BtoB CutEdge - Col PDF

Back to Basics:
The Cutting Edge
Rachel Cole
Rachel Cole is a teacher at Cheltenham Ladies’ College and a Principal Examiner
Published by Anforme Ltd., Stocksfield Hall, Stocksfield, Northumberland NE43 7TN.

Tel: 01661 844000 Fax: 01661 844111 e-mail: anforme@aol.com www.anforme.co.uk
ISBN 978-1-905504-55-8 January 2011
Contents
Topic 1 Why does the supply curve slope upwards? 1
Topic 2 Elastic gymnastics – gain confidence in handling the concepts 5
Topic 3 What are the effects on the market of taxes and subsidies? 9
Topic 4 Why look at the margin? 14
Topic 5 Do firms exist just to make profit? 17
Topic 6 Economies and diseconomies of scale 23
Topic 7 Efficiency 28
Topic 8 Buffer stocks 33
Topic 9 What’s so bad about inflation? 38
Topic 10 The savings ratio 43
Topic 11 What is the economic meaning of investment? 49
Topic 12 Productivity 52
Topic 13 Aggregate demand and supply analysis 57
Topic 14 Absolute and comparative advantage – look, no numbers 62
Topic 15 Exchange rates 66
Topic 16 The National Minimum Wage 71
Topic 17 Index numbers 76

Topic 1
Why does the supply curve slope upwards?
Even if you have only had a week or two of economics lessons you will probably know by now that a demand
curve slopes downwards and a supply curve slopes upwards. The demand side seems pretty obvious. If you
can get something cheaper then you will want to buy more. Or as the economist would put it, there are
diminishing returns as you consume more of something, and so at higher quantities the amount you’re
prepared to pay for another goes down. But for supply it doesn’t seem so obvious. Of course firms would
like to make as much money as possible, but why do they only want to supply more when prices are higher?
Surely it’s cheaper to supply more per unit, and don’t firms offer discounts to people who want to buy more?
So here is the point of this article – why do most supply curves in textbooks slope upwards?
Before we look at the standard response to this question, let’s just use some common sense. Supply is
pretty well fixed for many goods and services. Say you want to go to a sold-out concert on Saturday and
you’ll pay anything for a ticket. Too bad. The concert promoters would lose their licence if they overfill the
seats. Maybe if there is so much demand and people are really prepared to pay anything the promoters will
decide to increase supply by offering one more night. But this is with reluctance (the band will lose their
day off, perhaps) and it will only happen if prices people are prepared to pay are high enough.
So why is it that costs rise when you produce more? It’s true that this is only a short run phenomenon
because clearly if the concert promoter knew in advance that you could sell more nights of the concert it
probably would be cheaper per night to book two. The whole reason for the shape of the supply curve is
based on the fact that some factors are fixed and you can’t increase output without incurring extra costs.
Costs of supply tend to go up because some factors of production are restricted in supply in the short run.
The amount of many goods and services currently available in the market cannot be increased
instantaneously. If you really want more you’ll have to pay more to get it shipped over from another
country, with the added expense of changing currencies and tariffs may have to be paid if sourced from
outside the EU. Or it may mean that people have to work overtime, for which workers will expect higher
pay. While this is not true for many mass-produced, processed and storable items, it is true for many other
things that we want to buy. Look at eBay and see prices go up as demand rises. If there’s more than one
person aiming to buy a unique item then prices rise. But if there are many items very similar for sale on
eBay then there doesn’t seem to be a bidding war, and you can just ‘buy it now’ for a reasonable price.
So one way to explain why supply curves usually slope upwards is that as the price of the product rises
producers will find it more profitable to offer goods and services for sale, given their existing productive
capacity. This is because any increase in costs incurred by increasing output will be covered by the higher
price.
The law of diminishing returns

The key to explaining this is the law of diminishing returns, which can also be expressed as the law of
increasing costs. For example, imagine you have a farm with some hens in a meadow. Now let’s say you
want to draw the supply curve for the eggs that your farm will sell. The hens have to go inside to lay, and
they can only lay a maximum of one egg per day, and that’s if you’re looking after them properly and
keeping them happy. There is a cost of around 10p per egg in food. So the factors of production are the
meadow (land, a fixed factor), the hens and food (known as working capital, variable factors) and the hen
house (capital, probably a fixed factor). So what happens as prices rise? You are likely to want to buy some
more hens, currently at around £12 each. You bring the hens to your meadow and give them some extra
food. Now the market for food is so competitive that even if you have thousands of chickens the price of
the chicken food won’t change much. So why will costs start to rise as you try to produce more eggs?
Back to Basics: The Cutting Edge 1

The answer lies in the fact that the meadow is a fixed factor. As you try to get more and more hens into
one meadow they will find it harder to get good pecking spots, and eventually you’ll get to the point where
you cannot get any more eggs out of the farm even if you buy more hens. The hens that are there will stop
laying even if the newcomers will lay. The number of eggs you can get reaches a ceiling, and total output
of eggs will not rise even though your input rises. This is a law of economics, in the sense that logically it
must be true: if you keep adding more and more of a variable factor to a fixed factor then the increase in
output will eventually fall. We call this the law of diminishing returns. You can express exactly the same law
in a different way: as more of a variable factor is applied to a fixed factor, the cost of producing an extra
unit of output will rise. The cost of producing an extra output is called the marginal cost and so the rule
says that ‘marginal costs will eventually always rise’.
So if supply curves were the same things as marginal costs curves, the answer is simple. Higher prices mean
higher marginal costs so firms will only supply more or new firms will only enter the market as prices rise.
Prices have to cover costs so if costs are rising then supply only increases if prices rise too. But of course
life is more complicated. It can be true that supply curves are equal to marginal cost curves, as long as the
firm is covering its average variable costs, but this only happens in a market structure known as perfect
competition. In the real world firms and consumers have market power, when a firm or consumer can
have some control over price, because they can control quantity supplied.
Market power
A firm with monopoly power can restrict supply and thereby charge a lot more for it. Designer brands are
a clear example of this. Firms making perfume could probably sell a lot more if prices were lower, but this
would mean a fall in their enormous profit margins. Perfume has a low price elasticity, which means that
if prices fall total revenue falls. It is in the interest of firms to make as much profit as possible. Another law
of economics (that is, something which is true by definition) is that if demand has price elasticity below
one then the firm will make more money if it raises the price. In the scenario above where markets are
perfectly competitive then they can’t raise price. If they did then other firms would simply undercut them
and sales would fall to zero. But if a firm has any market power at all then it can raise price without losing
all of its market. When price elasticity of demand is inelastic the firm makes more money by supplying less
at a higher price. Lower supply at a higher price? Sounds like the supply curve is downwards sloping in
some cases. So if there is a degree of market or monopoly power, it seems that the supply curve is not
always upward sloping. It’s very difficult, however, to draw a supply curve in situations like this, because
clearly the supply depends on the price elasticity of demand. And because it’s not easy to draw you won’t
often see this type of supply curve in a textbook. But certainly most supply curves do have some degree
of uncertainty about them for the reason that demand is not perfectly elastic, which is why supply curves
always drawn going upwards is a little simplistic.
Another good example to think of is OPEC, the Organisation of Petroleum Exporting Countries, and the
way in which it works to keep the price of oil high. It has low oil production costs (less than $5 a barrel)
and has the most spare capacity of all the oil producer outlets. It sells 40% of the world’s daily oil supply,
and when it has political reasons to take a swipe at its Western buyers of oil it can restrict its supply. The
effect of course, owing to price inelastic demand for oil, is that prices zoom up. Why then don’t other
suppliers enter the market to take advantage of the higher prices? It may be that there aren’t stocks of oil
available in other countries, or maybe other countries just enjoy the price hikes because their own income
rises. Firms are much happier supplying when prices are high, and certainly don’t want to destroy that
equilibrium by starting a price war. This enters the field of game theory which you might look at when you
study oligopoly at A2 level.
Backward bending supply curves

To make matters even more extreme it also seems that some supply curves are not only impossible to draw
owing to market power, but also that some which can be drawn are shown as backward bending. So while
the economist happily draws an upward slope it gets to the point as prices rise where the supplier starts to

supply less. This happens when the laws governing economics start to break down – you might start to
wonder whether they are really best called laws. Let’s imagine a situation where supply is fairly inelastic,
that is, you can’t increase supply easily and price will have to increase a good deal to encourage firms to
supply more. Now add to this a so-called ‘income effect’ meaning that the amount that is supplied depends
on the suppliers’ real income and the choice between work and leisure. So let’s say you are trying to earn
a bit of extra money working at the weekends in a restaurant. The wages are notoriously low but you work
hard hoping to get some tips, but unfortunately you have to share these with the kitchen staff and the
boss. Now the manager is keen for you to do some extra hours. You’re not very keen because it’s going to
compromise your studies. So the manager says you can keep all the tips. Do you offer to work more hours?
Maybe, but maybe the extra pay inducement will keep you on your current hours, and maybe even cut
them and still have more than you had before. Seems a bad decision by the manager, but that’s how tough
it can be for firms when the supply of labour is price inelastic. A pay rise can in some rare cases make
people less keen to supply, making the top part of an inelastic supply curve bend backwards to the left. Or
in normal English, part of the supply curve is downward sloping.
Back in class your teacher reminds you that supply curves are upwards sloping. Just accept it, you tell
yourself. Certainly this makes for easy mechanics of price determination and analysing how changes in
demand and supply affect prices and output. But in reality you should always remember that there are
some fundamental assumptions behind the upward sloping curve, and that the assumptions underlying it
are very high price elasticity of demand and supply (perfectly competitive markets), and that at least one
factor is fixed. In the long run the supply curve is quite variable!
1. Elasticities tend to rise over time. Why is this?

2. If you draw a supply curve that is very steep but crosses the vertical axis above the origin you will
Questions for Discussion
be able to calculate that its elasticity is above one, not price inelastic as you might expect with a
steep curve. Can you explain that in common sense terminology?
3. Spare capacity is one reason why costs of production do not rise when demand rises. Does this
mean that a country should always aim to have a great deal of idle resources at all times?
4. Marginal costs can begin to rise while average costs are falling. Do you think firms use marginal or
average costs when choosing prices – or neither? If they use average costs are they being rational?
5. Market power appears to be the key determinant of prices and output for many goods and services.
However, the power is not always on the suppliers’ side. Buyers can also have market power. If the
government is seen as a powerful buyer of labour in the health service, what do you think is the
implication for the wages paid to nurses?

● Short run – when at least one factor is fixed. This means that at least one of the factors of
production, or resources used to produce all goods and services, can’t be changed.
● Long run – all factors are variable.
● Law of diminishing returns – if you keep adding more and more of a variable factor to a fixed
factor then the increase in output will eventually fall. It only holds true in the short run which
means that at least one factor is fixed.
● Law of increasing costs – as more of a variable factor is applied to a fixed factor, the cost of
producing an extra unit of output will rise.
Key Terms
● Fixed factor – when a firm cannot change how much it has. For example the number of A level
subjects you can do is determined by the amount of time you have. In the short run it’s fixed by the
number of hours in the school timetable. In the long run – after you leave school, say, you can take
as many extra A levels as you like as your life goes by. Or maybe your brain capacity is fixed too?
● Factors of production, or resources used to produce all goods and services. Economists call them
land, labour, capital and enterprise.
● Perfect competition – a market structure where there are many buyers and sellers, none of which
have any control over price.
● Market power – a measure of the control a buyer or seller has over price, because they can control
quantity supplied.
● Price elasticity of demand – the responsiveness of demand to a change in price.

Topic 2 Elastic gymnastics – gain confidence
in handling the concepts
Imagine that you run a business. It is not making very much profit. You have tried all the normal things –
a bit more marketing, trying to get more investment in new technology, taking on or removing staff – but
things aren’t getting better. What can you do?
Well, you might consider changing the price of your product. The problem is that it is not always clear
which way you should go. If you raise the price, you’ll lose some customers, but if you cut the price you’ll
lose money on everything that you sell. Which is the best option? The answer lies in the value of price
elasticity of demand.
Elasticity is one of the most useful tools to an economist. A good understanding of it will not only help you
increase your grades but also help you if you ever need to do any marketing, which most people do at
some point in their lives. It is a measure of the response by either consumers or producers when something
changes in the economy. It measures the percentage of the response, not the total amount, so that we can
tell how big the change is relative to where it was before and also in proportion to how big the original
change was. This makes the calculations a little longer, but the only maths you need to know for this topic
is the rule for percentages: change over original times 100.
In some markets if a firm puts its prices up it will make more money. Yes, a higher price might mean you
sell less, but you get a higher revenue from the larger mark up on each item. Here’s an example. Say you
run an independent opticians. The staff want higher wages, the business rates are going up, and health
and safety regulations mean that you have to invest more money in the business. You need to increase
revenue to cover these costs. What do you do? The demand for opticians services is very inelastic – once
a family has started using one, it’s likely to be the family opticians for years. People don’t like switching
opticians so when fees go up the consumer is very unlikely to shift to another optician (especially when all
opticians are likely to be increasing prices for the same reasons). It is true that some people will stop going
to the optician at all as price increases, but total revenue for the optician is almost certain to increase
because there is some, but not much, alternative to local services. Opticians can charge virtually what they
like, and as prices rise total revenue for opticians increases proportionately. Therefore opticians are making
more money as they raise prices, although it reaches a point when people will hunt around for cheaper
options or not go for check-ups very often.
Let’s now consider what happens if the demand is price elastic. Price elasticity of demand is higher when
there are lots of substitutes, if the cost is a large proportion of income, if the good is perceived as a luxury
or if the time period under consideration is extended. One example is the very competitive market in
student loans. When you start a full-time higher education course beyond the age of eighteen, you will be
able to choose from a large selection of banks eager to offer you a cheap loan to cover your costs while
you are at college. The products offered are very similar, and the existence of close substitutes makes the
elasticity very high. The proportion of income spent on repaying this loan is also likely to be very high.
While this may not fit with all the other characteristics of high PED it is fairly likely that you’ll be very
sensitive to the various offers advertised by the major loan providers. For example, Barclays will give you a
free iPod, Lloyds a free rail card, and HSBC offers a combination of the two. That the offers are very similar
in monetary value indicates that the suppliers recognise that your PED is incredibly high. In other words,
you are very sensitive to price or other value changes. The lower the price the more the proportionate
increase in demand is likely to be. In very competitive markets the consumer does well because the
excellent choice forces down price and increases the options available.
The way to know what is going to happen to revenue, whether you raise or lower prices, is to look at the
marginal revenue. What happens at the margin, that is one extra unit increased or decreased, can show
whether the situation gets better or worse. If you raise the price and you gain more on each unit sold than

you do from lost customers, then marginal revenue is positive, whereas if you cut the price and make more
in sales, than you lose on each item sold, then marginal revenue is again positive. Ignoring costs, a firm
clearly wants to increase revenue, so to maximise revenue it should raise prices with inelastic demand until
it ceases to be inelastic, and it should cut prices with elastic demand until it ceases to be elastic. The mid-
point between elastic and inelastic is called unitary elasticity, and it coincides with maximum possible
revenues. In economics we say that if the PED is greater than 1 it is elastic, and if less than 1 it is inelastic.1
The figure you have is a coefficient – that is, it doesn't have any units of its own, but goes together with
whatever you’re calculating. For example if PED is 3 and you raise your price by 10%, then demand falls
by 3 times 10%. PED of 3 is an enormous reaction then – if you make a 10% price change your market will
change by about a third, certainly a factor to consider carefully before raising prices, because demand will
fall by 30%.
If you are in a market where there are lots of people producing the same thing, PED is likely to be high,
and if you keep price constant and other firms are cutting prices, you are likely to lose a lot of custom. For
example, fifteen years ago there were plenty of independent bakers and booksellers. But now even the
independently run bakers are a chain of bakers with large economies of scale, such as Greggs or Delice de
France, but many other firms have gone out of business. The large supermarkets have cut prices for bread
and the bakeries have taken in less revenue, to the point where they cannot compete. It is not enough to
say that a local monopoly will keep a firm afloat. While some corner shops survive, in general many firms
are losing out to the falling prices of goods in the wider market. This is because the elasticity of demand
for many foodstuffs and fuel is fairly elastic, and when supermarkets cut prices on the well known items
such as bread, milk and petrol they bring in a large number of new customers – and profits can be made
by encouraging them to buy other products with a higher mark up.
Consider for a moment that you walk into a supermarket looking for your normal food items and you see
a pair of boots you like for £30. If buying these means that you can’t top up your mobile, can’t send your
aunt a birthday card and won’t be able to chew gum for a week then maybe you will think twice before
buying. In other words, the proportion of your spending money that’s involved is one of the main
determinants of elasticity. Another factor is that you might think that you will shop around a bit before
buying the boots, just to check they are the best value and the best price – there may well be plenty of
substitutes for this particular pair of boots, probably online. A branded pair of boots are hardly a necessity,
unless you are a slave to fashion. For these reasons I should imagine that your price elasticity of demand
will be fairly high, and you will be very sensitive to the price of these boots. In fact this might be why the
boots are priced relatively cheaply, compared to the ones you might see in a specialist clothing store.
But if you are a Premier League football player and you happen to be clothes shopping, then none of these
considerations is likely to come into play. The price will not be a key factor; and the style, quality and brand
name will be far more important. It’s a case of very low PED, and non-price competition will be more
important. When the amount spent is a very small proportion of income, you are less likely to be sensitive
to price, and the time factor might be more significant. The PED is almost zero.
Some figures from UK data2
The price elasticity of demand

The price elasticity of demand for corn in the corn belt in the US, where millions of tonnes of corn are
produced each year, is estimated to be (-) 31,000. So if a farmer takes his corn to market and thinks to
make a quick dollar by increasing the price a little, he will be disappointed – he will find no one to buy the
product. There are very many other sellers with similar products. But if he cuts price in order to sell more
he won’t make any more money either – at the market price he can already sell everything he has, and he
is a very small player in the field. His product is exactly the same as anyone else’s – at least, can you tell
where your cornflake was grown? The corn producer is a price taker in a market which is so purely
1. The formula is percentage change in income divided by percentage change in price. If one goes up the other goes down, and vice versa, so the sign is always negative. Because
a comparison between negative numbers is sometimes a little confusing (e.g. negative 3 bigger in effect than negative 1 but smaller numerically) we usually ignore the negative
sign. But when we look at income elasticity and cross price elasticity it is very important not to ignore it!
2. The figures in this section come from www.sussex.ac.uk/economics/documents.

competitive it is virtually perfect competition. By contrast, the PED for dairy products is (-) 0.05 (extremely
inelastic) and for alcoholic spirits (-) 1.27 (elastic) but (-) 0.83 for alcohol in general.
Income elasticity of demand (YED)3

Income elasticity is useful for firms, not so much because of individual incomes changing, but when
considering groups of consumers. The top 0.5% of earners have had their incomes accelerating4 and it
means that there has been accelerating demand for houses over £1 million while other house prices in the
UK fell from 2007 for several years. The changes in incomes are very significant for estate agents. Similarly,
the sales of foreign holidays have fallen since the 2008 credit crash, despite falling fuel costs and a
strengthening pound making the prices fall. This signifies that the income impact is more important that
the prices (YED is 1.14). Alcohol has YED of 2.6 while dairy produce is at 0.53, so off-licences and pubs
are hit more than farms in a global downturn. Some firms such as Primark found the value of their sales
increased in the recession, meaning that the income elasticity is negative. When sales rise in response to a
fall in incomes we call this an inferior good or service.
Cross-price elasticity of demand (XED or CPED)5

Another helpful figure for a firm is the cross-price elasticity of demand – the closer the product is related
to another, the higher the figure. As with income elasticity of demand the positive or negative sign is very
important – for substitutes the figure is positive, and negative for goods that are bought in conjunction
with others (that is, complements). If the figure is very close to zero the figure is not very important for
firms. But for items that are strongly related the XED will help a firm to decide how to react to changes in
the economy. For example the XED for a Dell PC and a Compaq PC is 0.74 (fairly significant substitutes)
but a Dell PC and an Apple iMac is 0.07 meaning that if Dell are dropping their prices Apple Macintosh do
not need to enter a price war.
Price elasticity of supply (PES)

Consider these figures: the price elasticity of supply for green peppers is 0.26 and for spinach 4.7. This is
useful to know if you are trying to assess the impact on suppliers when there is a change in price – perhaps
because there is an increase in demand for green vegetables. The price of peppers will rise much more
sharply than the price of spinach. The reason for this is that spinach can be grown in almost all soil types
and the plant is resistant to wider variations in temperature and water. The resources used to grow spinach
are less specific than for green peppers, and this explains why the price of spinach is less volatile than that
of peppers when demand changes.
Elastic Case – Peppers Inelastic Case – Spinach

b
S (inelastic)
a
S (elastic)
b
P1
a b
P1 P
a
P
a b
P0 P0
D1 D1
D0 D0
Q0 Q1 Q0
3. We use a Y (a Greek I) instead of I because I already stands for Investment in many economics contexts.
4. The Economist, 21 October 2006.
5. X in XED is short for a cross sign, but the more logical acronym is the initials of Cross Price Elasticity of Demand.

Revision tips
The main determinants of the value of PED:
Number and closeness of substitutes
Proportion of income spent
Whether the item is viewed as a necessity/habitual purchase or a luxury
The time period under consideration
The sign for income elasticity tells you whether the product is normal (+) or what economists call inferior
(-), which means that as you get more income you spend less on this item.
The sign for cross price elasticity tells you whether the goods are substitutes (+) or complements (-), and
the larger the figure in any direction the greater the relationship between the two.
If the price elasticity of supply is greater the easier it is to change supply. PES increases over time, and the
difference between the short run and long run can be illustrated on a cobweb diagram. In other words the
supply curve gets flatter over time.
1. Is it rational for a firm ever to produce at a point where demand is inelastic? If you have learnt about
MC = MR you will know that the firm must always produce where MR is positive because MC is
always positive. And if demand is inelastic then MR is …… ?
2. Firms make great efforts to reduce the PED for their products. For example they might increase
brand loyalty or improve the quality of service. Name three other ways in which they might try to
do this. Is this good for consumers?
3. Using the real world data, estimate the PED for each of the following and give a justification for
your decision:
Halal kebabs in Sheffield Hallam University campus (there’s just one halal food outlet on the
campus, and Muslim students are the majority ethnic group).

Chips in a café in a once-busy beach town. There are still many chip shops but not many customers
across the year.

4. Why do flowers cost more on Valentine’s day? Use PED and PES in your discussion.
● Elasticity – a measure of responsiveness of one factor to changes in another factor.
● Price elasticity of demand (PED) – the percentage change in quantity demanded in response to
a percentage change in price.
● Income elasticity of demand (YED) – the percentage change in quantity demanded in response
Key Terms
to a percentage change in income.
● Cross elasticity of demand (XED or CPED) – the percentage change in quantity demanded of
one product in response to a percentage change in price of another.
● Price elasticity of supply (PES) – the percentage change in quantity supplied in response to a
percentage change in price.
● Revenue – the amount of money a firm receives, calculated as price times quantity.

Topic 3 What are the effects on the market
of taxes and subsidies?
Governments intervene in markets in many ways: sometimes they want to discourage production or
consumption, in which case they raise a tax; and sometimes they want to encourage production or
consumption and might choose to offer a subsidy. There are many other ways in which governments can try
to alter our levels of production and consumption, but in this Back to Basics we will look specifically at taxes
and subsidies, illustrating them with simple diagrams, analyse who is paying the tax or receiving the benefit
of the subsidy (incidence), and discuss the contexts in which they are likely to be most effective. Finally we
will evaluate them by asking whether they are the best measures to achieve government objectives.
Taxes
Taxes are a requirement by law to pay money to government. There are two main types. Most of this article
focuses on indirect taxes, but we take a quick look at direct taxes first:
Direct taxes are taxes on income, such as income tax, which are taken directly or straight out of incomes.
Rather perversely, direct taxes can have an indirect impact on market prices. For example, when income tax
fell to 20p per pound in April 2008, then I’m sure I wasn’t the only person feeling a little bit better off at
the end of the month, and planning to increase demand for luxury products. This affects prices if enough
of us do that. So a cut in taxes is likely to put upward pressure on some prices. Similarly the 2010 cut in
corporation tax from 28% to 27% in 2011 (a proportion of a firm’s profits) might allow firms to cut prices.
So while it is true that direct taxes can have very significant effects on prices, the issue is more likely to
come up on a macro economics paper, rather than trying to apply the tax system to the ways in which
markets work in micro.
Indirect taxes are taxes on expenditure, such as value added tax (VAT). They are paid by any firm which
sells anything, unless it’s a small firm or a charity. When the government wants to alter production and
consumption patterns the main way to do this is by indirect tax rather than direct tax, as this will affect
prices. The reason that it is called indirect tax is that the consumer does not pay the money directly to the
government, but the firms which sold the goods or services must pay. The consumers do end up paying at
least part of these taxes, as the cost of the tax is passed onto the consumer. You will feel some effect from
the 20% VAT from January 2011.
Indirect taxes come in two versions too: specific taxes, which are a fixed sum per unit sold, and ad valorem
taxes, which are added on as a percentage of the price. The specific tax on wine in the UK currently
depends on the amount of alcohol, not the price at which it sells. This is shown in Table 1.
Table 1: The specific taxes per litre of wine since the March 2010 Budget
Wine (not sparkling): Exceeding 5.5% – not exceeding
15% alcohol by volume £2.25
Wine (not sparkling): Exceeding 15% – not exceeding
22% alcohol by volume £2.99
Source: www.hmrc.gov.uk
It doesn’t matter whether you buy vin de grotsville or chateaux de poshville, the tax is the same per volume
and strength. A specific tax is one which varies not with the price but with another factor, such as alcohol
strength.
The second type of indirect tax is the ad valorem tax. Ad valorem is the Latin for corresponding to the
value. The more something costs the higher the tax rate. VAT is the most well known example. If I buy
anything which might be seen as a luxury then I’m likely to have 20% tax hidden in the price.

