1|Page

THE BASIC ECONOMIC PROBLEM

“Economics is the social science that describes the factors that determine the production,
distribution and consumption of goods and services.”
(Source: Wikipedia)

The Nature of the Economic Problem

Resources: are the inputs required for the production of goods and services.
Scarcity: a lack of something (in this context, resources).
The fundamental economic problem is that there is a scarcity of resources to satisfy all
human wants and needs. There are finite resources and unlimited wants. This is applicable
to consumers, producers, workers and the government, in how they manage their resources.

Economic goods are those which are scarce in supply and so can only be produced with an
economic cost and/or consumed with a price. In other words, an economic good is a good
with an opportunity cost. All the goods we buy are economic goods, from bottled water to
clothes.
Free goods, on the other hand, are those which are abundant in supply, usually referring to
natural sources such as air and sunlight.

The Factors of Production

Resources are also called ‘factors of production’ (especially in Business). They are:

• Land: all natural resources in an economy. This includes the surface of the earth,
lakes, rivers, forests, mineral deposits, climate etc.
• The reward for land is the rent it receives.
• Since, the amount of land in existence stays the same, its supply is said to
be fixed. But in relation to a country or business, when it takes over or
expands to a new area, you can say that the supply of land has increased,
but the supply is not depended on its price, i.e. rent.

2|Page
 • The quality of land depends upon the soil type, fertility, weather and so
on.

• Since land can’t be moved around, it is geographically immobile but

since it can be used for a variety of economic activities it is occupationally
mobile.

• Labour: all the human resources available in an economy. That is, the mental and
physical efforts and skills of workers/labourers.

• The reward for work is wages/salaries.

• The supply of labour depends upon the number of workers available
(which is in turn influenced by population size, no. of years of schooling,
retirement age, age structure of the population, attitude towards women
working etc.) and the number of hours they work (which is influenced by
number of hours to work in a single day/week, number of holidays, length
of sick leaves, maternity/paternity leaves, whether the job is part-time or
full-time etc.).
• The quality of labour will depend upon the skills, education and
qualification of labour.
• Labour mobility can depend up on various factors. Labour can achieve
high occupational mobility (ability to change jobs) if they have the right
skills and qualifications. It can achieve geographical mobility (ability to
move to a place for a job) depending on transport facilities and costs,
housing facilities and costs, family and personal priorities, regional or
national laws and regulations on travel and work etc.

• Capital: all the man-made resources available in an economy. All man-made goods
(which help to produce other goods – capital goods) from a simple spade to a
complex car assembly plant are included in this. Capital is usually denoted in
monetary terms as the total value of all the capital goods needed in production.
• The reward for capital is the interest it receives.

3|Page
 • The supply of capital depends upon the demand for goods and services,
how well businesses are doing, and savings in the economy (since capital
for investment is financed by loans from banks which are sourced from
savings).

• The quality of capital depends on how many good quality products can be
produced using the given capital. For example, the capital is said to be of
much more quality in a car manufacturing plant that uses mechanisation
and technology to produce cars rather than one in which manual labour
does the work.
• Capital mobility can depend upon the nature and use of the capital. For
example, an office building is geographically immobile but occupationally
mobile. On the other hand, a pen is geographically and occupationally
mobile.

• Enterprise: the ability to take risks and run a business venture or a firm is called
enterprise. A person who has enterprise is called an entrepreneur. In short, they are
the people who start a business. Entrepreneurs organize all the other factors of
production and take the risks and decisions necessary to make a firm run successfully.
• The reward to enterprise is the profit generated from the business.
• The supply of enterprise is dependent on entrepreneurial skills (risk-taking,
innovation, effective communication etc.), education, corporate taxes (if
taxes on profits are too high, nobody will want to start a business),
regulations in doing business and so on.
• The quality of enterprise will depend on how well it is able to satisfy and
expand demand in the economy in cost-effective and innovative ways.
• Enterprise is usually highly mobile, both geographically and occupationally.

All the above factors of productions are scarce because the time people have to spend
working, the different skills they have, the land on which firms operate, the natural resources
they use etc. are all in limited in supply; which brings us to the topic of opportunity cost.

4|Page
Opportunity Cost

The scarcity of resources means that there are not sufficient goods and services to satisfy all
our needs and wants; we are forced to choose some over the others. Choice is necessary
because these resources have alternative uses- they can be used to produce many things.
But since there are only a finite number of resources, we have to choose.

When we choose something over the other, the choice that was given up is called the
opportunity cost. Opportunity cost, by definition, is the next best alternative that is
sacrificed/forgone in order to satisfy the other.

Example 1: the government has a certain amount of money and it has two options: to
build a school or a hospital, with that money. The govt. decides to build the hospital.
The school, then, becomes the opportunity cost as it was given up. In a wider
perspective, the opportunity cost is the education the children could have received, as
it is the actual cost to the economy of giving up the school.

Example 2: you have to decide whether to stay up and study or go to bed and not study.
If you chose to go to bed, the knowledge and preparation you could have gained by
choosing to stay up and study is the opportunity cost.

5|Page
Production Possibility Curve (PPC) Diagrams

Because resources are scarce and have alternative uses, a decision to devote more resources
to producing one product means fewer resources are available to produce other goods. A
Production Possibility Curve diagram shows, the maximum combination of two goods that
can be produced by an economy with all the available resources.

The PPC diagram above shows the production capacities of two goods- X and Y- against each other.
When 500 units of good X are produced, 1000 units of good Y can be produced. But when the units of
good X increase to 1000, only 500 units good Y can be produced.

Let’s look at the PPC named A. At point X and Y it can produce certain combinations of good
X and good Y. These are points on the curve- they are attainable, given the resources. Th
economy can move between points on a PPC simply by reallocating resources between the
two goods.
If the economy were producing at point Z, which is inside/below the PPC, the economy
is said to be INEFFICIENT, because it is producing less than what it can.
Point W, outside/above the PPC, is unattainable because it is beyond the scope of the
economy’s existing resources. In order to produce at point W, the economy would need
to see a shift in the PPC towards the right.

6|Page
For an OUTWARD SHIFT to occur, an economy would need to:
• discover or develop new raw materials. Example: discover new oil fields
• employ new technology and production methods to increase productivity
• increase labour force by encouraging birth and immigration, increasing retirement
age etc.
An outward shift in PPC, that is higher production possibility, will lead to economic growth.

In the same way, an INWARD SHIFT can occur in the PPC due to:
• natural disasters, that erode infrastructure and kill the population
• very low investment in new technologies will cause productivity to fall over time
• running out of resources, especially non-renewable ones like oil or water
An inward shift in the PPC will lead to the economy shrinking.

How is opportunity cost linked to PPC?

Individuals, businessmen and the government can calculate the opportunity cost from PPC
diagrams. In the above example, if the firm decided to increase production of good Y from
500 to 750, it can calculate the opportunity cost of the decision to be 250 units of
good X (as production of good X falls from 1000 to 750). They are able to compare the
opportunity cost for different decisions.

7|Page
ALLOCATION OF RESOURCES

Economy: an area where people and firms produce, trade and consume goods and services.
This can vary in size- from your local town to your country, or the globe itself.

MICROECONOMICS AND MACROECONOMICS

Microeconomics is the study of individual markets. For example: studying the effect of a
price change on the demand for a good. Microeconomic decision makers are producers and
consumers (who directly operate in markets)

Macroeconomics is the study of an entire economy, as a whole. Examples include studying

the total size of the economy or the unemployment rate, among other things.
Macroeconomic decisions are made by the government of the particular economy – a town,
state or country)

The Role of Markets in Allocating Resources

Resource allocation: the way in which economies decide what goods and services to
provide, how to produce them and who to produce them for.
These questions- what to produce, how to produce, and for whom to produce – are
termed ‘the basic economic questions. In short, resource allocation is the way in which
economies solve the three basic economics questions.

Market is any set of arrangement that brings together all the producers and consumers of
a good or service, so they may engage in exchange. Example: a market for soft drinks.
Goods and services are bought and sold in a market at an equilibrium price where demand
and supply are equal. This is called the price mechanism. It helps answer the three basic
economic questions. Producers will produce the good that consumers demand the most, it

8|Page
will be produced in a way that is cost-efficient, and will be produced for those who are willing
and able to buy the product. More on these topics below:

Demand

Demand is the want and willingness of consumers to buy a good or services at a given
price. Effective demand is where the willingness to buy is backed by the ability to pay. For
example, when you want a laptop but you don’t have the money, it is called demand. When
you do have the money to buy it, it is called effective demand.
The effective demand for a particular good or service is called quantity demanded.
(Individual demand is the demand from one consumer, while market demand for a
product is the total (aggregate) demand for the product, or the sum of all individual
demands of consumers).

The law of demand states that an increase in price leads to a decrease in demand, and
a decrease in price leads to an increase in demand (it’s an inverse relationship between
price and demand. However it’s worth noting that an increase in demand leads to an increase
in price and a decrease in demand leads to a decrease in price. The law of demand is
established with respect to changes in price, not demand, hence the difference).

9|Page
This is an example of a demand curve for Coca-Cola.
Here, a decrease in price from 80 to 60 has increased its demand from 300 to 500.
The increase in demand due to changes in price (without changes in other factors) is
called an extension in demand. Here the extension in demand is from A to B.
In the above example, an increase in price from 60 to 80, will decreased the demand from
500 to 300. The decrease in demand due to the changes in price (without changes in
other factors) is called a contraction in demand. Here the contraction in demand will be
from B to A.

In this example, there is a rise in the demand of Coca-Cola from 500 to 600, without any
change in price. A rise in the demand for a product due to the changes in other factors
(excluding price) causes the demand curve to shift to the right (from A to B).

In this example, there is a fall in demand of Coca-Cola from 500 to 400, without any
change in price.

A fall in demand for a product due to the changes in other factors (excluding
price) causes the demand curve to shift to the left (from A to B).

10 | P a g e
Factors that cause shifts in a demand curve:

Factors that cause shifts in the demand curve;

• Consumer incomes: a rise in consumers’ incomes increases demand, causing a shift to right.
Similarly, a fall in incomes will shift the demand curve to the left.
• Taxes on incomes: a rise in tax on incomes means less demand, causing a shift to the left;
and vice versa.
• Price of substitutes: Substitutes are goods that can be used instead of a particular product.
Example: tea and coffee are substitutes (they are used for similar purposes). A rise in the price
of a substitute causes a rise in the demand for the product, causing the demand curve to shift
to the right; and vice versa.
• Price of complements: Complements are goods that are used along with another product.
For example, printers and ink cartridges are complements. A rise in the price of a
complementary good will reduce the demand for the particular product, causing the demand
curve to shift to the left; and vice versa.
• Changes in consumer tastes and fashion: for example, the demand for DVDs have fallen
since the advent of streaming services like Netflix, which has caused the demand curve for
DVDs to shift to the left.
• Degree of Advertising: when a good is very effectively advertised (Coke and Pepsi are good
examples), its demand rises, causing a shift to the right. Lower advertising shifts the demand
curve to the left.
• Change in population: A rise in the population will raise demand, and vice versa.
• Other factors, such as weather, natural disasters, laws, interest rates etc. can also shift the
demand curve.

Supply

Supply is the want and willingness of producers to supply a good or services at a given
price. The amount of goods or services producers are willing to make and supply is called
quantity supplied.
(Market supply refers to the amount of goods and services all producers supplying that
particular product are willing to supply or the sum of individual supplies of all producers).
The law of supply states that an increase in price leads to a increase in supply, and a
decrease in price leads to an decrease in supply (there is a positive relationship between
price and supply. However, it’s also worth noting that, an increase in supply leads to a
decrease in price and a decrease in supply leads to an increase in price. The law of supply is
established with respect to changes in price, not supply, hence the difference).

11 | P a g e
This is an example of a supply curve for a product.
Here, an increase in price from 60 to 80, has increased its supply from 500 to 700.
The increase in supply due to changes in price (without changes in other factors) is
called an extension in supply.
A decrease in price from 80 to 60, will decreased the supply from 700 to 500. The decrease
in supply due to changes in price (without the changes in other factors) is called a
contraction in supply.

In this example, there is a rise in the supply of a product from 500 to 700, without any
change in price. A rise in the supply for a product due to the changes in other factors
(excluding price) causes a shift to the right.

12 | P a g e
 A fall in supply from 500 to 300, without any changes in price is also shown. A fall in the
supply for a product due to the changes in other factors (excluding price) causes a
shift to the left.
Factors that cause shifts in supply curve:
• Changes in cost of production: when the cost of factors to produce the good falls,
producers can produce and supply more products cheaply, causing a shift in the supply curve
to the right. A subsidy*, which lowers the cost of production also shifts the supply curve right.
When cost of production rises, supply falls, causing the supply curve to shift to the left.
• Changes in the quantity of resources available: when the number of resources available
rises, the supply rises; and vice versa.
• Technological changes: an introduction of new technology will increase the ability to
produce more products, causing a shift to the right in the supply curve.
• The profitability of other products: if a certain product is seen to be more profitable than
the one currently being produced, producers might shift to producing the more profitable
product, reducing supply of the initial product (causing a shift to the left).
• Other factors: weather, natural disasters, wars etc. can shift the supply curve left.

13 | P a g e
MARKET PRICE

The market equilibrium price is the price at

which the demand and supply curves in a given market meet.
In this diagram, P* is the equilibrium price.

Disequilibrium price is the price at which market demand and supply curves do not meet,
which in this diagram, is any price other than P*.

Price Changes

In this diagram, two disequilibrium prices are marked- 2.50 and 1.50.
At price 2.50, the demand is 4 while the supply is 10. There is excess supply relative to the
demand. When the price is above the equilibrium price, a surplus is experienced.
(Surplus means ‘excess’).
14 | P a g e
At price 1.50, the demand is 10 while the supply is only 4. There is excess demand relative
to supply. When the price is below the equilibrium price, a shortage is experienced.
(This shortage and surplus is said in terms of the supply being short or excess respectively).

