Economics PDF

a Zayan Zaman
9708
ECONOMICS
AS & A LEVEL
These notes are intended for an organized and detailed revision. You may use the notes at
your own risk; If any of the statements, diagrams, or information in this document is
inaccurate or incorrect, I will not be taking any responsibility.
Information collected from class notes and ‘AS and A Level Economics Course Book by
Bamford and Grant’.
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a
ECONOMICS 9708
Contents
# Chapter AS A2
1 Basic Economic Ideas and Resource Allocation 03-11 12-15
2 The Price System and the Microeconomy 16-20 21-36
3 Government Microeconomic Intervention 37-40 41-46
4 The Macroeconomy 47-60 61-72
5 Government Macroeconomic Intervention 73-76 77-78
Updated for the 2021 syllabus.

Definitions and formulae are given in a separate document.
In these notes, the term ‘product’ refers to both goods and services.
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Basic Economic Ideas
and Resource Allocation
People have infinite wants but the resources (factors of production) used to satisfy these
wants are limited. This mismatch between what people want and the maximum that can be
produced gives rise to the economic problem.
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Economic resources are termed as factors of production. They are:
→ Land: Any natural resource used in the production process. Aside from its traditional
meaning, it also includes resources beneath it (i.e. coal), what occurs naturally on it (i.e.
rainforests), or what is found in it (i.e. animals). The reward for owning land is the income
generated/rent.
→ Labour: Any human effort, physical and mental, involved in the production process. The
reward for labour is the salary/wage received.
→ Capital: Any man-made aid to production; They are not wanted for their own sake, but
instead for what they can produce. The reward for capital is the rate of return earned.
→ Enterprise: Involves the risks borne by the entrepreneur in combining all other factors of
production to produce/provide goods/services. The reward for enterprise is profit.
Supply of Land: The amount of physical land in existence does not change much with time.
Some natural resources however, can change quite significantly
Mobility of Land: Most land is occupationally mobile and can be used for several purposes.
Land in its traditional sense however is geographically immobile. Forms of land in its wider
meaning, may be mobile/immobile depending on their characteristics.
Supply of Labour: The number of workers available is determined by: the size of the
population, the age structure of the population, the retirement and school leaving age, and
the attitude towards working disabled people and women. The number of hours they are
available for depends on the length of the average working day, whether it is full/part-time
work, duration of overtime, length of holidays, and the amount of time lost due to illness.
Mobility of Labour: Depends on each person’s skills and propensity to move. A person may
be geographically immobile due to external influences (i.e.: government restrictions, family
ties, unavailability of housing, lack of information, difference in education systems, etc.).
Supply of Capital: Overtime some capital goods physically wear out or become outdated. The
total value of the output of capital goods produced is referred to as gross investment.
Mobility of Capital: Varies according to the type of capital goods.
Supply of entrepreneurs: A good educational system including university degree courses may
help to develop entrepreneurs in an economy, Lower taxes on firms’ profits and a reduction in
government regulations may also encourage more people to set up their own businesses.
The Mobility of Enterprise: Enterprise is both occupationally and geographically mobile since
entrepreneurs have the ability to make their own decisions about what responsibilities they
will be undertaking, what they want to produce/sell and where they want to locate.
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As resources are scarce, choices have to be made about the method and purpose of their use
(i.e.: consumers decide what to buy, governments decide what to spend on, businesses
decide what to produce, and much more). This leads to opportunity cost.
It is important to distinguish between needs and wants. Needs are necessities required to
survive, such as food, shelter, healthcare, clothing, and education. An increase in income and
standards of living can increase the amount of essentials (e.g.: a phone may be essential for a
rich person while may be a luxury for a poor person).
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Due to scarcity, all economies have to answer three basic economic questions: what to
produce (as scarce resources must be allocated efficiently), how to produce it (to get the
maximum output from minimum resources), and whom to produce it for (since limited
resources cannot satisfy everyone’s needs/wants). These questions are answered differently by
different economic systems.
When answering the fundamental questions, there should also be moral considerations (e.g.:
ensuring the provision of basic necessities, conserving resources, not underpaying workers,
limiting pollution, not engaging in illegal business activities, etc.).
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Economists often use the Latin term ceteris paribus, which refers to a situation where other
factors remain equal. It is used to simplify an actual situation by assuming that apart from a
single change of circumstances, everything else is unchanged.
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Many aspects of microeconomics involve analysing decisions ‘at the margin’ – a small change
in one economic variable will lead to further small changes in other variables. Looking at
changes in a marginal way allows to predict the impact of the change.
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When taking change into account, it is necessary to specify the time dimension and how time
can influence the concepts economists are seeking to model and explain.
In terms of factors of production: In the short term, only some inputs (e.g.: labour) can be
changed. In the long term, all factors of production and key inputs can be changed.
Firms can usually be more efficient in the longer term as they will have had enough time to
respond to changes in market conditions and alter their inputs in order to increase efficiency,
productivity, and profitability. Once these have been optimised, any change will be
detrimental as long as conditions remain the same.
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Economists make positive and normative statements. Positive statements are statements of
what will happen, based on actual evidence; no value or opinion judgements are involved.
They are widely used to describe something that can be measured.
Normative statements are statements where value or opinion judgements are made; it is
subjective about what should happen. They are less certain but are used to form the basis of
policy-making by firms and governments to solve economic problems.
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Households, workers, firms, governments, etc. may all choose to undergo specialization (e.g.:
they may choose to specialize in cleaning, medicine, toys, garments, etc. respectively).
Advantages and Disadvantages of Specialization
Advantages Disadvantages
• Focusing on one thing that the • Leads to a loss in self-sufficiency.
entity is best at is likely to • Due to rapid technological growth and
produce better results (including advancements in society, it is possible that skills,
but not limited to higher quality goods, services, etc. that an entity has
output, better pay, and specialized in will no longer be in demand.
economies of scale). • Unvaried work can lead to boredom.
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Technological advancements have led to large scale production processes. These processes
require the division of labour – splitting the manufacturing process into a sequence of
individual tasks done by particular workers (e.g.: in garments, each operative produces one
part of an item such as the shirt sleeve or buttons.).
In modern times, humans have been replaced by machinery to do monotonous tasks. This
has reduced the need to do boring tasks but has also led to unemployment. In other cases,
manufacturers have tried multi-skilling workers and moving them around the production
plant to do different jobs (job rotation) to counteract boredom.
The introduction of conveyor belts and just in time systems (i.e.: stock and needed materials
delivered just when needed, eliminating need of storage) have helped to boost production
and reduce average costs (e.g.: through advanced technology and eliminating human errors).
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The structure of an economy is the way in which an economy is organized in terms of sectors.
There are four main sectors of an economy:
→ Primary Sector: The extraction of raw materials (e.g.: agriculture, fishing, mining, etc.).
→ Secondary Sector: The manufacturing of raw materials into finished products (e.g.: food
processing, textiles, steel production, vehicle manufacturing, electronics, etc.).
→ Tertiary Sector: All services (e.g.: shops, transport, logistics, banking, education, etc.).
→ Quaternary Sector: The knowledge-based part of the economy, especially the provision of
information (e.g.: ICT, research, product development, computing, etc.).
The economic structure changes (i.e.: concentration of workers/capital and production

changes from primary to secondary to tertiary to quaternary) as economies develop.
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As noted before, the resource allocation in different economic systems varies with each
economic system. There are three distinct economic systems:
The Market Economy is an economic system where consumers determine what is produced.
Private sector firms decide how to produce the products, and resources are allocated by the
price mechanism. Land and capital are privately owned; government intervention is minimal.
Recipients of the product depends on demand, supply, wealth, and income (e.g.: USA).
Firms in the market economy aim to maximize profit by selling at high prices while keeping
costs low. They must be efficient, innovative, and competitive to survive in the market, attract
consumers, increase profits, and expand. If they fail to do so, consumers may shift to buying
from competitors, leading to the business failing.
Advantages and Disadvantages of a Market Economy
• Firms do not consider external costs and
• Very responsive to changes in
benefits; they may only consider short-
consumer demand.
term profits rather than long-term
• Consumers have a lot of variety to
sustainability.
choose from.
• Monopolies can exploit consumers, and
• Efficiency, low prices, less wastage, etc.
provide limited or no choice/variety.
are rewarded with profit while the
• Firms may not be able to respond to
contrary is punished through losses.
changes in consumer demand if
• High incomes provide an incentive for
resources are immobile.
people to work hard and for
• Asymmetric information can lead to the
entrepreneurs to set-up/expand firms.
under/overproduction goods.
• Firms try to be allocatively,
• Firms will not make products unless they
productively, and dynamically efficient.
think they can charge for them.
(maximizing consumer satisfaction,
• Advertising can distort consumer choice
producing at lowest possible costs, and
• There can be a very uneven distribution
using resources efficiently).
of income that increases over time.
A perfectly free-market economy does not exist in today’s complex, globalized economy.
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The Planned Economy is an economic system where the government gives directives to state-
owned enterprises on what to produce and how it is to be produced. The public sector owns
all of the land and capital, and employs employers. Recipients of the products are determined
by wealth and income (through payments received by their employer – the government) or
social status. Planned economies will usually provide basic necessities and important products
such as housing/transportation/education free of cost or at a low price. (e.g.: North Korea)
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Advantages and Disadvantages of a Planned Economy
• Social costs and benefits are considered. • Relies heavily on a fair and
• The government can provide public goods, corruption-free government being
encourage the consumption of merit goods established.
and discourage the consumption of demerit • Unresponsive to changes in
goods through subsidies/taxes, providing consumer demand.
information, or passing laws. • Less variety and limited choice for
• The government can prevent the exploitation consumers.
of consumers. • No profit incentive to be efficient,
• The government may plan ahead to a higher charge low prices, create less
extent and devote more resources to capital wastage, etc.
goods (i.e.: future economic growth). • State-owned enterprises may
• The government is likely to make maximum become reliant on subsidies and
use of resources. regular reinvestments from the
• The government can help vulnerable groups government, which raises costs
and create a more even distribution of income. and reduces profits.
Planned economies focus on achieving as high of economic growth as possible. To do so,

they may invest more into capital goods than consumer goods, henceforth sacrificing current
consumption and living standards.
On the contrary, market economies aim to invest more on consumer goods to maximize
consumer satisfaction and profit, improving current living standards. However, this may put
the living standards of future generations at risk and slow down economic growth. The
allocation of resources towards capital/consumer goods can be illustrated using a production
possibility curve.
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The Mixed Economy is an economic system that has a combination of the features of a
planned and market economy. Some firms are privately owned (in the private sector) and
some are government owned (in the public sector). Some prices are determined by market
forces while others are set by the government. In this economic system, both the consumers
and the government influence what is produced (e.g.: Bangladesh).
A mixed economy is the most common form of economy in today’s globalized world. It gains
advantages of both a market economy and a planned economy whilst avoiding their
disadvantages (given there is proper execution, with some exceptions). Due to this, most
countries are currently moving towards the mixed economic system.
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There are quite a few issues in transitioning

from a planned to a marked/mixed
economy.
It is a long and tedious process. Due to the

large scale of changes that take place, it is
also very expensive. The expense is paid for
by taxes and external loans, meaning that a
robust tax regime must be introduced during
and after the transition.
If external loans become too high, the country may experience a balance of payments deficit.
Movement of labour from public to private sectors can also create a surplus (as governments
tend to employ more people than private firms), causing workers to be made redundant and
hence increasing unemployment.
However, as mentioned in the sections before, there are numerous benefits of moving
towards a market/mixed economy. It is also beneficial as moving towards a free market
economy is required for taking loans from the World Bank and joining the European Union.
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The role of enterprise in the modern economy is to produce and provide goods and services
to satisfy consumer needs/wants.
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Production Possibility Curves or Frontiers (PPCs/PPFs) are simple graphical representations
that show the maximum output of two types of products, and the combination of those
products that can be produced with existing resources and technology at full efficiency, in a
given time period. Its other names are: Production possibility boundary, Product
transformation curve, and Opportunity cost curve.
The PPC helps to illustrate scarcity of resources, opportunity cost, allocative efficiency, and
productive efficiency. It assumes that: the economic resources are used to produce one or
both of only two goods/services; the total quantity of resources does not change; technology
and production techniques remain unchanged; resources are used at full attainable efficiency.
They are plotted using information from production possibility schedules.
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The position of the PPC is determined by the quantity

and quality of available factors of production, and the
state of technology, and management expertise. Shifts
in production possibility curves occur when there is a
change in these determinants.
An ‘outward shift’ in the PPC means that the quantity

or quality of resources/technology has improved and
the country now has a higher maximum output, while an ‘inward shift’ means the opposite.
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Resources may be allocated towards consumer or capital goods. Developing countries face a
hard choice as they have poor living standards and are in need of economic growth. To
achieve economic growth, they must divert resources from consumer goods to capital goods,
further decreasing their current living standards. However, if they divert resources from capital
to consumer goods, there may be recessions/poor economic growth in the future, although
living standards in the present may improve.
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Money is anything that is generally acceptable as a means of payment. Money itself does not
need to have any intrinsic value.
The 7 basic characteristics of money are: generally acceptable, limited in supply, durable,
portable, divisible, homogenous (every unit of it must be exactly same), and recognizable.
Non-cash assets that can be quickly turned into cash (i.e.: by selling) are called ‘near money’.
These include foreign currencies, savings accounts, bonds, certificates of deposits, etc. These
assets contribute to liquidity, providing a supply of cash if needed to meet liabilities.
There are four main functions of money:
→ Medium of Exchange: It allows people to buy and sell goods and services.
→ Store of Value: It can be saved (because it is unlikely to deteriorate with time and will be
acceptable in the future).
→ Unit of Account: (or measure of value) It is used to place a value on an item in monetary
terms; enables buyers and sellers to agree on what items are worth relative to each other.
→ Standard for Deferred Payments: It allows people to borrow and lend. Someone buying
something now can get it by borrowing money from someone who does not want to use
it now. They can then agree terms on repayment (e.g.: they might add interest).
Hyperinflation is a case where there is a very rapid rise in the price levels, causing the value of
money to fall so rapidly that people lose confidence in using the country’s currency as money.
When this occurs, economic collapse is inevitable.
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Goods and services can be classified into different types.

Private goods (economic goods) are excludable and rival products that have a cost in terms
of resources used in producing them, and are scarce. A price must therefore be charged
when they are consumed. These goods are bought/consumed by individual consumers for
their own benefit.
Free goods are non-excludable and non-rival products that have no opportunity cost as their
consumption is not limited by scarcity. Examples include water from rivers, wind, sunlight, etc.
Public goods are non-excludable and non-rival goods which have a cost in terms of resources
used in producing them. However, due to their non-excludable trait, a price cannot be
charged when they are consumed. These goods are hence, often provided by the
government. Examples include street lamps, lighthouses, defence, etc.
Quasi-Public Goods are those which has some, but not all characteristics of public goods
(e.g.: A beach may be non-excludable, unless it is privately bought. It may also be non-rival,
unless it gets crowded and people’s ability to enjoy it is limited.).
Merit Goods are those that have more benefits when consumed than people realize, and are
hence underproduced and under-consumed when left to market forces. Examples involve
education, healthcare, most essential goods, etc.
Demerit Goods are those that have more harmful effects when consumed than people
realize, and are hence overproduced and over-consumed when left to market forces.
Examples involve cigarettes, junk food, alcohol, etc.
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The under/overconsumption of products depicts information failure – people are unaware of
the true benefits/costs of consumption. Governments tend to help provide merit goods at
low/no cost through state-owned corporations or grants and subsidies to private firms. In
extreme cases, it may make the consumption of some merit goods mandatory. On the
contrary, governments refuse to provide demerit goods and aim to highly tax private firms
providing them. In extreme cases, it may completely ban the consumption of demerit goods.
The idea of merit and demerit goods involve value judgements and implies that the society
has a right to decide, for someone else, what is right and wrong for someone else – accepting
that ‘society knows best’. This is an example of paternalism (a situation where society is said to
know best and has some right to make a value judgement).
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The problem caused by public goods is that they are non-excludable and non-rival. Hence, in
most circumstances they are not produced when left to the market system.
In example, once one fisherman has provided a lighthouse close to some dangerous rocks for
his own benefit, then all other fishermen will also benefit from it while not having to pay for it.
In this case, all fishermen would sit back for one foolish fisherman to install it at his/her own
cost for everyone to enjoy; implying that the lighthouse wouldn’t be built. In another scenario,
the fishermen could agree to jointly pay for it. However, a portion of them may conceal their
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desire for the lighthouse being built and refuse to chip in, yet still exploit its benefits when it is
built. Hence, the fishermen may again refuse to build the lighthouse in the first place.
Due to this reason, governments must provide public goods free of cost.
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Moral hazard and adverse selection are two more examples of information failure.
Moral hazard occurs when a party that has agreed to a transaction provides misleading
information (i.e.: asymmetric information between the two parties) or changes their behaviour
because they believe that they won't have to face any consequences for their actions.
In addition, moral hazard may also mean a party has an incentive to take unusual risks in a
desperate attempt to earn a profit before the contract settles.
Adverse selection describes a situation in which one party in a deal has more accurate and
different information than the other party. The party with less information is at a disadvantage
to the party with more information.
This asymmetry causes a lack of efficiency in the price and quantity of goods and services.
Most information in a market economy is transferred through prices, which means that
adverse selection tends to result from ineffective price signals.
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Example of Moral Hazard: Consider the implications of buying insurance. Assume a homeowner is very
careful and subscribes to a home security system that helps prevent burglaries. When there are storms, he
prepares for floods by clearing the drains and moving furniture to prevent damage.
However, the homeowner is tired of always having to worry about potential burglaries and preparing for
floods, so he buys the home and flood insurance. After his house is insured, his behaviour changes and he
is less attentive, he leaves his doors unlocked, cancels the home security system subscription and does not
prepare for floods. In this case, the insurance company is faced with the risks of floods and burglaries and
their consequences, and the problem of moral hazard arises.
Example of Adverse Selection: Assume there are two sets of people in the population that buy health
insurance, those who smoke and do not exercise, and those who do not smoke and do exercise. It is
common knowledge that those who smoke and don't exercise have shorter life expectancies. However, the
insurance company, without further information, cannot differentiate between the individual who smokes
and doesn't exercise and the individual that does the opposite.
The insurance company asks the individuals to fill out questionnaires to distinguish them. However, the
individual that smokes and doesn't exercise knows that answering truthfully means higher insurance
premiums, so he lies and says he doesn't smoke and exercises daily. This leads to adverse selection, where
the life insurance company is at a disadvantage and then charges the same premium to both individuals.
However, insurance is more valuable to the non-exercising smoker than the exercising non-smoker because
one party has more to gain. The non-exercising smoker needs health insurance more and benefits from the
lower premium.
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Economic efficiency is a desirable situation where scarce resources are used in the most
efficient way to produce maximum output – an ideal solution for the basic economic problem.
Economic efficiency consists of productive and allocative efficiency.
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Productive Efficiency is when production occurs at the lowest possible cost. To do so, the use
of resources must be minimal, and at the minimum possible cost. The economy must also
operate on its production possibility frontier.
Competitive markets often constrain firms to produce at the lowest possible cost to gain an
advantage over others as failure in doing so usually leads to the firm going out of business.
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Allocative Efficiency is when firms produce the combination of products that are most in
demand on the market, and the price of the products equals the marginal cost (the additional
cost of producing one more unit of the product) of production.
This is because the price that consumers are willing to pay is equivalent to their marginal
utility (the additional benefit they get from consuming one more unit of the product).
Therefore, the optimal distribution is achieved when the marginal utility of the good equals
the marginal cost.
Competitive markets often cause firms to produce products that are most in demand on the
market to generate a profit, whereas failing to do so can lead to the business closing down.
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The best possible use of scarce resources is when both parts of economic efficiency co-exist. It
is suggested that economic efficiency will be omnipresent in fully competitive markets. (see
chapter 2: A2 for more on economic efficiency).
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Pareto optimality is an economic state where resources cannot be reallocated to make an
individual better off without making at least one individual worse off. It is likely to occur when
an economy is operating on its PPC.
While allocating resources when in this state, some

