C5 EcoEnviron

COURSE MANUAL
C5 Economic Environment of Business
Open University of Mauritius

Reduit
MAURITIUS
Copyright
© Commonwealth of Learning, 2012
All rights reserved. No part of this course may be reproduced in any form by any means
without prior permission in writing from:
Commonwealth of Learning
1055 West Hastings Street
Suite 1200
Vancouver, BC V6E 2E9
CANADA
Email: info@col.org
Open University of MauritiusMAURITIUS

Reduit
MAURITIUS
Fax: +(230) 464 8854
Tel: + (230) 403 8200
E-mail: academic-affairs@open.ac.mu
Website: www.open.ac.mu
March 2013
Acknowledgements
The Commonwealth of Learning (COL) wishes to thank those below for their contribution to the
development of this course:
Course author Farrokh Zandi, PhD
Professor, Schulich School of Business
York University
Toronto, Canada
Course designer Catherine Kerr, BEd

Principal, Bookthought Content Company
Vancouver, Canada
Course reviewer and revision Professor Choong Chee Keong

author Dean, Faculty of Business and Finance
Department of Economics
University Tunku Abdul Rahman
Petaling Jaya,Malaysia
Instructional designer Pooja A. Nadkarni

Vile Parle (East)
Mumbai, India
Revision coordinator Prakash V. Arumugam, MA

School of Business and Administration
Wawasan Open University
Penang, Malaysia
Course editor Symbiont Ltd.

Otaki, New Zealand
COL would also like to thank the many other people who have contributed to the writing of this
course.
Contents
About this course manual 1
How this course manual is structured ............................................................................... 1
The course overview ............................................................................................... 1
The course content .................................................................................................. 1
Resources ................................................................................................................ 1
Course overview 2
Welcome to Economic Environment of Business ............................................................ 2
Economic Environment of Business — is this course for you?........................................ 2
Course outcomes ............................................................................................................... 3
Timeframe ......................................................................................................................... 3
Study skills ........................................................................................................................ 4
Getting around this course manual 5

Margin icons ..................................................................................................................... 5
Module 1 6
Introduction to the Economic Environment and Understanding the Market Mechanism 6
Introduction ............................................................................................................. 6
Terminology ...................................................................................................................... 7
Introduction to the Economic Environment ...................................................................... 7
Introduction ............................................................................................................. 7
Costs ........................................................................................................................ 8
The economic way of thinking ................................................................................ 9
Rational choices ..................................................................................... 9
Opportunity cost .................................................................................... 9
Benefit: What you are willing to sacrifice ........................................... 10
At the margin ....................................................................................... 10
Responding to incentives ..................................................................... 10
Economic environment of business....................................................................... 11
Making economic choices in business .................................................................. 12
PEST Analysis ............................................................................................. 13
Political/legal/institutional factors ....................................................... 13
Economic factors ................................................................................. 13
Social and cultural factors ................................................................... 13
Technological factors .......................................................................... 13
Government intervention in business .................................................................... 14
Three dominant macroeconomic principles ................................................. 14
Types of economic evaluation............................................................................... 14
Accepted government objectives ......................................................... 15
Economic debate ................................................................................................... 16
ii Contents
Activity 1.1 ..................................................................................................................... 17

Understanding the market mechanism and analysing market demand ........................... 18
Introduction ........................................................................................................... 18
Command economy ............................................................................. 18
Laissez-faire economy ......................................................................... 18
The market system in action ................................................................ 19
What is a market? .................................................................................................. 19
The market system ....................................................................................... 19
Foreign and government sectors .......................................................... 20
Business in a competitive market ................................................................ 20
Price theory and the price mechanism................................................................... 21
Price theory .................................................................................................. 21
The demise of the command systems .................................................. 21
The coordination problem ................................................................... 22
The incentive problem ......................................................................... 22
Product (Output) market........................................................................................ 22
Demand ................................................................................................ 22
Market demand and individual demand .............................................. 22
Determinants of demand ...................................................................... 22
Price and quantity demanded: The law of demand ...................................... 23
The demand schedule and the demand curve .............................................. 24
Shifts in the demand curve ........................................................................... 25
Average income ................................................................................... 25
Prices of related goods ......................................................................... 25
Population ............................................................................................ 26
Distribution of income ......................................................................... 26
Tastes and preferences of the household ............................................. 27
Movements along the curve versus shifts of the curve ................................ 27
An illustration of change in demand versus quantity demanded ................. 28
Supply.................................................................................................................... 30
What is quantity supplied? ........................................................................... 30
Quantity supplied and the law of supply...................................................... 30
The supply schedule and the supply curve .................................................. 31
Shifts in the supply curve............................................................................. 32
Influences on supply .................................................................................... 32
Price of inputs (Changes in costs of production) ................................. 32
Technology .......................................................................................... 32
Taxes and subsidies ............................................................................. 33
Price of other goods ............................................................................. 33
Producer expectations .......................................................................... 33
Number of firms .................................................................................. 33
Shifts in a supply curve versus movements along a supply curve ............... 35
Supply and demand together ................................................................................. 37
Market equilibrium ...................................................................................... 37
The effect of changes in demand and supply ............................................... 38
A change in demand ............................................................................ 39
A change in supply .............................................................................. 39
A change in both demand and supply .................................................. 40
Consumer Surplus, Producer Surplus and Market Efficiency............................... 41

Demand and marginal benefit ...................................................................... 41
Supply and marginal cost ............................................................................. 42
Markets efficiency ....................................................................................... 43
Interfering with the law of supply and demand ........................................... 46
Price ceilings: The case of rent control ............................................... 47
Price floors: The case of minimum wage laws .................................... 48
Taxes ............................................................................................................ 50
Ad valorem taxes ................................................................................. 52
Exports and imports .............................................................................................. 52
Market Demand and Pricing Decision ............................................................................ 55
Introduction ........................................................................................................... 55
Demand elasticity .................................................................................................. 56
Different types of elasticity .......................................................................... 58
Factors that determine price elasticity ................................................................... 62
Elasticity of a product versus elasticity of a brand................................................ 63
Point elasticity and the price range factor ............................................................. 64
Practical application of price elasticities ............................................................... 66
Other types of elasticity......................................................................................... 66
Income elasticity .......................................................................................... 67
Business implications of income elasticity .......................................... 68
Cross-price elasticity .................................................................................... 69
Advertising elasticity ................................................................................... 70
The price elasticity of supply ....................................................................... 71
Determinants of the price elasticity of supply ............................................. 71
Computing the price elasticity of supply ............................................. 71
Tax incidence and tax burden .............................................................. 72
Activity 1.2 ..................................................................................................................... 73
Module summary ............................................................................................................ 74
Assignment ..................................................................................................................... 75
Assessment ...................................................................................................................... 79
Assessment answers ........................................................................................................ 86
Module 2 91
Production, Costs and Profit, and Market Structure ....................................................... 91
Introduction ........................................................................................................... 91
Terminology .................................................................................................................... 92
Production, Costs and Profit ........................................................................................... 93
Introduction ........................................................................................................... 93
Choice of technology ................................................................................... 94
What are costs?...................................................................................................... 95
Opportunity costs ......................................................................................... 96
Distinguishing between relevant and irrelevant cost............................................. 97
Economic profit ........................................................................................... 98
Time as a factor in the determination of relevant cost .......................................... 99
Production in the short run .................................................................................. 100
Total, average and marginal product ................................................................... 100
iv Contents
Diminishing marginal returns.............................................................................. 101

The three stages of production ............................................................................ 102
The production function to the total-cost curve .................................................. 104
Cost curves and their shapes ............................................................................... 108
Shift in short-run cost curves .............................................................................. 110
Production in the long run ................................................................................... 111
Economies and diseconomies of scale ....................................................... 111
Division of labour and specialisation ......................................................... 112
Specialised capital ............................................................................. 112
Economies of scope ................................................................................... 115
The learning curve ..................................................................................... 115
Break-even analysis............................................................................................. 116
Limitations of break-even analysis ............................................................ 118
Activity 2.1 ................................................................................................................... 118
Market Structure ........................................................................................................... 119
Introduction ......................................................................................................... 119
Market structure ......................................................................................... 119
Key assumptions used in the microeconomic theory of the firm ........................ 120
The output decision of a firm in a perfectly competitive market ........................ 120
Output decisions: Short-run profit maximisation ...................................... 122
The short-run supply curve ........................................................................ 125
Output decisions: Long-run optimisation .................................................. 126
Price makers (imperfect competition) ................................................................. 129
Monopoly ................................................................................................... 129
Short-run profit maximisation.................................................................... 132
Monopoly in the long run .......................................................................... 133
Monopoly versus perfect competition ....................................................... 134
Allocative efficiency .................................................................................. 135
Price discrimination ................................................................................... 137
Social benefits of monopoly ...................................................................... 138
Economies of scale ............................................................................ 139
Invention and innovation ................................................................... 139
Government policy toward monopoly ....................................................... 139
Monopolistic competition ................................................................................... 141
Short-run profit maximisation.................................................................... 142
Long-run optimisation ............................................................................... 144
The firm in an oligopoly...................................................................................... 148
Pricing under oligopoly.............................................................................. 148
Cooperative or collusive mechanisms ....................................................... 149
Non-cooperative (Competitive) mechanism .............................................. 150
Oligopoly and the prisoner's dilemma ....................................................... 151
Pricing strategies in imperfectly competitive markets ............................... 153
Limit pricing ...................................................................................... 153
Network externalities ......................................................................... 153
Market penetration pricing ................................................................ 153
Advertising ........................................................................................ 154
Activity 2.2 ................................................................................................................... 154

Module summary .......................................................................................................... 155
Assignment ................................................................................................................... 156
Assessment .................................................................................................................... 157
Assessment answers ...................................................................................................... 163
Module 3 167
The Macroeconomy: Aggregate Demand and Supply .................................................. 167
Introduction ......................................................................................................... 167
Terminology .................................................................................................................. 168
Measures of Economic Question .................................................................................. 169
Introduction ......................................................................................................... 169
Management and measurement ......................................................... 169
Gross domestic product (GDP) .................................................................. 170
Unemployment rate .................................................................................... 170
Measuring economic performance: Output and income ..................................... 172
GDP versus GNP ....................................................................................... 172
Income, expenditure and the circular flow ................................................ 173
Value added and intermediate goods ......................................................... 174
Several measures of income ................................................................................ 176
Potential GDP ............................................................................................ 177
Real versus nominal GDP ................................................................................... 177
Phases of the business cycle ...................................................................... 178
Price indexes and inflation .................................................................................. 179
The consumer price index (CPI) ................................................................ 179
Implicit GDP deflator ................................................................................ 179
Inflation rate ............................................................................................... 180
Unemployment statistics ..................................................................................... 181
Problems with unemployment statistics..................................................... 181
Aggregate Demand, Aggregate Supply and Economic Fluctuation ............................. 182
Introduction ......................................................................................................... 182
Aggregate demand and its components ............................................................... 184
The aggregate demand curve ..................................................................... 184
Changes in aggregate demand ................................................................... 186
Consumption and its determinants ...................................................................... 187
Marginal Propensity to Consume (MPC) .................................................. 188
Marginal Propensity to Save (MPS) .......................................................... 188
Disposable income ..................................................................................... 190
Wealth ........................................................................................................ 190
Consumer expectations .............................................................................. 190
Interest rates ............................................................................................... 190
Investment and its determinants .......................................................................... 191
Nonresidential fixed investment ................................................................ 191
Residential construction ............................................................................. 192
Change in business inventories .................................................................. 192
Investment demand curve .................................................................. 193
Government purchases ........................................................................................ 194
vi Contents
Net exports .......................................................................................................... 194

Foreign income .......................................................................................... 194
Exchange rates ........................................................................................... 195
Trade policies ............................................................................................. 195
Money and aggregate demand............................................................................. 196
Money, interest rates and the price level ................................................... 196
The money market ..................................................................................... 196
The demand for money ...................................................................... 196
The supply of money ......................................................................... 197
Output, aggregate supply and its components ..................................................... 200
The aggregate supply curve ....................................................................... 200
Determination of natural level of output .................................................... 202
Short-run versus long-run aggregate supply curve ............................................. 203
Changes in aggregate supply ..................................................................... 203
Input prices ........................................................................................ 203
Resource supplies .............................................................................. 204
Technological knowledge .................................................................. 204
Government policies .......................................................................... 204
Factors causing the short-run aggregate supply curve to slope upwards
........................................................................................................... 204
Factors causing a shift in the short-run aggregate supply curve........ 206
General equilibrium ................................................................................... 206
Short-run macroeconomic equilibrium and business cycles ...................... 207
Adjustments in the long run ....................................................................... 208
Causes of economic fluctuations ......................................................................... 209
Shifts in aggregate demand ........................................................................ 209
Shifts in aggregate supply .......................................................................... 211
Module summary .......................................................................................................... 213
Assignment ................................................................................................................... 214
Assessment .................................................................................................................... 215
Module 4 222
Government Macroeconomic Policy ............................................................................ 222
Introduction ......................................................................................................... 222
Financial Markets, Monetary and Fiscal Policy ........................................................... 224
Introduction ......................................................................................................... 224
Money.................................................................................................................. 224
Definition and functions of money ............................................................ 224
Means of payment ............................................................................. 224
Store of value ..................................................................................... 225
Unit of account .................................................................................. 225
The supply of money ................................................................................. 225
Currency ............................................................................................ 225
Deposits ............................................................................................. 225
The demand for money .............................................................................. 226
Bonds ................................................................................................................... 227
Financial systems ................................................................................................ 230

Financial intermediaries ...................................................................................... 230
Commercial banks ..................................................................................... 230
Near banks ................................................................................................. 231
Cash reserves ............................................................................................. 231
Fractional reserve banking system ............................................................. 232
The banking (money) multiplier ......................................................................... 233
Central bank ........................................................................................................ 234
Monetary policy .................................................................................................. 235
Tools of monetary policy ........................................................................... 235
Open-market operations .................................................................... 235
Reserve requirements ........................................................................ 237
The central bank rate ......................................................................... 237
Transmission mechanism of monetary policy ..................................................... 238
How much extra aggregate demand is needed?................................. 239
Objectives of monetary policy ............................................................................ 239
Ingredients of a successful price stability programme ...................... 240
Budget deficits, debts and fiscal policy ............................................................... 241
Discretionary versus automatic policy ....................................................... 241
The multiplier effect .................................................................................. 242
A successful expansionary fiscal policy .................................................... 244
A successful contractionary fiscal policy .......................................... 245
Effect of a tax cut ................................................................................................ 245
The crowding-out effect on investment .............................................................. 248
Government budgets .................................................................................. 249
Deficits and debts....................................................................................... 249
The limits of policy activism ............................................................................... 250
Inflation and Unemployment ........................................................................................ 251
Introduction ......................................................................................................... 251
Inflation ............................................................................................................... 252
Causes of inflation ..................................................................................... 252
Demand-pull inflation........................................................................ 252
Cost-push inflation ............................................................................ 253
Money supply and inflation ....................................................................... 254
The inflationary process ............................................................................. 256
Inflation, unemployment and the Phillips curve ................................................. 257
Short-run Phillips curve ............................................................................. 257
Costs of inflation ........................................................................................ 259
Redistribution effect of inflation ................................................................ 259
Other impacts of inflation .......................................................................... 262
Shoe-leather costs .............................................................................. 262
Tax distortions ................................................................................... 262
Confusion and money illusion ........................................................... 262
Inflation variability ............................................................................ 262
Inflation tax........................................................................................ 262
The benefits of inflation ............................................................................. 263
Unemployment .................................................................................................... 263
The labour force survey ............................................................................. 265
viii Contents
The official unemployment rate ................................................................. 265

Drawbacks of the official unemployment rate ........................................... 266
Underemployment ............................................................................. 266
Discouraged workers ......................................................................... 267
Anatomy of unemployment ....................................................................... 267
The unemployment pool ............................................................................ 267
Types of unemployment ............................................................................ 268
Frictional unemployment ................................................................... 268
Structural unemployment .................................................................. 268
Cyclical unemployment ..................................................................... 269
Seasonal unemployment .................................................................... 269
Full employment ........................................................................................ 269
Determinants of the natural rate ........................................................ 269
Reducing the natural rate of unemployment...................................... 270
Public policy ........................................................................................................ 270
Unemployment insurance .......................................................................... 271
Minimum wages......................................................................................... 271
Unions and collective bargaining............................................................... 272
Reservation wage and efficiency wage ...................................................... 272
Costs of unemployment ............................................................................. 273
Module summary .......................................................................................................... 274
Assignment ................................................................................................................... 275
Assessment .................................................................................................................... 276
Module 5 285
The Open Economy ...................................................................................................... 285
Introduction ......................................................................................................... 285
Overview ....................................................................................................................... 286
The balance of payments accounts ...................................................................... 287
The current account ........................................................................... 288
Trade in goods (merchandise) .................................................................... 288
Trade in non-merchandise.......................................................................... 288
Services .............................................................................................. 288
Net investment income ...................................................................... 289
Transfers ............................................................................................ 289
Current account balance ............................................................................. 289
The capital and financial account .............................................................. 289
Portfolio investment .......................................................................... 290
Direct investment ............................................................................... 290
Capital (financial) account balance ..................................................................... 290
The official settlements account ................................................................ 290
Balance of payments balance ..................................................................... 291
Current account, lending and borrowing ................................................... 291
Exchange rates..................................................................................................... 292
Exchange rate determination...................................................................... 293
Foreign exchange market .................................................................................... 293
Demand for foreign currency (exchange) .................................................. 293