Price Elasticity of Demand (PED)

The PED of a product refers to the responsiveness of the quantity demanded to changes
in its price.
PED (of a product) = % change in quantity demanded / % change in price

For example, calculate the price elasticity of demand of Coca-Cola from this diagram.

PED= [(500-300/300) *100] / [(80-60/80) *100]

= 66.67 / 25
= 2.67

In this example, the PED is 2.67, that is, the % change in quantity demanded was higher than
the % change in the price. This means, a change in price makes a higher change in
quantity demanded. These products have a price elastic demand. Their values are always
above 1.

15 | P a g e
When the % change in quantity demanded is lesser than the % change in price, it is said to
have a price inelastic demand. Their values are always below 1. A change in price makes a
smaller change in demand.

When the % change in demand and price are equal, that is value is 1, it is called unitary

price elastic demand.

16 | P a g e
When the quantity demanded changes without any changes in price itself, it is said to
have an infinitely price elastic demand. Their values are infinite.

When the price changes have no effect on demand whatsoever, it is said to have a
perfect price inelastic demand. Their elasticity is 0.
What affects PED?

• No. of substitutes: if a product has many substitute products it will have an elastic demand.
For example, Coca-Cola has many substitutes such as Pepsi and Mountain Dew. Thus a
change in price will have a greater effect on its demand (If price rises, consumers will quickly
move to the substitutes and if price lowers, more consumers will buy Coca-Cola).
• Time period: demand for a product is more likely to be elastic in the long run. For example,
if the price rises, consumers will search for cheaper substitutes. The longer they have, the
more likely they are to find one.
• Proportion of income spend on commodity: goods such as rice, water (necessities) will
have an inelastic demand as a change in price won’t have any significant effect on its demand,
as it will only take up a very small proportion of their income. Luxury goods such as cars on
the other hand, will have a high price elastic demand as it takes up a huge proportion of
consumers’ incomes.

Relationship between PED and revenue and how it is helpful to producers:

Producers can calculate the PED of their product and take a suitable action to make the
product more profitable.

17 | P a g e
Revenue is the amount of money a producer/firm generates from sales, i.e., the total
number of units sold multiplied by the price per unit.

So, as the price or the quantity sold changes, those changes have a direct effect on revenue.

If the product is found to have an elastic demand, the producer can lower prices to
increase revenue. The law of demand states that a price fall increases the demand. And
since it is an elastic product (change in demand is higher than change in price), the demand
of the product will increase highly. The producers get more revenue.
If the product is found to have an inelastic demand, the producer can raise prices to
increase revenue. Since quantity demanded wouldn’t fall much as it is inelastic, the high
prices will make way for higher revenue and thus higher profits.

Price Elasticity of Supply (PES)

The PES of a product refers to the responsiveness of its quantity supplied it to changes
in its price.
PES of a product= %change in quantity supplied / %change in price
Similar to PED, PES too can be categorized into price elastic supply, price inelastic supply,
perfectly price inelastic supply, infinitely price elastic supply and unitary price elastic supply.
(See if you can figure out what each supply elasticity means using the demand elasticities
above as reference, and draw the diagrams as well!)

What affects PES?

• Time of production: If the product can be quickly produced, it will have a price elastic supply
as the product can be quickly supplied at any price. For example, juice at a restaurant. But
products which take a longer time to produce, such as cars, will have a price inelastic supply
as it will take a longer time for supply to adjust to price.

• Availability of resources: More resource (land, labour, capital) will make way for an elastic
supply. If there are not enough resources, producers will find it difficult to adjust to the price
changes, and supply will become price inelastic.

18 | P a g e
MARKET ECONOMIC SYSTEM

In a market economic system or free market economic system, all resources are allocated
by the market – private producers and consumers; that is, there is no or very little
government intervention in resource allocation. (There are virtually no economies in the
world that follow this system – there is a government control everywhere, although Hong
Kong and Singapore do come close – check out the Index of Economic Freedom to see the
ranking of economies on the basis of how market-friendly they are ).

Features:
• All resources are owned and allocated by private individuals.
• Government refrains from regulating markets. It instead tries to create very business-friendly
environments and any intervention is mostly limited to protecting private property. The
demand and supply fixes the price of products. This is called price mechanism.
• What to produce is solved by producing the most-demanded goods for which people
spend a lot, as their only motive is to generate a high profit.
• How to produce is solved by using the cheapest yet efficient combination of resources –
capital or labour- in order to maximise profits.
• For whom to produce is solved by producing for people who are willing and able to pay
for goods at a high price.

Advantages:
• A wide variety of quality goods and services will be produced as different firms will
compete to satisfy consumer wants and make profits. Quality is ensured to make sure that
consumers buy from them. There is consumer sovereignty.
• Firms will respond quickly to consumer changes in demand. When there is a change in
demand, they will quickly allocate resources to satisfying that demand, so as to maintain
profits.
• High efficiency will exist. Since producers want to maximise profits, they will use resources
very efficiently (producing more with less resources).
• Since there is hardly any government intervention (in the form of regulations, extra fees and
fines etc. for example), firms will find it easy and inexpensive to start and run businesses.

19 | P a g e
Disadvantages:
• Only profitable goods and services are produced. Public goods* and some merit goods* for
which there is no demand may not be produced, which is a drawback and affects the
economic development.
• Firms will only produce for consumers who can pay for them. Poor people who cannot
spend much won’t be produced for, as it would be non-profitable.
• Only profitable resources will be employed. Some resources will be left unused. In a
market economy, capital-intensive production is favoured over labour- intensive production
(because it’s more cost-efficient). This can lead to unemployment.
• Harmful (demerit) goods may be produced if it is profitable to do so.
• Negative impacts on society (externalities) may be ignored by producers, as their sole
motive is to keep consumers satisfied and generate a high profit.
• A firm that is able to dominate or control the market supply of a product is called
a monopoly. They may use their power to restrict supply from other producers, and even
charge consumers a high price since they are the only producer of the product and consumers
have no choice but to buy from them.
• Due to high competition between firms, duplication of products may take place, which is a
waste of resources.

*Public goods: goods that can be used by the general public, from which they will benefit.
Their consumption can’t be measured, and thus cannot be charged a price for (this is why a
market economy doesn’t produce them). Examples are street lights and roads.

*Merit goods: goods which create a positive effect on the community and ought to be
consumed more. Examples are schools, hospitals, food. The opposite is called demerit goods
which includes alcohol and cigarettes

*Subsidies: financial grants made to firms to lower their cost of production in order to lower
prices for their products.

20 | P a g e
MARKET FAILURE AND
GOVERNMENT INTERVENTION

Before we dive into what market failure is, let’s get familiar with some terms related to market
failure:

Public goods: goods that can be used by the general public, from which they will benefit.
Their consumption can’t be measured, and thus cannot be charged a price for (this is why a
market economy doesn’t produce them). Examples include street lights and roads.

Merit goods: goods which create a positive effect on the society and ought to be consumed
more. Examples include schools and hospitals. The opposite is called demerit goods which
include alcohol and cigarettes.

External costs (negative externalities) are the negative impacts on society (third-parties)
due to production or consumption of goods and services. Example: the pollution from a
factory.

External benefits (positive externalities) are the positive impacts on society due to
production or consumption of goods and services. Example: better roads in a
neighbourhood due to the opening of a new business.

Private costs are the costs to the producer and consumer due to production and
consumption respectively. Example: the cost of production.

Private benefits are the benefits to the producer or consumer due to production and
consumption respectively. Example: the better immunity received by a consumer when he
receives a vaccine.
Social Costs = External costs + Private Costs
Social Benefits = External benefits + Private benefits

21 | P a g e
Market Failure

Market failure occurs when the price mechanism fails to allocate resources effectively.
This is the most disadvantageous aspect to the market economy. Causes of market failure
are:

• When social costs exceed social benefits (especially where negative externalities (external
costs) are high).
• Over-provision of demerit goods like alcohol and tobacco: the external costs arising from
demerit goods are not reflected in the market and so they are overproduced.

• Under-provision of merit goods such as schools, hospitals and public transport, since the
external benefits of these goods are not reflected in the market, they are underproduced.

• Lack of public goods such as roads, bus terminals and street lights: since their consumption
cannot be measures and charged a price for, they are not produced by the private sector.

• Immobility of resources: when resources cannot move between their optimal uses and thus
are not used to the maximum. For example, when workers (labour) don’t have occupational
or geographic mobility.

• Information failure: when information between consumers, producers and the government
are not efficiently and correctly communicated. Example: a cosmetics firm advertises its
products as healthy when it is in fact not. The consumers who believe the firm and use its
products might suffer skin damage.

• Abuse of monopoly* powers: monopolistic businesses may use their powers to charge
consumers a high price and only produce products they wish to, since they know consumers
have no choice but to buy from them.

*Monopoly: a single supplier who supplies the entire market with a particular product,
without any competition. Example: public utilities like water, gas and electricity in many
countries are provided by their respective governments with no other producer allowed in
the market.

22 | P a g e
Mixed Economic System

In a mixed economic system, both the market and government intervention co-exist.
Examples include almost all countries in the world (India, UK, Brazil etc.). This is because it
overrides all the disadvantages of both the market and planned (govt. only) economies. It
identifies the importance of the price mechanism in operating an efficient resource
allocation and also the role of the government in correcting (any) market failures.

Features:
• both the public and the private sector exists
• planning and final decisions are made by the govt. while the market system can determine
allocation of resources owned by it, along with the public organizations.

Advantages:

• The govt. can provide public goods, necessities and merit goods. The private businesses can
provide profitable and most-demanded goods (luxury goods, superior goods). Thus,
everyone is provided for.
• The govt. will keep externalities, monopolies, harmful goods etc. in control.
• The govt. can provide jobs in the public sector (so there is better job security).
• The govt. can also provide financial help to collapsing private organizations, so jobs are kept
secure.

Disadvantages:
• Taxes will be imposed, which will raise prices and also reduce work incentive.
• Laws and regulations can increase production costs and reduce production in the economy.
• Public sector organizations will still be inefficient and will produce low quality goods and
services.
The specific ways in which the government, in a mixed economic system, can correct market
failures of the market:

• Legislation and regulation – the government can make laws that regulate market activity,
for example, prohibit smoking in public (which would cause a negative externality). One
important kind of legislation the govt. can undertake is price controls – setting a minimum
price or maximum price on goods.

23 | P a g e
Minimum price or price floor is set to control a decreasing tendency of price. The minimum
wage laws in many countries are an example of minimum price. The government sets the
minimum wage above the existing market equilibrium wage, to ensure that all workers get a
basic minimum wage to sustain them. But even as low-income workers now get better wages,
the higher wage will cause the demand for labour to contract, as shown in the diagram to the
left. There will also be higher supply of labour (workers who want work) because of higher
wages. A reduced demand and increased supply will cause excess supply of labour i.e.,
unemployment.

Maximum price or price ceiling is set to control an increasing tendency of price. It is

usually set on rent (this is called rent control), to ensure that low-income tenants can afford
to rent homes. But as a result of the lower rent, landlord will stop renting more homes,
causing supply to contract, as shown in the diagram to the left. At the same time, lower rent
will increase the demand for homes. A reduced supply of homes and higher demand for
them will cause a shortage of supply in relation to demand.
24 | P a g e
 • Direct provision of merit and public goods – since there is little incentive for the price
mechanism to supply these goods, governments usually provide them. For example, free
education, free healthcare, public parks. One way the govt. can do this is
by nationalising certain products it considers essential to be provided by a governing
authority, rather than the market. For example, in India, the government operates the only
railway network because only it can provide cheap services to its millions of poor, daily
passengers.

• Taxation on products – imposing a tax on products (indirect taxes) with negative externalities
can discourage its production and consumption. For example, a tax on tobacco will make it
expensive to produce and consume. In the diagram below, a tax has been imposed on a
product, causing its supply to shift from S to S1. The price rises from P to P1 because of the
additional tax amount, and the quantity traded in the market falls

from Q to Q1.

• Subsidies – a subsidy is a grant (financial aid) on products that have a positive externality.
Subsidising, for example, cooking gas for the poor, will increase the living standard of the
population. In the diagram below, a subsidy has been imposed on a good, causing its supply
to shift from S to S1. It results in a fall in price from P to P1 and subsequently, an increase in
the quantity traded in the market from Q to Q1.

25 | P a g e
 *Note: movements along a demand or supply curve of a good only happen as a result of a direct
change in price of the good; changes caused by any other factor, tax and subsidy included, is
represented by a shift in the curves

• Tradable permits – firms will have to buy permits from the government to do
something, for example, pollute at a certain level, and these can be traded among
firms. Since permits require money, firms will be encouraged to pollute less.

• Extension of property rights – one of the main reasons for pollution in public spaces
is that it is public – it does not harm a specific private individual – the resource is the
government’s who cannot charge compensations easily. So the government can
extend property rights (right to own property) of public places to private individuals.
This will effectively privatise resources, create a market for these spaces and then
individuals can be fined for polluting

• International cooperation among governments – governments work together on

issues that affect the future of the environment.
As you can see, market failure can be corrected by governments in a variety of ways and the
presence of a government is quite indispensable in any modern economy. Planned
(government-only) economies are too inefficient and free market (no government)
economies result in market failures. So a mixed economic system tries to balance both sides.
That being said, there are certain drawbacks to government intervention in an economy.

26 | P a g e
• Political incentives: this occurs when there is a clash between political and
economics (because a government is a political entity with political incentives). For
example, even though mining companies cause a lot of environmental damage, the
government may encourage and promote their activities to garner political and
financial support from them.

• Lack of incentives: in the free market, individuals have a profit incentive to innovate
and cut costs, but in the public sector, such an incentive is absent since the
government will pay them salaries regardless of their performance. So, even as the
government provides certain public and merit goods directly to the people at low
costs, they tend to be very inefficient.