The main difference between a specific and ad valorem tax is that the specific tax is not trying to gain more
revenue from people who are prepared to pay more. It is a tax which is not targeting redistribution of
spending power in the economy but instead trying to target something else, such as drinking. The ad
valorem tax by contrast is a good money earner for the government, in that it taxes the people who are
prepared to spend more. An ad valorem tax is redistributive – but this makes a critical assumption that it is
the higher income groups who spend more and thus are taxed more. In fact as a percentage of income it
is often the case that the poor pay much more in terms of indirect taxes, relative to the higher income
groups, and for this reason we say that most indirect taxes are regressive – that is, taxing lower income
groups more in proportionate terms.
The tax on cigarettes is a mix between the two – 24% of the retail price plus £114 per 1000 cigarettes
(June 2009 Budget). Then there is VAT. £4.10 of the £5.50 cost of a packet of cigarettes goes to the
government. So if you smoke a lot and smoke expensive brands you are paying a lot of both types of tax.
Subsidies
A subsidy is a grant given to producers (or consumers). There are two main reasons that a government
might offer a subsidy to affect market prices:
It may be that the government thinks that the market price is too low for firms, and may want to support
the firms’ incomes to stop the firms shutting down. This will encourage production, which not only keeps
firms in business, but can mean that supplies of services are guaranteed, especially in the case of some
foodstuffs which are considered essential. Another advantage is that jobs are not lost in the industry. For
example the government subsidised £5,000 per car made in the UK in 2010.
By contrast it may be that the government thinks that the market price is too high for consumers, and
that if prices were lower people would consume an amount which more accurately reflects the value they
will gain from consumption. This is a situation where there are positive externalities. For example the
government subsidises train operating companies heavily (which may surprise you considering some
fares), helping to ensure unprofitable routes are kept running. That is, there is a social benefit.
The effect of subsidies is to lower prices but the cost to the government of doing this is high, as is shown
in the following diagrams. The consumer might feel better off because of lower prices but there may be an
opportunity cost to be paid through taxes. These can destroy incentives in an economy such as the desire
to work long hours, and the effects of the subsidy can be seen as worse than if the government hadn’t got
involved in the market at all. The amount paid and the amount that benefits the consumer and the
producer is shown neatly with a diagram showing the incidence of taxation.
Figure 1: An indirect tax and a subsidy

P
S + tax
tax
S
P2 e2
subsidy
S + subsidy
P1 e1
P3 e3
D
0
Q2 Q1 Q3 Q
Figure 1 shows the difference between an indirect tax and a subsidy. The indirect tax is the vertical distance
between the supply curves, and pushes prices and costs upwards. The subsidy is again the vertical distance
between the supply curves but instead pushes the costs or prices downwards. When calculating the total

tax revenue the government receives as a result of a tax, you need to multiply the tax per unit by the
number of units sold.
Figure 2 shows the incidence of a specific tax. Consumers pay the amount of tax per unit equal to the
change from the old price to the new price. We draw a vertical line at the new equilibrium point. Producers
pay the amount of tax per unit which is the difference between the amount they now receive after tax and
the amount they would have received at that output. So in this case consumers pay P1P2 whereas producers
pay a larger proportion of the tax. There is a greater vertical distance between P1 – t and P1 than between
P1 and P2.
Figure 2
P
S + tax
e2
P2
e1
P1
P1 - t
0
Q2 Q1 Q
The dynamics of the diagram work in just the same way for the ad valorem tax (except for the steeper slope
for the new supply curve). In Figure 2 the demand is drawn quite flat, implying that it is fairly price elastic
– this means that if prices change a little then demand changes proportionately more. So when taxes put
these prices up, the quantity reduces significantly, and the producer ends up paying most of the tax.
Contexts in which indirect taxes are likely to be most effective

Before you can say whether a tax is effective you must first decide what you want to achieve. Are you
considering the amount that consumption or production changes, or are you thinking in terms of
government revenue? If the government wants to raise a lot of money, it should tax a product which has
a low price elasticity of demand – such as cigarettes or fuel. But in taxing cigarettes there is also a social
objective. Research by Ash, the anti smoking lobby, estimates that taxing cigarettes is the only method
which has any effect on the amount smoked1 – education does not seem to work to change demand at all.
The tax raises £9.3bn a year – more than four times the cost of treating smoking-related diseases. So
although the tax might reduce demand by a small proportion, it is most effective at raising revenue.
Contexts in which subsidies are likely to be most effective

Subsidies are effective in expanding output when the demand is elastic (and also supply, but discussing
this goes beyond Basics). If government wants to increase output then it should offer a subsidy where the
price elasticity of demand is high. But usually the demand for foodstuffs and other commonly subsidised
goods is inelastic so although there is a major subsidy the output doesn’t increase much at all. For example
the government is trying to encourage the output and use of bio fuels, but because you need a different
car to use them demand has not responded quickly to lower prices or more output. Often the subsidy does
not increase output at all – it just stops the output from falling. In the recent recession the UK government
was keen on subsidising ailing firms such as car producers, and while in the short run some job losses were
prevented, in the long run it seems this was money wasted. Subsidies are best in thriving industries with
relatively elastic demand.
1. With a 10% increase in price causing an overall reduction in cigarette consumption by 3% to 5%, with young people and low waged more likely to cut consumption.

Table 2: The incidence and output effects of an indirect tax
Demand is price elastic Demand is price inelastic
Effect on Output falls greatly but Prices rise greatly but
consumers prices change little output changes little
Effect on Output and profits fall Very little change to firms
producers output or profits
What are the problems with indirect taxes and subsidies?

There are three main problems with indirect taxes. First, they make goods and services more expensive. The
result is that our cost of living rises – that is our basket of goods as measured by inflation will cost more.
Secondly, as a country we may be uncompetitive if indirect taxes abroad are lower – which might lead to
illegal smuggling of cigarettes for example. Thirdly, that there is a disincentive for firms to set up or invest
in our country – one of the main causes of growth in an economy.
There are three main problems with subsidies. First, they are very expensive to operate, and must be
funded out of tax payers’ money (for which there is an opportunity cost). Secondly, while they may lower
prices for the consumer and guarantee a higher income for producers, the level of that income is not
guaranteed – it depends what the market price was before the subsidy was given. If in one year prices fall
very low the subsidy might not be enough to maintain incomes; whereas in another year the producer
might do a little too well out of the government handout. Thirdly, they distort the market, and the economy
fails to enjoy the benefits of comparative advantage. If we can get cheaper foods from outside the EU
rather than the subsidised food from within it, trade will be created, and everyone can be made better off
without anyone being made worse off. The EU Common External Tariff is one of the key reasons why
international trade talks with developing countries break down.
In conclusion, taxes and subsidies can be used to change output and price levels, and the effects depend
on the ways in which they are applied and on the elasticities of demand and supply. The side effects of
taxes can be to change levels of welfare, equality and international competitiveness. They have a large but
often hidden effect on our daily lives, and for that reason are favourite topics for politicians, green activists,
but perhaps most important of all, economics examiners.
1. Draw a summary table similar to Table 2, but this time for subsidies. What pattern emerges?
2. If you have been studying macroeconomics you may have got the impression that subsidies are a
supply side policy. The reason for saying this is that subsidies encourage firms to produce more and
at a lower price. However what is the difference between subsidies and a supply side policy? Think
micro, macro.
3. The price elasticity of demand is of crucial importance when considering the incidence of taxes and
subsidies, as discussed above when looking at the shift in supply curves. But is the price elasticity
of supply important? Remember that the shift in the supply curve is a vertical movement so if it is
very steep it will not move left or right very much.
4. If indirect taxes are the only way to stop people smoking, why not double the tax on cigarettes? Or
is the smoking ban (since July 2007) going to have more effect, with fines ranging from £30 to
£2,500?

● Direct tax – taxes on income, e.g. income tax, which come directly or straight out of incomes.
● Indirect tax – taxes on expenditure, e.g. value added tax (VAT), tax on petrol.
● Specific tax – tax based on quantity not value.

Key Terms
● Ad valorem tax – tax based on value not quantity.
● Subsidy – a grant given to producers.
● Incidence – who pays the tax (or receives benefit of the subsidy).
● Price elasticity – a measure of response by consumers or firms when prices change.
● Common External Tariff – the EU imposes some taxes on outside countries which all member
countries impose at the same rate. These vary from 7% (footwear) to 236% (food products).

Topic 4
Why look at the margin?
Imagine that I need to lose some weight. I’m sitting typing this, feeling a little peckish just at the thought
of a diet. The last few biscuits in the tin seem to be calling out to be eaten. There is a decision to be made
– whether to eat another biscuit and carry on, or whether to switch off the computer and go for a run. How
much is just one more biscuit (the variable) going to affect my progress?
This decision is made at the margin, that is, what I will do next disregarding what’s happened up till now.
I might have been scoffing food all day or running a marathon, but an economist likes at times to ignore
what’s been done so far when deciding what to do next. What I’ve been doing all day does of course matter
when I add up my totals for the day, to see how I’ve done. But if I’m trying to reach a target or trying to
make some changes, then what I do next should be considered in isolation. And if every decision along the
way is made using the margin, then I will maximise, minimise or whatever my original target was.
One really useful concept that comes out of considering the margin is externalities. Externalities are
the spill-over effects, or impact on a third party when an economic transaction takes place. Everyone
knows that driving cars causes global warming but it doesn’t seem to have much effect on our decision-
making when we need a lift into town. It is not a reasonable economic policy to expect people to give
up their cars or to stop using fossil fuels to heat their houses. But you can look at whether people might
occasionally share lifts or turn the heating down when they could wear a jumper instead. In other words,
to change the levels of carbon that we emit, it is more effective to alter behaviour with incremental steps
rather than total bans. If we believe in market forces rather than authoritarian control then changing
people’s behaviour by means of the price system is the only viable option. The problem of externalities
can be addressed if the price system can be used to take account of the marginal social cost (or benefits)
rather than just the marginal private costs (or benefits).
So let’s look at the marginal social cost of my driving to work. The car is already taxed and insured, so
these costs are not part of the marginal cost. The marginal private cost (this is my personal spending) is
the petrol at £2, and any congestion or parking charge that I face. There is then the cost to other people
not part of the transaction, in other words, the third party effects. The people are paying the negative
externality – the extra congestion and the increased wait at traffic lights for other motorists, and the risk
to pedestrians such as a minute contribution to a person’s asthma or the increased risk to someone of
being run over. Add this increased externality to the marginal private cost and you get the marginal social
cost, the full cost to society of my driving to work. If I then add in the fact that it’s actually quicker and
better for me on my bike then the costs are outweighed by the benefits, and this explains why in fact I
never do drive to work. But I do have my own car – it’s just that making the journey to work is not
economic for me. By using a road toll or congestion charge the externalities can be internalised. The
big problem of course is knowing just how much the marginal externality is, and therefore the correct
amount for the tax or toll. Knowing how big the margin is becomes a very important question for
governments, high on the agenda for any modern democracy.
A second economic use of the concept of the margin is diminishing marginal returns. Let’s go back to
that packet of biscuits. When I have had four or five biscuits, I begin to find that each extra biscuit gives
me less enjoyment or payback. The concept is fundamental to the way in which cost curves are drawn,
and from there supply curves. It also explains why a production possibility frontier bows outwards. The
key thing here is that it is the extra enjoyment that is diminishing, not the enjoyment from eating the
biscuits as a whole. When the extra benefit exceeds the costs of buying the next item I’ll keep on buying,
and so this continues until the cost is the same as the marginal benefit. And where there is more than
one item I need to get the marginal benefit relative to price equal on every item to maximise my
enjoyment relative to the amount I have to spend.

A third place that the margin is used is when looking at how to maximise profits, revenue or sales volume
when running a business. Business people often talk about their margins – how much extra profit they’ll
make if they take a certain course of action. Let’s say an owner of a chain of shops is considering setting
up another branch. He or she will consider what the sales are likely to be in the new store (marginal
revenue), and the costs of setting up and running the new store (marginal cost). As long as the marginal
revenue is greater than the marginal cost then profits will increase and the decision is worthwhile. Even
if the marginal revenue is just a few pounds over the marginal cost then the store owner is wise to
expand. Or even a few pence – after all, as long as marginal costs are not greater than the extra money
coming in then the owner will make more profit rather than less. Of course the very last store where
marginal revenue equals marginal cost is adding nothing further to profits, but then it’s not making a loss
either. Every store up to this one is adding to profits and you might even argue that it’s worth running
the last store that’s not adding anything to the bottom line in that it’s increasing market presence.
Another way of looking at this is to say that marginal revenue is the gradient of the total revenue curve,
and marginal cost is the gradient of the total cost curve, so where these are equal the total revenue and
costs are running parallel and therefore this may be the furthest apart they get, that is, maximum profit.
A fourth common use of the margin is when considering the concept of allocative efficiency, where
price equals marginal cost. The problem for many consumers is that they don’t pay for every unit, or at
least don’t see the money going down when they consume each unit. If you had to put money in a meter
to keep your television on standby overnight you probably would turn off the TV rather than put in the
20 pence it would cost you. If you have to put coins in a parking meter you’re probably really careful
about how long you pay for. It might be only 0.2p a litre when you’re on a water meter for domestic
water use, but in houses where people pay for every litre there’s a certain stinginess about water that can
have almost unhygienic consequences, although of course as an economics observer I’m pleased to see
that the water that is used is because it is valued. Ofwat, the water regulator, has estimated that people
use 30% less water when they are on meters.1 This is the basic meaning of allocative efficiency: we use
something up to the point where we are only just prepared to pay for the last unit and no more. If we
consume any more then the cost is greater than the amount we value it and we quickly stop consuming.
So to achieve allocative efficiency the marginal cost to us will be equal to the amount that we value it,
that is the price that we are prepared to pay.
There are other uses of the margin. In your A-level course, you may come across marginal cost pricing,
the marginal efficiency of capital, marginal land, marginal physical product, marginal revenue product,
marginal productivity of capital, productive efficiency, the marginal propensity to consume, save, tax or
import and even possibly the marginal rate of substitution. But I have the feeling that if I were to start
telling you all about these here, the law of diminishing returns will set in and you’ll be putting down this
article and running off, with or without those famous biscuits.
Box 1: Marginal analysis

The rules for the relationship between averages and marginal values.
You can replace x with a variable such as cost or revenue.
If marginal x is less than average x then average x is falling
If marginal x is greater than average x then average x is rising
If marginal x is equal to average x then average x is constant
1. www.ofwat.gov.uk

1. When people talk about profit margins do you think they are using the concept of margin correctly?
2. Using Box 1, replace the x with cost, revenue, or any other marginal concept that you have come
across. Is the rule always true? (Clue – the law of diminishing returns might help.)
3. When marginal cost equals marginal revenue then marginal profit is zero. What does marginal profit
mean? Why does it need to be zero in order to maximise profit?
4. If you’re driving at 56mph you use 10% less petrol per mile than driving at 70 mph. In the USA the
speed limit on interstate highways is 55mph dating back to the oil price hikes in the 1970s. What
ways could you suggest where you live to get people to drive to use less petrol per mile – that is,
make the choice of speed allocatively efficient?
5. There are many price comparison websites. Look up the relative cost of water per litre or electricity
per litre. Would you advise your parents to switch suppliers?
● The margin – the effect per unit of a small change in any variable.
● Allocative efficiency – where resources in an economy are shared out to maximise the benefit for
society as a whole. It would not be possible to make anyone better off without someone else being
made worse off.
● Diminishing marginal returns – as more of a unit is consumed or produced, the increase in
benefit or output will eventually fall.
● Externalities – the effects of an economic decision that are not accounted for by either the buyer
or seller, that is outside the private costs and benefits. They are also called the spill-over effects, or
impact on a third party when an economic transaction takes place.
Key Terms
● Internalising the externalities – a process of making externalities internal, or part of the

economic decision made directly by consumers and producers. A clear example of this is an indirect
tax.
● Marginal private cost – the cost to the individual or firm when one more unit is consumed or
produced.
● Marginal private benefit – the benefit to the individual or firm when one more unit is consumed
or produced.
● Marginal social cost – the cost to society as a whole when one more unit is consumed or produced.
● Marginal social benefit – the benefit to society as a whole when one more unit is consumed or
produced.
● Price system – where resources are allocated according to the forces of demand and supply, rather
than by governmental control.

Topic 5
Do firms exist just to make profit?
Or, how realistic is the assumption of profit maximisation?
Firms don’t exist unless they make a profit. But do all firms
have to make as much profit as they can? It might be better to This section looks at four tools
make increased investment now in order to get more profits in used to help us understand profit
the future. It might be that the people running the firm are maximisation at A2 level:
not the main beneficiaries of increased profits, and they might
A summary of essential theory
have other goals – especially if their pay is based on sales
of the firm
revenue rather than profit. Sometimes firms like us to think
An explanation of what MC =
they have other motives than profit maximisation – for
MR is using marginal analysis
example BP’s tagline is ‘Beyond Petroleum’ – but the bottom
Some ideas as to why MC = MR
line is in this case very focused on profits. In this Back to Basics
is useful for a firm
we are going to consider the objectives of firms, starting with
A selection of other goals
the profit maximising goal, to see first of all if it has any
besides profit maximisation
practical use in economics today.
that a firm might have
It’s easy to learn the formula for profit maximisation, that
marginal cost (MC) equals marginal revenue (MR). On a visit
to the head office at a locally-based multinational company one of my students asked the managing
director whether the firm actually operates at MC = MR. Of course the answer was a blank, and when we
got back to class it was asked why we bother learning the formula if real businesses don’t use it. The
answer is that many businesses do use it but don’t call it that. Many firms do use marginal analysis, and
most firms need to maximise profits in the long run if they are going to survive.
Profit maximisation – the essential theory of the firm

Suppose you want to start up a business. Let’s say you have a good idea for a product, say transparent
boots, and you have developed a prototype that really works. You have found a firm in the Far East that
will manufacture the basic product. All you need now is a lump sum of cash to invest in your business. How
do you approach potential investors? The first thing is that you must be able to give a business plan with
a breakdown of your overheads – costs you must pay even if you produce nothing at all, and your variable
costs, the costs that increase as you produce more, in this case the price per unit, that is, pair of boots. The
two added together are unsurprisingly called total costs, and the change in total costs when one more
unit is produced is called the marginal cost.
Fixed costs must decrease per unit as output increases – they are ‘spread out’ and provide firms with an
incentive to increase output. You will have to pay for some advertising but as more boots are sold so the
cost per boot for the advert decreases. Average fixed costs fall as more are produced.
Variable costs, for example each extra pair of boots, increase in total when more is produced, but the
average will most likely fall at first then start to increase. The non-linear relationship between variable
costs and output is explained by the law of diminishing returns. As more of a variable factor is added
to a fixed factor the increase in output will eventually fall… otherwise expressed as a law of increasing
costs where for a steady increase in inputs we see outputs slowing down eventually, if we keep at least one
factor constant, such as factory size.
Put the two average costs together – average fixed costs always falling, and average variable costs
eventually rising, and you get a saucer-shaped average total cost curve. All firms will have the same
shape costs in the short run – that is, with at least one factor fixed.

Marginal costs can be derived from the total cost curve. The
Box 1: MC = zero
MC is the extra cost of making another unit – the new cost
less the old cost when one more is made. The shape of the Only when all costs are fixed, that
curve looks like a Nike tick symbol, and as it is needed to work is, there is no increase in cost at
out short run equilibrium, it needs some further discussion. all when another unit is made.
Let’s go back to total costs, to see how MC is derived. This might seem unlikely, but
here is an example: you go to
Total costs are usually going to rise so marginal costs are hear a band in a local pub. The
positive – except in the case when they are zero – see Box 1. band cost a fixed fee, the bar has
So MC is positive, so what? This doesn’t mean that it is always its overheads, but you standing
rising; costs can increase at a slower rate, and MC would fall in an empty spot aren’t costing
while still being above zero. Eventually MC has to rise – this is anyone anything. Just so long as
because of the fixed factors – there will come a point where it there is spare capacity then the
is becoming harder to obtain further output from a fixed marginal cost is zero.
resource. Imagine an orchard of apples, the fixed resource.
Now try producing more: add more labourers, and you will get
to the point where the extra apples are costing you increasing amounts – workers have to climb to the high
and spindly branches of the trees, and the increase in output from each extra worker eventually falls, and
the apples are costing you more if you’re paying each worker a fixed daily rate.
If you are profit maximising when do you stop employing workers? Surely not at the point when every apple
is picked, if it means ages spent trying to clamber up a weak limb of a tree to get those last apples. You must
consider the cost of the last worker (MC), and compare it to the amount that worker has contributed to the
business – not simply what was picked, but the change in total revenue when that worker came along. And
when you find the marginal revenue then you compare it to the marginal cost, and the point at which they
are equal is your profit maximising output. It’s neither the price that you charge, nor the cost of production
– it is simply the optimum amount for a firm to produce if it is aiming to maximise profits. You can’t make a
penny more profit – if you cut output you lose, and if you increase it you lose.1
You might find that the last worker picked so much that you can’t sell everything without lowering the
price; although you get more money for the extra produce, you lose money on all the other produce
because all the output now sells at the lower price. In other words, the marginal revenue could well be
negative. This could never be profit maximisation – you could make more profit by raising the price. How
can we be so sure? The marginal cost is certainly not negative, but the marginal revenue is. So at this point,
marginal cost is greater that marginal revenue. The last unit is costing more than the firm gets for it – so a
loss is made on it. Better not to make it. It is giving profit away.
From this reasoning we can also prove that a profit maximising firm will never operate where demand is
price inelastic. Inelastic demand means that the firm loses revenue when the price falls, and gains revenue
when price rises. If you make less money when you cut the price then your marginal revenue is less than
zero. MC is never less than zero. So if MR is less than zero and MC is greater than zero then MR < MC, and
the firm is not profit maximising.
So far we know therefore, when we make the assumption that firms aim to maximise their profits, we can
form rigid conclusions about their price and output behaviour. For a little light relief, see if you can spot
the statement that isn’t true (check answer at * at the end):
All profit maximising firms operate at MC = MR and this is their short-run equilibrium.
Marginal costs are always positive (or at least zero) and while they may not always be rising, they will rise
eventually.
All firms operate where MR is positive (or at least zero) which means that demand is relatively elastic.
Marginal revenue is always positive because when you sell something you get more money.
1. The technique of considering what would happen if one more or one less is produced is called marginal analysis. So when we assume that all firms aim to maximise profits,
for this so-called short-run equilibrium we say that the cost of producing the last unit, marginal cost, is equal to the increase in revenue for the firm when that last unit is
sold, marginal revenue. In brief, MC = MR. This can be explained by considering the situation when the two are not the same.
• If the marginal revenue was greater than the cost of producing one more unit, then the firm is missing out on potential profits – if the firm sold another good more would be
gained than lost.
• If marginal cost is greater than the amount the firm receives by making another unit then the firm would do better not producing it.

Now we can show whether a firm, operating at MC = MR makes supernormal profits, breaks even, makes
a loss but continues in business, or even closes down.
Rule 1: MC = MR for profit maximisation.
Rule 2: A price (average revenue) must cover a firm’s average variable costs or it should close down
immediately. Any revenue above this will make a contribution towards the fixed costs, which will
have to be paid in any event, so even if a firm is making a loss it minimises these losses.
Rule 3: A price (average revenue) must cover its average costs in order for a firm to make enough profit
for survival in the long run. Average costs include an element of normal profit, which is just
enough profit to keep the firm doing what it currently does. Any profit above normal profit,
sometimes referred to as abnormal, supernormal or excess profits, does not have the function of
keeping the firm in place.
Total profit is by definition at a maximum where MC = MR, and the firm is at an equilibrium, or no tendency
to change output, in the given situation of costs and prices.
Non-profit maximising theories

There is no doubt that all firms must make some profit if they are to survive without government or
charitable support. Some economists such as Milton Friedman2 believed strongly that firms should be left
to make maximum profits, and this motive would lead to a better outcome for all. In fact many firms might
enjoy making profit, but are not aiming to profit maximise. They may be aiming to increase profits but
maybe not in the short term. They might have other aims such as increased international reputation, or
they may be ignorant of how to increase profits. But whether profits are maximised is open to question.
We can use a standard diagram to illustrate a variety of possible goals that a firm with some market power
can achieve. If the firm has no market power (that is, a perfectly competitive firm) it has no choice but to
stay at MC = MR.
So when we assume that all firms aim to maximise profits, for this so-called short-run equilibrium we say
that the cost of producing the last unit, marginal cost, is equal to the increase in revenue for the firm
when that last unit is sold, marginal revenue. In brief, MC = MR. This can be explained by considering the
situation when the two are not the same:
If the marginal revenue was greater than the cost of producing one more unit, then the firm is missing
out on potential profits – if the firm sold another unit more would be gained than lost.
If marginal revenue is less than the amount the firm spends in making another unit then the firm would
do better not producing it.
Total profit is by definition at a maximum where MC = MR, and the firm is at an equilibrium, or no tendency
to change output, in the given situation of costs and prices. Figure 1 illustrates this output (at point A)
along with other output points the firm might choose. These other points are not profit maximisation, but
they might be equally valid as a long term goal for a rational firm.
Revenue maximisation – this (point B) describes a situation where the firm tries to make as much money
as possible, that is making the most turnover and ignoring the costs. This will occur at a higher output than
profit maximisation unless marginal costs are zero. Revenue is maximised where MR is zero (where it
crosses the horizontal axis), which is also where the price elasticity of demand is unitary (one in value) on
the demand curve. A firm might wish to revenue maximise if it has a cash-flow problem which requires an
immediate injection of cash to the business. An author who receives royalties on her book might well wish
that the firm would revenue maximise, if she is going to receive a percentage of the turnover and she faces
none of the costs. But for most business decisions, where costs have to be considered, revenue maximisation
is only rational as a short run policy to increase revenue.
2. Friedman, Milton, ‘The Social Responsibility of Business is to Increase Its Profits’, The New York Times Magazine, 13 September, 1970.

