IGCSE ECONOMICS NOTES (0455)

The Basic Economic Problem

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

The Nature of the Economic Problem

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

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

The Factors of Production

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

• Land: all natural resources in an economy. This includes the surface of the
earth, lakes, rivers, forests, mineral deposits, climate etc.
• The reward for land is the rent it receives.

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• Since, the amount of land in existence stays the same, its supply is said to be
fixed. But in relation to a country or business, when it takes over or expands to
a new area, you can say that the supply of land has increased, but the supply is
not depended on its price, i.e. rent.
• The quality of land depends upon the soil type, fertility, weather and so on.
• Since land can’t be moved around, it is geographically immobile but since it
can be used for a variety of economic activities it is occupationally mobile.
• Labour: all the human resources available in an economy. That is, the mental
and physical efforts and skills of workers/labourers.
• The reward for work is wages/salaries.
• The supply of labour depends upon the number of workers available (which is
in turn influenced by population size, no. of years of schooling, retirement age,
age structure of the population, attitude towards women working etc.) and
the number of hours they work (which is influenced by number of hours to
work in a single day/week, number of holidays, length of sick leaves,
maternity/paternity leaves, whether the job is part-time or full-time etc.).
• The quality of labour will depend upon the skills, education and qualification
of labour.
• Labour mobility can depend up on various factors. Labour can achieve high
occupational mobility (ability to change jobs) if they have the right skills and
qualifications. It can achieve geographical mobility (ability to move to a place
for a job) depending on transport facilities and costs, housing facilities and
costs, family and personal priorities, regional or national laws and regulations
on travel and work etc.
• Capital: all the man-made resources available in an economy. All man-made
goods (which help to produce other goods – capital goods) from a simple
spade to a complex car assembly plant are included in this. Capital is usually
denoted in monetary terms as the total value of all the capital goods needed
in production.  The reward for capital is the interest it receives.
• The supply of capital depends upon the demand for goods and services, how
well businesses are doing, and savings in the economy (since capital for
investment is financed by loans from banks which are sourced from savings).
• The quality of capital depends on how many good quality products can be
produced using the given capital. For example, the capital is said to be of much
more quality in a car manufacturing plant that uses mechanisation and
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technology to produce cars rather than one in which manual labour does the
work.
• Capital mobility can depend upon the nature and use of the capital. For
example, an office building is geographically immobile but occupationally
mobile. On the other hand, a pen is geographically and occupationally mobile.
• Enterprise: the ability to take risks and run a business venture or a firm is
called enterprise. A person who has enterprise is called an entrepreneur. In
short, they are the people who start a business. Entrepreneurs organize all the
other factors of production and take the risks and decisions necessary to make
a firm run successfully.
• The reward to enterprise is the profit generated from the business.
• The supply of enterprise is dependent on entrepreneurial skills (risk-taking,
innovation, effective communication etc.), education, corporate taxes (if taxes
on profits are too high, nobody will want to start a business), regulations in
doing business and so on.
• The quality of enterprise will depend on how well it is able to satisfy and
expand demand in the economy in cost-effective and innovative ways.
• Enterprise is usually highly mobile, both geographically and occupationally.
All the above factors of productions are scarce because the time people
have to spend working, the different skills they have, the land on which
firms operate, the natural resources they use etc. are all in limited in
supply; which brings us to the topic of opportunity cost.

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

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

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Example 1: the government has a certain amount of money and it has

two options: to build a school or a hospital, with that money. The
govt.
decides to build the hospital. The school, then, becomes the
opportunity cost as it was given up. In a wider perspective, the
opportunity cost is the education the children could have received, as it
is the actual cost to the economy of giving up the school.
Example 2: you have to decide whether to stay up and study or go to bed
and not study. If you chose to go to bed, the knowledge and
preparation you could have gained by choosing to stay up and study is
the opportunity cost.

Production Possibility Curve Diagrams (PPC)

Because resources are scarce and have alternative uses, a decision to
devote more resources to producing one product means fewer
resources are available to produce other goods. A Production Possibility
Curve diagram shows this, that is, the maximum combination of two goods
that can be produced by an economy with all the available resources .
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The PPC diagram above shows the production capacities of two goods-
X and Y- against each other. When 500 units of good X are produced,
1000 units of good Y can be produced. But when the units of good X
increases to 1000, only 500 units good Y can be produced.

Let’s look at the PPC named A. At point X and Y it can produce certain
combinations of good X and good Y. These are points on the curve- they
are attainable, given the resources. Th economy can move between
points on a PPC simply by reallocating resources between the two
goods.
If the economy were producing at point Z, which is inside/below the
PPC, the economy is said to be inefficient, because it is producing less
than what it can.
Point W, outside/above the PPC, is unattainable because it is beyond
the scope of the economy’s existing resources. In order to produce at
point W, the economy would need to see a shift in the PPC towards the
right.
For an outward shift to occur, an economy would need to:
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• discover or develop new raw materials. Example: discover new oil fields 
employ new technology and production methods to increase productivity
• increase labour force by encouraging birth and immigration, increasing
retirement age etc.
An outward shift in PPC, that is higher production possibility, will lead
to economic growth.

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

How Markets Work

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

Microeconomics and Macroeconomics

Microeconomics is the study of individual markets. For example: studying the
effect of a price change on the demand for a good. Microeconomic decision
makers are producers and consumers (who directly operate in markets)
Macroeconomics is the study of an entire economy, as a whole. Examples include
studying the total size of the economy or the unemployment rate, among other
things. Macroeconomic decisions are made by the government of the particular
economy – a town, state or country)

The Role of Markets in Allocating Resources

Resource allocation: the way in which economies decide what goods and services
to provide, how to produce them and who to produce them for.
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These questions- what to produce, how to produce, and for whom to produce –
are termed ‘the basic economic questions’. In short, resource allocation is the
way in which economies solve the three basic economics questions. Market is
any set of arrangement that brings together all the producers and consumers of
a good or service, so they may engage in exchange. Example: a market for soft
drinks.
Goods and services are bought and sold in a market at an equilibrium price where
demand and supply are equal. This is called the price mechanism. It helps answer
the three basic economic questions. Producers will produce the good that
consumers demand the most, it will be produced in a way that is cost-efficient,
and will be produced for those who are willing and able to buy the product. More
on these topics below:

Demand
Demand is the want and willingness of consumers to buy a good or services at a
given price. Effective demand is where the willingness to buy is backed by the
ability to pay. For example, when you want a laptop but you don’t have the
money, it is called demand. When you do have the money to buy it, it is called
effective demand.
The effective demand for a particular good or service is called quantity
demanded.
(Individual demand is the demand from one consumer, while market demand for
a product is the total (aggregate) demand for the product, or the sum of all
individual demands of consumers).
The law of demand states that an increase in price leads to a decrease in
demand, and a decrease in price leads to an increase in demand (it’s an
inverse relationship between price and demand. However it’s worth noting that
an increase in demand leads to an increase in price and a decrease in demand
leads to a decrease in price. The law of demand is established with respect to
changes in price, not demand, hence the difference).

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This is an example of a demand curve for

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

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

In this example, there is a fall in demand of Coca-Cola from 500 to 400, without
any change in price.
A fall in demand for a product due to the changes in other factors (excluding
price) causes the demand curve to shift to the left (from A to B).
Factors that cause shifts in a demand curve:
• Consumer incomes: a rise in consumers’ incomes increases demand, causing a
shift to right. Similarly, a fall in incomes will shift the demand curve to the left.
• Taxes on incomes: a rise in tax on incomes means less demand, causing a shift to
the left; and vice versa.
• Price of substitutes: Substitutes are goods that can be used instead of a
particular product. Example: tea and coffee are substitutes (they are used for
similar purposes). A rise in the price of a substitute causes a rise in the demand
for the product, causing the demand curve to shift to the right; and vice versa.
• Price of complements: Complements are goods that are used along with another
product. For example, printers and ink cartridges are complements. A rise in the
price of a complementary good will reduce the demand for the particular
product, causing the demand curve to shift to the left; and vice versa.
• Changes in consumer tastes and fashion: for example, the demand for DVDs
have fallen since the advent of streaming services like Netflix, which has caused
the demand curve for DVDs to shift to the left.

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• Degree of Advertising: when a good is very effectively advertised (Coke and Pepsi
are good examples), its demand rises, causing a shift to the right. Lower
advertising shifts the demand curve to the left.
• Change in population: A rise in the population will raise demand, and vice versa.
• Other factors, such as weather, natural disasters, laws, interest rates etc. can also
shift the demand curve.

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

This is an example of a supply curve for a

product.
Here, an increase in price from 60 to 80, has increased its supply from 500 to 700.
The increase in supply due to changes in price (without changes in other factors)
is called an extension in supply.
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A decrease in price from 80 to 60, will decreased the supply from 700 to 500. The
decrease in supply due to changes in price (without the changes in other factors)
is called a contraction in supply.

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

A fall in supply from 500 to 300, without any changes in price is also shown. A fall
in the supply for a product due to the changes in other factors (excluding price)
causes a shift to the left.
Factors that cause shifts in supply curve:
• Changes in cost of production: when the cost of factors to produce the good falls,
producers can produce and supply more products cheaply, causing a shift in the
supply curve to the right. A subsidy*, which lowers the cost of production also

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shifts the supply curve right. When cost of production rises, supply falls, causing
the supply curve to shift to the left.
• Changes in the quantity of resources available: when the amount of resources
available rises, the supply rises; and vice versa.
• Technological changes: an introduction of new technology will increase the ability
to produce more products, causing a shift to the right in the supply curve.
• The profitability of other products: if a certain product is seen to be more
profitable than the one currently being produced, producers might shift to
producing the more profitable product, reducing supply of the initial product
(causing a shift to the left).
• Other factors: weather, natural disasters, wars etc. can shift the supply curve left.

Market Price

The market equilibrium price is the price

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

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

In this diagram, two disequilibrium prices

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

Price Elasticity of Demand (PED)

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

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For example, calculate the price elasticity of

demand of Coca-Cola from this diagram.

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

= 66.67 / 25 = 2.67

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

When the % change in quantity demanded is lesser than the % change in price, it
is said to have a price inelastic demand. Their values are always below 1. A
change in price makes a smaller change in demand.
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When the % change in demand and price are equal, that is value is 1, it is called
unitary price elastic demand.

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

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

• No. of substitutes: if a product has many substitute products it will have an

elastic demand. For example, Coca-Cola has many substitutes such as Pepsi and
Mountain Dew. Thus a change in price will have a greater effect on its demand (If
price rises, consumers will quickly move to the substitutes and if price lowers,
more consumers will buy Coca-Cola).
• Time period: demand for a product is more likely to be elastic in the long run. For
example, if the price rises, consumers will search for cheaper substitutes. The
longer they have, the more likely they are to find one.
• Proportion of income spend on commodity: goods such as rice, water
(necessities) will have an inelastic demand as a change in price won’t have any
significant effect on its demand, as it will only take up a very small proportion of
their income. Luxury goods such as cars on the other hand, will have a high price
elastic demand as it takes up a huge proportion of consumers’ incomes.
Relationship between PED and revenue and how it is helpful to producers:

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

Revenue is the amount of money a producer/firm generates from sales, i.e., the
total number of units sold multiplied by the price per unit. So, as the price or the
quantity sold changes, those changes have a direct effect on revenue.

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

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

• Time of production: If the product can be quickly produced, it will have a price
elastic supply as the product can be quickly supplied at any price. For example,
juice at a restaurant. But products which take a longer time to produce, such as
cars, will have a price inelastic supply as it will take a longer time for supply to
adjust to price.
• Availability of resources: More resource (land, labour, capital) will make way for
an elastic supply. If there are not enough resources, producers will find it difficult
to adjust to the price changes, and supply will become price inelastic.

Market Economic System

In a market economic system or free market economic system, all resources are
allocated by the market – private producers and consumers; that is, there is no
or very little government intervention in resource allocation. (There are virtually
no economies in the world that follow this system – there is a government control
everywhere, although Hong Kong and Singapore do come close – check out the
Index of Economic Freedom to see the ranking of economies on the basis of how
market-friendly they are ).
Features:
• All resources are owned and allocated by private individuals.
• Government refrains from regulating markets. It instead tries to create very
business-friendly environments and any intervention is mostly limited to
protecting private property. The demand and supply fixes the price of products.
This is called price mechanism.

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• What to produce is solved by producing the most-demanded goods for which

people spend a lot, as their only motive is to generate a high profit.
• How to produce is solved by using the cheapest yet efficient combination of
resources – capital or labour- in order to maximise profits.
• For whom to produce is solved by producing for people who are willing and able
to pay for goods at a high price.
Advantages:
• A wide variety of quality goods and services will be produced as different firms
will compete to satisfy consumer wants and make profits. Quality is ensured to
make sure that consumers buy from them. There is consumer sovereignty.
• Firms will respond quickly to consumer changes in demand. When there is a
change in demand, they will quickly allocate resources to satisfying that demand,
so as to maintain profits.
• High efficiency will exist. Since producers want to maximise profits, they will use
resources very efficiently (producing more with less resources).
• Since there is hardly any government intervention (in the form of regulations,
extra fees and fines etc. for example), firms will find it easy and inexpensive to
start and run businesses.

Disadvantages:
• Only profitable goods and services are produced. Public goods* and some merit
goods* for which there is no demand may not be produced, which is a drawback
and affects the economic development.
• Firms will only produce for consumers who can pay for them. Poor people who
cannot spend much won’t be produced for, as it would be non-profitable.
• Only profitable resources will be employed. Some resources will be left unused.
In a market economy, capital-intensive production is favoured over labour-
intensive production (because it’s more cost-efficient). This can lead to
unemployment.
• Harmful (demerit) goods may be produced if it is profitable to do so.
• Negative impacts on society (externalities) may be ignored by producers, as their
sole motive is to keep consumers satisfied and generate a high profit.
• A firm that is able to dominate or control the market supply of a product is called
a monopoly. They may use their power to restrict supply from other producers,
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and even charge consumers a high price since they are the only producer of the
product and consumers have no choice but to buy from them.
• Due to high competition between firms, duplication of products may take place,
which is a waste of resources.
*Public goods: goods that can be used by the general public, from which they will
benefit. Their consumption can’t be measured, and thus cannot be charged a
price for (this is why a market economy doesn’t produce them). Examples are
street lights and roads.
*Merit goods: goods which create a positive effect on the community and ought
to be consumed more. Examples are schools, hospitals, food. The opposite is
called demerit goods which includes alcohol and cigarettes
*Subsidies: financial grants made to firms to lower their cost of production in
order to lower prices for their products.

Market Failure and Government Intervention

HomeNotesEconomics – 04552.10 – 2.11 – Market Failure and
Government Intervention
Before we dive into what market failure is, let’s get familiar with some
terms related to market failure:
Public goods: goods that can be used by the general public, from which
they will benefit. Their consumption can’t be measured, and thus
cannot be charged a price for (this is why a market economy doesn’t
produce them). Examples include street lights and roads.
Merit goods: goods which create a positive effect on the society and
ought to be consumed more. Examples include schools and hospitals.
The opposite is called demerit goods which include alcohol and
cigarettes.
External costs (negative externalities) are the negative impacts on society
(third-parties) due to production or consumption of goods and services.
Example: the pollution from a factory.
External benefits (positive externalities) are the positive impacts on society
due to production or consumption of goods and services. Example:
better roads in a neighbourhood due to the opening of a new business.
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Private costs are the costs to the producer and consumer due to
production and consumption respectively. Example: the cost of
production.
Private benefits are the benefits to the producer or consumer due to
production and consumption respectively. Example: the better
immunity received by a consumer when he receives a vaccine.
Social Costs = External costs + Private Costs
Social Benefits = External benefits + Private benefits

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

• When social costs exceed social benefits (especially where negative externalities
(external costs) are high).
• Over-provision of demerit goods like alcohol and tobacco: the external costs
arising from demerit goods are not reflected in the market and so they are
overproduced.
• Under-provision of merit goods such as schools, hospitals and public transport,
since the external benefits of these goods are not reflected in the market, they
are underproduced.
• Lack of public goods such as roads, bus terminals and street lights: since their
consumption cannot be measures and charged a price for, they are not produced
by the private sector.
• Immobility of resources: when resources cannot move between their optimal
uses and thus are not used to the maximum. For example, when workers (labour)
don’t have occupational or geographic mobility.
• Information failure: when information between consumers, producers and the
government are not efficiently and correctly communicated. Example: a
cosmetics firm advertises its products as healthy when it is in fact not. The
consumers who believe the firm and use its products might suffer skin damage.
• Abuse of monopoly* powers: monopolistic businesses may use their powers to
charge consumers a high price and only produce products they wish to, since they
know consumers have no choice but to buy from them.
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*Monopoly: a single supplier who supplies the entire market with a

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

2.11 – Mixed Economic System

In a mixed economic system, both the market and government intervention
co-exist. Examples include almost all countries in the world (India, UK,
Brazil etc.). This is because it overrides all the disadvantages of both the
market and planned (govt. only) economies. It identifies the importance
of the price mechanism in operating an efficient resource allocation and
also the role of the government in correcting (any) market failures.
Features:
• both the public and the private sector exists
• planning and final decisions are made by the govt. while the market system can
determine allocation of resources owned by it, along with the public
organizations. Advantages:
• The govt. can provide public goods, necessities and merit goods. The private
businesses can provide profitable and most-demanded goods (luxury goods,
superior goods). Thus, everyone is provided for.
• The govt. will keep externalities, monopolies, harmful goods etc. in control.
• The govt. can provide jobs in the public sector (so there is better job security).
• The govt. can also provide financial help to collapsing private organizations, so
jobs are kept secure. Disadvantages:
• Taxes will be imposed, which will raise prices and also reduce work incentive.
• Laws and regulations can increase production costs and reduce production in the
economy.
• Public sector organizations will still be inefficient and will produce low quality
goods and services.
The specific ways in which the government, in a mixed economic
system, can correct market failures of the market:
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• Legislation and regulation – the government can make laws that regulate market
activity, for example, prohibit smoking in public (which would cause a negative
externality). One important kind of legislation the govt. can undertake is price
controls – setting a minimum price or maximum price on goods.

Minimum price or price floor is set to

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

Maximum price or price ceiling is set to

control an increasing tendency of price. It is usually set on rent (this is called rent
control), to ensure that low-income tenants can afford to rent homes. But as a
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result of the lower rent, landlord will stop renting more homes, causing supply to
contract, as shown in the diagram to the left. At the same time, lower rent will
increase the demand for homes. A reduced supply of homes and higher demand
for them will cause a shortage of supply in relation to demand.
• Direct provision of merit and public goods – since there is little incentive for the
price mechanism to supply these goods, governments usually provide them. For
example, free education, free healthcare, public parks. One way the govt. can do
this is by nationalising certain products it considers essential to be provided by a
governing authority, rather than the market. For example, in India, the
government operates the only railway network because only it can provide cheap
services to its millions of poor, daily passengers.
• Taxation on products – imposing a tax on products (indirect taxes) with negative
externalities can discourage its production and consumption. For example, a tax
on tobacco will make it expensive to produce and consume. In the diagram
below, a tax has been imposed on a product, causing its supply to shift from S to
S1. The price rises from P to P1 because of the additional tax amount, and the
quantity traded in the market falls from Q to Q1.

• Subsidies – a subsidy is a grant (financial aid) on products that have a positive

externality. Subsidising, for example, cooking gas for the poor, will increase the
living standard of the population. In the diagram below, a subsidy has been
imposed on a good, causing its supply to shift from S to S1. It results in a fall in
price from P to P1 and subsequently, an increase in the quantity traded in the
market from Q to Q1.

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*Note: movements along a demand or supply curve of a good only happen as a

result of a direct change in price of the good; changes caused by any other factor,
tax and subsidy included, is represented by a shift in the curves.
• Tradable permits – firms will have to buy permits from the government to do
something, for example, pollute at a certain level, and these can be traded among
firms. Since permits require money, firms will be encouraged to pollute less.
• Extension of property rights – one of the main reasons for pollution in public
spaces is that it is public – it does not harm a specific private individual – the
resource is the government’s who cannot charge compensations easily. So the
government can extend property rights (right to own property) of public places to
private individuals. This will effectively privatise resources, create a market for
these spaces and then individuals can be fined for polluting
• International cooperation among governments – governments work together on
issues that affect the future of the environment.
As you can see, market failure can be corrected by governments in a
variety of ways and the presence of a government is quite
indispensable in any modern economy. Planned (government-only)
economies are too inefficient and free market (no government)
economies result in market failures. So a mixed economic system tries
to balance both sides. That being said, there are certain drawbacks to
government intervention in an economy.
• Political incentives: this occurs when there is a clash between political and
economics (because a government is a political entity with political incentives).
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For example, even though mining companies cause a lot of environmental

damage, the government may encourage and promote their activities to garner
political and financial support from them.
• Lack of incentives: in the free market, individuals have a profit incentive to
innovate and cut costs, but in the public sector, such an incentive is absent since
the government will pay them salaries regardless of their performance. So, even
as the government provides certain public and merit goods directly to the people
at low costs, they tend to be very inefficient.
• Time lags, information failure: these are some of the government failure arising
because of a lack of incentive. Government offices and employees don’t have an
incentive to provide timely services or give accurate information and this leads to
very inefficient systems.
• Welfare effects of policies: government policies such as taxation and welfare
payments distort the market. This means that such policies will influence demand
and supply in the economy and cause markets to move away from the efficient
points produced by a market system. For example, high corporate taxes will deter
companies from expanding their operations and making more profits or deter
new enterprises from entering the market. Unemployment benefits given out by
the government may cause people to stay unemployed and receive free benefits
instead of working.

Money and Banking

HomeNotesEconomics – 04553.1 – Money and Banking

Money
What is money?
A medium of exchange of goods and services.
Why do we need money?
We need money in order to exchange goods and services with one another. This
is because we aren’t self-sufficient – we can’t produce all our wants by ourselves.

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Thus, there is a need for exchange.

In the past, barter system (exchanging a good or service for another good or
service) prevailed. This had a lot of problems such as the need for the double
coincidence of wants (if the person wants a table and he has a chair to exchange,
he must find a person who has a table to exchange and is also willing to buy a
chair), the goods being perishable and non-durable, the indivisibility of goods,
lack of portability etc.
Thus the money we use today is in the form of currency notes and coins, which
are durable, uniform, divisible (can be divided into 10’s, 50’s , 100’s etc),
portable and is generally accepted. These are the characteristics of what is
considered ‘good money’.
The functions of money:
• Money is a medium of exchange, as explained above.
• Money is a measure of value. Money acts as a unit of account, allowing us to
compare and state the worth of different goods and services.
• Money is a store of value. It holds its value for a long time, allowing us to save it
for future purposes.
• Money is a means of deferred payment. Deferred payments are purchases on
credit – where the consumer can pay later for the goods or service they buy.

Banking
Banks are financial institutions that act as an intermediary between borrowers
and savers. It is the money we save at banks that is lent out as loans to other
individuals and businesses.
Commercial banks are those banks that have many retail branches located in
most cities and towns. Example: HSBC. There is also a central bank that governs
all other commercial banks in a country. Example: The Reserve Bank Of India
(RBI).
Functions of a commercial bank:
• Accept deposits in the form of savings.
• Aid customers in making and receiving payments via their bank accounts.
• Give loans to businesses and private individuals.
• Buying and selling shares on customers’ behalf.
• Provide insurance (protection in the form of money against damage/theft of
personal property).
• Exchange foreign currencies.
 IGCSE ECONOMICS NOTES (0455)

• Provide financial planning advice.

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

Households
HomeNotesEconomics – 04553.2 – Households
Disposable income is the income of a person after all income-related taxes and
charges have been deducted.

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

Factors affecting consumption:

• Disposable income: the more the disposable income, the more people consume.
• Wealth: the more wealthy (having assets such as property, jewels, company
shares) a person is, the more he spends.

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• Consumer confidence: if consumers are confident of keeping their jobs and their
future incomes, then they might be encouraged to spend more now, without
worries.
• Interest rates: if interest rates provided by banks on saving are high, consumers
might save more so they can earn interest and thus consumer expenditure will
fall.

Saving
Saving is income not spent (or delaying consumption until some later date).
People can save money by depositing in banks, and withdraw it a later date with
the interest.
Factors affecting saving:
• Saving for consumption: people save so that they can consume later. They save
money so that they can make bigger purchases in the future (a house, a car etc).
Thus, saving can depend on the consumers’ future plans.
• Disposable income: if the amount of disposable income people have is high, the
more likely that they will save. Thus, rich people save a higher proportion of their
incomes than poor people.
• Interest rates: people also save so that their savings may increase overtime with
the interest added. Interest is the return on saving; the longer you save an
amount and the higher the amount, the higher the interest received.
• Consumer confidence: if the consumer is not confident about his job security and
incomes in the future, he may save more now.
• Availability of saving schemes: banks now offer a variety of saving schemes.
When there are more attractive schemes that can benefit consumers, they might
resort to saving rather than spending.

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

Expenditure patterns between income groups

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

Workers
HomeNotesEconomics – 04553.3 – Workers

Labour Market
Labourers need wages to satisfy their wants and needs.

Payments for labour:

• Time-rate wage: wage given based on the no. of hours the employee has
worked. Overtime wages are given to workers who have worked extra no. of
hours, which will usually be 1.5 times or even twice the normal time rate.
• Piece-rate wage: wage given based on the amount of output produced. The
more output an employee produced, the more wage he/she earns. This is used

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in industries where output can be easily measured and gives employees an

incentive to increase their productivity.
• Salary: monthly payments made to workers, usually managers, office staff etc.
usually in non-manual jobs.
• Performance-related payments: payments given to individual workers or
teams of workers who have performed very well. Commissions given to
salespersons for selling to a targeted no. of customers is a form of
performance-related pay.
What affects an individual’s choice of occupation?
• Wage factors: the wage conditions of a job/firm such as the pay rate, the
prospect for performance-related payments and bonuses etc. will be
considered by the individual before he chooses a job.
• Non-wage factors: This will include:
• hours of work
• holiday entitlements
• promotion prospects
• quality of working environment
• job security
• fringe benefits (free medical insurance, company car, price discounts on
company products etc.)
• training opportunities
• distance from home to workplace
• pension entitlement
Labour demand is the number of workers demanded by firms at a given wage
rate. Labour demand is called ‘derived demand’, since the level of demand of a
product determines that industry’s demand for labour. That is, the higher the
demand for a product, the more labour producers will demand to increase
supply of the product.
When the wage increases, the demand for labour contracts (and vice versa).
Labour supply is the number of workers available and ready to work in an
industry at a given wage rate. When the wage rate increases, the supply of
labour extends, and vice versa.
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We also know that as the number of hours

worked increases, the wage rate also increases. However, when a person get to
a very high position and his wages/salary increases highly, the number of hours
he/she works may decrease. This can be shown in this diagram, called a
backward-bending labour supply curve. CEOs and executive managers at the
top of the management tend to have backward-bending labour supply curves.
Just like in a demand and supply curve analysis, labour demand and supply will
extend and contract due to changes in the wage rate. Other factors that cause
changes in demand and supply of labour will result in a shift in the demand and
supply curve of labour.
Factors that cause a shift in the labour demand curve:
• Consumer demand for goods and services: the higher the demand for products,
the higher the demand for labour.
• Productivity of labour: the more productive labour is, the more the demand for
labour.
• Price and productivity of capital: capital is a substitute resource for labour. If the
price of capital were to lower and its productivity to rise, firms will demand more
of capital and labour demand will fall (labour demand curve shifts to the left).
• Non-wage employment costs: wages are not the only cost to a firm of employing
workers. Sometimes, employment tax, welfare insurance for each employee etc.
will have to be paid by the firm. If these costs increase, firms will demand less
labour.
Factors that cause a shift in the labour supply curve:
• Advantages of an occupation: the different advantages a job can offer to
employees will affect the supply of labour- the people willing to do that job.
Example: if the number of working hours in the airline industry increases, the
labour supply there will shift to the left.

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• Availability and quality of education and training: if quality training and

education for a particular job, say pilots, is lacking, then the labour supply for it
will be low. When new education and training institutes open, the labour supply
will rise (labour supply curve shifts to the right).
• Demographic changes: the size and age structure of the population in an
economy can affect the labour supply. The labour supply curve will shift to the
right when more people come into a country from outside (immigration) and
when the birth rate increases (more young people will be available for work).
Why would a person’s wage rate change overtime?
As a beginner, the individual would have a low wage rate since he/she is new to
the job and has no experience. Overtime, as his/her experience increases and
skills develop, he/she will earn a higher wage rate. If he/she gets promoted and
has more responsibilities, his/her wage rate will further increase. When he/she
nears retirement age, the wage rate is likely to decrease as their productivity and
skills are likely to weaken.

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

Why do wages differ between people doing the same job?

• Regional differences in labour demand and supply: for example, if the demand in
an area for accountants is very high, the wage rate for accountants will be high;
whereas, in an area of low demand for accountants, the wage rate for
accountants will be low. Similarly, a high supply of accountants will cause their
wages to be low, while a low supply (scarcity) of accountants will cause their
wages to be high. It’s the law of demand and supply!
• Fringe benefits: some firms which pay a lot of fringe benefits, will pay less wages,
while firms (in the same industry) which pay lesser fringe benefits will have higher
wages.
• Discrimination: workers doing the same work may be discriminated by gender,
race, religion or age.
• Length of service: some firms provide extra pay for workers who have worked in
the firm for a long time, while other firms may not.
• Local pay agreements: some trade unions may agree a national wage rate for all
their members – therefore all their members (labourers) will get a higher wage
rate than those who do the same job but are not in the trade union. This depends
on the relative bargaining power of the trade union.
• Government labour policies: wages will be fairer in an economy where the
government has set a minimum wage policy. The government’s corporate tax
policies can also influence the amount of wage firms will be willing to pay out.
Other wage differentials:
• Public-private sector pay gap: public sector jobs usually have a high wage rate.
But sometimes public sector wages are lower than that of the private sector’s
because low wages can be compensated by the public sector’s high job security
and pension prospects.

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

Division of Labour/Specialisation
Division of labour is the concept of dividing the production process into different
stages enabling workers to specialise in specific tasks. This will help increase
efficiency and productivity. Division of labour is widely used in modern
economies. From the making of iPhones (the designs, processors, screens,
batteries, camera lenses, software etc. are made by different people in different
parts of the world) to this very website (where notes, mindmaps, illustrations,
design etc. are all managed by different people).

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
Advantages to workers:
• Become skilled: workers can get skilled and experienced in a specific task which
will help their future job prospects
• Better future job prospects: because of the skill and training they acquire,
workers will, in the future, be able to get better jobs in the same field.
• Saves time and expenses in training Disadvantages to workers:
• Monotony: doing the same task repetitively might make it boring and lower
worker’s morale.
Margin for errors increases: as the job gets repetitive, there also arises a chance
for mistakes.
Alienation: since they’re confined to just the task they’re doing, workers will feel
socially alienated from each other.
Lower mobility of labour: division of labour can also cause a reduced mobility of
labour. Since a worker is only specialised in doing one specific task(s), it will be
difficult for him/her to do a different job.
• Increased chance of unemployment: when division of labour is introduced, many
excess workers will have to be laid off. Additionally, if one loses the job, it will be
harder for him/her to find other jobs that require the same specialisation.
Advantages to firms:
• Increased productivity: when people specialise in particular tasks, the total
output will increase.
• Increased quality of products: because workers work on tasks they are best
suited for, the quality of the final output will be high.
• Low costs: workers only need to be trained in the tasks they specialise in and not
the entire process; and tools and equipment required for a task will only be
needed for a few workers who specialise in the task, and not for everybody else.
• Faster: when everyone focuses on a particular task and there is no need for
workers to shift from one task to another, the production will speed up
• Efficient movement of goods: raw materials and half-finished goods will easily
move around the firm from one task to the next.

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
• Better selection of workers: since workers are selected to do tasks best suited for
them, division of labour will help firms to choose the best set of workers for their
operations.
• Aids a streamlined production process: the production process will be smooth
and clearly defined, and so the firm can easily adapt to a mass production scale. 
Increased profits: lower costs and increased productivity will help boost
profits. Disadvantages o firms:
• Increased dependency: The production may come to a halt if one or more
workers doing a specific task is absent. The production is dependent on all
workers being present to do their jobs.
• Danger of overproduction: as division of labour facilitates mass production, the
supply of the product may exceed its demand, and cause a problem of excess
stocks of finished goods. Firms need to ensure that they’re not producing too
much if there is not enough demand for the product in the first place.
Advantages to the economy:

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
Better utilisation of human resources in the economy as workers do the job
they’re best at, helping the economy achieve its maximum output.
Establishment of efficient firms and industries, as the higher profits from division
of labour will attract entrepreneurs to invest and produce.
Inventions arise: as workers become skilled in particular areas, they can innovate
and invent new methods and products in that field.
Disadvantages to the economy:
• Labour immobility: occupational immobility may arise because workers can only
specialise in a specific field.
• Reduces the creative instinct of the labour force in the long-run as they are only
able to do a single task repetitively and the previous skills they acquired die out.
• Creates a factory culture, which brings with it the evils of exploitation, poor
working conditions, and forced monotony.

Trade Unions
HomeNotesEconomics – 04553.4 – Trade Unions
Trade Unions are organizations of workers that aim at promoting and protecting
the interest of their members (workers). They aim on improving wage rates,
working conditions and other job-related aspects.
The functions of a trade union:
• Negotiating improvements in non-wage benefits with employers.
• Defending employees’ rights.
• Improving working conditions, such as better working hours and better safety
measures.
• Improving pay and other benefits.

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
• Supporting workers who have been unfairly dismissed or discriminated against.
• Developing the skills of members, by providing training and education.
• Providing recreational activities for the members.
• Taking industrial actions (strikes, overtime ban etc.) when employers don’t
satisfy their needs. These are explained later in this topic.
Collective bargaining: the process of negotiating over pay and working
conditions between trade unions and employers.
When can trade unions argue for higher wages and better working conditions?
Prices are rising (inflation): the cost of living increases when prices increase and
workers will want higher wages to consume products and raise their families.
The sales and demand of the firm has increased.
• Workers in other firms are getting a higher pay.
• The productivity of the members has increased.

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

• Overtime ban: workers refuse to work more than their normal hours.
• Go-slow: workers deliberately slow down production, so the firm’s sales and
profits go down.
• Strike: workers refuse to work and may also protest or picket outside their
workplace to stop deliveries and prevent other non-union members from
entering. They don’t receive any wages during this time. This will halt all
production of the firm.
Trade union activity has several impacts: Advantages

to workers:

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
• Workers benefit from collective bargaining power by being able to establish
better terms of labour.
• Workers feel a sense of unity and feel represented, increasing morale.
• Lesser chance of being discriminated and exploited.
Disadvantages to workers:
• Workers might get lesser wages or none if they go on strike – as the output and
profits of the firm falls and they refuse to pay.
Advantages to firms:
• Time is saved in negotiating with a union when compared to negotiating with
individuals workers.
• When making changes in work schedules and practices, a trade union’s
cooperation can help organise workers efficiently.
• Mutual respect and good relationships between unions and firms are good for
business morale and increases productivity.
Disadvantages to firms:
Decision making may be long as there will be need of lengthy discussions with
trade unions in major business decisions.
Trade unions may make demands that the firm may not be able to meet – they
will have to choose between profitability and workers’ interests.
Higher wages bargained by trade unions will reduce the firm’s profitability.
• Businesses will have high costs and low output if unions organise agitations.
Their revenue and profits will go down and they will enter a loss. They may also
lose a lot of customers to competing firms.
Advantages to the economy:
• Ensures that the labour force in the economy is not exploited and that their
interests are being represented Disadvantages to the economy:
• Can negatively impact total output of the economy.
• Firms may decide to substitute labour for capital if they can’t meet trade unions’
expensive demands, and so unemployment may rise.
• Higher wages resulting from trade union activity can make the nation’s exports
expensive and thus less competitive in the international market In modern
times, the powers of trade unions have drastically weakened. Globalisation,

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

Firms
HomeNotesEconomics – 04553.5 – Firms

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

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

• Primary: all economic activity involving extraction of raw natural materials. This
includes agriculture, mining, fishing etc. In pre-modern times, most economic

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

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

Small Firms
A small firm is an independently owned and operated enterprise that is limited in
size and in revenue depending on the industry. They require relatively less
capital, less workforce and less or no machinery. These businesses are ideally


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suited to operate on a small scale to serve a local community and to provide

profits to the owners.
Advantages of small businesses:

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

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

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

• Size of the market: when there is only a small market for a product, a firm will
see no point in growing to a larger size. The market maybe small because:
• the market is local – for example, the local hairdresser.
• the final product maybe an expensive luxury item which only require smallscale
production (e.g. custom-made paintings)
• personalised/custom services can only be given by small firms, unlike large firms
that mostly give standardised services (e.g. wedding cake makers).
• Access to capital is limited, so owners can’t grow the firm.

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

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

Internal Growth/Organic Growth

This involves expanding the scale of production of the firm’s existing operations.
This can be done by purchasing more machinery/equipment, opening more
branches, selling new products, expanding business premises, employing more
workers etc. External Growth
This involves two or more firms joining together to form a larger business. This is
called integration. This can be done it two ways: mergers or takeovers. A
takeover or acquisition happens when a company buys enough shares of
another firm that they can take full control. The firm taken over loses its identity
and becomes a part of what is known as the holding company. A well-known
example would be Facebook’s acquisition of Whatsapp in 2014.
A merger occurs when the owners of two or more companies agree to join
together to form a firm.
Mergers can happen in three ways:

• Horizontal Integration: integration of firms engaged in the production of the

same type of good at the same level of production. Example: a cloth
manufacturing company merges with another cloth manufacturing company.
Advantages:

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

Disadvantages:

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

managerial and operational issues leading to higher costs.
• Reduced flexibility: the addition of more employees and processes means the
need for more transparency and therefore more accountability and red tape,
which can slow down the rate of innovating and producing new products and
processes.
• Vertical Integration: integration of firms engaged in the production of the
same type of good but at different levels of production
(primary/secondary/tertiary). Example: a cloth manufacturing company
(secondary sector) merges with a cotton growing firm (primary sector).
• Forward vertical integration: when a firm integrates with a firm that is at a
later stage of production than theirs. Example: a dairy farm integrates with a
cheese manufacturing company.
• Backward vertical integration: when a firm integrates with a firm that is at an
earlier stage of production than theirs. Example: a chocolate retailer integrates
with a chocolate manufacturing company. Advantages:

• It can give a firm assured supplies or outlets for their products. If a coffee
brand merged with coffee plantation, the manufacturers would get assured
supplies of coffee beans from the plantation. If the coffee brand merged with

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 IGCSE ECONOMICS NOTES (0455)

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

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

managerial and operational issues leading to higher costs

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• Reduced flexibility: the addition of more employees and processes means the
need for more transparency and therefore more accountability and red tape,
which can slow down the rate of innovating and producing new products and
processes
• It’s a difficult process: The firms, when vertically integrated, are entering into
a stage of production/sector they’re not familiar with, and this will require
staff of either firm to be educated and trained. Some might even lose their
jobs. It can be expensive as well.
• Lateral/Conglomerate integration: this occurs when firms producing different
type of products integrate. They could be at the same or different stages of
production. Example: a housing company integrates with a dairy farm. Thus,
the firm can produce a wide range of products. This helps diversify a firm’s
operations. Advantages:

• Diversify risks: conglomerate integration allows businesses to have activities

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

• Inexperience can lead to mismanagement: if the firms are in entirely different

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

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Scale of Production
As a firm’s scale of production increases its average costs decrease. Cost saving
from a large-scale production is called economies of scale.
Internal economies of scale are decisions taken within the firm that can bring
about economies (advantages). Some internal economies of scale are:
• Purchasing economies: large firms can be buy raw materials and components in
bulk because of their large scale of production. Supplier will usually offer price
discounts for bulk purchases, which will cut purchasing costs for the firm.
• Marketing economies: large firms can afford their own vehicles to distribute their
products, which is much cheaper than hiring other firms to distribute them. Also,
the costs of advertising is spread over a much large output in large firms when
compared to small firms.
• Financial economies: banks are more willing to lend money to large firms since
they are more financially secure (than small firms) to repay loans. They are also
likely to get lower rates of interest. Large firms also have the ability to sell shares
to raise capital (which do not have to be repaid). Thus, they get more capital at
lower costs.
• Technical economies: large firms are more financially able to invest in good
technology, skilled workers, machinery etc. which are very efficient and cut costs
for the firm.
• Risk-bearing economies: large firms with a high output can sell into different
markets (even overseas). They are able to produce a variety of products
(diversification in production). This means that their risks are spread over a wider
range of products or markets; even if a market or product is not successful, they
have other products and markets to continue business in. Thus, costs are less.

External economies of scale occur when firms benefit from the entire industry
being large. This may include:
• Access to skilled workers: large firms can recruit workers trained by other firms.
For example: when a new training institution for pilots and airline staff opens, all
airline firms can enjoy economies of scale of having access to skilled workers, who
are more efficient and productive, and cuts costs.
• Ancillary firms: they are firms that supply and provide materials/services to larger
firms. When ancillary firms such as a marketing firm locates close to a company,
the company can cut costs by using their services more cheaply than other firms.

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
• Joint marketing benefits: when firms in the same industry locate close to each
other, they may share an enhanced reputation and customer base.
Shared infrastructure: development in the infrastructure of an industry or the
economy can benefit large firms. Examples: more roads and bridges by the govt.
can cut transport costs for firms, a new power station can provide cheaper
electricity for firms.

Diseconomies of scale occur when a firms grows too large and average costs
start to rise. Some common diseconomies are:
• Management diseconomies: large firms have a wide internal organisation with
lots of managers and employees. This makes communication difficult and
decision-making very slow. Gradually, it leads to inefficient running of the firms
and increases costs.
• Too much output may require a large supply of raw materials, power etc. which
can lead to shortage and halt production, increasing costs.
• Large firms may use automated production with lots of capital equipment.
Workers operating these machines may feel bored in doing the repetitive tasks
and thus become demotivated and less cooperative. Many workers may leave or
go on strikes, stopping production and increasing costs.
• Agglomeration diseconomies: this occurs when firms merge/acquire too many
different firms producing different products, and the managers and owners can’t
coordinate and organise all activities, leading to higher costs.
• More shares sold into the market and bought means more owners coming into
the business. Having a lot of owners can lead to a lot of disputes and conflicts
among themselves.
• A lot of large firms can face diseconomies when their products become too
standardised and less of a variety in the market. This will reduce sales and
profits and increase average costs.
A firm that doubles all its inputs (resources) and is able to more than double its
output as a result, experiences increasing returns to scale.
A firm that doubles all its inputs and fails to double its output as a result,
experiences a decreasing or diminishing returns to scale.

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Firms and Production

HomeNotesEconomics – 04553.6 – Firms and Production

Demand for Factors of Production

Some factors that determine the demand of factors of production:

• The demand for the product: if more goods and services are demanded by
consumers, more factors of production will be demanded by firms to produce and
satisfy the demand. That is, the demand for factors of production is derived
demand, as it is determined by the demand for the goods and services (just like
labour demand).
• The availability of factors: firms will also demand factors that are easily available
and accessible to them. If the firm is located in a region where there is a large
pool of skilled labour, it will demand more labour as opposed to capital.
• The price of factors: If labour is more expensive than capital, firms will demand
more capital (and vice versa), as they want to reduce costs and maximize profits.
• The productivity of factors: If labour is more productive than capital, then more
labour is demanded, and vice versa.
Labour-intensive and Capital-intensive production
Labour-intensive production is where more labourers are employed than
other factors, say capital. Production is mainly dependent on labour. It is
usually adopted in small-scale industries, especially those that produce
personalised, handmade products. Examples: hotels and restaurants.
Advantages:

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

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

• Relatively expensive: in the long-term, when compared to machinery, labour has

higher per unit costs due to lower levels of productivity.
• Inefficient and inconsistent: compared to machinery, labour is relatively less
efficient and tends to be inconsistent with their productivity, with various
personal, psychological and physical matters influencing their quantity and quality
of work.
• Labour relation problems: firms will have to put up with labour demands and
grievances. They could stage an overtime ban or strike if their demands are not
met.
Capital refers to the machinery, equipment, tools, buildings and vehicles used in
production. It also means the investment required to do production.
Capitalintensive production is where more capital is employed than other
factors. It is a production which requires a relatively high level of capital
investment compared to the labour cost. Most capital-intensive production is
automated (example: carmanufacturing). Advantages:

• Less likely to make errors: Machines, since they’re mechanically or digitally

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

• Expensive: the initial costs of investment is high, as well as possible training costs.

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• Lack of flexibility: machines need not be as flexible as labourers are to meet

changes in demand.
• Machinery lacks initiative: machines don’t have the intuitive or creative power
that human labour can provide the business, and improve production.

Production and Productivity

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

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

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

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

Factors that influence productivity:

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

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Firms’ Costs, Revenue

and Objectives
HomeNotesEconomics – 04553.7 – Firms’ Costs, Revenue and Objectives
Costs of Production
Fixed costs (FC) are costs that are fixed in the short-term running of a business
and have to be paid even when no production is taking place. Examples: rent,
interest on bank loans, telephone bills. These costs do not depend on the amount
of output produced.
Average Fixed Cost (AFC) = Total Fixed Cost (TFC) / Total Output

Variable costs (VC) are costs that are variable in the short-term running of a
business and are paid according to the output produced. The more the
production, the more the variable costs are. Examples: wages, electricity bill, cost
of raw materials.

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Average Variable Cost (AVC) = Total Variable Costs (TVC) / Total Output

Total Costs (TC) = Total Fixed Costs (TFC) + Total Variable Costs (TVC)

This is a simple graph showing the relation

between TC, FC and VC. The gap between the TC and TVC indicates the TFC
Average cost or Average total Cost (ATC) is the cost per unit of output.
Average Total Cost (ATC) = Total Cost (TC) / Total Output or
Average Cost (AC) = Average Variable Cost (AVC) + Average Fixed Cost (AFC)

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

Let’s calculate some costs in an example:

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

No. of units of TVs produced = 1000

Total Fixed Costs for one month = $900

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

Variable Cost of producing one unit of TV = $500

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

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

Revenue
Revenue is the total income a firm earns from the sale of its goods and services.
The more the sales, the more the revenue.
Total Revenue (TR) = No. of units sold (Sales) * Price per unit (P)
Average Revenue = Total Revenue (TR) / No. of units sold (Sales) (= Price per
unit (P)!)

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Suppose, from the example above, a TV is sold at $800 and the firm sells all the
units it produces, what is the firm’s Total Revenue and Average Revenue, for a
month?
No. of units sold (Sales) in a month = No. of units produced in a month = 1000
Total Revenue = Sales * Price ==> 1000 * $800 = $800,000
Average Revenue = Total Revenue / Sales = $800,000 / 1000 = $800

Total Revenue – Total Cost = Profit

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

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

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A business’ objectives do not remain the same forever. As market situations

change and as the business itself develops, its objectives will change to reflect its
current market and economic position. For example, a firm facing serious
economic recession could change its objective from profit maximization to short
term survival.

Market Structure
HomeNotesEconomics – 04553.8 – Market Structure

Competitive Markets
Firms compete in the market to increase their customer base, sales, market share
and profits.

Price competition involves competing to offer consumers the lowest or best

possible prices of a product. Non-price competition is competing on all other
features of the product (quality, after-sales care, warranty etc.) other than price.
Informative advertising means providing information about the product to
consumers. Examples include advertising of phones, computers, home appliances
etc. which include specific information about their technical features.
Persuasive advertising is designed to create a consumer want and persuade them
to buy the product in order to boost sales. Examples include advertisements of
perfumes, clothes, chocolates etc.
Pricing Strategies
What can influence the price that producers fix on a product?

• Level and strength of consumer demand.

• The amount of competition from rival producers in the market.
• The cost of production and the level of profit targeted.
Price skimming: When a new and unique product enters the market, its
producers charge a very high price for it initially as consumers will be willing to
pay more for the new product. As more competitors begin to launch similar

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

Perfect Competition
In a perfectly competitive market, there will be many sellers and many buyers – a
lot of different firms compete to supply an identical product.
As there is fierce competition, neither producers nor consumers can influence
market price – they are all price takers. If any firm did try to sell at a high price, it
would lose customers to competitors. If the price is too low, they may incur a
loss.
There will also be a huge amount of output in the market. Advantages:
• High consumer sovereignty: consumers will have a wide variety of goods and
services to choose from, as many producers sell similar products. Products are
also likely to be of high quality, in order to attract consumers.
• Low prices: as competition is fierce, producers will try and keep prices low to
attract customers and increase sales.

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• Efficiency: to keep profits high and lower costs, firms will be very efficient. If they
aren’t efficient, they would become less profitable. This will cause them to raise
prices which would discourage consumers from buying their product. Inefficiency
could also lead to poor quality products.
Disadvantages:
• Wasteful competition: in order to keep up with other firms, producers will
duplicate items; this is considered a waste of resources.
• Mislead customers: to gain more customers and sales, firms might give false and
exaggerated claims about their product, which would disadvantage both
customers and competitors.

Monopoly
Dominant firms who have market power to restrict competition in the market
are called monopolies. In a pure monopoly, there is only a single seller who
supplies a good or service. Example: Indian Railways. Since customers have no
other firms to buy from, monopolies can raise prices – that is they are able to
influence prices as it will not affect their profitability. These high prices result in
monopolies generating excessive or abnormal profits.
Monopolies don’t face competition because the market faces high barriers to
entry – obstacles preventing new firms from entering the market. That is, there
might be high start-up costs (sunk costs), expensive paperwork, regulations etc. If
the monopoly has a very high brand loyalty or pricing structures that other firm
couldn’t possibly compete with, those also act as barriers to entry.
Disadvantages:
• There is less consumer sovereignty: as there are no (or very little) other firms
selling the product, output is low and thus there is little consumer choice.
• Monopolies may not respond quickly to customer demands.
• Higher prices.
• Lower quality: as there is little or no competition, monopolies have no incentive
to raise quality, as consumers will have to buy from them anyway. (But since they
make a lot of profit, they may invest a lot in research and development and
increase quality).
• Inefficiency: With high prices, they may create high enough profits that, costs due
to inefficiency won’t create a significant problem in their profitability and so they
can continue being inefficient.
Why monopolies are not always bad?

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• As only a single producer exists, it will produce more output than what individual
firms in a competition do, and thus benefit from economies of scale.
• They can still face competition from overseas firms.
• They could sell products at lower price and high quality if they fear new firms
may enter the market in the future.

The Macroeconomic
Aims of Government
HomeNotesEconomics – 04554.1 – 4.2 – The Macroeconomic Aims
of Government

The Role of Government

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

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

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

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• Governments also manage its trade in goods and services with other countries by
negotiating international trade deals.

Government Macroeconomic Aims

The government’s major macroeconomic objectives are:

• Economic Growth: economic growth refers to an increase in the gross

domestic product (GDP), the amount of goods and services produced in the
economy, over a period of time. More output means economic growth. But if
output falls over time (economic recession), it can cause:
• fall in employment, incomes and living standards of the people
• fall in the tax revenue the govt. collects from goods and services and incomes,
which will, in turn, lead to a cut in govt. spending
• fall in the revenues and profits of firms
• low investments, that is, people won’t invest in production as economic
conditions are poor and they will yield low profits.
• Price Stability: inflation is the continuous rise in the average price levels in an
economy during a time period. Governments usually target an inflation rate it
should maintain in a year, say 3%. If prices rise too quickly it can negatively
affect the economy because it:
• reduces people’s purchasing powers as people will be able to buy less with the
money they have now than before
• causes hardship for the poor
• increases business costs especially as workers will demand higher wages to
support their livelihood
• makes products more expensive than products of other countries with low
inflation. This will make exports less competitive in the international market.
• Full Employment: if there is a high level of unemployment in a country, the
following may happen:
• the total national output (goods produced) will fall
• government will have to give out welfare payments (unemployment benefits)
to the unemployed, increasing public expenditure while income taxes fall –
causing a budget deficit

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• large unemployment causes public unrest and anger towards the government.
• Balance of Payments Stability: economies export (sell) many of their products
to overseas residents, and receive income and investment from abroad; they
also import (buy) goods and services from other economies, and make
investments in other countries. These are recorded in a country’s Balance of
Payments (BoP).
Exports > Imports = Surplus in BoP
Exports < Imports = Deficit in BoP
All economies try to balance this inflow and outflow of international trade and
payments and try to avoid any deficits because:
• if it exports too little and imports too much, the economy may run out of
foreign currency to buy further imports
• a BoP deficit causes the value of its currency to fall against other foreign
currencies and make imports more expensive to buy, while a BoP surplus
causes its currency to rise against other foreign currencies and make its
exports more expensive in the international market.
• Income Redistribution: to reduce the inequality of income among its citizens,
the government will redistribute incomes from the rich to the poor by
imposing taxes on the rich and using it to finance welfare schemes for the
poor. All governments struggle with income inequality and try to solve it
because:
• widening inequality means higher levels of poverty
• poverty and hardship restricts the economy from reaching its maximum
productive capacity.

Conflict of Macroeconomic Aims

When a policy is introduced to achieve one macroeconomic aim, it tends to
conflict with one or more other aims. In other words, as one aim is achieved,
another aim is undone. Let’s look at some conflicts of government
macroeconomic aims.

Full Employment v/s Price Stability

Low rates of unemployment will boost incomes of businesses and workers. This
rise in incomes, mean higher demand and consumption in the economy, which
causes firms to raise their prices – resulting in inflation. This is probably the most

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prominent policy conflict in the study of Economics. Economic Growth & Full
Employment v/s BoP Stability
Once again, as incomes rise due to economic growth and low unemployment,
people will import more foreign products and consume relatively less domestic
products. This will cause a rise in imports relative to exports and a deficit may
arise in the balance of payments. Economic Growth v/s Full Employment
In the long run, when economic growth is continuous, firms may start investing in
more capital (machinery/equipment). More capital-intensive production will
make a lot of people unemployed.

Fiscal Policy
HomeNotesEconomics – 04554.3 – Fiscal Policy
Budget: a financial statement showing the forecasted government revenue and
expenditure in the coming fiscal year. It lays out the amount the government
expects to receive as revenue in taxes and other incomes and how and where it
will use this revenue to finance its various spending endeavours. Governments
aim for its budgets to be balanced.

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

Reasons governments spend:

• To supply goods and services that the private sector would fail to do, such as
public goods, including defence, roads and streetlights; merit goods, such as

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hospitals and schools; and welfare payments and benefits, including

unemployment and child benefits.
• To achieve supply-side improvements in the economy, such as spending on
education and training to improve labour productivity.
• To spend on policies to reduce negative externalities, such as pollution controls.
• To subsidise industries which may need financial support, and which is not
available from the private sector, usually agriculture and related industries.
• To help redistribute income and improve income inequality.
• To inject spending into the economy to aid economic growth.

Effects of government spending

• Increased government spending will lead to higher demand in the economy and
thus aid economic growth, but it can also lead to inflation if the increasing
demand causes prices to rise faster than output.
• Increased government spending on public goods and merit goods, especially in
infrastructure, can lead to increased productivity and growth in the long run.
• Increased government spending on welfare schemes and benefits will increase
living standards, and help reduce inequality.
• However too much government spending can also cause ‘crowding out’ of
private sector investments – private investments will reduce if the increase in
government spending is financed by increased taxes and borrowing (large
government borrowing will drive up interest rates and discourage private
investment).

Tax
Governments earn revenue through interests on government bonds and loans,
incomes from fines, penalties, escheats, grants in aid, income from public
property, dividends and profits on government establishments, printing of
currency etc; but its major source of revenue comes from taxation. Taxes are a
compulsory payment made to the government by all people in an economy.
There are many reasons for levying taxes from the economy:
• It is a source of government revenue: if the government has to spend on public
goods and services it needs money that is funded from the economy itself. People
pay taxes knowing that it is required to fund their collective welfare.

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• To redistribute income: governments levy taxes from those who earn higher
incomes and have a lot of wealth. This is then used to fund welfare schemes for
the poor.
• To reduce consumption and production of demerit goods: a much higher tax is
levied on demerit goods like alcohol and tobacco than other goods to drive up its
prices and costs in order to discourage its consumption and production. Such a
tax on a specific good is called excise duty.
• To protect home industries: taxes are also levied on foreign goods entering the
domestic market. This makes foreign goods relatively more expensive in the
domestic market, enabling domestic products to compete with them. Such a tax
on foreign goods and services is called customs duty.
• To manage the economy: as we will discuss shortly, taxation is also a tool for
demand and supply side management. Lowering taxes increase aggregate
demand and supply in the economy, thereby facilitating growth. Similarly, during
high inflation, the government will increase taxes to reduce demand and thus
bring down prices. More on this below.
Classification of Taxes
Taxes can be classifies into direct or indirect and progressive, regressive or
proportional.

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

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• Inheritance tax: tax levied on inherited wealth.

• Property tax: tax levied on property/land. Advantages:

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

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

• Cost-effective: the cost of collecting indirect taxes is low compared to collecting

direct taxes.
• Expanded tax-base: directs taxes are paid by those who make a good income, but
indirect taxes are paid by all people (young, old, unemployed etc.) who consume
goods and services, so there is a larger tax base.

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 IGCSE ECONOMICS NOTES (0455)

• Can achieve specific aims: for example, excise duty (tax on demerit goods) can
discourage the consumption of harmful goods; similarly, higher and lower taxes
on particular products can influence their consumption.
• Flexible: indirect tax rates are easier and quicker to alter/change than direct tax
rates. Thus their effects are immediate in an economy. Disadvantages:

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

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

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

• The main purpose of tax is to raise income for the government which can lead to
higher spending on health care and education. The impact depends on what the
government spends the money on. For example, whether it is used to fund
infrastructure projects or to fund the government’s debt repayment.
• Consumers will have less disposable income to spend after income tax has been
deducted. This is likely to lead to lower levels of spending and saving. However, if
the government spends the tax revenue in effective ways to boost demand, it
shouldn’t affect the economy.
• Higher income tax reduces disposable income and can reduce the incentive to
work. Workers may be less willing to work overtime or might leave the labour
market altogether. However, there are two conflicting effects of higher tax:

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• Substitution effect: higher tax leads to lower disposable income, and work
becomes relatively less attractive than leisure – workers will prefer to work less.
• Income effect: if higher tax leads to lower disposable income, then a worker may
feel the need to work longer hours to maintain his desired level of income –
workers feel the need to work longer to earn more.
• The impact of tax then depends on which effect is greater. If the substitution
effect is greater, then people will work less, but if income effect is greater, people
will work more
• Producers will have less incentive to produce if the corporate taxes are too high.
Private firm aim on making profits, and if a major chunk of their profits are eaten
away by taxes, they might not bother producing more and might decide to close
shop.

Fiscal Policy
Fiscal policy is a government policy which adjusts government spending and
taxation to influence the economy. It is the budgetary policy, because it
manages the government expenditure and revenue. Government
aims for a balance budget and tries to achieve it using fiscal policy. A
budget is in surplus, when government revenue exceed government
spending. While this is good it also means that the economy hasn’t
reached its full potential. The government is keeping more than it is
spending, and if this surplus is very large, it can trigger a slowdown of
the economy.
When there is a budget surplus, the government employs an expansionary fiscal
policy where govt. spending is increased and tax rates are cut.
A budget is in deficit, when government expenditure exceeds
government revenue. This is undesirable because if there is not enough
revenue to finance the expenditure, the government will have to
borrow and then be in debt.
When there is a budget deficit, the government employs contractionary fiscal
policy, where govt. spending is cut and tax rates are increased.

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Fiscal policy helps the government achieve its aim of economic growth,
by being able to influence the demand and spending in the economy. It
also indirectly helps maintain price stability, via the effects of tax and
spending.
Expansionary fiscal policy will stimulate growth, employment and help
increase prices. Contractionary fiscal policy will help control inflation
resulting from too much growth. But as we will see later on, controlling
inflation by reducing growth can lead to increased unemployment as
output and production falls.

Monetary Policy
HomeNotesEconomics – 04554.4 – Monetary Policy
The money supply is the total value of money available in an economy at a
point of time. The government can control money supply through a variety of
tools including open market operations (buying and selling of government bonds)
and changing reserve requirements of banks. (The syllabus doesn’t require you to
study these in depth)
The interest rate is the cost of borrowing money. When a person borrows money
from a bank, he/she has to pay an interest (monthly or annually) calculated on
the amount he/she borrowed. Interest is also be earned on the money deposited
by individuals in a bank.
(The interest on borrowing is higher than the interest on deposits, helping the
banks make a profit).
Higher interest rates will discourage borrowing and therefore, investments; it will
also encourage people to save rather than consume (fall in consumption also
discourage firms from investing and producing more).
Lower interest rates will encourage borrowing and investments, and encourage
people to consume rather than save (rise in consumption also encourage firms to
invest and produce more).

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The monetary authority of the country cannot directly change the general
interest rate in the economy. Instead, it changes the interest rates of borrowing
between the central bank and commercial banks, as well as the interest on its
bonds and securities. These will then influence the interest rate provided by
commercial banks on loans and deposits to individuals and businesses.

Monetary Policy
Monetary policy is a government policy controls money supply (availability and
cost of money) in an economy in order to attain growth and stability. It is usually
conducted by the country’s central bank and usually used to maintain price
stability, low unemployment and economic growth.
Expansionary monetary policy is where the government increases money supply
by cutting interest rates. Low interest rates will mean more people will resort to
spending rather than saving, and businesses will invest more as they will have to
pay lower interest on their borrowings. Thus, the higher money supply will mean
more money being circulated among the government, producers and consumers,
increasing economic activity. Economic growth and an improvement in the
balance of payments will be experienced and employment will rise.
Contractionary monetary policy is where the government decreases money
supply by increasing interest rates. Higher interest rates will mean more people
will resort to saving rather than spending, and businesses will be reluctant to
invest as they will have to pay high interest on their borrowings. Thus, the lower
money supply will mean less money being circulated among the government,
producers and consumers, reducing economic activity. This helps slow down
economic growth and reduce inflation, but at the cost of possible unemployment
resulting from the fall in output.

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Supply-side Policy
HomeNotesEconomics – 04554.5 – Supply-side Policy
Supply side policies are microeconomic policies aimed at increasing supply and
productivity in the economy, to enable long-term economic growth. Some of
these policies include:
• Public sector investments: investments in infrastructure such as transport and
communication can greatly help the economy by making the flow of resources
quick and easy, and facilitate faster growth.
• Improving education and vocational training: the government can invest in
education and skills training to improve the quality and quantity of labour to
increase productivity.
• Spending on health: accessible, affordable and good quality health services will
improve the health of the population, helping reduce the hours lost to illnesses
and increasing productivity.
• Investment on housing: as more housing spaces are built, the geographical
mobility of the population will increase, helping increase output.
• Privatization: transferring some public corporations to private ownership will
increase efficiency and increase output, as the private sector has a profit-motive
absent in public sector.
• Income tax cuts: reducing income tax will increase people’s willingness to work
more and earn more, helping increase the supply in the economy.
• Subsidies are financial grants made to industries that need it. More subsidies
mean more money for producers to produce more, thereby increasing supply.
• Deregulation: removing or easing the laws and regulations required to start and
run businesses so they can operate and produce more output with reduced costs
and hassle, encouraging investments.
• Removing trade barriers: the govt. can reduce or withdraw import duties, quotas
etc. on imports so that more resources, goods and services may be imported to
increase productivity and efficiency in the domestic economy. It can also reduce
export duties to increase export of resources, goods and services to other
nations, thereby encouraging domestic firms to increase production.
• Labour market reforms: making laws that would reduce trade union powers
would reduce business costs and increase output. Minimum wages could be
reduced or done away with to allow more jobs to be created. Welfare payments

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like unemployment benefits could be reduced so that more people would be

motivated to look for jobs rather than rely on the benefits alone to live. These will
not only increase the incentive to work but also increase the incentive to invest.
For example, India, in the early 1990’s undertook massive privatisation,
liberalisation and deregulation measures; abolishing its heavy licensing and red
tape policies, allowing private firms to easily enter the market and operate, and
opening up its economy to foreign trade by reducing the excessive trade tariffs
and regulations. This led to a period of high economic growth and helped India
become the emerging economy it is today.

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

Economic Growth
HomeNotesEconomics – 04554.6 – Economic Growth
Economic growth is an increase in the amount of goods and services produced
per head of the population over a period of time.
The total value of output of goods and services produced is known as the national
output. This can be calculated in three ways: using output, income or
expenditure.
GDP (Gross Domestic Product): the total market value of all final goods and
services provided within an economy by its factors of production in a given period
of time.
Nominal GDP: the value of output produced in an economy in a period of
time, measured at their current market values or prices is the nominal GDP.

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Real GDP: the value of output produced in an economy in a period of time,

measured assuming the prices are unchanged over time. This GDP, in constant
prices, provides a measure of the real output of a country.
GDP per head/capita: this measures the average output/ income per person in an
economy. Since this takes into account the population, it provides a good
measure of the living standards of an economy.
GDP per capita = GDP / Population
An increase in real GDP over time indicates economic growth as goods and
services produced have increased. It indicates that the economy is utilizing its
resources better or its productive capacity has increased. On a PPC, economic
growth will be shown by an outward shift of the PPC, which is also called
‘potential growth’. ‘Actual growth’ occurs when the economy moves from a point
inside the PPC to a point closer to the PPC.

This diagram shows ‘actual growth’ as

the economy realizes its potential growth. In order to experience potential
economic growth, the PPC would have to shift outwards. Causes of
economic growth
• Discovery of more natural resources: more resources mean more the production
capacity. The discovery of oil and gas reserves have enabled a lot of economies
(Norway, Saudi Arabia, Venezuela etc.) to grow rapidly.
• Investment in new capital and infrastructure: investment in new machinery,
buildings, technology etc. has enabled firms and economies to expand their
production capacities. Investment in modern infrastructure such as airports,
roads, harbours etc. have improved access and communication in economies,
helping in achieving quicker and more efficient production.

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• Technical progress: New inventions, production processes etc. can increase the
productivity of existing resources in industries and help boost economic growth.
• Increasing the quantity and quality of factors of production: A larger and more
productive workforce will increase GDP. More skilled, knowledgeable and
productive human resources thus help increase economic growth. Similarly, good
quality capital, use of better natural resources, innovative entrepreneurs all aid
economic growth in the long run.
• Reallocating resources: Moving resources from less-productive uses to
moreproductive uses will improve economic growth. The benefits of economic
growth:

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

• Technical progress may cause capital to replace labour, causing a rise in

unemployment. This will be disastrous for highly populated underdeveloped and
developing economies, pulling more people into poverty
• Scarce resources are used up rapidly when production rises. Natural resources
may get depleted over time.
• Increasing production can increase negative externalities such as pollution,
deforestation, health problems etc. Climate change is a consequence of rapid
global economic growth.
• If the economy produces over its productive capacity and if the growth in demand
outstrips the growth in output, economic growth may cause inflation
• Economic growth has also been accused of widening income inequalities in
developing economies, because rich investors and businessmen gain more than
the working class and poor during growth – the benefits of growth are not evenly
distributed. This will cause relative poverty to rise.

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Governments aim for sustainable economic growth which refers to a rate of

growth which can be maintained without creating significant economic problems
for future generations, such as depletion of resources and a degraded natural
environment.

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

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• Fall in asset prices (e.g. fall in house prices/stock market): recessions trigger a
crash in the stock markets and other asset markets as investors’ and consumers’
confidence in the well-being fall of the economy during a recession. The shares
owned by investors will be worth less.
• Higher budget deficit: due to falling consumption and incomes, the government
will see a fall in tax revenue, causing a budget deficit to grow.
• Permanently lost output: as firms go out of business and employment falls, it
results in a permanent loss of output, as the economy moves inwards from its
PPC.

If the economy was producing at A on its

PPC, a recession will cause production to fall to B.

Policies to promote economic growth

Expansionary fiscal and monetary policies (demand-side policies) and
supplyside policies described in the previous sections can be employed to
promote economic growth, depending on the nature of the problems that are
holding back the economy from growing. For example, if it is the poor quality of
human capital (labour) that is preventing the economy from achieving its
maximum productive capacity, the government should invest in education and
vocational training centres to improve the quality of the labour force and increase
productivity. If it is a lack of effective demand causing slow growth, the
government should focus on cutting income taxes, indirect taxes and interest
rates to boost spending. Effectiveness of such policies:
• Demand-side policies that increase the rate of growth above the long-run trend
rate will cause inflation and quickly lead to a recession if not controlled.

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• Supply-side policies can take considerable time to take effect. For example, if the
government invested in better education and training, it could take several years
for this to lead to higher labour productivity.
• In a recession, supply-side policies won’t solve the fundamental problem of
deficiency of aggregate demand. Increasing the flexibility of labour markets and
encouraging investment may help to some extent, but unless there is sufficient
demand, firms will be reluctant to increase production and make new
investments.

Employment and
Unemployment
HomeNotesEconomics – 04554.7 – Employment and Unemployment
Some terms to be familiar with while we’re discussing employment:

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

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

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Changing patterns and level of employment

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

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

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

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Measuring unemployment
Economies periodically calculate the number of people unemployed in their
economies, to check the unemployment rate and see what policies they should
implement to reduce it if it is too high. They can do this in two ways:

• Claimant count: unemployed people can file for unemployment claims

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

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

labour force

There are some problems with measuring employment.

Under-employment: people may be officially classed as employed but they may
be working fewer hours than they would like. For example, they may have a
parttime job, but want a full-time job. This is considered as unemployment
because they may not fulfil the working hours needed to be considered
employed. Inactivity rates: the long-term unemployed may become discouraged
and leave the labour market completely. In effect they are not working, but they
are classed as economically inactive rather than unemployed. So, the
unemployment rate can be understated.
The causes/types of unemployment
• Frictional unemployment: this occurs as a result of workers leaving one job and
spending time looking for a new one. This type of unemployment is short-lived.
• Cyclical unemployment: this occurs as a result of fall in aggregate demand due to
an economic recession. When demand falls, firms will cut their production and
workers will lose their jobs. There will be a nation-wide rise in unemployment.
• Structural unemployment: this occurs due to the long-term change in the
structure of an economy. Workers end up having the wrong skills in the wrong
place – causing them to be unfit for employment. This can be explained by
dividing it further:

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• Technological unemployment: this has rose in recent times as industrial robots,

machinery and other technology are being substituted for labour, leaving people
jobless.
• Sectoral unemployment: unemployed caused as a sector/industry declines and
leave its workers unemployed.
• Seasonal unemployment: this occurs as a result of the demand for a product
being seasonal. For example, the demand for umbrellas will fall in non-monsoon
seasons, and so workers in umbrella manufacturing firms will become
unemployed over those seasons.
• Voluntary unemployment: when people choose not to work for various reasons –
they want to pursue higher education, would like to take a break etc. Because
they’re not actively looking for work, voluntarily unemployed people do not
belong to the labour force!

The consequences of unemployment

• People will lose their working skills if they remain unemployed for a long time
and may find it even harder to find suitable jobs. As people remain unemployed,
their incomes will be low, and living standards will fall.

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

Policies to reduce unemployment

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

• Expansionary policies to increase demand: expansionary fiscal policies like

cutting down taxes and increasing government spending (which also creates
jobs) and expansionary monetary policies like cutting interest rates will help
boost demand in the economy, to keep production and employment high.
However these will take effect only with a time lag. Cutting tax rates won’t help if

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

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across the economy, requiring training centres to be built, and trainers to be

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

Inflation and Deflation

HomeNotesEconomics – 04554.8 – Inflation and Deflation

Inflation
Inflation is the general and sustained rise in the level of prices of goods and
services in an economy over a period of time.
For example, the inflation rate in UK in 2010 was 4.7%. This means that the
average price of goods and services sold in the UK rose by 4.7% during that year.
Inflation is measured using a consumer price index (CPI) or retail price index
(RPI).
The consumer price index is calculated in this way:
• A selection of goods and services normally purchased by a typical family or
household is identified.
• The prices of these ‘basket of goods and services’ will then be monitored at a
number of different retail outlets across the country.

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
• The average price of the basket in the first year or ‘base year’ is given a value of
100.
• The average change in price of these goods and services over the year is
calculated.
• If it rises by an average of 25%, the new index is 125% * 100 = 125%. If in the
next year there is a further average increase of 10%, the price index is 110% *
125 = 137.5%. The average inflation rate over the two years is thus 137.5 – 100 =
37.5% Causes of Inflation

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
Demand-pull inflation: inflation caused by an increase in aggregate demand is
called demand-pull inflation. This is also defined as the increase in price due to
aggregate demand exceeding aggregate supply. Demand could rise due to higher
incomes, lower taxes etc. The demand curve will shift right, causing an extension
in supply and a rise in price.
• Cost-push inflation: inflation caused by an increase in cost of production in the
economy. The cost of production could rise due to higher wage rate, higher
indirect taxes, higher cost of raw materials, higher interest on capital etc. The
supply curve will shift left causing a contraction in demand and a rise in price.
• A lot of economists agree that a rise in money supply in contrast with output is
the key reason for inflation. If the GDP isn’t accelerating as much as the money
supply, then there will be a higher demand which could exceed supply, leading to
inflation.
The consequences of inflation
• Lower purchasing power: when the price level rises, the lesser number of goods
and services you can buy with the same amount of money. This is called a fall in
the purchasing power. When purchasing power falls, consumers will have to
make choices on spending.
• Exports are less internationally competitive: if the prices of exports are high, its
competitiveness in international markets will fall as lower priced foreign goods
will rival it. This could lead to a current account deficit if exports lower (especially
if they are price elastic).
• Inflation causing inflation‘: during inflation, the cost of living in the economy rises
as you have to pay more for goods and services. This might cause workers to
demand higher wages increasing the cost of production. If the price of raw
materials also increase, the cost of production again increases, causing cost-push
inflation.
• Fixed income groups, lenders, and savers lose: a person who has a fixed income
will lose as he cannot press for higher wages during inflation (his/her real wages
fall as purchasing power of his/her wages fall). Lenders who lent money before
inflation and receive the money back during inflation will lose the value on their
money. The same amount of money is now worth less (here, the people who
borrowed gain purchasing power). Savers also lose because the interest they’re
earning on savings in banks does not increase as much as the inflation, and savers
will lose the value on their money. Policies to control inflation

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
Contractionary monetary policy that will reduce demand: contractionary
monetary policy is the most popular policy employed to curtail inflation. Raising
interest rates will discourage spending and investing (as cost of borrowing rises)
and reduce the money supply in the economy, helping cut down on demand. But
this depends a lot on the consumer and business confidence in the economy.
Spending and investing may still continue to rise as confidence remains high.
There is also a considerable time lag for monetary policy to take effect.
• Contractionary fiscal policy that will reduce demand: raising taxes will discourage
spending and investing and cutting down on government spending will reduce
aggregate demand in the economy, helping bring down the price level. However,
this is an unpopular policy only employed when inflation is severe.
• Supply side policies: supply-side policies such as privatisation and deregulation
hope to make firms competitive and efficient, and thus avoid inflationary
pressures. But this is a long-term policy only helping to keep the long-term
inflation rate stable. Sudden surges in inflation cannot be addressed using supply
side measures
• Exchange rate policy: Appreciating the domestic currency can lower import prices
helping reduce cost-push inflation arising from expensive imported raw materials.
It also makes export more expensive, helping lower the export demand in the
economy as well as creating incentives for exporting firms to cut costs to remain
competitive.

Deflation
Deflation is the general fall in the price level.
Deflation is also measured using CPI, but instead of showing figures above 100, it
will show an index below 100 denoting a deflation. For example, a drop in the
average prices of the basket of goods in a year is 10%, the deflation will be 100 –
(90% * 100 = 90%) = 10%. Causes of deflation
• Aggregate supply exceeding aggregate demand: when supply exceeds demand,
there is an excess of output in the economy not consumed, causing prices to fall.
• Demand has fallen in the economy: during a recession, a fall in demand in the
economy causes general prices to fall and cause a deflation.
• Labour productivity has risen: higher output will lead to lower average costs,
which could reflect as lower prices for products.

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
• Technological advance has reduced cost of production, pulling down cost-push
inflation.
Consequences of deflation
Lower prices will discourage production, resulting in unemployment.
• As demand and prices fall, investors will be discouraged to invest, lowering the
output/GDP.
• Deflation can cause recession as demand and prices continue to fall and firms are
forced to close down as enough profits are not being made.
• Tax revenue of the government will fall as economic activity and incomes falls.
They might be forced to borrow money to finance public expenditure.
• Borrowers will lose during a deflation because now the value of the debt they
owe is higher than when they borrowed the money.
• Deflation will increase the real debt burden of the government as the value of
debt money increases. Policies to control deflation
• Expansionary monetary policy to revive demand: cutting interest rates will
encourage more spending and investment in the economy which will stimulate
prices to rise. However, if interest rate is already at a very low point where
decreasing it any further won’t increase spending, because people still prefer to
save some money and pay off debts, and banks are not willing to lend at a very
low interest rate, (this situation is called a liquidity trap), then cutting interest
rates will have no effect on spending.
• Expansionary fiscal policy to revive demand: increasing government spending in
the economy, especially in infrastructure will help raise demand, along with cuts
in direct taxes. The money for this expenditure can be created via quantitative
easing (selling government bonds to the public).
• Devaluation: devaluing the currency through selling domestic currency and/or
increasing the money supply will cause export prices to fall, encouraging
production of exports, resulting in higher demand; and also increase prices of
imported products which will raise costs and prices for products in the economy.
• Change inflation expectations: when a deflation is expected, businesses won’t
increase wages and consumers won’t pay higher prices (because they expect
prices to fall in the future). This will cause the deflation they expected. But if the
monetary authorities indicate that they expect higher inflation, firms will pay
their workers more and consumer will spend more now, avoiding a deflation.

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Living Standards
HomeNotesEconomics – 04555.1 – Living Standards
Living standards or standards of living refer to all the factors that contribute to a
person’s well-being and happiness Measuring Living Standards
• GDP per head/capita: this measures the average income per person in an
economy.
Real GDP per capita = Real GDP / Population
Merits of using GDP per capita to measure living standards:

• GDP is a useful measure of the total production taking place in the country, and
so indicates the material well-being of the economy
• it also takes population into consideration, adding emphasis on the goods and
services available to individuals
• since it is calculated on output, is a good indicator of the jobs being created
• GDP data is readily available so is population data

Limitations of using GDP per capita to measure living standards:

• it takes no account of what people can buy using their incomes. A country with a
high GDP per head may be no better off than a country with a low GDP per head,
if there are far fewer products to choose from
• similarly, GDP doesn’t consider changes in technology that can have a large
impact on living standards. People might have had more income in the last
decade but they couldn’t benefit from all the technology available today
• distribution of income is very unequal in reality, so the GDP per head isn’t
accurate. Some people might be very rich while others very poor, but the GDP per
head will only give the average incomes
• real GDP excludes the unpaid work people do for charities and voluntary
organizations etc. Thus, it understates the total output
• GDP also doesn’t differentiate between the positive and negative values
economies place on different output/expenditure. For example, if the output
rises because the sales of tobacco, alcohol or pornographic materials, it might
show in the records as a rise in GDP per head but might not actually make people

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better off. Similarly, GDP might rise if the government has to rebuild after a
natural disaster, which doesn’t mean living standards have risen
• the official GDP figures can be overstated due to technical errors or by political
manipulation to look good, and give a wrong picture of living standards
• this measure doesn’t consider leisure activities, health and education levels,
environmental quality- all that determines people’s happiness and well-being
• in order to effectively compare GDP per head across countries, they need to be
converted to a common currency and adjusted for differing purchasing power in
different countries
• comparing GDP per head can also be unreliable as GDP accounting methods can
be different for different countries.

• Human Development Index (HDI): used by the United Nations to compare living
standards across the globe, the HDI combines different measures into one to give
a HDI value from 0 (lowest) to 1(highest). These are:
• Income index, measured using the average national income – GNI per head
adjusted for differences in exchange rate and prices in different countries
(purchasing power parity)
• Education index, measured by how many years on average, a person aged 25 will
have spent on education (mean years of schooling) and how many years a young
child entering school can now be expected to spend in education in his entire life
(expected years of schooling)
• Healthcare index: measured by average life expectancy at birth The benefits of
using HDI to measure living standards:

• it takes into account some major indicators of living standards

• recognises that it is not just output or income that determines living standards,
but also social factors
• it is a useful method to compare global living standards– it shows clear patterns
of living standards
• it is very useful and reliable measure since its produced by the UN and is thus
also widely used and recognised
The limitations of HDI to compare living standards:

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• it combines a set of separate indicators into one, so a country with good literacy
rates and living standards but poor life expectancy can have a low HDI value
• there are wide divergences in HDI within countries
• GNI per head doesn’t say anything about inequalities in income and wealth
within countries
• it doesn’t consider other factors such as environmental quality, access to safe
drinking water, political freedom, crime rates etc. which are also important
indicators of living standards
• the HDI information for all countries may not be available such as war-struck
countries where civilisation has been disrupted
In the 2019 HDI index published by the UN, Norway comes first with an HDI index
of 0.954 while Niger comes last with an index of just 0.377 owing to very low
levels of education and GNI per head. See the full list
at http://hdr.undp.org/en/content/2019-human-development-index-ranking

Reasons for differences in living standards and income distribution within and
between countries

These have been discussed above in the merits and limitations of using GDP per
capita and HDI. More will be discussed in the coming chapters. Some other
reasons are discussed below

Difference in living Standards within a country: there can be variations in living

standards within a country. An excellent example of this is the high living
standards of the Indian state of Kerala (where IGCSE AID is based!) which has a
HDI index of 0.779 while the poorest state of Bihar stands at 0.567 (2018).

• Regional variances in income and consumption

• Major type of sectors/jobs: manufacturing and services heavy regions will have
higher incomes, education and health services compared to agricultural regions
• Local government provisions of education and health Difference in living
Standards between countries:
• Productivity of industries: more productive industries yield more output and
incomes

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• Major industries: what makes countries like Qatar and Norway achieve some of
the world’s highest per capita incomes is that their income comes mostly from
petroleum industries that are scare and highly demanded internationally
• Population: dense population lower per capita income and put pressure on
scarce resource
• Ability of citizens pay taxes: higher tax-base and taxable incomes allow
governments to invest in infrastructure and welfare programmes
• Provision of health and educational facilities
• Variety of goods/services produced: if citizens can choose from a wide variety of
products, living standards rise. Western countries like US enjoy this
• War, crime and natural disasters: war-struck countries of Asia, the high crime
rates of Latin America and frequent natural disasters in island countries, drive
down their living standards as they damage infrastructure and put people into
hardship

Poverty
HomeNotesEconomics – 04555.2 – Poverty
Absolute poverty: the inability to afford basic necessities needed to live (food,
water, education, health care and shelter). This is measured by the number of
people living below a certain income threshold (called a poverty line).
Relative poverty: the condition of having fewer resources than others in the same
society. It is measured by the extent to which a person’s or household’s financial
resources fall below the average income level in the economy. Relative poverty is
basically a measurement of income inequality since a high relative poverty should
indicate a higher income inequality. Causes of poverty
• Unemployment: when people are unemployed and have to go without income
for a long time, they may end up having to sell their possessions, consume less
and go and into poverty.
• Low education levels: this means that people are uneducated, unskilled and
unable to find better jobs, keeping them in poverty.

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• The size of family: more family members with only a few people earning, means
more costs of living, pulling the family into poverty if they’re not earning much.
• Age: older people are likely to have more health problems and be less suitable for
further employment, causing poverty. Young people are still employable and may
find ways to earn an income.
• Poor government support for basic services.
• Poor health: ill mental and physical health is both a cause and result of poverty.
• Overpopulation: high population density will put pressure on scarce resource and
the economy may not be able to produce and provide for everyone, causing
poverty.
• Minority group/ethnicity/migrants: will face discrimination from bureaucrats,
employers and the society at large and so won’t be able to access and enjoy all
services. E.g.: African-Americans in the US tend to be poorer than their white
counterparts.
• Gender: women usually face discrimination, especially in employment and end up
being poorer than men. Policies to alleviate poverty
• Introduce measures to reduce unemployment: an expansionary fiscal/monetary
policy will increase aggregate demand and increase employment opportunities.
Income and standards of living will rise.
• Impose progressive taxes: income taxes are progressive, that is, they increase as
income increases. Imposing these will mean that people on higher incomes will
pay a large percentage of their incomes as tax and help reduce relative poverty.
• Introduce welfare services: money from taxes can be provided as income support
to people with very low incomes. It can also be used to provide free or low-cost
homes, healthcare and education.
• Introduce minimum wage legislation to raise the wage of low-paid employees.
• Increase the quantity and quality of education.
• Attract and invite inward investments from firms abroad to provide jobs and
incomes for people.
• Overseas aid could be gained from foreign governments and aid agencies. This
will include food aid, financial aid, technological aid, loans and debt relief.

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Population
HomeNotesEconomics – 04555.3 – Population
Population is the total number of people inhabiting a specific area. Two-hundred
years ago, the world population was just over a billion, now it is about 7.7 billion,
with China and India having populations above 1 billion each! It is projected to hit
10 billion by 2056.

Factors that affect population

• Birth rates: the average number of children born in a country each year
compared to the total population of an economy is known as the birth rate.
This is usually expressed as the number of births for every 1000 people in the
population.
Why do different countries have different birth rates?
• Living standards: improved quality and availability of food, housing, clean
water and medical care result in fewer babies dying. Countries where children
often die due to poor living standards have higher birth rates (people have
more children fearing that some of their children might die. These children can
then work to produce food and earn incomes).
• Contraception: increased use of contraception and legalisation of abortion
have reduced birth rates in developed countries.
• Customs and religion: many religious beliefs don’t allow the use of
contraceptive pills, so birth rates in those communities rise. In developed
economies it is now less fashionable to have large families, so birth rates have
fallen.
• Changes in female employment: more females in developed countries
entering the labour force has resulted in falling birth rates since they do not
want motherhood to affect their careers.
• Marriage: in developed countries, people are tending to marry later in life, so
birth rates have reduced.
• Death rates: the number of people who die each year compared to every 1000
people of the population is the death rate of an economy.
Reasons for differing death rates in different economies:

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• Living standards: just as birth rates, death rates also tend to be very high in
less-developed economies due to lack of good-quality food, shelter and
medical care. Malnutrition remains the major cause of high death rates in
these countries. In developed countries, the major causes of death include
lifestyle diseases, mostly caused by unhealthy diets.
• Medical advances and heath care: lack of medical care and infrastructure in
less-developed countries continue to be a cause for high death rates.
• Natural disasters and wars: hurricanes, floods, earthquakes and famine due to
lack of rain and poor harvests, and wars and civil conflicts increase death rates.
• Net Migration: migration refers to the number of people entering
(immigration) and leaving (emigration) the country. Net migration measures
the difference between the immigration and emigration to and from an
economy. A net inward migration will increase the working population of the
economy, but can put pressure on governments finances as demand for
housing, education and welfare increase. A net outward migration may
increase the income per capita (if the emigrants send money to families back
home) and thus the HDI, but can result in loss of skilled workers.
Reasons for differing net migration in different economies:
• Living standards: people move to countries where living standards are high
which they can benefit from.
• Employment/wages: people migrate mainly to seek better job opportunities.
Widespread unemployment and low wages in the home country will cause
people to move to countries with better employment opportunities and higher
wages.
• Climate: very cold or very warm countries/regions will face more emigration
than other countries.

Population structure
The structure of a population can be analyzed using:

• Age distribution: the number of people in each age-group.

Falling birth and death rates mean that the average age in developed countries
are rising whereas in developing and less-developed economies, high death and
birth rates result in low average ages. The median age in developed Monaco is
highest at 53.1 while in under-developed Niger it is just 15.3. Dependency ratio is
the ratio of the dependent population (those outside the labour force – children

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and senior citizens – who depend on the labour force to supply them with goods
and services by paying taxes) to the total population in an economy. A high
dependency population, such as in Japan, put pressure on the government to
increase taxes rates in order to raise more revenue to support the dependents,
putting pressure on the labour force. Consequences of an ageing population:
• The workforce will decline and there will be much dependence on the taxpaying
population to fund the welfare of old people.
• Increase in demand for products for old people including healthcare.
• The government will have to spend more on housing, old age welfare schemes
etc.
• Old people are less mobile and so the economy will be slow to adapt to new
technologies.
• Gender distribution: the balance of males and females. The sex ratio measures
the no. of males to the no. of females (the global sex ratio is 101:100; while Arab
countries have sex ratios as high as 2.87, island countries register low sex ratios).
Since the average female lives longer than the average male, there are more
females in the older age-groups than males. Gender imbalance is an excess of
males or females and is caused by  Wars killing many young males
• Violence towards females (honour killings, rapes)
• Sex-specific immigration – more males immigrate to a country looking for work
Consequences of changes in the gender distribution:
• having more females will encourage birth rates to rise and increase population
growth
• more females in employment will increase productivity
• more females in education and employment will increase living standards
• a more balanced gender distribution can aid better social equality as social
attitudes towards women in education and employment become progressive
Population pyramids display the age and gender distribution of an economy. The
vertical axes show the age groups and the horizontal axes show the gender
groups- males on the left and females on the right.

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• Geographic distribution: where people live. 90% of the world population live in
developing countries. This puts a lot of pressure on scarce resources in these
countries. About half of the world population live in urban areas, and this
continues to rise, which has helped increase production and living standards but
resulted in rapid consumption of natural resources and high levels of pollution
and congestion.
• Occupational distribution: what jobs people work in. In developed economies,
more people work in the service sector while in less-developed economies, most
people work in agriculture. In developing economies, there is a huge migration of
workers from primary production to manufacturing and service sectors. Female
employment and self-employment are also rising, which will add to production
and higher living standards.
An optimal population is one where the output of goods and services per head
of the population is maximised. An economy is underpopulated when it does not
have enough labour to make the best use of its resources; and it is overpopulated
when the population is too large given the resources it has.

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Effects of increasing population size

• Increases size of the home market and thus potential for increase in aggregate
demand in the long-run.
• Higher demand and incomes will lead to more economic growth and expansion.
• Increased supply of labour.
• Puts more pressure on already scarce resources, especially land.
• More capital goods will have to be produced to sustain and satisfy the needs and
wants of the enlarged population.
• Fall in rate of productivity in line with the law of diminishing returns – too many
people working on limited resources means low productivity.
• Shift of employment and output from the primary sector towards the services
sector because land for primary activities is fixed, but want for services is
practically infinite as population grows, and the emergence of mechanisation and
technologies will force people out of the primary sector.
• Congestion of urban centres: as population and incomes rise, people will move to
cities and towns which will become crowded. There will be need for heavy
transport, communications, housing, waste management infrastructure spending.

Developed and
Lessdeveloped
Economies
HomeNotesEconomics – 04555.4 – Developed and Less-developed Economies
Economic development refers to the increase in the economic welfare of people
through growth in productive scale and wealth of an economy. Governments aim

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for their countries to expand from developing economies to developed

economies.
Developed countries are characterised by high GDP per capita, high life
expectancy, high literacy rate, a stable or dwindling population growth, excellent
infrastructure, high levels of foreign investments, excellent healthcare, high
productivity, and a relatively large tertiary sector. Example: Japan
Under-developed economies or less-developed economies are characterised by
very low GDP per capita, high population growth, poor infrastructure, healthcare
and education, low literacy rates, low levels of foreign investments, poor
productivity, and a relatively large primary sector.
Example: Somalia
Developing economies are countries that are becoming more developed through
expansion of the industrial sector and fewer people suffering the extremes of
poverty. They may attract high levels of foreign investments and will be
undergoing major economic shifts towards the tertiary sector. However they may
still have a low standard of living, owing to high population growth. Example:
India
The reasons for low economic development
• Over-dependence on agriculture: farming is the most common work in
lessdeveloped economies. Most people work to feed themselves and their
families and sell off any surplus. This means that there is little or no trade
happening , which results in poor incomes, no economic growth or development.
• Domination of international trade by developed economies: the more wealthier
developed economies have exploited poorer countries by buying up their natural
resources at low prices and selling products made from them in international
markets at higher prices. Rich countries also protect their industries by paying
subsidies to domestic producers, increasing global supply, and in turn, lowering
prices. Poor economies cannot compete with these very low prices, and they lose
their jobs and incomes.
• Low levels of savings because of low incomes and widespread poverty.
• Lack of capital: low incomes in under-developed economies lead to a lack of
savings that could be invested in industries.
• Poor investment in infrastructure: good infrastructure in transport, health and
education is essential for growth and development.
• High population growth: rapidly expanding populations (due to high birth rates)
in less-developed countries will reduce the real GDP/income per head.

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• Wars and conflicts deplete resources: there is little scope for development when
the country is a war zone.
• Corrupt and/or unstable governments: causes neglect of economy and citizens’
welfare
The opposites are true for developed economies.

Some development indicators that are used to measure how developed an

economy are: GDP per capita, population living on less than $1 a day, life
expectancy at birth, adult literacy rate, access to safe water supplies and
sanitation, proportion of workers in different sectors of production etc.

International Specialization
HomeNotesEconomics – 04556.1 – International Specialization
To know more about specialization in microeconomics, click here
Specialisation is when a nation concentrates its productive efforts on producing
a limited variety of goods and services in which they’re really efficient and
productive at and have an advantage over other economies in.
For example, due to the existence of vast oil and gas reserves in the region,
Middle-Eastern countries concentrate their production on petroleum and have
made a fortune off of it.

Specialisation is determined on the basis of either resource allocation or of cost of

production.

Absolute advantage: when one country can produce more efficiently than
another either by producing more of a good or service with same amount of
resources or producing the same amount of a good or service with fewer
resources.
For example, India has an absolute advantage in operating call centres because of
its abundant and cheap labour force, compared to western countries.
Comparative advantage: when one country can produce a good at a lower
opportunity cost (in terms of other goods and services being forgone) than

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another country. It takes into account the opportunity cost incurred in producing
each good.
For example, India may have an absolute advantage in operating call centres
(against Philippines), but it has lower opportunity costs in other IT industries, than
Philippines. Thus, Philippines has, in recent years, seen a growing call centre
industry while India has seen theirs decline.
Note: you are not required by the syllabus to know the terms ‘absolute advantage’
and ‘comparative advantage’, but only the principles. Advantages of international
specialisation:

• Economies of scale and efficiency: just like specialisation by individuals, countries

can specialise in what they do best, and this leads to efficiency and economies of
scale. It can therefore increase output while reducing costs. When more countries
specialise, world output increases.
• Job creation: specialisation leads to increased output and therefore it could lead
to more investment and thus jobs are created. Moreover, it requires skilled
labour and thus earnings are higher.
• Allows more international trade to take place. Therefore goods and services
produced under the most efficient conditions can be traded and all countries can
benefit from them.
• Revenue to the government: as income increases and more trade takes place, it
can increase government revenue from taxes.
• Wider markets: specialisation and trade allow firms to sell their products to
international markets, helping them build international brands and increase
market shares and profits.
• Consumer sovereignty: consumer across the globe will now be able to buy cheap
and high quality products from around the world. Because of specialisation and
trade, we now can get the best chocolate from Switzerland, the best coffee from
Ghana and Colombia, cheap IT services from India, oil from the Middle East, and
budget cars from Japan.
Disadvantages of international specialization:

• Structural unemployment: even though national level specialisation usually

creates more jobs, there is a risk that certain types of structural unemployment
might occur. As the country moves towards specialisation, the workers in the
declining industries will be put out of work.

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• Over-exploitation of resources: output maybe increased by over-exploiting

Today, international specialization and trade is causing rapid depletion of
nonrenewable resources like oil and coal. Middle Eastern countries are depleting
their oil resources so quickly, they are now building new industries to sustain
them in the future.
• Threat of foreign competition: non-specialised industries of a country will face
fierce competition from the foreign countries that specialise in them.
• Risk of over-specialisation: because of more international dependence on other
countries for trade (they will have to sell their specialised products to other
countries and buy other products they need from abroad), any global economic
change will greatly affect highly specialised countries. For example,
petroleumexporting countries have seen their revenues dip when oil prices fall.
They are now trying to diversify into other products like tourism to sustain them.
• Strategic vulnerability: relying on other countries for vital goods and services
makes a country dependent on those countries. Political or economic changes
abroad may impact the supply of goods or services available to the country.

Globalisation, Free
Trade and Protection
HomeNotesEconomics – 04556.2 – Globalisation, Free Trade and Protection
Globalisation is a process of interaction and integration among the people,
companies, and governments of different nations, a process driven by
international trade and investment and aided by information technology
[definition by: www.globalization101.org)

Multinational Corporations (MNCs)

Businesses which have their operations, factories and assembly plants in more
than one country are known as multinational businesses. Examples include

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Starbucks, IKEA, Toyota, Adidas etc. The country they are based in is called the
home country, and the countries they operate in are called host countries.
Advantages to home country:

• MNCs create opportunities for marketing the products produced in the home
country throughout the world.
• They create employment opportunities to the people of home country, both at
home and abroad.
• It aids and encourages the economic growth and development of the home
country.
• MNCs help to maintain favourable balance of payments of the home country in
the long run as they export their products abroad. Advantages to host country:

• Provides significant employment and training to the labour force in the host
country.

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• Transfers of skills and expertise, helping to develop the quality of the host labour
force.
• MNCs add to the host country’s GDP through their spending, for example with
local suppliers and through capital investment.
• Competition from MNCs acts as an incentive for domestic firms in the host
country to improve their competitiveness and efficiency.
• MNCs extend consumer and business choice in the host country.
• MNCs bring with them efficient business practices, technologies and standards
from across the world, which can influence the industries in the home country.
• Profitable MNCs are a source of significant tax revenues for the host economy
(for example on profits earned as well as payroll and sales-related taxes).
Disadvantages to home country:

• MNCs transfer capital from the home country to various host countries causing
unfavourable balance of payments.
• MNCs may not create employment opportunities to the people of home country
if it employs labour from other countries, perhaps due to lower costs or better
skills.
• As investments in foreign countries is more profitable, MNCs may neglect the
home country’s industrial and economic development. Disadvantages to host
country

• Domestic businesses may not be able to compete with MNC’s efficiency, low
costs, low prices and brand image, and may be forced to close shop.
• MNCs may not act ethically or in a socially responsible way, especially by taking
advantage of weak countries who gain a lot from the MNCs presence in their
country. For example, exploiting workers with low wages and poor working
conditions in a country where labour laws are weak.
• MNCs may be accused of imposing their culture on the host country, perhaps at
the expense of the richness of local culture.

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• Profits earned by MNCs may be remitted back to the MNC’s home country
rather than being reinvested in the host economy.
MNCs may make use of transfer pricing and other tax avoidance measures to
reduce the profits on which they pay tax to the government in the host
country.

Free Trade and Protection

Free trade is when there are no restrictions for trade between economies. The
advantages of free trade:

• Allows countries to benefit from specialisation: if there was no international

trade, then countries wouldn’t be able to specialise – that is, they would have to
become self-sufficient by producing all the goods and services they require
themselves. Total output would lower and costs would rise. With specialization
and free trade, output, incomes and living standards will improve.
• Increases consumer choice: consumers can now enjoy a variety of products from
around the globe.
• Increases competition and efficiency: international trade means that there will
be more competition among firms in different countries. This would help increase
efficiency.
• Creates new business opportunities: free trade will allow businesses to produce
and sell goods for overseas consumers and expand and grow their operations by
doing so. Profits and revenue would rise.
• Enables firms and economies to benefit from the best workforces, resources
and technologies from around the world.
• Increases economic inter-dependency and thus fosters cooperation and reduces
potential for international conflicts. The disadvantages of free trade:

• Free trade may reduce opportunities for growth in less-developed economies

and threaten jobs in developed economies. Small businesses in developing
countries may not be able to compete with larger foreign firms. Established
businesses in developed countries may lose market share as new firms keep


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entering the market. The US has seen considerable unemployment in

manufacturing sectors since China joined the WTO and flooded international
markets with their cheap products.
• Causes rapid resource depletion and climate change as more resources are used
up by firms.
Exploitation of workers and the environment: free trade has allowed firms to
relocate to countries with lower costs (usually lower wages), where workers and
the environment can be exploited (as health, safety and environmental laws in
such countries are likely to be relaxed).
• Income inequality worsens: multinational firms and consumers have dominated
the international supply and demand. This means that the rich keep getting richer
(by buying and selling more products) while the poor lose out on products and
resources.
Protection involves the use of trade barriers by governments to restrict
international market access and competition. Trade barriers include:
• Tariffs: these are indirect taxes on imported (or exported) goods that make them
more expensive, imposed in order to discourage domestic consumers from
buying them.
• Subsidies: government allows subsidies to domestic producers so that they can
increase their output and reduce costs and in turn reduce prices, in the hope that
consumers will be encouraged to buy inexpensive domestic goods rather than
imports.
• Quotas: this is a limit on the number of imports allowed into a country in a given
period. Restricting supply will push up their market prices and discourage
consumption of those imports.
• Embargo: this is a complete ban on imports of a good to a country.
• Excessive quality standards: imports may only enter a country after extensive
quality checks which will be costly and so foreign producers will be discouraged to
sell their products in the country, reducing imports. Reasons for protection:

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• To protect infant industries: trade barriers will help protect infant/sunrise

industries (industries that are new and are hoping to grow). Lesser competition
from foreign firms will increase their chances of survival and growth.
• To protect sunset industries: sunset industries are those that are on their
declining stage. They would still employ many people and closure of firms in that
industry will result in high unemployment. Lesser competition from foreign firms
will decrease their rate of decline.
• To protect strategic industries: strategic industries will include transport, energy,
defence etc. and governments will want to protect these so they are not
dependent on supplies from overseas. If foreign firms supplied these, they would
restrict output and raise prices.
To limit over-specialization: if a country specializes in the production of a narrow
range of products and there is a global fall in demand for one of them, then the
economy is at risk. Protectionism will ensure diversification into producing more
products and reduce this risk.

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• To protect domestic firms from dumping: dumping is a kind of predatory pricing,

that occurs when imports are sold at a price either below the price charged in the
home market or below its cost of production. As a result, domestic firms will be
unable to compete and be forced to go out of business. Once this happens, the
foreign firms will raise their prices and enjoy monopolistic power. Trade barriers
will eliminate the risk of dumping.
• To correct a trade imbalance: protectionism can reduce the imports coming into
a country and thus reduce expenditure on imports by domestic consumers. If a
country is experiencing a deficit (imports exceeding exports), then protectionism
will correct this imbalance.
• Because other countries use trade barriers. Consequences of protection:

• They restrict consumer choice.

• They restrict new revenue and employment opportunities.
• High levels of import tariffs and quotas will increase the costs of production at
home and drive up prices, causing cost-push inflation.
• They protect inefficient domestic firms: when trade barriers are used to protect
domestic industries, it might include inefficient industries. Protectionism means
that even very inefficient industries are protected (when they are better off being
exposed to foreign competition and being forced to become more efficient).
• Other countries may retaliate: if a country introduces trade barriers to restrict
imports from other countries, the countries that are affected by this will also
impose similar trade barriers. A trade war may develop. Relations between
countries will worsen.
• In today’s globalised society, being heavily protected and not engaging in free
trade will result in the country being out of pace with the rest of the world. They
will be unable to grow and develop, and will lose out on the benefits of free
trade.
Tip: If you have trouble remembering all the pros and cons listed above, just
remember this: basically, the advantages of free trade are the disadvantages of
protectionism and the disadvantages of free trade are the advantages of
protectionism.

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Foreign Exchange
Rates
HomeNotesEconomics – 04556.3 – Foreign Exchange Rates
The foreign exchange rate is the value or price of a currency expressed in terms
of another currency. For example, £1 = $1.2
This exchange rate will be used when these countries trade and need to convert
money. So if a person were to convert £100 into dollars, he would get $120 (100 *
1.2).
The foreign exchange rate of each currency is determined by the market demand
and supply of the currency.
• Demand for the a currency, say the pound sterling, exists when foreign
consumers want to buy and import goods and services from the UK, when
overseas companies buy pounds to invest in the UK etc. Here, the UK’s currency is
being demanded abroad.
• Supply of a currency, say the pound sterling, exists as UK consumers want to buy
and import goods and services from other countries, when UK companies buy
foreign currencies to invest abroad. Here the UK’s currency is being supplied
abroad.
• The price at which demand and supply of the currency equals is the equilibrium
market foreign exchange rate value of a currency against another currency. An
increased supply and decreased demand causes the exchange rate to fall, while a
decreased supply and increased demand causes the exchange rate to rise.

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Causes of foreign exchange rates fluctuations:

• Changes in the demand for exports and imports: when a country’s import value
is greater than its export value (which is a deficit), it means that more of their
currency is being supplied (going out) than being demanded. The exchange rate
for the country’s currency will fall. If there is a surplus in the current account, the
exchange rate will rise.
• Inflation: if the inflation in a country is higher than that of other countries it
trades with, the price of that country’s goods in the international market will be
higher compared to goods from other countries. The demand for the country’s
goods will fall and the so the currency demand will also fall, causing a fall in
exchange rate.
• Changes in interest rate: if a country’s interest rate rises, overseas residents may
be keen to save or invest money in that country. The demand for the currency will
rise, and the exchange rate will rise. If interest rates fall below that of other
countries, the currency will fall in value as overseas demand falls.
• FDI/MNCs: globalisation and economic activities of multinational companies
mean that investment in overseas production plants requires the use of foreign
currencies. For example, a US company with factories in UK needs to pay its
labour with pound sterling, not with the US dollars, increasing the demand for the
pound. Thus, inward FDI will boost the demand for a currency and increase its
foreign exchange value. In contrast, outward FDI will increase the supply of a
currency and cause its foreign exchange rate to fall.

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• Speculation: foreign exchange traders and investment companies move money

around the world to take advantage of higher interest rates and variations in
exchange rates to earn a profit. As huge sums of money are involved (known as
‘hot money’), this can cause exchange rate fluctuations, at least in the short run.
If speculators lack confidence in the economy they will withdraw their
investments in that country, thereby causing a fall in the value of the currency. In
contrast, high confidence in the economy will invite investments and raise the
foreign exchange value of the currency.
• Government intervention: government intervention in the foreign exchange
market can affect the exchange rate. For example, if greater demand for British
goods causes a rise in the value of the pound, the Bank of England (UK’s central
bank) can sell their reserves of pound sterling in the foreign exchange market to
increase it’s supply and cause a fall in its value.

A rise in demand for the

domestic currency (or a fall in supply – shift of supply curve to the left) causes its

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exchange rate to rise A fall

in
demand for the domestic currency (or a rise in supply – shift of supply curve to
the right) causes its exchange rate to fall
Consequences of foreign exchange rate fluctuations:
• A fall in the foreign exchange rate causes import prices to rise and export prices
to fall.
A fall in the foreign exchange rate, of say the pound, means that now you have
to pay more pounds when you’re importing an American good to the UK, for
example. If the initial exchange rate is $1 = £0.8, and the original price of the good
was $2, you’d have to pay £1.6 ($2 * £0.8) to buy the good. Now, suppose the
exchange rate falls to $1 = £1 (a pound is now worth lesser dollars), you’d have to
pay £2 ($2 * £1) to buy the good.
Similarly, a fall in the foreign exchange rate of the pound means that now you’ll
to get fewer dollars when you’re exporting a British good to America. Using the
initial exchange rate as described above, an export initially costing £2 means
American consumers will have to pay $2.5 (£2 / £0.8) to buy it. After the exchange
rate falls, they will have to pay only $2 (£2 / £1).
• A rise in the foreign exchange rate causes import prices to fall and export prices
to rise.
A rise in the foreign exchange rate, of say the pound, means that now you have
to pay fewer pounds when you’re importing an American good to the UK, for
example.

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If the initial exchange rate is $1 = £0.8, and the original price of the good was $2,
you’d have to pay £1.6 ($2 * £0.8) to buy the good. Now, suppose the exchange
rate rises to $1 = £0.5 (a pound is now worth more dollars), you’d have to pay
only £1 ($2 * £0.5) to buy the good.
Similarly, a rise in the foreign exchange rate of the pound means that now you’ll
get more dollars when you’re exporting a British good to America. Using the initial
exchange rate as described above, an export initially costing £2 means American
consumers will have to pay $2.5 (£2 / £0.8) to buy it. After the exchange rate
rises, they will have to pay $4 (£2 / £0.5).
• Now, if the country’s export and import demands are price elastic (relatively
more sensitive to price changes), a fluctuation in the exchange rate and the
subsequent changes in the prices of exports and imports will change the demand
for them. A fall in exchange rate will make imports expensive and exports
cheap, so import demand and spending will fall and export demand and
spending will rise.
A rise in the exchange rate will make imports cheaper and exports expensive,
so import demand and spending will rise and export demand and spending will
fall.
• Hence, we can conclude that when PED > 1 (elastic), a fall in foreign exchange
rate will improve the trade balance (reduce deficits) of the country as exports
will rise relative to imports.
• On the other hand, when PED < 1 (inelastic), a rise in foreign exchange rate will
worsen the trade balance (but reduce surplus) of the country as imports will rise
relative to exports.

Floating Foreign Exchange Rate

This is an exchange rate that is determined freely by market demand and supply
conditions, and so will fluctuate regularly.
The rise in the value of one currency against others, on a floating exchange rate is
known as appreciation of the currency.
The fall in the value of one currency against others, on a floating exchange rate is
known as depreciation of the currency.
Advantages:
• Automatic Stabilisation: any disequilibrium in the balance of payments would be
automatically corrected by a change in the exchange rate. For example, if a
country suffers from a deficit in the balance of payments, then the country’s

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currency should depreciate. This would cause the country’s import demand to fall
(as imports become expensive) and export demand to rise (as export prices fall).
The balance of payments equilibrium would therefore be restored. Similarly, a
surplus would be eliminated as the currency appreciates.
• Frees up internal policy: a floating exchange rate allows a government to pursue
internal policy objectives such as full employment and growth, not having to
worry about balance of payments imbalances as they will be automatically
adjusted.
• Insulated from external changes: a floating exchange rate helps to insulate a
country from inflation elsewhere. If a country were on a fixed exchange rate then
it would ‘import’ inflation through higher import prices. A floating exchange rate
would automatically adjust demand and supply in the economy and avoid such
external disturbances.
• Don’t need too much foreign reserves: under a floating exchange rate system,
there is no need to maintain reserves to deliberately change the exchange rate.
These reserves can therefore be used to import capital goods in order to promote
faster economic growth. Disadvantages:
• Uncertainty: since currency values fluctuate constantly, businesses, investors and
consumers will be uncertain about the economy and its future. They may lose
confidence in the economy if it fluctuates too rapidly.
• Lack of Investment: the uncertainty introduced by floating exchange rates may
discourage direct foreign investment. They will prefer to invest in countries with
fixed exchange rate systems where they can effectively predict economic
conditions and act accordingly.
• Speculation: the day-to-day fluctuations in exchange rates may encourage
speculative movements of ‘hot money’ from country to another, thereby causing
more exchange rate fluctuations.

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
Lack of Discipline: the need to maintain an exchange rate imposes a discipline
upon the national economy, which is absent in a floating exchange rate regime.
With a floating exchange rate, short-run problems such as domestic inflation may
be ignored until they lead to a crisis.

Fixed Foreign Exchange Rate

A fixed exchange rate is one that is fixed and controlled by the central bank,
acting on behalf of the government of the country. The central bank will
intervene in the market by buying and selling its currency in the foreign
exchange market to maintain a fixed exchange rate.
A deliberate fall in the value of a fixed exchange rate is called a devaluation.
A deliberate rise in the value of a fixed exchange rate is called a revaluation.
Advantages:
• Certainty: since the currency value is kept in check, there will be more certainty
in the economy and businesses, consumers, investors and governments won’t
have to worry about the effects of automatic changes in exchange rate.
• Stability encourages investment: a fixed exchange rate provides greater certainty
and encourages firms to invest. One of the reasons Japanese firms are reluctant
to invest in UK is because the pound works on a flexible exchange rate (unlike the
Euro which is on a fixed system), causing uncertainty about the economy.
• Keep inflation low: depreciation of a currency can cause inflation as demand,
prices and costs for firms rise. On a fixed exchange rate, firms have an incentive
to keep cutting costs to remain competitive.
• Balance of Payments stability: since the exchange rate is not determined by
market forces, sudden changes in the balance of payments will be eliminated,
keeping it stable instead.
Disadvantages:
• Conflict with other macroeconomic objectives: the goal to maintain a fixed
exchange rate may conflict with other macroeconomic objectives when the
government intervenes with its policies. For example, if it raises interest rates to
remove the pressure of the currency to fall, economic growth might be adversely
affected.
• Less flexibility: in a fixed exchange rate, it is difficult to respond to temporary
shocks. For example, if the price of oil increases, a country which is a net oil

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 IGCSE ECONOMICS NOTES (0455)

importer will see a deterioration in the current account balance of payments. But
since the country operates a fixed exchange rate, it cannot devalue the currency
too much and thus cannot make an effective intervention to improve the current
account.
• Risk of overvaluation or undervaluation: it is difficult to know the right rate to fix
the exchange rate at. If the rate is too high, it will make exports uncompetitive. If
it is too low, it could cause inflation. It is difficult to ascertain the optimum foreign
exchange rate.

Current Account of
Balance of Payments
HomeNotesEconomics – 04556.4 – Current Account of Balance of Payments The
Balance of payments is a record of all the monetary transactions between
residents of a country and the rest of the world over a given period of time. It is
divided into three main accounts: the current account, the capital
account and the financial account.
(In the explanation below, we’ll look at the balance of payments from
the point of view of the UK)

The Current Account

The Current account records the following:

• The visible trade (in goods)

• The invisible trade (in services)

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
• Net income received or made in payment for the use of factors of production
( also called net primary income):
• income debits (outflows) include wages paid to overseas residents working in
the UK, interests, profits and dividends paid out to overseas residents and
firms who have invested in the UK
• income credits (inflows) include wages paid to UK residents working overseas,
interests, profits and dividends earned by UK residents and firms on
investments they have in other countries
• income received – income paid = net income received
Net current transfers, which include payments between governments for
international co-operation and other transactions that involve payments for
nonproductive activities (also called net secondary income):
• debits (outflows) will include financial aid, donations, pension payments etc.
paid to overseas residents and foreign governments, and tax and excise duties
paid by UK residents on foreign purchases
• credits (inflows) will include financial aid, donations, grants, pension payments
etc. received from overseas residents and foreign governments, and tax and
excise duties paid by overseas residents on UK purchases  transfers received
– transfers paid = net transfers A current account example:
Item $ (billion)

Visible exports (Xv)

784.2

Visible imports (Mv)

1230.4

Balance of trade (Xv – Mv =A) -446.2

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Invisible exports (Xi)

286.4

219.9
Invisible imports (Mi)

Balance on services (Xi – Mi =B) 66.5

Net primary income (C) 21.0

Net secondary income (D) -58.6

Current account balance (A + B + C + D) -417.3

Current Account Deficit

When the financial outflows in the current account exceed the financial
inflows, the current account is in deficit.

Causes:
• Higher exchange rate: if the currency is overvalued, imports will be cheaper and
therefore there will be a higher quantity of imports. Exports will become
uncompetitive and therefore there will be a fall in the quantity of exports.
• Economic growth: if there is an increase in aggregate demand and national
income increases, people will have more disposable income to consume goods. If
producers cannot meet the domestic demand, consumers will have to imports
goods from abroad. Thus faster economic growth enables the possibility of a
current account deficit developing.

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
• Decline in competitiveness: if export industries are in decline and cannot
compete with foreign countries, the exports fall, ushering in a deficit. This is a
major reason for many countries today experiencing current account deficits.
• Inflation: this makes exports less competitive and imports more competitive
(cheaper).
• Recession in other countries: if the country’s main trading partners experience
negative economic growth then they will buy less of the country’s exports,
worsening the current account.
• Borrowing money: if countries are borrowing money from other countries to
finance their expenditure and growth, current account deficits will develop.
Consequences:
• Low growth: a deficit leads to lower aggregate demand and therefore slower
growth.
Unemployment: deficit can lead to loss of jobs in domestic industries as demand
for exports is low and demand for imports is high.
• Lowers standard of living: in the long run, persistent trade deficits undermine the
standard of living as demand and income fall, especially if the net incomes and
transfers show a negative balance.
• Capital outflow: currency weakness can lead to investors losing confidence in the
economy and taking capital away.
• Loss of foreign currency reserves: countries may run short of vital foreign
currency reserves as more foreign currency is being spent on imports and foreign
currency revenues from exports is falling.
Increased Borrowing: countries need to borrow money or attract foreign
investment in order to rectify their current account deficits. In addition, there is
an opportunity cost of debt repayment, as the government cannot use this
money to stimulate economic growth.
• Lower exchange rate: a fall in demand for exports and/or a rise in the demand for
imports reduces the exchange rate. While a lower exchange rate can mean
exports becoming more price-competitive, it also means that essential imports
(such as oil and foodstuffs) will become more expensive. This can lead to
imported inflation.

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The severity of these consequences depends on the size and duration

of the deficit. Persistent deficits can harm the economy in the long-run
as low export growth causes unemployment.

Correcting a current account deficit

• Do nothing because a floating exchange rate should correct it: if there is a trade
deficit, a depreciation will occur as more currency is being spent than received.
Depreciation will make imports more expensive and exports cheaper. As a result,
domestic demand for imports will fall and foreign demand for exports will rise,
reducing the deficit.
• Use contractionary fiscal policy: a government can cut public expenditure and
increase taxes to reduce total demand in the economy, which will reduce demand
for imports and improve the trade balance. However, a fall in demand may affect
firms in the economy who may cut output and employment in response.
• Use contractionary monetary policy: a higher interest rate will attract more
direct inward investments and nullify the trade deficit. Higher interest rates will
also make borrowing from banks more expensive and increase the incentive to
save, thus discouraging consumers from spending. The govt. can also devalue the
exchange rate to improve export competitiveness and demand.
• Protectionist measures: these measures reduce the competitiveness of imports,
thereby making domestic consumption more attractive. For example, tariffs raise
the price of imports while quotas limit the amount of imports in the economy.

Current Account Surplus

When the financial inflows in the current account exceed the financial
outflows, the current account is in surplus.

Causes:

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
Improved competitiveness: exports may have become more price-competitive in
the international market, due to perhaps, better labour productivity or low prices.
• Growth in foreign countries: export demand may have risen due to trading
partners experiencing growth and higher incomes.
• High foreign direct investment: strong export growth can be the result of a high
level of foreign direct investment.
• Depreciation: a trade surplus might result from a currency depreciation .
• High domestic savings rates: high levels of domestic savings and low domestic
consumption of goods and services cause more products to be exported and
imports to fall.
• Closed economy: some countries have a low share of national income taken up
by imports, perhaps because of a range of tariff and non-tariff barriers.
Consequences:
• Economic growth: net exports is a component of GDP, so a rise in exports and
incomes will cause economic growth.
• Appreciation: as exports increase, the demand for the currency increases and
therefore the value of the currency increases, which will make exports more
expensive and cause its demand to fall.
• Employment: since exports have increased, jobs in the export industries will have
increased too.
• Better standards of living: higher net incomes, transfers and export revenue
make the country’s citizens better off.
• Inflation: higher demand for exports can lead to demand-pull inflation. This can
diminish the international competitiveness of the country over time as the price
of exports rises due to inflation. Correcting a current account surplus:
• Do nothing because a floating exchange rate should correct it: if there is a trade
surplus, an appreciation will occur as more currency is being demanded. An
appreciation will make imports cheaper and exports expensive. As a result,
foreign demand for exports will fall and domestic demand for imports will rise,
reducing a trade surplus.
• Use expansionary fiscal policy: increasing public expenditure and cutting taxes
can boost total demand in an economy for imported goods and services.

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• Use expansionary monetary policy: lower interest rates will make borrowing
from banks cheaper and increase the incentive to spend, thus encouraging
consumers to spend on imports and correct a trade surplus.
Remove protectionist measures: reducing tariffs and quotas cause imports to rise
and close a surplus in the current account.

Foreign Exchange Rates

HomeNotesEconomics – 04556.3 – Foreign Exchange Rates
The foreign exchange rate is the value or price of a currency expressed in terms
of another currency. For example, £1 = $1.2
This exchange rate will be used when these countries trade and need to convert
money. So if a person were to convert £100 into dollars, he would get $120 (100 *
1.2).
The foreign exchange rate of each currency is determined by the market demand
and supply of the currency.
• Demand for the a currency, say the pound sterling, exists when foreign
consumers want to buy and import goods and services from the UK, when
overseas companies buy pounds to invest in the UK etc. Here, the UK’s currency is
being demanded abroad.
• Supply of a currency, say the pound sterling, exists as UK consumers want to buy
and import goods and services from other countries, when UK companies buy
foreign currencies to invest abroad. Here the UK’s currency is being supplied
abroad.
• The price at which demand and supply of the currency equals is the equilibrium
market foreign exchange rate value of a currency against another currency. An
increased supply and decreased demand causes the exchange rate to fall, while a
decreased supply and increased demand causes the exchange rate to rise.

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Causes of foreign exchange rates fluctuations:

• Changes in the demand for exports and imports: when a country’s import value
is greater than its export value (which is a deficit), it means that more of their
currency is being supplied (going out) than being demanded. The exchange rate
for the country’s currency will fall. If there is a surplus in the current account, the
exchange rate will rise.
• Inflation: if the inflation in a country is higher than that of other countries it
trades with, the price of that country’s goods in the international market will be
higher compared to goods from other countries. The demand for the country’s
goods will fall and the so the currency demand will also fall, causing a fall in
exchange rate.
• Changes in interest rate: if a country’s interest rate rises, overseas residents may
be keen to save or invest money in that country. The demand for the currency will
rise, and the exchange rate will rise. If interest rates fall below that of other
countries, the currency will fall in value as overseas demand falls.
• FDI/MNCs: globalisation and economic activities of multinational companies
mean that investment in overseas production plants requires the use of foreign
currencies. For example, a US company with factories in UK needs to pay its
labour with pound sterling, not with the US dollars, increasing the demand for the
pound. Thus, inward FDI will boost the demand for a currency and increase its

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 IGCSE ECONOMICS NOTES (0455)

foreign exchange value. In contrast, outward FDI will increase the supply of a
currency and cause its foreign exchange rate to fall.
Speculation: foreign exchange traders and investment companies move money
around the world to take advantage of higher interest rates and variations in
exchange rates to earn a profit. As huge sums of money are involved (known as
‘hot money’), this can cause exchange rate fluctuations, at least in the short run.
If speculators lack confidence in the economy they will withdraw their
investments in that country, thereby causing a fall in the value of the currency. In
contrast, high confidence in the economy will invite investments and raise the
foreign exchange value of the currency.
• Government intervention: government intervention in the foreign exchange
market can affect the exchange rate. For example, if greater demand for British
goods causes a rise in the value of the pound, the Bank of England (UK’s central
bank) can sell their reserves of pound sterling in the foreign exchange market to
increase it’s supply and cause a fall in its value.

A rise in demand for the

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
domestic currency (or a fall in supply – shift of supply curve to the left) causes its

exchange rate to rise A fall in

demand for the domestic currency (or a rise in supply – shift of supply curve to
the right) causes its exchange rate to fall
Consequences of foreign exchange rate fluctuations:
• A fall in the foreign exchange rate causes import prices to rise and export prices
to fall.
A fall in the foreign exchange rate, of say the pound, means that now you have
to pay more pounds when you’re importing an American good to the UK, for
example. If the initial exchange rate is $1 = £0.8, and the original price of the good
was $2, you’d have to pay £1.6 ($2 * £0.8) to buy the good. Now, suppose the
exchange rate falls to $1 = £1 (a pound is now worth lesser dollars), you’d have to
pay £2 ($2 * £1) to buy the good.
Similarly, a fall in the foreign exchange rate of the pound means that now you’ll
to get fewer dollars when you’re exporting a British good to America. Using the
initial exchange rate as described above, an export initially costing £2 means
American consumers will have to pay $2.5 (£2 / £0.8) to buy it. After the exchange
rate falls, they will have to pay only $2 (£2 / £1).
• A rise in the foreign exchange rate causes import prices to fall and export prices
to rise.

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A rise in the foreign exchange rate, of say the pound, means that now you have
to pay fewer pounds when you’re importing an American good to the UK, for
example.
If the initial exchange rate is $1 = £0.8, and the original price of the good was $2,
you’d have to pay £1.6 ($2 * £0.8) to buy the good. Now, suppose the exchange
rate rises to $1 = £0.5 (a pound is now worth more dollars), you’d have to pay

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 IGCSE ECONOMICS NOTES (0455)

only £1 ($2 * £0.5) to buy the good.

Similarly, a rise in the foreign exchange rate of the pound means that now you’ll
get more dollars when you’re exporting a British good to America. Using the initial
exchange rate as described above, an export initially costing £2 means American
consumers will have to pay $2.5 (£2 / £0.8) to buy it. After the exchange rate
rises, they will have to pay $4 (£2 / £0.5).
• Now, if the country’s export and import demands are price elastic (relatively
more sensitive to price changes), a fluctuation in the exchange rate and the
subsequent changes in the prices of exports and imports will change the demand
for them. A fall in exchange rate will make imports expensive and exports
cheap, so import demand and spending will fall and export demand and
spending will rise.
A rise in the exchange rate will make imports cheaper and exports expensive,
so import demand and spending will rise and export demand and spending will
fall.
• Hence, we can conclude that when PED > 1 (elastic), a fall in foreign exchange
rate will improve the trade balance (reduce deficits) of the country as exports
will rise relative to imports.
• On the other hand, when PED < 1 (inelastic), a rise in foreign exchange rate will
worsen the trade balance (but reduce surplus) of the country as imports will rise
relative to exports.

Floating Foreign Exchange Rate

This is an exchange rate that is determined freely by market demand and supply
conditions, and so will fluctuate regularly.
The rise in the value of one currency against others, on a floating exchange rate is
known as appreciation of the currency.
The fall in the value of one currency against others, on a floating exchange rate is
known as depreciation of the currency.
Advantages:
• Automatic Stabilisation: any disequilibrium in the balance of payments would be
automatically corrected by a change in the exchange rate. For example, if a
country suffers from a deficit in the balance of payments, then the country’s
currency should depreciate. This would cause the country’s import demand to fall
(as imports become expensive) and export demand to rise (as export prices fall).

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The balance of payments equilibrium would therefore be restored. Similarly, a

surplus would be eliminated as the currency appreciates.
• Frees up internal policy: a floating exchange rate allows a government to pursue
internal policy objectives such as full employment and growth, not having to
worry about balance of payments imbalances as they will be automatically
adjusted.
• Insulated from external changes: a floating exchange rate helps to insulate a
country from inflation elsewhere. If a country were on a fixed exchange rate then
it would ‘import’ inflation through higher import prices. A floating exchange rate
would automatically adjust demand and supply in the economy and avoid such
external disturbances.
• Don’t need too much foreign reserves: under a floating exchange rate system,
there is no need to maintain reserves to deliberately change the exchange rate.
These reserves can therefore be used to import capital goods in order to promote
faster economic growth. Disadvantages:
• Uncertainty: since currency values fluctuate constantly, businesses, investors and
consumers will be uncertain about the economy and its future. They may lose
confidence in the economy if it fluctuates too rapidly.
• Lack of Investment: the uncertainty introduced by floating exchange rates may
discourage direct foreign investment. They will prefer to invest in countries with
fixed exchange rate systems where they can effectively predict economic
conditions and act accordingly.
• Speculation: the day-to-day fluctuations in exchange rates may encourage
speculative movements of ‘hot money’ from country to another, thereby causing
more exchange rate fluctuations.
• Lack of Discipline: the need to maintain an exchange rate imposes a discipline
upon the national economy, which is absent in a floating exchange rate regime.
With a floating exchange rate, short-run problems such as domestic inflation may
be ignored until they lead to a crisis.

Fixed Foreign Exchange Rate

A fixed exchange rate is one that is fixed and controlled by the central bank,
acting on behalf of the government of the country. The central bank will
intervene in the market by buying and selling its currency in the foreign
exchange market to maintain a fixed exchange rate.

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A deliberate fall in the value of a fixed exchange rate is called a devaluation.

A deliberate rise in the value of a fixed exchange rate is called a revaluation.
Advantages:
• Certainty: since the currency value is kept in check, there will be more certainty
in the economy and businesses, consumers, investors and governments won’t
have to worry about the effects of automatic changes in exchange rate.
• Stability encourages investment: a fixed exchange rate provides greater certainty
and encourages firms to invest. One of the reasons Japanese firms are reluctant
to invest in UK is because the pound works on a flexible exchange rate (unlike the
Euro which is on a fixed system), causing uncertainty about the economy.
• Keep inflation low: depreciation of a currency can cause inflation as demand,
prices and costs for firms rise. On a fixed exchange rate, firms have an incentive
to keep cutting costs to remain competitive.
• Balance of Payments stability: since the exchange rate is not determined by
market forces, sudden changes in the balance of payments will be eliminated,
keeping it stable instead.
Disadvantages:
• Conflict with other macroeconomic objectives: the goal to maintain a fixed
exchange rate may conflict with other macroeconomic objectives when the
government intervenes with its policies. For example, if it raises interest rates to
remove the pressure of the currency to fall, economic growth might be adversely
affected.
• Less flexibility: in a fixed exchange rate, it is difficult to respond to temporary
shocks. For example, if the price of oil increases, a country which is a net oil
importer will see a deterioration in the current account balance of payments. But
since the country operates a fixed exchange rate, it cannot devalue the currency
too much and thus cannot make an effective intervention to improve the current
account.
• Risk of overvaluation or undervaluation: it is difficult to know the right rate to fix
the exchange rate at. If the rate is too high, it will make exports uncompetitive. If
it is too low, it could cause inflation. It is difficult to ascertain the optimum foreign
exchange rate.

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