• Time lags, information failure: these are some of the government failures arising
because of a lack of incentive. Government offices and employees don’t have an
incentive to provide timely services or give accurate information and this leads to very
inefficient systems.

• Welfare effects of policies: government policies such as taxation and welfare

payments distort the market. This means that such policies will influence demand and
supply in the economy and cause markets to move away from the efficient points
produced by a market system. For example, high corporate taxes will deter companies
from expanding their operations and making more profits or deter new enterprises
from entering the market. Unemployment benefits given out by the government may
cause people to stay unemployed and receive free benefits instead of working.

27 | P a g e
MICROECONOMIC DECISION MAKERS

Money and Banking

Money

A medium of exchange of goods and services.

Why do we need money?
We need money in order to exchange goods and services with one another. This is because
we aren’t self-sufficient – we can’t produce all our wants by ourselves. Thus, there is a need
for exchange.
In the past, barter system (exchanging a good or service for another good or service)
prevailed. This had a lot of problems such as the need for the double coincidence of wants
(if the person wants a table and he has a chair to exchange, he must find a person who has
a table to exchange and is also willing to buy a chair), the goods being perishable and non-
durable, the indivisibility of goods, lack of portability etc.
Thus the money we use today is in the form of currency notes and coins, which are durable,
uniform, divisible (can be divided into 10’s, 50’s , 100’s etc), portable and is generally
accepted. These are the characteristics of what is considered ‘good money’.

The functions of money:

• Money is a medium of exchange, as explained above.

• Money is a measure of value. Money acts as a unit of account, allowing us to compare and
state the worth of different goods and services.
• Money is a store of value. It holds its value for a long time, allowing us to save it for future
purposes.
• Money is a means of deferred payment. Deferred payments are purchases on credit – where
the consumer can pay later for the goods or service they buy.

28 | P a g e
BANKING

Banks are financial institutions that act as an intermediary between borrowers and savers. It
is the money we save at banks that is lent out as loans to other individuals and businesses.

Commercial banks are those banks that have many retail branches located in most cities
and towns. Example: HSBC. There is also a central bank that governs all other commercial
banks in a country. Example: The Bank of Ghana, Reserve Bank of India (RBI).

Functions of a commercial bank:

• Accept deposits in the form of savings.
• Aid customers in making and receiving payments via their bank accounts.
• Give loans to businesses and private individuals.
• Buying and selling shares on customers’ behalf.
• Provide insurance (protection in the form of money against damage/theft of personal
property).
• Exchange foreign currencies.
• Provide financial planning advice.

Functions of a central bank:

• It issues notes and coins of the national currency.
• It manages all payments relating to the government.
• It manages national debt. Central banks can issue and repay public debts on the
government’s behalf.
• It supervises and controls all the other banks in the whole economy, even holding their
deposits and transferring funds between them.
• It is the lender of ‘last resort’ to commercial banks. When other banks are having financial
difficulties, the central bank can lend them money to prevent them from going bankrupt.
• It manages the country’s gold and foreign currency reserves. These reserves are used to make
international payments and adjust their currency value (adjust the exchange rate).
• It operates the monetary policy in an economy. (This will be explained in a later chapter)

29 | P a g e
HOUSEHOLDS

Disposable income is the income of a person after all income-related taxes and charges
have been deducted.

SPENDING (CONSUMPTION)

The buying of goods and services is called consumption. The money spent on
consumption is called consumer expenditure.
People consume in order to satisfy their needs and wants and give them satisfaction.

Factors affecting consumption:

• Disposable income: the more the disposable income, the more people consume.
• Wealth: the more wealthy (having assets such as property, jewels, company shares) a person
is, the more he spends.
• Consumer confidence: if consumers are confident of keeping their jobs and their future
incomes, then they might be encouraged to spend more now, without worries.
• Interest rates: if interest rates provided by banks on saving are high, consumers might save
more so they can earn interest and thus consumer expenditure will fall.
Saving

Saving is income not spent (or delaying consumption until some later date). People can save
money by depositing in banks, and withdraw it a later date with the interest.
Factors affecting saving:
• Saving for consumption: people save so that they can consume later. They save
money so that they can make bigger purchases in the future (a house, a car etc). Thus,
saving can depend on the consumers’ future plans.
• Disposable income: if the amount of disposable income people have is high, the
more likely that they will save. Thus, rich people save a higher proportion of their
incomes than poor people.
• Interest rates: people also save so that their savings may increase overtime with the
interest added. Interest is the return on saving; the longer you save an amount and
the higher the amount, the higher the interest received.

30 | P a g e
 • Consumer confidence: if the consumer is not confident about his job security and
incomes in the future, he may save more now.
• Availability of saving schemes: banks now offer a variety of saving schemes. When
there are more attractive schemes that can benefit consumers, they might resort to
saving rather than spending.

Borrowing

Borrowing, as the word suggests, is simply the borrowing of money from a

person/institution. The lender gives the borrower money. The lender is usually the bank
which gives out loans to customers.

Factors affecting borrowing:

• Interest rates: interest is also the cost of borrowing. When a person takes a loan, he must
repay the entire amount at the end of a fixed period while also paying an amount of interest
periodically. When the interest rates rise, people will be reluctant to borrow and vice versa.
• Wealth/Income: banks will be more willing to lend to wealthy and high-income earning
people, because they are more likely to be able to repay the loan, rather than the poor. So
even if they would like to borrow, the poor end up being able to borrow much lesser than
the rich.
• Consumer confidence: how confident people feel about their financial situation in the future
may affect borrowing too. For example, if they think that prices will rise (inflation) in the
future, they might borrow now, to make big purchases now.
• Ways of borrowing: the no. of ways to borrow can influence borrowing. Nowadays there are
many borrowing facilities such as overdrafts, bank loans etc. and there are more credit (future
payment) options such as hire purchases (payment is done in installments overtime), credit
cards etc.

Expenditure patterns between income groups

The richer people spend, save and borrow more amounts than the poor.
The poor spend higher proportions of their disposable income, especially on necessities,
than the rich.
The poor save lesser proportions of their disposable income in comparison with the rich.

31 | P a g e
32 | P a g e
WORKERS

Labour Market

Labourers need wages to satisfy their wants and needs.

Payments for labour:

• Time-rate wage: wage given based on the no. of hours the employee has
worked. Overtime wages are given to workers who have worked extra no. of hours,
which will usually be 1.5 times or even twice the normal time rate.
• Piece-rate wage: wage given based on the amount of output produced. The more
output an employee produced, the more wage he/she earns. This is used in industries
where output can be easily measured and gives employees an incentive to increase
their productivity.
• Salary: monthly payments made to workers, usually managers, office staff etc. usually
in non-manual jobs.
• Performance-related payments: payments given to individual workers or teams of
workers who have performed very well. Commissions given to salespersons for
selling to a targeted no. of customers is a form of performance-related pay.

What affects an individual’s choice of occupation?

• Wage factors: the wage conditions of a job/firm such as the pay rate, the prospect
for performance-related payments and bonuses etc. will be considered by the
individual before he chooses a job.
• Non-wage factors: This will include:
• hours of work
• holiday entitlements
• promotion prospects
• quality of working environment
• job security
• fringe benefits (free medical insurance, company car, price discounts on
company products etc.)
• training opportunities
• distance from home to workplace
• pension entitlement
33 | P a g e
Labour demand is the number of workers demanded by firms at a given wage
rate. Labour demand is called ‘derived demand’,

since the level of demand of a product determines that industry’s demand for labour. That
is, the higher the demand for a product, the more labour producers will demand to
increase supply of the product.
When the wage increases, the demand for labour contracts (and vice versa).
Labour supply is the number of workers available and ready to work in an industry at
a given wage rate. When the wage rate increases, the supply of labour extends, and vice
versa.

We also know that as the number of hours worked increases, the wage rate also increases.
However, when a person get to a very high position and his wages/salary increases highly,
the number of hours he/she works may decrease. This can be shown in this diagram, called
a backward-bending labour supply curve.

CEOs and executive managers at the top of the management tend to have backward-
bending labour supply curves.
Just like in a demand and supply curve analysis, labour demand and supply will extend
and contract due to changes in the wage rate. Other factors that cause changes in
demand and supply of labour will result in a shift in the demand and supply curve of
labour.

34 | P a g e
Factors that cause a shift in the labour demand curve:

• Consumer demand for goods and services: the higher the demand for products, the higher
the demand for labour.
• Productivity of labour: the more productive labour is, the more the demand for labour.
• Price and productivity of capital: capital is a substitute resource for labour. If the price of
capital were to lower and its productivity to rise, firms will demand more of capital and labour
demand will fall (labour demand curve shifts to the left).
• Non-wage employment costs: wages are not the only cost to a firm of employing workers.
Sometimes, employment tax, welfare insurance for each employee etc. will have to be paid
by the firm. If these costs increase, firms will demand less labour.

Factors that cause a shift in the labour supply curve:

• Advantages of an occupation: the different advantages a job can offer to employees will
affect the supply of labour- the people willing to do that job. Example: if the number of
working hours in the airline industry increases, the labour supply there will shift to the left.
• Availability and quality of education and training: if quality training and education for a
particular job, say pilots, is lacking, then the labour supply for it will be low. When new
education and training institutes open, the labour supply will rise (labour supply curve shifts
to the right).
• Demographic changes: the size and age structure of the population in an economy can
affect the labour supply. The labour supply curve will shift to the right when more people
come into a country from outside (immigration) and when the birth rate increases (more
young people will be available for work).

Why would a person’s wage rate change overtime?

As a beginner, the individual would have a low wage rate since he/she is new to the job and
has no experience. Overtime, as his/her experience increases and skills develop, he/she will
earn a higher wage rate. If he/she gets promoted and has more responsibilities, his/her
wage rate will further increase. When he/she nears retirement age, the wage rate is likely to
decrease as their productivity and skills are likely to weaken.

35 | P a g e
WAGE DIFFERENTIALS

Why do different jobs have different wages?

• Different abilities and qualifications: when the job requires more skills and
qualifications, it will have a higher wage rate.
• Risk involved in the job: risky jobs such as rescue operation teams will gain a higher
wage rate for the risks they undertake.
• Unsociable hours: jobs that require night shifts and work at other unsociable hours
are paid more.
• Lack of information about other jobs and wages: Sometimes people work for less
wage rates simply because they do not know about other jobs with higher wage rates.
• Labour immobility: the ease with which workers can move between different
occupations and areas of an economy is called labour mobility. If labour mobility is
high, workers can move to jobs with a higher pay. Labour immobility causes people
to work at a low wage rate because they don’t have the skills or opportunities to move
to jobs with a higher wage.
• Fringe benefits: jobs which offer a lot of fringe benefits have low wages. But
sometimes the highest-paid jobs are also given a lot of fringe benefits, to attract
skilled labour.

Why do wages differ between people doing the same job?

• Regional differences in labour demand and supply: for example, if the demand in
an area for accountants is very high, the wage rate for accountants will be high;
whereas, in an area of low demand for accountants, the wage rate for accountants
will be low. Similarly, a high supply of accountants will cause their wages to be low,
while a low supply (scarcity) of accountants will cause their wages to be high. It’s the
law of demand and supply!
• Fringe benefits: some firms which pay a lot of fringe benefits, will pay less wages,
while firms (in the same industry) which pay lesser fringe benefits will have higher
wages.
• Discrimination: workers doing the same work may be discriminated by gender, race,
religion or age.
• Length of service: some firms provide extra pay for workers who have worked in the
firm for a long time, while other firms may not.

36 | P a g e
 • Local pay agreements: some trade unions may agree a national wage rate for all
their members – therefore all their members (labourers) will get a higher wage rate
than those who do the same job but are not in the trade union. This depends on the
relative bargaining power of the trade union.
• Government labour policies: wages will be fairer in an economy where the
government has set a minimum wage policy. The government’s corporate tax policies
can also influence the amount of wage firms will be willing to pay out.

Other wage differentials:

• Public-private sector pay gap: public sector jobs usually have a high wage rate. But
sometimes public sector wages are lower than that of the private sector’s because low wages
can be compensated by the public sector’s high job security and pension prospects.
• Economic sector: workers in primary activities such as agriculture receive very low wages in
comparison to those in the other sectors because the value of output they produce is lower.
Further still, workers in the manufacturing sector may earn lesser than those in the services
sector. But it comes down to the nature of the job itself. A computer engineer in the
manufacturing sector does earn more than a waiter at a restaurant after all.
• Skilled and unskilled workers: Skilled workers have a higher pay than unskilled workers,
because they are more productive and efficient and make lesser mistakes.
• Gender pay gap: Men are usually given a higher pay than women. This is because women
tend to go for jobs that don’t require as much skill as that is required by men’s jobs (teaching,
nursing, retailing); they take career breaks to raise children, which will cause less experience
and career progress (making way for low wages); more women work part-time than full-time.
Sometimes, even if both men and women are working equally hard and effectively,
discrimination can occur against women.
• International wage differentials: developed countries usually have high wage rates due to
high incomes, large supply of skilled workers, high demand for goods and services etc; while
in a less-developed economy, wage rates will be low due to a large supply unskilled labour.

37 | P a g e
DIVISION OF LABOUR/SPECIALISATION

Division of labour is the concept of dividing the production process into different stages
enabling workers to specialise in specific tasks.

This will help increase efficiency and productivity. Division of labour is widely used in modern
economies. From the making of iPhones (the designs, processors, screens, batteries, camera
lenses, software etc. are made by different people in different parts of the world) to this very
website (where notes, mindmaps, illustrations, design etc. are all managed by different
people).

Advantages to workers:
• Become skilled: workers can get skilled and experienced in a specific task which will help
their future job prospects
• Better future job prospects: because of the skill and training they acquire, workers will, in
the future, be able to get better jobs in the same field.
• Saves time and expenses in training

Disadvantages to workers:
• Monotony: doing the same task repetitively might make it boring and lower worker’s morale.
• Margin for errors increases: as the job gets repetitive, there also arises a chance for
mistakes.
• Alienation: since they’re confined to just the task they’re doing, workers will feel socially
alienated from each other.
• Lower mobility of labour: division of labour can also cause a reduced mobility of labour.
Since a worker is only specialised in doing one specific task(s), it will be difficult for him/her
to do a different job.
• Increased chance of unemployment: when division of labour is introduced, many excess
workers will have to be laid off. Additionally, if one loses the job, it will be harder for him/her
to find other jobs that require the same specialisation.