Changes in the demand for dollars............................................................. 295
Interest rates ....................................................................................... 295
Incomes .............................................................................................. 295
Inflation rates ..................................................................................... 295
Exchange rate expectations ............................................................... 296
Supply of foreign currency (exchange)...................................................... 296
Changes in the supply of dollars ................................................................ 298
Interest rates ....................................................................................... 298
Incomes .............................................................................................. 298
Inflation rates ..................................................................................... 298
Exchange rate expectations ............................................................... 298
Market equilibrium ............................................................................ 299
Changes in exchange rates ......................................................................... 300
Real exchange rates ........................................................................... 300
Exchange rate regimes ....................................................................... 302
The exchange rate and the aggregate demand curve ........................................... 305
Current account ................................................................................................... 305
Net exports .......................................................................................................... 305
Interest rate parity................................................................................................ 307
Exchange rate policy ........................................................................................... 308
High exchange rates (low currency values) ............................................... 308
Low exchange rates (high currency values)............................................... 309
Monetary policy and exchange rates ................................................. 309
The exchange rate in the long run: Purchasing power parity..................... 310
The importance of current account ............................................................ 311
Corrective policy options ........................................................................... 312
Causes and implications of trade deficits .......................................... 313
Increased current consumption .......................................................... 313
Increased indebtedness level ............................................................. 313
International trade ............................................................................................... 314
Why do countries trade? ...................................................................................... 314
Specialisation and trade ............................................................................. 314
Absolute advantage............................................................................ 315
Comparative advantage ..................................................................... 315
Terms of trade ............................................................................................ 317
The sources of comparative advantage ...................................................... 319
Trade policy......................................................................................................... 321
The case for trade protection ............................................................. 322
Activity 5.1 ................................................................................................................... 324
Trade agreements and trade liberalisation ......................................... 324
Regional trade agreements................................................................. 324
Economic integration between countries ........................................... 325
Understanding World Trade Organization (WTO) ........................... 325
x Contents
Module summary .......................................................................................................... 328

Assignment ................................................................................................................... 329
Assessment .................................................................................................................... 330
References and suggested course readings ................................................................... 341
About thiscourse manual
How this course manual is

structured
The course overview
The course overview gives you a general introduction to the course.
Information contained in the course overview will help you determine:
• If the course is suitable for you
• What you will already need to know
• What you can expect from the course
• How much time you will need to invest to complete the course.
The overview also provides guidance on:

• Study skills
• Where to get help
• Course assignments and assessments
• Activity icons
• Modules.
We strongly recommend that you read the overview carefully before

starting your study.
The course content

This course consists of five modules. Each module comprises:
• An introduction to the modulecontent
• Moduleoutcomes
• New terminology
• Core content of the module with a variety of learning activities
• A modulesummary
• Assignments and/or assessments, as applicable.
Resources
For those interested in learning more on this subject, we provide you with
a list of additional resources at the end of this course manual; these may
be books, articles or websites.
1
Course ovverview
Cou
urse ovverview
w
Welccome to
o Econo
omic En
nvironm
ment of Business
Ecoonomics is the study of ho ow individuaals and societties choose to use
scarrce resourcess. It is a behaavioural sciennce of how ppeople make choices.
Thiss course is orrganised into ofive modulees addressingg topics of ecconomic
issuues faced in business
b enviironment. Thhe course beggins with an
overrview on thee economic en nvironment and
a the markket mechanissm. The
moddules that folllow explore production theory,
t cost ttheory, mark
ket
structure, aggreggate demand d and supply, and governm ment macroeeconomic
poliicy. In module five, economy in an oppen environm ment will be covered.
Econ
nomic Environ
E ment of Busin
ness —is this
coursse for you?
y
Thiss course is inntended for people
p who need
n to underrstand the wo
orkings
of thhe environment within which
w a businness operates. Business managers
m
and students alikke would neeed to know how
h much thee economic condition
c
of a country govverns the mov vements in businesses.
b
2
Course outcomes
Upon completion of Economic Environment of Business you will be able
to:
• summarisebenefits of studying economic issues and describe

insights into society and international affairs resulted
fromthinking in economic terms.
• describethe overall market system.
Outcomes • distinguishbetweendifferent types of elasticity.
• explain the particular meaning ofcost and profits in economics.
• describe the various types ofmarket structure.
• account for the different approaches to measuring GDP.
• state how shifts in aggregate demand or supply can cause booms
and recessions.
• describe how fiscal policy influences the economy differently
frommonetary policy.
• outline the concept of the trade-offbetween inflation and
unemployment.
• elaborate on the reasons for which countries engage in
international trade.
Timeframe
This course will take approximately 120 hours of study time.
How long?
3
Course ovverview
Study skillss
As an
a adult learnner your approach to learrning will be different to that
from
m your schoool days: you will w choose whatw you waant to study, you y will
havee professionaal and/or perrsonal motivaation for doinng so and yo ou will
mosst likely be fiitting your sttudy activitiees around othher profession
nal or
dommestic responnsibilities.
S
Study skills
Esseentially you will
w be takin ng control of your learninng environmeent. As a
conssequence, yoou will need to
t consider performance
p issues relateed to
timee managemennt, goal-setting, stress maanagement, eetc. Perhaps you will
also need to reaccquaint yoursself in areas such as essay planning, coping
c
withh exams and using the Web as a learnning resourcee.
derations willl be time andd space– the time

Youur most significant consid
you dedicate to your
y learning
g and the envvironment inn which you engage
e
in thhat learning.
We recommend that you take time now— —before startting your self-
studdy—to familiiarise yourself with thesee issues. Therre are a numb
ber of
exceellent resourcces on the Web.
W A few suuggested linkks are:
• http://www.h
h how-to-study
y.com/
The “How too study” website is dedicaated to studyy skills resourrces.
T
Y will findd links to study preparatioon (a list of nnine essentiaals for a
You
g
good study place), taking
g notes, strateegies for readding text boo
oks,
u
using referennce sources, test
t anxiety.
• http://www.u
h ucc.vt.edu/std
dysk/stdyhlp.html
This is the website of the Virginia Tech, Division of Student Affairs.
T A
Y will findd links to tim
You me schedulingg (including a “where doees time
g
go?” link), a study skill checklist, bassic concentraation techniquues,
c
control of thee study envirronment, notee taking, how
w to read esssays for
a
analysis, mem mory skills (““rememberinng”).
• http://www.h
h howtostudy.o
org/resourcess.php
Another “Hoow to study” website withh useful linkss to time
A
m
management , efficient reaading, questiioning/listening/observin
ng skills,
g
getting the most
m out of do oing (“hands-on” learningg), memory building,
b
t for stayinng motivated
tips d, developingg a learning pplan.
The above links are our sugg gestions to sttart you on your way. At the time
of writing
w these Web links were
w active. If I you want too look for more
m go to
www w.google.com m and type “self-study
“ baasics”, “self--study tips”, “self-
studdy skills” or similar.
s
4
Getting around this course manual
Margin icons
While working through this course manual you will notice the frequent
use of margin icons. These serve to “signpost” a particular piece of text, a
new task or change in question; they have been included to help you to
find your way around this course manual.
A complete icon set is shown below. We suggest that you familiarise

yourself with the icons and their meaning before starting your study. Not
all icons are used in the course. The icon for “Study Skills” indicates that
you have to answer questions about what you have read.
Reading and References. All course readings and references are listed
at the end of Module 5.
Activity Assessment Assignment Case study
Discussion Group Question Help Note it!
Outcomes Reading Reflection Study skills
Summary Terminology Time Tip
5
Module 1
Mod
dule 1
Introduction
n to thee Econo
omic Ennvironm
ment
andUUndersttanding the Maarket Meechanissm
Introduction
Ecoonomics is the study of ho ow individuaals and societties choose to use
scarrce resourcess. It is a behaavioural scieence of how ppeople makee choices.
In thhis module, you

y will learrn that the funndamental prroblem of ecconomic
quesstions stem from
f scarcity
y. You will explore the diistinction bettween
maccroeconomics and microeeconomics annd use PEST T analysis to make
a explore the differencce
econnomic choicees in businesss. You will also
betw
ween normattive and posittive economyy.
Theen we will revview commaand, laissez-ffaire and marrket econom mic

systtems. We willl explain thee role of pricce as a rationiing device to
o allocate
scarrce resourcess and how yoou could applly the demannd and supply y models
in economics. WeW will also explain
e the effect
e of taxes, price ceilin
ngs,
pricce floors and conditions th
hat determinne the patternn of internatio onal
tradde.
Lasttly, you will also exploree consumers’’ responses too price chang ges i.e.,
the concept of ellasticity, deteerminants off price elasticcity and the
calcculation of inncome, cross--price and addvertising elaasticity of deemand.
Upoon completioon of this module you willl be able to:
• discuss thhe efficiency of free markket competitiion.

• explain thhe conditionss that determine the patterrn of internaational
trade.
• describe alternative
a raationing mechanisms.
O
Outcomes
• summarisse the concep
pt of elasticitty.
• distinguissh between th
he different types
t of elastticity.
• calculate elasticity.
• predict thhe relationshiip between ellasticity and total revenu
ue.
• describe the
t impacts of
o the determ
minants of priice elasticity.
• distinguissh between an
nd calculate income and cross-price elasticity
of demandd.
6
Terminology
Cross-price The percentage of change in the quantity
elasticity of demanded to changes in the price of a particular
demand: good, Good A, relative to changes in the price of
substitute or complementary products, Good B.
Terminology Demand: The quantity of a good or service that a household
or a firm chooses to buy at a given price.
Economics: The study of how individuals and societies choose

to use scarce resources.
Income elasticity of The percentage of change in the quantity

demand: demanded with the percentage of change in
income.
Law of demand: The law of demand states that there is a negative

relationship between the price and the quantity
demanded of a product. When the price of an item
increases, we buy less.
Law of supply: Relationship between the price of the product and

the quantity supplied. As per law of demandthe
price of the product and the quantity supplied are
related positively with other things being equal. In
other words, the higher the product’s own price,
the more its producers will supply; and the lower
the price, the less its producers will supply.
Marginal analysis: Marginal analysis refers to the benefit from a one-

unit change in an Question (defined as marginal
benefit) to the cost of making a one-unit change in
an Question (defined as marginal cost).
Opportunity costs: The alternatives that one forgoes to obtain the best.
Introduction to the Economic

Environment
Introduction
Economics is the study of how individuals and societies choose to use
scarce resources that nature and previous generations have provided.
Economics is a behavioural science that concerns the study of how people
make choices.
7
Module 1
Theere are four main

m reasons to study ecoonomics: to leearn a way of o
thinnking, to understand the society,
s to unnderstand gloobal affairs and
a to be
an innformed citizen (voter). Probably
P thee most imporrtant reason for
f
studdying econommics is to leaarn a particular way of thiinking. Somee basic
quesstions on ecoonomics are:
1. What is produced an
nd in what quuantities?
2. How aree these goods and servicees produced??
3. For whoom are they produced?
p
4. Who takkes economicc decisions and
a by what pprocess?
In thhe process off studying ecconomics, yoou will be aw ware of the

funddamental prooblem from which
w econom mic questionns stem: that human
beinngs have limiited resourcees but unlimiited wants. W When wants exceed
e
the resources
r avvailable to sattisfy them, thhere is scarcity. Scarcity is
prevvalent. Peoplle want good d health and long
l life, maaterial comfort,
secuurity, physicaal and mentaal recreation, and knowledge. None of these
wannts is compleetely satisfiedd and everyone has some wants that remain r
unsaatisfied. Howwever, it is saafe to say thaat no one feeels entirely saatisfied
withh his/her state of health and
a expected length of liffe. Furthermo ore, no
one has enough time for sports, travel, vaacation, movvies, theatre, reading
and other leisuree pursuits.
Econnomics is thee study of ho

ow—
A. Scarce resources
r aree used to satissfy unlimitedd wants.
B. We chooose to use un
nlimited resoources.
S
Study skills C. Limitlesss resources are
a used to satisfy scarcee wants.
D. Society has no choicce.
Solu
ution:
A. Econommics is about choice—how
w we allocatee limited reso
ources to
unlimiteed wants.
Costs
Faceed with scarccity, people must
m make choices.
c Wheen we cannott have
everrything we want,
w we choose among thhe alternatives available. The
conccepts of scarrcity and chooice provide a definition oof economicss as the
studdy of how people make ch hoices to coppe with scarccity. Becausee scarcity
forcces people to make choicees, economiccs is sometim mes called the science
of chhoice– the sccience that ex
xplains the choices
c that ppeople make and
preddicts how chooices changee as circumsttances changge.
8
Choosing more of one thing means having less of something else. In

other words, in making choices, we face costs. Economists use the term
opportunitycost to emphasise that making choices in the face of scarcity
implies a cost. Perhaps it might be playing a round of golf or studying for
an economics examination. The opportunity cost of the trip to the zoo is
the value you attach to the option that you would otherwise have chosen.
Question:
Does your opportunity cost of attending university include—
A. The money you spend on meals while at university.
Study skills B. Your tuition and the money you spend on traveling between
home and university.
C. The income you could have earned if you had been employed full
time.
D. Both B and C.
Solution:
D. You will buy food whether or not you attend university. Both
other expenses occur solely because of attending university.
The economic way of thinking

Five core economic ideas indicate the economic way of thinking on the
choices that must be decided:
1. Rational choices.
2. Opportunity cost.
3. Benefit is what is gained when you get something and is
measured by what you are willing to give up to get it.
4. A rational choice is made at the margin.
5. Choices respond to incentives.
Rational choices
• People make rational choices by comparing between costs and
benefits.
• If a person uses the available resources or information effectively
in making his/her choice, then he/she has made a rational choice.
The rational choice is made by comparing the marginal costs and
marginal benefits, that is, it is responses to incentives.
Opportunity cost
• The opportunity cost of something is the best thing you must
give up to get it.
• Choices have opportunity costs; for instance, the opportunity cost
of travelling forgone from going to university to attend lectures
9
Module 1
becausee a student is not able to do d these diffeerent things at

a the
same timme. There is a trade-off too the studentt for choosin ng one of
these acctivities sincee time is a lim
mited resourcce to him/herr.
• A sunk cost is a costt that has beeen incurrred and cannot be
b
recovereed. A prospeective cost iss a future cosst.
Ben
nefit: What you
y are willin
ng to sacrifice
• The bennefit or advan
ntage of sommething is thee pleasure orr gain it
embodiees. Economissts measure the
t gain of soomething by y what a
person is
i willing to sacrifice
s to obtain
o it.
At the margin
• “At the marggin” means making

m a deccision based on comparisson and
choosing whhat is a little bit better.
• People make
m choices based on thhe marginal analysis thaat is,
compariing all the relevant choices or alternattives increm
mentally
and systtematically.
• Marginaal analysis reefers to the benefit from a one-unit ch
hange in
an econoomic questioon (defined asa marginal benefit) to th he cost
of makinng a one-uniit change in ana economic question (deefined as
marginal cost).
• If the marginal
m beneefit of an econnomic questiionis more th
han the
marginaal cost of the question, then the ration
nal choice iss to
proceedd with the queestion.
Ressponding to incentives
• An inceentive is a rewward that encourages an action. A
nalty that disccourages an action.
disincenntive is a pen
• Changess in marginal benefits and marginal ccosts affect th he
incentivves that people face in maaking rationaal choices. Peeople’s
decisionns change wh hen incentivees change. Foor instance, if
i
homewoork assignmeents are weigghed more heeavily in a cllass’s
final graade, the marg
ginal benefit of completinng homeworrk
assignmments has beeen raised andd more studeents tend do the
t
homewoork assignmeents.
10
Consider the following:

In making your decision whether to take a trip during summer semester
break, you compare all the other choices you could undertake. As a
consequence, you—
Study skills
A. incur a sunk cost.
B. are making a choice at the margin.
C. are not making a rational choice.
D. do not face an opportunity cost.
Solution:
Discuss your answer with your tutor.
Economic environment of business

Economic news is exchanged in the public media every day because
economic issues affect everyone. Business conditions exist within an
economic environment containing technological, institutional, cultural
and political factors. Reciprocally, the economic environment is affected
by business decisions in which economic principles are variously
implicit, consciously applied, or present in the background; in the form of
government policies towards businesses. Corresponding to the two sides
of this reciprocal influence are the two branches of economics.
Macroeconomics focuses on aggregate economic conditions – those
conditions that set the environment within which a business operates and
microeconomics focuses on the economic forces that influence the
decisions made by individual consumers, firms and industries. These
decisions are often made in an instinctive way, yet consistent economic
forces underlie them. Thus, an explicit recognition and understanding of
the forces that influence these decisions is a vital part of a manager’s
intellectual equipment.
Macroeconomics is concerned with the economy as a whole. Thus it is

concerned with aggregate demand and aggregate supply. Aggregate
demand accounts for the total amount of spending in the economy, by
consumers, overseas customers for our exports, the government or firms
when they buy capital equipment or stock up on raw materials. On the
other hand, aggregate supply accounts for the total national output of
goods and services. The overall economic question is measured in a
variety of ways. These measurements – the number of people with jobs,
the total income of persons, the output of factories, and the amount of
total goods and services produced in the economy (GDP) are regularly
reported in newspapers, business periodicals, news through television and
radio. These reports often fail to explain the importance of these as well
as other economic indicators. A business manager should be able to put
these announcements in perspective with regard to both the relationships
among indicators and the manager’s own business.
11
Module 1
Miccroeconomiccs is concern ned with the individual

i paarts of the economy.
It is concerned with
w the dem mand and suppply of particcular goods, services
and resources suuch as cars, clothes
c and haircuts;
h electricians, secrretaries,
blasst furnaces, computers
c an
nd coal. The most
m basic economic forces a
firm
m has to address are thosee that shape the
t supply annd demand fo or the
goods or servicees it producess. Even as buusinesses aroound the worrld are
undergoing massive manageement changees, it is increasingly recognised
that changing market
m conditiions provokee these respoonses. The cru ux of
micrroeconomic influences on o business decision-mak
d king is the annswer to
the two-part
t queestion: How much
m shouldd the firm prooduce, and how
h
mucch should it charge
c for th
his output?
Whiich one of thhe following is

i true?
A. Microecconomics stu
udies consum
mer behaviourr, while
macroecconomics stu
udies produceer behaviourr.
S
Study skills B. Microecconomics stu
udies produceer behaviour,, while
macroecconomics stu
udies consum
mer behaviouur.
C. Microecconomics stu
udies behavioour of individdual househoolds and
firms, while
w macroecconomics stuudies nationaal aggregatess.
D. Microecconomics stu
udies inflationn and opporttunity costs, while
udies unemplloyment and sunk costs.
macroecconomics stu
Solu
ution:
C. Microecconomics stu udies the behaaviour of inddividual deciision-
makers, firms and ho ouseholds, whereas
w macrroeconomics studies
aggregatte concepts, inflation , unnemploymennt, interest rates,
exchangge rates, etc..
Making econom
mic choicces in business
Firm
ms will norm mally want to make as muuch profit as ppossible, or at a the
veryy least to avooid a decline in profits. Inn order to meeet these and
d other
objeectives, manaagers must make
m choicess in terms of what types ofo output
to produce, how w much to pro oduce and at what price; what techniq ques of
prodduction to usse, how many y workers to employ andd what type, whichw
supppliers to use for raw mateerials, equipm ment, etc. In each case, weighing
w
the alternatives can
c be less onerous
o for a manager whho is aware of o the
typees of influencces that cann
not be avoideed in businesss decision making.
m
Havving acquiredd the knowledge of these external factors, how do o firms