Figure 1
Costs &
Revenue MC
AC
E
C
A
AR
B
MR Quantity
The most efficient output point, or minimum average cost, is a possible aim for firms. It sounds as
though a firm would always want to be there, at C, but that is not the case. Only by coincidence would it
happen also to be at profit or revenue maximisation, except in the unique case of perfect competition in
the long run. A firm is always interested in lowering the entire cost curve, but there is never any particular
reason from the firm’s point of view for being at the lowest point of the existing average cost curve – it is
more important for a firm to relate its costs to the amount the output can be sold for. It could certainly be
rational from the government or the consumers’ point of view, but consumers aren’t usually the agents
making the pricing decision.
Welfare maximisation point – this (point D) is otherwise known as the point of maximum allocative
efficiency, or the point of socially optimum output, or the point of Pareto optimality, where no one can
be made better off without someone else being made worse off. It occurs where Price = MC, because
before this point the value that society puts on the next unit (price is read off the demand curve) is always
above the cost to society of producing the next unit (the firm’s MC). Except in perfect competition, welfare
maximisation is always at a lower price and a greater output than profit maximisation, or in other words,
the price is greater than the marginal revenue, and the price is equal to the marginal cost, therefore the
marginal revenue is not the same as the marginal cost. You cannot welfare maximise and profit maximise.
You can in perfect competition, which is where we move on to next, and it is a market structure where,
uniquely, the firm has the same marginal revenue as price.
Output maximisation – this occurs where total revenue and total costs are the same (TC = TR), or where
price per unit is the same as cost per unit (AC = AR). Be careful not to confuse this point with revenue
maximisation. It is also called the upper break-even point, where the firm is as large as it possibly can be
without making a loss (point E on Figure 1). The firm is making normal profits. This will occur at a higher
output than profit maximisation. A firm may wish to do this (and sacrifice present profit) if it wishes to
become larger and expand, perhaps into other markets, which may lead to higher future profit. A conflict
may exist between the owners of a firm (the shareholders), who may look for maximum profit, and the
managers, who do not own the firm and whose motivation may be linked more to growth and expansion.
If there is a divorce between ownership and control then the controllers may try to maximise output, but it
is doubtful that they will keep their jobs in the long run if they ignore the bottom line, or final profit figure.
Satisficing behaviour – satisficing is a made-up word, combining satisfying and sufficing – keeping the
owners (usually the shareholders) happy, and doing just enough to get by. This is a compromise, usually
between the extremes of profit and output maximisation. Having achieved the minimum level of profit to
stop shareholders selling their shares, for example, controllers of the firm can seek any objectives they
wish – improving their golf handicap, having a top sports-car or just fewer risks or keeping a business
family-run.
Limit pricing – a perfectly legal way to combat the threat of potential competition is to cut the price of
your product so that any new firm – which is likely to have higher average costs when it starts business –
will never be able to make a profit. A new firm is likely to start small scale and without the benefits of
economies of scale and therefore have higher average costs. A limit-pricing firm cuts its price so that it

retains some profit, but deters the entry of new firms because these wouldn’t be able to cover costs. In
terms of regulation this does represent a dilemma: the incumbent firm is lowering price so that is good for
the consumer; but choice is being limited by the exclusion of new firms, and there might be x-inefficiencies
that creep in as a firm enjoys the competition-free status. Don’t confuse this with predatory pricing
which is neither legal nor stable. It involves setting price below average cost as a short run policy to remove
the threat of competition.
In conclusion, there are two major strands to the theory of the firm: profit maximisation and profit-making-
but-with-some-other-short-run-objective. The latter strand is an attempt at realism by economists, and
therefore the theory becomes twisted and turned, so much so until you reach satisficing when you come
to the conclusion that there is no foolproof theory, just as long as you can get by with the profits you’re
earning now. We can, however, make out some useful theories as to how much firms might charge, and
how much they produce, if they were acting as if they were the only firm in the market. The next building
block of theory to consider is market structures or, how firms relate – or conflict – with each other in order
to reach their targets.
*Spot the error? Marginal revenue is not always positive. True you always get more money coming in when
you sell another item. But you lose money on all the items you are already selling when you cut the price
to sell one more.
1. What would you reply to the person who asks whether a firm is operating at MC = MR?
2. Are charities profit maximisers? What about public sector firms, such as the Post Office? What
would happen in the long run if they didn’t make profit?
3. If you ran your own business, how much profit would you need to make to keep running it? Most
people running their own businesses are happy to work for less pay than if they were working for
someone else – does this suggest they are satisficing? Or, that the pleasure of being your own boss
is worth a certain amount. Or do self employed people only accept less money because they think
that in the long run they will be able to make larger profits, have more leisure time, or control their
own – or others’ – working lives?

● Barriers to entry and exit – Anything that prevents a new firm from setting up immediately is
called a barrier to entry. Examples are bureaucratic costs, legislation concerning health and safety
of a product, cost of building up a strong brand image, or the predatory action of firms currently in
the market when they see a new firm is trying to set up. Examples of exit barriers are those
difficulties of selling assets when prices fluctuate widely, the difficulty of selling a brand image, the
virtual impossibility of selling on costs of software and networking within an office setup, or the
‘waste’ of training of personnel if you end your business. According to W.J. Baumol all barriers to
entry or exit are reducible to sunk costs, which are those that can never be retrieved when a firm
leaves a market.3 All other costs by definition are recoverable so do not represent a long-term
barrier.
● Normal profit – this occurs where total revenue exactly equals total cost, or average revenue
equals average cost. The costs include land, labour, capital and enterprise (risk taking), and the risk
taker needs to make a profit in order to keep the resources in the current use. Normal profit is the
minimum profit needed to keep the risk taker keeping his or her assets in their current use.
Key Terms
● Supernormal profit – any profit above normal profit is supernormal profit. It acts as a signal to
other firms to enter the market. If there are no barriers to entry or exit, then firms will enter a
market where supernormal profits are being made. This increase in competition is likely to make
prices fall, and the increased competition for the factors of production is likely to put costs up – and
both of these will tend to erode supernormal profit in the long run. In other words you can only
make long run supernormal profits if there are barriers to entry or exit.
● Satisficing – this is a behavioural theory of the firm which suggests that firms make just enough
profits in order to keep those with vested interests in the company both satisfied enough to keep
their interests in the firm and making sufficient profits to keep the firm in business, whilst also
satisfying the interests of the people that run the firm and perhaps don’t enjoy the full benefits of
maximising profits. It was a word made up by Herbert Simon4 based on the idea that profit is not a
goal but a constraint – a certain minimum level must be made and thereafter other goals can be
pursued. Humans are not very good at maximising, and instead need to meet some certain minimum
points. This ‘bounded rationality’ might well be the best explanation of behaviour by firms. But all
firms must make some degree of profit to survive, and the more competitive a market the more that
goal coincides with profit maximisation. Simon's conclusions do not negate all that we have
discussed about profit maximisation – rather they show that they might be an extreme case.
3. W.J. Baumol, Markets and Contestability, New York (1980).

4. H. Simon, Models of Bounded Rationality, Volumes 1 and 2, MIT Press (1982).

Topic 6
Economies and diseconomies of scale
Do bigger firms do better? Although several well-known names have disappeared as a result of bankruptcy,
it seems that the really big firms were best placed to weather the recession. Big companies such as Lloyds
Banking Group, General Motors and Citigroup have soaked up the shocks in the economy even if some of
them have had to accept government bailouts. Like many trends, big is now in vogue, but it has not always
been so. In this article we review why in some industries some firms are better being large in size and in
other industries being small-sized is efficient.
In the mid-1990s, small firms came into fashion. For example, Yahoo – with the same market value as
Boeing – employed 637 people as opposed to Boeing’s quarter of a million employees.1 But now big is
back in vogue as it was in the 1960s and 1970s. It’s never completely clear why the fashions change – some
are logical reasons, and some are panic decisions or perceptions that sway shareholders or other
stakeholders. Some industries will always be dominated by large firms, some will always have many
competing small firms, and many swing between these two extremes as market conditions change. One of
the main reasons for growing big is that the cost per unit of production goes down as more is made, and a
main reason for not growing is that costs can start rising per unit if the firm gets too large. This rationale
for the changing level of long-run average costs is called economies and diseconomies of scale, but it is
only one of the many reasons why firms do better when they are large, while others benefit from staying
small.
A large firm can often work at a lower cost per unit of output than a small firm. It can hire specialised staff,
bulk-buy in raw materials at cheaper prices, and can make 24-hour-a-day use of its large-capacity
transporting systems. But a small firm can also be more cost-efficient than a larger one because it can fully
control itself, and knows itself well, routing out inefficiencies as they arise, while a large firm can have
pockets of expenditure that are well hidden. A small firm can respond quickly when the market changes
because the firm has short chains of management, and there may well be good knowledge of what is going
on within a small firm. The benefits of large scale production are known as economies of scale, and in
many large scale businesses you can see them in operation. The costs of growing too large are diseconomies
of scale, when costs per unit start to rise as output increases beyond a certain level. The point at which
economies of scale turn into diseconomies depends on the type of business, the state of technology and
many other factors. For some types of output economies of scale set in at low levels of output – for others
they don’t set in even when the whole market demand is saturated.
What determines whether there are economies or diseconomies of scale?

Primary and secondary industries (extraction and manufacture, mainly) tend to be more likely to enjoy
scale economies. Service industries, on the other hand, are not always able to benefit, but there are clearly
many service costs that can be cut although this can cause problems on the demand side. First let us
consider the reasons why it is cheaper for an extraction or manufacturing firm to cut costs by producing
more. We might call these ‘plant’ factors, or issues to do with the way physical resources are produced and
brought to market.
Some firms need to be big

It is clear that for mining firms, with enormous start-up costs and need for large-scale capital equipment,
big is the only way to be an efficient producer. Similarly, pharmaceutical firms and researchers for medical
1. ‘Big is Back’, The Economist, 29 August 2009.

products have to spend years on research and testing, and small output would not be viable. Many firms
need a lot of marketing to convince consumers to part with their money, which is clear to see in the sale of
new cars. One entry on Dragons’ Den recently from Bee Autos was laughed out of the contest for suggesting
that he could sell a new electric car with a marketing budget of only £0.5 million.2
Some firms are better small

If you want your computer mended, it’s often better to visit a specialist computer shop. You will be able to
ask direct and personal questions, and get things sorted out without fear of having someone you have
never seen wiping all your work. The personal touch in a skills-based service industry can often make small
firms thrive. Communication with the customer is good, and relationships are built up. The same is often
true for hairdressers, dentists and specialist food shops. By contrast, there are other services which do not
require the same level of one-on-one trust, and it is not true that all service industries are better suited to
high levels of competition. Accountants, banking and hospitals, for example, have suited the large scale
model, and many customers and patients prefer the anonymity that a large organisation provides.
There is a list of factors you’ll find in any economics textbook explaining why these economies exist. They
are now briefly outlined, but remember that learning lists will not help you much in exams. You need to be
able to apply concepts, and evaluate whether these factors are significant or long term.
With the use of capital equipment, the following economies of scale are prevalent:
Technical economies
The high cost of some specialised equipment may mean that it must be used day and night, weekdays and
holidays, in order to make it a worthwhile investment. These also apply to storage, transportation and
distribution networks. If you double the dimensions in a lorry (height, width and length) it will carry eight
times the volume. It still needs just one driver and one tax disk, and the fuel bill will not increase in the
same proportion as the volume. These technical economies can be applied to many aspects of large firms,
and are of course much more significant in industries which involve high-bulk output.
Indivisibilities
Some machines are not worth buying for just a small output. For example arable farms in the American
mid-West can use combine harvesters to the full and they are worth the large-scale investment. The
counter-argument to this is that small firms are often better at working out cooperative schemes, and
resources can be used efficiently if information flows well and markets work efficiently.
Some economies of scale relate to all industries, whether or not they depend on capital equipment.
Bulk buying
Large firms can negotiate good deals on buying raw materials, distribution and marketing. It is often in the
interests of firms to control the distribution outlets, such as car showrooms, or when ‘exclusivity deals’ are
offered to shops. This anticompetitive behaviour can be illegal, but large firms often have so much to gain
in that the legal costs are small in comparison to the potential gains.
Financial economies
In May 2009, Lloyds Banking Group was able to raise £5.6 billion by offering to all its current shareholders
the chance to buy heavily-discounted new shares in a ‘rights issue’. The take-up rate was 87% and investors
effectively gave the large firm, struggling with the debt it had inherited when it bought out HBOS, a cheap
and sizable loan but smaller firms would crumple under the weight of debt that Lloyds had. Many large
firms can enjoy a wider source of finance, and at better rates. Small firms often have no choice other than
to borrow from banks at very high interest – that’s always assuming they can get a loan at all in the current
economic climate.
2. See www.beeautomobiles.com for the clip and more insight.

Managerial economies
Large firms can afford to employ full-time specialist staff, while small firms might have to buy in services,
or make do with a ‘jack-of-all-trades’, or perhaps someone who can just about manage the job but might
not know much about it. For example, I teach in a large school. Because of this I can specialise and only
have to teach economics. In the smaller school where I used to teach, I gave lessons in history, maths, RS,
business studies, politics, drama and even netball. Pity my poor students when they needed a good
referee! I certainly didn’t know the latest developments in the netball rule book, and I confess I hadn’t read
the latest copy of Religion Today to get up to date on current topics. Now that I am a specialist I can be
expected to know what’s going on in my field, and spend my free time pondering the issues that economics
students always get wrong in exams, such as economies of scale.
Marketing
Large firms can spread the costs of using celebrities and clever advertising companies. Once a firm is big it
can stay big at a relatively low cost per unit. Would a small firm ever be able to sell age protection cream
in a market that is now dominated by firms such as Boots’ ‘Perfect and Protect’ which has been developed
with years of expensive research and – according to ‘reliable’ sources – is the ‘only anti-ageing cream that
actually works’?3
Economies of scope
When a firm diversifies, or offers a wider product range, it is said to be diversifying. Trying out new products
can be very risky, and there are often heavy research and promotion costs. But the benefits might be great.
In a large firm it may be possible to take these risks without putting the whole firm in jeopardy, because
other established parts of the business can carry through the firm if things go wrong. So a large firm can
afford to rake risks, offer the consumer more choices, and adapt with the market rather than sticking to its
comfort zone. These are sometimes called ‘risk-bearing’ economies.
Good things don’t last forever

As firms expand they might enjoy economies of scale up to a certain level, and then find the average costs
stop falling as output rises. Once there are specialised staff, or the pantechnicons are carrying as much as
the roads will bear, the benefits of growing larger might be outweighed by some of the costs. These costs
of increasing size in the long run are called diseconomies of scale. These mainly arise because of the
inability of managers and workers to cope with complicated things, and to do with the way we are
motivated. The four main types are:
Managerial defects. As organisations get bigger it is hard to see where costs have risen and whether they
could have been kept down. In 1995 Ryman’s the stationers went into receivership, and would have
disappeared had not it been bought out by a businessman who saw that with drastic cost savings the
business could not only survive but return to trade profitably. Big firms can have pockets of wastefulness.
People are kept in their jobs when many of their functions have become obsolete.
Workers feel unmotivated so they do not work as hard as they would in a small team. They might find
themselves filling their time with things that are not needed, because their only interest is to fill the
hours and not cut costs for the firm.
A hitch in the production has wide-reaching effects. In a large firm with highly specialised staff, things
could go catastrophically wrong if some key person is off sick. For example, if the pay-roll officer takes
ill and no one knows how to cover the job, chaos could follow.
Customers feel alienated by large firms, and costs might need to be increased to improve the levels of
personal communication. This has been a major cost for banks such as NatWest, trying to outface its
competitors by offering customers the opportunity to talk to someone by phone in their own branch in
2003, meaning 1,000 new staff had to be employed.
3. http://www.guardian.co.uk/science/2009/apr/28/boots-protect-perfect-anti-wrinkle-cream, 28 April 2009.

Short run or long run
Throughout this article we have been looking at the long run, that is, when all factors are variable. In other
words, we consider what would be the lowest cost if we can change how big factories are, where they are
based, and who is employed. The long run may be decades, especially when there is need for research,
planning consent, high precision construction and more as in the building of oil platforms. But much of the
analysis in economics considers the short run, when at least one of the factors of production is fixed. For
example, what would be the optimum size of output from a given factory. The shape of the short run cost
curve is governed by the law of diminishing returns, and has been discussed in much detail elsewhere.4
A useful way to put these theories together is by using the following curves, where SRAC1 is a short run
average cost curve in one time period, SRAC2 is another set of costs on a different scale in another time
period. The Long Run Average Cost Curve, LRAC, is the envelope of all SRAC curves. With economies and
diseconomies of scale, the minimum points of the SRAC curves do not all lie on the LRAC.
Figure 1: Short run and long run costs

Average
Cost £
SRAC1
SRAC2 SRAC3
SRAC4
LRAC
0
Q1 Q2 Q3 Q4 Q5 Quantity
External economies and diseconomies of scale

Until now we have considered the benefits or costs to a firm when it itself changes in size. These are
internal economies. Perhaps just as important to a firm’s cost structure are changes in the industry as a
whole, the external economies which arise from the increased size of an industry and external disecono-
mies as it becomes too big. As more firms turn towards producing bio-fuels, new techniques are being
developed in the production and in car technology that will help any one particular bio-fuel producer. As
more independent book retailers put their items on Amazon the choice for the consumer is so much
improved that the independent firm has less marketing to do. If just one estate agent uses the internet to
sell its properties the customer may not be nearly so easy to woo than if all the estate agents offer their
properties online, making comparisons easier and therefore marketing costs to the agents fall. However,
external diseconomies of scale can set in too. For example, too much choice on the internet gives us choice
fatigue and we stop surfing the choices and go back to what we know – that is, heavily-marketed brands.
Too much competition in markets can make firms’ prospects unsure, and they might invest less if they
cannot be sure they will be in existence in the longer term as other firms wade in to absorb profits.
So it seems that many firms are successful and large because of economies of scale, such as Toyota and
Unilever, while others grow too large and become difficult to manage or lose their appeal to consumers,
such as Woolworths. The trend for size depends in a large part on the long run average costs, but not
entirely. There will always be niche markets and other reasons to stay trim, and there is beauty as well as
profit in being small.
4. R. Cole, ‘Why does the supply curve slope upwards’, Economics Today, Vol. 16, No. 1, September 2008. (You can obtain back copies of Economics Today on CD Rom from the
www.economics.ac website.)

1. The theory of perfect competition assumes that all firms have the same access to resources, and
therefore their costs will be the same in the long run. It also assumes that there are many firms, and
no one firm can influence price. Is perfect competition incompatible with the concept of economies
of scale?
2. Can a firm have economies and diseconomies of scale at the same time? Would you have to assume
that some were internal and some external?
3. Why does the LRAC not join together the lowest points on all the SRACs in Figure 1? By taking the
tangential points it is not taking the lowest points. To answer this you might have to consider what
would happen in the short run if output increased from any one point where SRAC and LRAC meet
– would costs fall more quickly in the long run if a different level of output was chosen?
4. If economies of scale are the same concept as increasing returns to scale, but from the viewpoint of
costs rather than output, what is the equivalent short run concept of the law of increasing costs?
5. Economies of scale must be a good thing if they mean that we use less of the world’s resources to
get the same amount of output. But perhaps they mean that firms just produce more and more,
and although prices might fall, the things that are made are not really wanted. The late J.K. Galbraith
discussed this in The Affluent Society back in 1958. You could buy a copy and set up an Economics
society in school to discuss it, if you want something to put on your UCAS application form!
● Economies of scale – falling long run average costs of production as output increases.
● Diseconomies of scale – increasing long run average costs of production as output increases.
● Internal economies or diseconomies of scale – the concept of changing long run average costs
Key Terms
applied within any one firm.
● External economies or diseconomies of scale – the concept of changing long run average costs
applied to a firm within the collection of firms, or industry, changes size.
● Increasing returns to scale – this is the same concept of economies of scale, but looking from
the perspective of getting more output from the same inputs. Thus if you double inputs you get
more than a doubling of output.

Topic 7
Efficiency
Efficiency means that the cost of producing a given output is as low as possible. There are two main types
of efficiency that economists are concerned about – productive and allocative efficiency. It is important to
know whether a firm is efficient for many reasons – if the government is regulating an industry it will want
to know if a firm can cut costs and if so it might set price caps. If potential investors are going to put money
into a firm then they will want to know if costs are being kept to a minimum. And perhaps most significant
are the workers – if they see that the firm is inefficient it might affect their own productivity. Efficiency is
crucial to the customers – higher costs usually mean higher prices, and this will also affect our international
competitiveness and therefore our balance of payments. These issues are best considered by looking at
some examples of firms in the UK today. There are other kinds of efficiency that you might have learnt
about – dynamic and x-inefficiency, and these will be considered at the end.
Productive efficiency
Firms usually want to cut costs, because if this is done while revenues stay the same, profits will increase.
This does not mean that all firms aim to be productively efficient – that is because demand by customers
and competition from other firms are often more important in determining total profits. However, in very
competitive markets firms have to be productively efficient or they will make a loss. The following case
studies show how some firms and industries have been increasing their productive efficiency.
Dyson cuts costs

James Dyson moved the manufacturing part of his vacuum cleaner manufacturing processing from
Malmesbury (a small market town in Wiltshire, UK) to Malaysia in 2002. Costs were much lower there, and
the manufacturing plant was closer to components and to new markets in Japan, Australia and New Zealand.
While the research and innovation still goes on in the UK, the costs are much cheaper per unit in a low wage,
low rent, and low tax environment. Shipping is still a relatively small component of total costs. This is an
example of an effective and now frequently used method of improving productive efficiency – known as
outsourcing. Dyson now employs more people in the UK than before the cost cutting procedure, because
demand has grown. Increased productive efficiency does not necessarily mean cutting jobs!
Tickets
If you buy a ticket to go on an international flight and you request a piece of paper telling you that you
have a right to fly, the chances are that your ticket will be organised from Mumbai in India. Mumbai is
technologically very advanced, and there is a large pool of skilled operatives of the IT equipment required
to produce the ticket. This means that the firms can be much more effective at adjusting prices to get every
seat filled. It is certainly more efficient to run a plane with every seat filled, even if some pay a lot less than
others. When governments start to carbon tax planes per flight rather than per person on the flight, there
will be further incentive to use planes only when every seat is filled.
Airports
British Airports Authority (BAA), the owner of Heathrow, Gatwick and Stansted airports, was reported to
the Competition Commission by the OFT, which ordered the company to sell off Gatwick in 2008; as a
monopoly it was judged to be inefficient. BAA controlled 65% of the national market (in terms of the
percentage of passengers using British airports) and 90% of passengers going via London. But will the firm
be more efficient broken up? Heathrow is by far the most dominant airport in the UK market – and with
its new Terminal 5 (T5) it will always be the most attractive to passengers. Even separated it is unlikely that
Gatwick is able to draw customers from Heathrow. BAA can also subsidise the building of a new runway at

Stansted for which it has permission (Heathrow besides T5 cannot extend before 2015, nor Gatwick before
2019). But what might be a more efficient solution would be to allow landing fees to rise at Heathrow,
rather than capping them as the OFT has done. The consumer would pay more, but paying for what one
wants to buy will be more allocative efficient. The price will reflect some of the external costs that the
private costs fail to take account of – noise and air pollution are at their most extreme around Heathrow.
Shipping ports
A much more competitive market is the shipping ports (The Economist, 26 May 2006). It might seem that
ports are unable to compete directly as ports themselves can’t enter a new market. Unlike airports (heavily
regulated) and roads and railways (heavily subsidised), ports are run by the private sector. One way to
measure the efficiency is to measure productivity – how much output can be gained from a certain amount
of inputs. The cargo handled per square metre of quay space shows that Britain’s ports are the most
efficient in Europe, with Southampton docks handling over 1000 units of cargo per square metre compared
to less than 500 in Le Havre. Competition is one of the best ways to reduce x-inefficiency, the rise in
costs that firms experience when there is no direct competition or the government effectively removes the
competitive forces by offering subsidies. This is discussed at the end of this article.
Allocative efficiency
So far we have considered the concept of productive efficiency, cutting costs per unit of output, ignoring
the demand by the consumer. Now we turn to look at efficiency in terms of what is best to produce as a
whole. It’s no good making millions of an item if no one wants to buy them and they are going to sit unsold
in a warehouse for years. Output must be optimised in accordance to the amount people are prepared to
pay for the last unit produced, a concept we call allocative efficiency.
If goods and services in an economy are distributed so that no one can be made better off without
someone else being worse off, the market system is said to be allocatively (or Pareto) efficient.1 Another
way of explaining allocative efficiency is to say that the cost of producing the last item is exactly equal to
the benefit derived by the person prepared to pay for that unit, or marginal cost equals price. It may appear
to be a fairly abstract concept, but in practice it is clearly a good policy for government: which will make
people better off without any opportunity cost.
Charges for higher education – is it allocatively efficient?