Advantages to firms:
• Increased productivity: when people specialise in particular tasks, the total output will
increase.
• Increased quality of products: because workers work on tasks they are best suited for, the
quality of the final output will be high.

38 | P a g e
 • Low costs: workers only need to be trained in the tasks they specialise in and not the entire
process; and tools and equipment required for a task will only be needed for a few workers
who specialise in the task, and not for everybody else.
• Faster: when everyone focuses on a particular task and there is no need for workers to shift
from one task to another, the production will speed up
• Efficient movement of goods: raw materials and half-finished goods will easily move
around the firm from one task to the next.
• Better selection of workers: since workers are selected to do tasks best suited for them,
division of labour will help firms to choose the best set of workers for their operations.
• Aids a streamlined production process: the production process will be smooth and clearly
defined, and so the firm can easily adapt to a mass production scale.
• Increased profits: lower costs and increased productivity will help boost profits.

Disadvantages o firms:
• Increased dependency: The production may come to a halt if one or more workers doing a
specific task is absent. The production is dependent on all workers being present to do their
jobs.
• Danger of overproduction: as division of labour facilitates mass production, the supply of
the product may exceed its demand, and cause a problem of excess stocks of finished goods.
Firms need to ensure that they’re not producing too much if there is not enough demand for
the product in the first place.

Advantages to the economy:

• Better utilisation of human resources in the economy as workers do the job they’re best
at, helping the economy achieve its maximum output.
• Establishment of efficient firms and industries, as the higher profits from division of labour
will attract entrepreneurs to invest and produce.
• Inventions arise: as workers become skilled in particular areas, they can innovate and invent
new methods and products in that field.

Disadvantages to the economy:

• Labour immobility: occupational immobility may arise because workers can only specialise
in a specific field.
• Reduces the creative instinct of the labour force in the long-run as they are only able to do
a single task repetitively and the previous skills they acquired die out.
• Creates a factory culture, which brings with it the evils of exploitation, poor working
conditions, and forced monotony.

39 | P a g e
TRADE UNIONS

Trade Unions are organizations of workers that aim at promoting and protecting the
interest of their members (workers). They aim on improving wage rates, working
conditions and other job-related aspects.

The functions of a trade union:

• Negotiating improvements in non-wage benefits with employers.
• Defending employees’ rights.
• Improving working conditions, such as better working hours and better safety measures.
• Improving pay and other benefits.
• Supporting workers who have been unfairly dismissed or discriminated against.
• Developing the skills of members, by providing training and education.
• Providing recreational activities for the members.
• Taking industrial actions (strikes, overtime ban etc.) when employers don’t satisfy their
needs.
These are explained later in this topic.

Collective bargaining:
The process of negotiating over pay and working conditions between trade unions and
employers.

When can trade unions argue for higher wages and better working conditions?
• Prices are rising (inflation): the cost of living increases when prices increase and workers will
want higher wages to consume products and raise their families.
• The sales and demand of the firm has increased.
• Workers in other firms are getting a higher pay.
• The productivity of the members has increased.

Industrial disputes
When firms don’t satisfy trade union wants or refuse to agree to their terms, the members
of a trade union can organize industrial disputes. Here are some:

• Overtime ban: workers refuse to work more than their normal hours.
• Go-slow: workers deliberately slow down production, so the firm’s sales and profits go down.

40 | P a g e
 • Strike: workers refuse to work and may also protest or picket outside their workplace to stop
deliveries and prevent other non-union members from entering. They don’t receive any
wages during this time. This will halt all production of the firm.
Trade union activity has several impacts:

Advantages to workers:
• Workers benefit from collective bargaining power by being able to establish better terms of
labour.
• Workers feel a sense of unity and feel represented, increasing morale.
• Lesser chance of being discriminated and exploited.

Disadvantages to workers:
• Workers might get lesser wages or none if they go on strike – as the output and profits
of the firm falls and they refuse to pay.

Advantages to firms:
• Time is saved in negotiating with a union when compared to negotiating with individuals
workers.
• When making changes in work schedules and practices, a trade union’s cooperation can
help organise workers efficiently.
• Mutual respect and good relationships between unions and firms are good for business
morale and increases productivity.

Disadvantages to firms:
• Decision making may be long as there will be need of lengthy discussions with trade unions
in major business decisions.
• Trade unions may make demands that the firm may not be able to meet – they will have
to choose between profitability and workers’ interests.
• Higher wages bargained by trade unions will reduce the firm’s profitability.
• Businesses will have high costs and low output if unions organise agitations. Their
revenue and profits will go down and they will enter a loss. They may also lose a lot of
customers to competing firms.

Advantages to the economy:

• Ensures that the labour force in the economy is not exploited and that their interests are
being represented

41 | P a g e
Disadvantages to the economy:
• Can negatively impact total output of the economy.
• Firms may decide to substitute labour for capital if they can’t meet trade unions’ expensive
demands, and so unemployment may rise.
• Higher wages resulting from trade union activity can make the nation’s exports expensive
and thus less competitive in the international market

In modern times, the powers of trade unions have drastically weakened. Globalisation,
liberalisation and privatisation of economies are making markets more competitive. Firms
have more incentive to reduce costs of production to a minimum in order to remain
competitive and profitable. Therefore, it is much harder for unions to force employers to
increase wages. Most unions operating nowadays are more focused on bettering working
conditions and non-monetary benefits.

42 | P a g e
FIRMS

CLASSIFICATION OF FIRMS
Firms can be classified in terms of the sectors they operate in and their relative sizes.

Firms are classified into the following three categories based on the type of operations
undertaken by them:

• Primary: all economic activity involving extraction of raw natural materials. This includes
agriculture, mining, fishing etc. In pre-modern times, most economic activity and
employment was in this sector, mostly in the form of subsistence farming (farming for self-
consumption).
• Secondary: all economic activity dealing with producing finished goods. This includes
construction, manufacturing, utilities etc. This sector gained importance during the industrial
revolution of the 19th and 20th centuries and still makes up a huge part of the modern
economy.
• Tertiary: all economic activity offering intangible goods and services to consumers. This
includes retail, leisure, transport, IT services, banking, communications etc. This sector is now
the fastest-growing sector as consumer demand for services have increased in developed
and developing nations.
Firms can also be classified on the basis of whether they are publicly owned or privately
owned:

• Public: this includes all firms owned and run by the government. Usually, the defence, arms
and nuclear industries of an economy are completely public. Public firms don’t have a profit
motive, but aim to provide essential services to the economy it governs. Governments do
also run their own schools, hospitals, postal services, electricity firms etc.
• Private: this includes all firms owned and run by private individuals. Private firms aim at
making profits and so their products are those that are highly demanded in the economy.
Firms can also be classified on their relative size as small, medium or large depending on the
output, market share, organisation (no. of departments and subsidiaries etc).

43 | P a g e
Small Firms
A small firm is an independently owned and operated enterprise that is limited in size and
in revenue depending on the industry. They require relatively less capital, less workforce
and less or no machinery. These businesses are ideally suited to operate on a small scale to
serve a local community and to provide profits to the owners.

Advantages of small businesses:

• Independence: owner(s) are free to run the business as he/she pleases.

• Control: the owner(s) has full control over the business, unlike in a large business where
multiple managers, departments and branches will exist.
• Flexibility: small businesses can adapt to quick changes as the owner is more involved in the
decision-making.
• Better communication: since there are fewer employees, information can be intimated easily
and quickly.
• Innovation: small businesses can tend to be innovative because they have less to lose and
are willing to take risks.

Disadvantages of small businesses:

• Higher costs: small firms cannot exploit economies of scale – their average costs will be
higher than larger rivals.
• Lack of finance: struggles to raise finance as choice of sources of acquiring finance is limited.
• Difficult to attract experienced employees: a small business may be unable to afford the
wage and training required for skilled workers.
• Vulnerability: when economic conditions change, it is harder for small businesses to survive
as they lack resources.

44 | P a g e
Small firms still exist in the economy for several reasons:

• Size of the market: when there is only a small market for a product, a firm will see no point
in growing to a larger size. The market maybe small because:
• the market is local – for example, the local hairdresser.
• the final product maybe an expensive luxury item which only require small-scale
production (e.g. custom-made paintings)
• personalised/custom services can only be given by small firms, unlike large firms
that mostly give standardised services (e.g. wedding cake makers).

• Access to capital is limited, so owners can’t grow the firm.

• Owner(s) prefer to stay small: a lot of entrepreneurs don’t want to take risks by growing
the firm and they are quite satisfied with running a small business.
• Small firms can co-operate: co-operation between small firms can lead them to set up
jointly owned enterprises which allow them to enjoy many of the benefits that large firms
have.
• Governments help small firms: governments usually provide help to small scale firms
because small firms are an important provider of employment and generate innovation in the
production process. In most countries, it is the medium and small industries that contribute
much of the employment.

Growth of Firms
When a firm grows, its scale of production increases. Firms can grow in to ways: internally or
externally.

Internal Growth/Organic Growth

This involves expanding the scale of production of the firm’s existing operations. This
can be done by purchasing more machinery/equipment, opening more branches, selling
new products, expanding business premises, employing more workers etc.

External Growth
This involves two or more firms joining together to form a larger business. This is
called integration. This can be done it two ways: mergers or takeovers.

45 | P a g e
A takeover or acquisition happens when a company buys enough shares of another
firm that they can take full control. The firm taken over loses its identity and becomes a
part of what is known as the holding company. A well-known example would be Facebook’s
acquisition of Whatsapp in 2014.

A merger occurs when the owners of two or more companies agree to join together to
form a firm.
Mergers can happen in three ways:

Horizontal Integration:
Integration of firms engaged in the production of the same type of good at the same level
of production. Example: a cloth manufacturing company merges with another cloth
manufacturing company.

Advantages

• Exploit internal economies of scale: including bulk-buying, technical

economies, financial economies.
• Save costs: when merging, a lot of the duplicate assets including employees can
be laid off.
• Potential to secure ‘revenue synergies’ by creating and selling a wider range of
products.
• Reduces competition: by merging with key rivals, the two firms together can
increase market share.

Disadvantages:

•
• Risk of diseconomies of scale: a larger business will bring with a lot of
managerial and operational issues leading to higher costs.
• Reduced flexibility: the addition of more employees and processes means the
need for more transparency and therefore more accountability and red tape,
which can slow down the rate of innovating and producing new products and
processes.

46 | P a g e
 Vertical Integration
Integration of firms engaged in the production of the same type of good but at different
levels of production (primary/secondary/tertiary). Example: a cloth manufacturing company
(secondary sector) merges with a cotton growing firm (primary sector).

• Forward vertical integration: when a firm integrates with a firm that is at a later
stage of production than theirs. Example: a dairy farm integrates with a cheese
manufacturing company.
• Backward vertical integration: when a firm integrates with a firm that is at an
earlier stage of production than theirs. Example: a chocolate retailer integrates
with a chocolate manufacturing company.

Advantages:

• It can give a firm assured supplies or outlets for their products. If a coffee brand
merged with coffee plantation, the manufacturers would get assured supplies of
coffee beans from the plantation. If the coffee brand merged with a coffee shop
chain, they would have a permanent outlet to sell their coffee from.
• Similarly, one firm can prevent the other firm from supplying materials or
selling products to competitors. The coffee brand can have the coffee plantation
to only supply them their coffee beans. The coffee brand can also have the coffee
shop chain only selling coffee with their coffee powder.
• The profit margins of the merged firm can now be absorbed into the merging
firm.
• The firms can increase their market share and become more competitive in the
market.

Disadvantages:

• Risk of diseconomies of scale: a larger business will bring with a lot of

managerial and operational issues leading to higher costs
• Reduced flexibility: the addition of more employees and processes means the
need for more transparency and therefore more accountability and red tape,
which can slow down the rate of innovating and producing new products and
processes

47 | P a g e
 • It’s a difficult process: The firms, when vertically integrated, are entering into a
stage of production/sector they’re not familiar with, and this will require staff of
either firm to be educated and trained. Some might even lose their jobs. It can be
expensive as well.
• Lateral/Conglomerate integration: this occurs when firms producing different type of
products integrate. They could be at the same or different stages of production. Example: a
housing company integrates with a dairy farm. Thus, the firm can produce a wide range of
products. This helps diversify a firm’s operations.

Advantages:

• Diversify risks: conglomerate integration allows businesses to have activities in

more than one market. This allows the firms to spread their risks. In case one
market is in decline, it still has another source of profit.
• Creates new markets: merging with a firm in a different industry will open up the
firm to a new customer base, helping it to market its core products to this new
market.
• Transfer of ideas: there could be a transfer of ideas and resources between the
two businesses even though they are in different industries. This transfer of ideas
could help improve the quality and demand for the two products.

Disadvantages:

• Inexperience can lead to mismanagement: if the firms are in entirely different industries
and have no experience in the other’s industry, cooperating and managing the two industries
may be difficult and could turn disastrous.
• Lose focus: merging with and focusing on an entirely new industry could cause the firm to
lose focus of its core product.
• Culture clash: as with all kinds of mergers, there could be a culture clash between the two
firms’ employees on practices, standards and ‘how things are done’.

48 | P a g e
SCALE OF PRODUCTION

FIRMS AND PRODUCTION

Demand for Factors of Production

Some factors that determine the demand of factors of production:

• The demand for the product: if more goods and services are demanded by consumers,
more factors of production will be demanded by firms to produce and satisfy the demand.
That is, the demand for factors of production is derived demand, as it is determined by the
demand for the goods and services (just like labour demand).
• The availability of factors: firms will also demand factors that are easily available and
accessible to them. If the firm is located in a region where there is a large pool of skilled
labour, it will demand more labour as opposed to capital.
• The price of factors: If labour is more expensive than capital, firms will demand more capital
(and vice versa), as they want to reduce costs and maximize profits.
• The productivity of factors: If labour is more productive than capital, then more labour is
demanded, and vice versa.