puts, marketing, investm
deciide on pricess, outputs, inp ments andso on?
o Here
busiiness econommists can play y a major rolle in helpingg firms achiev
ve their
busiiness objectivves.
Thee external inffluences outside the direcct control of a firm are thee
commpetition it faaces, the pricces it pays foor raw materiials, the statee of the
econnomy (whethher static, gro owing or in recession)
r annd the level ofo
interest rates. Buusinesses willl need to obtain a clear uunderstandin ng of
their environmennt before theey can set aboout making tthe right deciisions.
12
(You will notice that most external factors to the firm are also external to
the industry, i.e., macroeconomic. Other factors, though outside the firm,
are within the industry and so are microeconomic in nature.)
PEST Analysis
The division of the factors affecting a firm into political, economic, social
and technological factors is known as a PEST analysis. It is widely used
by businesses to study their environment and to help them establish a
strategic approach to their business activities.
Political/legal/institutional factors
Firms will be directly affected by the actions of government, since the

role of the government is to make law and modern governments enact
laws such as industrial relations legislation, product safety standards and
laws preventing collusion between firms to keep prices up. Political
developments such as the collapse of communism strongly affect the
business community.
Economic factors
Economic factors constitute a wide range of factors from rising costs of

raw materials to the market entry of a new rival, from the forthcoming
budget to the instability of international exchange rates. A business
organisation must constantly take such factors into account when
devising and acting upon its business strategy. As discussed above, it is
conventional to divide the economic environment, in which the firm
operates into two levels, macroeconomics and microeconomics, and you
must consider both realms in making decisions.
Social and cultural factors
Social attitudes and values may or may not be codified in law and they
include attitudes towards working conditions and the length of the
working day, equal opportunities for different groups of people (by
ethnicity, gender, physical attributes, etc.), the use and abuse of animals
and images portrayed in advertisements. The social/cultural environment
also includes demographic trends such as an increase in the average age
of the population or changes in attitudes towards seeking paid
employment while bringing up small children. In recent times, various
ethical issues, especially those concerning the protection of the
environment have had a big impact on the actions of business and the
image that many firms seek to present.
Technological factors
Over the last 20 years, the pace of technological change has quickened,
transforming not only how firms produce products but also how their
business is organised. The use of robots and other forms of computer-
controlled production has changed the nature of work for many workers.
It has also created a wide range of new opportunities for business, many
of which are yet to be realised. The information-technology revolution
also enables rapid communication with the opportunity for many workers
13
Module 1
to work
w from hoome or while travelling.
Goverrnment in
nterventio
on in business
Deaaling with goovernment po olicies towardd business iss a very impo ortant
subjject in the prrivate sector and implemeenting such ppolicies is a major
m
funcction of the public
p sector. Most citizeens of modernn developed
counntries expectt government policy to pllay an imporrtant role in their
t
lives. We expectt governmen nts to providee law enforceement, educaation and
a vaariety of otheer goods and services witth the expectaation that
governments will finance theese activitiess by imposing taxes, subssidies
andsso on. Most of us also recognise that governmentt policy has some s
influuence on thee rate of unemmployment, inflation,
i inteerest rates an
nd
geneeral businesss conditions. However, manym people are surprised d when
theyy discover the extent to which
w businesss decisions of private seector
firm
ms are affecteed by govern nment interveention.
Thrree dominaant macroeconomic principless

Ecoonomic policiies throughou
ut the world have recentlly converged
d around
threee basic princciples:
1. Increasiing emphasiss on using maarket mechannisms to achiieve
objectivves rather thaan supplantinng them withh state interveention.
2. Formulaation of moree macroeconnomic policiees to ensure a stable
economic frameworkkrather than to achieve proactive cou unter-
cyclical targets or naational plannned growth raates and inveestment
targets.
3. More ouutward-lookiing national policies
p as a result of a stteady
increasee in the mem
mbership of thhe World Traade Organizaation
(WTO),, the relaxatio
on of controlls on capital mobility and d the
globallyy more benig
gn stance tow
wards foreignn investment.
Such policy changes in Euro ope, North America,

A Asiaa and elsewh
here have
a prrofound effecct on the busiiness environnment. Throuughout Easteern
Euroope and the former
f Sovieet Union, pollicymakers hhave turned away
a
from
m economic planning
p d price controols and are searching for ways to
and
makke their markkets function more efficieently.
Typess of econo
omic evaluation
Youu might wondder what gov vernment inteervention is iintended to achieve
a
and why governnments choosse the policiees they do. Economists arre often
calleed upon to make
m judgem
ments on mattters of publicc policy. Sho ould the
government reduuce the deficcit? If so, how w? In this typpe of public policy
disccussion, econnomists tend to disagree. They differ iin their descrription
of thhe economy and in their predictions
p o the conseqquences of ceertain
of
actioons. When thhey describe the economyy and constru ruct models that
preddict either hoow the econoomy will channge or be afffected by diffferent
poliicies, they aree engaged in
n positive ecoonomics. Whhen they evalluate
14
alternative policies, they are engaged in what is called normative

economics.
Positive economics is concerned with what is, with a description of how

the economy functions. It is, therefore, ‘descriptive’ in the sense that it
tries to explain or describe why things are as they are. The positive
approach to policy analysis focuses on the objectives, behaviour and
interaction of individuals and groups who influence policy decisions.
Instead of focusing on what a policy should be as normative analysis
does, positive analysis examines the reasons why a policy takes the form
it does.
One important influence on policy decisions is voting. Another influence

arises from special interest groups including business lobbies who spend
time and energy trying to influence government policies. Public sector
managers (or bureaucrats) themselves are an important influence as are
elected politicians.
Normative economics deals with what should be, by making judgements

about the desirably of various courses of action. Normative economics is,
therefore, ‘prescriptive,’ because in answering it we are trying to suggest
or prescribe what governments should do. The starting point in the
analysis of this question is that government policies towards business
should seek to promote public interest. However, it is difficult to say
exactly what public interest is. One policy may benefit some people,
another may benefit others. One policy is not unambiguously better than
another. It depends on your own personal view.
Accepted government objectives
Nevertheless, there is a well-established set of goals that is widely

accepted as legitimate objects of government attention. These include:
1. Economic efficiency that corresponds to trying to make the per
capita benefits from the consumption of goods and services as
high as possible.
2. Macroeconomic stabilisation and growth which relates to the
objectives to smooth the business cycle, keep unemployment
rates and inflation rates low and stable and to assist in promoting
economic growth.
3. Fairness (equity) in seeking to make the overall size of the
‘economic pie’ as large as possible. Fairness or equity is
concerned mainly with the distribution of that pie among
different claimants and other social objectives.
It is possible that actual policies towards business will be just as

normative analysis suggests they should be. However, actual policies
often coincide very poorly with normative analysis Therefore we are
forced to conclude that general public interest is not the major
determinant of policies.
15
Module 1
nsider the foollowing:

Con
A diifference bettween positiv
ve economicss and normattive economiics is
that—
—
S
Study skills A. Positivee statements are
a true by definition.
d
B. Only poositive statem
ments are subjject to empirrical verificaation.
C. Econommists use posiitive statements and politticians use no
ormative
statemennts when discussing econnomic matterrs.
D. Positivee economics involve
i value judgments.
ution:
Solu
B. Clearly, D and C aree wrong.
Positive staatements can be disprovedd by empirical verificatio
ons.
Econo
omic debaate
Stattements made by those en ngaged in poositive economics are nott
neceessarily true;; they can bee disproved byb empirical vverification.
Nevvertheless, noormative stattements, beinng theoreticaal, are not sub bjected
to emmpirical veriification at all
a if their bassis is based oon value judggements.
Hennce the imporrtance of deb bate i.e. accuuracy and reliiability imprrove as
diffe
ferent judgemments are aireed and considdered by diffferent individ duals.
Ecoonomists are often called upon to makke judgementts on matterss of

public policy. Thhey differ in
n their views of on how thhe world worrks, for
two reasons:
nt objectivess. In macroeconomics, foor example,
1. Differen
econommists place diffferent weighhts on objecttives such as:
a. To reduce wage
w inequaliity.
n (or increasee) economic growth.
b. To maintain
c. To reduce th
he inflation rate.
r
d. To reduce th
he unemployyment rate.
2. Absence of controllled experim ments. Actuall economies area
highly complex,
c connsisting of many
m individuuals, firms an
nd
marketss. This compllexity prevennts macroecoonomists from m
conductting controlleed experimennts to study, for example, the
effects of
o monetary policy on thee economy. A As a result, different
d
macroecconomists caan look at thee same eventt and reach different
d
conclusiions.
16
Activity 1.1
Choose a firm or a business that you are familiar with. Briefly describe
that firm or business. Discuss how various aspects of business
environment – internal, external and global could have influenced its
performance.
Activity
17
Module 1
Undeerstanding thee market

mechhanism and an nalysing
g markeet
demaand
Introduction
Now w that you haave understood the essenttial economiic problem ass scarcity
in itts most objecctive sense, let us exploree how differeent economicc systems
answ wer the folloowing questioons:
1. How dooes price worrk as a rationning device (aallocating scarce
resourcees)?
2. How effficient is a prrice system?
Com
mmand econ
nomy
In a command economy, a central authorrity or agency draws up a plan

that establishes what
w will be produced annd when; setss production n goals
and makes ruless for distributtion. Even inn a pure plannned economy y, the
public exercises choices by setting
s the voolume that itt wishes to co
onsume.
Laisssez-faire ecconomy
Laisssez-faire1 is a French ph hrase which means:

m ‘allow
w to do’. Thiis is an
econnomy in whiich individuaal householdss and firms ppursue their own o self-
interests withoutt any central direction orr regulation. IIn this enviro
onment
(knoown today ass a market ecconomy), no central direcction or regu ulation
coorrdinates the decisions
d of individual households
h annd firms. Somme
marrkets are simpple and otherrs are complex, but they all involve buyers
b
and sellers engaging in diffeerent exchangges. The behaviour of buyers and
selleers in a laisseez-faire econnomy determmines what geets produced, how it
is prroduced and who gets to buy the goods.
Nevvertheless, thhe involvemeent of the govvernment cannnot be denieed. In

everry market economy today y, governmennts produce m many servicees,
rediistribute incoome through taxes and exxpenditures rregulate manyy
activvities.
Pricces in a free market

m act ass a signallingg device. A rise in the priice of a
prodduct indicatees that this prroduct has beecome scarceer. The price increase
signnals to consumers the neeed to purchasse less by seeeking cheapeer
subsstitutes, for instance, andd it signals too a business tthe need for more
m
suppply. If the freee market system is to opperate efficieently, it requiires an
adeqquate instituttional framew work of law,, custom andd behaviour. In I long-
estaablished markket economiees, this backgground tendss to be taken for
grannted. Its abseence however, can be cosstly as the neewly liberalissed
econnomies of Euurope have discovered.
d
1
Oxfford dictionary pronunciation code
c is ‘lesei’ fer,
f roughly equuivalent to ‘less-ay-fair’
18
The market system in action
The free market consists of many interconnected markets which, for the
purposes of this course, you can assume to be highly competitive and
they operate free of government interference.
In reality, many markets are subjected to imperfectly competitive and

monopolistic influences and government intervention in the market
system is a feature of even the most enthusiastically capitalist society.
Indeed, in some circumstances, such intervention can be shown to be a
necessary condition for achieving economic efficiency.
What is a market?
There are many types of market but the type of market structure truest to
the traditional model of a physical marketplace is a perfectly competitive
market with the following characteristics:
• Large number of sellers and buyers, each acting independently
and exerting no individual monopolistic power.
• Full information: Everyone knows what the going price is and
can evaluate the quality of the good or service being produced.
• Consumers aim to maximise utility (i.e., personal satisfaction)
and firms aim to maximise profits.
• Prices are flexible in all markets.
Given these conditions, the market system fulfills the function of

allocating resources between different users and among different people.
It acts as an equilibrating mechanism between supply and demand. Prices
act as signals and the price system is the coordinating mechanism that
ensures that markets are ‘clear’: supply equals demand in each market.
The market system

Your reading on economic measurements has brought three key elements
of the market system to your attention, one being the product market: the
markets for individual goods and services. The others are the labour
market – the buying and selling of labour – and the capital market – the
lending and borrowing of capital. In each market, the typical buyers and
sellers are firms and households. Households sell their labour to firms
and with the income earned in such a way, they buy goods and services
from firms. Firms produce goods and services by hiring labour and
capital from households (and other firms). Households and firms also
interact on the capital market. If individuals choose not to spend all their
income, their savings are channelled to firms by intermediaries such as
banks and pension funds. If they choose to spend more than their income,
loans will be supplied by the same intermediaries. This is a much-
simplified conceptualisation of the market system as we know it in the
real world, However, it is sufficient to illustrate the strong
interconnections between markets as depicted in Figure 1.1.
19
Module 1
Figu
ure 1.1
Foreeign and go
overnment seectors
Twoo other markket participan nts must be considered: thhe foreign seector and
the government
g sector. Dommestic firms do
d not have too sell their entire
outpput to domesstic consumerrs. They alsoo have the opption of expo orting.
Likeewise, houseeholds can im mport goods anda services instead of buying
the output of dom mestic firmss. Imports, exxports and thhe foreign traade
marrket are an inntegral part of an analysiss of the markket system. Factors of
prodduction suchh as capital an nd labour cann also be tradded internationally.
Thee rise in globaal capital moobility, especcially betweeen developedd
counntries, indicaates that the domestic
d ecoonomy is no longer restriicted to
dommestic savinggs for its supp ply of investmment funds. Since the miiddle of
the twentieth
t cenntury, the forreign sector has been groowing rapidly y in
relattive importannce.
Thee governmentt is also an im mportant parrticipant in thhe market. Th he size

of government
g s
spending as a percentage of the nationn’s aggregatee
spennding varies from one naation to the neext, but in inndustrial coun ntries,
government spennding amoun nts to about 40
4 per cent oof total nationnal
expeenditure. Thee role of govvernments is very importaant in the lab bour
marrket. They hirre civil servaants directly or indirectlyy in the form of
conttracts with thhe private secctor to acquiire services, ssupervise
proccurements anndso on. Pub blic interventiion takes maany forms in addition
to government
g s
spending. Alll areas of ecoonomic life aare subjectedd to
officcial regulatioons. Examplees are planniing requirem ments for neww
builldings, healthh and safety regulations
r a well as envvironmental
as
restrrictions.
Statte-owned com mmercial com mpanies are another vehiicle of goverrnment

influuence whichh is not refleccted in the sppending GDP
P ratio.
Bussiness in a competittive market

If a firm wants to
t increase its profits, shoould it raise iits prices, or should it
lower them? Shoould it increaase or reducee its output? Should it mo odify its
20
product, or keep the product unchanged? The answer to these and many
other questions is that it depends on the market in which the firm
operates. If the market is buoyant, the firm might be well advised to
increase its output in anticipation of greater sales. If customers give
evidence of being willing to pay more for the product, a price rise might
also be a good idea. If, however, the market is declining, the firm may
well decide to reduce output, or cut prices, or diversify its product line.
Price theory and the price mechanism

Price theory
The basic coordinating mechanism in a market system is price. A price is
the amount that a product sells for per unit, and it reflects what society is
willing to pay. Prices of inputs i.e. labour, land and capital determine the
production cost of a product. Prices of various kinds of labour (wage
rates) determine the rewards for working in different jobs and
professions. Many of the independent decisions made in a market
economy involve the weighing of prices and costs, so it is not surprising
that much of economic theory focuses on the factors that influence and
determine prices. This is why microeconomic theory is often simply
called price theory.
In a free market, individuals are free to make their own economic

decisions. Consumers are free to decide what to buy with their incomes:
free to make demand decisions. Firms are free to choose what to sell and
what production methods to use: free to make supply decisions. The
resulting demand-and-supply decisions of consumers and firms are
transmitted to each other through their effect on prices: through the price
mechanism.
The market system, also called the price system, performs two important
and closely related functions in a society with unregulated markets. First,
it provides an automatic mechanism for distributing scarce goods and
services. In other words, it serves as a price-rationing device for
allocating goods and services to consumers when the quantity demanded
exceeds the quantity supplied. Second, the price system ultimately
determines both the allocation of resources among producers and the final
mix of outputs.
The demise of the command systems
The market system, or price system has three merits, namely efficiency,
incentives and freedom. However, in the command system (also known
as socialism or communism) governments own most economic resources
and the decisions are making via a central economic plan. This central
economic board examines production levels for each business or firm and
determines the total amount of resources to be allocated to each firm in
achieving its production goals. Nevertheless, this system has two main
problems.
21
Module 1
Thee coordinatio
on problem
Thee central plannner or goverrnment is reqquired to cooordinate the millions

m
of inndividual deccisions by coonsumers, seellers and bussinesses. Forr
exam mple, if the central
c plann
ners had to seet up a factorry to producee 10,000
carss, they had too ensure the availability
a o all necessaary inputs such as
of
laboour, capital, equipment,
e steel,
s tyres, electric power, paint, glasss,
trannsportation, etc.
e for the prroduction andd delivery off those 10,00 00 cars.
Hennce, the failurre of the production is reelative high aas the outputss of
manny industries serves as inp puts to otherr industries. IIf any of the industry
failss to achieve its
i target in the
t productioon chain, thenn the producction of a
good is delayed or failed.
Thee incentive problem
p
Thee command system also facesfa the probblem of provviding incentiive. In

this system, the central plann ners determinne the output mix. If theyy
misjjudged the tootal numberss of goods orr services reqquired at the
government-deteermined pricces, then perssistent shortaages or surplu uses of
thosse goods or services
s arisee. However, asa long as thhe person-in-ccharge
whoo oversaw thee production n of those gooods or servicces was rewaarded for
meeeting their assigned produ uction targetss, they had nno incentives to adjust
suppply in responnse to the shoortages or suurpluses. Morreover, centrral
plannning did nott trigger the profit
p motivee, nor did it rreward innov
vation
T route forr obtaining addvancement was mainly via
and enterprise. The
partticipation in the
t political hierarchy off the Commuunist Party.
Produ
uct (Outpu
ut) markeet
Dem
mand
In economics, thhe concept off demand is used

u to descrribe the quan
ntity of a
good or service that a househ
hold can, or a firm choosses, to buy att a given
pricce.
Marrket demand
d and individ
dual demand
d
Thee market demmand for a go

ood or servicee is simply thhe total quan
ntity that
all the
t consumerrs in the econnomy are willling to demaand for a timme period
at a given price.
Deteerminants of
o demand
Thee amount of a product thaat consumers wish to buyy in a given period

p is
influuenced by thhe following variables:
• The product’s own price
p
• The pricce of related products
• Averagee income of households
h
• Tastes and
a preferencces
• Income distribution
22
• Population.
It is difficult to consider the impact of changes in all these variables at

once. Studying each variable in isolation is only possible in theory, but
theory still improves understanding. Therefore, this module will employ a
convenient assumption called ceteris paribus to focus on the impact of a
single variable at a time (ceteris paribus means ‘everything else
remaining constant’).
Price and quantity demanded: The law of demand