Everybody hates higher taxes when they are personally affected. If you are a smoker you will be angered
by the amount you pay when you consider the prices for tobacco on the continent. If you are a car driver
you are bound to hate congestion charges and road tolls. And almost certainly if you are taking the trouble
to read this you are considering a university career, and you will be angered that tuition fees are over
£3,000 a year, and increasing in line with inflation, before you factor in any living costs.
For some however this is all a question of allocative efficiency. If you don’t charge people for the benefit
they receive then they may abuse the benefit, or just ignore it. When university is free, anyone with the
minimum grades can go and because it is free there may be less incentive to work hard or attend lectures.
After all if it doesn’t cost you anything, why bother? However is it fair that non-graduate workers such as
the postman, who doesn’t get any direct benefit from your university education, should contribute to the
cost of that education though his taxes? This by some is said to be allocatively inefficient – only people
who really want to study should study and they should be prepared to pay the extra cost that that study
incurs. If they pay the cost relative to the amount that they will receive in the long run, no-one loses. In an
allocatively efficient place people only study to the extent that they are prepared to pay, even if any
rewards are many years ahead. If society could become more allocatively efficient then we would see fewer
people failing exams and dropping out of courses. As an economist, therefore, you might reconsider
university tuition fees, seeing them as a way of making sure that the people taking courses really want to
see them through. If people pay fees they will study harder. This is the key to the understanding of
allocative efficiency – you only get what you are prepared to pay for.
1. Vilfredo Pareto, (1909), Manual of Political Economy, English translation by A.S. Schwier, (1971), New York.

Let us now look at efficiency from a firm’s perspective.
Pricing along the demand curve

In Hay on Wye there are 42 bookshops, and many, many more set up for the annual Hay book festival. In
one shop I visited recently there were 15 copies of the same book ranging from £1.95 to £4.95. The price
difference reflected the difference in condition, and a comment on the quality in each of the books was
written on a post-it note inside the front cover of each book. So which book do I choose? If the steps are
large between the prices one might just go for the extremes. But if the steps are very small then one can
gauge how much quality one is prepared to pay for, the extra benefit from paying more is exactly
represented by the amount paid. The prices offered match the amount that people are prepared to pay.
When the price paid matches the amount that consumers are willing to pay the market is said to be
allocatively efficient. In contestable markets, that is one which firms can enter or leave freely, firms will
enter when there is a consumer demand not being met, and firms cannot charge enormous prices because
if they did try to, other firms would enter the market. But on the other hand, if markets are allocatively
efficient the firm can charge exactly what the consumer is prepared to pay, and the consumer surplus will
be zero. In Hay I was pleased to have the chance to choose and not to be exploited. In effect, allocatively
efficient markets are better for both producer and consumer, and welfare is maximised.
Reserved parking
In many school car parks you will see a bollard reserving a parking place for a visitor. If it’s just one-off
maybe you won’t mind, but if empty places are continually being held all day for an evening appointment,
surely you as an economist will be asking if there is a market solution? If markets were left to work
themselves to allocate resources then the result would be that the parking space would be used every
minute of the day, but the ‘law’ that the school can choose who parks there means that the allocation of
resources is very inefficient. Why not take action and ask your school finance officer to make people pay
for parking at your school? It would encourage some people to share lifts, and maybe others would come
by bike. And if you can to pay to book parking you would be more likely to find a place because the
evening visitors won’t be booked out for the whole day. The department might pay out of its budget, with
the result that there would be fewer resources for books and photocopies. But no, you may reply, this isn’t
fair. Only rich people can park, or the people at the top of the wage pile. The way round this is to give
everyone a proportion of parking permits for the term – this could even be done in a way so that the
‘deserving’ get more. If they want to park every day then they will have to buy some tokens – and the
people who would rather have the money could sell their tokens. This way the school isn’t extracting more
money but there will never be parking problems and the lower income people can gain at the cost of the
rich. So socialists can have a market solution too!
Photocopying and paper use

Whenever I give my class some worksheets and they are not photocopied back-to-back I get into trouble
with students for wasting paper. Even better if I can shrink the size of the text, or even better get them to
bring in their textbooks. Does your teacher give you lots of exam papers to practice which you will throw
away when you finish the course? What would happen to the amount of waste if the teacher had to pay
for the costs out of his or her own pocket? Perhaps too drastic a measure – if that were the case my classes
might end up with no worksheets at all! But if the budget of the department was very tightly controlled
and the teacher had to choose between wasteful photocopying (but quick) or more careful copies and
another set of copies another time, the teacher would probably choose the careful option. Here the
market, or at least the use of a careful budgeting process, will mean much more efficient resource allocation.
Waste collection
I know for sure that if I had to pay for every kilo of rubbish in my wheelie bin it would be almost empty
every week. But there often is no real incentive to recycle if there is no return to you, except the ‘feel-good
factor’. In the early days of bottled drinks there was a refund if you returned the bottle. The result was that
there were very few thrown away bottles. I remember picking up discarded bottles to take to a shop to
claim the cash deposit. So it is for all other recyclable rubbish: if we could get a financial return for the
efforts of recycling then we’re more likely to do it. When you save money in the bank you expect to get a

reward, that is, interest payments. Allocative efficiency needs pricing at the cost of doing one more
pollutive action – for example, consider the idea of giving some allowance in their waste permits. Maybe
parents with newborn children should get a little more allowance to ‘finance’ the enormous number of
nappies a newborn works through. Or maybe people in shared housing should be given an allowance for
not being able to access a compost heap? Charging for waste weight will almost certainly increase the
amount of fly-tipping (where people dump their rubbish away from their homes) but this may be a small
cost relative to land-fill of the whole, generally law-abiding population.
Agriculture – dynamic efficiency?

The definition for allocative efficiency is that the price must be equal to the marginal cost – in other words,
the amount that the consumer pays. In very competitive markets, firms are likely to be highly allocatively
efficient in the long run. For example, a producer of sugar beet only grows the beet that he can sell while
still covering his costs. If he plants one more field of it, he might find that the costs rise above the amount
he’d get – maybe the soil is poorer (marginal costs are higher) or he thinks that if there’s too much on the
market he’ll have trouble selling it – that is the price would be depressed. So the farmer makes a decision
based not on what is cheapest alone, but also taking into account the price he’ll get. In a perfectly
competitive market the two coincide – the firm is both productively and allocatively efficient. But clearly
farmers are not allocatively efficient. Farmers’ incomes in the UK have decreased by 60% over the last ten
years. Part of this is explained by the concept of dynamic inefficiency – inefficiency over time. The problem
with agriculture is two-fold: first, prices of commodities are volatile, owing to very low price elasticity of
demand and supply. And secondly, the products are difficult to store, so supply in the short run is almost
perfectly inelastic. If a farmer brings produce to market, he has to sell at the prevailing price, or else take
the goods home and let them rot. So he will sell whatever the price. And if it’s a bad year then next year
he will produce less. In a good year with a high price he will be encouraged to produce more. Output is
determined by what happened last year, and that outcome was determined by very short run decision-
making. There is likely to be inefficiency in the long run as farmers make compound decisions based on
past information. Poor decisions feed though to poor profits, and in the long run a country imports
agricultural products to compensate for its inefficiency.
X-inefficiency
When firms don’t face any clear competition they are likely to become overweight in terms of costs. The
‘flab’ might be seen in the employees who are not adding as much to the business as they take in terms of
wages, or workers who are ‘clock watching’ and let hours drift by without adding to the bottom line that
is the profit. Two clear examples have been Marks and Spencer’s and Sainsbury’s, both of which have made
a recent comeback. Marks and Spencer arguably became complacent with its image in the 1990s of
respectability and fair quality, and was not prepared for the savage competition from low cost suppliers.
Sainsbury’s had become stale and ‘middle aged’, and has needed Jamie Oliver and several other marketing
tricks to renew its youthful image. Competition keeps a firm on its toes, makes it cut costs, and forces it to
adapt – or die.
Efficiency is a powerful concept that makes firms change; the consumer may not react immediately to
inefficiency, but ultimately in the market economy, consumer sovereignty can make firms fit and healthy.
Efficiency is at the heart of economics: it is about using resources to their full. Less input for more output
makes everyone better off in the end.

1. Discuss whether a cost-plus pricing firm is likely to be more efficient than
a profit maximising firm?
a revenue maximising firm?
2. Perfect competition is the only market structure that is productively and allocatively efficient in the
long run. Does this mean it is the best market structure? Should governments aim to make all
industries perfectly competitive? What happens to research and development, investment and risk
taking when a market is fully competitive?
3. Email the financial controller or the chair of governors for your school with some suggestions about
allocative efficiency. Here are some ideas, which I’ve asked the financial controller at my school – if
you get any replies at all I’d be interested to hear at coler@cheltladiescollege.org.
What has been the effect on paper use of charging each teacher and pupil for photocopying
against a personal or departmental budget?

If the school’s rubbish bins were weighed each week and charged accordingly, what would you
take out?
Why don’t we have timer switches on lights in rooms where, for example, lessons never last more
than an hour? Why are computers always left on at school?

When someone is visiting and the host books parking, the parking space is left empty all day if
the visit is an evening one. Would you consider sub-letting that parking space to make some
revenue, on the condition that the person who sublets it gets out by the required time?
4. How can you tell if a firm is allocatively efficient? The textbooks say that price equals the cost of
producing the last unit, P = MC. What signs of this can you see in the world in practice? Do you
think ‘green’ economists prefer productive or allocative efficiency?
5. Perfectly competitive firms are productively and allocatively efficient in the long run. But they
cannot achieve economies of scale, and small firms tend to duplicate the provision of resources. Do
you think perfect competition is quite as perfect as it sounds?
● Productive efficiency – when a firm operates at the lowest average cost. It is the lowest point on
the average cost curve. The amount of inputs relative to outputs is at a minimum.
● Allocative efficiency – when price is equal to the cost of producing the last unit. Or, resources are
allocated efficiently, and no one can be made better off without someone else being worse off.
Key Terms
● X-inefficiency – when there is no competition firms might become complacent and ineffectual in
cutting costs. A bit of wilderness treatment, being out there in the cold winds of competition might
well make them cut costs, take risks, and be innovative.
● Dynamic efficiency – efficiency in the above situations has only been considered in the static
sense – at this point in time, are costs at their lowest. Dynamic efficiency introduces the time
concept, that although a firm might be inefficient in the short run – maybe overspending on costs
– in time this might mean a larger market share and the chance to obtain economies of scale in the
long run.

Topic 8
Buffer stocks
How times change. Five or six years ago everyone was talking about cheap food. Now the big news is high
food prices, and other commodity prices too such as oil and metals. Prices of commodities tend to be very
variable, and especially so for agricultural products. Low prices can be just as damaging to various groups
as high prices are to others. Volatile prices tend to be damaging to exporting and importing countries, and
have implications for growth rates, investment, confidence, currencies as well as the more immediate
problems of poverty and cash crises on balance of payments. On average, primary products account for
about half of developing countries' export earnings, and many derive the bulk of their export earnings
from one or two commodities. There are good economic reasons for intervening to prevent wildly oscillating
prices, as predictability and stability is good for both consumer and producer. One method which has often
been used, for almost as long as economies have existed, is a buffer stock scheme.
Figure 1: Commodity price index, monthly price

250
200
Index Number
150
100
50
0
’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10
Source: http://www.indexmundi.com/commodities/?commodity=commodity-price-index&months=300
What is a buffer stock scheme?

When a train ‘hits the buffers’, it is cushioned from going off the end of the rails, thus avoiding damage to
the train or the passengers. A buffer is a soft landing or a cushioning in some way, and in economics it
refers to the softening of price extremes. For some products, usually storable commodities with very low
price elasticity of demand and/or supply, prices can be very volatile, and this tends to be harmful to
producers and markets as a whole. A buffer stock scheme might be set up to prevent prices from moving
too high or too low.
Buffer stocks are usually organised by a group of suppliers or a government. When prices fall below a
certain level the scheme organisers buy up any further production of the item. They are buying cheap, and
the extra demand means that prices stop falling. When prices rise above a certain level then the scheme
operators sell the stocks. They sell at a high price, increasing supply on the market. Increasing supply stops
prices rising further. In theory they should be in a ‘win-win’ opportunity; buying cheap and selling dear. In
other words the organisers should be able to make money running a buffer stock. The way in which buffer
stock schemes is meant to work is shown in Figure 2.
In the market for sugar, assume that the equilibrium price and output in a normal year is at e, where
demand meets supply (S). Note we assume world supply is a fixed quantity denoted by a vertical supply
curve. Now let’s suppose one year there is a bumper crop and prices are set to fall, as supply increases to
S1 and the equilibrium falls to f. The scheme operators have decided that prices should not fall below P1,

the ‘floor’ intervention price. This may be because prices are below production costs in the long term, or
that speculators will just push the prices down further. So now the scheme operators buy up quantity a to
b which effectively shifts the demand curve to the right to that it intersects the supply curve at b. This is a
new equilibrium point and prices stop falling.
Figure 2: How a buffer stock operates

Price
S2 S S1
P2 c d
Ceiling
a b
P1 Floor price
f
Demand
Quantity
Now in another year when supplies of sugar are poor due to growing conditions there is a new equilibrium
at g. This is above the ‘ceiling’ intervention price and can be damaging to purchasers of the commodities,
and if it is a foodstuff there might be widespread problems if people cannot afford to eat properly. There
can be inflationary pressures across the economy, and export earnings might falter. So the scheme
operators decide to release some of their buffer stocks. The amount is distance c to d on the graph and
prices are now at a new equilibrium of P2 and supply has effectively shifted to the right causing a new
equilibrium at d.
Which markets can use buffer stock schemes?

Buffer stocks come into their own in commodity markets, because prices tend to be very unstable, and
more specifically in commodities which can be stored effectively and at relatively low cost. What are
commodities? Commodities are goods which are fairly uniform, and one producer cannot distinguish the
supply from the supply of another. Examples are copper or milk. Because they are standardised they can
be traded in bulk. They are mostly the output of the primary sector, agriculture or minerals, but also some
partly-manufactured goods which are indistinguishable, such as semi-conductors. There are two main
types of commodities, with one very key distinction – mined products such as metals which can be stored
or warehoused are referred to as ‘hard’ commodities; but agricultural ones, often less easily and cheaply
stored, such as milk, are known as ‘soft’. Buffer stocks tend to be more effective in markets for hard
commodities, because the key idea is that the commodity will be bought up when the prices are low (which
stops prices falling further) and stored until prices rise again when they are sold (which stops prices rising
further). The more perishable the commodity the less likely the buffer stock is to work well, in the sense of
keeping the price within the intended price range.
Why are buffer stock schemes hard to get going?
The need for significant start up capital

The scheme organisers need to buy up the initial stock, warehouse it, and there is the bureaucratic and
administration overhead of running the scheme.
Storage costs, especially if refrigeration is required

Some products for which buffer stock schemes have been tried, such as cocoa beans, have had problems
with limited storage life.

Cooperation between suppliers
Some may refuse to join the scheme, in which case they can undermine the whole working of it. For
example, if the scheme is trying to hold prices high by buying, an outsider can rid itself of any produce
at a high price. By bucking the system it may make more money, so careful negotiation is needed to
make sure that the major producers join in.
The problems involved in setting up a buffer stock scheme are hardly insurmountable, especially if
governments are involved. However, once set up they tend to break down over time, owing to some
intrinsic problems with the operation of buffer stock schemes.
Why do most buffer stock schemes collapse?
When the intervention price is ‘too high’ at the bottom end of the price range
This means that the scheme enters the market too early, has to store too much commodity, and doesn’t
actually prevent any hardship of the producers. Why is it set too high? It is in the interests of suppliers
to get the highest price band possible, and if the scheme is set up by suppliers they tend to bias the
lower price limit upwards.
When the intervention price is too low at the top end of the price range
If the scheme has to sell when prices rise but there are inadequate stocks then the scheme will collapse
and prices will soar. This is likely to happen if there has been a series of poor harvests or yield of
commodities.
Inadequate finance to operate a scheme

If a buffer stock has insufficient funds to purchase a lot of the commodity when supplies are plentiful
then it cannot hope to keep market prices above the floor price. Also critical is how price sensitive is
the buffer stock’s actions in buying supplies. What is the price elasticity of demand? Remember this
aspect is easily overlooked when drawing a simple supply and demand diagram in the abstract. In the
real world price elasticities, both on the demand side and the supply side, are crucial factors in how
market forces work.
Adaptive expectations
If you are a producer and you know that the buffer stock scheme will buy anything you make at a
minimum price then you are likely to produce as much as you can. There is an incentive to produce more
and more, by using more fertilisers and pesticides and giving your crops a lot of attention. The result is
persistent surpluses; the scheme always has to buy and never to sell, so in the end it runs out of money.
Game theory
If you are part of a club that keeps prices high it is going to make you a large profit if you secretly over
produce and sell at the high price. Whatever the penalty for being caught as a cheat it’s unlikely to be as
large as the profits you can make. If everyone does this then production will be bulging out everywhere
and prices will collapse further than if perhaps there had been no organisation at all.
Time frame
The longer it takes for a price shock to revert to norm, the less likely it is that price stabilisation schemes
will be viable. Stocks will either become too abundant or disappear, depending on the type of shock.
International political pressure

Price fixing is not a concept that fits happily in the World Trade Organisation vocabulary. Although the
schemes might prevent small producers from ceasing to exist, there may well be pressure from many
sources to operate a ‘free market’. Buyers of commodities take a dim view of regulated prices and may
try to prevent what they see as a cartel.

Buffer stocks in action
In 2000-2001 the price of sugar was at a low as shown in Figure 3.
Figure 3: World price of sugar, US cents per pound (lb) of raw sugar
22.5
20.0
US cents per pound (lb)
17.5
15.0
12.5
10.0
7.5
5.0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: Reuters Eco Win
In India the Ministry of Food in 2002 decided to create a buffer stock of two million tonnes
of sugar for a period of one year in order to mitigate the hardship of sugarcane growers. For
the last three sugar seasons, the industry had been carrying increasingly large stocks. The
carryover stocks from the 2001-02 sugar seasons were around 10 million tonnes. The
expected production in 2002 was around 17 million tonnes against domestic consumption
of around 18 million tonnes. Export demand for sugar was predicted to be around one
million tonnes. These forecasts meant that stocks of sugar would remain at around eight
million tonnes at the end of 2002.
(This data was found on the Department of Food and Public Distribution, Government of
India webpage in July 2002.)
By 2007 the price of sugar was soaring and the same webpage source explains the state of the sugar
market six years later.
The government in India announced release of three millions tonnes of sugar buffer stock
as from August 2008.
Evaluation – the value of the buffer stock system

Price fluctuations of commodities can have far-reaching and damaging effects on both sellers and buyers.
Left to itself the free market in commodity trading demonstrates significant market failure. For commodities
that can be stored effectively and cost-efficiently the buffer stock system seems to be an ideal solution
being self-financing in that the scheme buys at a low price and sells at a high price. However in practice
most of the schemes that have been set up hit problems, and these are often caused by incorrect setting
of intervention prices, and lack the flexibility to change the intervention prices when there are structural
changes in the demand and supply factors. The alternative appears to be a process of talks, international
agreements and guidelines, which perhaps for many commodities is the best form of stabilisation possible.
The main obstacle to the progress of the talks tends to be the existence of subsidies, trade protection deals
and trade blocs.

1. Buffer stocks often seem to work for a while and then collapse, leaving a more volatile situation
than at the start. Does this mean that they should never be used?
2. Unlike many other attempts to remove market failure, buffer stock schemes are usually organised
by producers not governments. Why do you think this is so? Do you think the government should
step in when things go wrong, as they usually do?

3. Why are price elasticities of supply and demand relevant to the operation of a buffer stock scheme?
4. Has the sugar buffer stock scheme in India been a success? What further information would you
want before making a final judgement on its operation?
5. Do you agree that buffer stocks are a way to protect incomes of the often poor individual producers
of commodities faced with the powerful and sometimes exploitative power of large buyers in the
rich countries?
6. Can you describe what has happened to world food prices in your own words, using Figure 1?
7. Some textbooks just give one intervention price for buffer stocks rather than both the ceiling and
floor version as in this article. It makes the diagram easier to understand but the logic for making a
profit disappears. Why is this?
● Buffer stock – a store of a commodity which is used to keep prices stable. It can be sold as prices
start to rise, preventing further price rises. The stock is bought at low prices, which prevents further
price falls.
● Intervention price – the level at which the operators of the buffer stock scheme agree to enter
trading in the market with a floor and ceiling price.
● Hard commodity – a product which can be stored, such as oil or coal, and has usually been mined.
These commodities are easy to store and therefore a buffer stock system is feasible.
Key Terms
● Soft commodity – an agricultural commodity such as cocoa or coffee.
● Commodity – something which in supply has very low quality differences. There must be some
demand, but the demand does not distinguish between suppliers. Supply is often produced on a
large scale.
● Commodity market – where buyers and sellers of commodities trade. Because commodities are
fairly uniform there does not need to be inspection of the produce, and therefore trade is efficient,
large scale and often very sensitive to market changes. Commodity market prices are considered to
be a ‘leading’ or advance indicator of changes that are going to happen in the economy as a whole.
● Price volatility – the free market price tends to go up and down sharply, quickly, and over a wide
range. Primary products are the most susceptible to price volatility, owing to low levels of price
elasticity of demand and supply. Cobweb analysis helps explain price volatility.

Topic 9
What’s so bad about inflation?
Or, ‘Everything costs so much these days”
Ask your parents or your grandparents how much a Mars Bar used to cost when they were young. 2p? 10p?
Compare it to the price today: the product is the same – or maybe even a little smaller – but the price in
pence is so much more. Now ask yourself whether the Mars Bar is really more expensive in terms of what
you are prepared to give up to get it. Does it feel more costly? The answer is that because everybody earns
a lot more and that all prices have gone up (on average) the real effect is very small or even unnoticeable.
Real values take into account the effects of inflation and the adjustment must be made before we can
make any observations about changes in an economy. That 2p that your grandma used to pay for her Mars
Bar would have been the same proportion of her pocket money as the current price is to you. And so long
as prices and incomes (and stored up income, that is, wealth) stay in line with each other, then inflation
does not seem to be a problem. First find out how much inflation there is, then accommodate to it. Thus,
some would argue, it is best to know what inflation is, and what causes it, and then live with it. Most would
say that high rates of inflation must be fought, but disagree about the degree to which it can be ignored.
For the lower your tolerance of inflation, the more you have to give up of other things in the economy,
such as jobs and cheap loans. The questions about inflation are: 1. How can we look at economics without
the distorting effect of inflation; 2. Why does inflation happen; 3. Does inflation matter; and 4. How low
should inflation be?
Adjusting for inflation

So how do we measure inflation? The consumer price index (CPI) is a figure constructed by civil servants
making price surveys across the country of a selection of 600 goods and services that are deemed to be in
an average family's expenditure pattern: the so-called 'basket of goods'. The data is collected every month
and then the price changes are weighted according to how much people spend on these items as a
proportion of their income – which involves another survey, of 7,000 households, called the family
expenditure survey. Say for example the average family spends 10% of their income on food and 90% on
everything else. Let’s say that food goes down in price by 10% and everything goes up in price by 10%.
Do these balance each other out? The answer is 'no' – and here is how to calculate what would happen to
the CPI:
% change % income spent (weight)
Food -10 x 10 = -100
Everything else +10 x 90 = +900
Total 100 +800
Here we have multiplied the percentage change in price by the weight (which is the percentage spent) and
then added the results together (+800). This is then divided by the sum of the weights (which in this case
is 100) to take out the increase in values that the weights have given and you are left with an 8% increase
in the CPI. As long as the 'basket of goods' represents the goods that people really do buy and the family
expenditure surveys are representative, this should give a good indication of the impact of price changes
to the economy as a whole. Inflation defined as an increase in the cost of living, or an increase in the
average price level, is the percentage increase in the CPI.
The CPI does not give a very good indication for any one person and there are many problems with the
figures. For example, an increase in price often represents an increase in quality especially in high-tech
products and quality changes cannot be registered in this method of calculating inflation. Different
countries use differing measures and it is therefore unreliable for international comparison. Many analysts
prefer to use the RPIX which excludes factor 'X' (the changes in mortgage interest repayments). There is a

cunning reason behind this. The Monetary Policy Committee (MPC) uses interest rates to try to control
inflation. If interest rates are raised, the mortgage interest rate will almost certainly follow. Mortgage
interest rates are a major component of the cost of living. So an increase in the interest rate will increase
any measure such as the old Retail Price Index (RPI). Raising interest rates does tackle the causes of
inflation but it makes it appear higher. It is therefore helpful to have an inflation indicator that does not
rise when interest rates are raised. Because the policy makers do not want to be seen to be stumbling at
the first hurdle, the CPI is targeted by the MPC and thought of as the underlying rate of inflation.
Sometimes RPIY is preferred by policy makers in that it excludes the effect of changes in taxation of goods
and services. This core rate of inflation similarly removes a policy change which may be intended to tackle
the causes of inflation.
We can use our final estimate of inflation – despite all its inadequacies – to correct nominal or current
values in economic data. The simplest way to do this, when looking at a percentage increase, is to subtract
the percentage increase in the CPI to give the real increase. For example, if the economy has grown by 10%
and the CPI has gone up by 3%, then the real growth is 7%.
So this leads us on to ask:
What causes inflation?