LABOUR-INTENSIVE AND CAPITAL-INTENSIVE PRODUCTION

Labour-intensive production is where more labourers are employed than other factors, say
capital. Production is mainly dependent on labour. It is usually adopted in small-scale
industries, especially those that produce personalised, handmade products. Examples: hotels
and restaurants.
Advantages:

• Flexibility: labour, unlike most machinery can be used flexibly to meet changing levels of
consumer demand, e.g., part-time workers.
• Personal services: labour can provide a personal touch to customer needs and wants.

49 | P a g e
 • Personalised services: labourers can provide custom products for different customers.
Machinery is not flexible enough to provide tailored products for individual customers.
• Gives feedback: labour can give feedback that provides ideas for continuous improvements
in the firm.
• Essential: labour is essential in case of machine breakdowns. After all, machines are only as
good as the labour that builds, maintains and operates them..

Disadvantages:

• Relatively expensive: in the long-term, when compared to machinery, labour has higher per
unit costs due to lower levels of productivity.
• Inefficient and inconsistent: compared to machinery, labour is relatively less efficient and
tends to be inconsistent with their productivity, with various personal, psychological and
physical matters influencing their quantity and quality of work.
• Labour relation problems: firms will have to put up with labour demands and grievances.
They could stage an overtime ban or strike if their demands are not met.

Capital refers to the machinery, equipment, tools, buildings and vehicles used in production.

It also means the investment required to do production. Capital-intensive production is

where more capital is employed than other factors. It is a production which requires a

relatively high level of capital investment compared to the labour cost. Most capital-intensive
production is automated (example: car-manufacturing).

Advantages:

• Less likely to make errors: Machines, since they’re mechanically or digitally programmed to
do tasks, won’t make the mistakes that labourers will.
• More efficient: machinery doesn’t need breaks or holidays, has no demands and makes no
mistakes.
• Consistent: since they won’t have human problems and are programmed to repeat tasks,
they are very consistent in the output produced.
• Technical economies of scale: increased efficiency can reduce average costs
50 | P a g e
Disadvantages:

• Expensive: the initial costs of investment is high, as well as possible training costs.
• Lack of flexibility: machines need not be as flexible as labourers are to meet changes in
demand.
• Machinery lacks initiative: machines don’t have the intuitive or creative power that human
labour can provide the business, and improve production.

PRODUCTION AND PRODUCTIVITY

A firm combines scarce resources of land, labour and capital (inputs) to make (produce)
goods and services (output). Production is thus, the transformation of raw materials
(input) to finished or semi-finished goods and services (output).
In other words, production is the adding of value to inputs to create outputs. It is the
production that gives the inputs value.

Some factors that influence production:

• Demand for product: the more the demand from consumers, the more the production.
• Price and availability of factors of production: if factors of production are cheap and
readily available, there will be more production.
• Capital: the more capital that is available to producers, the more the investment in
production.
• Profitability: the more profitable producing and selling a product is, the more the
production of the product will be.
• Government support: if governments give money in grants, subsidies, tax breaks and so on,
more production will take place in the economy.
•
Productivity measures the amount of output that can be produced from a given
amount of input over a period of time.
Productivity = Total output produced per period / Total input used per period

51 | P a g e
Productivity increases when:

• more output or revenue is produced from the same amount of resources

• the same output or revenue is produced using fewer resources.
(Labour productivity is the measure of the amount of output that can be produced by each
worker in a business).

Factors that influence productivity:

• Division of labour: division of labour is when tasks are divided among labourers. Each
labourer specializes in a particular task, and thus this will increase productivity.
• Skills and experience of labour force: a skilled and experienced workforce will be more
productive.
• Workers’ motivation: the more motivated the workforce is, the more productive they will
be. Better pay, working conditions, reasonable working hours etc. can improve productivity.
• Technology: more technology introduced into the production process will
increase productivity.
• Quality of factors of production: replacing old machinery with new ones, preferably with
latest technologies, can increase efficiency and productivity. In the case of labour, training
the workforce will increase productivity.
• Investment: introducing new production processes which will reduce wastage, increase
speed, improve quality and raise output will raise productivity. This is known as lean
production.

52 | P a g e
FIRMS’ COSTS, REVENUE AND OBJECTIVES

Costs of Production
Fixed costs (FC) are costs that are fixed in the short-term running of a business and have to
be paid even when no production is taking place. Examples: rent, interest on bank loans,
telephone bills. These costs do not depend on the amount of output produced.
Average Fixed Cost (AFC) = Total Fixed Cost (TFC) / Total Output

Variable costs (VC) are costs that are variable (change) in the short-term running of a
business and are paid according to the output produced. The more the production, the more
the variable costs are. Examples: wages, electricity bill, cost of raw materials.
Average Variable Cost (AVC) = Total Variable Costs (TVC) / Total Output

53 | P a g e
Total Costs (TC) = Total Fixed Costs (TFC) + Total Variable Costs (TVC)

This is a simple graph showing the relation between TC, FC

and VC. The gap between the TC and TVC indicates the TFC

Average cost or Average total Cost (ATC) is the cost per unit of output.
Average Total Cost (ATC) = Total Cost (TC) / Total Output or
Average Cost (AC) = Average Variable Cost (AVC) + Average Fixed Cost (AFC)

(Remember ‘average’ means ‘per unit’ and so will involve dividing the particular cost by the
total output produced. In the graphs above you will notice that the average variable costs
and average total costs first fall and then start rising. This is because of economies of scale
and diseconomies of scale respectively. As the firm increases its output, the average costs
decline but as it starts growing beyond a limit, the average costs rise).

54 | P a g e
Let’s calculate some costs in an example:

Suppose, a TV manufacturer produces 1000 TVs a month. The firm’s fixed costs in rent
is $900, and variable cost per unit is $500. What would its TFC, TVC, AVC, AFC, AC and
TC be, in a month?

No. of units of TVs produced = 1000

Total Fixed Costs for one month = $900

Average Fixed Cost = $900 / 1000 = $0.9 per unit

Variable Cost of producing one unit of TV = $500

Total Variable Costs for producing 1000 TVs in a month = $500 * 1000 = $500,000
Average Variable Cost = $500,000 / 1000 = $500 (AVC is the same as VC per unit!)

Total Costs = Total Fixed Costs + Total Variable Costs ==> $900 + $500,000 = $500,900
Average Costs = Total Costs / Total Output ==> $500,900 / 1000 = $500.9
or Average Costs = AFC + AVC ==> $0.9 + $500 ==> $500.9

Revenue
Revenue is the total income a firm earns from the sale of its goods and services. The
more the sales, the more the revenue.
Total Revenue (TR) = No. of units sold (Sales) * Price per unit (P)
Average Revenue = Total Revenue (TR) / No. of units sold (Sales) (= Price per unit (P)!)
Suppose, from the example above, a TV is sold at $800 and the firm sells all the units it
produces, what is the firm’s Total Revenue and Average Revenue, for a month?
No. of units sold (Sales) in a month = No. of units produced in a month = 1000
Total Revenue = Sales * Price ==> 1000 * $800 = $800,000
Average Revenue = Total Revenue / Sales = $800,000 / 1000 = $800

Total Revenue – Total Cost = Profit

55 | P a g e
Objectives of Firms
Objectives vary with different businesses due to size, sector and many other factors.
However, many business in the private sector aim to achieve the following objectives.

• Survival: new or small firms usually have survival as a primary objective. Firms in a highly
competitive market will also be more concerned with survival rather than any other objective.
To achieve this, firms could decide to lower prices, which would mean forsaking other
objectives such as profit maximization.
• Profit: profit is the income of a business from its activities after deducting total costs from
total revenue. Private sector firms usually have profit making as a primary objective. This is
because profits are required for further investment into the business as well as for
the payment of return to the shareholders/owners of the business. Usually, firms aim
to maximise their profits by either minimising costs, or maximising revenue, or both.
• Growth: once a business has passed its survival stage it will aim for growth and expansion.
This is usually measured by value of sales or output. Aiming for business growth can be very
beneficial. A larger business can ensure greater job security and salaries for employees. The
business can also benefit from higher market share and economies of scale.
• Market share: market share can be defined as the sales in proportion to total market sales
achieved by a business. Increased market share can bring about many benefits to the business
such as increased customer loyalty, setting up of brand image, etc.
• Service to the society: Some operations in the private sectors such as social enterprises do
not aim for profits and prefer to set more social objectives. They aim to better the society by
aiding society financially or otherwise.
A business’ objectives do not remain the same forever. As market situations change and as
the business itself develops, its objectives will change to reflect its current market and
economic position. For example, a firm facing serious economic recession could change its
objective from profit maximization to short term survival.

3.8 – Market Structure

HomeNotesEconomics – 04553.8 – Market Structure

Competitive Markets
Firms compete in the market to increase their customer base, sales, market share and profits.
56 | P a g e
Price competition involves competing to offer consumers the lowest or best possible prices
of a product. Non-price competition is competing on all other features of the product
(quality, after-sales care, warranty etc.) other than price.
Informative advertising means providing information about the product to consumers.
Examples include advertising of phones, computers, home appliances etc. which include
specific information about their technical features.
Persuasive advertising is designed to create a consumer want and persuade them to buy
the product in order to boost sales. Examples include advertisements of perfumes, clothes,
chocolates etc.
Pricing Strategies
What can influence the price that producers fix on a product?

• Level and strength of consumer demand.

• The amount of competition from rival producers in the market.
• The cost of production and the level of profit targeted.
Price skimming: When a new and unique product enters the market, its producers charge
a very high price for it initially as consumers will be willing to pay more for the new product.
As more competitors begin to launch similar products, producers may lower prices. Apple’s
iPhones are good examples – they are very expensive at launch and get cheaper overtime.
Penetration pricing: when producers set a very low price which encourages consumers to
try the product, helping expand sales and increase loyalty. This way, the product is able to
penetrate a market, especially useful when there are a lot of existing rival products. Netflix,
when it first started out as a DVD rental service, used penetration pricing ($1 monthly
subscription!) to encourage customers to try their service which helped it create a large
customer base.
Destruction pricing (predatory pricing): prices are kept very low (lower than the cost of
production per unit) in order to ‘destroy’ the sales of existing products, as consumers will
turn to the lowest priced products. Once the product is successful, it can raise prices and
cover costs. India’s Reliance Jio, a telecom company, was accused of predatory pricing during
its initial launch years. Predatory pricing is illegal in many countries as it creates a non-
competitive business environment and encourages monopoly practices.
Price wars happen when competing firms continually trying to undercut each other’s prices.
Cost-plus-pricing: this involves calculating the average cost of producing each unit of
output and then adding a mark-up value for profit.
Price = (Total Cost/Total Output) + Mark-up
This ensures that the cost of production is covered and that each unit produces a profit.

Perfect Competition
In a perfectly competitive market, there will be many sellers and many buyers – a lot of
different firms compete to supply an identical product.
57 | P a g e
As there is fierce competition, neither producers nor consumers can influence market
price – they are all price takers. If any firm did try to sell at a high price, it would lose
customers to competitors. If the price is too low, they may incur a loss. There will also be a
huge amount of output in the market.
Advertisements

REPORT THIS AD

Advantages:
• High consumer sovereignty: consumers will have a wide variety of goods and services to
choose from, as many producers sell similar products. Products are also likely to be of high
quality, in order to attract consumers.
• Low prices: as competition is fierce, producers will try and keep prices low to attract
customers and increase sales.
• Efficiency: to keep profits high and lower costs, firms will be very efficient. If they aren’t
efficient, they would become less profitable. This will cause them to raise prices which would
discourage consumers from buying their product. Inefficiency could also lead to poor quality
products.
Disadvantages:
• Wasteful competition: in order to keep up with other firms, producers will duplicate items;
this is considered a waste of resources.
• Mislead customers: to gain more customers and sales, firms might give false and
exaggerated claims about their product, which would disadvantage both customers and
competitors.

Monopoly
Dominant firms who have market power to restrict competition in the market are
called monopolies. In a pure monopoly, there is only a single seller who supplies a good
or service. Example: Indian Railways. Since customers have no other firms to buy from,
monopolies can raise prices – that is they are able to influence prices as it will not affect
their profitability. These high prices result in monopolies generating excessive or abnormal
profits.
Monopolies don’t face competition because the market faces high barriers to entry –
obstacles preventing new firms from entering the market. That is, there might be high start-
up costs (sunk costs), expensive paperwork, regulations etc. If the monopoly has a very high
brand loyalty or pricing structures that other firm couldn’t possibly compete with, those also
act as barriers to entry.
Disadvantages:
• There is less consumer sovereignty: as there are no (or very little) other firms selling the
product, output is low and thus there is little consumer choice.
• Monopolies may not respond quickly to customer demands.
• Higher prices.

58 | P a g e
 • Lower quality: as there is little or no competition, monopolies have no incentive to raise
quality, as consumers will have to buy from them anyway. (But since they make a lot of profit,
they may invest a lot in research and development and increase quality).
• Inefficiency: With high prices, they may create high enough profits that, costs due to
inefficiency won’t create a significant problem in their profitability and so they can continue
being inefficient.
Why monopolies are not always bad?
• As only a single producer exists, it will produce more output than what individual firms in a
competition do, and thus benefit from economies of scale.
• They can still face competition from overseas firms.
• They could sell products at lower price and high quality if they fear new firms may enter the
market in the future.