How are prices determined? To develop a theory, we need to study the
relationship between the quantity demanded of each product and that
product’s price. This requires that we hold all other influences constant
and ask, “How will the quantity of a product demanded change as its
price changes?”
The headlines announce a move by the Organization of Petroleum

Exporting Countries which states ‘Major cutback in OPEC production
and exports of crude oil’. Shortly afterwards, you find that oil and gas
prices – wherever not regulated by government – have doubled at service
stations. What do you do? If you have a fixed transportation budget but
drive a car, you will cut down on the use of your car. Perhaps you will
drive less and might substitute public transport for private transportation.
Perhaps in time you will consider buying a smaller car.
Why might this be so? There is almost always more than one product that
will satisfy any desire or need. For example, the desire for a new car may
be satisfied by a variety of different cars of a certain category: imported,
domestic, sedan, coupe andso on.
This is simply an illustration of the general relationship between price

and consumption. When the price of a good rises, the quantity demanded
will fall. This relationship is known as the law of demand. The law of
demand states that there is a negative relationship between the price and
the quantity demanded of a product. When the price of an item increases,
we buy less. There are two reasons for this predictable response to a price
increase:
1. People will feel poorer. They cannot afford to buy so much of the
good with their money. The purchasing power of their income
(their real income) has fallen. This is called the income effect of a
rise in price.
2. The good will now be dearer relative to other goods. Thus,
people will switch to alternative or substitute goods. This is
called the substitution effect of a rise in price.
Similarly, when the price of a good falls, the quantity demanded will rise.
People can afford to buy more (the income effect), and they will switch
from consuming alternative goods (the substitution effect). The amount
by which the quantity demanded falls will depend on the size of the
23
Module 1
incoome and subsstitution effeect.
Thee demand schedule and the deemand currve

A demand scheddule is one way w of showinng the relatioonship betweeen
quanntity demandded and the price
p of a prooduct with thhe assumption
n that
otheer things beinng equal. It is a numericaal tabulation that shows th
he
quntity that is deemanded at certain
c pricess.
Prrice per app

ple Quan
ntity demandded
(per
( week)
0.60 30
0.50 35
0.40 40
0.30 45
0.20 50
0.10 55
Tab
ble 1.1
A demand curvee is a graphiccal representaation of a demand schedu ule such

as thhat of Table 1.1. A strictt and regular relationship between thee X and Y
entities produces a straight slope,
s not thee swoop you might expecct when
you think about the ‘learning g curve’ and similar grapphs. When th he word
‘shaape’ is used about
a a curvee, it refers to the directionn of the curv
ve either
o down, in thhe case of a simple slopee.
up or
Thee position andd shape of th

he market dem mand curve ddepends on the
t
posiitions and shhapes of the individual coonsumers’ deemand curvess from
which it is derivved. Howeverr, it also depends on the nnumber of in ndividual
conssumers who consume in that market. Figure 1.2 sshows the deemand
curvve for appless. The price-q
quantity com mbinations shhown in Tablle 1.1 are
plottted on the grraph shown ini Figure1.22. Price is plootted on the vertical
v
axiss and quantityy on the horiizontal axis.
24
Figure 1.2
The smooth curve drawn through these points is called a demand curve. It
shows the quantity that purchasers would like to buy at each price. The
negative slope of the curve indicates that the quantity demanded increases
as the price falls. Each point on the demand curve indicates a single
price-quantity combination. The demand curve represents the relationship
between quantity demanded and price with other things being equal.
As you see, the term ‘demand’ refers to the entire relationship between
the quantity demanded of a producer and the price of that product (as
shown, for example, by the demand schedule in Table 1.1 or the demand
curve in Figure 1.2). In contrast, a single point on a demand schedule or
curve is the quantity demanded at that point. This distinction between
‘demand’ and ‘quantity demanded’ is an extremely important one and
both terms will be examined in detail later in this section.
Shifts in the demand curve

Now consider what happens if income, tastes, population and the prices
of all other products remain constant and the price of only one product
changes.
Average income
As the price goes up, that product becomes increasingly expensive to

satisfy a desire. Some consumers will stop buying it altogether; others
will buy smaller amounts; and some may still continue to buy the same
quantity. Because many consumers will switch wholly or partly to other
products to satisfy the same desire, fewer consumers would buy the
product whose price has risen. For instance, as meat becomes more
expensive, consumers may to some extent switch to meat substitutes; they
may also forgo meat when having their meals and eat less meat at others.
Conversely, as the price goes down, the product becomes a cheaper

method of satisfying a desire. Households will buy more of it.
Consequently, they will buy less of similar products whose prices have
not fallen and as a result have become expensive relative to the product in
question. When a bumper tomato harvest drives prices down, shoppers
switch to tomatoes and cut their purchases of many other vegetables that
will look relatively more expensive atthe time.
Prices of related goods
You have seen that the negative slope of a product’s demand curve
occurs because the lower its price, the cheaper the product becomes
relative to other products that can satisfy the same needs or desires. These
other products are called substitutes, each being a good that can be used
in place of another good. For example, a bus ride is a substitute for a train
ride; therefore, a bus ride can become cheap relative to a train ride
probably because the price of the bus ride falls or because the price of the
train ride rises. Either change will increase the demand for (frequency of)
bus rides that consumers wish to buy as consumers substitute train rides.
25
Module 1
Thuus a rise in thhe price of a substitute

s forr a product shifts the dem
mand
curvve for the prooduct to the right.
r More will
w be demaanded at each h price.
Com mplements arre products th hat tend to bee used jointlyy. Cars and petrol
p are
commplements; soo are hamburrgers and Freench fries, D DVDs and DV VD
playyers. Becausee complemen nts tend to bee consumed ttogether; a fall
fa in the
pricce of one willl increase thee demand forr both produccts. Thus a fall
fa in the
pricce of a compllement for a product will shift that prroduct’s dem mand
curvve to the righht. More willl be demandeed at each priice. For exam mple, a
fall in the price of
o a DVD player will leaad to a rise inn the demand d
forDDVDs, even though
t the price
p of DVD Ds is unchangged.
Pop
pulation
Demmand also deepends on thee size as welll as the compposition of thhe

population. The larger the po opulation (w
with all else being the samme), the
greaater the demaand is for all goods and services
s and vvice versa.
Poppulation growwth does not create new demand

d unlesss the additio
onal
peopple have the means to pu urchase goods; that is unleess they have
purcchasing power. If there iss an increase in populatioon with purch hasing
powwer – for exammple, the immmigration off wealthy forreigners – thee
dem
mands for all the productss purchased by b the immiggrants will risse. Thus
we expect
e that an
a increase in n population will shift thee demand cuurves for
mosst products too the right, in
ndicating thaat more will bbe demanded d at each
pricce.
Thee compositionn or the age structure

s of a population is importantt as well.
Demmand for certtain productss depends very much on tthe proportioon of the
population in a given
g age. Foor example, the
t older thee population the
t
greaater the demaand for nursiing homes.
Disttribution of income
If a constant totaal income is redistributedd among the population, demands

d
mayy change. If, for example, the governm ment increasses the deducctions
that may be takeen for childreen on incomee-tax returns and compen nsates by
raisiing basic taxx rates, incom
me will be traansferred from childless persons
p
to households
h w large fam
with milies. Demannds for produucts bought byb
childless people will declinee while demaands for prodducts bought by
households withh large familiies will increease. A changge in the disttribution
of inncome will thherefore cau use an increasse in the dem
mand for prodducts
bought by most households whose w incom
me have increeased and a decrease
d
in thhe demand foor products bought
b by moost househollds whose inccome
havee decreased.
Connsider an incrrease in houssehold incomme while pricce remains co onstant.

If hoouseholds inncrease their purchases
p off the productt, the new quuantity
demmanded cannoot be represeented by a pooint on the orriginal deman nd curve.
It must
m be repressented on a new n demand curve that iss to the right of the
old curve. Thus the rise in coonsumer incoome shifts thhe demand cu urve to
the right,
r as showwn in Figuree 1.3. This illlustrates the operation off an
impportant generaal rule.
26
Tastes and preferences of the household
Tastes have an effect on people’s desired purchases. A change in taste

may be long-lasting as seen in the shift from fountain pens to ballpoint
pens or from typewriters to computers. It may also be short-lived, such as
the fad for hula hoops or collapsible scooters. In either case, a change in
taste in favour of a product shifts the demand curve to the right.
Therefore more will be demanded at each price.
Households’ tastes and preferences tend to change for time to time. For
example, in societies such as Canada, anti-smoking campaigns have been
so strong that demand for cigarettes has diminished for a large segment of
the population.
Figure 1.3
You can study the influence of changes in variables other than price by
determining how changes in each variable shift the demand curve. Any
change will shift the demand curve to the right if it increases the amount
that households wish to buy with other things remaining equal. On the
contrary, it will shift the demand curve to the left if it decreases the
amount that households wish to buy with other things remaining equal.
Note that changes in people’s expectations about future values of
variables such as income and prices can also influence the current
demand. However, to simplify, we consider only the influence of changes
in the current values of these variables.
Movements along the curve versus shifts of the curve

Suppose that you read in today’s newspaper that the soaring price of
heating oil has been caused by an increased demand for heating oil. The
next day, you read that the rising price of heating oil is reducing typical
consumers’ purchases of heating oil, as shoppers switch to burning
natural gas, coal and wood. The two stories appear to be in contradiction
27
Module 1
withh each other. The first asssociates a rissing price witth a rising deemand;
the second assocciates a risingg price with a declining ddemand. Can n both
stateements be truue? The answwer is yes beecause they reefer to differrent
circuumstances. The
T first desccribes a shiftt in the demaand curve; th he second
refeers to a moveement along a demand cuurve in responnse to a chan nge in
pricce.
Firsst, consider thhe statement that the incrrease in the pprice of heatiing oil is
caussed by an inccrease in demmand for heaating oil. Thiss statement refers
r to
a shhift in the dem
mand curve for
f heating oil.
o In this casse, the deman nd curve
musst have shifteed to the righ
ht, indicatingg more heatinng oil demand ded at
eachh price. This shift, as we will see laterr in this chappter; will increase the
pricce of heating oil as depictted in Figuree 1.4.
Noww consider thhe statement that less heaating oil is beeing bought because
b
heatting oil has become
b moree expensive. This refers tto a movement along
a givven demand curve and reeflects a channge between two specificc
quanntities being bought, onee before the price
p rose andd one afterw
ward.
Figu
ure 1.4
As indicated
i aboove, to preveent the type of
o confusion caused by ouur two
storries in the newwspaper, eco onomists usee a specialised vocabulary
y to
distiinguish betwween shifts off curves and movements along curvess.
We have seen thhat demand refers

r to the whole
w demannd curve, whhereas
quanntity demandded refers to a specific quuantity that is demanded at a
speccified price, as indicated by a particullar point on tthe demand curve.
c In
Figuure 1.4, for example,
e dem
mand is given by the curvve D; at a priice of
$4.000, the quanttity demandeed is 1.25 milllion gallons of heating oil
o per
monnth, as indicaated by Pointt A.
An illustration of chang
ge in demaand versuss quantity
dem
manded
Here is an exam
mple that poinnts out the difference betw
ween a ‘chan
nge in
quanntity demandded’ and ‘a change
c in dem
mand’.
In Figure
F ve a demand curve for thee Honda Civ
1.5 beelow, we hav vic on the
left and the com
mpeting Toyo ota Corolla onn the right. Innitially, the price
p of
28
the Honda Civic is $22,000 and 10,000 units are demanded per year.
Toyota Corolla sells for $21,000 and has a demand of 8,000 at that price
per year. (Note: it is irrelevant whether the Honda Civic’s price is above,
below or equal to that of the Toyota Corolla.)
Figure 1.5
Suppose that the price of the Honda Civic decreases to $20,000. More
Civics will be purchased and there will be an increase in quantity
demanded as there is a movement along the demand curve from A to B.
Some of the new Civic customers would have been Corolla drivers but
now they are not. Therefore at the price ($21,000), the demand for
Corolla has decreased, perhaps to 7,000. Note that the increased demand
for Civic (by 1,500 units) rises partly because some of the existing
Corolla customers switched to Civic. Potential car buyers might find the
reduced price of Honda Civic more attractive.
1. Refer to Table 1.1. Suppose that prices of other fruits you might buy
increase. What would happen to the number of apples you demand
per month? Sketch this change on your diagram. Label the demand
curve D2. What is likely to happen to the price of apples?
Study skills
Solution:
1. Refer to Figure 1.3. Presumably, you would demand more apples
at each price. The demand curve shifts right, to D2. Because
apples are more popular now, the price will likely rise.
29
Module 1
Supplyy
Wheen we refer to t the econommy of our ow wn country, w we find that the
t
econnomy, in the most recentt year for which statistics are available,
prodduced goods and servicess worth milliions, or billioons, or even perhaps
p
trilliions in the loocal currency
y. In studyingg the subjectt of productioon, there
is a single questiion that econ nomists attemmpt to answeer: What deteermines
the quantities
q off products thaat will be prooduced and ooffered for sa ale?
Such an attemptt requires an examinationn of the basicc relationship p
betwween the pricce of a produ uct and the quuantity produuced and offfered for
salee as well as ann examinatio on of the forcces that lead to shifts in this
t
relattionship.
Wh
hat is quan
ntity suppliied?
Thee amount of a product thaat firms wish to sell in som me period is called
the quantity suppplied of that product. Quuantity suppliied is a flow;; it is so
mucch per unit off time. Note also that quaantity supplieed is the amo ount that
firm
ms are willingg to offer forr sale; it is noot necessarilyy the amountt that
theyy succeed in selling.
Thee amount of a product thaat firms are willing

w to prooduce and offfer for
salee is influenceed by the following imporrtant variablees:
• Product’s own pricee
• Prices of
o inputs
• Technollogy
• Numberr of supplierss.
Theere are severaal influencing

g variables and
a we will uuse the ceteriis
pariibus assumpttion (everyth hing else rem
maining consttant) to study
y the
influuence of the variables, on
ne at a time.
Quaantity supplied and the

t law of supply
We begin by holding all otheer influencess constant annd ask how we
w expect
the quantity of a product sup
pplied to varyy in its own pprice.
A basic hypotheesis of economics is that forf many prooducts, the prrice of

the product
p and the quantity supplied aree related posiitively with other
o
thinngs being equual. In other words,
w the hiigher the prooduct’s own price,
p the
morre its produceers will suppply; and the loower the pricce, the less itts
prodducers will suupply.
Whyy might this be so? It is true

t because the profits eaarned from
prodducing a prodduct will inccrease if the price
p of that pproduct risess while
the costs of inpuuts used to prroduce it rem
main unchangged. This willl make
ms, which aree in business to earn profi
firm fits, wish to pproduce moree of the
prodduct whose price
p has riseen.
30
The supply schedule and the supply curve

The general relationship discussed earlier can be illustrated by a supply
schedule which indicates the relationship between quantity supplied of a
product and the price of the product with the assumption of other things
being equal. A supply schedule is analogous to a demand schedule; the
former shows what producers are willing to sell, whereas the latter shows
what households are willing to buy at alternative prices of the product.
Table 1.2 presents a hypothetical supply schedule for apples.
Price per apple ($) Quantity supplied (per week)

0.60 120
0.50 110
0.40 100
0.30 90
0.20 80
0.10 70
Table 1.2
A supply curve, the graphical representation of the supply schedule, is

illustrated in Figure 1.6.
Each point on the supply curve represents a specific price-quantity

combination. However, the supply curve shows more information
besides this combination.
Figure 1.6
The supply curve represents the relationship between quantity supplied

and price, assuming other things being equal. Its positive slope indicates
31
Module 1
that quantity suppplied varies in the same direction as price. When n

econnomists makke statementss about the coonditions of supply, they y are not
refeerring just to the particulaar quantity beeing suppliedd at the mom
ment, that
is, not
n to just onne point on th he supply currve. Instead, they are refeerring to
the entire supplyy curve,that isi the compleete relationshhip between desired
salees and all posssible prices of the produuct.
Suppply refers to the entire reelationship beetween the qquantity supp plied of a
prodduct and the price of thatt product withh other thinggs being equaal. A
singgle point on the
t supply cu urve refers too the quantityy supplied att that
pricce.
Thee position andd shape of th he market suppply curve deepends on th

he
posiitions and shhapes of the individual firrm’s supply ccurves from which it
is deerived. Neveertheless, it also
a depends on the numbber of individ dual
firm
ms in the marrket.
Shiifts in the supply

s currve
Thee supply curvve will shift to
t a new posiition with a cchange in any y of the
variiables (other than the product’s own price)
p that afffects the amoount of a
prodduct firms arre willing to produce
p and sell. A shift in the supplly curve
meaans that at eaach price, thee quantity suppplied will be different. An
A
incrrease in the quantity
q suppplied at each price is showwn in Figuree 1.7.
Thiss change apppears as a rightward shift in the supplyy curve. In contrast,
c
a deecrease in thee quantity su
upplied at eacch price appeears as a leftw
ward
shifft. A shift in the
t supply cu urve must bee the result off a change in
n one of
the factors that influence
i thee quantity suppplied other than the prod duct’s
ownn price.
Influences on
n supply
As indicated
i beffore, supply depends on several
s factoors other than
na
good’s own pricce. Changes in i these other factors are sources of sh hifts in
marrket supply cuurves, similaar to the markket demand ccurves discu ussed
prevviously.
Pricce of inputs (Changes in
n costs of prroduction)
Item
ms that a firmm uses to prod duce its outpputs such as m materials, lab
bour and
macchines are called the firm m’s inputs. Otther things beeing equal, th he higher
the price
p of any input used to o make a prooduct, the lesss will be thee profit
from
m making thaat product. We W expect, thherefore, thatt the higher th he price
of any
a input used by a firm, the lower wiill be the amoount that thee firm
willl produce andd offer for saale at any givven price of tthe product.
Theerefore, a risee in the pricee of inputs shhifts the suppply curve to the left,
indiicating that leess will be suupplied at anny given price. A fall in thhe cost
of innputs shifts the
t supply cu urve to the right.
Tecchnology
At any
a time, whhat is produceed and how it
i is producedd depends on n what is
known. Over tim
me, knowledg ge changes; so do the quaantities of in
ndividual
32
products supplied. The technological improvements in the computer

industry over the past two decades have led to a rightward shift in the
supply curve.
Taxes and subsidies
Firms view most taxes imposed by the government as part of their

production costs. For example, an increase in sales or excise taxes will
increase production costs and, hence, reduce supply. On the other hand, if
the government provides subsidies to firms for their production, it will
decrease the costs of production and increase supply.
Price of other goods
A substitute in production is a good that can be produced in place of

another good, such as Dell Computer and Acer Computer. A complement
in production is a good that must be produced along with the initial good,
such as computer and computer software. A fall in the price of a
complement in production or a rise in the price of a substitute in
production decreases the supply of the good.
Producer expectations
Producer expectations about future prices influence current supply. For

example, if the price of a good is anticipated to increase in the future, the
current supply of the good falls.
Number of firms
If firms that produce for a particular market are earning high profits, other
firms may be tempted to go into that business. When the technology to
produce computers for home use became available, literally, hundreds of
new firms got into the act. The popularity and profitability of the Internet
led to the formation of Internet service providers (ISPs). When new firms
enter an industry, the supply curve shifts to the right. When firms go out
of business or exit the market, the supply curve shifts to the left.
Suppose that the price of sugar rises. How does this affect the demand for
ice cream? Sugar is an input into the production of ice cream. An increase
in the price of an input tends to raise the cost of production and lowers
profitability. In response to increased cost, ice cream producers will cut
their supply of ice cream. At any given price of ice cream, suppliers will
be less inclined to continue producing the same amount. As they produce
less, the supply curve for ice cream shifts to the left. Figure 1.7 exhibits
the shift in the supply curve to the left for any change that reduces the
quantity that suppliers wish to produce at any given price and to the right
for any change that increases the suppliers’ wish to produce at any given
price.
33
Module 1
Figu
ure 1.7
34
Fill in the blanks:

