1. The Basic Economic Problem.

Scarce resources infinite wants

Consumers have to make choices. This is as true for big firms and Governments as it is for individuals. When we choose something, we sacrifice something else; the thing we give up is the opportunity cost- the next best alternative foregone. All the time we are trying to maximise our utility or satisfaction. Often we are operating at the margin; when we feel we might not be maximising our satisfaction we dont give up all spending on cinema visits or all spending on going swimming; instead we change the last couple of cinema visits or visits to the pool.

Wants and needs

We draw a distinction between wants and needs;- in economics needs are things that we cannot do without; food, clothing, water, shelter. Wants are things that we would like; a playstation or a new CD. The first solution to satisfying wants and needs was barter, this meant that one person who wanted a chicken might barter a chicken for a pot that they owned. The problem with barter is that it requires a double coincidence of wants- you have got to have what the other person wants, and vice- versa.

Money
Several thousand years ago the barter process began to be replaced by money. The key with money is that when people accept it, in exchange for something valuable, then they know that the money will be able to be used at some time in the future to obtain something else of value. Money has four functions: 1) It is a means of exchange, 2) It is a store of value, 3) It is a measure of value, 4) It is a means of deferred payment. Money must also have a number of characteristics: 1) It must be in limited supply, 2) It must be divisible, 3) it must be portable, 4) It must be durable, 5) It must be homogenous, 6) It must be generally acceptable.

Specialisation and the division of labour

In ancient societies, and through to the present day people have found that productivity is increased by the division of labour. This means that some people do some tasks while other people do others. Division of labour was relatively disorganised until the industrial revolution, at that time manufactures realised that by breaking down the production process into specialised tasks workers could develop expertise in carrying out a very small range of tasks and so productivity overall would improve. For example if a textile manufacturer employed 30 workers to produce woollen cloth, he would find that it was more productive to give them specialised tasks, carding, spinning, and weaving rather than allowing each worker to carry through the whole process. This coupled with mechanisation vastly increased output.

Income And Wealth

Income and wealth shouldnt be confused. Income is a flow of earnings, wealth is a store of value. The levels, and the distribution of income in a country determines the types of goods that will be produced and sold in that country. People on low incomes tend to spend their money on necessities such as food and housing, sometimes we can describe basic foodstuffs, cheaper clothing, public transport and so on as inferior goods. As incomes rise so consumption patters change consumers will tend to move away from inferior goods and necessities towards normal goods and luxuries. Wealth. The distribution of wealth in the UK is important. Wealth is unequally distributed in the UK, so that the top 1% owns 18% of the wealth, the top 10% owns 50% of the wealth and the top 50% owns 92% of the wealth. This is significant when it comes to issues like poverty and redistribution.

2. Demand, Supply, the Market and Elasticity.

Demand.
The demand curve slopes down left to right reflecting the fact that as prices fall more is demanded.

Movement along the Demand Curve.

Demand extends down the D curve or contracts up the D curve as prices change. Factors affecting demand. Most important is the price. Other factors include 1. Size of population, 2. income, 3. price of other goods, 4. advertising, 5. tastes and preferences, 6. fashion.

Shifting the Demand Curve.

The demand curve shifts when there is some change in consumers attitudes, or desires. This could be due to changes in consumer incomes, population changes, health issues, fashion, technological change, advertising or whatever.

Do these Examples:
1. The interest rate has gone down, and this has made it much cheaper to borrow in order to buy a house. Draw a graph to show what might happen to demand in the housing market. 2. Pokemon products are a craze that appears to be becoming less popular. 3. Rises in income have affected the demand for both foreign, and domestic holidays. Draw 2 graphs and write a brief explanation of each.

Supply.
This is the amount that producers are willing to bring to the market at various prices. If we show this on a graph we can see that generally, The supply curve slopes up left to right reflecting the fact that as prices rise more is supplied. Movement along the Supply Curve. Supply extends down the S curve Or contracts up the S curve as prices change.

Shifting the Supply Curve

Factors that can shift supply include: 1. The cost of raw materials 2. The cost of labour 3. The interest rate 4. changes in taxes and subsidies,
3

5. technological change, 6. weather conditions 7. the time period over which the changes take place.

The Market Price.

In Economics we say that the Market Price is determined by the forces of Supply and Demand. Price is at equilibrium, when the same amount is offered for sale as is being demanded. This is called various things including Market Equilibrium, and the Market Clearing Price. Equilibrium is the price that is agreed when buyers and sellers come together. Prices can change as attitudes of buyers or sellers change. Look at the list below and try to work out using graphs why the market price has changed. Over the last 10 years the average UK house price has risen from 98000 to 184000. In the last few months the price of oil has risen from around $70 a barrel to $95 a barrel. Recently Ford have decided to reduce their world supply of cars by 15% 4. Over the early 1990s, prices of Beef fell in the UK by up to 50%. More recently prices have risen back to early 1990s levels.
1. 2. 3.

We see excess demand or shortage when the price is below that which the market will pay. Conversely there is a surplus or glut when the price is above that which the market will pay.

Price Elasticity of Demand

Price Elasticity of Demand, sometimes called PED, refers to the responsiveness of demand to changes in price. PED = %age change in Quantity Demanded %age change in Price Price elasticity of demand tells us what will happen to total consumption as the result of a price change. If demand is price elastic then a price change will prompt a bigger than proportionate change in demand. If demand is inelastic then a price change will prompt a smaller than proportionate change in demand. This is illustrated on the graph. Price has fallen from P to P2. On the inelastic curve this has led to a small increase in demand, and overall spending on the product has fallen. By contrast the price reduction has led to a big increase in
4

demand for the product with an elastic demand curve, and therefore spending on this product has risen. By contrast a price rise has the reverse effect on total spending on elastic and inelastic products- cutting spending on those with a high PED and increasing it on those with a low PED. PED is generally represented graphically showing curves that are steeply sloped to indicate inelastic PED, and gently sloped to indicate an elastic PED. Calculate the following: 1. A 10% increase in price leading to a 25% decrease in consumption. 2. A 22% decrease in price leading to a 14% change in consumption. 3. A 30% decrease in price leading to a 44% increase in consumption. 4. A price fall from 10p to 5p leading to an increase in consumption from 25 000 units to 35 000 units 5. A price rise from 18p to 24p leading to a decrease in consumption from 55 to 24 units 6. A price rise from 10.60 to 11.40 leading to a decrease in demand from 5 000 to 4 500 units 7. A price fall from $8.60 to $6.70 leading to an increase in consumption from 1.2m to 1.5m units 8. A price increase of 33% and a cut in demand of 5%.