According to John Maynard Keynes, there are two types of inflation: 1. Demand-pull inflation; 2. Cost-push
inflation.
1. In the latter part of the 1980s – in particular 1987/88 – consumer confidence was high. It was very easy
to borrow money and the Conservative chancellor Nigel Lawson was intent on cutting taxes. The effect was
that total demand for goods and services increased more quickly than the supply of them and the inevitable
consequence was a rise in prices. For example, in the housing market there was a limited supply of houses.
New houses cannot be built very quickly (for reasons of planning and building) and because housing is
such an important part of people's well-being they are prepared to pay more for their houses when they
have more money. During the 'Lawson boom' people felt very wealthy and so were prepared to spend more
and house prices were bid upwards as buyers competed against each other for the scarce resource. The
more difficult it is to increase supply in general – which economists refer to as an inelastic aggregate
supply curve – the more likely that an increase in demand will hit prices rather than total production in
an economy.
2. Prices may rise because the costs of production in general may have risen. For an open economy such
as the UK which imports 40% of everything that we buy in the shops, the most critical factor might be a
depreciation in the value of the pound. If the pound cannot buy as many euros as it has done in the past,
then we will need more pounds to buy products from the rest of the EU (excepting Denmark and Sweden,
of course). So, there would be a general rise in prices of imported products and it is true for any country
that a devaluation of the currency will cause inflation. Other reasons why firms find their costs in general
are increasing may be a higher national minimum wage, an increase in the price of oil, or an increase in VAT.
Because these affect all firms, we say that there is a shift in aggregate supply, and firms will be willing to
raise prices knowing that they will not lose customers to other suppliers. It can lead to a vicious circle –
known as a wage-price spiral: when costs of production go up, firms have to increase their prices,
workers then insist on higher wages in order to maintain living standards, and the consequent wage
increases are another cost increase for the firm which then has to raise prices again.
To conclude: inflation is caused either because buyers are out-bidding each other forcing prices up, or
because costs of production have increased. There is another view that inflation is directly related to the
amount of money in the economy: the more money there is, the higher the prices will be if the amount of
goods and services remain the same. This monetarist view was popular in the 1980s and many
governments still target the growth in money supply – although this is not currently seen as an indicator
independent of the interest rate. Too much money chasing too few goods does seem a plausible explanation
but it is not clear whether it is the money increases causing the inflation or the inflation causing the money
increases.

To control inflation, then, we need to know the cause. If it is demand-pull, we can cut demand by fiscal
policy (increase tax and cut spending), or monetary policy (cut interest rates). If it is cost-push inflation,
we could cut taxes, increase the exchange rate (which makes imports cheaper), or be tough on wage
demands. Supply-side policies will have the effect of keeping down cost-push inflation through
programmes such as re-training, privatisation and deregulation. Monetary inflation is also controlled by
cutting interest rates although the most direct solution might be for governments in some economies to
stop printing new money!
Does inflation matter?

Almost everyone agrees that double-digit inflation is destabilising to an economy and therefore bad for
economic growth. It causes problems with the balance of payments, inward investment, and exchange rate
values. It may be a sign that the economy is overheating and therefore about to ‘boil over’. There may be
very little saving in the economy as the real value of money is eroded, and as people spend more the
demand pressures increase even further. Modern governments stand or fall by their record on inflation.
The most classic case of inflation spiralling out of control was Germany in 1923 when hyper-inflation
meant that the currency ceased to operate as money. There are many countries today with rates of 10%,
100% or even 1000% and in these cases inflation is certainly public enemy number one.
But what about if inflation is at a predictable, reasonable rate? Say it was 8%. Would this matter? Let's
assume that everyone's incomes rise in line with this predictable rate of inflation. Interest rates take this
inflation into account and are higher than 8% so that in real terms they are still positive. Pensions and
other transfer payments – payments for which there is no corresponding production – are all adjusted in
line with this inflation. In other words they are index-linked – in real terms, no one is any worse or better
off.
Even so, 8% inflation could be damaging to the economy. Reasons for this are:
Loss of competitiveness. The most obvious way is that the economy will become internationally
uncompetitive if we are assuming that other countries do not have inflation or have inflation at a lower
rate. Exports will become relatively expensive and imports will become relatively cheap; balance of trade
will deteriorate, and solving this problem might be painful.
Breakdown of the price mechanism. Prices act as signals to allocate resources. If prices go up, supply will
expand and demand will contract until a new equilibrium is reached. When the schools are off, prices for
holidays are much higher than at other times. The higher prices induce more holidays to be offered and
choke off the surplus demand. So the higher prices act as a signal to producers to increase production in
areas which are more profitable. However, if there is inflation, a higher price will not mean more profit.
An 8% increase in prices will be accompanied by an 8% increase in costs and the profit in real terms will
be the same. Suppliers should not therefore increase their supply and inflation can therefore be
misleading.
Menu and shoe-leather costs. A third reason why persistent inflation is thought to be harmful is the
constant need to change the prices of goods and services known as menu costs. An example of these
is the physical requirement to change the slot size in coin-operated machines such as telephones or
parking meters. Similarly, there is the need to hold less cash – because cash by its nature will be losing
value if held and therefore the consumer will have to go to the cash dispenser more often in order to hold
smaller amounts of money. This is known – in economists' approximation to humour – as shoe-leather
costs. Given that today many prices are bar-coded and menus can be reproduced very cheaply thanks
to the advances of technology and that cash payment is incredibly outmoded, these can hardly be said
to be significant worries for a policy maker.
Instability. While there is no reason why 8% inflation should be more unstable than 2%, in practice
higher rates discourage investment – the real value of the profits will be much smaller – and nominal
interest rates (including inflation) will seem painfully high.

“How low is low enough?”1
Everything costs more these days and so long as everybody's income goes up in line with these cost
increases then nobody is worse off. Even pensioners have their state payments adjusted in line with
inflation which in the year 2000 gave them what many regarded as a paltry 75p rise in their weekly benefit.
In fact, because inflation was so low, people felt that a rise in line with the retail price index was not
enough. Certainly, it meant that pensioners did not get a real rise; but neither did they get a real fall in the
value of their pension. Psychologically, most of us seem to like a little inflation in our incomes at least. In
the Con-Lib emergency budget of June 2010 one of the first actions was to restore the link between
pensions and average earnings.
The inflation target set indicates a reluctance to let inflation fall too far. The MPC is required to achieve
neither more nor less than 2.0%. The understanding by the Labour government is that rates below 2.0%
can be damaging to other areas of the economy, e.g. jobs and investment, and that a small amount of
inflation is actually healthy. Here are some reasons why:
Differentials. Nobody likes to have a pay cut; it is easier to give someone a pay increase below the rate
of inflation and thereby decrease the wage in real terms. This does imply a certain naivety of wage
earners, but there is an undoubted psychological effect in seeing one's wages decrease.
Unemployment. Some people believe that there is a trade-off between unemployment and inflation as
shown in the Phillips Curve. This means that if inflation is hammered so hard it approaches zero there
must be corresponding increases in unemployment. Let's say that the inflation is caused by too much
spending. The government increases taxes on workers who then spend less; firms therefore cut back on
workers because they cannot sell everything they are making. Alternatively, the MPC might raise interest
rates to remove inflation and this will cause a fall in investment by firms and spending by consumers
which comprises a fall in aggregate demand.
Sustainable rate. If the economy is growing at a sustainable rate – meaning that the productivity is
growing in line with the actual output – then a certain amount of inflation can be tolerated. If there are
more goods and services, then more money can chase them without any harmful effects.
So what's wrong with higher than 2.0%? Most governments fear higher rates of inflation because it feeds
upon itself. As rates rise there is no evidence that unemployment falls. Indeed, the uncertainty that
inflation creates is more likely to lead to higher unemployment. Many now argue that the most effective
model is to have a low inflation economy, and based on this all other objectives can be achieved including
low unemployment. This would explain the lowest rates of unemployment and inflation for 30 years that
the UK had enjoyed until the 2007 economic disaster struck. This is not denying that there might be a
short-run trade off between the two, but simply argues that low inflation is the sign of good health, and a
healthy economy grows quickly.
2.0% is the target that has been chosen by the government and is the job of the MPC to achieve. It is in
fact the only actual economic target of the government. It is a mark of the economic philosophy of current
politics that a figure below 2.0% is of concern as well as a figure above that.
At the current time there are world-wide fears of deflation, commonly understood to be negative inflation
(falling prices), and the problems of this can be as great as those of inflation. Debts become larger in real
terms, and unemployment rises as people cut back on their spending. Japan has been experiencing the
problem for two decades and many other countries are proving to be vulnerable today. The theory used to
be that, to avoid recession, interest rates may need to be cut, although this medicine has not been effective
in Japan where rates have been nearly zero. Inflation below 2.0% gives an early signal that there is a need
to expand the economy before getting anywhere to the perils of deflation, a case of ‘fiscal stimulus’ or
‘Keynesian economics’ which suddenly became popular in 2008 as many countries stood on the brink of
bankruptcy.
1. Economist, 7 November 1992, p. 21.

1. Do you think housing costs should be included in the standard measure of inflation? Do you still
Questions for Discussion think this when you consider that pay awards are based on this measure? What are the problems
with including them?
2. What is so bad about deflation? Is it worse than inflation? Is unemployment related to deflation?
3. Why do you think 2% is the target for inflation? Do you think it will get raised as it is becoming
increasingly difficult to reach it?
4. Do you think the amount of money (notes and bank deposits) in the economy has anything to do
with inflation? This is a loaded question!
5. Who is hurt most by high rates of inflation? And who is hurt most by policies used to bring inflation
down?
● Inflation – a general and sustained rise in prices.
● Deflation – a general and sustained fall in prices, or a policy of reducing demand in an economy
as a means to reduce inflation.
● Real values – values with the effects of inflation removed.
● Consumer price index – the main tool used in the UK to measure the average price level. Increases
in this index are known as consumer price inflation.
Key Terms
● Retail price index – a measure of average prices in the UK, including the effects of mortgage
interest repayments, a significant component of the expenditure of 10 million households in the UK.
● Aggregate demand – the amount that will be spent in total at various price levels in an economy.
● Aggregate supply – the amount that firms are willing to supply at various price levels in an
economy.
● Wage-price spiral – the impact that increased wages has on prices which can further increase
wage pressures and therefore price pressures, ad infinitum.
● The monetarist view – changing money variables directly affects other monetary variables. For
example, the more money there is, the higher the prices will be if the amount of goods and services
remain the same.

Topic 10
The savings ratio
One of the main reasons why the UK economy was so vulnerable to the 2008 credit crisis is that its
households had a very low savings ratio in the ‘noughties’ decade. For people in the UK and other rich
nations there has been a ‘trend to spend’, so when the crunch came, households were over-exposed
financially. In this article we are going to look at the impact of growth rates on the savings ratio and vice
versa, examine the size of the savings ratio over time, the multiplier, and how the current state of savings
ratios will affect you. The aim is to consider how these two macroeconomic variables, consumption and
saving, underlie much economic theory, without becoming wrapped up in Keynesian theories.
Consumption is a measure of current expenditure on goods and services. Saving is a measure of how
much is put aside for possible future expenditure on goods and services. The amount you spend relative to
how much you earn will vary at different stages in your life, and also in line with your confidence in the
economy. It will also depend on whether you think you’ll earn more or less money in the future and how
you think your career will progress. In the UK, household saving is clearly anti-cyclical – meaning that if
the economy is booming the percentage we save goes down. This doesn’t mean that the total amount we
save falls, but that as a percentage we spend more and save less. In a recession people start saving, which
helps restore balance in an economy that has been over-exposed to risk. But it is bad news if, like the
government, you want to see sales rising and the recovery get under way. But if households stop spending
too quickly this will cause other major problems in the economy. Spending keeps businesses in profit, and
therefore workers in their jobs. So there is a fine line between too high and too low a level of savings for
every economy, and this varies for different stages of the economic cycle.
Figure 1: Household savings ratio, UK

14
Percentage of disposable income that is saved
12
10
-2
’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09
1.5
GDP growth, quarter on previous quarter, %
1.0
0.5
-0.5
-1.0
Six successive
falls in GDP
-1.5
-2.0
-2.5
’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09
Source: www.statistics.gov.uk

Figure 1 shows the UK savings ratio aligned with changes in GDP, that is, growth. There was continuous
economic growth from the third quarter of 1993 until the second quarter of 2008, the longest period of
growth on record in the UK. In the same period the savings ratio just fell and fell, despite there being more
money available. What happened was that as our income grew so did our spending habits and choices. This
is seen in Figure 2, showing that although income rises, savings do not rise as quickly.
High household debt made the economy unstable and although interest rates were very low after 2008,
insulating the problems of high debt repayments, problems occur when rates rise. As consumers we wanted
to ‘have it all now’, ‘jam today’ rather than wait for jam tomorrow. The supply of credit was also too loose.
Over exposure to easy credit caused a ‘bubble’ in house prices and other assets, with banks too keen to
lend to customers some of whom turned out to be unable to pay back in full. Over-indebtedness was a
problem in much of the Western world during the prosperous times, and over-exposure to bad debts
triggered by falls in house prices was the primary cause of the 2008 credit crisis.
It is not the same in every country. In China for example the savings ratio rose even further as the boom
went on, as is clear in Figure 3.
Figure 2: Average savings and income per head, UK pounds sterling

85 1400
Average saved per head (lhs)
Mean income (rhs)
82 1450
79 1300
76 1250
73 1200
70 1150
2005 2006 2007 2008 2009
Source: www.nsandi.com
Figure 3: China’s savings ratio in 1992-2007 (%)

60
49.9
50 47.9
46.1 47.5
42.1
39.1 38.4 39.3
40 37.8 37.2 37.7 37.8 36.6 36.9 37.7
36.0
30
20
10
0
’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07
Source: http://docs.google.com/viewer?a=v&q=cache:NYzVzgj02gYJ:www.bnm.gov.my/files/publication/conf/hilec2009/01_
slides_zhou.pdf+statistics+savings+ratio+world&hl=en&gl=uk&sig=AHIEtbSNxYMbeSzH3rMdZnYOeva7_6z5QQ&pli=1
Why do Asian nations save more, on average, as the economy grows? One factor is a culturally cautious
outlook on life. Another is that as savings rise so do the benefits of saving, which in turn can fuel future
growth. Chinese people may have a longer view in their consumption requirements. China uses its savings
to buy much of the US debts (47% of GDP or over $7 trillion), putting China on a strong footing in
international negotiations on trade. And for China, exports are the main source of growth. In January 2010
it became the world’s biggest exporter by value. So although in the short term savings might dampen

demand, there is much to suggest that higher savings make an economy grow. The savings ratio is thought
to be too high in China with the government trying to get people to save less not more.1 By contrast, in
the West, a savings gap triggers many problems that in the long run will damage the economy, not just
imbalances on the macro level, but microeconomic problems such as poverty and being forced to leave
your home because you cannot keep up with mortgage payments.
Financial literacy
Perhaps one of the main reasons why people over-spend is that many are not financially literate. Companies
selling the finance might be said to have asymmetric information because they know more about what
they are selling than the buyer. We quite easily fall for what seems like cheap monthly payments not
realising what they add up to, and we quickly make assumptions. How many times have you fallen for the
slogan ‘0% finance’ or ‘pay nothing for six months’? Try the following question from a debt literacy quiz
conducted across the world in 2009.2
You owe £3,000 on your credit card. You pay a minimum payment of £30 each month. At an Annual
Percentage Rate of 12% (1% a month), how many years would it take to eliminate you credit card debt if
you made no additional new charges? (The answer is in the footnote)
• Less than 5 years?
• Between 5 and 10 years?
• Between 10 and 15 years?
• Never?
• Don’t know?
And here’s another one to try:
If interest rates are 20% how many years will it take to double a £100 debt? The answer is 3 years and ten
months (almost)3 but most people think it’s a lot longer.4
Figure 4: How long to double debt at 20%?

40%
35%
Percentage of people surveyed
Grossly underestimate compounding
30%
25%
20%
15%
10%
5%
0%
< 2 years < 5 years 5-10 years > 10 years Don’t Refuse
(correct) (widely know
wrong)
Some theory basics

If there were no government and no foreign trade then we either consume (C) or save (S) all our income
(Y), so Y = C + S. This is from the consumer’s point of view. From the firm’s perspective, all income is either
1. BBC World Service programme ‘Saving China’ 3 September, 2009. The programme is available to listen at: http://www.bbc.co.uk/worldservice/documentaries/2009/09/
090903_assignment_030909.shtml.
2. http://www.oecd.org/dataoecd/53/48/32023442.pdf. The correct answer is ‘never’. What is really scary, though, is that although 35% got the answer correct, one in five
admitted that they had no idea.
3. The formula is premium times interest rate to the power of the number of years (x). So it’s 100 x 1.2x then take logs of both sides so x log 1.2 = log 2, and divide both sides
by log 1.2. X is 3.801.
4. http://www.oecd.org/dataoecd/34/9/44280581.pdf OECD conference Brazil December 2009, result of independent research by phone of 1000 adults in 80 countries.

used on paying to produce goods and services, or for investment in capital goods so that goods and
services can be produced in the future. So for a firm, Y = C + I, with I meaning investment, the increase in
capital stock. It’s not a great mathematical mystery revealed to say that if Y = C + S and Y = C + I, then, by
definition, I and S must be equivalent. In other words people save the same amount that firms invest,
which is an amazing observation if it means that more saving means that firms invest more. Actually, this
causal relationship does not follow. Nor does it mean that more investment will mean that it will make
people want to save more. What it does mean is that there is a proportion of income that is not spent, and
this will have a major impact on the amount of activity or consumption in the economy.
Impact of savings on growth

If people save more then firms cannot sell everything they intended to sell, leaving unsold stock that
appears on their accounts as investment. The next year they will produce less (because there are unsold
stocks) so there will be less money in the circular flow of income. A rise in savings slows down consump-
tion so in the short run it makes the economy look worse off in GDP. Our tendency to spend or save
explains the multiplier effect, and the higher the saving the lower the multiplier. But a low multiplier can
be a good thing. A large multiplier makes injections have a greater boost on the economy, but in reverse a
large multiplier can throw an economy into recession. A small multiplier means that growth is on a steadier
course, and the higher levels of savings keeps consumers more confident, and firms less volatile. It means
capital markets are less volatile, and there is less cause for alarm concerning pensions.
Savings and the multiplier

Savings are a leakage out of the circular flow of income. The more we save, the less money will be spent,
earned and re-spent in the economy, and the multiplier effect is smaller. The lower the marginal propensity
to consume, the lower the multiplier.
When you consider the size of the multiplier you will earn evaluation marks in your economics exam, so it
is good to consider factors such as savings when considering the full impact on any shift in aggregate
demand on the price level and real output. You may also argue that changes in total spending cannot be
affected by changes in aggregate demand (if the aggregate supply is vertical) so the impact of changes in
injections will only impact upon the price level.
In the UK household consumption is 65% of GDP, meaning that consumption is a highly significant part of
total demand. Discussing the importance of consumption to the UK economy, for example with the
contrast of 36% of China’s GDP, is another way to earn evaluation marks.5
Savings and pensions

In your grandparents’ generation, pensions were something to look forward to. Many workers had their
income linked to their final salaries, meaning that for the rest of their lives they could earn a good
percentage of the amount they got in their last few years of work, linked to average incomes, so that it
would not fall in real terms. This is no longer true: 90% of final salary schemes are closed to new members,
and many workers are no longer guaranteed income after they retire. Since 1980 pensions have been
linked only to the price level, not to average incomes, so with accelerating incomes the gap between wages
and pensions grows ever larger, although this was reversed in the June 2010 budget. Two-thirds of workers
under the age of 30 have no pension at all. In many UK and US firms, the pensions deficit is causing many
problems, for example in some car manufacturing plants where the pension bill is already up to 25% of the
wage bill. The cost attributed to pensions in a new GM car is $1,120 (2006 figures).6 Today we need to save
if we want to be guaranteed a good income when we retire, and living on the state pension alone (£95 a
week) would leave you below the poverty line (£115 in 2008). According to research by the government’s
5. http://www.mckinsey.com/mgi/mginews/unleashing_ chinese_consumer.asp.
6. http://www.bloomberg.com/apps/news?pid=20601101 &sid=agvBuODXiKKs.

National Savings and Investments, more than half of the UK population (53%) do not save any extra
money a month, and of the rest, 90% have an average total savings of just above £7,000.7
Figure 5: How much is a state pension worth?

30
1980 – Link between pensions and earnings cut
25
% of average earnings
20
15
10
0
’78 ’80 ’82 ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08
Source: DWP
Consumption may fuel growth, but savings prevent us from long-term poverty. In the short term macro-
economists may like everyone to spend as much as possible to keep national income up, which will bring
short term benefits to income and wealth. Savings bring longer term prosperity to a country, but if they
grow too large they stifle the growth in the economy, reducing the size of the multiplier. The imbalances
caused by increased household debt have been highlighted as one other main cause of the credit crisis,
and this must be addressed if the future is going to avoid ‘the boom and bust’ extremes. One solution is
to start raising interest rates, which might slow the pace of the recovery but will stop households from
taking out even more debt. Household debt is becoming the trendy credit crisis now the banking system’s
credit crisis moves into history.
1. When household debt grows too large and there is a sudden cut in consumption, the effects can be
made less damaging to the economy by a cut in the interest rates by the MPC. Why do you think
interest rates were kept high in the 1990s in the Netherlands despite the sharp rise in household
debt? Remember that the Netherlands is part of the Euro area.

2. Why are savings anti-cyclical against economic growth in the West and not so in Asia? What do you
think the pattern is in Latin America?
3. Why might fixed-rate mortgages make unreliable the prediction of the effect of interest rate
changes on consumption?
4. In 2018 the pension age will phase in changes from 60 to 66 for women by April 2020. This is quite
a large jump, and will affect women currently under 46. What effect will this have on the supply of
labour and average real wages? Do you think younger people will lose out on jobs to people who
stay in work longer as they grow older? What will happen to the quality of labour as the length of
the working life increases? Remember that many of your examiners are over 50 before you come to
sweeping conclusions!
7. http://www.nsandi.com/pdf/QSS_Autumn09.pdf.

● Savings – the amount of current income put aside for future expenditure on goods and services.
● Savings gap – the difference between actual savings and the amount of savings needed for wealth
to grow in line with incomes, estimated to be between £16.5bn and £66bn according to NIESR:
http://ner.sagepub.com/cgi/content/abstract/191/1/79.
● Saving ratio – how much we save on average out of income.
● Marginal propensity to consume – the amount of any extra income that is spent on goods and
services.
Key Terms
● Marginal propensity to save – the amount of any extra income that is put aside for future
purchases of goods and services.
● The multiplier – the magnified effects on income as money that is earned is re-spent in the
economy repeatedly through consumption within the economy.
● Anti-cyclical – when a variable moves inversely with the economic cycle. Savings as a ratio go up
when growth falls in western economies.
● Pension – a tax efficient source of post-retirement income, part of which the government provides
to people who have worked in the UK.
● Pension gap – the difference between actual pension outcomes and the amount of pensions
needed for post-retirement income to grow in line with incomes of people currently in work.

Topic 11
What is the economic meaning of investment?
Economics is really a study of everyday life using common sense. Most people can have a good go at the
subject if they like thinking and keep up with the news. However there is one topic which the non-student
will get wrong every time, and sad to say, many A-level students get wrong too. Find someone who doesn’t
know much Economics and ask them this question:
“What happens to investment when the interest rate falls?”
I tried it on two non-students today at lunch and they both thought that investment would fall. The logic
in both cases went something like this:
If interest is the amount you get on your investment, then if interest rates go down you get
less for your investment, so people don’t want to invest so much.
This is completely the wrong answer. If interest rates fall, that is, the cost of borrowing money falls, then
people are more likely to invest because investment is an increase in the capital stock, an action which
either involves borrowing money or not spending money on something else (in which case the opportunity
cost is the money that would be gained if the money were saved). Investment can also be defined as an
increase in human capital, where resources are used to increase the skills and abilities of the current or
future workforce. You taking time to read this is an investment.
Not the same as saving

Saving means that money is taken out of the circular flow of income and spending in the economy. If the
savings ratio goes up then people are being more cautious and not spending as much as usual. So some
money is put aside for another time. True, much of this money will get back into the economy as investment,
if the money is saved in the bank and the banking system then lends the money to a firm which increases
its capital stock, for example by buying a new machine. But the process of saving in itself slows the
economy down, and this fall in spending is made even more effective thanks to the multiplier effect. The
multiplier is the knock-on effect on spending when there is a change in any injections such as investment,
or leakages such as saving. It occurs because spending becomes other people’s income, which is then spent
and becomes income and so on. So a change in saving or investment will have a larger effect on the
national income than the initial change. Saving will decrease it, other things being equal, and investment
will increase it. If interest rates fall as they have recently in the UK, we would expect savings to fall and
investment to rise.
Jam tomorrow
Investment is generally seen to be a good thing in an economy. Likened to ‘jam tomorrow’, investment has
the promise of good things to come in the future, paid for by cutting back today.1 Investment brings good
things (jam) in the future because it means that the economy will be able to produce more output from the
same amount of inputs. We show this by shifting out the Production Possibility Frontier. It means that
the economy can make more of everything in the long run, when the economy can produce more without
anyone being made worse off.
1. The phrase ‘jam tomorrow’ is borrowed from Lewis Carroll’s Through the Looking Glass, written long ago in 1871, in which the White Queen offers Alice ‘jam tomorrow’ which
never comes because it’s always today. However, unlike the White Queen’s offer, the phrase is now taken to mean the promise of good times ahead in return for a little austerity
in the meantime.