1. Battery brands such as Energizer and Duracell’s Coppertop are
substitutes. The ‘Energizer Bunny’ advertising campaign increases
the price of Energizer batteries. Therefore the Energizer price will
Study skills and quantity exchanged will in the market for Duracell.
A. rise, rise
B. fall, rise
C. fall, fall
D. rise, fall
2. The supply of four-cylinder cars will shift to the right if⎯

A. consumers switch over to six- (and higher) cylinder cars.
B. manufacturers of four-cylinder cars see the price of larger
cars (six-cylinder and higher) decreasing permanently.
C. the cost of labour inputs stays constant.
D. consumers experience an increase in their income.
Solutions:
1. A.If Energizer increases the price of its batteries, consumers will
switch over to substitutes such as Duracell, increasing the
demand for Duracell. This will raise both equilibrium price and
quantity.
2. B.As the price of larger cars drops, car manufacturers will switch
overto another production option: 4-cylinder cars.
Shifts in a supply curve versus movements along a supply

curve
A point on the supply curve shows the quantity supplied at a given price.
A movement along the supply curve shows a change in quantity
supplied.
35
Module 1
Figu
ure 1.8
If thhe price of icce cream channges but eveerything else remains con nstant,
therre is a movem ment along th
he supply currve as the seller attemptss to
resppond to a chaange in this market
m signall. If the pricee of ice cream
m
rem
mains the sam me but other factors
f that innfluence suppply change, for
instaance the pricce of inputs (sugar),
( suppply changes aand there will be a
shifft of the suppply curve. (R
Refer to Figurre 1.8).
1 If the farrmers produccing wheat must

m obtain a higher pricee than
they didd previously to
t produce thhe same leveel of output as
a before,
then we can say thatt there has beeen⎯
A. an increase in quantiity supplied.
Study skills
S
B. an increase in supply
y.
C. a decreaase in supply.
D. a decreaase in quantitty supplied.
ution:
Solu
C. Draw thhe supply currve. At the saame output leevel and at a higher
price, pllace a point. Draw a line parallel to thhe first supplly curve
through this point. The
T new line (curve) will be to the lefft and
above thhe initial sup
pply curve—aa decrease inn supply.
36
2 It is expected that the price of palm oil will increase in one

month. This belief will lead to ⎯
A. a decrease in the current supply of palm oil.
Study skills B. a decrease in the future supply of palm oil.
C. an increase in the current quantity supplied of palm oil.
D. an increase in the current supply of palm oil.
Solution:
Discuss your answers with your tutor.
Supply and demand together

Having analysed supply and demand separately, we now combine them to
see how they determine the quantity of a good sold in a market and its
price.
Market equilibrium
In discussions so far, there has been a clear distinction of two things: one
involves household decisions on how much to demand; and the other
involves firms’ decisions on how much to supply. The operation of the
market, however, clearly depends on the interaction between suppliers
and demanders. At any moment, one of following three conditions
prevails in every market:
1. If the quantity demanded exceeds the quantity supplied at the
current price, a situation called excess demand or shortage
happens is represented by DC in Figure 1.9. In this market for
ice cream, at the price of $0.50 (per cone of ice cream), the
quantity demanded - Point C on the demand curve is 30,000
cones, while the quantity supplied – represented by Point D on
the supply curve is 5 thousand cones. The size of excess demand
is 25,000 cones.
2. If the quantity supplied equals the quantity demanded at the price
of $1.00, it is a situation called equilibrium. The quantity
demanded is equal to quantity supplied i.e. 20,000 cones.
3. If the quantity supplied exceeds the quantity demanded at the
current price, a situation called excess supply or surplus happens.
This is represented by Points BA in Figure 1.9. At the price of
$1.25, the size of the excess supply is 15 thousand cones of ice
cream.
Equilibrium is a situation in which supply and demand have been brought

into balance. The equilibrium price is the market-clearing price because
at this price, the needs of the buyers are exactly matched by the desire of
37
Module 1
selleers to sell. At
A the equilibrrium, there is no tendenccy for price to
o
channge.
Figu
ure 1.9
Thee adjustment of price is th he rationing mechanism

m iin free markeets. In
suchh markets, prrice rationingg means that whenever thhere is a need d to
ratioon a good – when
w excess demand exists, the pricee of the good d will rise
untiil the quantityy supplied eq
quals the quaantity demannded,until thee market
cleaars.
Wheen and if the market pricee is controlleed (typically by a govern nment) or

is unnable to adjuust freely, a different
d typee of rationingg, quantity raationing,
willl be required. In this casee, the mechannics of the freee market sy ystem
willl be replaced by a govern nment-controolled mechannism. A typiccal
exammple of quanntity, or non--price, rationning would be rationing by b
couppons. Rationn coupons weere employedd in most parrts of the worrld
duriing the yearss of the Greatt Depressionn, from 1929--1933, and allso
duriing the 1940ss, where mosst governmennts imposed price ceiling gs on
meaat, sugar, petrrol and many y other itemss. The ration coupon entittled a
fam
mily to a speciific quantity of the produuct per monthh and was su upposed
to ennsure that evveryone receiived the sam me amount, reegardless of their
t
incoome. This praactice still exxists in most developing countries tod day.
Wheen ration couupons are useed with no prrohibition aggainst trading g them,
the result
r is simiilar to a systeem of price rationing.
r Thhose who are willing
and able to pay thet most will simply buyy up the couppons and use them to
purcchasepetrol, chocolate, frresh eggs or anything
a elsee that is sold
d at a
restrricted price. This means that the pricee of the restrricted good willw
effeectively rise to
t the markett-clearing priice. For instaance, supposse you
deciide not to selll your rationn coupon. Yoou are then foorgoing what you
wouuld have receeived by selliing the coupoon. Thus the real price off the
good you purchaase will be higher
h (if onlyy in opportunnity cost) thaan the
restrricted price.
Thee effect of changes in demand and suppply

Howw will the priice mechanissm respond to t changes inn consumer demand
d
or producer
p suppply? After alll, the patternn of consumeer demand ch
hanges
38
over time. For example, people may decide they want more DVDs and
fewer VCRs. Likewise, the pattern of supply also changes. For example,
changes in technology may allow the mass production of computer hard
drives at lower cost while the production of hand-built cars becomes
relatively expensive. In all cases of changes in demand and supply, the
resulting changes in price act as both signals and incentives.
A change in demand
A rise in demand is signalled by a rise in price. This acts as an incentive

for supply to rise. What in effect is happening is that the high price of
these goods relative to their costs of production indicates that consumers
are willing to see resources diverted from other markets. Firms respond
by doing just that. They divert resources from goods with lower prices
relative to costs (and hence lower profits) to those goods that are more
profitable.
A fall in demand is indicated by a fall in price. This acts as an incentive

for supply to fall as these goods are now less profitable to produce.
Returning to the market for ice cream, suppose that due to a possible
consequence of the demographic from anaging population, the demand
for ice cream drops. This causes the demand curve to shift to the left as
seen in Figure 1.10. As a result, the new equilibrium will result in a
lower price and lower quantity.
Figure 1.10
A change in supply
A rise in supply is signalled by a fall in price. This acts as an incentive for

demand to rise. A fall in supply is signalled by a rise in price. This, on the
other hand, acts as an incentive for demand to fall.
Let us explore these dynamics in the market for ice cream. As noted
before, let us assume that sugar has become more expensive. As a result,
39
Module 1
at eaach price, thee suppliers of

o ice cream will
w cut backk their supplyy hence
the supply curvee shifts to thee left as seenn in Figure 1.11. Therefo
ore, the
neww equilibrium m will result in
i a higher prrice and reduuced quantityy of ice
creaam.
Figu
ure 1.11
A ch
hange in both demand and
a supply
Supppose that theere has been a change in supply due tto an increasee in the
pricce of sugar simultaneously with a channge in demannd due to thee aging
factor. In this caase, both curv
ves shift to thhe left as shoown in Figurre 1.12.
Thee new equilibbrium point will
w be associiated with a llower quantiity but an
ambbiguous pricee. The price level
l could rise
r or fall orr stay the samme
depeending on thhe relative shifts of these two curves aand their slop pes. We
call the impact ono the price in
i this case as
a indeterminnate.
ure 1.12
Figu
In thhis case, Poinnt B lies slightly above Point

P A, indiccating a smalll
incrrease in pricee whereas thee quantity haas unambiguoously droppeed. The
40
fact is that Point B could be placed below Point A to mark a fall in price
or it could be placed horizontally to the left of point A, in which case the
price would have remained unchanged.
The following Table 1.3 helps summarise the outcome of a simultaneous

shift in both the demand curve and the supply curve when the magnitudes
of the shifts are unknown.
Scenario Price Change QuantityChange

Demand rise, supply rise Uncertain Rise
Demand rise, supply fall Rise Uncertain
Demand fall, supply rise Fall Uncertain
Demand fall, supply fall Uncertain Fall
Table 1.3
Consumer Surplus, Producer Surplus and Market Efficiency

Demand and marginal benefit
• Marginal benefit refers to the value of one more unit of a good
or service. It is measured as the maximum price that people are
willing to pay for another unit of a good or service. The demand
for a good or service is determined by the willingness to pay for
it.
• Hence, a demand curve for a good or service is also its
marginal benefit curve, as shown in the figure 1.13
• The demand curve in the figure indicates that the maximum price
a consumer is willing to pay for the 6,000,000th gallon of milk
per month is $3, so $3 is the value and marginal benefit of this
gallon.
• The difference between marginal benefit from a good or service
and the price paid for it is called Consumer surplus. The shaded
triangle as shown in the figure is the consumer surplus when the
price is $3 per gallon.
41
Module 1
Figuure 1.13
ure 1.13
Figu
Sup
pply and marginal
m co
ost
• Marginaal cost refers to the cost of
o one producing more un nit of a
good or service. It iss measured as
a the minimuum price thaat
produceers must receeive to inducee them to prooduce anotheer unit of
the goodd or service. Hence, a supply curve ffor a good or o
service is also its marginal
m costt curve, as shhown in the figure
1.14.
• The upwward sloping supply curvve in the figurre shows thaat the
minimum price a pro oducer must receive to bee willing to produce
p
the 6 miillionth gallo
on of milk peer month is $3, so $3 is th
he
marginaal cost of thiss gallon.
• The diffference betw
ween the pricee of a good aand its the maarginal
cost of producing
p it is the produccer surplus, ssummed oveer the
quantityy produced. The
T shaded trriangle as shhown in the figure
f is
the prodducer surplu us when the price is $3 pper gallon.
42
Figure 1.14
Markets efficiency
• A competitive equilibrium is defined as the point where the
quantity demanded is equal to the quantity supplied in the
market. As shown in the figure, the equilibrium quantity is 6
million gallons with the equilibrium price $3 per gallon. At this
equilibrium point, the market is efficient as marginal benefit of
the last unit produced equals its marginal cost. Hence, the
equilibrium quantity is also the efficient quantity.
• The total surplus from a good or service is the sum of the
consumer surplus plus the producer surplus. As the figure
illustrates, when the efficient quantity of milk is produced, the
sum of the consumer surplus and producer surplus is maximised.
43
Module 1
Figu
ure 1.15
• Howeveer, if the marrket does not produce thee efficient quantity, it
will eithher produce less
l than the efficient quaantity
(underproduction) or produce moore than the efficient quaantity
(overprooduction). In
n either case, a deadweighht loss occurrs. A
t decrease in the consuumer surplus and
deadweeight loss is the
produceer surplus thaat results from
m producingg an inefficien
nt
quantityy of a good. Figure
F 1.15 shows
s the deeadweight losss from
overproduction of milk
m and from m underproduuction.
• The maiin obstacles to
t achieving an efficient allocation off
resourcees in a markeet are price and
a quantity regulations and
a
taxes annd subsidies imposed
i by government.
g .
Figu
ure 1.16
44
1. Jason just bought a used computer. When he was leaving the shop, he
thought that he such a great deal and would have paid $100 more dollars
for the stick. Jason received ⎯
A. consumer surplus.
Study skills
B. producer surplus.
C. marginal cost.
D. total surplus.
2..Consumer surplus exists when ⎯

A. consumers value the good more highly than what they must pay
to buy it.
B. the price of the good is smaller than the marginal cost of
producing a unit of the good.
C. it costs less to produce goods than buyers must pay for them.
D. taxes on goods are less than the appropriate amount.
45
Module 1
3 Mary’s
M o making an additional roocking chair is $85. ⎯
cost of
A If she seells it for a $1
A. 100, her prodducer surpluss is $15.
B. Her marrginal cost is equal to $155.
C. The marrginal benefitt to the consuumer from thhe chair will be $85.
D. Both ansswers A and B are correcct.
o marginal benefit, then tthe⎯

4 Iff marginal coost is equal to
A. sum of producer
p surp
plus and connsumer surpluus is as largee as
possible.
B. producerr surplus is equal
e to the consumer
c surrplus.
C. deadweiight loss is more
m than zerro but less thaan its maxim
mum.
D. sum of producer
p surp
plus and connsumer surpluus equals zerro.
5 When
W ved, the sum of the total aamount of producer
efficienncy is achiev
surpplus and conssumer surplu us is ⎯
A. equal to the deadweiight loss.
B. minimissed.
C. maximissed.
D. equal to zero.
Solu
utions:
Discuss youur answers with your tutoor.
Inteerfering wiith the law

w of supplyy and demaand
On many
m occasiions, governmments and soometimes private firms may m
deciide to use som me mechanissm other thann the markett system to raation an
item
m for which there
t is excesss demand att the current price. This was
w often
the case depictedd in the form mer Soviet Unnion and othher communisst
nations such as China.
C The rationale
r behhind the use oof these mech hanisms
is faairness. This is because thhe law of suppply and dem mand which governs
g
the level
l at whicch prices are set, can prodduce results tthat some ind dividuals
or groups
g do nott like. For ex n ‘fair’ to llet landlords charge
xample, it is not
highh rents, or for oil compan nies to hike thhe price of ppetrol andoil.
Thee purpose of this

t section is i to study hoow governmeent policies control
c
pricces and hencee market outccomes. We use
u the tools of demand and
a
suppply to analysse various typ
pes of governnment policiies.
Thee equilibrium
m price in a frree market occcurs at the pprice at whicch
quanntity demandded equals qu uantity suppllied. Governnment price controls
c
are policies
p that attempt to hold
h the pricee at some dissequilibrium value
that could not bee maintainedd in the absennce of the goovernment’s
intervention. Wee begin by loooking at twoo basic policiies: price ceiilings,
which impose a maximum price p that cann be charged for a product and
46
price floors, which impose a minimum price. Rent control laws and
agricultural support policies are examples of price ceilings and price
floors.
In the case of price ceilings, the control mechanism holds the market
price below its equilibrium value. This creates a shortage, with quantity
demanded exceeding quantity supplied at the controlled price. If the price
ceiling is set above the equilibrium price, it has no effect because the
equilibrium remains attainable. If, however, the price ceiling is set below
the equilibrium price, the price ceiling lowers the price and is said to be
binding or effective.
In the case of price floors, the control mechanism holds the price above
the equilibrium price. This creates a surplus, with quantity supplied
exceeding quantity demanded at the controlled price. If the price floor is
set below the equilibrium price, it has no effect because the equilibrium
remains attainable. If, however, the price floor is set above the
equilibrium price, it raises the price floor and is said to be binding or
effective.
Price ceilings: The case of rent control
Rent controls are perhaps the most extensively studied form of price
ceilings and they provide a vivid illustration of the short and long-term
effects of this type of market intervention. Note, however, that the
specifics of rent-control laws vary greatly and have changed significantly
since they were first imposed many decades ago. In particular, current
laws often permit exemptions for new buildings and allowances for
maintenance costs and inflation. Moreover, in many countries, rent
controls have evolved into the second generation where they focus more
on regulating the rental housing market rather than simply controlling the
price of rental accommodation.
Figure 1.17 illustrates the effect of rent control laws as an example of a

price ceiling. In Panel A, R* is the market equilibrium rental rate, where
the demand for housing equals the supply. However, the local
government is concerned that at R* many poor people cannot afford a
house in the city, so it imposes a law that says that rents may be no higher
than Rc. At Rc, there is an excess demand (shortage) for rental units that
worsens as time passes. While the motives behind the government action
may have been praiseworthy, the government has created an artificial
scarcity.
The short-run supply of housing is shown by the vertical curve SS. Thus
quantity supplied remains at Q1 in the short run and the shortage is Q1Q2.
This is because in the short run, landlords have a fixed number of
apartments to rent and they cannot adjust their number quickly as market
conditions change. Over time, the quantity supplied shrinks, as shown by
the long-run supply curve SL. In the long run, there are only Q3 units of
rental accommodation, fewer than when controls were instituted. The
housing shortage of Q2Q3, which occurs after the supply has fully
adjusted, is larger than the initial shortage of Q1Q2.
47
Module 1
Figu
ure 1.17
Thee long-run stoory is differeent from the short

s run in tthe sense thaat neither
sidee of the markket is constraiined by timee and both caan respond frreely to
marrket conditionns. As the returns from innvesting in nnew rental ho ousing
fall significantlyy below whatt can be earnned on compaarable investtments,
fundds will go elssewhere. New w constructioon will be haalted and oldd
builldings will bee converted tot other usess or will simpply be left to
deteeriorate. Thiss implies thatt the long-runn supply currve for rentall
accoommodation which referss to the quanntity suppliedd after all adjjustments
havee been madee is flat.
w many government policies,