form of compensation is offered to those (directly
and) negatively affected by it (e.g.: money offered
to people losing their homes due to the
construction of a new road). Others however (e.g.:
people nearby affected by noise pollution) may not
be compensated. Nevertheless, there should be an
overall efficiency gain (e.g.: significantly improved
traffic flow due to the road).
If the allocation of resources is not Pareto efficient (optimal), then there is scope for
improvement as resources can be allocated to make someone better off without making
someone else worse off.
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Dynamic Efficiency is a long-term phenomenon, that is a form of productive efficiency. It is
the process of investing money (sourced from within or out of the firm) into research,
development, and product innovation so that resources may be reallocated to enact new
production processes. This is done to remain competitive by meeting the changing needs of
the market, and lowering costs (and hence prices).
Although it can lead to higher costs in the short-term (i.e.: due to R&D costs), it leads to a fall
in the long-term average costs (economies of scale). Failure to do achieve dynamic efficiency
can make the firm uncompetitive, and drive them out of the market.
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When a completely free market without any form of government intervention fails to achieve
economic efficiency via market forces (demand & supply), it is said to have undergone market
failure; scarce resources are not used optimally. (see ch.1: AS for the causes of market failure).
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When the decisions or actions of an entity affects a third party, an externality is said to arise.
An externality (also called spill-over effect) is when the actions of producers or consumers
give rise to side effects on third parties, who are not involved in the action. A positive
externality suggests that there was a positive impact on third parties, and provided benefits to
them while a negative externality (which is more common) suggests the opposite.
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Externalities as a result of production or consumption decisions
Production Externalities Consumption Externalities

Negative: Spill-over effects that occur as a Negative: Spill-over effects that occur as a
result of production activity (e.g.: pollution). result of consumers using a product (e.g.:
passive smoking).
Positive: Benefits to third parties through Positive: Benefits to third parties through the
production (e.g.: vaccines not only helping consumption of a product (e.g.: the
consumers, but those around them as well). consumption of merit goods like education).
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Private costs are the costs borne by an entity that is directly involved in
a decision or action whereas external costs are externalities; they are
costs imposed on a third party that is not directly involved in the
decision or action. Social costs are total costs.
(therefore, social costs = private costs + external costs).
The opposite is true in terms of private benefits, external benefits, and social benefits.
Example: When going out by car, the driver’s private costs include fuel and toll prices. The
external costs include pollution from exhaust fumes. The social costs include both.
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Externalities are a barrier to achieving economic efficiency in a free market, and thus causes
market failure.
This is because private producers only consider private costs and benefits, rather than social
costs and benefits when producing a product. As external costs and benefits are not
considered, there can be an understatement of cost or understatement of benefits which
causes the price set to be too low or too high respectively. This leads to overproduction or
underproduction (respectively) – scarce resources are not being allocated in the right
amounts, and the market has failed.
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The public sector almost always uses the cost-benefit analysis (CBA) as a coherent framework
for making decisions where the market mechanism is not fully functional or appropriate, such
as in the case of major-budget economic projects.
The CBA involves a complete analysis on the full social benefits and costs of various possible
outcomes or sources of action involved in the project, and attempts to quantify the
opportunity cost as well as intangible costs and benefits in monetary terms.
It helps the users of that data to make decisions such that social benefits are maximized and
social costs are minimized. This helps to avoid substantial side effects where externalities fall
upon people and communities that have no direct connection with the project.
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The CBA approach differs from private-sector methods of appraisal in two main aspects: it
includes all costs and benefits(1) instead of just private ones, and it assigns a shadow price(2) on
costs and benefits where no market price is available (e.g.: placing a monetary value on the
time that can be saved when travelling, due to a new road).
A shadow price is a price that is assigned where there is no recognized market available.
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After fulfilling the stages in a cost-benefit analysis (see diagram), the government will check if
the value of social benefits exceeds the value of social costs. If that is the case, then the
project will be deemed worthwhile. From all pending projects, the ones with the highest
benefit/cost ratio along with suitable funding will be commenced first.
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Challenges faced during the stages of a cost-benefit analysis include:
→ Identifying every single cost and benefit, specially when some are controversial, or
because it is not possible to determine exactly which groups of entities or up-to which
geographical region the impact will occur for, etc.
→ Shadow pricing, such as placing a value on time saved on new roads or human lives
where accidents may take place, etc.
→ Employing statistical forecasting techniques when estimating future costs and benefits.
→ Collating all the gathered data to calculate a benefit/cost ratio.
Other drawbacks may also include that:
→ The CBA does not always reflect the distribution of consequences from certain decisions,
especially where public sector investment is involved (e.g.: the social benefits of a retail
store opening is calculated for a widespread area while the social costs are only calculated
for the local area).
→ Public sector projects can be highly controversial, and the outcome of a CBA may be
rejected due to political reasons. This can completely dismiss CBAs as irrelevant.
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The Price System
and the Microeconomy
In a market and mixed economy to an extent, the price for these products, as well as the
allocation of scarce resources are determined by the price mechanism.
Price Mechanism: The means of allocating resources in a market/mixed economy.
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The demand for a product is a market force, and a part of the price mechanism.
Demand: The quantity of a product that consumers are willing and able to buy at different
prices within a specified time period.
Notional Demand: Speculative demand, not always backed up by the ability to pay.
Effective Demand: Demand supported by the ability to pay.
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Demand can be illustrated by demand curves.
These can be drawn using demand schedules.
Demand Schedule: The data from which a
demand curve is drawn.
Demand Curve: A graphical representation of
the quantity demanded (QD) for a product at
different prices; it shows the relationship
between QD and price.
Market Demand: The total quantity demanded
by all the consumers.
The law of demand states that demand and price have a negative (inverse) relationship – as
price rises, demand falls and as price falls, demand rises. Due to this negative relationship,
demand curves have negative gradients (and are hence downward sloping).
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There are some factors which influence demand:
→ Disposable Income: An increase in disposable income raises consumers’ purchasing

power and can result in an increase in demand for normal products. However, it will
result in a decrease in demand for inferior products.
→ Price and availability of related products: The demand for a product and the price of its
substitute goods has a positive relationship. The extent of the change in demand
depends on the degree of substitutability.
The demand for a product and the price of its complementary goods has a negative
relationship. Complements have a joint demand.
→ Fashion, taste, and attitudes: Trends in products particularly influence the demand.
→ Advertising: Advertising will bring the product to the notice of some new costumers or
encourage existing customers to buy more of the product.
→ Population: If there is an increase in the number of people in the country, demand for
most products will increase. The population structure also matters (i.e.: whether there are
more young or elderly people).
The Price System
→ Others: These include, but are not limited to changes in weather conditions, expectations
of future price changes, special events, brand image, etc.
These factors can cause demand curve shifts to the left (demand decreases) or right (demand
increases). Price changes cause movement along the demand curve but no shifting.
Normal Product: A product whose demand increases with income.

Inferior Product: A product whose demand decreases as income increases. Examples include
button phones, public transport, affordable housing, etc. (often replaced by normal products
like smart-phones, private cars, penthouses, etc. respectively).
Disposable Income: The income a person has left (available for spending) after paying taxes.
Substitute Product: An alternative product.
Complementary Product: A product consumed with another.
Degree of Substitutability: The extent to which one product can be used to fulfil the demand
for another product.
Joint Demand: When two goods are consumed together.
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The supply for a good/service is a market force, and a part of the price mechanism.
Supply: The quantity of a product that producers are willing and able to sell at different prices
within a specified time period.
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Supply can be illustrated by supply curves. These can be drawn using supply schedules.
Supply Schedule: The data from which a supply curve is drawn.
Supply Curve: A graphical representation of the quantity supplied (QS) for a product at
different prices; it shows the relationship between QS and price.
Market Supply: The total quantity supplied by all the suppliers.
The law of supply states that supply and price have a positive relationship – as price rises,
supply rises and as price falls, supply falls. Due to this positive relationship, supply curves have
positive gradients (and are hence upward sloping).
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There are some factors which influence supply:
→ Cost of production: A lower cost of production can allow a higher quantity to be supplied.
→ Size of the industry: A larger industry means higher demand, hence a higher supply.
→ Level of technological advancement: Better technology can make production and
distribution more efficient and easier, increasing the quantity that can be supplied.
→ Taxes and subsidies: Taxes on firms including corporate and indirect taxes tends to
decrease QS. Subsidies lower costs provide a financial incentive to supply more.
→ Weather conditions and Health of livestock and/or crops: Weather affects agricultural
products such as crops. Ideal conditions will increase supply (however, different weather
conditions can affect the supply of different products differently). Health also influences
supply; the outbreak of disease will reduce supply.
The Price System
→ Price of other products: Firms that produce a range of products divert the resources from
the production of other products when one product becomes more popular than the
other to produce more of it. The price of these other products does not change but the
firms now supply less at each and every price.
→ Disasters/Wars: Natural disasters can result in a significant decrease in supply. However, it
greatly increases the supply of survival products.
→ Discoveries and Depletions of Commodities: Supply of commodities such as coal, gold, oil,
etc. is affected by the discovery of new sources.
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The concept of elasticity is crucial for businesses to understand so that they may make
informed decisions on pricing, marketing, and developmental strategies.
Elasticity: A numerical measure of the responsiveness of one variable following a change in
another variable, ceteris paribus.
Percentage Change in Dependent Variable
Elasticity =
Percentage Change in Independent Variable
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Degrees of Elasticity
Degree Elasticity Value Explanation

When a change in the independent variable
Perfectly Inelastic Elasticity = 0
causes no change in the dependent variable.
When the relative change in the dependent
Inelastic 0 < Elasticity < 1 variable is smaller than the change in the
independent variable.
When the change in the independent variable
Unit Elasticity Elasticity = 1 is equal (in %) to the change in the
dependent variable.
When the relative change in the dependent
Elastic 1 < Elasticity < ∞ variable is greater than the change in the
independent variable.
When a change in the independent variable
Perfectly Elastic Elasticity = ∞ causes a drastic change in the dependent
variable.
The Price System
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The price elasticity of demand is an important factor to consider for pricing strategies.
• When demand is elastic, a firm can raise total revenue by lowering price, however if it
increases price, total revenue will fall.
• When demand is inelastic, a rise in price will cause demand to fall but by a smaller
percentage than the change in price – hence more revenue will be earned. If price is lowered,
more products will be demanded but not enough to prevent total revenue from falling.
• When demand is unitary elastic, any price change will still keep the revenue unchanged.
PED always gives a negative value due to the relationship between price and demand.
Price Elasticity of Demand: The responsiveness of quantity demanded to a change in price.
Percentage Change in Quantity Demanded
PED =
Percentage Change in Price
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The factors determining PED are:
→ Proportion of income spent on the product: If a purchase of the product takes a small
proportion of the consumer’s income, demand is inelastic.
→ The Availability of substitutes: If a product does not have a close substitute, demand is
inelastic and a rise in price would not cause a significant fall in demand (allowing the firm
to increase revenue).
→ Whether the product is a necessity: If it is a necessity, the demand is inelastic since
consumers must buy them.
→ Whether the product is addictive: Products such as cigarettes will have inelastic demand
since people find it hard to stop buying and consuming them.
→ Whether purchasing the product can be postposed: If purchase is delayed or pre-
ordered, the demand will be elastic because if the price rises then people may postpone
the purchase.
→ How the market is defined and the time period under consideration: Longer time periods
make the demand more elastic as there is more time to change their mind.
The opposite scenario is true for all of the above.

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The price elasticity of supply is also an important calculation used by businesses, to
understand how efficiently they can respond to price changes.
PES always gives a positive value due to the relationship between price and supply.
Price Elasticity of Supply: The responsiveness of quantity supplied to a change in price.
Percentage Change in Quantity Supplied
PES =
Percentage Change in Price
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The Price System
The factors determining PES are:
→ Time taken for and cost of production: Quick/cheap production leads to elastic PES.
→ Cost of supply: If cost of supplying the good itself is low then PES is elastic.
→ Feasibility of storage: If it can be stored or discarded easily when required, PES is elastic.
→ Time period: Supply becomes more elastic when considering a larger time range.
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Businesses often look forward to set a price where there is no scarcity or surplus of the
product. This price, known as market-clearing or equilibrium price can be found by
comparing the demand and supply schedules. It can also be found by examining a demand
and supply diagram; It occurs where demand & supply curves interact.
In the price mechanism, prices act as a signal to both producers and consumers (e.g.: a rise in
QD signals to producers that consumers like the product and want them to increase QS. This
is called the transmission of preferences.
Market Equilibrium: A situation where there is no tendency for change.