Income Elasticity of Demand

Income Elasticity of Demand measures responsiveness of demand to changes in income. YED = %age change in Quantity Demanded %age change in Income Normal and Inferior goods respond differently to changes in Income. When income rises demand for normal goods shifts to the right but demand for inferior goods shifts to the left when income rises. Eg, as incomes rise demand for cars (normal) increases but demand for public transport (inferior) goes down. In economics we use the term normal good to refer to any good that sees an increase in demand when incomes rise- it could be something like cars or ipods, or it could be something like luxury watches or jewellery.

Cross Elasticity of Demand

Cross Elasticity of Demand is sometimes expressed as XED. It measures the changing demand for one good as a result of the changing price of another. There are 2 important kinds of good here;- substitutes and complements. If a fall in price for one good prompts a big fall in demand for another then the goods can be said to be close substitutes, (a positive
5

relationship). On the other hand if a fall in the price of a good prompts a rise in the demand for another good then they can be said to be complements (a negative relationship). XED = %age change in Quantity Demanded of A %age change in Price of B

3. The Labour Market.

Labour is a derived demand- we want labour not because it looks pretty but because it carries out work. When we talk about the demand for labour there are a number of terms to be aware of: the population of working age is all those people between the school leaving age and retirement age in the UK who are theoretically available for work. The working population is those who are working and actively seeking work, and the workforce in employment is those who are actually working. There are a number of factors that help to explain what determines wage differentials: 1. Qualifications, skills, abilities, experience- the more of these you have, the fewer of you there are in supply. The higher the wages. 2. The financial value of what you do- a share trader working at a stockbrokers will probably add more to the value of the firms earnings than a cleaner at the same firm. They are likely to be rewarded accordingly. 3. Marginal revenue product this idea suggests that as the number of workers employed rises so additional output from each new worker falls. Firms will employ workers up to the point where the last person adds the same to revenue as he or she costs in wages. 4. Difficult or dangerous work. 5. Labour versus capital- another view is that labour is in competition with capital, if wages rise too much it might encourage employers to use more capital which has now become cheaper. 6. Trade Union power- train drivers might be able to push up wages because there are relatively few of them and it is a skilled and responsible job. It is also true to say that they have a strong union and they are a fairly vital group of workers. The minimum wage is currently 4.10 per hour for workers over 22 and 3.50 per hour for 1821 year olds. Draw a graph to show, and explain what will happen to a group of low paid workers if the new minimum wage increases their earnings from 3.80 to 4.10

Trades Unions
Trades Unions exist to protect the rights of their members. In a trade union workers have banded together to improve their bargaining power with employers. We talk about Unions engaging in collective bargaining with management over pay and conditions. What this means is that one representative of the workers meets employers to resolve disputes on working time, wages breaks, unfair dismissals and so on. There are 4 types of Union;- craft, industrial, general and professional association. It has been argued by some that over- powerful unions have damaged the UK economy. The argument goes that Unions have forced wages too high making British goods uncompetitive, they have forced employers to take on too many workers, or keep them on when circumstances change causing unnecessary costs, they have forced employers to accept unrealistic conditions for workers and they have been too quick to strike. Trade Union membership was at its highest in 1979 when there were 13 million members or 1 in 2 workers. By 1997 that had dropped to seven and a half million workers or around 1/3 of all workers. Today in 2007 there are about six and a half million trade unionists. The decline was due to a number of factors including the stricter laws imposed by Mrs Thatchers Government on Unions, she agreed with the anti- union views set out above. Her Government made changes that made it more difficult to set up closed shops, or vote for a strike or take industrial action including striking. It was also true to say that the trade union mark- up went down over the period making it less financially attractive to be a member. Unions are less powerful today than 25 years ago.

4. Businesses in the Economy.

The Aims of Firms. Firms can have a number of different aims. These five aims are common to most commercial organisations:1. 2. 3. 4. 5. to survive, to increase market share, to improve the quality of their products, to satisfy shareholders management, and staff, but the main aim of most firms is to maximise profits.

In economics we often assume that profit maximisation is the only aim. In order to calculate profitability, a firm must be able to calculate costs and revenues. Profit = Total revenue - Total cost Total revenue = Total cost = Fixed cost + variable cost

Fixed and Variable Costs.

As the names suggest, fixed costs are constant and dont change as output changes. Often these will include costs like: rent, repayment of bank loans, and basic wage bill. Variable costs will include things like: raw materials and components, overtime, fuel costs, and any other costs that can be directly tied to a certain amount of production. The important thing is that as output changes so does variable cost. A typical taxi firm might have the following weekly costs: Fixed Costs Rent of offices Bank loan repayment Staff wages Variable Costs Fuel Vehicle maintenance Driver overtime 300 500 950 10p per mile 30p per mile 5.00 per hour

We can also talk about things like energy costs that are semi- variable In that they dont change precisely with output.

Total, Average and Marginal Costs.

The total cost of production (TC) is all of the costs involved in a given level of output. The average cost of production (AC) is total cost divided by output, and is given by the equation TC/Q. The marginal cost of production is the change in total costs caused by producing one more unit of output. It is given by the seemingly complicated equation: MC= TCn -TCn-1

Long run costs: Economies of Scale.

Large firms have advantages in production over small firms. They can produce a unit of a good more cheaply than their smaller competitors. Thus the average cost per unit is lower. This is shown on the diagram. As output increases (Q) so Cost per unit (C) falls. At some point the firm will not be able to achieve any more economies of scale. We call that the point of productive efficiency. Internal economies are economies that the firm generates within itself. Examples include; a specialised skilled workforce and specialised managers, bulk buying, discounts on loans, lower average transport costs because lorries and vans are always full, the principle of multiples; that is having the right amount of capital at each stage of production, spreading advertising costs over more output, reduced interest on bigger loans. External economies are economies which arise outside a firm because of its size; Government agencies may be prepared to pay grants to a large employer if it intends to move to an area of high unemployment, Local Government may be prepared to make infrastructure changes such as increasing the capacity of an airport, or widening a road to help incoming firms, Local Colleges may run night classes in courses which will help employees at a new firm; for example Colleges in Wales ran courses in Korean and Japanese to help employees at inward investing firms.

