Unit 7: The Price System and the Microeconomy

Topic 7.1: Utility

‘Utility’ refers to the satisfaction received from consumption - this assumes that satisfaction
can be quantified into units
1.​ Total utility - Overall satisfaction gained from the consumption of all units of a good
over a period of time
2.​ Marginal utility - Additional satisfaction gained from the consumption of an
additional unit of a good
The concept of utility may be used to consider how consumers rank their purchases based on
their utility to maximise their utility

The ‘law of diminishing marginal utility’ states that as consumption increases, the
satisfaction gained from consumption decreases. This law can be explained through the
difference in a consumer’s demand to a discounted good on sale - if a good is on sale, then a
consumer is more likely to purchase the product whereas if a product is priced above the
expected price, they are less likely to purchase the product (hence linking the price of a
product to its utility).

The ‘equi-marginal principle’ refers to when a

consumer cannot increase total utility by switching
expenditure and consumption from one product to
another. This principle assumes that:
●​ Consumers have limited incomes
●​ Consumers will behave in a rational manner
●​ Consumers seek to maximise their utility

The main limitation of the marginal utility theory is that it assumes that consumers
purchase their goods in a rational manner which is not the case as real world evidence
proves that external factors influence spending.
Topic 7.2: Indifference Curves and Budget Lines
An indifference curve is a graph
that shows all the combinations of
two goods that give consumers
equal satisfaction / utility.

The slope of the curve (how steep it

is) represents the ‘marginal rate of
substitution’ which is the rate at
which consumers are willing to
substitute one good for another.

A budget line numerically represents the combination

of two goods that can be purchased within a given
income and given price

When the price of one good changes while income

stays the same, the graph will pivot

When the price of one good changes -

assuming that the price of the other good
along with income stays the same - then:
●​ Substitution effect - Consumers will
opt to purchase the cheaper product
●​ Income effect - When the price of a
good falls, consumer real income increases as
consumers are able to purchase more of the
good

A consumer’s choice of goods is optimal when

the indifference curve touches / is tangent to
the budget line.

When income increases, then the budget line

shifts outwards hence allowing consumers to
consume more of both products, hence
shifting the indifference curve as well
However if the good is an inferior good, a
change in income will cause an opposite
reaction - a decrease in income and the budget
line shifting to the right will cause the optimal
point to be higher for the inferior good (the
shift in the indifference curve will not be
parallel).

If the price of Good X increases, then:

●​ The budget line will pivot from B1 to
B2 as only the price of Good X changes
●​ Substitution effect - There will be a
movement along I1 to E2 as consumers will
opt to purchase more of Good Y since it is
relatively cheaper than Good X
●​ Income effect - Since income stays
the same, consumers would be able to
purchase less of both products and hence
there is a shift in the indifference curve from
I1 to I2, leading to a shift from E2 to E3

If the price of Good X decreases, then:

●​ The budget line will pivot from B1 to B2
●​ Substitution effect - There will be a
movement from E1 to E2 along the imaginary
budget line (which represents how a consumer
will purchase more of Good X compared to
Good Y as Good X is cheaper)
●​ Income effect - Real income rises
following the price fall hence I1 shifts to I2
causing E2 to shift to E3
 When Good X is an inferior good and real
income rises, the substitution effect will
come into play and the equilibrium point
will shift from E1 to E3 as consumers
would opt to substitute Good X for a
more expensive high quality good (Good
Y)

Another type of inferior good is a ‘Giffen good’

where quantity demanded changes
proportionally to a price change (quantity
demanded rises as price rises and falls as price
falls). Giffen goods are typically necessities
(such as rice, wheat, etc) - as the price increases
for such goods, consumers would reduce
expenditure on other goods and increase
spending on the Giffen goods.

The main limitation of indifference curves are that:

●​ In reality, consumers have to pick from many goods and much more than just two
●​ It assumes that consumers purchase with a rational manner
●​ It assumes that consumers are willing to accept any combination given by the curve,
however consumers may rank goods differently based on other external factors

Topic 7.3: Efficiency and Market Failure

‘Economic Efficiency’ refers to when scarce resources are used in the most optimum way to
maximise output. This consists of:
1.​ Productive efficiency - Firms produce using the best possible resources at the lowest
possible cost
2.​ Allocative efficiency - Firms produce the combination of goods and services that are
most wanted by consumers
At a global level, economic efficiency is achieved when economies utilise the world’s
resources in the best way possible and maximise opportunities for trade, however
protectionism prevents this from happening.

A firm’s productive efficiency can be

graphically represented through an average
cost curve

An economy’s productive efficiency can be

demonstrated through a Production
Possibility Curve (PPC)

Within a competitive market, firms are forced

to produce at the lowest cost possible in order
to gain profits and prevent bankruptcy. This is
demonstrated through this graph, where
firms achieve productive efficiency when they
produce at the lowest point within the
average cost curve
Allocative efficiency exists when the price of a product (set by what consumers are willing to
pay) are equal to the marginal cost of production (cost of producing an extra unit)

In the table above, a quantity of 4 would achieve allocative efficiency.

Within competitive environments, firms will be forced to allocative efficiency because:

1.​ They aim to maximise profits by producing wanted goods at a low cost
2.​ They would be forced to follow market demand and produce what consumers want

‘Pareto Optimality’ states that it is impossible to make someone better off without making
someone worse off - Ie expanding an airport would increase the facilities for travellers,
however it would negatively affect the residents living near the airport.

‘Pareto Improvement’ refers to a situation that harms no one and benefits at least one person
- Ie a shift in the PPC from an inefficient point to a point on the curve showing that all
resources are employed.

‘Pareto Efficiency’ implies that resources are allocated in the most economically efficient
manner - Ie if person A likes Apples but not Bananas, and person B likes Bananas but not
Apples, the pareto efficient thing to do is give person A all apples and person B all bananas.

‘Dynamic efficiency’ refers to

when resources are allocated
efficiently over time. This can be
done through meeting the
changing needs within a market
through different production
processes and adjustments to
competition. Dynamic efficiency
is a long-run concept.

Dynamic efficiency is achieved

when a firm’s long run average
cost slopes downward

The consequences of market failure include:

●​ Lack of provision of merit and over-provision of demerit goods
 ●​ Lack of provision of public and quasi-public goods
●​ Information failure
●​ Abuse of monopoly power

Topic 7.4: Private Costs and Benefits, Externalities and Social Costs and
Benefits
‘Externalities’ refer to the consequences of producers and/or consumers on third parties that
are not directly involved in the action. The types of externalities are:
●​ Positive externality
●​ Negative externality

The 3 types of costs and benefits are:

1.​ Private Costs and Benefits - Experienced by those directly involved in the business’
decision-making
2.​ External Costs and Benefits - Consequences of externalities that arise from a
particular action where the costs / benefits are not paid for, nor do the advantages
affect the business directly
3.​ Social Costs and Benefits = Private + External

An example of negative production externality is the environmental pollution emitted from

production factories

Negative externalities are a cause of market failure

due to a misallocation of resources which can be
graphically represented

The triangular area XYZ is the ‘deadweight welfare

loss’ which is the loss in welfare that arises from
poor allocation of resources due to overproduction

An example of a positive production externality is new medical research and reforestation

‘Marginal Social Costs’ are the costs that society

pays as a result of production of additional units; if
there are external benefits, then the overall cost
reduces
The deadweight welfare loss in this scenario
represents underproduction as they are producing
below the most efficient level (which is MSC)
An example of a negative consumption externality is passive smoking where non-smokers
are affected by smokers

The deadweight welfare cost ZXY represents the

overconsumption of tobacco. The socially
efficient quantity to produce is Q at point Z,
however due to overconsumption caused by
increased demand, there is a deadweight
welfare loss

An example of a positive consumption externality is free education and healthcare

The deadweight welfare loss ZXY represents the

underconsumption of the free education and
healthcare (government-provided merit goods)

‘Asymmetric information’ refers to when one party has more / better information than the
other in a business transaction. The types of asymmetric information include:
1.​ Hidden characteristics - Where one party knows more than the other hence causing
‘adverse selection’ (seller knows more about the product’s quality compared to the
buyer and vice versa)
2.​ Hidden actions - Where one party does something without the other knowing. Ie if a
business is insured, then it is more willing to take certain risks knowing that they
would be reimbursed by their insurance. This is known as ‘moral hazard’ (the
temptation to take risks knowing the other party is covering the risks)

‘Cost-benefit analysis’ is a method of decision-making which involves taking into account all
the costs and benefits associated with an action. The steps are:
1.​ Identification of all relevant costs and benefits
2.​ Putting a monetary value on all relevant costs and benefits
3.​ Forecasting future costs and benefits
 4.​ Decision-making - where the cost-benefit analysis will be interpreted