Equilibrium Price: The price where demand and supply are equal.
Equilibrium Quantity: The amount that is traded at the equilibrium price.
Disequilibrium: A situation where demand and supply are not equal.
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The market mechanism is not always the best allocator of resources. Due to this, government
intervention in the allocation of resources in a market system is often necessary. For example,
to correct the underproduction of merit/public goods and overproduction of demerit goods.
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For any product, there are always some people prepared to pay
above the given price to obtain it (e.g.: to watch a concert,
someone may be willing to pay more than the actual price to
obtain a ticket). This is known as consumer surplus.
Consumer Surplus: The difference between the payment needed
to actually purchase a product and the payment a consumer is
willing to make to purchase it.
On the contrary, a producer surplus is when producers are

willing to supply at a price P but end up selling at a price higher than that (e.g.: due to
consumer willingness to pay more).
Producer Surplus: The difference between the price a producer is willing to accept and what is
actually paid.
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The Price System
The concept of (total) utility and marginal utility have been mentioned in chapter 1. The
concept assumes that utility can be measured in numerical terms. To summarize:
Total Utility: The total satisfaction received from consumption.
Marginal Utility: The utility derived from the consumption of one more unit of the product.
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Marginal utility tends to fall as consumption increases. (e.g.: a second ice cream on a warm
summer day would taste good, but probably not as good as the first one). It is possible to
eventually reach a point where marginal utility is negative – indicating dissatisfaction/disutility.
Diminishing Marginal Utility: The fall in marginal utility as consumption increases.
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The equimarginal principle states that consumers choose combinations of various goods in
order to achieve maximum total utility relative to the price, so that:
Marginal Utility of Product A Marginal Utility of Product B Marginal Utility of Product C
Price of Product A
= Price of Product B
= Price of Product C
…
Equimarginal Principle: Consumers maximize their utility where their marginal valuation for
each product consumed is the same.
The equimarginal principle assumes that: consumers are rational, utility can be described in
monetary units, incomes and prices are constant, and goods can be split into small units.
Therefore, its limitations include that: consumers are not always rational (e.g.: buying on
emotional impulses, advertisement distorting choice, etc.), consumers don’t have time to work
out marginal utility/price so they purchase out of habit or gut feeling, there are numerous
goods to choose between in reality, it is difficult to evaluate utility, complement goods always
have to be bought together, and some goods cannot be split into units.
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The concept of marginal utility can be used to prove why demand curves slope downwards.
MU
An increase in the price of a good A will cause its value of P
to fall. So, the marginal utility of
the product per dollar spent will be less than on any other goods. The consumer will try to
increase total utility again by spending less on good A and more on other goods.
So, as price increases, the consumer is buying less of good A. This proves the inverse relation
between price and demand, showing that the demand curve is downward sloping.
The Price System
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Behavioural economic models explore why consumers make irrational decisions, against what
might have been predicted by conventional economic theories.
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Due to limited incomes, consumers
have to choose what to buy. They can
do so with the help of a budget line,
which is similar to a PPC, but for
consumption.
Budget Line: The combinations of two

products obtainable with given
incomes and prices.
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The budget line shifts when there is a change in price in either product, or due to a change in
the budget itself. When shifting, these two effects arise:
Substitution Effect: Where following a price change, a consumer buys more (by allocating
more of the budget to this product rather than its substitute product(s), if there is a price
decrease) or less (by diverting budget from the product to its substitute product(s), if there is
a price increase) of a product.
Income Effect: Where following a relative price drop, a consumer has a higher real income
and will purchase more of each product (given they are normal goods). For inferior goods,
the income effect is negative and consumers buy less of it as real income rises.
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Apart from budget and prices, consumer preferences also determine what is purchased.
These preferences can be shown using indifference curves.
Indifference Curve: A graphical representation of the different combinations of two goods

that give a consumer equal satisfaction.
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The Price System
The budget line and indifference curve can then

be drawn together. A consumer’s choice is
optimal at the point of intersection of these two –
ergo, there is maximum combined consumption
of the two goods (given the budget constraint) at
that point.
If the budget increases (as shown in the image)

the consumer can choose a better combination of both goods. Usually, this means an
increase in the consumption of both goods (if they are both normal goods, as in the image).
A decrease in consumption when the budget rises would mean that the product is an inferior
good. The opposite scenario is true for when the budget decreases.
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A private firm’s task is usually to combine all factors of production in
an effective manner to be competitive and profitable. Firms therefore,
have to choose between alternative production methods. When doing
so, they may use isoquants.
Isoquant: A curve/line that joins points that give a particular level of

output. (see image)
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Consider a short-term scenario where labour is the only mobile factor of production:
The Price System
As seen in the image, the relationship between the quantity of factor inputs (in this case,
labour) and the total product can be shown using a short-term production function.
Production Function: A graph that shows the maximum possible output from a given set of
factor inputs.
Marginal Product: The change in output arising from the use of one more unit of a factor of
production.
Law of Diminishing Returns: The observation that the output from an additional unit of input
leads to a fall in the marginal product. After a point, marginal product may even be negative.
It can also be observed from the table that an increase in factor inputs leads to a fall in the
output per factor input (average product). Output per worker is termed labour productivity.
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A firm aims to keep its costs of production low to achieve profit
maximization.
Firm: Any business that hires factors of production in order to
produce products.
Profit Maximization: The assumed objective of firms; it is when the
difference between total revenue and total costs is maximum.
Short-term costs consist of:

Fixed Costs: Costs that are completely independent of output in the short-term.
Variable Costs: Costs that vary directly with output; all costs are variable in the long-term.
Total Cost
• Total Costs = Fixed Costs + Variable Costs • Average Cost =
Output
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Marginal Cost: The addition to the total cost when making one extra unit of the product.
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As stated before, all long-term costs are variable, alongside all factor inputs. Therefore, firms
in the long-term, should adapt and reorganize their production process so that:
Marginal Product of Factor Input A Marginal Product of Factor Input B Marginal Product of Factor Input C
Price of Factor Input A
= Price of Factor Input B
= Price of Factor Input C
…
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The Price System
A long-term production function (LRPF) an be

drawn using an isoquant map (a set of several
isoquant curves, showing different outputs using
various combinations of factor inputs).
The actual mix of capital and labour will depend on

their respective prices. The point where the isocost
(lines – see image – which show all combinations of inputs which cost the same total amount)
is tangential to an isoquant represents the best combination of factors for the firm to employ.
Hence, the LRPF can be drawn by joining all those tangential points together. Some
limitations of this entire analysis are that: it is difficult to determine isoquants, it is difficult to
switch factor inputs, and employers may be reluctant to switch labour and capital.
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An isoquant map can also be used to demonstrate returns to scale.

Increasing Returns to Scale: When output increases at a proportionately faster rate than the
increase in factor inputs. – and vice versa for Decreasing Returns to Scale.
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Evolutions in mobility, technology, and production processes mean firms can find a way of
lowering its cost structure over time. The long-term average cost curve assumes that all factor
inputs are variable and that the firm has chosen the optimal factor mix for producing any level
of output. The costs it shows are therefore the lowest costs possible for each level of output.
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The shape of the LRAC curve (also known as the planning curve or envelope curve) can be
explained by economies and diseconomies of scale.
The Price System
Internal Economies of Scale: The benefits gained from falling long-term average costs as a
firm’s scale of output increases.
External Economies of Scale: The benefits gained from falling long-term average costs
resulting from a growth in the size of the industry; The advantages are gained by all the firms
in the industry.
Internal Diseconomies of Scale: Where long-term average costs increase as a firm’s scale of
output increases too much.
External Diseconomies of Scale: Where long-term average costs increase, resulting from an
industry growing too large.
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Internal economies of scale:
→ Purchasing Economies – Large firms buy raw materials and capital goods in bulk and
receive discounts, meaning they pay less for each purchase.
→ Managerial Economies – Large firms employ specialist/expert staff as they can spread
their pay over many units, and use their expertise to reduce wastage. This is likely to
increase efficiency and reduce the average cost of production.
→ Financial Economies – Large firms have cheaper and easier access to loans as processing
big loans cost less than small loans on average, and there is lower perceived risk for the
bank. Large firms can also sell shares which is not an option to smaller businesses
modules such as sole traders and partnerships.
→ Technical Economies – Large firms may use technologically advanced machinery to lower
average costs. Using online services can also help.
→ Research and Development Economies – Large firms have research and development
departments, which may help to reduce average costs.
→ Marketing Economies:
– A large volume of output can decrease average advertising costs (e.g.: A company sells
a total of 10,000 pens and advertises them. The company can then increase the supply to
20,000, but the advertising cost will remain the same.
– The total cost of distributing goods can also decrease with sales. (e.g.: A truck with spare
capacity can transport more goods at a time, and in doing so, reduce the average
distribution/transport costs).
→ Risk Bearing Economies – Large firms can diversify their products to spread the risks of
trading. If one product’s profit falls, it can shift resources to produce the other products.
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External economies of scale:
→ A skilled labour force – A firm can recruit workers trained by other firms in the industry,
reducing average training costs.
→ Good reputation – An area can gain a reputation for high quality production, reducing the
firm’s average marketing costs.
The Price System
→ Specialist Suppliers of raw materials and capital goods – When an industry is large
enough, subsidiary industries set up to provide for the needs for that industry (e.g.: The
tire industry supplies specialized products and material to the automobiles industry).
→ Specialist Services – Universities and colleges may run courses for workers in large
industries; Banks and transport firms may provide services specially designed to meet the
specific needs of firms in the industry.
→ Specialist Markets – Some large industries have specialist selling places and arrangements.
→ Improved Infrastructure – The growth of an industry may encourage a government and
private sector firms to provide better road links, electricity supplies, build airports, etc.
External economies of scale are more likely to arise if the firms in the industry are located at
one area. They are sometimes referred as economies of concentration.
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Internal diseconomies of scale:
→ Difficulties controlling the firm – It is difficult to supervise everything in a large firm. This
may raise administrative costs and slow the firm when responding to market changes.
→ Communication Problems – It is difficult to ensure that everyone in a large firm has full
knowledge of their duties and available opportunities.
→ Poor Industrial Relations – Large firms may be at greater risk from lack of worker
motivation, strikes, and industrial action as problems take longer to be solved and workers
may have a lower sense of belonging in general.
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External diseconomies of scale: An industry can also grow too large. Increases in distribution
and transport may cause congestion, increased journey times, higher transport costs, and
possibly reduced productivity. An increase in competition for resources may also occur,
pushing up prices of key sites, capital equipment, and labour.
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The firm’s revenue is the income generated from sales, and can be expressed as follows:
Total Revenue = Price x Quantity Sold • Average Revenue = Total Revenue ÷ Output
Hence, the firm’s demand curve is the average revenue line.

Marginal Revenue: The addition to the total revenue resulting from the sale of one more unit.
MR is always less than AR since the firm can only sell more by reducing the price.
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A firm’s objective has been assumed as making a profit.
Profit: The difference between total revenue and total costs.
Economists intend to recognize the full private cost of economic activity, and hence consider
normal profit as a cost.
Normal Profit: The minimum profit the firm requires to continue production – it is considered
to be a cost of production and the entrepreneur’s reward.
The Price System
Pure, supernormal, or abnormal profit is profit that motivates entrepreneurs to take risks, and
acts as a signal for other firms to move into a market.
Abnormal Profit: Any profit which is earned above normal profit.
∴ Profit = Total Revenue – Total Costs (including normal profit)
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A firm is a business that combines factor inputs to produce products for a profit. They can
come in the form of sole traders, partnerships, cooperatives, limited companies, state-owned
corporations, multinational/transnational, etc. (see business notes for details)
SMEs: Small/medium enterprises; firms with fewer than 250 (medium) / 50 (small) employees.
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An industry is the sum of firms producing the same product, or in the same line of business.
Firms, including MNCs, can make different products and operate in more than one industry.
Multinational Corporations (MNCs): Firms that produce products in more than one country.
Market Share: The sales of a firm expressed as a percentage of the total sales in the industry.
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The structure of a market, and the different market structures themselves can be defined as:
Market Structure: The way in which a market is organized, in terms of the number of firms
and the barriers to the entry of new firms.
Barriers to Entry: Restrictions that prevent new firms from entering an industry.
Apart from the factors in the picture, the market structure can be determined by: using a
concentration ratio to compare the combined market share of the biggest firms of the
industry as a percentage of the industry total, or considering the importance of economies of
scale (if it is important, then the industry will be closer to an oligopoly).
Imperfect Competition: Any market structure except for perfect competition.
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Perfect competition is a theoretical extreme that acts as a benchmark for real-world
competition. It has the following characteristics:
→ A large number of buyers and sellers with perfect knowledge of the market and price.
→ The ruling price is determined by market forces, and no firm has any influence over it.
→ All products are homogenous.
→ There is complete freedom of entry into, and exit from the market.
→ All firms and consumers have complete information on products, prices, and production.
In this market structure, consumer sovereignty and efficient production would prevail without
the possibility of exploitation since each individual firm would make such a small contribution
to the total output that it would be unable to influence the market supply and price. Due to
this, the firm’s demand curve would also be perfectly elastic, at the ‘ruling’ market price.
The Price System
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Hence, the firm just has to decide what quantity to supply at the market price – based on
their costs of production. In perfect competition, firms only make different amounts of profit if
their costs are different; this is achieved by different productivity levels leading to lower ATCs.
Note that when demand is perfectly elastic, the demand curve also represents the marginal
and average revenue (hence they are all unvaried over output).
To maximize profit, the output chosen will be where TR-TC is maximized, or MC = MR.
This is because marginal cost declines as production increases at first but then increases after a point, due to
the law of diminishing returns. If the firm is producing at a quantity where MR>MC, then it can increase
profit by increasing output. The reason is since the marginal revenue exceeds the marginal cost; additional
output is adding more to profit than it is taking away. If the firm is producing at a quantity where MC>MR,
then it can increase profit by reducing output (since MR is unchanged over output). The firm’s profit-
maximizing level of output will hence occur where MR=MC (or at a level close to that point).
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The absence of barriers to entry and exit means an abnormal profit in perfect competition is
unsustainable since it will attract a large number of new firms into the market, which can
increase market supply enough to reduce the price, and hence total revenue and profit.
On the other hand, a sustained fall in the market price can cause TR to fall below TC and lead
to a large number of firms leaving the industry as they would be operating at a loss. This can
in turn decrease the market supply enough to raise the price so that TR≥TC – allowing the
remaining firms to continue production (at at-least a normal profit).
So, the long-term equilibrium is where only efficient firms remain, making a normal profit.
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Monopolistic competition is the market structure that is closest to the model of perfect
→ A large number of buyers and sellers.

→ Firms have some influence on the market price; they are price makers.
→ Few barriers of entry into and exit from the market.
→ Variety of choice from differentiated products; each firm may have their own USP.
Like perfect competition, abnormal profit can only be achieved in the short-term due to few
barriers to entry. A large presence of substitutes mean that demand is relatively elastic.
The Price System
Firms in monopolistic competition can hence lower price to adequately increase demand.
Most firms also invest on their brand image to create a strong USP that differentiates
themselves from competitors and builds brand loyalty. This can help make demand relatively
inelastic, and is often achieved by advertising and promotions.
Successful campaigns can attract new and recurring consumers and deprive competitors of
them. The price can then be raised to increase revenue without losing significant demand.
Unsuccessful campaigns however, can raise costs and have little or very temporary effect.
There is a possibility that a combination of marketing and product innovation may enable
individual firms to sustain abnormal profit given that the total market is growing.
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The main factor separating perfect and monopolistic competition from oligopolies and
monopolies is the amount of barriers to entry (or exit). These include:
→ Economic activity is state-owned and there is a natural monopoly.

→ High fixed or set up costs, and difficulty in attaining capital.
→ The risk of sunk costs can discourage entry into the industry.
→ Brand proliferation by existing firms.
→ Economies of scale giving larger firms an advantage, combined with predatory pricing.
→ Difficulty in attaining the required technology/information due to patents.
→ Pre-existing firms may have monopoly access to raw materials and retail outlets.
→ Difficulty in penetrating rapidly changing industries (e.g.: IT) without strong USPs.
→ Limit pricing by collusion to hide abnormal profits and deter new firms.
→ Collaboration between pre-existing firms.
→ Unsuitable market conditions, such as a recession.
Natural Monopoly: When a single supplier has high cost advantages such that an introduction
of competitors would raise costs and duplication will result in the inefficient use of resources.
Sunk Costs: Costs of shutting down a business, including the loss of capital investment made.
Brand Proliferation: Providing an apparent abundance of choice and closing market niches.
Predatory Pricing: Setting a price below competing firms’ costs of production, in hopes to
drive them out of the market.
Patent: A legal license granting the right to exclude others from making, using, or selling an
invention for a reasonable time; it is intended to reward entrepreneurs for original ideas.
Limit Pricing: When firms deliberately lower prices and abandon a policy of profit
maximization to stop new firms from entering a market.
The Price System
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Oligopoly is the market structure where the total output is concentrated within a few large
firms. It has the following characteristics:
→ The market is dominated by a few firms.

→ Business decisions are based on the activities of close rivals.
→ Substantial barriers to entry.
→ Uncertainties and risks associated with price competition can lead to price rigidity.
Oligopolies can follow two very different cultures – one of aggressive competition between
the top firms, and the other of collaboration/collusion (to maximize the profits of the whole
group by acting as a single monopolist) amongst the top firms.
Cooperation: Firms working together (e.g.: through joint ventures or knowledge-sharing).
Tacit Collusion (By Price Leadership): When a dominant firm sets a price and other firms
charge a similar price based on that price. Price leadership is legal.
Formal Collusion (Cartel): When the largest firms in a market formally agree on a price to
restrict competition; Cartels are illegal.
Since they are price makers, oligopolistic firms may choose to lower prices to increase
competitiveness. However, this can lead to price wars (a spiral of firms lowering prices more
than the other) and cause losses once the price has fallen too low.
The uncertainty of the effect of changing the price means that firms may prefer non-price
competition, so the price in oligopolies tend to be similar between firms, and stable over time.
Instead of worrying about prices, firms can then instead focus on promotions, product
innovation, brand proliferation, market segmentation, and process innovation. The firm can
also grow rapidly by horizontal integration or by becoming a multinational corporation.
Horizontal Integration: When a firm grows through a merger or acquisition (takeover) of
another firm in the same sector of an industry.
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A Monopoly is the structural extreme opposite to perfect
→ A single seller with no close substitutes.