As with p theree are some ggainers and loosers.
Thee gainers willl be the households that happen
h to be lucky enoug gh to
havee a rental uniit. Their rentt will be loweer than it othherwise woulld have
beenn. Among thhe losers will be the owneers of rental aaccommodattion, who
willl receive low
wer rents and incomes com mpared to thee situation beefore the
impplementation of rent contrrols. There arre also potenntial landlord ds who
wouuld have suppplied rental accommodat
a ion at the maarket price bu
ut are
unabble to cover costs at the controlled
c rent. Perhaps tthe most impportant
loseers are the hoouseholds thaat are unable to find any rrental
accoommodation, given the liimited supplyy. Among thhese will be low-
incoome househoolds that are presumably
p t ones the policy was meant
the m to
beneefit.
Pricce ceilings ussually give riise to black markets.

m A black market is any
marrket in whichh goods are so old at prices that violate a legal pricee control.
Effeective price ceilings
c creatte the possibility for a blaack market because
b a
proffit results froom buying at the controlleed price and selling at the black
marrket price.
Pricce floors: Th
he case of minimum
m wag
ge laws
Govvernments soometimes establish a price floor, whicch is the minimum

missible price that can bee charged forr a particularr good or serv
perm vice.
48
Price floors may be established by rules that make it illegal to sell the
product below the prescribed price, as in the case of a minimum wage.
Effective price floors lead to excess supply. Either an unsold surplus will
exist, or someone must enter the market and buy the excess supply. The
consequences of excess supply will, of course, differ from product to
product. If the product is labour which is subjected to a minimum wage,
excess supply translates into people without jobs. If the product is wheat,
and more is produced than the quantity sold to consumers, the surplus of
wheat will accumulate in grain elevators or government warehouses. On
the other hand, price ceilings are meant to help demanders (buyers), price
floors are meant to help suppliers (sellers). With a price floor such as a
minimum wage, buyers (employers) cannot pay less than the
government-set minimum wage. The effects of binding price floors are
illustrated in Figure 1.18.
Figure 1.18
As indicated before, the short end of the market determines the quantity
exchanged. In this case, the lesser of the market is demand. At the
minimum wage (RM6), only QA units (hours) of labour are demanded but
QB units (hours) are supplied. Therefore, QAQB units are considered
unemployed. Note that only QE — QA units of labour are displaced. The
remaining part of unemployment (QB - QE) is due to the increased number
of workers who have been drawn to the labour force in response to the
higher wage ($6 versus the market rate, $5) in their search for a job. With
only QA employed, the remaining quantity QAQB, will continue to spend
time and resources searching for a job. The diagram indicates that these
unemployed individuals are willing to supply their labour services for as
little as $4. (Why $4? This is a good test of your knowledge of supply
and demand theory.)
In the case of minimum prices, agricultural price supports are designed

with the purpose of making suppliers (farmers) better off. Note, however,
that the excess supply, in the case of agricultural products, is pure waste
49
Module 1
from
m an efficienncy point of view.
v
Alteernatively, goovernments can

c regulate quantities trraded on marrkets, and
therreby indirectlly determinee market prices. For exam mple, if goverrnments
can restrict the quantity
q of a product suppplied, this will artificiallyy
incrrease the marrket price to producers peer unit of theeir restricted
prodduction. Thiss would be thhe case sincee consumers are willing to pay a
highher price for it.
Wheen a price flooor is establisshed above the

t equilibriuum price, wee can say
that—
—
A. quantityy demanded is
i less than quantity
q suppplied
Study skills
S B. quantityy demanded decreases
d
C. quantityy supplied inccreases
D. all of thee above
Solu
ution:
C. As the price
p increasees, there willl be an upwaard movemen nt along
both currves, not a sh
hift in these curves.
c The qquantity supp
plied
increasees while quanntity demandded decreasess.
Taxxes
Wheen you buy products
p subjjected to salees taxes, youu pay the pricce tag
pluss the tax. In some
s countriies, sales taxes are pervassive and cover a large
nummber of goods and servicees. In others, this is not thhe case. In so ome
counntries and taxx jurisdictionns, sales taxees are incorporated into thhe price
tagss, so you do not
n pay for taaxes separateely, whereas in other cou untries,
the sales tax is added
a to the price.
p The immportant questions hightllighted in
relattion to taxes are:
1. How doo we analyse the impact of
o sales taxess in the
supply/ddemand fram
mework?
2. What poortion of the sales tax willl consumerss and produceers end
up payinng? Will con
nsumers end up paying alll of it?
50
Figure 1.19
Figure 1.19 shows the market for petrol. The demand and supply curves
before the tax are represented by D and S. The equilibrium price and the
quantity before tax are $0.50 (50 cents)and 40 million litres per week.
Suppose the government levies a sales tax onpetrol, let us say $0.05 (5
cents) per litre of petrol ($/litre). What are the effects of this tax on the
quantity and price paid by consumers and those received by producers?
When the sales tax is introduced, it leaves the demand curve intact while
it raises the supply curve by the amount of the tax of5 cents. To see this
logic, remember that the supply curve represents the quantities that a firm
is to offer at alternative prices. The supply curve in Figure 1.19 reflects
the prices excluding taxes charged by the sellers. When the tax is levied,
the price charged by the sellers must reflect the tax. Therefore, the supply
curve shifts up (a decrease in supply) by the amount of tax (5 cents on the
vertical axis). Note that this shift is a parallel shift since the amount of tax
is fixed per litre of petroland does not change with the volume of
consumption. The tax-inclusive supply curve reflects the fact that sellers
are willing to supply the same quantities only if they get paid 5 cents
more than before per litre. The 5 cents added to the price is the sellers’
new obligation to the government. In other words, sellers are willing to
sell as much petrol as before at the same (net of the tax) prices.
At the new equilibrium, Point B, the price has risen and the volume of
transactions has fallen.
However, the equilibrium price of53 cents is the price paid by consumers.
Note that the price does not rise by the full amount of 5 cents to
consumers even though the government has levied a 5- cent tax. In order
to clarify this point, remember that the vertical distance between the two
supply curves is 5 cents. As long as the demand curve is not perfectly
vertical, consumers will pay only a portion of the tax. The remaining
portion is paid by sellers (suppliers) who receive 48 cents per litre as
opposed to 50 cents (Point C). Therefore, the burden of the tax is shared
51
Module 1
by both
b consumers and prod ducers: 3 centts by the form
mer and 2 ceents by
the latter.
l The goovernment collects its 5 cents
c regardlless of how the
t
burdden is sharedd. In fact, thee governmentt revenue froom new taxattion is
equaal to the voluume of petrol sold after thhe imposition of tax (30 million
litrees) multipliedd by 5 cents per This is equal to the
p litre ($1.5 million). T
areaa of the shadeed rectangle in Figure 1..19.
A fiinal point of this analysiss is how the burden

b of thee tax is shareed
betwween the twoo sides. In thiis example, the t consumerrs’ share of the t new
salees tax (3 centts) is greater than the prodducers’ sharee (2 cents). In
geneeral, who getts to pay a biigger portionn of the tax iss a function of o the
sloppes of the demmand and sup pply curve. The
T steeper tthe demand curve c
forppetrol, the greeater the porrtion of the 5 cents that w will be paid by
conssumers. In coontrast, the flatter
f the dem mand curve, the smaller the t
conssumer’s sharre. Furthermo ore, the flatteer the supplyy curve, the bigger
b the
porttion paid by consumers and a vice versa.
Ad valorem
v taxxes
In many
m circumsstances, the sales
s tax – whether
w leviedd on buyers or sellers
– may
m take the form
f of a perrcentage of thhe price (knoown as ad va alorem
tax)) as opposed to a fixed am mount of tax per unit (speecific tax). TheT case
illusstrated abovee is the latterr. In terms off the outcomee, a specific tax
t and
an ad
a valorem taax of equal value
v result inn the same ooutcome pertaaining to
pricce, quantity and
a government tax revennue. For exam mple, in the above
diaggram, the equuivalent perccentage tax too 5 cents perr litre would be b 10
per cent i.e. 10 per
p cent of 50 0 cents = 5 cents.
c The onnly differencee
betwween the twoo types of tax xes would bee in the way tthey make th he curves
shifft. A specific tax results in n a parallel shift
s whereass the shift fro
om an ad
valoorem tax is non-parallel.
n Obviously, the
t higher thee price, the greater
g
the dollar amounnt of tax for a given fixedd percentage (for examplle 10 per
centt of 50 cents is 5 cents, whereas
w 10 peer cent of onne dollar is 10 0 cents).
Theerefore, the vertical
v distannce between the supply ccurve (or dem mand
curvve) excludingg and includiing the tax widens
w as the price increaases.
Exporrts and im
mports
Eveery nation prooduces little or none of ceertain produccts. Any dom mestic
conssumption of these produccts must therrefore be satiisfied by imp ports
fromm other counntries. For example, manyy countries ddo not producce oil,
wheereas some produce and export
e oil. Oiil is an exam
mple of a min neral that
is allso considereed a commod dity. It is stanndardised, eaasily gradablle and
internationally trradable. Theere are numerrous other exxamples of
commmodities succh as gold, other
o precious metals, forrest products such as
timbber, as well as
a agriculturaal products. Certainly,
C exxports and im
mports
are not
n limited to commoditiies. These daays, the bulk of world traade is in
the form of servvices.
It is believed thaat markets fo

or commoditiies around thhe world shou uld
commmand a singgle price. In other
o words, the price of crude oil sho ould be
the same in the world
w markeets irrespectivve of the marrket location
n. A
singgle world pricce situation, however, reqquires that trransactions costs
c (the
52
costs of buying and selling as well as transportation costs) be

insignificant. The concept of a single world price or law of one price,
therefore, applies to commodities. The world price for a tradable
commodity is the price that is determined by world demand and world
supply. The law of one price does not apply to manufactures and services
that are differentiated. Naturally, it does not apply to products that are
non-tradable internationally.
How much influence a country may have on the world market depends on
the relative importance (supply and demand) of that country in the world
market. For example, Saudi Arabia is a major player in the market for oil
and Canada for nickel, uranium and wheat. However, the simplest case
for us to study arises when a country accounts for only a small part of the
total worldwide demand and supply. As a small economy, the country
neither buys nor sells quantities large enough to influence the world price
significantly. Assuming that the law of one price prevails in this case,
producers and consumers in the small economy face a world price that
they cannot influence by their own actions. This implies that in a small
importing nation, consumers can buy whatever amount of the product
they choose at that price. The world price does not change irrespective of
the volume of the nation’s purchase. In other words, a horizontal world
supply curve prevails.
Similarly, in a small exporting nation, producers can sell whatever

amount of the product they choose at that price. The world price does not
change irrespective of the volume of the nation’s sale. Therefore a
horizontal world demand curve prevails.
To determine the pattern of trade for a nation, we first show the domestic
demand and supply curves for some product, for example: oil. The
intersection of these two curves tells us what the price and quantity would
be if there is no foreign trade. Now compare this no-trade price with the
world price of that product. If the world price is lower, the actual
domestic price will fall below the no-trade price and there will be an
excess demand for the product. The shortage of domestic supply will be
imported from abroad. Conversely, if the world price is higher, the actual
price in the nation will exceed the no-trade price and will be an excess of
domestic supply over domestic demand. The surplus will be exported for
sale abroad.
Figures 1.20 and 1.21 show respectively, the case of an exporting and
importing nation.
Suppose the exporting market is the market for wheat. DS and SS are the
small nation’s demand and supply curve respectively. DW and SW refer to
the world demand and supply curves in the wheat market. PS and PW are
the small nation’s domestic price and the world price of wheat
respectively.
53
Module 1
Figu
ures 1.20
Faciing the worldd price level,, PW, which is

i above the domestic priice PS,
the nation’s
n consumers will demand less, QD., and itss producers will
w
prodduce more QS. The resultting excess suupply (surpluus) for wheaat, QSQD.
willl be exportedd abroad as seeen in Figurre 1.20.
ket is the marrket for oil. DS and SSare the small

Supppose the impporting mark
nation’s demandd and supply curves respeectively. DW and SW reprresent
worrld demand and
a supply cu urves in the oil
o market.PS and PW reprresent
the small nation’s domestic and
a the worlld price of oiil respectively y.
ure 1.21
Figu
Faciing the worldd price level,, PW, which is

i below the domestic priice, PS,
the nation’s
n consumers will demand morre, QD, and itts producers will
prodduce less, QS. The resultiing excess deemand (shorttage) for oil, QSQD,
willl be importedd from abroad as seen in Figure 1.21..
54
Study skills
1. If the world price of $25 per barrel is the market price in the small
nation, then there will be an of million barrels per day.
A. excess supply, 1.2
B. excess supply, 2.6
C. excess demand, 3.8
D. excess demand, 2.6
2. If the world price $25 per barrel is the market price in the small
nation, then the nation’s domestic production will be and its imports
will be million barrels per day.
A. 3.8, 3.8
B. 3.8, 1.2
C. 1.2, 1.6
D. 3.8, 2.6
Solution:
1. D.At $25 per barrel, quantity supplied is 1.2 million and quantity
demanded is 3.8 million.
2. C.At $25 per barrel, quantity supplied is 1.2 whereas quantity
demanded is 3.8 million, leaving an excess demand of 1.6 to be
imported.
Market Demand and Pricing

Decision
Introduction
Suppose you are the CEO of a major airline. The current economic
recession has decreased the demand for air travel. As a result, you decide
to build air traffic by offering low airfares between major destinations. In
doing so, you also hope to increase your demand by taking a certain
55
Module 1
amoount of the shhrinking marrket for air trravel from yoour competito ors.
How wever, you wonder
w if the increased voolume that yoou hope to generate
g
is laarge enough to
t make up for f the loss of
o income cauused by the lower
l
pricces you are innitiating. Youu can also prredict that yoour major com
mpetitors
willl quickly mattch your pricce cuts with the
t result thaat everyone inn the
induustry suffers from the red ductions.
It is important thhat managerss understand consumers’ responses to o price

channges. Managgers also need d to understaand other prooducers’ resp
ponses. In
this section, we will focus onn the former – consumerss.
Demand elasticcity
As discussed
d in the previouss section, the amount thatt people are willing
w
to buy of a goodd or service and
a its price area inverselyy related. In other
o
worrds, consumeers will buy more
m as the price
p of a goood or servicee
decrreases and will
w buy less as a the price inncreases. Airr Canada, Geeneral
Mottors and Com mpaq could th herefore assuume that theyy were going g to sell
morre when theyy lowered theeir prices. Whhat they did not know forr certain
wass whether thee increase in unit sales waas going to bbe sufficient to
t offset
their price reducctions. From the seller’s standpoint,
s itt is importan
nt to
know the extent of the consu umer’s respoonse relative tto price channges.
Supppose at a price of $6, con nsumers buy 1,000 units per time period of a
partticular produuct. The total revenue earnned by sellerrs is determin ned by
the unit
u price muultiplied by thet quantity purchased.
p T
Thus, at the price
p of
$6, sellers’ revennue is equal to $6,000. Suppose now that the pricce falls to
$5 and,
a as a resuult, consumerrs increase thheir purchasees to 2,000 unitsu per
timee period. In terms
t of totall revenue, thhis price reduuction will beenefit the
selleers because the
t total reveenue will incrrease to $10,,000. But wh hat if the
pricce reduction from
f $6 to $5 causes the quantity dem manded to in ncrease to
onlyy 1,100 unitss? This will hurt
h sellers because their revenue willl drop to
$5,5500 (see Tab ble 1.4 for ex
xamples of deemand scheddules).
In Table
T 1.4, eaach demand schedule
s has the same sett of prices. The
T only
diffe
ference is thee responsiven ness of the buuyers to the ddifferent pricces.
Demmand 1 has thhe more resp ponsive set of buyers; whhen the price falls
m $6 to $5 too $4, the increase in the quantity
from q demaanded is morre than
enouugh to comppensate for th he decrease inn price. Hencce, total reveenue
(TRR) increases. When
W these same reductiions in price occur in Demand 2,
the increase
i in quantity
q ot enough to compensate for the pricee
is no
reduuction and soo total revenuue falls. In Demand
D 3, thee change in the
t
quanntity demandded is just en nough to offsset the changge in the pricee. Thus,
total revenue is unchanged,
u regardless
r off the directioon of change in price.
56
Demand 1 Demand 2 Demand 3
P Q TR* P Q TR P Q TR
$6 1,000 6,000 $6 1,000 6,000 $6 1,000 6,000
$5 2,000 10,000 $5 1,100 5,500 $5 1,200 6,000

1,500
$4 3,000 12,000 $4 1,200 4,800 $4 6,000
Table 1.4 Three demand schedules
Table 1.5 summarises the relationship between elasticity, price changes

and changes in total revenue. It shows that when the price decreases and
the total revenue increases, consumers are so responsive that their
increase in purchases is more than enough to compensate for the price
reduction. This type of response is called elastic and also implies that
when the price increases, the negative response by consumers is large
enough to offset that increase. Thus, sellers end up generating less total
revenue. A decrease in price accompanied by a decrease in total revenue
indicates an inelastic demand. When the price changes and there is no
change in total revenue, demand is called unit elastic.
Elastic Inelastic Unitary
Price rises TR falls TR rises No Change
Price falls TR rises TR falls No Change
Table 1.5 Price changes, elasticity and changes in total revenue
We have just discussed the concept of elasticity in terms of the impact

that price changes will have on total revenue earned by sellers. Elasticity
can also be measured in a more precise way by comparing the degree of
responsiveness among buyers to changes in price. This measure is
defined as the percentage ofchange in quantity demanded relative to the
percentage of change in price. That is:
Percentage change in Q (Q2 – Q1)/Q1