The relationship between interest rates and the level of investment
If the monetary authorities such as the Monetary Policy Committee of the Bank of England (MPC) and the
Federal Reserve (Fed) in the US cut interest rates then they are trying to encourage people to spend more
and businesses to invest more.
Imagine you are a money-lending firm with a large stash of money that you do not need for a while. There
are two things you could do with it: put it in the money markets by buying financial assets such as bonds,
or put it into businesses by lending it to firms so that they can expand. The latter is investment as we
understand it, and it will increase if there are not many profitable opportunities in the bond market. The
process is as follows:
When interest rates fall then people with money to invest won’t be able to find so many good opportunities
in the money markets, so they are likely to consider investment in businesses. True this might be risky, but
there’s a cushion of interest to account for this. So as interest rates fall, investment options which had
seemed not really worth the risk now become competitive, and more money will be available for investment.
Of course this is not always true – not everything in a study of everyday life is always going to be true. In
the recent credit crunch in the money markets, there has been little money available for any investment
despite the fact that the MPC and the Fed have cut rates.
So investment depends on interest rates, not just in the domestic economy but worldwide. It also depends
on levels of spending and saving, confidence levels, and expectations of macroeconomic indicators such as
national income and unemployment. But this is really only considering domestic investment. There is
another whole area of economics concerned with investment, and this involves the movement of funds
between countries. The first type, Foreign Direct Investment (FDI), is investment in the sense of
increasing capital stock as discussed so far. The second type is just speculative flows of money (hot
money), but the effect on the economy can look a lot like investment and distort the effects we would
otherwise expect when there are changes in the money markets.
Investment abroad: FDI and hot money

There are two main types of international investment, and both have a different response when interest
rates change. The key thing is not to blur the two, since a cut in interest rates can make FDI rise but hot
money decrease.
Foreign Direct Investment is the international movement of funds that occurs when multinational firms
decide to increase capital stock in another country or purchase a company in another country. You should
never make a bold assumption about what will happen to FDI when interest rates change. There are strong
cases on both sides of the argument here.
If interest rates fall in the UK this might attract some FDI, the main reason being that a fall in interest rates
tends to make the currency fall in value, and therefore it will be cheaper for companies abroad to invest in
the UK. Also with a lower exchange rate, FDI might increase because it will make the price of any exported
goods cheaper – important in an EU context for example. There are other reasons why a fall in interest rates
might increase FDI: it might be that the foreign firm will want to use UK capital markets to obtain pounds,
and in this case borrowing will be cheaper. The cut in rates is a sign that aggregate demand is about to
increase, so a firm looking to increase sales in the UK will find it is a growing market.
However it is not at all certain that a cut in interest rates increases FDI: first, cuts in rates are sometimes a
sign that things are going wrong in the economy, for example there might be a recession on its way;
secondly, the fall in the currency is likely to mean that the value of the investment in pounds is going to
fall, and thirdly, falls in UK interest rates are unlikely to affect FDI as the borrowing is likely to be sourced
from local money markets where the information about risks of the borrower are better understood. But
while recognising these aspects overall a fall in interest rates is generally thought to encourage FDI.
Hot money (or foreign portfolio investment) is the movement of funds from one country to another, as
speculators seek increased exchange rates, relatively high interest rates or an increase in share prices. It is
clear that a decrease in the UK interest rates is likely to decrease the amount of hot money buying into

sterling, although the current MPC rate of 0.5% is only just above the Fed funds rate of 0.25% whilst the
ECB rate is currently 1%. So in the case of hot money we can be more confident and state that, a fall in
interest rates will cause a fall in hot money ‘investment’.
Just remember two main things. Investment is not the same as saving, and the effect of interest changes
on investment depends on the type of investment that you are considering. Invest a little time over lunch
and ask your friends what they think.
1. What is the difference between saving and investment? Is there a causal relationship between the
two?
2. When interest rates fall, investment increases. Is this always true?
3. Investment is a component of aggregate demand but changes in aggregate demand also cause
changes in investment. This rather circular situation means that changes in investment cause
changes in investment – part of what’s known as the accelerator effect. Is this going to have the
same effect as the multiplier? Or does it have a different effect when investment starts to slow
down but spending is still rising?
● Circular flow of income – a model of the economy which shows spending and incomes, and the
interrelationship.
● Credit crunch – a sudden reduction in the ability to gain loans to finance borrowing, as lenders
lose their nerve in a tight money market. The effects of the tight borrowing make investment more
difficult and interest rates in commercial markets tend to rise.
● Foreign Direct Investment (FDI) – this is the international movement of funds that occurs when
multinational firms decide to increase their capital stock in another country or purchase a company
in another country.
● Hot money (or foreign portfolio investment) is the movement of funds from one country to
another, as speculators seek increased exchange rates, relatively high interest rates or an increase
in share prices.
● Human capital – the skills and abilities of the labour force.
● Injections – investment, government spending and exports: these cause money to enter the
circular flow.
● Leakages – savings, tax and imports: these cause money to leave the circular flow.
Key Terms
● Interest rate – the cost of borrowing money, or the return from saving. It can be seen as the price
of using money, and because the various uses have different levels of risk and time periods, the
prices vary. So there are many interest rates, but the most commonly used one in economics is the
rate set by the MPC.
● Investment – in economics, it is an increase in the capital stock, or build-up of assets. In
accountancy terms if stocks of goods are unsold from one year to another they appear as investment,
but their effects on the economy are to slow it down rather than the building up sense that the
economics investment implies.
● Monetary Policy Committee of the Bank of England (MPC) – a group of nine people which
meets at least once a month to set the rate at which banks borrow from the Bank of England in a
crisis (such as Northern Rock in the autumn of 2007).
● Federal Reserve (Fed) – the US decision maker of interest rates.
● European Central Bank – the euro-area decision makers of interest rates.
● Multiplier – the amount by which a change in an injection such as investment impacts upon
national income.
● Savings – the amount of income that is not immediately spent on consumer goods and services,
tax or imports.

Topic 12
Productivity
On a train to London this morning I typed 1,000 words for this article, but on the way back I wrote just two
sentences. I put in the same number of hours and used the same laptop. But I can produce more with the
same amount of inputs in various contexts. In plain English, my productivity is much better in the morning.
When I have a week to write an article it takes me the whole week, but when I have just one day then the
result is always better. There is an optimum amount of hours and as the time allocation decreases, there
comes a point when the job can’t be done properly in the time available. Finding that point is a search for
increased productivity, or the most output relative to inputs. Economists study the efficient allocation of
scarce resources, so productivity is a basic concept. But what causes it, and what will be the effects of
increased productivity and is it something all should aim for?
Causes of productivity improvements
Increased investment and technology

When at school I went to Office Skills lessons, in the hope of learning to increase my typing skills. By
today’s standard, they were very peculiar. Lessons involving centring data on a page meant that I had to
count up the number of characters in the text, take this away from 91, halve the remainder and then
start typing after that number of spaces. For every line of text! It took a whole lesson for me to type out
a menu, but I made a mistake on the last line so I had to start again. Computer software can now do it
in less time than it took you to read this sentence. Similarly, grocery store owners used to employ people
to count the number of items left on the shelves, and phone in an order for things that were running low.
Now of course the barcode gives all the necessary information, and the orders are made without much,
if any, human intervention. Car plants and other manufacturing would often be held up waiting for parts,
and productivity was low as a result. Now ‘Just in Time’ ordering can mean that parts are ordered to arrive
when needed, and there is no need to warehouse stock, a productivity improvement in the UK that owes
much to alliances with Japanese motor manufacturing. Investment in capital and research means that
productivity will improve.
Workforce motivation
There are two ways to consider motivation, just as there are two ways to spur a donkey to walk faster.
You can dangle a carrot on a string in front of its nose and it will walk forwards trying to eat it, or you
can beat it with a stick. On the carrot side with human beings, if workers are offered the prospect of
more pay or promotion they will want to work well, and are more likely to find ways to increase their own
productivity. If this motivation can be extended to the company as a whole, productivity can be improved.
When I worked in the headquarters of a FTSE 100 firm one summer what impressed me was the free
food, the gym and the onsite hairdresser. I was told by everyone that “they treat us well” and staff
turnover was very low. This means that new people do not have to be trained in new jobs, and time is
not wasted trying to appoint suitable people. Absenteeism was also relatively low and the company was
highly competitive.
Another way to get workers to do more is the stick approach, e.g. threaten them if they do not improve.
If workers are not punished for working slowly then there is no reason for them to go any faster than the
slowest worker. You will probably know of the type of job where you find yourself staring at the clock
waiting to get through the hours, and you will want to take breaks for as long as possible. About 100
years ago F.W. Taylor wrote about scientific management and that a manager must provide targets to
reach and all workers should be subject to ‘time and motion studies’.1 This in turn provided the basis for
1. Frederick W. Taylor, The Principles of Scientific Management, (New York: Harper Bros., 1911).

mass manufacturing at the Ford motor company on one extreme, and Soviet planning on the other. If
workers do not produce what the best of the workers can produce they must be slacking. It certainly
increases productivity if someone is watching you work, especially if you can lose everything when you
don’t meet the target.
Level of trade union activity

Days lost through industrial action have a negative impact on productivity figures. The number of days
lost has fallen as union membership has declined in the UK. Weaker unions might be seen as one of the
main reasons why UK productivity is growing faster than, say, France. But unions can also improve
productivity where workers’ rights are protected and motivation and morale is kept high as a result.
Training, health and education

A healthier workforce can be expected to take fewer days off sick, and a more educated workforce
should be more able to adjust to the impact of technological change.
Competitive environment
If the government has implemented successful supply side policies such as deregulation there is likely to
be pressure in firms to cut costs and use better technology. If firms can enter and leave the industry
easily – that is, it is contestable – then firms are likely to be productive even if there are not many firms
actually producing.
Management
A well-organised firm divides its labour effectively and enjoys the benefits of specialisation, economies
of scale and derives the most that it can from its workforce. Good management uses the strengths of its
resources to the maximum.
Impact of productivity improvements

An economy that becomes more productive generates more output from the same amount of inputs. An
alternative way of looking at it is to state the economy can produce the same output with fewer inputs.
Revenues will rise or costs will fall – either way, profit rises. Efficiency is also ‘green’ (using fewer resources,
more sustainable or releasing less carbon) and prices should fall in the economy improving standards of
living and making the economy more competitive in the global market. It means we can have higher
incomes for the same amount of work, or we could work less hard. With revenues rising or costs falling,
investors are attracted, innovation is encouraged and this stimulates yet more productivity growth. Incomes
may rise as a result. This has multiplier effects, which might stimulate yet more investment and growth.
There are, however, possible negative impacts too. Firms might have to shed labour if they can produce the
same amount with a smaller workforce, if they can’t increase sales. Workers might become very de-
motivated if they feel that they might lose their job at any time, are being made to work harder, or that
their bosses are ‘only in it for the money’. Shedding workers can mean that human capital is wasted, that
is, the investment in people that comes as people have been working for longer. Unlike physical capital,
human capital is not owned by the firm. But there is another side to this. A classical economist would argue
that the worker will have to go to work for another firm, and the increased competition for jobs there
pushes wages down. If this situation applies throughout the economy this makes firms able to employ their
workforces even more efficiently. Hence the country as a whole will become more competitive and employ
more people, not fewer, as a result of the productivity improvements. Also a more fluid workforce means
there can be more self-motivation amongst workers who are keen to be seen to do well.
The UK record
Why are cars and restaurant meals cheaper in the US than the UK? Part of the reason is the productivity,
with the US producing more than 30% more GDP per worker, as shown in Figure 1.

Figure 1: GDP per worker
140
120
Index Numbers (UK = 100)

100
80
60
40
20
0
Japan UK = 100 Canada Germany Italy France G7 exc. UK US
Source: ONS
Since 1991 the UK has experienced faster productivity growth than all the other G7 countries. The UK GDP
per worker productivity grew by 39% between 1991 and 2007, compared to the G7 average (excluding the
UK) of 29%.2 UK productivity growth at over 3% a year over the last 16 years sounds impressive. This
compares with just over 2% for the other G7 countries. Don’t be too fooled by the statistics, however,
because a larger productivity growth might mean that the economy was very unproductive at the beginning.
10% of 10 is the same as 1% of 100 in absolute terms. Also remember that charts such as Figure 1 showing
UK = 100 does not mean that UK productivity isn’t changing! It grows but the UK is being used as the base
for comparison.
Problems in measuring productivity
Measuring productivity in the service sector

This is almost impossible. Some meaningful measures can be used between firms in the same industry or
between different countries, but national measures are always problematic.
The quality issue

Changing output levels might reflect volume but not quality. Volvo cars are made by a team of workers,
not using a production line, and the cost per car is much higher in terms of hours put in. But the number
of defective cars is considerably lower than mass-produced cars, and the cars can be sold for a higher
price because of quality.
Increased spending automatically makes productivity figures fall

“NHS output in terms of operations, consultations, drugs and fewer deaths has risen by half between
1995 and 2006 but the annual budget over the same period more than doubled from £39 billion to
£89.7 billion. This means productivity fell by an average of one per cent a year.”3 Spending more on
doctors and nurses from 2001 to 2005 has made productivity in the health service fall by 2% a year,4 but
this is not, in most people’s view, going to worsen the living standards in the UK.
Arbitrary targets
Productivity is often measured using arbitrary targets. For example, in the NHS it is calculated using how
many people are treated, short term survival and health gains after treatment and by assessing patients’
experiences. Hospitals can improve their ‘performance’ by targeting these specific areas, while other
areas such as long term survival or minutes waiting in the emergency room might be the real issues.
2. http://www.anforme.co.uk/blog/?cat=273.
3. http://www.telegraph.co.uk/health/1576999/NHS-gets-more-money-but-productivity-falls.html, 30 January 2008.
4. http://news.bbc.co.uk/1/hi/health/7610103.stm.

Figures might be misleading when there are fixed factors
Royal Mail volume of letters has fallen by 10% a year with the increased competition from other providers
and from electronic communication. But a postal worker still has to deliver to every house, whether there
are 1 or 10 letters. So by definition productivity must be falling and there is little workers can do except
strike to make the point.
In conclusion, productivity growth is a key determinant of economic growth and standards of living in a
country, and there are benefits of productivity growth beyond mere income. Productivity growth does
not come without deliberate efforts by governments (supply side policies), firms (carrots and sticks) and
individuals (self motivation), nor does it come without costs for many. It is almost impossible to measure
in some industries, but measures are taken which can be of use for comparison between similar firms in
the same industry and between countries. We must avoid using productivity to measure the effectiveness
of workers if there are fixed factors or quality issues which are ignored. Sometimes a fall in productivity
means that the services provided are better – smaller classes, more nurses on a ward, or more police out
on the streets. So remember to see both sides to the productivity question.
Extract 1: Royal Mail in crisis as union readies for national strike

For the Communication Workers Union it is a dispute over consultation. It accepts the need for
change as new sorting technology is brought in to counter the threat of competition, but argues
that Royal Mail management ignores its wishes when implementing new working practices. It cites,
for example, a decision to replace bicycles with vans in the congested city of Cambridge. It also
argues that budget targets mean some postmen are unable to complete their deliveries in the
allotted time and are forced into unpaid overtime or faced with disciplinary action.
For the Royal Mail, the dispute is about modernisation and the union’s bargaining power in a
powerful but waning monopoly business. It has already shed tens of thousands of jobs through
voluntary redundancy and natural churn, but feels caught between growing private sector
competition, high legacy costs such as a pension fund deficit of more than £3bn, and the
requirement to continue operating a fully national delivery service.
Source: http://www.guardian.co.uk/uk/2009/oct/07/royal-mail-postal-strikes-union guardian.co.uk, Wednesday 7 October 2009, Dan Roberts
Extract 2: A postie writes

Sir, I'm a postman from West London. When I started seven years ago, I had one manager and
thirty-eight postman to cover this postcode. We now have twenty-seven postmen and two
managers. For the last two years and up until a month ago I had three managers. All of these
managers and all of those above them will get a bonus, starting at around 10% of their salary. This
bonus is based not on quality or performance but merely on budget. They are virtually guaranteed
this bonus as we have lost a further two jobs. Obviously ordinary postmen are not party to this
scheme.
We have a disparate workforce with ages starting from 18 all the way to 64. Our older postmen
cannot sustain the same walking pace as the younger members and some cannot now complete
their longer routes within their paid hours. Our older postmen bring other strengths to the job,
including, in my experience, a much greater concern for quality of service and a deep local
knowledge. No allowance is made for the varying speeds and no attempt is made to make the
quicker ones help the slower ones.
There is an argument to be had about mail volumes but it is without question that we have had
around 1,000 addresses added to this postcode since the last wave of job cuts. These all need
delivering to whether they have 1 or 10 letters.
Clearly there is much to this strike but I would just like the public to get an idea of how we're run.
Source: Reproduced by kind permission of Private Eye magazine, 30 October 2009, p.15, www.private-eye.co.uk

1. It may well be that you can write two essays before breakfast if you have to. But what might happen
to quality when you go faster? Is it possible to measure quality of services? Can ‘tests’ be planted
in service operations to check quality?
2. At my school we have new software which measures who writes the quickest and the longest
reports, how long everyone spends writing them, the number of mistakes and who starts earliest in
the morning or logs off latest at night. Are speed and quantity a good indicator that the teacher
has thought up useful things to say about the student? Is this a carrot or a stick approach to
management?
3. Mass production relies on productivity improvements, and the concept is fundamental to capitalism.
But productivity is also a core concept of central planning – if you cannot motivate people to work
harder in order to make more profit or higher wages, productivity targets is the obvious way to
motivate workers. Are there any other concepts that are common to the extreme forms of economic
belief?
4. Look at the views of productivity expressed in Extracts 1 and 2. What do you think has caused
productivity changes in the postal service?
● Labour productivity – output per unit of labour employed.
● Hourly productivity – output per unit of input per hour.
● Production – total output, measured by total incomes, total spending or the total amount produced
in money terms. It differs from productivity in that there is no sense of inputs.
Key Terms
● Productivity gap – this is the difference between productivity changes in different countries.
Productivity in the UK measured as GDP per hour worked increased by 49% from 1991-2007 which
was the fastest growth rate of any G7 country over this period, and compared to the average
(excluding the UK) of 36% meaning the productivity gap compared to the rest of the G7 is widening.
This is good for UK competitiveness.
● Index numbers = 100 – often you will be given data on productivity, and for ease of comparison,
index numbers are used. These show percentage changes relative to a base year or base country.
The base or comparator is given the value 100, and a figure for 130, say, for the US means it is 30%
more productive, relative to its inputs.

Topic 13
Aggregate demand and supply analysis
Macroeconomics is the study of what goes on in the economy as a whole. Whereas in microeconomics we
look at what explains the demand, say, for individual goods, or the output of individual firms, it is the
demand and supply in aggregate that we study in macroeconomics. The word aggregate here has exactly
the same meaning as it does in football when the away and home scores are combined – putting the
respective components together for each team. In terms of demand and supply, the individual quantities
are added together against the average price level. We can derive one crucial diagram that can be used to
explain many concepts, for example, the impact on output and jobs as a whole of changes in prices, costs,
wages, exchange rates, interest rates, or government policy. This article explains the reasoning behind the
two curves.
Aggregate Demand
Aggregate Demand (AD) shows the total expenditure on goods and services in an economy at any price
level. Spending by consumers makes up about 60% of aggregate demand. We call this consumption, and
in the diagram below it is labelled C. The remainder comprises spending by firms on investment projects
(investment, I), the government’s annual outlay (government spending, G) – for instance on health,
education and defence; and the amount that people abroad spend on our domestic production (exports,
X). To calculate aggregate demand we subtract the value of imports (M). This is because spending by
anyone in the UK on goods and services from abroad is not a factor in terms of demand pressure for UK
resources. Instead, imports are taken into account when we look at shifts in aggregate supply, see below.
Putting together these components C + I + G + (X – M) we can draw an AD curve, Figure 1. What this shows
us is that when prices are high there is less demand, point A on the curve. When prices are lower, planned
expenditure is higher, point B. Few would disagree that the curve is downward sloping against the price
level.
Figure 1: Aggregate Demand

Average
Price A
Level
Aggregate Demand = C + I + G + (X – M)
Real National Income
A common question at A level is “Why is the AD curve downward sloping?” The reasons for the downward
slope are open to debate. Here is a selection of reasons you might give:
1. Horizontal summation of microeconomic demand curves

The most obvious explanation is that the AD is the horizontal summation – adding together along the
output axis rather than up the price axis – of individual demand curves. Aggregate is the total, and we add

the quantities on the horizontal axis for each price to get all the demands for all the goods and services.
The problem with this approach is that it does not give us a useful tool for analysis – how will changes in
the components of AD affect the position of the curve?
2. Total expenditure argument

Another completely different way of looking at this is to consider the total expenditure in the economy. In
Figure 2, the amount that people want to purchase multiplied by the prices of these purchases is
represented by the shaded area for the point X.
Figure 2: Total expenditure

Average
Price
Level
AD
This shaded area will be constant for any point on the curve. We assume here that total real income is a
constant (that is, disregarding the effects of inflation) and any rectangle that is drawn under the curve
must have the same area, for example those drawn with dotted lines. Therefore the AD curve is a downward
sloping curve. Good point. This of course is true if you make a large amount of other factors constant – but
again the theory is not very useful as a tool for explaining macroeconomic changes.
3. Looking at changes in the constituents of aggregate demand

For a clearer understanding of how macroeconomics works it is better to try to explain the shape via the
components themselves:
Look again at Figure 1. Let us assess how the constituents of demand react when prices are generally high
(at point A). If apples go up in price, the microeconomics scenario is that we might buy more pears. But if
all fruit goes up in price consumers cannot now just substitute cheaper goods for higher priced goods as
in general all domestically produced goods have become more expensive. This so-called ‘substitution
effect’ only works when we consider M in isolation from C. Imports (M), we might assume, have not gone
up in price at the same time (the ceteris paribus1 assumption is always useful at times like this) so we might
spend more on M. Put an increase in M in the formula C + I + G + (X – M) and the result is that AD falls.
At high price levels relative to other countries we do import more. This is why there has been a decline in
manufacturing across developed countries – AD falls for our own produce because the Far East can produce
the equivalent far more cheaply as we substitute C for M. At point B on Figure 1, by contrast, our economy’s
goods are internationally competitive – not only do we consume these instead of imports, but we would
also expect a rise in exports which is one of the components of AD. So at lower price levels, AD is higher.
Another reason for low AD at point A is that interest rates are likely to have been raised when the general
price level is high, so there’ll be less consumer spending (C) on interest-sensitive goods such as cars and
electrical equipment. Yet another reason is that as prices rise, values of money-based assets go down
(inflation can be seen as a fall in the value of money) so assets such as savings are worth less in real terms
and people feel less wealthy. This means that they might spend less and save more (C falls as savings rise),
which is known as the wealth effect.
1. The Latin phrase meaning other things are equal is a useful tool for isolating economic impacts. When it comes to evaluation in your argument you need to think of what would
happen when other things are not equal (ceteris non sunt paribus).

Ensure that you can give at least one convincing macroeconomic reason as to why the AD slopes
downwards. Avoid microeconomic arguments – such as the idea that you substitute cheaper goods for dear
ones when prices go up, which is not convincing when you remember that ALL prices have gone up.
Having established that AD is, for whatever reason, downward sloping, we now turn to the firms’
perspective, Aggregate Supply.
Aggregate Supply
Aggregate Supply (AS) shows the total amount that firms are willing to produce at any given price level in
the economy. According to many economists2 firms are willing to produce more if prices are in general
higher – this way there is more scope for making a profit, and less efficient firms can join with the very
efficient ones to increase supply (part A in Figure 3). Firms are willing and able to produce more as prices
rise.
Figure 3: Aggregate Supply

Average
Price C Aggregate Supply
Level
This is only true up to a certain point, or so the theory goes. As the economy runs short of workers with
the right skills or land in the right places, so there will be less scope for profitable expansion as prices rise.
The squeeze on profits as costs go up are known as bottlenecks (point B) and make the AS curve get
steeper. As prices go up even further so the point will come when firms cannot produce any more and make
a profit on it as costs become prohibitive. This is known as full capacity in the economy and is shown by a
vertical AS curve (point C). Firms will not be able to produce any more, whatever the price they can
achieve. It’s the same concept as the production possibility frontier – the firms are producing at their
maximum potential and efficiency and there are no unemployed resources.
Not everyone agrees with this analysis – the so-called neo-classicists would argue that there can be no
genuine equilibrium unless the economy is at full capacity. For example, if there is wasted land where you
live, it will eventually get used by some business if the price is low enough. So, the argument continues, in
the long run, all factors of production will be used if the price falls, so the AS curve can only be drawn as
a vertical line – full capacity. In considering this counter-argument in your answers you will earn marks for
evaluation.
Putting together Aggregate Demand and Aggregate Supply

When we put the two concepts together we can determine the equilibrium level of output and the price
level for an economy. Equilibrium means that there is no tendency to change, given that other things
remain equal – that is, the factors of AD and AS themselves do not change. The equilibrium position can
be seen in Figure 4.
2. In the Keynesian school of thought, an economy can be in an equilibrium position even when it is not at full capacity – that is, there can be some unemployed resources and
no tendency for the economy to change. Neo classicists, by contrast believe that there can only be equilibrium when markets have ‘cleared’ – there cannot be unemployed
resources in the long term – instead, prices of these resources fall until they find employment.