→ High barriers to entry.
→ The monopolist is a price maker.
Monopolies can even be small firms in local markets with

high costs/low profit prospects. It is also possible for large
dominant monopolies to be ousted by new competition.
The image shows that monopolies usually maintain long-term abnormal profit due to high
barriers of entry. However, there may be exceptions where high fixed costs prevent this.
The monopolist’s profits can also be increased using price discrimination.
Price Discrimination: Charging different prices to different customers to maximize revenue.
The Price System
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A natural monopoly is a market situation where a monopolist has an overwhelming cost
advantage – it would be extremely expensive and wasteful for competitors to enter the
market. Most natural monopolies are government owned, providing services like water, gas,
electricity, public transport, etc. Subsidies are required to operate on a socially optimum level.
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The figure to the left shows the comparison between the perfect
competition equilibrium and a deregulated monopoly
equilibrium. It can be noted that the monopoly price is higher
while the output is lower, and its abnormal profit is sustainable.
The firm in perfect competition on the other hand, is
productively and allocatively efficient as it produces the
optimum output and where price=MC. If a perfectly competitive
industry was turned into a monopoly, here would be a welfare
loss of area x in addition to greater allocative inefficiency.
The classic case against monopolies is that its performance and behaviour (e.g.: inefficiency,
consumer exploitation, etc.) is undesirable compared to firms in competitive markets due to a
lack of incentive. They may even invest in increasing barriers to entry to the market.
X-Inefficiency: When typical costs are above those experienced in a more competitive market.
However, some positives may be that abnormal profit is not guaranteed if fixed costs are
high, or abnormal profits can support future investments in process/product innovation.
Economies of scale can also benefit consumers in the form of lower prices.
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All market structures except monopolies & oligopolies, to an extent, are contestable markets.
Contestable Market: Any market structure with a threat of potential entrants into the market.
Hence, these markets have penetrable barriers to entry, a flexible number of firms, normal
profits in the long-term, identical regulations regardless of size, controls against unfair pricing,
and no cross-subsidization.
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In developed economies around 90% business units are small with less than ten employees.
The Price System
The reason so many small firms exist in a world dominated by large MNCs include:
→ The size of the market is too small to → There are obstacles to growth (e.g.:
support large firms difficulty in taking loans).
→ The business involves specialist skills. → The entrepreneur wants a small firm.
→ The product is a service (e.g.: dentist). → Recession/poor economic conditions.
→ The firms are new and growing. → Small businesses may get exclusive
→ Increased access to technology making government support.
small firms more efficient.
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On the contrary, reasons for which firms may want to grow include:
→ To earn a higher profit by gaining more market share.

→ To diversify the product range and spread the business’ risks.
→ To acquire underutilized resources from other firms through takeovers/mergers.
→ To achieve lower average costs.
Economies of Scope: A reduction in average total costs made possible by a firm increasing
the different goods it produces (diversification).
Asset Stripping: The practice of taking over a company in financial difficulties and selling each
of its assets separately at a profit without regard for the company's future.
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The main ways in which firms can grow are:
→ Internal Growth: When a business expands its existing operations.

→ External Growth: When a business takes over or merges with another business.
→ Conglomerate Integration (Diversification): When one firm merges with or takes over
another firm in a completely different industry and/or a different stage of production.
Merger: When the owners of two or more firms agree to join their businesses into one. The
owner of the new business is decided through mutual agreement.
Takeover: When one business buys out the owners of another business by acquiring the
highest percentage of shares. The ownership shifts to the buyer of those majority shares.
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External growth can be further divided as follows:
→ Horizontal Integration: When one firm merges with or takes over another in the same
industry at the same stage of production.
→ Vertical Integration: When one firm merges with or takes over another firm in the same
industry but at a different stage of production. There are two ways of doing so:
❖ Forward Vertical Integration: When one firm merges with or takes over another firm in
the same industry but at a higher stage of production.
❖ Backward Vertical Integration: When one firm merges with or takes over another firm in
the same industry but at a lower stage of production.
The Price System
See more on integration in business notes.

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As noted earlier, cartels occur when the largest firms in a market reach a formal agreement to
restrict competition; they are illegal. The long-term survival of the cartel depends on the high
barriers to entry. However, some threats to cartels include:
→ A price war when one firm breaks the agreement, to catch a bigger market share.
→ A firm earning lower profits due to higher costs while all firms charge the same price.
→ Lacking a dominant power to control the member firms.
→ Legal obstacles wherein cartels are illegal (e.g.: in the EU and the US).
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All firms do not necessarily aim for profit maximization. Objectives of firms can include:
→ Profit Maximization: Producing at the point where MC = MR to maximize abnormal profit.

This is a common objective, which intends to reward the entrepreneurs.
→ Sales Revenue Maximization: Producing at the point where MR = 0 and PED = 1. This
objective is often set when manager salaries are based on revenue.
→ Sales Volume Maximization: Producing at the break-even point or at a loss-making output
to maximize the number of units sold. (The loss can be covered by cross-subsidization).
This objective can be set for merit goods or new products to build their consumer base.
→ Profit Satisficing: Producing at a point where just sufficient/adequate profit is made to
satisfy shareholders as well as other stakeholder groups.
→ Loss Minimization: Producing at a point where losses are minimized. This objective is often
set for firms exiting a market, poor economic conditions, new businesses, etc.
→ Ethical Objectives: Producing at a corporate socially responsible level where social costs
are minimized. (e.g.: minimizing pollution, not underpaying labour/using child labour,
providing suitable work conditions, using sustainable products and methods, etc.). This
objective is set for firms that want to give back to society, or gain a marketing advantage.
Cross-Subsidization: The practice of charging higher prices to one consumer group (e.g.: for
consumer of product A) to artificially lower prices for another group (e.g.: consumers of B).
Shareholders: Entities that own shares (part-ownership) of a business.
Stakeholders: Any entity that is affected by the activities of the business. This can include
shareholders, governments, banks, the local/international community, workers, etc.
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Apart from those stated above, reasons a firm may not want to maximize profits also include:
the difficulty in identifying the output at which MC=MR, wanting to evade government
attention, avoiding abnormal profits from attracting new firms, desiring to be socially
responsible or to not exploit consumers, avoiding takeovers, etc.
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The Price System
In large firms, shareholders appoint directors to run the business. This gives rise to the
Principal-Agent problem – where there is a risk that the director (agent) has their own agenda
and is ignoring the objectives set by the shareholder (principal). This risk is higher where the
shareholders follow a ‘hands-off’ approach and information failure occurs.
______________________________________________________________________________________________
Game Theory: Where competing firms exhibit interdependent behaviour, such that the
actions of one will impact all other firms involved. Example: The prisoners’ dilemma.
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As stated before, oligopolies can either be very competitive or have firms in collusion. A
kinked demand curve is used to study the behaviour of firms in oligopolies without collusion:
However, evidence does not always support this model. Hence, game theory is increasingly
used to practically explain the behaviour of oligopolists:
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Different businesses may use varied pricing policies for different products.
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Price Discrimination is when the business charges differently based on the scenario and
customer so that consumer surplus is reduced and converted to producer surplus. There are
three recognized types of price discrimination:
The Price System
→ 1st Degree: The price is unique with each transaction based on the consumer’s ability and
willingness to pay (e.g.: a private doctor charging more for rich patients while less for
low-income patients).
→ 2nd Degree: The price falls as more units are bought; progressive discounts are offered.
(e.g.: bulk discounts given to buyers of raw materials). These discounts increase the
consumers’ willingness to purchase more units of the product.
→ 3rd Degree: The price is set based on the active discrimination of consumers and their
personal PED for the product. Those whose demand is inelastic are charged more. (e.g.:
air fare for tickets booked earlier are cheaper than those booked close to departure).
Price discrimination can be useful when charging a single price would return a loss:
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Limit Pricing is used by monopolies and oligopolies. They set a low short-term price to
restrict abnormal profits so that new firms do not enter the market.
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Price Leadership is common in oligopolies – all firms in the market set a price similar to the
one set by a dominant firm (i.e.: the brand leader or majority market share holder). It helps
to avoid price wars while maximizing total profit for all firms.
However, this may mean smaller firms with higher average fixed costs will be forced to set
low prices if the dominant firm does so. This can lead to losses and exit from the market.
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See more on pricing methods in business notes.
_____________________________________________________________________________________________
In terms of efficiency, perfect competition is the only market structure where firms are
productively and allocatively efficient (economically efficient) in the long term, making it the
world benchmark. In other structures, barriers to entry combined with high market share
(e.g.: by combining large firms through mergers and takeovers or internal growth), collusion,
firms having control over the price, etc. all lead to economic inefficiency.
The models of market structure assume that each firm will seek to maximize its profits all the
time, but in reality, this is clearly not the case. Alternative motives therefore often make it
difficult to predict the conduct of firms in respect to price and output.
_____________________________________________________________________________________________
Government
Microeconomic Intervention
As seen in chapter 1: AS, there are various faults in the market system which can lead to
market failure. Due to this, government intervention is often necessary.
______________________________________________________________________________________________
Methods of government intervention include:
→ Regulations: Legal restrictions on prices, quality, consumption, etc. followed by

environmental, fiscal, supply-side, and monetary policies helps to control the market.
→ Financial Intervention: Taxes and subsidies are used to ensure that key industries are
protected, and there is a reasonable amount of merit/demerit/public goods produced.
→ Government Provision: The government can nationalize a product (e.g.: electricity, water,
etc.) and provide them at low prices/free of cost.
→ Price Controls: A minimum or maximum price can be set to ensure or prevent the
consumption of certain products.
Market Failure: When the free market does not make the best use of scarce resources.
Regulation: The means by which governments seek to control production and consumption.
Taxes: Charges imposed by governments on incomes, profits, products, etc.
______________________________________________________________________________________________
Analysing maximum and minimum prices set by the government:
______________________________________________________________________________________________
Taxes are used to raise finance for government spending, discourage the consumption of a
product, redistribute income, raise costs of firms imposing costs on others (e.g.: through
pollution), discouraging imports, influencing economic activity, and more.
Government spending is mainly focused on public goods, merit goods, administration,

welfare, subsidies, and imposing policies and regulations.
A good tax system should follow the canons of taxation, proposed by Adam Smith:
→ Equitable: The rich should pay more than the poor.

→ Economic: The revenue should be much greater than the costs of collection.
→ Transparent: Taxpayers should know exactly what they are paying.
→ Convenient: It should be easy to pay.
→ Flexible: The tax should be changeable if economic activity or government aims change.
Government
→ Efficient: A tax should improve the performance of markets or prevent significant

reduction of market efficiency. This can be done through windfall taxes, taxes on pollution,
and lower income taxes (so that effort is not discouraged in the economy).
Tax burden: The tax that is paid by an entity. Higher tax burdens mean a greater percentage
of the entity’s income must be paid as tax.
Incidence of tax: The distribution of the burden of an indirect tax. It is shared between
consumers and producers.
Tax base: The source of tax revenue.
______________________________________________________________________________________________
There are two main types of tax, distinguished by what the tax is levied on.
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Direct Taxes are paid directly to the government by taxpayers, either as individuals or
companies, from their incomes.
Direct Tax: A tax levied on income of people and firms.
If direct taxes are set too high, it may discourage effort, enterprise, and saving. High rates of
income tax may stop people from working overtime or taking promotions. Others may
choose to become economically inactive. High corporate taxes will discourage entrepreneurs
from setting up or continuing their business in the economy.
Adversely, high tax rates may encourage some to work harder if they have fixed financial
commitments or goals. However, as people have lower disposable income with high taxes,
they save less.
Overall, direct taxes are the main method of redistributing income and wealth. They act as
automatic stabilizers and a good source of tax revenue in countries with organized labour
markets, high income, and high literacy. The forms of direct tax include:
Income Tax: A tax charged on the income of a person.

Corporate Tax: A tax charged on the profit of a firm.
Inheritance tax: A tax charged on the amount inherited by a person.
Excise duties: A tax charged on domestically produced demerit goods.
Customs duties: A tax charged on imports.
Local tax: A tax charged on local services (e.g.: fire dept., local school, etc.).
Windfall tax: An extra one-off tax imposed on high supernormal profits. This discourages firms
from settings prices that are too high.
Automatic Stabilizers: Forms of government expenditure and taxation that reduce fluctuations
in economic activity, without any change in government policy.
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Indirect taxes include VAT, GST, etc. Indirect taxes can be further distinguished as ad valorem
taxes and specific taxes. They are widely used to discourage the consumption of demerit
goods while increasing government revenue.
Government
Indirect taxes are regressive in nature. They also tend to raise prices which stimulates workers
to press for wage increases so they can retain their real disposable income. As wages
increase, the cost of production of products increase and the prices increase again. This sets
up an ongoing trend of rising prices that is inflation.
Indirect taxes however, are cheap to collect, not evadable, act as less of a disincentive than
direct taxes, helps to reduce consumption of demerits, and is optional (consumers choose
what to buy and pay tax accordingly). It is also a useful source of government income,
especially in countries where most workers are in the informal sector.
Informal Sector: Parts of the economy consisting of undeclared, illegal, and/or unmonitored
economic activity (it is also known as the black market).
Indirect Tax: A tax levied on the expenditure on goods/services.

Specific Tax: A fixed amount per unit purchased is charged.
Ad Valorem Tax: A proportion or percentage of the price charged by the retailer is charged.
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There are three natures of taxation:
→ Progressive Tax: The percentage of tax charged increases with wealth.

→ Proportional Tax: All entities pay the same percentage of tax regardless of wealth.
→ Regressive Tax: The percentage of tax charged decreases with wealth.
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The government uses subsidies to increase production and reduce the market price of merit,
public, or key products, create an equitable distribution of income, raise low earning producers’
incomes, provide an opportunity for exporters to lower prices and become more competitive,
reduce the dependence on imports by funding domestic producers, etc.
Subsidies: Direct payments made by governments to producers.
Government
__________________________________________________________________________________________________
The government may make transfer payments to vulnerable groups (e.g.: old age pensions to
the elderly, payments to the disabled, unemployment benefits to the unemployed, housing
allowances/food coupons/child benefits/etc to the poor, etc.).
Transfer payments can only be made if there is adequate tax revenue. They can result in less
poverty and more equitable distribution of income. However, it may act as a disincentive to
accepting work. As a consequence, unemployment rates rise and the economy will fail to
work with maximum efficiency.
Transfer Payments: A hand out or payment made by the government to certain members of
the community, without an exchange.
______________________________________________________________________________________________
The government may also engage in the direct provision of goods and services. This involves
offering free key services (e.g.: healthcare and education), aiming for an equitable distribution.
The main criticism of transfer payments is that the market overprovides (especially when no
direct charge in made) and resources are not allocated efficiently. Moreover, this can again
act as a disincentive towards work.
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Nationalization vs. Privatization
Nationalization Privatization
• When governments take over a private sector • When state-owned public sector
business and transfer it to the public sector. businesses are sold to the private-
• The government will take all costs and benefits sector.
of their decisions into account. • Reduces government burden and
• There is little sense in duplicating certain involvement in the economy.
• Widens share ownership among
services (e.g.: railway, water, etc.), largely
the population (leads to higher
because of excessive costs.
income).
• Any profits made shall be reinvested in the
• They will try to be efficient and
firm for the benefit of the public. constantly improve the quality of
• Loss making services that have social benefits products.
will not be dissolved. • Benefits in the form of lower
• Long-term planning and the full use of prices..
available resources is likely. • Profit maximization motives can
• Consumers will not be exploited. help increase the country’s
income.
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The broader definition of privatization involves: the deregulation of an industry, franchising to
give new private sector owners the right to operate a particular public sector service for a
given length of time, and contracting out services previously provided by publc sector firms.
______________________________________________________________________________________________
Government
The demand curve is also known as the marginal private benefit (MPB) curve. supply curve is
also known as the marginal private cost (MPC) curve.
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When the market fails, it can generate deadweight losses.
Deadweight Loss: A cost to society created by market failure, which occurs when desirable
consumption and production does not occur. It represents an inefficient allocation of resources.
__________________________________________________________________________________________________
Positive/negative externalities occur when marginal private benefits/costs are greater than
marginal social benefits/costs. Negative externalities can be corrected by the government, using:
indirect taxes, regulation, pollution permits, subsidies, provision of information, etc.
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Negative production externalities are a common form of market failure. It can be corrected by tax:
Another way is to set and enforce regulations, such as placing a limit on pollution and fining
uncomplying firms. These help to prevent big negative externalities from arising in the first place.
Regulations: Various legal requirements set by governments and organizations.
A free market solution can involve pollution permits. If a firm does not reach the pollution limit,
they can sell their remaining allocation to others; The cleanest firms sell their permits while more
polluting firms buy them. Hence, it rewards cleaner firms and imposes costs on polluting firms.
However, the government must be sure not to oversupply permits.
Pollution Permits: Tradable permits that allow firms to pollute up to a certain level.
Property rights gives entities the right to own resources such as housing, rivers, etc. and use it as
they will. A firm with negative production externalities and property rights can refuse to relocate,
for example, unless they are paid an amount equal to the costs they would incur for relocating.
On the other hand, individuals with property rights can sue firms creating negative externalities in
their area, although this may be difficult if the firm is large or a big MNC.
Government
A lot of bargaining usually occurs in property rights cases, until a settlement is reached.
Property Rights: When owners have a right to decide how their assets may be used.
__________________________________________________________________________________________________
Negative consumption externalities are another form of market failure. Examples include health
problems caused by passive smoking. This can also be corrected by tax:
Regulations on consumption, and the provision of information (e.g.: warning posters on the
adverse effects of smoking and passive smoking) can also be useful in these cases.
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Contrarily, positive production externalities are also a form of market failure. Examples include
vaccines preventing widespread disease. Since externalities are not considered by producers, the
product’s benefits are understated, and it is undersupplied. This can be corrected using subsidies:
__________________________________________________________________________________________________
On the other hand, examples of positive consumption externalities include receiving education
that benefits the economy with a better workforce and supply of enterprise. However, these
externalities are also overlooked, and so this problem is also corrected using subsidies:
__________________________________________________________________________________________________
The nudge theory is a paternalistic approach to achieve beneficial economic and social outcomes
without the need for regulations. It does so by providing information and presenting choices in a
way that nudges them towards it.
Government
An example may be launching a media campaign regarding the benefits of cycling or public
transport, in order to reduce the number of cars on the road. It can also be done though letters,
emails, or other personal communication networks.
Nudge theory can be effective, but only to a limited extent as individuals retain their freedom to
choose. It is most effective when used alongside pre-existing policies dealing with market failure.
__________________________________________________________________________________________________
The arguments for nationalization and privatization are noted earlier in the chapter.
In reality, firms may be privatized mainly because breaking up a state monopoly is likely to
produce greater economic efficiency. This is because private firms are profit motivated and
require efficiency to survive and thrive, while state-owned firms can face x-inefficiency, make
losses, and rely on subsidies. Moreover, private firm managers are also accountable to
shareholders whereas the general public has limited property rights over a nationalized company.
Alternatively, firms may retain state-ownership if duplication would be wasteful (e.g.: railways), a
private monopoly would be formed, or regulation and control is essential.
__________________________________________________________________________________________________
Equity, has two branches:
→ Horizontal Equity: Entities with the same circumstances should pay the same level of tax.
→ Vertical Equity: Taxes should be fairly apportioned between the rich and the poor.
Equity: When the distribution of something is fair and impartial, according to each entity’s needs.
Efficiency: Making the best use of available resources.
Policies improving efficiency may increase inequity; governments often find it necessary to choose
between them and strike some balance.
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A Lorenz curve is used to represent inequality in an economy.
Wealth: An accumulated stock of assets.