EP = =
Percentage change in P (P2 – P1)/P1
where
EP = the elasticity coefficient,
Q1 = the original quantity demanded,
Q2 = the new quantity demanded,
P1 = the original price, and
57
Module 1
P2 = the new priice.
If thhe percentagee of change in i quantity demanded

d excceeds the perrcentage
off change
c in priice, the elastticity coefficiient EP will hhave a value greater
thann one – it is elastic.
e If thee percentage of change inn the quantity y
demmanded is less than the peercentage of changec in prrice, then EP will be
less than one. Thhis, by definition, is an innelastic demand. If EP is equal to
one,, demand is unitary
u elasttic.
Fromm Table 1.5 we can calcu ulate the pricce elasticity of demand. Using
U
Demmand 1, we sees that the percentage off increase in qquantity is 100 per
centt i.e. (2,000 – 1,000)/1,00
00. The perceentage of chaange in pricee is -
16.667 per cent (55 – 6 divided
d by 6). Thuss, EP is equall to 100 dividded by -
16.667 or -6. Usinng the same formula for Demand 2, w we see that th
he
decrrease in pricee from $6 to $5 indicatess an elasticityy coefficient of - 0.6.
Thee percentage of increase in quantity inn this case woould be 10 per cent,
(1,100 –1,000)/11,000, whereeas the percenntage of channge in price remains
at –16.67.
To handle
h this innherent ambiiguity, we em
mploy a form
mula that adjuusts the
ference in basse numbers. This formulaa is expresseed as follows:
diffe
(Q2 – Q1) (P2 – P1)

EP = ÷
(Q1 + Q2)/2 (P1 + P2)/2
By dividing
d the change in qu uantity and price
p by the rrespective miidpoints
betw
ween the chaanges, this formula providdes a commoon base from m which
o decreases can be calcuulated. Thus, for any
either percentagge increases or
two prices and quantities,
q the elasticity coefficient
c would remain the same
no matter
m whichh direction th
he price has changed.
c Forr example, in
n Demand
1, between $6 annd $5, elasticcity coefficieent is -3.67. IIn Demand 2,
2 it is -
0.522. In Demandd 3, the elasticity coefficiient is - 1, whhich explain
ns why
econnomists call this type of demand
d channge unitary eelastic.
Diffferent typees of elasticity

Dem
mand responssiveness may
y be classifieed in absolutte terms as:
a. Perfectllyelastic Ep= ∞(infinity),

∞
b. Elastic Ep>1,
c. Unitarillyelastic Ep= 1,,
d. Inelastic Ep<1,
e. Perfectllyinelastic Ep= 0..
ure 1.22 provides a graph

Figu hic representtation of the five degreess of
dem
mand responssiveness.
58
Five demand curves are shown representing five different elasticity

situations. D1 represents the perfectly elastic, D2 the elastic, D3 the
inelastic, D4 the perfectly inelastic and D5 the unitarily elastic situation.
Figure 1.22
Pointers on Figure 1.22: Initially, you might confuse the two extreme
cases, perfectly inelastic and perfectly elastic. In the case of ‘perfectly’
think ‘completely’. If you have a ‘complete’ lack of response to higher
prices, what would happen to the amount you buy? Higher prices will not
change the amount you buy. Demand is totally unresponsive and is drawn
as a vertical curve. If you have a ‘complete’ response to a higher price,
what would happen to the amount you buy? The demand is perfectly
elastic and graphically, you are ‘off’ the horizontal demand curve. You
buy none of the good.
Total revenue can be viewed as P × Q (Price × Quantity) and that is

represented by the area of the two rectangles in Figure 1.23. It
demonstrates the three states of elasticity:
• When demand is elastic, D in Figure 1.23 (a), a drop in the price
increases the total revenue – (P2 × Q2) > (P1 × Q1). In terms of the
diagram, a price reduction means a larger rectangle.
• Predictably, for inelastic demand, the same drop in price implies a
decrease in the size of the rectangle.
• When elasticity is equal to one, unit elastic, the demand curve –D in
Figure 1.23 will be a curvilinear boundary marking a rectangle (P ×
Q) which remains unchanged in area.
59
Module 1
Figu
ure 1.23
60
Use the following information to answer questions 1 and 2. Double Triple

Pizza has been experimenting with the price of its Extra Thick Pan Pizza.
At the price of $12, the quantity demanded is 100 pizzas. At $10, the
quantity demanded increases to 120 pizzas. When the price is $8, the
Study skills quantity demanded increases to 140 pizzas.
1. Using the midpoint formula, determine whether the price elasticity of

demand between $12 and $10 is—
A. elastic with a coefficient of -2
B. unitarily elastic with a coefficient of -1
C. elastic with a coefficient of -10
D. inelastic with a coefficient of -.1
2. Using the midpoint formula, determine whether the price elasticity of

demand between $12 and $8 is—
A. elastic with a coefficient of -6/5
B. elastic with a coefficient of -5/6
C. inelastic with a coefficient of -6/5
D. inelastic with a coefficient of -5/6
3. A 10 per cent fall in the price of shampoo results in a 5 per cent

increase in the quantity of shampoo demanded. Demand is—
A. inelastic
B. elastic
C. unitarily elastic
D. perfectly elastic
4. The price elasticity of demand can be calculated by—

A. multiplying the percentage of change in quantity demanded
by the percentage of change in price.
B. dividing the percentage of change in quantity demanded by
the percentage of change in price.
C. dividing the percentage of change in price by the percentage
of change in quantity demanded.
D. multiplying the percentage of change in price by the
percentage of change in quantity demanded.
61
Module 1
5. The supply of
o cooking oil
o increases. There is no effect on thee
equilibrium quantity. Deemand is—
A. perffectly inelastiic.
B. Elasstic.
C. Inelastic.
D. perffectly elastic..
Solu
utions:
1. B. P1 is 12; P2 is 10; Q1 is 100; Q2 is 120. Pluug the values into the
formula. Note: Conffirm your ressult by using the total rev venue
test.
2. D. P1 is 12; P2 is 8; Q1 is 100; Q2 is 140. Optiions B and C must be
incorrecct—an elasticc demand cannnot have a ccoefficient of -5/6
and an innelastic dem
mand cannot have
h a coeffiicient of -6/5
5. Note:
Confirmm your ‘inelasstic’ result byy using the ttotal revenuee test.
3. A. The percentage
p ch
hange in the quantity is lless than thatt in the
price.
4. See the definition off elasticity.
5. A. A perrfectly inelasstic demand curve is a veertical deman nd curve.
This impplies, a downnward shift inn the supply curve has no o effect
on quantity. Also, in
ntuitively, whhen demand is perfectly inelastic,
i
a changee in price hass no effect onn the quantitty of output
demanded.
Factorrs that deetermine price elasticity

Theere are four key
k characterristics of a prroduct that innfluence its elasticity.
e
Theey are:
A. The deggree to which
h it is viewedd as luxury orr necessity
B. The num
mber of substtitutes that arre available tto buyers.
C. The pricce of the prod
duct in relatiion to buyerss’ incomes.
D. The amoount of time allowed for buyers to reaact to price changes.
c
Ellastic In
nelastic
1. Luxury 1. Necessity
2. Many substiitutes availab
ble 2. Few substiitutes availab
ble
3. Price is a larrge part of in
ncome 3. Price is a ssmall part off income
4. Long-run tim
me period 4. Short-run time period
Tab
ble 1.6 Deterrminants of elasticity off market dem
mand
Connsider the folllowing exam

mples as illusstrations of thhe points maade in
Tabble 1.6.
62
Electricity has few substitutes; therefore the demand for it is inelastic. As

more substitutes become available, demand becomes more elastic. AZT,
the drug that combats AIDS, at one time had no substitutes; therefore,
demand for it was inelastic. The emergence of substitutes will make
AZT’s demand more elastic.
Suppose the price of salt or pepper doubled. It is such a small portion of

expenditures for most people in North America that the price increase
there would pass almost unnoticed, and quantity demanded would
respond only slightly: inelastic demand. In contrast, a doubling in the
price of a good that is important in one’s budget (petrol, perhaps) will
provoke a great response. This is a good example of the role price plays
in the household budget.
The demand for oil offers a good example of short and long-run
elasticity. When OPEC conspired to raise the price of oil in 1973 and
again in 1979, consumers, especially in industrialised oil importing
nations, responded by reducing their purchases by a relatively small
amount. One economic study at that time pointed out that the short-run
elasticity of demand for oil was about -0.10, a coefficient indicating a
very inelastic demand. In the 1980s, however, these consumers had
changed their pattern of consumption by car pooling, driving their cars at
lower speed, using more fuel-efficient cars and turning their thermostats
down. Producers in these countries complemented this response by using
more fuel-efficient machinery. Thus, the long-run response to increased
oil prices was much more elastic than the short-run response.
Elasticity of a product versus elasticity of a brand

When you examine the elasticity of demand for a product, you must
distinguish between the responsiveness of consumers to changes in a
given product category and the responsiveness related to a particular
brand name within the category. As you might expect, responsiveness is
generally greater for a brand than for the product category due to the
simple reason that competing brands within the category offer more
substitutes to consumers.
For example, if Petro Canada, a nation-wide distributor in Canada, were

to increase the price of itspetrol, Canadians would anticipate a relatively
elastic responsiveness in the quantity purchased because of the decrease
in consumption from those who regularly buy this brand. These buyers
would be enticed by the relatively lower prices of Petro Canada’s rivals.
(This example assumes that the sellers of the competing brands do not
match Petro Canada’s price hike.) An increase in the average price of
petrol would probably generate a less elastic response because car drivers
might not view such substitutes as taxis, publictransport, car pooling
andso on. as being close alternatives to driving their own cars – at least in
the short run.
63
Module 1
Point elasticityy and the price ran

nge facto
or
In determining
d t degree off price elasticcity, it is alsoo important to
the t
conssider the range in which changes in price
p and quaantity occur. Suppose
we extend
e the chhanges in priice and quanntity in Tablee 1.4 by exacctly the
sam
me incrementss. That is:
64
P Q R
$6 1,000 $6,000
$5 2,000 $10,000
$4 3,000 $12,000
$3 4,000 $12,000
$2 5,000 $10,000
$1 6,000 $6,000
You will notice that as the price drops from $6 to $1, the pattern of
change in total revenue alters. Down to $4, revenue increases, implying
an elastic response. Between $4 and $3, there is no change, implying
unitary elasticity. As the price drops below $3, the same incremental
response of 100 units results in a decrease in total revenue. Generally, at
higher price levels, price decreases produce elastic responses in quantity
demanded; at lower price levels, price reductions are accompanied by an
inelastic response. There is no magic in this observation; it is all in the
arithmetic of the elasticity formula and in the demand schedule itself.
The formula for determining elasticity utilises the percentage of change,

not the absolute change, in quantity demanded relative to price. In the
upper half consists of the price range (the lower half consists of the
quantity range), any decrease in price is bound to be relatively small in
percentage terms because the base price is relatively high. By the same
concept, the corresponding increases in quantity must be relatively high
in percentage terms because the base quantities from which the
percentage is calculated are relatively low. This is illustrated in Figure
1.24, which shows that the upper half of the demand line is elastic,
whereas the lower half is inelastic. At the half point, demand is unitary
elastic. In fact, as long as the demand is a straight line as in Figure 1.24,
we can state that it will have an elastic half and an inelastic half with
unitary elasticity occurring right in the middle. If the demand curve is not
linear, then the relationship between range of prices and elasticity does
not hold.
65
Module 1
Figu
ure 1.24
Practical appliccation of price elaasticities

Pricce elasticity has
h several immportant praactical uses. T
The followin
ng is a
shorrt list of som
me of the appllications.
• Govern nments have a keen intereest in price eelasticities beecause of
the helpp they give inn determiningg products too levy taxes and a the
rate of tax to imposee. Clearly, prroducts with low price elaasticity
of demaand such as to obacco, alcooholic drinks and energy, are the
ones to tax. Impositiion of a tax ono such prodducts has a sm mall
effect onn quantity annd hence proves a lucrativve source off tax
revenuee. Luxury goo ods are attracctive to tax aauthorities foor the
same reaason. Knowlledge of dem mand theory aand empiricaal
estimatees of the shap pe of the demmand curve aalso help to determine
d
the rate of tax to lev
vy. As prices rise as a resuult of indirecct taxes,
price elaasticity tendss to increase.. After a poinnt, a rise in taax could
lead to a fall in total tax revenue. This is partticularly likeely where
taxes caan be evaded through smuuggling.
• Businessses use elastticities to esttimate the efffects of chan
nges in
their ow
wn price as well
w as the priice of their competitors on o their
revenuee. They also use
u this conccept to estimaate the impacct of
governmment taxes onn their revenuue, their sharre of the tax burden
andso onn.
• Centrall banks use elasticities
e too estimate the effects of changes
c
in exchaange rates onn imports andd exports andd more broad dly in
assessinng the effectss of movemennts in an ecoonomy’s costt
competiitiveness on GDPG and em
mployment.
Other types of elasticityy

In addition
a to prrice elasticity
y, there are thhree other im
mportant typees of
elassticity that ecconomists traack: income elasticity,
e crooss-price ela
asticity
and advertising elasticity. Th hese elasticitties measure,, respectively
y, the
66
responsiveness of demand to changes in consumers’ income, the price of

substitute goods and advertising expenses.
Income elasticity
You can reasonably expect that when income rises, consumers will buy
more of a particular product, less when their income falls. In fact, goods
and services that exhibit such a relationship are called normal. However,
where there is an inverse relationship between changes in income and
consumer demand, the products are called inferior. Examples of inferior
products or services are less expensive means of transportation (bus
versus plane), low quality rice, and no-name products. As people’s
income rises, they start to replace these products with higher-priced
substitutes such as branded products.
Income elasticity is measured in the same way as price elasticity. The

percentage of change in the quantity demanded is compared with the
percentage of change in income. That is:
Percentage of change in quantity

EI =
Percentage of change in income
Where, EI denotes income elasticity.
We can categorise the results of this computation as follows:
If the income elasticity coefficient is positive, it indicates a movement in

the same direction for both income and quantity demanded. Products with
coefficients greater than zero are called normal. As your income
increases, you will probably increase your spending on soft drinks, books,
clothes, CDs and so on. (EI has a positive sign).
If the income elasticity is negative, it indicates that quantity demanded

and the level of income move in opposite directions. Therefore, the
product is inferior. Potatoes, beans and generic aspirin are good examples
of inferior goods. As your income increases, you will probably decrease
your spending on such goods (negative elasticity, EI< 0). Conversely, if
real income levels decline, the quantity demanded of an inferior good will
increase.
If the income elasticity coefficient is greater than one, it indicates that

demand is very sensitive to changes in income. In this case, we can refer
to the product as a luxury or superior product.
Home ownership might be a luxury. If your income is low, you can only
rent. If your income rises, you may qualify for mortgage loans and enter
the house-purchasing market. In such a case, expenditure on house
purchases rises more than the increase in income.
Graphically, the impact of an increase in income on the demand for a

necessity good, given ceteris paribus, can also be shown as a shift
67
Module 1
outw
ward of the demand
d curve (D2 in Figu
ure 1.25).
Thee extent of the outward sh hift will be leess than for a luxury good
d, of
courrse, since thee demand forr necessities is less responsive to channges in
incoome than luxxury goods, D3. Note that both luxuriees and necesssities
exhiibit a positivve income efffect.
Thee shift of the demand curv ve for an infeerior good is in the oppossite
direection to the change
c in inccome. In Figgure 1.25 wee also show the
demmand curve shhifting back to the left, D4, followingg an increase in
conssumer incom me. Consumeers now buy less l of this product than they t did
befoore, as a resuult of the incrrease in theirr income. The extent of th he shift
depeends, of courrse, on the vaalue of incom me elasticity: small negattive
valuues mean small shifts to the t left whilee relatively laarge negativee income
elassticities meann relatively laarge shifts too the left, in rresponse to an
a
incrrease in real income.
i
Figu
ure 1.25
Bussiness impliccations of in
ncome elastticity
Thee implications of income elasticity of demand to bbusiness decision-

makkers are conssiderable. If the
t income elasticity for yyour productt exceeds
one,, the demandd for your pro oduct will grrow more rappidly than tottal
conssumer incom me. Contrastin ngly, it will fall more rappidly than tottal
conssumer incom me when inco ome levels arre generally ffalling. Hencce, while
incoome elasticityy greater thaan one in a grrowing econoomy indicatees a
growwth industry, it also indiccates a greateer vulnerabillity to downtu urns in
the level
l of aggrregate economicactivity. Contrastinglly, if the inco ome
elassticity of dem
mand for your product is positive
p but lless than onee, the
demmand for yourr product willl grow moree slowly thann the gross naational
prodduct or consuumer incomee. (However, it will be relatively recession-
prooof, in the sennse that the demand
d n react in thhe volatile faashion of
will not
luxuury goods.) Third,
T if yourr product is regarded
r as aan inferior go
ood by
the market
m as a whole,
w you must
m expect the t quantity demanded off your
prodduct to declinne as the grooss national product
p rises..
68
Therefore, knowledge of a product’s income elasticity can help managers

in several different ways. First, it can alert them to the impact on demand
caused by movements in the macro economy. A recession is expected to
reduce the demand for normal or superior products. In an economic
recovery or expansion, similar products should experience rising demand.
For example, during the sustained economic expansion of the 1980s,
companies that sold luxury consumer products with high-status designer
names did very well. In the 1990s, however, many of the same companies
experienced sluggish sales because of the slowdown in the economy.
To offset the impact of the business cycle on product demand, a manager

might do well to select a portfolio of goods and services with a variety of
income elasticities. Thus, in a recession, the demand for a company’s
inferior or low-income-elasticity products will be sustained and may even
increase. In expansionary economic times, the company’s high-income-
elasticity products would take the lead in sales.
Cross-price elasticity
Cross-price elasticity is a measure of the responsiveness of consumers to
changes in the price of a particular good, Good A, relative to changes in
the price of substitute or complementary products, Good B. The cross-
elasticity of demand provides a measure of the degree of
complementarity between Product X and some other product.
Cross-elasticity of demand is defined as the percentage of change in