Figure 4: Aggregate Supply and Demand equilibrium
Average
Price
Level
AD
AS
Ye Yf Real National
Income
Ye is the point of equilibrium in Figure 4, but this is at a lower level of real national income than Yf which
represents the full employment level of national income which corresponds to the economy being on the
Production Possibility Frontier. Because Ye is less than Yf, this means that the economy has an output gap
which means that it is operating inside its PPF. Equilibrium will be disturbed when either the AD or the AS
curve shifts due to some sort of exogenous shock. For example, if government increases its spending it will
shift the AD curve out to the right and will cause equilibrium to shift to a higher level of real national
income. On the other hand, if a major component of firms’ costs suddenly rises, such as an increase in
National Insurance contributions, this may cause AS to fall (other things being equal) and a new equilibrium
will be achieved at a lower level of real national income.
Where do we go next?
Rises in the price level are known as inflation, and rises in national output are known as economic growth.
An understanding of what shifts either Aggregate Demand or Supply will furnish us with an explanation of
these important macroeconomic indicators. If AD is rising we could call it demand-pull inflation, and if AS
is decreasing (leftwards or upwards shift) we might say that it is cost-push inflation. Once we know the
causes of inflation it is much easier to cure it; similarly, if we know the causes of economic growth then
perhaps we can determine its pace! But a fuller investigation into what causes shifts in AD/AS curves will
have to be left to a further article.
1. What are the factors that underlie the Aggregate Demand curve?
2. What arguments can you put forward for the AD curve being downward sloping?
3. How would you account for the vertical element in the AS curve?
4. How would the AD curve be affected if interest rates were lowered?
5. How would the AS curve be affected if there was a sudden increase in oil prices?

● Aggregate Demand – the total demand in an economy for goods and services, comprising
consumer demand for goods and services (around 65%), investment by firms and governments,
government current spending and the flow of income from exports less imports.
● Aggregate Supply – the amount that firms are wiling to supply at any given price within an
economy.
● Multiplier – the magnified impact of a change of injections on the total change in national income.
Key Terms
● Injections – Investment, Government Spending and Exports. These all push pressure into the
circular flow of income.
● Leakages – Savings, Taxation and Imports. These all take pressure from the circular flow of income.
● Keynesians – economists who believe that aggregate demand can be boosted in a recession to
stimulate aggregate demand, therefore preventing a very deep recession and high levels of
unemployment.
● Neo-classicals – people who believe that aggregate demand boosts will only lead to inflation in
the long run, and that an economy is best left to market forces to determine the long run equilibrium
level of prices and unemployment, i.e. laissez faire.

Topic 14 Absolute and comparative advantage –
look, no numbers
As a teacher I probably spend two hours a week by the photocopier. Sometimes queuing, maybe cursing
when it jams, but eventually after several attempts I get the machine to operate in a way that I can tolerate.
It’s not uncommon for my students to be given an apology with a photocopied handout – the holes in the
wrong place, the pages slightly out of order, or just a few copies having some pages missing where the
machine had overheated and malfunctioned. As I give out my sheets I tell the class that I just don’t have a
comparative advantage in photocopying. Actually I don’t have an absolute advantage either. In this article
I will explain my economic advantage in what seems like a failure scenario.
To understand the concepts of absolute and comparative advantage, it’s best to think in terms of costs.
How much does it cost the headteacher to employ me for the two hours of photocopying? Could she buy
that photocopying any more cheaply from someone else? It’s made simpler if you could imagine that
teachers are paid by the hour and produce a certain value in every hour that they teach, and that they also
produce value when photocopying but not as much per hour.
The headteacher at my school pays me around £30 an hour when I’m at work, which makes it expensive
photocopying – and that’s before all the damage I’ve done kicking the paper-feeder and the queue I’ve
caused by doing the job just before lessons start when everyone else also wants to photocopy. There’s a
willing junior secretary who will do the job, and she’ll take far less time, make fewer mistakes, and can
prevent the build-up of a queue by using the machine when all the teachers are in lessons. This is a clear
cut economic decision – the school will get more output from the same input by employing secretaries to
do all the photocopying.
If it is so clear cut, why doesn’t my school do it? There are three obvious reasons. First, when I get two
freed-up hours the school won’t save any money as I won’t accept a cut in my pay. Second, the secretaries
are always too busy. Third, I know exactly what I want photocopied and it will be quicker for me to do it
than explain to someone else how to do it. None of these are very good economic arguments. The first two
are shown to be flawed by using the theory of absolute advantage, and the third can be shown to be weak
by comparative advantage.
Absolute advantage
If my cost of producing an extra unit (that is, marginal cost) is less than the cost of someone else producing
that unit then I have an absolute advantage. If I can produce more value for the school by teaching more
lessons or helping students with problems I have an absolute advantage in teaching Economics. If the
secretary is the most efficient at photocopying then she has an absolute advantage in that. I should
specialise in teaching and the secretary in photocopying. Even if it means taking on more secretaries the
school will get better value from its resources if it uses this division of labour. In fact most schools do have
secretaries with time allotted for this as this is now required by national agreement.1
At this point most people writing about absolute advantage give some figures to prove the case. It is
important to have an analytical tool to use to describe what is going on, but I find it is best using pictures.
If you like you can use the numbers on these figures to extract cost ratios, but alternatively you can just
look at the slopes and see which is steeper relative to an axis, and which is further away from the origin.
The production possibility frontier (PPF) shows the most that can be produced if resources are used to the
full. If the resource here is time, I could spend an hour teaching (producing £30 in value) or an hour
photocopying (producing £20 in value). I will do a combination of both and because I can’t just do the
1. Raising Standards and Tackling Workload National Agreement between Government, employers and five teaching unions, January 2003.

teaching I won’t be able to produce the maximum value from my time, £30. In this example the secretary
could work as a teaching assistant and can earn £10 an hour. But she is a very efficient copier and the value
of her output is £30 if she specialises in that. She is so efficient there might not be enough photocopying
to keep her busy all week – one of the conditions of this argument is that there is a big enough market. It
also assumes that we do not get worse at what we do if we spend too long on it – that is, in the long run,
that there are no diseconomies of scale.
Figure 1: Production possibility frontiers

£s earned
by teaching The teacher’s PPF
The secretary’s PPF
30
20
10
10 20 30 Value of output
from photocopying
Given these facts, it is clear that for every hour worked there will be £30 worth of output from each worker
if we specialise. We can then ‘trade’ what we produce – actually the school does this, as schools are run a
little like a planned economy – but effectively I ‘buy’ the copying from the secretary and there is more
output at a lower price. The PPF can be seen to shift outwards in Figure 2 when people start specialising,
and then they ‘trade’, in line with their absolute advantage.
Figure 2: Absolute advantage

£s earned
30 The new PPF for
either worker after
specialisation and
trade
20
10
from photocopying
So we are producing more value, and that’s even ignoring the fact that the amount we are paid is different.
Looking briefly at costs rather than output, say that the secretary costs £10 an hour and I cost £30, but
the secretary does it in less time. If I could be persuaded to teach more classes rather than photocopy the
school makes a net gain of £20. You don’t need a degree in management to see that employing more
secretaries is a good decision, even if the teachers get cross. The head teacher could even give the money
saved back to both types of staff – so everyone could gain.
The principle of absolute advantage demolishes the first two reasons for not getting the secretary to do
my photocopying. The school does save a lot of money although it might not be clear and it might take
time and angry unions to change the timetable. And if the secretaries are too busy then a school which

wants to save money will actually take on more secretaries. But what about the third argument – that I am
the best person to do my own photocopying. I am the most efficient at doing my own copying and it would
take me longer to explain to someone else to do it than just do it myself. I am arguing that I have an
absolute advantage in both activities. In this case surely specialisation is not a good economic decision?
Comparative advantage
The comparative advantage argument is that even though I might be better at both activities, I am
relatively better at one rather than the other. I am able to produce much more value for the school by
teaching (£30 relative to the £10 which the secretary could earn as a teaching assistant). Let’s now assume
that the secretary can only produce £15’s worth of copying in an hour, and I can produce more than the
secretary per hour (£20) in terms of copying because I know what I’m doing and would take longer to
explain how to do it rather than do it myself. Here it is still better if I specialise and then trade, because I
can produce more value in each hour worked, and can buy in the copying at a lower cost.
Figure 3: Comparative advantage

£s earned
30
20
10
from photocopying
We can still produce a higher value of output between us if I stick at what I am best at, and the secretary
does what she’s best at. I have an absolute advantage in both activities – better money earned by teaching
than she could get and also I am better at doing my own photocopying because I am sure of what I’m
doing, even if I do get frustrated. However it would still be better for me to do an extra hour of teaching,
worth £30, with which I could ‘buy in’ photocopying as long as that didn’t cost more than £30. In Figure
3 I could get £30’s worth of photocopying if the secretary did it, rather than £20’s worth if I did it. Okay,
the secretary would take longer, but the total bill for her is less than £20. So the school has paid less and
got more out. I have got a comparative advantage in teaching and the secretary has a comparative
advantage in photocopying, even if I’m actually better at both. The secretary is relatively better at copying
than me, her opportunity cost is lower, and therefore by specialising and ‘trading’ we can get more output
from the same amount of inputs.
This can be shown by adding a new PPF in Figure 4 which shows the total amount that can now be
produced if there was specialisation and trade. More output from the same amount of inputs is the same
as saying there is a shift outward of the PPF. This is shown by the new PPF shown in orange. It’s a slightly
complicated issue in that in just one hour I can’t now gain the full £30 value of copying. But I could if more
secretary time were used, and that would still be profitable because the secretary is working for only £10
an hour but producing a value of output of £15. That is why the right-hand section of the PPF is shown as
a broken line.
This can be applied to workers, firms and whole countries. Yes there are some assumptions such as there
needs to be enough demand and there must be either constant or increasing returns to scale. Transport
and transaction costs of traded goods and services must be cheap and the exchange rate benefiting both
sides. We also ignore any external costs as production levels rise. But if you can ignore these things, you

have more output from the same inputs. Everyone can be better off with no one being worse off. Surely
that makes good economics sense?
Figure 4: Specialisation and trade

£s earned
30 The new PPF with
specialisation and
trade (the dotted part
not possible in
current scenario)
20
10
from photocopying
1. A doctor is earning £80 an hour in a clinic, but paperwork is taking up 10 hours a week and she
doesn’t get anything extra for that. Her managers have tried to persuade her to delegate paperwork
to a secretary but she insists she is the most efficient person to do her own paperwork. Imagine you
are a management consultant brought in to help improve the productivity in the clinic and to make
the doctor delegate and morale improve to reduce staff turnover. What would you suggest?
2. How much should the secretary be paid in the photocopying example? Should the rewards from
specialisation be shared between the teacher and the secretary, or taken by the organisation that
governs the trade? In a free market would the gains from trade be split equally?
3. Rice is grown quite cheaply in Italy but much more cheaply in Vietnam. The UK buys a lot of rice
from Italy – why is that?
4. One of the main arguments in favour of globalisation is that more trade means everyone can be
better off with no one being worse off. However every year there are protests at any talks aimed at
increasing trade between countries. What is it about the terms of trade that might mean that not
all countries enjoy the benefits of comparative and absolute advantage?
● Absolute advantage – when an economic agent can produce more efficiently than another
economic agent, or uses fewer resources per unit of output, or has higher productivity.
Key Terms
● Comparative advantage – when an economic agent can produce relatively more efficiently than
another economic agent, or has a lower opportunity cost in the production when compared to
another economic agent.
● Law of comparative advantage – the principle that economic agents should specialise in the
activity in which they have a comparative advantage, meaning that there will be more output for
the same amount of inputs.

Topic 15
Exchange rates
At around $1.50 to a pound, sterling hit a five-year low against the dollar. Only a few months previously
you could buy more than two dollars to a pound, which made going to America for the January 2009 sales
shopping very attractive. By contrast in 1985 a dollar cost you almost a whole pound. So the questions I
find myself asking are what causes these currency changes, what will be the effects on exports and
imports, and is a falling exchange rate a quick and easy way to get rid of problems of competitiveness?
There is much more to ask about exchange rates, but this article just aims to demystify a few starter
questions about the value of the pound.
When Mervyn King, the governor of the Bank of England, announced that yes, Britain was at the threshold
of a recession, the pound immediately fell in value.1 Why? The reason is that currency traders who are
holding pounds will sell if they suspect that interest rates will fall. Falling interest rates mean that they get
less return on their currency holdings, so they sell their pounds. More pounds relative to demand on the
market makes prices fall, and so the pound falls against the dollar. Strange really, when there were clearly
worries about the US economy. But confidence is a relative thing.
So what actually determines the value of one currency in terms of another? Clearly interest rates, confidence
and speculation are major factors, but there are basic economic forces influencing the currency movements,
which boil down to simple demand and supply.
Figure 1: The pound against the dollar since 1945

4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: DWP
Just another application of demand and supply?

In 2009 1.5 million cars were made in Britain, of which up to 80% were exported, mostly to the euro zone
countries. The workers making these cars didn’t want to be paid in euros. But the people buying them in
the euro zone didn’t tend to have sterling bank accounts. Although the workers and the buyers in the car
showrooms may not be aware of it, some currency changing must take place at some point. People need
to buy pounds, which is ‘demand’ for a currency. To do this, buyers of British exports go to the foreign
exchange market (forex), where buyers and sellers of currency meet and exchange. This is most likely to
happen online, but also happens by going into a bank or other retail outlet to get pounds. So exports hold
up the value of a currency, and an increase in exports will make the currency stronger, or fall less sharply.
1. Speech on 21 October 2008, one of only three that he gives annually on the state of the economy.

By contrast, when I want to buy the latest hi-tech gadget it certainly isn’t likely to have been made in
Britain. Or at least if it was it would have been made in the UK for, and with profits being sent to, a
multinational company abroad. This is true too for most clothes, heavily-branded food or drink. Even when
you shop at Boots, a company which seems very British, the profits go to the USA because it is American-
owned. And so technically, your spending means that on the foreign currency markets you are supplying
more pounds to pay profits to American shareholders in dollars. To get foreign currency I need to supply
my pounds, either online in the forex, or via a retail outlet. For these items I am ultimately putting pounds
into the forex and there is pressure on the pound to go down – supply of pounds is increasing. An increase
in imports will make the currency fall, or rise less quickly.
All the millions of purchases made every day for goods and services across international borders affect the
value of currencies. These individual demand and supply forces determine the equilibrium price, which is
the exchange rate. If a country is making things that other countries think are good value or quality then
the currency will tend to rise. But if firms are becoming complacent or lack efficiency and innovation then
the currency is likely to fall.
Let’s try to show this on a diagram. Remember that this is the market for pounds, and you can’t show the
price of pounds in pounds, just as you can’t say the price of an apple is an apple, but you could say it was
two pears. So the price I’ve chosen here on the vertical axis is dollars, but you could use any currency. Here
demand is determined by the success of exports. Assume British goods become less competitive relative to
products made in another country. The demand for pounds will fall (to D2 in Figure 2) and the exchange
rate will fall. Luckily for Britain this fall in the pound will make its products more competitive again.
Figure 2: The forex market

Price of
pounds S (Importers
in dollars supply £s)
e1
P1
e2
P2
D1 (Exporters
demand £s)
D2
Q2 Q1 Quantity of pounds
Or an international casino?
However, only a small fraction – about 5% – of the pressure on exchange rates comes from trade in goods
and services. Speculation is a far bigger influence on exchange rates than the physical effects on trade of
exports and imports, and it is the buying and selling of currencies in the expectation that prices will change
in the near future which causes most currency movement. If people holding pounds for speculative
purposes think that the pound will fall then they will sell pounds, which is what has been happening
recently as the pound is falling against many currencies. This must mean that people do not want to hold
pounds, or at least that holding other currencies offers a greater return. The problem in countries such as
Hungary, South Korea and Argentina in Autumn 2008 was that so many people were convinced that the
credit crunch was going to make the currencies fall that they sold the currencies in enormous quantities,
and the increase in supply itself pushed the prices right down. As a currency trader you can make money
by selling a falling currency and buying it back when it’s cheaper, and buying one that’s about to rise. It’s
like a massive casino, as Keynes said – you can make money if you know what is going to happen.

A basket of currencies
Although the pound has been strong against the dollar for the past few years and only recently headed
downwards, against the euro it has been getting weaker since the start of 2002 as shown in Figure 3.
Many think that the pound will settle in at these lower rates, and most argue that this will be good for
exporters. However there are two important issues as to whether a weak pound is going to improve our
trade balance: first, what proportion of exports is sold to countries in which a low pound will give us an
advantage? And secondly, how much of our exports rely on imported raw materials, which of course are
now costing us more? For both of these questions a trade-weighted exchange rate index is far more useful
in helping to predict the impact on trade. We do most of our trade with the EU – almost 60% – and so
exchange rates with the euro are more significant than with other countries, such as the dollar which
accounts around 17% of our trade. We must factor into our equation the proportion of trade with a
country before we can assess how the change in exchange rates will affect net trade.
Figure 3: The pound against the euro, since it was formed in 1999
1.70
1.65
1.60
1.55
1.50
1.45
1.40
1.35
1.30
1.25
1.20
1.15
1.10
1.05
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: http://www.taprofessional.de/charts/Pfund-Euro-Bar-Chart.htm
Do falling exchange rates improve the balance of trade?

How responsive are consumers when the exchange rates change? In economics the key measure of
responsiveness is always elasticity, and the way to apply this concept to exchange rates is using the
Marshall-Lerner condition.
Alfred Marshall is the economist perhaps most famous for his explanations about elasticity. When elasticity
is applied to exchange rates (there are some modifications by Abba Lerner) we get a formula for deciding
whether a change in the exchange rate will improve or worsen our net trade. The condition states that, for
a currency devaluation to have a positive impact on net trade, the sum of price elasticity of demand for
exports and imports must be greater than 1. Look it up on Wikipedia and you will see a complex set of
equations, but essentially, changing exchange rates only affects the balance of trade if people respond to
price changes, which clearly they often don’t, at least not straightaway.
What about inflation and exchange rates?

It looks as if a floating exchange rate will mean that a country can restore its competitiveness through
devaluation. Britain is suffering from inflation at 3.3% CPI and this is higher than its major trading partners.
So if people who usually buy British cars start thinking that domestic car prices are becoming expensive,
they could buy a more competitively-priced car from another country. If this happens the demand for
British cars falls and so does the demand for British pounds. The price of the currency falls and eventually,
as this starts to happen in a wide range of goods, the pound will go down. So it might appear that we can
‘export the inflation’ problem, and some see this as a good reason for having a floating exchange rate – it
restores international competitiveness and removes Balance of Payments problems.

But the problem for the UK is that when the pound falls in value its imports become expensive. 40% of
everything we buy is imported. So devaluation doesn’t export the inflation, but actually causes inflation.
The weaker pound will affect our export prices too because components will become more costly.
Devaluation as a way of trying to make a country more competitive can have the reverse effect.
So this ‘quick fix’ solution of course has its own problems, and many economists argue that we should
return to a fixed exchange rate, such as the euro, or even go back to fixing to gold.
Is it time to go back to the gold standard?

The gold standard is a system where a currency has a fixed exchange rate against gold. It is an alternative
to having a floating currency, where fickle demand and supply determine the value of our pound. If
someone wants to buy a pound, they have to pay the equivalent value of their own currency in gold. If all
exchange rates were linked to the value of gold then all exchange rates would be fixed to each other. This
is not a new idea, but our several attempts at imposing it have resulted in misaligned trading patterns, and
ultimately breakdown. It is like having any fixed price in a free market mechanism: it causes distortions. The
Wonderful Wizard of Oz written a hundred years ago is a story which parodies the gold standard with the
imagery of a ‘yellow brick road’ to success, with ounce being ‘oz’ for short. There had been a run on the
banks in 1893 quite similar to 2008’s, and it had been followed by widespread unemployment. Similarly
when the film of the book was released in 1939 the worldwide recession was coming to an end and it was
felt that there was a need to fix currencies for the sake of the war. Today with the evident problems of
allowing free markets to do as they will, and the powers of speculation and unstable markets, some
economists are arguing for a return to regulations and controls, an end to volatility and some sort of
structure. What are the arguments for fixing the currency? Should we follow another yellow brick road?
There are not many people who are convinced by fixing values to gold to stop currencies moving, but you
can see the advantages of having exchange rates that do not move when people trade or speculate. Some
more rigidity in the economic system might be what we are all now looking for after the credit crisis of
2008. Certainly you will not hear much this year of people wanting to let markets just do whatever they
will. Unless of course you’re one of those lucky traders benefiting from the latest wild fluctuation in the
exchange rate.
1. Textbook theory tells us that if interest rates fall then the pound will fall. The argument is based on
‘hot money’ leaving the country, the supply of pounds increasing and the price falling. Why then
do so many who struggle in A Level examinations feel tempted to argue that the pound will rise?
2. When should I buy my holiday money? Visit Google finance and find the trend for the pound
against the currency of the place you are visiting. (If you really could answer this question then I
shouldn’t be sitting in this classroom discussing this – get out there!)

3. As an exam tip, you can never be too careful when dealing with changes in direction of exchange
rates. Even examiners get it wrong sometimes, as with a major international paper in Summer 2008
with a question that assumed that the increased amount of a currency needed to buy a dollar
meant that there was a revaluation. Though rest assured it wasn’t the exam board I work for! Can
you think of a rule of thumb, which makes it clear that the currency has got stronger?
4. ‘0% commission finance’ is a wonderful marketing tool. Many people really do believe that Marks
and Spencer give away foreign currency out of pure philanthropy! You of course know that M&S
exists to make profit. So how do they make money on this currency deal?
5. You might be keen on buying some shares now that the financial crisis is over. However when you
log onto the internet share dealing service there are shares listed from across the world’s stock
exchanges. In what way should you take into account the strength of the currency when buying
shares from abroad?

● Euro zone countries – those European countries that have adopted the common euro currency.
● Exchange rate – the price of one currency in terms of another.
● Exchange rate index – a basket of exchange rates, weighted according to the amount of trade
that the countries do in these currency forms.
Key Terms
● Forex – a short hand phrase for the foreign exchange market.
● Foreign exchange market – where buyers and sellers of currency come together and exchange.
This is most likely to happen online, but also happens when you go into a bank or other retail outlet
to get foreign currency.
● Speculation – the buying and selling of currencies in the expectation that prices will change in the
near future.

Topic 16
The National Minimum Wage
We have had the National Minimum Wage (NMW) since 1999 and have grown quite used to it. It seems
a good time to look at both its rationale and impact over more than a decade. Does it make people
better off or does it put workers out of jobs? Is it a way of ensuring that workers aren’t exploited or
does it just make UK firms uncompetitive? Would a regional minimum wage be more effective than a
national one?
Before looking at the numbers, a recap of some of the key data handling tools you will need. When looking
at income distribution, that is, the gap between the incomes of various groups within an economy
compared say, to the average, the most commonly used measure of averages is the median.1 Let us also
look at deciles. Keep everyone in the country lined up in your mind, in order of incomes. Now divide up the
people into 10% groups. There will be nine dividing lines between the ten groups and the middle one is
the median. These dividing lines are called deciles, and they are useful for making comparisons between
groups. Having discovered the median, we can now measure poverty. You might not think poverty exists
in the UK today, but it is alive and well. Not absolute poverty, earning less than a couple of pounds a day
– this measure is not very useful here. But poverty, as defined in relative terms, is earning 60% less than
median earnings or under.
Introduced on 1 April 1999 the NMW was introduced at 48% of the level of all employees’ median hourly
earnings. At £3.60 for those aged 22 years old+ it was targeted to impact upon almost 1.3 million people
who were then being paid below that rate, 5.6% of all workers. By 2008 the NMW was 52% of the level of
median earnings, meaning that it had increased its redistributive potential. The NMW has moved closer to
earnings levels in the lowest decile. This is below the relative poverty definition of 60% of median incomes,
so the NMS is targeted at the poor. But it has not brought earnings much closer to those in the top decile,
because top earnings have raced away. So it has been seen to redistribute incomes, but most significantly
in bringing the lowest paid into line with others in the lowest decile. When compared to the lowest decile
the NMW has increased from 87% in 1999 to 92%. When compared to the highest it has risen only 1% to
23%, meaning that a worker on the NMW earns 23% of someone earning in the lower end of the top 10%
income bracket.
There are still 1.1% of workers earning below the NMW, which includes people under 16 or people working
for themselves or informally, e.g. in the family. It includes people on apprenticeships or on a training
course, who are usually exempt. If you have a job such as being a caretaker then your free accommodation
can be offset against your wages so again you might legally work below the NMW.
In 2004 an NMW was introduced for 16-17 year olds. There are some other issues that this brings up. As a
teacher I of course think that 16-17 year olds would benefit from staying on at school but the NMW might
encourage them to think they could do better working. But it applies to weekend and holiday work too,
and can prevent younger workers from falling into unemployment traps. Most students of that age still
have to work to pay for the essentials in life such as phone credit, and they have very little wage negotiating
power because there aren’t many jobs going that can only be done outside lesson time, relative to the
supply of workers.
Raising the rate in Autumn 2009 by only 7p to £5.80 was the first time the rate was increased below the
rate of inflation (if you use the CPI measure). A recession changes the impact of the NMW, making it more
likely that people will be priced out of work, and it also changes people’s perception of the NMW.
Unemployment is a lagging indicator, so although the world recession may be over, the full effect of rising
1. If you lined up everyone in the country in order of how much they earn, and found the middle person, he or she would be the median. Median is really useful because it tells
us about how we are doing relative to other people, that is, relative incomes. If you took the mean, total income divided by the total number of workers, it would be too high,
because the mean gets dragged up by the very high salaries at the top end of the scale. The mode isn’t very useful as it doesn’t tell us about how well some people are doing
relative to others. It just tells us the most common.

unemployment takes longer to work through – maybe five or six years. The argument that the NMW
worsens the prospects may become more fierce.
By any measure, however, there is no evidence that the NMW has increased unemployment, and many
argue that employment has actually increased as a result of it. There are several reasons to explain this, and
some important issues that are hidden when we just look at the broad figures. For example there might be
more people in the labour market owing to immigration or increased participation. We first need to consider
the effect of elasticities on employment and unemployment as one reason why these figures might have
been so seemingly contradictory to economic theory.
Elasticities
The impact that the NMW has on employment and wage levels is dependent on many things, but one
major factor is the price elasticity of demand (PED) and price elasticity of supply (PES). If there is
no real alternative to a certain type of worker, then if the price of the worker goes up, the worker will still
be employed but other costs might have to be made elsewhere. We say that the price (or in this case,
‘wage’) elasticity of demand is low. This means that prices (wages) can rise but quantity doesn’t change
much. In jobs where PED is low, the NMW is likely to have little direct effect on employment levels, and
workers as a whole gain more revenue. The reverse is true if PED is high. If wages go up the employer will
look for alternatives, such as increased use of machinery. For example if a café owner has to pay higher
wages for the person cleaning the dishes, there will be a strong incentive to buy a bigger dishwashing
machine.
The application of elasticities also applies to the supply side. This means that workers respond differently
when the NMW changes. In many types of unskilled work, where virtually anyone could do the job, if there
is an increase in the wage the market may be flooded with people willing to put in some hours. But if it’s
a skilled job or not very pleasant working conditions, then an increase in NMW will not have an enormous
influence on the number of people willing to work. The effect on employment levels depends too on how
high the out-of-work benefits are. If benefits are very high and it is easy to live on benefits then an
increase in minimum wage will have little effect. But supply becomes more elastic or responsive when there
isn’t an easier alternative.
The usual question you will see on the NMW concerns the likely effect on employment or unemployment
levels. One of the clearest ways to illustrate the impact using the elasticity arguments is to use two NMW
diagrams, one with low elasticity and the other with high. See Figures 1 and 2.
One of the biggest problems for economics students in exams is in choosing to apply this concept to
employment or unemployment. It’s just two letters different but it can make the difference between an A
and an E in your grade. If you want to discuss employment you must identify the equilibrium point before
the NMW was imposed, point A in Figure 1 for example. Then you should show that employment falls to B
as demand contracts as wages rise. But if you want to show the effect on unemployment you also need to
take into account point C, which incorporates the extension in supply – the fact that more people are
willing to work when wages are higher. So the impact on unemployment, B to C, is much larger than the
impact on employment, A to B.
But there might be no effect on employment or unemployment if the NMW is imposed below the
equilibrium wage. See Figure 3. If the going wage for a good secretary in London is £15 an hour there will
be no direct effect on employment when the NMW rises. It won’t have an impact on poverty either, so a
secretary on this wage might not be able to cover daily living costs. It might be that there is an indirect
effect on people on higher wages, and therefore it will have an impact on employment, unemployment or
poverty, and this is when we start looking at differentials.

Figure 1: Low supply and demand elasticity
Wage
Supply of workers (S)
W b c
NMW NMW
We e
Demand for workers (D)

0
B A C Quantity of Workers
Figure 2: High supply and demand elasticity

Wage
W b c
NMW NMW
We e

0
Figure 3: A NMW below the equilibrium level

Wage
We e
W b c
NMW
NMW
0
Differentials
The gap between the wages of workers, that is, the differential, has an important economic function in the
economy. Sometimes there are problems caused by differentials, for example between people doing the
same or similar jobs, such as those employed directly and those employed by a temping agency, or between
men and women, full-timers and part-timers. Most of these differentials are illegal or in the process of
becoming illegal, and not central to the argument here. Let’s consider the paying of workers different
amounts for valid economic reasons. If I pay more for a good typist then he is more likely to stay working
for me, and there is an incentive for poor typists to improve so that they can earn more. If a good chef is

paid more then she is more likely to stay in the job and there is an incentive for the sous chef to learn the
trade and get higher wages. So wage differentials perform an important economic function, giving
incentives and rewarding good work and building up experience.
The relevance of wage differentials is that if the bottom wage is raised, those above will want a raise in
their wages to restore the differential. If all the unskilled workers at the bottom in a restaurant get a higher
NMW then all the workers up the rung will want more, or the incentive effects will break down. So over the
passage of time the NMW might have a larger effect on employment or unemployment than shown in the
simple market for these workers. Also there might be an increase in prices in the restaurant and other
workplaces. This would make the output of the economy less attractive to the consumer – people might
start to cook more at home, in this example, if restaurant prices go up too much. Or it might be that the
economy becomes less competitive internationally and jobs are lost as work is outsourced to workers
abroad. Whole firms might close down or be relocated abroad if the NMW makes a workforce uncompetitive.
More immigrants may be attracted meaning that although employment levels rise, unemployment might
also rise as local people are displaced.
Regional issues – a RMW?

An alternative is to have a regional minimum wage, and the present government has been in discussions
about this and suggested ways to link the minimum wage to regional costs of living. This is not the place
to discuss this, but there are issues such as measuring the cost of living and problems of enforcement
which might make this policy unworkable.
Not working?
Many argue that the NMW does not work, and it would not be improved by regionalising it. They want it
cut in real terms, to restore labour market flexibility, one of the competitive advantages of the UK economy.
The argument may say that the price floor must cause unemployment, but it is hidden from the figures as
people who are displaced from work may leave the job market. It might not relieve poverty if the worker is
the second earner in a household, or if there are other income streams that the worker might rely on. The
impact on costs ratchets up costs, and is a deterrent to foreign investors. It might not be the wage that is
the problem but the lack of jobs or the fact that people are moving in and out of worklessness. Another
problem is that it entices people into low-skilled jobs, such as minimum entry nursing,2 which will not
provide a career development and so these workers will eventually leave. Better for potential nurses to do
a degree in nursing. The starting wage is perhaps only £5,000 higher but the dividends will come in the
long run. The counter argument is that the minimum wage is good, but not yet enough to lift people out
of poverty or worklessness. While it can be shown that the national minimum wage might have little effect
on employment or unemployment, perhaps policies should be more clearly targeted on solving poverty
problems.
It’s a good thing to read biographies about people who have tried living on the NMW such as Fran Abrams’
Below the Breadline or Barbra Erhenreich’s Nickel and Dimed. There are many books like this, and TV
programmes too which suggest that even working full time the NMW won’t cover basic living costs in some
parts of the country. You will have your own opinion on the NMW, but you must be able to see the counter
arguments.
2. Nurses entering the profession with no qualifications do earn around £15,000, well in excess of the minimum wage, but it might be argued that this is still a wage floor, and it
is influenced by differentials from the NMW.

1. The best way of measuring inequality is by choosing groups and comparing one with another. For
example, how does a change in interest rates affect income distribution? Consider groups of people
such as savers and borrowers. Remember that this is an area rich for evaluation – there are no
obvious conclusions because of course it is not only the lowest income groups who borrow and the
highest who save!
2. What would be the main problems of a regional minimum wage? Enforcement? Fairness? Employers
relocating? The ‘postcode lottery’ where people could earn very different wages across regional
borders? Having considered some of the costs, assess whether the benefits in terms of poverty and
employment might be outweighed by these costs.
3. Do you agree that the NMW should be increased more slowly in a recession? Might there be an
implementation lag – that is, by the time the new rates kick in the economic cycle will have moved
on?
4. Should the NMW be linked to average earnings or to the cost of living? If the former, remember
then there are problems when earnings are falling, and if it is average earnings which type of
average should be used? If linked to the cost of living then might there be regional issues, or
problems for some groups. For example if you’re a vegetarian you might have seen fresh vegetables
increase in price far more quickly than meat, and it seems unfair to base your cost of living on what
you never buy. Is there a better alternative?
5. Should out-of-work benefits be cut to increase the price elasticity of supply? What are the economic
arguments for raising benefits?
● National minimum wage – a price floor in the labour market, legally binding on employers, in all
areas of the country.
● Regional minimum wage – a price floor in the labour market, legally binding on employers, which
varies between geographical areas in the country. It might be linked to the cost of living.
● Elasticity of demand – the responsiveness of demand to a change in a factor such as price or
wages. Here we have been considering how firms change their demand for employees when there
is a legally imposed minimum wage.
● Elasticity of supply – the responsiveness of supply to a change in a factor such as price or wages.
Here we have been considering the way in which workers or non-workers react when there are
different wages on offer in the labour market.
● Decile – when data is presented in a serial order, a decile marks boundaries between 10% band
widths. Deciles are used for comparison between sets of data, and have the advantage that they
are not distortions on the extremes of a distribution.
Key Terms
● Income gap or Income inequality – a measure of the gap between the incomes of various groups
within an economy often shown by plotting the average incomes of those between the lowest and
highest decile (see www.statistics.gov.uk). The wage difference between these two tends to widen
in periods of economic growth, and can be altered by changes to taxes and benefits.
● Unemployment rate – the percentage of the workforce (that is, able and willing to work) that is
not currently employed.
● Unemployment traps – this occurs where it is not worth people starting work, owing to loss of
other income such as unemployment benefits.
● Cost of living – a measure of how much has to be spent to maintain living standards. It is usually
measured by comparing the prices of a selection of items known as the ‘basket of goods’, and
persistent increases in this cost is measured in an inflation index.
● Absolute poverty – a measure of those earning less than a certain nominated amount of income
over a certain time period, for example £2 a day.
● Relative poverty – a measure of poverty using the distribution of incomes of one group in relation
to another, e.g. earning 60% less than median earnings or under.

Topic 17
Index numbers
“With the FTSE Aim 100 having plummeted 64% in 2008 to 1852 – far worse than the FTSE 100 31%
tumble and the FTSE 250’s 40% crash – investors are hoping for a better year this year,”1 This might have
been a headline from any business newspaper in 2009. You can guess something dramatic was happening,
but the use of index numbers can make it quite hard to follow. The aim of this article is to help you feel
more confident in handling numbers-with-no-units, the strangely simple-looking index numbers, which
are perhaps even simpler than they appear to be.
Maths is what puts many people off economics. But the only maths you really have to understand fully at
A level is percentage change, and to be able to apply this to various contexts, one of which is index
numbers. Index numbers are used to collect data from various sources and give a special kind of average.
They are a simplifying device for showing changes and comparisons in data by showing percentage changes
relative to a chosen base year, which is normally given the value 100, but when more detailed changes are
wanted such as the stock market sometimes 1000 is the base. A base is simply a comparison year, and there
is some evaluation you might do about which date is chosen for a comparison, which we discuss at the end.
Figure 1: House prices in the UK

120
Peak in October 2007 = 100
100
80
60
40
20
0
’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10
The index shown is an average of Halifax and Nationwide house price indices. House price projections are based on a range of forecasts from ‘Forecasts for the UK economy:
a comparison of independent forecasts’, October 2008 (compiled by HM Treasury). Source: http://www.bankofengland.co.uk/publications/inflationreport/ir10nov1.ppt
Figure 1 is a simple use of an index. The base year has been chosen as the peak in UK house prices, and it
is therefore easy to see the falls since October 2007 in percentage terms. It is also useful in that you can
see when prices in 2009 fall to the level that they were in 2004. Rather than house prices in raw terms, it
is easy to see what has happened on average over a defined period of time.
Before going on to look at some of the problems of index numbers, we look at some of their other
applications, and then incorporate the concept of weights.
The FTSE (pronounced ‘Footsie’)

The UK daily newspaper most respected by economists is probably The Financial Times. Although owned
by Pearson, a very large publishing firm originating in the US, it has the age-old credentials for giving
reliable reports on the share prices in the London Stock Exchange. So the FTSE is a collaboration between
The Financial Times (FT) and the Stock Exchange (SE) to give the index of the leading shares.
1. A. Monaghan, ‘The New Year brings a key resolution’, The Daily Telegraph, 5 January 2009.

There are several versions of the FTSE, however, and a useful way to distinguish between movements in
the largest shares from the movement in companies more generally is to use the FTSE 100 and compare it
to the FTSE 250, 350 or the Alternative Investment Market (AIM). The FTSE 100 charts the changes in
share prices of the top 100 shares when ranked in order of size, or ‘market capitalisation’ as explained
below. The FTSE 100 started at a base of 1000 in 1984 and before the credit crunch was coming close to
7000 in 2007. This means that in just over 20 years share prices were seven times their starting price, which
isn’t a bad rate of return if you compare that with what would happen if you had put money in a bank – at
5% it would be at around 3386.
Weighted indices
An index should be able to tell you how you have been affected by changes in the economy. Because of
this, it is a useful tool for policy makers to decide how much your allowance should rise if you are on
government income, for instance job seekers’ allowance, maternity benefits or pensions. But just knowing
how much prices have changed on their own is of little relevance. If you are a pensioner you are less likely
to be worried about the rising cost of school fees but rather more worried about the changing price of
heating fuel. If you are a parent claiming paternity or maternity benefits then the cost of nappies might be
more significant than that of a can of Red Bull. Whilst on income support the price of rent might be more
significant than that of bingo tax. The point of these examples is to illustrate that the cost of living index
should be related to what people actually buy, and in the proportion that they buy these things.
The way in which an index is related to the amount actually bought or traded is by using weights, to form
a trade weighted index. Clearly if the stock markets were not weighted then a spike in the price of a small
firm could make things look a lot more optimistic than they actually are. The change in share price must be
multiplied by the market capitalisation which shows how much the company is worth if you multiply price
per share with the number of shares issued. Then as with all weights, you divide out the weights at the end
so that the rather random total of the number of shares is removed, just their influence on prices remains.
CPI and RPI

Until December 2003 the main index for prices in the UK was the Retail Price Index (RPI), with a very
useful modification, the RPIX, which removed the effect of the changes in mortgage interest repayments.
This index is still used for setting pensions in the UK, and therefore cannot be scrubbed from the economics
text books. However in the UK the government now pins its eyes on the Consumer Price Index (CPI)
which does not include any housing costs at all (no council tax, for example) and is based using a geometric
mean, which suffice it to say you don’t need to know in great detail, but it makes the variations look
smaller when individual items change.
Some fundamental problems with indices

Comparing changes from year to year is not always as simple as it ought to be. If the base year that is given
is 2004 for house prices, and the news tells us that house prices have fallen back to their 2004 level, then
it’s clear that they are back at 100. But how do I know the change in house prices this year if all I have is
the index for 2005 at 80 and 2006 at 86. Is it just a 6% rise? Sadly not. Here you need to make use of that
never-fail formula for percentage changes, change over original times 100. As you plug in the number for
the original, in this case 80, you will find the result is a good deal larger, 7.5%. So prices have risen by 7.5%
compared with 2005, but only 6% when compared with the peak. This is very useful for explaining just how
much of the change over the period happened in one last year though it often hides the fact that prices
might have risen or fallen quite considerably in the intervening period.
Another problem with index numbers is that sometimes more than one factor is changing. In Figure 2 there
are two base years being used. Figure 2 illustrates one of the main causes of globalisation, one of the BBC’s
special reports in 2008 (see source).

Figure 2: Falling transport and communication costs
120
Transatlantic phone calla
Sea freightb
Air transportc
100 Satellite charges
80
60
40
20
0
1930 1940 1950 1960 1970 1980 1990 2000
a = Cost of three minute telephone call from New York to London; b = Average ocean freight and port charges per short ton of import and export cargo; c = Average air transport
revenue per passenger mile. Data is measured relative to costs in 1990. Source: www.bbc.co.uk http://news.bbc.co.uk/1/shared/spl/hi/guides/457000/457022/html/nn3page1.stm
Here the base year for three types of cost is 1930 and changes are shown relative to this year. Clearly the
changes for satellite charges cannot be based on 1930 as the technology had not been developed then, so
there is another base used in 1970. The use of index numbers is a powerful and simple tool to show some
dramatic changes in the fall in transport and communication costs.
Some common mistakes when handling index numbers

The most common mistake, outlined above when discussing house prices, is the failure to take account of
the original year in question, and most calculations that students use in exams simply forget the change
over original formula, or just don’t seem to know that the original is the first of the figures, chronologically.
Hopefully by reading this far you are now going to be able to avoid that problem in future.
Another very common mistake is to add some units. For example, when describing the changes in house
prices as a fall of 6 index points, you might be tempted to add ‘thousand pounds’ at the end. When asked
to describe changes in index numbers, students strive to show some units, such as pounds or millions.
Unfortunately, because the changes shown are percentage changes, you cannot simply switch back to the
units. You would have to know the value for the original base year, and you are not often given that. So
avoid the temptation to embellish your answer with some irrelevant symbols.
Figure 3: Hourly productivity in five countries

140
France Germany
United States Japan
130
120
Index Numbers
110
Britain = 100
100
90
80
70
’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05
Source: ONS
A very common use for index numbers is to show changes between sets of data, for example by country,
removing the absolute values and just showing the relative changes. It’s a common trick by examiners,
trying to see whether you can understand that one set of data has been chosen as a base, given the value

100, and other countries’ data is simply whether the gap is widening or narrowing. Figure 3 was used on a
recent examination paper for macroeconomics, and the data originally came from the Office of National
Statistics but then quoted in The Economist:2
The most surprising conclusions were drawn by the candidates. Almost 90% of respondents could not see
that productivity in Britain could still be rising even though there was an index number of 100. The productivity
of France is not actually falling, but is instead rising more slowly than that of Britain, and the productivity gap
is closing. What was supposed to be a simple question fooled most people. It makes me wonder how many
people would have read this article in The Economist and drawn the wrong conclusion themselves.
Exchange rate index

When trying to show what has happened to the buying power of a currency it is just as important to weight
the exchange rates against those with whom the trade happens. It may well be that the pound has risen
against the Argentinean peso but this is not going to make it much easier for importers in the UK. Much
more significant is the euro, since we do around 57% of our trade with the 13 euro zone countries, and the
US dollar, where we trade about 17%, against which currencies the pound has recently fallen dramatically.
Because of this, UK importers will find it very difficult to make a profit. The change in relative currencies
should be weighted in accordance with this proportion of foreign spending, giving a much more meaningful
exchange rate index which you will come to see is quoted more often than you realised now you know what
it means!
Scope for evaluation?

As with all Economics, there is scope for evaluation when considering index numbers. One area is the
reasons for choice of the base. If you want to make percentage increases in crime look small then choose
a base year which was particularly bad for crime. If you want to argue that your pocket money should go
up in line with inflation then use the 2007-2008 figures and you’ll get a real increase, but in nominal levels
if you use just the 2009 figures. When politicians use statistics that look simple like index numbers then
they can be used to mislead us much more convincingly.
Another issue is that the figures are over-simplified. We use the weighting system just to look at around
650 goods and services in the CPI, but this leaves out many items that many of us buy. The statisticians
upgrade the basket of goods once a year, much more slowly than new innovations come to market.
Further, index numbers can break down whenever you need to change the pattern of the weights. Statisticians
are not happy if you compare price changes over time when the pattern of spending changes. This can lead
to dramatic imbalances in the data because you are no longer comparing like with like. As it happens, the
Office of National of Statistics has recently updated its figures retrospectively going back decades.
But it is worth bearing in mind that none of these problems are new. Here’s an extract from a very old book
that I happened to be reading over the holidays:
Index numbers are a widespread disease of modern life, a symptom of the modern disease
of constantly keeping a close check on everything. So many of these index numbers are so
ancient and out of date, so out of touch with reality, so completely devoid of any practical
value when they have been computed, that their regular calculation must be regarded as a
widespread uncontrollable impulse. Only lunatics and public servants with no choice go on
doing silly things and liking it. Yet we become more and more the servants of our servants,
and they persist in tying us down to this dismal system whereby we all have our difficulties
compressed into the brevity of an index number.
Source: Adapted from M.J. Moroney, Facts from Figures, Pelican Books, 1951
Index numbers can actually cause more problems than they solve and you should be careful before handing
them to politicians. But as economists just remember that they are meant to be there to help!
2. ‘A lost opportunity’, The Economist, 1 February 2007.

1. Why are index numbers based on 100?
2. What factors influence the decision to choose one base year over another? Can political motives
influence the choice?
3. Weights show the proportion spent. Does it matter what the weights add up to?
4. Can data be over-simplified?

5. Look again at Figure 2 where the data is shown with 1930 and 1970 as the base years but with
1990 also as a point of comparison because the value of money changed over the 70 year period.
Thus the data shows the fall in transport cost in real terms. What is significant about this data? How
different would the cost data have looked if it had been shown in nominal terms?
6. Consider the reasons why index numbers are so unreliable. These might include the changes in
technology, the effect of short-term price changes that might go unrecorded, the problem of being
untypical where price changes are linked to an average. Why then do we base our very important
decisions such as rises in pensions and benefits on these index numbers? Is it better to have more
indices to give averages for smaller groups, such as the pensioner price index? What’s wrong with
taking this further – for example, a vegetarian price index to reflect the increased price of fresh
vegetables relative to meat, or an index based on gender as after all girls have to spend so much
more on their appearance, don’t they?
● Index – a device for showing changes in trends, usually relative to a base year or a comparator
country.
● Weights – a system for attaching the significance or importance of one item relative to another.
For example a weight can show the proportion spent on certain goods and services in a chosen
basket or selection of items.
● Basket of goods – a selection of goods and services chosen to be a representative sample of what
people spend their money on.
● Market capitalisation – the value of a company when calculated as share price multiplied by
Key Terms
number of shares.
● FTSE 100 – the top 100 shares listed on the London Stock Exchange, when ranked by market
capitalisation.
● CPI – the Consumer Price Index, used as the main indicator of the average price level in the UK
since December 2003. More details and a comparison with other price indices can be found at
www.statistics.co.uk.
● Base year – a year chosen for comparison. It is usually chosen for being a ‘normal’ year and
therefore the percentage change since then will give a clear sense of change over time.
● Exchange rate index – a composite index of exchange rates in a basket of currencies, linked to
the amount traded.

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Back to Basics:

The Cutting Edge

Rachel Cole is a teacher at Cheltenham Ladies’ College and a Principal Examiner

Published by Anforme Ltd., Stocksfield Hall, Stocksfield, Northumberland NE43 7TN.

Topic 1 Why does the supply curve slope upwards? 1

Topic 2 Elastic gymnastics – gain confidence in handling the concepts 5

Topic 4 Why look at the margin? 14

Topic 5 Do firms exist just to make profit? 17

Topic 6 Economies and diseconomies of scale 23

Topic 8 Buffer stocks 33

Topic 9 What’s so bad about inflation? 38

Topic 10 The savings ratio 43

Topic 11 What is the economic meaning of investment? 49

Topic 13 Aggregate demand and supply analysis 57

Topic 14 Absolute and comparative advantage – look, no numbers 62

Topic 15 Exchange rates 66

Topic 16 The National Minimum Wage 71

Topic 17 Index numbers 76

The law of diminishing returns

Back to Basics: The Cutting Edge 1

Backward bending supply curves

Back to Basics: The Cutting Edge 2

1. Elasticities tend to rise over time. Why is this?

Back to Basics: The Cutting Edge 3

● Long run – all factors are variable.

● Price elasticity of demand – the responsiveness of demand to a change in price.

Back to Basics: The Cutting Edge 4

Back to Basics: The Cutting Edge 5

Some figures from UK data2

The price elasticity of demand

Back to Basics: The Cutting Edge 6

Income elasticity of demand (YED)3

Cross-price elasticity of demand (XED or CPED)5

Price elasticity of supply (PES)

Elastic Case – Peppers Inelastic Case – Spinach

Back to Basics: The Cutting Edge 7

campus, and Muslim students are the majority ethnic group).

across the year.

● Elasticity – a measure of responsiveness of one factor to changes in another factor.

to a percentage change in income.

Back to Basics: The Cutting Edge 8

Back to Basics: The Cutting Edge 9

Figure 1: An indirect tax and a subsidy

Back to Basics: The Cutting Edge 10

Contexts in which indirect taxes are likely to be most effective

Contexts in which subsidies are likely to be most effective

Back to Basics: The Cutting Edge 11

What are the problems with indirect taxes and subsidies?

Back to Basics: The Cutting Edge 12

● Specific tax – tax based on quantity not value.

● Ad valorem tax – tax based on value not quantity.

● Subsidy – a grant given to producers.

● Price elasticity – a measure of response by consumers or firms when prices change.

Back to Basics: The Cutting Edge 13

Back to Basics: The Cutting Edge 14

Box 1: Marginal analysis

Back to Basics: The Cutting Edge 15