Income: The reward for the services of a factor of production.
Lorenz Curve: A graphical representation of inequality.
Gini Coefficient: A numerical measure of inequality (=area x ÷ (area x + area y)).
__________________________________________________________________________________________________
Government
Government policies to redistribute income and wealth:
→ Providing Benefits: The government can provide means-tested benefits, but must ensure to
not be too generous (to avoid poverty traps), and that only those who need it, receive it. They
can also provide universal benefits, but this involves payments to many who do not need it.
→ Tax: Progressive direct taxes can help to redistribute income by charging the rich more.
However, the tax should not be too high (to avoid being a disincentive to work).
→ Other Policies: The government can provide important services for free, maintain price stability
(stabilize real income), impose a negative income tax, maintain intergenerational equity, etc.
Negative income taxes work by keeping a flat tax rate and providing a fixed universal annual benefit of $x. If the tax paid
on earnings is less than this amount, the person receives the difference from the government. If it is more (in case of
higher earners), they have to pay that amount in direct tax.
Means-tested Benefits: Benefits paid only to those whose incomes fall below a certain level.
Examples include unemployment benefits, food coupons, etc.
Universal Benefits: Benefits that are available to all, irrespective of income or wealth. Examples
include universal state pensions, healthcare, and child benefits.
Poverty Trap: Where an individual or family are better off on means-tested benefits than working.
Negative Income Tax: A unified tax and benefits system where people are taxed, or receive
benefits according to a single set of rules.
Intergenerational Equity: The responsibility that the government has to provide for a more
equitable future distribution of income and wealth.
__________________________________________________________________________________________________
Demand for labour is derived demand. A firm should only hire workers up to the point where the
marginal revenue product of labour is zero, as after that point additional workers will not add to
the revenue. The market wage is partly determined by the marginal revenue product of labour –
which is also the firm’s demand curve for labour.
Derived Demand: When demand depends upon the use that can be made from it.
Marginal Revenue Product: The addition to revenue as a result of employing one more worker.
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Supply of labour is the availability of willing and able workers. It is affected differently at different
levels; the individual’s supply of labour changes with the wage (see below) and tax rate. The labour
supply to a firm or industry consists of the sum of all individual supply curves of the workers
employed in that firm or industry (see below).
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Government
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The wage paid to labour is equal to the value of the marginal product of labour, and the
willingness of labour to supply their services is dependent on that wage. Overall, the equilibrium
wage in perfect markets is the equilibrium of the demand and supply of labour.
The demand curve for labour represents the marginal product of labour, and the firm will only
hire until the value of marginal product equals the wage. Hence, the wage received at equilibrium
is equal to the marginal revenue productivity.
Of course the wage market is dynamic, so there may be changes in the wage rates over time –
due to shifts in demand and supply.
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The equilibrium wage in imperfect markets is also partly determined by demand and supply, but
external intervention from governments, trade unions, and others may be ubiquitous.
Trade unions usually aim to increase wages, improve working conditions, fight job losses, maintain
pay differentials between skilled and unskilled workers, secure additional working benefits, etc.
Trade Union: An organized association of workers collectively bargaining to protect and further
their rights and interests. They do so through strength in numbers.
It is theorized that strong trade unions can increase wage to a point above the equilibrium. Doing
so creates a surplus of labour in the market as: people attracted to the wage enter the workforce,
and as it is increasing labour costs, firms hire less. This can then force firms to relocate in countries
with lower labour costs, in order to continue production while maintaining low costs.
The most common form of government intervention in the labour market is the minimum wage.
This prevents the exploitation of workers, reduces government burden on state benefits, and
slightly increases tax revenue, However, it can create a surplus and subsequent job losses
(especially where demand for labour is elastic), alongside cost-push inflation (especially when
people try to maintain wage differentials).
__________________________________________________________________________________________________
Earnings can be split into two elements:
Transfer Earnings: The amount earned by a factor of production in its best alternative use – so, it
is the minimum payment necessary to keep labour in its present use.
Economic Rent: Any payment made to a factor production above that of transfer earnings.
Government
When the total supply of a factor is perfectly inelastic, no price is needed to be paid in order to
induce it to be available for production, so their reward is completely economic rent.
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The concept of demand and supply explains the difference in pay between people. Someone like
Messi has high demand but a perfectly inelastic supply, so they are paid more and their wage is
completely economic rent. Someone like a street cleaner requires no skills so their perfectly elastic
supply is much higher than their demand. Their wage is much lower - They only choose to do that
work as gives better wages than the next best alternative (transfer earning).
__________________________________________________________________________________________________
A monopsony in the labour market occurs when there is a sole or a dominant employer (e.g.:
NASA for astronauts). This gives them wage-setting power in the market.
Monopsony: A market situation in which there is only one buyer.

__________________________________________________________________________________________________
Government intervention can lead to government failure in the following cases:
→ Imperfect Information: Not having enough/correct information can lead to greater inefficiency
(e.g.: miscalculating negative externalities and charging the wrong amount of tax).
→ Undesirable Incentives: Policies such as taxes may act as a disincentive to work and generate
inefficiency; Political agendas can cause the government to act in a way to remain in power
rather than increase efficiency; Directors of public services may also not have raising
inefficiency as a main target, and may lack incentives to improve the system.
→ Policy Conflict: Government policies may conflict with each other (e.g.: a subsidy for fossil fuel
companies can encourage production and economic growth but it will be detrimental for the
government’s environmental sustainability policies due to increased pollution).
Government Failure: When government intervention to correct failure causes further inefficiencies.
__________________________________________________________________________________________________
The Macroeconomy
The macroeconomy refers to the economy as a whole. The level of activity in an economy is
determined by aggregate (total) demand and supply.
__________________________________________________________________________________________________
Aggregate demand consists of four components:
→ Consumption (C): Consumer expenditure (i.e.: household spending on products).

→ Investment (I): Spending by private sector firms on capital goods.
→ Government Spending (G): Public sector expenditure on goods and services.
→ Net Exports (X-M): Exports (X) subtracted by imports (M) by the country.
Aggregate Demand (AD): The total spending on an economy’s goods and services at a given
price level and time period.
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An aggregate demand curve can be drawn using data from aggregate demand schedules.
Shifts in the aggregate demand curve may occur due to:
→ Consumption: May change with income tax cuts, consumer confidence, wealth, money supply,
and population.
→ Investment: Depends on corporate tax cuts, business confidence, economic stability, and
technological advances.
→ Government Spending: May change due to changes in government policies or political
agendas (e.g.: trying to remain in power during an election).
→ Net Exports: Varies with the exchange rate, the quality of domestically produced products, and
incomes earned abroad.
__________________________________________________________________________________________________
Aggregate supply is distinguished by the time-period under consideration.
Aggregate Supply (AS): The total output (real GDP) that producers in an economy are willing and
able to supply at a given price level and time period.
Short-Run Aggregate Supply (SRAS): The total output of an economy that will be supplied when
there has not been enough time for the prices of factors of production to change.
Long-Run Aggregate Supply (LRAS): The total output of an economy supplied in the period when
the prices of factors of production have fully adjusted, following a change.
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This distinction means there are two aggregate supply curves based on time period. The short-
term aggregate supply curve (SRAS) is an upward sloping curve.
The Macroeconomy
Shifts in the short-term aggregate supply curve may occur due to:
→ Changes in the price of factors of production

→ Changes in direct and indirect taxation
→ Changes in factor productivity and the quality of resources
→ Changes in the quantity of resources
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There are two long-term aggregate supply curves, based on different economic approaches.
Keynesians: Followers of economist John Maynard Keynes who maintain that government
intervention is needed to achieve full employment.
New Classical Economists: Those who think the LRAS curve is vertical and that the economy will
move towards full employment without government intervention.
Macroeconomic Equilibrium: The point where there is an interaction of aggregate demand and
aggregate supply curves.
The causes of shifts in the LRAS curve are simply changes in the quality and quantity of resources.
__________________________________________________________________________________________________
Inflation refers to a sustained rise in the general price level.
Creeping inflation: A low rate of inflation.
Hyperinflation: A very rapid rise in the general price level, causing the value of a currency to fall so
rapidly that people lose confidence in using it as money.
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To asses changes in the cost of living, governments construct consumer price indices which can
act as a measurement of inflation.
Cost of living: The cost of a representative basket of products.
Consumer Price Index (CPI): An index that shows the average change in the costs of living (by
comparing past and present prices of a representative basket of products).
The Macroeconomy
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Inflation can occur in two main ways:
Menu Cost: The costs involved in having to change prices due to inflation.
Shoe-Leather Cost: The costs involved in moving money around in search of the highest interest
rates (on savings), and lowest prices.
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The positive consequences of inflation are as follows:
→ Firm expansion: A low and stable rate of inflation may encourage firms to expand and
produce a higher output.
→ Reduction of debt burden: Inflation reduces the real burden of borrowers or people in debt as
the purchasing power of each unit decreases. Households and firm may avoid bankruptcy.
→ Avoiding redundancy: Inflation keeps some workers from being made redundant in a
declining industry or region. This is because workers may accept their wages rising by a rate
less than the rate of inflation. In such a case, the firm’s real wage costs will fall without the
need for dismissal or nominal wage cuts.
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The Macroeconomy
Adversely, the negative consequences of inflation are as follows:
→ Inflation causes a fall in the value of money. If prices are rising, each unit of money will have a
lower purchasing power.
→ Inflation redistributes income in an unplanned way: Workers receiving wage rises that are
more than the inflation rate gain while others lose. Borrowers benefit if the rate of inflation is
above the interest rate:
(e.g.: A man borrowed $100. If the inflation rate is 12%, he would have to pay back $112 for the lender to gain back
the same amount of purchasing power. However, if the rate of interest is, say 8%, he would only pay back $108). As
borrowers are benefitting, savers are likely to lose.
→ Inflation imposes additional costs on firms: This includes shoe-leather and menu costs.
→ Inflation creates uncertainty and discourages investment: Price uncertainty makes it difficult to
plan ahead. This discourages firms from investing.
→ Fall in net exports (balance of payments worsens): If a country’s inflation rate is higher than
that of its rivals, its products will become less price competitive. This can result in a deficit in
the balance of payments as export revenue decreases.
→ Fiscal drag: When tax brackets are not adjusted with inflation, people’s incomes get dragged
into higher tax brackets (leaving them with a lower real disposable income).
→ Inflationary noise (‘Money Illusion’): Consumers and firms confuse price signals (e.g.: a rise in
the price of a product may not mean it has had an increase in price due to higher demand.
Instead it may simply be due to a rise in the general price level – inflation). This can result in
wrong decisions being taken (e.g.: misallocation of resources).
→ Inflation causing inflation: Expectation of future price rises may increase short-term demand,
wages, and prices (due to expected increase in costs) – leading to even more inflation.
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The factors influencing the consequences of inflation include:
→ The cause of inflation: Demand pull inflation is likely to be less harmful as it is affiliated with
rising output while cost push inflation is associated with a falling output.
→ Rate of inflation: A high rate of inflation is more harmful.
→ Whether the rate is accelerating or stable: A fluctuating rate of inflation causes uncertainty,
and is likely to be more harmful than a stable one.
→ How the rate compares with that of other countries: If it is similar to the rate of other
countries, it is likely to be less harmful as international competitiveness can be maintained.
→ Whether the rate is one that had been expected.
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Alternatively, deflation is a fall in the general price level.
The difference between deflation and disinflation is that when disinflation occurs, there is still a rise
in the general price levels, but the rate of the rise is lowered. When deflation occurs, there is
always a fall in the general price level (in other words, the rate of inflation is negative).
Disinflation: A fall in the inflation rate.
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The Macroeconomy
Deflation may result from the supply-side or demand-side of the economy. The price level may be
reduced due to advances in technology or increases in labour productivity. Deflation can also be
caused due to a decrease in aggregate demand.
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The consequences of deflation are dependent on its cause:
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The Balance of Payments:
The Macroeconomy
Balance of Payments: A record of all economic transactions between the residents of the country
and the rest of the world in a particular period of time (usually a year).
Direct Investment: The purchase of businesses or the establishment of a new business in another
country by the home country (debit item), or by a foreign country in the home country (credit).
Portfolio Investment: The purchase and sale of government bonds and shares (of PLCs).
Other investment: Short-term movements of financial investment including Trade credits, bank
loans and inter-government loans.
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A balance of payments surplus/deficit occurs when the total amount of money coming into the
country is more/less than the amount of money going out of the country.
A current account deficit may be caused due to:
→ A growing domestic economy: Firms increasingly import raw materials or capital to expand.
Export revenue may decline due to exports being diverted from foreign to domestic markets.
This cause is not one to worry about since growth leads to investment in the country.
Moreover, it can be short-term and self-correcting as the imported materials are used to
create products which might be sold abroad (and increase net exports in the future).
→ Declining economic activity in trading partners (Cyclical deficit): If the importers of the home
country’s goods are facing a recession or slump, their imports may fall significantly or rise
more slowly, leading to a current account deficit for the home country. This can also be
relatively short-term and self-correcting.
→ Structural Problems: There may be a deficit if exports are less due to lack of international
competitiveness (e.g.: because of overvalued exchange rates, high inflation, low productivity,
etc.), and having to borrow to finance the surplus imports in the economy. This cause is a
concern since it will not be self-correcting.
The Consequences of an Unbalanced Current Account
Current Account Deficit Current Account Surplus

Positives: The residents of the country can Positives: The country may have a budget
consume more to improve living standards. surplus. Other countries may be indebted to
the country. The budget surplus can help to
improve living standards.
Negatives: The deficit must be financed Negatives: The residents are not enjoying as
through borrowing (which may cause debt) high a living standard as possible. The high
or investment coming in. The country may level of demand and money supply can lead to
also face a fall in AD, which can slow inflationary pressure as well.
economic growth.
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A financial account deficit is not considered as a problem since it is related to investment and
loans which will give rise to an inflow of profits, interest, and dividends from investments made (in
the long-term). The problem may also be short-term if it was caused by hot money flowing out of
the country in search of higher interest rates or belief that other currencies may rise in value.
The Macroeconomy
However, it may be of concern if the deficit is due to a long-term lack in confidence in the
country’s economic prospects as this can lead to capital flight and a subsequent reduction of tax
revenue and employment. This can result in a recession and further problems in the long-term.
Hot money flows: The flow of funds (or capital) from one country to another in order to earn a
short-term profit on interest rate differences and/or anticipated exchange rate shifts.
Capital flight: A large-scale exodus of financial assets and capital from a nation due to political or
economic instability, lack of confidence, currency devaluation, or the imposition of capital controls.
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When trading with other countries, the exchange rate plays a key role.
Nominal Foreign Exchange Rate: The price of one currency in terms of another currency.
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It is possible for the country’s currency value to increase against one currency while decrease
against another. To understand the general change in its exchange rate, a country may calculate
its trade weighted exchange rate (multinational exchange rate), in index form. The currencies are
weighted according to the relative importance of the countries in the country’s trade.
Trade Weighted Exchange Rate: The price of one currency against a basket of currencies.
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To include the effect of price changes (e.g.: inflation) along with exchange rate changes,
economists measure the real effective exchange rate. This helps to accurately assess changes in
the competitiveness of a country’s products in global markets.
For example, goods worth 10tk were bought with $5. But as the nominal rate of taka fell, goods worth 10tk could be
bought with $1. However, inflation in Bangladesh rose the price of those goods to 50tk. So, at the end, the buyers must
still pay $5 for the same goods. Assessing the nominal exchange rate would show a rise in international competitiveness
for Bangladesh whereas the real effective exchange rate shows that there is no change in their intl. competitiveness.
Real Effective Exchange Rate: A currency’s value in terms of its real purchasing power.
Nominal Exchange Rate x Domestic Price Index
Real effective exchange rate = Foreign Exchange Rate
The REER may rise either due to currency appreciation or inflation.