A ‘shadow price’ is the price applied when there is no established market price

‘Benefit:Cost ratio’ is the proportion of net benefits to net costs

Topic 7.5: Types of costs, revenue and profit, short-run and long-run
production
On the lines B, A, and C, points are
plotted showing the combination of
labour and capital needed to produce a
certain level of output. Connecting
these points will create a curve called a
‘isoquant’

Total product = Total output

A ‘Production Function’ is a graph that

represents the maximum output from a
given set of factor inputs

‘Marginal Product’ refers to the difference in

output from the use of one more factor
input

The ‘law of diminishing returns’ (otherwise known as the ‘law of variable proportions’) refers
to where the output from an additional unit of input leads to a fall in the marginal product

Average Product = Total Product / Number of workers employed

‘Profit Maximization’ is the assumed objective of any private firm where the difference
between total revenue and total costs is maximised
The two types of costs are:
1.​ Fixed Costs (FC) - Stay constant
within a level of output
2.​ Variable Costs (VC) - Costs that vary
directly with output

The five types of short-run costs are:

1.​ Total Cost (TC) = Total Fixed Cost +
Total Variable Cost
2.​ Average Fixed Cost (AFC) = Total
Fixed Cost / Output
3.​ Average Variable Cost (AVC) = Total
Variable Cost / Output
4.​ Average Total Cost (ATC) = Total Cost
/ Output
5.​ Marginal Cost (MC) = Change in Cost
/ Change in Output

The reason the ATC curve is a ‘U’ is due to

the law of diminishing returns where
after a certain level of output, the average
variable costs will outweigh the falling
fixed cost per unit

In economics, the ‘short run’ refers to the time where not all factors of production are variable
and at least one is fixed (Ie Capital)

Firms should aim for:

 This isoquant map represents how much
labour and capital is needed to produce a
certain level of output. The map shows how as
production increases from 100 to 200,
relatively less amounts of labour and capital
are needed per unit of output. This is referred
to as the ‘increasing returns of scale’ where
output increases at a proportionally faster
rate than the increase in factor input.

The map also shows how as production

further expands, the width between each
curve increases as more capital and labour
are needed. This is referred to as the ‘decreasing returns of scale’ where factor inputs
increase at a proportionally faster rate than the increase in output.

An ‘isocost’ is a line that represents the

different combinations of capital and labour
that can be purchased within an estimated
total cost

Firms decide upon how to produce by finding

the point on the isoquant that is tangent to
the isocost.

Practically, this analysis for decision-making

is flawed because:
●​ It is difficult to determine isoquants - firms lack the data and staff to determine this
●​ It is assumed that in the long run it is possible to switch between factors of
production - which is not easily done
●​ Employers may be reluctant to switch between labour and capital - caused by social
obligations to maintain employment levels

The Long-run Average Cost (LRAC) curve

(otherwise known as the ‘envelope curve’)
envelopes a series of SRAC curves at
different levels of output where the lowest
points of each SRAC curve is tangent to the
LRAC curve hence showing how the LRAC
curve shows the lowest possible average
cost for each level of production where all
factors of production are variable
The ‘minimum efficient scale’ refers to where the average cost is at its lowest. In the graph
above, the minimum efficient point is Q. The number of firms competing are highest in the
lowest point and decrease as the point increases

The downward slope of the LRAC curve represents the increasing utilisation of economies of
scale; however after the minimum point ‘Q’, the LRAC curve slopes upwards representing
‘diseconomies of scale’ where average costs increase as scale of output increases.

The types of economies of scales are:

1.​ Technical economies - Advantages gained directly in the production process due to
more efficient production methods
2.​ Purchasing economies - Ie Bulk buying / Increased discount received due to long term
relations with suppliers
3.​ Marketing economies - Large-scale firms are able to promote their products whilst
paying lower rates as they are able to purchase longer amounts of air time and space
(on television)
4.​ Managerial economies - In large-scale firms, specialists are hired to manage
departments (Ie finance, HR, sales) which allow for cost-saving decisions to be made
5.​ Financial economies - Large-scale firms have better access to borrowed funds

‘External economies of scale’ are cost

saving accruing to all firms as the scale
of the industry increases - Ie more roads
built which could reduce the logistics
and costs of transportation

Examples of diseconomies of scale

include mismanagement of resources as
scale of operations rapidly increase, and
workers feeling demotivated due to their
repetitive tasks.

Examples of external diseconomies of scale include:

●​ Traffic congestion causing distribution costs to increase
●​ Land shortages increasing fixed costs
●​ Shortage of skilled labour hence causing a rise in variable costs

The three revenue concepts are:

1.​ Total Revenue (TR) = Price (P) x Quantity (Q)
2.​ Average Revenue (AR) = Total Revenue / Quantity
3.​ Marginal Revenue (MR) = Change in Total Revenue / Change in Quantity
 In a highly competitive market, firms are ‘price
takers’ as they are unable to influence the
market price of products

Graph A represents the market of price-taking

firms

Graph B represents the demand of a price-taking

firm

When a firm is a ‘price maker’, it can choose what

price to sell its goods in the market. Increasing
output would cause a reduction in price and vice
versa. The change in revenue will be dependent on
the product’s PED.

The firms demand curve is its Average Revenue (AR)

curve, with the Marginal Revenue (MR) curve being
lower than the AR curve as firms would have to
reduce their prices to sell more products

Profit = Total Revenue - Total Costs

‘Normal Profit’ is defined as the cost of production that is just sufficient / enough for a firm
to keep operating in a particular industry. Normal profit refers to when a firm’s revenue
covers its costs

Profit = Total Revenue - Total Costs (including Normal Profit)

Supernormal Profit = Total Profit - Normal Profit

‘Subnormal Profit’ refers to when the profit earned by a firm is lower than its normal profit
Topic 7.6: Different Market Structures
‘Market structure’ refers to the way a market is organised in terms of certain characteristics
(Number of buyers and sellers, nature of the product, ease of entry, extent to which all firms
have the same information) and describes the way that goods and services are sold

‘Perfect competition’ (otherwise known as total competition) refers to when there is a large
number of buyers and sellers selling identical products with no barriers to entry

‘Imperfect competition’ refers to any market structure except perfect competition:

●​ Monopolistic competition - a market structure where there are many firms selling
differentiated products with few barriers to entry
●​ Oligopoly - a market structure where there are few firms and high barriers to entry
●​ Monopoly
○​ Pure Monopoly - a single seller in the market
○​ Monopolistic industry - a single firm dominating the market by having a high
market share
○​ Natural Monopoly - where with falling long-run average costs, it makes sense
to have a singular seller for a good or service

Ways to identify the type of market

structure:
1.​ Count the number of firms
2.​ Use a concentration ratio (Adding
the market share percentages of
the top 3-5 firms) - The higher the
ratio is, the closer the market is to
an oligopoly
a.​ Concentration ratio = Top 4
firms’ market share / total
market x 100
3.​ Consider the barriers to entry
4.​ Considering the utilisation of economies of scale

Barriers to entry and exit:

●​ Legal barriers
●​ Market barriers (whether a market has existing brands with high customer loyalty)
 ●​ Cost barriers
●​ Physical barriers (lesser access to cheaper raw materials)
●​ Barriers to exit - A restriction that prevents firms from leaving a market

The characteristics of perfect competition include:

●​ Large number of buyers and sellers
●​ All firms are price takers
●​ Products are identical
●​ No barriers to entry and exit
●​ All buyers and sellers have complete information

Supernatural profit only occurs in the short-run due to it attracting new entrants hence
decreasing the market price

‘Shut-down price’ is the price set by firms when they are closing as their price falls below
their Average Variable Cost (AVC)
 Within this graph, MC represents short-run supply and
the different prices a firm is willing to sell their good
(above the point ‘x’ as it is the lowest point in the AVC
curve)

Within the long-run, only the most efficient firms would

be present within the market due to the lack of
supernormal profit, hence proving the efficiency of the
market structure

The characteristics of monopolistic competition include:

●​ Large number of buyers and sellers
●​ Few barriers to entry
●​ Consumers face a wide choice of differentiated products
●​ Firms have some influence on the market price and are therefore price makers

‘Price competition’ refers to firms competing on setting prices to attract customers

‘Non-price competition’ refers to firms competing to attract customers through on-price

methods (Ie developing a USP, after-sales service, loyalty programs)

Within the short run, firms would try to obtain supernormal profit by setting high prices,
however due to competition, they would be forced to reduce their prices to a point tangent to
the ATC curve. Both in the short and long run, firms are inefficient as they do not set their
prices at the optimum point (where the ATC and MC curve meet) in an attempt to maximise
profits while staying competitive. Additionally firms are not allocatively efficient as P > MC
The characteristics of an oligopoly include:
●​ The market is dominated by a few firms
●​ Decisions taken by firms are interdependent - The behaviour of one firm impacts the
entire market
●​ High / substantial barriers to entry
●​ Products may be differentiated or undifferentiated
●​ The uncertainty and risks behind price competition may lead to price rigidity (price
being fixed)