Diseconomies of Scale
Diseconomies of Scale occur when production has gone beyond the point of productive efficiency. For example if workers are being asked to carry out overtime and they are not as productive or waste more resources through tiredness, or if machines are being overworked and so break down more frequently. Diseconomies often occur in organisations that have problems with internal communication- management dont know exactly what is going on, and what are the barriers to effective performance. Workers often dont get clear signals about what changes are required in working patterns.

Types of Business.
The main business types that concern us are: 1. Sole proprietor, 2. partnership, Private Limited Company, (Ltd), 3. Public Limited Company (PLC) 4. Franchises 5. Public Corporations (PCs).

Sole proprietors
Sole proprietors are the most numerous type of business, this is because they are easy to start, requiring little capital. The advantages of being a sole proprietor are: 1. own boss, 2. easy to start up, 3. keep profits, 4. tax affairs kept private, 5. use own name. Disadvantages, 1. unlimited liability, 2. lack of continuity, 3. lack of specialist skills, 4. difficult to raise capital.

Partnerships
A partnership usually requires a deed of partnership, and is a natural way for a successful sole proprietor to grow. Advantages of a partnership; 1. more specialist skills, 2. more capital, 3. sleeping partners have limited liability. Disadvantages; 1. lack of clarity in deed leads to arguments disagreements, 2. have to share profits 3. responsible for debts run up by partner.

Private Limited Companies (Ltds)

If a sole trader or partnership is successful then it will very likely grow. As the business grows it will engage in bigger more lucrative contracts and the risk will also grow. A way for this sort of business to reduce risk is to become a private limited company or Ltd. A Private Limited Company (Ltd) requires 4 documents;1. Memorandum of Association, explaining what the business will do, and its organisation 2. Articles of Association, explaining the rules of the company. These 2 documents should be sent to the Registrar of Companies. 3. Certificate of Incorporation, This is issued by the Registrar of Companies stating that the company is recognised as a legal organisation. The certificate allows the business to trade 4. Audited accounts must be lodged with Companies House once a year.
10

Advantages are; 1. limited liability; 2. this is a good way to grow, 3. A good way to raise extra capital 4. continuity, 5. the owners keep control because shares arent traded publicly. Disadvantages include 1. lack of privacy, company information must now be made public 2. disputes about the strategic development of the company.

Public Limited Companies (PLCs)

A Public Limited Company (PLC) requires the same documents as the Ltd. The difference is that shares can be traded on the stock market. PLCs tend to be the largest type of private business. Advantages include; 1. limited liability, 2. specialist management and workers, 3. the ability to raise capital. Disadvantages include, 1. lack of privacy- accounts must be published, 2. divorce of ownership and control 3. a conflict of objectives between stakeholders (workers, management, shareholders, the community), loss of control by the original owners, increased regulation.

Franchises
An agreement whereby one business sells to another the right to use its name, product, etc. This is a quick way to grow the business. Examples include McDonalds, The Body Shop etc.

Public Corporations (PCs)

These are sometimes referred to as Nationalised industries. Nationalised Industries were created mainly by the Labour Governments of 1945- 51 and 1964- 70. There were a number of reasons for the creation of Public Corporations: 1) the business would fail if it wasnt taken into public ownership, eg British Rail, and Rolls Royce, 2) the business was already a monopoly, and Government wanted to defend consumers from the bad aspects of monopoly, eg BBC, British Airways 3) the business was at risk from overseas competition and the UK Government felt that Britain needed its own domestic industry eg steel, ship building, 4) there was a socialist will to make a business a nationalised industry eg coal- mining.

11

5. Competition and Monopoly- how markets work

Competition
A Competitive market is a situation where there are a very large number of producers. A highly competitive market sees a lot of small companies competing to gain custom, all of them with products that are similar, or in the case of the perfectly competitive model, identical. There are 4 assumptions that we make about businesses and consumers in competition.
1.

There are no/few barriers of entry or exit.

2. There are many buyers and sellers 3. The product is homogenous meaning that there are no brands or differences between the goods that people consume,
4.

There is perfect knowledge meaning consumers and producers know all of the options available to them Decisions are made by consumers solely on price.

5.

Conservatives and free- marketeers like competition, they are in favour of a competitive solution to economic problems as they regard this as the most efficient way of solving economic problems.

Monopoly
Monopoly is when there is only one or a very few producers in the market. In the UK, a company with 25% share of a market is usually regarded as being a monopoly. This can happen for a number of reasons: 1. There are large economies of scale in a market (British Gas), 2. A producer has patents or copyrights on products (Microsoft), 3. Government has created a legal monopoly (Royal Mail) 4. A company has control of raw material supplies (De Beers and diamonds). In other words there are significant barriers to entry to the market. Monopoly is often regarded as bad by both free marketeers and Government because;- they can restrict supply, they reduce consumer choice, they can drive up prices. There are several other models of how firms work in the economy. The third is Monopolistic Competition;- this is when there are many producers but products are differentiated by branding and advertising. The fourth model of how firms work in the economy is Oligopoly, sometimes called Competition of the few. In oligopoly firms avoid price competition or price wars, they like to concentrate on non- price competition like branding advertising, quality technological advantages and so on. Supermarkets, car producers and oil companies are examples.

12

The Competition Commission

The Competition Commission is a government regulatory body. Its function is to investigate Monopolies and proposed Mergers in order to ascertain whether a Monopoly, or proposed Merger would is in the public interest. Broadly speaking the Commission starts from the point of view that the control of a market by a single firm, or small group of firms will not be in the public interest. As a result of this it is up to firms which dominate a market need to prove that consumers will benefit from a merger. This could be the case, for example a producer might need to be very large to obtain all of the economies of scale that are available.

Takeovers and Mergers

A takeover is when one firm buys another, a merger is when two firms voluntarily join together.

Horizontal and Vertical Integration

A horizontal merger occurs when 2 firms at the same level of production merge to become a single company. Eg Nestle and Rowntree. A vertical merger occurs when a company in the chain of production merges with a firm that precedes it, eg Cadburys and Cocoa growers or follows it, eg Nissan and Nissan dealers. It may well be that a merger will lead to the new single firm dominating, or obtaining a dramatically increased share of a market, as with Nestle and its merger with Rowntrees in 1989, or Stagecoach and its purchases of a number of local Bus Companies in the early 90s. A conglomerate merger is when two firms in different areas of activity join together, eg a bank and a transport company.