59 | P a g e
The Macroeconomic Aims
of Government
HomeNotesEconomics – 04554.1 – 4.2 – The Macroeconomic Aims of Government

The Role of Government

The public sector in every economy plays a major role, as a producer and employer.
Governments work locally, nationally and internationally. Here are the roles they play in the
economy:

• As a producer, it provides, at all levels of government:

• merit goods (educational institutions, health services etc.)
• public goods (streetlights, parks etc.)
• welfare services (unemployment benefits, pensions, child benefits etc.)
• public services (police stations, fire stations, waste management etc.)
• infrastructure (roads, telecommunications, electricity etc.).
• As an employer, it provides at all levels of government, employment to a large population,
who work to provide the above mentioned goods and services. It also creates employment
by contracting projects, such as building roads, to private firms.
• Support agriculture and other prime industries that need public support.
• Help vulnerable groups of people in society through redistributing income and welfare
schemes.
• Manage the macroeconomy in terms of prices, employment, growth, income redistribution
etc.
• Governments also manage its trade in goods and services with other countries by negotiating
international trade deals.

Government Macroeconomic Aims

The government’s major macroeconomic objectives are:

• Economic Growth: economic growth refers to an increase in the gross domestic product
(GDP), the amount of goods and services produced in the economy, over a period of time.
More output means economic growth. But if output falls over time (economic recession), it
can cause:
• fall in employment, incomes and living standards of the people

60 | P a g e
 • fall in the tax revenue the govt. collects from goods and services and incomes,
which will, in turn, lead to a cut in govt. spending
• fall in the revenues and profits of firms
• low investments, that is, people won’t invest in production as economic conditions
are poor and they will yield low profits.
• Price Stability: inflation is the continuous rise in the average price levels in an economy
during a time period. Governments usually target an inflation rate it should maintain in a year,
say 3%. If prices rise too quickly it can negatively affect the economy because it:
• reduces people’s purchasing powers as people will be able to buy less with the
money they have now than before
• causes hardship for the poor
• increases business costs especially as workers will demand higher wages to
support their livelihood
• makes products more expensive than products of other countries with low
inflation. This will make exports less competitive in the international market.
• Full Employment: if there is a high level of unemployment in a country, the following may
happen:
• the total national output (goods produced) will fall
• government will have to give out welfare payments (unemployment benefits) to
the unemployed, increasing public expenditure while income taxes fall – causing
a budget deficit
• large unemployment causes public unrest and anger towards the government.
• Balance of Payments Stability: economies export (sell) many of their products to overseas
residents, and receive income and investment from abroad; they also import (buy) goods
and services from other economies, and make investments in other countries. These are
recorded in a country’s Balance of Payments (BoP).
Exports > Imports = Surplus in BoP
Exports < Imports = Deficit in BoP
All economies try to balance this inflow and outflow of international trade and payments and
try to avoid any deficits because:
• if it exports too little and imports too much, the economy may run out of foreign
currency to buy further imports
• a BoP deficit causes the value of its currency to fall against other foreign currencies
and make imports more expensive to buy, while a BoP surplus causes its currency
to rise against other foreign currencies and make its exports more expensive in
the international market.
• Income Redistribution: to reduce the inequality of income among its citizens, the
government will redistribute incomes from the rich to the poor by imposing taxes on the rich
and using it to finance welfare schemes for the poor. All governments struggle with income
inequality and try to solve it because:
• widening inequality means higher levels of poverty
• poverty and hardship restricts the economy from reaching its maximum
productive capacity.
61 | P a g e
Conflict of Macroeconomic Aims
When a policy is introduced to achieve one macroeconomic aim, it tends to conflict with one
or more other aims. In other words, as one aim is achieved, another aim is undone. Let’s look
at some conflicts of government macroeconomic aims.

Full Employment v/s Price Stability

Low rates of unemployment will boost incomes of businesses and workers. This rise in
incomes, mean higher demand and consumption in the economy, which causes firms to raise
their prices – resulting in inflation. This is probably the most prominent policy conflict in the
study of Economics.
Economic Growth & Full Employment v/s BoP Stability
Once again, as incomes rise due to economic growth and low unemployment, people will
import more foreign products and consume relatively less domestic products. This will cause
a rise in imports relative to exports and a deficit may arise in the balance of payments.
Economic Growth v/s Full Employment
In the long run, when economic growth is continuous, firms may start investing in more
capital (machinery/equipment). More capital-intensive production will make a lot of people
unemployed.

62 | P a g e
Fiscal Policy
HomeNotesEconomics – 04554.3 – Fiscal Policy

Budget: a financial statement showing the forecasted government revenue and expenditure
in the coming fiscal year. It lays out the amount the government expects to receive as
revenue in taxes and other incomes and how and where it will use this revenue to finance its
various spending endeavours. Governments aim for its budgets to be balanced.

Government spending
Governments spend on all kinds of public goods and services, not just out of political and
social responsibility, but also out of economic responsibility. Government spending is a part
of the aggregate demand in the economy and influences its well-being. The main areas of
government spending includes defence and arms, road and transport, electricity, water,
education, health, food stocks, government salaries, pensions, subsidies, grants etc.

Reasons governments spend:

• To supply goods and services that the private sector would fail to do, such as public goods,
including defence, roads and streetlights; merit goods, such as hospitals and schools;
and welfare payments and benefits, including unemployment and child benefits.
• To achieve supply-side improvements in the economy, such as spending on education and
training to improve labour productivity.
• To spend on policies to reduce negative externalities, such as pollution controls.
• To subsidise industries which may need financial support, and which is not available from
the private sector, usually agriculture and related industries.
• To help redistribute income and improve income inequality.
• To inject spending into the economy to aid economic growth.
Effects of government spending

• Increased government spending will lead to higher demand in the economy and thus aid
economic growth, but it can also lead to inflation if the increasing demand causes prices to
rise faster than output.
• Increased government spending on public goods and merit goods, especially in
infrastructure, can lead to increased productivity and growth in the long run.
• Increased government spending on welfare schemes and benefits will increase living
standards, and help reduce inequality.
• However too much government spending can also cause ‘crowding out’ of private sector
investments – private investments will reduce if the increase in government spending is
financed by increased taxes and borrowing (large government borrowing will drive up interest
rates and discourage private investment).
63 | P a g e
Tax
Governments earn revenue through interests on government bonds and loans, incomes
from fines, penalties, escheats, grants in aid, income from public property, dividends and
profits on government establishments, printing of currency etc; but its major source of
revenue comes from taxation. Taxes are a compulsory payment made to the
government by all people in an economy. There are many reasons for levying taxes from
the economy:
• It is a source of government revenue: if the government has to spend on public goods and
services it needs money that is funded from the economy itself. People pay taxes knowing
that it is required to fund their collective welfare.
• To redistribute income: governments levy taxes from those who earn higher incomes and
have a lot of wealth. This is then used to fund welfare schemes for the poor.
• To reduce consumption and production of demerit goods: a much higher tax is levied on
demerit goods like alcohol and tobacco than other goods to drive up its prices and costs in
order to discourage its consumption and production. Such a tax on a specific good is
called excise duty.
• To protect home industries: taxes are also levied on foreign goods entering the domestic
market. This makes foreign goods relatively more expensive in the domestic market, enabling
domestic products to compete with them. Such a tax on foreign goods and services is
called customs duty.
• To manage the economy: as we will discuss shortly, taxation is also a tool for demand and
supply side management. Lowering taxes increase aggregate demand and supply in the
economy, thereby facilitating growth. Similarly, during high inflation, the government will
increase taxes to reduce demand and thus bring down prices. More on this below.
Classification of Taxes
Taxes can be classifies into direct or indirect and progressive, regressive or proportional.

Direct Taxes are taxes on incomes. The burden of tax payment falls directly on the person
or individual responsible for paying it.
• Income tax: paid from an individual’s income. Disposable income is the income left after
deducting income tax from it. When income tax rise, there is little disposable income to spend
on goods and services, so firms will face lower demand and sales, and will cut production,
increasing unemployment. Lower income taxes will encourage more spending and thus
higher production.
• Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is increased,
businesses will have lower profits left over to put back into the business and will thus find it
hard to expand and produce more. It will also cause shareholders/owners to receive lower
dividends/returns for their investments. This will discourage people from investing in
businesses and economic growth could slow down. Reducing corporate tax will encourage
more production and investment.

64 | P a g e
 • Capital gains tax: taxes on any profits or gains that arise from the sale of assets held for
more than a year.
• Inheritance tax: tax levied on inherited wealth.
• Property tax: tax levied on property/land.
Advantages:

• High revenue: as all people above a certain income level have to pay income taxes, the
revenue from this tax is very high.
• Can reduce inequalities in income and wealth: as they are progressive in nature – heavier
taxes on the rich than the poor- they help in reducing income inequality.
Disadvantages:

• Reduces work incentives: people may rather stay unemployed (and receive govt.
unemployment benefits) rather than be employed if it means they would have to pay a high
amount of tax. Those already employed may not work productively, since for any extra
income they make, the more tax they will have to pay.
• Reduces enterprise incentives: corporate taxes may demotivate entrepreneurs to set up
new firms, as a good part of the profits they make will have to be given as tax.
• Tax evasion: a lot of people find legal loopholes and escape having to pay any tax. Thus tax
revenue falls and the govt. has to use more resources to catch those who evade taxes.
Indirect Taxes are taxes on goods and services sold. It is added to the prices of goods and
services and it is paid while purchasing the good or service. It is called indirect because it
indirectly takes money as tax from consumer expenditure. Some examples are:
• GST/VAT: these are included in the price of goods and services. Increasing these indirect
taxes will increase the prices of goods and services and reduce demand and in turn profits.
Reducing these taxes will increase demand.
• Customs duty: includes import and export tariffs on goods and services flowing between
countries. Increasing tariffs will reduce demand for the products.
• Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce its demand.
Advantages:

• Cost-effective: the cost of collecting indirect taxes is low compared to collecting direct taxes.
• Expanded tax-base: directs taxes are paid by those who make a good income, but indirect
taxes are paid by all people (young, old, unemployed etc.) who consume goods and services,
so there is a larger tax base.
• Can achieve specific aims: for example, excise duty (tax on demerit goods) can discourage
the consumption of harmful goods; similarly, higher and lower taxes on particular products
can influence their consumption.
• Flexible: indirect tax rates are easier and quicker to alter/change than direct tax rates. Thus
their effects are immediate in an economy.
Disadvantages:

65 | P a g e
 • Inflationary: The prices of products will increase when indirect taxes are added to it, causing
inflation.
• Regressive: since all people pay the same amount of money, irrespective of their income
levels, the tax will fall heavily on the poor than the rich as it takes more proportion of their
income.
• Tax evasion: high tariffs on imported goods or excise duty on demerit goods can encourage
illegal smuggling of the good.
Progressive Taxes are those taxes which burdens the rich more than the poor, in that the
rate of taxation increases as incomes increase. An income tax is the perfect example of
progressive taxation. The more income you earn, the more proportion of the income you
have to pay in taxes, as defined by income tax brackets.
For example, a person earning above $100,000 a month will have to pay a tax rate of 20%,
while a person earning above $200,000 a month will have to pay a tax rate of 25%.
Regressive Taxes are those taxes which burden the poor more than the rich, in that the rate
of taxation falls as incomes increase. An indirect tax like GST is an example of a regressive
tax because everyone has to pay the same tax when they are paying for the product, rich or
poor.
For example, suppose the GST on a kilo of rice is $1; for a person who earns $500 dollars a
month, this tax will amount to 0.2% of his income, while for a richer person who earns
$50,000 a month, this tax will amount of just 0.002% of his income. The burden on the poor
is higher than on the rich, making its regressive.
Proportional Taxes are those taxes which burden the poor and rich equally, in that the rate
of taxation remains equal as incomes rise or fall. An example is corporate tax. All
companies have to pay the same proportion of their profits in tax.
For example, if the corporate tax is 30%, then whatever the profits of two companies, they
both will have to pay 30% of their profits in corporate tax.

Qualities of a good tax system (the canons of taxation):

• Equity: the tax rate should be justifiable rate based on the ability of the taxpayer.
• Certainty: information about the amount of tax to be paid, when to pay it, and how to pay it
should all be informed to the taxpayer.
66 | P a g e
 • Economy: the cost of collecting taxes must be kept to a minimum and shouldn’t exceed the
tax revenue itself.
• Convenience: the tax must be levied at a convenient time, for example, after a person receives
his salary.
• Elasticity: the tax imposition and collection system must be flexible so that tax rates can be
easily changed as the person’s income changes.
• Simplicity: the tax system must be simple so that both the collectors and payers understand
it well.
Impacts of taxation
Taxes can have various direct impacts on consumers, producers, government and thus, the
entire economy.

• The main purpose of tax is to raise income for the government which can lead to higher
spending on health care and education. The impact depends on what the government
spends the money on. For example, whether it is used to fund infrastructure projects or to
fund the government’s debt repayment.
• Consumers will have less disposable income to spend after income tax has been deducted.
This is likely to lead to lower levels of spending and saving. However, if the government
spends the tax revenue in effective ways to boost demand, it shouldn’t affect the economy.
• Higher income tax reduces disposable income and can reduce the incentive to work.
Workers may be less willing to work overtime or might leave the labour market altogether.
However, there are two conflicting effects of higher tax:
• Substitution effect: higher tax leads to lower disposable income, and work
becomes relatively less attractive than leisure – workers will prefer to work less.
• Income effect: if higher tax leads to lower disposable income, then a worker may
feel the need to work longer hours to maintain his desired level of income –
workers feel the need to work longer to earn more.
• The impact of tax then depends on which effect is greater. If the substitution effect
is greater, then people will work less, but if income effect is greater, people will
work more
• Producers will have less incentive to produce if the corporate taxes are too high. Private firm
aim on making profits, and if a major chunk of their profits are eaten away by taxes, they
might not bother producing more and might decide to close shop.

Fiscal Policy
Fiscal policy is a government policy which adjusts government spending and taxation
to influence the economy. It is the budgetary policy, because it manages the government
expenditure and revenue. Government aims for a balance budget and tries to achieve it
using fiscal policy.
A budget is in surplus, when government revenue exceed government spending. While this
is good it also means that the economy hasn’t reached its full potential. The government is
keeping more than it is spending, and if this surplus is very large, it can trigger a slowdown
67 | P a g e
of the economy.
When there is a budget surplus, the government employs an expansionary fiscal
policy where govt. spending is increased and tax rates are cut.
A budget is in deficit, when government expenditure exceeds government revenue. This is
undesirable because if there is not enough revenue to finance the expenditure, the
government will have to borrow and then be in debt.
When there is a budget deficit, the government employs contractionary fiscal policy,
where govt. spending is cut and tax rates are increased.
Fiscal policy helps the government achieve its aim of economic growth, by being able to
influence the demand and spending in the economy. It also indirectly helps maintain price
stability, via the effects of tax and spending.
Expansionary fiscal policy will stimulate growth, employment and help increase prices.
Contractionary fiscal policy will help control inflation resulting from too much growth. But
as we will see later on, controlling inflation by reducing growth can lead to increased
unemployment as output and production falls.

68 | P a g e
Monetary Policy
HomeNotesEconomics – 04554.4 – Monetary Policy

The money supply is the total value of money available in an economy at a point of
time. The government can control money supply through a variety of tools including open
market operations (buying and selling of government bonds) and changing reserve
requirements of banks. (The syllabus doesn’t require you to study these in depth)
The interest rate is the cost of borrowing money. When a person borrows money from a
bank, he/she has to pay an interest (monthly or annually) calculated on the amount he/she
borrowed. Interest is also be earned on the money deposited by individuals in a bank.
(The interest on borrowing is higher than the interest on deposits, helping the banks make
a profit).
Higher interest rates will discourage borrowing and therefore, investments; it will also
encourage people to save rather than consume (fall in consumption also discourage firms
from investing and producing more).
Lower interest rates will encourage borrowing and investments, and encourage people to
consume rather than save (rise in consumption also encourage firms to invest and produce
more).
The monetary authority of the country cannot directly change the general interest rate in
the economy. Instead, it changes the interest rates of borrowing between the central bank
and commercial banks, as well as the interest on its bonds and securities. These will then
influence the interest rate provided by commercial banks on loans and deposits
to individuals and businesses.

Monetary Policy
Monetary policy is a government policy controls money supply (availability and cost
of money) in an economy in order to attain growth and stability. It is usually conducted
by the country’s central bank and usually used to maintain price stability, low unemployment
and economic growth.
Expansionary monetary policy is where the government increases money supply by
cutting interest rates. Low interest rates will mean more people will resort to spending
rather than saving, and businesses will invest more as they will have to pay lower interest on
their borrowings. Thus, the higher money supply will mean more money being circulated
among the government, producers and consumers, increasing economic activity. Economic

69 | P a g e
growth and an improvement in the balance of payments will be experienced
and employment will rise.
Contractionary monetary policy is where the government decreases money supply by
increasing interest rates. Higher interest rates will mean more people will resort to saving
rather than spending, and businesses will be reluctant to invest as they will have to pay high
interest on their borrowings. Thus, the lower money supply will mean less money being
circulated among the government, producers and consumers, reducing economic activity.
This helps slow down economic growth and reduce inflation, but at the cost of
possible unemployment resulting from the fall in output.

Supply-side Policy
HomeNotesEconomics – 04554.5 – Supply-side Policy

Supply side policies are microeconomic policies aimed at increasing supply and
productivity in the economy, to enable long-term economic growth. Some of these
policies include:
• Public sector investments: investments in infrastructure such as transport and
communication can greatly help the economy by making the flow of resources quick and
easy, and facilitate faster growth.
• Improving education and vocational training: the government can invest in education and
skills training to improve the quality and quantity of labour to increase productivity.
• Spending on health: accessible, affordable and good quality health services will improve the
health of the population, helping reduce the hours lost to illnesses and increasing
productivity.
• Investment on housing: as more housing spaces are built, the geographical mobility of the
population will increase, helping increase output.
• Privatization: transferring some public corporations to private ownership will increase
efficiency and increase output, as the private sector has a profit-motive absent in public
sector.
• Income tax cuts: reducing income tax will increase people’s willingness to work more and
earn more, helping increase the supply in the economy.
• Subsidies are financial grants made to industries that need it. More subsidies mean more
money for producers to produce more, thereby increasing supply.

70 | P a g e
 • Deregulation: removing or easing the laws and regulations required to start and run
businesses so they can operate and produce more output with reduced costs and hassle,
encouraging investments.
• Removing trade barriers: the govt. can reduce or withdraw import duties, quotas etc. on
imports so that more resources, goods and services may be imported to increase productivity
and efficiency in the domestic economy. It can also reduce export duties to increase export
of resources, goods and services to other nations, thereby encouraging domestic firms to
increase production.
• Labour market reforms: making laws that would reduce trade union powers would reduce
business costs and increase output. Minimum wages could be reduced or done away with to
allow more jobs to be created. Welfare payments like unemployment benefits could be
reduced so that more people would be motivated to look for jobs rather than rely on the
benefits alone to live. These will not only increase the incentive to work but also increase the
incentive to invest.
For example, India, in the early 1990’s undertook massive privatisation, liberalisation and
deregulation measures; abolishing its heavy licensing and red tape policies, allowing private
firms to easily enter the market and operate, and opening up its economy to foreign trade
by reducing the excessive trade tariffs and regulations. This led to a period of high economic
growth and helped India become the emerging economy it is today.

Supply-side policies have the direct effect of increasing economic growth as the productive
capacity of the economy is realised. In doing so, it can also create more job opportunities
and help reduce unemployment. Trade reforms will also enable to it to improve its
balance of payments.
However, the reliance on public expenditure and tax cuts mean that the government may
run large budget deficits. Deregulation and privatisation will also reduce government
intervention in the economy, which may prompt market failure.

Economic Growth
HomeNotesEconomics – 04554.6 – Economic Growth

Economic growth is an increase in the amount of goods and services produced per
head of the population over a period of time.
The total value of output of goods and services produced is known as the national output.
This can be calculated in three ways: using output, income or expenditure.
GDP (Gross Domestic Product): the total market value of all final goods and services
provided within an economy by its factors of production in a given period of time.
71 | P a g e
Nominal GDP: the value of output produced in an economy in a period of time, measured
at their current market values or prices is the nominal GDP.
Real GDP: the value of output produced in an economy in a period of time, measured
assuming the prices are unchanged over time. This GDP, in constant prices, provides a
measure of the real output of a country.
GDP per head/capita: this measures the average output/ income per person in an economy.
Since this takes into account the population, it provides a good measure of the living
standards of an economy.
GDP per capita = GDP / Population
An increase in real GDP over time indicates economic growth as goods and services
produced have increased. It indicates that the economy is utilizing its resources better or its
productive capacity has increased. On a PPC, economic growth will be shown by an outward
shift of the PPC, which is also called ‘potential growth’. ‘Actual growth’ occurs when the
economy moves from a point inside the PPC to a point closer to the PPC.

This diagram shows ‘actual growth’ as the

economy realizes its potential growth. In order to experience potential economic growth, the PPC
would have to shift outwards.

Causes of economic growth

• Discovery of more natural resources: more resources mean more the production capacity.
The discovery of oil and gas reserves have enabled a lot of economies (Norway, Saudi Arabia,
Venezuela etc.) to grow rapidly.
• Investment in new capital and infrastructure: investment in new machinery, buildings,
technology etc. has enabled firms and economies to expand their production capacities.
Investment in modern infrastructure such as airports, roads, harbours etc. have improved
access and communication in economies, helping in achieving quicker and more efficient
production.
• Technical progress: New inventions, production processes etc. can increase the productivity
of existing resources in industries and help boost economic growth.

72 | P a g e
 • Increasing the quantity and quality of factors of production: A larger and more
productive workforce will increase GDP. More skilled, knowledgeable and productive human
resources thus help increase economic growth. Similarly, good quality capital, use of better
natural resources, innovative entrepreneurs all aid economic growth in the long run.
• Reallocating resources: Moving resources from less-productive uses to more-productive
uses will improve economic growth.
Advertisements

REPORT THIS AD

The benefits of economic growth:

• Greater availability of goods and services to satisfy consumer wants and needs.
• Increased employment opportunities and incomes.
• In underdeveloped or developing economies, economic growth can drastically improve
living standards and bring people out of poverty.
• Increased sales, profits and business opportunities.
• Rising output and demand will encourage investment in capital goods for further
production, which will help achieve long run economic growth.
• Low and stable inflation, if growth in output matches growth in demand.
• Increased tax revenue for government (as incomes and spending rise) that can be invested
in public goods and services.
The drawbacks of economic growth:

• Technical progress may cause capital to replace labour, causing a rise in unemployment. This
will be disastrous for highly populated underdeveloped and developing economies, pulling
more people into poverty
• Scarce resources are used up rapidly when production rises. Natural resources may get
depleted over time.
• Increasing production can increase negative externalities such as pollution, deforestation,
health problems etc. Climate change is a consequence of rapid global economic growth.
• If the economy produces over its productive capacity and if the growth in demand outstrips
the growth in output, economic growth may cause inflation
• Economic growth has also been accused of widening income inequalities in developing
economies, because rich investors and businessmen gain more than the working class and
poor during growth – the benefits of growth are not evenly distributed. This will
cause relative poverty to rise.
Governments aim for sustainable economic growth which refers to a rate of growth which
can be maintained without creating significant economic problems for future generations,
such as depletion of resources and a degraded natural environment.

73 | P a g e
Recession
Recession is the phase where there is negative economic growth, that is real GDP is falling.
This usually happens after there is rapid economic growth. High inflation during the boom
period will cause consumer spending to fall and cause this downturn. Workers will demand
more wages as the cost of living increase, and the price of raw materials will also rise, leading
to firms cutting down production and laying off workers. Unemployment starts to rise and
incomes fall.
Causes of recession:
• Financial crises: if banks have a shortage of liquidity, they reduce lending and this reduces
investment.
• Rise in interest rates: increases the cost of borrowing and reduces demand.
• Fall in real wages: usually caused when wages do not increase in line with inflation leading
to falling incomes and demand.
• Fall in consumer/business confidence: reduces both supply and demand.
• Cut in govt. spending: when government cuts spending, demand falls.
• Trade wars: uncertainty in markets, and thus businesses will be reluctant to invest during a
trade war, causing supply to fall.
• Supply-side shocks: e.g. rise in oil prices cause inflation and lower purchasing power.
• Black swan events: black swan events are unexpected events that are very hard to predict.
For example, COVID-19 pandemic in 2020 which disrupted travel, supply chains and normal
business activity, as well consumer demand, has caused recessions in many countries.
Consequences of recession:
• Firms go out of business: as demand falls, firms will be forced to either reduce production
to a level that is sustainable or close shop.
• Unemployment: cuts in production will cause a lot of people to lose work.
• Fall in income: cuts in production also causes fall in incomes.
• Rise in poverty and inequality: unemployment and lack of incomes will pull a lot of people
into poverty, and increase inequality (as the rich will still find ways to earn).
• Fall in asset prices (e.g. fall in house prices/stock market): recessions trigger a crash in the
stock markets and other asset markets as investors’ and consumers’ confidence in the well-
being fall of the economy during a recession. The shares owned by investors will be worth
less.
• Higher budget deficit: due to falling consumption and incomes, the government will see a
fall in tax revenue, causing a budget deficit to grow.
• Permanently lost output: as firms go out of business and employment falls, it results in a
permanent loss of output, as the economy moves inwards from its PPC.

74 | P a g e
 If the economy was producing at A on its
PPC, a recession will cause production to fall to B.

Policies to promote economic growth

Expansionary fiscal and monetary policies (demand-side policies) and supply-side
policies described in the previous sections can be employed to promote economic growth,
depending on the nature of the problems that are holding back the economy from growing.
For example, if it is the poor quality of human capital (labour) that is preventing the economy
from achieving its maximum productive capacity, the government should invest in education
and vocational training centres to improve the quality of the labour force and increase
productivity. If it is a lack of effective demand causing slow growth, the government should
focus on cutting income taxes, indirect taxes and interest rates to boost spending.
Effectiveness of such policies:
• Demand-side policies that increase the rate of growth above the long-run trend rate
will cause inflation and quickly lead to a recession if not controlled.
• Supply-side policies can take considerable time to take effect. For example, if the
government invested in better education and training, it could take several years for this to
lead to higher labour productivity.
• In a recession, supply-side policies won’t solve the fundamental problem of deficiency of
aggregate demand. Increasing the flexibility of labour markets and encouraging investment
may help to some extent, but unless there is sufficient demand, firms will be reluctant to
increase production and make new investments.

75 | P a g e
Employment
and Unemployment
HomeNotesEconomics – 04554.7 – Employment and Unemployment

Some terms to be familiar with while we’re discussing employment:

Labour force – the working population of an economy, i.e. all people of working age who
are willing and able to work.
Dependent population – people not in the labour force and thus depend on the labour
force to supply them with goods and services to fulfill their needs and wants. This includes
students in education, retired people, stay at home parents, prisoners or similar institutions
as well as those choosing not to work.
Employment is defined as an engagement of a person in the labour force in some
occupation, business, trade, or profession.
Unemployment is a situation where people in the labour force are actively looking for jobs
but are currently unemployed.
All governments have a macroeconomic objective of maintaining a low unemployment rate.

Full Employment is the situation where the entire labour force is employed. That is, all the
people who are able and willing to work are employed – unemployment rate is 0%.

Changing patterns and level of employment

Over time, patterns and levels of employment change. It could be due to the effects of the
business cycle that every economy goes through from time to time (growth and recession).
It could be due to the changes to the demographics (population- age and gender) of the
country. It could also be due to structural changes (dramatic shifts in how an economy
operates). Let’s look at some ways in which this happens:

Advertisements

REPORT THIS AD

As an economy develops, it undergoes a structural change as output and employment

shifts from primary sector to manufacturing and then to the
tertiary (services) sectors. This can be seen in rapidly developing countries like India where
there employment in agriculture and allied industries are rapidly falling and people are
moving towards the fast-growing service sector, especially IT and retail.
In the same way, employment moves from the informal sector (formally unrecognised
trades such as street vending- output is not included in GDP and incomes are not taxed) to
76 | P a g e
the formal sector (recognised – included in GDP and taxes) as economies develops. People
who previously worked as street vendors may work in registered firms, as the economy
develops.
Overtime, as an economy develops, the labour force also sees an increase in the proportion
of female labour. As social attitudes become progressive and women are encouraged to
work, more women will enter the labour force and contribute to growth.
Similarly, as the country develops, the proportion of old people may increase in
proportion to young and working people (because death and birth rates fall). This will cause
the labour force to shrink and cause a huge burden on the economy. Japan is now facing
this problem as their birth rates are falling and it is up to a shrinking labour force to support
a growing dependent senior population.
As economies become more market-oriented (government enterprises and interventions
decline), the economy will naturally see a large proportion of the labour force shift to the
private sector.

Measuring unemployment

Economies periodically calculate the number of people unemployed in their economies, to

check the unemployment rate and see what policies they should implement to reduce it if it
is too high. They can do this in two ways:

• Claimant count: unemployed people can file for unemployment claims (benefits/allowances
provided to the unemployed job seekers) by the government. The government can count the
total number of unemployment claims made in the economy to measure unemployment.
• Labour surveys: economies conduct surveys among the entire labour force to collect data
about it. This will include data on the number of people unemployed.

Unemployment rate = number of people unemployed / total no. of people in the labour
force

There are some problems with measuring employment.

Under-employment: people may be officially classed as employed but they may be working
fewer hours than they would like. For example, they may have a part-time job, but want a
full-time job. This is considered as unemployment because they may not fulfil the working
hours needed to be considered employed.
Inactivity rates: the long-term unemployed may become discouraged and leave the labour
market completely. In effect they are not working, but they are classed as economically
inactive rather than unemployed. So, the unemployment rate can be understated.

77 | P a g e
The causes/types of unemployment
• Frictional unemployment: this occurs as a result of workers leaving one job and spending
time looking for a new one. This type of unemployment is short-lived.
• Cyclical unemployment: this occurs as a result of fall in aggregate demand due to an
economic recession. When demand falls, firms will cut their production and workers will lose
their jobs. There will be a nation-wide rise in unemployment.
• Structural unemployment: this occurs due to the long-term change in the structure of an
economy. Workers end up having the wrong skills in the wrong place – causing them to be
unfit for employment. This can be explained by dividing it further:
• Technological unemployment: this has rose in recent times as industrial robots,
machinery and other technology are being substituted for labour, leaving people
jobless.
• Sectoral unemployment: unemployed caused as a sector/industry declines and
leave its workers unemployed.
• Seasonal unemployment: this occurs as a result of the demand for a product being seasonal.
For example, the demand for umbrellas will fall in non-monsoon seasons, and so workers in
umbrella manufacturing firms will become unemployed over those seasons.
• Voluntary unemployment: when people choose not to work for various reasons – they want
to pursue higher education, would like to take a break etc. Because they’re not actively
looking for work, voluntarily unemployed people do not belong to the labour force!

The consequences of unemployment

• People will lose their working skills if they remain unemployed for a long time and may find
it even harder to find suitable jobs. As people remain unemployed, their incomes will be low,
and living standards will fall.
• Unemployment will also lead to poverty, homelessness and ill health and encourage people
to steal and commit other crimes to make money– crime rates will rise.
• People losing skills is not just detrimental to the unemployed individuals but also to firms
who may employ these people in the future. They will have to retrain these workers.
• Firms will have to pay redundancy payments to workers they lay off.
• Workers will be demotivated as they fear they could lose their jobs, especially in a recession.
• As firms lay off workers, they will be left with spare capacity- unutilised machinery, tools and
factory spaces, leading to higher average costs.
• Due to low incomes, people’s purchasing power/consumption will fall, causing demand to
fall.
• People will need to rely on charity or government unemployment benefits to support
themselves. These benefits are provided from tax revenue. But now, as incomes have fallen
tax revenue will also fall. This might mean that people remaining in work will have to pay
more of their income as tax, so that it can be distributed as unemployment benefits to the
unemployed. The burden on tax-payers will rise.
• Public expenditure on other projects such as schools, roads etc. will have to be cut down to
make way for benefits. There is opportunity cost involved here.

78 | P a g e
 • The economy doesn’t reach its maximum productive capacity, i.e., they are economically
inefficient on the PPC. The economy loses output.

Policies to reduce unemployment

Both demand-side policies and supply-side policies help reduce unemployment. Demand-
side policies will address the unemployment caused by demand deficiency (cyclical) while
the supply-side measures will curtail structural and frictional unemployment.

• Expansionary policies to increase demand: expansionary fiscal policies like cutting down
taxes and increasing government spending (which also creates jobs) and expansionary
monetary policies like cutting interest rates will help boost demand in the economy, to keep
production and employment high. However these will take effect only with a time lag. Cutting
tax rates won’t help if people don’t have confidence in the economy and prefer to save.
Similarly, cutting interest rates will also be ineffective if banks are unwilling to lend to
businesses, due to low confidence in the economy.
• Depreciate the exchange rate: as the currency depreciates, the country’s exports will
become cheaper and so export demand from abroad will increase, helping boost production
and employment in the export industries.
• Control inflation: higher inflation causes firms to lay off workers to reduce costs. So if the
government tries to control inflation via monetary tools, it will help reduce firm costs and
increase employment. But there is also the argument that as unemployment rises, incomes
will also rise, driving up prices again.
• Cutting unemployment benefits to provide incentive to work: many people don’t work
because they are comfortable living off the unemployment benefits provided by the
government. Cutting down on these benefits, will persuade them to look for work and earn.
But this would of course, go against the welfare principle of the government.
• Restricting imports and encourage exports: a lot of unemployment occurs when good
quality and cheaper foreign products put domestic industries out of business. Controlling
imports using import tariffs and quotas will encourage domestic firms to emerge and increase
production and thus increase employment. Similarly, easing controls on labour-intensive
export industries will open up new job opportunities. However such protectionist measures
can harm the country in the long-run as efficient competition from abroad reduces.
• Cutting down minimum wages: minimum wages increase firms’ labour costs and so they
will lay off workers. Lowering the minimum wages will encourage firms to employ more
labour.
• Remove labour market regulations: letting the market have a free hand in the labour
market – abolishing maximum working weeks, minimum wages, making it easier to hire and
fire workers – will improve the labour market flexibility, can improve imperfections in the
labour market. However, this can cause temporary unemployment and cause greater job
insecurity.
• Training/Retraining: structural employment issues can be eliminated by retraining the
unemployed in skills required in modern industries. This will also improve occupational
mobility. This is very expensive when done on a large scale across the economy, requiring

79 | P a g e
 training centres to be built, and trainers to be employed. The benefits of providing skills and
training will only be reaped in the long-term.
• Promote industries in unemployed areas: a lot of employment is created when
government provide subsidies and tax breaks for new industries which set up shop in certain
backward regions.
• Increase geographical mobility of labour: frictional unemployment is caused because
people can’t move around to find good jobs. The government can improve labour mobility
by investing in transport and housing services.
• Provide information: frictional unemployment can be eliminated to an extent by making
information available about job vacancies to the unemployed through job centres,
newspapers, government websites etc.

Inflation and Deflation

HomeNotesEconomics – 04554.8 – Inflation and Deflation

Inflation
Inflation is the general and sustained rise in the level of prices of goods and services in
an economy over a period of time.
For example, the inflation rate in UK in 2010 was 4.7%. This means that the average price of
goods and services sold in the UK rose by 4.7% during that year.
Inflation is measured using a consumer price index (CPI) or retail price index (RPI).
The consumer price index is calculated in this way:
• A selection of goods and services normally purchased by a typical family or household is
identified.
• The prices of these ‘basket of goods and services’ will then be monitored at a number of
different retail outlets across the country.
• The average price of the basket in the first year or ‘base year’ is given a value of 100.
• The average change in price of these goods and services over the year is calculated.
• If it rises by an average of 25%, the new index is 125% * 100 = 125%. If in the next year there
is a further average increase of 10%, the price index is 110% * 125 = 137.5%. The average
inflation rate over the two years is thus 137.5 – 100 = 37.5%
Causes of Inflation
• Demand-pull inflation: inflation caused by an increase in aggregate demand is called
demand-pull inflation. This is also defined as the increase in price due to aggregate demand

80 | P a g e
 exceeding aggregate supply. Demand could rise due to higher incomes, lower taxes etc.
The demand curve will shift right, causing an extension in supply and a rise in price.
• Cost-push inflation: inflation caused by an increase in cost of production in the economy.
The cost of production could rise due to higher wage rate, higher indirect taxes, higher cost
of raw materials, higher interest on capital etc. The supply curve will shift left causing a
contraction in demand and a rise in price.
• A lot of economists agree that a rise in money supply in contrast with output is the key
reason for inflation. If the GDP isn’t accelerating as much as the money supply, then there
will be a higher demand which could exceed supply, leading to inflation.
The consequences of inflation
• Lower purchasing power: when the price level rises, the lesser number of goods and services
you can buy with the same amount of money. This is called a fall in the purchasing power.
When purchasing power falls, consumers will have to make choices on spending.
• Exports are less internationally competitive: if the prices of exports are high, its
competitiveness in international markets will fall as lower priced foreign goods will rival it.
This could lead to a current account deficit if exports lower (especially if they are price elastic).
• Inflation causing inflation‘: during inflation, the cost of living in the economy rises as you
have to pay more for goods and services. This might cause workers to demand higher wages
increasing the cost of production. If the price of raw materials also increase, the cost of
production again increases, causing cost-push inflation.
• Fixed income groups, lenders, and savers lose: a person who has a fixed income will lose
as he cannot press for higher wages during inflation (his/her real wages fall as purchasing
power of his/her wages fall). Lenders who lent money before inflation and receive the money
back during inflation will lose the value on their money. The same amount of money is now
worth less (here, the people who borrowed gain purchasing power). Savers also lose because
the interest they’re earning on savings in banks does not increase as much as the inflation,
and savers will lose the value on their money.
Policies to control inflation
• Contractionary monetary policy that will reduce demand: contractionary monetary policy
is the most popular policy employed to curtail inflation. Raising interest rates will discourage
spending and investing (as cost of borrowing rises) and reduce the money supply in the
economy, helping cut down on demand. But this depends a lot on the consumer and business
confidence in the economy. Spending and investing may still continue to rise as confidence
remains high. There is also a considerable time lag for monetary policy to take effect.
• Contractionary fiscal policy that will reduce demand: raising taxes will discourage spending
and investing and cutting down on government spending will reduce aggregate demand in
the economy, helping bring down the price level. However, this is an unpopular policy only
employed when inflation is severe.
• Supply side policies: supply-side policies such as privatisation and deregulation hope to
make firms competitive and efficient, and thus avoid inflationary pressures. But this is a long-
term policy only helping to keep the long-term inflation rate stable. Sudden surges in inflation
cannot be addressed using supply side measures

81 | P a g e
 • Exchange rate policy: Appreciating the domestic currency can lower import prices helping
reduce cost-push inflation arising from expensive imported raw materials. It also makes
export more expensive, helping lower the export demand in the economy as well as creating
incentives for exporting firms to cut costs to remain competitive.

Deflation
Deflation is the general fall in the price level.
Deflation is also measured using CPI, but instead of showing figures above 100, it will show
an index below 100 denoting a deflation. For example, a drop in the average prices of the
basket of goods in a year is 10%, the deflation will be 100 – (90% * 100 = 90%) = 10%.
Causes of deflation
• Aggregate supply exceeding aggregate demand: when supply exceeds demand, there is
an excess of output in the economy not consumed, causing prices to fall.
• Demand has fallen in the economy: during a recession, a fall in demand in the economy
causes general prices to fall and cause a deflation.
• Labour productivity has risen: higher output will lead to lower average costs, which could
reflect as lower prices for products.
• Technological advance has reduced cost of production, pulling down cost-push inflation.
Consequences of deflation
• Lower prices will discourage production, resulting in unemployment.
• As demand and prices fall, investors will be discouraged to invest, lowering the
output/GDP.
• Deflation can cause recession as demand and prices continue to fall and firms are forced to
close down as enough profits are not being made.
• Tax revenue of the government will fall as economic activity and incomes falls. They might
be forced to borrow money to finance public expenditure.
• Borrowers will lose during a deflation because now the value of the debt they owe is higher
than when they borrowed the money.
• Deflation will increase the real debt burden of the government as the value of debt money
increases.
Policies to control deflation
• Expansionary monetary policy to revive demand: cutting interest rates will encourage more
spending and investment in the economy which will stimulate prices to rise. However, if
interest rate is already at a very low point where decreasing it any further won’t increase
spending, because people still prefer to save some money and pay off debts, and banks are
not willing to lend at a very low interest rate, (this situation is called a liquidity trap), then
cutting interest rates will have no effect on spending.
• Expansionary fiscal policy to revive demand: increasing government spending in the
economy, especially in infrastructure will help raise demand, along with cuts in direct taxes.
The money for this expenditure can be created via quantitative easing (selling government
bonds to the public).

82 | P a g e
• Devaluation: devaluing the currency through selling domestic currency and/or increasing
the money supply will cause export prices to fall, encouraging production of exports, resulting
in higher demand; and also increase prices of imported products which will raise costs and
prices for products in the economy.
• Change inflation expectations: when a deflation is expected, businesses won’t increase
wages and consumers won’t pay higher prices (because they expect prices to fall in the
future). This will cause the deflation they expected. But if the monetary authorities indicate
that they expect higher inflation, firms will pay their workers more and consumer will spend
more now, avoiding a deflation.

83 | P a g e