The dangers of oligopolists being price makers are that they can incite price wars where they
will destructively price their products at low prices in order to remain competitive. Since
most firms in an oligopoly are highly diversified, they are more willing to sacrifice the profits
of one product in order to maintain customer demand

The traditional model of a firm’s behaviour in an

oligopoly is the ‘kinked demand curve’

Even if MC1 shifts to MC2, the price will stay the

same at P due to ‘price rigidity’ where prices do
not change despite a change in costs

Due to the uncertain outcome of competition, firms within an oligopoly result in non-price
competition. Such tactics include:
●​ Advertising and promotion
●​ Product innovation - attempt to make the product more appealing
●​ Brand proliferation - firms produce lots of brands to saturate the market
●​ Market segmentation - producers produce differently for different markets of
consumers with different needs and preferences
●​ Process innovation - cutting costs without sacrificing profits

The prisoner’s dilemma in oligopolistic markets

Forms of collusion include:
1.​ ‘Price leadership’ refers to a situation in the market where the dominant firm has the
power to change prices, of which the other firms in the market follows in order to
maximise profits
2.​ ‘Cartels’ are formal agreements where firms agree to limit competition by either
limiting output or fixing prices. This is illegal

It is difficult to identify informal or formal agreements as price similarities could either be

caused by aggressive competition or collusion within an oligopoly. Hence investigations into
anti-competition are inconclusive and time consuming

The characteristics of a monopoly include:

●​ A single seller
●​ No close substitutes
●​ Higher barriers to entry
●​ The monopolist is a price maker

Supernormal Profit = TR - TC

A profit-maximising monopoly
would pick the output level where
MC = MR

Since monopolies are the single

sellers in a market, they have no
incentive to produce and sell less
than the profit-maximising
output level of Q

A natural monopoly exists when a single firm has sole ownership over certain resources
which give them a major cost advantage as it would be extremely expensive and wasteful for
firms to try and duplicate this. Examples include: water, gas, and electricity

In this case, the natural monopoly would

produce at quantity Q as that is where LRMC
= MR (both curves intersect) and price their
product at point P in order to make a
supernatural profit of (P x Q) - (C x Q)

If the monopoly behaved like a competitive

firm, they would price their product at the
point that AR intersects with LRMC -
however this is a loss-making situation, hence this only happens if the government is willing
to subsidise the monopoly as a public service. The only alternative is that the government
nationalise the monopoly and bears the losses made

This graph compares perfect competition

to a monopoly.

Monopolies would produce at the point

where MC intersects with MR and price
their product at the level where this meets
the D = AR curve

Perfect competition would price and

produce their product at the point where
MC intersects with ATC in order to remain
competitive

The following observations can be made:

●​ The price of monopolies are higher
than the prices of perfect competition
●​ The monopoly output is lower than
that in perfect competition
●​ The monopolist is making short and long-term supernormal profit
●​ The firm in perfect competition is productively efficient as it is producing at the
optimum output, and allocatively efficient as they are producing where the price = MC
●​ The monopolist turns consumer surplus into supernormal profit
●​ The monopolist is both productively and allocatively inefficient
●​ If a firm in perfect competition were to become a monopoly, there would be a welfare
loss (labelled as ‘x’)

The inefficiencies of comparing the equilibrium positions of a monopoly and perfect

competition industry include:
●​ Consumer surplus is lower in a monopoly as their price is higher
●​ Producer surplus is higher in a monopoly due to the higher price as well as the lower
output which has taken away some of the consumer surplus
●​ The deadweight loss is the sum of the loss in consumer and producer surplus

The criticism against comparing monopolies to perfect competition is that perfect

competition is only theoretical and a more realistic comparison would be to compare
monopolies with monopolistic competition or oligopolies - which are also inefficient.
Additionally, the comparison assumes that monopolies price their products above perfect
competition prices, however since monopolies would have better access to economies of
scale, they may reduce their prices hence making consumers better off while they are still
making supernatural profit

The positive aspects of monopolies in certain circumstances include:

●​ Monopolies do not always make supernatural profit due to high costs
●​ Since monopolies can plan for future investments due to guaranteed profits, they can
offer consumers higher quality goods and workers better work security
●​ Investment may be in the form of process innovation which would reduce the overall
costs and allow for a reduction in prices without sacrificing profit levels
●​ They would have better access to economies of scale allowing them to reduce price
levels and pass the benefit onto consumers

Due to the inefficiencies of monopolies, their

LRAC may be higher than its potential, hence
causing them to suffer from the ‘X-inefficiency’
where the firm’s costs are above those
experienced in a more competitive market

‘Contestable markets’ are markets where there are no barriers to entry as it is free, and there
are no costs to exit. Although ‘contestability’ - the extent to which barriers to entry and exit
are free - contestable markets are not a form of market structure and instead a set of
conditions that can be found in imperfect market structures.

‘Sunk costs’ are costs that have already been incurred and cannot be recovered - particularly
when a firm is closing (such as capital investment)

A market is perfectly contestable when:

●​ There are many entrants seeking to enter the market
●​ Entry and exits are costless
●​ All firms are subject to the same regulations and state of technology
●​ Mechanisms are in place to prohibit limit pricing
●​ Firms already in the market are vulnerable to ‘hit and run’ competition

If there are no barriers to entry in a monopoly, then the

monopolist making supernormal profit would incentivise
firms to enter the market hence forcing monopolies to
reduce their price to P1 while still producing at Q
In theory, a perfect competition industry is similar to a perfectly contestable market because:
●​ Only normal profit is earned in the long run
●​ Firms are not able to apply cross-subsidization
●​ Prices cannot be set below average cost to deter new entrants
●​ Allocative and productive efficiency is achieved
●​ The number of firms in the market does not matter

Topic 7.7: Growth and Survival of Firms

Reasons why small firms exist:
●​ Economic activities where the size of the market is too small for large firms
●​ Firm may involve specialist skills possessed by very few people
●​ Where the product is a specialist service, the firm will be small to offer customers
personal attention which can be charged high prices
●​ Current small firms may grow in market share in the future
●​ There are particular obstacles to the growth of small firms
●​ Business owners may prefer to stay small
●​ Recession and rising unemployment may cause start-ups to be formed
●​ Small businesses may receive financial aid from governments
●​ Increased access to technology has made small businesses more efficient

Motives for a firm’s growth include:

●​ Utilise economies of scale by reducing long-run average costs
●​ Achieve a bigger market share and increase profits
●​ Diversify their product range and achieve ‘economies of scope’ where they can reduce
their average costs by changing / diversifying the products they produce
●​ Capture the resources of other businesses

The two way firms can grow are:

1.​ Internal growth
a.​ ‘Diversification’ is the process of
producing many different products
2.​ External growth (acquisitions / takeovers
and mergers)
a.​ Horizontal integration (same level
in the same industry)
b.​ Vertical integration (acquiring a
business above or below them in
the supply chain)
‘Cartels’ are formal agreements between firms to limit competition by either limiting the
quantity sold, or setting a fixed price. The survival of the cartel is dependent on the
cooperation of all firms, and the high barriers to entry; however the threats to a cartel include:
●​ Possibility of a price war, where one firm works against the agreement to gain a larger
market share
●​ If some firms incur higher costs than others, they may not agree on the fixed price as
they will receive lesser profits
●​ If there is no dominant member that has the power to control the other firms
●​ Legal obstacles against cartels

The ‘principal-agent problem’ refers to when one firm (‘agent’ who is typically the market
leader) makes decisions for the ‘principal’ (the rest of the market)

Topic 7.8: Differing Objectives and Policies of Firms

A profit maximising firm will only sell up to the point
where MR=MC.

However there are several reasons why firms do not

sell at the profit maximising level of output,
including:
●​ It is difficult to identify the level of output
●​ Short-term profit maximisation may not be
in the long-term interest of the firm
●​ Large supernormal profits would attract new
entrants
●​ Higher profits may damage the relationship between the firm and stakeholders
●​ Profit maximisation may not be the primary objective

Other Objectives:
●​ Survival
●​ Profit Satisficing - A firm reaching a satisfactory / minimum level of profit
●​ Sales maximisation - A firm’s objective to maximise their volume of sales
●​ Revenue maximisation - A firm’s objective to maximise their revenue

The types of price discrimination are:

1.​ First degree: Selling each unit to a different consumer at a different price based on
what they are willing to pay (ie selling a second-hand car)
2.​ Second degree: Consumers are willing to purchase more of a product if the price falls
as more units are bought, where the marginal price reduces (ie bulk buying food
items)
3.​ Third degree: Discriminating between consumers on their price elasticities of demand
Other types of pricing:
●​ Limit pricing
●​ Predatory pricing
●​ Price leadership

In this graph, it shows how firm A (price leader)

sells their product at Oa and Pa forcing firm B to
sell at Pa which is lower than their optimum price
(Pb) else they will lose revenue

Unit 8: Government Microeconomic Intervention

Topic 8.1: Government Policies to achieve Efficient Resource Allocation

and correct Market Failure
Policies to correct Negative Production Externalities:
●​ Specific and Ad Valorem Tax - Point ‘Y’
represents the point where firms should
price their products to make up for its total
social cost including the negative
externalities, however ‘X’ is the set price;
hence a tax of y-z is set in order to reduce its
production
●​ Regulations - Legal restrictions set on
producers by the government
●​ Property Rights - A legal system where
owners may decide how to use their asset
●​ Pollution Permits - A licence given by the
government allowing a firm to pollute up to a given
level; since governments aim to limit pollution, the
number of permits would be fixed and hence the
price of each permit is dependent on its demand
Policies to correct Negative Consumption Externalities:
●​ Specific Indirect Tax - Due to consumption
externalities, MPB is above MSB hence causing
the output of the product to be above its
socially optimum point ‘Q1’, hence governments
set a specific tax to raise the price and reduce
the supply to ‘Q1’
●​ Price Controls, Provision of Information,
Production Quotas

Policies to correct

Positive Production Externalities Positive Consumption Externalities

In order for the quantity consumed to align

with the socially acceptable / optimum
As per this graph, the market under point ‘Q1’, governments would subsidise
produces the good producing a positive such merit goods to decrease its price and
externality - as MSC is below MPC - hence incentivise consumers to purchase and
the government would subsidise its consume it hence shifting from point ‘Y’ to
production to increase supply to point ‘Q1’ point ‘Z’

The ‘Behaviour nudge theory’ is a strategy where governments influence the choices of
consumers by ‘nudging’ individuals towards making more effective decisions (ie provision of
information)

Sometimes governments would create ‘direct provisions for goods and services’ where they
would produce and distribute certain merit and public goods. The reasons include:
1.​ Positive externalities produced from production and consumption
2.​ Imperfect information
3.​ Wider economic benefits
Causes of government failure:
1.​ Imperfect information
a.​ There is a lack of information with regards to the value of negative
externalities
b.​ Economists are unsure of the specific price that should be set for certain
policies (ie taxes)
c.​ Governments lack the information of consumer demand for merit goods like
healthcare
2.​ Unintended consequences (ie increasing taxes could discourage working more and
encourage importation instead of demanding domestic products)
3.​ Policy conflict

Topic 8.2: Equity and Redistribution of Income and Wealth

‘Equity’ occurs if a society distributes its resources fairly according to the different situations
of each individual. Its aspects include:
1.​ ‘Horizontal Equity’ where individuals with the same circumstances should pay the
same taxes
2.​ ‘Vertical Equity’ where taxes should be apportioned between the rich and the poor in a
society

‘Equality’ is where all individuals are treated the same

Types of Poverty:
●​ ‘Absolute Poverty’ also known as ‘Extreme Poverty’ is when consumers live below the
poverty line
●​ ‘Relative Poverty’ is when household income is 50% or less than the average income

Tax revenue is used to redistribute income through:

●​ ‘Means-tested benefits’ where benefits are only given to low-income households;
however this might lead to the ‘poverty trap’ where obtaining such benefits is better
than working
●​ ‘Universal benefits’ where benefits are given to all individuals irrespective of income
●​ ‘Universal basic income’ which is a regular unconditional cash payment made by the
government

‘Negative income tax’ is the amount of money paid out by the government to those earning
below an agreed annual fixed limit (ie if the tax paid is $3000 but the benefit received is
$4000, then the government will pay the individual an additional $1000)
Topic 8.3: Labour Market Forces and Government Intervention
‘Marginal Revenue Product’ is the additional revenue earned from employing one more
employee. Firms will continue to hire employees until the Marginal Revenue Product is lower
than the wage rate creating a negative contribution. The MRP curve is therefore the demand
curve for labour

Profit maximising firms will continue to employ so long as the MRP is higher than the wage
rate so that a positive contribution will be created. The limit is set at the point where MRP =
Wage Rate

The demand for labour by a firm is based on the assumptions that:

1.​ A firm wishing to hire labour is in a perfectly competitive market
2.​ The firm is a profit maximising firm

The factors that affect the demand for labour in a market are:
1.​ Wage rate
2.​ Productivity
3.​ Demand for the product

For an individual’s supply of

labour, low-level employees
would be willing to devote more
time to work for higher wages,
but after a certain point -
particularly with high-level
employees - they may wish to
spend more time for recreational
and leisure purposes and would
hence work less despite being
paid more

Another explanation for this graph could be ‘progressive tax rates’ where employees paid less
pay a lower proportion of their income for tax, whereas higher paid employees pay more and
hence are less willing to work more
 The supply of labour in a market is the
sum of all individual supply curves and is
upward sloping as workers are typically
willing to work more to earn more.

Elasticities differ as some jobs require a

special skillset and/or have a higher
demand (ie Lawyers are more demanded
and require more specialised skills than
taxi drivers)

The factors that affect long-run

aggregate supply and cause shifts
include:
●​ Size of the population
●​ Labour participation rate
●​ Tax and benefit levels
●​ Immigration and Emigration

Aside from monetary incentives,

non-monetary advantages (ie
insurance) influence the decision to
work for individuals

This graph works based off two

features / assumptions:
1.​ Wages paid = MRP
2.​ Willingness of labour to supply
their services is dependent on wage
rates

Shifts in the supply / demand of

labour will cause wages paid to
change
Within an imperfect market, wages are also influenced by external factors such as:
●​ Trade unions
●​ Minimum wage rates
●​ Monopsonies
Trade unions would aim to:
●​ Increase wages
●​ Improve working conditions
●​ Maintain pay differentials
●​ Fight job losses
●​ Provide a safe working environment
●​ Secure additional working benefits
●​ Prevent unfair dismissals

A strong trade union would be able to raise

the wage rates for workers causing a
surplus in supply as businesses aren’t
willing to pay the same amount of workers a higher wage rate as it would incur higher costs
without return

Introducing a minimum wage rate would create a surplus of labour, with the elasticity of
demand for the service being the factor that affects the size of the surplus

‘Monopsonies’ refers to a
scenario where there is a
singular buyer in a market (ie
firms hiring skilled workers)

The point where Marginal Cost

meets MRP will determine the
quantity of labour needed (Lm),
and the point where Average
cost intersects with Lm will
determine the wages paid to
the workers, making Wmrp - Wm the additional supernormal profit made from the reduction
in labour costs

‘Wage differentials’ are differences in the wage rates of workers with different skills and
responsibilities. They are caused by:
●​ Bargaining strength of workers
●​ Difference in education and training between workers
●​ Skilled v Unskilled workers
●​ Male v Female workers
●​ Hours of work
●​ Government policy

‘Transfer earnings’ refer to the minimum amount needed to keep labour in their present use
‘Economic rent’ = Wage rate - Transfer earnings

a)​ Skills are needed and demand has a normal

elasticity (ie teachers)
b)​ Scarce skills needed and hence supply is
highly inelastic (ie pop stars)
c)​ No skill set needed and hence supply is
highly elastic (ie maids)
 Unit 9: The Macroeconomy

Topic 9.1: The Circular Flow of Income

The ‘Multiplier’ is a numerical estimate of a change in spending in relation to the final
change in GDP. The multiplier effect occurs because a rise in expenditure will create income,
some of which would be spent then creating more income

Within a closed economy without a government sector, all money is either spent (MPC
‘Marginal Propensity to Consume’) or saved (MPS ‘Marginal Propensity to Save’)

In this type of economy, the multiplier can be

calculated by:
●​ Multiplier = 1 / MPS
●​ Multiplier = 1 / 1 - MPC
(Ie if $100 is earned and $70 is spent, MPC is 0.7, hence 1 - 0.7 = 0.3 MPS)
Equilibrium Income is achieved when Expenditure = Output (C + I = Y)
Injections = Withdrawals (I = S (Savings))

In a closed economy with a government sector, there are extra injections

(government expenditure) and leakages (taxes) hence this is the new
formula
MRT is the ‘Marginal Rate of Tax’ which is the proportion of extra income that is taxed (=
Change in Tax / Change in Income)
Equilibrium Income is achieved when Expenditure = Output (C + I + G = Y)
Injections = Withdrawals ( I + G = S + T)

Within an open economy, it includes all possible sectors including

foreign trade partners (importers/exporters)
MPM is the ‘Marginal Propensity to Import’ which is the proportion of extra income spent on
importations
Equilibrium Income is achieved when Expenditure = Output (C + I + G + [X - M] = Y)
Injections = Withdrawals (I + G + X = S + T + M)
 The Keynesian 45 Degree is a graph
that illustrates Aggregate Demand and
finds ‘National Income’ by finding the
equilibrium point between AD and Y

A shift in AD will cause income to

increase in order to reach Equilibrium
Income where Aggregate Expenditure =
National Income

APC (Average Propensity to Consume) = Amount Spent / Income

APS (Average Propensity to Save) = Amount Saved / Income

The ‘Consumption Function’ is the relationship between spending and Income

C = a + bY
a = ‘Autonomous Spending’ which is the amount spent regardless of income
b = MPC
Y = Disposable Income

The ‘Saving Function’ is the relationship between income and saving

S = -a + sY
a = ‘Autonomous Dissaving’ which is the amount of savings people will withdraw when their
income is 0
sY = ‘Induced Saving’ which is the level of savings based on income

‘Autonomous Investment’ is the level of investments made independent from income, whilst
‘Induced Investment’ is the amount of investment that is dependent on income

The ‘Accelerator Theory’ is a model that suggests investment depends on the rate of change
in income

Assuming that 1 machine depreciates per year, this table depicts the amount of investments
made per year as well as the ‘Capital-Output Ratio’ which is a measure of the amount of
capital used to produce a given level of output
An ‘Inflationary Gap’ occurs when aggregate
expenditure is above the potential output of an
economy

‘a’ represents the aggregate expenditure level, but

Y depicts equilibrium and hence the potential
output, hence a→b is the inflationary gap

To combat an inflationary gap, governments would

reduce expenditure in order to make point ‘b’ the
new equilibrium

A ‘Deflationary Gap’ occurs when aggregate

expenditure is below the potential output of an
economy

‘w’ represents the expenditure level and Y shows

the equilibrium and the potential output of the
economy, hence v→w is the deflationary gap

According to the Keynesian 45 model, the solution

to solving a deflationary gap is by increasing
government expenditure
Topic 9.2: Economic Growth and Sustainability
‘Actual Economic Growth’ refers to an increase in real GDP as output increases

In order for an economy to continue to grow, ‘Potential Economic Growth’ must take place
where there is an increase in the productive capacity of an economy - otherwise known as
‘Long-run Economic Growth’

The difference between actual output and potential output is called an ‘Output Gap’

A ‘Negative Output Gap’ occurs when

Actual Output < Potential Output
A ‘Positive Output Gap’ occurs when
Actual Output > Potential Output

This may occur as for a short period of

time, machinery would work continuously
to produce more output than the regular
amount, however this cannot be
sustained as machines would eventually
need maintenance and / or repair, and
workers wouldn’t want to work overtime

The business cycle consists of:

●​ Upturn - Expansion of the
economy, referred to as economic
boom
●​ The Peak - Leads to demand-pull
inflation
●​ The Downturn - Negative Economic
Growth occurs
●​ The Through - The lowest point in
the cycle which would experience
negative output gaps and could
potentially lead to recessions and
even depressions

The causes of a business cycle:

●​ Fluctuations in Aggregate Demand
○​ Changes in Money Supply
●​ Fluctuations in Aggregate Supply
○​ Supply-side Shocks (large shortages in short-run aggregate supply)
●​ Political cycles

‘Automatic Stabilizers’ consist of government policies and strategies to offset fluctuations in

economic activity, ie:
●​ An economic boom would be offset by progressive taxes and corporate taxes
●​ An economic recession would be combated by an increase in government expenditure

In order to promote economic growth and reduce a negative output gap, governments would
aim to increase aggregate demand through expansionary fiscal and monetary policies as
well as supply side policies for potential economic growth
‘Inclusive Economic Growth’ is defined as economic growth that is distributed fairly across
society to create opportunities for all and is economic growth that allows all individuals to
benefit

The ‘Gig Economy’ consists of labour markets based on short-term contracts

Policies to promote inclusive economic growth:

●​ Progressive taxes and Transfer payments
●​ Improved access to high quality education
●​ Relatively high minimum wage
●​ Anti-discrimination legislation
●​ Trade union legislation (to give trade unions more power)

‘Sustainable Economic Growth’ is economic growth that does not threaten the future
generation’s ability to experience economic growth

Policies to promote sustainable economic growth:

●​ Subsidise cleaner energy sources
●​ Provision of information on the damage caused by certain activities
●​ Banning the production and consumption of certain products
●​ Carbon tax - this follows the ‘Polluter Pays Principle’ which is a policy that makes
those responsible for emissions pay a tax
●​ Using pollution permits

Topic 9.3: Employment and Unemployment

‘Full Employment’ refers to where all those wishing to work have found jobs, excluding
frictional unemployment

‘Equilibrium Unemployment’ exists when Aggregate Demand for Labour (ADL) is equal to
Aggregate Supply of Labour (ASL) at the real wage of W

‘Aggregate Labour Force’ (ALF) includes all those

prepared to work at the real wage W along with
those looking for higher-paying jobs and those who
can’t work due to geographical immobility. ALF
moves closer to ASL as the wage rate increases as
more workers are willing to work for higher real
wages
‘Disequilibrium Unemployment’ exists when ASL is
higher than ADL at a given real wage rate otherwise
known as ‘Cyclical Unemployment’

Economies can also experience Equilibrium and

Disequilibrium Unemployment at the same time,
this is because equilibrium could be below the real
wage rate for reasons such as ADL falling, and
minimum wage rates

X→Z is the unemployment within the economy, of

which X→Y is disequilibrium unemployment, and
Y→Z is equilibrium unemployment

‘Voluntary Unemployment’ is when workers choose

not to work at a given wage rate, whilst
‘Involuntary Unemployment’ includes most Structural (caused by changes in the economy)
and Cyclical Unemployment (caused by shortage in demand)

The ‘Natural Rate of Unemployment’ exists when ADL is at equilibrium with ASL, but is more
complex than equilibrium unemployment. New Classical Economists believe that even with
government intervention, the natural rate of unemployment will always be maintained - ie if
governments spend to increase AD to raise employment, price levels will rise and inflation
will cause AD to fall and unemployment to rise again hence maintaining the same rate of
unemployment. The factors that determine the natural rate of unemployment are supply-side
factors including:
●​ Value of unemployment benefits relative to the value of low pay
●​ National Minimum Wage
●​ Quality of Education and Training
●​ How are workers affected by periods of unemployment
●​ Quantity and Quality of job vacancies and worker’s skills and qualifications
●​ Degree of labour mobility
Policies to reduce the natural rate of unemployment:
●​ Widen the gap between low pay and unemployment benefits
●​ Remove minimum wage rates
●​ Improve education and training - this can prevent ‘Hysteresis’ which is when workers
unskilled and unmotivated to work after long periods of unemployment
●​ Increase quality and quantity of information about the job market
●​ Improve ‘Labour Mobility’ which is the ability for workers to change where they work
and their occupation
●​ Increase flexibility within the labour force

Patterns and trends of unemployment:

●​ Unemployment is higher in declining industries and occupations
●​ Unemployment is higher among young workers
●​ Certain social groups (related to gender, race, and health conditions / impairments)
face higher unemployment rates

The measure for an economy’s employment can be done using these factors:
●​ Industrial structure
●​ Proportion of women in the workforce
●​ Employed and Self-employed
●​ Full-time and Part-time
●​ Employment in the Formal and Informal economy (whether they are protected by
government legislation)
●​ Secure and Insecure unemployment (ie being employed in the gig economy where
there is a lack of job security)
●​ Private and Public sector employment

‘Occupational mobility’ is the ability of a worker to move from one job to another. The factors
that affect this include:
●​ Quality of Education and Training
●​ Information available
●​ Barriers to entry and exit
●​ Time period for workers to move between jobs (the longer the time period, the more
able they are to move as they can learn the needed skills)

‘Geographical mobility’ is the ability of a worker to move to a job in a different location. The
factors that affect this include:
●​ Price and availability of housing
●​ Information available
●​ Personal ties
Factors that influence the movement between countries:
●​ Immigration controls
●​ Language barriers
 ●​ Cultural differences
●​ Difference in pay and living standards

Policies to reduce unemployment:

●​ Expansionary Fiscal Policy
○​ Reduction in indirect or direct taxation to increase consumer expenditure
○​ A cut in corporate taxes to stimulate investment
○​ An increase in government spending
●​ Expansionary Monetary Policy
○​ Reduce the rate of interest to increase consumer expenditure and investment
○​ Increase the money supply
○​ Lower the exchange rate
However the expansionary fiscal and monetary policies have a time lag, hence when it
addresses unemployment as a problem, other factors affecting unemployment may arise
●​ Supply-side Policies (to tackle frictional and structural unemployment)
○​ Cut in income tax
○​ Improve education and training
○​ Trade Union reform (to stop trade unions from pushing for higher wages)
However supply-side policies have a longer time lag, as well as could cause an increase in
unemployment if the problem is due to a lack of aggregate demand

Topic 9.4: Money and Banking

Money is an item used to buy and sell goods and services

Functions of Money Characteristics of Money

●​ Medium of Exchange ●​ Generally Acceptable

●​ Store of Value ●​ Recognisable

●​ Unit of Account ●​ Portable

●​ Standard of Deferred Payment ●​ Divisible

●​ Homogenous (Similar)

●​ Limited Supply

‘Money Supply’ refers to the amount of money circulating in an economy. The types of money
supply are:
1.​ ‘Narrow Money’ which is money that can be spent directly (ie notes and coins)
2.​ ‘Broad Money’ which is money that is used for spending and saving which includes
narrow money as well as money put in savings accounts
The ‘Quantity Theory of Money’ is a theory that links inflation in an economy to changes in the
money supply. This theory is based on the ‘Fisher Equation’ (MV = PT)

M (Money Supply) x V (Velocity / Movement of Money) = P (Price) x T (Transactions / Output)

Monetarists assume that V and T are constant and aren’t affected by the money supply

Keynesians believe that if left to market forces (of demand and supply), economies would not
achieve full employment, hence governments should prioritise implementing measures to
reduce unemployment; whereas Monetarists believe that governments should focus on
managing inflation and the money supply as reducing unemployment would only lead to
further inflation and wouldn’t reduce the natural rate of unemployment - they believe that
economies are stable unless there are erratic changes in their money supply

Functions of a Commercial Bank:

●​ Providing deposit accounts
○​ ‘Demand deposit accounts’ are bank accounts that allow the holder to make
and receive payments
○​ ‘Savings deposit accounts’ are bank accounts that give interest and require
notice before the holder withdraws money
●​ Holding assets such as
○​ Cash
○​ ‘Government Securities’ which are bills and bonds issued by governments to
raise money
○​ ‘Equities’ are shares in firms
●​ Offer loans
○​ ‘Overdrafts’ which is a permissible amount that can be spent over the amount
in a holder’s demand deposit account
○​ Long-term loans

The ‘Reserve Ratio’ is the proportion of liquid assets to total liabilities

The ‘Capital Ratio’ is a bank’s financial capital as a percentage of its riskier assets

The objectives of a commercial bank are:

●​ Profitability
●​ ‘Liquidity’ is the ability to turn assets into cash quickly and without loss
●​ Security
However, these objectives conflict: as to maintain security, banks would reduce their
profitability by increasing their costs and keeping a certain level of assets liquid would be
unprofitable as it won’t gain value over time

Main causes of an increase in the money supply within an open economy:

1.​ An increase in commercial bank lending
2.​ An increase in government spending financed by borrowing from commercial banks
 3.​ An increase in government spending financed by borrowing from central banks
4.​ The sale of government bonds to private sector financial institutions (Quantitative
Easing)
5.​ More money entering than leaving the country

The ‘Bank Credit Multiplier’ is the process by which the bank can make more loans than
deposits available

Liquidity Ratio = (Current Asset - Inventory) / Current Liability

Reserve Ratio - If a bank keeps a reserve ratio of 5%, then the bank credit multiplier is 100/5 =
20. With this the bank can determine how much it can lend. The bank would then work out
the possible increase in its total liabilities - this is done by multiplying the change in assets
by the multiplier, assuming the change is $40 million, 40 million x 20 = $800 million. To work
out the change of loans in advance, the bank would subtract the change in liabilities by the
change in assets as the total liabilities includes deposits given, hence it is
$800 million - $40 million = $760 million

Capital Ratio - If a bank keeps a capital ratio of 8%, then that means 8% of its riskier assets is
covered by readily available financial assets

The roles of a central bank are:

●​ Act as a banker to commercial banks
●​ Implement the government monetary policy
A central bank can influence the amount of lending done by a commercial bank by selling
government securities in order to reduce the amount of liquid assets they hold as individuals
would withdraw their deposits in order to buy the securities

‘Quantitative Easing’ is a situation when a central bank buys public and private securities /
bonds in order to increase the money supply within an economy and boost stimulate
economic activity

The ‘Total Currency Flow’ is the net amount of money that flows into or out of an economy
depending on their international transactions

The effectiveness of policies to reduce inflation:

●​ Identifying the type of inflation would allow the government to implement suitable
measures - ie if it is cost-push inflation, then the government should aim to increase
unemployment in order to reduce the costs incurred by businesses, this could be
done through contractionary fiscal and monetary policies; whereas some policies can
reduce both types of inflation, ie investing in education and training may lead to
short-term demand-pull inflation, but in the long run, cost-push inflation would
 reduce as a result of increased productivity, and the economies growth would be able
to sustain a larger amount of aggregate demand without experiencing inflation
●​ Governments make policies based on their forecasts of the future, however the further
they forecast, the more uncertain they become
●​ If the country is part of an ‘Economic and Monetary Union’ (a group of countries that
coordinate policies and use a singular currency, ie EU) they will not be able to set their
own interest rates
●​ Governments may determine the increase of money supply as the cause of inflation,
but cannot directly control the money supply as commercial banks have a profit
motive which incentivizes then to keep on lending
●​ The responsiveness of consumers and households to the government measures will
affect the effectiveness of the policies

The ‘Monetary Transmission Mechanism’ is the process by which a change in the monetary
policy works through an economy via changes in aggregate demand, price levels, and GDP

The ‘Liquidity Preference’ is a Keynesian concept which explains why people demand money.
There are 3 motives behind households wanting to hold wealth in the form of money:
1.​ ‘Transactions Motive’ which is the desire to hold money for day-to-day expenditure
2.​ ‘Precautionary Motive’ which is the reason where people hold money for unexpected
and unforeseen events - this amount of money is referred to as ‘Active Balances’
which is the amount households hold for near-future usage
3.​ ‘Speculative Motive’ which is the reason for holding money in order to make future
gains by buying financial assets - this amount of money is referred to as ‘Idle
Balances’ which is the amount temporary held as the return from holding financial
assets is too low

Interest rates (R) are set at the point where the

liquidity level (L) intersects with the money
supply (MS)

If the money supply increases, then the interest

rate will decrease, this is because households
would have more money that they would want to
hold, as a results, they use some to buy financial
assets

The ‘Liquidity Trap’ is a situation where interest

rates cannot be reduced any more in order to
stimulate an upturn in economic activity
The ‘Loanable Funds theory’ suggest that interest
rates are based off the amount of funds that can
be loaned out to individuals

If the supply of loanable funds increase, this would

reduce the interest rate due to the decrease in
scarcity of supply

Unit 10: Government Macroeconomic Intervention

Topic 10.1: Government Macroeconomic Policy Objectives

●​ Governments aim to maintain a low and stable inflation rate by employing
anti-inflationary policies (ie contractionary demand-side policies)
●​ Governments aim for the current accounting credit side to equal to the debit side in
the long run and avoid any large changes in the current account balance
●​ Governments aim to keep unemployment low and the duration short
●​ Governments aim to increase their economy’s growth rate and promote potential
economic growth with supply-side policies
●​ Governments aim to improve the living standards of their citizens through economic
development
●​ Governments aim for ‘sustainable development’ (which is development that ensures
that the needs of the present generation can be met without harming the well-being
of future generations
●​ Governments aim to redistribute income from the poor to the rich through
progressive taxes
Topic 10.2: Links between Macroeconomic Problems and their
Interrelatedness
1. The Relationship between the Internal and External Value of Money

The internal value of money is influenced by inflation whilst the external value of money is
influenced by the depreciation / appreciation of an economy’s currency

Inflation will cause a currency to depreciate

as their exports will become more
expensive hence making them less
internationally price competitive leading to
a reduction in net exports

A fall in a country’s exchange rate will

cause imports to be more expensive hence
leading to cost-push inflation

2. The Relationship between the Balance of Payments and Inflation

If a country’s inflation rate rises, its exports will lose price competitiveness leading to a
decrease in net exports and may cause the current account to go into a deficit; whereas a
current account surplus may cause inflation as it is likely due to an increase in net exports
hence causing demand-pull inflation

A net inflow on the financial account of a country may reduce a country’s inflation rate as the
inflow of advanced technology will allow the country to become more internationally
competitive

3. The Relationship between the Growth and Inflation

A high rate of inflation is likely to reduce a country’s growth rate as consumers would be
more inclined to save till prices reduce, this is also because net exports are likely to fall due
to their fall in international price competitiveness

An increasing growth rate may cause both cost-push inflation (as growth may be
accompanied by decreasing unemployment rates) and demand-pull inflation (as national
income and hence spending increases)
Potential economic growth can reduce inflation as it will increase an economy’s ability to
sustain higher levels of demand without experiencing demand-pull inflation

4. The Relationship between Growth and the Balance of Payments

Economic growth may be export led hence causing a current account surplus; however in the
short run a current account deficit (caused by an increase in imports) may lead to economic
growth as domestic firms import raw materials and capital goods to improve the efficiency
and effectiveness of their production

5. The Relationship between Inflation and Unemployment

The ‘Phillips Curve’ is a curve that shows

the relationship between the
unemployment rate and the inflation
rate over a period of time

If unemployment rates are low, then the

inflation rate will be high due to:
-​ Cost-push inflation as cost of
labour will increase
-​ Demand-pull inflation as
national income will increase hence
demand will increase

The ‘Expectations-Augmented Phillips

Curve’ is a diagram that shows that
while there may be a trade-off between
unemployment and inflation in the
short run, there is no trade-off in the
long run

The diagram shows how a shift from

SPC → SPC1 causes unemployment to
reduce from 8% to 4% causing inflation
rates to increase to 5%, however in the
long run, employers will realise that
their increase in costs is not accompanied by an increase in real profits, hence they will cut
costs by reducing their employment rate, however the 5% inflation rate has already been built
into the economy and will hence remain

Phillips Curve → Keynesian Theory

Expectations-Augmented Phillips Curve → Monetarist Theory
Topic 10.3: Effectiveness of Policy Options to meet all Macroeconomic
Objectives
1.​ The Effectiveness of the Fiscal Policy in relation to Different Macroeconomic
Objectives

Reasons why the Fiscal Policy may not be effective in achieving all macroeconomic
objectives:
●​ Objective conflicts (Growth and Employment v BOP and Stable inflation)
●​ ‘Crowding In’ is the idea that higher public sector spending will increase private
sector spending (as AD and National Income increases hence causing an increase in
employment and an increase in consumer expenditure)
●​ ‘Crowding Out’ is the idea that higher public sector spending will decrease private
sector spending (as a larger proportion of the money supply is borrowed by the
government hence consumers are unable to borrow and spend)
●​ Unexpected responses
●​ Time lags
●​ Difficulties of reversing an increase in government spending
●​ Redistribution of income and development v Incentive to work (higher progressive tax
rates [MRT] will discourage workers from working overtime)

The ‘Laffer Curve’ is a curve showing tax revenue

rising at first as the tax rate increases but falling
beyond a certain point

The curve depicts:

1.​ Where tax revenue is maximised
2.​ 2 different tax rates can collect the same
level of revenue

However, empirical evidence suggests that belief

in the curve can lead to government failure, as
after the curve was introduced, a decrease in tax rates was introduced which led to a
decrease in tax revenue within the US

2.​ The Effectiveness of the Monetary Policy in relation to Different Macroeconomic

Objectives

Reasons why the Monetary Policy may not be effective in achieving all macroeconomic
objectives:
●​ Objective conflicts (Growth and Employment v BOP and Stable inflation)
●​ Time lag (Interest rates take 18 months to become fully effective)
●​ How commercial banks respond
 ●​ Liquidity trap
●​ Influences of changes in other countries
●​ Unexpected responses
●​ Demand and Supply shocks (sudden decreases)
●​ Mobility of Financial investments
●​ Coordination

3.​ The Effectiveness of Supply Side Policies in relation to Different Macroeconomic

Objectives

Supply-side Policies can be split up into 2 types:

●​ Market-based Supply-side Policy

This includes policies that aim to increase the role of market forces (by reducing government
intervention):
-​ Cuts in direct tax
-​ Reducing unemployment benefits
-​ Privatisation
-​ Deregulation and labour market reforms

While these policies may achieve economic growth and reduce inflation, it will conflict with
the objective of redistributing income and lowering unemployment as the private sector
operates with the profit motive

●​ Interventionist Supply-side Policy

This includes governments taking a larger role in the economy in order to foster potential
economic growth:
-​ Investment in Education and Training
-​ Investment in Healthcare

These changes may achieve growth and reduce unemployment due to the increase in
government spending (and hence aggregate demand), but can also cause structural
unemployment as a result of government investments into advanced technology

4.​ The Effectiveness of Exchange Rate Policies in relation to Different Macroeconomic

Objectives

Reasons why Exchange Rate Policies may not be effective in achieving all macroeconomic
objectives:
●​ Objective conflicts (Stable BOP and Economic Growth v Employment and Stable
Inflation)
●​ PED of exports and imports
 ●​ Speculation (over the economy’s external value of money)
●​ Objectives of other countries
●​ Availability of foreign currency
●​ Actions of other central banks

5.​ The Effectiveness of International Trade Policies in relation to Different

Macroeconomic Objectives

If a government is in favour of free trade, then they will remove and restrictions on imports
and exports; alternatively if they are against it, they will employ protectionist policies in order
to restrict importation in order to protect domestic firms

6.​ Problems arising from Conflicts between Policy Objectives

●​ Low Unemployment and Economic Growth v Price Stability

●​ Low Inflation v BOP Stability
●​ Redistribution of Income v Economic Growth

In order to avoid conflicts between policy objectives, governments employ a mix of all forms
of government policies in order to achieve many macroeconomic objectives

7.​ Government Failure in Macroeconomic Policies

‘Government Macroeconomic Failure’ is the act of government intervention policies reducing

rather than increasing economic performance. The reasons for this include:
●​ Miscalculating the size of the Multiplier
●​ Time Lags
●​ Desire to win elections (Political agendas)
●​ Pressure groups and corruption
 Unit 11: International Economic Issues

Topic 11.1: Policies to Correct Disequilibrium in the Balance of Payments

The Balance of Payments include these components:
●​ Current Account
○​ Balance of trade in goods and services
○​ Net income from abroad
○​ Net current transfers
●​ Capital Account (includes non-produced, non-financial assets ie. debt forgiveness)
●​ Financial Account (records movements of funds in and out of the country)
1.​ Direct Investment
a.​ Debit → Building a factories / Merging with a firm in another country
b.​ Credit → Foreign firms building factories and merging domestically
2.​ Portfolio Investment (includes the purchase and sale of government bonds
and shares)
3.​ Other Investments (ie government loans between countries)
4.​ Reserve Assets (which include the governments’ reserve of gold and foreign
currency)

○​ A financial account deficit is not necessarily a problem as it is likely to lead to

an inflow of profit in the long run
■​ The deficit may also be in the short-run as a result of hot money
outflows in search of more profitable interest rates
■​ The deficit is a problem if it is a result of long-run lack of confidence in
the country’s economic prospects
○​ A financial account surplus occurs when more portfolio investment and loans
enter the country rather than leave it
■​ The surplus may create employment and lead to economic growth
■​ However, in the long-run it can lead to higher outflow of profit and
dividends
●​ ‘Net Errors and Omissions’ is a figure included to ensure the BOP values balances
(sometimes called the balancing figure)

Effects of government policies on the BOP:

●​ Contractionary demand-side policies can decrease the value of importations and
encourage firms to export their products rather than sell them domestically
●​ Supply-side policies can be introduced to improve a country’s international
competitiveness
●​ Changes in the exchange rate can influence the value of net exports
●​ Protectionist policies can be used to reduce demand for imports
There are instances where employing a policy will lead to unintended consequences (ie
lowering interest rates to reduce unemployment can cause an increase in importation)

‘Expenditure Switching Policies’ are tools designed to encourage people to switch from
buying imports to buying domestically-produced products. These include:
●​ Supply-side Policies
●​ Protectionism
●​ Exchange Rate Policies

‘Expenditure Reducing Policies’ are tools designed to reduce imports and increase exports by
reducing (domestic) demand. These include:
●​ Contractionary Fiscal Policies
●​ Contractionary Monetary Policies

Topic 11.2: Exchange Rates

‘Real Exchange Rates’ are a currency’s value in terms of its real purchasing power

‘Trade-Weighted Exchange Rates’ is the price of one currency against a basket of currencies

A ‘Fixed Exchange Rate’ system is an exchange rate set by the government and maintained by
the central bank
Central banks maintain a fixed exchange
rate through ‘direct intervention’ where they
buy / sell foreign reserves in order to
influence the demand / supply of their
currency to maintain the exchange rate

It is easy to maintain a fixed exchange rate

if the rate is similar to the long-run
equilibrium value of the currency

The benefits of a fixed exchange rate

include creating certainty (to avoid
speculation) which can promote
international trade and investment, as well as avoids inflationary pressure and prevents a
loss in international competitiveness from putting downward pressure on the exchange rate

A disadvantage of a fixed change rate is the need for a central bank to keep reserves
‘Devaluation’ is a decision by a government to lower the international price of a country’s
currency

‘Revaluation’ is a decision by a government to raise the international price of a country’s

currency

A ‘Managed System’ is where the exchange

rate is influenced by state intervention (it
combines the features of both a floating
exchange rate system and a fixed
exchange rate system), it involves
governments allowing an exchange rate to
be influenced by market forces within a
given upper and lower limit

The ‘Marshall-Lerner Condition’ states that the requirement for a fall in the exchange rate to
be successful in reducing the current account deficit, the sum of the price elasticities of
demand for exports and imports must be greater than 1

The ‘J Curve Effect’ states that a fall in the exchange

rate causes an increase in the current account
deficit before it reduces due to the time it takes for
demand to respond

Whereas the ‘Reverse J Curve Effect’ will show

that a rise in the exchange rate will increase a
current account surplus before reducing it
possibly into a deficit
Topic 11.3: Economic Development
Economies can be categorized based on their level of development into:
●​ Developed Economies - which usually includes:
○​ High incomes
○​ Mature markets
○​ High standards of living
○​ High levels of productivity
●​ Developing Economies

Economies can also be categorized based on their level of national income into:

‘Poverty Cycles’ are the links between for example low income, low savings, low investment,
and low productivity

‘Development Traps’ are restrictions on the growth of developing economies that arise from
low levels of savings and investment

In order to measure economic development, economists use indicators which are measured
using:
●​ GDP
●​ GNI
●​ NNI
●​ ‘Purchasing Power Parity’ (PPP) which is a way of comparing international living
standards by using an exchange rate based on the amount of each currency needed to
purchase the same basket of products
‘Composite Indicators’ are measures that include a number of indicators of living standards
to give a single, combined figure. They include:
1.​ ‘Human Development Index’ (HDI) is a composite measure of living standards that
include GNI per head, literacy rates and life expectancy (income, education,
healthcare)
2.​ ‘Measurable Economic Welfare’ (MEW) is a composite measure of living standards
that adjusts GDP for factors that reduce living standards and factors that improve
living standards
3.​ ‘Multidimensional Poverty Index’ (MPI) is a composite measure of deprivation /
poverty in terms of the proportion of households that lack the requirements for a
reasonable standard of living

The ‘Kuznets Curve’ is a curve that shows

the relationship between economic growth
and income inequality

The curve depicts how within the initial

stages of growth, inequality increases
until a certain level of GDP per head is
reached, and then inequality begins to
decrease

However, this suggested trend is not followed by developed economies (ie it doesn't explain
the increasing income inequality in developed economies such as the US)

The ‘Shadow Economy’ (also referred to as underground economy) is where the output of
goods and services are hidden from the authorities, also refers to undeclared economic
activity

Comparison of living standards over time:

●​ Comparing the Real GDP per Capita between 2 different years may not show an
accurate representation of a change in living standards as Real GDP per Capita does
not represent the income inequality present in an economy
●​ A change in Real GDP does not always represent a true change in the quantity of goods
and services due to the existence of undeclared economic activity
●​ Choice between Consumer and Capital Goods:
Producing more capital goods in the short run will
reduce consumption and may reduce GDP, but in the
long run will cause potential economic growth and
lead to an increase in Real GDP
 ●​ Even if consumption increases, it doesn't mean happiness increases as well as the
rise of high-quality products will cause the desire for even better products
●​ Real GDP measures the quantity of output but not the quality
●​ Working conditions may also increase but a decrease in working hours may cause
Real GDP to stay the same despite an increase in living standards

Comparison of living standards between countries:

●​ In order to accurately compare living standards, Real GDP must be converted into a
common currency to avoid the differences caused by exchange rate values
●​ A higher GDP per head does not necessarily mean higher living standards (ie Kuwait
has one of the highest GDP per Capita, but a majority of their immigrant population
receive one of the lowest wages)
●​ Comparing living standards between countries must take into account factors that
are not measured or given by those main indicators (ie working hours and conditions,
fear of crime, freedom of expression)

Topic 11.4: Characteristics of Countries at Different Levels of Development

‘Demographers’ are people who study changes in the structure of human populations. The
key data they measure include:
●​ Birth rate (live births per thousand within 1 year)
●​ Death rate (deaths per thousand within 1 year)
●​ Infant mortality rate (deaths of kids below 1 per thousand within 1 year)
●​ Net migration (Immigration - Emigration)
○​ Net migration rate (number of incoming migrants per thousand within 1 year)
○​ ‘Positive Net Migration’ refers to when more people come into a country to live
compared to the number of those leaving a country to live elsewhere

‘Natural Increase of Population’ refers to when the birth rate of a country exceeds its death
rate

‘Dependency Ratios’ are the proportion of the economically inactive (x<18 and x>60)
compared to the labour force

‘Optimum Population’ is the size of population

that maximises GDP per head

As the population grows, they can make use of

the stock capital as returns are increasing,
below the optimum point is considered
underpopulated, and over it is overpopulated as
they experience decreasing returns
 The ‘Gini Coefficient’ is a numerical measure
of the extent of inequality that produces
values between 0 to 1; which is represented by
the ‘Lorenz Curve’ which is a diagram
illustrating the extent of income / wealth
inequality

The further the red line (more curved) is from

the equality line, the more unequal the
income distribution is, and the higher the gini
coefficient is

A gini coefficient of 0 is perfect equality

Types of Economic sectors:

1.​ ‘Primary Sector’ (agricultural) which includes industries involved in the extraction of
raw materials
2.​ ‘Secondary Sector’ (manufacturing) which includes turning raw materials into
finished goods
3.​ ‘Tertiary Sector’ (service sector)

Topic 11.5: Relationship between Countries at Different Levels of

Development
1.​ International Aid

‘Aid’ includes any form of assistance given to other countries on favourable terms. They
consist of:
●​ ‘Tied Aid’ which is aid with conditions attached
●​ ‘Untied Aid’ which is aid without any conditions attached
●​ ‘Bilateral Aid’ which is aid given to one country from another
●​ ‘Multilateral Aid’ which is aid given by international organisations or a group of
countries

Both tied and untied aid directly increases the demand for the donor country’s exports, and
bilateral / multilateral aid can be given for humanitarian purposes (ie the receiving country
has to end child labour)
 A ‘Virtuous Cycle’ includes the link between for
example an increase in investment, productivity,
savings, and income

2.​ Trade

Low-income countries often argue for trade instead of aid because:

●​ Economies of scale become possible because of the larger market
●​ Increased competition encourages domestic producers to innovate
●​ Trade leads to a transfer of skills and technology from high to low-income economies
●​ Specialisation
●​ Trade increases income leading to increased investment

As low-income countries often specialize in the primary sector, they are at a disadvantage in
trading relations as:
●​ The YED for primary products are so low that a large increase in income would
minimally increase demand and instead cause consumers to switch to manufactured
goods
●​ Producers of manufactured goods in high-income economies often benefit from
monopolies
●​ Subsidies given to farmers in the US and Europe put downward pressure on global
agriculture prices

3.​ Investment

Investment flows between countries in search of profit, dividends and interest

Low-income economies often have a deficit in their current accounts due to low incoming
investment levels, but if they experience a sudden increase in investment, they become
‘Emerging Economies’ which are economies that make quick progress towards becoming
high-income economies

4.​ Multinational Companies (MNCs)

An MNC is a firm that operates in more than one country

‘Foreign Direct Investment’ (FDI) includes the setting up or production units or the purchase
of existing production units in other countries

Multinationals

Advantages Disadvantages

●​ Increases FDI ●​ Export leakage

●​ Brings in new technology and ideas ●​ Domestic firms are threatened

●​ Can add to the GDP of low-income ●​ Usage of non-renewable methods

economies and energy sources

5.​ External Debt

External Debt

Causes Consequences

●​ A structural current account deficit ●​ Debt can divert funds that may be
prevents a country from paying off intended to improve education and
their debt healthcare

●​ Countries may be overconfident in ●​ Build up of interest repayable

the amount they can pay back

●​ Funds borrowed aren’t used ●​ Reduced ability to obtain future

efficiently / for good use loans until existing loans are repaid

●​ Unexpected events

6.​ The role of the IMF and World Bank

The aim of the IMF is to:

●​ Promote international monetary cooperation
●​ Facilitate the expansion and balanced growth of international trade
●​ Promote exchange rate stability
●​ Assist in setting up a multilateral system of payments
●​ Make resources available for countries experiencing BOP difficulties

The World Bank provides loans that aim to:

●​ Improve healthcare and education
●​ Improve agriculture and rural development
●​ Promote environmental protection
 ●​ Develop infrastructure
●​ Prevent corruption from occurring

Topic 11.6: Globalisation

‘Globalisation’ is the process by which the world is becoming increasingly interconnected
through trade and other links

Globalisation

Causes Consequences

●​ Advances in communication and ●​ Consumers benefit from a greater

technology variety of products

●​ Greater speed, reliability, and lower ●​ Free movement of direct and

cost associated with transport of portfolio investment reduces income
goods inequality between countries

●​ Removal of trade restrictions ●​ As countries are interdependent on

each other, they are more susceptible
to negative demand and supply-side
shocks

●​ Removal of restrictions for firms to ●​ Countries will experience the pareto

base its operations in optimality effect

‘Trade Blocs’ are regional groups of countries that have entered into trade agreements

‘Free Trade Areas’ are regions where the governments agree to remove trade restrictions
between themselves

‘Customs Unions’ are trade blocs where there is free trade between members and a common
external trade tariff on the imports of non-members (Ie GCC)

‘Monetary Unions’ are trade blocs which include members operating in the same currency,
having one exchange rate, and the same interest rate (Ie Euro Currency)

A ‘Full Economic Union’ is a trade bloc where there is free trade between members, a common
external tariff, common economic policies, and the same currency (Ie EU)
‘Trade Creation’ is where
high-cost domestic production
is replaced by more efficiently
produced imports from within
the customs union

‘Trade Diversion’ is where trade

with a low-cost country
outside a customs union is
replaced by higher-cost
products supplied from within
a customs union