Nationalisation and Privatisation

Nationalisation. This is the process where the Government buys or takes an industry out of the ownership of individuals. The 1945-51 Labour Government engaged in large scale nationalisation of many of the biggest industries in the UK. Coal, steel, rail electricity generation and gas production were all nationalised at this time. The reasons for this were: 1. Provision of essential services for all 2. National defence 3. Regeneration of these industries 4. Create employment 5. Social commitment to public ownership Privatisation. The 1980s and 1990s saw the Conservative Government seriously reduce the numbers of Public Corporations. In the 60s and 70s the Public Corporations had often lost money and had to be supported by the taxpayer. The Government engaged in a series of Big sell-offs in which firms like BT and British Gas were sold to private shareholders. Conservatives viewed the Public Corporations as inefficient, over- manned, wasteful, with powerful trade unions imposing all sorts of restrictive practices. There was a lot of support for the idea of opening up the PCs to competition from private companies;- taking away the monopoly powers that often existed because the Government had created them (legal monopolies). Privatisation is a term that is used to cover deregulation of markets so that in the 80s the Government was keen on reducing the amount of interference red- tape that affected businesses. Critics argue that this led to things like the mis-selling of pensions in the deregulated financial services sector.
13

Mrs Thatcher argued that PCs drove up price restricted choice and were far too producerorientated. Another advantage for the Government of privatisation is revenue raising. The Conservatives regularly raised 5 billion per year in the 1980s in this way. This revenue went into public spending, and allowed Government to keep taxes down.

Private Costs and Externalities.

In economics we talk about the private cost and externalities of any activity. Private cost is what it costs the individual or business to carry out an activity. The full economic cost is what it costs the individual and the rest of society when we carry out an economic activity. For example, if a company chops down a forest then it will have all of the costs like labour, capital, transport and so on that are associated with that activity, all private costs. The externalities are all of the other costs, noise, congestion, pollution, the loss of an attractive amenity. These are borne by society. Clearly these are negative externalities, but there could be positive externalities such as training, employment, improvement of roads, and so on.

14

6. Market Failure
There are two ways in which markets might fail: 1. Some goods will not be provided at all by markets 2. Markets do not produce what consumers want 1. Goods which markets will not provide at all This occurs if the good is a Public Good. A Public Good is essentially unlimited in supply. This means that once it is provided for one person, it is automatically provided for everyone (nuclear defence, roads, etc), and that consumption of the good does not reduce the amount available for other people (Street lights). A private firm providing lighthouses will need to charge for its services. It cannot do so because of the Free-rider problem if the good is automatically provided for everyone, then some people can consume it without paying hence no-one pays, and the firm goes bust. 2. Markets do not produce what consumers want
a.

Monopolies restrict supply and raise prices. They limit consumer choice, and misallocate resources away from consumers to the firm. Externalities. See above. Markets over-produce goods with negative externalities, and under-produce goods with positive externalities. Information problems In the 1950s cigarette firms promoted their product as healthy, and the lack of information given to consumers meant they bought a product that they didnt really want!!!

b.

c.

Correcting market failure.

Governments can intervene into specific markets to correct these failures:
1. 2. 3.

Taxes Congestion charge, petrol taxes, etc are there to make individual consumers pay some of the external costs of their consumption. Regulation and control of monopolies Direct Government provision libraries, roads, lighthouses.

Government Failure
When Governments intervene in markets they can sometimes introduce the wrong policy at the wrong time in the wrong way, and actually make the market work less well than before. Eg: In an attempt to regenerate East London the 2012 Olympic Games will be staged there, at a cost of 9bn it is likely that this cost will outweigh the benefits.

15

7. National Income.
In a simple model of the UK economy, Households sell their labour to Firms in return for wages. In turn Firms sell goods and services to Households for payment. This is illustrated in the diagram. Goods and services flow from Firms, and consumers pay for those goods and services. At the same time Labour is provided to business, and workers are paid for that Labour. Obviously consumers and workers are very often the same people, and most consumption is funded through earnings made by workers. In a more complex model firms and individuals trade labour and products for wages and revenue, but there are also injections into, and withdrawals from, the economy. Injections include sale of exports, government spending, and investment. Withdrawals include savings imports, and taxes. We say that injections speed up the economy and make national income grow, while withdrawals slow down the economy and make it shrink. Draw the more complex model. The National Income is the value of all goods and services produced in the UK economy in a year. We measure National Income using Gross Domestic Product (GDP), this is the value of all income, or output, or expenditure over a time period, usually a year. Another measure is called Gross National Product (GNP) this includes incomes earned by British people and firms from foreign investments, but subtracts earnings by foreign national from investments in Britain.

In 2006 National Income was about 1300 billion.

Types of Production. In economics we talk about Primary, Secondary, and Tertiary production. Primary is the sector that gains raw materials and includes farming, fishing, mining, extraction of ore, drilling and so on. 2. Secondary is sometimes referred to as the transformative sector. It includes manufacturing, and takes raw materials and transforms them into finished goods. 3. Tertiary is the service sector, this is the part of the economy where products are sold and includes things like banking, retail, tourism, estate agencies and so on.
1.

A problem for the UK economy is a long term decline in primary and secondary, while tertiary continues to grow. When we talk about deindustrialisation in the UK we are referring to the decline of primary and secondary and the rise of tertiary. This could be a potential problem because as the UK economy grows we become more and more reliant on imported goods. This is not a problem if imports are cheap and easily obtained but it could cause difficulties in the future if prices rise or supplies are interrupted. If and when this happens we are likely to see imported inflation.
16

8. Measuring Economic Performance

As we said earlier, Gross Domestic Product is the measure of all value of goods and services in the UK. The UK is one of the wealthiest economies in the world and we are fortunate that we have amongst the highest earnings. The indicators used to measure how well a country is doing are: 1. 2. 3. 4. Growth in GDP Rate of Unemployment Rate of Inflation Balance of Payments Current Account

The Business Cycle

The Business Cycle measures the rate of economic growth over time. A business cycle tends to last for approximately 10 years. It is characterised by: 1. A period of rapid growth when output and consumption rise. This often then leads to inflation, which acts as a brake on growth, and can in turn lead to recession. 2. A period of decline/recession when the rate of economic growth falls. Usually unemployment rises over this period, and wages are depressed. This can make the economy more competitive.

17

9. The Government and the Economy.

The Public Sector is that part of the Economy that is controlled by Government. There are a number of different parts to the Public Sector: Central Government, Local Government, Public Corporations, (Nationalised Industries) Other bodies. The Public Sector provides us with certain goods and services which at some point in the past it was felt were not being properly provided by the Private Sector. There are a number of reasons for the provision of goods by the Public Sector. Some goods are what are known as Public Goods. This means that once these goods are paid for, then everyone benefits- for example we all benefit from the fact that Britain has an Army. We all benefit from street- lighting, and road traffic signs. As a result it is generally agreed that they will be provided by the state. Another reason is that certain types of goods would not be provided, or would be under provided by the private sector, for example Education and Health Care. In our society we have agreed that we want to see these goods provided to a minimum level. These types of goods are called Merit Goods. Left and right on Economics. In the past the debate in British politics and economics has often been between those on the left and in the Labour party those on the right and in the Conservative party. Broadly speaking Labour supporters favoured increased direct, progressive taxes, and more public spending to increase equality; Conservative supporters were much less concerned with equality and favoured smaller taxes, Conservatives are more concerned with the opportunities for entrepreneurs to succeed. Conservatives tend to favour the use of indirect taxes such as VAT and tend to be suspicious of the Governments ability to improve society with spending. Over the last 7 or 8 years this picture has changed somewhat; the Labour party is now less keen to spend under Tony Blair and prudent Gordon Brown. The Conservatives under David Cameron have begun to accept that some public services cannot be privatised.

18

10. Unemployment
Unemployment is defined as the percentage of the working population, able to work and currently claiming benefits (registered as unemployed). We talk about 4 types of unemployment. Frictional unemployment occurs when workers move from job to job we might expect around 3% of all workers to be frictionally unemployed at one time so that if the unemployment figure falls below that number we can talk about over- full employment and we risk production problems and wage inflation. 2. Structural unemployment occurs when an industry like coal- mining or ship- building is in long term decline and workers are made unemployed, often the nature of these industries means that a particular area or region will be affected- regional unemployment. 3. Seasonal unemployment occurs in sectors such as building and tourism where many more workers are required in summer than in winter. As a consequence of this workers are likely to have short term summer contracts and are likely to have to find casual or agency work in the winter. 4. Cyclical unemployment occurs when there is an economic downturn, and recession employers are likely to respond by downsizing their work force.
1.

Who suffers? There are a number of people and institutions that pay the cost of unemployment. Firstly, the unemployed themselves. Most of the workforce want to work, and they are upset at the loss of income and status that unemployment brings. Unemployment also causes ill- health and other social problems such as drinking and drug taking. Those in work suffer because the unemployed no longer contribute to tax revenue but instead are now a drain on resources, through the job seekers allowance that they are paid. The government loses revenue and needs to pay out more benefit, and the economy as a whole suffers because a scarce resource- labour is standing idle. What causes unemployment? There are 2 views and a variety of explanations. The Neo- classical view states that workers sometimes 'price themselves out of a job,' wage rises, trade union actions, and the minimum wage make it impossible for employers to take on, or retain as many workers as previously. In the diagram wages have been pushed up above the market rate by one of these factors and caused unemployment. Keynesians argue that the neo- classical view is too simple. Their view is that more employment is created if there is more spending, if in a recession there is more saving, or less borrowing to spend or a cut in government spending then this is much more likely to have an effect.

19

Possible cures for unemployment

Economists have identified a variety of possible cures for unemployment. These include:

Cause
Frictional

Cure
More information eg Job Centres, more regular contact between unemployed and job centre Retraining, information Retraining, Regional Policy Reduction in benefits, more information Government Spending

Type of Policy
Supply Side

Seasonal Structural Voluntary Cyclical (Keynesian)

Supply Side Supply Side and Demand Management Supply Side Demand Management, Fiscal Policy, Monetary Policy

20

11. Inflation
Inflation is a general rise in the level of prices over time. In other words if a tin of beans costs 30p today, it might cost 40p in a years time. Inflation erodes the value of money; 100 today buys a lot less than it did 10 years ago. Inflation used to be measured using the Retail Price Index, but for the last few years we have used the consumer price index (CPI) This is a weighted index that is measured by the government. It looks at a very large number of goods, and sees how their prices have changed over a period of time. The statisticians then check to see how important an item is for the average household and weight the value accordingly. For example, it might be that housing costs account for 2/5 of the average household spend. If mortgage costs rise by 10% then we multiply 10% by 2/5 to get a value of 4% added to RPI. If the other prices rise by 5% then we multiply 5% by 3/5 this gives us a value of 3%. These 2 values added together give an RPI of 7%.

The Causes of Inflation

There is an argument going on between economists about what are the most important factors in inflation. These are the 2 main views: 1. Monetarists argue that inflation is caused by the amount of money circulating in the economy; the money supply. If government spending increases, or if borrowing to spend on credit, or if savings are run down then there will be too much money in the economy if there is too much money in the economy chasing too few goods then this will cause prices to rise. 2. Keynesians argue that inflation is caused by bigger forces in the economy than just the supply of money. They point to the ideas of Demand Pull and Cost- Push. Demand Pull occurs when there is an excess of demand in the economy; consumers feel confident and go out and spend to reflect their confidence. This drives up prices. Cost Push occurs when the cost of factors of production rises. For example if oil or other imports rise in price then the costs of all sorts of production rise and consequently we get inflation. A problem that can come out of this kind of inflation is that workers then expect their wages to rise to keep pace with the higher prices. If the workers arent any more productive then these wage rises act as fuel for further inflation, and we get a so- called wage price spiral.

The Costs of Inflation

It erodes values, Inflation drives down the purchasing power of money- in periods of inflation money is worth less than it used to be.

Who suffers from inflation?

There are a number of different groups of people who can suffer as a result of inflation:
1.

Pensioners who are on fixed pensions- a pension that looks good when a person retires can quickly be eroded when a person retires. The higher the rate of inflation the quicker a fixed pension loses value. Workers who are unable to get wage increases in line with inflation. This is particularly problematic if the economy is suffering high unemployment, low growth and
21

2.

inflation,- so called stagflation. This problem often particularly affects unskilled and semiskilled workers.
3.

Savers who find that the rate of interest is lower than the inflation rate- over time the purchasing power of their savings is declining.