Currency Depreciation: A fall in the value of a currency due to natural market forces.
Devaluation: A fall in the value of a currency due to deliberate manipulation of demand/supply.
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There are three exchange rate determining systems:
Floating Exchange Rate: An exchange rate that is determined by demand and supply.
Fixed Exchange Rate: An exchange rate set by the government, maintained by the central bank.
Managed Float: An exchange rate influenced by state intervention up-to a certain extent.
The Macroeconomy
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In a floating exchange rate system, the rate is determined solely by market forces.
Analysing the Floating Exchange Rate System

Benefits Drawbacks
• It helps to correct a balance of • The exchange rate may fluctuate
payments surplus/deficit, given there is significantly, making trade calculations
elastic demand for exports/imports. difficult and discouraging investment.
• Reserves of foreign currency do not • It puts pressure on the government to
need to be held and can be used for maintain price stability.
other purposes.
Elaboration on disadvantages: A fall in the exchange rate will increase inflationary pressure due to the cost of imported
capital/raw-materials increasing and leading to an increase in the prices within the country. There is also no guarantee
that a floating exchange rate will eliminate a BOP disequilibrium (e.g.: exchange rate may still rise during a deficit in the
current account if speculators buy the currency expecting it to rise in value).
Forward Markets: When there are uncertain fluctuations in a floating exchange rate, the buyer and
seller agree on a fixed value to be paid for the product beforehand – this value is paid regardless
of the exchange rate at the time of payment.
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In a fixed exchange rate system, the value of the currency is determined by the government (e.g.:
the government sets the rate to be US$1 = AU$2).
The central bank maintains the rate by buying (to revaluate)/selling (to devaluate) the currency
from/to the foreign exchange market and manipulating its supply. It can also increase (to
revaluate)/decrease (to devaluate) the interest rate to manipulate the demand.
Analysing the Fixed Exchange Rate System

Benefits Drawbacks
• A non-fluctuating rate creates certainty • It prevents the self-correction of a balance
and allows for proper trade calculations, of payments surplus or deficit.
as well as investment into the country. • Reserves of foreign currency need to be
• It imposes discipline on a government to held; there is an opportunity cost as it could
keep inflation low so that a loss in have been used elsewhere.
international competitiveness does not • The government may have to sacrifice other
put downward pressure on the rate. policy objectives to maintain the set rate.
If the rate is overvalued, the central bank may deplete foreign reserves trying to keep it at a level
that does not reflect its market value. Moreover, If the central bank raises interest rates, it may
reduce aggregate demand and conflict with other government policies like economic growth.
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A managed float exchange rate combines the features of a floating and
fixed exchange rate system – it allows the exchange rate to be
determined by market forces within a given band/range. When the
exchange rate moves out of this range, the central bank uses foreign
reserves or alters interest rates to move it back within the range.
The Macroeconomy
__________________________________________________________________________________________________
Factors which cause changes in the demand for a currency – Demand may increase due to:
→ Rising exports (purchase of goods and services from the country).

→ Investment (may be direct/portfolio/other) in the country.
→ Speculation (People buy the currency as they expect its value to rise in the future).
→ Saving in domestic banks by local and foreign nationals due to higher interest rates.
→ Increased FDI due to improved labour productivity.
Factors which cause changes in the supply for a currency – Supply may increase due to:
→ Rising imports (purchase of goods and services from foreign countries).

→ Increase in foreign travel (i.e.: rising import of services).
→ Investing (may be direct/portfolio/other) abroad.
→ Speculation (People sell the currency as they expect its value to fall in the future).
→ Increased FDI abroad.
Effects of the Devaluation or Depreciation of a Currency

Benefits Drawbacks
• Exports become cheaper and imports • Inflationary pressure from higher AD.
become expensive, improving balance of • As the economy approaches full capacity,
payments position. resources become scarce and expensive.
• Enables domestic firms to expand by • Costs of production may rise due to
selling more both home and abroad. reaching full capacity alongside the increase
• Higher AD leads to higher output, lower in the cost of imported raw materials.
unemployment, higher tax revenue, etc.,
all leading to better living standards.
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The effects of changing foreign exchange rates on the economy in the case of a
depreciation/devaluation may not always include a corrected current account deficit:
Normally the lower exchange rate would increase international competitiveness and encourage
exports while making imports expensive (hence discouraging them). This would theoretically result
in the elimination of a current account deficit.
Other effects: Increased AD, employment, output, living standards, etc. but also full employment
of resources in the long-term leading to cost-push and demand-pull inflationary pressure.
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The effects of changing foreign exchange rates on the economy in the case of an
appreciation/revaluation may not always include a corrected current account surplus:
Normally the higher exchange rate would reduce international competitiveness and lower exports
while making imports cheaper. This would theoretically eliminate a current account surplus.
Other effects: Opposite of those stated above.
The Macroeconomy
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For the aforementioned theories to be true, the Marshall-Lerner condition must be fulfilled.
Marshall-Lerner Condition: The requirement that for a fall/rise in the exchange rate to be
successful in reducing a current account deficit/surplus, the sum of the price elasticities of demand
for exports and imports must be greater than 1 – The greater the combined PED is, the smaller will
be the fall in exchange rate required to impact the current account position.
This is because a fall/rise in the E.R will not greatly influence demand if it is price inelastic. In this
case, the rate should instead be revaluated/devaluated to get more/less revenue from exports,
__________________________________________________________________________________________________
J-Curve Effect: A fall in the exchange rate causes an increase in a current account deficit before it
moves towards a surplus due to the time it takes for demand to adjust.
Reverse J-Curve Effect: A rise in the exchange rate causes an increase in a current account surplus
before it moves towards a deficit due to the time it takes for demand to adjust.
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The terms of trade, can be used to understand the value of exports required by the country to
import a given quantity of products.
Terms of trade: A numerical measure of the relationship between export and import prices.
Index of export prices
Terms of trade index = x 100
Index of import prices
The price is taken as an average of most of the products trade internationally. It is weighted by the
relative importance of each product traded. An increase in the index is a favourable movement –
less exports have to be sold to buy a given quantity of imports.
Calculation and gains of terms of trade: https://www.youtube.com/watch?v=C-xLUS5JGIM

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Changes in the terms of trade can be caused by:
Short Term Factors:
→ The demand and supply of exports and imports.

→ Inflation (increases terms of trade but may not be good for the economy as prices are rising).
→ Changes in the exchange rate.
Long Term Factors:
→ Changes in income.
→ Increases in the quantity and quality of factor inputs.
The Macroeconomy
Prebisch-Singer Hypothesis: The terms of trade tend to move against primary producing
(underdeveloped/developing) countries – this is because the demand and value of manufactured
goods and services are/rise more than that of primary products (e.g.: agriculture).
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The impact of changes in the terms of trade depends on its cause. An increase in the index will be
favourable if the price of exports rises due to higher demand. But it will be bad if the increase in
export prices is due to rises in costs of production, inflation, or inefficiency.
A fall in the index can be good (e.g.: by reducing a deficit in the current account) if the Marshal-
Lerner condition is met (a fall in export prices relative to import prices should increase export
revenue relative to import expenditure).
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The link between absolute/comparative advantage and the term of trade can be understood in
the same previously linked video (https://www.youtube.com/watch?v=C-xLUS5JGIM).
Absolute Advantage: A country has an absolute advantage in producing a product if it can

produce more of a product with the same quantity of resources than another country ¬– If each
country produces the product in which they have an absolute advantage and trades then total
output should rise (considering opp. cost ratios) and all countries involved should be able to
consume more products.
Comparative Advantage: A country has a comparative advantage when they can produce a
product at a lower opportunity cost than another country – most trade is based on comparative
advantage as it enables producers to concentrate on producing those products that they are even
better at producing. Trading based on comparative advantage can help both countries receive
products beyond their productive potential.
Assumptions made when considering comparative advantage include that:
→ There are only 2 countries and each of them produce only two products.
→ Labour is the only factor of production, the quality of labour in both countries is the same.
→ Cost of production is constant in both countries.
→ Factors are mobile within the country but immobile between countries.
→ There are no transport costs or tariffs (there is free trade).
→ No technological change occurs within the countries.
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The benefits of free trade:
→ No taxes/limits/unnecessary paperwork – this allows exporters to charge a lower price.

→ Costs of production may be reduced due to lower prices of imported materials or capital.
→ No subsidies are given to distort cost advantages.
→ Allows an efficient allocation of resources and economies of scale (due to larger market).
→ Increased competition; can pressurize to improve efficiency and quality/variety of products.
→ Increased world output and employment, and subsequently living standards.
→ Individual countries can the reap benefits of factor endowments.
The Macroeconomy
Free Trade: International trade not restricted by tariffs and other protectionist measures.
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A trading possibility curve can help to understand the potential outcome of trades. This is also
explained in the same previously linked video (https://www.youtube.com/watch?v=C-xLUS5JGIM)
Trading Possibility Curve: A graph showing the effects of a country specializing and trading.
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Free trade may be limited to a certain region in the form of a trade bloc.
Trade Bloc: A regional group of countries that have entered into trade agreements.
Free Trade Area: A trade bloc where member governments agree to remove trade restrictions
among themselves.
Customs Union: A trade bloc where there is free trade between member countries and a common
external tariff on imports from non-members.
Economic Union: A trade bloc where there is free trade between member countries, a common
external tariff, and some common economic policies (e.g.: a common currency).
Form of Trade Bloc Features

Economic Customs Free Trade Removal of trade restrictions between member countries.
Union Union Area
Common External Tariff on trade with non-members.
Removal of restrictions on movement of capital and labour.

Example: Example: Example: Single market.
NAFTA Common currency.
European SACU
One central bank sets a single interest rate.
Union
Some other common economic policies.
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__________________________________________________________________________________________________
Governments enforce protectionist measures to try and ensure that domestic businesses can
survive or thrive in the globalized market.
Protectionism: The act of protecting domestic producers from foreign competition through the
restriction of free trade or other related measures.
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The common methods of protectionism are listed below.
The Macroeconomy
→ Tariff (Customs Duties): A tax imposed on imports and exports – they are charged on imports
to raise revenue (effective if PED is elastic), discourage the consumption of imports (effective if
PED is inelastic), or encourage the consumption of domestic goods.
→ Quota: A limit on the physical quantity/amount/value of imports or exports – this is imposed
for the same reasons as a tariff other than for raising revenue (since no extra cost is charged).
It works by decreasing supply to drive up the price.
→ Exchange Control: Restrictions on the purchases of foreign currency – this is set to indirectly
restrict the amount of imports that can be brought into the country. The method works
because foreign currency is required to purchase imports.
→ Export Subsidy: Subsidies given to exporters and domestic firms that compete with imports –
this enables domestic producers to be competitive by charging lower prices using the subsidy.
→ Embargo: A complete ban on imports or exports – this is done to completely restrict the
import of an undesirable product. This may include demerit goods or products competing
with key industries of the country.
→ Voluntary Export Restraint: A limit placed on imports reached with the agreement of the
supplying country – This agreement may be done in return for the importing country also
agreeing to limit exports it sells to that country. The supplying country may also be pressured
into the deal (e.g.: if they are given an ultimatum by a more economically powerful country).
→ Economic and Administrative Burdens (Red Tape): Intentionally requiring suppliers of imports
to fill out time consuming forms and setting artificially high product standards – these may
make firms hesitant to export to the home country. Absurdly high product standards (e.g.:
requiring 0% fat in fast-foods) may be an indirect way to impose an embargo on the import.
→ Keeping the Exchange Rate below its Market Value: Devaluing the currency would make
imports expensive while exports cheaper, giving producers a price advantage on the
international market, and consumers an incentive to buy domestically produced goods.
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Despite the benefits of free trade, some arguments for protectionism include:
→ Protecting infant (sunrise) industries: Protecting new industries until they can grow large
enough to avail cost advantages. In the future, the government and economy may be
rewarded by tax revenue from high profits that can be used to improve living standards. There
is however a risk that the firm may fail even after protectionism policies.
→ Protecting declining (sunset) industries: Protecting dying industries to give its employees
enough time to find work elsewhere or to allow for the restructuring of the industry.
→ Protecting strategic industries: Strategic industries may be protected as they may give stability
or political advantages. It can allow the country to be independent in these areas, which may
be vital (e.g.: if Y imported fuel from Z, but they had a military conflict, then households in Y
would be gravely disadvantaged if Z stopped supplying fuel to them because of it).
→ Preventing dumping: Dumping can drive domestic firms out of the market. Although
beneficial for consumers in the short-term, in the long-term these foreign firms may become
monopolies and exploit the consumers with high prices. They will also prevent new firms from
being established, reducing investment in the country as well as exports.
The Macroeconomy
→ To improve the terms of trade:

Demand Side: If a country purchases a large proportion of another country’s exports, it may
have a big influence on its demand. If a tariff is imposed, demand for that country’s exports
may fall significantly, forcing them to reduce price even though their cost (due to tariff) is
increasing. This will improve the home country’s terms of trade and allow it to purchase more
imports while exporting the same quantity.
Supply Side: if a country accounts for a significant proportion of the world’s supply of a
product, quotas on its exports may improve its terms of trade. Restricting the supply of
exports will drive up their price and so increase the purchasing power of exports. Such action
however, distorts trade and is likely to reduce global output. It may also provoke retaliation.
→ To improve balance of payments: A country with a balance of payments deficit can move
towards a surplus by improving their current account through the rise of its exports and fall of
imports due to protectionist policies. This can also provoke retaliation. In addition, if the home
country’s products are not internationally competitive, trade restrictions would only help for
the short-term, before consumers switch to alternatives.
→ To provide protection from cheap labour: Countries with very low wage rates can exploit
labour to keep costs low and hence prices low. A tariff on them would support moral
arguments and also make up for the higher price in the home country (which may be due to
higher labour costs/wages). However, it may be that these trade restrictions drive wages down
even further in the supplying countries to maintain their profit.
→ Other reasons: Includes persuading other governments to reduce trade restrictions (i.e.: by
retaliation). However, there is a risk that a trade/retaliation war will develop. In addition, the
government may seek to protect a range of industries to avoid the risks attached to
overspecialization (such as high levels of interdependency).
Infant industries: New industries that have low output and high average cost.
Dumping: Selling products in a foreign market at a price below their cost of production.
Retaliation: Any punitive action taken by a country whose exports are adversely affected by the
raising of tariff or other trade-restricting measures by another country.
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Turn over for continuation.
The Macroeconomy
Recently, economics have found it important to distinguish economic growth, and development.
Economic Growth: A short-term increase in the country’s output followed by an increase in its
productive potential in the long-term; this may not always lead to economic development.
Economic Development: An increase in welfare and the quality of life. Except economic growth, it
depends on multidimensional factors like education, holistic well-being, equality, freedom, etc.
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Efforts to achieve sustainable development has introduced three objectives:
→ Economic: Making better use of resources and investing in the betterment of factor inputs.
→ Social: Distributing the benefits of growth equitably amongst the population.
→ Environmental: Responsibly using natural resources, preferably for long-term growth.
Sustainable Development: Development that ensures that the needs of the present generation
can be met without compromising the well-being of future generations.
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Actual and potential economic growth can be shown in PPCs (see chapter 1). On AD/AS diagrams,
actual growth occurs when AD shifts outwards & potential growth occurs when AS shifts outwards.
Actual Economic Growth: An increase in the real GDP.
Potential Economic Growth: An increase in the productive capacity of an economy.
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The output gap is the difference between actual and potential output. A positive output gap is
unsustainable but possible in the short-term - where superfluous demand causes the economy to
work beyond its maximum potential (i.e.: workers work overtime and machines work at full power).
Output gaps change with the trade cycle (or business or economic cycle).
Trade Cycle: Fluctuations in economic activity over a period of years.
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The Consequences of Economic Growth
Benefits Drawbacks
• Higher government tax revenue, which • May cause Inflationary pressure.
can be invested in development. • Resources become scarce and expensive.
• Better living standards resulting from • The production of demerit products can
lower unemployment, higher availability have adverse effects on the population.
of products, investment, etc. • Negative effects on the environment if
• Greater control over the world economy, sustainable methods are not used.
and higher voting power in the IMF.
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The Macroeconomy
Arguments for conserving resources include sustainable development (conserving for future
generations or better economic conditions), maintaining natural beauty and diversity, preventing
climate change, etc. Arguments against include boosting economic growth and living standards,
meeting excess short-term demand, paying national debts, etc.
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An economy is considered to do well if its output is growing at a high, sustained, and sustainable
rate based on the country’s potential. National income statistics may be used for comparisons.
The GDP and GNI/GNP are widely used measures of national income.
National Income: The total income for an economy.
Gross Domestic Product: The monetary value of all finished products made within a country
during a specific period.
Gross National Income: The monetary value of all finished products made by a country’s nationals,
regardless of where they produce it – during a specific period.
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There are three methods of measuring GDP:
→ Output: Adding up all the output produced by all the industries in the country. It must be
carefully done so that the same output is not counted twice.
e.g.: if the value of cars sold by manufacturers is added to the value of output of the tyre firms, double counting of
the tyres will occur. To avoid this, economists calculate the ‘value added’ by each firm at each stage of production.
→ Income: Adding up all the incomes which have been earned in producing the country’s
output. Transfer payments such as pensions and unemployment benefits must not be
included as there is no corresponding output of products with them.
→ Expenditure: Adding up all the expenditure on the country’s finished output. It is necessary to
add expenditure on exports (as it represents output and creates income in the country) and
subsidies but deduct expenditure on imports and indirect taxes.
Value-Added: The difference between the price set and the cost of raw materials used.
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Nominal GDP may increase without a rise in output, due to inflated prices. For a more accurate
perspective, the real GDP is calculated using the GDP deflator.
Nominal GDP (Money GDP): Total output measured in current prices.
Real GDP: Total output measured in constant prices (adjusted for inflation).
Nominal GDP x Price Index in the Base Year
GDP Deflator: Real GDP = Price Index in the Current Year
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GDP tends to understate the true level of output due to the existence of shadow economies (black
market or informal sector), which covers undeclared economic activity – often due to the activity
being illegal, attempting to evade tax, or low literacy rates making legal procedures seem
complicated. Unmarketed products like domestic services, voluntary work, subsistence work, etc.
are also not included in GDP figures.
Shadow Economy: The output of products not included in official national income figures.
__________________________________________________________________________________________________
The Macroeconomy
Indicators of living standards:
The Real GDP Per Head: The total real GDP of the country divided by its population. To date, it is
the main indicator used to measure living standards. However, it has numerous limitations:
→ It does not consider the product being produced (i.e.: whether they were capital or consumer
products, demerit or merit products, poor quality or good quality products, etc.).
→ The figures on products available to people may be understated as the informal sector is not
recorded (It may also overstate a fall in the quality of output due to the same reason).
→ The real GDP is not evenly distributed, so income inequality is not measured – some people
may receive large amounts of extra income while others receive none.
→ A rise in some services may not be a good indicator for improved living standards if, for
example, police services increase due to increased crime rates.
→ Living standards may be influenced by other factors (such as working conditions, freedom,
national stability, etc.) which are not taken into account when calculating GDP per capita.
Human Development Index (HDI): A composite measure of living standards by the United Nations
that includes GNI per head, education, and life expectancy. It has a maximum value of one and
countries are divided into different categories (very high, high, medium, or low human
development) based on the value of their HDI.
Measurable Economic Welfare (MEW): A composite measure of living standards that adjusts the
GDP for factors that reduce living standards and factors that improve living standards.
Multidimensional Poverty Index (MPI): A composite measure of deprivation in terms of the
proportion of households lacking the requirements for a reasonable standard of living.
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The comparison of living standards between countries is also mainly measured by GDP per head.
Although it takes different population sizes and adjustments for inflation into account. there is a
chance that the comparison can be distorted by exchange rate changes. For this reason,
economists use the purchasing power parity (PPP) exchange rate.
For example, suppose the exchange rate is 6MR = US$1, and the US has a real GDP/head of $50,000 while Malaysia has
a real GDP/head of MR12,000 ($2000). This might show that the people in the US are on average, 25 times better off
than those in Malaysia. However, if $1 can buy more products in the USA than in Malaysia, then using the exchange rate
to convert MR into $ would exaggerate Malaysia’s output – a basket of products may sell for $200 in the USA but that
same basket would cost MR2,400 ($400) in Malaysia. So in terms of purchasing parities, 12MR = US$1. This shows that
people in the US are actually 50 times better off than people in Malaysia. However, it is important to remember that a
higher PPP also does not necessarily mean that people are better off in that country due to the other previously stated
limitations of using Real GDP as an indicator of living standards.
Purchasing Power Parity (PPP): A way of comparing living standards by using an exchange rate
based on the amount of each currency needed to purchase an imaginary basket of products.
__________________________________________________________________________________________________
The national debt is expressed as a percentage of the GDP. It increases with budget deficits and
can decrease with budget surpluses, and usually occurs during economic downturns, wars, etc.
Disadvantages of having national debt include huge opportunity costs of the interest payments
made on the debt, increased reluctancy to lend money, higher interest rates and tax burdens, etc.
National Debt: The total amount of money owed by the government.
The Macroeconomy
__________________________________________________________________________________________________
Developed Economy: Economies with high GDP per head – they tend to have mature markets,
high living standards and productivity, etc.
Developing Economy: An economy with a low GDP per head – their characteristics tend to greatly
vary with different countries, often due to geographical conditions.
Development Traps: Restrictions on the growth of developing economies that arise from low
levels of savings and investment.
Poverty Cycles: Representations of the links between low incomes, savings, investment, etc.
Emerging Economy: Economies with a rapid growth rate and good investment opportunities.
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The Malthusian theory of population argued that population pressures would prevent the rise of
living standards. It claimed that population grows at a geometric rate (2,4,6,8,16…) whilst food
production grows at an arithmetic rate (1,2,3,4,5…).
Such a relationship would result in the population doubling every 25 years or so and outstripping
food production. The theory also explained that population can be kept in check in two ways:
Positive Checks: Factors which cause a rise in the death rate, including epidemics, famine,
infanticide, and wars.
Preventive Checks: Factors which prevent an increase in birth rate including contraception (birth
control) and ‘moral restraint’ (delaying marriage).
The Macroeconomy
Fortunately, however, Improvements in transport, capital goods, and technology have enabled
food production to rise more than population. The world saw population and living standards rise.
Actually, the Malthusian theory overlooks that people are producers as well as consumers.
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Nevertheless, malnourishment and famine remain problems in some economies due to an uneven
distribution of resources, poor agricultural management, and sudden supply shocks (e.g.: floods).
Regardless, developing countries tend to maintain high birth rates due to a lack of contraceptives,
high infant mortality rates, low costs of raising children, and because having lots of children can
ensure future financial support. This can in turn lead to high dependency ratios in the short-term.
As birth and death rates in developed countries are low, they tend to have ageing populations.
This can also lead to high dependency ratios while increasing government burden through
transfer payments (e.g.: pensions).
Dependency Ratio: The proportion of the economically inactive, to the labour force.
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See chapter 1 for factors that influence the size of a country’s labour force (supply of labour).
Labour Force: All members of a nation who are available for work.
Labour Productivity: The output per worker hour (the hourly output of an economy).
Unemployment: The state of being willing and able to work but without a job.
Full Employment: The level of employment corresponding to where all who wish to work have
found jobs, excluding frictional unemployment (Unemployment rate ~ 3%).
Natural Rate of Unemployment: The rate of unemployment that exists when the AD for labour
equals the AS of labour at the current wage and price level.
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The causes of unemployment are classified, and sub-divided, as follows:
→ Frictional Unemployment: Brief unemployment that arises when people are in-between jobs.
❖ Search Unemployment: When workers do not accept the first few jobs offered but instead
spend time looking for a better job.
❖ Casual Unemployment: When workers are out of work between periods of employment
(e.g.: an actor unemployed when they’re not cast in a role).
❖ Seasonal Unemployment: When workers are out of work for a specific time of the year
(e.g.: a tourist guide out of work during off-season).
→ Structural Unemployment: Unemployment due to changing structures of economic activity.
❖ Technological Unemployment: When workers are out of work due to advances in
technology leading to that technology replacing labour.
The Macroeconomy
❖ International Unemployment: When workers are out of work due to demand switching
from domestic industries to more competitive foreign industries.
❖ Regional Unemployment: When structural unemployment is concentrated in an area.
→ Cyclical Unemployment: Unemployment due to a lack of aggregate demand.
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The Consequences of Unemployment:
→ Firms find it easier to recruit new workers if they wish to expand.

→ It keeps down inflationary pressure by lowering wage rates due to the increased ASL.
→ Those unemployed suffer a fall in income, and perhaps no financial assistance.
→ Financial assistance (e.g.: unemployment benefits) are significantly lower than regular wages.
→ Those unemployed may face a loss of work habit, self-worth, stress, and relationship issues.
→ An average fall in living standards may occur for not being able to afford things like education,
healthcare, insurance, entertainment, etc.
→ Being unemployed actually reduces the chances of a person getting a job.
→ The economy faces an opportunity cost as full employment of resources isn’t achieved.
→ The government tax revenue decreases.
→ Decreased spending due to unemployment can reduce firms’ output – this can pressurize the
government to increase public expenditure (which has opportunity costs of its own).
→ There may be an increase in the crime rate.
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Unemployment is measured using claimant counts of labour force surveys.
Claimant Count: Measuring unemployment by counting the receipts of people who receive
unemployment benefits. It is cheap and quick. However, it can be inaccurate if unemployed
people are not registered for it or are transitioning between jobs. Some employed people may
also fraudulently claim unemployment benefits. Furthermore, those on government training
schemes, or pursuing higher education, or past the retirement age do not receive the benefits.
Some countries do not offer unemployment benefits entirely.
Labour Force Surveys: Measuring unemployment through surveys. It tends to be more accurate
and also allows scope for making international comparisons (since it is a widely used method). It
also allows to collect other relevant data at the same time.
However, it is time consuming and expensive. The accuracy also depends on how the questions
are asked and interpreted., People may possibly lie on their surveys.
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The Macroeconomy
Unemployment can be reduced in the long term using expansionary fiscal policies such as: a cut in
income and corporate taxes, and increases in government expenditure. Possible expansionary
monetary policies include: reducing interest rates, increasing the money supply, and decreasing
the exchange rate. Some supply side policies may include: reductions in unemployment benefits
and trade union restrictive practices, and improving labour mobility through education and
training programs.
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The circular flow of income is varied between open and closed economies.
Circular Flow of Income: A model of the process by which income flows around the economy.
Open Economy: An economy that is involved in trade with other economies.
Closed Economy: An economy that does not trade with other economies.
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The multiplier in terms of the gross domestic product, causes gains in total output to be greater
than the change in spending that caused it.
For example, if people spend 80% of any extra income, an increase in government spending of $20bn will raise the GDP
by $100bn (see the next example for mathematical proof as to why it rises by 100bn). This is theoretically explained as
the initial $20bn spent will create higher incomes, and people will spend $16bn (80%) of these extra incomes. This
expenditure generates a further increase of incomes. Of the $16bn, $12.8bn (80%) will be spent. This process will
continue until incomes increase to $100bn and the change in injections is matched by the change in withdrawals.
Change in GDP
Multiplier =
$100bn
Multiplier = =5
Change in Injection $20bn
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Sectors Multiplier Equilibrium Income

1
2 3 4 Firms & Households C+I=Y I=S
MPS
1
Government C+I+G=Y I+G=S+T
MPS+MRT
1
Foreign Trade C + I + G + (X – M) = Y I+G+X = S+T+M
MPS+MRT+MPM
**In the equilibrium income column, first column: Aggregate Expenditure = Output | second column: Injections = Withdrawals
***S: Savings, I: Investment, G: Government Expenditure, C: Consumption, X: Exports, M: Imports. MPS: Marginal Propensity to Save,
MRT: Marginal Rate of Taxation, MPM: Marginal Propensity to Import, Y = GDP.
****The four-sector economy is the most realistic model, with firms, households, governments, and the foreign trade sector.
The previous example includes the government, so it is a three-sector economy. But – there is no tax so exclude the
marginal rate of taxation. Instead of the marginal propensity to save, use (1 - marginal propensity to consume). In the
aforementioned example, the MPC is 80% (=0.8). Hence, the multiplier = 1 ÷ (1 - 0.8) = 5. Now place this 5 in the
equation: Multiplier = Change in GDP ÷ Change in Injection. Using that previous example’s data, 5 = x / 20bn. Equate
to find that x = 100bn. This mathematically proves the previous example.
The Macroeconomy
Equilibrium Income: When aggregate expenditure equals output, or injections equal withdrawals.
Injections: Variables in an economy that add to the circular flow of income. It includes investment,
government spending, and exports.
Withdrawals (Leakages): Variables in an economy that leak out of the circular flow of income, and
reduce the size of national income. It includes savings, taxation, and imports.
Marginal Propensity to Save or Consume: The proportion of extra income saved or consumed.
Marginal Rate of Taxation: The proportion of extra income taken as tax.
Marginal Propensity to Import: The proportion of extra income spent on imports.
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In equilibrium, Aggregate Demand = Aggregate Expenditure = Aggregate Income = GDP.
Aggregate Expenditure: The total amount spent in the economy at different levels of GDP/income.
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Consumption depends on disposable income, the distribution of income, interest rates, the
availability of loans, expectations on market conditions, and wealth. As income rises, so does
spending. However, the proportion of disposable income that is spent falls. This is because the
marginal propensity to consume decreases significantly after a certain level of income.
C = a + bY
Consumption Function = Autonomous Consumption + (Marginal Propensity to Consume x Disposable Income)
S = - a + sY
Saving Function = Autonomous Dissaving + (Marginal Propensity to Save x Disposable Income)
Change in Consumption Change in Saving

MPC = Change in Income
| MPS = Change in Income | MPC + MPS = 1
Consumption Saving
APC = Disposable Income | APS = Disposable Income | APC + APS = 1
Average Propensity to Save or Consume: The proportion of total income saved or consumed.
Dissaving: Spending more than their income; usually financed by past savings or borrowing.
Consumption or Saving Function: The relationship between income, and consumption or saving.
Autonomous Consumption (a): Consumption which does not vary with income. This is true even if
income is zero, in which case, it leads to dissaving.
Income Induced Consumption (bY): Consumption determined by income.
Autonomous Dissaving (-a): Amount of savings people will draw on when income is zero.
Income Induced Saving (sY): Saving determined by income.
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Investment varies based on changes in consumer demand, interest rates, the state of technology,
the cost of capital equipment, expectations on market conditions, and government policies.
Investment: Spending by firms on capital goods.
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Government spending is influenced by government policies, tax revenue, and demographics.
Government Spending: The total of local and national government expenditure.
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Net export levels are determined by the country’s GDP, other countries’ GDP, the relative price
and quality competitiveness of the country’s products, and its exchange rate.
Net Exports: Exports minus imports.
The Macroeconomy
__________________________________________________________________________________________________
The level of income (equilibrium income) in an economy is where aggregate expenditure is equal
to output and injections into the circular flow of income are equal to the withdrawals from it. If
income is not in equilibrium, it can lead to output gaps – Inflationary gaps are then reduced by
deflationary fiscal policies while deflationary gaps are reduced by reflationary fiscal policies.
Inflationary Gap: A positive output gap; where superfluous demand causes excess aggregate
expenditure which is beyond the economy’s potential output.
Deflationary Gap: A negative output gap; where a shortage of demand causes a lack of aggregate
expenditure so that it is below the economy’s potential output.
The accelerator theory suggests that investment (expenditure on capital goods) depends on the
rate of changes in income (hence demand for consumer goods), and that a change in GDP
(income) will cause a greater proportionate change in investment. =
Accelerator Coefficient: The quotient of the change in induced investment to the change in GDP.
Autonomous Investment: Investment that is made regardless of income.
Induced Investment: Investment made in response to changes in income.
Induced investment remains unchanged if GDP rises at a constant rate since firms can then buy
the same number of equipment per year to expand capacity. Alternatively, a change in the rate of
change of income (GDP) will influence investment.
It should be noted however, that increased demand for consumer goods will not result in a
greater percentage change in the demand for capital goods if firms already have spare capacity
or do not expect the rise in consumer demand to last. Due to advances in technology, the capital-
output ratio may also change such that fewer machines are needed to produce a given output.
Paradox of Thrift: Where saving more actually results in a fall in saving. This occurs as higher
saving can cause GDP (hence income) to fall and subsequently reduce households’ ability to save.
Capital-Output Ratio: The amount of capital used to produce a given amount/value of output.
__________________________________________________________________________________________________
The Fisher Equation: MV = PT (or commonly written as MV = PY)
M: Money Supply, V: Velocity of Circulation (Amount of times money changes hands), P: Price, T/Y: Economic Output,
In the quantity theory of money, monetarists assume that V and Y are constant such that a
change in money supply causes an equal percentage change in the price level, to conclude that
inflation is a monetary phenomenon. However, Keynesians argue that the conclusion is flawed.
The Macroeconomy
That is because V and Y can change with a change in the money supply.
Quantity Theory of Money: The theory that links inflation to changes in the money supply.
Monetarists: Economists who argue that money supply is the primary factor affecting demand.
__________________________________________________________________________________________________
The government uses different measures of money supply due to the flexible definition of money:
→ Narrow Money: Money that can be spent directly; it includes notes in circulation and cash held
in banks or in balances held by commercial banks at the central bank.
→ Broad Money: Money used for spending and saving; it includes narrow money and a range of
items concerned with money’s function as a store of value (e.g. money in savings accounts).
Money supply can increase due to increases in commercial or central bank lending (possibly to
finance additional government expenditure – see below), the sale of government bonds to private
sector financial institutions, and more money entering the country than leaving it.
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Commercial banks make profit by lending to customers and charging interest. Most of these
banks partake in fractional reserve banking, in which only a fraction (10% in USA) of people’s
deposits in the bank have to be legally kept as actual cash on hand and available for withdrawal.
This works since most people use electronic means of transfer such as credit cards.
The practice allows the bank to lend the remaining 90% of deposits and stimulate the economy.
The process is referred to as ‘creating money’ since the bank is lending money which does not
actually physically exist as a liquid asset available for credit. This is also why it can be risky in cases
where there is a sudden increase in demand for physical cash, since then the banks may not have
enough cash or liquid assets available for withdrawal.
Liquidity: The availability of liquid assets (cash or assets that can quickly be converted into cash).
Liquidity Ratio: The proportion of liquid assets to total liabilities.
Banks find out how much additional liquid assets will enable them to increase their liabilities by
using the credit creation multiplier. [https://www.youtube.com/watch?v=SsbwUo-M5Yo&t]
Credit Multiplier = Value of money created ÷ Value of change in liquid assets (e.g.: new deposits)
Credit Multiplier = 100 ÷ Liquidity Ratio
Credit Multiplier: The process by which banks can make more loans than deposits available.
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Banks may not lend as much as they can if there is a lack of willing borrowers or if the number of
defaulters is high. A central bank can influence commercial banks’ ability to lend by buying or
selling government securities to increase or reduce banks loans. The sellers (from which they will
buy these securities) would make deposits of the money they earn in commercial banks, causing
the banks’ liquid assets to fall (and vice versa in the case of reducing bank loans).
The money supply doesn’t change due to government borrowing by selling government securities
to non-bank entities because purchasers will withdraw money out of banks, reducing the banks’
liquid assets. However, supply will increase if the government borrows directly from banks or by
selling them short-term government securities (also liquid) as these increase their liquid assets.
Government Securities: Bills and bonds issued by the government to raise money.
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The Macroeconomy
When interest rates are low, the central bank can buy long-term government bonds from the
open market to increase money supply and encourage lending (aided by low interest rates) and
investment. This is a form of monetary policy known as quantitative easing.
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A net currency inflow may occur if the central bank maintains an exchange rate below the
equilibrium as doing so requires selling the currency. This currency is bought by foreigners buying
to pay for exports from the country. Exporters will then deposit the money earned into the
country’s banks, which will lead to a multiple increase in money supply.
Total Currency Flow: The total outflow and inflow of money recorded in the balance of payments.
__________________________________________________________________________________________________
Keynesians argue that the interest rate is determined by the demand and supply of money, and
that the supply of money is determined by monetary authorities and is fixed in the short-term. The
liquidity preference theory expressed in terms of motives that determine the demand for liquidity:
→ Transactions Motive: For buying day-to-day buying of products.

