 1990s when the Irish boom was at
its peak, the trend growth rate was over 7% a year, enough for her GDP to double virtually every
ten years. This trend rate has come down but remains more than double that of the average for the
countries inside the Euro Zone. Spain is another country enjoying a relatively fast growth of
potential GDP and this has been accompanied by a rise in her relative living standards over the last
twenty years.

Hungary, one of the ten countries that joined the European Union in May 2004 when the EU
enlarged, has a trend growth rate of 4% per year. This is typical of low to middle-income countries
with fairly strong growth potential, as they experience high levels of inward investment and rising
incomes.

625
1
The effects of an increase in long run aggregate supply are traced in the diagram below. An
increase in LRAS allows the economy to operate at a higher level of aggregate demand – leading to
sustained increases in real national output.

626
1
Government policies to improve the trend growth rate
Over the last twenty years, government of different political persuasions, have put in place policies
which they expect will be successful in raising investment, encouraging entrepreneurship and
improving incentives to work. Potential output in the long run depends on the following factors

(1) The growth of the labour force

If the government can increase the number of people willing and able to seek paid work, then the
employment rate increases leading to a higher output of goods and services. The Government has
relied on a number of job schemes designed to raise employment including New Deal and changes
to the tax and benefit system. Changes in the age structure of the population also affect the total
number of people seeking work. And we might also consider the effects that migration of workers
into the UK from overseas, including the newly enlarged European Union, can have on the UK’s
labour supply.

(2) The growth of the nation’s stock of capital

A rise in capital investment adds directly to GDP in the sense that capital goods have to be
designed, produced, marketed and delivered. Higher investment also provides workers with more
capital to work with. New capital also tends to embody technological improvements which
providing workers have sufficient skills and training to make full and efficient use of their new
capital inputs, should lead to a higher level of productivity after a time lag.

(3) The trend rate of growth of productivity of labour and capital.

For most countries it is the growth of productivity that drives the long-term growth. The root causes
of improved efficiency come from making markets more competitive and achieving better

627
1
productivity within individual plants and factories. Increased investment in the human capital of
the workforce is widely seen as essential if the UK is to improve its long run productivity
performance – for example – increased spending on work-related training and improvement in the
UK education system at all levels.

(4) Technological improvements

Changes in technology are important because they reduce the real costs of supplying goods and
services which leads to an outward shift in a country’s production possibility frontier

Economic growth and causation – different schools of thought

For many years, economists have been discussing the causes of growth and development. There is
little sign of a consensus emerging! Here are some of the main lines of thought.

Neo-Classical Growth
The “neo-classical” model of growth was first devised by Nobel Prize winning Economist Robert
Solow over 40 years ago. The Solow model believes that a sustained increase in capital investment
increases the growth rate only temporarily: because the ratio of capital to labour goes up (i.e. there
is more capital available for each worker to use). However, the marginal product of additional units
of capital is assumed to decline and thus an economy eventually moves back to a long-term growth
path, with real GDP growing at the same rate as the growth of the workforce plus a factor to reflect
improving productivity.

A ‘steady-state growth path’ is eventually reached when output, capital and labour are all growing
at the same rate, so output per worker and capital per worker are constant.
Neo-classical economists who subscribe to the Solow model believe that to raise an economy's long
term trend rate of growth requires an increase in the labour supply and also a higher level of
productivity of labour and capital.

Differences in the rate of technological change between countries are said to explain much of the
variation in growth rates that we see. The neo-classical model treats productivity improvements as
an ‘exogenous’ variable, meaning that productivity improvements are assumed to be independent
of the amount of capital investment.

The significance of productivity as a source of supply-side performance and as a contributor to

long-term growth is now widely accepted by many economists. A recent analysis of the long term
prospects for Britain from the International Monetary Fund argued that the main challenge for the
UK in the years ahead is to improve factor productivity since there remains a sizeable productivity
gap between the UK and many of our major international competitors.

Growth of labour productivity for OECD countries 1988-2006

Annual average % change Annual average % change

628
1
Poland 4.8 Total OECD 1.6

Slovak Republic 4.0 Germany 1.5

Korea 4.0 Australia 1.5

Hungary 3.3 Japan 1.5

Ireland 3.1 Portugal 1.4

Czech Republic 3.1 Belgium 1.4

Turkey 2.9 France 1.4

Norway 2.4 Luxembourg 1.3

Finland 2.3 Euro area 1.2

Sweden 2.2 Canada 1.2

Greece 2.1 Italy 1.2

Iceland 2.0 New Zealand 1.1

Austria 1.9 Netherlands 1.0

Denmark 1.8 Spain 0.8

United Kingdom 1.7 Switzerland 0.8

United States 1.7 Mexico 0.5

Endogenous Growth Theory

Endogenous growth economists believe that improvements in productivity can be linked directly to
a faster pace of innovation and extra investment in human capital. They stress the need for
government and private sector institutions which successfully nurture innovation, and provide the
right incentives for individuals and businesses to be inventive. There is also a central role for the
accumulation of knowledge as a determinant of growth. We know for example that the knowledge

629
1
industries (typically they are in telecommunications, electronics, software or biotechnology) are
becoming increasingly important in many developed countries.

Supporters of endogenous growth theory believe that there are positive externalities to be exploited
from the development of a high valued-added knowledge economy which is able to develop and
maintain a competitive advantage in fast-growth industries within the global economy.

The main points of the endogenous growth theory are as follows:

 The rate of technological progress should not be taken as a constant in a growth model –
government policies can permanently raise a country’s growth rate if they lead to more
intense competition in markets and help to stimulate product and process innovation.
 There are increasing returns to scale from new capital investment. The assumption of the
law of diminishing returns which forms the basis of so much textbook economics is
questionable. Endogenous growth theorists are strong believers in the potential for
economies of scale (or increasing returns to scale) to be experienced in nearly every industry
and market.
 Private sector investment in research & development is a key source of technical progress.
 The protection of private property rights and patents is essential in providing appropriate and
effective incentives for businesses and entrepreneurs to engage in research and development
 Investment in human capital (including the quantity and quality of education and training
made available to the workforce) is an essential ingredient of long-term growth. This is
discussed next.
 Government policy should encourage entrepreneurship as a means of creating new
businesses and ultimately as an important source of new jobs, investment and innovation.

The Importance of Human Capital

The basis of human capital lies in the theories of the Theodore Schultz, an economist at the
University of Chicago who was awarded the Nobel Prize for Economics in 1979. Schultz, an
agricultural economist, produced his ideas of human capital as a way of explaining the advantages
of investing in education to improve agricultural output. Schultz demonstrated that the social rate
of return on investment in human capital in the US economy was larger than that based on
physical capital such as new plant and machinery.

Gary Becker, the 1992 Nobel Prize winner for economics, built on the ideas first put forward by
Schultz, explaining that expenditure on education, training and medical care could all be considered
as investment in human capital. He wrote that “people cannot be separated from their knowledge,
skills, health or values in the way they can be separated from their financial and physical assets."

Innovation
Innovation is the creation of new intellectual assets. We can make a useful distinction between:

Process innovation: This relates to improvements in production processes, the more efficient use
of scarce resources to produce a given quantity of output - leading to improvements in productive

630
1
and technological efficiency

Product innovation: This is the emergence of new products which better satisfy our ever-
increasing needs and wants - leading to improvements in the dynamic efficiency of markets in
providing goods and services
Indeed, it is often the ‘drive to innovate’ which is the primary motive for capital investment in the
first place, not least in international markets where a firm's competitive edge is determined by the
success of strategies designed to find viable innovations that give it what is often called ‘first mover
advantage in a market’. Innovation in the pharmaceutical industry; in telecommunications; in
household goods and in biotechnology is good examples of sectors where successful innovation is
the key to maintaining a competitive advantage.

In short - successful innovation is a stimulus to long-run growth because:

 It acts as a catalyst for higher rates of investment in fixed capital and increased investment
in human capital which helps to shift out the production possibility frontier
 It can act as a spur to faster productivity growth (with time lags) because of its impact on
technological progress
 Innovation also creates a demand for new products from consumers for example in
industries where existing products are nearing the end of their product life-cycle

Social benefits from innovation

There are potentially huge positive externalities from technology spill-over effects arising from
innovation for example in the pharmaceutical industry where new drugs improve the quality of life
and increase life expectancy and also improvements in car manufacture and design that reduce the
risk of serious injury from road accidents.

Inter-firm collaboration in the creation and use of innovations can also act as a key contributor to
industry-wide growth leading to external economies of scale. Indeed this form of co-operative
behaviour between businesses is judged to be legal by the European competition authorities
whereas price fixing and other forms of anti-competitive behaviour is now the subject of frequent
investigations and legal action.

The US economist William Baumol in his recent book “The Free-Market Innovation Machine”
stresses that firms use innovation as a ‘prime competitive weapon’. However, firms do not wish to
risk too much innovation, because it is costly, and can be made obsolete by rival innovation. So,
firms have responded to this through the sale of technology licenses and participation in
technology-sharing compacts with other firms that can pay huge dividends to the economy as a
whole. According to Baumol, innovative activity becomes mandatory, in his words, ‘a life-and-
death matter for the firm.’

Social capital and economic growth

We have seen that investment in physical capital and human capital are both regarded as important
sources of long term growth for modern countries competing in the global economy. There is also

631
1
increasing interest in a concept known as social capital – if you like, a third strand in the idea that
capital promotes growth.

Social capital focuses on the value of social networks in improving productivity in an economy.
According to the author Robert Putnam in a book entitled “Bowling Alone”, “it refers to the
collective value of all social networks and the inclinations that arise from these networks to do
things for each other"? So, social capital cites the interrelationships between individuals as a major
driver of growth.

Putnam talks about “bonding” and “bridging” social capital, with the latter as the one which
enhances productivity. This is the idea that social groups bridge from one to another through shared
interests, such as ten-pin bowling. This creates an atmosphere of trust and friendliness between
people, which has numerous benefits for society as whole, which some would term as positive
externalities. For example, a sense of “togetherness” among the bowling fraternity will indeed
increase the growth of the bowling sector of the economy, since more meetings will require more
money to be spent on hiring bowling alleys and buying all the other ingredients for a great night’s
bowling. However, the atmosphere of trust and friendliness created may also allow people to be
more amiable to the idea of sharing lifts to and from meetings, thus lowering car pollution. A trivial
example it may be, but it suffices to show how social capital can have an impact on the society as a
whole.

“Bonded” social capital, on the other hand, creates exclusivity. Groups, such as gangs, are based on
hierarchical patronage rather than meritocratic methods, potentially meaning that productivity falls.
However, in both these examples social capital is being used for advantage. The problem with the
latter is that this advantage is for a number of individuals rather than for collective society.

Social networks can be used to spread beneficial ideas, causing individuals and society to
simultaneously progress. An example of this would be, in times of low savings (which could
potentially cause a pensions crisis in the future), social networks spreading the “acceptability of
saving, and thus benefiting the economy.

632
1
Sunrise in India – how quickly will the emerging market countries including India, China, Mexico,
Indonesia, Brazil and Russia come to dominate the global economy? Can they maintain their fast
growth rates?

 Key Points
Economic growth is a long-run increase in the capacity of the economy to produce goods
and services, and can be illustrated by an outward shift in the production possibility frontier.
 Trend growth is the long term non-inflationary increase in output (GDP) caused by an
increase in productive capacity i.e. LRAS.
 Growth occurs because of an increase in the quantity and/or quality of factor resources.
Human capital is the skill and knowledge level of the workforce, as well as their health. The
higher the quality of human capital, the higher the productivity as workers adapt more
effectively to new technologies and learns to perfect their respective specialised jobs. Actual
skill levels, as opposed to educational qualifications, are now seen as powerful drivers of
economic growth.
 Social capital represents the networks and shared values which lead to greater social co-
operation and mutual trust

 Innovation is a major determinant of growth. It helps to lower costs and it also creates new
markets, a source of demand, revenue and profits for businesses in the domestic and the
international economy.

Author: Geoff Riley, Eton College, September 2006

633
1
A2 Macroeconomics / International Economy
National Income and Changes in Living Standards

How well off are we compared to recent years and in comparison with people in other countries? What do we
actually mean by the standard of living and can routine information on national income give us a reliable
indication of our economic well-being. In this chapter we look at living standards and the development of
alternative measures of welfare and the quality of life.

Defining and measuring the standard of living

The standard of living is a measure of the material welfare of the inhabitants of a country. The baseline measure of
the standard of living is real national output per head of population or real GDP per capita. This is the value of
national output divided by the resident population. Other things being equal, a sustained increase in real GDP
increases a nation’s standard of living providing that output rises faster than the total population.

However, it must be remembered that real income per capita on its own is both an inaccurate and insufficient
indicator of true living standards both within and between countries.
National income data can be used to make cross-country comparisons. This requires

 Converting GDP data into a common currency (normally the dollar or the Euro)
 Making an adjustment to reflect differences in the average cost of goods and services in each country to
produce data expressed at a ‘purchasing power parity’ standard

Problems in using national income statistics to measure living standards

GDP data on its own is an insufficient indicator of our economic well-being. The following quote adapted from an
article in the Independent in December 2002 sums up the issue quite well.

‘Improving living standards is about poor families gaining access to what is available at the time to make life
comfortable, healthy and rewarding. In the end, economic statistics only measure what they measure, which may
not bear much relation to how well off we are.’
Source: Adapted from the Independent

The table below provides time series data on per capita national incomes for the twenty five nations of the European
Union. Ireland has made huge strides in improving her relative standard of living. In 1994 Ireland’s GDP per capita
was just 84% of the EU average but extremely rapid economic growth allowed the Irish economy to surge past the
EU15 average in 1999 and this progress has been maintained. In contrast, Germany’s relatively slow growth has
seen erosion in her relative advantage in living standards – from a level 10% above the EU average in 1994 to a
level only 3% above the average in 2002. In 2004, Britain had a per capita income (adjusted for differences in living
costs) some ten per cent higher than the European average.

Average GDP per head of the ten accession countries in the year 2000 was only 46% of the EU average although it
should be pointed out that there has been progress in closing this gap over recent years. Many transition economies

634
1
experienced a deep recession in the early 1990s but have grown more quickly since then. Of the ten accession
countries, Cyprus and Slovenia are closest to the EU average in terms of a PPP adjusted income per capita.

GDP and living standards - problems of accuracy

Official data on a nation’s GDP tends to understate the true growth of real national income per capita over time due
to the expansion of the shadow (or underground) economy and also the value of unpaid work done by millions
of volunteers and people caring for their family members.

Various definitions are used to describe the "shadow economy" but the definition usually embraces a range of
illegal activities such as drug production and distribution, prostitution, theft, fraud and concealed legal activities
such as tax evasion on otherwise-legitimate business activities such as unreported self-employment income. The
scale of the “shadow economy” varies widely across countries at different stages of development. According to the
IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern
Europe it may be up to 30% of GDP and in the leading industrialised countries of the OECD, the shadow economy
may be in the region of 15% of GDP.

GDP and living standards – problems of interpretation

635
1
Here are reasons why GDP data may give a distorted picture of living standards in a country:

 Regional Variations in income and spending: National GDP data can hide regional variations in output,
employment and income per head of the population. The table below provides some evidence for this with
household disposable income per head in Inner London over seventy-five per cent higher than the national
average and several of our major cities having disposable incomes per head at only three quarters of the
average (or less). The Office for National Statistics provides a useful regional snapshot which offers
economic and social information on each of the UK’s major regions.

Household disposable income per head, in 2003

Index (UK=100)

Inner London - West 177.6Leicester 78.8

Surrey 139.3Kingston Upon Hull, City of 78.3

Buckinghamshire 133.1Nottingham 77.4

Hertfordshire 128.0Stoke-on-Trent 76.9

Outer London - West and North West 120.9West and South West of Northern Ireland 75.3

Outer London - South 119.4North of Northern Ireland 73.9

Berkshire 116.7Blackburn With Darwen 73.3

Source: ONS Regional Trends

 Inequalities of income and wealth: The Lorenz Curve and the Gini-coefficient are two ways of
measuring inequality and relative poverty– an outward shift in the Lorenz Curve would indicate a widening
of income and wealth inequality. Since 1979, there has been a rise in inequality as the gap between the rich
and poorer sections of society has widened. The distribution of wealth is even more unequal than that for
income in the UK.

Distribution of real disposable household income in 2004

£ per week at 2003/04 prices

10th 90th Ratio of 90th to 10th percentile

636
1
 percentile Median percentile

1971 103.4 188.0 328.0 3.2

1979 124.7 217.2 372.8 3.0

1989 130.7 268.9 526.9 4.0

1999 147.1 292.5 604.6 4.1

2004 171.1 335.7 673.9 3.9

Source: ONS, Low income households

 Leisure and working hours: An increase in real GDP might have been achieved at the expense of leisure
time if workers are working longer hours. Several reports have highlighted the fact that British workers have
the longest working week in Europe which can cause stress and damage family life – two social indicators
that potentially create some negative externalities for society as a whole.

637
1
  Imbalances between consumption and investment: If an economy devotes too many scarce resources to
satisfying the short run needs & wants of consumers, there may be insufficient resources for capital
investment and over-consumption can lead to an over-exploitation of scarce finite resources thereby limiting
future growth prospects.
 Changes in life expectancy: Improvements in life expectancy have a huge impact on people’s living
standards but don’t always show through in the GDP accounts. Reductions in infant mortality have been
accompanied by the prevention or cure of diseases that might have led to the premature death of even the
richest of our ancestors at any time. Putting a monetary value on the benefits of increased longevity is
difficult, but surely it must be factored into any overall assessment of living standards and the quality of life.
 The value of non-marketed output including work done in the home

Much useful and valuable work is not produced and sold in markets at market prices. The value of the output of
people working unpaid for charities and of housework might reasonably be added to national income statistics.

 Innovation and the development of new products: One of the problems in comparing and contrasting
living standards and the quality of life across different generations is that new goods and services become
available because of competition, investment, invention and innovation that simply would not have been
available to the richest person on earth less than fifty years ago. About half of what we spend our money on
now was not invented in 1870. Examples include air travel, cars, computers, antibiotics, hip replacements,
insulin and many other life-enhancing and life-saving drugs
 Environmental considerations: Rising output might have been accompanied by an increase in air and noise
pollution and other externality effects that have a negative effect on our social welfare. Faster economic
growth may cause long term damage to our eco-systems, threatening the long-term sustainability of the
economy.
 Defensive expenditures: Much spending in an economy is on defensive expenditure – not spending on
tanks and armaments! But spending to defend yourself against an “economic or social bad” e.g. crime, or
spending to recover the damage from externalities (e.g. cleaning up the effects of pollution, managing the
huge and growing volume of waste; driving long distances to and from work. This spending adds directly to
our GDP but does it really add to our material welfare? Some economists believe that adjustments should be
made to officially published data for GDP to take into account items of this defensive spending.

Purchasing power - differences in the cost of living between countries

Data on relative standards of living is normally adjusted to reflect estimates of purchasing power parity to take
account of differences in the cost of living – so that each unit of currency has (approximately) the same purchasing
power. One Euro of income in each country may not have the same real purchasing power because of differences in
the average cost of living. For example, relative prices of a basket of goods and services for consumers in Britain
are estimated in 2003 to be 18% higher than the EU15 average.
The Scandinavian countries have significantly higher prices whereas Mediterranean countries have relative price
levels less than four fifths of the EU average. As the following passage makes clear, movements in the exchange
rate also have an effect on the relative cost of living in different locations around the world.

The world’s most expensive cities

Rank Mercer Consulting (2006) Economist Intelligence UBS Survey(2005)

638
1
 Unit (2006)

1 Moscow Oslo London

2 Seoul Tokyo Oslo

3 Tokyo Reykjavik New York

4 Hong Kong Osaka Tokyo

5 London Paris Copenhagen

6 Osaka Copenhagen Hong Kong

7 Geneva London Zurich

8 Copenhagen Zurich Paris

9 Zurich Geneva Chicago

=10 Oslo Helsinki Geneva

=10 New York

Limitations of the purchasing power parity adjustment

At any given time, the current exchange rate for a country is unlikely to be at PPP levels. Currency speculation or
other factors may have driven the exchange rate above or below its estimated PPP level. The PPP
calculation/estimation is also constrained by the fact that:

o Not all output is traded internationally – some goods and services are produced only for domestic
consumption and do not find their way onto international markets
o Price differences in different countries may reflect product differentiation
o Differences in degree of competition in local and national markets affect relative prices – for example the
high level of new car prices in the UK compared to most other countries in the EU is partly a result of
oligopoly power among leading UK car retailers
o Local indirect taxes and tariffs cause differences in the cost of living
o Central bank intervention in the currency markets can take the actual exchange rate out of PPP alignment
because they are trying to manage the value of the currency

639
1
Alternative measures of economic and social welfare
Having focused on income as a key measure of living standards, we briefly consider some of the alternative
approaches.

1990 1995 2000 2004

Cable television subscribers (per 1,000 people) 3 24 57 74

Internet users (in 1000s) 1100 18000 23505

Mobile phones (per 1,000 people) 19 98 727 883

Personal computers (per 1,000 people) 108 201 338 367

One of the simplest ways of judging whether we are better off materially than we were a few years ago is to track
ownership of consumer durables. The table above draws on some of the information provided over the years 1990 –
2004. Ownership levels are affected by the trend in price levels, household incomes, changes in tastes and
preferences, the emergence of new general purpose technologies and factors such as consumer borrowing and
confidence.

The Human Development Index (HDI)

The Human Development Index (HDI) has been published by the United Nations each year since 1990. The HDI is
the average of three indices based on three different variables:

 Life expectancy at birth

 Education – a weighted average of adult literacy (two-thirds) and average years of schooling (one third)
 Real GNP per capita – measured in US dollars, at purchasing power parity exchange rates.

Clearly, this index gives us a better way of estimating standards of living than just GNP taken on its own. However,
it is still far from perfect. Economists have recently been looking at ways to include other factors in the
measurement, such as income distribution (perhaps using the Gini coefficient), gender inequalities, and inequalities
by region or by ethnic group. Since 2001, Norway has come top of the international rankings for human
development. Canada held the top spot from 1996 to 2000. Iceland and Australia also figure prominently at the top
of the Human Development Index with Niger and Sierra Leone at the bottom.

World demographic indicators, 2004

Population Infant Total Life expectancy at birth

(millions) mortality rate Fertility (years)

640
1
 (*) Rate Males Females

Asia 3,860 53.7 2.47 65.4 69.2

Africa 887 94.2 4.97 48.2 49.9

Europe 729 9.2 1.40 69.6 78.0

Latin America & Caribbean 554 26.0 2.55 68.3 74.9

North America 327 6.8 1.99 74.8 80.2

Oceania 33 28.7 2.32 71.7 76.2

World 6,389 57.0 2.65 63.2 67.7

* Per 1,000 live births.

Source: United Nations Statistics Division

The Human Poverty Index (HPI)

The Human Poverty Index (HPI) published annually by the United Nations focuses on four basic dimensions of
human life -– longevity, knowledge, economic provisioning and social inclusion. The latest published data shows
the UK ranked only 15th out of 17 leading industrialised countries with only Ireland and the United States below us.
The most recent data for the Human Poverty Index is shown in the table below together with the factors that go into
creating the Human Poverty Index ranking.

Country Human Probability at birth People lacking Long-term Proportion of

Poverty of not surviving to functional unemployment the population
Index age 60 literacy skills (as % of living on less
Ranking (% of cohort) (% age labour force) than 50% of
2000-05 16-65) 2001 median income
1994-98 c 1990-2000

Sweden 1 7.3 7.5 1.1 6.6

Norway 2 8.3 8.5 0.2 6.9

641
1
Finland 3 10.2 10.4 2.4 5.4

Netherlands 4 8.7 10.5 1.6 8.1

Denmark 5 11 9.6 0.9 9.2

Germany 6 9.2 14.4 4.2 7.5

Luxembourg 7 9.7 .. 0.5 3.9

France 8 10 .. 3.3 8

Spain 9 8.8 .. 4.6 10.1

Japan 10 7.5 .. 1.4 11.8

Italy 11 8.6 .. 6.1 14.2

Canada 12 8.7 16.6 0.7 12.8

Belgium 13 9.4 18.4 3.2 8

Australia 14 8.8 17 1.4 14.3

United Kingdom 15 8.9 21.8 1.3 12.5

Ireland 16 9.3 22.6 3.2 12.3

United States 17 12.6 20.7 0.3 17

The Measure of Domestic Progress

The Measure of Domestic Progress (MDP) is published by economists at the New Economics Foundation and is
supposed to reflect progress in Britons' quality of life and progress towards a sustainable economy by factoring in
the social and environmental costs of economic growth, and benefits of unpaid work such as household labour,
that are currently excluded from official GDP.

The Gross National Happiness Index

Bhutan, the Himalayan kingdom the size of Switzerland with no McDonalds, no ATM machines, no traffic lights,

642
1
and until five years ago no TV, is for many people a species of Shangri-La. Bhutan is ranked 130th in the UN
Development Program's ratings, close to Haiti and Bangladesh. Most visitors rate it almost infinitely higher,
however, and the measure they use is one let fall by the country's king in 1987 "Gross National Happiness." This is
no joking contrast with Gross National Product, but a serious measure of how any place might be assessed - not by
per capita income, the number of concrete roads, dams and parking lots, but by the simple quality of life. This most
observers believe Bhutan's is enviably high.
Happy Planet Index
The South Pacific island nation of Vanuatu is the happiest place on the planet according to the Happy Planet Index,
has been constructed by the New Economics Foundation and Friends of the Earth using three factors: life
expectancy, human wellbeing and damage done via a country's "environmental footprint".
The UK's heavy ecological footprint, the 18th biggest worldwide, is to blame for the country's low rating in the
index. Life satisfaction varies greatly from country to country: questioned on how satisfied they were with their
lives, on a scale of one to 10, 29% of Zimbabweans, who have a life expectancy of 37, rate themselves at one and
only 6% rate themselves at 10.
Source: Adapted from the Guardian, 12th July 2006 and BBC news online

Key Points

 The basic measure of the standard of living refers to per capita real GDP. It is found by dividing real GDP
by the size of the population.
 This figure is an average and gives no indication of the distribution of income
 To ensure purchasing power parity between countries, the current exchange rate is adjusted so that a basket
of goods and services can be bought for the same amount of dollars. GDP data can then by expressed at
purchasing power standard (PPS)
 There are limitations in the use of purchasing power parity estimates
 Omissions and inaccuracies suggest that officially published GDP figures are a debatable guide to the
quality of life and the standard of living
 A range of alternative “composite” measures of economic welfare and the quality of life have been
developed – happiness is now a firm part of the agenda of public policy!

 These include the Human Development Index, the Human Poverty Index, the Index of Sustainable
Economic Welfare and the newly established Happy Planet Index!

Author: Geoff Riley, Eton College, September 2006

Enter your search terms Submit search

form

643
1
A2 Macroeconomics / International Economy
Natural Rate of Unemployment

At A2 level, students are expected to understand the idea of an equilibrium rate of

unemployment. We now turn to the concept of the natural rate.

Equilibrium unemployment in an economy

The natural rate of unemployment is defined as the equilibrium rate of unemployment

i.e. the rate of unemployment where real wages have found their free market level and
where the aggregate supply of labour is in balance with the aggregate demand for labour.
At the natural rate, all those wanting to work at the prevailing real wage rate have found
employment and thus there is assumed to be no involuntary unemployment. There
remains some voluntary unemployment as some people remain out of a job searching for
work offering higher real wages or better conditions.

It is worth stating at this point that some economists simply do not believe in the validity
of a simple natural rate of unemployment when the labour market is in balance and where
a rate of unemployment “settles” at a level consistent with stable wage and price
inflation. The natural rate concept is supported by economists who believe in the power
of markets to clear at an equilibrium price and who view the labour market much as any
other market in the economy.

Consider the next diagram which shows some labour demand and supply analysis. At the
real wage rate W1, E1 workers are employed. But at this prevailing wage rate, the total
labour force exceeds than the employed labour force. The natural rate of unemployment =
AB and consists of frictional and structural unemployment. The government might
attempt to reduce the natural rate by bringing down the horizontal distance between the
supply of labour and the labour force curve.

644
1
Any supply-side policy that can increase the number of people willing of working age
that are willing and able to find employment in the labour market will shift the labour
supply curve to the right, thus narrowing the gap. This is shown in the second diagram.

645
1
Policies to reduce the natural rate of unemployment normally focus on improving the
efficiency of the labour market be removing what are called “labour market
imperfections”. For example a government wanting to achieve a lower equilibrium rate
of unemployment might do the following:

 Reform the system of welfare benefits so as to reduce the risk of the “poverty
trap”
 Reforming trade unions to reduce their collective bargaining power and also
reducing some of the barriers to labour mobility put up by professional bodies and
associations which have the effect of limiting the supply of labour into an
occupation
 Reducing income tax to improve the incentives to look for and accept paid work
 Adopting a more relaxed approach to labour migration

In general terms, economists who believe that the natural rate of unemployment can be
reduced argue that government policies should seek to make labour markets more
competitive and flexible. We now move on to discuss the nature of flexible labour
markets as part of strategies to boost employment and thereby reduce unemployment.

Economic activity and inactivity

646
1
 Millions

Total economically Total in employment Economically inactive

active

1980 26.9 25.2 15.8

1990 28.9 26.9 15.9

1993 28.2 25.3 16.8

2000 29.1 27.4 17.0

2005 30.1 28.7 17.6

Source: ONS

Data is for the spring of each year. Includes people aged 16 and over

The economically active are those in work or actively searching for work. As we can see
from the table above, since the end of the last recession in 1993 the number of
economically active in the UK has grown by nearly two million people. But over the
same time period, there has also been a rise in the number of people classified as
economically inactive. There are various reasons for inactivity. People may choose to
return to or stay in full-time education beyond the age of 16; others will leave the labour
market to raise a family or look after ill relatives. Others may choose to take early
retirement. And for some, the experience of long term unemployment is enough for them
to give up the search for work; they move into the welfare system and become almost
permanent claimants of a variety of state welfare benefits. If the economy can reduce the
number of inactive people, the benefit would be an expansion in the active labour supply
and a boost to our long-term growth potential.

The importance of human capital in raising employment and reducing

unemployment

Employment rate: by sex and highest qualification, 2005

Percentages

647
1
 Men Women All

Degree or equivalent 89 87 88

Higher education 87 84 85

GCE A level or equivalent 81 73 77

Trade apprenticeship 83 73 81

GCSE grades A* to C or equivalent 79 71 75

Qualifications at NVQ level 1 and below 75 63 69

No qualifications 54 42 48

All 79 70 74

Percentage of the working-age population in employment

Source: Labour Force Survey, ONS

Upgrading and improving the skills of people is really important in raising employment
rates. The data in the table above is taken from 2005 and shows that employment rates
among people of working age is significantly higher for people with a good base of
GCSE qualifications or above or vocational qualifications at level 1 or above.

Key Points

 Equilibrium in the labour market is when labour demand equals labour supply
Even when the labour market is in equilibrium there will still be frictional and
structural unemployment and also some seasonal unemployment
 The natural rate of unemployment can be reduced mainly through supply-side
labour market policies which improve work incentives and re-skill people looking
for work
 It is very difficult to observe the natural rate of unemployment directly because it
is rare for the labour market to be in a state of equilibrium!

648
1
 Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

FThe Phillips Curve

The essence of the Phillips Curve is that there is a short-term trade-off between
unemployment and inflation. But the original Phillips Curve has come under sustained
attack – in particular from monetarist economists, and when we consider the data for
unemployment and inflation in Britain over the last fifteen years, we will find that the
nature of the trade-off has certainly changed for the economy and others as well.

The basic Phillips Curve idea – economic trade-offs

In 1958 AW Phillips from whom the Phillips Curve takes its name plotted 95 years of
data of UK wage inflation against unemployment. It seemed to suggest a short-run trade-
off between unemployment and inflation. The theory behind this was fairly
straightforward. Falling unemployment might cause rising inflation and a fall in inflation
might only be possible by allowing unemployment to rise. If the Government wanted to
reduce the unemployment rate, it could increase aggregate demand but, although this
might temporarily increase employment, it could also have inflationary implications in
labour and the product markets.

The key to understanding this trade-off is to consider the possible inflationary effects in
both labour and product markets arising from an increase in national income, output and
employment.

The labour market: As unemployment falls, some labour shortages may occur where
skilled labour is in short supply. This puts extra pressure on wages to rise, and since
wages are usually a high percentage of total costs, prices may rise as firms pass on these
costs to their customers
Other factor markets: Cost-push inflation can also come from rising demand for
commodities such as oil, copper and processed manufactured goods such as steel,
concrete and glass. When an economy is booming, so does demand for these components
and raw materials.
Product markets: Rising demand and output puts pressure on scarce resources and can
lead to suppliers raising prices to widen profit margins. The risk of rising prices is
greatest when demand is out-stripping supply-capacity leading to excess demand (i.e. a
positive output gap)

Explaining the Phillips Curve concept using AD-AS and the output gap

649
1
Let us consider the explanation for the trade-off using AD-AS analysis and the concept of
the output gap. In the next diagram, we draw the LRAS curve as vertical - this makes
the assumption that the productive capacity of an economy in the long run is independent
of the price level.

We see an outward shift of the AD curve (for example caused by a large rise in consumer
spending) which takes the equilibrium level of national output to Y2 beyond potential
GDP Yfc. This creates a positive output gap and it is this that is thought to cause a rise in
inflationary pressure as described above. Excess demand in product markets and factor
markets causes a rise in production costs and this leads to an inward shift in short run
aggregate supply from SRAS1 to SRAS2. The fall in supply takes the economy back
towards potential output but at a higher price level.

So this might help to explain the Phillips Curve idea. We could equally use a diagram
that uses a non-linear SRAS curve to demonstrate the argument. The next diagram shows
the original short-run Phillips Curve and the trade-off between unemployment and
inflation:

650
1
The NAIRU

Milton Friedman, who criticised the basis for the original Phillips Curve in a speech to
the American Economics Association in 1968, introduced the concept of the NAIRU. It
has been further developed by economists both in the United States and the UK. Leading
figures developing the concept of the NAIRU in the UK include Sir Richard Layard and
Prof. Stephen Nickell at the LSE. Nickell is now a member of the Monetary Policy
Committee involved in the setting of interest rates.

The NAIRU is defined as the rate of unemployment when the rate of wage inflation is
stable.

The NAIRU assumes that there is imperfect competition in the labour market where some
workers have collective bargaining power through membership of trade unions with
employers. And, some employers have a degree of monopsony power when they
purchase labour inputs.

According to proponents of the concept of the NAIRU, the equilibrium level of

unemployment is the outcome of a bargaining process between firms and workers. In
this model, workers have in their minds a target real wage. This target real wage is
influenced by what is happening to unemployment – it is assumed that the lower the rate
of unemployment, the higher workers’ wage demands will be. Employees will seek to
bargain their share of a rising level of profits when the economy is enjoying a cyclical
upturn.

651
1
Whether or not a business can meet that target real wage during pay negotiations depends
partly on what is happening to labour productivity and also the ability of the business to
apply a mark-up on cost in product markets in which they operate. In highly competitive
markets where there are many competing suppliers; one would expect lower mark-ups
(i.e. lower profit margins) because of competition in the market. In markets dominated by
monopoly suppliers, the mark-up on cost is usually much higher and potentially there is
an increased share of the ‘producer surpluses that workers might opt to bargain for.

If actual unemployment falls below the NAIRU, theory suggests that the balance of
power in the labour market tends to switch to employees rather than employers. The
consequence can be that the economy experiences acceleration in pay settlements and
the growth of average earnings. Ceteris paribus, an increase in wage inflation will cause a
rise in cost-push inflationary pressure.

The expectations-augmented Phillips Curve

The original Phillips Curve idea was subjected to fierce criticism from the Monetarist
school among them the American economist Milton Friedman. Friedman accepted that
the short run Phillips Curve existed – but that in the long run, the Phillips Curve was
vertical and that there was no trade-off between unemployment and inflation.

He argued that each short run Phillips Curve was drawn on the assumption of a given
expected rate of inflation. So if there were an increase in inflation caused by a large
monetary expansion and this had the effect of driving inflationary expectations higher,
then this would cause an upward shift in the short run Phillips Curve.

The monetarist view is that attempts to boost AD to achieve faster growth and lower
unemployment have only a temporary effect on jobs. Friedman argued that a
government could not permanently drive unemployment down below the NAIRU – the
result would be higher inflation which in turn would eventually bring about a return to
higher unemployment but with inflation expectations increased along the way.

Friedman introduced the idea of adaptive expectations – if people see and experience
higher inflation in their everyday lives, they come to expect a higher average rate of
inflation in future time periods. And they (or the trades unions who represent them) may
then incorporate these changing expectations into their pay bargaining. Wages often
follow prices. A burst of price inflation can trigger higher pay claims, rising labour costs
and ultimately higher prices for the goods and services we need and want to buy.

This is illustrated in the next diagram – inflation expectations are higher for SPRC2. The
result may be that higher unemployment is required to keep inflation at a certain target
level.

652
1
The expectations-augmented Phillips Curve argues that attempts by the government to
reduce unemployment below the natural rate of unemployment by boosting aggregate
demand will have little success in the long run. The effect is merely to create higher
inflation and with it an increase in inflation expectations. The Monetarist school believes
that inflation is best controlled through tight control of money and credit. Credible
policies to keep on top of inflation can also have the beneficial effect of reducing
inflation expectations – causing a downward shift in the Phillips Curve.

The long run Phillips Curve

653
1
The long run Phillips Curve is normally drawn as vertical – but the long run curve can
shift inwards over time

An inward shift in the long run Phillips Curve might be brought about by supply-side
improvements to the economy – and in particular a reduction in the natural rate of
unemployment. For example labour market reforms might be successful in reducing
frictional and structural unemployment – perhaps because of improved incentives to find
work or gains in the human capital of the workforce that improves the occupational
mobility of labour.

What has happened to the inflation-unemployment trade off for the UK?

The disappearing Phillips Curve

Conventional economic wisdom suggests that rising real GDP growth and falling
unemployment will lead to higher inflation and, furthermore, that any attempt to hold
activity above its sustainable long-run level indefinitely is likely to result in inflation
accelerating. But, over the last decade, inflation has been both subdued and stable, while
the unemployment rate has fallen. Any positive relationship between economic activity
and inflation has all but disappeared.
Charles Bean, Chief Economist of the Bank of England, speech given in November 2004

654
1
The evidence is that the supposed trade-off for the UK has improved over the last ten to
fifteen years. Indeed since the early 1990s, Britain has enjoyed a long period of falling
unemployment and stable, low inflation. The next table provides some supporting data
for this view.

Factors that might explain the improved trade-off

No single factor on its own is sufficient to explain the changing (or improving) trade-off.
Some of the key ones are highlighted and explained below:

1. The flexibility of the UK labour market - A more flexible labour market has
increased the size of the labour supply and a reduction in trade union power has
reduced the collective bargaining power of many workers. Falling long-term
unemployment is a sign of a reduction in structural unemployment rates. We can
be pretty certain that the NAIRU (the non accelerating inflation rate of
unemployment) has come down. Although the NAIRU is not something we can
observe and measure directly, it is estimated that the NAIRU has fallen from
nearly 10% of the labour force in 1992 to around 5% in the last few years.
2. Benefits of immigration – although the precise effects of the economic effects of
labour migration are very hard to quantify with any accuracy, a rise in the size of
655
1
 inward migration, from the ten EU accession countries and elsewhere, may have
helped to relieve labour shortages in some sectors of the economy and therefore
help to control upward pressures on wage inflation.
3. The effect of credible inflation targets: The use of inflation targets which were
introduced in1992 has helped to reduce inflation expectations. For Britain, the
adoption of inflation targets has been an important step in establishing a credible
monetary policy framework as a way of “embedding” low-inflation in the British
economy.
4. Low inflation in the global economy: External economic factors are important
too! For a decade or more, cost and price inflation in many parts of the global
economy has been on a downward path. Indeed the buzz word has been the threat
of deflation in many developed countries. The rapid advance of globalization has
increased the intensity of competition between nations and reduced the prices of
many imported products. The pricing power of manufacturing businesses in a
huge number of international markets has been greatly diminished by the
pressures of globalisation. It has become much harder to make price increases
“stick” when there so many competing suppliers in different countries.
5. Technological change and innovation has raised labour productivity and cut
production costs across many different industries. This fundamental change in the
supply-side of the British and international economy has been a key factor
keeping inflation low even though unemployment has been falling.
6. Increased competition in domestic and international markets – the British
economy has been affected greatly by the process of deregulation in many
domestic markets and by the increased competitive pressures that come from the
globalisation of the world economy. There is strong evidence that shifts in
comparative advantage may have worked in our favour in recent years. According
to research from the Bank of England, the international terms of trade – that is
the price of the goods and services we export relative to the price of those we
import – has moved in Britain’s favour. That means that if the earnings of people
in work were merely to rise in line with the price of UK output, the purchasing
power of UK workers – who buy imported goods as well as goods produced here
– would nevertheless be rising. That in turn has reduced the pressure for higher
wages. This is known as the real-product wage effect. Cheaper imports increase
the real purchasing power of the wages earned by people living and working in
the UK.

Why does a change in the Phillips Curve / NAIRU matter?

Our focus here is the possible consequences for the operation of government
macroeconomic policy.

Setting interest rates: Firstly a reduction in the NAIRU will have implications for the
setting of short term interest rates by the Monetary Policy Committee. If they believe that
the labour market can operate with a lower rate of unemployment without the economy

656
1
risking a big rise in inflation, then the Bank of England may be prepared to run their
monetary policy with a lower rate of interest for longer. This has knock-on effects for the
growth of aggregate demand as lower interest rates work their way through the
transmission mechanism.

Forecasts for economic growth: Secondly the trade-off between unemployment and
inflation affects forecasts for how fast the economy can comfortably grow over the
medium term. This information is a vital for the government when it is deciding on its
key fiscal policy decisions. For example how much they can afford to spend on the major
public services education, health, transport and defence. Forecast growth affects their
expected tax revenues which together with government spending plans then determine
how much the government may have to borrow (the budget deficit).

Key Points

 The potential for a short run trade off between unemployment and inflation
continues to exist! If aggregate demand is allowed to grow well above an
economy’s potential output, then unemployment will fall but there is a risk of
rising inflation

657
1
  Changes in inflation expectations alter the position of the short run Phillips Curve
in the x-y axis space – a fall in expectations of inflation causes a downward shift
of the SRPC
 Monetary policy is probably most influential in affecting expectations of inflation
– the success of the BoE since 1997 has influenced the unemployment-inflation
trade off for the UK. Low global inflation rates have also had the effect of
reducing inflation expectations.
 Supply side policies that raise productivity and increase potential output can help
to cause an inward shift in the long run Phillips Curve
 There has been a fall in the NAIRU in the UK over the last fifteen years because
of a decline in the equilibrium rate of unemployment
 By most estimates, the UK has a lower NAIRU than most of the twelve countries
inside the single currency (Euro Zone). The NAIRU is probably around 5% of the
labour force
 Although unemployment has remained low, some external factors have kept
inflationary pressures in check (including the strong exchange rate and falling
commodity prices)

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Causes of Inflation

The basic causes of inflation were covered at AS level. This note considers the demand and supply-
side courses in more detail including the impact of changes in the exchange rate and the prices of
goods and services in the international economy.

Cost Push Inflation

Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in
order to maintain their profit margins. There are many reasons why costs might rise:

Rising imported raw materials costs perhaps caused by inflation in countries that are heavily
dependent on exports of these commodities or alternatively by a fall in the value of the pound in the
foreign exchange markets which increases the UK price of imported inputs. A good example of cost
push inflation was the decision by British Gas and other energy suppliers to raise substantially the
prices for gas and electricity that it charges to domestic and industrial consumers at various points
during 2005 and 2006.

Rising labour costs - caused by wage increases which exceed any improvement in productivity.
This cause is important in those industries which are ‘labour-intensive’. Firms may decide not to
pass these higher costs onto their customers (they may be able to achieve some cost savings in other
areas of the business) but in the long run, wage inflation tends to move closely with price inflation

658
1
because there are limits to the extent to which any business can absorb higher wage expenses.

Higher indirect taxes imposed by the government – for example a rise in the rate of excise duty
on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value
Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied
on producers (suppliers) who, depending on the price elasticity of demand and supply for their
products, can opt to pass on the burden of the tax onto consumers. For example, if the government
was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push
inflation.

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve.
This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of real
national output together with a rise in the general level of prices.

Demand Pull Inflation

Demand-pull inflation is likely when there is full employment of resources and when SRAS is
inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise
for a number of reasons – some of which occur together at the same moment of the economic cycle

 A depreciation of the exchange rate, which has the effect of increasing the price of

659
1
 imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while
foreigners buy more exports, AD will rise. If the economy is already at full employment,
prices are pulled upwards.
 A reduction in direct or indirect taxation. If direct taxes are reduced consumers have
more real disposable income causing demand to rise. A reduction in indirect taxes will
mean that a given amount of income will now buy a greater real volume of goods and
services. Both factors can take aggregate demand and real GDP higher and beyond potential
GDP.
 The rapid growth of the money supply – perhaps as a consequence of increased bank and
building society borrowing if interest rates are low. Monetarist economists believe that the
root causes of inflation are monetary – in particular when the monetary authorities permit an
excessive growth of the supply of money in circulation beyond that needed to finance the
volume of transactions produced in the economy.
 Rising consumer confidence and an increase in the rate of growth of house prices –
both of which would lead to an increase in total household demand for goods and services
 Faster economic growth in other countries – providing a boost to UK exports overseas.

The effects of an increase in AD on the price level can be shown in the next two diagrams. Higher
prices following an increase in demand lead to higher output and profits for those businesses where
660
1
demand is growing. The impact on prices is greatest when SRAS is inelastic.

In the first diagram the SRAS curve is drawn as non-linear. In the second, the macroeconomic
equilibrium following an outward shift of AD takes the economy beyond the equilibrium at
potential GDP. This causes an inflationary gap to appear which then triggers higher wage and
other factor costs. The effect of this is to cause an inward shift of SRAS taking real national output
back towards a macroeconomic equilibrium at Yfc but with the general price level higher than it
was before.

The wage price spiral – “expectations-induced inflation”

Rising expectations of inflation can often be self-fulfilling. If people expect prices to continue
rising, they are unlikely to accept pay rises less than their expected inflation rate because they want
to protect the real purchasing power of their incomes. For example a booming economy might see a
rise in inflation from 3% to 5% due to an excess of AD. Workers will seek to negotiate higher
wages and there is then a danger that this will trigger a ‘wage-price spiral’ that then requires the
introduction of deflationary policies such as higher interest rates or an increase in direct taxation.

Inflation influences in the British economy

661
1
The diagram summarises some of the key influences on inflation. Reading from left to right:

o Average earnings comprise basic pay + income from overtime payments, productivity
bonuses, profit-related pay and other supplements to earned income
o Productivity measures output per person employed, or output per person hour. A rise in
productivity helps to keep unit costs down. However, if earnings to people in work are rising
faster than productivity, then unit labour costs will increase
o The growth of unit labour costs is a key determinant of inflation in the medium term.
Additional pressure on prices comes from higher import prices, commodity prices (e.g. oil,
copper and aluminium) and also the impact of indirect taxes such as VAT and excise duties.
o Prices also increase when businesses decide to increase their profit margins. They are more
likely to do this during the upswing phase of the economic cycle.

662
1
Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Deflation

Increasing attention is now being placed on deflationary pressures in modern economies.

What causes deflation and why are economists and policy-makers concerned about it?

What is deflation?

Deflation is defined as a period when the general price level falls. It is normally
associated with falling level of AD leading to a negative output gap where actual GDP <

663
1
potential GDP. But deflation can also be caused by an increase in a nation’s productive
potential which leads to an excess of aggregate supply over demand. We will look at
perhaps the most prominent example of a country that has suffered deflation – Japan’s
deflationary spiral – a little later in this note.

664
1
Possible Economic Costs of Deflation

1. Holding back on spending: Consumers may opt to postpone consumption if they

expect prices to fall further in the future
2. Debts increase: The real value of household, corporate and government debt rises
when the price level is falling – another factor that might cause people to cut back
on their spending
3. The real cost of borrowing increases: Real interest rates will rise if nominal
rates of interest do not fall in line with prices – another factor driving spending
lower
4. Lower profit margins: Company profit margins come under pressure unless
costs fall further than final prices to consumers – this can lead to higher
unemployment as firms seek to reduce their costs. Weaker profit margins can also
have a negative effect on stock markets because of a fall in expected profits and
dividends to shareholders
5. Confidence and saving: Falling asset prices such as price deflation in the housing
market hit personal sector financial wealth and confidence – leading to further
declines in AD and a rise in precautionary savings (the average and marginal
propensity to save will tend to rise)

“Deflation is a sustained period over which the general price level is falling. But just as
there are many different strains of influenza, some of them lethal, and some of them

665
1
producing just temporary discomfort, so it is with deflation. And just as a bad cold may
generate 'flu-like symptoms, so economies may exhibit some of the symptoms of
deflation without suffering from the virus.”
Charles Bean, Bank of England Chief Economist, October 2002

Difference between Benign and Malign Deflation

Deflation is not necessarily bad! If falling prices are caused by higher productivity, as
happened in the late 19th century, then it can go hand in hand with robust growth. On the
other hand, if deflation reflects a slump in demand and excess capacity, it can be
dangerous, as it was in the 1930s, triggering a downward spiral of demand and prices. If
the falling prices are simply the result of improving technology or better managerial
practices, that is fine. Consider what has happened to the costs of transport and
telecommunications over the years.

Today we have something of that benign deflation. When you make a telephone call to
the United States for 3p a minute or fly on a low cost airline to European destinations for
less than £30, the consumer is getting the benefit of technology and increased
competition in the form of lower prices leading to an improvement in economic welfare!

Malign Deflation

Malign deflation occurs when prices fall because of a structural lack of demand which
creates huge excess capacity in an economic system. If there is a slump in demand,
companies go out of business and sack people, and hence demand falls again – the
negative multiplier effect starts to have its effect.

The Situation in the UK

Although there has been genuine deflation in several industries within the UK over the
last few years, notably in textiles and clothing, audio-visual equipment and airline
transport, the economy as a whole has experienced low but positive inflation as measured
by the consumer price index. The risks of deflation are mitigated by the symmetrical
inflation target given to the Bank of England – recognition that deflation can be as
costly and dangerous to the health of the British economy as a sharp acceleration in
inflation. The Bank of England stands ready to boost aggregate demand through interest
rate cuts if there is a serious threat of inflation under-shooting the target. Another factor
to consider is that inflationary expectations in Britain remain positive at or around 2.5%
per year – people do not yet consider outright deflation to be a probably outcome for the
economy.

Low and stable inflation which does not affect the day to day decisions of businesses and
consumers is known as price stability.

666
1
Can economic policy reduce the risk of deflation?

Monetary Policy

Cuts in interest rates can be made to stimulate the demand for money and thereby boos
consumption. But this is not always an effective strategy for reducing the risks of
deflation:

1. If consumer confidence is low, the impact of a monetary stimulus might be small

as people are more likely to save any increment to their income perhaps to enable
them to pay off some of their accumulated debt
2. If asset prices are falling, the demand for cash savings will remain high –
therefore consumption may not respond to lower interest rates
3. There are limits to how far monetary policy can go in boosting demand because
nominal interest rates cannot fall below zero

When cuts in interest rates have little or no impact on demand, then the economy is said
to be experiencing a liquidity trap. When interest rates are close to zero, people may
667
1
expect little or no real rate of return on their financial investments, they may choose
instead simply to hoard cash rather than investing it. If monetary policy is therefore
ineffective in stimulating demand, the solution may be to use fiscal policy as a means of
kick-starting demand and output.

One possible solution is to seek to “monetise the economy” by large scale buy-backs of
government debt by the central bank to inject cash or liquidity into the economy. This
was an option considered by the Japanese government during their deflationary recession
in the late 1990s.

Fiscal Policy

A fiscal expansion of AD can come directly through higher government spending and/or
an increase in public sector borrowing. Secondly the threat of deflation might be reduced
through lower direct taxes to boost household disposable incomes. Both of these
strategies seek to boost incomes and inject extra spending power into the circular flow of
income and spending. The tax cuts might be announced as temporary to deal with a
specific deflationary threat. But again there may be some limits to the effectiveness of
fiscal policy in these circumstances:

1. There are consequences for national debt and the interest payments on this debt if
the fiscal expansion package is too large. The government might end up providing
a short term boost to demand, but have to cope with a significant increase in debt
repayments in future years
2. Low consumer and business confidence might again reduce the impact of any
fiscal stimulus
3. Lower taxes and higher public spending might stoke up some inflationary
pressure if too much stimulus is applied for too long (once the economy starts to
recover)
4. If tax cuts or public-works programmes are seen as temporary, while confidence
is low, then extra incomes tend to be used to re-paying debt or restoring savings.
Households may see this as their priority, rather than fuelling increases in
consumption

668
1
The risks of deflation for the UK are fairly small. We must be careful to make a
distinction between disinflation in industries due to technological change, excess supply,
regulatory intervention or productivity improvements – such as in telecommunications,
motor vehicles and audio-visual equipment, and deflation across the whole economy
which in theory poses much greater risks. Providing that economic policy-makers are
alert to the possible causes of genuine deflation, and respond at the right time when those
risks are clear, then they should have enough flexibility in their monetary and fiscal
policy armouries to counter the threat posed by deflation.

Suggestions for further reading and research

Consumers enjoy falling prices (Evan Davis, BBC)
Japan price rise means end to deflation (BBC) see also “Japan scraps zero interest rates”

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Government Macroeconomic Policy

669
1
A central issue in macroeconomics is whether or not markets, left alone, automatically
bring about long run economic equilibrium. If the free operation of market forces
eventually resulted in a full employment level of national income with stable prices and
economic growth, there would be no need for government intervention in the macro
economy - no need for fiscal monetary exchange rate and supply side policies. The reality
is that all governments intervene through their macroeconomic policies in a bid to
achieve certain policy objectives and improve the performance of the economy.

Targets, instruments and goals of macroeconomic policy

Policy goals are the ultimate aims, challenges and objectives of macroeconomic policy.
The main policy goals of the current government are listed below:

o Sustained economic growth

o High employment
o Stable prices (low inflation)
o A rise in average living standards
o Sustainable position on the balance of payments

670
1
Policy Instruments

Policy instruments are the main options available to a government for managing the
economy. There are broadly speaking three main policy groups:

Fiscal Policy
Fiscal policy involves changes in the composition and level of government spending,
taxation and borrowing to influence both the pattern of economic activity and also the
level and growth of aggregate demand, output and employment.

Monetary Policy
Monetary policy involves the use of changes in interest rates to control the level and rate
of growth of aggregate demand in the economy mainly by changing the cost of borrowing
money, influencing the rate of return on savings and thereby changing the overall demand
for and supply of money
Monetary policy also involves the effects of changes in the exchange rate – the external
value of one currency against another – on the wider economy. The government (through
the central bank) may choose to intervene in the foreign exchange market to influence the
value of one currency against another

671
1
Supply-side Policies
Supply-side economic policies are mainly micro-economic policies designed to improve
the supply-side potential of an economy, make markets and industries operate more
efficiently and thereby contribute to a faster rate of growth of real national output.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Exchange Rate

We now turn to focus to the effects of exchange rates on the macroeconomy and in
particular to the economics of fixed versus floating exchange rate systems as part of the
operation of macroeconomic policy in a country.

672
1
Measuring the exchange rate

Exchange rate prices are expressed in various ways:

o Spot Exchange Rate - the spot rate is the actual exchange rate for a currency at
current market prices. This is determined by the FOREX market on a minute-by-
minute basis on the basis of the flow of supply and demand for any one particular
currency.
o Forward Exchange Rate - a forward rate involves the delivery of currency at
some time in the future at an agreed rate. Companies wanting to reduce the risk of
exchange rate uncertainty by buying their currency ‘forward’ on the market often
use this.
o Bi-lateral Exchange Rate - this is simply the rate at which one currency can be
traded against another. Examples include:
o $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro
o Effective Exchange Rate Index (EER) - the EER is a weighted index of
sterling's value against a basket of international currencies the weights used are
determined by the proportion of trade between the UK and each country
o Real Exchange Rate - this measure is the ratio of domestic price indices between
two countries. A rise in the real exchange rate implies a worsening of
international competitiveness for a country.

Exchange rate systems

System Main Characteristics Recent UK History

Free
Floating The value of the pound is determined Rare for pure free floating to exist
Exchange purely by market demand and supply of Sterling has floated freely on the
Rate the currency foreign exchange markets since
Both trade flows and capital flows affect the UK suspended membership of
the exchange rate under a floating system the ERM in September 1992
No target for the exchange rate is set by The Bank of England has not
the Government intervened officially in the markets
There is no need for official intervention to influence the pound’s value
in the currency market by the central since it became independent
bank
Managed Governments normally engage in
Floating The value of the pound determined by managed floating if not part of a
Exchange market demand for and supply of the fixed exchange rate system.
Rate currency

673
1
 Central banks may to try to iron out big
changes in exchange rates on a day-to-
day basis Managed floating was a policy
Some currency market intervention pursued from 1973-1990
might be considered as part of macro-
economic demand management (e.g. a
desire for a slightly lower currency to
boost export demand or the desire for a
strong currency to control inflationary
pressures)
Semi-Fixed
Exchange The exchange rate is given a specific The last time the UK operated a
Rates target semi-fixed system was during
The currency can move between October 1990 - September 1992
permitted bands of fluctuation on a day- the period of the UK’s short-lived
to-day basis period of ERM membership
Exchange rate becomes an target of Sterling was allowed to vary
economic policy-making (interest rates between 6% either side of DM2.95
are set to meet the exchange rate target) Sterling eventually forced out of
The Bank of England might have to the ERM by a wave of speculative
intervene to maintain the value of the selling
currency within the set targets if it moves
outside the agreed range
Re-valuations are seen as a last resort
Fully-Fixed
Exchange The government makes a commitment to The Bretton Woods System which
Rates a fixed exchange rate lasted from 1944-1972 was a fixed
The exchange rate is pegged rate system where currencies were
There are no fluctuations from the tied to the US dollar
central rate Gold Standard in the inter-war
System achieves exchange rate stability years – with currencies linked to
but perhaps at the expense of domestic gold
stability Countries joining EMU fixed their
A country can automatically improve its exchange rates until 1st Jan 2002
competitiveness by reducing its costs when the Euro came into common
below that of other countries – knowing circulation
that the exchange rate will remain stable

Fixed versus floating exchange rates – which is best for an economy?

Each country must decide on the most appropriate currency regime or system. There is an
ongoing debate in economics about the merits and de-merits of fixed versus floating
exchange rates.
674
1
  1973-1990: UK operated with a managed floating exchange rate. There was some
intervention by the central bank to influence the exchange rate and government
was in control of interest rates
 October 1990- September 1992: UK a member of the European exchange rate
mechanism (ERM) – the exchange rate was a specific target of economic policy.
Interest rates had to be set at a level consistent with keeping sterling within the
agreed ERM bands (limits)

 September 1992 – present day: the UK has operated with a free-floating

exchange rate – no intervention by the Bank of England. Exchange rate is purely
market determined. Since 1999, the Euro has been in existence as twelve nations
have established a single currency. Sterling floats freely against the Euro and also
against the dollar, yen etc.

The case for floating exchange rates:

The main arguments for adopting a floating exchange rate system are as follows:

1. Reduced need for currency reserves: There is no exchange rate target so there is
little requirement for the central bank (e.g. the Bank of England) to hold large

675
1
 scale reserves of gold and foreign currency to use in possible official intervention
in the markets
2. Useful instrument of macroeconomic adjustment: A floating rate can act as a
useful tool of macroeconomic adjustment – for example depreciation should
provide a boost to net export demand and therefore stimulate growth. This
assumes that the gains from a lower exchange rate are not dissolved in higher
wage claims or export prices. The countries inside the Euro Zone for example
might be hoping for a more competitive exchange rate as a means of creating an
injection of demand into their slow-growing economies.
3. Partial automatic correction for a trade deficit: Floating exchange rates offer a
degree of adjustment when the balance of payments is in fundamental
disequilibrium – i.e. a large trade deficit puts downward pressure on the exchange
rate which should help the export sector and control demand for imports because
they become relatively expensive
4. Reduced risk of currency speculation: The absence of an explicit exchange rate
target reduces the risk of currency speculation. Often, currency market speculators
target an exchange rate target that they believe to be fundamentally over or
undervalued.
5. Freedom (autonomy) for domestic monetary policy: The absence of an
exchange rate target allows short term interest rates to be set to meet domestic
macroeconomic objectives such as stabilising growth or controlling inflation. The
Bank of England has enjoyed the autonomy that a floating exchange rate gives
since it was made independent in May 1997.
6. Floating exchange rates are not always volatile exchange rates - although the
sterling exchange rate has been floating, the volatility has not been that great.
Businesses have learnt to cope with modest fluctuations – helped by having a
flexible labour market.

676
1
The Case for Fixed Exchange Rates

The main arguments for adopting a fixed exchange rate system are as follows:

1. Trade and Investment: Currency stability can help to promote trade and
investment because of lower currency risk – this is one of the reasons why
currencies were locked within the Euro Zone in preparation for the launch of the
Euro.
2. Some flexibility permitted: Some adjustment to the fixed currency parity is
possible if the economic case becomes unstoppable (i.e. the occasional
devaluation or revaluation of the currency if agreement can be reached with other
countries). That said, countries with fixed exchange rates are often reluctant to
make parity adjustments – these decisions are often see as politically damaging.
3. Reductions in the costs of currency hedging: Because we can never predict
what will happen to the market value of a currency, many businesses hedge
against this volatility by buying the currency they need in the forward currency
markets. With fixed exchange rates, businesses have to spend less on currency
hedging if they know that the currency will hold its value in the foreign exchange
markets (hedging involves risk)
4. Disciplines on domestic producers: A stable (fixed) currency acts as a discipline
on producers to keep their costs and prices down and may lead to greater pressure
677
1
 for exporters to raise labour productivity and focus more resources on research
and innovation. In the long run, with a fixed exchange rate, one country’s
inflation must fall into line with another (and thus put substantial competitive
pressures on prices and real wages)
5. Reinforcing gains in comparative advantage: If one country has a fixed
exchange rate with another, then differences in relative unit labour costs will quite
easily be reflected in changes in the rate of growth of exports and imports.
Consider the example of China and the United States. China has a $100 billion
trade surplus with the United States and it has also fixed its exchange rate against
the US dollar. The pegged exchange rate between the Yuan and the dollar has
been in place for several years. Most estimates indicate that the Chinese currency
is undervalued against the dollar. This makes Chinese products cheaper than they
would otherwise be and has led to a surge in import penetration from China into
the US economy. This has led to numerous calls from US manufacturers for the
Chinese to be persuaded to switch to a floating exchange rate or to adjust their
currency by appreciating against the dollar. Finally in July 2005, the Chinese
authorities did revalue their currency against the dollar and announced a new
policy of allowing the Yuan to move against a basket of currencies, dominated by
the dollar.

The relationship between interest rates and the exchange rate

In a floating exchange rate system relative interest rates do have an influence on the
market value of one currency against another. To understand this, consider the risks and
returns that face investors when deciding in which country to allocate their financial
investments.

If UK interest rates are relatively higher than rates on offer in the Euro Zone, then ceteris
paribus we expect to see a net inflow of currency into UK banks and other financial
institutions. The higher the interest rate differential, the greater is the incentive for funds
to flow across international boundaries and into the economy with the higher interest
rates.

Speculative flows of currency will also flow into those economies where the expected
returns on other types of investment are also higher. For example, money may flow into
the UK as investors look to put their money into property or the stock and bond markets.
Such a wall of speculative funds can have a powerful effect in the currency markets. You
could show this by drawing an outward shift in the demand for sterling, leading to an
appreciation in the value of the currency.

There are inevitable risks in shifting funds across international markets. What might
happen to the currency if you leave $200,000 worth of cash in a UK bank account? What
happens to the value of your investment if sterling depreciates against the US dollar?
What are the risks in exchanging a similar value of US dollars and putting it into the UK
stock market or into government bonds?

678
1
Investors often consider the risk-adjusted relative rate of return from different
financial investments. Thus if UK interest rates are persistently above those in other
countries, and the risks are pretty similar, then we would expect to see a rising demand
for sterling and an appreciation of the currency. Interest rates are not the only factor that
drives the external value of a currency in the foreign exchange markets – but they
undoubtedly do have some effect.

How the exchange rate influences policy objectives, such as inflation, unemployment
and the balance of payments.

For A2 economics, it is important to understand the transmission mechanism between a

change in the exchange rate and its impact on the wider macro-economy. Recent trends in
currencies and currency forecasts certainly figure prominently in the assessment of
economic conditions made each month by the Monetary Policy Committee, although the
Bank does not formally target the exchange rate since the UK operates with a floating
exchange rate system.

Time lags of exchange rate changes

For evaluation, remember that the macroeconomic effects of exchange rate movements
are always subject to a time lag. Research from the Bank of England suggests that the
effects take two years to feed through.

The exchange rate and inflation:

The exchange rate affects the rate of inflation in a number of direct and indirect ways:

 Changes in the prices of imported goods and services – this has a direct effect
on the consumer price index. For example, an appreciation of the exchange rate
usually reduces the sterling price of imported consumer goods and durables, raw
materials and capital goods. The effect of a changing currency on the prices of
imported products will vary by type of import and also the price elasticity of
demand which is influenced by the extent of competition within individual
markets.
 Commodity prices and the CAP: Many internationally traded commodities are
priced in dollars – so a change in the sterling-dollar exchange rate has a direct
impact on the £ price of commodities such as oil. The operation of the Common
Agricultural Policy (CAP) can also help to absorb fluctuations in the prices of
imported foodstuffs because of the variable import tariff. If world prices rise, the
import tariff can fall to insulate the EU from the effects of higher import costs.
 Changes in the growth of UK exports – movements in the exchange rate affect
the competitiveness of UK export industries in global markets. A higher exchange
rate makes it harder to sell overseas because of a rise in relative UK prices. If
exports slowdown (price elasticity of demand is important in determining the
scale of any change in demand), then exporters may choose to cut their prices,
reduce output and cut-back employment levels. A fall in export demand will

679
1
 reduce real national income relative to potential output – and thus might lead to a
negative output gap. This puts downward pressure on inflation
 The exchange rate and wage bargaining – some economists believe that the
exchange rate influences the power of employees to bargain for increases in real
wages. When the exchange rate is high, there is pressure on businesses to control
their costs of production in order to remain competitive – this may lead to
downward pressure on wage inflation.

Bank of England research suggests that a10% depreciation in the exchange rate can add
up to 3% to the level of consumer prices three years after the initial change in the
exchange rate.

Interest rate response:

The final effects on inflation depend also on the response of economic policies to
exchange rate movements. For example if a rising value of sterling causes inflation to
drop below target, the Monetary Policy Committee might opt to reduce short term interest
rates in order to stabilise demand and prevent the risk of price deflation.

The exchange rate and unemployment

To the extent that movements in the exchange rate affect the growth of demand, output
and investment in those sectors of the economy exposed to international trade, the rate of
unemployment can also be influenced by currency fluctuations. In broad terms:

An exchange rate appreciation tends to cause a slower rate of growth of real GDP (e.g.
because of a fall in net exports)
A reduction in demand and output may cause job losses as businesses seek to control
costs. Some job losses are temporary – reflecting short term changes in export demand
and import penetration. Others are permanent if domestic industries move out of some
export markets or if imports take up a permanently higher share of the UK market
Some industries are more exposed than others to currency fluctuations – e.g. sectors
where a high percentage of total output is exported and where demand is highly price
sensitive (price elastic)

AD-AS analysis can be used to illustrate the effects. In the first diagram, we see an
inward shift in the AD curve due to a rise in net imports and in the second diagram we
draw the effects of a reduction in production costs arising from cheaper raw material and
component prices.

Inflation

680
1
 Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Direct and Indirect Taxation

We now focus on taxation. Taxation is any compulsory levy from private sector
households and businesses to the government in the form of direct or indirect taxes.

The main objectives of the UK tax system

The current government's objectives for the British tax system are broadly as follows:

 The burden of tax: To keep the tax burden as low as possible (the burden of tax
for a country can be measured by the % of GDP taken in taxes and is shown in the
chart above)

681
1
  To improve incentives: The government believes that reducing tax rates on
income and business profits helps to sharpen incentives to work and create wealth
in the economy as a strategy to enhance long-run growth
 Tax spending rather than income: To shift the balance of taxation away from
taxes on income towards taxes on spending – this is because it is thought that
taxes on income have a greater effect on work incentives
 Equitable taxes: To ensure taxes are applied equally and fairly to everyone.
Equality is not always the same as fairness – see the notes below on the canons of
taxation
 Correct for market failure: As with many other governments in other countries,
the UK government believes in the use of taxes to make markets work better
(including taking account of externalities) – this is an important microeconomic
objective. The government is committed to using the tax system as an instrument
of correcting for market failures.

The table below shows the main sources of direct and indirect tax revenues for the UK
projected for the 2004-05 financial year. Income tax and national insurance
contributions together account for over £205 billion of government tax revenues each
year. VAT is the biggest single source of indirect tax revenue although over £40 billion
of revenue comes each year from excise duties.

682
1
Income from taxation for the UK government 1999-00 2004-05

£ billion £ billion

Income tax 95.7 127.2

National Insurance contributions 56.1 78.1

VAT 56.4 73.0

Corporation tax 34.3 34.1

Fuel duties 22.5 23.3

Council Tax 13.1 20.1

Business rates 15.4 18.7

Other taxes 8.1 11.7

Stamp duties 6.9 9.0

Tobacco duty 5.7 8.1

Vehicle excise duty 4.9 4.7

Beer & cider duties 3.0 3.3

Inheritance tax 2.1 2.9

Spirits duties 1.8 2.4

Insurance Premium tax 1.4 2.4

Capital gains tax 2.1 2.3

Wine duties 1.7 2.2

Customs Duties & levies 2.0 2.2

683
1
Betting & Gaming duties 1.5 1.4

Petroleum revenue tax 0.9 1.3

Air Passenger duty 0.9 0.9

Climate Change Levy 0.0 0.8

Land fill tax 0.4 0.7

Aggregates levy 0.0 0.3

Oil royalties 0.4 0.0

What are the principles of a good tax system?

If you were creating a new tax system from scratch, what would be the main principles
on which your system might be based? One set of principles known as the canons of
taxation was developed by classical economist Adam Smith in his famous work on the
‘Wealth of Nations’ published in the late 18th century. When you are asked to discuss the
justification for different forms of taxation, it is often worth coming back to these
principles when evaluating the relative merits and de-merits of alternative forms of
taxation

 Efficiency - an efficient tax system raises sufficient revenue to pay for

government spending, without creating negative distortions such as reducing
work-incentives for individuals and investment incentives for companies
 Equity – the principle of equity is that taxes should be fair and based on people's
‘ability to pay’. Income tax satisfies this condition because it is a progressive tax
system, the marginal and average rate of tax rises with income – but some indirect
taxes may not – for example the duty on cigarettes is said to have a regressive
effect on the overall distribution of income
 The ‘benefit principle of taxation’ – this principle is that taxes paid by people
have a link with the benefit that the person paying the tax actually receives from
government spending. However, there are some problems with too much
emphasis on the benefit principle. Firstly if ignores the redistributive aims of
taxation. For example, the government might introduce a new tax or raise an
existing one with purely redistributive aims in mind i.e. a desire to reduce relative
poverty. The benefit principle is mainly concerned with allocative efficiency
rather than equity. A second problem is that the benefit principle assumes correct
revelation of preferences by consumers – whereas in reality many consumers do
not have to pay for the public goods and services provided for them (consider the
684
1
 ‘free rider problem’). It is also difficult for the government to assess individual
benefits from public goods.
 Transparency and certainty - taxpayers should understand how the system
works and should be able to plan their tax affairs with a reasonably degree of
certainty. Taxes should also be difficult to evade – we know that in many
countries there is a fast-growing industry that provides information to people on
how to reduce their tax liabilities. Collection costs should be kept to an acceptable
level so that the costs of collection are very low relative to the total tax revenues
collected.

The progressivity of the income tax system in the UK

To what extent does the income tax system work to reduce the gap between the highest
and lowest paid households in the UK? In a progressive tax system the average rate of tax
rises with income. And we see from the table below that income tax is indeed progressive
in its effects on disposable income. The average rate of tax rises from around 5% on
incomes between £7,500 - £9,999 to three times for people in the £20-£30k income
bracket. For people earning over £50,000 per year, over a quarter of their income is paid
directly in income tax.

But the system is not as progressive as it might be and as it was over twenty years ago.
The extent of the "progressivity" of the income tax system has been reduced over the
years. Before 1979, the top rate of income tax was 83 per cent, with a 15 per cent
supplement for investment income. Now most taxpayers face a similar marginal tax rate
of 22% compared with a top rate of 40 per cent but on top of the basic rate there is
national insurance contributions (NICs) at 11 per cent and 1 per cent extra on NICs for
higher earners, making the overall rates 33 per cent, and 41 per cent. This is not such a
great progression. If a government wanted to use the income tax system to achieve a
more even final distribution of income, it could

 Raise the top rate of income tax above 40%

 Increase the tax free allowance for people
 Introduce lower marginal rates of tax for lower-income households

Income tax payable: by annual income, in

2005/06

Number of Total tax Average Average

taxpayers liability rate of tax amount
(millions) (£ million) (percentages) of tax
(£)

£4,895–£4,999 0.1 1 0.1 5

685
1
£5,000–£7,499 2.9 369 2.0 126

£7,500–£9,999 3.5 1,580 5.1 445

£10,000–£14,999 6.1 7,560 9.8 1,220

£15,000–£19,999 5.1 11,500 13.0 2,260

£20,000–£29,999 6.4 24,000 15.4 3,760

£30,000–£49,999 4.3 28,900 17.9 6,690

£50,000–£99,999 1.5 25,900 25.7 17,000

£100,000 and over 0.5 34,200 33.4 71,100

All incomes 30.5 134,000 18.2 4,390

Source: Social Trends 36, ONS

The easiest thing to do would be to increase the higher rate of income tax but this might
create incentive problems in the labour market.

Direct versus Indirect Taxation

o Direct taxes – are paid directly to the Exchequer by the individual taxpayer –
usually through “pay as you earn”. The same is true of corporation tax. Tax
liability cannot be passed onto someone else
o Indirect taxes – include VAT and a range of excise duties on oil, tobacco,
alcohol. The burden of an indirect tax can be passed on by the supplier to the final
consumer – depending on the price elasticity of demand and supply for the
product.

In the last twenty years there has been a shift towards indirect taxation – economists
differ in their views about what is the optimum mix of taxation between indirect and
direct taxes

Arguments For Using Indirect Taxation Arguments Against Using Indirect

Taxation
 Changes in indirect taxes are more  Many indirect taxes make the
effective in changing the overall distribution of income more

686
1
 pattern of demand for particular unequal (less equitable) because
goods and services i.e. in changing indirect taxes are more regressive
relative prices and thereby affecting than direct taxes
consumer demand (e.g. an increase
in the real duty on petrol)
 They are a useful instrument in  Higher indirect taxes can cause cost-
controlling and correcting for push inflation which can lead to a
externalities – all governments have rise in inflation expectations
moved towards a more frequent use
of indirect taxes as a means of
making the polluter pay and
“internalizing the external costs” of
production and consumption
 Indirect taxes are less likely to  There is no hard evidence that
distort the choices that people have cutting direct tax rates has much of
to between work and leisure and an incentive effect on people’s
therefore have less of a negative decisions about whether or not to
effect on work incentives. Higher work. If indirect taxes are too high –
indirect taxes allow a reduction in this creates an incentive to avoid
direct tax rates (e.g. lower starting taxes through “boot-legging” – a
rates of income tax) good example of this would be
attempts to evade the high levels of
duty on cigarettes
 Indirect taxes can be changed more  Revenue from indirect taxes can be
easily than direct taxes – this gives uncertain particularly when inflation
economic policy-makers more is low or there is a recession causing
flexibility when setting fiscal policy. a fall in consume spending
Direct taxes can only be changed
once a year at Budget time
 Indirect taxes are less easy to avoid  There is a potential loss of
by the final tax-payer who might be economic welfare (taxes can create a
unaware of how much indirect tax deadweight loss of consumer and
they are paying producers surplus)
 Indirect taxes provide an incentive  Higher indirect taxes affect
to save (and thereby avoid the tax)- a households on lower incomes who
higher level of savings might be used are least able to save in the first place
by the economy to finance a higher
level of capital investment
 Indirect taxes leave people free to  Many people are unaware of how
make a choice whereas direct taxes much they are paying in indirect
leave people with less of their gross taxes – this goes against one of the
income in their pockets basic principles of a good tax system
– namely that taxes should be
transparent

687
1
Flat Rate Taxes

“In the eyes of many fiscal conservatives, the flat-tax is the Holy Grail of public policy:
One low income tax rate paid by all but the poorest wage-earners, who are exempt. No
loopholes for the rich to exploit. No graduated rates that take a higher percentage of
income from people who work hard to earn more. No need for a huge bureaucracy to
police fiendishly complex tax laws.
Source, Allston Mitchell, January 2005

A ‘flat tax’ means that everyone is taxed at just one rate. I.e. everyone pays the same
percentage (%) tax on any income earned above the tax threshold (the tax-free allowance.
A similar system is often used for corporate taxes – taxes on company profits and also on
indirect taxes such as VAT.

The size of the tax free allowance is an important issue – it needs to be large enough to
persuade people to prefer paying taxes rather than avoiding them. But if it is set too high,
then the government may not get enough tax revenue to pay for government spending.
Some theorists in favour of flat taxes have suggested the countries should introduce a
large personal allowance, with the most detailed research by the Adam Smith Institute
hinted at a £12,000 personal allowance up from the current rate of £4895.

Examples of countries that have moved towards flat rate tax systems include Estonia,
Latvia, Poland, Lithuania, Russia, Slovakia and most recently, Hungary. From being a
theoretical curiosity in the lecture halls for university economics courses, flat taxes are
now being applied in different countries and there is an active debate about their merits
and demerits.

Why have flat rate taxes?

Supply-side economists are often fans of flat rate taxes because they think that they will

 Help reduce red tape and reduce the resources wasted on tax forms, chasing up
non-payers and enforcing complex tax laws. This would reduce the money spent
on administering the tax system.
 Reduce inequity (because there is the same tax rate for all) – and having a
generous tax free allowance is good news for low income families, improving
their incentives to earn extra income.
 Boost incentives for people to work, to save (e.g. for retirement) and for
companies to use profits to invest - both of which could increase the country’s
potential growth rate.
 Generate increased tax revenue – based on the idea of the Laffer Curve – that
cutting tax rates can actually boost the supply-side so much that the government
ends up with more tax revenue coming in allowing it to finance increased
spending on priority areas.

688
1
  A flat tax may make the British economy more attractive to foreign investment. In
a global economy in which investors can move freely across country borders, a
simple fiscal system attracts inward investment.
 A lower level flat rate tax on savings will positively impact the household savings
ratio and thereby have a positive impact on future economic growth. Increased
saving would help protect developed economies from threats, such as huge
pension deficits, one of the biggest structural threats to developed economies. It
can also help to provide the funds for future investment strengthening growth and
raising living standards. Currently, income tax is considered to hamper saving and
the introduction of a flat rate tax is expected increase the saving rate. The key
reason for this is the double taxation of personal savings, firstly on income and
secondly on investment income or, once on company profits then on dividends.

Arguments against

 Flat rate taxes are no longer progressive (at least as far as the 'marginal' rates are
concerned) and so the distribution of income will become more unequal –
certainly in the short and medium term.
 Flat rate taxes tend to favour the wealthy at the expense of the poor because the
wealthy are no longer taxed at high rates on their savings, their dividend incomes
and their inheritance wealth.
 Flat taxes can form part of a “race to the bottom” with governments competing
with each other to offer the lowest rates of tax to entice inward investment and
skilled workers. The result is a widening gap between the wealthy and the poor
and less revenue for the government to commit to social welfare spending.
 There is no guarantee that people will look to work more if tax rates are lower,
indeed some people may choose to work less because they can earn the same
income from working fewer hours.
 There is no guarantee that businesses will engage in more investment and R&D if
company taxes are lower – they may simply offer more in the way of dividends to
their shareholders!
 Tax reforms such as flat taxes are not the only key factor in determining flows of
foreign investment around the world economy. John Chambers CEO of Cisco
Systems has been quoted as saying that “Jobs are going to go where the best-
educated workforce is with the most competitive infrastructure and environment
for creativity and supportive government.” In addition people living in those
respective countries do not want to see a reduction in spending on their services at
the benefit of reduced taxation.

Suggestions for further reading and research

 Flat tax creator turns critic (BBC news)

 East Europeans opt for flat-rate tax (BBC news)
 Flat tax, the British case (Adam Smith Institute)

The Laffer Curve

689
1
The Laffer Curve is a theory built on the incentive effects of lower taxation which
suggests that total tax revenue coming into the government may increase at a lower tax
rate. As the tax rate further increases, the marginal revenue from lower taxes may tend to
fall at an increasing rate up to optimal tax revenues, at tax rate X. After this point, any
increase in the tax rate prompts people to work less, or to do more to avoid the tax,
thereby reducing total revenue as the opportunity cost of paying the tax rises.
Hypothetically at a 100 percent tax rate, nobody would have any incentive to work at all,
since the Government collects everything people earn. Laffer’s ultimate prediction is if
you cut taxes you can increase tax revenues and create a virtuous circle.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Pattern of International Trade

An introduction to the importance of trade for the UK within the global economic system

Open economy

The UK is an open economy and a rising share of output is exported overseas and a
growing percentage of AD is satisfied by imports of goods and services. The UK
currently is the world’s 8th largest exporter of goods and the 2nd largest exporter of
services. In terms of capital flows, Britain has the highest ratio of inward and outward
investment to GDP of any leading economy.

Over time, it is inevitable that the pattern and balance of trade in goods and services
changes, reflecting shifts in comparative advantage and movements in relative prices
of traded products in many international markets. The pattern of trade is also affected
by the economic growth and development of particular countries or regions and by the
foreign investment decisions of UK and overseas companies.

The majority of UK trade in goods and services is with our partner countries within the
European Union. There has been a long-term shift in our trade with EU since the UK
joined the EEC in January 1973. The growth of trade has been encouraged by the Single
Market which has led to trade creation and trade diversion effects.

The share of UK trade with North American countries has declined, but the United States
remains the largest single export market accounting for 15% of total UK exports. Trade
with oil exporting countries has fallen in relative importance over the last fifteen years In
1979, 10% of UK exports went to oil exporting countries, this has now declined to just
over 3% as has the share of imports from these countries.

690
1
The other significant change in the geographical pattern of trade for the UK is an
increasing share of trade with emerging economies in Asia including China, Singapore,
Malaysia, South Korea, Taiwan and Thailand. The growth of the Indian economy should
also help to boost exports to the sub-continent in the years to come, providing that UK
businesses take advantage of the export opportunities available there.

Trade profile for the United Kingdom in 2004

Population (thousands, 2004) 59 405 Ranking in world Exports Imports

trade, 2004

Merchandise 8th 5th

Commercial services 2nd 3rd

Trade to GDP ratio (2002- 53.8 %

2004)

Share in world total exports 3.79 Share in world total imports 4.88
(2004) (2004)

Exports of goods Imports of goods

By main commodity group By main commodity group

Agricultural 6.4 Agricultural products 10.3

products

Fuels and mining products 11.6 Fuels and mining products 8.6

Manufactures 80.8 Manufactures 77.9

By main destination By main origin

691
1
1. European Union 57.8 1. European Union (25) 55.4
(25)

2. United States 15.1 2. United States 9.2

3. Japan 2.0 3. China 5.7

4. Canada 1.8 4. Norway 3.3

5. 1.6 5. Japan 3.3

Switzerland

Trade in services

2004 2004

Share in world total exports 8.08 Share in world total imports 6.50

Breakdown in economy's total Breakdown in economy's total

exports imports

Transportation services 15.7 Transportation services 24.2

Travel services 15.9 Travel services 41.0

Other commercial services 68.4 Other commercial services 34.8

692
1
Although the UK is now a net importer of manufactured goods (our last trade surplus
in manufactured products was achieved in 1983), in several industries, the UK retains a
significant position in international markets and we achieve a trade surplus in power
generating equipment, pharmaceuticals, telecoms equipment and scientific instruments
and other items of specialized machinery.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Trade & Development - Introduction

Trade has often been viewed as an integral part of economic development for poorer
countries. But the merits and de-merits of different trade policies for developing
countries remains a controversial issue.

Trade and growth

693
1
During the 1990s, the annual growth of GDP for the developing countries as a whole
increased to 4.3 per cent from 2.7% in the 1980s, and some of this acceleration in
economic growth is attributed to the success of a number of countries in liberalising their
economies, becoming more open to global trade and successfully competing and
integrating with the rest of the global economy.

Global trade expanded rapidly during the 1990s with global exports growing at an
average rate of 6.4 per cent, reaching $6.3 trillion in 2000. Trade in manufactured goods
and in services has continued to grow at rates far in excess of national output implying an
increased dependency on trade for countries rich and poor.

Trade in manufactured goods has risen by a huge amount in the last ten years and the
share of manufactured exports taken up by developing countries has continued to rise
reflecting their increasing success in building up manufacturing production and export
capacity. Despite this change, many of the world’s poorest countries remain partially
dependent on exports of primary commodities and therefore vulnerable to price volatility
in world markets.

In 2004 global merchandise trade amounted to $8.9 trillion with $6.6 trillion accounted
for by manufacturing and $783 billion of agricultural products. The remainder is taken up
by fuels and mining products. $2.1 trillion worth of commercial services were exported
around the world economy in 2004.

World trade in goods

Rank Exporters Value Share Rank Importers Value Share

$ bn $ bn

1 Germany 912.3 10.0 1 United States 1525.5 16.1

2 United States 818.8 8.9 2 Germany 716.9 7.6

3 China 593.3 6.5 3 China 561.2 5.9

4 Japan 565.8 6.2 4 France 465.5 4.9

5 France 448.7 4.9 5 United Kingdom 463.5 4.9

6 Netherlands 358.2 3.9 6 Japan 454.5 4.8

7 Italy 349.2 3.8 7 Italy 351.0 3.7

8 United Kingdom 346.9 3.8 8 Netherlands 319.3 3.4

694
1
9 Canada 316.5 3.5 9 Belgium 285.5 3.0

10 Belgium 306.5 3.3 10 Canada 279.8 2.9

11 Hong Kong, China 265.5 2.9 11 Hong Kong, China 272.9 2.9

12 Korea, Republic of 253.8 2.8 12 Spain 249.3 2.6

13 Mexico 189.1 2.1 13 Korea, Republic of 224.5 2.4

14 Russian Federation 183.5 2.0 14 Mexico 206.4 2.2

15 Taipei, Chinese 182.4 2.0 15 Taipei, Chinese 168.4 1.8

16 Singapore 179.6 2.0 16 Singapore 163.9 1.7

17 Spain 178.6 2.0 17 Austria 117.8 1.2

18 Malaysia 126.5 1.4 18 Switzerland 111.6 1.2

19 Saudi Arabia 126.2 1.4 19 Australia 109.4 1.2

20 Sweden 122.5 1.3 20 Malaysia 105.3 1.1

Source: World Trade Organisation, world trade statistics 2005 edition

World trade in services

Rank Exporters Value Share Rank Importers Value Share

$ bn % $ bn %

1 United States 318.3 15.0 1 United States 260.0 12.4

2 United Kingdom 171.8 8.1 2 Germany 193.0 9.2

3 Germany 133.9 6.3 3 United Kingdom 136.1 6.5

4 France 109.5 5.1 4 Japan 134.0 6.4

695
1
 5 Japan 94.9 4.5 5 France 96.4 4.6

6 Spain 84.5 4.0 6 Italy 80.6 3.8

7 Italy 82.0 3.9 7 Netherlands 72.4 3.5

8 Netherlands 73.0 3.4 8 China 71.6 3.4

9 China 62.1 2.9 9 Ireland 58.4 2.8

10 Hong Kong, China 53.6 2.5 10 Canada 55.9 2.7

11 Belgium 49.3 2.3 11 Spain 53.7 2.6

12 Austria 48.3 2.3 12 Korea, Republic of 49.6 2.4

13 Ireland 46.9 2.2 13 Belgium 48.3 2.3

14 Canada 46.8 2.2 14 Austria 47.1 2.2

15 Korea, Republic of 40.0 1.9 15 India 40.9 2.0

16 India 39.6 1.9 16 Singapore 36.2 1.7

17 Sweden 37.8 1.8 17 Denmark 33.4 1.6

18 Switzerland 36.8 1.7 18 Sweden 33.0 1.6

19 Singapore 36.5 1.7 19 Russian Federation 32.8 1.6

20 Denmark 36.3 1.7 20 Taipei, Chinese 29.9 1.4

Source: World Trade Organisation, world trade statistics 2005 edition

The geographical distribution of trade in goods Value Share of world trade

2004 1990 2000

696
1
 $ bn % %

World 8907 100.0 100.0

North America 1324 16.6 19.5

United States 819 11.6 12.5

South and Central America 276 3.1 3.1

Brazil 96 0.9 0.9

Europe 4031 - 42.0

European Union (25 countries) 3714 - 38.9

Commonwealth of Independent States (CIS) 266 - 2.3

Russian Federation 183 - 1.7

Africa 232 3.1 2.3

South Africa 46 0.7 0.5

Middle East 390 4.1 4.3

Asia 2388 21.8 26.4

China 593 1.8 4.0

Japan 566 8.5 7.6

Memorandum items:

ASEAN (10 countries) 552 4.2 6.9

MERCOSUR (4 countries) 136 1.4 1.3

Trade and Economic Development – Import Substitution and Export Promotion

697
1
One of the main aims of developing countries is to pursue industrialisation by
expanding their industrial sector. And trade provides a means by which this development
strategy can be pursued. There are two main strategies that countries can follow with
regards this problem.

Import substitution:

The idea is to domestically produce what was previously imported from elsewhere. There
are some economically sound reasons for doing this; producing rather than importing will
save valuable foreign exchange and ease the balance of payments deficit that most poor
countries have. Moreover, there is obviously a ready-made market for the product,
because people are already buying it from abroad.

In theory, new firms would start by importing ‘capital goods’ - plant and machinery and
the latest technology - ‘intermediate goods’ [raw materials and other components], and
technical expertise. Once off the ground, the industry would be able to import capital
goods to make all the necessary machinery themselves. The government would remove
the tariffs once the industry was ready to compete with producers from around the world
(see the later section on import protectionism and the infant industry argument).

In reality, firms have rarely got beyond the first stage. Import tariffs have remained in
place, since producers were unprepared to face global competition – and so they had no
incentive to become efficient and competitive.

Export Promotion

This was the approach adopted by the ‘East Asian Tiger’ economies in their expansion
of hi-tech manufacturing industries. Countries try to find markets in which they can
successfully exploit their comparative advantages and sell their products to buyers
elsewhere in the world.

1. Production centred on labour-intensive technologies (for the comparative

advantage!) – I.e. production has been based on much lower unit labour costs.
2. Industry made up of private-sector firms driven by the profit motive.
3. Government provides incentives for firms to export.

Many of the Asian Tiger economies have been incredibly successful in implementing
export promotion strategies and for them the process of globalisation has been a huge
stimulus to their economic growth and development over the last ten – twenty years.

The New Globalizers

Many developing countries—sometimes known as the ‘new globalizers’— have made

huge progress in building and sustaining a strong position in world markets for
manufactured goods and services. For example there has been a sharp rise in the share of
manufactured goods in the exports of developing countries: from about 25 percent in

698
1
1980 to more than 80 percent today and a decline in the dependency of some countries on
exporting primary commodities.

These ‘new globalizers’ have managed to exploit their competitive advantage in

manufacturing based on a fast growth of labour productivity, much lower unit labour
costs, high levels of capital investment, (much of it linked to inward investment) and
crucially a reduction in the tariff levels imposed by industrialised economies.

Technological progress has also speeded up the expansion of trade in manufactured

goods from developing economies with improvements in containerisation and airfreight
reducing the costs of transportation.

Developing countries have become important exporters of manufactures

Many developing countries have successfully exploited the rapid growth in demand for
transistors, valves, semi-conductors, telecommunications equipment, electrical power
machinery, office machines, computer parts and other electrical apparatus. These are all
fast-growing industries, although in many cases, price levels are falling as production
shifts across the globe to lower cost production centres. The huge increase in out-
sourcing of manufacturing production has been a major factor behind the speedy growth
of export industries in many developing countries, not least the emerging market
economies of south East Asia and more recently in eastern Europe.

Further evidence on the extent to which developing countries are building and then
harnessing new comparative advantages in many manufacturing industries is shown in
the following table of data again drawn from information published by UNCTAD.

Two industries where this ‘global shift’ in manufacturing production has become ever
more transparent are in the transport equipment sector and in textiles and clothing.

The expansion of trade from developing countries is not focused solely on manufactured
goods the share of services in developing country exports has grown from 9% in the early
1980s to 17% at the end of the 1990s. For rich countries, the share of services in total
exports is only a little higher at 20%. Relatively low-income countries such as China,
Bangladesh, and Sri Lanka have manufactures shares in their exports that are above the
world average of 81 percent. Others, such as India, Turkey, Morocco, and Indonesia,
have shares that are nearly as high as the world average.

Author: Geoff Riley, Eton College, September 2006

699
1
A2 Macroeconomics / International Economy
International Trade - BRICS

The BRICs

BRIC is a term used to refer to the combination of Brazil, Russia, India, and China – and,
according to a major piece of research from Goldman Sachs, a US investment bank, these
are four countries that are likely to become major if not dominant players in the global
economy over the next twenty to thirty years. The Goldman Sachs forecast for size of
GDP is as follows:

Largest economies in 2003 Largest economies in 2025 Largest economies in 2050

USA USA China

Japan China USA

Germany Japan India

UK Germany Japan

France India Brazil

China UK Mexico

Italy France Russia

India Russia Germany

Brazil South Korea UK

2000-05: BRICs contributed 28% of global economic growth

2005: BRICs had 15% share of global trade, double the level of 2001
2005: BRICs held 30% of global reserves of gold and foreign currency
2005: BRICs received 15% of global foreign direct investment and took 3% of FDI
outflows
Since 2003, their stocks markets have increased by approximately 150%

700
1
Projected real growth in GDP, GDP per capita and working age population: 2005-50
(% per annum)
Source: PriceWaterhouseCoopers

GDP in US GDP per GDP GDP GDP at GDP at

$ terms capita at PPPs (PPP (PPP market market
terms) in terms) in exchange exchange
2005 2050 rates in rates in 2050
2005

% change pa % change pa US=100 US=100 Percentage Percentage of

of US level US level

India 7.6 4.3 30 100 6 58

Indonesia 7.3 4.2 7 19 2 19

China 6.3 3.8 76 143 18 94

Turkey 5.6 3.4 5 10 3 10

Brazil 5.4 3.2 13 25 5 20

Mexico 4.8 3.3 9 17 6 17

Russia 4.6 3.3 12 14 5 13

S. Korea 3.3 2.6 9 8 6 8

Canada 2.6 1.9 9 9 8 9

Australia 2.6 2 5 6 5 6

US 2.4 1.8 100 100 100 100

Spain 2.3 2.2 9 8 9 8

UK 1.9 2 16 15 18 15

France 1.9 2.1 15 13 17 13

701
1
Italy 1.5 1.9 14 10 14 10

Germany 1.5 1.9 20 15 23 15

Japan 1.2 1.9 32 23 39 23

The new workshop of the world – China

A huge amount of discussion has been generated in recent years with the phenomenal
growth of the Chinese economy. The basic statistics of her growth are staggering
although such rapid expansion in output and investment is inevitably creating social,
environmental, economic and political pressures along the way. Production of factory
goods in China has surged by 5-10 per cent a year for over a decade and China now
contributes an estimated seven per cent of global manufacturing production. Since the
mid 1990s, nearly £280 billion of foreign direct investment has found its way into the
Chinese economy. China has developed a huge comparative advantage in the production
of motherboards for personal computers and in many other areas of manufacturing, the
economy is poised to reap the benefits of high foreign direct investment and a large jump
in spending on research and development. R&D spending in China increased from just
0.6% of GDP in 1996 to 1.1% in 2001.

China joined the World Trade Organisation in December 2001.

Annual growth in export and import volumes 2000 2001 2002 2003 2004 2005 2006

China 25.3 6.9 25.7 28.2 22.7 19.4 21.7

World 12.2 0.2 3.5 5.4 10.4 7.5 9.3

Australia, Japan, Korea and New Zealand 12.3 -2.9 7.1 8.1 12.8 6.8 8.3

OECD Europe (inc the UK) 11.6 2.6 1.5 2.6 6.9 5.1 7.3

NAFTA 11.5 -3.8 1.1 2.8 9.4 6.4 7.1

Source: OECD World Economic Outlook, data for 2006 is a forecast

702
1
 703
1
Suggested reading on the Chinese economy:

 Briefing on the Chinese economy (Economist)

 China and India – emerging giants (BBC news special report)
 China plan to protect the environment (BBC news, July 2006)
 China set to be largest economy (BBC news, July 2006)
 China’s growth soars to fastest for a decade (Guardian, July2006)
 Chinese economy could overheat (BBC news, July 2006)
 Downsides to China’s runaway growth (BBC news special, January 2006)
 Economist country profile on China
 Guardian special report on China
 Is this China’s century? (BBC Open University programme)
 Economist articles on China and Hong Kong

Author: Geoff Riley, Eton College, September 2006

704
1
A2 Macroeconomics / International Economy
Globalisation - Introduction

The global economy is in the midst of a radical transformation, with far-reaching and
fundamental changes in technology, production, and trading patterns. Faster information
flows and falling transport costs are breaking down geographical barriers to economic
activity. The boundary between what can and cannot be traded is being steadily eroded,
and the global market is encompassing ever-greater numbers of goods and services.
Treasury: Long-term global economic challenges and opportunities for the UK,
December 2004

What is Globalisation?

Globalization is an issue that rouses strong emotions among people. The first step in
understanding the topic is to define what it means. We are hampered by the reality that
there is no one single agreed definition – indeed the term globalisation is used in slightly
different ways in different contexts by various writers and commentators. What is
common to all usages is an attempt to explain, analyse and evaluate the rapid increase in
cross-border (trans-national) business that has take place over the last 10/15 years.

Trends in global trade and output

% change per annum unless stated

1980-89 1990-99 2000-04

Global GDP growth 3.3 3.2 3.8

World trade growth in goods and services 4.5 6.5 6.2

World trade (% of GDP) 19 21 25

The OECD defines globalization as

“The geographic dispersion of industrial and service activities, for example research and
development, sourcing of inputs, production and distribution, and the cross-border
networking of companies, for example through joint ventures and the sharing of assets”

Globalisation is essentially a process of deeper international economic integration that

involves:

705
1
 1. A rapid expansion of international trade in goods and services between
countries.
2. A huge increase in the value of transfers of financial capital across national
boundaries including the expansion of foreign direct investment (FDI) by trans-
national companies.
3. The internationalization of products and services by large firms.
4. Shifts in production and consumption from country to country – for example the
rapid expansion of out-sourcing of production.

All merchandise products Trade Production

Average % change per annum

1950-63 7.7 5.2

1963-73 9.0 6.1

1973-90 3.8 2.7

1990-04 5.7 2.5

Manufactured goods

Trade Production

1950-63 8.6 6.6

1963-73 11.3 7.4

1973-90 5.5 3.1

1990-04 6.3 2.6

The data table above drawn from statistics published by the World Trade Organization
shows how the annual growth in merchandise trade (trade in manufactures, agricultural
products, fuels and mining products) has consistently out-paced the growth of output.
This means that trade as a share of output in the global economy has continued to
increase – marking an increase in trade integration within the world economic system.

706
1
Another way of describing globalisation is to describe it as a process of making the
world economy more interdependent. The expansion of trade in goods and services, the
huge increase in flows of financial capital across national boundaries and the significant
increase in multinational economic activity means that most of the world’s economies are
increasingly dependent on each other for their macroeconomic health.

Shares in world exports 1991 2006Change 1991-2006

Canada 3.4 3.4 -0.1

France 6.2 4.0 -2.1

Germany 10.8 8.6 -2.2

Italy 4.9 3.5 -1.4

Japan 8.0 5.0 -2.9

United Kingdom 5.5 4.4 -1.1

United States 13.7 10.1 -3.6

Non-OECD Asia inc China 11.5 19.3 7.8

Latin America 2.6 3.0 0.4

Source: OECD World Economic Outlook, June 2006

For example, a deflationary monetary or fiscal policy introduced in one country which
leads to changes in AD inevitably affects the ability of other countries to export to that
economy. Consider for example a decision by the Federal Reserve Bank in the United
States to raise their interest rates in response to the threat of a rise in inflation. This could
conceivably have important feedback effects throughout the international economy. The
rate of growth of the US economy is likely to slow and this will then have an effect on
the strength of demand from US consumers for overseas products.

Secondly, changes in the structure of company taxation and personal taxation from
country to country tends to influence flows of investment and have feedback effects in
the long term on national income, employment and wealth.

707
1
Trends in global capital flows

1989 1999 2003

Stock of Foreign Direct Investment (% of GDP) 8.0 16.0 22.1

Foreign assets (% of GDP) 62.6 139.6 186.1

Source: International Monetary Fund

Different Waves of Globalisation

Globalisation is not new! Indeed there have seen several previous waves of globalisation.
Nick Stern, Chief Economist of the World Bank has identified three major stages of
globalization:

o Wave One: Began around 1870 and ended with the descent into global
protectionism during the interwar period of the 1920s and 1930s. This period
involved rapid growth in international trade driven by economic policies that
sought to liberalize flows of goods and people, and by emerging technology,
which reduced transport costs. This first wave started the pattern which persisted
for over a century of developing countries specializing in primary commodities
which they export to the developed countries in return for manufactures. During
this wave of globalisation, the level of world trade (defined by the ratio of world
exports to GDP) increased from 2 per cent of GDP in 1800 to 10 per cent in 1870,
17 per cent in 1900 and 21 per cent in 1913.
o Wave Two: After 1945, there was a second wave of globalization built on a surge
in world trade and reconstruction of the world economy. The rapid expansion of
trade was supported by the establishment of new international economic
institutions. The International Monetary Fund (IMF) was created in 1944 to
promote a stable monetary system and so provide a sound basis for multilateral
trade, and the World Bank (founded as the International Bank for Reconstruction
and Development) to help restore economic activity in the devastated countries of
Europe and Asia. Their aim was to promote lasting multilateral economic co-
operation between nations. The General Agreement on Tariffs and Trade (GATT)
signed in 1947 provided a framework for progressive mutual reduction in import
tariffs.
o Wave Three: The current wave of globalisation which is demonstrated for
example by a sharp rise in the ratio of trade to GDP for many countries and
secondly, a sustained increase in capital flows between counties and trade in
goods and services
o

708
1
Main Motivations and Drivers for Globalisation

As the well respected commentator Hamish McRae has argued, “Business is the main
driver of globalization!” The process of globalisation is motivated largely by the desire of
multinational corporations to increase profits and also by the motivation of individual
national governments to tap into the wider macroeconomic and social benefits that come
from greater trade in goods, services and the free flow of financial capital.

Among the main drivers of globalisation are the following:

o Improvements in transportation including containerisation – the reduced cost

of shipping different goods and services around the global economy helps to bring
prices in the country of manufacture closer to prices in the export market, and
adds to the process where markets are increasingly similar and genuinely
contestable in an international sense.
o Technological change – reducing massively the cost of transmitting and
communicating information - sometimes known as “the death of distance” – this
is an enormous factor behind the growth of trade in knowledge products using
internet technology. Advances in transport technology have lowered the costs,
increased the speed and reliability of transporting goods and people – extending
the geographical reach of firms by making new and growing markets accessible
on a cost-effective basis.

709
1
 o De-regulation of global financial markets: The process of deregulation has
included the abolition of capital controls in many countries. The opening up of
capital markets in developed and developing countries facilitates foreign direct
investment and encourages the freer flow of money across national boundaries
o Differences in tax systems: The desire of multi-national corporations to benefit
from lower labour costs and other favourable factor endowments abroad and
therefore develop and exploit fresh comparative advantages in production
o Avoidance of import protection: Many businesses are influenced by a desire to
circumvent tariff and non-tariff barriers erected by regional trading blocs – to give
themselves more competitive access to fast-growing economies such as those in
the emerging markets and in eastern Europe
o Economies of scale: Many economists believe that there has been an increase in
the estimated minimum efficient scale associated with particular industries. This
is linked to technological changes, innovation and invention in many different
markets. If the MES is rising this means that the domestic market may be
regarded as too small to satisfy the selling needs of these industries. Overseas
sales become essential.

Division of labour on a global scale

The ease with which goods, capital and technical knowledge can be moved around the
world has increasingly enabled the division of labour on a global scale, as firms allocate
their operations in line with countries’ comparative advantage. As a result, there has been
a significant increase in the number of firms that locate, source and sell internationally,
reflecting the new opportunities presented by the ICT revolution, alongside falling
transport costs and easing trade and capital restrictions.

Source: Treasury Report on Global Economic Challenges, December 2004

Globalization no longer necessarily requires a business to own a physical presence in

terms of either owning production plants or land in other countries, or even exports and
imports. For instance, economic activity can be shifted abroad by the processes of
licensing and franchising which only needs information and finance to cross borders. And
increasingly we are seeing many examples of joint-ventures between businesses in
different countries – e.g. businesses working together in research and development
projects.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Trade and the law of Comparative Advantage

International trade now accounts for nearly 25% of world GDP. The liberalisation
(opening-up) of trade in goods and services, and the rapid increase in foreign direct

710
1
investment across national boundaries have been and will continue to be hugely
important for the development of the global economy. In this chapter we look at the
theory of international trade.

The virtues of international trade and exchange

Economists are normally positive about the economic consequences of trade. Granted
there are those who highlight the inequities of the global trading system and in particular,
the marginalisation of developing countries who have struggled to build and maintain a
competitive advantage in key markets? But taken as a whole, the consensus among
economists is that there are significant gains in economic welfare and efficiency arising
from the continued expansion of trade and investment between nations.

In this section we consider some of the theory of free trade and then analyse and evaluate
the arguments for and against import protectionist policies.

“If there were an Economist’s Creed, it would surely contain the affirmations “I believe
in the Principle of Comparative Advantage” and “I believe in Free Trade”.”
Paul Krugman, Professor of Economics at MIT, Cambridge

The concept of comparative advantage

First introduced by David Ricardo in 1817, comparative advantage exists when a

country has a ‘margin of superiority’ in the production of a good or service i.e. where
the marginal cost of production is lower.

Countries will usually specialise in and then export products, which use intensively the
factors inputs, which they are most abundantly endowed. If each country specialises in
those goods and services where they have an advantage, then total output can be
increased leading to an improvement in allocative efficiency and economic welfare. Put
another way, trade allows each country to specialise in the production of those products
that it can produce most efficiently (i.e. those where it has a comparative advantage).

This is true even if one nation has an absolute advantage over another country. So for
example the Canadian economy which is rich in low cost land is able to exploit this by
specialising in agricultural production. The dynamic Asian economies including China
have focused their resources in exporting low-cost manufactured goods which take
advantage of much lower unit labour costs.

In highly developed countries, the comparative advantage is shifting towards

specialising in producing and exporting high-value and high-technology manufactured
goods and high-knowledge services.

Comparative advantage for the UK

711
1
Using trade data drawn from our balance of payments with other countries, the UK’s
comparative advantage now lies in the following areas: oil, chemicals & pharmaceuticals,
aerospace and medical technology, insurance, financial services, computer services &
software, other business services, and entertainment. We have lost much if not all of our
comparative advantage in textiles, steel, coal and many other areas of traditional
manufacturing industry where we run structural trade deficits.

Worked example of comparative advantage

Consider two countries producing two products – digital cameras and vacuum cleaners.
With the same factor resources evenly allocated by each country to the production of both
goods, the production possibilities are as shown in the table below.

Pre-specialisation Digital Cameras Vacuum Cleaners

UK 600 600

United States 2400 1000

Total 3000 1600

Working out the comparative advantage

To identify which country should specialise in a particular product we need to analyse the
internal opportunity costs for each country. For example, were the UK to shift more
resources into higher output of vacuum cleaners, the opportunity cost of each vacuum
cleaner is one digital television. For the United States the same decision has an
opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage
in vacuum cleaners.

If the UK chose to reallocate resources to digital cameras the opportunity cost of one
extra camera is still one vacuum cleaner. But for the United States the opportunity cost is
only 5/12ths of a vacuum cleaner. Thus the United States has a comparative advantage in
producing digital cameras because its opportunity cost is lowest.

Output after Specialisation

Digital Cameras Vacuum Cleaners

UK 0 (-600) 1200 (+600)

712
1
United States 3360 (+960) 600 (-400)

Total 3000 1600

3360 1800
o The UK specializes totally in producing vacuum cleaners – doubling its output to
1200
o The United States partly specializes in digital cameras increasing output by 960
having given up 400 units of vacuum cleaners
o As a result of specialisation according to the principle of comparative advantage,
output of both products has increased - representing a gain in economic welfare.

For mutually beneficial trade to take place, the two nations have to agree an acceptable
rate of exchange of one product for another.

There are gains from trade between the two countries. If the two countries trade at a rate
of exchange of 2 digital cameras for one vacuum cleaner, the post-trade position will be
as follows:

o The UK exports 420 vacuum cleaners to the USA and receives 840 digital
cameras
o The USA exports 840 digital cameras and imports 420 vacuum cleaners

Post trade output / consumption

Digital Cameras Vacuum Cleaners

UK 840 780

United States 2520 1020

Total 3360 1800

Compared with the pre-specialisation output levels, consumers in both countries now
have an increased supply of both goods to choose from.

Assumptions behind trade theory

This theory of the potential benefits from trade and exchange using the law of
comparative advantage is based on a number of underlying assumptions:

1. Perfect occupational mobility of each of the factors of production (land, labour,

capital etc.) -this means that switching factor resources from one industry to

713
1
 another involves no loss of relative efficiency and productivity. In reality of
course we know that factors of production are not perfectly mobile – labour
immobility for example is a root cause of structural unemployment
2. Constant returns to scale (i.e. doubling the inputs used in the production process
leads to a doubling of output) – this is merely a simplifying assumption.
Specialisation might lead to diminishing returns in which case the economic
benefits from trade are reduced. Conversely, increasing the scale of production
can generate increasing returns to scale - in which case the benefits from trade are
even stronger than the numerical example we have considered
3. No externalities arising from production and/or consumption – meaning that
there is no divergence between private and social costs and benefits. Again this is
a simplifying assumption. No discussion about the overall costs and benefits of
specialisation and trade should ignore many of the environmental
considerations arising from increased production and trade between countries.

What Determines Comparative Advantage?

A country's place in the global economy seems neither predestined nor predictable.
Comparative advantage is almost impossible to spot in advance.
Source: The Economist, April 2004

Comparative advantage is best viewed as a dynamic concept meaning that it can and
does change over time. Some businesses find they have enjoyed a comparative advantage
within their own market in one product for several years only to face increasing
competition as rival producers from other countries enter their markets and under cut
them on price or take market share through non-price competition. For a country, the
following factors are often seen as important in determining the relative costs of
production:

1. The quantity and quality of factors of production available (e.g. the size and
efficiency of the available labour force and the productivity of the existing stock
of capital inputs)
2. Investment in research & development (this is important in industries where
patents give some firms a significant market advantage) – there is quite strong
evidence that an emerging comparative advantage often comes from
entrepreneurial trial and error – the never ending process of engaging in research
and innovation to find more efficient process and new products
3. Fluctuations in the real exchange rate which then affect the relative prices of
exports and imports and cause changes in demand from domestic and overseas
customers
4. Import controls such as tariffs, export subsidies and quotas can be used to
create an artificial comparative advantage for a country's domestic producers
5. The non-price competitiveness of producers (e.g. covering factors such as the
standard of product design and innovation, product reliability, quality of after-
sales support)

714
1
Gross domestic expenditure on Research & Development

As a percentage of GDP, data is for 2003, source: OECD

2003 2003

Sweden 3.98 EU15 1.91

Finland 3.48 United Kingdom 1.88

Japan 3.15 Netherlands 1.84

United States 2.68 Norway 1.75

Korea 2.63 China 1.31

Denmark 2.62 Russian Federation 1.29

Germany 2.52 Czech Republic 1.26

France 2.18 Ireland 1.19

Canada 1.95 Spain 1.05

Comparative advantage is often a self-reinforcing process.

Entrepreneurs in a country develop a new comparative advantage in a product (either

because they find ways of producing it more efficiently or they create a genuinely new
product that finds a growing demand in home and international markets). Rising demand
and output encourages the exploitation of economies of scale; higher profits can be
reinvested in the business to fund further product development, marketing and a wider
distribution network. Skilled labour is attracted into the industry and so on.

The wider benefits of international trade

James Wolfenson on the gains from trade and the costs of protectionism
Expanding trade by collectively reducing barriers is the most powerful tool that countries,
working together, can deploy to reduce poverty and raise living standards. A growing

715
1
body of evidence shows that countries that are more open to trade grow faster over the
long run than those that remain closed. And growth directly benefits the world's poor. A
one percentage point increase in growth on average reduces poverty by more than 1.5 per
cent each year.
Increased trade also benefits consumers and efficient producers, through lower prices and
access to a wider variety of goods. This is because trade encourages greater specialisation
- which dramatically lowers costs - and more intense competition, which is central to
innovation. In sharp contrast, trade barriers can impose high costs on society - and
particularly on those that can least afford them. For example, it has been estimated that
barriers to imports in the 1990s saved 226 jobs in the US luggage industry, but at a cost
to American consumers of nearly $1.3m per year for each job. And taxpayers in the
European Union spend over $500m annually to subsidise the production of peas and
beans.
Source James Wolfensohn, Former President of the World Bank

One way of expressing the gains from trade in goods and services between countries is to
distinguish between the static gains from trade (i.e. improvements in allocative and
productive efficiency) and the dynamic gains (the gains in welfare that occur over time
from improved product quality, increased choice and a faster pace of innovative
behaviour)

Some of the broader gains from free trade are outlined below:

1. Welfare gains – allocative efficiency: Free trade can be shown under certain
conditions to lead to significant increases in welfare. Neo-liberal economists who
support the liberalisation of trade between countries believe that trade is a
‘positive-sum game’ – in other words, all counties engaged in open trade and
exchange stand to gain.
2. Economies of scale - trade allows firms to exploit scale economies by operating
in larger markets. Economies of scale lead to lower average costs of production
that can be passed onto consumers.
3. Competition / market contestability – trade promotes increased competition
particularly for those domestic monopolies that would otherwise face little real
competition. For example, Corus faces competition from overseas steel producers
and is effectively a price-taker in the world market. The Royal Mail will have to
fight hard to maintain its market position during the phased liberalization of the
European postal services market between now and 2007.
4. Dynamic efficiency gains from innovation - trade also enhances consumer
choice and international competition between suppliers help to keep prices down.
Trade in ideas stimulates product and process innovations that generates better
products for consumers and enhances the overall standard of living.
5. Access to new technology: Trade, like investment, is also an important
mechanism by which countries can have access to new technologies. Although the
importation of new technology may have negative employment consequences for
those workers who lose their jobs because of capital-labour substitution, provided
that an economy is flexible enough to be able to reemploy these workers, there

716
1
 should be no net loss of jobs as a result. To the contrary, new technology creates
new jobs in support industries.
6. Rising living standards and a reduction in poverty - James Wolfeson (Head of
the World Bank) has argued that trade can be a powerful force in reducing
poverty and raising living standards. A growing body of evidence shows that
countries that are more open to trade grow faster over the long run than those that
remain closed. And growth directly benefits the world's poor. A one percentage
point increase in growth on average reduces poverty by more than 1.5 per cent
each year.

Virtuous trade
“Trade's virtuous effects are of two distinct kinds. First, trade helps countries make the
most of what they already have. It frees countries to allocate their resources—whether
they be cheap labour, fertile land or educated minds—as efficiently as possible. But,
secondly, trade can also allow countries to accumulate resources more quickly. Indeed,
the biggest prizes lie in faster growth, not heightened efficiency; in accumulation and
innovation, not allocation.”
Source: Adapted from the Economist, July 20th 2006

The Terms of Trade

The terms of trade measures the rate of exchange of one good or service for another when
two countries trade with each other. For international trade to be mutually beneficial for
each country, the terms of trade must lay within the opportunity cost ratios for both
countries. We calculate the terms of trade as an index number using the following
formula:

Terms of Trade Index (ToT) = 100 x Average export price index / Average import
price index

If export prices are rising faster than import prices, the terms of trade index will rise. This
means that fewer exports have to be given up in exchange for a given volume of imports.
If import prices rise faster than export prices, the terms of trade have deteriorated. A
greater volume of exports has to be sold to finance a given amount of imported goods and
services.

The terms of trade fluctuate in line with changes in export and import prices. Clearly the
exchange rate and the rate of inflation can both influence the direction of any change in
the terms of trade.

717
1
 Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Balance of Payments - Introduction

In this note we consider the numbers which tell us something about how well Britain is
doing in paying her way in the international economy.

The balance of payments records financial transactions between Britain and the
international economy. The accounts are split into two sections with the current account
measuring trade in goods and services and net investment incomes and transfers whilst
the capital account tracks capital flows in and out of the UK. This includes portfolio
capital flows (e.g. share transactions and the buying and selling of Government debt) and
direct capital flows arising from foreign investment.

Components of the UK current account of the balance of payments

718
1
 Balance of Balance of Net Investment Current Current
trade in goods trade in Income transfers account
services balance

£ billion £ billion £ billion £ billion £ billion

1997 -12.3 14.1 3.3 -5.9 -0.8

1998 -21.8 14.7 12.3 -8.4 -3.2

1999 -29.1 13.6 1.3 -7.5 -21.7

2000 -33.0 13.6 4.5 -10.0 -24.8

2001 -41.2 14.4 11.7 -6.8 -21.9

2002 -47.7 16.8 23.4 -9.1 -16.5

2003 -48.6 19.2 24.6 -10.1 -14.9

2004 -60.9 25.9 26.6 -10.9 -19.3

2005 -67.3 17.9 29.9 -12.2 -26.6

719
1
 720
1
 721
1
 722
1
 723
1
 724
1
The causes of a trade deficit

It is useful to group the explanations for a trade deficit in goods into short-term, medium-
term and long-term factors. Some relate to the demand-side of the economy, others to
supply-side economic influences

Short-term factors

 Strong consumer demand – real household spending has grown more quickly
than the supply-side of the economy can deliver, leading to a high level of
demand for imported goods and services. Research evidence suggests that UK
consumers have a high income elasticity of demand for overseas-produced
goods – demand for imports grows quickly when consumer demand is robust.
Nicholas Fawcett and Professor Mike Kitson estimated that the income elasticity
is around +2.3 suggesting that a 2% increase in real incomes boosts demand for
imports by 4.6%. Because the overseas demand for UK exports rarely keeps pace
with the surging demand for imported products, so the trade deficit widens when
the economy enjoys a period of consumption-led growth.
 The strong sterling exchange rate has helped to reduce the UK price of imports
causing an expenditure-switching effect away from domestically produced

725
1
 output. In technical terms, the high pound has improved the terms of trade
between the UK and other countries, allowing us to buy and consume more
imports with each pound we earn. Consumers have taken advantage of the high
pound!
 The weakness of the global economy and in particular the slow growth in the
Euro Zone has damaged UK export growth. Nearly 60% of UK manufactured
goods exports and over 50% of our exports of services are to fellow members of
the European Union. The Euro Zone economy grew by only 0.3% in 2003 and
real GDP growth for the Euro Zone has been below 1% pa in each of the last three
years.

Medium-term factors

 UK trade balances have been affected by important shifts in comparative

advantage in the international economy – for example the rapid growth of China
as a source of exports of household goods and other countries in South-east Asia
who have a cost advantage in exporting manufactured products
 The availability of imports from other countries at a relatively lower price
inevitably causes a substitution effect from British consumers.

Longer-term factors

726
1
  Much of our trade deficit is due to structural rather than cyclical factors
 Our trade performance has been hindered by supply-side deficiencies which
impact on the price and non-price competitiveness of British products in global
markets
o A relatively low rate of capital investment
o The persistence of a productivity gap with our major competitors –
measured by differences in GDP per person employed or per hour worked
– this is linked to low investment and also to the existence of a skills-gap
between UK workers and employees in many other countries
o A relatively weak performance in terms of product innovation –
linked to a low rate of business sector spending on research and
development
 The UK manufacturing sector has been in long-term decline for more than twenty
years. Although we still have some world class manufacturing companies, the size
of our manufacturing sector is not large enough both to meet consumer demand in
the UK and also to export sufficient volumes of products to pay for a growing
demand for imports

727
1
 Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Balance of Payments - National Income

National income and the balance of payments

What are the links between the rate of growth in an economy and movements in the
balance of payments? Normally, as domestic incomes rise we expect to see an increased
demand for imports. This can come from both consumers and firms. The extent to which
imports rise when incomes grow is shown by the income elasticity of demand for
imports. In the diagram below, spending on imports is assumed to be directly linked to
the level of national income. The higher the marginal propensity to consume the steeper
will be the gradient of the import function. Exports are assumed to be exogenous of the
level of domestic national income.

If the marginal propensity to import is high then imports will rise quickly when the
economy experiences economic growth. Unless there is a corresponding rise in the
volume of exports sold overseas, the balance of trade will worsen.

The balance of payments and living standards

728
1
A common misconception is that balance of payments deficits are always bad for the
economy. This is not necessarily true. In the short term if a country is importing a high
volume of goods and services this acts as a short-term boost to living standards since it
allows consumers to buy a higher level of household durables and other items. A
widening trade deficit might also be the result of an increase in imports of capital
equipment and technology which will provide a boost to a country’s potential national
output. If imports of investment goods improve our competitiveness, this raises the
prospect of an increase in employment and real incomes arising from a better supply-side
economic performance.

However in the long term, if the trade deficit is a symptom of a weakening domestic
economy and a lack of international competitiveness then living standards may decline.

Policies to control / reduce a balance of payments deficit

Which policies are likely to be most effective in improving the current account deficit of
the balance of payments? We need to make a distinction between demand and supply-
side causes of the problem. If the root cause of a high trade deficit is an excessive level of
aggregate demand, the deficit may improve automatically in the event of an economic
downturn or recession, when real incomes and spending slow down. However if the
deficit is largely the consequence of supply-side economic weakness, then policies need
to be effective in improving our cost and non-price competitiveness and in expanding the
economy's productive potential is essential - particularly the tradable sector, to allow it to
grow without its external position continuing to deteriorate.

729
1
Central to improving the UK’s trade performance is the health of the manufacturing
sector: although services are a growing part of the economy, manufacturing still accounts
for about 75% of exports. The government's growth strategy is focused on improving the
supply side of the economy such policies may be effective but they will take time to
work.

Expenditure Reducing Policies

These are policies that aim to reduce the real spending power of consumers

 Fiscal policy can be used (e.g. a rise income tax that reduces disposable income)
 Higher interest rates would dampen consumer spending and reduce economic
growth

Expenditure Switching Policies

These are policies that attempt encourage consumers to switch their spending away from
imports towards the output of domestic firms. ‘Expenditure-switching’ occurs if the
relative price of imports can be raised, or if the relative price of UK exports can be
lowered. Measures might include:

730
1
  A depreciation of the exchange rate which has the effect of increasing the UK
cost of imports and reduces the foreign price of UK exported goods and services.
A lower exchange rate also increases the profitability of exporting products
overseas, and this profit signal should, over time, act an as incentive for UK
businesses to reallocate factor resources towards potential export markets
 Tariffs or other import controls can occasionally be used – but the UK is
bound by its commitments to the World Trade Organisation. Protectionist policies
are not a viable option for an economy wishing to control its total trade deficit
 Policies that reduce the rate of inflation in the economy below that other
international competitors leading to a gradual improvement in price
competitiveness

The key to controlling the BoP deficit in the long term is for the economy to achieve
relatively low inflation with sufficient productive capacity to meet the domestic demand
from consumers. Often, price is not the deciding factor in winning the demand from
buyers in highly competitive international markets. Competitiveness in global markets is
driven by many factors, one of which is the level of research and development spending,
an area where the UK continues to lag behind.

The UK continues to lag behind in research and development

Despite numerous attempts by the government to stimulate research and development
spending, the level of R&D investment by UK companies is continuing to the
Department of Trade and Industry's "2005 R&D scoreboard". Total R&D spending by
British industry fell 1 per cent last year to £17bn. By contrast the scale of R&D
investment by the world's top 1,000 companies climbed by 5 per cent to £220bn. It seems
that the introduction of tax incentives that allow businesses to offset more than 100 per
cent of their research investment against tax has yet to cause the surge in R&D that the
government wants. Is this a case of government failure? Internationally, spending on
R&D was equivalent to 3.8 per cent of turnover but in the UK the figure was only 2 per
cent. Of the 31 UK industrial sectors covered in the scoreboard, 19 reported a decline in
spending and ten showed an increase.
The DTI R&D scoreboard provides a succinct explanation of the potential importance of
research spending both to the competitiveness of a single business operating in a
particular market and also to the health of the economy as a whole:
“R&D generates the new products, processes and services that give companies a
competitive edge in the market. A company that consistently under-invests in R&D
relative to its best competitors will lose its competitive edge and find it is competing
increasingly on price in the area of lower value added products and services.” (Source:
DTI)

Top 15 UK companies by size of R&D investment

Company Position in R&D Growth of R&D Sector

2000 (1 year)

731
1
 1. GlaxoSmithKline 2 £2839m +2% Pharmaceuticals

2. AstraZeneca 1 £1981m +10% Pharmaceuticals

3. BAe Systems 4 £1110m +1% Aerospace

4. Ford ** 8 £763m -12% Automotive

5. Unilever 5 £736m -2% Food Producers

6. Pfizer** 10 £598m +8% Pharmaceuticals

7. Airbus** -* £345m -1% Aerospace

8. Shell 11 £288m -5% Oil & Gas

9. Rolls-Royce 12 £282m 0 Aerospace

10. BT 9 £257m -23% Telecoms

11. BP 14 £229m +26% Oil & Gas

12. Land Rover** -* £227m -7% Automotive

13. Vodafone 37 £219m +28% Telecoms

14. Marconi 6 £186m -6% IT Hardware

15. Amersham† 16 £182m -1% Health

** Foreign-owned. * Not in 2000 Scoreboard.

Limits to the impact of a depreciation of the currency

The risks of inflation

A lower exchange rate can lead to an increase in the costs of imported goods and services
risking higher ‘cost-push’ inflation.

It is important to remember that a depreciation or devaluation of the exchange rate will

not normally be enough on its own to correct a balance of payments deficit for an
economy. This is particularly the case if the causes of the deficit are long term and

732
1
structural. Other policies are required that improve the supply-side performance of the
economy and make domestically produced goods and services more competitive in
international markets

The ‘J-Curve’ effect

In the short term a depreciation of the exchange rate may not improve the current account
deficit of the balance of payments. This is due to the low price elasticity of demand for
imports and exports in the immediate aftermath of an exchange rate change. Initially the
volume of imports will remain steady partly because contracts for imported goods will
have been signed. However, depreciation raises the sterling price of imports causing total
spending on imports to rise. Export demand will also be inelastic in response to the
exchange rate change in the short term. Therefore the earnings from exports may be
insufficient to compensate for higher spending on imports. The balance of trade may
worsen in the immediate aftermath of a fall in the external value of the currency. This is
widely known as the ‘J-Curve’ effect.

Providing that the elasticity of demand for imports and exports are greater than one, then
the trade balance will improve over time. This is known as the Marshall-Lerner
condition.

Export and Import Volumes - the importance of Elasticity of Demand

Original exchange rate £1 = $1.80

733
1
Exports of Pocket PCs from the UK Imports of US DVD players

UK price (£) £350 USA price ($) 450

US price ($) 630 UK price (£) 250

Demand 40,000 Demand 60000

Export revenue (£) 14,000,000 Import spending (£) 15,000,000

New exchange rate £1 = $1.60

Ped for UK exports = 1.4 Ped for US imports = 0.5

UK price (£) £350 USA price ($) 450

US price ($) 560 UK price (£) 281.25

Demand 46,220 Demand 56670

Export revenue (£) 16,177,000 Import spending (£) 15,938,438

% change in ex rate 11.1 % change in ex rate 11.1

% change in demand 15.55 % change in demand 5.55

Net trade balance

Original exchange rate £1 = $1.80 -1,000,000Deficit

New exchange rate £1 = $1.60 +238,562.5Surplus

734
1
Combined elasticity of demand for X and M + 1.4 + 0.5 = 1.9

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Globalisation - Effects
0

The launch of the Euro as a new currency in circulation in January 2002 marked a
fundamental change in monetary arrangements for all members of the European Union.
No country is immune to some of the static and dynamic effects of the creation of a single
currency covering twelve of the fifteen member nations of the EU.

The European Central Bank

The ECB is in charge of setting a common interest rate for the twelve countries inside
the Euro Zone (Slovenia joins the Euro as the 13th member in January 2007). The main
policy objective is to achieve price stability – defined as “a year-on-year increase in the
Harmonised Index of Consumer Prices of below 2%”. The British Monetary Policy
Committee has a symmetrical inflation target – this is not the case with the ECB.

The ECB targets the growth of the broad money supply as a guide to the future direction
of interest rates. Broad money is basically determined by the growth of bank deposits –
the majority of which are created through bank loans and over-drafts. The ECB does not
have an exchange rate target, although it has intervened on a few occasions to influence
the external value of the Euro. The main differences between the ECB and the Bank of
England are summarised in the table below:

A common currency requires a common interest rate. But arguments continue to rage as
to whether the twelve countries within the Euro Zone stand to benefit from a ‘one-size
fits all monetary policy’. Are they sufficiently similar (or convergent) in terms of
economic performance for the benefits of Euro membership to outweigh the costs of
having to accept a single rate of interest?

European Central Bank Bank of England

Location Frankfurt London

Goal Price stability Price stability

735
1
Chairman Jean-Claude Trichet Governor: Mervyn King

Inflation Target Euro-Zone price inflation below Consumer price inflation of 2%

2% Permitted band of fluctuation = +/-
Inflation target is non-symmetrical 1%

Policy Tool Euro Zone interest rate Short term base interest rates

Voting Votes split between countries who Nine member MPC - meets monthly
each have representation on the - one vote each – governor has
ECB Council casting vote

Joining the Euro – convergence criteria

Countries wishing to join the single currency must meet four convergence criteria.

1. Stable prices: Inflation must not be more than 1.5 percentage points higher than
the average in the three member countries with best price stability, i.e. lowest
inflation.
2. Stable exchange rate: The national currency must have been stable relative to
other EU currencies for a period of two years prior to entry into the monetary
union (ERMII entry).
3. Sound government finances:

a. Gross government debt must not exceed 60 per cent of GDP.

b. The annual government budget deficit must not be greater than 3 per cent
of GDP.

1. Low interest rates: The 5-year government bond rate must not be more than 2
percentage points higher than in the three member countries where inflation is
lowest.

The Case for UK Membership of the Euro

Trade, investment and productivity: The Treasury’s official assessment of its five
economic tests published in June 2003 acknowledged that EMU membership for the UK
could enhance productivity by increasing trade flows between the UK and other EU
nations; boost investment and stimulate competition in product markets. It could also
help to promote supply-side reforms in the EU and encourage specialization and further
exploitation of the UK’s comparative advantage in several sectors of the economy in the
longer term.
Increased price transparency: Membership of the Euro should in practice make it

736
1
easier for consumers and businesses to compare relative prices levels across member
nations. This will encourage cross-border trade and increase the competitive pressures
across many different markets. There are potential gains in consumer welfare if price
transparency leads to improvements in allocative efficiency.
Business uncertainty and transactions costs: Joining the Euro would reduce exchange
rate uncertainty for British businesses and lower transactions costs for companies and
tourists. Nearly 60% of our trade in goods and services is conducted with other members
of the European Union – a figure that will grow in future years
The Euro as a complement to the working of the Single Market: The Euro is vital as a
complement to the success of the Single European Market. This should lead to an
increase in intra-European trade flows and higher inward investment within the EU
region.
Britain’s flexible labour market would enhance our performance within the Euro
Zone: Britain's flexible labour market would be highly effective inside a single currency
area and would help to attract even more inward investment from outside the EU.
Foreign investment flows and the development of UK multinational enterprises:
Britain has been a major recipient of foreign direct investment in recent years. Some
commentators believe this would be threatened if the UK remains outside the system in
the long run. By removing a currency barrier to trade and potentially improving access to
funding, EMU could also facilitate the development of UK-owned multinational
enterprises.
Higher wages and employment for UK workers: EMU could have long-term benefits
for households, including potentially lower prices and higher wages – although the
potential benefits here do depend greatly on the degree of sustainable convergence
between the UK and other Euro Zone countries
Political and economic influence: Britain stands to lose political and economic
influence in shaping future economic integration if it remains outside the monetary
system.

Transactions costs and price transparency explained

Transactions Costs
When each country has its own currency, transactions between two countries will incur
currency conversion costs. A “round trip” of 40,000 Belgian Francs, through 10
European countries finished as 21,300 Belgian Francs: 47% of the funds were lost
through currency conversion costs. By forming a common currency area the transactions
and reporting costs are eliminated.
Price Transparency
The price of the same good can differ between countries, shielded by the price of the
good being given in different currencies. While must of the price difference is due to
differences in VAT, some is due to the use of difference currencies. Such price
differences can be eliminated by forming a common currency area, which increases price
transparency. Firms that charge a higher price due to inefficient production methods may
lose business by the price transparency and resulting increase in competition.
Source: Richard Ashlin, LSE

737
1
The Case against UK Participation

Critics of the Euro argue that the new currency does not meet the requirements of an
optimal currency area and that structural differences between member nations
threaten to undermine the success of the project. Other economists believe that the UK
can continue to enjoy a sustained period of macroeconomic prosperity outside the Euro
Zone whilst still deriving some of the benefits from participation in the single European
market.

1. Past history and deflationary bias: Currency unions have collapsed in the past.
There is no guarantee that EMU will be a success. It may indeed prove to be a
recipe for economic stagnation including slower growth and high unemployment
if the ECB pursues a deflationary monetary policy to keep inflation within the 2%
limit. Many economists have been critical of the reluctance of the ECB to cut
interest rates in a more aggressive manner during its first six and a half years in
operation.
2. The Euro is not an optimal currency area: The Euro Zone does not meet the
conditions required for an optimal currency area (OCA). By this we mean that
within the Euro Zone countries there is immobility of labour and there is
insufficient wage flexibility inside European labour markets to cope with the
inevitable external economic shocks.
3. A lack of real economic convergence: Member economies have not converged
fully in a real or structural sense. And, at some stage, there is a risk that
excessively high interest rates will be set across the Euro Area because of an
inflationary fear in one part of the zone that is unsuited to another area. This is the
essence of the argument that in a currency union comprising many countries, it is
virtually impossible for the official short-term interest rates to be at a level than is
optimum for any one country.
4. Loss of domestic monetary policy freedom: Joining a single currency reduces
Britain’s monetary policy autonomy. Britain might wish to retain the flexibility to
set short term interest rates to meet her own internal macroeconomic objectives.
Entry to the Euro Zone means a permanent transfer of domestic monetary
sovereignty to the ECB.
5. Constraints of the fiscal stability pact: Countries joining the Euro signed up
initially to the fiscal stability pact which limited the scale of government
borrowing to 3% of national income. Several nations have already broken the
conditions of the pact and it has now effectively been abandoned. But remaining
outside the Euro Zone gives the UK a degree of fiscal policy freedom not
available to member states.
6. Monetary policy asymmetry between the UK and the Euro Zone: There is
plenty of evidence that the British economy is more sensitive to the effects of
interest rate changes than other EU countries. In part this is because of the high
scale of owner-occupation in the housing market on variable-rate mortgages.
Joining a currency union with little monetary flexibility requires the UK to have
more flexibility in labour markets, product markets and in the housing market.
But the British rented housing sector is too small to be a good substitute for

738
1
 owner-occupation and major change will have to be made to the structure of
housing finance. Another factor behind monetary policy asymmetry is that British
companies rely more heavily on debt finance to pay for their investment projects
rather than the issuing of new equity (shares) through the capital markets. They
are more exposed to changes in interest rates than businesses in other EU
countries.
7. Adjustment costs: The change over process to the introduction of the Euro will
involve substantial menu costs for businesses and banks. These menu costs will
bear heavily on small-medium sized enterprises.
8. Foreign investment issue: Opponents of Euro membership argue that Britain can
continue to attract capital inflows outside of the Euro Zone. Favourable supply-
side factors in both product and labour markets make the UK attractive for foreign
investment.
9. The performance of the Bank of England since 1997: The Bank of England’s
success in keeping inflation within target and at the same time changing interest
rates to keep the economy on track for sustained growth, may have undermined
the case for UK entry into the Euro Zone for the UK. Would macroeconomic
performance using the Euro be noticeably better?

Why are UK interest rates higher than the Euro Zone?

739
1
The UK and the Euro Zone share a common inflation target – consumer price inflation of
two per cent – yet we see a consistent difference between interest rates. Why is this
happening?

The main reason for the divergence in interest rates is that each Central Bank take a
different view of the risk of cost push and demand pull inflation. Historically inflation
has been more of a problem for the UK than it has for continental economies of Western
Europe especially Germany. Short term interest rates are often a clear guide to official
expectations of inflation. The Bank of England has done a good job since 1997 of
keeping inflation down and the economy growing, but there remains a residual fear of a
return to higher wage inflation and some concern that rapid asset price inflation
especially in the housing market could lead to too fast a growth of consumer spending.

Optimal Currency Areas

An OCA works best when the countries within it are already highly integrated with each
other and where each has a sufficiently flexible labour market to cope with external
economic shocks. The OCA is also likely to work well when the monetary policy
transmission mechanism works in similar ways within each country – in other words, the
effects of interest rate changes have a broadly similar impact on businesses and
h00000000000000000000ouseholds, and the time lags involved in interest rate changes
working their way through to affect output, employment and prices are pretty close to
each other.

In most important respects, the Euro Zone is not an OCA – although a small group of
countries within it are probably closely convergent in a structural sense. An OCA is
better placed to succeed with a small cluster of countries rather than the looser coalition
of twelve nations that count themselves as founder members of the single currency.

Another important issue for the UK is illustrated in the next figure.

740
1
The basic argument is this. A country might want all three of the features shown in the
boxes below: Free capital mobility helps to attract inward investment and permits the free
flow of investment capital overseas to take advantage of overseas investment
opportunities. Secondly the freedom to pursue an independent domestic monetary policy
(i.e. set your own interest rates to meet an inflation target or some other objective).
Thirdly the benefits that might flow from having stable fixed exchange rate.

Only two of the three features can be chosen at any one time. If a country desires
exchange rate stability and also capital mobility, it must use monetary policy to set
interest rates to meet an exchange rate target. This was the case when the UK was a
member of the exchange rate mechanism from October 1990 to September 1992. Interest
rate policy was constrained by the need to keep sterling within the agreed bands of the
ERM. Once the UK had left the ERM and moved to a free-floating exchange rate, this
freed up domestic monetary policy. Interest rates could now be set to keep the growth of
aggregate demand in line with aggregate supply so that the economy continued to grow
but keeping inflation within target range.

At the moment the Government is keen to retain these two elements – a floating currency
and an independent monetary policy. It believes that the Bank of England has done a
good job in setting interest rates and the free flow of capital allows the balance of
payments deficit on the current account to be financed whilst the sterling exchange rate is
left to find its own level in the foreign exchange markets.

The 5 Economic Tests

The Labour Government's decision on EMU membership reflects what it believes is best
for the long-term economic interests of the British people and the performance of the UK
economy.
(Statement of Policy on the 5 Economic Tests, June 2003)

741
1
The Labour government is committed to holding a binding referendum on the issue of the
single currency before making a decision on entry. Gordon Brown has outlined five
economic tests to be met before he will recommend membership of the single currency.

1. Economic Convergence: This test revolves around the following question. Are
UK and Euro Zone business cycles and economic structures compatible so that we
and others could live comfortably with euro interest rates on a permanent basis?
2. Economic Flexibility: This test considers whether there is sufficient flexibility in
the system to cope with economic shocks. Brown wants there to be more
flexibility in the European labour market and increased competitive pressures in
markets for goods and services. Some of this may happen naturally (driven for
example by the impact of the Internet) but the European labour markets may
require root and branch reforms. The British government is certainly pushing
strongly for wider economic reforms in Europe before it will countenance
membership of the single currency
3. Investment: This test focuses on whether membership of the single currency has
a beneficial effect on the level of capital investment across many sectors of the
economy. This includes the potential impact of foreign direct investment from
within and outside of the Euro Zone. Would joining EMU create better conditions
for overseas firms making long-term decisions to invest in Britain?
4. The Financial Services Industry: This test is not the most important one. It
considers the likely impact of Euro participation on the health of the UK's
financial services industry
5. Employment: Whether the Euro is good in the long term for raising employment
and reducing unemployment – according to the Treasury, this test can be summed
up as follows: ‘Will joining EMU promote higher growth, stability and a lasting
increase in jobs?’

The Importance of Economic Convergence

The idea of convergence is perceived to be the single most important test against which
the UK government is assessing the costs and benefits of UK participation in the Euro.
Countries are convergent for a monetary union are convergent if they have similar
economic structures, so will respond to the same shocks in a similar way, and are
unlikely to be hit by a large number of country-specific shocks.’ Three different types of
convergence can be identified:

1. Cyclical convergence: This considers the extent to which the economic cycles of
the UK and the Euro Zone have aligned sufficiently. Numerous indicators can be
used to judge the degree of cyclical convergence – some of which are considered
briefly below
2. Structural convergence: Economic structures in the UK and the Euro Area are
compared and the implications in terms of aggregate demand and aggregate
supply-side economic shocks and their impact on prices, output and jobs are
assessed

742
1
 3. Endogenous convergence: Endogenous convergence describes the convergence
that may occur as a result of joining EMU – for example the extent to which wage
bargaining and price-setting might be affected by being inside a single currency
area, or possible changes in the balance between fixed and variable rate
borrowing for households and businesses.

Cyclical Convergence
The main indicators of cyclical convergence are

1. National output: The ‘base indicator’ of convergence is the rate of real GDP
growth. The chart above tracks the growth rate for the UK and the Euro Zone.
2. Short-term interest rates: Interest rates are the main instrument for the monetary
authorities in both the UK and the euro area. Differences in short-term interest
rates indicate disparities in either inflation targets or perceived inflationary
pressures
3. Real interest rates: Real interest rates are the nominal rate of interest adjusted
for inflation – important as a factor influencing investment decisions by
businesses
4. The output gap: The output gap is measured as the difference between actual and
potential output. The output gap is used as an indicator of future inflationary
pressure and is often at the forefront of decisions of central banks when setting
interest rates to meet an inflation target
5. Labour market conditions: Labour market indicators would include the annual
growth of wages and earnings, the rate of unemployment and surveys of skills
shortages – reflecting the changing balance of labour demand and supply in an
economy
6. Long-term interest rates and inflation expectations: These indicate the success
and credibility of monetary policy and macroeconomic policy more generally.
The long term rate of interest on ten year Government bonds is widely perceived
as the bond markets best forecast of inflation expectations for a country going
forward
7. The exchange rate: This is a further important indicator of the state of the
economy because changes in the exchange rate can have a major effect on the
pattern of demand and short term growth

000000

Structural convergence

Structural convergence analyses whether the supply-side structures of the British

economy might be different to countries within the Euro Area. And, if they are, the extent
to which different structures could make the UK more vulnerable to economic shocks
that do not affect the rest of the euro area (for example, volatility in house prices). There
is also the risk that the UK could react differently to changes in circumstances that affect
the whole of the monetary union (e.g. changes in Euro Zone interest rates).

743
1
The main structural features are:

1. The sector composition of national output (e.g. the contribution to GDP in each
country made by manufacturing, services, agriculture and the energy industries)
2. Patterns of trade within and outside the Euro Area for each country
3. The structure of financial markets including the structure of finance used in
housing markets
4. Differences in estimated equilibrium rates of unemployment – this affects the
nature of the inflation – unemployment trade-off in each country and also impacts
on how quickly an economy can grow without running into inflation problems.
The evidence is that the Euro Zone has a poorer unemployment-inflation trade off
indicated by differences in the estimated non-accelerating inflation rate of
unemployment (NAIRU).

Consider the structure of output between the UK, Germany and France, details of which
appear in the next table: Germany has a relatively larger manufacturing base. Indeed its
short-run economic cycle is extremely closely tied to global trends in the strength of
demand for manufactured goods. In contrast the UK has moved more decisively towards
a post-industrial economy with nearly three-quarters of final output coming from the
service sector.

744
1
Comparing the structure of GDP by sector across three countries

Per cent of total output, data is for 2001 UK Germany France

Agriculture, hunting, forestry, fishing 0.9 1.1 2.8

Manufacturing, mining, utilities 19.9 24.2 20.1

Construction 5.5 4.4 4.7

Distribution, hotels, transport, communications 22.9 18.6 19.3

Finance, real estate, other business activities 27.9 30.1 30.1

Public admin, social security, education, health, 22.8 21.6 23.1

defence

Services total 73.6 70.2 72.4

Differences in the transmission mechanism of monetary policy

Taken together, the structural features discussed above will influence how monetary
policy affects the real economy: the so-called monetary policy transmission mechanism.
If a change in Euro Zone interest rates causes a different response in the UK compared to
euro area countries, in terms of the speed of response or its overall effect on output and
inflation, this might result in a divergent cyclical path or greater volatility of output and
inflation in the UK. We have already referred to this as monetary policy asymmetry – and
it is a hugely important aspect of the Euro debate.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Consumer Spending & Saving

The basic determinants of consumer spending and saving were covered as part of the AS
course. In this section we delve deeper into the determinants of consumption exploring in
particular the Keynesian approach and alternative theories of consumption and saving.

745
1
The consumption function
The consumption function is simply a theoretical relationship between income and
consumer expenditure. The Keynesian theory describes a consumption function where
household spending is directly linked to people’s disposable income. A simplified
consumption function diagram is shown below.

The standard Keynesian consumption function is written as follows:

C = a + c (Yd) - where

 C is total consumer spending

 a is autonomous spending
 And c (Yd) is the propensity to spend out of disposable income

Autonomous spending (a) is consumption which does not depend on the level of
income. For example people can fund some of their spending by using their savings or
by borrowing money from banks and other lenders. A change in autonomous spending
would in fact cause a shift in the consumption function leading to a change in consumer
demand at all levels of income.

The key to understanding how a rise in disposable income affects household spending is
to understand the concept of the marginal propensity to consume (mpc). The marginal
propensity to consume is the change in consumer spending arising from a change in
disposable income. If for example your disposable income rises by £5,000 and you

746
1
choose to spend £3000 of this on extra goods and services, then the mpc is £3000/£50000
or 0.66. If you chose instead to spend only £2500 of the increase in income, then the mpc
would be 0.5.

The gradient of the consumption function shown in the previous diagram is determined
by the value for marginal propensity to consume. A change in the mpc (shown in the
next diagram) would cause a pivotal change in the consumption function. For example, a
decision to save less of any increase in income would lead to a rise in the mpc and a
steeper consumption curve.

The consumption function - a simple numerical example

Disposable Income Consumption (C) Average Propensity to Marginal Propensity

(Yd) Consume = C/Yd to Consume = change
in C from a £1 change
in Yd

10000 8500 0.85

20000 16000 0.80 0.75

30000 23600 0.79 0.76

40000 29450 0.74 0.59

50000 33200 0.66 0.38

In our example above, as disposable income rises in blocks of £10,000, so does total
consumption. But the rate at which consumer spending is increasing is declining. The
marginal propensity to consume is falling and this brings down the average propensity
to consume. The Keynesian theory did actually argue that the marginal propensity to
consume would fall as income increases, but the evidence for the UK over many years
disputes this.

The Savings Function

We assume that any disposable income that is not spent is saved, so we can deduce from
our numerical example above, that because the marginal propensity to consume is falling,
then the marginal propensity to save must be rising as is the average propensity to
save (otherwise known as the household savings ratio).

747
1
This is shown in the table below which is drawn from the data on consumption and
income used in the first table.

The Savings Function - a simple numerical example

Disposable Income Saving Average Propensity to Marginal Propensity

(Yd) £ £ Save = S/Yd to Save = change in S
(= Yd – C) from a £1 change in
Yd

10000 1500 0.15

20000 4000 0.20 0.25

30000 6400 0.21 0.24

40000 10550 0.26 0.41

50000 16800 0.33 0.62

748
1
The savings ratio is quite volatile but what have been the main trends since 1990?

Looking at the data for the household savings ratio we find that it has been quite volatile
over the last fifteen years ranging from over 13% of disposable income in 1992 to just
3% of disposable income in 2004. It is noticeable that in recent years, households have
chosen to save a lower percentage of their after-tax income than in previous periods.
Much of this has been the result of the boom in consumer borrowing, including a huge
level of mortgage equity withdrawal from the housing market.

By the summer of 2005 it was clear that the borrowing boom was coming to an end in
part the result of a sharp slowdown in the rate of growth of house prices. In the last
couple of years there has been a steady rise in the savings ratio with its value heading up
towards 6%. This has coincided with a period of weaker consumer demand for goods and
services. People have obviously decided to save a little more in order to repay some debt
and generally improve their household finances. Perhaps they fear rising unemployment
and the risks of defaulting on their loans?

749
1
Unemployment and interest rates both influence savings decisions

In the chart above we track the household savings ratio, the base rate of interest set by the
Bank of England and the seasonally adjusted rate of unemployment as measured by the
claimant count. The general trend is that the savings ratio has declined over the last
decade or more, a time when both unemployment and interest rates have also fallen. If
people have reasonable expectations of job security and if the rate of return on their
savings is lower than in the past, here are two reasons to save less and borrow more.

Notice in the next chart how the incredibly strong demand for consumer borrowing has
tailed off in the last two years. The annual growth in demand for consumer credit
exceeded 10% from 1994 through to the middle of 2005. The growth rate has since
dipped sharply lower; perhaps our love affair with the plastic card (40 years old in 2006)
is coming to an end? In contrast, the rate of increase in borrowing secured on the value of
property has remained very strong. Borrowing money represents dis-saving because it
allows someone to spend in excess of their current income.

The issue of consumer debt is a long-standing one. It certainly raises risks for the UK
economy in the years ahead because the accumulation of debt creates the cost of
servicing this debt, thousand of people have problems in simply paying the interest on
their loans and the number of personal insolvencies in the UK has reached a record high.
750
1
The last ten years has seen a credit boom in the UK – now coming to an end?

751
1
Personal insolvencies are now at a record high – too much borrowing? Or is it now too
easy to declare oneself bankrupt and avoid repaying existing debts?

752
1
 There is a strong relationship between people’s disposable income and their spending

753
1
Shifts in the Consumption Function

A change in any factor affecting consumption other than a change in income is said to
lead to a shift in the consumption function. These factors include the following:

o A change in interest rates – for example a cut in interest rates will boost
consumption at each level of income and cause an upward shift in the
consumption function. Lower interest rates act to lower the cost of servicing the
debt on a mortgage and thereby increase the effective disposable income of
homeowners. In contrast a period of higher interest rates is designed to curb
consumer spending.
o A change in household wealth – for example a rise in house prices or in share
prices encourages higher levels of borrowing and an upward movement in the
consumption curve
o A change in consumer confidence – for example, expectations of rising
unemployment and worsening expectations of changes in income might lead to a
reduction in confidence and a fall in spending at each level of income. Conversely
an improvement in consumer expectations about the health of the economy will
increase confidence and planned spending

Consumer spending in Britain has grown consistently strongly in recent years although
during 2005 there was a clear slowdown from the fast rates of growth seen particularly in
1999 and 2000. It is also interesting to note that household consumption has been
growing more quickly than real national income implying that consumption as a share of
GDP has also been rising. The evidence for this is shown in the next table.

754
1
 Consumption Real Real GDP Average Consumption / GDP
Disposable Propensity
Income to
Consume

£ billion at constant 2002 prices =C/Yd Ratio of consumption to real GDP

1997 558.1 625.2 936.7 0.89 0.60

2005 731.1 768.6 1167.8 0.95 0.63

Source: ONS, Blue Book

We now turn to some non-Keynesian theories of what determines consumer spending.

755
1
Alternative theories of consumption

The life—cycle model

The life-cycle model of consumption was developed by Franco Modigliani who argued
that households form a view about their likely or expected income over a large slice of
their life-cycle, and then base their spending decisions around this. This helps to explain
why people in reasonably well paid jobs in their early twenties are prepared to borrow
heavily to finance current consumption (a new car, furnishings for a property) because
they expect to be able to repay loans as their disposable income increases. Similarly
people reaching middle age frequently tend to become net savers because they are
anticipating saving for their retirement. One of the results of the life-cycle model is that
changes in the age structure of the population can have sizeable effects on total consumer
spending in the economy.

The permanent income model

This model of consumption is associated with the US economist Milton Friedman and it
is, in many ways, a development of the life-cycle mode. Friedman believed that people
base their spending decisions on expectations of permanent income. Permanent income
might be described as the average income that people can earn over their lifetime. A
distinction is made between transitory income (e.g. a windfall gain in income which has
not been earned) and permanent income. Friedman believed that changes in transitory
income would not fundamentally affect spending and saving decisions. But that shifts in
permanent income would be important in shaping our spending levels.

For example, a rise in household wealth increases the ability of people to spend perhaps
through borrowing secured on the value of a property. Lower interest rates tend to
increase both share and house prices adding to household wealth. That said lower interest
rates also cut the income flowing to people with net savings.

According to the permanent income model, only changes in permanent income have any
long term effect on consumption. But transitory changes in spending power can lead to a
more volatile pattern for the propensity to consume.

Key Points

 Keynesian theories of consumption focus on current disposable income as the

main determinant of household spending
 Other theories argue that expectations of income and wealth in the future also
affect people’s spending decisions
 Borrowing allows people to spend more than their current income. Borrowing is
dis-saving
 The consumer borrowing boom has lasted more than a decade
 Household debt is now at a record high although interest rates remain low by
historical standards
 Rising house prices have boosted personal wealth and consumer confidence

756
1
  Personal insolvencies are rising, debt is likely to be a major constraint on
consumer demand for goods and services in the years ahead

A2 Macroeconomics / International Economy

Cyclical fluctuations - demand and supply-side shocks

A shock is an unexpected or unpredictable event that affects an economy. In this note we

look at some of the shocks that hit countries at different points in time and how
macroeconomic policy can be used to act as a shock absorber for an economy.

Open economies and macroeconomic shocks

The UK is an open economy, one that is highly integrated within the global economy.
From one perspective this increases the sensitivity of our economy to outside events for
example a recession or slowdown in key export markets will inevitably have downside
effects on demand, output and employment in the UK.
However the integration of the economy with other nations also provides opportunities to
smooth our own economic cycle – depending on what is happening to cycles, exchange
rates and policy changes elsewhere. Much rests on the flexibility of our economy to be
able to absorb external economic shocks and then bounce back when the opportunity
arises.
The table below provides a listing of some of the world’s major economies. Clicking on
each country’s name will send you to a country profile, either at the Economist website or
the BBC news web site. This will allow you to find out a little more about the economic
structure and recent performance of each country.

European Union (25 countries) NAFTA (3 countries)

Countries in italics joined in 2004 North American Free Trade Area

Germany Greece United States

Austria Czech Republic Canada

France Poland Mexico

Italy Slovenia

Netherlands Slovakia Other OECD (but non-EU)

Belgium Latvia

Luxembourg Lithuania Norway

757
1
Ireland Malta Switzerland

Finland Cyprus Iceland

Portugal Hungary Turkey

Spain Estonia Australia

Sweden Denmark New Zealand

UK Japan

Emerging Markets including South Korea

China

India OPEC nations

Russia inc

Brazil Saudi Arabia

South Africa Nigeria

Shocks to the system!

Like all economies, Britain is susceptible to exogenous shocks – i.e. unexpected
economic events which originate independently from outside our own system and which
may have the effect of driving the economy off course.
Exogenous shocks can be split into two main groups
Demand side shocks – these are shocks affecting the rate of growth of demand both in the
UK and other countries

Supply-side shocks – these are shocks affecting costs and prices in different countries

Possible demand-side shocks might include:

A capital investment boom e.g. a construction boom or rapid growth of spending on ICT
A pre-election government spending spree (e.g. the government opting for a fiscal policy
expansion before an election)
A sudden and significant rise or fall in the exchange rate – affecting net export demand
and having follow-on effects on output, employment, incomes and profits of businesses

758
1
linked to export industries
A change in the rate of economic growth in one or more of the countries of our major
trade partners which affects the demand for our exports of goods and services
An unexpected cut or an unexpected rise in interest rates (i.e. a “monetary policy shock”)
Changes in aggregate demand brought about by a demand-side shock will then translate
into changes in the short term rate of growth as measured by the annual change in real
GDP. This can create disequilibrium in the economy which takes growth, prices and
incomes away from their projected levels. The ripple effects of an external shock can take
some time to work their way through the circular flow of income and spending.
The government and/or the central bank may decide to make “policy changes” in order to
absorb the shock effects. For example their might tighten monetary policy if demand is
expected to rise too quickly; or they might inject some liquidity /spending power into the
economy if a negative demand shock raises the risk of a deflationary recession.

Cyclical fluctuations in the USA – the world’s largest economy

Supply-side shocks to the economy – oil prices

There are many possible supply-side shocks to the global economy. Some of them prove
to have long-term beneficial effects, for example the emergence, adoption and take-up of
a new production technology arising from invention and innovation that has the effect of
reducing cost for producers and prices for consumers. Often it takes several years for the
759
1
full impact of such supply-side shocks to become apparent and for their full significance
to be recognised.

We will focus here on the effects of volatile prices in the global oil market and in
particular, the dramatic rise in oil prices in recent years. The financial pages of the press
have been full of commentaries on the possible impact of this inflationary oil price shock
in the global economy. What follows below is a discussion of some of the
macroeconomic effects of rising oil prices.
The macroeconomic implications of rising oil prices depend on several factors

 The extent to which rising oil prices are temporary (i.e. lasting only a few months
before falling back) or regarded as more permanent (e.g. a period of 3-4 years of
high prices). In general, the impact of higher oil prices will be larger the longer
the price rise lasts. The possibility exists of “super-spikes” in oil prices, short but
sharp movements in prices driven higher or lower by speculative buying and
selling.
 Whether a country is a net importer or exporter of oil – Britain is still a net
exporter of oil (though we import a lot too!) whereas Germany is a large importer
of oil.
 The scale of oil dependency of an economy i.e. the ratio of oil used per unit of
national output produced. Some countries have a reliance on high-energy using
industries and are therefore more susceptible to changing commodity prices.
Others have a much smaller manufacturing base and national output is dominated
by industries that are less energy intensive
 The extent to which oil users (consumers) can switch their demand away from oil
towards alternative energy substitutes. In the short term, demand is said to be
inelastic (i.e. Ped<1).
 The macro-economic policy response to rising oil prices from central banks (e.g.
changes in monetary policy) and the government (e.g. changes in fiscal policy)
 The effects of exchange rate changes arising from oil price movements e.g. the
pound might rise against the US dollar which could absorb some of the effects of
higher oil prices on the British economy.
 The extent to which the labour market is flexible (in particular the flexibility of
real wages) and the ways in which businesses react to higher oil costs

760
1
 How high can oil prices rise? What might be the economic implications of oil priced at
over $100 per barrel?

Main disadvantages of higher oil prices for the UK economy

 A fall in aggregate supply and higher inflation: The main effect of rising oil
prices in the short term is on aggregate supply. A higher price causes an inward
shift in SRAS and puts upward pressure on the general price level. This is an
example of an ‘exogenous inflationary shock’. Research carried out by the
International Energy Agency suggests that if world oil prices were to remain 10%
above a base forecast level for two years this would add 0.4% to the average rate
of inflation for leading economies in each year. The effects on inflation can be
increased if “wages follow prices” – because if inflation expectations rise, this
can cause an increase in wage demands as people seek to protect their real
incomes. Higher oil costs work their way through the supply chain. So
manufacturers pass on higher costs to wholesalers who do the same to retailers.
Consumers often end up paying the price for higher oil prices when they make
their final purchase. Air fares rise and petrol prices increase – these are two most
obvious symptoms of higher oil prices in the immediate term. Higher prices for
consumers reduces their purchasing power in real (inflation adjusted) terms. But
gradually higher oil prices filter their way through most parts of our economy.

761
1
  Slower economic growth: Higher oil prices act as a dampening effect on the rate
of growth of real GDP. According to the IEA research mentioned above, a
sustained $10 per barrel increase in oil prices from $25 to $35 would result in the
OECD as a whole losing 0.4% of GDP in the first and second years of higher
prices. This is because higher prices cut into people’s real incomes and their real
purchasing power. And because companies are making less profit (because of
higher costs) this can lead to a reduction in planned capital investment. Both
consumption and investment are important components of aggregate demand. The
result can be a slowdown in growth leading to actual GDP falling below potential
– i.e. a negative output gap. And slower growth will hit jobs, not just in those
industries that depend on oil but across the whole economy. Another effect of
rising oil prices could be to erode business confidence. This too will have a
negative effect on output and investment intentions. Similarly a reduction in
company profits might have a negative effect on share prices, falling share
valuations effectively increases the cost of capital for firms wanting to issue new
shares to finance an expansion and a decline in equities would also hit consumer
confidence. The actual effect of higher oil prices on world economic growth
depends in part on what those countries that are accumulating huge trade
surpluses as a result of being oil exporters, decide to do with these surpluses.
 A worsening of the terms of trade – the terms of trade measure the relative price
of imports compared to the prices that exporters receive for selling their output
overseas. An oil-price increase leads to a transfer of income from importing to
exporting countries through a shift in the terms of trade – i.e. the terms of trade
for oil importing countries gets worse because they are now having to pay more
per barrel for their oil – and therefore having to export a greater volume of
exports to pay for this. Conversely, higher oil prices improve the terms of trade
for the leading oil-exporting countries. Their oil is worth much more on the global
market, their potential export revenues are much higher as a result and this is will
be an injection of income and demand into their circular flow.
 Impact on the balance of payments - the effects of higher oil prices on the
balance of payments are somewhat different for the UK compared to most other
Western European countries. The UK has large reserves of North Sea Oil and we
have run surpluses in trade in oil for over twenty years as the next chart shows.
Higher oil prices will increase the cost of out imports of crude, but the value of
our exports of Brent crude also rise. The net effect is probably positive for the
current account of the balance of payments. However exporters of non-oil
products may suffer from the oil price shock. Since higher oil prices reduce real
incomes of oil consumers around the world, firms suffer not only from a drop in
demand in their home market but from overseas as well. So exports fall causing a
reduction in aggregate demand and exacerbating the fall in GDP growth.

So how great is the current world oil price shock?

Oil Market Supply and Demand 2000 2005

762
1
 (in million barrels per day)

Demand for Oil

OECD 47.9 49.7

of which: North America 24.1 25.4

Europe 15.1 15.6

Pacific 8.7 8.6

Non-OECD 28.7 34.0

Total 76.6 83.7

Supply of Oil

OECD 21.9 20.3

OPEC total 30.9 33.9

Former USSR 7.9 11.6

Other non-OECD 16.2 18.2

Total 76.9 84.1

Trade in Oil

OECD net imports 26.2 29.6

Former USSR net exports 4.3 7.8

Other non-OECD net exports 21.9 21.7

Prices

Brent crude oil import price

763
1
 ($ per barrel) 28.4 54.4

Source: International Energy Agency

The recent rise in the real oil price has been not been as large as the surges seen in 1972-
74 and 1978-80. Even after the recent rise, oil prices are still lower in real terms than they
were in 1981 and the major developed countries are less dependent on oil now than at the
time of the 1979-80 oil shock, reflecting both improved energy efficiency and the shift
away from energy-intensive industries towards the service sectors.

Higher oil prices have supply and demand-side effects on the UK and the international
economy – thus far the sharp rise in oil prices has not led to an acceleration in inflation
and a high risk of a recession.

Oil prices and interest rates

Will higher oil prices lead to an increase in interest rates? In theory it might well be the
case because higher crude oil prices will feed through to an increase in the general price
level and may threaten to take consumer price inflation above the Government target of
2.0%. A tightening of monetary policy designed to dampen down the threat of cost-push
inflation would then have negative effects on aggregate demand and GDP growth.

764
1
But a rise in interest rates is not automatic, because the Bank of England takes a full
range of inflation indicators into account when making decisions on the direction of
monetary policy. It does not have a specific target for oil prices – indeed the price of
crude is only one part of a jigsaw of factors that they must consider when considering the
likely path of inflation over the next two years.

The evidence for the UK over recent years is that the volatility in crude oil prices is no
longer as important in influencing the rate of inflation as it was in the past. Our oil-
energy ‘dependency ratio’ has declined and the flexibility of our labour and product
markets has increased, which has the effect that pay is more flexible in response to
changes in inflationary pressure (i.e. wages no longer automatically rise when inflation
surges).

To add to this, many businesses have experienced a decline in their ability to pass on
increases in their input costs when there are changes in raw material prices – this is partly
due to the fierce competition in many industries arising from globalisation.

We should be wary of analysts who exaggerate the likely impact of the current oil price
shock on the British macro-economy both in the short and the medium term. There are
risks to the whole global economy from a period of much dearer oil, but the risk that
higher oil prices will tip the global economy into a recession or slump are not as great as
people often believe.

Suggestions for further reading on the oil price issue

 Guardian special report on oil

765
1
  How long can high oil prices endure? (Guardian July 2006)
 North Sea oil faces dark times (BBC)
 Oil price increases of 2004-2006 (Wikipedia)
 OPEC
 Oxford Institute for Energy Studies
 Petrol pump price set to reach £1 (BBC)

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Costs and Benefits of Economic Growth

The advantages and disadvantages of economic growth are fiercely debated by

economists, environmentalists and other commentators. In this note we consider some of
the economic and social costs and benefits from expanding levels of production and
consumption. In particular we focus on the idea of sustainable growth.

The Benefits of Economic Growth

According to the UK government, ‘a healthy economy leads to higher living standards

and greater prosperity for individuals. It also helps businesses to be profitable, which
generates employment and income’. This quote highlights some of the benefits of growth
– developed further below:

Improvements in living standards: Growth is an important avenue through which better

living standards and lower rates of poverty can be achieved. This is particularly true for
countries who regard growth as a key route for poverty reduction among their population.
According to a report published in August 2004 by the Asian Development Bank (ADB),
rapid growth in many of the countries in the Asian region has reduced the number of
people living on less than $1 a day fell to 22% of the region's population in 2002. That
compares with 34% in 1990 and shows "considerable progress in the fight against
poverty."

Rising Employment: Growth stimulates higher employment. As we can see from the
chart below, the sustained growth in the British economy since 1993 has helped to bring
about a large rise in total employment, the number of people in work has risen from 2.53
million at the start of 1993 to nearly 29 million thirteen years later. This is a very
impressive employment creation record, much better than most other countries in the
European Union.

766
1
The accelerator effect of growth on capital investment: Rising AD and output encourages
investment in capital machinery – this helps to sustain growth by increasing LRAS.

Greater business confidence: Growth has a positive impact on company profits &
business confidence – good news for the stock market and for the growth of small and
large businesses.

The “fiscal dividend” to the government: Government finances are cyclical in nature
because a growing economy boosts the tax revenues flowing into the Treasury and it also
provides the government with more money to finance spending projects.

Potential environmental benefits – richer countries have more resources available to

invest in cleaner technologies. And, as nations move to later stages of development,
energy intensity levels start to fall. Much depends on how many resources an economy is
willing to devote to environmental improvement and protection. Over the last thirty
years, the ratio of energy consumption per unit of GDP has fallen quite significantly.
The reduction in energy intensity is a reflection of improvements in production
technologies and also a gradual switch towards a low carbon economy. Much more
progress needs to be made. Organisations such as the Carbon Trust sponsor research into

767
1
low carbon technologies and many environmental groups believe that greater investment
should be made in alternative sources of energy.

“We now expect to live on average 30 years longer, to work almost half the amount of
time we used to every year, and to enjoy an array of new goods and services, including
air travel, antibiotics, computers and televisions. Economic growth and rising living
standards has also meant a cut in rates of carbon emissions and natural resource depletion
never possible in the 20th century”
Source: Professor Nick Crafts, 2002 Royal Economic Society Public Lecture, December
2002

The Disadvantages of Economic Growth

Economic growth does not come risk-free. Although our material progress can be
measured in part by the growth of national output, income and spending, if the economy
grows too quickly, it can bring about short and long-term problems.

Inflation risks: There is the danger of demand-pull and cost-push inflation if demand
grows faster than long run productive potential High and rising inflation can be
destabilizing for an economy because it puts pressure on interest rates to rise and can
cause a loss of competitiveness for domestic businesses in international markets

The environment: Economic growth cannot be separated from its environmental impact.
Fast growth of production and consumption can create negative externalities such as
increased noise and air pollution and road congestion. Environmental damage can have a
negative effect on our quality of life and limits our sustainable rate of growth. For
example, road transport is responsible for 25% of UK CO2 emissions once emissions
from fuel processing and vehicle manufacturing are taken into account.

Inequalities of income and wealth: Not all of the benefits of growth are evenly
distributed. We can see a rise in real GDP but also growing income and wealth inequality
in society which is reflected in an increase in relative poverty. The Gini coefficient is one
way to measure the inequalities in the distribution of income and wealth in different
countries. The higher the value for the Gini co-efficient (the maximum value is 1), then
greater the inequality. Countries such as Japan, Denmark and Sweden typically have
very low values for the Gini coefficients; whereas African and South American countries
have an enormous gulf between the incomes of the richest and the poorest elements of the
population.

Regional disparities: Although average living standards may be rising, the gap between
rich and poor can widen leading to an increase in relative poverty and a widening of the
gap between different regions.

Sustainability of Economic Growth

768
1
Many of the world’s most valuable finite resources are being extracted at such a rapid
rate that it questions the long-term sustainability of growth. Renewable resources are
also being depleted because of over-consumption. Examples include the destruction of
rain forests, the over-exploitation of fish stocks and loss of natural habitat created through
the construction of new roads, hotels, retail malls and industrial estates. Some of the main
environmental threats include:

 The depletion of global resource base and the impact of global warming. There
are plenty of examples around of the “tragedy of the commons”, the permanent
loss of what should be renewable resources that result from over-extraction of
some of our environmental resources.
 A huge expansion of waste and pollution of the environment
 Over-population (particularly in urban areas) putting pressure on scarce land and
other resources
 Species extinction leading to a loss of bio-diversity

Pollution in Guangzhou – China’s fast growth is creating huge environmental concern

China hit by rising air pollution

Pollution problems have grown along with China's economy. Rising sulphur dioxide
emissions in China are causing environmental harm and economic loss according to a
new report from the Chinese government. China is already the world's largest sulphur
dioxide polluter, emitting nearly 26m tons of the gas in 2005. This was a 27% increase
since 2000 and coincided with a rise in coal consumption. The gas contributes to acid
rain, which damages buildings, soil and crops, and can cause health problems in humans.

769
1
Much of the pollution came from burning coal. Coal accounts for 70% of China's energy
consumption. There is mounting concern over the environmental impact of China's
rapidly expanding economy. In July, China announced it planned to spend 1.4 trillion
Yuan ($175bn) over the next five years to improve water quality, and cut air and land
pollution and soil erosion. In July 2006, the US Environmental Protection Agency
estimated that on certain days nearly 25% of pollution in the skies above Los Angeles
could be traced to China.
Adapted from news reports, August 2006

Green National Income Accounts

National income accounts have not, until recently, made any adjustment for the
environmental impact of economic growth. Critics argue that because of this omission,
the statistics misrepresent improvements in social welfare. For example, no allowance is
made for environmental depletion or money spent on correcting environmental
damage that is actually recorded as an addition to GDP. GDP only records marketed
transactions - at present, there is no market for many important environmental resources
and it is also difficult to place monetary values on them.

One alternative measure is the Index of Sustainable Economic Welfare (ISEW)

developed by economists at the New Economics Foundation who have been at the
forefront of developing a system of environmental accounts that make allowance for the
impact of economic activity on the environment. The ISEW adjusts official data on real
national output and makes an allowance for defensive spending (i.e. that incurred in
cleaning up for pollution and other forms of environmental damage, together with money
spent commuting to work). Not surprisingly, the net growth of ISEW is well below that
of the official data for national income, output and spending.

What is Sustainable Development?

The term 'sustainable' means 'enduring' and 'lasting' and 'to keep in being'. So, sustainable
development is economic development that lasts! According to one of the finest
environmental economists of his generation, the late David Pearce, sustainable
development means that each generation should pass on at least as much "capital" as it
inherits, the Pearce approach defines capital in broad terms, to include physical capital
(machinery and infrastructure); intellectual capital (knowledge and technology) and also
environmental capital (environmental quality and the stock of natural resources).

In 1987 the Bruntland Commission on Environment and Development defined

sustainable development as: "development that meets the needs of the present without
compromising the ability of future generations to meet their own needs”. The current
Government supports the concept of sustainable development and focuses on four main
objectives set out below:

 Social progress which recognises the needs of everyone: Everyone should share
in the benefits of increased prosperity and a clean and safe environment. Needs

770
1
 must not be met by treating others, including future generations and people
elsewhere in the world, unfairly.
 Effective protection of the environment: We must limit global environmental
threats, such as climate change to protect human health and safety from hazards
such as poor air quality and toxic chemicals and to protect things which people
need or value, such as wildlife, landscapes and historic buildings.
 Prudent use of natural resources: We need to make sure that non-renewable
resources are used efficiently and that alternatives are developed to replace them
in due course. Renewable resources, such as water, should be used in ways that do
not endanger the resource or cause serious damage or pollution.
 Maintenance of high and stable levels of economic growth and employment,
so that everyone can share in high living standards and greater job opportunities.

The UK government publishes an annual report on progress towards sustainable

development.

Growing interest in the impact of economic activity on our natural and man-made
resource base has led to the development of concepts such as ecological footprints and
carbon footprints. The BBC has recently focused on this issue with a series of reports on
ethical man.

Many environmentalists are inherently cautious about the long term impact of growth on
our living environment. They are deeply sceptical about the effects that growth might
have in preserving and or improving it. But others argue that the pessimists are over-
stretching their case. Bjorn Lomborg in “The Sceptical Environmentalist” challenges
widely held beliefs that the environmental situation is getting worse and worse. His
personal web site is here.

Key points

 Economic growth provides important long-term benefits for the population of a

country. It can be a route out of poverty and it creates jobs and wealth.
 Inequalities in income and wealth mean that, in many countries, the benefits from
growth are not distributed evenly. This raises questions of equity (fairness) and
impacts on our interpretations of how to measure standards of living.
 The environmental consequences of growth cannot be ignored.
 Sustainable growth meets the needs of the present without compromising the
ability of future generations to meet their own needs.
 There are environmental benefits from countries becoming richer
 However, there are major concerns about the impact of fast growth on the world’s
environmental resources.
Economic growth is just one indicator of a country’s economic performance.
Alternative measures, such as the United Nation’s Human Development Index &
the Index of Sustainable Economic Welfare, take account of other indicators.

Author: Geoff Riley, Eton College, September 2006

771
1
A2 Macroeconomics / International Economy
Unemployment

In this note we consider in more depth the causes and consequences of unemployment.
After over a decade of falling unemployment, the number of people out of work in the UK
economy is rising again, and this highlights some of the economic and social effects of
people being unable to find paid work.

Measuring unemployment in the UK

Claimant Count
The claimant count includes those people who are eligible to claim the Job Seeker's
Allowance (JSA). Claimants who satisfy the criteria receive the JSA for six months
before moving onto special employment measures. One problem with the claimant count
is that it excludes many people who are actually interested in finding work and who
might have searched for work in the recent period – but they don’t meet all of the criteria
for claiming and therefore are not included in the unemployment count. In 2003, the
claimant count averaged 933,000 or 3.0% of the labour force.

Labour Force Survey

The labour force survey (LFS) measure of unemployment covers those people who have
looked for work in the past month and are able to start work in the next two weeks. On
average, the labour force survey measure has exceeded the claimant count total by about
400,000 in recent years.

Labour Force LFS Claimant Count Claimant Count

Survey (LFS) Unemployment unemployment Per cent of the
unemployment Per cent of the labour force
labour force

1996 2,344 8.3 2,088 6.9

1997 2,045 7.2 1,585 5.3

1998 1,783 6.3 1,348 4.5

1999 1,759 6.1 1,248 4.1

772
1
2000 1,638 5.6 1,088 3.6

2001 1,431 4.9 970 3.2

2002 1,533 5.2 947 3.1

2003 1,476 5.0 933 3.0

2004 1,426 4.8 854 2.7

2005 1,425 4.7 862 2.7

Source: UK Labour Market Statistics

Some basic labour market definitions

Unemployment rate: = the percentage of the workforce that is registered as
unemployed
The labour force: = the number of people in employment + the registered
unemployed
Working population: = the population of working age (estimated in 2002 to be
36.5 million)
Participation rate: = the percentage of working population who are in the
labour force

You can find our information about unemployment in your own local area by using the
Nomis data

773
1
 Trends in the two main measures of unemployment for the UK economy

The Causes of Unemployment

Frictional Unemployment

This is voluntary or transitional unemployment due to people moving between jobs:

For example, newly redundant workers, or workers entering the labour market for the
first time such as graduates and school-leavers take time to find jobs at wage rates they
are prepared to accept. Many of the frictionally unemployed are out of work for a short
time whilst engaged in job search.

Imperfect information in the labour market may lead to frictional unemployment if the
jobless are unaware of the available jobs. Often this information failure is localised – for
few workers scan the vacancies available across the whole economy, they tend to restrict
their search for work to a local area. Geographical mobility in the UK and also in the EU
is lower than it is in the USA for example.

Incentives to look for work are also important! Some people may opt not to accept jobs
at prevailing market wage rates if they believe the income tax and benefit system will

774
1
reduce the net increase in income people can expect from taking paid work. This problem
is referred to as the unemployment trap.

Structural Unemployment

Structural unemployment occurs when people are made jobless because of ‘capital-
labour substitution’ which reduces the demand for labour in an industry, or when there
is a long run decline in demand which causes redundancies and worker lay-offs.
Structural unemployment exists where there is a ‘mismatch’ between their skills and the
requirements of the new job opportunities.

Skills are required to cope with structural changes in output and employment
Structural change is a constant feature of a flexible economy. As some sectors decline, so
other sectors – requiring different skills – will expand. The pace of technological change
and global integration will increase demand for a more highly skilled workforce with the
ability to adapt to changing technologies and shifting product demand.
Source: HM Treasury, the Benefits of a Flexible Economy, April 2004

Many of the unemployed from coal, steel and heavy engineering have found it difficult to
gain re-employment without re-training. This problem is one of the occupational
immobility of labour. The long-term decline in industrial employment has continued (a
process known as deindustrialisation) and there has been a huge shift into service-based
employment, especially in banking, finance and insurance, other business services and
distribution, hotels and restaurants.

775
1
 The changing pattern of jobs in the UK

Employment change in the UK economy 1990 2005% change

000s 000s 1990-2005

Banking, finance and insurance 4442 6097 27.1

Education and health 6470 7790 16.9

Distribution, hotels & restaurants 6463 7078 8.7

Transport & communication 1680 1839 8.6

Construction 2357 2099 -12.3

Agriculture & fishing 641 446 -43.7

776
1
Manufacturing 5203 3383 -53.8

Mining, electricity, gas & water 398 171 -132.7

Source: UK Labour Market Statistics

Employment programmes to reduce unemployment

The Labour Government's New Deal programme (www.newdeal.gov.uk) has focused

attempts to reduce long-term unemployment by increasing the human capital of the
unemployed and improving their employability in the eyes of potential employers. The
New Deal is also designed to bring back into the labour market people who have given up
the active search for work. These ‘discouraged workers’ are long- term unemployed
who have been out of formal employment for many months and whose motivation to
engage in job search has declined to low levels. There is often a “catch-22” in the labour
market. It is difficult to find new work without having relevant experience but experience
can only come from having a relevant job.

Cyclical Unemployment

Cyclical unemployment is involuntary or "demand deficient" unemployment due to a

lack of aggregate demand. This is also known as Keynesian. When there is a recession
we see rising unemployment because of plant closures and worker lay-offs. The fall in
AD shown in the left hand diagram below takes the economy further away from full-
capacity national output and leads to a negative output gap where actual GDP lies below
potential GDP. Because labour has a derived demand, a fall in real national output leads
to a contraction in total employment.

Voluntary and Involuntary Unemployment

An important distinction is to be noted between voluntary unemployment when a worker

chooses not to accept a job at the going wage rate and involuntary unemployment which
occurs when a worker would be willing to accept a job at the going wage but cannot get
an offer.

777
1
 778
1
 There is a cyclical relationship between output and unemployment

High Wage or Classical Unemployment

779
1
Classical unemployment is the result of real wages being above their market clearing
level leading to an excess supply of labour. Some economists believe that the national
minimum wage risks creating unemployment in industries where global competition
from low-cost producers is severe.

Consequences of Unemployment

To many economists, persistent unemployment is a sign of market failure because

unemployment is a waste of scarce resources and leads to a loss of potential output and a
reduction in allocative efficiency. The economy is operating below the maximum output
it could achieve. This might be illustrated by making use of a PPF or using the concept of

780
1
the output gap.

When unemployment is rising for example during a recession, real national output will be
contracting and the economy will be operating well below full-capacity. This is shown in
the chart below, notice how during the depression during the early 1990s, the output gap
became negative as the unemployment rate climbed towards 10 per cent of the labour
force. Once the recovery had become well established, unemployment began its descent
and the economy moved towards macroeconomic equilibrium with the negative output
gap closing.

Around the turn of the decade, the UK economy was estimated to be running pretty close
to its potential level, with real GDP growing just above the trend rate of 2.5% per year.
Unemployment drifted lower, mainly as a result of successful attempts to bring down
structural and frictional unemployment. In 2005 however there was a marked economic
slowdown, the output gap became negative again and we started to see the rate of
unemployment edge higher. No recession, but we again saw the cyclical relationship
between the growth of output and the rate of unemployment.

781
1
There are further costs associated with high or rising unemployment besides simply the
lost output.

Redundancies waste resources invested in training and educating workers and the
longer each person’s period of time out of work, the greater the loss of skill and
motivation. A high rate of long term unemployment can therefore have a negative effect
on a country’s economic growth potential. High unemployment also affects
government finances with higher spending on unemployment benefits and other welfare
payments plus falling revenues from income tax, national insurance and VAT. There is
also a strong link between unemployment and consumer spending. As consumer’s
confidence falls, so the willingness of people to spend declines and people build up their
precautionary savings.

Hysteresis effects

The hysteresis effect describes a possible consequence of a country experiencing

persistently high rates of long term unemployment. Hysteresis means “to be behind”
and it relates to the economic costs of unemployment because of the damage that
unemployment does to the skills and employability of those people out of work. The
longer someone remains out of a paid job, the less attractive they become to a potential
employer. Technical and social skills can become eroded. The incentives to prolong the
782
1
search for work are damaged and the end result can be an increase in “core” structural
unemployment and a consequent rise in the natural rate of unemployment.

Overcoming the problem of hysteresis is now a major policy issue within the European
Union where several countries are suffering from extremely high and damaging rates of
unemployment, much of which is long term in nature.

Social Costs of Unemployment

Rising unemployment is linked to social deprivation leading to negative externalities.

There is some relationship with crime, and other aspects associated with social
dislocation (for example via increased divorce rates, worsening health and lower life
expectancy). Areas and regions of persistently high unemployment see falling real
incomes and a worsening in inequalities of income and wealth. It can become very
difficult and expensive to reverse the decline of localities where unemployment rates are
incredibly high and where employment opportunities are poor. This remains a major
social and political problem for the UK despite the general progress in reducing
unemployment.

There has been a welcome reduction in long term unemployment over the last twelve
years

783
1
Possible benefits from unemployment

One benefit of rising unemployment is that it helps to keep the rate of inflation down
since high unemployment is often associated with a reduction in the bargaining power of
workers to bid for higher wages and salaries. There might also be an environmental gain
if unemployment is linked to a slower rate of growth of consumption and production,
reducing the pressures on scarce environmental resources. Having some people
unemployed in a frictional sense might also be regarded as beneficial in that it means that
there is a pool of unemployed workers who can take up new jobs as they become
available. But this depends on these workers having sufficient geographical and
occupational mobility. Full-employment in any economy is highly unlikely to be
achieved.

Government Policies to Reduce Unemployment

The government does not have a specific target for any particular rate of unemployment.
Instead its objective for the labour market is expressed in terms of a broad ambition to
keep employment high and provide employment opportunities for all.

Distinction can be made between demand-side and supply-side policies to improve the
working of the labour market in matching people to the available jobs and to the
changing demands and requirements of different industries. There are inevitably limits to
what the government can do to achieve sustainable reductions in unemployment. And
often the policies that are introduced to boost employment can be costly and involve an
opportunity cost.

Reducing occupational immobility of labour (supply-side policy)

Immobility of labour is a cause of labour market failure and structural unemployment.

Policies aimed at reducing this problem aim to provide the unemployed with the skills
they need to find re-employment and also to improve the incentives to find work.
Improvements in the availability and quality of education and work-place training will
increase the human capital of unemployed workers and help to ensure that more of the
unemployed have the right skills to take up the available job opportunities. For many
years the relative paucity of work-place training has been seen as a weakness in the UK
labour market. Both employers and employees may actually underestimate the long-term
value of training in terms of the potential benefit to a business and the long term gains to
a worker. The free-rider problem may also contribute to a sub-optimal level of training
from society’s point of view.

Benefit and tax reforms (supply-side policy)

To some economists, a policy that reduces the value of welfare benefits might increase
the incentive for the unemployed to take a job. The evidence drawn from recent
experience in the UK is that simply cutting the value of state welfare payments in reality
makes little difference to the level of unemployment in the long run. It is rare that the root

784
1
cause of someone staying out of work is the prospect of generous out of work welfare
handouts. Instead, targeted measures to improve people’s incentives, including the
linking of welfare benefits to participation in genuine work experience programmes
which is part of the New Deal programme or the introduction of lower marginal income
tax rates for people on low incomes might by contrast have a noticeable impact.

Reflating aggregate demand (demand-side policy)

The government can use the traditional weapon of macro-economic policies designed to
increase AD and thereby generate a higher level of national income and employment.
Reflationary policies can help to mitigate the effects of an economic recession but there
are risks involved in using both fiscal and monetary policy simply to boost demand when
output is low.

The government might also make more active use of regional policies to encourage
inflows of foreign investment from multinational companies particularly to those areas
and regions where unemployment is persistently above the national average. The main
weakness of relying too heavily on demand-management policies to reduce
unemployment is that much unemployment is not cyclical; rather it is frictional and
structural in origin and cannot be solved simply by injecting vast amounts of money into
the circular flow of income and spending.

Employment subsidies (demand-side policy)

Government subsidies for businesses that take on the long-term unemployed will create
an incentive for firms to increase the size of their workforce. Employment subsidies may
also be available for overseas firms locating in the UK in regions of below-average
economic prosperity.

Summary: The government’s current labour market strategy is firstly to rely on

monetary and fiscal policy to maintain a stable rate of economic growth as a pre-
condition for high and stable rates of employment. Macroeconomic stability is regarded
as essential for creating the right climate in which new jobs become available. Secondly,
supply-side policies and in particular active labour market strategies such as New Deal
and other welfare and education reforms are given a higher weighting in seeking to
reduce structural aspects of the unemployment problem.

The British economy has made substantial and significant progress in reducing
unemployment over the last fifteen years. Despite a recent upturn in unemployment (the
result of a slowdown in growth) the UK still has one of the lowest unemployment rates in
the European Union.

785
1
Key Points

 Unemployment occurs when individuals are jobless but willing and able to work
at the going wage rate. Official government figures only count people who
register as unemployed and are actively searching for work.
 Discouraged workers who want a job but have given up looking because they
have decided the search is hopeless – many are suffering from long-term
structural unemployment.
 Unemployment in the UK fell almost continuously from the summer of 2003 to
the start of 2005.Since then there has been a modest upturn in unemployment on
both the claimant count and the labour force survey measure. By the summer of
2006, unemployment had risen to a four year high.
 Unemployment has both demand and supply-side causes. Some unemployment
can be due to the voluntary decisions of people in the labour market, but most
unemployment is involuntary
 The economic and social costs of unemployment are greatest when
unemployment is long term
 There are strong links between high unemployment and inequality and risk of
relative poverty for households where no-one is in paid work. The unemployed
tend to have some of the lowest incomes in society.

786
1
 Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Flexible Labour Markets

Over the last twenty-five years, governments of both political persuasions appear to have
become wedded to the concept of ‘labour market flexibility’. In this chapter we look at
the meaning of a flexible labour market and consider its pros and cons.

What is a Flexible Labour Market?

Economists who believe in the power of freely functioning markets for goods, services,
capital and people are frequently strong supporters of flexible labour markets. But there is
no unique definition of the term. In fact we find that a flexible labour market has several
characteristics

Occupational (functional) flexibility – this refers to the ability of the workforce to

perform different tasks and to acquire and apply transferable skills. A worker with
transferable skills will be able to move easily from one job to another – they will be
occupationally mobile. Flexibility can also be encouraged by better training, and provide
incentives for people to adapt their skills. There is still a ‘skills gap’ between the UK and
many of our main international competitors. Rapid technological change and the
pressures of globalization are putting a premium on raising the skills of the workforce
and increasing the adaptability of people in work.
Ease and cost of hiring and firing workers: Reforms to UK employment laws now make
it easier to hire and fire workers - this reduces the costs to the employer of making
modifications to the size of their employed labour force. Output and employment can
more easily be matched during the different stages of an economic cycle.

Contractual flexibility: In many industries, workers are now offered jobs on six months,
sometimes on month-to-month contracts. There are even some instances of zero hour
contracts – where the number of hours that someone is asked to work will vary from
week to week – but with no guarantee of any hours being available at all! Part-time
workers now make up around 25 per cent of the UK workforce this is high in comparison
to much of Europe. Compared to the EU as a whole there are also a relatively high
number of employees with flexible working patterns in the UK, such as shift and
weekend working.

Wage flexibility: Wage flexibility refers to the ability of changes in real wages to
eliminate imbalances between the supply of and demand for labour. This can be seen in
the expansion of performance related pay (where some part of the total pay package is
linked to productivity, company profits or to other indicators of performance. In many
industries there is evidence of regionalization of pay awards so that payment can reflect

787
1
differences in regional demand for and supply of labour and also variations in regional
living costs

Geographical flexibility: Many businesses now expect their workers to be able to move
within and across different regions and countries as part of their career development.
There are always natural barriers to geographic mobility of labour, particularly across
national borders, but also within individual countries. These barriers relate to family
commitments, career progression and benefits and property (for example the costs
involved in moving home and the constraints imposed by wide regional variations in
house prices).

The UK is generally regarded as having a flexible labour market with the United States
measured as having the highest degree of flexibility. But not every country has to follow
the same labour market model! There is no unique template for success in raising
employment and reducing unemployment whilst at the same time protecting the
employment rights of people in work. The Danish economy has recently been praised for
its model of “flexicurity”!

Flexibility as a broad economic idea is basically the ability to respond to economic

change efficiently and quickly while safeguarding a degree of fairness. Changes include
the impact of innovation and changing technology, shifts in consumer preferences and
788
1
external shocks to the UK economy, such as the recent global slowdown or the surge in
world oil prices. According to the Treasury, a high degree of flexibility means that the
British economy will be more resilient in the face of such exogenous shocks and will
therefore minimise the costs in terms of lost output and jobs.

The table below summarises different aspects of labour market flexibility with examples
for each:

Price (wage) Numerical Temporal Functional Location

Flexibility Flexibility Flexibility Flexibility Flexibility

Regional and local pay Expansion of Flexibility of Ability of labour Geographical

agreements rather than short term working time i.e. force to use flexibility
national wage employment overtime and varied
settlements contracts weekend working technology

Pay packets reflecting Growth of homeIncreased use of Transferable

skill differentials working part-time staff to skills within the
meet changes in workplace
demand

Wider use of Core of full-time

performance related employees on
pay as an incentive to contracts
boost labour
productivity

789
1
Employment Rates in the UK economy

Percentages of adults aged 16+

Men Women All

1981 82.1 59.1 71.0

1991 79.9 66.2 73.3

2005 79.0 70.1 74.7

Source: Labour Force Survey

Has the flexible labour market model developed in the UK been beneficial to our growth
prospects? There is certainly no consensus on this answer, some economists believe that
the labour market flexibility has led to an increase in wage inequality but other analysts

790
1
argue that continued low levels of unemployment and inflation are testimony to a better
performance.

OECD hails UK flexible labour as key to success

The UK’s flexible labour market has led to employment levels that are the envy of
Europe and the USA, according to new research from the OECD. The UK came seventh
out of 30 OECD countries in terms of employment levels, with 74% of the working age
population having jobs.
Source: OECD and Personnel Today, July 2005

Do the Danes have the answer?

Due to its outstanding success, the Danish “flexicurity” model is much discussed at EU
and member states' level. The model has resulted in a decline of unemployment from
12% to 5%, while keeping the growth of wages at a steady 3% to 5% per year. A flexible
labour market makes it easy for employers to hire and fire, but high unemployment
benefits of up to 90% of the latest wage make transition from one job to another easy.
The concept of employment security thus replaces traditional job security. An active
labour market policy includes the right and the duty to training and job offers.
Source: adapted from the Euroactiv website

Advantages of a flexible labour market

 Neo-classical Economists believe that flexible wages and flexible employment

helps to ensure that markets clear rapidly eliminating any excess supply or
demand, so economies automatically move into long run equilibrium at potential
output.
 Improved occupational mobility of labour leading to less structural
unemployment and a reduction in the natural rate
 Stronger employment creation during an economic upturn
 Flexibility makes the British economy more attractive to inward investment
 Higher productivity growth in the long run (which then helps to improve
competitiveness)
 Contributes to an improvement in the inflation-unemployment trade off (see the
next chapter on the Phillips Curve)
 The economy can respond more flexibly to an external economic shock – because
wages and employment are more flexible

Disadvantages of a flexible labour market

 There are concerns about a lack of training for workers on short term contracts
which has a long term effect on their ability to regain employment if they lose
their jobs. This ties in with broader concerns about skills gaps in the economy.

791
1
  Shorter term contracts might lead to job insecurity – for some people, the concept
of “job security” is being gradually replaced by the concept of “employability”.
Frequent job changes for workers can be unsettling for them and for their
families.
 There are concerns about the link between a flexible labour market and growing
relative poverty – because of the reduction in trade union membership and less
employee-bargaining power in many jobs.
 Shorter term employment contacts and eligibility for occupational pensions may
lead to increased pensioner poverty in the long run, many people on short term
contracts do not enter into any occupational pension.
 There is a risk of “slash and burn” during an economic slowdown / recession as
companies seek to cut their workforces aggressively during a downturn.
 Longer term social implications of labour market flexibility – the “24 hours per
day” work culture and the possible effects on family life.

Barriers to labour market flexibility

 Although workers in the UK and the USA are probably subject to fewer
government regulations than in most other Western European countries, there
remain plenty of laws and regulations affecting workers which limit the flexibility
of the labour market. Each of them can be justified either on economic or social
grounds.
 The National Minimum Wage
 The European Union Working Hours Directive
 Laws on minimum holiday entitlements, maternity and paternity leave and health
and safety at work.
Employment laws which protect workers from unfair dismissal.

Reforms to national labour markets remains an important economic policy topic at the
moment as many European countries look to increase their employment rates (partly as a
solution to the impending pensions crisis) and reduce what, for many countries, has
become a deeply-rooted unemployment problem.

Key Points

 Flexible labour markets are a supply-side policy designed to increase

employment, raise productivity and keep labour costs under control.
 The strongest supporters of flexile labour markets are neo-classical economists
who believe in the power of free markets and argue for less government
intervention in the labour market
 The UK labour market has undoubtedly become more flexible in the last twenty
years with rising part-time employment for most of this period; greater
localization of pay agreements and a shift toward short-term contracts in many
(but not all) occupations and industries
 There are plenty of barriers and imperfections in the UK labour market

792
1
 Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Measuring Inflation

Inflation is best defined as a sustained increase in the general price level leading to a
fall in the value of money. In this section we will concentrate on the measurement of
inflation in the UK.

The UK consumer price index since 1930 – notice the effect of the high rates of inflation
during the 1970s and the 1980s.

The consumer price index (CPI) is a weighted price index which measures the monthly
change in the prices of goods and services. The spending patterns on which the index is
weighted are revised each year, mainly using information from the Family Expenditure
Survey. The expenditure of some of the higher income households, and of pensioner
households mainly dependent on state pensions, is excluded. As spending patterns change

793
1
over time, the weightings used in calculating the CPI are altered. The consumer price
index is now used as the main official measure of inflation in the UK. It is a weighted
price index. The current weights used in the calculation of the price level are summarised
in the table below:

Weights used in the consumer price index

Food & Alcohol and Clothing Housing, Household Health Transport

Non- Tobacco & water & furnishings
Alcoholic Footwear fuels
Drinks

1988 184 67 84 134 76 5 159

2004 106 46 62 103 75 22 151

Transport Communication Recreation Education Hotels, Miscellaneous

& Culture Cafes goods &
services

1988 159 20 94 9 118 50

2004 151 26 150 16 137 106

The changes in these weights reflect significant shifts in spending patterns of households
in the British economy. The weighting attached to food and non alcoholic drinks has
declined from 184/1000 in 1988 to just 106/1000 this year. In contrast families are
spending proportionately more of their budgets on recreation and cultural activities,
hotels and cafés!

Calculating a weighted price index

The following hypothetical example shows how to calculate a weighted price index for a
number of categories of consumer spending.

Category Price Index Weighting Price x Weight

794
1
Food 104 19 1976

Alcohol & Tobacco 110 5 550

Clothing 96 12 1152

Transport 108 14 1512

Housing 106 23 2438

Leisure Services 102 9 918

Household Goods 95 10 950

Other Items 114 8 912

100 10408

Weights are attached to each category and then we multiply these weights to the price
index for each item of spending for a given year.

 The price index for this year is: the sum of (price x weight) / sum of the weights
 So the price index for this year is 104.1 (rounding to one decimal place)

The rate of inflation is the % change in the price index from one year to another. So if in
one year the price index is 104.1 and a year later the price index has risen to 112.5, then
the annual rate of inflation = (112.5 – 104.1) divided by 104.1 x 100. Thus the rate of
inflation = 8.07%.

795
1
The inflation target for the UK

The inflation target for the UK economy is consumer price inflation of 2.0%. This
inflation target is set each year by the Chancellor and it is the task of the Bank of
England (BoE) to meet this target. There is a permitted band of fluctuation of +/- 1%. The
inflation target was changed in December 2003. Between May 1997 and December 2003
the inflation target was for CPIX (retail price inflation excluding mortgage interest rates)
and the target was 2.5%.

796
1
The progress of the UK economy in keeping to the 2% inflation target since the
millennium

Limitations of the Consumer Price Index as a measure of inflation

The retail price index is a thorough indicator of consumer price inflation for the British
economy but there are some weaknesses in its usefulness for some groups of people.

 The CPI is not fully representative: Since the CPI represents the expenditure of
the ‘average’ household, it may be inaccurate for the ‘non-typical’ household.
14% of the index is devoted to motoring expenses - inapplicable for non-car
owners. Single people have different spending patterns from households that
include children, young from old, male from female, rich from poor and minority
groups. We all have our own ‘weighting’ for goods and services that does not
coincide with that assigned for the retail price index.
 Housing costs: The ‘housing’ category of the CPI records changes in the costs of
rents, mortgage interest, property and insurance, repairs. It accounts for around
16% of the index. Housing costs vary greatly from person to person, from the
young house buyer, mortgaged to the hilt, to the older householder who may have
paid off his or her mortgage.

797
1
  Changing quality of goods and services: Although the price of a good or service
may rise, this may be accompanied by an improvement in quality as the good. It is
hard to make price comparisons of, for example, electrical goods over the last 20
years because new audio-visual equipment is so different from its predecessors. In
this respect, the CPI may over-estimate inflation. The CPI is slow to respond to
the emergence of new products and services.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Consequences of Inflation

High and volatile inflation is widely seen by economists to have a range of economic and
social costs – hence the continued importance attached to the control of inflationary
pressure in an economy by both the government and also the central bank (in the UK’s
case, the Bank of England). This chapter considers some of the effects of inflation on an
economy.

Why does inflation matter?

The impact of inflation on individuals and businesses depends in part on whether

inflation is anticipated or unanticipated:

o Anticipated inflation: When people are able to make accurate predictions of

inflation, they can take steps to protect themselves from its effects. For example,
trade unions may exercise their collective bargaining power to negotiate with
employers for increases in money wages so as to protect the real wages of union
members. Households may also be able to switch savings into deposit accounts
offering a higher nominal rate of interest or into other financial assets such as
housing or equities where capital gains over a period of time might outstrip
general price inflation. In this way, people can help to protect the real value of
their financial wealth. Companies can adjust prices and lenders can adjust interest
rates. Businesses may also seek to hedge against future price movements by
transacting in “forward markets”. For example, most of the major airlines buy
their aviation fuel several months in advance in the forward market, partly as a
protection against fluctuations in world oil prices.
o Unanticipated inflation: When inflation is volatile from year to year, it becomes
difficult for individuals and businesses to correctly predict the rate of inflation in
the near future. Unanticipated inflation occurs when economic agents (i.e. people,
businesses and governments) make errors in their inflation forecasts. Actual
inflation may end up well below, or significantly above expectations causing
losses in real incomes and a redistribution of income and wealth from one group
in society to another.

798
1
Money Illusion

It is a fact of life that people often confuse nominal and real values in their everyday lives
because they are misled by the effects of inflation. For example, a worker might
experience a 6 per cent rise in his money wages – giving the impression that he or she is
better off in real terms. However if inflation is also rising at 6 per cent, in real terms there
has been no growth in income. Money illusion is most likely to occur when inflation is
unanticipated, so that people’s expectations of inflation turn out to be some distance from
the correct level. When inflation is fully anticipated there is much less risk of money
illusion affecting both individual employees and businesses

The Main Costs of Inflation

What are the main costs of inflation? Why is the control of inflation given such a high
priority in macroeconomic policy-making? Supporters of tough inflation control would
support the arguments made in this quote in a speech delivered in 2002 from Mervyn
King.

The case for maintaining price stability

‘It is clear that very high inflation – in extreme cases hyperinflation – can lead to a
breakdown of the economy. There is now a considerable body of evidence that inflation
and output growth are negatively correlated in high-inflation countries. For inflation rates
in single figures, the impact of inflation on growth is less clear.’
Source: Mervyn King, Governor of the Bank of England

In explaining and assessing the costs of inflation, we must be careful to distinguish

between different degrees of inflation, since low and stable inflation is perceived to
have less of a damaging effect than hyper-inflation where prices are out of control.
Another important part of your evaluation is to be aware that inflation will have differing
effects both on individuals and also the performance of the economy as a whole.

Impact of Inflation on Savers:

Inflation leads to a rise in the general price level so that money loses its value. When
inflation is high, people may lose confidence in money as the real value of savings is
severely reduced. Savers will lose out if nominal interest rates are lower than inflation –
leading to negative real interest rates. For example a saver might receive a 3% nominal
rate of interest on his/her deposit account, but if the annual rate of inflation is 5%, then
the real rate of interest on savings is -2%.

Inflation Expectations and Wage Demands

Inflation can get out of control because price increases lead to higher wage demands as
people try to maintain their real living standards. Businesses then increase prices to
maintain profits and higher prices then put further pressure on wages. This process is

799
1
known as a ‘wage-price spiral’. Rising inflation leads to a build-up of inflation
expectations that can worsen the trade-off between unemployment and inflation.

Arbitrary Re-Distributions of Income

Inflation tends to hurt those employees in jobs with poor bargaining positions in the
labour market - for example people in low paid jobs with little or no trade union
protection may see the real value of their pay fall. Inflation can also favour borrowers at
the expense of savers as inflation erodes the real value of existing debts. And, the rate of
interest on loans may not cover the rate of inflation. When the real rate of interest is
negative, savers lose out at the expense of borrowers.

Business Planning and Investment

More generally, inflation can disrupt business planning. Budgeting becomes difficult
because of the uncertainty created by rising inflation of both prices and costs - and this
may reduce planned capital investment spending. Lower investment then has a
detrimental effect on the economy’s long run growth potential

Competitiveness and Unemployment

Inflation is a possible cause of higher unemployment in the medium term if one country
experiences a much higher rate of inflation than another, leading to a loss of
international competitiveness and a subsequent worsening of their trade performance. If
inflation in the UK is persistently above our major trading partners, British exporters may
struggle to maintain their share in overseas markets and import penetration into the UK
domestic market will grow. Both trends could lead to a worsening balance of payments.
The UK government believes that monetary stability (i.e. low inflation) is a precondition
for sustained economic expansion. As the chart below demonstrates, the UK has made
progress in reducing the volatility of its inflation rate in the last decade. The era of high
and volatile inflation may have come to an end.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Monetarism and the Quantity Theory of Money

In this section we consider briefly the main principles of the monetarist theory of inflation
and the role that monetary policy can play in stabilising prices and output in an
economy.

The basics of monetarism

800
1
The key features of monetarist theory are as follows:

o The main cause of inflation is an excess supply of money leading to in the words
of Monetarist Economist Milton Friedman, “too much money chasing too few
goods”. We will see graphically how this can lead to a build up of inflationary
pressure in an economy.
o Tight control of money and credit is required to maintain price stability
o Attempts by the government to use fiscal and monetary policy to “fine-tune” the
rate of growth of aggregate demand are often costly and ineffective. Fiscal policy
has a role to play in stabilising the economy providing that the government is
successfully able to control its own borrowing.
o The key is for monetary policy to be credible – perhaps in the hands of an
independent central bank – so that people’s expectations of inflation are
controlled.

A simple way of explaining how a surge in the amount of money in circulation can feed
through to higher inflation is shown in the next flow chart.

Excess money balances held by households and businesses can affect demand and
output in several directions. Consumers will often increase their own demand for goods
and services adding directly to aggregate demand (although a high proportion of this
extra spending may go on imports).

Secondly some of the excess balances will be saved in bonds and other financial assets,
or invested in the housing market. An increase in the demand for bonds causes a
downward movement in bond interest rates (there is an inverse relationship between the
two) and this can then stimulate an increase in investment.

Similarly money that flows into housing will push house prices higher, and we know
understand quite well how a booming housing market stimulates consumer wealth,
borrowing and an increase in spending.

801
1
The Quantity Theory of Money

The Quantity Theory was first developed by Irving Fisher in the inter-war years as is a
basic theoretical explanation for the link between money and the general price level. The
quantity theory rests on what is sometimes known as the Fisher identity or the equation
of exchange. This is an identity which relates total aggregate demand to the total value
of output (GDP).

MxV=PxY
Where

1. M is the money supply

2. V is the velocity of circulation of money
3. P is the general price level
4. Y is the real value of national output (i.e. real GDP)

802
1
The velocity of circulation represents the number of times that a unit of currency (for
example a £10 note) is used in a given period of time when used as a medium of
exchange to buy goods and services. The velocity of circulation can be calculated by
dividing the money value of national output by the money supply.

In the basic theory of monetarism expressed using the equation of exchange, we

assume that the velocity of circulation of money is predictable and therefore treated as a
constant. We also make a working assumption that the real value of GDP is not
influenced by monetary variables. For example the growth of a country’s productive
capacity might be determined by the rate of productivity growth or an increase in the
capital stock. We might therefore treat Y (real GDP) as a constant too.

If V and Y are treated as constants, then changes in the rate of growth of the money
supply will equate to changes in the general price level. Monetarists believe that the
direction of causation is from money to prices (as we saw in the flow chart on the
previous page).

The experience of targeting the growth of the money supply as part of the monetarist
experiment during the 1980s and early 1990s is that the velocity of circulation is not
predictable – indeed it can suddenly change, partly as a result of changes to people’s
behaviour in their handling of money. During the 1980s it was found that direct and
predictable links between the growth of the money supply and the rate of inflation broke
down. This eventually caused central banks in different countries to place less importance
on the money supply as a target of monetary policy. Instead they switched to having
exchange rate targets, and latterly they have become devotees of inflation targets as an
anchor for the direction of monetary policy.

Measuring the money supply

803
1
There is no unique measure of the money supply because it is used in such a wide variety
of ways:

M0 (Narrow money) - comprises notes and coins in circulation banks' operational

balances at the Bank of England. Over 99% of M0 is made up of notes and coins as cash
is used mainly as a medium of exchange for buying goods and services. Most economists
believe that changes in the amount of cash in circulation have little significant effect on
total national output and inflation. At best M0 is seen as a co-incident indicator of
consumer spending and retail sales. If people increase their cash balances, it is mainly a
sign that they are building up these balances to fund short term increases in spending. M0
reflects changes in the economic cycle, but does not cause them.

M4 (Broad money) is a wider definition of what constitutes money. M4 includes

deposits saved with banks and building societies and also money created by lending in
the form of loans and overdrafts.

M4 = M0 plus sight (current accounts) and time deposits (savings accounts).

804
1
When a bank or another lender grants a loan to a customer, bank liabilities and assets
raise by the same amount and so does the money supply. Again M4 is a useful
background indicator to the strength of demand for credit. The Bank takes M4 growth
into account when assessing overall monetary conditions, but it is not used as an
intermediate target of monetary policy. Its main value is as a signpost of the strength of
demand which can then filter through the economy and eventually affect inflationary
pressure.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Government Monetary Policy

How does monetary policy work? What does the Bank of England consider when setting
interest rates and how effective has the Bank been in handling monetary policy since it
was made independent of government in May 1997. These are some of the issues that we
consider in this chapter.

A recap on the basics of monetary policy

Monetary policy involves changes in the base rate of interest to influence the growth of
aggregate demand, the money supply and price inflation. Monetary policy works by
changing the rate of growth of demand for money. Changes in short term interest rates
affect the spending and savings behaviour of households and businesses and therefore
feed through the circular flow of income and spending.

The transmission mechanism of monetary policy works with variable time lags
depending on the interest elasticity of demand for different goods and services. Because
of the time lags involved in setting an appropriate level of short-term interest rates, in the
UK the Bank of England sets rates on the basis of hitting the inflation target over a two
year forecasting horizon.

805
1
 All countries experience an interest rate cycle as monetary policy responds to changing
economic conditions

Independence for the Bank

The Bank of England has been independent of the Government since 1997. In that time
there has been a cycle of small changes in interest rates. They have varied from 3.75% (in
the late autumn of 2003) to 7.5% in the autumn of 1997. Interest rates in the UK were
raised from 4.5% to 4.75% in August 2006 at a time when interest rates in other countries
including the United States and Japan have been rising. Generally though, the UK
economy has experienced a sustained period of low interest rates over recent years. And,
this has had important effects on the wider economy.

The Bank of England through the decisions of the Monetary Policy Committee prefers a
gradualist approach to monetary policy – believing that a series of small movements in
interest rates is a more effective strategy in achieving their aims rather than sharp and
unexpected jumps in the cost of borrowing money. Knee jerk changes in monetary policy
can be very unsettling for both consumers and businesses throughout the economy.

The role of monetary policy

806
1
A summary of the role that monetary policy plays is provided in this quote from the
Government of the Bank of England, Mervyn King.

The role of monetary policy – the Governor’s view

What is the mechanism by which monetary policy contributes to a more stable economy?
I would argue that monetary policy is now more systematic and predictable than before.
Inflation expectations are anchored to the 2% target. Businesses and families expect that
monetary policy will react to offset shocks that are likely to drive inflation away from
target. In the jargon of economists, the “policy reaction function” of the Bank of England
is more stable and predictable than was the case before inflation targeting, and easier to
understand. More simply, monetary policy is not adding to the volatility of the economy
in a way that it did in earlier decades.
Adapted from “The Inflation Target – Ten Years On”, Mervyn King in October 2002

Monetary Policy and the Exchange Rate

There is no official exchange rate target for the British economy. The UK operates within
a floating exchange rate system and has done ever since we suspended our membership
of the European exchange rate mechanism (the ERM) in September 1992. The Monetary
Policy Committee has occasionally discussed the relative merits and de-merits of
intervening in the current markets to influence the external value of the pound but no
official intervention has occurred for over a decade. There are in any case doubts about
the effectiveness of direct intervention in the foreign exchange markets as a means of
achieving a desired exchange rate.

Monetary policy and the money supply

There are currently no targets for the growth of the money supply measured by MO
and M4. Data on the growth of the stock of money provides useful information for the
MPC on the strength of aggregate demand but interest rates are not determined with
reference to specific targets for the money supply. In addition the UK no longer imposes
supply-side controls on the growth of bank lending and consumer credit. Instead
monetary policy in the UK is designed to control the growth in the demand for money
through changing the cost of loans and influencing the incentive to save via changes in
interest rates.

The determination of interest rates – how the Bank gets to work in the markets

It is important to understand how the BOE influences interest rates via daily intervention
in the London money markets. Each day there are huge flows of money from the
government to banks and vice versa. Usually more money flows from the banks to the
government (for example people and companies paying their income tax) so, each day
there is a shortage in the market.

The BOE is the main provider of liquidity to the wider financial system, in the
markets it is known as the “lender of last resort”. It can choose the interest rate it wishes

807
1
to charge to financial institutions requiring money. The interest rate at which the BOE is
prepared to lend to the financial system is quickly passed on, influencing interest rates in
the whole economy - for example the rate of interest on mortgages and the rates on offer
to savers.

Monetary policy in Britain is designed to be pro-active and forward-looking because

changes in interest rates always take time to work through the economy. The reaction of
businesses and consumers to interest rate movements is uncertain, as are the time lags
involved. The belief is that by making interest rate changes in a pre-emptive fashion, for
example raising rates before the rate of growth of AD becomes too fast, or cutting rates to
reduce the risks of recession, then the scale of interest rate changes needed to meet the
inflation target will be reduced. The thinking is that a monetary policy regime that offers
the prospects of relatively stable interest rates over time can help to promote consumer
and business confidence.

Factors considered by the Monetary Policy Committee

Before each meeting of the Monetary Policy Committee, a huge raft of economic
information is put before members of the MPC rate-setting board. Much of the data that
is considered will be information that you may have become familiar with during your
AS and A2 economics courses. The economic data considered each month by the MPC
includes the following:

 GDP growth and spare capacity: The rate of growth of real national output and
the estimated size of the output gap are central to discussions within the MPC
about setting the appropriate level of interest rates. Their main task is to set
monetary policy so that demand grows more or less in line with the increase in the
country’s productive potential.
 Bank lending and consumer credit figures including the levels of mortgage
equity withdrawal from the housing market and also monthly data on credit card
lending.
 Equity markets (share prices) and house prices - both are considered important
in determining household wealth which then feeds through to borrowing and retail
spending. The state of play in the UK housing market has been influential in
shaping interest rate decisions over the last two to three years although we must
remember that the monetary policy committee has no official target for the annual
rate of house price inflation.
 Consumer confidence and business confidence indicators – confidence surveys
are thought to provide useful “advance warning” of possible turning points in the
economic cycle. So for example, a sharp dip in consumer optimism might herald a
retrenchment of spending which could lead to slower GDP growth and a
weakening of inflationary pressure.
 The growth of wages, average earnings and unit labour costs in the labour
market – these are considered important as indicators of demand pull and cost
push inflationary pressure. The Monetary Policy Committee might become

808
1
 concerned if the annual rate of wage inflation surged above the 5% mark as this
might eventually feed through into a rise in consumer prices.
 Unemployment figures and survey evidence on the scale of shortages of skilled
labour – these are also labour market indicators as was mentioned in the last bullet
point.
 Trends in global foreign exchange markets – for example the trend in the value
of sterling against the Euro or the US dollar. A weaker exchange rate could be
seen as a threat to inflation because it raises the prices of imported goods and
services.
 Forward looking indices such as the Purchasing Managers’ Index and quarterly
surveys of business confidence including data from the Confederation of British
Industry and the British Chambers of Commerce
 International economic data including recent macroeconomic developments in
the twelve member nations of the Euro Zone and the world’s largest economy, the
United States.

The neutral rate of interest

One interesting and important feature of interest rate setting both in the UK and overseas
is the concept of a neutral rate of interest. The idea behind this is that there might be a
rate of interest that neither deliberately seeks to stimulate aggregate demand and growth,
809
1
nor deliberately seeks to weaken growth from its current level. In other words, a neutral
rate of interest would be that which is set at a level which encourages a rate of growth of
demand close to the estimated trend rate of growth of real GDP. There can be no such
thing as an exact measure of the neutral rate, and it will certainly differ from country to
country.
Students who want to explore this further might want to read up on something called the
Taylor Rule

In Britain over the last two to three years, interest rates set by the Bank of England have
almost certainly been below the estimated neutral rate. Why? Well the Bank has been
careful to maintain economic growth given the absence of any serious threat from higher
inflation. In the summer of 2003, the MPC cut interest rates to 3.5% and it was quite clear
at the time that monetary policy was being expansionary. This means that monetary
policy was actively seeking to stimulate confidence and spending in the domestic British
economy at a time of great global economic uncertainty.

A recent survey of city economists (admittedly a small but pretty high-powered sample!)
puts the neutral rate of interest in the UK at between 4.5 – 5.5%. At the time of writing
UK official short-term interest rates are at 4.75%. This suggests that monetary policy in
the UK is now broadly neutral in terms of its effect on the rate of growth of demand.

The monetary policy transmission mechanism

The usual view of the transmission mechanism of monetary policy is illustrated in the
flow chart below:

810
1
Time lags and asymmetries in the transmission mechanism

Although a change in interest rates affects the macro-economy in several ways, there are
inevitable time lags in involved. It is also worth stressing that some sectors of the
economy are more affected by base interest rate changes than others and some regions of
the economy are also more exposed to a change in the direction of interest rates. For
example industries that export a high percentage of their output will be more exposed to
movements in the exchange rate that might follow from a change in monetary policy.
Similarly markets whose demand is sensitive to interest rate changes will be affected to a
greater extent than markets where the interest elasticity of demand is lower.

Consider for example the effect of a 2% rise in interest rates over a period of 6 months.
The demand for basic foods and clothing is unlikely to be influenced much by this
whereas the demand for new cars, expensive household durable goods and other “interest
sensitive” products will probably experience a much greater change in demand from
consumers.

811
1
The impact of interest rate movements is not uniform throughout the economy. But the
Bank of England sets interest rates to meet a national inflation target, and cannot be
expected to determine interest rates to meet the particular needs of an individual industry,
sector or region of the country.

Macro-policies that seek to raise the level of demand and output in the domestic economy
are called “accommodatory policies”. In other words, they boost demand beyond what
would normally happen through the working of the automatic stabilisers.

The Role of Inflation Targets

Inflation targets have been in place in the UK since the autumn of 1992 and they have
also become a frequent feature of macroeconomic policy-making in many other
countries. They were first introduced following the UK’s departure from the ERM
because it was believed that a credible anti-inflation economic policy needed a clear
anchor by which the policy could be judged.

The inflation target that has been introduced in Britain is symmetrical – this means that
temporary deviations of inflation below the target are treated with the same degree of
importance as deviations above the target. The main reason for this design of the inflation
target is that monetary policy should not only deliver price stability, but also seeks to
support the broader aims of sustained economic growth and high employment.

If the inflation target was set at 2% or below, there might be a tendency for the Bank of
England to drive inflation as low as possible to ensure they meet the inflation target. But
this would risk creating deflationary pressures in many sectors of the economy to such an
extent that unemployment might be higher and national output lower than desired. The
Bank of England is as concerned to avoid some of the economic and social costs of
deflation as it is the well documented implications of a surge in inflation.

Inflation has been remarkably stable since the early 1990s. The next table provides long-
term data for UK inflation since 1950. The average annual rate of inflation fell from
13.1% during the 1970s to just 2.5% since the introduction of the inflation targets. Notice
too that the standard deviation of inflation (a measure of variance) has also come down
sharply over the last ten years. The 1970s and 1980s were by and large, decades of high
and volatile inflation. By contrast, the last fifteen years has been a period of much greater
stability, leading to a sustained fall in inflationary expectations

Long Term Inflation Data for the UK

Annual average percentage change in retail prices

Mean Inflation Standard Deviation

1950-59 4.1 1.06

812
1
1960-69 3.7 0.72

1970-79 13.1 1.81

1980-92 6.4 1.14

1993-02 2.5 0.21

Source: Bank of England www.bankofengland.co.uk

There is now a consensus that low and stable inflation can contribute to growth and
employment creation in the long run. To that end, many countries have put in place
inflation targets.

Main Advantages of a Credible Inflation Target

Business planning and investment: Businesses are better able to plan ahead if they
believe that the inflation target will be met. They will be more certain about their costs
and expected rates of return on investment
Policy transparency: An inflation target provides improved transparency and
accountability for the conduct of monetary policy – the general public can see for
themselves whether the target is being achieved and whether economic policies are being
effective. The target provides clear rules for monetary policy which in the long term
enhances policy-making effectiveness.
Controlling inflationary expectations: A credible target lowers expectations of inflation –
and this helps to control the growth of wages, in other words, a well designed inflation
target can be seen as a key policy “anchor.”

The Problems involved in Forecasting Inflation

Inflation in any economy can never be forecast with perfect accuracy! For a start, the
published inflation measure is the result of millions of pricing decisions made by
businesses large and small operating in thousands of different markets and sub-markets.
The calculation of the consumer price index in the UK although extremely thorough, is
always subject to error and omission.

Furthermore, the complex nature of the inflation process makes it difficult to forecast,
even when inflationary conditions appear to be benign. External economic shocks can
make forecasts inaccurate. For example, a jump in world oil prices or the deep falls in
global share prices both have feedback effects through the economic system. The
exchange rate might fluctuate leading to volatility in the prices of imports.

The Bank of England in its quarterly Inflation Report does not even attempt to forecast a
precise rate of inflation over its two year forecasting horizon. Instead it produces a

813
1
colourful ‘fan-chart’ which encompasses its central forecast for inflation based on the
probabilities of inflation falling within certain ranges over the next twenty-four months.
The central projection is always that the inflation target will be met. But it could not be
otherwise, for if the Bank was to say that its current interest rates were not appropriate to
meeting the inflation target going forward, and then a change in policy would be
required!

Price stability

Inflation has been low and stable in recent years. The former Chairman of the US Federal
Reserve, Alan Greenspan has defined price stability as follows:

“We will be at price stability when households and businesses need not factor
expectations of changes in the average level of prices into their decisions. Price stability"
implies that business and household decision-making should be able to proceed on the
basis that "real" and "nominal" values are substantially the same over the planning
horizon
Source: Alan Greenspan, Chairman of the US Federal Reserve, in a speech made in
2000. The current chairman of the US Federal Reserve is Ben Bernanke

There is no hard and fast numerical rule for price stability – but steady inflation of 1-3%
must come close to meeting the requirements – in this sense, the British economy has
enjoyed a return to price stability in recent years.

Reasons for low inflation in the UK in recent years

Average Unit Labour Producer Retail Price Consumer Price

Earnings Costs Prices Index (CPI) Index (CPI)

% change % change % change % change % change

2000 5 3.4 -0.2 2.9 0.8

2001 5.2 3.8 -0.6 1.8 1.2

2002 3.7 2.6 -0.1 1.6 1.3

2003 3.3 1.9 1.3 2.9 1.4

2004 4.5 2.2 1.2 2.9 1.4

Average 4.5 3.1 0.0 2.5 1.4

814
1
1997-2004

Among the factors helping to keep inflation in Britain low, we can identify the following:

 Low wage inflation from the labour market: There has been a very subdued
growth of wages and earnings which have grown at a fairly modest rate in recent
years, staying close to the Bank of England’s desired upper limit of
approximately 4.5% per year despite the sustained fall in unemployment. As the
table above illustrates, during the years 1997-2004, the average rate of growth of
earnings has indeed been 4.5%.
 Low global inflation and deflation in some countries: The absence (until
recently) of major external global inflationary shocks such as a sharp jump in
international commodity prices. There has been a clear fall in the average rate of
inflation among leading economies, and this decline in global inflation has filtered
through to the UK. Oil prices have soared during 2004 – but thus far, the effect on
the rate of inflation in the UK has remained modest. This is explored in a separate
section on the macroeconomic effects of an oil price shock in an earlier section of
this study companion.

815
1
  The effectiveness of monetary policy in the UK: The success of the Bank of
England in keeping aggregate demand under control through interest rate changes
 Increased contestability of many markets: Microeconomic supply-side reforms
has led to much greater competitive pressure in many industries – many markets
have become more contestable in the last decade and this extra competition has
placed a discipline on businesses to control their costs, reduce profit margins and
seek improvements in efficiency. In some industries there has been a huge
reduction in the pricing power of businesses, globalisation has accelerated this
process
 Strength of the exchange rate: The recent strength of the pound over the years
1996-2002 has undoubtedly helped to keep inflation under control because it
lowers the sterling cost of imported products and also squeezes demand for UK
exporters
 Information technology effects: The rapid expansion of information and
communication technology has helped to reduce costs and has made prices more
transparent for consumers
 Price cuts within the utilities: Cuts in the prices charged by many of the
privatised utilities under the regulatory regime of bodies such as OFTEL and
OFGEM
 Sharp decline in inflation expectations: Expectations of inflation have fallen –
leading to a fall in inflationary wage demands. The wage price spiral has been
largely absent from the British economy over the last decade or more. The
Governor of the Bank of England, Mervyn King has coined the 1990s as the
“nice decade” – a period of time when a combination of favourable factors has
kept inflation in check allowing continued economic growth and a fall in
unemployment!

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Fiscal Policy

The government’s handling of its own spending, taxation and government borrowing are the key
components of fiscal policy. In this note we delve deeper into some aspects of fiscal policy drawing
on the concepts covered at AS level.

What is Fiscal Policy?

Fiscal policy involves the use of government spending, taxation and borrowing to influence both
the pattern of economic activity and also the level and growth of aggregate demand, output and
employment. A rise in government expenditure, or a fall in the burden of taxation, should increase
aggregate demand and boost employment. The size of the resulting final change in equilibrium
national income is determined by the multiplier effect. The larger the national income multiplier,
the greater the change in national income will be.

816
1
However fiscal policy is also used to influence the supply-side performance of the economy. For
example, changes in fiscal policy can affect competitive conditions individual markets and
industries and change the incentives for people to look for work and for companies to invest and
engages in research and development. Government capital spending on transport infrastructure and
public sector investment in education and health can also have a direct but unpredictable effect in
the long run on the competitiveness and costs of businesses in every industry.

Government Spending

Government spending can be broken down into three main categories:

o General government expenditure - consists of the combined capital and current spending
of central government including debt interest payments to holders of government debt
o General government final consumption - is government expenditure on current goods and
services excluding transfer payments
o Transfer payments – transfers are transfers from taxpayers to benefit recipients through the
working of the social security system. The total welfare bill now exceeds £140 billion per
year

Government Spending and Fiscal Policy Objectives

The Treasury has outlined the main goals of fiscal policy to be the following:

o Equity concerns: To ensure that government spending and taxation impact fairly within and
across generations – fiscal policy should be equitable to current and future generations
o Funding government spending: To meet the government’s spending and tax priorities
without a damaging rise in the burden of government debt
o The benefit principle: This principle seeks to ensure that those who benefit from public
services such as the benefits from education, health and transport also meet as far as
possible the costs of the services they consume
o Macroeconomic stability: Fiscal policy in the UK is now designed to support monetary
policy in ‘smoothing the path of aggregate demand over the economic cycle’ and in
contributing to an environment of sustainable growth and stable inflation – this is the main
macroeconomic objective of fiscal policy. Gordon Brown has introduced two fiscal rules to
support this objective

817
1
With the total level of government spending rising above £480 billion in 2004, much concern has
been given to the actual results from this level of public sector spending. In particular the size of the
state sector has been criticised by those who claim that public sector spending is open to a high
level of waste and lack of efficiency. The media often talk of the need for the public services to
“deliver” value for money in terms of meeting people’s needs and wants.

Successive governments have striven to improve the efficiency with which public services are
provided. This has included the widespread use of contracting-out and competitive tendering
where private sector businesses compete with the public sector for the contracts to provide services
such as NHS catering, laundry and cleaning services, together with maintenance of the road
network and aspects of the prison service. The government has also introduced value for money
audits for each major government spending department together with a huge and growing number
of performance targets.

818
1
 819
1
Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Fiscal Policy Effects

Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour
of individual households and businesses – hence in this note we consider some of the
microeconomic effects of fiscal policy before considering the links between fiscal policy
and aggregate demand and key macroeconomic objectives.

The microeconomic effects of fiscal policy

1. Taxation and work incentives

820
1
Can changes in income taxes affect the incentive to work? This remains a controversial
subject in the economic literature!

Consider the impact of an increase in the basic rate of income tax or an increase in the
rate of national insurance contributions. The rise in direct tax has the effect of reducing
the post-tax income of those in work because for each hour of work taken the total net
income is now lower. This might encourage the individual to work more hours to
maintain his/her target income. Conversely, the effect might be to encourage less work
since the higher tax might act as a disincentive to work. Of course many workers have
little flexibility in the hours that they work. They will be contracted to work a certain
number of hours, and changes in direct tax rates will not alter that.

The government has introduced a lower starting rate of income tax for lower income
earners. This is designed to provide an incentive for people to work extra hours and keep
more of what they earn.

Changes to the tax and benefit system also seek to reduce the risk of the ‘poverty trap’ –
where households on low incomes see little net financial benefit from supplying extra
hours of their labour. If tax and benefit reforms can improve incentives and lead to an
increase in the labour supply, this will help to reduce the equilibrium rate of
unemployment (the NAIRU) and thereby increase the economy’s non-inflationary growth
rate.

2. Taxation and the Pattern of Demand

821
1
Changes to indirect taxes in particular can have an effect on the pattern of demand for
goods and services. For example, the rising value of duty on cigarettes and alcohol is
designed to cause a substitution effect among consumers and thereby reduce the demand
for what are perceived as “de-merit goods”. In contrast, a government financial subsidy
to producers has the effect of reducing their costs of production, lowering the market
price and encouraging an expansion of demand.

The use of indirect taxation and subsidies is often justified on the grounds of instances of
market failure. But there might also be a justification based on achieving a more
equitable allocation of resources – e.g. providing basic state health care free at the point
of use.

3. Taxation and labour productivity

Some economists argue that taxes can have a significant effect on the intensity with
which people work and their overall efficiency and productivity. But there is little
substantive empirical evidence to support this view. Many factors contribute to
improving productivity – tax changes can play a role - but isolating the impact of tax cuts
on productivity is extremely difficult.

4. Taxation and business investment decisions

822
1
Lower rates of corporation tax and other business taxes can stimulate an increase in
business fixed capital investment spending. If planned investment increases, the nation’s
capital stock can rise and the capital stock per worker employed can rise.

The government might also use tax allowances to stimulate increases in research and
development and encourage more business start-ups. A favourable tax regime could also
be attractive to inflows of foreign direct investment – a stimulus to the economy that
might benefit both aggregate demand and supply. The Irish economy is often touted as an
example of how substantial cuts in the rate of corporation tax can act as a magnet for
large amounts of inward investment. The very low rates of company tax have been
influential although it is not the only factor that has underpinned the sensational rates of
economic growth enjoyed by the Irish economy over the last fifteen years.

Capital investment should not be seen solely in terms of the purchase of new machines.
Changes to the tax system and specific areas of government spending might also be used
to stimulate investment in technology, innovation, the skills of the labour force and social
infrastructure. A good example of this might be a substantial increase in real spending on
the transport infrastructure. Improvements in our transport system would add directly to
aggregate demand, but would also provide a boost to productivity and competitiveness.
Similarly increases in capital spending in education would have feedback effects in the
long term on the supply-side of the economy.

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as an instrument of demand management.

This means that changes in spending and taxation can be used “counter-cyclically” to
help smooth out some of the volatility of real national output particularly when the
economy has experienced an external shock.

Discretionary changes in fiscal policy and automatic stabilisers

Discretionary fiscal changes are deliberate changes in direct and indirect taxation and
govt spending – for example a decision by the government to increase total capital
spending on the road building budget or increase the allocation of resources going direct
into the NHS.

Automatic fiscal changes are changes in tax revenues and government spending arising
automatically as the economy moves through different stages of the business cycle. These
changes are also known as the automatic stabilisers of fiscal policy

 Tax revenues: When the economy is expanding rapidly the amount of tax
revenue increases which takes money out of the circular flow of income and
spending
 Welfare spending: A growing economy means that the government does not
have to spend as much on means-tested welfare benefits such as income support
and unemployment benefits

823
1
  Budget balance and the circular flow: A fast-growing economy tends to lead to
a net outflow of money from the circular flow. Conversely during a slowdown or
a recession, the government normally ends up running a larger budget deficit.

Estimates from economists at the OECD have found that the effects of the automatic
stabilisers of fiscal policy can reduce the volatility of the economic cycle by up to 20%.
In other words, if the government is prepared to allow the automatic stabilisers to work
through fully, the fiscal policy can help to curb the excessive growth of demand during a
boom, but also provide an important support for income and demand during an economic
downturn.

Measuring the fiscal stance

The fiscal stance is a term that is used to describe whether fiscal policy is being used to
actively expand demand and output in the economy (a reflationary or expansionary fiscal
stance) or conversely to take demand out of the circular flow (a deflationary fiscal
stance).

A neutral fiscal stance might be shown if the government runs with a balanced budget
where government spending is equal to tax revenues. Adjusting for where the economy is
in the economic cycle, a neutral fiscal stance means that policy has no impact on the level
824
1
of economic activity
A reflationary fiscal stance happens when the government is running a large deficit
budget (i.e. G>T). Loosening the fiscal stance means the government borrows money to
inject funds into the economy so as to increase the level of aggregate demand and
economic activity.
A deflationary fiscal stance happens when the government runs a budget surplus (i.e.
G<T). The government is injecting fewer funds into the economy than it is withdrawing
through taxes. The level of aggregate demand and economic activity falls.

The table below summarises the main changes in government spending and tax revenues
and government borrowing during recent years.

Govt Spending % of GDP Tax Revenues % of GDP Govt Borrowing % of GDP

1993 277.8 42.6 232.3 35.7 50.8 7.8

1997 318.5 38.8 308.7 37.6 10.2 1.2

2000 363.9 37.9 378.8 39.5 -14.9 -1.5

2004 488.0 41.4 454.0 38.5 34.1 2.9

From 2001-2004 there was a huge fiscal stimulus to the UK economy through
substantial increases in government spending on transport, and in particular heavier
spending in the twin areas of health and education. The real level of government
spending grew from £364 billion in 2000 to £488 billion in 2004 – a rise of 34%. The
share of GDP taken up by government spending has also increased from 38% in 2000 to
41.4% in 2004. This significant increase in government spending has helped to maintain
Britain’s short-term economic growth at a time when some components of AD (notably
export demand and investment) have been weak.

The Keynesian school argues that fiscal policy can have powerful effects on aggregate
demand, output and employment when the economy is operating well below full capacity
national output, and where there is a need to provide a demand-stimulus to the economy.
Keynesians believe that there is a clear and justified role for the government to make
active use of fiscal policy measures to manage the level of aggregate demand.

825
1
Monetarist economists on the other hand believe that government spending and tax
changes can only have a temporary effect on aggregate demand, output and jobs and that
monetary policy is a more effective instrument for controlling demand and inflationary
pressure. They are much more sceptical about the wisdom of relying on fiscal policy as a
means of demand management. We will consider below some of the criticisms of using
fiscal policy as a tool of stabilising demand and output in the economy.

The multiplier effects of an expansionary fiscal policy depend on how much spare
productive capacity the economy has; how much of any increase in disposable income is
spent rather than saved or spent on imports. And also the effects of fiscal policy on
variables such as interest rates

826
1
Problems with Fiscal Policy as an Instrument of Demand Management

In theory a positive or negative output gap can be relatively easily overcome by the fine-
tuning of fiscal policy. However, in reality the situation is complex and many economists
argue for ignoring fiscal policy as a tool for managing aggregate demand focusing instead
on the role that monetary policy can play in stabilising demand and output.

Recognition lags and policy time lags

o Inevitably, it takes time to for government policy-makers to recognise that AD is

growing either too quickly or too slowly and a need for some active discretionary
changes in spending or taxation
o It then takes time to implement an appropriate policy response – government
spending plans are subject to a three year spending review and cannot be changed
immediately. Likewise the tax system is highly complex – for example – income
tax can only normally be changed once a year at the time of the Budget. Indirect
taxes can be changed more quickly but they have less of an effect on the level of
aggregate demand

827
1
 o It then takes time for the change in fiscal policy to work, as the multiplier process
on national income, output and employment is not instantaneous.

The importance of the national income multiplier – imperfect information

Suppose a government wanted to eliminate a deflationary gap of £1000m. The increase

needed in government expenditure will depend on the size of the multiplier. The problem
lies in knowing the exact size of the multiplier. If the multiplier is 2, then government
expenditure would have to rise by £500m. However, if the multiplier was 4, a rise of only
£250m would be needed. Without knowing the precise value of the national income
multiplier it is difficult to fine-tune the economy accurately.

Fiscal Crowding-Out

The “crowding-out hypothesis” became popular in the 1970s and 1980s when free market
economists argued against the rising share of national income being taken by the public
sector. The essence of the crowding out view is that a rapid growth of government
spending leads to a transfer of scarce productive resources from the private sector to the
public sector. For example, if the government seeks to reflate AD by reducing taxation,
or by increasing government spending, then this may lead to a budget deficit. To finance
the deficit the government will have to sell debt to the private sector. Attracting
individuals and institutions to purchase the debt may require higher interest rates. A rise
in interest rates may crowd out private investment and consumption, offsetting the fiscal
stimulus.

This type of crowding out is unlikely to make fiscal policy wholly ineffective – but large
budget deficits do require financing and in the long run, this requires a higher burden of
taxation. Higher taxes affect both businesses and households – neo-liberal economists
believe that higher taxation acts as a drag on business investment, labour market
incentives and productivity growth – all of which can have a negative effect on economic
growth potential in the long run.

828
1
The Keynesian response to the crowding-out hypothesis is that the probability of 100%
crowding-out is extremely remote, especially if the economy is operating well below its
productive capacity and if there is a plentiful supply of savings available that the
government can tap into when it needs to borrow money. There is no automatic
relationship between the level of government borrowing and the level of short term and
long term interest rates. We can see from the previous chart that there has been a
downward trend in long term interest rates over the last tent to twelve years. Indeed in
2003 the yield (rate of interest) on ten year government bonds dipped below 4 per cent –
one of the lowest long term interest rates in recent history.

Reaction to Tax Cuts – Rational Expectations

According to a school of economic thought that believes in ‘rational expectations’,

when the government sells debt to fund a tax cut or an increase in expenditure, then a
rational individual will realise that at some future date he will face higher tax liabilities to
pay for the interest repayments. Thus, he should increase his savings as there has been no
increase in his permanent income. The implications are clear. Any change in fiscal policy
will have no impact on the economy if all individuals are rational. Fiscal policy in these
circumstances may become impotent.
Partly because of the limitations of fiscal policy as a tool of demand management, many
governments have switched the focus of fiscal policy towards using it to improve
829
1
aggregate supply as a means of creating the conditions for sustainable economic growth.
This is certainly the case with the current government.

Government borrowing

The level of government borrowing is an important part of fiscal policy and management
of aggregate demand in any economy. When the government is running a budget deficit,
it means that in a given year, total government expenditure exceeds total tax revenue. As
a result, the government has to borrow through the issue of debt such as Treasury Bills
and long-term government Bonds. The issue of debt is done by the central bank and
involves selling debt to the bond and bill markets.

Recent trends in UK government borrowing

Government finances have moved from surplus in the late 1990s to a deficit of over 2.5
% of GDP in 2003-04. The emergence of a rising budget deficit has been due to a weaker
economy and the effects of substantial increases in government spending on priority areas
such as health, education, transport and defence. Both current and capital spending are
rising sharply in real terms. Critics of Gordon Brown argue that he risks losing control of
the budget deficit if tax revenues continue to come in below forecast whilst public sector
830
1
spending remains high. Gordon Brown’s reputation of fiscal prudence has come under
pressure both before and after the most recent election.

Does a budget deficit matter?

There is a consensus that a persistently large budget deficit can be a problem for the
government and the economy. Three of the reasons for this are as follows:

 Financing a deficit: A budget deficit has to be financed and day-today, the issue
of new government debt to domestic or overseas investors can do this. In a world
where financial capital flows freely between countries, it can be relatively easy to
finance a deficit. But it may be that if the budget deficit rises to a high level, in the
medium term the government may have to offer higher interest rates to attract
sufficient buyers of government debt. This in turn will have a negative effect on
economic growth
 A government debt mountain? In the long run, government borrowing adds to
the accumulated National Debt. This means that the Government has to spend
more each year in debt-interest payments to holders of government bonds and
other securities. There is an opportunity cost involved here because this money
might be used in more productive ways, for example an increase in spending on
health services or extra investment in education. It also represents a transfer of
income from people and businesses that pay taxes to those who hold government
debt and cause a redistribution of income and wealth in the economy
 Crowding-out - the need for higher interest rates and higher taxes. Eventually
the budget deficit has to be reduced. This can be achieved by either by cutting
back on public sector spending or by raising the burden of taxation. If a larger
budget deficit leads to higher interest rates and taxation in the medium term and
thereby has a negative effect on growth in consumption and investment spending,
then a process of ‘fiscal crowding-out’ is said to be occurring.
 Wasteful public spending: Neo-liberal economists are naturally opposed to a
high level of government spending. They believe that a rising share of GDP taken
by the state sector has a negative effect on the growth of the private sector of the
economy. They are sceptical about the benefits of higher spending believing that
the scale of waste in the public sector is high – money that would be better off
being used by the private sector.

831
1
Potential benefits of a budget deficit

What are the main economic and social justifications for a higher level of government
spending and borrowing? Two main arguments stand out

1. Government borrowing can benefit economic growth: A budget deficit can

have positive macroeconomic effects in the long run if it is used to finance extra
capital spending that leads to an increase in the stock of national assets. For
example, spending on the transport infrastructure improves the supply-side
capacity of the economy. And increased investment in health and education can
bring positive effects on productivity and employment.
2. The budget deficit as a tool of demand management: Keynesian economists
would support the use of changing the level of government borrowing as a
legitimate instrument of managing aggregate demand. An increase in borrowing
can be a useful stimulus to demand when other sectors of the economy are
suffering from weak or falling spending. The fiscal stimulus given to the British
economy during 2002-2004 has been important in stabilizing demand and
output at a time of global economic uncertainty. Perhaps Keynesian fiscal
demand management has once more come back into fashion! The argument is that
the government can and should use fiscal policy to keep real national output
closer to potential GDP so that we avoid a large negative output gap.
832
1
The current situation

 Government borrowing in the UK has shot up to 3.4 percent of GDP in the last
fiscal year, in excess of the 3.0 percent limit set by Europe's Stability and Growth
Pact. But as the UK is not participating in the single currency, the UK is not
bound by the terms of the fiscal stability pact and this gives it more flexibility in
terms of how much the UK government can borrow
 The government has allowed the automatic stabilisers to work during the current
cycle. In other words, it has allowed an increase in government borrowing
brought about by a slowdown in domestic demand and output.
 Gordon Brown has introduced his own fiscal rules – including the golden rule
that government spending on currently provided goods and services should be
financed by taxation over the course of the economic cycle. Government capital
spending (public sector investment) can be financed by borrowing because it
results in the accumulation of capital which has long term economic benefits for
the country

 Although government borrowing is currently high, there is little upward pressure

on long-term interest rates (indeed they are low). Financing the budget deficit is
not a major problem for the UK as it seems able to attract inflows of financial
capital from overseas – and foreign investors are happy to purchase new issues of
government debt. This reduces the risk of the crowding out effect taking place
 Total government debt as a percentage of GDP remains low by historical
standards (less than 40% of GDP). And with interest rates remaining low, the
government is not facing up to a huge cost of servicing this debt
 It is difficult to forecast government borrowing with great accuracy. Firstly this is
because government tax revenue and spending is sensitive to changes in the
economic cycle. Secondly, we are dealing with huge numbers! Total government
spending in 2003-04 is forecast to be £459 billion and total tax receipts £422
billion (giving a forecast budget deficit of £37 billion). It only takes government
spending and tax revenues to be 1% or 2% different from current forecasts for the
budget deficit to change significantly

Inter-relationships between Fiscal & Monetary Policy

Fiscal policy should not be seen is isolation from monetary policy.

For most of the last thirty years, the operation of fiscal and monetary policy was in the
hands of just one person – the Chancellor of the Exchequer. However the degree of
coordination the two policies often left a lot to be desired. Even though the BoE has
independence that allows it to set interest rates, the decisions of the MPC are taken in full
knowledge of the Government’s fiscal policy stance. Indeed the Treasury has a non-
voting representative at MPC meetings. The government lets the MPC know of fiscal
policy decisions that will appear in the budget.

Impact of fiscal policy on the composition of output

833
1
Monetary policy is often seen as something of a ‘blunt policy instrument’ – affecting all
sectors of the economy although in different ways and with a variable impact. Fiscal
policy changes can to a degree be targeted to affect certain groups (e.g. increases in
means-tested benefits for low income households, reductions in the rate of corporation
tax for small-medium sized enterprises and more generous investment allowances for
businesses in certain regions)

Consider the effects of using either monetary or fiscal policy to achieve a given increase
in national income because actual GDP lies below potential GDP (i.e. there is a negative
output gap)

o Monetary policy expansion: Lower interest rates will (ceteris paribus) lead to an
increase in both consumer and business capital spending both of which increases
equilibrium national income. Since investment spending results in a larger capital
stock, then incomes in the future will also be higher through the impact on LRAS.
o Fiscal policy expansion: An expansionary fiscal policy (i.e. an increase in
government spending or lower taxes) adds directly to AD but if this is financed by
higher borrowing, this may result in higher interest rates and lower investment.
The net result (by adjusting the increase in G) is the same increase in current
income. However, since investment spending is lower, the capital stock is lower
than it would have been, so that future incomes are lower.

Effectiveness of Monetary and Fiscal Policies

When the economy is in a recession, monetary policy may be ineffective in increasing

spending and income. In this case, fiscal policy might be more effective in stimulating
demand. Other economists disagree – they argue that changes in monetary policy can
impact quite quickly and strongly on consumer and business behaviour.

However, there may be factors which make fiscal policy ineffective aside from the usual
crowding out phenomena. Future-oriented consumption theories based round the concept
of rational expectations hold that individuals ‘undo’ government fiscal policy through
changes in their own behaviour – for example, if government spending and borrowing
rises, people may expect an increase in the tax burden in future years, and therefore
increase their current savings in anticipation of this

Differences in the Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect the time lags
are variable

Monetary policy in the UK is flexible since interest rates can be changed by the Bank of
England each month and emergency rate changes can be made in between meetings of
the MPC, whereas changes in taxation take longer to organize and implement.

834
1
Because capital investment requires planning for the future, it may take some time before
decreases in interest rates are translated into increased investment spending. Typically it
takes six months – twelve months or more before the effects of changes in UK monetary
policy are felt. The impact of increased government spending is felt as soon as the
spending takes place and cuts in direct and indirect taxation feed through into the
economy pretty quickly. However, considerable time may pass between the decision to
adopt a government spending programme and its implementation. In recent years, the
government has undershot on its planned spending, partly because of problems in
attracting sufficient extra staff into key public services such as transport, education and
health.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Trade Agreements

Trade agreements in the international economy

Trade agreements and trade liberalisation are two essential components in the drive to
increase the rate of growth of world trade.

o Trade agreements can involve two countries reducing tariffs on each other’s
goods, or perhaps reducing bureaucracy by simplifying import/export procedures.
o Trade liberalisation might involve creating free-trade areas. This creates larger
markets, greater access to raw materials, and more competition. The happy ending
should be lower unit costs, since firms are able to gain economies of scale. From
the consumers’ point of view, lower prices and greater choice should make them
happy too.

Briefly now we consider the emergence of regional trading agreements between

countries.

Growth of Regional Trade Agreements

An important feature of international trade arrangements between countries over the last
two decades has been a significant expansion of regional trade agreements (RTAs)
across the global economy. Some of these agreements are simply free-trade agreements
which involve a reduction in current tariff and non-tariff import controls so as to
liberalise trade in goods and services between countries. The most sophisticated RTAs go
beyond traditional trade policy mechanisms, to include regional rules on flows of
investment, co-ordination of competition policies, agreements on environmental policies
and the free movement of labour.

835
1
Examples of regional trade agreements:

o The European Union (EU) – a customs union, a single market and now with a
single currency
o The European Free Trade Area (EFTA)
o The North American Free Trade Agreement (NAFTA) – created in 1994
o Mercosur - a customs union between Brazil, Argentina, Uruguay, Paraguay and
Venezuela
o The Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA)
o The Common Market of Eastern and Southern Africa (COMESA)
o The South Asian Free Trade Area (SAFTA) created in January 2006 and
containing countries such as India and Pakistan

Economic Integration between Countries

There are many different types of economic integration between countries and these are
summarised below. A free trade area is a fairly loose form of integration where countries
simply agree to remove tariff and non-tariff barriers between them to promote free trade
in goods and services. The North American Free Trade Area (NAFTA) is a good example
of this as is the European Free Trade Area (EFTA). ASEAN (Association of South East
Nations), the Andean Pact, and Mercosur are other examples.

Stage of No Internal Common Factor and Common Common

Economic Trade External Asset Currency Economic
Integration Barriers Tariff Mobility Policy
Free Trade Area
X
Customs Union
X X
Single Market
X X X
Monetary Union
X X X X
Economic Union
X X X X X

Customs Union

The EU is a customs union. A customs union comprises two (or more) countries which
agree to:
836
1
 1. Abolish tariffs and quotas between member nations to encourage free
movement of goods and services. Goods and services that originate in the EU
circulate between Member States duty-free. However these products might be
subject to other charges such as excise duty and VAT.
2. Adopt a common external tariff (CET) on imports from non-members
countries. Thus, in the case of the EU, the tariff imposed on, say, imports of
Japanese TV sets will be the same in the UK as in any other member country. The
important point about a common external tariff is that it prevents individual
countries imposing their own unilateral tariffs on different products that differ
from other nations in the customs union.
3. Preferential tariff rates apply to preferential or free-trade agreements which the
EU has entered into with third countries or groupings of third countries.

EU tariffs on selected products, 2005

% tariff % tariff

Product Average Most Favoured Nation rate Maximum rate

Cereals 14 15.2

Meat 11.2 12.1

Dairy products 9.7 10.3

Other agriculture 8.9 179.7

Food products 19.5 236.4

Tobacco 47.3 81.9

Clothing 11.6 13

Footwear 7.4 17

The EU, as well as all its member states are a member of the World Trade Organisation
and, officially at least, subscribes to its free trade ethos. The EU certainly argues in
principle for more free trade, but mainly in areas where free trade is to the advantage of
the EU! For example, the EU is ready to use the WTO appeals mechanism in its frequent
disputes with the USA (the recent battle over the introduction of US steel tariffs is a good
example to quote).

837
1
A customs union shares the revenue from the CET in a pre-determined way – in this case
the revenue goes into the main EU budget fund. In 2003, 80% of total EU expenditure
goes on agricultural spending and cohesion funds. We shall return to this when we
consider agricultural policy and regional policy.

The EU receives its revenues from customs duties from the common tariff, agricultural
levies and countries paying 1% of their VAT base. Payments are also made through
contributions made by member states based on their national incomes. Thus relatively
poorer countries pay less into the EU and tend to be net recipients of EU finances.

A single market represents a deeper form of integration than a customs union. It involves
the free movement of goods and services, capital and labour and the concept are
broadened to encompass economic policy harmonisation for example in the areas of
health and safety legislation and monopoly & competition policy. Deeper economic
integration requires some degree of political integration, which also requires shared aims
and values between nations.

The economic effects of the creation and development of a customs union can be
analysed both in the short term and the long term. We make an important distinction
between trade creation and trade diversion effects

Trade Creation

This involves a shift in domestic consumer spending from a higher cost domestic
source to a lower cost partner source within the EU, as a result of the abolition tariffs on
intra-union trade. So for example UK households may switch their spending on car and
home insurance away from a higher-priced UK supplier towards a French insurance
company operating in the UK market.

Similarly, Western European car manufacturers may be able to find and then benefit from
a cheaper source of glass or rubber for tyres from other countries within the customs
union than if they were reliant on domestic supply sources with trade restrictions in place.
Trade creation should stimulate an increase in intra-EU trade within the customs union
and should, in theory, lead to an improvement in the efficient allocation of scarce
resources and gains in consumer and producer welfare.

838
1
Trade Diversion

Trade diversion is best described as a shift in domestic consumer spending from a lower
cost world source to a higher cost partner source (e.g. from another country within the
EU-15) as a result of the elimination of tariffs on imports from the partner. The common
external tariff on many goods and services coming into the EU makes imports more
expensive. This can lead to higher costs for producers and higher prices for consumers if
previously they had access to a lower cost / lower price supply from a non-EU country.
The diagram next illustrates the potential welfare consequences of imposing an import
tariff on goods and services coming into the European Union.

839
1
In general, protectionism in the forms of an import tariff results in a deadweight social
loss of welfare. Only short term protectionist measures, like those to protect infant
industries, can be defended robustly in terms of efficiency. The common external tariff
will have resulted in some deadweight social loss if it has in total raised tariffs between
EU countries and those outside the EU.

The overall effect of a customs union on the economic welfare of citizens in a country
depends on whether the customs union creates effects that are mainly trade creating or
trade diverting.

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Globalisation - Africa

Globalisation and the marginalisation of African Countries

840
1
Exports of the least developed countries by major product in 2003
Source: World Trade Organisation

Per cent 2003 2000

Others 21.6 15.3

Textiles 1.7 1.9

Other semi-manufactures 3.5 6.5

Raw materials 5.4 5.9

Food 11.9 13.3

Clothing 19.9 21.4

Fuels 36.0 35.6

The African continent remains by and large marginalized in the world economy, with
over half of the population living under US$1 a day per person. If the major Millennium
Development Goal of reducing poverty by half by the year 2015 is to be achieved in
Africa, a major policy shift is required, both at the national and international levels, to
help boost growth and development in Africa.
Source: UNCTAD web site

Some regions and countries have struggled to make any sustained progress in using trade
as an instrument for long term growth and development. Africa, for example,
experienced marginal economic growth during the 1990s leading to an ever-widening gap
between living standards in Africa and the rest of the world. Its share of world trade
continued to fall, from only 2.7 per cent in 1990 to 2.1 per cent in 2000, and critics argue
that the global trading system continues to discriminate against the world's poorest
countries.

They argue that high-income countries continue to protect their agricultural industries
against imports from low-income economies, pointing in particular to the inequities
created by the European Union Common Agricultural Policy whereas developing
countries' markets have been liberalised opening them up to exports from the developed
world. Developed nations spent £154bn on agricultural support in 2005 according to the
Organisation for Economic Cooperation and Development (OECD). In fact Average
tariff levels on agricultural products coming into developed countries are far higher than
those set for industrial products.

841
1
Inequities in the global trading system

In a recent report on Global Poverty and Fair Trade, Oxfam argued that "global trade has
the potential to act as a ‘powerful motor for the reduction of poverty, as well as for
economic growth, but that potential is being lost’. The problem according to Oxfam is not
that international trade is inherently opposed to the needs and interests of the poor, but
that the rules that govern it are rigged in favour of the rich. Barriers to imports in the
advanced countries are, argues Oxfam, ‘biased against the exports of developing
countries at a cost to the latter of $100bn (or nearly £70bn) a year. The Make Poverty
History campaign also focuses on some of the barriers to fair trade that holds back the
growth and development of many of the world’s poorest countries.

Many development economists claim that the current asymmetry of international trade
barriers is actually biased against high-income countries. Tariffs on industrial products
set by high-income countries average 3% whereas poor countries' tariffs average 13%.

Dependence on Primary Exports

The least developed countries have a greater dependence on exports of primary

commodities despite attempts at import substitution. For many of the poorest African
countries, primary exports account for over 90% of total exports
842
1
Demand for fair access
Low-income countries should look to the international system to meet their very
reasonable demands—not for special preferences to some markets and exemptions from
rules, but for non-discriminatory market access to every market in products in which they
have a comparative advantage
Source: Adapted from “Global Trade Prospects 2004”, World Bank www.worldbank.org

For many developing countries, free market access to the high income and high spending
markets of developed countries remains the single most important objective in trade
negotiations with other countries. Domestic markets for lower income nations can often
be small-scale – so producers have little chance of achieving important economies of
scale that would reduce their average costs and allow them to generate a higher rate of
profit from their production. This, added to the fact that foreign markets in developed
countries are often protected by high tariffs, means that industries and firms based in
developing economies will find it difficult to become competitive in the international
market.

843
1
Export subsidies promote cotton dumping
A decision by the World Trade Organisation that found the US’s $3 billion support for
cotton growers violates global trade rules. The WTO has found in favour of a complaint
from Brazil that US subsidies distorted world cotton prices, allowing the US to dump
cotton on world markets at the expense of growers in poor countries, such as Mali and
Burkina Faso. The subsidy allows the high-cost American growers in the southern states
to gain market share at the expense of farmers in the developing world. The WTO also
found that $1.6 billion of US export credits, which include price support for corn, soya
beans and oil-seed products were distorting trade and must be removed.
Source: Adapted from newspaper reports, June 2004

That said it is often the case that tariffs on trade between developing countries are in fact
much higher than between developing and developed nations. There is much to do to
bring tariff rates down and to gradually erode the wide range of non-tariff barriers that
exist all of which distort the nature of free trade based on the principle of comparative
advantage.

Suggested reading

 Africa – after the promises (BBC news)

 Economy of Africa (Wikipedia)
 United Nations Human Development Reports
 Human development in animation (United Nations)
844
1
  How fair is fair trade? (BBC Money Programme)
 Make Poverty History
 Oxfam “Make Trade Fair”

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Globalisation - Effects

Globalisation – Opportunities and Threats

As we have mentioned already, there are hugely diverging viewpoints on the costs and
benefits of the current process of globalisation. One thing is certain, globalisation is here
to stay.

Employment effects

Concern has been expressed in some quarters that economic activity and employment in
the advanced economies will drain away to the developing countries. Inevitably some
jobs are lost as firms switch their production to countries with lower unit labour costs.
But the neo-classical theory of international trade and most past experiences suggest that
all nations in the globalization process will gain in the long run – as trade is an important
determinant of long run growth and rising living standards

That has not allayed concerns that certain sections of the population in richer countries -
notably relatively unskilled workers - will lose as an abundance of low-skilled labour in
developing countries makes itself available to the world's companies at much cheaper
costs – leading to a fall in the demand for lower skilled workers in industrialised
countries. Critics of globalisation in some developed countries point to the risks of
increasing income equalities and greater job insecurity together with the threat of
structural unemployment in industries where demand for labour falls.

Unemployment in the World

Total Male Female

million million million

845
1
 1995 157.3 92.7 64.7

2000 177.2 104.7 72.5

2002 191.4 113 78.5

2005 191.8 112.9 78.9

Source: International Labour Office

Static and Dynamic Efficiency Gains

For consumers and capitalists, the rapid expansion of international trade and foreign
investment is a normally considered good thing. Textbook theory suggests that increased
competition from overseas leads to improvements in static and dynamic efficiency and
gains in economic welfare. Vigorous trade has made for more choice in the High Street,
greater spending, rising living standards and a growth in international travel.

Expansion of Multinational Activity

The growth of multinational activity throughout the world is the result of a mix of
economic and political factors. Most outward investment from one country to another
takes places between developed countries. Indeed in 2000, 99% of outward direct
investment from the United States went to high-income (81%) and middle-income
countries (18%).

The main motivations for the rapid expansion of multinational activity are as follows:

o Higher profits and a stronger position and market access in global markets
o Reduced technological barriers to movement of goods, services and factors of
production
o Cost considerations – a desire to shift production to countries with lower unit
labour costs
o Forward vertical integration (e.g. establishing production platforms in low cost
countries where intermediate products can be made into finished products at
lower cost)
o Avoidance of transportation costs and avoidance of tariff and non-tariff barriers
o Extending product life-cycles by producing and marketing products in new
countries
o The urge to merge – the financial incentives created by the global deregulation
of capital markets is making it easier to achieve acquisitions and mergers and
thereby encouraging the external growth of a business

Impact of Globalisation on the UK Economy

846
1
The UK is a highly open economy. Openness to the global economy can increase the size
of commercial markets available to domestic producers, encourage the transfer of
technology and knowledge and also permit countries to specialise in those goods and
services they produce efficiently by exploiting their comparative advantage.

In 1979, the UK abolished its foreign exchange controls were abolished and the major
financial markets have been gradually deregulated. This means that each day there is a
huge amount of trade within our stock markets, the short-term money markets and the
bond markets.

UK trade with other countries continues to take a high and rising percentage of our total
national output. Clearly, the globalisation process impacts significantly on the British
economy with benefits and costs along the way:

The UK has been a favoured venue for overseas direct investment – indeed a large
percentage of total investment into the European Union from non-EU countries has come
into the UK. Many factors explain this trend – including improvements in the supply-side
performance of the economy, a favourable tax system and a much improved record on
industrial relations. At the same time, UK investment overseas has soared partly as a
result of a high level of merger and takeover activity.

 Rising level of import penetration – particularly in those industries where

Britain’s previous comparative advantage has been eroded such as textiles and
clothing and the manufacture of lower-valued added electronic products
 Competitive forces for nearly all sectors: Globalisation increases the
importance for Britain of continuing to develop a competitive advantage in
industries with major growth-potential as a means of improving living standards
in the long term. Globalisation has involved a speeding up of the process by
which comparative advantage can change over time – not least because of the
faster diffusion of technological progress. Greater investment is needed in high
value goods and services – for example in high and medium-high technology
manufacturing and in knowledge-intensive service sectors
 Structural change in industries – for example the long-term loss of output and
employment in industries such as textiles. This creates problems where factor
resources are occupationally and geographically immobile

The current wave of globalisation places increasingly heavy emphasis on the importance
of human capital as a factor determining long-run economic growth. The UK has
probably lost forever its comparative advantage in producing low-value added
manufacturing products. Other countries with significantly lower labour costs can now
meet global demand for many textile and clothing products and cheaper electronic
products at much lower cost than we can. Whereas the global demand for high skill
services and high value-added manufacturing output remains strong and a rising share of
UK exports overseas are in hi-tech manufacturing industries and knowledge-intensive
services. Maintaining this emerging comparative advantage in a globalised economy

847
1
requires a substantial improvement in the skills and flexibility of the workforce – a point
emphasized in this statement from a recent CBI research report.

“We should no longer be trying to compete in international markets on the basis of low
cost, low value-added manufacturing, but rather through innovative, high technology
products and processes”
Source: CBI Policy Statement on Manufacturing and Globalization, March 2002
www.cbi.org.uk

Impact of Globalisation on the British Government

Globalisation is also having an effect on the British government – for example in

prompting pressure for changes in the corporate tax regime and demands for further
reforms of our labour markets and the welfare system. Some economists believe that
globalisation reduces the ability of governments to levy business taxes – because
multinational corporations can move their production to countries offering the lowest tax
base and the taxation of knowledge products transmitted across international boundaries
becomes ever-more difficult.

But this issue ignores the fact that many complex factors influence business location
decisions (including proximity to growing “emerging” markets) and relative tax burdens
between different countries are often not the decisive factor in determining where
financial capital flows to

Globalisation and the Unemployment-Inflation Trade-Off

Globalisation has increased competitive pressures on British businesses in tradable goods

industries. Has this helped to improve the trade-off between unemployment and inflation
illustrated by the Phillips Curve? Cheaper prices for many international commodities and
finished manufactured goods have certainly helped to control inflation in recent years and
therefore reduce inflationary expectations.
Writers on globalisation

There are many people writing on globalisation issues and they often have a very
different perspective on the advantages and disadvantages of global economic
integration. Here are some links to some higher-profile writers.

 Globalization Institute
 Guardian Special Report on Globalisation
 Joseph Stiglitz
 Martin Wolf
 Naomi Klein
 Philippe Legrain
 Thomas Friedman

Author: Geoff Riley, Eton College, September 2006

848
1
A2 Macroeconomics / International Economy
Protectionism

Why are there so many trade disputes around the world economy? Can protectionism
ever be justified? This chapter considers the issue of import controls.

Over many years, the world economy has seen a rise in the volume and value of trade.
Most countries recognise the long-term benefits of free trade in goods and services
between nations although there are disputes about what free trade actually means! Trade
is widely regarded as a catalyst for growth both on the demand and supply-side of their
economies. But frequently there are trade disputes between countries – as often as not
because one or more parties believes that trade is being conducted unfairly, on an uneven
playing field, or because they believe that there is an economic or strategic justification
for some form of import control.

Whether or not there is ever a fully persuasive justification for protectionist measures
from a purely economics vantage point is open to discussion and debate. In this section
we consider some of the options for controlling imports; the arguments for introducing
them and an evaluation of their economic consequences.

Expanding trade in the global economy Trade Production

All merchandise trade, annual average % change

1950-63 7.7 5.2

1963-73 9.0 6.1

1973-90 3.8 2.6

1990-01 5.7 2.1

Source: World Trade Organisation

Free trade produces winners and losers - not all countries benefit at the same time from
trade particularly those with poor competitiveness. If a country believes that it is not
benefiting fairly from participating in free international trade, it is more likely to want to
introduce some form of import control or protectionist measure.

What is protectionism?

849
1
Protectionism represents any attempt by a government to impose restrictions on trade in
goods and services between countries:

o Tariffs - import taxes.

o Quotas - quantitative limits on the level of imports allowed.
o Voluntary Export Restraint Arrangements – where two countries make an
agreement to limit the volume of their exports to one another over an agreed
period of time.
o Embargoes - a total ban on imported goods.
o Intellectual property laws (patents and copyrights).
o Export subsidies - a payment to encourage domestic production by lowering
their costs.
o Import licensing - governments grants importers the license to import goods.
o Exchange controls - limiting the amount of foreign exchange that can move
between countries.

Quotas, embargoes, export subsidies and exchange controls are all examples of non-tariff
barriers to international trade.

Tariffs

A tariff is a tax that raises the price of imported products and causes a contraction in
domestic demand and an expansion in domestic supply. The net effect is that the volume
of imports is reduced and the government received some tax revenue from the tariff.

Average import tariffs between OECD countries are around 3 per cent; but tariff peaks
reach 506 per cent in the EU, and 350 per cent in the US. The highest tariffs are typically
levied on goods from the developing world. Among non-agricultural products, the EU
has 135 tariff lines over 15 per cent and about 600 tariff lines between 10 and 15 percent,
many in labour-intensive products in which developing countries have a comparative
advantage. The USA has 230 tariff lines above 15 per cent, and Australia has nearly 800.

Import Protection in the European Union – selected products

Average tariff rate Non tariff barrier Anti-dumping duty Overall %

(%) % %

Cereals 14.0 5.0 19.0

Meat 11.2 64.8 76.0

Dairy Products 9.7 100.3 110.0

Tobacco 47.3 47.3

850
1
Clothing 11.6 19.0 30.6

Footwear 7.4 17.5 24.9

Import Quotas

The Government might seek to limit the level of imports through a quota. Examples of
quotas were found in the textile industry under the terms of the Multi-Fibre Agreement
which expired in January 2005 and which led, in 2005, to a trade dispute between the EU
and China over the issue of textile imports.

Quotas introduce a physical limit of the volume (number of units imported) or value
(value of imports) permitted

Administrative Barriers

Countries can make it difficult for firms to import by imposing restrictions and being
'deliberately' bureaucratic. These trade barriers range from stringent safety and
specification checks to extensive hold-ups in the customs arrangements. A good example
is the quality standards imposed by the EU on imports of dairy products.

Preferential Government Procurement Policies and State Aid

Free trade can be limited by preferential behaviour by the government when allocating
major spending projects that favour domestic rather than overseas suppliers. These
procurement policies run against the principle of free trade within the EU Single Market
– but they remain a feature of the trade policies of many developed countries within
Western Europe. Good examples include the award of contracts to suppliers of defence
equipment or construction companies involved in building transport infrastructure
projects.

The use of financial aid from the state can also distort the free trade of goods and
services between nations, for example the use of subsidies to a domestic coal or steel
industry, or the widely criticized use of export refunds (subsidies) to European farmers
under the Common Agricultural Policy (CAP) which is criticized for damaging the
profits and incomes of farmers in developing countries.

Economic justifications for protectionism

Infant Industry Argument

The essence of the argument is that certain industries possess a potential (latent)
comparative advantage but have not yet exploited the potential economies of scale. Short-
term protection from established foreign competition allows the ‘infant industry’ to
develop its comparative advantage. At this point the trade protection could be relaxed,
851
1
leaving the industry to trade freely on the international market. The danger of this form of
protection is that the industry will never achieve full efficiency. The short-term
protectionist measures often start to appear permanent.

Protection – a reaction against “import dumping”

The nature of dumping

Dumping is a type of predatory pricing behaviour and is also a form of price

discrimination. The concept is used most frequently in the context of trade disputes
between nations, where businesses in one or more countries may seek to produce
evidence that manufacturers in another country are exporting products at a price below
the true cost of production. True dumping according to the definitions employed by the
World Trade Organisation is illegal under WTO rules. But it can be difficult, time-
consuming and costly to prove allegations of dumping, not least the problems in
calculating the production costs of a supplier in their own domestic market.

Export subsidies and dumping in developing countries

Many developing countries have complained about the effects of dumping caused by the
system of export refunds (subsidies) offered to producers by the European Union. These
subsidies have the effect of reducing the costs of suppliers and allow them to offload their
surplus production into overseas markets. This can have a very damaging effect on
prices, demand and profits for the domestic producers of developing countries trying to
compete in their home markets.

The charity Oxfam has been especially vocal in its criticism of the effects of the trade
policies of the developed world in sustaining high levels of poverty in many of the
world’s poorest nations. You can read more about their current campaign on trade by
accessing this site: http://www.oxfam.org.uk/what_we_do/issues/trade/

Protection against dumping

Anti-dumping is designed to allow countries to take action against dumped imports that
cause or threaten to cause material injury to the domestic industry. Goods are said to be
dumped when they are sold for export at less than their normal value. The normal value is
usually defined as the price for the like goods in the exporter’s home market.
Source: DTI web site www.dti.gov.uk

Anti-dumping tariffs - recent examples

Tyres:
India has initiated anti-dumping investigations against imports of bus and truck tyres
from China and Thailand

Norwegian salmon:
The European Union (EU) has imposed anti-dumping measures on Norwegian farmed

852
1
salmon in the form of a minimum import price of 2.80 Euro per kilogram. The EU acted
in response to complaints from EU salmon farmers, mainly in Scotland and Ireland, that a
sudden surge in imports from Norway was driving them out of business.

Television picture tubes

The European Commission has opened an investigation into claims that Chinese, Korean,
Malaysian and Thai companies are selling cathode-ray colour television picture tubes in
Europe at prices below their cost. The EU industry group provided evidence that cathode
ray imports had increased volume and market share. In the recent past, the EU has
antidumping duties against a range of Chinese products from aluminium foil to zinc
oxides. China is the EU's second largest trading partner after the United States,
accounting for 12 percent of all EU imports in 2004 - mostly machinery, vehicles and
other manufactured goods.

Shoes:
European shoemakers have alleged that China and Vietnam shoe producers are illegally
dumping leather, sports and safety shoes on the European market. The EU Trade
Commissioner Peter Mandelson has said that “China has a responsibility to ensure that
illegal dumping does not take place” and an investigation is now underway.

If a company exports a product at a price lower than the price it normally charges on its
own home market, it is said to be “dumping” the product. In the short term, consumers
benefit from the low prices of the foreign goods, but in the longer term, persistent
undercutting of domestic prices will force the domestic industry out of business and
allow the foreign firm to establish itself as a monopoly. Once this is achieved the foreign
owned monopoly is free to increase its prices and exploit the consumer. Therefore
protection, via tariffs on 'dumped' goods can be justified to prevent the long-term
exploitation of the consumer.

The World Trade Organisation allows a government to act against dumping where there
is genuine ‘material’ injury to the competing domestic industry. In order to do that the
government has to be able to show that dumping is taking place, calculate the extent of
dumping (how much lower the export price is compared to the exporter’s home market
price), and show that the dumping is causing injury. Usually an ‘anti-dumping action’
means charging extra import duty on the particular product from the particular exporting
country in order to bring its price closer to the “normal value”.

Externalities, Market Failure and Import Controls

Protectionism can also be used to take account of externalities and dealing with de-
merit goods. Goods such as alcohol, tobacco and narcotic drugs have adverse social
effects and are termed de-merit goods. Protectionism can safeguard society from the
importation of these goods, by imposing high tariff barriers or by banning the importation
of the good altogether.

Non-Economic Reasons

853
1
Countries may wish not to over-specialise in the goods in which they possess a
comparative advantage. One danger of over-specialisation is that unemployment may
rise quickly if an industry moves into structural decline as new international
competition emerges at lower costs

The government may also wish to protect employment in strategic industries, although
clearly value judgements are involved in determining what constitutes a strategic sector.
The recent trade dispute arising from the decision by the United States to introduce a
tariff on steel imports is linked to this objective. The US steel tariff was declared
unlawful by the WTO in July 2003 and eventually the United States was pressurized into
withdrawing these tariffs in the late autumn of 2003.

Tariffs are not usually a major source of tax revenue for the Government that imposes
them. In the UK for example, tariffs are estimated to be worth only £2 billion to the
Treasury, equivalent to only around 0.5% of the total tax take. Developing countries tend
to be more reliant on tariffs for revenue.

Economic Arguments against Import Controls

Protectionism – Hurting Consumers

Tariffs, non-tariff barriers and other forms of protection serve as a tax on domestic
consumers. Moreover, they are very often a regressive form of taxation, hurting the
poorest consumers far more than the better off. In the EU for instance, the nature of
existing protection means that the heaviest taxes tend to fall on the necessities of life such
as food, clothing and footwear.
Source: DTI Economics Report on Trade Liberalisation and Investment, April 2004
www.dti.gov.uk

According to Professor Jagdish Bhagwati, “the fact that trade protection hurts the
economy of the country that imposes it is one of the oldest but still most startling insights
economics has to offer.”

The folly of protection has been confirmed by a range of studies from around the world.
These indicate that that it has brought few benefits but imposed substantial costs. Among
the main criticisms of protectionist policies are the following:

 Market distortion: Protection has proved an ineffective and costly means of

sustaining employment.

a. Higher prices for consumers: Trade barriers in the form of tariffs push
up the prices faced by consumers and insulate inefficient sectors from
competition. They penalise foreign producers and encourage the
inefficient allocation of resources both domestically and globally. In
general terms, import controls impose costs on society that would not exist
if there was completely free trade in goods and services. It has been
estimated for example that the recent tariff and other barriers placed on

854
1
 imports of steel into the US increased the price of every car produced
there by an average of $100
b. Reduction in market access for producers: Export subsidies, depressing
world prices and making them more volatile while depriving efficient
farmers of access to the world market. This is a major criticism of the EU
common agricultural policy. In 2002 the EU sugar regime lowered the
value of Brazil, Thailand and South Africa’s sugar exports by over $700
million – countries where nearly 70 million people survive on less than $2
a day.

 Loss of economic welfare: Tariffs create a deadweight loss of consumer and

producer surplus arising from a loss of allocative efficiency. Welfare is reduced
through higher prices and restricted consumer choice.
 Regressive effect on the distribution of income: It is often the case that the
higher prices that result from tariffs hit those on lower incomes hardest, because
the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall on those products that
lower income families spend a higher share of their income. Thus import
protection may worsen the inequalities in the distribution of income making the
allocation of scarce resources less equitable
 Production inefficiencies: Firms that are protected from competition have little
incentive to reduce production costs. Governments must consider these
disadvantages carefully
 Little protection for employment: One of the justifications for protectionist
tariffs and other barriers to trade is that they help to protect the loss of relatively
low skilled and low paid jobs in industries that are coming under sever
international competition. The evidence suggests that, in the long term, tariffs are
a costly and ineffective way of protecting such jobs. According to the DTI study
on trade published in 2004, since 1997 UK employment in textiles manufacturing
has fallen by 45%, in clothing manufacture by nearly 60%, and in footwear
manufacturing by around 50% - and this despite the protection afforded to
European Union textile manufacturers. The cost of protecting each job runs into
hundreds of thousands of Euros for the EU as a whole. Might that money have
been spent more productively in other ways? Often there is a huge opportunity
cost involved in imposing import tariffs.
 Trade wars: There is the danger that one country imposing import controls will
lead to “retaliatory action” by another leading to a decrease in the volume of
world trade. Retaliatory actions increase the costs of importing new technologies
 Negative multiplier effects: If one country imposes trade restrictions on another,
the resultant decrease in total trade will have a negative multiplier effect affecting
many more countries because exports are an injection of demand into the global
circular flow of income. The negative multiplier effects are more pronounced
when trade disputes boil over and lead to retaliation.

855
1
The diagram below shows the welfare consequences of imposing an import tariff

In a new study of the benefits of global trade and investment published in May 2004, the
UK Department of Trade of Industry outlined their opposition to import controls
(protectionism)

Higher taxes and higher prices

Protectionism imposes a double burden on tax payers and consumers. In the case of
European agriculture, the cost to tax payers is about €50 billion a year, plus around €50
billion a year to consumers via artificially high food prices – together the equivalent of
over £800 a year on the annual food budget of an average family of four.
Furthermore huge distortions in international agriculture markets prevent the world’s
poorest countries from trading in the products they are best able to produce. Continuing
barriers to trade are costing the global economy around $500 billion a year in lost
income.
Source: www.dti.gov.uk (Economics Paper 10)

Protectionist policies rarely achieve their aims. They can be costly to administer and they
nearly always provide domestic suppliers with a protectionist shield that encourages
inefficiencies leading to higher costs.

Protectionism is a ‘second best’ approach to correcting for a country’s balance of

payments problem or the fear of rising structural unemployment. And import controls go
against the principles of free trade enshrined in the theories of comparative advantage. In

856
1
this sense, import controls can be seen as examples of government failure arising from
intervention in markets.

Economic nationalism

Economic nationalism is a term that has become used more frequently in recent years. It
is used to describe policies which are guided by the idea of protecting a country's home
economy, i.e. protecting domestic consumption, jobs and investment, even if this requires
the imposition of tariffs and other restrictions on the movement of labour, goods and
capital. Economic nationalism may include such doctrines as protectionism and import
substitution.

Examples of economic nationalism include China's controlled exchange of the yuan, and
the United States' use of tariffs to protect domestic steel production. The term gained a
more specific meaning in 2005 and 2006 after several European Union governments
intervened to prevent takeovers of domestic firms by foreign companies. In some cases,
the national governments also endorsed counter-bids from compatriot companies to
create 'national champions'. Such cases included the proposed takeover of Arcelor
(Luxembourg) by Mittal Steel (India). And the French government listing of the food and
drinks business Danone (France) as a 'strategic industry' to pre-empt a potential takeover
bid by PepsiCo (USA).

Further reading on trade and protectionism

 BBC special report on the “Battle over Trade”

 China faces Indian dumping allegations (BBC news – July 2006)
 Foreign lesions (James Surowiecki – The Guardian)
 Guardian special report on fair trade
 OECD international trade and investment research articles
 Oxfam campaign for fair international trade
 Patriotism and protectionism in the European Union (BBC news – March 2006)
 US steel tariffs (2002)
 Why developing countries should liberalise their trade (Globalisation Institute)
 World Trade Organisation – 2006 World Trade Report

Author: Geoff Riley, Eton College, September 2006

A2 Macroeconomics / International Economy

Balance of Payments - Deficits

857
1
What does a current account deficit mean?

Running a sizeable deficit on the current account basically means that the UK economy is
not paying its way in the global economy. There is a net outflow of demand and income
from the circular flow of income and spending. The current account does not have to
balance because the balance of payments also includes the capital account. The capital
account tracks capital flows in and out of the UK. This includes portfolio capital flows
(e.g. share transactions and the buying and selling of Government debt) and direct capital
flows arising from foreign investment.

Does a current account deficit really matter?

Should we be concerned if, as an economy, we are running a large current account

deficit? The UK has run large current account deficits in recent years with barely any
effect on the overall performance of the economy. The United States economy is also
experiencing a huge trade deficit at the moment. What are the implications of this?

In the 1950s, 60s and 70s, small balance of payments deficits in the UK caused
‘economic crises’ with periods of strong speculative selling of sterling on the foreign
exchange markets and much political instability. The devaluation of the pound in 1967

858
1
led directly to the resignation of the then Chancellor, James Callaghan. These days, trade
deficits of enormous proportions seem to have little effect in global currency markets.

Some policymakers and economists believe the balance of payments no longer matters
because of globalisation and financial liberalisation: in other words, trade and current
account deficits can be more easily financed by globally integrated capital markets freed
from the capital controls that have been dismantled since the end of the 1970s.

This free movement of global financial capital has allowed countries, in principle, to
increase their domestic investment beyond what could be financed by a country’s own
savings. Increasingly what we want to consume is produced abroad and if a country
wants to operate with a sizeable current account deficit, then provided there is a capital
account surplus, there is no fundamental economic constraint.

Britain has been a favoured venue for inward investment (an inflow of capital) and our
relatively high interest rates compared to the USA and the Euro Zone has also attracted
large-scale inflows of money into our banking systems. In this way the current account
has been financed with little obvious economic pain.

UK Foreign Direct Investment

Millions of US dollars

Inward Outward

2001 56623 58855

2002 24029 50300

2003 20298 66457

2004 78399 65391

Stock of UK foreign direct investment

859
1
 Inward Outward

1980 63014 80434

1990 203905 229307

2000 438631 897845

2004 771658 1378130

Stock of UK foreign direct investment as a share of GDP

Inward Outward

1980 11.8 15

1990 20.6 23.2

2000 30.5 62.4

2004 36.3 64.8

Presence of UK corporations in the world's 100 largest non-financial trans-national corporations

Ranked by foreign assets, 2003

Corporation World ranking Foreign assets

Vodafone Group 2 243839

British Petroleum 5 141551

860
1
Royal Dutch/Shell 7 112587

Unilever 43 28654

Glasxosmithkline 56 23893

Source: UNCTAD, World Investment Report 2005

The main arguments for being relaxed about a current account deficit are as follows:

 Partial auto-correction: If some of the deficit is due to strong consumer demand,

the deficit will partially-self correct when the economic cycle turns and there is a
slowdown in spending
 Investment and the supply-side: Some of the deficit may be due to increased
imports of new capital and technology which will have a beneficial effect on
productivity and competitiveness of producers in home and overseas markets
 Capital inflows balance the books: Providing a country has a stable economy
and credible economic policies, it should be possible for the current account
deficit to be financed by inflows of capital without the need for a sharp jump in
interest rates. The UK has run an average annual current account deficit of £10
billion from 1992-2004 and yet the economy has also enjoyed one of the longest
sustained periods of growth and falling unemployment during that time

But

 Structural weaknesses: The trade / current account deficit may be a symptom of

a wider structural economic problem i.e. a loss of competitiveness in overseas
markets, insufficient investment in new capital or a shift in comparative
advantage towards other countries.
 An unbalanced economy – too much consumption: A large deficit in trade is a
sign of an ‘unbalanced economy’ typically the consequences of a high level of
consumer demand contrasted with a weaker industrial sector. Eventually these
“macroeconomic imbalances” have to be addressed. Consumers cannot carry on
spending beyond their means for the danger is that rising demand for imports will
be accompanied by a surge in household debt.
 Potential loss of output and employment: A widening trade deficit may result in
lost output and employment because it represents a net leakage from the circular
flow of income and spending. Workers who lose their jobs in export industries, or
whose jobs are lost because of a rise in import penetration, may find it difficult to
find new employment.
 Potential problems in financing a current account deficit: Countries cannot
always rely on inflows of financial capital into an economy to finance a current

861
1
 account deficit. Foreign investors may eventually take fright, lose confidence and
take their money out. Or, they may require higher interest rates to persuade them
to keep investing in an economy. Higher interest rates then have the effect of
depressing domestic consumption and investment. The current situation in the
United States is very interesting in this respect. Such is the size of the current
account deficit that the USA must rely on huge capital inflows each year and
eventually investors in other countries may decide to put their money elsewhere –
this would put severe downward pressure on the US dollar (see below)
 Downward pressure on the exchange rate: A large deficit in trade in goods and
services represents an excess supply of the currency in the foreign exchange
market and can lead to a sharp fall in the exchange rate. This would then threaten
an increase in imported inflation and might also cause a rise in interest rates from
the central bank. A declining currency would help stimulate exports but the rise in
inflation and interest rates would have a negative effect on demand, output and
employment.

The UK has run a current account deficit in each year since 1998 but that the size of the
deficit expressed as a percentage of national income (GDP) has actually been falling in
the last three years – it is now less than 2% of GDP – a manageable level with few
obvious painful consequences. Hopefully our trade balances will improve if:

 UK businesses successfully improve their cost and price competitiveness

 The exchange rate depreciates to provide the export sector with a competitive
boost
 The UK manages to take advantage of a forecast acceleration in the rate of growth
of world trade in the next few years

862
1
In contrast the US economy is operating with a current account deficit on an enormous
scale and this is part of the “twin deficit problem” that will have to be addressed in the
near term (The US government is facing up to huge current account and budget deficit
problems).

Risks from a current account deficit

The economic history of Britain has been heavily influenced by its balance of payments
position. For policymakers, it's always difficult working out how much of any current
account deficit is sustainable and how much may be contributing to future economic
difficulties. Nowadays, it's quite possible to run current account deficits for a long time,
reflecting a country's ability to attract the world's increasingly mobile capital. The
problem, though, is that the very same capital can swiftly head for the exit at the first sign
of trouble.
Source: Stephen King, Independent, December 2004

Author: Geoff Riley, Eton College, September 2006

863
1