The problem of the erosion of values can be solved by index linking,- that is linking payments to the RPI. When this happens pensions and Social Security payments rise with Inflation, and in fact most of these payments are index linked. You hear older people say things like, 20 years ago 100 000 was a lot of money. This means that today the value of 100 000 as a lump sum has declined. This has been caused by inflation.

Why can inflation be so damaging for economic performance?

Inflation causes Uncertainty. High inflation means that we lose sight of the price that we should pay for things. In Argentina they are currently experiencing inflation at several hundred per cent, in those circumstances, with prices changing daily what is a fair price for something? In these circumstances producers will find it difficult to work out costs and therefore prices, foreign importers will not want to buy British because of the uncertainty, further damaging the economy. Inflation causes Unemployment. Neo- classical economists argue that inflation causes unemployment. Domestic consumers are treacherous,- they are quite willing to buy foreign goods if they are cheaper. And obviously if British consumers dont want British goods, why should we expect EU or North Americans to buy British? As well as this workers will demand increasingly high pay rises when they see the effects of inflation on their incomes,- further fuelling increases in costs As a result, rising prices leads to falling demand for British goods. As labour is a derived demand from products this leads, it is argued, to unemployment.

Who benefits from inflation?

Whilst most people would regard inflation as damaging to the economy, some can benefit from it. Those who can benefit include: 1. A mortgage holder- a mortgage is long term borrowing, and inflation cuts into the value that a mortgage holder has borrowed 2. Businesses that owe substantial amounts of borrowed capital. The same applies as with the mortgage holder 3. Someone with a big credit card debt- they will see the value of the capital that they owe decline.

Cures for Inflation

1.

Interest rates. The Bank of Englands MPC (Monetary Policy Committee) set interest rates every month. Recently rates have risen, but are expected to fall in 2008. If interest rates rise:

a. Consumers spend and borrow less. This reduces demand in the economy b. Firms borrow less, and reduce Investment

If demand in the economy falls, firms have too much stock, and are under pressure to cut prices (This in turn should lead to lower inflation).
22

2.

Controlling the growth of the money supply (monetarism) if money grows at the same rate as output, prices should not rise.

23

12. International Trade.

Ever since economic activity began countries have traded. Evidence shows that international trade has taken place over a very long period. The benefits of trade: 1. 2. 3. 4. 5. Choice Quality Prices Bigger market Economies of Scale

Absolute and Comparative advantage

We say that producers who use fewer resources to produce a given output have an absolute advantage in the production of that product. So India has an absolute advantage with motorcycles, and Britain with computer software. Some countries are better at all kinds of production than their trading partners, the question then becomes; is it worth their while to trade? The answer is probably yes. The reason is that they will be considerably better at some production and marginally better at others. The dominant country should focus on what it is far and away the best at, and allow the other country to produce that which they are relatively best at. If the countries don't do this, then both will lose out, because resources that are given over to one kind of production can't be used for anything else. This is the principle of comparative advantage. For example, in a world economy with just 2 countries, the USA might use fewer resources than Mexico to produce cars and grow oranges. Nevertheless it would be best if the USA focuses on car production as it uses a lot fewer resources to produce cars, and if it engaged in both kinds of production then it would have fewer resources for that which it is best at.

Protectionism
Protectionism means that the Government of a country restricts or prevents imports from other countries. There are 3 main methods of protectionism: Tariffs, Quotas, Regulations.

Advantages of Protectionism
The reasons for protectionism are generally to do with protecting and helping domestic industries, and we can probably identify 3 advantages: 1. Protecting a mature industry. A country that has a sizeable part of its workforce employed in a particular industry is unlikely to wish to see that industry destroyed by foreign competition. 2. Protecting an infant industry. New industries offer opportunities for countries to develop new specialisms and advantages, and governments will often want to prevent those industries being swamped by foreign competition. 3. Protecting domestic culture. If we think critically about UK TV, and popular music that is consumed in the UK we realise that a lot of it is imported. In some countries Governments will limit these cultural imports to protect domestic culture.

24

Disadvantages of Protectionism
Protectionism is the enemy of Free Trade. British Governments have long been strong supporters of the idea of free trade and we can certainly identify a number of advantages: Free trade gives consumers more choice. British consumers will suffer a lack of choice if they arent able to buy the lager that they would like. We would all be sad if we werent allowed Nike hats anymore. 2. Protectionism encourages inefficiency. It is argued that domestic producers wont have any reason for improving quality or cutting prices if they have a guaranteed market with little or no competition. 3. Other countries will retaliate. As was shown in the late 1990s when Britain refused to take American bananas, the American Government responded by putting high tariffs on a range of UK products.
1.

In many ways free trade looks good, however it is true to say that Japan has prospered while being quite a protectionist nation. A cynic might say that the best thing to be is a protectionist nation when everyone else is practising free trade.

The Balance of Payments

We divide the UKs international trade into exports and imports, and visibles and invisibles. Visibles are physical goods,- both finished goods, such as cars and clothing; and commodities- raw materials such as grain or oil. Invisibles are services, they are intangibles such as insurance, banking charges, interest, profits and dividends on overseas investments, transport services like shipping, and so on. We call the difference between visible imports and exports the Balance of trade.

Money flows
When we sell exports foreign buyers need to change their own currencies into s to pay for the goods and services, when we buy imports sterling needs to be changed into $s or euros to pay for the imports.

The Balance of Payments Account

This shows values for all overseas trade. There are two parts to the account. The current account shows the balance on visibles and on invisibles taken together. If we look at the figures, we can see that the UK generally runs a deficit on visibles or goods, and a surplus on invisibles or services. A structural problem for the UK is that the invisible surplus is not as large as the balance of trade deficit so we generally run an overall balance of payments deficit. This means that more money is flowing out of the UK economy than into it. The capital account shows the balance on investment, saving and borrowing. For example if a Spanish pharmaceuticals company bought s to establish a research plant in St Ives it would be a
25

capital inflow. When profits were returned to Spanish investors from the plant that would be a capital outflow. If a British music company buys shares in a Greek company that is a capital outflow, but when a dividend is paid that is an inflow. This is sometimes called the net transactions in UK external assets and liabilities.