→ Precautionary Motive: For unexpected or unforeseen events.
→ Speculative Motive: To make future gains from buying financial assets.
Liquidity Preference: A Keynesian concept that explains why people demand money.
Active Balances: Money held by households or firms for future use (precautionary motive).
Government Bonds: Government securities representing loans to the government.
Liquidity Trap: A situation where interest rates cannot be reduced to stimulate economic activity.
__________________________________________________________________________________________________
A country may receive foreign aid in many forms, like grants, low-interest loans, technical
assistance, direction provision of products, etc. These may be tied/untied or bilateral/multilateral.
Foreign Aid: Assistance given (mostly to developing economies) on favourable terms.
Dependence: When the economic development of a developing economy is hindered by its
relationships with developed economies – (e.g. when developed economies exercise more power
in international trade negotiations due to conditions explained in the Prebisch-singer hypothesis,
or when they fall into huge debt due to too much dependency on foreign aid).
Tied Foreign Aid: Aid which comes with conditions that the receiver must follow.
Multilateral Foreign Aid: Aid given by countries to international organizations (e.g.: the UN), which
then distribute it to other countries.
Bilateral Foreign Aid: Aid given by one country to another country.
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Developing countries argue for fair trade deals as it can be very beneficial with:
The Macroeconomy
→ Economic growth by accessing a much larger market and increasing output.

→ Lower average costs through economies of scale, innovation to remain competitive, a transfer
of skills/tech from developed to developing economies, or specialization on specific exports.
As stated before, however, the Prebisch-singer theory analyses that developing countries are
disadvantaged in international trade. To overcome this, countries have adopted protectionist
policies and import substitution, as well as a steady shift towards the manufacturing sector.
__________________________________________________________________________________________________
Foreign Direct Investment (FDI) The act of setting up production units or purchasing existing
production units in other countries.
__________________________________________________________________________________________________
As stated before, external debt can be a major obstacle growth to economic development due to
huge opportunity costs of the interest payments made on it, difficulty to get further loans, higher
national interest rates and tax burdens, etc.
__________________________________________________________________________________________________
The role of the International Monetary Fund (IMF) is to help the world economy by:
→ Promoting international monetary cooperation

→ Facilitating expansion and balanced growth of international trade
→ Providing exchange rate stability
→ Assisting in setting up a multinational system of payments
→ Making resources available to members experiencing balance of payments difficulties
The IMF has three main functions, known as: surveillance, technical assistance, and lending.
__________________________________________________________________________________________________
The role of the World Bank is to provide financial support for internal investment payments.
It consists of five constituent agencies: International Bank for Reconstruction and Development (IBRD), International
Development Association (IDA), International Finance Corporation (IFC), Multilateral Investment Guarantee Agency
(MIGA), and International Centre for Settlement of Investment Disputes (ICSID).
The IDA and IBRD provide low-interest loans to developing countries for health and education,
agriculture and rural development, environmental protection, infrastructure, and governance.
Grants may be provided, but only to the world’s poorest economies. The loans provided tend to
be linked to conditions which involve countries needing to change their economic policies. Some
of these conditions, such as imposing the Washington Consensus are often criticised.
__________________________________________________________________________________________________
Corruption is gross misuse and wastage of received aid or tax revenue and is proved to be
extremely detrimental to economic growth.
Government
Macroeconomic Intervention
The government may intervene in the market via different policies in order to try and achieve their
macroeconomic aims, which generally include:
→ Full Employment → Low and Stable Rate of Inflation (Price Stability)

→ Balance of Payments Equilibrium → Steady and Sustained Economic Growth
→ Exchange Rate Stability → Environmentally Sustainable Economic Growth
__________________________________________________________________________________________________
Government policies are categorized as the fiscal, monetary, and supply side policies.
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__________________________________________________________________________________________________
The government can correct balance of payments disequilibrium in two ways:
→ Expenditure switching policies: Policy measures designed to encourage people to switch from
buying foreign produced products to buying domestically produced products.
❖ Convincing people in the host country to buy domestically produced products.
❖ Convincing people in foreign countries to buy products produced in the host country.
Government
→ Expenditure dampening policies: Policy measures designed to dampen (reduce) imports and
increase exports by reducing demand.
❖ There will be a reduction in spending in the domestic economy, which will ‘dampen’
the domestic market.
❖ To compensate for the ‘dampened’ domestic market, the domestic country will try to
increase sales abroad.
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Executing the expenditure switching and dampening policies:
Fiscal Policy
Expenditure switching: The government may impose or raise tariffs to increase the cost of
purchasing imports and hence increase the demand for locally produced goods.
Expenditure dampening: The government can increase income tax to reduce disposable income
so that demand decreases. They can also lower government spending to directly reduce demand.
Both of these will reduce imports and domestic spending, and also pressure firms to export more.
Effectiveness of the fiscal policy:
Expenditure switching: The fiscal policy cannot be used to raise foreign nationals’ demand for
domestic goods. Also, tariffs cannot be imposed within a trade bloc, and imposing tariffs on other
countries can provoke retaliation. Making the market less competitive by restricting imports can
also reduce the pressure on domestic firms to be efficient.
Expenditure dampening: Income taxes can lead to lower demand and cause slower economic
growth, unemployment, disincentives for work, etc.
Both: The fiscal policy is unlikely to bring any long-term changes to the current account (as
stopping the policy will make people return to previous spending habits). It will also only work
effectively when domestically produced substitutes are available, and the demand for imports are
relatively elastic. Moreover, implementing the policies can take a very long time.
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Monetary Policy
Expenditure switching: Reducing the interest rate when there is a low rate of inflation and current
account deficit can put downward pressure on a floating exchange rate, and make the country’s
products internationally competitive. The government may also devalue a fixed exchange rate to
get the same effect of increased international competitiveness.
Expenditure dampening: Increasing the interest rate can increase the cost of borrowing, hence
decreasing aggregate demand as well as inflationary pressure.
Both: Reducing the growth of money supply.
Effectiveness of the monetary policy:
Expenditure switching: Decreasing interest rates can cause hot money outflows and inflationary
pressure in the country. Moreover, lowering the exchange rate will not work if demand for exports
and imports is price inelastic, or if the relative quality of the country’s products falls.
Government
Expenditure dampening: Increasing interest rates can discourage FDI as it would increase costs
and they may expect demand to fall in the country. Higher interest rates can also raise a floating
exchange rate, which can reverse the fall in demand for imports in the domestic country.
Both: It can be difficult to control the money supply, partly since commercial banks have a strong
incentive to lend for profit. It also takes a long time to implement changes in interest rates.
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Supply Side Policy
Expenditure switching: Domestic products can be made lucrative through deregulation, trade
union reforms, and privatisation. Investment in the quality and quantity of resources can increase
the aggregate demand for domestic goods in the long-term.
Expenditure Dampening: Not possible using supply side policies.
Effectiveness of the supply side policy:
Expenditure switching: Some supply-side measures can take a very long time to take effect. The
outcome of policies can also be uncertain (e.g.: low-quality education will be ineffective).
Privatisation may fail to increase efficiency if industries become monopolies or ignorant of external
costs/benefits. Deregulation and union reforms may not work if it leads to increased inefficiency
and a relaxed market. Policies such as providing subsidies may not work if they are not passed on
as lower prices to the consumer or if firms become too reliant on them. Furthermore, subsidies
can provoke retaliation from foreign governments who see it as unfair competition.
Please note that although the sections of information above were written in the context of correcting a balance of
payments deficit, some of these policy measures can also be altered to correct a balance of payments surplus.
__________________________________________________________________________________________________
The macroeconomic policies can also be used in correcting inflation.
Demand pull inflation
Deflationary fiscal policy: Income tax rates, bracket, and base will be increased (to reduce
spending power and decrease AD). Governments will cut their own spending (to reduce spending
power by reducing provisions, benefits, etc. and hence decrease AD).
Deflationary monetary policy: The rate of interest is increased (to increase the cost of lending and
benefits of saving, and hence decrease AD. It may also attract hot money flows to increase the
exchange rate and therefore competitive pressures to reduce prices). The money supply may also
be reduced (to limit the amount of money in hand and decrease AD).
Supply side policies: If the quantity and quality of resources can be improved to increase AS at a
rate that will match increases in AD, it can offset demand pull inflation in/for the long-term.
Effectiveness in correcting demand-pull inflation:
Deflationary fiscal policy: Raising income tax can adversely cause cost push inflation. It can also
create disincentives to work and make skilled workers emigrate.
Deflationary monetary policy: Countries in economic unions may have restrictions on the interest
rates/exchange rate they can set. Central banks may be reluctant to increase interest in countries
with fixed exchange rates as it can put upward pressure on the rate. There is also no guarantee
that commercial banks will raise their interest rates in line with the central bank. Even still, higher
Government
interest rates may not offset spending if consumers are optimistic about the future (same with
income tax rises – households may reduce saving instead of spending if they think incomes will
rise in the future). A rise in interest rates can also have an adverse effect on investment.
Supply side policies: Although supply side policies can correct inflation in the long term, it can
increase it in the short term (e.g.: increased govt. spending and cuts in taxes aimed to increase AS
may increase the AD at first, leading to further demand-pull inflation). Moreover, the effects of
supply side policies are uncertain.
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Cost push inflation
Deflationary monetary policy: A short-term rise in the exchange rate to reduce the cost of
imported resources.
Supply side policies: Increased govt. spending on resources can increase productivity and reduce
average costs. Lower corporate tax can encourage firms to invest on better resources. Subsidies
may be provided to reduce the burden of production costs as well.
Effectiveness in correcting cost push inflation
Deflationary monetary policy: A rise in the exchange rate may not reduce inflation if foreign
producers keep the price of exports unchanged in the country’s currency.
Supply side policies: Increased spending on resources may be unsuccessful in correcting inflation if
their subsequent price rise due to better quality is more than the money saved using them. Lower
corporate tax will also not result in more investment if the future is uncertain. There is also a risk
that subsidies can raise AD (and hence cause demand pull inflation).
*Cost push inflation caused by wage rises can be controlled (but not necessarily corrected) using
the fiscal policy by reducing income tax so that people do not ask for further wage rises.
__________________________________________________________________________________________________
The macroeconomic policies can also be used in correcting bad deflation:
Reflationary fiscal policy: Increasing in government spending and lowering tax rates.
Reflationary monetary policy: Reducing interest rates and increasing the money supply.
Effectiveness in correcting bad deflation:
Both policies: Households are likely to be pessimistic during periods of deflation and may not
spend more even if disposable incomes rise and it becomes cheaper to borrow (hence rises in
government spending in benefits, provisions, new projects to create employment, etc. may be a
better option). Moreover, interest rates may already be low during the period and there may be
restrictions on decreasing it further. Banks may be reluctant to lend at this period due to low
interest rates and lack of creditworthy buyers as well.
__________________________________________________________________________________________________
A major reason for government failure is policy conflicts. For example, the Phillips curve shows
how the government may increase inflation when trying to reduce unemployment. It may also
decrease its own tax revenue by increasing tax rates, as shown by the Laffer curve.
__________________________________________________________________________________________________
Government
The information above can be used to identify the relationship between the balance of payments
and inflation. Inflation can make the country’s products price uncompetitive, and cause export
revenue to decline. It may also increase imports of cheaper substitutes. This leads to a balance of
payments deficit, and vice versa in the cases of disinflation or deflation.
An increase in current account surplus may also cause inflation in the short-term (until the
exchange rate rises due to high demand) as more money is entering the country than leaving it.
__________________________________________________________________________________________________
__________________________________________________________________________________________________
To avoid policy conflicts, the government may maintain Tinbergen’s rule. For example, a
government may cut income tax to reduce unemployment, while it may devalue the currency to
reduce a current account deficit. Hence, governments use a combination of fiscal, monetary, and
supply-side policies together in an economy.
Tinbergen’s Rule: For every policy aim, there must be at least one policy measure.
__________________________________________________________________________________________________
Reasons for government macroeconomic failure are extensive. For instance, policy measures may
have time lags:
→ Recognition Lag: Time taken to recognize a problem (e.g.: inflation that is already occurring).
→ Implementation Lag: Time taken to draft and impose a policy measure.
→ Behaviour Lag: Time taken for the policy to influence the behaviour of households and firms.
By the time policy measures have an impact, the situation may have changed such that it is no
longer suitable. This can sometimes reinforce the trade cycle rather than being counter-cyclical.
Government Macroeconomic Failure: Where government macroeconomic intervention causes
further deterioration of the economy.
Counter-Cyclic: To be against fluctuations in economic activity.
There is also the chance that firms and households may not respond the expected way, if the
government does not consider all factors or possibilities. Asymmetric information may bring huge
opportunity costs if the government overspends on any particular issue.
Government
Aside from that, government failure can arise from policies to gain political support (e.g.:
hyperinflation in Venezuela occurring due to extreme levels of government spending). Policy
measures influenced by powerful pressure groups (e.g.: monopolist multinational companies
blackmailing the government to give them hefty tax breaks) can also harshly affect the economy.
Corruption was also mentioned before as another detrimental issue.
Corruption Perception Index: A measure of the amount of corruption in a country. It is scored on
a scale of 0 (Highly Corrupt) to 100 (Very Clean).
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End of Syllabus
Economics 9708
Zayan Zaman

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a Zayan Zaman

1 Basic Economic Ideas and Resource Allocation 03-11 12-15

2 The Price System and the Microeconomy 16-20 21-36

3 Government Microeconomic Intervention 37-40 41-46

4 The Macroeconomy 47-60 61-72

5 Government Macroeconomic Intervention 73-76 77-78

Updated for the 2021 syllabus.

Advantages and Disadvantages of Specialization

The economic structure changes (i.e.: concentration of workers/capital and production

Advantages and Disadvantages of a Market Economy

Advantages and Disadvantages of a Planned Economy

Planned economies focus on achieving as high of economic growth as possible. To do so,

There are quite a few issues in transitioning

It is a long and tedious process. Due to the

The position of the PPC is determined by the quantity

An ‘outward shift’ in the PPC means that the quantity

There are four main functions of money:

Goods and services can be classified into different types.

While allocating resources when in this state, some

Externalities as a result of production or consumption decisions

Production Externalities Consumption Externalities

Other drawbacks may also include that:

→ Disposable Income: An increase in disposable income raises consumers’ purchasing

Normal Product: A product whose demand increases with income.

Degree Elasticity Value Explanation

The opposite scenario is true for all of the above.

The factors determining PES are:

Market Equilibrium: A situation where there is no tendency for change.

On the contrary, a producer surplus is when producers are

Budget Line: The combinations of two

Indifference Curve: A graphical representation of the different combinations of two goods

The budget line and indifference curve can then

If the budget increases (as shown in the image)

Isoquant: A curve/line that joins points that give a particular level of

Short-term costs consist of:

A long-term production function (LRPF) an be

The actual mix of capital and labour will depend on

An isoquant map can also be used to demonstrate returns to scale.

Hence, the firm’s demand curve is the average revenue line.

→ A large number of buyers and sellers.

→ Economic activity is state-owned and there is a natural monopoly.

→ The market is dominated by a few firms.

→ A single seller with no close substitutes.

Monopolies can even be small firms in local markets with

→ To earn a higher profit by gaining more market share.

→ Internal Growth: When a business expands its existing operations.

See more on integration in business notes.

→ Profit Maximization: Producing at the point where MC = MR to maximize abnormal profit.

→ Regulations: Legal restrictions on prices, quality, consumption, etc. followed by

Government spending is mainly focused on public goods, merit goods, administration,

→ Equitable: The rich should pay more than the poor.

→ Efficient: A tax should improve the performance of markets or prevent significant

Income Tax: A tax charged on the income of a person.

Indirect Tax: A tax levied on the expenditure on goods/services.

→ Progressive Tax: The percentage of tax charged increases with wealth.

Subsidies: Direct payments made by governments to producers.

Nationalization vs. Privatization

Wealth: An accumulated stock of assets.

Government policies to redistribute income and wealth:

Monopsony: A market situation in which there is only one buyer.

→ Consumption (C): Consumer expenditure (i.e.: household spending on products).

Shifts in the aggregate demand curve may occur due to: