ee 0030-1 0] |) Economics for the IB DIPLOMA “ / = "ee i oy saree | Paul Hoang .REVISION GUIDE Economics for the IB DIPLOMA Paul Hoang <> HoDpeER ? EDUCATION ZN HACHETTE UK COMPANYEvery effort has been made to trace all copyright holders, but ifany have been. inadvertently overlooked the Publishers will be pleased to make the necessary, arrangements atthe fest opportunity Although every effort has been made to ensure that website addresses are correct at time (of going to press, Hodder Education cannot be held responsible for che content of any ‘website mentioned in this book, Its sometimes possible to find a relocated web page by typing in the address of the home page for a website in the URL window of your browser Hachette Livre UK's policy isto use papers that are natural, renewable and recyclable ‘products and made from wood grown in sustainable forests. The logging and fnanufacturing processes are expected fo conform to the enviconmental regulations of the country of origin (Orders: please contact Roskpoint Ltd, 130 Milton Park, Abingdon, Oxon OX14 4SB. ‘Telephone: (44) 01235 827827, Pax: (44) 01235 400401. Lines are open 9.00-5.00,, ‘Monday to Saturday, with a 24-hour message answering service. ‘Visit our website at wiwwihodderedhcation.com, © Paul Hoang 2014 First published in 2014 by Hodder Education ‘An Hachette UK Company London NWI 3BH Impression number 5 43.2 1 Year 2016 2015 2014 All rights reserved. Apart from any use permitted under UK copyright law; no part of this, ‘publication may be reproduced or transmitted in any form or by any means, electronic ‘or mechanieal, including photocopying and recording, or held within any information storage and retrieval system, without permission in writing from the publisher or under licence from the Copyright Licensing Agency Limited. Further details of such licences (for reprographic reproduction) may be obtained from the Copyright Licensing Agency Limited, Safiton House, 6-10 Kirby Street, Loron ECIN 8TS, Cover photo © jgroup/iStockphoto IMlustrations by Aptara, Inc ‘Typeset in 10/12 Goudy Old Style by Apeara, Inc. Printed in Spain A catalogue record for this title is available from the ISBN: 978.1471807183 fish LibraryContents How to use this revision guide Getting to know the exam Assessment objectives and command terms Countdown to the exams Section 1 Microeconomics Section 2 Macroeconomics Section 3 International economics Section 4 Development economics Are you ready? My revision notes Glossary vii viii xii 58 111 143 170 175 178Dedications ‘This book is dedicated to Mr Graham Hollamby, my economics teacher at Southwark College, London, ‘My heartfete thanks and love to Kin, Jake and Luke for always puting up with me, [My sincere thanks to my publisher (and fellow Arsenal fan), So-Shan Au, for her help and guidance throughout this project. Finally, my gratitude to Samson Wong, an outstanding student who provided invaluable feedback from the perspective of an IB Teasner. Acknowledgements ‘The Publishes would like co thank the following for prmiston to reproduce copyright Photos: 'P- 86 © Tevangieayi Mulewazhi/AP/Press Association Images ‘Text: 1p 150: Figure 4.2, redrawn from htp//en.wikipedia.org/wiki/Listof-counteies-by- Human-Development-Index Every effort has been made to trace all copyright holders, but ifany have been ‘inadvertently overlooked the Publishers will be pleased to make the necessary arrangements atthe first opportunityHow to use this revision guide Welcome to the Economics forthe IB Diploma Revision Guide. This book will help you plan your revision and work through it in a methodological way. It follows the Economics syllabus topic by topic, with revision and exam practice questions to help you check your understanding. Features to help you succeed Ee ‘These tips give advice that will help These identify typical mistakes that Definitions are provided on the you boost your final grade. students make and explain how you pages where the essential key ‘can avoid them. terms appear. These keywords are those that you can be expected to define in exams. A glossary of other essential terms, highlighted throughout the text, is given at the end of the book. Worked examples Some parts of the course require you to carry out mathematical calculations, plot graphs, and so on. These examples show you how. EXAM PRACTICE Exam practice is given for the type of questions you might get. For the longer ‘essay questions, sample sentences and paragraphs are given to show what ‘examiners are looking for in your essay answers. For easy reference, the exam paper is indicated for each question. Use these questions to consolidate your revision and to practise your exam skills. EXAM PRACTICE (HL ONLY) ‘Some parts ofthe Economics course require you to carry out mathematical calculations, plot graphs and so on. There are sample Paper 3 exam questions. interspersed in the chapters, with suggested answers online, You can keep track of your revision by ticking off each topic heading in the book. There is also a checklist at the end of the book. Use this checklist to record progress as you revise. Tick each box when you have: f= revised and understood! a topic ‘= used the Exam practice questions and gone online to check your answers. Use this book as the comerstone of your revision. Don’t hesitate to write in it and personalise your notes. Use a highlighter to identify areas that need further work. You may find it helpful to add your own notes as you work through each, topic. Good luck!Economics for the IB Diploma Getting to know the exam Exam paper Duration Format Topics Total marks Paper t 1S hours Essay and? 50 Paper 2 1S hours Data response Band 4 40 Paper 3 (HL only) hour Structured questions All 50 At the end of your Economies course you will sit two papers ~ Paper I and Paper 2. Paper | is worth 30% of the final marks and Paper 2, 50% of the final marks. The other assessed part of the course (20%) is made up of the Internal Assesment, which is marked by your teacher. HL students will sit an additional paper— Paper 3, worth 20%. For HL students, Paper 1 is worth 30% of the final marks, and Paper 2 also 30% of the final marks. The other assessed part of the course (20%) is the Internal Assessment (or IA) which is marked by your teacher. Here is some general advice for the exams | Make sure you have leamed the command terms (e.g, evaluate, explain, ‘outline). There is a tendency to focus on the content in a question rather than the command term, bur if you do not address what the command term, isasking of you then you will not he awarded marks. (Command terms are covered on page x.) If you run out of room on the page, use continuation sheets and indicate clearly that you have done this on the cover sheet. The fact that the question continues on another sheet of paper needs to be clearly indicated in the text box provided. = Plan your time carefully before the exams Paper 1 Paper 1 (1.5 hours) contains two sections: Section A is based on, Microeconomics and Section B is based! on Macroeconomics. You will need to answer one of the two questions from each section. Part a) of each essay is worth 10 marks and part b) is worth 15 marks. Hence, the total number of marks for this paper is 50. a Irisnecessary to include definitions in the essays, so make sure you have Jeamed the keyword definitions in this book. = Asthe paper is only out of 50 marks, the questions cannot cover all aspects ‘of Microeconomics and Macroeconomics. It is therefore essential that you thoroughly revise the whole of Topics 1 and 2 of the syllabus so that you can tackle any questions that come up. The 10-mark questions do not involve any evaluation, but do require a ‘concluding statement that answers the question, The 15-mark questions do require an evaluation, = Wherever appropriate, inclule fully labelled diagrams and the application of real-world examples to substantiate your answersHow to use this revision guide ix Paper 2 Paper 2 (1.5 hours) contains two sections: Section A contains two data-response {questions on Intemational economics; you must answer one of these, which is ‘worth a total of 20 marks. In Section B you must answer one of the two data- response questions on Development economies, again worth 20 marks. The total marks for the paper is therefore 40. In Paper 2 you may be given a range of daca in various forms (e.g. diagrams, taphs, charts and data tables) relating to a specific ease study on International economies and Development economics. Questions will test your knowledge of Topic 3 and Topic 4 of the syllabus, and your ability to apply this to the given, case studies = Do not spend tao much time on one of the two sections, = Plan your time carefully (do this before the exam!). You should spend no ‘more than 45 minutes on each section, By practising past exam papers, you will be able to fine-tune your time ‘management; this may vary from student to student Choose your questions carefully. Look at all sections of the data-response questions before making your choices. = You will be required to provide definitions (for the 2-mark questions) and to I then supply is price elastic, ic. responsive to changes in price (see Figure 1.26). = IFPES <1 supply is price inelastic, ie. unresponsive to changes in price (see Figure 1.27), = IFPES = 0 supply is perfectly price inelastic, ic. a change in price has no impact on the quantity supplied, as there is absolutely no spare capacity to raise outpat (see Figure 1.28), ‘= IF PES = 0 (infinity) supply is perfectly price elastic, ic. supply can change without any corresponding change in price due to the spare capaeity that ‘exists at the current price level (see Figure 1.29). = IFPES= | supply has unitary price elasticity, i. the percentage change in the quantity supplied matches the proportional change in price (see Figure 1.30). EXAM PRACTICE (HL ONLY) PAPER 3 14 Calculate the value of PES ifthe market price of beans increases from $2 per Kilo to $2.20 per kilo and causes the quantity supplied to rise from 10,000 Klos to 10,500 kilos. Q Keyword definition Price elasticity of supply (PES) measures the degree of responsiveness of quantity supplied ofa product following a change in its price alonga given supply curve.Section 1_ Microeconomics 17 Int cat, hn pico os om Supply ito Pa thre pont of spar SEH Copocty br ho oho ‘lant sipped con increase by {lec proparicn Fem Gyo Gp, ie sipiy pce lose Eagles of prods wh price laste supply ae massprodied (rocks os catboncd sok Sinks and wothpas Pice 181 ° a & ‘Gvonmy supplied Figure 1.26 The price elastic supply curve 7 In this case, when price ies from eel P; to Pa, there ie vor le spare ‘capo forthe fm, $0 the ‘Quanity supplied con only isa by {smaller proportion ftom © to Op. Exar are fesh fut and ‘agate thal take te to grow bo spp is rlavely Uuwesponsva Yo changes in price, Price ° ae ‘Qvoniny supplied Figure 1.27 The price inelastic supply curve Here, supply is pefcty ple Supely inlosc a G Inespocine of pico changes, fs fim can only apply ‘ rresimom of 30 changer in Price have no pt one ent suppliad. Le. PES = O. An Sel tel ssn ore concert hal hat comet ‘cconmods mex hen the seating copay Price (8) Quantty supplied Figure 1.28 The perfectly price inelastic supply curve Hote, spy spac pce sas a Oped P For angle, Dual mht have & huge sock of bas, so Supe, Gry nesease nde sail py tea n mere Drcal bots Belna {2 who pre bang oe Hono, os uary supped cam inemata hom Gy No Gy ierpectve ofa price change, he PES om ° a & ‘Quariy supplied Figure 1.29 The perfectly price elastic supply curve18 Economics for the IB Diploma Any supply curva sis frecrignfarhos y, Ser sl fos PES volves equi 1 Us “his hoorteal ovtome meats ata change n pice 5, couts tho samo prpanonal chonge quant uppled ° (Quantiy supplied Figure 1.30 The unitary price elasticity supply curve Mathematically, supply curves have a different PES value at different points. ‘Supply is more price elastic at lower prices and more inelastic at higher prices. EXAM PRACTICE (HL ONLY) PAPER 3 15 Angry Birds isa highly popular video game created by Finnish company Rovio, \with over 12 millon customers having paid $0.99 each to download the game from Apple's App Store. With the use of an appropriate diagram, explain why the high level of demand for Angry Birds games has no effect on the selling price, [4] Determinants of price elasticity of supply ‘= The time period ~ Supply tends to be price inelastic in the short run, for ‘example the supply of fresh vegetables is dependent om the time it takes to harvest the products. In the long run, firms can adjust their levels of production according to price changes in the market. 1 The level of stocks ~ Firms with high inventories (stocks of unused raw material, ‘work-in-progress and finished goexk) tend to have relatively price elastic supply as they are more able to respond quickly to a change in market prices. The degree of spare productive capacity — A firm with plenty of spare capacity ‘can increase supply with relative ease (without increasing its costs of proxluction), so supply is relatively price elastic, The opposite applies for the long run, = The case and cost of factor substitution - The easier itis to substitute factors of production (such as labour and capital), the more price elastic supply tends to be. Similarly, the more mobile factors of production are, the ‘greater the PES will be, ceteris paribus Applications of price elasticity of supply The determinants of supply elasticity can be remembered by the acronym Tics: Time Inventory (stocks) Capacity Substitution (of factors of production) ‘= Firms that have a high PES are highly responsive to changes in price and other market conditions, so this makes them more competitive, = The PES for primary products is relatively low due to the comparatively long time it takes to increase primary sector output, such as ol, iron, coal and agricultural harvests = By contrast, the PES for manufactured products is generally higher because ‘many of these ean be mass-produced in shorter time periods, for example toothpicks, nails and LEGO toys EIR (inventories). a sre ee ‘the products get to the customers). Peres eee een ‘mobility (to perform a range of jobs).EXAM PRACTICE (HL ONLY) PAPER 3 1G A 10% increase in the price of computer keyboards leads to an increase in ‘output of 20%, Calculate the price elasticity of supply of computer keyboards, following this change in price. Rl 1.3 Government intervention Indirect taxes Section 1_ Microeconomics 19 Ema ‘A key determinant of PES is the nature of barriers to entry. The existence of copyrights and patents, for example, reduces the number of potential firms in the industry and therefore lowers the value of PES, ceteris paribus. (a CI ra Specific taxes and ad valorem taxes and their impact on markets “Taxes arc levies (or charges) imposed by the government, thereby limiting the output of certain goods and services and/or taising the price of goods and services paid by consumers Indirect taxes raise the costs of production. Specific taxes cause a parallel shift in the supply curve to the left (see Figure 1.31), whilst ad valorem taxes pivor the supply curve (see Figure 1.32). The government will often intervene ifthe price mechanism fails to establish the socially optimal cquilibrium for example, taxing demerit goods such as aleohol and tobacco to reduce their consumption. Indirect taxes are a major source of government revenue. They can be used to correct market failures, such as imposing fuel taxes on motorists. On a macroeconomic scale, indirect taxes can be used to affect the level of aggreyate demand, by changing the rate of sales taxes, for example. They are used! to protect domestic firms from overseas rivals by imposing tariffs on imports. ‘The imposition of indirect taxes means that consumers tend to lose out as they have to pay higher prices, especially if he demand is price inelastic Producers alo lose our as their costs of production increase. However, if PED is low then they are able to pass most of the tax onto customers without largely affecting the level of demand. The tax also creates a deadweight loss (the combined lass of consumer and producer surplus), as shown hy the shaded area in Figure 1.31 Pa a ta Pico 8) pny to spactic tax. ° a a Guonmy unis Figure 1.31 Imposition of a specific tax Keyword definitions An indirect tax is a government levy on the sale of certain goods and services. Examples include specific taxes and ad! walorem raxes A specific tax, also known as a per unit tax, imposes a fixed amount of tax on each product. Examples inchide taxes on cigarettes, ait passenger tax and electronic road pricing and road tolls. ‘An ad ealorem tax imposes a peteentage tax on the value of a good or service. Examples include property taxes, tariffs (taxes on imports) and sales taxes. The specific tx causes a parallels in the supply eve fom S; Sp Inleoting an inctease In eoas of predicton, Ths raises the matlet equim pce om FP edz he fod from Qy 10 Gp, The verical Isiance botwoon 5} and Sy she val ef the20 Economics for the IB Diploma Tha ed valorem (perconiagel tox causes @ 5) uct cht inthe supply eur ram S) te aA Sy becatee the sbsceomcun of he ox Bh, ‘areae che mee pro increas oe = indicated by the two red orrows). The higher price redvces the equiloam quaity traded from G) 10 Gy ° eo {Gwony uns) Figure 1.32 Imposition of an ad valorem tax Tax incidence, and price elasticity of demand and supply (HL only) A greater proportion of the incidence of tax falls on consumers if the PED is low, ic. there is a lack of substitutes. This means that firms can pass on most of the higher costs to consumers (see Figure 1.33). The opposite is true when demand is price elastic, i.e. producers are unable «0 pass on most of the indirect tax co the consumer because customers are highly responsive to an increase in price (see Figure 1.34) Ifthe PES is high, consumers pay a greater proportion of the incidence of tax. This is because firms are less able and willing to supply if production costs ,s0 buyers end up paying a greater burden of the tax (see Figure 1.35), The imposition ofa spacticindvet tx shits the supply cure fom §) 19 Syoq thus ring Ste equlleram pics from Py fo"F. With the relatively price Inelatie demand curve, mast the incidence of he tx spt by Consumers (chown by the area in creng). Th rst of he fox f pad by the producer shown bythe crea > in rod ° @ a ‘vant units) Figure 1.33 Tax incidence and price inelastic demand Het, he lot prceelaite demand mans thet ar plenty of ther susttes, so the fim Canna smply poet on ha fx fo consumer In fem of ier pes, The hgh ED mans nso ll ba ry fesponse fon reese impresThs, th odie poy fe Lxger ropotion of tho as icidence {Quanity ents Figure 1.34 Tax incidence and price elastic demand Soon Here, the relatively price elastic supply cone means fms are highly responsive 1 changes in rice, so must poss on the tax consumars in ode for them fo be able to supply. Thus, ‘he consumer poys the loiger proportion ofthe tox ineldance Price (8) z > oP ‘Quon unis) Figure 1.35 Tax incidence and price elastic supply The incidence of tax falls mainly upon the stakeholder group (consumers or producers) that is less responsive to Changes in price, Le. the group that has the most price inelastic function.Section 1_ Microeconomics 21 Cay euch a eA) PAPER 3. 10 20 30 40 50 ‘Quanity (000 unit 17 With reference to the above graph, calculate the following: Total tax revenue collected by the goverment from the imposition of this tax, QI bb Incidence of tax paid by the consumer. ri ‘¢ The change in consumer spending (or producer revenue) following the Imposition of the tax. pI The deadweight loss resulting from the tax. Rl The value of the producer surplus after the imposition of the tax. Rl {The change in the value of consumer surplus after the tax has been imposed. a Subsidies nope rere Impact on markets impacton markers ae Subsidies reduce the costs of production for firms, thus shifting the supply curve ‘outwards to the right (see Figure 1.36). Subsidies are given to producers for ral reasons Toencourage the output of merit healthcare services. = To limit negative extemaliti technologies. = To protect certain industries and to prevent a subsequent decline in ‘unemployment. ‘Consumers generally benefit from subsidies as the market price is lowered, thus more people are able and willing to buy the good or service Producers also benefit from the subsidy as theit production costs are reduced This helps to improve their competitiveness and profitability. Whilst the government spends money on financing the subsidy, and there is ‘an opportunity cost in doing so, the net benefits to society may outweigh the costs (in theory, at least). However, subsidies distort market forces and may subsequently protect inefficient firms, goods such as education, training and such as pollution by subsidising ‘green’ The subd enable fm o produce more pt ord eh on every love of cue, ines he wc fom 8 ‘is eke ale pce fom 0 8, with quantity aed essa fom Qo Gs, cate pars, once, procuers poss tie goon ecton oe bs {ontuoss ond rin th re econ for _owerngprcicton ons ) z> Fu ° aa Gori jn) Figure 1.36 Subsidies and markat outcomes Keyword definition A subsidy is financial assistance from the government to encourage output (such as the sale of exports), tw reduce the price of certain merit soos Guch as education, training ‘and healthcare), oF to keep down the cost of living (such as food prices).22 Economics for the IB Diploma Cay euch a eA) PAPER 3 18 Suppose the demand and supply functions for a product are given as: (Q4= 100 5P Q,=20+3P a Calculate the equilibrium price and quantity Bl bb Calculate the price required for producers to sell 80 units. rl ‘© Suppose the government grants a $2.67 per unit subsidy on the product. Calculate the new equilibrium price and quantity, BI Using your answers from parts a and c calculate the difference in consumer spending on the product, i) Calculate the total amount spent by the government on the subsidy. [2] Price controls GE Price ceilings: rationale, consequences and examples A price ceiling can be used to protect the interest of consumers fom scaring prices, such as escalating rents ot food prices. Following the imposition of a price ceiling, consumer surplus is increased but prexlucer surplus is reduced. ‘Consumers can benefit from the lower price after the imposition of the price ceiling (see Figure 1.37). However, price ceilings distort market forces and therefore can result in an inefficient allocation of scarce resources. This creates, a deadweight loss (see Figure 1.38). The excess demand can cause non-price rationing mechanisms (systems t0 restrict the allotment of goods and services). Examples include queuing (using waiting time as 2 means of distributing products), ration coupons (tickets that centile individuals to buy a certain amount of a product) and mostfavoured customers (those who receive special, preferential treatment). Maximum prices can also cause underground parallel markets to appear due to the shortages in supply. In Figure 1.37, traders in parallel markets will charge the high price of Pi Keyword definition A price ceiling (also known as a maximum price) occurs when the government sets a price below the market equilibrium price to encourage ourput and consumption. ‘The maximum price, in his ease imposed to contol residential ens, results in mere demand (0) ham i supplied a he Lona price (P3)This = results in excess demand, as shown by the area 2", feseinneee averse ora 4] ne ae i Saree Sy 0 Qvony (uns) igure 1.37 Impacts of price ceilings Deodvoigh be Th meni pice raciessppl tS, creng 0 sotoge. Ths weds bah orm Ge peda pc iil shaded Sra, << Preocting deadweight soc well es S 0; (ua nts) Figure 1.38 Welfare loss of price callingsSection 1_ Microeconomics 23 Cay euch a eA) PAPER 3. ‘Quon unis 19 With reference to the above graph, identify the following: a The change in the value of consumer surplus following the imposition of the price ceiling. Rl bb The value of producer surplus after imposition of the price ceiling. [1] ¢ The change in the firm's revenue. RI The value of the shortage in the market, Rl Price floors: rationale, consequences and examples me rrr Excess supply occurs when a price floor is imposed above the market equilibrium price, because supply outweighs demand when prices are so high, (sce Figure 1.39). “The minimum prio, in this care fred fo cogil formers ghee an incentive Fr frodices to supply mexe [Shon Is demanded {Byatt Meher pice (i ose im cess suey hon by feceop omnge. The Sup bought af price of P, bythe {gommnen 0 support hs fomats ard eleased Sho he market cng fies of bod hanes! fo Sebi food pices Price (8) ‘Quon unt) Figure 1.39 Consequences of price floors A price floor guarantees suppliers higher price than before. This also applies in the labour market where more workers supply their labour services if there is «1 minimum wage (sce Figure 1-40), ‘The national minimum wage NMUV fs imposed above the equilbrium wage rate, fo ensure al ‘workers have @ decent Income, However, this resus nthe apply of labour |G) being greater than the demard for kabour (0) In theory, the NM ross in excess supply of labour, ie, the higher cos of labour cause unemployment, colors panbus. Wage ce (8) ° a a ‘Gvonty (labour Figure 1.40 Consequences of a minimum wage Keyword definition A price floor, also known as a minimum price, is the imposition of a price guarantee set above the market price to encourage supply of a certain good or service.24° Economics for the IB Diploma The inefficient allocation of resources results in a deadweight loss (see Figure LAL), Price foot ‘The minimum price reduces demand to Oy, creating © suphis. This reduces both constiner fond producer surplus ox shown by the choded trea, 29 thee is. 8 deadweight less o social. Price ($) oD Si {Guonity (units Figure 1.41 Welfare loss of price floors ‘Consumers tend to pay higher prices if price floors are imposed, EXAM PRACTICE (HL ONLY) PAPER 3. 20 Refer to the diagram below and answer the questions that follow. (Quantity ons) Explain what situation arises ifthe government imposes a price floor ‘of $30 for the product. 'b Calculate the change in consumer spending following the imposition of the price floor. ‘© Caleulate the change in producer revenue following the imposition of the price floor. 1d Suppose the government exports all the excess supply at $20 per unit. Calculate the amount of taxpayers’ money needed to support this price control scheme, ‘Whether a NMW causes unemployment is debatable and empirical studies are not conclusive. For ‘example, the higher wage rates fuel extra consumption in the economy, thereby creating employment ‘opportunities, The government might also have other priorities, for example to correct market failure in the labour ‘market, such as the exploitation of low-skilled labour, to combat poverty in the economy or simply to create incentives to work.Section 1_ Microeconomics 25 1.4 Market failure The meaning of market failure Market failure as a failure to allocate resources efficiently Examples of market failure include: ‘= under-provision of merit goods, such as education and healthcare, as these services would only be provided to those who were willing and able to pay ‘= under provision of public goods, such as strect lighting and public roads, because producers cannot exclude those who do not pay from benefiting from the provision of the service ‘= overprovision of demerit goods such as tobacco, alcohol and gambling (as, there isa lack of government intervention in such markets) ‘= abuse of monopoly power — changing customers prices above market ‘equilibrium —and hence the associated inefficiencies. Market failure occurs when the price mechanism cannot allocate resources efficiently but causes extemal costs or extemal benefits of production or consumption. = Private benefits are the benefits of production and consumption enjoyed by a firm, individual or government. 1» Private costs of production and consumption are the actual costs incurred by a fim, individual or government. = Social benefits are the true (or full) benefits of consumption or proxluction, i.e. the sum of private benefits and external benefits © Social costs are the true (or full) costs of consumption or production, ie. the sum of private costs and external costs, Types of market failure Keyword definition Market failure exists when the price mechanism (the market forces of demand and supply) allocates scarce resources in an inefficient way, ie. there is either over-provision or under-provision of certain gooxls and services. The meaning of externalities Pee CI Marginal private benefit (MPB) is the additional value enjoyed by households and firms from the consumption or production (output) of an extra unit of a particular good or service. Marginal private cost (MPC) is the additional cost of production for firms ‘orthe extra charge paid by customers for the output or consumption of an extra Unit of a good or service. External costs (also known as negative externalities) are costs incurred by a thied party in an economic transaction for which no compensation is paid Examples of extetnal costs include: ‘= second-hand (passive) smoking ‘= air pollution caused by fumes from a factory = noise pollution from a nightclub or nearby aiepore litter on public beaches = child obesity from junk food and carbonated soft drinks ‘= climate change fuelled by continual demand for higher levels of consumption f= excessive advertising (known as advertising clutter) that causes visual blight. External benefits (also known as positive externalities) are benefits enjoyed by a thind party from an economic transaction, Examples of products with, extemal benefits for which no money is paid directly by the beneficiary include: ‘= national defence s» lawand order systems, for example police and emergency services Externalities (or spillover effects) are the external costs or benefits of fan economic transaction, causing the marker to fail to achieve a social optimum level of ourput, where marginal social benefits equal ‘marginal social casts (MSB= MSC)26 Economics for the IB Diploma flood defence systems sewage and waste disposal systems street lighting lighthouses public parks, libraries and museums public fireworks displays, Marginal social benefit (MSB) is the adked benefit to society from the production or consumption of an extra unit of output, i. the sum of MPC and marginal external costs. Marginal social cost (MSC) is the extra cost of an economic transaction to, society, ie. the sum of MPB and marginal extemal benefits. The production and consumption of public goods and merit goods exert positive extemalities. The production and consumption of demerit goods exert negative externalities such as pollution. Negative externalities of production and consumption Negative externalities arise from the production ot consumption of goods or services that create negative spillover effects on a third party. These products are known as demerit goods (see Figures 142 and 1.45), Examples include: cigarettes, alcohol, hard drugs, recreational drugs, junk food, prostitution and gambling, ‘Although it is assumed that people are rational economic agents, itis often the case that they are not the best judge of theie own welfare, so the government intervenes to discourage the prosluction andl consumption of demerit goods — for example, age limits for drinking, smoking and driving, msc + In. fee market without government Intervention, cufpie will Be at Cl where the MAC = MPB of production * However, he socially optimal love of MPC ice ‘higher pice of P. being charged, ‘Hanes, fom sociy’s point of view, ihete is overproduction of deme goods + The shaded aree shows the welore gain from reducing ouput ofthe 1PB-= SB demeiit good fiom Q,lo Figure 1.42 Negative externalities of production (of demerit goods) MsC= MC + na mata, ouput, ich eats he sesh opin eal Sire he MSC = AB of conan « The nage extomaiy cece rh Gores bowen he AS ond MB. « Hie tee omceimpn o deer goods ine absence of vara onion « Frese creo sows the wlio oe of consmpton (ot posi wah vege cnet) Price Figure 1.43 Negative externalities of consumption (of demerit goods) Culput sa Qs where MSC = HSB, wth Keyword definition Demerit goods are proxduets that create negative spillover effects (or negative extemalities) to society. Hence their production and consumption result in social costs being greater than private costs of production and consumption, ic. MSC > MPC. Eras ‘When price is set equal to marginal cost (P= MC), economic welfare is maximised, ie. consumer and producer surplus are maximised. This Is because the price that consumers are wiling and able to pay matches that of the producersSection 1_ Microeconomics 27 Policy responses to negative externali’ Governments try to solve market failure in two main ways = market-based policies — intervention in the price mechanism to make the market forces of demand and supply operate more effectively — for example, taxation and tradable permits = government regulations such as environmental standands Taxation is used to ‘intemalise’ negative externalities, i, the buyer and/or seller pay for the true costs of their actions without any burden being placed on third parties (see Figure 1.44) — for example, taxes on fuel, aleohol, tobacco and the use of plastic cartier bags. In Figure 1.44, the tax imposed on cigarettes has caused the supply curve to shift from S; t0 Sia causing price to rise from P; to P and the quantity demanded to fall from Qy to Qs. Remember that a specific taxis shown ae by the vertical distance between the a, aecierig eee ora zBh pays a higher price (P, —,) and the 6% producer pays the remainder (P, ~ F). ‘ ‘The more price inelastic the demand for ° or the product, the greater the proportion Quon of cigars ofthe tax paid by the consumer. Figure 1.44 Indirect tax on cigarettes Table 1.3 The advantages and disadvantages of Imposing a tax on the production or consumption of products with negative externalities ‘Advantages Disadvantages = It increases the price and therefore should decrease the = The demand for many of these products (such as quantity demanded, for example Ireland's tax on plastic cigarettes, alcohol and petrol tend to be price inelastic, ie. cartier bags aimed at reducing wastage and litter cut the tax may have little impact on the level of consumption, demand by 90% in the first 3 months of implementation. = The tax on many of these products is regressive, so has s It creates tax revenue for the government, which can be a greater impact on low-income earners than on high- Used on other goods and services. Scotland, for example, _ income earners. introduced a5 pence tax per single-use bag in October." It can encourage smuggling and unofficial market activity. 2013 following success in countries such as Ireland, Wales, Germany and Hong Keng. Another market-based policy is to use tradable permits. These are pollution rights issued to firms, thus capping the level of pollution from economic activity The policy ereates incentives nor to pollute so that excess permits ean be sold t0 other, less efficient, firms. ‘An increase in the demand for pollution permits would raise the price of pollution tights, just like in any other market, but without affeeting the level of ‘output and hence the level of pollution (see Figures 1.45 and 1.46). Hence, an increase in the price of tradable permits also increases the opportunity cost to firms that pollute, «Tradable permis can be highly effective in irtmalising negate frais of production. An increase In demon fr peas hom Dy to Dp singly ‘aus the price to rio fom P10 Pe, «The level of potion is copped by the ptfectly pice inelastic supply curve oF pollsion petmits Price of perm) Quon of permits Figure 1.45 Increased demand for tradable permits28 Economics for the IB Diploma + Oro ne, ho goverment might decide fo {uth number oF permis, Hus shitng the supply potion paris fem St 5 Ths cousts on ineecsa inthe pice of potion pris, creating on roentv—e for firms be mee Siento i nvet In clnanar tachreogiae + Goverment venue fom suing the 5 pants ncrooses fom ©, Py, 8, yf Shp, A. Gp do oho finely reo inclatic demand for he poston pois Price of paltion ° ao Guomiy of poumts Figure 1.46 Reduced supply of tradable permits Apart from market-based policies, governments ean also impose regulations to deal with negative extemalities from production and consumption. Examples include: = Taws to regulate where people ean drive, eyele and gamble ‘= laws to make it illegal for people to smoke, eat oF to talk on a mobile phone while driving f= motoreyelists being seat belts ‘= airport authorities regulating the number of night flights to limit noise pollution for nearby residents ‘= Tnws on the minimum age that a person must be before being legally allowed to purchase cigarettes or alcohol, thus helping to reduce the consumption ‘of such demerit goods (see Figure 1.47). [tis illegal to sell alcohol in Iran, Bangladesh, Brunet Darussalam and Saudi Arabia. = regulations restricting where people can smoke. In many countries, smoking is banned in public places such as shopping malls, bars, restaurants, airports railways stations and the beach. nade to wear a helmet and car passengers having to wear Zz '* The ban on smoking In public places shifts i the demand cane Yor agaretes fom a tooo. : «areas hh uci of grees ar omorcod ofall dom C8 Gor i ° Quanity of eigareas Figure 1.47 The impact of regulations on the demand for cigarettes Table 1.4 The advantages and disadvantages of imposing rules and regulations to correct market failures Advantages Disadvantages ‘= Consumption of the good or service may Restrictions cause underground (illegal) markets to develop where the be reduced. ‘goad or service can be purchased, often at a vary high price. ‘= Awareness of the negative impacts of ‘= The government has no control over the quality of the goods produced demerit goods (such as drinking and in underground markets, which in some cases can be dangerous for driving) may change the behaviour of consumption, such as illegaly distilled vodka or contaminated baby milk. people in the long term, powder, = Awareness of the positive impacts of «= People may stil choose to break the rules — for example, underage smokers consumption of merit goods (such as and drinkers of alcohol can bypass the law by obtaining false ID cards. education) is raised. ‘= The fine or punishment for ignoring the ban must be enforced and set high enough to discourage consumption of the good or service.Section 1_ Microeconomics 29 EXAM PRACTICE PAPER 1 241 With the aid of a market failure diagram, explain why a government might use congestion zone charging to reduce the use of motor vehicles in city centres Government regulation can be very effective in correcting market failures. Parents in the UK get fined if they do not send their children to school, and from 2015, full-time education in the UK will be compulsory for children Up to the age of 18, The Hong Keng {government imposes a fina of HKS 1500 ($193) for each item of ltering and for such as London and Paris [10] ‘ bs smoking in public areas Positive externalities of production and consumption Examples of merit goods include education, healthcare provision, training, research and development expenditure, and the proviston of public sports and recreation facilities (such as public swimming pools, sports grounds, museums | Keyword definition and public libravies). Meri goods are deemed to be of value by society (due to the positive extemalities of production and consumption), ie. they improve the general standard of living in the economy. Price (8) ° ae Out Figure 1.48 Positive externalities of consumption of @ merit good In Figure 1.48, positive externalities exist because MSB > MPB of consumption at all levels of output. This is due to the existence of positive extemalities of consumption. Hence, there is market failure at the feee market equilibrium (Q, and P,), ie. there is underconsumption of the merit good ‘The socially desirable level of ourput is where MSB = MSC, i.e. at output level Qs. The shaded area in Figure 1.49 represents welfare loss due to the tunderconsumprion. With government intervention, resources ate more efficiently allocated with a greater level of output at Qs. +The fa meat falls 0 supply goods wath postive eemalites at the socly optimum Fovel of ouput, 9. whore MSC = MSB (eral Ps and Gi). + There i undexpovision ofthese goods ond services os put only G, causing the ae price 1 be higher at Py i «The chaded arza reprsants tha welare lass fe foscetatad with fa market Faure ance production is wer than the sockaly optimum level) ot Q, ond price ot P, * Government inisvention means that ouput increases fo tha sacialy optimum level, Le ‘at Qvand a fall i pics oP ° aa Output Figure 1.49 Positive externalities of production Merit goods are products that create positive externalities (spillover effects) when they are produced tor consumed. Hence, the social benefits from the production and consumption of merits goods are greater than the private benefits Do not confuse the definition of public goods with that for merit ‘goods. Both the state (public) and private sector of the economy provide merit goods, such as education and health services. Merit goods can also be rivalrous and excludable, for ‘example selective grammar schools, single-gender schools, religion-based ‘schools or private health clinics30 Economics for the IB Diploma Government responses to positive externalities A subsidy is a sum of money given to a producer to reduce the costs of prexluction (to encourage higher levels of output) or to consumers to reduce the price of consumption. For example, governments often subsidise public transport to discourage people from using private ears (see Figure 1.50). + thus operotorsreceve 0 ssid, ther prediction cos al, ths shifing tho Supply rom MPC to MSC. 1 The sibsidy provides on incon for more people o consume the good, this thing damand fom M8 SB 1 Pce as fom Py to P, ad the qucrdly Semone neredsas fom Gy oy ° Gn, On [Quon of public anepa supply Figure 1.50 The effects of a producer subsidy on public transport In Figure 1.50, the specific subsidy is shown by the vertical distance between MPC ang MSC. The producer passes some of this subsidy to consumers in the form of lower prices (from P,, 0 P,) and keeps the remainder in the form of lower production eosts ‘An increase in the use of public transport, due to the subsidy, should lower congestion. Therefore the subsidy reduces the extemality caused by driving private vehicles In another example, the government in China provides a subsidy of up to 60,000 yuan ($9800) to buyers of electric and hydrogen vehicles in a hid to combat rising air pollution, Limitations of using subsidies to correct market failures include the following: = Just as with taxation on negative production and consumption extemalities, it is difficult to set a precise subsidy thar ensures MPC = MSC and MPB = MSB. '= The social return on the production and consumption of merit goods (such as education or the provision of libraries, sports facilities and museums) is difficult, if not subjective, to measure. 1 IF the price clasticity of demand for the good or service is inelastic, the lower price (due to the subsidy) has little impact on the quantity demanded. = There is always an opportunity cost in the provision of subsiclies as the money could have been used on other government projects. Legislation is another goverment response to deal with the positive extemalities of production and consumption. Laws are used to encourage greater consumption of goods and services with positive externalities such as ‘= compulsory education for children = the requirement for school children to be vaccinated against certain diseases. Advertising is a third approach to correcting marker failures by influencing behaviour, Le. informing and educating the public abour the benefits of| increased consumption. Examples inelude: = the ‘5-a-Day' programme nun in countries such as Germany, the UK and the USA in line with the World Health Organication’s statement that people should eat at least 400 grams (or five portions) of fruits and vegetables each day (see Figure 1.51) 1» schools educating students about safe sex and family planning ‘= advertising of health screening, for example to measure levels of cholesterol, blood pressure and risks of chronic illnesses such as diabetes, stroke and ‘= advertising about the importance of environmental protections, for example conserving energy, waste minimisation and recycling.Section 1_ Microeconomics 31 1 Elective advertaing sf the demand for hesh futs and ‘vegetables fom PB to SB. ‘This boosts consumes fom Gy ‘+ Hecthior people should mean less absences from work and school, with sorrel benefits to sockety and the economy. ‘vegetables © Price of fats ond wea_D~ se ° Oe Oe ‘Guaniy tuts ond vegottle) Figure 1.51 The impact of advertising on demand for fruits and vegetables Table 1.5 The advantages and disadvantages of education and advertising to combat the problems of market failure Advantages Disadvantages ‘= Behaviour and consumption patterns of individuals and» Not all advertising is effective, ie. advertising tactics may firms change ~ there is arise in the consumption of merit not necessarily work in changing peoples behaviour. goods and a fallin the demand for demerit goods. For It can take a long time to educate people and for the example, people learn about the dangers of smoking, so advertised message to be accepted and acted upon, fewer people smoke, 1» There is an opportunity cost of government expenditure 1» Successful advertising may lead to a cultural change on advertising, ie. the money might have been spent on in behaviour, such as healthier diets, increased use of something else deemed to be more beneficial to society. electric cars, recycling, waste reduction and the use of renewable energy. Direct provision of goods and services isa fourth government response market failure, such as provision of public teansportation services, education and healthcare. The key advantage of direct government provision is that meric goods and public goods become accessible to everyone, regariless of their income or social status. However, government provision also has its limitations: ‘= Economic inefficiency — healthcare services (such 2s the UK's National Health Service) might encourage consumption beyond the socially optimum level. If people do not have to pay for healthcare, they are more likely to overuse it f= There is an opportunity cost of government provision as the money could hhave been spent on something else, such as paying off government debt or possibly lowering tax rates. = In the case of a shortage of supply duc to excess demand, it can be difficult to decide who should be able to take advantage of the free government service, For example, the waiting list fora hip replacement operation ina ‘government hospital may be very long. Lack of public goods ‘The two main characteristics of public goods are: = Non-rivalrous — A person’s consumption of a public good does not limit the benefits available to other people. By contrast, a person’s consumption of a private good reduces the amount available for other individuals. = Non-excludable ~ Firms cannot exclude people from the benefits of consumption, even if they do not pay. Hence, private-sector firms are unlikely to supply public goods Examples of public goods inclucle: national defence, the emergency services (police, fire and ambulance), steetlighting, lighthouses, weather warning systems, public firework displays, radio broadeasts, drainage systems andl free downloadable apps for smartphones and tablet computers. By contrast, private goods are rivalrous (e.g. cinema or theatre tickets), excludable (e.4. airlines, restaurants and hotels) and rejectable (e.g. rice, books ‘or nail polish). Keyword definition Public goods are goods and services that exert positive externalities with two key characteristics: no rivalrous and non-excludable.32 Economics for the IB Diploma The lack of provision of public goods is another source of market failure. This, is largely due to the free rider problem — where these who do not pay cannot ‘be excluded from henefiting from the provision of public goods. Free riders are people who take advantage of the goods or services provided by the government but have not contributed to government revenue through taxation. ‘The existence of the free rider problem means that the market demand for a public good does not actually exist. In addition, its supply will be significantly below the social optimum level ~if it exists at all. Direct provision of public good is generally seen favourably as these improve well-being in the economy (since the MSB > MPB of proxluction and consumption). For example, most public goods would simply not be available if it were not for government provision. However, there is always ‘an opportunity cost involved in direct government provision. There is also potential government failure from intervening in markets, as governments do not necessarily know what is best for society. ‘Students often confuse merit goods with public goods. Whilst itis true that merit {goods and public goods both have positive externalities, public gaods (uch as rational defence and strealighting) are highly unlikely to be provided by private-sector firms due to the free-rider problem. By contrast, merit goods are excudable (e.g ‘education, healthcare and staf training) so are often provided by private-sector firs. EXAM PRACTICE PAPER 1 2 Explain how merit goods and public goods are examples of market failure. [10] Common access resources and the threat to sustainability Students often claim that public goods are those provided by the public sector. This is incorrect. Public goods have three key characteristics resulting in no incentives for any private-sector firm to provide such goods and services. Hence, the government must do so. However, this is a consequence, rather ‘than a definition, of public goods. Note that some goods and services are non-rivalrous and non-excludable only to some extent, for example public roads, There is rivalry to some extent (which is why we have traffic congestion) and there is some degree of excludabilty (as divers need a licence). Such products are known as quasi-public goods. —E, £, _____grrreqggsry ‘Common access resources are, by definition, not owned by any particular privare individual so are vulnerable ro overuse and abuse. Hence, they are often referred to as open-access resources. Examples of CARs include: forest, fishing grounds, rivers and the atmosphere. The negative externalities linked to CARs include: deforestation, overfishing, congestion, pollution, soil erosion, destruction of natural habitats and climate change. ‘The lack of an effective pricing mechanism for CARs results in overuse (or abuse), depletion and degradation of the resources because consumers «do not pay to use them. Clearly, this is inefficient and poses a threat to the sustainability of the common access resource. The tragedy of the commons describes the consequences of the abuse and inefficient use of CARS, where the users self-interest leads to the destruction of these resources in the long run. CARs and the resulting tragedy of the commons present problems for economic sustainability as it becomes difficult to maintain or preserve the resources for future generations The use of fossil fuels (those formed by natural processes, such as coal, crude oil and natural gas) to satisfy economic activity can pose a threat to sustainability. Fossil fuels can take millions of years to generate, so economic activity depletes these scarce, non-renewable resources The existence of poverty in less economically developed countries (LEDCs) can create a threat to sustainability because the over-exploitation of land for agricultural use can lead to negative externalities, for example soil erosion, Keyword definition Common access resources (CARs), also known asa common- pool resources (CPRs), refer t0 ‘communal or public property. They are rivalrous in nature, but are non-excludable. As these resources are used hy the general public, they suffer from overuse and therefore lack of sustainability ‘Common access resources differ from public goods because they are subtractable (overused) rather than nonevarous (the use by an individual does not diminish the amount available for others).Section 1_ Microeconomics 33 Government responses to threats to sustainability Legislation (laws and regulations) on the use of scarce resources include: f= Tnws to protect fish and marine life ‘= Tegislation to curb CO} emissions from cars and commercial vehicles, ‘A carbon tax is a per unit tax on greenhouse gas emissions. The purpose is to create incentives for firms (and households depending on the scope of the carbon tax) to reduce pollution in onder to reduce their tax liability. = Carbon taxes are set by assessing the pollution costs and the associated alministrative costs of controlling the pollution. = Establishing the correct tax level is key to the effectiveness of carbon taxes in responding to market failures. Ifthe tax is too low firms will simply continue to pollute, whereas if the tax is too high the escalated costs negatively affect profits, employment and consumers ‘Cap-and-trade schemes (CATS) are government-regulared emissions trading schemes using a market-based approach. The regulator sets a limit (the cap) ‘on the total amount of emissions allowed in an industry andl fiems are issued emissions permits ‘= Permits within a cap-and-trade scheme are freely traded (based on the price mechanism), allowing more efficient firms to sell their excess permits. This also creates an incentive for firms to develop clean technologies, = Whilst CATS help to reduce carbon emissions, they ean also raise a significant amount of revenue for the government: = The European Union Emissions Trading Scheme (UTS), set up in 2005, isone of the largest cap-and trade schemes. It aims to regulate economic activity to prevent dangcrous climate change. = Critics of CATS argue that they are anti-competitive (against smaller firms) and they can cause jab losses (due to higher casts of proshuction), Funding for clean technologies is provided by governments to create Incentives for fiems to adopt a sustainable approach. It includes: ‘= subsidies for the adoption of renewable energy sources, such as wind, sun and biomass 1» forest investment funding programmes to reduce emissions from deforestation and the negative impacts of forest degradation, However, policy responses to the threat to sustainability ate limited by: 1» the global lack of ownership of common access resources, f= the escalating global demand for scarce resources, including fossil fuels, due to higher levels of economic activity and globalisation f= the need for international cooperation to deal with these global issues threatening sustainability (such as deforestation, overfishing and climate change). Asymmetric information Asymmetric information exists when one economic agent (buyer or seller) in an economic transaction has more information than the other in a certain market — for example, life assurance policies, stock market products, pension fund schemes, second-hand cars and works of art. ‘The existence of asymmetric information between buyers and sellers in a market results in market failure and inefficiencies, ic. consumer and producer surplus are not maximised Governments can deal with this type of market failure ina number of ways: ‘= legislation, for example health warnings on cigarette packets ‘= regulation, for example rules and regulations about advertising (e.g. the UK's Advertising Standards Authority, which requites adverts to be ‘legal, decent, honest and truthful’) 1» provision of information, for example nutritional information on food packaging.34 Economics for the IB Diploma Abuse of monopoly power mm ‘The lack of competition means that profit-maximising monopolists are likely to supply less than the social optimum and charge higher prices, i.e. there is productive and allocative inefficiency. This results in a welfare loss for society, so the abuse of monopoly power (such as theie ability to exploit consumer surplus by using price discrimination) is a type of market failure. Examples of abuse of monopoly power include: ‘= monopolists charging excessively high prices ‘= collusion ~ the agreement between firms with market power to set higher prices = predatory pricing ~ setting low prices, perhaps below the costs of proxtuction, to force rival firms out of the industry. Possible government responses to the abuse of monopoly power (to prevent the market failing to reach an optimal allocation of resources) include the following: ‘= Legislation — Icis illegal in most countries for monopolists to abuse their ‘monopoly power, such as charging excessively high prices or cutting prices below production costs to force out rivals. In extreme eases, the government ‘can break up a monopoly if it becomes too powerful = Regulation — Rules are set by governments to control the operation of fiems ‘with monopoly power. For example, European Competition Law prohibits anti-competitive acts and the abuse of monopoly power. Rail regulators check ‘= Nationalisation — This occurs when the government takes control of Do not assume that monopolist an industry previously in the private sector in order to run it in the best are ae se ‘the scone. rete interest of the public. Government control of certain industries prevents the consider the extent to ir = Trade liberalisation ~ This refers to the reduction or removal of barriers Seer to the exchange of goods and services between countries. This creates TREC Manne S Hela ‘greater competition and thus reduces the potential for firms to exploit their jMterest of socety as a whole ‘monopoly power. EXAM PRACTICE (HL ONLY) PAPER 3. 23 Calculate the total value of the positive externality of production from the information in the diagram. rl ° 200 300 400 ‘Quon (200 unis)Section 1_ Microeconomics 35 1.5 Theory of the firm and market structures (HL only) Production and costs (HL only) Production in the short run: the law of diminishing returns (HL only) Keyword definitions ‘The short run is the period of time when at least one factor of production, such as land or capital, is fixed in the production process. ‘The long run is the period of time when all factors of production are variable, so all costs of production ate variable. Diminishing returns occur in the short run when a variable factor input (such as labour) is suecessively added to a fixed factor (such as capital), which eventually reduces the marginal and hence total output. In the short run, capital is likely to be a fixed factor because factory buildings, ‘machinery and capital equipment cannot be varied in the limited time period In the long run, the quantities of all factors of production are variable as there sufficient time to change output based on changes in the level of demand. © Average product refers to the output per unit of factor input — for example, the average product of labour calculates the value of output per worker. ‘= Marginal product measures the extra output due toa change in factor inputs. [tis calculated by dividing the change in total output by the change in factor inputs. ‘= Total product is the sum of all physical output for a given amount of factor inputs, for example the total output of the country’s labour force, The relationship between AP, MP and TP is shown diagrammatically in Figure 1.52. Opt rts Fctor inputs los Figure 1.52 Relationship between marginal and average product costs36 Economics for the IB Diploma Average product is maximised at the output level where the average product (AP) is equal co the marginal product (MP). This is because: = ifMP> AP the latter will rise = fMP< AP the latter will fall. Hence, AP is maximised when MP= AP. Total prostuct (TP) is maximised when the marginal product is equal to zero because: = ifMP>0 (ice. positive) TP will rise = IFMP-<0 (i.e. negative) TP will fall, Hence, TP must be maximised when MP = zero. ‘To understand the relationship between marginal and average product, consider the example of average and marginal homework arades. If your last (marainal) ‘essay grade is greater than the average of all your previous essays, this would increase your overall average essay grade. However, if your last essay was below the average of your grades then the average essay grade would fall Finally, if the marginal essay grade is the same as your average, then there is no change to your ‘overall average essay grade. Cay Neu ah g/ eA) PAPER 3. 24 Study the data below for two real estate firms selling residential property over a typical weekend. The number of units sold and the number of sales staff involved are also shown. cr BCL UTE) Teo ONG ‘Sharma Realty 3,950,000 10 8 ‘Mintjens Realty 3,800,000 14 10 Calculate the average product as measured by sales volume and sales value per worker for both Sharma Realty and ‘Mintjens Realty. Comment on which firm is more productive. 14) 25 a Calculate the missing average, total and marginal product values from the information show in the table below. [4] Pein ht no tas fone ea WORKERS) ° = 0 8 1 8 2 2 3 15 4 60 5 70 6 10 b Using your calculations, plot a diagram on graph paper to show the average, total and marginal product curve. [4] ¢ Identify the units of labour that maximise total product. 1Section 1_ Microeconomics 37 Cost of production: economic costs (HL only) Economic costs are the explicit and implicit costs of all resources used by a firm in the production process. Explicit costs are the identifiable and therefore accountable casts related to the ‘ourput of a product. Examples incluste wages, raw material costs, utility bills and rene Implicit costs are the opportunity costs of the output Le. the income from the best alternative that is foregone. For example, a student might give up the opportunity to work in a job that pays $25,000 per year and choose to study at university, which costs her $15,000 ‘year. The economic cost to the student is therefore $15,000 + $25,000 = $40,000 per year, Costs of production in the short run (HL only) ‘The shore run (when there is at least one factor input fixed in supply) will vary between industries —for example, the short run for aircraft manufacturers is longer than that for bakers Total fixed costs are production costs that do not change with the level of ‘ourput, for example rent, management salaries and loan interest repayments. Total variable costs are production costs ineurred directly from the output of 1 particular good or service — for example, variable costs for Emirates Airlines include fuel and in-flight meal Total costs are the aggregate amount of proxhuction costs spent on the output ofa given good or service. They are calculated using the formula TC=TFC +TVC Average costs are the unit costs of production. These are is calculated by dividing the total costs of production (TC) by the output level (Q) Ac= Marginal costs are the costs of producing an extra unit of output. They are calculated by dividing the change in total costs by the change in the level of output: aA AQ Mc: * The doumseropog scton of fo ‘SRAC curve is ceased by MC bing lower than AC. Mc {© AC wll reach ts minimum point when INC = AC, Le. a the minimum pola! SRAC onthe SRAC cone, ed SRA 6 When MC > AC, the SRAC curve will bgin to ie due lo diminishing marginal rehims 1+ Noses tha he rlationehip ie he same for fe cverage produc end margin product Coats (§) ‘o. ‘uantty Figure 1.53 The rel nship between AC and MC In the short run, average fixed costs (ARC) will continually fall with increased levels of output hecause the fixed costs are spread over an increasingly larger level of output. For example: = Assume fixed costs = $5000 and unit variable costs = Ar 1000 units of output, AFC = (5000/1000) + 10 = $15.0 ‘= Ar 2000 units of output, AFC = (5000/2000) + 10 = $12.5, Keyword definition Fixed costs, such as insurance premiums and advertising costs, do not change with the level of output. By contrast, variable costs (uch as labour costs and! raw material costs) continually rise with greater levels of ourput Students often state that fixed costs are those that do nat change. This is incorrect, as fixed costs can and do change ~ for example, rents and salaries can change over time. The key is that fixed costs are the same, irrespective of the level of output.38 Economics for the IB Diploma This relationship is shown by the short run average variable cost (SRAVC) curve. The vertical distance between SRAC and SRAVC is the AFC at each ‘ourput level. Notice that this is greater ac a lower level of ourput than at larger levels of output. EXAM PRACTICE (HL ONLY) PAPER 3 26 Calculate the following costs from the data below: fixed costs of production 2} average fixed costs at 10 units and 15 units of output BI ‘© average variable costs at 10 units and 15 units of output BI average costs at 10 units and 15 units of output BI @ the marginal cost of production pl CT TL eee COLL Veer) 2000 4545, 2850 5395 The relationship between the product curves and the cost curves are shown in Figure 1.54. i ac 7 + The Ushoped average cst (AQ) cane is << diminahing, |” caused by te law oF dminshing marge zl teu (DAM nthe sot + into some way, te worage rc [AM eR estar ces Bi wes in he APs G10 tower rate boore declining def he law of minting iinshing ge a la magn ee Onput ° Labour (ont) Figure 1.54 The relationship between marginal and average product and costs Produc (HL only) > OEE Increasing returns to scale occur when factor inputs are inereased hy a certain amount, leading to output increasing by proportionately more, Thus, average costs of production fal Decreasing retuens to scale occur when factor inputs are increased by a certain amount, leading to output increasing by proportionately less. Thus, average costs of production rise. nin the long run: returns to scaleSection 1_ Microeconomics 39 ‘Constant returns to seale occur when factor inputs are increased by a certain amount, leading to output increasing by the same proportion. Thus, average costs remain constant, Costs of production in the long run (HL only) ‘The long run average cost (LRAC) curve is ‘U'-shaped duc to economies and. diseconomies of scale (see Figure 1.55). The minimum efficient scale occurs when all economies of seale have been exploited, shown by the bottom of the LRAC curve. The LRAC curve encompasses all short run average cost (SRAC) curves. 1 The TRAC curva encompasses al SRAC cee, peetonng he minimum average costs of eoch lvel of cup 1 The lowe point on the RAC cue represents maximum ficiency, known os the minimum efter ecala WES) of production TRinimu aficient scale (MES) RAC, SRAC TRAC Corts ° ‘Guentty Figure 1.55 The long run average cost (LRAC) curve Internal economies of seale are generated and enjoyed within the firm that operates on a large scale. By contrast, external economies of scale occur within the industry, chus benefi economies of scale include the following: 1 Specialisation ~ Specialised labour (such as divorce or criminal lawyers, ‘economics professors and aircraft pilots) is highly productive in the ‘output of goods and services, thus helping to reduce the average costs of production, = Efficiency ~ Specialised machinery, equipment and tools can be used 0 their full potential to raise ourput (such as in car manufacturing oF the production of ball bearings), again helping to reduce the average costs of production, = Marketing — Effective advertising and branding boosts sales, so firms are able to produce on a large scale. For example, Nike and McDonald's are able to market their brands to a global audience, thus reducing their marketing costs per unit of sales ‘= Indlivisibilities ~ Large plants can only work effectively if large volumes of ‘output are generated, for example mass-produced cars, jam, soft drinks or bottled water. By contrast, product differentiation, such as bespoke wedding, dresses, leads to higher unit costs ‘External economies of seale arise from having specialised back-up services available in a particular region where firms are located. For example, Silicon Valley in California, USA is home to many of the best-known technology companies. Diseconomies of seale occur when a firm becomes too large to manage effectively, causing its unit costs to increase — for example, a firm increases its factor inputs by 50% but the subsequent ourput only increases by 20%. Diseconomies occur at all output levels beyond the MES point Internal diseconomies of scale are caused by problems of coordination, control and communication within a firm. For example, as fitms get larger, managers find it more difficult © coordinate, concrol and communicate with a larger workforce, resulting in higher unit costs. ‘Causes of external diseconomies of seale (those that affect al firms in an. industry) include: ‘= traffic congestion causing cests to increase ‘= higher rent costs due to the high clemand for firms locating in a certain area = labour shortages in a particular area, thus leading to increased labour costs. all firms, Factors that give rise to internal ee Students often state that costs of production wil fall as a firm increases the scale of its operations. This is not quite corract - clearly itis cheaper to produce 1000 cans of Coca-Cola than it is to produce 500,000 cans. However, itis cheaper to produce each can on a larger scale, ie. economies of scale reduce the average costs of production. ‘Whereas internal economies of ‘scale involve a movement down the LRAC curve, external economies of scale wil involve a downward shift of the whole LRAC curve, Likewise, internal diseconomies are shown by a movement up along the LRAC curve, whilst external diseconomies shift the Whole LRAC curve upwards.40 Economics for the IB Diploma Cay euch a) eA) PAPER 3 27 Cispian’s Candies has monthly fixed costs of $4800 and average variable costs elas Carats 400d ileal novi Tapers price is $4. Students need to demonstrate that a Calculate the average costs for Crispian's Candies each month, [2] they dearly eo the Cee i rari between internal economies of scale Balt the nits of ouput requ fo Cpls Candies to aj (whic at toa spect frn and reel 21 extemal economies of scale which ‘© Calculate the profit made by Crspian’s Candies each month [2] relate to the whole industry). Revenues (HL only) Total revenue, average revenue and marginal revenue (HL only) | Total revenue is the overall amount of money received by a firm from selling its entire output. For example, Nike and Adidas receive most of theie revenues from the sale of sports apparel and sports equipment. It is calculated using the following formula, where P= price and Q-= quantity sold: TR=PxQ Average revenue refers to typical price received from the sale of a good or service. [tis calculated using the formula: Anak ‘Average revenue (AR) is mathematically the same as the price per unit (P). This is because: Ape ot. Q and TR=PxQ oe Q Hence AR=P For example, if cinema ears $60,000 from the sale of tickets to 7500 customers, the average revenue (or average price) would be $60,000/7500= $8 per ticket. Marginal revenue is the extra revenue received from the sale of an extra unit, of output: [tis calculated by dividing the change in total revenue by the change in the level of output:Section 1_ Microeconomics 41 Mathematically, the marginal revenue (MR) curve intersects the axis at the mid-point of a downward sloping demand (average revenue) curve, as in. Figure 1.56. «The linear demond cune (overage revenue cune! is downward sloping due fhe kw of domnd «The marginal everve cur falls fice as dap os fhe AR cure. The ‘Ag cue con only decine fhe M4 falls ct faster rat, ‘| When MIP 0, fe ttl revenue wil fe ‘+ Wren MR < 0, fe total revenue wil fal ‘+ Hence, TR is maximised when MR = 0 Revenues [$) a ‘Ouput Figure 1.56 The relationship between marginal, average and total revenue EXAM PRACTICE (HL ONLY) PAPER 3 28 a Use the diagram below to calculate the total revenue at $16. Rl Identity the average revenue when 120 units are sold. Ml © Outline what the difference between area A and area B shows. R Students often incorrectly use the terms ‘cost’ and ‘price’ interchangeably, Remember, costs (of production) are paid for by firms in Price () ° 90120 the production process, whereas price isa meal Shady te ostorerte mcs Profit (HL only) a Economic profit and normal profit (HL only) ‘Normal profit is the minimum revenue needed to keep a firm in business Hence, it is also referred to as zero economic profit and occurs at the point where a firm breaks even by covering both economic and implicit costs from its sales revenue. Break even means a firm does not make a profit or a loss. This occurs when. Keyword definition price is equal ro average cost, of total revenue equals total costs, Le: Economie profit (abnormal profit) exists when total revenue exceeds P=ACorTC=TR the economic costs of a transaction, Economic profit occurs when toral revenue exceeds total economic costs. It thus creating incentives for firms to {s profit that is over and above normal profit. A firm might choose to continue Produce. ro operate even if eams ze economic profi because total revenue covers all42 > Economics for the IB Diploma cononnic costs (both implicit plus explicit costs), 50 itil earns normal profit. TDS Se sand the concept of seo Senses iaancsies tee Semen cata ao lege Pp ia of a worker who earns $45,000, If ene eae eee ‘worker, the minimum salary offered EXAM PRACTICE (HL ONLY) would have to be $45,000, ceteris PAPER 3 29 The table below refers to the costs and revenues of Tandy Toys Ltd when ‘operating at 5000 units of output per month. fou COST/REVENUE (5) Price $20 Raw materials per unit 38 Rent $7000 Salaries $8000 ‘a. Calculate the total cost of producing 5000 units. pi 1b Calculate the profit made by Tandy Toys Ltd if allits output is sold. [2] Table 1.6 Costs and revenues formulae table ‘Type of cost or revenue Formula Annotation total costs “quantity produced Average cost ‘otal fred cost arc, Average fixed cost " “quantity produced q total variable cost Aver able cost e——— rage variable cost uty poamet totalrevenue A i — werage revenue (or price) Goantty raced changein total costs Marginal cost eee ° changeinoutput evel changein totalrevenue Marginal revenue ‘change in outputlevel Total cost total fixed costs + total variable costs TC=TRC+ IVE Total revenue unit price x quantity traded TR=PxQ Goals of firms (HL only) Profit ma: ation (HL only) Son It is generally assumed that firms are profit maximisers, seeking to produce at the level of output that generates the highest level of profits. This occurs at the level of output where marginal cost equals marginal revenue (ie. MC = MR): = IFMR > MC, firms increase their output because profits will rise.Section 1_ Microeconomics 43 = IFMG> MR, firms reduce their output as the marginal eost outweighs the ‘marginal revenue = Hence, profits are maximised when MC = MR. Alternative goals of firms (HL only) Keyword definition Profit maximisation is the assumed fundamental goal of private-sector firms. Icoccurs when there is the greatest positive difference between total revenue and total costs Table 1.7 Alternative goals of firms Revenue maximisation Some firms might choose not to profit maximise (so earn less profits) but opt to sell more, thus raising the popularity of the praduct to keep aut other firms from entering the industry. Growth maximisation ‘Many firms seek to expand their operations. Firms such as Coca-Cola, Subway and McDonald's have expanded throughout the world Satisficing This goal occurs when firms aim for a satisfactory or adequate level of profit, rather than the maximum profit, This is because profit maximisation might require significant expenditure of time, effort and financial resources. Corporate social responsibility (CSR) Firms are increasingly involved in CSR, i, they consider the impact of business activity on the environment and on social welfare, Examples include business ethics (such as avoiding unethical advertising), sustainable operations (such as avoiding excessive packaging) and measures to boost the welfare of workers. (such as a pleasant working environment and decent wages for al staff) Perfect competition (HL only) Assumptions of the model (HL only) Assumed characteristics of perfect competition inelude the following = A very large number of buyers and sellers exist in the market. ‘= Allfirms in the industry sell a homogeneous product, ie. products are identical = Firms are price takers —no indiviclual firm is large enough to have the ‘market power to influence the equilibrium output or the price ‘= Extremely low barriers to entry ~ there is freedom of entry into and exit from the perfectly competitive industry. = Perfect information ~ buyers and sellers have perfect knowledge of prices. © There is perfect factor mobility ic, there are no barriers to the use of land, about, capital and enterprise, which are all adjusted according to changing ‘market conditions, ‘Where appropriate, try to use real-world examples in your written answers. For perfect competition, a real-world example could be markets that sell fresh fruit and vegetables, where the demand is highly price elastic because firms sell homogeneous products (carrots or oranges from one vendor are no different from those sold by other firms in the market). No individual firm is large enough ‘0 influence market supply or market price, ie. firms are price takers. Its also relatively easy for firms to enter or leave the market, Revenue curves (HL only) Corr C1 Keyword definitions Market structure refers to the key characteristics of a particular industry, for example the number and size of firms, the degree and intensity of price and non-price competition, and the nature of harriers to entry. Perfect competition describes a ‘market structure where there is an. intensive degree of competition, with no individual fiem being large enough to have any market power to influence the price or quantity traded ‘The demand curve for an individual firm in perfect competition is perfectly price elastic (see Figure 1.57). A price above the marker price means no demand, due to perfect substitutes, yer there is no advantage in reducing price as firms can sell their entire output at the higher price.44 Economics for the IB Diploma ‘As the MR curve for an individual firm in perfect competition is horizontal, the AR curve is also constant, ie. itsells all output at the same marker price Mathematically, since P= AR and AR is constant, then: MR=AR under perfect competition. The perfectly competitive firm’s average revenue curve (AR =MR =D) is determined by the market forces of demand and supply (see Figure 1.57). Price ° Quonsy ‘Qvonnty Figure 1.57 Revenue curves under perfect competition Profit maximisation in the short run (HL only) ‘As there is perfect knowiedge, a firm trying to cut price would simply result in others following, so there is no benefit in doing so. Besides, firms are assumed to be price takers, so accept the market price. In the short run, itis possible for a perfectly competitive firm to make economic profit (see Figure 1.58), negative economic profit (see Figure 1.59) or normal profit (see Figure 1.60). The prot maxing frm proces Qs our where Bre AAR oor pico Ios rete hen hese tn average ca [le fim Imes ciormal pcx Shown by he shaded oreo amy seAc D=AR= MR (Costs ond revenues (6) sz oT a Cup Figure 1.58 Short-run economic profit, Sea The profit maximising fim produces where MC'= MP, Le. ot Qe. As ce (cs less han the Grerage cost (the frm makes loss in the shon fn, shown by the shoded area 9, 6 dre. D~ AR~ MR (Corls and revenues (] ° ao Oupet Figure 1.59 Short-run negative economic profit, eee ‘When drawing diaorams for theory of the firm and market structures, make sure you do not label the y-axis as ‘Price’. The diagrams contain both cost and revenue curves, so the correct label is ‘Costs and revenues (8)° instead. Ea To gain top marks, you must show evidence af critical thinking. This ‘means you should consider the advantages and disadvantages of operating in competitive markets — for example, healthy competition ‘can ensure consumers get the right products at the right price in an efficent way. However, there are limitations to the model - few industries, if any, actually fit the ‘model in the real world. Branding ‘means that most products are heterogeneous in realty and itis not possible for consumers to have perfect Information about all prices for al products.Section 1_ Microeconomics 45 RAC he profit maximising fim producar where MC= MR, Le. 1 +. As D = AR= MR price [a equal he ‘average cost), he fim ‘makes @ 2er0 economic eo i. breaks even} (Coats ane revenues | ° o Oupat Figure 1.60 Short-run zero economic profit, Profit maximisation in the long run (HL only) In the long run, perfectly competitive firms can only earn normal profits (zero economic profit), as shown in Figure 1.60. Any lesses in the industry (see Figure 1.59) lead to some firms exiting, so toral supply falls, leading to a higher market price until the industry returns to normal profit. Any abnormal profits in the industry will attract more firms to enter (see Figure 1.61) duc to the absence of barriers to entry. This raises market supply (from S; to S;) and reduces the price (from P, to P,) until equilibrium is restored. (Coats and revenues ($) ° ups Figure 1.61 Long-run equilibrium competition up Hence, in the long run, perfectly competitive firms ean only make normal profits, Le. AR = AC. As these firms are also profit maximisers, they produce at the output level where MC = MR. This means the following long-run condition. must hold in perfectly competitive markets MR=MC = AR=AC Shut-down price and break-even price (HL only) An individual firm in perfect competition will not necessarily shut down ifit makes a loss in the short run, However, it has fixed costs irrespective of its level of output: Therefore, by continuing to operate, even at a loss in the short run, any revenue it can earn over and above its variable costs contributes towards paying is fixed costs. The shut-down price for peofit-maximising firms in perfect competition ‘occurs at the point where MC = MR = AVC. The perfeetly competitive firm's short-run supply curve will therefore be the part of the MC curve above its AVC curve (shown by the red line in Figure 1.62). In the long rum, the perfectly competitive firm will not produce unless itean coverall its costs. Hence, its supply curve is the MC curve above the SRAC. curve (the red line in Figure 1.63).46 Economics for the IB Diploma Guoniy Figure 1.62 The short-run shut-down price mc RAC Cost (61 Quowniy Figure 1.63 The long-run shut-down price EXAM PRACTICE (HL ONLY) PAPER 3 30 Use the information below to calculate: a. the break-even price bb the shut-down price. i Monthly production costs for Adrian's Awning Company ° ern PUR $35,500 Mca 45,000 ca $30,000 MAC} 500 Perfect competition and efficiency (HL only) Cx) Alllocative efficiency occurs when firms proxhice at the optimal level of output from society's point of views ic. where the marginal social costs (MSC) of production equal the marginal social benefits (MSB) of consumption. It is achieved when firms charge a price equal to the marginal cost of proxtuction, i.e, P= MC (or when MSB= MSC), ic. no one can be made better off without making someone else worse off Productive efficiency occurs at the output level where average costs are minimised, ic. where MC-= AC, Hence, there is no wastage or unemployment of scarce resources. It requires technical efficiency — when the maximum output is produced with the minimum amount of factor inputs ie. the least-cost method of output.Section 1_ Microeconomics 47 ‘On a macroeconomic scale, proxluctive efficiency occurs when the economy ‘operates on its production possibility curve, ic. itis nor possible to produce more goods and services for one stakeholder group without producing less for another stakeholder group. A key advantage of perfect competition is economic efficiency, because firms are: = allocatively efficient (charging a price that is equal to marginal cost) in both the short run and che long run = productively efficient (they operate ar the lowest point on the average cost ‘curve) in the long run, although not necessarily in the short run (as they can ‘temporarily eam abnormal profit). Monopoly (HL only) ‘An economy can be productively efficient but allocatvely inefficent at the same time, because the latter is concerned with the optimal distribution ‘of scarce resources, For example, an ‘economy might devote a significant ‘amount of resources to efficiently supply national defence (resulting in ‘a socially undesirable allocation of resources) rather than to supply public ‘edlucation and healthcare services (which are more socially desirable). monopoly tmontyh rer Assumptions of the model (HL only) A pure monopoly exists if only one firm supplies the whole market. In the USA, this would include the United States Postal Service (the only service provider of first class postage) and the Federal Reserve (the sole supplier of banknotes and coins), In reality, a monopoly exists in a market dominated by one firm with significant market power, e.g. Coca-Cola (carbonated soft drinks), YKK (sip fasteners), Tetra Pak (packaging) and Mabuchi (which makes 90% of the micro- motors used to adjust rear-view mirrors in cars). ‘The monopolist has significant market power as it controls enough of the market supply to be able charge higher prices. Hence, it isa price maker (or price setter). Yet due to the absence of competition, the monopolist can supply ata lower level of output. Therefore, monopoly is less efficient than perfect competition due to the combination of higher prices and lower output than would be the case under perfect competition. ‘A monopolist is able to protect its prestigious position as customers and rivals have imperfect knowledge. This includes the monopolis’s ability to protect its trade secrets. Monopolists can earn abnormal profit in the long run as there are extremely h barriers to entry chat prevent other firms from setting up in the industry, i.e. there are no close substitutes Barriers to entry (HL only) Keyword definition A monopoly is a market structure where there isa single supplier of a particular good or service, thus having the power to influence the marker supply and price. Its incorrect to claim that 'monopolists can charge ‘whatever’ price they want because they are the single supplier of a good or servic. Whilst monopolists have the ability to control market supply, they cannot control the level of market demand. Customers will switch to, or seek, alternatives if prices rise too high. Hence, monopolists must lower prices if they want to sell more A monopolist can only remain so ifin the long rum there are extremely high barriers to entry. These are obstacles that prevent other firms from effectively entering the market. Hence, the nature and scale of barriers to entry permit the monopolist to ear economic profit (abnormal profit). Barriers co entry can be classed as either artificial barriers or natural barriers, Artificial barriers are deliberately set up by monopolists to prevent competition, Whereas narural barriers are obstacles that simply exist characteristically in the industry Examples of artificial barriers to entry include the following: = Advertising and branding, if effective, can act as significant entry barriers due tw the established brand loyalty of customers — for example, imagine trying to ‘compete against Coca-Cola! = The existence of intellectual property rights, such as traskemarks, copyright and patents, helps to establish market power and market dominance. = Large advertising budgets of existing firms can act as a deterrent to new entrants, = Predatory pricing involves the lowering of prices to prevent new firms ‘entering the market or to force weaker rivals out of the industry Keyword definition Barriers to entry are the obstacles that prevent other firms from effectively entering a particular market, for example extremely high set-up costs or legal barriers.48 Economics for the iB Diploma = Loyalty schemes, such as those used by credit cant companies (e.g. American Express and Visa), help to establish customer loyalty = Switching costs mean that cuscomess find ic uneconomical to change between brands oF proxucts. For example, Apple uses a different operating system and power chargers from its rivals Examples of natural barriers to entry include the following: = High set-up costs discourage firms from entering some industries, for example airline manufacturing and pharmaceuticals, ‘= Sunk costs are those that cannot be recovered if a firm is unsuccessful and exits the industry, so high sunk costs act as an entry harrier. ‘= High research and development (R&D) costs in an industry act asa signal to potential entrants that they need large financial reserves to compete, 1s Huge economies of scale eamed by the existing monopolist can deter new entrants, ‘= Ownership and control of esential resources for a certain industry create a considerable barrier to entry — for example, favourable access to taw materials such as oil. 1» Legal constraints exist in some industries to prevent wasteful competition — for ‘example, pascal services, railroad networks and electricity power generation. Revenue curves and profit and revenue maximisation (HL only) Whether branding and advertising represent inefficiencies depends on perspective and context. They can help aligopolistic and monopolistic firms to boost their sales thereby achieving some productive efficiency {gains through economies of scale However, they can also create inefficiencies if branding and advertising act as a major artificial barrier to entry, given certain brands’ significant monopoly power. ‘The AR curve for a monopolist is the market demand curve, as itis assumed there isa single supplier, ie. the firm is the industry. Hence, the AR = D curve is downward sloping because the monopolist must reduce price in order to sell more output. ‘The gradient of the linear MR curve is twice that of the linear AR curve, because for the AR to fall continually, the MR must fall at a faster rate. The revenue-maximising monopolist will supply at the output level where MR=0, at Quy and charge a price of Pra (see Figure 1.64). The profit- ‘maximising monopolist will supply at the ourput level where MC = MR, ic at Qpm and charge a price of Pye whilst average costs are AC}. The abnormal profit eared is therefore shown by the red shaded area, In the short run, a monopolist might choose to deliberately operate at a loss shown by the shaded green area (see Figure 1.65) in order to deter new entrants ‘orto force out a rival firm from the industry. In reality, such actions ate likely to be deemed illegal in most countries. Mathematically, MR = 0 at the mid-point of the AR curve for the monopolist. To the left of the mid-point of the AR curve, demand is relatively price elastic. The monopolist will never choose to operate on the inelastic half of its AR curve because MR will be negative, ic, both revenue and profit cannot be maximised if MR is negative (Costs and verve 18) Figure 1.64 Monopoly (long-run abnormal profit position)Section 1_ Microeconomics 49 Cost end revenues (9 Students who claim that itis not possible for a monopolist to make a loss, given the lack of competition, should really consider why a Oupur monopolist might deliberately make a Figure 1.65 Monopoly (short-run loss-making position) loss inthe short un, Ca Neh Gg) ead) PAPER 3 31 With reference to the diagram below, identity the following: a. The price charged by the profit. maximising monopolist. ti The total costs for the profit maximising monopolist. Ml ‘© The amount of abnormal profit eamed by the profit-maximising monopolist. i The output level ofthe revenue-maximising monopolist. i EXAM PRACTICE PAPER 1 32 Explain why a monopolist is able to earn abnormal profits in the Jong run. [10] Natural monopoly (HL only) cm A natural monopoly exists when the industry can only sustain one supplier, to avoid wasteful competition ang! to maximise economies of scale by having single provider. Natural monopolies exist in industries that have extremely high fixed costs and sunk costs requited to ensure supply. Hence, these costs can deter entrants to the industry. Ik is more economical to have a single supplier of postal services, gas pipes, telephone cables, electricity cables and railway tracks since a monopolist could provide these with substantial cst savings compared with many smallee firms in direct competition. Therefore, trying to increase competition in such industries actually creates a potential loss of efficiency as new entrants would mean a ‘wasteful duplication of scarce resources.50 Economics for the IB Diploma However, as there is the potential for natural monopolist to exploit their power, governments tend to nationalise these industries or regulate them heavily to protect the general public. (2 The unagulted profitmaximising monopolist wil supply & Opn where MC MB, thus eating aber Broil shorn by the red area) ‘= Asingle supplier can achiowe huge ‘cost savings by operating oa loger Seale along is [RAC cue, ‘¢ The naira! monpelit con svppy ToFe ot Qyq where P= MC, but wall nak « les shown by he gieen ‘area). This loss could be subsided by the gowomment Cost cred revenues (9) uonty Figure 1.66 Natural monopoly Monopoly and efficiency (HL only) Productive inefficiency occurs when a profit-maximising monopoly lacks incentives to operate at the lowest point ofits AC curve (see Figure 1.67). It «can limit supply, enabling it to charge a higher price than would be the case in competitive markets. Allocative inefficiency occurs when there is no incentive for a profi maximising monopolist to supply where P = MC due to the lack of competition, Instead, for the monopolist, P > MC. Arguably, if the market was more competitive, the output would be higher at ‘Qpe and price would be lower at P,.. The resulting welfare loss (the combined loss of consumer and producer surplus) is shown by the shaded red area. Nevertheless, there are reasons why, despite their inefficiencies, monopolies are desirable: = Asa monopolist controls the market supply, it can achieve huge economies ‘of scale, ic. it can sell larger quantities and at lower average prices. = A monopolist, rather than small highly competitive firms, is more likely to have the financial ability to finance research and development (R&D) from its economic profits = R&D helps to create new innovations (ideas, products and processes), thus improving the productive capacity and international competitiveness of the ‘economy. Costs ond revenues (8) Odtpur Figure 1.67 Monopoly and efficiencySection 1_ Microeconomics 51 Policies to regulate monopoly power (HL only) If monopolies exploit their market power and act against the public interest (perhaps by deliberately charging unreasonably high prices, restricting competition, or by engaging in price fixing) then the government can intervene to break up their monopoly powers. For instance, a merger between the two largest firms in an industry can be prohibited if it is believed that the resulting monopolist’s market dominance will be against the public’s interest: In 2013, Visa and Mastercard were fined a record $7.25 billion for colluding to fix their fees to commercial customers (retailers who pay to process credit card payments) Advantages and disadvantages of monopoly compared with perfect competition (HL only) —E—E—E—~—E E—_— er) _——C—C TD Table 1.8 Advantages and disadvantages of monopolies ‘Advantages Disadvantages "= As monopolsts control industry supply, they operate on = Monopolias can be inefficient in terms of resource ‘a vary large scale, thus benefiting from huge economies allocation. In pursuit of profit maximisation, they can Of scale, i. they can actually supply more output and at —_restrict output and/or charge a higher price, thus creating a lower prices. welfare loss ‘= Monopolists have the financial resources to invest in = High barriers to entry prevent new firms from entering the innovation, R&D expenditure can help to generate new ‘market, This limits the degree of competition and ensures ideas, new products and production processes that monopolists can continue to charge relatively high ‘= Therefore, monopoly power can be an important source of prices. international competitiveness against foreign competitors. = Imperfect knowledge about prices and products can make ‘= Some monopolies can eliminate wasteful competition. it difficult for consumers to make rational choices — for For example, it makes more economic sense to have one __—_ example, the confusing pricing policies used by mobile supplier of postal services rather than allowing private- pphone service providers mean that customers find it sector firms to compete to provide such services since troublesome to switch between suppliers. profit-seeking firms could be reluctant to service remote = Monopolists may have less incentive to innovate than firms areas, in competitive markets. The lack of competitive pressure can mean that monopolists become complacent. Monopolistic competition (HL only) ‘The assumed characteristics of monopolistic competition are: ‘= a large number of relatively small firms, each with insignificanc marker power and supplying differentiated products f= absence of harriers to entry and! exit from the industry. Examples include clothing fiems (such as H&M, Zara and Uniqlo), haindresset, florists and restaurants. Product differentiation gives monopolistically competitive firms a small degree of market power, ic. such firms face a negatively sloping demand curve for their product. In the short run, these firms can car abnormal profit. However, the lack of entry barriees will attract new firms to the industay, thus reducing the matket price and profits. Equally, the firms can also make a loss (see Figure 1.68). At the profit-maximising (or the loss-minimising) level of output, AC > AR, so a los is made, shown by the shaded area. In the long run, abnormal profits attract new entrants, whercas losses cause lower market supply, due to the absence of barriers to exit. Hence, only normal profit is made in the long run (see Figure 1.69).52 Economics for the IB Diploma AC Corl and revenues ° Me Ouput Figure 1.68 Monopolistic competition (short-run loss minimisation position) Costs are cevanus ° g Ourput Figure 1.69 Monopolistic competition (long-run normal profit position) EXAM PRACTICE PAPER 1 33 Explain why product differentiation leads to a negatively sloped demand curve in monopolstcally competitive markets. no] Non-price competition (HL only) ‘Since monopolistically competitive firms produce differentiated products, non- price competition isa key feature in such industries. Price competition is the Use of pricing strategies to compete. Examples include: ‘= going-rate pricing — the pricing decision is based on the average price charged by firms in the industry 1 loss-leader pricing ~ setting the price of a product below its eost price to entice customers, who might alo buy other, often relaced, products sold by the firm, ‘= penetration pricing — used by new entrants that seta low introductory price to establish some market share ‘= promotional pricing ~ charging a low price to attract customers to raise brand awareness and to develop customer loyalty ‘= psychological pricing —for example, $9.99 can seem much cheaper than $10 Non-price competition refers to all other forms of competition. Examples include the following: = Advertising is used extensively to differentiate between the products of firms, Branding is used in an attempt to gain customer loyalty, f= Packaging can be used to distinguish products from one another and to act as a distinctive selling point, for example fruit juices, potato chips (crisps) and, specialised boxes for jewellery.Section 1_ Microeconomics 53 ‘= Product development, such as special features and limited editions of a product, or new innovative produets being released to the market. = Quality of service (the level of customer service) at hairdressers, restaurants and other retailers can give firms a competitive advantage over their rival ‘= Similarly, aftersales care can also create competitive advantages for ‘monopolistically competitive firms, for example guarantees (warranties), technical support and delivery service. Monopolistic competition and efficiency (HL only) Ca) Like monopolists, monopolistically competitive firms are neither allocatively efficient nor productively efficient in both the short run and long run. Inefficiencies can occur in monopolistically competitive markets due to the vast degree of choice that consumers have. Monopolistically competitive firms do not operate at the lowest point on their AC curve (see Figure 1,69) because there are limited opportunities to exploit economies of seal. Like a monopolist, the monopolistically competiti {although to a lesser extent), s0 its price exceeds mar seen in Figure 1.69. Monopoli competition compared with perfect competition and monopoly (HL only) c firm is a price maker al cost (P > MC), as Like perfect competition, there are many small producers in monopolistic competition Product differentiation exists under monopolistic competition but not necessarily under monopoly (despite being the only supplies, monopolists can supply undifferentiated products). Due to this product differentiation, variety (choice) is greater in monopolistic competition than in perfect competition where firms only supply homogencous proxlucts Monopolistically competitive firms can enjoy some economies of scale although these are limited due to the size of the firm and the differentiated products they supply. Firms in perfect competition are productively and allocatively efficient in the long run, whereas those in monopolistic competition are nor. Both monopolistic competition and monopoly are inefficient market structures in both the short and long run, although monopolistically competitive firms have much less market power. Whilst competition is generally beneficial, natural monopolists eliminate wasteful competition. Monopolistically competicive firms have a small degree of monopoly power. Therefore, the demand curve of a monopolistically competitive firm is less price clastic than that of a perfectly competitive firm. ‘There is an absence of harriers to entry and exit under both perfect competition and monopolistic competition. Only monopolists earn abnormal profits in the long run due to the narute of barriers of entry. Oligopoly (HL only) Assumptions of the model (HL only) Ea “The assumed characteristics of an oligopoly are as follows: f= The industry s dominated by a small numberof large firms —for example, Samsung and Apple dominate the smartphone industry. An oligopoly is market structure = Mutual interdependence — fiems in oligopolistic markets consider the actions | in which a few large suppliers, each and reactions of their competitors when determining their price and nox with a high degree of market share, price strategies dominate the industry54 Economics for the IB Diploma ‘= Firms can produce differentiated products (e.g. breakfast cereal, book publishing and music entertainmenc) or homogeneous products (e.g oil, steel and aluminium), = Barriens to entry ~ there are considerable entry barriers to the industry, including huge set-up costs and sunk costs. Examples of oligopolistic industries include carbonated soft drinks, aircraft manufacturers, petroleum, sportswear and laptop manufacturers. Due to the market power that oligopolistic firms have, there is asymmetric information in the industry, for example trade secrets, Oligopolistic firms are often faced with the dilemma of whether to collude or to compete. Concentration ratio ‘A three-firm concentration ratio measures the combined market share of the thee largest firms in an industry — for example, the UK supermarket industry is «ominated by Tesco, Sainsbury's and Morrisons with a three-firm concentration ratio of over 65%. The higher the concentration ratio for an industry, the more concentrated (oligopolistic) the market tends to be. ‘Aclearer measure of market concentration is the Herfindahl Index, which gives ‘greater weighting to the market power of larger fms simply by squaring the value of each market share, Assume that the three-fitm concentration ratios for Industry A and Industry B are both 65%: = Industry A: Firm 1 = 30%, Fitm 2 = 20% and Firm C = 15% market share 1 Industry B: Fitm 1 = 25%, Firm 2 = 20% and Firm C = 20% market share ‘The Herfindahl index for Industry A = 302 +202 + 152 = 1525 The Herfindahl Index for Industry B = 252 +202 + 20? = 1425 Industry A has the higher Herfindahl Index value, so is mare oligopolistc than industry 8, even though they have the same three-firm concentration ratio. Game theory (HL only) In game theory, the outcome of a firm depends on the actions taken by other firms in the industry, with each firm having incomplete information about the competitor’ intentions Game theory, or the prisoner’ dilemma, shows that oligopolistic firms can increase their profits through collusion rather than competing independently. It also helps to explain why price fixing is unlikely to succeed duc to the tendency for firms to ‘cheat? (to outdo their rivals), as shown in Figure 1.70. ‘Adidas pricing palcy High tow g & 4 $50m 8 $60 p | $500 $20 = [ec [sion] 0 | soon #2 27 | 860m $30m Figure 1.70 Game theory f= The dominant strategy for Adidas and Nike isto collude and raise prices together (decision A), yielding $50 million for each firm. Apart from. collusion heing illegal in most parts of the world, there is always the ‘temptation for firms to cheat by opting for a low price strategy. Keyword definition Concentration ratio measures the degree of market power in an industry by adding the combined market shares of the largest few firms Keyword definition Game theory is an economic model that attempts co explain the nature of strategic interdependence in oligopolistic markets by considering the actions of competitors when making a decision, based on probable outcomes.Section 1_ Microeconomics 55 = However, if Adidas opts for a high-price strategy, Nike will eam $60 million by adopting a low-price strategy (decision C). f= Anticipating this, Adidas is likely to adope a low-price strategy, in the hope that its rival charges a high price (decision B), thus allowing Adidas to earn $60 million. = Therefore, independent decision making by Adidas and Nike is likely to lead to sub-optimal outcomes, with both failing to trust cach other, and thus both, adopting a low-price strategy (decision D), Open/formal collusion (HL only) Collusive oligopoly exists when firms openly work together to limit the degree of competition, thereby acting as a collective monopolist, for example firms ‘agreeing to simultaneously raise their prices. Collusion is more effective and easier to achieve if very small number of dominant firms in an industry produce a homogeneous product. The primary goal ofa cartel isto restrict competition in order to maximise the profits for the colluding firms, which act as if they were a collective monopoly, For example, oligopolistic firms might use limit pricing —a pricing strategy used in a collusive oligopoly to set prices ata level that discourages new firms from entering the industry, The most quoted example of a cartel is OPEC (Organization of Petroleum Exporting Countries), which limits the woeld supply of crude oi in order to keep prices high. However, cartels often breake down in the long eun because individual fiems have a tendeney to cheat (lower prices and increase ourput) 0 improve profitability at che expense of rival firms. Tacit/informal collusion (HL only) Keyword definition Collusion is the ageeement between two or more oligopolistic: firms to limit competition by restrictive trade practices, for example price fixing or collectively Timiting output. A cartel is formed when there isa formal agreement between oligopolistic firms to collude, for ‘example in fixing prices or the evel of output in the industry, thereby effectively acting as a monopolist. Price leadership, a common form of tacit collusion, occurs when a firm (usually the market leader) sets. price that is then accepted by other firms as the market price. Banks often adjust their savings and mortgage rates by following the pricing strategies of the largest firms in the industry. The same applies to pettol retailer. ‘As collusion i illegal in most countries, its usually undisclosed, i.e collusion takes place without any formal or written agreement. In 2015, the EU Commission fined electronics giants Samsung, Philips, Toshiba, Panasonic ancl LG a record €1.47 billion ($1.88bn) for conspiring to fix prices on some of their products between 1996 and 2006, Non-collusive oligopoly (HL only) Keyword definition Tacit collusion occurs when two or more oligopolistic firms implicitly (or informally) agree Wve trade practices, for example price cutting or price lead Price rigidity (stability) exists in non-collusive oligopolistic markers because competitors would simply retaliate by marching any price reduction from a rival firm. By contrast firms in non-collusive oligopoly would not follow an increase in price in order to gain a competitive edge. Keyword definition Non-collusive oligopoly exists where firms in che industry act strategically by competing independently, taking snto account the likely or posible actions of,56 Economics for the IB Diploma The kinked demand curve model is used to explain price rigidity (see Figure 1.71), Keyword definition The kinked demand curve is a model that shows price rigidity in oligopolistic markets because competitors do not match a price hike but will follow any price reduction, (Costs ard revenues ($) poe > ° Oupt Figure 1.71 Price rigidity under non-collusive oligopoly, In Figure 1.71, it ean be scen that the profit-maximising oligopolistic firm produces at the output level where MC = MR, thus supplying Qym ata price of OA, Since AC = OB whilst AR = OA, the oligopolistie firm eams abnormal profit, shown by the shaded area. Due to the assumptions of mutual interdependence (a price hike is not matched by competitors whereas a price reduction is followed by rivals) and asymmetric information (game theory), there isa kink in the demand curve at the price OA. The kink of the AR (demand) curve creates the vertical section of the MR curve due to the sucklen change in the slope of the AR curve. Since profit maximisation occurs at MC = MR, there is price rigidity (P remains at OA) even if MC fluctuates between OC and OD. In addition, the risk of price wars (when firms continually reduce prices to outstrip their rivals) can lead to huge losses for firms. Therefore, non-price ‘competition is common in oligopoly. Examples of non-price competition under oligopol ‘= branding, for example Coca-Cola and Pepsi, Nike and Adidas, McDonalds and Burger King or Apple and Samsung 1» added-value services, for example movies on-demand on certain airlines, ‘extended opening hours at certain supermarkets, or customer loyalty schemes ar certain retailers ‘= quality, for example Mercedes, BMW and Lexus, or Rolex and Omega. Price discrimination (HL only) cS Necessary conditions for the practice of price crimination (HL only) Firms with market power (oligopolists and monopolists) are able to use price discrimination. Itoccurs even if there are no differences in the cost of providing the service to different consumers groups. Examples of price discrimination used for students and adults include tickets for cinemas, airlines, swimming pools, ‘Keyword defiaidan public transport operators and theme parks. Price discrimination is the practice The following three conditions must exist for effective price discrimination, of charging different prices to to take place: different customers for essentially = The firm must have some degree of market power, ic. it must be a price- the same product. maker.Section 1_ Microeconomics 57 ‘= Different customer groups with different price elasticities of demand (PED) ‘must exist ~for example, adults and children have differenc willingness and ability to pay for certain products ‘= The firm must be able co separate the different consumer groups to prevent resale of the product from one group to another. The three degrees of price discrimination are as follows: = Firstlegree price discrimination occurs when a firm can get each consumer to pay the highest price that sfhe is able and willing to pay, thereby celiminating all consumer surplus, for example real estate agents and second hand car salespeople. = Sccond-degeee price discrimination occurs when discounted prices are used for customers buying in bulk — for example, theme parks use annual passes whilst supermarkets use ‘multipack’ offers. = Third-degree price discrimination occurs when a different price is charged to different customers hased on their different degrees of price elasticity of lemand - for example hotels, theme parks, cinemas, taxi firms and airlines ‘often charge different prices during peak and off-peak times Figure 1.72 shows a train operator charging higher prices for adults than, children due to the different degrees of PED. The firm produces where MC = MR. (MC is horizontal as the extra cost of providing the service to an extra customer ‘on the train és literally 2ero (assuring the train is not full). The firm can therefore ain revenue by using price discrimination to gain revenue from customers who might not be willing or able buy tickets at the higher price. Adulte Children (Cons and revenues [6] = 4 up Figure 1.72 Third-degree price discrimination and profit maximisation Do not assume that price ‘discrimination’ is necessarily a ‘bad’ act of monopolists. Price discrimination with relatively price elastic demand eee a single market price is charged to all Combinedaire Macroeconomics 2.1 The level of overall economic activity Economic activity The circular flow of income model In the circular flow model, households are individuals with effective demand for goods and services, whereas firms are businesses that produce (or supply) goods and services. ‘There are three types of withdrawal: savings (S), taxation (T) and import expenditure (M) as money leaves the circular flow to hanks, government and the foreign sector respectively. There are three types of injection: government spending (G), investment expenditure (1) and export earings (X) as money enters the circular flow thereby stimulating economic activity. For national income equilibrium, the following condition must hold: S+T+M=G+I+X The level of economic activity depends on the relative size of injections J) and withdrawals (W). If W’> J then economic activity declines, and vice versa. Income is the sum of the retums for use of the four factors of production: return (or income) for land = rent return for labour = wages (and salaries) return for capital = interest return for enterprise = profit Therefore, income = rent + wages + interest + profit Figure 2.1 shows the following: = Ina closed economy with only households and firms, households supply factors of production (land, labour, capital and enterprise) to firms 0 ‘generate output of goods and services. ‘= In retum, firms provide factor incomes to householls, i.e. rent, wages, interest and profit. ‘= With the income, houscholds spend their money on goods and services produced by firms, thus creating expenditure revenue for firms, ‘= Hence, the income flow is numerically the same value as the expendicure flow and the output flow. ‘= Inan open economy in the circular flow of income model, there isa ‘government sector, financial markets and foreign trade. f= Inthe financial sector, savings (8) represent a withdrawal whilst investments (Dare injections. = With a government sector, taxes () represent a withdrawal, whereas ‘government spending (G) is an injection, = Inan open economy, there isa foreign sector with international trade, Export revenue (X) represents an injection to the circular flow, whereas import ‘expenditure (M) isa leakage. = The circular flow of income and expenditure will change based on the relative size ofall withdrawals (W=S+T +M) and all injections U=G+X+D. Keyword definition The cireular flow of income model is a macroeconomic tool used to explain how economic activity and national income are determined foe Students often describe income as the earnings that people gain from work. This is true for people only able to supply their labour services. Those with other factors of production (capital, land and enterprise) are able to gain other sources of income (interest, rent and profit)Section 2_ Macroeconomics 59 Circular flow of income Leakages Injections © Investments © Exports Households Expenditure Factors of Goods and Rents wages, fon goods and Factors of ods and interest, services \ / profit Firms Figure 2.1 The circular flow of income Measures of economic activity (GDP and GNP/GNI) ‘* Government spending ‘There are three ways to measure economic activity: the value of national output (O), national income (Y) and national expenditure (E), = The output method of calculating economic activity adds up the final value ‘of newly produced goods and services during the year ‘= The expenditure method of calculating economic activity adds up the total spending on newly produced goods and services during the year. The income method of calculating economic activity adds up the total value of all factor incomes earned during the year Allthrce methods give the same numerical result, ie, O= Y= B, because the value of national output equals the value of what is spent on the output (national expenditure). This expenditure becomes the (national) income to households and firms that produced the output. Using the expenditure method of calculating GDP, economists add the totals ‘of consumption expenditure (C), investment expenditure (I), government, expenditure (G) and export camings (X) and then deduct the amount spent on imports (M) by using the formul GDP=C +1+G+4(X-M) Gress national product uses GDP but also accounts for net property income from abroad, ic. the difference between what residents eam from overseas investments minus income earned by foreign residents within the domestic economy: GNP = GDP + net property income from abroad ‘Net property income from abroad refers to the difference in value between, incomes eared and incomes paid abroad ‘Nominal GDP is measured using ciarent market prices, ie. the value of GDP at the time of measurement. Real GDP takes account of fluctuations in prices (inflation) over time. Using real GDP (or real GNP) figures allows better comparisons of economic activity over time by using constane marker prices (the values are adjusted for inflation over time). For example, if nominal GDP increases by 4% whilst the general price level rises by 3%, then the average person's income increases by ‘only 1% in real terms. (HL only) Keyword definitions Gross domestic product (GDP) is the value of all final ouput of goods and services proxluced by firms within a country, per year Gross national product (GNP) is the value of all final ourput of goods and services proxluced bya country’s citizens, both domestically and abroad.60 Economics for the IB Diploma GDP per capita means expressing the GDP per head of the population, ie. it averages out total GDP per person in the country. Iris calculated using the formula: total GDP GDP per capita= 2 GDP _ PeEeePAs™ population size GNP per capita (or GNI per capita) is calculated in the same way —by dividing the total GNP or GNI by the country’s population size. ‘A price deflator (or GDP deflator) is used to convert GDP at current prices to GDP at constant prices, (HL only) EXAM PRACTICE (HL ONLY) PAPER 3 1. Calculate the value of gross domestic product (GDP) and gross national product (GNP) from the given information: Consumption = $150bn, Investment expenditure = $60bn, Government spending = $55bn, Export earnings = $31bn, Import expenditures = $28bn, Net income earned abroad =-S8bn. BI 2. Calculate the real gross domestic product (GDP) in 2013 and in 2014 and explain your results. i EAR | NOMINAL GDP (SBN) | GDP DEFLATOR 2013 260.0 106.7 2014 262.4 108.5 The use of national income statistics ‘The terms gross national product (GNP) and gross national income (GN) can be used interchangeably for your IB examinations although in realty GNP differs slightly fra GNI. The latter method deducts indirect business taxes, which differ between countries, to enable more meaningful International comparisons of national ‘output and economic activity Tess of navonatincome Sates ___¢ryuarp country, i.e. ahigher real GDP per capita is associated with higher standards of living for the average person. This is because a person's standard of living is directly dependent upon the amount of goods and services that sfhe is able to consume. ‘National income statistics reveal the level of economic activity in the country, which directly affects the average person’s social and economic wellbeing. However, there are limitations in using national income statistics to measure standards of living in a country, including: '= the distribution of income and wealth in the country ‘= varying rates of direct and indirect taxes between countries ~ for example Andorra, Brunei Darussalam, Oman and Qatar have a zero rate of income tax ‘= differences in the cost of living, for example housing, education, healthcare and basic amenities the extent of social welfare benefits varying between countries ‘= exchange rate fluctuations making intemational comparisons of GDP over time less meaningful f= the composition of national output, for example North Korea’s heavy ‘expenditure on armaments and weapons compared with the huge spending ‘on welfare benefits in Australia and the UK f= the extent to which national output generates negative externalities, thereby limiting the sustainability of economic activity and the quality of life in the country ‘= Variations in the size of the unofficial economy (for goods and services that are not officially traded, such as home-grown fruits and vegetables and bartered services) ‘= consideration of alternative measures of GDP to measure of standards of living, for example the Human Development Index (HDI), Another alternative to measuring nominal (or real) GDP isto use green GDP. This is calculated using the formula: green GDP = nominal GDP ~ environmental production costs Keyword definition Green GDP is a meassre of GDP that accounts for environmental destruction of economic activity by deducting the environmental costs associated with the output of goods and services.Section 2_ Macroeconomics 611 The business cycle Short-term fluctuations and long-term trends ais ektieioe economic aavly| [A racoweiy i buona Ge coos whan ier ght fale teow creme Jreploynon oe, Pe eee pie cram ce eer eee cies aie nes condone eee ee eee eee rey Towel oro high, a ing yployment oppor ng = ek Trend 2 a 3 \ Rasgrary ‘ton Economic i aay t During @ boom (or economic grow), the vel a [of economic activity rises, caused eee ae am § inant govt ang dv expo ear, Tecaicoly,econonlc ow emeronneeae a voeaeene suse (mont a Time ae) Pease ee coro esto, Tecnica, a| | mug sald sent There be Fgh incnpoye See at ee ee GDP ols forvo conccune’”” || below. tony bushax wi hove colopsod or ies Dg arecsion tt | coumarins fe ery He Lesiee cae eter pend may be needed hp Te acon eee eee | moe anec ae niece Figure 2.2 The business cycle The boom is the peak of the business cycle where economic activity is at its highese level. Unemployment is low whilst consumer and business confidence levels are very high. During a recession the level of economie activity declines. Technically, this ‘occurs when GDP falls for two consecutive quarters. Business failure is common and unemployment rises, Recessions create uncertainty for firms and damage consumer confidence levels. The slump (or trough) occurs at the bottom of a recession. There is mass unemployment as consumption, investment and net export earnings remain low. ‘A recovery occurs when GDP rises after the trough. Consumption, investment and net exports gradually rise, thus creating employment ‘opportunities and increasing business confidence. ‘The potential national output (potential GDP) of an economy is shown by the long-term trend in the business cycle, Exogenous shocks that affect the potential growth of an economy include lobal financial crises, the outbreak of infectious diseases and natural disasters such as earthquakes, tsunamis and severe floosing. Boa Not all components of GDP necessarily fall during a recession — a boost in ‘government spending may be needed to help the economy recover from the Fecession, such as the fiscal stimulus policies of many countries during the financial isis of 2008, Keyword definition The business eyele describes the fluctuations in economic activity ina country over time. These fluctuations create a long-term, tuend of growth in the economy, Economic growth is the increase in the level of economic activity, Le. the annual percentage growth in national output. Common mistake Students should be aware of the difference between a fallin GDP and a fallin GOP growth. A fallin GDP (over two consecutive quartets) causes a recession, whereas a fallin GDP ‘growth means that the economy is. stil growing, only at a slower rate62 Economics for the IB Diploma Economic growth increases the long-term productive capacity of the economy, illustrated by an outwards shift of the production possibility curve. It suggests that the economy is mote prosperous, so the average person earns more income (see Figure 2.3). Ema The best-performing students are able to show skill of evaluation and critical thinking, Not all businesses suffer during a recession, Counter- Average pice lvl ( ° i ool nation ouput (GOP Figure 2.11 Long-run equilibrium ~ Monetarist model a Keyword definition The full employment level of output occurs when everyone who is willing and able to work is able to find employment. Itexists at the point where unemployment is at its natural rate that can be maintained with price stability (zero rate of inflation) Despite the terminology, its incorrect to assume that full ‘employment occurs when there is zero unemployment in the economy, There will aways be some degree of natural unemployment in the economy due to frictional unemployment (those between jobs) and structural unemployment (caused by skills mismatch). Instead, full employment, ‘occurs at the natural rate of unemployment.Section 2_ Macroeconomics 69 In the new classical model, any short term fluctuations in national output will only be temporary as marker forces will restore equilibrium to the full employment level of output in the long run. With reference to Figure 2.12 ‘= Long-run equilibrium is at the full employment level of national ourput (¥) with the average price level at Py = An increase in aggregate demand from AD; to ADs increases the average price level from Py to 2, causing AS to expand along the SRAS, curve. ‘= This temporarily increases national ourput beyond its capacity, and so raises production costs = Hence, aggregate supply shifts from SRAS) to SRAS;, causing the average price level to rise from Ps to Ps and the economy operating back at Ye Real national ouput (GDP) Figure 2.12 Fluctuations in short-run equilibrium (1) + Long 1un equlibism ict ¥, with he general SBS2 ace lvel ill of Py + An intease in production costs causes o shit SPAS; "in aggregate supply rn SPAS) lo SRAS), tus rabing the aveioge price level © Pp and ‘esuhing in fallin GDP from ¥5 oY, ‘+ Government nlevenion 0 raise aggregate demand tom AD 2 AD simply ieteoses he ‘average rice lvel rom Pato Ps, wih he Ady emo operating back oY ce bv e < ° " ¥ Real naonal opi [GDR] Figure 2.12 Fluctuations in short-run equilibrium (2) ‘Therefore, monetarists (new classical economists) argue that demand-side policies are ineffective in the long run. They prefer the use of supply-side policies to shift the LRAS outwards to achieve economic growth, ‘Changes in long-run equilibrium are caused by factors that shift the LRAS curve rightwands, ie. supply-side policies. These include: improved productivity of factors of production, technological progress and incentives to stimulate inventions and innovations,70 Economics for the IB Diploma Equi m in the Keynesian model Keynesians believe that wages are ‘sticky’ downwards, even during a recession, so market forces strugele to restore equilibrium atthe full employment level of national output without the need for goverment intervention (using expansionary fiscal policy and monetary policy) ‘The Keynesian model of macroeconomic equilibrium suggests that the economy can be in equilibrium at any level of real national output where AD intersects with AS (see Figure 2.14). Real ronal output (GDA) Figure 2.14 Keynesian equilibrium, According to Keynesian economists, an increase in aggregare demand (from AD, to ADz) will not cause inflationary pressures if there is spare capacity in, the economy. On the upwards sloping section of the AS curve, any increase in aggregate demand (from AD» to ADs ot from ADs to ADg) puts pressure on. resources (such as labour shortages) thus pushing up the average price level. aggregate supply is perfectly price inelastic (in the long run), any inerease in ageregare demand (beyond ADs) simply increases the average price level as the economy cannot increase national output beyond the full employment level (¥. ‘Contrary to the new classical model, the Keynesian model shows that increases in AD need not necessarily cause inflation in the economy, unless itis ‘operating at or near its full employment level of output. ‘A deflationary gap (also known as. recessionary gap) exists when the real national output equilibrium (P, and Ye in Figure 2.15) is below the full employment level of output (¥). Without government intervention, the economy can remain stuck in a deflationary gap. The defatonary gop shown by RAS "he sherfal of cha apa OY) fom pater cup The goverment ci lua hls recessionary gop by vin ‘xpanalonaty Fal end tronotany pls bs boost agape demand fom ADy a0: ° % ¥ Read nator oupu(GOP) Figure 2.15 Keynesian model deflationary gap By contrast, an inflationary gap exists if actual national output exceeds the full employment level of output, ic. AD increases along the vertical section of the LRAS curve (see Figure 2.16), causing an increase in the average price levelSection 2_ Macroeconomics 71 ‘An inflationary gap will occur if the government chooses to maintain full employment, despite rising levels of aggregate demand putting pressure on the ability of the economy to supply goods and services. This will lead to demand- pull inflation, ceteris paribus. ‘The inftionory gop ts shown by cathal out (Ya) excaading fll employment exp |i. ‘= The government can fedveo thie Inflotonary gap by using ight Fiscal and/or menoiary policies to reduce aggregale demand fem AD} fo AD ‘Average pice level ze % Peck national ouput (GDP) Figure 2.16 Keynesian model inflationary gap The Keynesian multiplier (HL only) The nature of the Keynesian multiplier (HL only) Injections to the circular flow (export earnings, government spending and investment) increase the value of the Keynesian multiplict. By contrast, leakages (taxes, import expenditure and savings) cause negative multiplier Keyword definitio effects. The larger the value of withdrawals, the lower the value of the The Keynesian multiplier shows multiplier, and vice versa that any inctease in the value of ‘The Keynesian multiplier shows the extent to which each additional dollar ‘injections results in an even greater injected into (or withdrawn from) the economy will increase (or reduce) the increase in the value of national value of aggregate demand, It can therefore aid government decisions about xcome. It also shows that any macroeconomic policies. increase in the value of withdrawals ‘The Keynesian multiplier is calculated using either of the formulae below: Teads wpa greater fall in the value of pnational our. 1 1 T=MPC MPS+MPT+MPM 1 MPS+ MPT + MPM MPC, MPS, MPT and MPM always equals 1 ‘The scale of the multiplier depends on the shape of the Keynesian AS curve (sce Figure 2.8), If the economy is on the horizontal section of the AS curve, the multiplier would increase real national output without any presure on the average price level due to mass unemployment. If the economy is on the upwards-sloping section of the AS eurve, the multiplier will have an impact on. both national output and the average price level. However, if the economy ison the vertical section of the AS curve, the ‘multiplier has no impact on national output, but the associated increase in AD simply leads to an increase in the average price level as the economy is already ‘operating at full employment. The effectiveness of the multiplier is also subject to time lags, ic. there is «delay between changes in injections and leakages and any corresponding changes in national output. 1 Note that is equivalent to because the sum of ore tre72 Economics for the 8 Diploma Keyword definitions ‘The marginal propensity to consume (MPC) measures the proportion of each extra dollar of household ineome that is spent by consumers, ie. Mpc = ©. An increase in the MPC will tend to increase the valuc of the multiplier. ‘The marginal propensity to save (MPS) measures the proportion of each extra dollar of income that is saved by houschokls, ie. AS. w ‘The marginal propensity to tax (MPT) measures the proportion of each extra dollar of household income that is levied by the government, EXAM PRACTICE (HL ONLY) PAPER 3 5 Ian economy's marginal propensity to consume is known to be 0.85, ‘calculate the size ofthe Keynesian multiplier. RI 6 If export earnings increase by $200 million and the multiplier is 2.2, ‘calculate the change in real national income. i) 7. government spending inereases by $85 million and the marginal propensity to consume is known to be 0.75, calculate the amount by Which the aggregate demand curve will shift. Rl 8 Suppose a country in recession has a deflationary gap of $92 billion and its marginal propensity to consume is 0.76. Calculate the amount of ‘government expenditure needed to close the recessionary gap in order to restore equilibrium Ri It might be more natural to think about the multiplier leading to positive impacts on the level of national output. However, the Keynesian multiplier also refers to negative multiplier effects caused by a fallin injections or an increase in withdrawals. For example, arise in marginal rates of income tax will cause negative multiplier effects. Students should take care when using abbreviations in the exam as understanding is often not shown, For example, ‘MPC’ can stand for a number of things: monetary policy committee, marginal private costs or the marginal propensity to consume. Be sure to explain any abbreviations that you use in the examinations.Section 2_ Macroeconomics 73 2.3 Macroeconomic objectives Low unemployment The meaning of unemployment ra Low unemployment is a key macrocconomic objective because it: ‘= complements economic growth (another macroeconomic objective) — higher ‘employment tends to lead to greater national expenditure. Hence, low ‘unemployment tends to increase the standards of living in an economy. 1 increases tax revenues from a range of sources such as income tax (from ‘employment), sales taxes (from increased expenditure) and stamp duty (from the sale and purchase of property) s= reduces the tax burden on the government because there is less of a need for taxpayers o fund welfare benefits as more people are working ‘= prevents a ‘brain drain’ from the economy, whereby skilled workers pursue better employment opportunities in other countries. ‘The unemployment rate calculates the percentage of the labour force that is unemployed. It is calculated using the formula: number of unemployed people Tbour force x 100 “The labour force consists of the employed, che self-employed and the tincmployed, i. all those in-work and all those actively secking employment For example, the unemployment rate in a country with a workforce of 50 million of which 5 million people are actively seeking employment but unakle to find employment is om; Som 10% ‘The United Nation’s International Labour Organization (ILO) states 15 as the minimum age to enter the labour force. There is no official upper limi, but many countries use a range between 65 and 70— for example, the official retirement age for women is 67 years in Norway, Poland and the USA. The ILO measures a country’ unemployment based on the number of people who are: ‘= willing to work, but unable to find ic = actively looking for work, i. they have looked fora job in the last 4 weeks, and able to start work within the next 2 weeks, or ‘= waiting to start a new job within in the next 2 weeks. Irrespective of the measure or definition of unemployment, it represents an, inefficient use of any economy's scarce resources, thereby hindering its potential national output Keyword definition ‘Unemployment occurs when, people are willing and able to work and actively secking employment but are unable to find work.74 Economics for the 18 Diploma EXAM PRACTICE (HL ONLY) PAPER 3 9 Use the data below for Country X to calculate the total number of people ‘unemployed. pl Werte RaW Ra eens CEs 35 million 10 Use the data below to calculate the unemployment rate. Bl ieee eu Pavan axoanela Ue Ma ato) 1100 million 74.8% 15 million Fea tN) ELEY 20% Difficulties in measuring unemployment Hidden unemployment ~ Some people escape the official measure of unemployment, resulting in an underestimation of the true rate of ‘unemployment. For example: = discouraged workers are nor willing to work, so are excluded from the calculation of unemployment. The ILO measure of unemployment only ‘considers those who have looked for a job in the past 4 weeks. ‘= overstaffing occurs in firms that employ workers who are not fully utilised, ‘perhaps due to seasonal fluctuations in demand or duc to legal constraints such as employment contracts. Underemployment - This exists when people are inadequately employed, reflecting the underutilisation of the employed population, ic. they are technically employed but in jobs that do not fully use theie skills or abilities, such as: ‘= involuntary part-time workers who cannot find full-time employment ‘= overqualified workers, who have education, experience, skills and ‘qualifications beyond the requirements of their jobs. Regional disparities — The measurement of unemployment is an average measure, so therefore ignores disparities in regional rates of unemployment. For example, unemployment in 2013 for the USA averaged 7.5%, but Nevada recorded 9.6% unemployment, whilst North Dakora saw only 3.1%. Ethnic disparities ~ Ethnic minority groups tend to suffer from higher- than-average rates of unemployment, and for longer periods. For example, the unemployment rate for African-Americans in New York is three times higher than the average official unemployment rate. ‘Age disparities — Unemployment rates among the young and older people are higher than those officially reported for the nation. For example, Greece and Spain experienced unemployment of around 28% in 2013, although youth unemployment reached 58.7% and 56.1% respectively. ‘Gender disparities — Females tend to experience higher average rates of unemployment than men, On average, men also re-enter the labour market ‘quicker. According to the ILO, gender inequalities in unemployment rates are exceptionally high in the Middle East and North Africa. EE Soe ia oceans Su ersten a ee ee ie me ees huge barriers to entering the labour force.Section 2_ Macroeconomics 75 EXAM PRACTICE PAPER 2 11 According to the International Monetary Fund (IMF), Pakistan's annual ‘unemployment rate between 2007 and 2013 was kept steady at 5-6%. This, according to the Central Intelligence Agency (CIA), meant that Pakistan's ‘gross domestic product grew by 3.7% in 2012 and another 5% in 2013, These ‘changes have helped to reduce some of the poverty in the country. Explain two reasons why it might be difficult at times to know the ‘exact rate of unemployment in a country. a bb Evaluate the possible consequences of low unemployment for the Pakistani economy. [8] Consequences of unemployment Reve ‘The economic consequences of unemployment include the following: A loss of GDP — Lower gross domestic product (negative economic ‘growth) has detrimental consequences on the economy, including a fall in its international competitiveness (ability to compete in overseas markets) = Loss of tax revenues ~ Unemployment results in lower income and ‘expenditure, thus resulting in lower cax revenues for the government. ‘= Increased cost of unemployment benefits ~ Unemployment ereates an increased opportunity cost of government expenditure on unemployment benefits. Prolonged petiods of high unemployment can therefore lead to increased government debts = Loss of income for individuals ~ Unemployment results in lower household income, with negative consequences for individuals and their families. IF prolonged, unemployment can cause (or increase) poverty in the economy. ‘= Greater disparities in the distribution of income ~ As women, the ‘young, ethnic minority groups and those living in rural areas tend to suffer more from profonged periods of unemployment, the resule will be greater discrepancies in the distribution of income and wealth. The social consequences of unemployment include the following: «= Stress — The unemployed suffer from stress, depression, health problems and low self-esteem. Prolonged periods of unemployment can lead to homelessness and family breakdowns, such as arguments, separation and dlivorce, In extreme cases, unemployment has led to suicides. ‘= Crime — The impact of unemployment in individuals can cause deprivation and desperation, thus leading to increased crime, such as theft and vandalism. ‘= Indebtedness ~ Lower income, caused by unemployment, leads to increased indebtedness for individuals, firms and the government, Indebtedness can ‘cause bankruptcy, leading to absolute poverty, hunger, disease, homelessness sand even suicides. ‘= Social deprivation ~ The local community can suffer if there is mass unemployment, for example poverty, falling house prices (and hence asset values) and increased erime rates Types and causes unemployment rReteed Frictional unemployment occurs when people are in transition between jobs dlue to the time delay berween leaving a job and finding or starting a new one. It ss aluays present because st takes time for the labour market ro match available jobs with suitable candidates. Structural unemployment (see Figure 2.17) oceurs when the demand for products in a particular industry continually falls, thus reducing the demand for particular labour skills Tecan also be caused hy changes in geographical76 Economics for the IB Diploma locations of industries (for cost advantages) and labour market rigidities (such as, the unwillingnes of workers to accept lower wage rates). + eda nfo de dona by bo Inon tdany fom By caves he Cropton vel ol fom hi Ny «The oy ss fom srl ond ong jam Gene ncbrend lv wage mi fang os Ws + hy ci hos in sct Anerley! fd ow eb wt ang + The Ur ramp, os expend tele uesnpoatnsiping, es, Soledad inn order aking Woge rate {$] S 5 Employment kvel Figure 2.17 Structural unemployment Seasonal unemployment is caused by regular and periodical changes in demand for certain products, For example, fruit pickers are in high demand luring the summer months whilst retailers in many parts of the world hire more temporary workers during the Christmas holiday season, ‘Cyclical unemployment (or demand-dleficient unemployment) is the most sevete type of unemployment as it can affect every industry in the economy. It is caused by a lack of aggregate demand, which causes a fall in national ineome (see Figure 2.18), ‘The concept of hidden ‘unemployment is important to economists. There are plenty of people who are not included in the Cfficial calculation of unemployment statistics (due to the choice of ‘measurement rather the core meaning Cf unemployment - the non-use of factors of production). It includes, for example, discouraged workers who = «The decline In aggregate demand fam z AD) 1S AD, coves natanal outta.” have stopped actively searching for a fall from ¥} to Yo, employment. «This crmaee widespread! unemployment ima oconomy ‘* Demaredeficon! unemployment is ‘azocicled wth a dace nthe business ele (curing recessions and shmp ‘average pn ° % National ouput Figure 2.18 Demand deficient unemployment Government policies to deal with unemployment Governments can deal with the problems of unemployment in various ways, depending on the types and causes of unemployment in the economy: ‘= Frictional unemployment — This type of unemployment can be reduced by improving information services to aid job seekers, However, imperfect information in the labour market can worsen frictional unemployment as people are unaware of available jobs. = Seasonal unemployment — Improving the skills of seasonally unemployed workers helps to reduce occupational immobility. Policies to improve ‘education and raining will give these people a better chance of re- ‘employment and the incentive to find work. ‘= Structural unemployment Governments can intrexluce a broader range of vocational training programmes, greater access to university courses (10 allow people to retrain) and offer more job training opportunities. However, this ‘comes at an opportunity cost to taxpayers. ‘= Cyclical unemployment ~ To combat this demand-deficient unemployment, the government might choose to use expansionary fiscal policy and/or ‘expansionary monetary policy to stimulate economic activity and hence t© reduce the level of unemployment:Section 2_ Macroeconomics 77 There are four generic policies for reducing unemployment as a whole: fiscal policy, monetary policy, supply-side policy and protectionist policies: = Expansionary fiseal policy — A reduction in taxes and/or increased ‘government expenditure should, all other things being equal, boost ageregate slemand and hence the derived demand for labour (see Figure 2.19), 1 Fiscal policy th usa of toxaion ond ‘a tacte unemployment caused by suciaral unemplayment + Tax culs and trereased goverment erage rice le AD, 10 ADs, hus 4 more employment opportuni. National income Figure 2.19 Expansionary fiscal policy to combat unemployment = Expansionary monetary policy — A cut in interest rates andor a devaluation of the currency should stimulate consumer and business confidence levels, alongside increased consumption and net exports. In time, this will boost the derived demand for labour in the economy (see Figure 2.20). += By lowering intrest rates, the cos! of borencing fal, thus encouraging households cod fms to spend and Ives, 19, AD increases «The higher AD boos the derved demand fr labour cuve fom 10 jo, thus reducing unemplyment The resting a0 in toal woes rom W) 8 Weatracts more labour, Le thete isan exponsion along the Sauve, Real wage a |S] s Employment of labour iN Figure 2.20 Expansionary monetary policy and the labour market ‘= Supply-side policies ~ These are government policies used to deal with imperfections in the labour market and to reduce unemployment caused by supply-side factors. Examples include the following: to Investment in education and training helps unemployed people to gain new skills so they can find employment ~ for example, retraining people structurally unemployed in the manufacturing sector so they can find employment in the tertiary sector. 15 Reduction in trade union powers will mean that labour unions are not in such a strong bargaining position for higher wages in excess of inflation Government intervention to reduce the influence and power of trade unions can help to reduce unemployment. 15 Employment incentives can be offered to firms for training and hiring the long-term unemployed — for example, the government can offer these firms tax allowances anor subsidies to reclce their costs of training and hiring workers 10 Reviewing of unemployment benefits can ensure that there are incentives to seck employment rather than to rely on state welfare benefits. By making it more difficult for people to claim unemployment benefits, people hhecome more proactive in searching for jobs. ‘= Protectionist policies ~ Trade harrier, such as tariffs and quotas, can be used to safeguard domestic jobs from the threat of international competition. For ‘example, Japan imposes up to 778% import taxes on rice ~ the highest rate in the world ~ to protect agricultural jobs in its country, demand side igsuds, such os cyclical and Sporn bens grog dona fom }00Hng rea national Income fom Yj 30 Ya. nr, hi val lead _goveminen! spending polices to influence ‘he level of eccnome detvty ean be used En ‘When evaluating the effectiveness ‘of demand-side policies in reducing tunemployment, note that fiscal and ‘monetary policies might not deal with the root cause(s) of unemployment, such as incentives to work and a Teluctance to accept paid work at prevalling wage rates. Whilst supply-side policies tend to employment, they take longer to eae ees unemployment in the economy.78 Economics for the IB Diploma Caceres PAPER 2 12 In June 2010, Tesco opened Britain's first supermarket without any checkout ‘workers. Instead, one person is hired to supervise the five checkouts, mainly to assist customers who have not used a self-service checkout before. The UK's largest retailer employs around 221,000 workers in the UK but criies argue that such technological advancement would cause mass job losses. {Define the term unemployment, Q) Explain how the UK government could deal with the ‘mass job losses’. a Low and stable rate of inflation ear C1 The meaning of inflation, disinflation and defla Keyword definitions Tnflation is the sustained rise in the average price level in an economy over time. This does not mean that the price of every good and service increases, Ema Make sure you can distinguish buon average the prices are rising. Governments set a target inflation rate} between disinflation and deflation. A asa key macroeconomic objective. fallin the rate of inflation (disinflation) Deflation refers to the persistent fall in the average price level in an ‘means that prices are stil rising on economy over time, ic. the inflation rate is negative. It is caused by a paler cae ee cee continual decline in aggregate demand and/or an increase in aggregate supply | aout the meaning of deflation - an stil by technologes! ees actual fallin the general price level Disinflation occurs when there is a fallin the rate of inflation (i.e. prices are still rising, but ata slower pace) rather than an actual fall in the general price level. Disinflation can lead to deflation if not controlled, with negative consequences for the economy and standards of living in the country. Diagrammatically, deflation results in lower average prices (see Figure 2.21) whereas disinflation is shown by a smaller proportional increase in average prices (see Figure 2.22) The fal n aggregate demand ton ADS Adon cen ‘up e drop Fem Fy 0 Ya Beporool pce lod tle fom Pers. Average pice lvl 6 ° % 4 National out Figure 2.21 DeflationSection 2_ Macroeconomics 79 4 An increase in eggregete demand trom AD fb ADs eoses natona cuperb isa om Yi Ya bar th sees ing fom PoP « Biseilaon occurs when he oof Ineroaeo in AD dows Gown from Dp AD}, wedcng ho tale of trceaso in he gonerl pre evel fom P10 P, Average pice bv ° YY Ye National outa Figure 2.22 Disinflation Inflation and deflation are typically measured by using a consumer price index (CPI). This weighted index measures the change in prices of a representative basket of goods and services consumed by the average household in the economy. The prices of items such as staple food products, clothing, pettol and transportation are likely to be included in the CPI. In the UK in 2013, chooks and blueberries were among the goods in the CPT basket. Different statistical weights are applied to reflect the relative importance of the average households expenditure. For example, a 10% inerease in the price of petrol will affect people far more than a 50% increase in the price of light bulbs, batteries or tomatoes ‘Some students tend to think that inflation is bad for the economy. This is not ikely to be true, Low rates of inflation, of 1-2%, are not usually harmful to the economy because higher prices can encourage firms to supply more output. its when inflation rises too quickly that it can disrupt decision making for households, firms and governments. In fact, deflation is far more of an economic problem than inflation tends to be. 1 weighting in the CPL is based on the proportion of the average income spent on the items in the representative hasket. For example, sal household spends 15% of its income on food, then 15% of the \weighting in the CPL is assigned to food prices. Therefore, items of expenditure that take a greater proportion of income are assigned a larger weighting. Changing fashions and trends, such as greater household expenditure on smartphones and tablet computers, require a review or update of the weighting in the CPI However, it must be noted that the CPI does not necessarily measure changes in average price levels (and hence the cost of living) for all stakeholders in the economy: = The CPL only considers the expenditure of the ‘average’ houschold; whatever this might actually mean ina multicultural society in the real world. ‘= Different income eamers can experience a different rate of inflation because their pattern of expenditure is not necessarily or accurately reflected by the CPL For example, the average pensioner or university student will have different spending habits from a ‘typical’ family household ‘= Inflation figures and calculations may not accurately reflect changes in. ‘consumption patterns due to time lags in collecting data to compile the CPI Economists calculate an underlying rate of inflation (or core rate of inflation), which is an adjusted! measure of inflation that eliminates the suclden, ‘or volatile fluctuations in prices of essential items of expenditure such as il, food and energy80 Economics for the IB Diploma Economists also find the calculation of a producer price index (PPI) useful for predicting inflation or deflation by mensiing changes in the prices of manufacturers and producers (rather than retailers who sell to consumers). The It should be noted that, as a price PPI consists of three price indices: index, the CPI ignores changes in the quality of goods and services ~ for example, the higher build quality of modern computers, televisions, cars and smartphones is not represented in the calculation of the CPI. ‘= raw materials, such as crude oil and copper ‘intermediate goouls, such as components and other semi-finished goods sold to other manufacturers and proxhucers f= finished goods that are sold to retailers, such as Honda or BMW selling their ‘cars to franchised car showroom dealers (operators). Calculating inflation (HL only) ‘The consumer prices index (CPI) isa weighted index of average consumer prices of goods and services over time. It is the most common method used to measure inflation (and hence changes in the cost of living) for a typical household in the economy. ‘A base year, with an index number of 100, is used as the starting period when calculating a price index such as the CPI. So, a price index of 115.2 means prices have in general increased by 15.2% since the hase year Percentage changes in the index number are used to show inflation in subsequent years, So, if prices were to rise by another 5% in the following year, the price index number would become 120.96 (i.e. 115.2 x 1.05), or 20.96% higher since the base year. In practice, price changes in the CPI are measured on a monthly basis but reported for a 12-month period. Calculating changes in the CPI will give the rate of inflation. There are two steps to do this: ‘= Collection of the price data (for the representative basket of goods and services of the average household), collected on a monthly basis. ‘= Assigning statistical weighting to each item of expenditure, representing, dlfferent patterns of spending over time. oe ‘The simplified example below, with three products in the representative basket of goods and services, shows how a CPI is calculated. Assume 2012 is the hase year, when the total price of the basket was $20. Product Price in 2013, Price in 2014 Pizza $9. $10 Cinema ticket 10 su Petrol 8 $35 Total basket price $22.0 S245 To calculate the inflation berween 2013 and 2014, fist calculate the price ines for the two years: = 2013: ex 100 = 110 (prices in 2013 were 10% higher on average than in 2012) = 2014: _— x 100= 122.5 (prices in 2014 were 22.5% higher on average than in 2012), “The inflation rate hetween 2013 and 2014 isthe percentage change in the price indices during these two periods: 1225-110 110 100 =11.36%Section 2_ Macroeconomics 81 eee einai) However, the products in the CPI are of different importance to the typical household, so statistical weighting is applied to reflect this. Suppose, for example, that food consumption accounts for 40% of average household spending, entertainment represents 20%, transport equals 25% and all other items account for the remaining 15%. To create a weighted CPI, economists multiply the price index of each item by the statistical weighting for the item, Applying the weights gives the following results: Product Food Price index 1100 115.0 Weight a40 0.20 Weighted index 10x 04 Entertainment 0.25 ous 1164 1233 Transport Others Weighted index Whilst the price of food has increased the least (only 10%), the spenkling on food accounts for 40% of the typical household so has a much larger impact on the cost of living, Without using weighting, the average price index would be 116.18, ie. Bones eae. The weighted index reduces the CPI to 114.6 because the relatively higher prices of non-food items account for a smaller proportion of spending by the typical houschold, Therefore, the use of a weighted CPI is more accurate in measuring changes in inflation and hence the cost of living. EXAM PRACTICE (HL ONLY) PAPER 3 13 The data below show the inflation rates for ¢ country over 3 years. ist 2nd 3rd 25 ig. 23 Define the meaning of ‘inflation rate’, Rl 'b Explain why inflation was a its highest level in the third year Bl 14 Calculate the weighted price index from the information below. BI ee BauaeNa Mite Food and drink 120 10 Transportation 130 20 Leisure and entertainment 140 30 Housing 150 40 15 Calculate the inflation rate ifthe consumer price index changes from 123.0 in Year 1 t0 129.15 in Year 2, rc 16 Calculate the consumer price index if there is 3.0% inflation during the year if the price index was previously at 130. Rl 17 Calculate how much a basket of goods and services which is currently priced at $1200 would be ifthe CPI increased from 125.0 to 135.0. BI Ema Although the CPl and RPI are the most widely used price indices for ‘measuring inflation, they only take an average measure. They therefore hide the fact that the prices of some products increase more rapidly than others, whilst the price of other products might have actually fallen. Em ‘When evaluating the measurement of inflation, itis worth remembering that there are limitations of using the CPI to measure inflation. For example, the CPi has no relevance for atypical households. Housing costs also vary enormously between countries, ‘making international comparisons difficult, Finally, the CPI does not reflect regional differences and disparities in inflation82 Economics for the IB Diploma Caceres PAPER 2 18 The data below are for @ hypothetical country, Jukeland. (Ea east Cen Clothing 110 10 Food 120 20 Housing 130 30 Others 140 40 Define what is meant by a ‘consumer price index’ (CPD. Rl 'b "The typical household in Jukeland spends more money on housing than on food or clothing’ Explain this statement. rl € Use the data above to calculate a weighted price index for Jukeland. [4] Consequences of inflation Students often define the CPI with reference to changes in the average price of a representative basket of goods, without acknowledging that ‘services are also included in the alculation. Inflation can complicate planning and decision making forhouscholds, firms and governments, with many consequences: = Menu costs ~ Inflation impacts on the prices charged by firms. Catalogues, price lists and menus have to be updated regularly and this is costly to businesses. ‘= Shoe leather costs — Inflation causes fluctuations in price levels, so customers spene mote time searching for the best deals, be it physically or online. They ight also have to make mote regular cash withdrawals. Shoe leather costs therefore represent an opportunity cost for customers. = Consumers — The purchasing power of consumers declines when there is inflation, ie. there isa fall in their real income because money is worth less than before. Therefore, as the cost of living increases, consumers need more ‘money to buy the same amount of goods and services. f= Savers ~ Savers, be they individuals, fiems oF governments, will lose out from inflation, assuming there is no change in interest rates for savings. Hence, inflation discourages savings as money hecomes less effective as a store of value. = Lenders — Creditor, be they individuals, fiems or governments, will also lose from inflation. This is because the money lent out to borrowers becomes ‘worth less than before due to inflation. = Borrowers ~ By contrast, horrowers tend to gain from inflation as the money they need to repay is worth less than when they initially borrowed it. For ‘example, a mortgage at 5% interest with inflation at 3.5% means that the real interest rate is only 1.5%, i the real value of the deb declines. 1» Fixed-income earners ~ Fixed: income earners (such as salaried workers and pensioners whose pay docs not change with their level of output) are worse ‘off than before as the purchasing power of their fixed income declines with higher prices. ‘= Low income earners — Inflation harms the poorest members of society far more than those on high incomes. They tend to have a high price elasticity ‘of demand for goods and services. By contrast, those on high incomes and accumulated wealth are not so affected by higher prices. ‘= Exporters ~The international competitiveness of a country tends to fall when there is domestic inflation as exports become less price-competitive This causes a drop in profits, leading to a fall in export earnings, lower ‘economic growth and higher unemployment. ‘= Importers ~ Imports become more expensive for individuals, firms and the ‘government due to the decline in the purchasing power of money. Hence, inflation can cause problems for countries without many natural resources such as petroleum, steel, rice and coffee. Governments aim to cantral inflation because it reduces the value of money and the spending power of households, governments and firms. For example, inflation was around 48% in Syria in 2013, meaning that the general price level increased by an. average of 48% in a year.Section 2_ Macroeconomics 83 ‘= Employers ~ Workers are likely to demand a pay rise during times of inflation to maintain their level of real income. As a result, labour costs of production rise and profits margins decline, ceteris paribus ‘= Business confidence levels ~ The combination of uncertainty and the lower expected real rates of return on investment (due to higher costs ‘of production) tends to lower the amount of planned investment in the ‘economy. = A wage-price spiral occurs when trade unions negotiate higher wages to keep income in line with inflation, but this simply fuels inflation as firms raise prices to maintain their profit margins. Therefore, high inflation makes conditions far less predictable for economic stability, ic. there is greater uncertainty for consumers, producers and the government Ca Neh GTA SD PAPER 3 19 Study the data below and answer the questions that follow. INFLATION RATE (95) | WAGE INCREASE (%4) 1 25 3.0 2 BA 35 3 29 [aa ‘a In which year was there the largest increase in real wages? Explain your answer, BI b Explain why average wages were higher in Year 3 than in Year 2. BI eee PAPER 2 20 Iran's inflation rate climbed above 30% in 2013, having reached 31.5% at the end of the Islamic country’s calendar year. The country, with a population of 74.8 million, had experienced double-digit inflation rates for most of the past decade. At the end of 2010, the government reduced food and fuel subsidies, thereby fuelling inflation. In addition, international sanctions due to Iran's, disputed nuclear programme forced down the value of the Iranian rial, the country's official currency. This meant added pressure on higher prices in the economy. Inflation rate in Iran March 2012 Dec 2012 ‘March 2013 ‘a With reference to the data above, explain why prices in Iran were generally higher in 2013 than in 2012. (4 Explain two reasons why the Iranian goverment might aim to control the level of inflation in its economy. ia ‘¢ Evaluate how some Iranians ate likely to have been moe affected than84 Economics for the IB Diploma Consequences of deflation ‘The consequences of deflation depend on the cause. Benign deflation is generally positive as the economy is able to proxhuce more (an outwards shift of the LRAS curve), thus boosting national output and employment, without an inerease in the general price level (see Figure 2.23). AS) ASy__* Dellaton can be caused by higher AS, |e, metesed prodcte capaci of the economy ' This cves down the generel pice level of goods and services rem P to Pp whist increasing national coms from Yb ¥. 1 Sich deflation ls colad benign dallaton [nonthreciening dofltion|, pathape caused by higher producti ‘or technological progress. ‘Average price kvl ° YY National income Figure 2.23 Deflation caused by supply factors Economists are concemed with malign deflation, which is generally harmful to the economy due to a decline in aggregate demand for goods and services, ‘often associated with an economic recession and rising levels of unemployment (see Figure 2.24), * Deflation can luo be caused by a lefwards shit of he aggregate demand cue kom AD\ Io AD This reduces national income fem Yo Ya, and forces down fe neal price level from F 1 Fa. + This causes malign deflation [deflation hs hail 6 the ‘economy i § é ° % Yi Navona income Figure 2.24 Deflation caused by demand factors, ‘The consequences of malign deflation include the following = Cyclical unemployment — As deflation usually occurs due to a fall in aggregate demand in the economy, this causes fall in the derived demand for labour, ie. deflation can cause huge job losses in the economy. = Bankruptcies ~ Consumers tend to spend less during periods of deflation, so firms suffer from lower sales revenues and profits. This makes i¢ more difficult for them to pay theie costs and liabilities (debts such as mortgages), thus ‘causing a large number of bankruptcies. ‘= Lower investment expenditure — Firms have less of an incentive to invest because they receive lower prices and hence profitability. This can have a detrimental impact on economie growth, = A rise in the real value of debts ~ The real cost of debts (borrowing) increases when there is deflation because real interest rates rise when the price level falls. For example, if interest rates average 1.0% but the inflation, rate is ~1.5%, then the real interest rate is 2.5%, * fallin the value of wealth ~ Duc to declining profitability sate rics fill "Th sent to which an economy luring times of deflation. This means that dividends and the capital returas Siete by malign deflation ll ‘on holding shares also fall, thus reducing the wealth of shareholders. orend crite amity cistron = Government debt ~ With more bankeuptcies, unemployment and Pongal avpelenon tesa aia lower levels of economic activity, tax revenues fall whilst the amount of inflation in 2013 would have been ‘government spending rises (due to the economic decline associated with, very different from Somalia’ ~15.35% ‘malign inflation). This can create a budget deficit for the government. inflation rate in the same year.Section 2_ Macroeconomics 85 = Declining confidence levels — With deflation and the subsequent rising real value of debts, both consumer and business confidence levels fall, further adding to the economic problems in the country — for example, consumers ‘may postpone their spending and firms postpone their investments. ees PAPER 2 21 For much of the past 20 years, Japan has suffered from deflation (see the chart below). JAPAN INFLATION RATE ‘Annual change on consumer price index 4 4 2 2 ° ° = a 4 4 Jn/95 — Jon/98——Jan/01. Jan /0A—Jon/07—Jon/10 fn /13 Define the term deflation. p) 'b Explain what evidence there is in the chart to suggest that Japan has suffered deflation for most of the past 20 years. ica} ‘¢_Explain the impacts of prolonged deflation for the Japanese economy. 14) Causes of inflation ‘There are two main causes of inflation: demand-pull inflation and cost-push, inflation, Demand-pull inflation is inflation triggered by higher levels of aggregate demand in the economy, which drives up the general price level (see Figure 2.25), Hence, an increase in any determinant of aggregate demand (changes in consumption, investment, government spending and net exports) will cause «lemand-pull inflation, for example higher GDP per capita, income tax cuts or lower interest rates + Dung an economic boom, consimplion ef goods and sanices inereoses de ks higher GDP per copa rd higher levee of employment. Tho stew bya aha i of 18 aggregate demand cine fom AD, to Abs sing ronal income fom {0 Yang increcung he general pce level ram Po Pa (General price evel 5) ° Ye Notional income Cost-push inflation is triggered by higher costs of production thus shifting "an increase in aggregate dernand has aggregate supply to the left andl forcing up average prices (see Figure 2.26). airinead nee on ten nahee ‘Causes of cost-push inflation include higher imported prices for raw is spare capacity in the economy, ie materials, components (semi-finished goods) and finished goods for sale, if aggregate supply is relatively price higher wages in the economy, increased corporation taxes and soaring rents for elastic. commercial properties.86 Economics for the IB Diploma ‘Higher ram material costs, increased wages, and sooring rene shit the aggregate supply ‘cure from SRAS} 10 SRAS: This forces up fe average price level fom Py to Py but duces aioe income fom ¥; 12 Ya (General price evel ° % Mi National income Figure 2.26 Cost-push inflation Types of inflation Aypes of inflation rep Table 2.3 Types of inflation croeping ‘Occurs when prices are rising slightly, Le. very low rates of inflation up to around 3% per annum. itis inflation the mildest form of inflation and presents few problems for the economy, More economically developed countries (MEDCs) tend to experience creeping inflation Moderate Refers to single-digit inflation rates (les than 10% per year). Professor Paul A. Samuelson argues that inflation ‘moderate inflation represents a stable rate of inflation and isnot a serious economic problem Strato Refers to double-digit, and often triple-digit, rates of inflation. It occurs if moderate inflation persists inflation (continues to increase) and is not controled. Prolonged periods of strato inflation (sometimes referred to 2 chronic inflation) can lead to hyperinflation, Hyperinflation Refers to extortionately high and uncontrollable rates of inflation — for example, Zimbabwe's macroeconomic mismanagement between 2003 and 2009 resulted in hyperinflation of 231,000,000% in July 2008, resulting in the issue of 100 trillion Zimbabwean dollar banknotes! Itis difficult for an economy to break out of a downward deflationary spiral Japan has Students are often quoted stating that suffered deflation for much of the past 20 years). Business and consumer confidence demand-pull and cost-push are the levels would need to increase significantly to boost aggregate demand. It might be two types of inflation. This is incorrect, possible, for example, to cut interest rates to encourage consumer spending and as these are the causes, not the types increased investment in the economy. of inflation.Section 2_ Macroeconomics 87 Government policies to deal with inflation In general, inflation can be controlled by limiting the factors that cause demand-pull inflation and cost-push inflation, For example, the government can raise taxes and interest rates to limit consumption and investment expenditure in the economy to control demand-pull inflation. Policies to deal with demand-pull inflation include the following: = Deflationary fiscal policy to reduce agercgate demand ~ for example raising both direct and indirect taxes to reduce consumption and/or lowering ‘government expenditure ‘= Contractionary monetary policy — for example, raising interest rates and/or reducing growth of the money supply to limit consumption and investment ‘expenditure. ‘= Supply-side policies to boost national output — for example, improving productivity and/or labour relations in onder to increase aggregate supply, thus dampening the impact of inflation, s= Import controls to reduce the chances of experiencing imported inflation (caused by higher import prices of esiential goods and services such as oil and financial services) Policies to deal with cost—push inflation include the following: ‘= Negotiations with labour unions to match any annual wage rises with higher productivity levels, thus limiting inflationary pressures by boosting aggregate supply: ‘© Government intervention to limit annual nominal wage inereases, thus preventing a potential wage-price inflationary spiral ‘= Subsidising prexiuction to moderate costs, and hence prices. Some countries, such as Tran and France, have uses subsidies for food and fuel to reduce price inflation in the economy. ‘= Revaluation of the currency on the foreign exchange market, as the higher ‘exchange rate helps to lower the cost of imported raw materials, components and finished goods Governments are likely to use a combination of contractionary monetary policy, deflationary fiseal policy and supply-side policies to combat inflation. Collectively, however, contractionary policies are likely to reduce the level ‘of economic activity, thus possibly harming economic growth, employment ‘opportunities and international trade. Possible relationships between unemployment and inflation (HL only) FReveed ‘The short-run Phillips curve shows a potential trade-off between inflation andl unemployment. A fll in unemployment, de to an increase in aggregate demand, creates more consumption expenditure in the economy, thereby fuelling inflation (see Figure 2.27). The model is named after New Zealand economist William Phillips (1958) ho used data from the UK from 1861 to 1957 to show the trade-off between, the unemployment rate and the rate of change in nominal wages (which correlates to pice stability). ‘The short-run Phillips curve shows that there is a natural rate of unemployment (NRU) ~ the unemployment rate that exists when the inflation rate is ero. The NRU és the unemployment rate that exists a fll employment, ‘ce. where the demand for lbour equals the supply of labour. It exists at the full employment level of output, 4. che sum of frictional, seasonal and structural unemployment When unemployment isahove its natural rate, deflation oceurs because the inflation rate becomes negative An increase in aggregate demand will rend to cause a movement up (to the lefe) along the short-run Phillips curve because unemployment falls whilst the average price level begins to rise.88 Economics for the IB Diploma Philips cure Wage ination 18 ° Unemployment rte (2) Figure 2.27 The short-run Phillips curve (SRPQ) The Phillips curve can shift over time. For example, a reduction in structural ‘unemployment will tend to shift the Phillips curve to the left. Supply shocks shift the short-run Phillips curve to the right (creating a higher NRU}, for example oil crises, financial crises, natural disasters (such as severe flooding or drought) and the spread of contagious (infectious) diseases. The Phillips curve lost some credibility in the 1970s due to the existence of stagflation — when unemployment rises (due toa fall in real national output) with inflation occurring in the economy, Stazflation is often eatised by supply shocks. Subsequent studies of the Phillips curve showed that the trade-off between. inflation and unemployment only seemed to exist in the short-run. In the long run, there is no trade-off (see Figure 2.28) because inflation woukd be stable, + The ovement fom ptt Ap pat con be caved by exponsenony fae ond rmonotny poles «Red yee lah wfston, so weskars paar ghar nominal weg, «Fass ot oacheble so fe sh Fhlips cr sham SC SRC wath rene rn NEL « Hence, orp recs eloyment bows real wl bo errr the ng nn shown bye mover fon part Bi pont Wage infaon (8) Unemployment a Fe Figure 2.28 The long-run Phillips curve (LRPC) The SRPC can shift ourwands due to a decrease in SRAS, pethaps caused by supply shocks such as an oil shortage, natural disaster or a global financial crisis. In extreme situations, this can lead to stagflation. Mose governments strive to reduce the NRU (shifting the LRPC to the left) by creating incentives to work and encouraging more (re)training, schemes for the unemployed ro improve their occupational mobility. Economic growth The meaning of economic growth Economists believe that sustained economic growth is an important ‘macroeconomic objective because itis the most practical measure of standards of living in a county. Economic growth represents the long-term expansion in the productive capacity of che economy, ie. the annual percentage change in GDP, Diazrammatically, economic growth can be shown by a rightwands shift of the long-run aggregate supply curve (see Figure 2.29) or an outwards shift of the production possibility curve (sce Figure 2.30), Economic growth occurs when there is an increase in the quantity and/or quality of factors of production, such as an increase in labour productivity or improvements in the state of technology. Negative economic growth results in a recession in the business cycle. tion Economic growth refers toan increase ina country's real gross domestic product over time, annual percentage change in real national output . theSection 2_ Macroeconomics 89 WRAS, RAS + Economic growth can be shown by 0 fitwarde chit the LRAS eure fom 3 {RAS LEAS, caused by on watove in i — Fe pont ep che scons. s « Thelscased by amines ne quaity = ‘and/or quality of factors of production, ° [Notional output Figure 2.29 Economic growth and the LRAS Figure 2.30 shows that economic growth occurs when there is an increase in the actual output of the economy. This can result from the use of unemployed resources (Point A to Point B) or from improved factor utilisation and increased procluctive efficiency (Point B to Point C). Eno Although economic growth is ‘generally regarded as the key indicator 4 + A combination ofan incase nthe of economic wellbeing or the general $ ‘quan are quoliy of faces of standard of living in a country, there ! fcc ai FPC caw ae other measures, such a5 the PAC to FAC, creating me Hyman Development Index (HDD. i po, Maer edansaaek ‘This composite index measures three dimensions of ving standards: healthcare (ite expectancy), education a (years of schooing) and income levels Sen (eal GOP per capita) ° Figure 2.30 Economic growth and the PPC Calculating economic growth (HL only) Economic growth is measured by calculating changes in real gross domestic product. ‘Changes in nominal GDP figures give gross domestic proxhuct at eurrent prices, whereas changes in real GDP figures give gross domestic product at ‘constant prices (allowing economists to compare growth rates over time without the impact of price inflation). A GDP deflator is an index number used to convert nominal GDP to real GDP by eliminating the impact of inflation on the calculation of GDF. It can therefore be seen as a measure of the general level of inflation in the economy. Real GDP is calculated by dividing nominal GDP by the GDP price deflator and then multiplying the result by 100. Coes Real Nominal Nominal | GDP GDP. growth Year | GDP (fbn) | deflator | (Sbn) | rate (%)__| rate (%) 2012 120.0 100.0 | 120.00 = = 2013, 126.5 1028 | 123.05 541 254 2014 136.2 1064 | 128.00 267 402 ‘With 2012 as the base year, the nominal GDP is equal to real GDP for the year, ie. $120bn. ‘With inflation cunning at 2.8% in 2013, the nominal value of GDP includes higher prices due to inflation. A GDP deflator of 102.8 means that real GDP. 126.5 102. is actually 123.05bn.90 Economics for the IB Diploma Wiens ‘The real growth rate between 2012 and 2013 is therefore: 123.05-120.0 120 ‘Note that growth in nominal GDP is higher: 126.05 - 120 120 Similarly, in 2014 the nominal GDP is deflated to yield x100=2.54% % 100= 5.41% 136.2 Jogg *100=$128.0bn ‘The growth rate between 2013 and 2014 is: 128-123.05 123.05, Note that growth in nominal GDP is again higher: 136.2 126.5 1265 100 = 4.02% 100 =7.67% Causes of economic growth Factor endowments refer to the quantity and quakity of a country’s factors of production — for example, Saudi Arabia is well-endowed in the supply of oil France has plenty of arable land for its agricultural output, and Australia has many natural resources such as ¢oal, gold and iron ore. Discovery of raw materials such as oil, or any other tradable commodity in a country, will increase its productive capacity and so tend to shife the PRC outwards, ‘The size and skills of the labour force impacts on the country’s economic: growth —for example, India’ lange labour force and Germany's highly skilled workers have contributed to the economic growth of these countries. The mobility of labour refers to the extent to which workers are willing and able to change jobs (occupational mobility) and move to different locations for employment (geographical mobility). The more mobile workers are, the greater economic growth tends to be, Labour productivity refers to the output proxluced in a given time period. It is determined by several interrelated factors such as the qualifications, experience, training, skills and motivation of the labour force. Higher productivity tends to lead to greater economic growth. Investment expenditure in capital and human resources is vital for long term competitiveness and economic growth as it boosts the country’s productive capacity —for example, foreign direct investment can stimulate economic growth and development. Nees PAPER 2 22 According to The Economist's Economist Intelligence Unit, Macau's economy _grew by 14.39 in 2013 — the highest economic growth rate for any coun the year. The island nation had enjoyed 9.8% growth in 2072 with gambling revenue increasing by approximately 14% to about $38 billion, making it the ‘world's biggest gambling market ahead of Las Vegas In 2011, Macau enjoyed a stunning 20.7% growth rate. The county i also investing huge amounts of ‘money to attract a wider range of tourists with casino giants such as Sands and [MGM Resort also investing large sums of money into the economy. Define the term ‘economic growth’. RI Explain how investment in Macau helps to boost its economic growth. [4]Section 2_ Macroeconomics 91 Consequences of economic growth Impacts on living standards ~ Economic growth tends to lead to higher standards of living for the average person. Higher real income per head enables people to spend more money to meet their needs and wants, thus helping to eliminace absolute poverty in the country. ‘Unemployment — Economic arowth leads to higher levels of employment in the economy. This helps to raise consumption and encourages further investment in capital, helping to sustain growth in the economy. Inflation ~ If the economy grows rapidly duc to excessive aggregate demand in the economy, there is the danger of demand-pull inflation. This can lead to the prices of goods and services rising to unstable levels, with a negative impact ‘on the economy's international competitiveness. Income distribution — Economic growth often creates greater disparities in the distribution of income and wealth, widening the gap between rich and poor However, economic growth also leads to greater tax revenues, enabling the government to redistribute income and wealth, ‘The current account of the balance of payments tend to improve with economic growth due to a hij component of aggregate demand). Sustainability ~ Growth usually creates problems for the sustainability of scarce resources and economic wellbeing, such as resource depletion (e-8 deforestation and overfishing), pollution, congestion, damage to ecosystems, land erosion and climate change. The current account value of net exports (a Equity in the distribution of income Eno Whilst economic growth is generally seen as a desirable macroeconomic objective, remember that individuals do not benefit equally from economic growth, sauty inane erseriurtion oF income __ grew The meaning of equity in the distribution of income ott ______W_qn Equity differs from equality in the distribution of income. Equity is based on the arzument that income inequalities (such as wage differentials) are needed to create incentives for people to study and work harder, Equality means equal distribution of income in the economy. Economies face unequitable distribution of income due to the natural ‘unequal ownership of factors of production in a free market economy. For example, consider the wage differentials between professional footballers, doctors or pilots and those earning the national minimum wage. Indicators of income equality/inequality Keyword definitions Equity means fairness, such as those with higher levels of qualifications, skills and experience heing paid ‘more, 50 justified inequalities exist. Equality means there is parity in income (earnings) between individuals, ie, everyone is paid equally, so no inequalities exist. The degree of income equality (or inequality) can be measured by the relative share of national income carned by given percentages of the population. Deciles refer to the statistical method of splitting data into tenths, with each part accounting for 10% of the population, For example, if the top decile (10%) of the income earners accounted for 45% of the national income, there would, be huge income inequalities. Quintiles are used to divide statistical data into fifths, with each part representing 20% of the population. The Lorenz curve, named after US economist Max Otto Lorene (1905), isa graphical representation of income distribution in a country. It shows the degree ‘of income inequality, such as the poorest 10% of income earners accounting for just 1% of the nation’s income. In Figure 2.31, the 45° line shows perfect equality in income distribution, For example, at point A the first four deciles account for 40% of the national92. Economics for the IB Diploma The Lorenz curve shows the actual income distribution in a country. Point B in Figure 2.31 shows the hypothetical situation where 60% of the population. account for just 20% of the nation’s income. So, the top four deciles must earn the remaining 80% of the national income, ‘The greater the area between the 45° line of total income equality and the Lorenz curve (as shown by the area between the two curves), the greater the income inequality in the country x 100 f° 5 60. 3 A = 40 zg # 2 Lorene cue z 8 ooo 0 20 40 60 80 100 ‘Curnultve share of population (8) Figure 2.31 The Lorenz curve The Gini coefficient, named after Italia statistician Corrado Gini (1912), isa statistical tool that measures income inequality, with the outcome ranging from 0 (complete equality) to 1 (total inequality). [tis a numerical representation of a country’s Loren: curve. ‘Arone extreme, if an individual accounted for all national income, the Loren? curve would pass through the coordinates (0, 0), (100, 0) and (100,100) leading to a Gini coefficient equal to 1. At the other extreme, there is total equality as shown by the (45°) ine of perfect equality. The Gini coefficient is calculated by the ratio of che area under the Lorenz curve to the area under the 45° line of complete equality, which has a total area of 100x109 _ 5999, In general, low-income countries and/or those that suffer from a high degree of corruption have a high Gini coefficient, such as Haiti (0.592) and South, Africa (0.631), High-income countries tend to have a low Gini coefficient, such ais Germany (0.283), Finland (0.269) and Denmark (0.240). Most governments strive to achieve greater income equality over time, ‘They can use the Gini coefficient to measure whether income distribution is increasing or decreasing Poverty ‘Common mistake Do not misinterpret the Gini coefficient as a comparative measure Cf national income between countries. Different countries with the same Gini coefficient do not have the same rational income (GDP), as this too! Is used simply to measure relative equality in income distribution. Poverty refers to the state of an individual, houschold or country being extremely poor, i. not having enough money to meet basic human needs such 1s food, clothing, shelter, healthcare and education. The World Bank describes poverty as a situation people want ro escape, Definitions of poverty are relative because it varies considerably depending ‘on the situation in different countries. Fecling poor in Finland or Norway is dlfferent from living in poverty in Sierra Leone or Namibia. Different degrees of poverty also exist within the borders of a country. The relative poverty in a country is determined by examining the percentage ‘of the population with eamings less than a predetermined percentage of the ‘median income within that country. ‘Tackling poverty is a key economic issue because, apart from humanitarian, reasons, it represents economic inefficiency preventing people and economies from reaching their full potential. Keyword definitions Absolute poverty exists when people are deprived of basic human needs for ‘human survival. Those in absolute poverty suffer from malnutrition, hunger, a lack of clean water, poor healthcare and inadequate shelter Relative poverty refers to incomes, and hence consumption, below the social norm within a country. It can lead to damaging effects on individuals and families, including social exclusion. It is a comparative measure, so relative poverty will differ from country to country.Section 2_ Macroeconomics 93 Causes of poverty Table 2.4 Possible causes of poverty Low income ‘Without sufficient money, households will not be able to meet their basic human needs. ‘According to The United Nations and World Health Organization, people earning less than 52 per day suffer from absolute poverty Unemployment ‘Without a job, people are unlikely to be able to sustain their standard of living. The consequences of unemployment include lower self-esteem and depression, and higher rates of crime, violence, health problems and homelessness, Lack of human capital The lack of sufficient provision of, and investment in, education and training leads to mass, poverty. Without the necessary knowledge and skil, the workforce will be unproductive and national income will be significantly lower than its potential, ‘Overpopulation The lack of population control means that GDP per capita will end to decline, thus causing ADp, ceteris pons + This increases reo national cutout from 1 Yi, hereby clsing he detlstonary _gop the diflerence betwen aquilinum Fotionel ouput ond the ful employment level of notional ou SPAS Price lvl (§ 2 yy Defatonay 9p Real national outpet Figure 2.34 Expansionary monetary policy and deflationary gaps104 Economics for the 8 Diploma Ifthe economy operates at less than the full employment level (ie. itis ‘operating on its SRAS curve), then expansionary monetary policy will tend t increase aggregate demand with a corresponding rise in real national output. However, a consequence of easy monetary policy is the potential emergence of inflationary pressures. This can be seen in Figure 2.34, with the average price level rising from P, to Ps. This is particularly the case if the economy is ‘operating on the vertical part ofits LRAS curve, Contractionary monetary policy (or tight monetary policy) can help to close an inflationary gap. An increase in interest rates, for example, tends to reduce consumption and investment in the economy, thereby reducing real national output (see Figure 2.35), ‘= Tight monetary policy (such os higher inerest res) shi the cagtegate demand ‘cure lefiwards from AD} fo ADp, cols ponbus «This chris real national ouput from fo Yj, 20 hat oct ouput no longer exceeds potential vip ‘= Thus, contactonary monetary policy helps to clase the inflationary gap, esoring pees bock to fom Py. ° ¥__i Infononery 2p Real national output Figure 2.35 Contractionary monetary policy and inflationary gaps Tight monetary policy can be used to control the threat of inflation, although higher interest rates can harm economic growth and therefore cause job losses in the long run. Monetary policy and inflation targeting Itis possible for the real interest rate to be negative. This happens when the nominal (actual) interest rate is less than the inflation rate — for ‘example, if the nominal interest rate is 3% whist the inflation rate is 4.296, then the real interest rate is 1.2% (ie. 3 - 4.2). This means that an individual with $1000 savings would earn $50 interest, ie. a total Of $1050 at the end of the year However, inflation causes something that cost §1000 a year ago to increase to $1060, so in real terms the money saved has faifen in value Too often, students say that higher Interest rates reduce aggregate demand because they create incentives to save. Whilst this is partially the case, the impact on borrowing is far more significant. Interest rates tend to change by 0.25% at a time, which is barely an incentive for most individuals to save more, However, an extra 0.25% interest charge on people's mortgages will certainly have an impact on their spending ability. The same applies to firms with loans and mortgages. An inflation rate target (or inflation targeting) refers to the practice of central ‘banks in some countries (such as Canada, Finland, New Zealand, South Africa tnd the UK) to use monetary policy to achieve a specific rate of inflation. An. inflation target is used to provide a transparent goal in onder to help control inflation, This is because price stability will enhance confidence in the economy. Central banks use monetary policy to influence rather than to ditectly determine rate of inflation, It is the role of the government, rather than a monetary authority, to focus ‘on achieving an! maintaining full employment and a low rate of inflation (although monetary policy is used to achieve an inflation target, be it explicit oF Implicit). If inflation is predicted to be higher than the target rate of inflation, pethaps duc to-2 housing hoom or increased consumer confidence in the economy, then contractionary monetary policy can be used, and vice versa,Section 2_ Macroeconomics 105 Evaluation of monetary policy ‘The effectiveness of monetary policy can be evaluated through consideration of the following factors: f= Independence of the central hank allows decision makers in theory, to act in the best interest of the economy, without political interferences. = The ability to adjust interest rates incrementally means that policy makers ‘can monitor the effectiveness of monetary policy. It is common for interest rates to change in increments of 0.25%, thus reducing the risks of causing huge disruptions to the economy. © The ability to implement changes in interest rates relatively quickly means that monetary policy can be used to influence and fine-tune mactocconomic ‘objectives. Central banks review the state of the economy and adjust interest rates acconfingly, often on a monthly basis, = Monetary policy may be preferred to fiscal policy because it can be implemented more quickly. Tax changes require careful planning and are time consuming, whilst government spending can be costly. ‘= However, there are time lags to the reaction of households and firms to ‘changes in interest rates in the economy. This can make the effectiveness of ‘monetary policy less certain. f= Changes in interest rates and the money supply can be destabilising to the economy. For example, whilst the property (housing) market in many ‘countries is a key determinant of consumer confidence levels it is highly vulnerable to changes in interest rates ‘= Consumption and investment are not entirely dependent on interest rates. The 2008 financial crisis meanc interest rates were close to 0% in Japan, the USA and Hong Kong, bur the lack of business and consumer confidence led toa prolonged economic recession. ‘= In ackltion, houscholds and firms have different interest elasticity of demand, i.e. some groups are more affected by changes in interest rates than others. This can make it dificult to estimate the extent to which monetary policy is effective in influencing macroeconomic objectives ‘= The effectiveness of monetary policies aimed at increasing aggregate demand is limited if the economy is in a deep recession because confidence levels are low, Firms will not borrow money to invest, even at low rates of interest, if the demand for their products remains low. = The effectiveness of monetary policies aimed at reducing aggregate demand is limited too, as‘hot money’ (the flow of money into the country to gain from higher rates of interest) will increase the exchange rate, This makes exports ‘more expensive and so worsens the trade balance, ‘= Conflict among government economic objectives exist so a cut in interest rates of an inerease in the money supply (to influence the level of economic activity, for example) can conflict with other macroeconomic objectives, such as inflation (price stability). ‘= The use of tight monetary policy can be councerproductive as it restricts ‘economic aetivity and discourages foreign direct investment in the country —for example, higher interest rates raise the costs of production, which negatively impacts on profits, jobs and economic growth, ‘= Monetary policy influences aggregate demand rather than having a direct impact on the economy's long-run aggregate supply. = In the shore run, monetary policy is generally more effective in dealing with demand-pull inflation than in getting an economy our of an economic depression, which might require the use of fiscal and supply-side policies,106 Economics for the IB Diploma Ca euch a eA) PAPER 3. 34 With the aid of an appropriate diagram, explain how the use of monetary policy can help to close a deflationary (recessionary) gap. i 35 The diagram below shows the market for money in an economy, where Dn is the demand for money and $,, shows the supply of money at varying rates of interest. @Outine why the supply of money curve (S,) is vertical at the quantity of money. ri 'b With reference to the diagram, explain which interest rate would ‘cause excess demand for money. rl 2.6 Supply-side policies The role of supply-side policies fe C1 ‘Suppl le policies and the economy SMpiy Side police and the economy ___ yyy ‘Supply-sice policies are aimed at increasing the production sid of an economy, i.e, boosting agarezate supply. This is achieved by improving the institutional Keyword definition framework (the country’s system of rules and regulations) and the economy's productive capacity to produce. government strategies aimed at The productive capacity of the economy is improved by increasing the boceting the productive capacity quantity and quality of the factors of procluction — for example, investment of the economy by increasing the in education and training can improve labour mobility and enhance labour quality and/or quantity of factors of productivity proxluction, for example spending Supply-side policies are used hecause increases in the productive capacity on education and training to cof the economy can only be achieved through an increase in the economy's crore the edocioniy Hun long-run aggregate supply, ic. they are designed to make the economy more capital. productively efficient in the long run, Examples of supply-side policies include the following: ‘= Cuts in welfare benefits, such as unemployment benefits, to create incentives to work. = Labour market reforms, such as greater spending on education and training t0 improve the quality and/or quantity of labour. = Using tax cuts to create incentives to work. = Removal of labour market imperfections, such as reducing the power of trade Supply-side policies can be categorised as either market-based or interventionist, although both aim to shift the LRAC curve outward, i. increasing the economy's potential outputSection 2_ Macroeconomics 107 Interventionist supply-side policies ‘The potential output of the economy refers to the productive capacity (maximum possible output) if ll factors of prexluction are used efficiently. Keyword definition Diagrammatically, the potential output of an economy is shown on its Interventionist supply-side production possibility curve (PPC), policies are the deliberate attempts The institutional framework refers to established systems, structures and by a government to deal with contexts that shape the economic behaviour in a country, for example cultural ‘market imperfections in the norms and the legal system. economy, for example government In the short run, interventionist supply-side policies (such as investment in | retraining programmes to improve human capital and new technology) increase aggregate demand but in the long | the occupational mobility of the rn will increase the economy's aggregate supply. structurally unemployed. Investment in human capital Human capital refers to the stock of knowledge, skills, expertise and experiences of the workforce ‘An important interventionist supply-side policy to increase human capital is to spend on education and training to raise the skills, mobility and productivity of the latour force. Government intervention in labour markets strives to enhance the demand for and supply of labour. It also aims to improve labour mobility Investment in human capital increases national income as the expenditure increases aggregate demand in the short run, In the long fun, investment in human capital improves the productive capacity of the economy as it inereases a country’s long-run aggregate supply Improved communication in the job market can help to reduce frictional unemployment in the economy. The increase in aggregate demand in the short run and the greater productive capacity in the long run mean that investment in human capital is vital for economic growth and development. Investment in new technology CEE Policies that encourage investment in new technology have a short-term effect ‘on ageregate demand because such expenditure will increase AD, ceteris paribus ‘Such policies include low interest rates and tax rebates, both of which can also encourage foreign direct investment. However, in the long fun, investment in new technology can increase the productive capacity and productivity of the economy, i. i shifts the country’s LRAS curve outwards Spencling on research and development (R&D) can improve work processes, thereby enhancing efficiency, for example automation in the car making industry or the use of wireless technology to improve operations in the workplace. R&D can also generate new products for consumption and export, for example energy-saving light bulks, daily disposable contact lenses, electric cars, smartphones and tablet computers. ‘Therefore, investment in new technology can be an important source of international competitive advantage. Investment in infrastructure As investment (I) is a key component of ageregate demand (AD=C +1+G-+ (X—M)), the expenditure on improving the nation’s infeasteucture will increase AD in the short un, thus boosting economic growth, ceteris paribus. In the long run, investment in infrastructure shifts the economy’ LRAS curve to the right and attracts foreign direct investment. This helps the economy to flourish further. Examples of such investments include spending money on transportation networks, telecommunications networks, electricity grids, waste disposal systems and sewerage systems.108 Economics for the IB Diploma Industrial policies Industrial policies are those that target specific key industries to promote economic growth — for example, tax allowances can be used to protect domestic infant industries from larger, well-known forcign rivals. Tax cuts targeted at strategic industries can help to revive these industries, helping them to grow in the long run. ‘A combination of tax breaks and subsidies on commercial loans can create incentives for firms to locate in less prosperous areas of a country, thus reducing unemployment and increasing the economy's long-run aggregate supply Subsidies can also be granted to firms that hire youth workers, mature staff and discouraged workers (those suffering from long-term unemployment). ‘Subsidies might also be offered on loans to encourage business start-ups. Inclustrial policies like all supply-side policies, can improve economic welfare in terms of lower unemployment and increased earnings for those working in. these industries. Thus, industrial policies improve the likelihood of sustainable economic growth, EXAM PRACTICE PAPER 1 36 Examine how supply-side policies can help to achieve any two ‘macroeconomic objectives. {10} Market-based supply-side policies Some students seem to think that industrial policy is used primarily to increase competition in an economy. This is incorrect as industrial poi an interventionist supply-side policy. Both interventionist anc market-based supply-side policies can be used to increase the long-run aggregate supply (LRAS) of the economy, thereby ‘boosting its potential ourput. Examples of market-based supply-side policies inelude the following: f= income tax reforms to improve the incentive to work f= Tabor market reforms to increase aggregate supply policies to encourage competition and efficiency ‘= tax incentives to encourage foreign direct investment. Policies to encourage competition Keyword definition Market-based supply-side policies focus on allowing the free market to operate with minimal government intervention by improving market incentives to increase investment and productivity. Privatisation is the sale or transfer of state-owned assets and operations to the private sector. It can make firms become more efficient in order to make a profit and to survive. Deregulation is the reduction or removal of barriets to entry into certain industries to make markets more competitive and efficient, for example getting rid of government niles and directives in a certain industry to promote competition and greater efficiency. Anti-monopoly regulation can also be used to promote competition in targeted industries, This refers to competition law that controls the restrictive practices of monopolists, hence limiting their market power in the industry. ‘Onan intemarional scale, trade liberalisation involves the reduction or removal of trade barriers, such as tariffs and subsidies, to encourage competition and efficiency. Allowing the free movement of capital flows and encouraging foreign direct investment are further examples.Section 2_ Macroeconomics 109 Labour market reforms ‘Supply-sicle economists argue that the underlying causes of imperfections in the labour market are high rates of income tax and excessive regulations that reduce | Keyword definitions incentives to work. Supply-side policies that target labour market reforms, such | Labour market reforms are as lower rates of income tax, create incentives © work, ie. they motivate people | government policies designed to seek employment opportunities. to create greater flexibility and Market-based supply-side policies aim to make the labour market more efficiency in the labour market, efficient, ie. responsive to changes in the market forces of demand and supply. | for example reducing the A flexible labour force is responsive to changes in the economy —for example, | power of labour unions, cutting workers are able to adapt from declining inclustries to growing industries ‘unemployment benefits and Reducing unemployment benefits can make the labour market more abolishing the national minimum responsive to market forces, as the unemployed can no longer rely on welfare wage, payments andl so have a greater incentive or need to seck employment: A trade union is an organisation Reducing the power of trade unions improves the efficiency of the labour that represents the common market, For example, trade unions push for a (higher) national minimum interest of its members in work- ‘wage but this can be highly costly to firms, thereby artificially reducing thei related matters, for example in international competitiveness. aepeatio erga aa working conditions. Incentive-related policies Reducing direct taxes, such as cutting personal income tax for those earning low incomes, can create incentives for people to work or to seck employment ‘opportunities. Hence, such market-based supply-side policies are designed to reduce the level of unemployment: ‘Cuts in business taxes are used to create incentives to invest by reducing the financial risks of investments. Similarly, cuts in capital gains taxes (imposed on the profit of an asset once sold) can also encourage risk taking and investments in the economy. Evaluation of supply-side policies eoa_r“nlppyeec pons __qamemarp The strengths and weaknesses of supply-side policies ‘The advantages of supply-side policies are summarised in Table 2.7 Table 2.7 The advantages of using supply-side policies to achieve macroeconomic objectives Improved economic Supply-side policies can be used to achieve sustainable economic growth by increasing the growth potential capacity of the economy ever time, Lower inflation ‘As supply-side policies increase the productive potential of the economy, they help to prevent the general price level from rising beyond control Lower unemployment An increase in the productive capacity will tend to increase national output, thereby creating jobs in the economy in the long term. Supply-side policies can also help to reduce both frictional and structural unemployment. Improved balance of Since supply-side policies can improve productivity and national output without pressures on payments ‘he general price level, the international competitiveness of the country should improve, thus helping to increase exports, Improved equity Interventionist supply-side polices can lower the natural rate of unemployment in the economy, thus reducing inequality.1110 Economics for the IB Diploma The limitations of using supply-side policies are outlined in Table 2.8. Table 2.8 The tations of using supply-side policies Time lag, ‘The main criticism of supply-side policies is the time that it takes to reap the benefits. For ‘example, it might take decades for a nation to enjay the benefits of an improved education system or infrastructure in the country Decreased equity Interventionist supply-side policies do not necessarily improve equity in the distribution of income in the economy, i.e. economic growth can create oreater disparities (inequalities) in Income distribution, Effect on the ‘Supply-side polices strive to increase the potential output of the economy but this can come at environment a huge opportunity cost to the natural environment.International economics 3.1 International trade Free trade The benefits of trade International trade is the exchange of goocls and services beyond national borders, It involves the sale of exports (goods and services sold to overseas buyers) and imports (foreign goods and services bought by domestic households and firms). Countries need to trade because scarce resources are unevenly dlistibuted between countries, i. countries have different factor endowments. Economists believe thar the benefits of free international trade tend to exceed the costs, ie. although not everyone gains from free international trade, or gains equally, the net benefits to society are positive. The benefits of international trade are outlined below: = Lower prices for consumers ~ Free trade reduces the costs of trading. For ‘example, unfavourable weather conditions in Sweden mean ic is better off importing cropical fruits from Jamaica. = Greater choice for consumers — Free trade enables consumers and firms to access a larger variety of goods and services from different proxlucers around the world. For example, Germans can choose to buy Lexus cars from Japan rather than being limited to Audi, BMW or Mercedes model = The ability of producers to benefit from economies of scale ~ By operating on a larger scale in intemational markets, free trade enables firms to benefit from ‘economies of scale, ic. cost savings that ean be passed onto consumers in the form of lower prices. = The ability to acquire needed resources ~ Through trade, countries can, access natural resources and capital goods that are not available domestically to further their production, For example, the Maldives can purchase laptops, ‘motor vehicles and Hollywood movies from the USA, = A more efficient allocation of resources — Free trade henefits the economy as it encourages an efficient allocation of the world’s scarce resources. Free trade forces domestic firms to focus on improving the quality of their output due to foreign competition. = Increased competition — Trade ensures that domestic firms become expesed ‘to competition from foreign firms. Hence, domestic fiems are forced t0 become more efficient, ie. to produce goods and services at the lowest possible cost = A source of foreign exchange ~ When countries sell exports, firms and ‘governments acquire foreign exchange (foreign currencies), This enables them to make payments to other countries for the purchase of foreign goods and services. = Increased market sise — International trade enables firms to earn more reventies and profits. For example, American firms can sell products to a domestic market of 316 million people, but can sell to a much larger market ‘of more than 2.4 billion potential customers in China and Incl, ‘= Improved international relations — The absence of trade barriers encourages international trade and cooperation between countries. By contrast, if ‘country uses trade barriers, then other countries are likely to retaliate by doing the same. Keyword definition Free trade occurs when nations can exchange goods and services ‘without any trade bartiers, such as quantitative limits or taxes being imposed on imports. Ee ‘Make sure you can distinguish between the merits of international trade and the merits of free trade — they are not quite the same because rt all international trade entails free trade. Thus, the merits of free trade (without any trade barriers) are greater than the benefits of international trade (which may invalve some trade barriers). ttip1112 Economics for the 18 Diploma PAPER 2 1 Bangladesh is one of the world’s largest producers of rice and tropical fruits. In Brunei Darussalam, crude oil and natural gas account for around 90% of the ‘country’s gross domestic product. This makes Brunel Darussalam one of the leading producers of oil in Southeast Asia. 2 Outline one problem for Brunei Darussalam relying on oll exports. [2] Explain two reasons why countries such as Bangladesh and Brunei Darussalam trade with each other. i ‘¢ Explain how Bangladesh's export of rice and tropical fruits helps its fatmers to achieve economies of scale. 14) Absolute and comparative advantage (HL only) Its incorrect to assume that free trade improves the welfare ofall members of society. For example, some exporters might lose out due to the fierce competition from foreign rivals. e An absolute advantage in the production of a good or service gives a country «competitive edige because itis more productive and efficient. Ifcountry A spends $10m to make 40,000 units of ourput of a particular good whilst country B can only produce 30,000 units with che same amount of money, then country A has an absolute advantage in the output of that product. By specialising in the output of the goods or service, the result is increased production and. consumption (see Figure 3.1) The concept of absolute advantage was coined by Scottish economist Adam ‘Smith (1723-90), extending his doctrine of specialisation and the division of labour. If countries specialised in the output of what they are most efficient at producing, world output would subsequently increase ‘Absolute advantage occurs mainly because different countries have different factor endowments — for example, Saudi Arabia is well endowed with oil, whilst ‘Thailand has the natural climate suitable for harvesting rice. By contrast, some countries have an absolute disadvantage, ic. they are inefficient and unproductive in the output of given goods or services relative to their trading partners Keyword definitions Absolute advantage occurs when a country can produce more of, 1 good or service than another country using the same amount of resources (oF is able to produce the same amount of a good or service using fewer resources). The term factor endowments refers to che quantity and quality of factors of production available in a country, such as natural resources and human capital. Countries well- endowed in natural resources tend tw have a comparative advantage in products using such resources. 50,000 *Broalls production possibilty Foner (FPF shows thal if ean preduce 100,000 units sa 4a;pOu) ‘of coffee leompraed vith Vienan’s 50,000 unt) or 50,000 unis ofinber (compared Broa ‘ith Vietnam's 40,000 unt). Thus, Broa has on absclle advantage in the culput of Boh coffe and hb. Tinker ° 50,000 Coffee 100 6000 Figure 3.1 Absolute advantageSection 3_International economics 113 Suppose two countries, with the same amount of resources, produce books and clothes, Also assume that both countries divide their resources equally between the production of books and clothes. The pre-trade situation is shown below: From the above, we can sce that Alpha has an absolute advantage in ‘bools), whilst Beta hasan absolute advantage in the output of clothe: If both countries decide to specialise based on their absolute advantage, then Alpha gives up 500 units of clothes to produce an extra 1000 units of books. Similarly, Beta gives up 750 u ‘clothes, increasing its total output by an extra. 1500 units: Therefore, total output increases absolute advantage. IF Alpha and Beta now trade now looks like this: Through trade, Alpha has an extra 200 units of books and an extra 300 units of clothes. Similarly, Beta has 50 more Country Books (units) | Clothes (units) Alpha 1000 500 Beta 750 1500 “Total outpue 1750 2000 Country Books (units) | Clothes (units) Alpha 2000 ° Bera ° 3000) Total output 2000 3000 via the countries specialising in the output of the product in which they hold an. 800 units of their surplus with each other, the post-trade s Books (units) | Clothes (units) Country Alpha 1200 800 Beta 800 2200 Total outpuc 2000 3000 units of books and 700 more units of clothes. producing books (itis more productive in producing 's (1500 units compared with Alpha’s 500 units). nits of books to specialise in the production of The theory of comparative advantage was put forward by British economist David Ricardo (1772-1823), who suggested that countries shoukl specialise in goods and services in which they have a comparative advantage (relatively lower unit costs of production). The theory suggests that countries should produce and trade products in which they have a comparatively low opportunity cost, even if the trading partner has an absolute advantage in the output of both products (see Figure 3.2) 50,000] 40,000] Tinbor Broa 50,000 Coffee 100,000 Figure 3.2 Comparative advantage * Despie Broz having an abot ecko Inte od of bah co ond ber conpavaine advoriage ss + Bras oppostiny cos of producing tinbor te Duns eee whereas Vamos eppatiniy costs only 1.25 unis feof, + Silay, Vienan’s oppernty cost f collar is 0.8 uns of mbar but tis oly 0.5 {er Brac, Hence tis cheaper fr Brot _8h0 up producing imbo. * Thorlo, Grom shou! spacial in and sxpor colle, whlst Venom should speciale inthe ouput ber: Keyword definition Comparative advantage exists when a country ccan produce a amount of output at a ower opportunity cost than another country, i. it gives up less resources than other countries producing a certain good,114 Economics for the IB Diploma Sources of comparative advantage include differences in ‘= factor endowments ~ for example, major oil exporting countries such as Saudi Arabia, Russia and che United Arab Emirates are well endowed in oil supply. These countries can inerease production and consumption through, specialisation and international trade. 1» levels of technology — for example, workers with access to the latest machinery and technology will be far more productive than those using ‘outdated techniques. ‘= investment in research and development (R&D) ~ this can give countries a competitive advantage in terms of innovation and inventions. R&D ‘expenditure can also generate new work processes that reduce the relative costs of proxluction. ‘= inflation — this can damage the comparative cost advantages of a country as higher prices mean that foreign buyers are less willing and able to purchase the exports of domestic firms, f= exchange rate fluctuations ~ these can affect the relative prices of exports and imports. A long-term unfavourable change in the exchange rate can cause a reduction in demand from domestic and overseas customers Wore ‘Suppose thar two countries, with the same amount of resources, produce books and clothes. Also assume that both countries divide their resources equally between the production of fits and toys. The pre-trade situation is shown below: Country | Fruits (units) | Toys (units) Delta 3000 1500 Gamma soo | te Total outpur 3500 | 2500 Delta has an absolute advantage in the production of both toys and fiuits, ie. it is better at proxlucing these goods than, country Gamma, However, Gamma can produce toys at a lower opportunity cost: Country Fruits (units) | Toys (units) Opportunity cost Delea 3000 1500 20:1 Gamma 500 1000 a5 | ‘Whilst Delta has to give up 2 units of fruits to gain L unit of toys, Gamma only has to give up 0.5 units of fruits to proxlace 1 unit of toys. Hence, Gamma should specialise in the output of toys. Likewise, if Delta gives up [unit of toys it can produce 2 units of fuits, whereas Gamma can only gain 0.5 units of fruits. Hence, Delta should specialise in the output of fits ‘Suppose Gamma specialises entirely in toysand Delta decides to switch 500 units of toys to produce (1000 extra units of) fruits instead. Hence, the total output increases by 500 units of both fruits and toys: Country Fruits (units) | Toys (units) Delta 4000 1000 Gamma 0 2000 Total ourput 4000 3000 If the countries trade their surpluses, say 700 units of each product, both countries now have more of fruits and toys compared with what chey started with, when there was no international trade: Country Fruits (units) | Toys (units) Delta 3300 1700 Gamma 700 1300 Total output 4000 3000Section 3_International economics 115 EXAM PRACTICE (HL ONLY) PAPER 3. 2. Use the production possibilities data below and an appropriate diagram to ‘explain which country should specialise in the production of Aris and which ‘country should specialise in the output of Walkers. i ees ARIS (UNITS) WALKERS (UNITS) Farrowland 1500 600 Mayland 2000) 500 Limitations of the theory of comparative advantage (HL only) The theory has several limitations: = Ieassumes that comparative advantage is fixed, whereas in reality it is nor. For example, Hong Kong no longer has a comparative advantage in textiles and the UK no longer has a relative cost advantage in che output of steel and. coal. ‘= Teassumes that there are no barriers to intemational trade, although this is not necessarily the case in the real workd, with tariffs and quotas still being imposed by countries, f= Ieisastatie model, which ignores the fact that comparative advantages ean shift between countries over time. = Whilst the theory explains how countries can gain from trade, it ignores the disparities ofthe relative gains from trade, i.e. some countries will gain more than others due to their hetter bargaining pesition and terms of trade. Susi ‘# Transportation costs of trace are ignored in the calculation of comparative When evaluating the reakworld advantage. So, even if Australia is able to produce textbooks relatively relevance. and Jintatons of fae cheaper than the EU, transportation costs to Europe could mean Australia Comparative advantage, ensure that hheaper than the EU, transportation costs to Europe could mean Austral ortaie Saleen has a comparative disadvantage = Ieisassumed that there is perfect occupational mobility of resources, i. factors of production can be switched between different industries without any loss of efficiency. This contradicts the idea of increased gains from trade through specialisation. shortcomings of the assumptions of the model of comparative advantage and (2) consider the arguments for and against free trade. The World Trade Organization (WTO) ‘The World Trade Organization (WTO) was established in 1995 to promote trade liberalisation, to oversee multilateral crade agreements (free trade aagecements between multiple counties) and to resolve trade disputes becween, member states. The objectives of the WTO are as follows: = Toencourage free international trade. Member states are obliged to reduce and remove artificial trade barriers such as subsidies (which reduce production costs for domestic firms). = To remove discriminatory treatment in trade relations between member nations (except for those in trading bloes that have their own set of agreed trate rules), = To help provide trade opportunities for economically developing countries in ‘order to enhance their growth and development prospects ‘The WTO has six functions: = Administering WTO trade agreements ~The WTO provides a forum for ‘members to negotiate trade rules and agreements, which become binding contracts for governments to keep their trade policies within agreed parameters.1116 Economics for the 18 Diploma 1» Forum for tracle negotiations ~ Members of the WTO are involved in ‘Rounds’ of negotiations. There have been nine Rounds so far, with the frst ‘one focusing on lowering tariffs on imported goods. The latest Doha Round ‘of negotiations started hack in 2001. = Handling trade disputes The WTO acts as an arbitrator in trade disputes between member states, It acts to settle such disputes ina quick and objective ‘= Monitoring national trade policies ~The WTO regularly monitors the national trade policies ofits member states through its Trade Policy Review Mechanism. This serves to encourage accountability and transparency on trade policies on a multilateral level = Technical assistance and training for economically developing countries — ‘Trade-related technical support and training are provided to help low-income ‘countries to better understand WTO obligations and agreements and thus build their capacity to trade, ‘= Cooperation with other international organisations ~ The WTO collaborates, ‘ith other organisations to promote economie cooperation and growth, such as the World Bank and the Organization for Economic Cooperation and Development (OECD). Restrictions on free trade: trade protection Ea Note that in some special circumstances the WTO will support maintaining trade barriers (rather than promoting free trade), for example to protect ‘consumers from the spread of disease (eg. bird flu and swine flu). Keyword definitions Trade protection is the use of barriers to trade to safeguard a country from excessive international trade and foreign competition, Barriers to trade are obstacles to free trade, imposed by a government to safeguard national interests by reducing the competitiveness of foreign firms, Types of trade protection Types of trade protection __ rap ‘Tariffs are import taxes —for example, the USA has used a 35% tariff on all tyres imported from China. Tariffs raise the costs of production to importers, thus raising the price of forcign goods in the domestic market, and thereby lowering the amount of imported products (see Figure 3.3). ‘A tariff increases costs of production, thus shifting the supply curve up from Saal cette) Sirs forcing the price up from P; to P2. Figure 3.3 shows the cffects of tariffs (or customs duties) on various stakcholden: = Domestic producers ~ Domestic firms will tend to gain from the tariff as they will receive a higher price (P2 rather than P), and sell a larger quantity (Qz rather than Q). The higher price also means that proxlucer surplus increases by the area a 1» Foreign producers — Importers tend to lose out asthe tariff reduces their price ‘competitiveness and they are only able to sella reduced amounts they could sell Q; ~Q, output before the tariff, bt are onty able to sell Q;~ Qs after the imposition of the tariff = Consumers ~ The value of consumer expenditure on imports is shown by the area ¢ +e. As consumers now pay a higher price of P), there is a loss in ‘consumer surplus, as shown by the area a+ ++ d. Hence, consumers lose ‘our from the imposition ofa tariff * The government ~ Tariffs help to raise revenue for the government. The tariff is shown by the vertical distance between P and P, and as the amount imported is shown by the distance Qy ~Qy, the government gains area ¢ as tax revenue. + Society —‘There is a welfare loss as a result of the imposition of the tariff, as shown by the areas b+ dSection 3_International economics 117 Supply = d Only higher level students need to »,| bbe able to use the tariff ciagram PLS (Figure 3.3) to calculate the effects | ‘on domestic producers, foreign i producers, consumers and the og & a government, ‘Guonty sped Figure 3.3 The effects of tariffs (HL only) Cay Neu hg en AA) PAPER 3 3. Use the diagram below to calculate the following: ‘a. Consumer surplus before the imposition ofthe tarft QI Producer surplus before the imposition of the tari a) ‘© Consumer surplus after the imposition of the taif Ql 1 Hence, if PED + PED\y= 1 then a currency devaluation or depreciation has 'no impact on the current account deficit. Likewise, if PED + PEDy Foreign aid refers to assistance in the form of goods and services granted to LEDCs for the purpose of economic development. It is concessional and non-commercial, i.e. it isa gift from the donor rather than a loan. Foreign aid makes up for the shortcomings of the free market that fails to provide assistance to LEDCs during times of need, such as emergency relief aid following a natural disasterSection 4_ Development economics 1611 Foreign aid to LEDCs can he granted by governments of donor countries or by non-governmental onganisations (NGOs), such as Oxfam. Donations by private individuals are usually made through an NGO. NGOs operate independently of any form of government, often pursuing aims to improve social wellbeing. Examples of such NGOs include Oxfarn and the Bill & Melinda Gates Foundation. Classifications and types of aid Official development assistance (ODA) is foreign aid from donor governments, rather than from NGOs. ‘Humanitarian aid refers to alteuistie aid, typically given to save lives and ‘maintain human dignity in response to violence, natural disasters and national emergencies. It consists of food aid, medical aid and emergency relief aid (e.2. aid for reconstruction work). Development aid is foreign aid aimed at helping recipient countries to achieve their economic development objectives, for example to eradicate extreme poverty, improve education, reduce child mortality and improve the ‘overall standards of living. Development aid can be provided by individual counties, by NGOs, or by multilateral organisations such as the Workl Bank and Save the Chikkren. In general, the priority of development aid from NGOs is to provide foreign, aid on a smal scale to help LEDCs to achieve development objectives, Development aid includes the following: ‘= Grants ~ These comprise non-repayable financial assistance provided by ‘governments, ic. they do not have to be repaid. Most grants are given to fund specific projects = Concessional long-term loans ~ Also known as soft loans, these are loans with highly favourable conditions, such as low interest rates and long, repayment periods. ‘= Project aid — As the name suggests, this is foreign aid for specific developmental projects, such as financial support for schools (education) oF for hospitals and sanitation (healtheate). ‘= Programme aid ~ This is financial aid given to a specific industry, for ‘example funding of education or the financial sector. ‘Tied aid is financial assistance granted with conditions attached — usually the need to spend the foreign aid on buying products from the donor country. Bilateral foreign aid is often a feature of ticd (conditional) aid. Tied aid is often criticised as the LEDC’s requirement to buy goods and services from the donating country might not be appropriate. It is often perceived a an ide cubs for upline donor coutry. Hence ted aid can harm the competitiveness of LEDCs. Nevertheless, a valid reason for (or Foreign aid can be classtied according advantage of) tied aid is that it ensures that financial aid is used for appropriate to the source and the purpose. purposes whilst benefiting the donor country. Motivation for giving aid Table 4.6 Motivation for giving aid ‘Motives for giving aid Details Humanitarian motives Foreign aid is provided for humanitarian reasons, for example emergency relief to help with natural disasters or wars. Itis also given to achieve the UN's Millennium Development Goals, (MDGs), such as eradicating famine and improving maternal health, Economic motives Donors alve ODA because its in thelr financial interest to do so as this bullds better economic {les with the recipient countries ~ for example, tied aid provides economic benefits to the donor county, Political motives ‘Many European countries such as the UK and France provide ODA to thelr former colonies. Historically, the USA has provided ODA to support capitalisin and free market practices, Japan has given aid to Nicaragua to influence its vote on banning whaling.162. Economics for the IB Diploma —————EEEE ee ae ee eG ‘httpu/tinyurl.comAt970z0 Evaluation of foreign aid Advantages of foreign aid ‘= Without foreign aid, many of the world’s poorest countries would struggle to ever get out of the poverty cycle. Thus, there are both humanitarian and ‘economic benefits to providing ODA. ‘= Foreign aid in the form of ODA and concessionary long-term loans can be used to increase the productive capacity of the LEDC, thus helping it to achieve economic growth. ‘= Foreign aid can help to reduce or eradicate extreme poverty (one of the UN's Millennium Development Goals). = Asa form of injection into the circular flow of income, foreign aid can help to reduce inequalities and unemployment in the LEDC. Disadvantages of foreign aid «= Foreign aid in the form of loans imposes interest repayments, 90 this adds to the financial burden of many LEDCs, especially as debts have to be repaid in foreign currencies, # LEDCs tend to prefer more favourable terms of international trade to help their economic development than outright foreign aid — for example, food aid and tied aid do little for the long-term prosperity of an LEDC. ‘= Most economists argue that economic development should be based on promoting free international trade, such as increasing the exports of LEDCs, instead of relying on foreign aid. This is because ODA does not necessarily lead to development, whereas trade does. ‘= Foreign aid can create economic depenclence on donoss from MEDCs. This does not help the country to develop in the long run. ‘= Comupe governments in LEDCS often misuse foreign aid rather than passing on the funds to local projects that woul henefit local industries and communities ‘= More often than net, ODA is insufficient to really help LEDCs develop theit ‘economies. The aftershock of the global financial crisis of 2008 also led to a decline in donations (as a percentage of the GDP of MEDC), ‘= The type of foreign aid given is nor always appropriare ~ for example it might promote capital-intensive projects rather than labour-intensive output, which are hetter suited for LEDCs, Foreign aid might alo involve political interferences rather than direct economic benefits. Multilateral development assistance Erma “Give aman a fish, and you feed him for a day; show him how to catch fish, ‘and you feed him fora lifetime” (Anne Isabella Thackeray Ritchie, 18371919). Thisis a useful quote to remember for the aid versus trade debate regarding economic development. Ema ‘When evaluating foreign aid, consider the following questions as a framework: ‘= What are the types of foreign aid being given? ‘= What are the underlying motives ‘behind giving this aid? «= Is the foreign aid being given for the right reasons? Multilaretal development assistance is foreign aid delivered through international institutions such as the World Bank and the International Monetary Fund (IMF). ‘These mulciaeral institutions are international organisations made up of member governments around the world. These member states pool resources together, thus enabling large-scale development programmes to be funded.Section 4_ Development economics 163 Multilateral development assistance is generally seen as a less political form, of foreign aid chan bilateral aid and tied aid as it encourages international cooperation rather chan focusing on the financial interests of donor counties, Multilateral development assistance often takes the form of non- concessionary loans, ise lending that incurs interest and repayment periods determined by market forces. However, this differs from commercial bank lending as the loans are specifically for development purposes The role of the International Monetary Fund (IMF) Cr) ‘The Intemational Monetary Fund (IMF) is an international multilateral financial institution set up in 1944 by 29 member countries. Toxay, there are 188 members of the IME Its goal is to oversee the intemational financial system and to promote global monetary cooperation. Thus, the IMF helps to facilitate sustainable economic growth and development. ‘The IMF fulfils its role by assessing the economic policies ofall member states in oder to stabilise exchange rates and making short-term non-concessional loans to countries that experience difficulties making their international payments. Traditionally, most of the lending from the IMF went to LEDCs. However, the global financial crisis of 2008 saw a significant amount of lending to MEDCs with huge balance of payments problems, sich as Portugal, Italy, Ireland and Greece The govemance of the IMF is often criticised because the wealthier member states have a greater share of the voting rights. Thus, the welfare of LEDCs and their development priorities are often overlooked. The role of the World Bank ‘The World Bank isthe international organisation that lends money to LEDCs for economic development projects and structural change. The majority of loans are for physical capital projects, for example irrigation systems, road networks, schools, hospitals and transportation links. The World Bank was set up in 1944 (at the same time as the IMF) to provide foreign development assistance (concessionary andl non-concessionary lending) to low- and middle-income countries to reduce poverty and improve standards of living, Itis made up of two international financial institutions: = The International Bank for Reconstruction and Development (IBRD) ~ The IBRD provides loans to middle-income countries (not LEDCS), so the funds are nor technically classified as foreign aid. Most of the lending from the World Bank is made by the IBRD. = The International Development Association (IDA) ~ Member countries of the IDA offer concessionary, interest-free loans of up to 30 years to low income countries in order to eechuce poverty. ‘The World Bank is the largest and most familiar development bank in the work: mae around 530 Filion in devclomentfoans and neste 2013, thas been criticised for offering most ofits lending to middle-income countries Many students tend to think of the rather than to LEDCs that face conditions of extreme poverty, especially as its World Bank as a single institution, but requirements for eligibility of funding disqualify many poor and heavily indebted It comprises the IBRD and the IDA. countries.164 Economics for the 8 Diploma Cay euch a eA) PAPER 3 13 In 1970, the world’s wealthiest countries agreed to donate 0.7% of their annual gross national income (GNI) as official development assistance (ODA). Although the USA is often the largest donor in monetary terms, it ranks amongst the smallest when measured against the 0.79% target. 12 (ODA cs patcont of CN °. 1960 1970 1980 1990) 2010 Figure 4.7 ODA from the USA at constant prices (USS billion) ‘ODA as percent of GNI 120121 ‘ODA-USD billon (2012) Greece. lewlond aly Groove Korea Luxembourg tea New Zealand pon Pongal United States ied keeknd ‘Asta Pongal Finland Aust Kote New Zeokand ae DAC Tord soln ‘Cenada Ausra na Gemony Dena en Soesond we leroy ees Sweden en asl Fintan Netherlands United Kingdom ‘Canod Netherands Jopon Denmark France N Gomany Sweden United Kingsiom Luxembourg United States 0 025 05 O75 1 ° 10 20 30 Figure 4.8 ODA from selected OECD countries Define the terms ‘gross national income (GNI)' and ‘official development assistance (ODA)’. 1) Using the information above, Figures 4.7 and 4.8, and your knowledge of economics, evaluate the effectiveness of foreign aid in contributing to economic development. 8]Section 4_ Development economics 165 4.7 The role of international debt Foreign debt The meaning of foreign debt Internal debt is the money owed by a country to domestic lenders, such as private banks, because the government has a budget deficit (government expenditure exceeds government revenuies). By contrast, external debt is money ‘owed to foreign creditors (lender). ‘Creditors are the financial institutions that lend money to others. Foreign, creditors include commercial banks, foreign governments and international financial institutions such as the World Bank and the IME. Debrs can be incurred by private individuals, firms and/or the government. Foreign debts are often incurred by countries with weak institutions (including the domestic monetary system) and poor infrastructure, forcing them to borrow from foreign creditors to develop their economies. Foreign debe is a potentially serious matter for many LEDCs because the burden of interest payments and striet loan terms have often resulted in huge ‘opportunity costs, for example cutting expenditure on exlucation and healthcare in onder to repay these loans. Itis not uncommon for LEDCs to be heavily indebted because relatively high interest rates andjor domestic inflation reduce the value of their currency (foreign debts have to be repaid in foreign currencies). This makes their debt financing increasingly unsustainable. ‘The problems of foreign debt ean be traced back to the global oil erisis of 1973 when oil prices increased by 500% due to the Arab-Israeli War (or the Yom Kippur War). This created a huge surplus of profit for exporters of oil, deposited in banks, with the money being lent to LEDCs. The subsequent oil crisis of 1979 caused a worklwide recession, with LEDCs tunable to export enough of their commodities to pay off their debts. Many LEDC; defaulted on their loans. Foreign debt can cause both economic and social instability. For example, the tlobal financial crisis caused huge problems, even for MEDCs — unemployment reached 28% in both Spain and Greece. Ultimately, high levels of foreign debts can make LEDCs even poorer Heavily indebted countries Keyword definition Foreign debt (or external debt) refers to loans of a country that need to be repaid to overseas lenders such as the Workl Bank and the IME, Not all debt is detrimental to the ‘wellbeing of LEDCs, This depends on, the level of affordability of the debt. Borrowing money to fund structural changes and economic development can be beneficial to LEDCs ~ itis when the foreign debt is unaffordable that problems arse ‘Some countries have become so heavily indebted that they have had to reschedule their debt repayments to banks and other lenders. Debt rescheduling means lengthening the time it takes to repay the loans, often leading to further borrowing and escalating debts. HIPCs are also highly vulnerable to external shocks that are beyond their control, such as natural disasters and oil crises (which cause inflation). These shocks add to theit soaring debs Some HIPCs suffer from debt overhang, i. existing debts are so unaffontable that they find it extremely difficult to borrow more money. Debts incurred by some HIPCs exceed government revenue from taxpayers, thus causing a debe trap, ie. they are unable to ever repay their debs In extreme cases, the failure of HIPCs to repay foreign debts has caused perpetual debts to occur, i. taking out subsequent loans to service (pay for) existing debts. This reduces their financial status, thus making future foreign investment in these countries less attractive. Tn many cases, LEDCs ineur huge debts because Loans and financial aid are misused by corrupt leaders, for example to finance military spending and weapons. Keyword definition A heavily indebted poor country (HIPC) is a low-income nation with a huge outstanding debt, making it eligible for special financial assistance from the IMF and the World Bank.1166 Economics for the IB Diploma The mounting debt burden faced by HIPCs has led to international pressures for creditors to cancel the debts (known as debt forgiveness) in an attempt to restart or improve the economic development of HIPCs. However, this could cause some HIPCs to become complacent (or reckless) as they are protected from their irresponsible behaviour, so may continue to be careless in the future, Instead, conditional assistance can be given to HIPCs, ie. debt relief granted con the condition that HIPCs meet a range of targets for structural changes, such as poverty-reduction programmes. Debt relief includes both partial and complete debt forgiveness for HIPCS. The rescheduling of debt and conditional assistance are mainly facilitated by international financial institutions such as the IMF and the World Bank. Both these organisations have key roles in resolving the international debt problems of LEDCs and HIPCs. ‘The International Monetary Fund (IMP) acts as an international lender ‘of last resort to countries with urgent or major balance of payments problems. Ifa country is expected to default on its loans, the IMF can intervene, wing conditional assistance. ‘The World Bank isan international finance organisation concerned with lending money on a long-term basis to LEDCS to assist in their economic development. International debt and the balance of payments ‘The servicing of intemational debts can cause balance of payments problems for the indebted country. Many LEDCs have a high debt service ratio (the ratio of foreign debt, including interest repayments, to its export earnings). This means that they need to generate more export earnings to fund their foreign debts. A low debt service ratio suggests a healthier financial position. HIPC’ import far less than their populations need from MEDCs as there is a long-term decline in the real value of theie own exports and their currencies ‘Some HIPCs spend more money on debt financing than they spend on education or healthcare. ‘There is less of an incentive for direct investment in highly indebted countries. This has negative impact on the financial account of the balance of payments of such countries. Portfolio investment in highly inclebted countries is also likely to fall, again, having a negative impact on the financial account. For example, investor confidence in Iceland fell dramatically following the nation’s debt erisis and collapse of banks during the global financial crisis. EXAM PRACTICE (HL ONLY) PAPER 3 14 With reference to the table below, explain why excessive foreign debt creates a problem for the economic development of a country. i en DEBT-TO-GDP RATIO (%) Bhutan ‘Guyana 633 pe HL students should consider the nature of deteriorating terms of trade faced by most LEDCS, 2. a fallin the index of average export prices to average import prices. This creates further problems for LEDCs as each unit of ‘exports is worth less than before in funding their import expenditure,Section 4_ Development economics 167 4.8 The balance between markets and intervention Strengths and weaknesses of market- orientated policies Market-orientated policies Market-orientated policies focus on increasing the productive capacity of the economy by improving healthcare, education and infrastructure to achieve economic development. They also focus on improving the supply-side of the economy by using the price mechanism (e.. floating exchange rates rather than fixed or managed exchange rate systems) and liberalised capital flows between countries (the free movement of foreign exchange). Supporters of market-orientated policies argue that market forces allocate resources efficiently, thus enhancing economic development. Such policies also create incentives to invest in the economy. Examples of market-orientated. policies include: ‘= Deregulation — This refers to the reduction or removal of rules and regulations in a particular industry, therefore creating a greater degree of ‘competition and encouraging market forces to allocate resources. ‘= Trade liberalisation ~ This refers to policies that encourage free trade, including the free movement of capital flows, by removing barriers to international trade, The IMF believes that trade liberalisation promotes ‘economie growth, development and poverty reduction. ‘= Privatisation — This is the process of transferring ownership of public-sector assets to private-sector ownership. Private-sector firms, driven by financial ‘motives, are argued to be more economically efficient than burcaucrats running public-sector organisations. = Labour market reforms ~ These are policies that remove inefficiencies in. the labour market, thereby creating greater flexibility and productivity, for ‘example reducing the power of labour unions, cutting unemployment benefits and abolishing minimum wages = Tax reforms — Lower rates of income tax anil corporation tax create incentives to work and to supply, ic. tax reforms can motivate people to seek ‘employment opportunities and firms give greater incentives for firms to raise ‘output, thus achieving growth and development. Strengths of market-orientated policies Keyword definition Market-orientated policies tre dynamic, outward-looking, macroeconomic policies used tc stimulate economic growth, and development via markec forces, for example using anti- monopoly regulation to encourage competition and efficiency. = Efficiency ~The key benefit of market-orientated development policies, such as trade deregulation and privatisation, is that resources are allocated more cfficiently than through government intervention in economic activity. = Competitiveness — Labour marker reforms, for example, create incentives work. These policies therefore help to improve labour market flexibility and productivity, resulting in a more internationally competitive labour force. = Economic growth ~ The profit motive in free markets encourages people to ‘work hard and firms to take entrepreneurial risks, such as expenditure on investment and innovation. Thus, market-orientated policies have a positive impact on economic growth, = Benefits of free trade — Free trade policies can lead to many benefits, such as increased consumer choice, lower prices and improved quality. They also ‘enable firms to sell to more customers, beyond the borders of the country, This inevitably contributes to growth and development.168 Economics for the IB Diploma ‘= Investment opportunities ~ The liberalisation of trade and capital flows reduces barriers to international trade and exchange. This is an important factor in attracting foreign direct investment (FDI), ie. the capital ‘expenditure of multinational corporations in overseas economies. Weaknesses of market-orientated policies = Marker failure ~ The inability of any market-orientated policy to deal with, ‘market failure is its main weakness — for example, negative production and consumption externalities are not dealt with, LEDCs also lack sufficient provision of merit goods such as education and healthcare = The development of a dual economy ~ This occurs when two distinct ‘economic sectors exist within a country, with different levels of development. Itis common in LEDCs with a low-income sector catering for local demand and another for export-driven international markets. ‘= Income inequalities ~The advantages of economic development do not automatically trickle down to benefit the poorer members of society, ‘government intervention is required to tackle the problems of income inequalities. Tax reforms can also cause income inequalities. Strengths and weaknesses of interventionist policies Interventionist-orientated policies Interventionist policies are used to correct market deficiencies, such as providing adequate housing to ensure a minimum social safety net for ail members of society. This is highly unlikely to occur in the absence of government intervention, ‘The provision of merit goods (such as education and healthcare) and public ‘goods (such as flood control systems and strect lighting) help to improve the economic development for the majority of people in society. ‘Government intervention is also required to provide appropriate infrastructure, such as toads, ports, airports and telecommunications networks, Proper infrastructure is needed to encourage foreign direct investment (FDI) to support economic development: Interventionist-orientated policies are used to protect the welfare of workers, for example by establishing health and safety at work legislation and by setting minimum wages, They can also be used to protect the welfare of consumers, for example anti-monopoly legislation, Strengths of interventionist policies Keyword definition Interventionist-orientated policies refer to the use of government involvement to stimulate or regulate economic growth and development. ‘= Provision of infrastructure — Without government intervention, there would be a lack of infrastructure (the physical structures requited for the effective ‘operation of society), for example roads, railways and telecommunications networks, = Investment in human capital ~The private sector is unlikely to provide sufficient investment in human capital through education and training, ‘especially in LEDCs. Thus interventionist policies are required to encourage ‘more provision of such merit goods ‘= Provision ofa stable macroeconomic economy ~ Development requires ‘government intervention to provide a safe and stable economic environment to protect the interest of the economy by interventionist demand and supply-side policiesSection 4_ Development economics 169 = Provision ofa social safety net — Interventionist policies through direct ‘government provision and a social welfare system ensure that all members of society have access to basic necessities, thus preventing absolute poverty in the economy. Interventionist policies can be used to tackle inequalities, which hinder the development and prosperity of LEDCs. For example, cultural and historical contexts in many countries mean that women are not given the same ‘opportunities as men. Thus, intervention is necessary. Intervention is also required when a country faces a major emergency or dlsaster, such as a civil war. Without intervention, the productive capacity of the country will decline along with a fall in FDI and standards of living. Weaknesses of interventionist policies Weanesse ot nterwentonst pets ___qaaarp = Excessive bureaucracy ~ This refers to administrative systems, structures and regulations. There is over-regulation in many LEDCs, which leads to ‘economic inefficiencies rather than economic growth and development, = Poor planning — Political instability and conflict, common in many LEDCs, ‘can cause major delays in prostuction, thus limiting opportunities for ‘economic development. The lack of market signals (forces of demand and supply) means that the planning is often uneealistie. = Corruption — Dishonest governments that misuse sources of finance reduce the effectiveness of policies intended to promote economic development: ‘Comuption reduces trust between individuals, firms and governments, thus acting asa deterrent to FDI. Market with government intervention Students often claim that eradicating corruption is a prerequisite to economic development. Its unlikely that corruption can be eradicated {it exists in economically developed countries too), but development foccurs when corruption is reduced. ‘Good governance refers to the moral conduct of public affairs and the management of public resources. It can be seen as the oppesite of cortuption, ‘0 is important for the development process of an economy. Good governance applies to anyone in a position of responsibility with decision-making power, including government officials, lawmakers, the military, scientific researchers and religious leaders ‘Good governance requites the following: ‘= transparency in government policies and government affairs ‘= determined effort to limit corrupt practices, such 2s enforced fines and sanetions = provision of a welfare safety net for citizens who suffer from ill health and/or unemployment ‘= accountable and law-abiding policies. Due to the advantages of interventionis-orientated policies and market- orientated policies, a complementary approach may be the best way to achieve economic development, i.e. a balanced use of both market-orientated development policies and government intervention, Evidence suggests that neither extremes work in the real world, for example the collapse of communism due to its bureaucratic inefficiencies in the latter part of the twentieth century and the need for government intervention, following the global financial meltdown of 2008.Are you ready? Use this checklist to recond progress as you revise. Tick each box when you: have: f= revised and understood a topic = tested yourself using the Exam practice questions and gone online to check ‘your answers. Section 1 Microeconomics Competitive markets: demand and supply Markets and demand The role of the price mechanism Market e! iency Elasticity Price elasticity of demand (PED) Cross price elasticity of demand (XED) Income elasticity of demand (YED) Price elasticity of supply (PES) Government intervention Indirect taxes Subsidies Price controls Market failure The meaning of market failure Types of market failureAre you 2471 7 Theory of the firm and market structures (HL only) Production and costs Revenues Profit Goals of firms Perfect competition Monopoly Monopolistic competition Oligopoly Price discrimination Section 2 Macroeconomics The level of overall economic activity Economic activity The business cycle Aggregate demand and aggregate supply Aggregate demand (AD) Aggregate supply (AS) Equilibrium The Keynesian multiplier (HL only) Macroeconomic objectives Low unemployment Low and stable rate of inflation Economic growth Equity in the distribution of income172 Economics for the IB Dif 7 Fiscal policy The government budget The role of fiscal policy Monetary policy Interest rates The role of monetary policy and short-term demand management Supply-side policies The role of supply-side policies Interventionist supply-side policies Market-based supply-side policies Evaluation of supply-side policies Section 3 International economics International trade Free trade Restrictions on free trade: trade protection Exchange rates Freely floating exchange rates Government intervention The balance of payments The structure of the balance of payments Current account deficits Current account surplusesAre you ready? 173 7" Economic integration Forms of economic integration The terms of trade (HL only) The meaning of the terms of trade (HL only) ‘Causes of changes in the terms of trade (HL only) Consequences of changes in the terms of trade (HL only) Section 4 Development economics Economic development The nature of economic growth and economic development Measuring development Measurement methods The role of domestic factors Domestic factors and economic development The role of international trade International trade and economic development The role of foreign direct investment (FD!) Foreign direct investment and multinational corporations (MNCs) The roles of foreign aid and multilateral development assistance Foreign aid Multilateral development assistance XX | | | ah174 Economics for the IB Dif The role of international debt Foreign debt The balance between markets and intervention Strengths and weaknesses of market-oriented policies Strengths and weaknesses of interventionist policiesMy revision notes1176 Economics for the 8 DiplomaMy revision notes 177Ad valorem tax imposes a percentage taxon the value of a good or service, Examples include property taxes, tariffs (taxes on imports) and sales taxes. Aggregate demand is the total value of all goods and services demanded in the economy, per time period, Alllocative efficiency happens when resources ate distributed so that ‘consumers and producers get the ‘maximum possible benefit; hus no ‘one can he made better off withoue ‘making someone else worse off Asymmetric information exists when ‘one economic agent (buyer or seller) in an economic transaction has more information than the ‘other in a certain market — for ‘example, life assurance policies, stock market products, pension fund schemes, second-hand cars and works of art Bilateral trade agreement isa ‘contractual trade arrangement between two countries, such as closer economic partnership agreements (CEPAS), Business cycle describes the fluctuations in economic act ina country over time. These fluctuations create a long-tesm ‘trend of growth in the economy. Cap-and-trade schemes (CATS) are -government-regulated emissions tracing schemes using a market- based approach. The regulator sets a limic (the cap) on the total amount of emissions allowed in an industry and firms are issued ‘emissions permits iy Circular flow of income model is a macroeconomic tool used t0 explain how economic activity and national income are determined Complements are products that are jointly demanded, such ascinema movies and popcom or pencils and Contraction see Movements Glossary Cost-push inflation is triggered by higher costs of production thus shifting aggregate supply co the left and forcing up average prices. Cross price elasticity of demand (XED) measures the degree of responsiveness of demand for one product following a change in the price of another product. Consumer surplus refers to the benefits to buyers who are able to purchase a product for less chan they are willing to do so. Current account deficit exists when the sum of the outflows from the ‘current account exceeds the inflows into the account —for example, net import expenditure on goods and fereater than net export Deflationary gap (also known asa recessionary gap) exists when the ‘eal national ourput equilibrium is below the full employment level of ‘output Demand-pull inflation is inflation triggered by higher levels of ageregate demand in the economy, which lives up the general price level. Diminishing returns occur in the short run when a variable factor input (such as labour) is succesively added to a fixed factor {such as capital), which eventually reduces the marginal and hence toca output. Disposable income is earnings after taxes have been accounted for, ic the actual take-home income that workers are able to spend. Economie costs are the explicie and implicit costs of all resources used bya firm in the production process. Economic growth is the increase in the level of economic activity, ie. the annual percentage growth in national output Economie profit occurs when coral revenue exceeds total economic ‘costs. It is profit that is over and above normal profit. A firm might ‘choose to continue, Expansion see Movements Expenditure reducing policies are designed to cut a current account deficit by lowering disposable income to limit aggregate demand and import expenditure in particular. Expenditure switching policies are intended to encourage households and firms to buy domestically produced goods and services rather than imported alternatives by rising the relative price of imports or reducing the relative price of exports Explicit costs are the identifiable and therefore accountable costs related to the output of a product. Examples inclucle wages, raw material costs, tility bills and rent External costs (also known as negative externalities) are costs incurred by a third party én an ‘economic transaction for which no ‘compensation is paid, Green GDP is a measure of GDP that accounts for envitonmental destruction from economic activity bby deducting the environmental costs associated with the ourput of goods and services, Gross domestic product (GDP) is the value of all final output of goods and services proxluced by firms within the country, per year Gross national product (GNP) is the value of all final output of goods and services produced by a country’ citizens, both domestically and abroad Human Development Index (HDI) is a composite indicator (of life cexpectaney, educational attainment and income) used as an altemative to real GDP or GNI per capita as a measure of economic development. Implicit costs are the opportunity costs of the output, ie. the income from the best alternative that is foregone.Glossary 179 Income elasticity of demand (YED) measures the degree of responsiveness of demand following, a change in income, Indirect tax is a government levy ‘on the sale of certain goods and services. It includes specific taxes and ad valorem taxes. Inferior goods have a negative relationship between income and quantity demanded, i. customers switch toa superior (luxury product as their income rises (c.8 ‘canned food products versus fresh food products), Tnterest rates can refer to the price ‘of borrowing money or the return from saving money at financial institutions such as banks, International trade is the exchange of goods and services beyond national orders. Ir involves the sale of ‘exports (goods and services sold to overseas buyers) and imports (foreign goods and services bought by domestic households and firms), Keynesian multiplier is model that shows that any increase in the value of injections results in an ‘even greater increase in the value ‘of national income. It ako shows thar any inerease in the value of withdrawals leads to a greater fall in the value of national output Labour force consists of the ‘employed, the setF-employed and the unemployed, ie. all those in ‘work and all those actively seeking ‘employment. ‘Long run is the period of time when all factors of proxluction are variable, so all costs of production are variable. Luxury goods are superior goods and services as their demand is highly income elastic, ie. an increase in income leads to a proportionally peas ian he deed ‘Marginal private benefit (MPB) isthe additional value enjoyed by houscholds and firms from, the consumption or production, (cutput) of an extra unit of a particular good or service. Marginal private cost (MPC) is the additional cost of proxluetion for firms or the extra charge paid by customers for the output or consumption of an extra unit of a 200d or service Marginal propensity to consume (MPC) menses the proportion of each extra dollar of houschold income that isspent by e. Mpc = 5S, av ‘An increase in the MPC will tend to inerease the value of the multiplier. Marginal propensity to import (MPM) measures the proportion of each extra dollar of household income that isspent on imports, ie. MPM = SM AY Marginal propensity to save (MPS) measures the proportion of each cextea dollar of income that is saved by households, ie. 48 Ww Marginal propensity to tax (MPT) measures the proportion of each extra dollar of houschold income that is levied by the government, ar ay Marginal social benefit (MSB) is the aclded benefit to society from the production of consumption of an extra unit of output ie. the sum of MPC and marzinal external costs Marginal social cost (MSC) is the extra cost of an economic transaction to society, ie. the s ‘of MPB and marginal external benefits Market equilibrium occurs when the ‘quancity demanded for a produce is equal to the quantity supplied of the product i. there are no shortages or surpluses Market failuce exists when the price mechanism (the market forces ‘of demand and supply) allocates scarce resources in an inefficient way, ie. there is either over- provision or under-provision of certain goods and services Merit goods are products that create positive externalities (spillover effects) when they are produced oor consumed, Hence, the social benefits from the production and consimption of merit goods are greater than the private benefits Micro-credit schemes are loans of small amounts to individuals on. low incomes in LEDCs for self ‘employment projects that generate income, so they can care for themselves and their families. Movements are caused by peice fluctuations along an existing demand curve. A rise in price results in a contraction in quantity demanded, whereas a fall in price ‘causes an expansion in quancicy demanded. Multilateral trade agreement is a legally binding trade deal between, more than two countries, for ‘example in a free trade area. Such. trade agreements are made within the guidelines of the World Trade (Organization (WTO). Natural monopoly exists when the industry can only sustain ‘one supplier, to avoid wasteful competition and to maximi ‘economies of scale by having a single provider. Normal goods are products that customers tend to buy more of as their income level increases. They comprise nevessities (such as food) and luxuries (such as cars). Normal profit is the minimum revenue needed to keep a firm in business. Hence, itis also referred to as zero economic profit and ‘occurs at the point where a firm breaks even by covering both ‘economic and implicit costs from its Poverty trap (or poverty cycle) isa ‘vicious cycle of poverty causing greater poverty. Low-income carers spend most, ffnot all, of their income on meeting their ‘essential needs, so they have insufficient funds to invest in their future and ate trapped in poverty.180 Glossary Price elasticity of supply (PES) measures the degree of responsiveness of quantity supplied ‘of a product following a change in its price along a given supply curve, Private benefits are the benefits ‘of production and consumption ‘enjoyed by a firm, individual or ‘government. Private costs of prosiiction and ‘consumption are the actual costs incurred by a firm, individual or government. between the price that firms actually receive and the price they ‘were willing and able to supply at. Revenue is the money received from, the sale of a firms output. Short run is the period of time when. at least one factor of production, such as land or capital, is fixed in the production process. Social benefits are the true (or full) benefits of consumption or production, i. che sum of private benefits and extemal benefits, Social costs are the true (or full) costs ‘of consumption or production, ice. the sum of private costs and ‘extemal costs. Specific tax, also known as a per unit ‘tax, imposes a fixed amount of tax ‘on each product. Examples include taxes on cigarettes, air passenger tax and electronic road pricing and ond tolls, Subsidy is financial assistance from the ‘government to encourage output (Guch as the sale of exports), to reduce the price of certain merit ‘goods (such as education, training and healthcare), or to keep down the cost of living (such as food prices). Substitutes are products thar ean be used instead of each other, such ‘as Coca-Cola of Pepsi and tea or coffee: Supply is the willingness and ability of firms to provide a good or service at siven price eves, per time period. ‘Trade creation occurs when economic integration shifts, trade deals away from higher-cost producers from ‘outside the trading bloc to lower- cost producers within the trading bloc, due to the removal of trade barriers, Trade {economic integration shifts trade deals away from lower-cost producers outside the trading bloc to higher-cost producers within the trading bloc due to the trade agreements of the customs union, sion occuts when ‘Unemployment occurs when people are willing and able to work and actively seeking employment but are unable to find work,