A Balance of Payments deficit

For many years now the UK has suffered a B of P deficit on current account we spend more on imports that we receive from exports. Economists argue that this is not a good position because we have to pay for this deficit from our stores of wealth. This makes the UK poorer over time. It also makes the UK vulnerable to Import Inflation. A balance of payments deficit can be cured by: 1. Raising interest rates, or other measures directed at reducing consumption 2. Subsidising exporters/protectionism

Questions about the Balance of Payments Account

1. What would the money flow be if a Japanese Company bought a Scottish Shipbuilders? Which part of the account would it be shown in? 2. What would the flow be if a Norwegian Company bought a ship from the builders? 3. Which part of the account would it be shown in? 4. What would the flow be when the parent company took its profits? 5. Which part of the account would it be shown in?

The Importance of Exchange Rates

If the value of the pound is high, as it is currently, then that is good for importers, and consumers of foreign goods. It means that the price of imported goods is low, that in turn makes them more attractive, and can help to keep inflation down. (This is because a lot of every day items are imported and appear in the RPI). However this can be bad for the Balance of Payments because we are drawing in lots of imports (a withdrawal from the circular flow) which we find it difficult to pay for because we are selling fewer exports now that they are relatively more expensive. A If the value of the pound is low, then that tends to be good for exporters and people who are employed by exporters. It makes British exports more attractive abroad, and tends to prevent imports. This in turn can be good for the Balance of Payments. British consumers buy cheaper British goods and are less likely to buy expensive imports. However it can be bad for inflation because there are a lot of imports which we simply must buy and these are now more expensive.
26

Most usually the value of a currency is determined by the forces of supply and demand. If more people want to buy the pound then that will force its value up. People want to hold the pound for 3 reasons: 1. Trade. Foreign consumers need pounds to buy UK products, and we need foreign currency for imports. 2. Changes in interest rates. A rise in UK interest rates makes pounds more attractive. Foreign investors will buy pounds because the return is better 3. Speculation. Speculators gang up and take on a currency that they see as weak at a particular time. When this happens there is far more currency being traded than is needed for simple trade. Sometimes Governments have decided that the market should be allowed to set currency values, at other times they have decided that the destructive power of the market is to be controlled. The Euro. In January 2002 12 of the 15 countries of the EU joined to form a single currency, the Euro. Since that time a further 12 more countries have joined the EU. So far none of the new countries except Slovenia have joined the Euro however 6 are scheduled to join within the next year. In the UK we are more sceptical about a common currency than in some countries, and we foresee problems if we join. The advantages of the Euro include, price transparency, reduction of risk, trade creation and trade diversion. The disadvantages include public dislike, the possible lack of convergence, and the problem of another body setting our rate of interest.

Fixed and Floating Exchange Rates

Between 1972 and 1990 the value of the was allowed to float against the value of other currencies, this meant that its value rose and fell according to the level of demand in the market. This is known as a floating exchange rate. Between October 1990 and September 1992 the was in the ERM. This fixed its value against other currencies. However in 1992 the was driven out of the ERM because of speculation against it. Since 1992 the Government has practiced managed or dirty floating against other currencies. This means that the currency is allowed to float, unless its value is badly affecting a macro policy objective,- usually Balance of Payments or inflation. When this happens the Government will intervene to try to raise or lower the value of the . What about the Euro? We might go in, we might stay out. If we stay out then an interesting test will come when the , as it surely must at some stage, seriously weakens against other currencies including the euro. Will we expect other governments to help prop up the ? Will we try to dash into the euro area? Will we simply try to ride an an exchange crisis and poor performances against macro economic objectives?

27

13. European Union

The UK is a member of the EU. The EU is a Free Trade Area. In practice this means that there are no tariff barriers or quotas against moving goods around within the EU. It also is a Customs Union this means that all EU countries operate a Common External Tariff (the same tariff level) on imports coming into the EU, and restrict the importation of some products from outside the EU. Britain joined the EU in 1973. At that time the EU was known as the European Economic Community (EEC). When we joined along with Ireland and Denmark the number of member states rose from 6 to 9. Since that time a further 18 countries have joined bringing the current membership to 27.

The Institutions of the EU

The Council of Ministers. This is like the Cabinet of the EU, it is made up of the most senior Ministers in each of the EUs member states. It meets periodically to decide policy in different areas. The European Commission. This is the equivalent of the Civil Service of the EU. There are members from each of the 15 countries. Once the Council of Ministers has decided on a policy then the Commission makes it into a directive that is legally binding in each of the 15 countries. The Commission comes in for some criticism for being too bureaucratic, and too interfering.

The European Parliament

There are 785 members of the European Parliament. They sit in political blocs rather than by country. The UK has 78 members.

The Court of Justice

The Court of Justice is made up of 15 judges. The judges apply European legislation and their decisions are binding on the Governments of member countries. You can see from the examples below, drawn from the Court website, that it applies the rights that are set up in the Treaty of Rome such as the free movement of goods, and the free movement of workers:

Trade
In 1992 Britain signed the Maastricht treaty which removed any remaining trade barriers, or limits on the movement of goods and factors of production between EU members. The Maastricht treaty moved us to a Single European Market. The objective of Maastricht was to remove all the non- price barriers to trade are removed. Most of the UKs foreign trade is with other EU members, in 1994 50% of our imports and 54% of our exports were with other EU countries. Those who advocate that we should leave the EU really need to make a credible case to say that we would either be able to continue this large volume of trade without any penalties, or that we would be able to generate significant trade elsewhere.

28

Economic Policies in the EU

Some of the main policies of the EU include: 1. Agricultural Policy. Spending on agricultural subsidies accounts for around 50% of all EU spending. The main objectives of agricultural policy are to guarantee supply, stable prices, and to guarantee farmers income. 2. Competition Policy. The Eu aims to eliminate all barriers to trade between countries, increase competition, and increase consumer choice. 3. Regional Policy. The EU is much more interventionist than Conservatives would like, and of course, intervention requires government spending and therefore higher taxes. If the EU is enlarged east to include Poland, Romania, Bulgaria and so on, then this problem will increase. 4. The Euro. This single currency has applied to 11 of the 15 EU nations since January 2002. It is expected to increase trade and to make trade easier between member nations. Any new EU entrant will have to join in the Euro.

29

14. Macro Policy Tools.

Macro policy tools are the group of policies that Government can use to try and manage the economy. The most important Macro Policy Tools are:
1. 2. 3.

Fiscal Policy- Taxation and Spending Monetary Policy- Control of the money supply Supply Side measures- policies to make sure Labour and Capital are as productive as possible

15. Fiscal Policy

Fiscal Policy is the group of policies associated with taxing and spending. The focus of fiscal policy is managing the amount of demand in the economy. (Demand management). In the Year 2006 GDP was around 13000 billion, or around 1.3 trillion pounds. Government took around 39% of that in the form of taxation. You can see below where the Revenue will come from, and where it will be spent. Sources of Government Revenue as a %age of all Revenue in 2006 Income Tax 25%, VAT 16%, National Insurance 16%, Excise Duties 10%, Corporation Tax 9%, Other24% Areas of Government Expenditure as a %age of all spending in 20016 Social Security 28%, Law and Order 5%, NHS 14%, Industry 4%, Education 12%, Debt Interest 7%, Defence 6%. Direct taxes include income and corporation taxes, indirect taxes include VAT and excise duties. Direct taxes are usually said to be progressive in that they take larger proportions of income from those on larger incomes. Indirect taxes are often regressive in that they take larger proportions of income from those on lower incomes.

30

16. Monetary Policy.

This is mainly focused on the management of the Money Supply. The main tool used is the rate of interest. This is altered in order to help control the level of inflation. The central bank in the UK is the Bank of England. The Interest Rate is set by the Monetary Policy Committee (MPC). The idea is that low interest rates encourage borrowing and spending, home- owners with mortgages have more disposable income available, business people will be encouraged to borrow for investment so that it is likely to lead to an injection into the economy. If the economy is suffering inflation then the MPC may rise interest rates to choke off spending, this will lead to less disposable income, and less borrowing and therefore it will form a withdrawal from the economy. The Bank of England controls the level of the rate of interest through its issue of Government stocks- if it issues more stocks then the Banks buy them and there is less money available to lend, if it issues less stocks then the banks buy less and there is more money to lend. This is called Open Market Operations. There are a number of other tools that the Government can use to push up or bring down inflation rates. The Government itself borrows to spend on Public Expenditure, if it engages in overfunding, then it borrows more than it needs and drives up the rate of interest. The Bank of England can tell the High Street Banks what proportion of their deposits they can lend out, and they can also order them to make special deposits at the Bank of England.

Credit Creation
Whenever we deposit money, banks lend most of that money out. (In fact the Banks are required by law to hold onto only 5% of deposits as cash. So for instance if we deposit 100 then 95 are available for lending). When the Banks lend money out the loans that are made will in turn be spent. Thus the 95 that has been lent from our deposit will go to shops and other businesses. They will in turn deposit some of the money. A small proportion of this loan will be kept (4.75) and the rest (90.25) will be loaned out again. Already we can see that a lot more than our initial 100 deposit has been loaned, and the cycle can theoretically continue to generate around 10 000 worth of lending from the initial 100 deposit! Imagine a situation in which banks need to hold onto 20% of all deposits and you put in 20. Follow the process of credit creation through 5 cycles. How much has been deposited? How much has been lent?

31

17. Supply Side Policies

Supply Side Policies are concerned with improving the efficiency of supply of goods and services in the economy, in order to increase total production. Broadly speaking they aim to shift the supply curve to the right. Supply- side policies aim at increasing flexibility in factor markets, they want to make the use of factors of production more efficient, and to help factors move more quickly between activities. So for example supply- side economists will be in favour of policies that help workers move from one kind of job to another more easily such as retraining, or job clubs. They will also be in favour of policies that reduce the power of Trade Unions. Supply Side Policies also favour lower social security payments in order to encourage people to work. Supply Side economists aim at deregulating markets to make them more responsive to the consumer. They favour freeer trade, cutting taxes and bureaucracy on entrepreneurship, privatisation and deregulation. Supply Side Policies favour reducing red tape, in relation to planning decisions, so that it is easier to move land between different kinds of production. Supply Side economists also aim at increasing the sources of capital available to producersGovernments should make it increasingly attractive for ordinary people to buy shares.

32

18. Regional Policy

Regional Policy is concerned with the different levels of prosperity, growth and employment in different regions. Uneven economic development is a problem. Some UK regions have suffered severe economic problems due to declining industries, lack of investment, and structural unemployment. Where supply- siders favour little government intervention, those who believe in the use of regional policy would argue that the government must often intervene. Government can intervene by giving subsidies to firms, for taking on and training workers, giving firms that invest in a particular region tax breaks, so that they don' t pay all of their local or national taxes, or improving the infrastructure that surrounds particular investments sites. Some of the agreements and disagreements between economists and politicians on economic policy Free marketeers argue that as many public goods and merit goods as possible should be provided by the market. Individuals should provide their own private health insurance, social security insurance and so on. Other economists emphasise that certain goods wouldn't be provided, or would be underprovided by the free market and therefore the government must tax and spend. This is one of the key areas of disagreement between groups of politicians and economists. Historically the Labour Party has been the Party of more taxation and expenditure while the Conservative Party have been the Party committed to less taxing and spending. New Labour are much less committed to taxing and spending, and are as keen on privatisation as the Conservatives of the 1980s. Those in favour of high progressive taxes and high levels of government spending are in disagreement with those who argue for low taxes and the right of those who have earned the money to keep it. The left in this discussion favour redistribution and more equality while the right argue that there will always be inequality, and it is necessary if the wealth creators (entrepreneurs) are going to be encouraged to come up with new and different kinds of production and add to the total value of the economy. Supply siders and supporters of Regional policies disagree. The supply-siders argue that Regional policy is generally ineffective,- the most productive firms are penalised and taxed highly in order to support less efficient producers. They argue that it doesn't tend to create permanent long- term jobs but that it also gives an unfair advantage to those firms who go to the poorer regions. Those in favour of Regional Policy see the problems of those regions as permanent, and unlikely to be solved by the free market. This is what we mean by market failure. One of the reasons why the Conservative Party are becoming increasingly sceptical of the EU is because they see that EU economic policy is likely to involve more Regional Policy measures in order to help the least developed regions.. Free marketeers suggest that the problem of negative externalities, pollution, congestion etc is overstated while those who favour intervention and regulation see these costs as significant and important. The recent discussion about road pricing highlights the differences between the 2 groups. Some economists favour protectionism and control of imports whereas others favour free trade. Both sides have advantages and disaadvantages. Monetarists see the Money Supply as the key factor in the creation of inflation whereas Keynesians see aggregate demand, 'cost push' and attitudes as being more important.
33