quantity demanded of Product A, divided by the percentage of change in
the price of some Product B
Percentage of change in QA
EC =
Percentage of change in PB
Where, EC is the cross-elasticity coefficient.
The main point here is the sign (positive or negative) of the relationship
rather than the magnitude. If it is a positive relationship, the goods are
substitutes; if it is negative, they are complements. As a secondary issue,
the larger (in absolute terms) the coefficient, the more related are the two
goods. For instance, a small decrease in the price of Pepsi may cause a
sizeable decrease in the demand for Coke (close substitutes) but a smaller
decrease in the demand for tea.
Knowledge about cross-price elasticity with respect to substitute products

is particularly useful to assess the impact on changes in sales in relation
to a competitor’s price. For example, what impact will a reduction in the
price of Microsoft Word have on the sales of Word Perfect? To minimise
the cross-price elasticity of a product with respect to changes in the price
of a substitute, companies spend a considerable sum on advertisements
which are designed to establish or strengthen brand loyalty. At present,
there appears to be an increase in cross-price elasticity in consumer goods
69
Module 1
marrkets evidencced by the growing markeet share of loower-priced, private-

labeel consumer products.
p Thhis situation poses
p anxietyy for the mak
kers of
leadding premium
m brands of consumer
c prooducts such aas Procter & Gamble,
Colggate-Palmoliive and Philiip Morris.
Thee cross-price elasticity of complementtary productss is also impo ortant for

mannagers to undderstand. Forr example, a seller of com mputer produ ucts can
reduuce the price of its PCs to o stimulate demand
d for itts software. If
I the
proffit margin is high for the product whoose demand iis affected by y the cut
in thhe price of thhe complemeentary produccts, this priciing tactic is
partticularly appeealing. For in nstance, a cloothing store might reducee the
pricce of its men’’s suits to stimulate the demand
d for high-profit maargin
item
ms such as tiees, shirts andd socks. Furthhermore, the degree of
commplementarityy between su uits and the fashion
f accesssories can be
stim
mulated by thhe friendly peersuasion of salespersonss.
Advvertising elasticity
e
We know that addvertising haas an impact on the quanttity of outputt sold.
Specifically, thee quantity dem manded of Product
P X willl typically sh
how a
posiitive responsse to advertissements in suupport of Prooduct X and a
negaative responsse to the adv
vertisements of o substitutes as well as a
posiitive responsse to the adveertising of coomplements.
Thee advertising elasticity off demand for Product X mmeasures the

respponsiveness of
o the changee in quantityy demanded tto a change in n the
adveertising budgget for Produuct X. We exppect a positivve relationsh
hip
betwween advertisements and quantity dem manded, but we also expeect that
the responsivene
r ess of sales through adveertisements wwill decline as
a
adveertising expeenditure conttinues to incrrease.
milarly, cross--advertising elasticity of demand meaasures the

Sim
respponsiveness of
o quantity demanded
d of Product X too a change in
n the
adveertising efforrts directed at
a another Prooduct Y.
As stated
s earlierr, one expectts cross-adveertising elastiicity to be neegative
betwween substituute products and positivee between com mplementary y
prodducts. For exxample, increeased advertiising efforts for a particular
movvie is expecteed to reduce the quantity demanded oof admission tickets
to other movies and attractio ons but to inccrease the salles at the refr
freshment
kiossk in the lobbby of that parrticular moviie theatre. Thhe increased
adveertising efforrts would hav ve shifted thhe demand cuurves to the left for
all substitute
s attrractions while shifting thhe demand cuurve to the riight for
the refreshment
r kiosk.
Peercentage of change
c in quuantity demannded for Pro
oduct X
EC =
Perccentage of ch
hange in the advertising bbudget for Prroduct Y
It is clear that we
w might calcculate the elasticity of dem
mand with reespect to
any variable that influences the demand for a productt.
70
The price elasticity of supply

The price elasticity of supply measures the responsive of the quantity
supplied due to a change in the price a good or service when all other
determinants of supply remain constant. In other words, the price
elasticity of supply reflects the percentage change in the quantity supplied
to the percentage change in the price of a good.
• If the percentage change in the quantity supplied is higher than
the percentage change in price, then supply is high, or elastic.
• If the percentage change in the quantity supplied is similar to the
percentage change in price, then supply is unit elastic.
• If the percentage change in the quantity supplied is smaller than
the percentage change in price, then supply is inelastic.
Determinants of the price elasticity of supply

The value of the elasticity of supply is influenced by two main
determinants:
1. Production possibilities: If the supply or substitute of the
productive inputs used to produce the good is limited, the
elasticity of supply is smaller (or inelastic). On the other hand, if
the productive resources used to produce the good are more
common, then the elasticity of supply is higher (or elastic).
2. Storage possibilities: If a good can be stored longer, the supply
of a good will be more elastic.
Computing the price elasticity of supply
The price elasticity of supply can be measured as follows:
Percentage change in quantity supplied

Price elasticity of supply =
Percentage change in price
For example, the following table has two points on the supply curve for
pie.
Price ($ per pie) Quantity supplied (pie per day)

1.00 100
2.00 300
• The percentage change in the quantity supplied is [(300 − 100) ÷

200] × 100 = 100 percent.
• The percentage change in price is [($2 − $1) ÷ $1.50] × 100 =
66.67 percent.
• Between these two points, the elasticity of supply is 100.00% ÷
66.67% = 1.50.
• The magnitude of price elasticity of supply for pie is 1.50
71
Module 1
(elastic)). This suggeests that if thee price of piee increases by 1 per

cent, theen the quantiity supplied ofo pie will chhange by 1.5per cent.
Taxx incidence and
a tax burd
den
Nowwadays, everry time consu umers buy soomething, theey pay a tax. On
me items, custtomers pay a sales tax that is added too the advertised price
som
while on other ittems, custommers pay an excise
e tax thaat is included
d in the
adveertised price. In paying th
he taxes, therre is a divisioon of the tax
x burden
betw
ween the buyyer and the seeller. This is called tax inncidence.
Figu ure 1.26 shoows the mark ket for DVDss. With no taxx, the equilib brium
pricce is $12 and the equilibriium quantityy is 10,000 unnits per month. When
a DV VD is taxed, it has two prices:
p a pricee before incluusion of the tax and a
pricce that includdes the tax. Buyers
B pay too the price thhat includes th
he tax
while sellers resspond to the price
p that exccludes the taax because thhis is the
pricce that they reeceive. Hencce, the tax immposed by thee governmen nt is a
diffe
ference betweeen these two o prices. Figgure 1.26 shoows the effecct of the
tax imposed
i by the
t governm ment on a DV VD. The tax im mposed will move
the supply curvee as the tax iss viewed as partp of the suupplier’s costt. Hence,
the initial
i supplyy curve, S moves to the left. The new w market equiilibrium
afterr tax occurs where the neew supply cuurve (S + taxx) intersects the t
demmand curve, D. D The buyerr pays the eqquilibrium priice $13. The seller
receeives the net--of-tax price $11. The diffference betw ween the pricce paid
by seller
s and buyyer is the tax
x imposed byy the governm ment. Govern nment
receeives tax reveenue of $18,000 ($2 × 9,0000 units). Inn this case, th he buyer
and seller split thhe $2 tax andd pay $1 eacch, namely thhey share thee tax
burdden equally. The tax incidence and taax burden shaared by buyeer and
selleer depend onn the elasticitties of demannd and supplly.
• For a given elasticityy of demandd, the more ellastic is the supply
s of
the goodd, the smalleer is the portion of the taxx paid by the seller.
• For a given elasticityy of supply, the more elaastic is the deemand of
the goodd, the smalleer is the portion of the taxx paid by the buyer.
Figu
ure 1.26
72
Activity 1.2
What would be your income elasticity of demand for:
a. Essential goods like sugar, salt and rice?
b. A vacation in Europe?
Activity
73
Module 1
Modu
ule sum
mmary
In thhismodule, you
y have been n exposed too the econom mic environm ment of
busiiness pertainiing to the stu
udy of econoomic decisionns made by business
b
in diimensions off microecono omics and macroeconom mics. PEST an nalysis is
usedd by businesss enterprises to determinee strategic appproaches to business
Summary activvities. The thhree basic priinciples of macroeconom
m mics are: incrreasing
empphasis on usinng market mechanisms
m too achieve obj
bjectives, formmulation
of more
m macroecconomic poliicies to ensure a stable ecconomic fram mework
and more outwarrd-looking national
n policcies. In the annalyses of
goveernment poliicy affecting business, tw wo sets of queestions arise,, the first
i referred to as normativ
set is ve or prescripptive and the second as po ositive
or descriptive.
d W
Well-establish hed set of gooals of the goovernment arre
econnomic efficieency, macroeeconomic staabilisation, grrowth and faairness
(equuity).
Youu have review wed the form mation of a suupply curve aand a demand d curve,
deteerminants of supply and demand,
d marrket supply ccurve and maarket
demmand curve, thhe differencee between movements
m aloong supply and
a
demmand curves anda shifts of these curvess. You have aalso learnt thhat
markket equilibriuum exists on nly when quaantity supplieed equals quaantity
demmanded. The market
m systeem – also called the pricee system – peerforms
two important fuunctions, nam mely provisioon of an autoomatic mechaanism
for distributing
d s
scarce goodss and servicess and determmination of booth the
alloccation of resources amon ng producers as well as thhe final mix of
o
outpputs. The govvernment maay implement price controols such as price
p
ceiliings and pricce floors. In an
a open econnomy, the paattern of tradee for a
natioon is determined by the relationship
r b
between its ddemand and supply
to thhe world’s deemand and su upply, and distinguishing
d g whether an
n
econnomy functioons as to be an a exporter or
o importer.
Youu have also leearnt the estimated functiions of price elasticity off
dem
mand, incomee elasticity off demand, crross-price elaasticity of dem mand,
adveertising elastticity and thee elasticities that
t could bee used as a baasis for
busiiness forecassting and deccision makingg.
In thhe following studymodulles, you will be looking aat the law of

diminishing marrginal returnss; shapes of the
t cost curvves; increasinng,
consstant and deccreasing returns to scale of
o a businesss and market
strucctures of perrfectly compeetitive, monoopolist, monoopolistic com
mpetitive
and oligopoly inndustries.
74
Assignment
75
Module 1
1. Define the meaning

m of ecconomics.
2. Differentiatee between macroeconomics and micrroeconomics..
3. What is opportunity costt?

Assignment
A
4. What is the difference beetween scarccity and shorttage?
5. Distinguish between norrmative and positive

p econnomics.
6. What is the link between

n scarcity andd choice?
7. Define margginal benefit and marginaal cost.
8. Explain the concepts of opportunity

o cost, marginnal cost, and marginal
m
benefit in making
m rationaal decisions.
9. How differeent is a markeet economy from

f a centraally planned
economy?
10. Discuss the precondition

p ns necessary for the smoooth functionin
ng of the
market systeem.
11. Does the exiistence of a shadow

s or 'black' econom my imply thaat the
price system
m is not workking? Is its exxistence conssistent with the
t laws
of demand and
a supply?
12. The governm mposing a salles tax. Who stands

ment gains reevenue by im
to lose the most,
m the consumer or thee producer, oor both?
13. It is often claimed that market

m forcess, with their eemphasis on selfish
motivation and
a profit-maaximisation, undermine eethics and yeet
arguably an ethical appro oach towardss contracts annd employeees by
business is essential
e t market syystem to funnction. Is the first
for the
assertion simmply incorrecct?
14. Is it true or false

f that a taax on the salee of beer shifts the supply
y curve
vertically byy the amountt of the tax?
15. Is it true or false

f that a price ceiling set
s above thee equilibrium
m price
will have noo effect on th he market?
16. Use the diaggram below tot decide which statemennt is false: ‘D
Demand
for this prodduct is _____
_____within the range _________’.
A. elastic; J to K.
B. elastic; J to L.
C. inelaastic; L to M.
M
D. elastic; K to L.
76
17. Define the following concepts

A. price elasticity of demand
B. cross-elasticity of demand
C. income elasticity of demand.
How are these elasticities estimated? Explain why it might be
important for a firm to know their values.
18. In what aspect would you expect determinants of the demand for
computers to differ from the determinants of the demand for milk?
19. Discuss why the price elasticity of demand is greater for goods and
services that have better close substitutes.
20. If demand is price inelastic, does revenue increase when price rises?
21. Is a perfectly elastic demand associated with a horizontal demand

curve?
22. Does total revenue fall if a price increases and demand is elastic?
23. Is the cross-elasticity of demand for two complements positive or

negative?
24. Rank the following items in ascending order of elasticity: jeans, black
Levi jeans, black jeans, black Levi 501 jeans, trousers, outer
garments, clothes.
25. Suppose that computers are a complement to computer software.

Suppose the price of a computer falls and at the same time, suppose
the number of firms selling computer software decreases. How do
these changes influence the price and quantity of computer software?
26. The table shows the demand and supply schedules for car.
77
Module 1
Pricce Quantitydem
Q manded Q
Quantitysup
pplied
(thousannd per
(cars per w
week)
carr)
100 35 5
200 30 10
300 25 15
400 20 20
500 15 25
600 10 30
700 5 35
A. Calcculate the equilibrium priice of a car, tthe consumeer

surpplus, and producer surpluus. What is thhe efficient quantity
q
of cars?
B. If thhe quantity demanded deccreases by 100 cars per weeek at
eachh price, whatt is the equiliibrium price and what is the
channge in total surplus?
s
C. If thhe quantity su
upplied decreeases by 10 ccars per week at each
price, what is thee equilibrium
m price and w
what is the chhange in
totall surplus?
D. If XYZ
X Cars, Incc., monopoliises the car pproduction in
n the
marrket and cuts production tot 10 cars a wweek, what is the
deaddweight loss that is createed?
78
Assessment
79
Module 1
1. Which of thee following statements

s arre positive annd which aree
normative?
A. The moon is maade of green cheese.
c
Assessment
A B. The central goveernment shouuld be made to balance itts
budgget.
C. The most serious economic problem
p connfronting the nation is
unem
mployment.
D. We should eradiicate povertyy.
2. Choose a loccal natural reesource with which you aare familiar with
w e.g.
a hectare of farmland or a nearby lakke.
A. Listt three alternaative uses for your choseen raw materiial.
B. Chooose one of th
he three usess. What is thee opportunity
y cost of
this use?
C. Is thhe resource renewable or not? If it is nnot renewablle should
this be factored into your callculations?
D. Describe how yo our communnity has choseen to use or not
n to
use the resource at all. Who and what dettermined thee choice?
3. Which one of
o the follow
wing best desccribes the stuudy of econo
omics?
Economics studies:
s
A. how
w businesses can make prrofits.
B. how
w the governm ment controls the econom
my and how people
p
earnn a living.
C. how
w society usess its scarce resources to ssatisfy its unlimited
desiires.
D. how
w income is allocated
a amoong differentt sectors of th
he
econnomy.
4. Macroeconoomics approaaches the studdy of econom
mics from the
viewpoint off ⎯
A. individual consu
umers.
B. the government.
g
C. the entire
e econom
my.
D. the operation
o of specific marrkets.
5. Microeconomics approaches the studdy of econom
mics from thee
viewpoint off ⎯
A. the entire
e econom
my.
B. the government.
g
C. the operation
o of specific marrkets.
D. the stock
s markett.
6. Which of thee following is
i most approopriately a m
microeconom
mic issue?
80
A. The study of the relationship between the unemployment rate

and the inflation rate.
B. The forces determining the price in an individual market.
C. The determination of total output in the economy.
D. The aggregate behaviour of all decision-making units in the
economy.
7. Which of the following economic variables would most likely be
studied in microeconomics?
A. The unemployment rate
B. Automobile production
C. Aggregate output
D. The aggregate price level
8. Which of the following economic variables would most likely be
studied in macroeconomics?
A. The price of personal computers
B. The production of macroeconomic textbooks
C. Aggregate output
D. The price of university tuition fees.
9. At the beginning of January 1992, price controls were lifted in
Russia. Within a day, food prices had increased by 250 per cent but
the food queues vanished overnight. Using the demand and supply
curves, explain what happened. How would you expect the supply of
food in the short run and in the long run? Which groups in the society
have gained and which have lost as a result of the abolition of food
price controls?
10. We know that the number of personal computers being sold has
increased and yet the price is falling. Use the supply and demand
curves to explain how this can happen.
11. Discuss what you would consider to be the main determinants of
demand and supply of rented apartments. Suppose the government
decides that rents are too high and sets a maximum rent. What would
you expect the consequences of this action to be for ⎯
A. apartment owners?
B. existing renters?
C. future renters?
12. Consider the supply curve of oil for central heating. In each of the
cases below, indicate whether there is a movement along the supply
curve (in which direction) or a shift of the supply curve (whether left
or right):
A. New oil fields enter production.
B. The demand for central heating rises.
81
Module 1
C. The price of coaal falls.

D. Oil companies anticipate
a an upsurge in thhe demand for
fo
centtral heating oil.
o
E. The demand for petrol rises.
w technology
F. New y decreases thhe costs of oil refining.
G. Oil products
p beccome more expensive.
13. A leftward shift
s of the su
upply curve of
o Pan Galacctic Gargle Blasters
B
causes pricee to rise by 10
0 per cent. Olivia
O Leung buys 20 per cent
T price hikee has causedd Olivia to ⎯
fewer Gargle Blasters. The
A. spennd less on Gaargle Blasterrs.
B. spennd more on Gargle
G
C. reduuce the quanttity bought. We
W cannot teell what has
happpened on how w much she spends.
D. incrrease the quantity bought. We cannot tell what hass
happpened on how w much she spends.
14. Consider thee following diagram
d that shows the m
market for miilk.
i thousands of litres.
Quantity is in
A. Calcculate total in
ncome for daairy farmers.
B. Suppose that this income levvel is felt to bbe inadequate and a
political decisionn is made to boost the farrm income too
$1,2200,000. Sup ppose the govvernment esttablishes a prrice floor
at $22.00 with thee governmennt buying thee excess suppply. How
mucch milk will beb supplied??
C. Whoo gets the miilk?
D. The plan achievees the incom
me objective bbut what elsee has it
donee? There are costs involvved with tamppering with the
t price
mecchanism. Wh hat are they?
Now supposse the govern
nment establiishes a price ceiling of $0
0.50 per
litre.
w much milk
E. How k would consuumers actuallly receive?
F. Whiich plan is beetter for a miilk consumerr who pays no
n
82
provincial tax? Why?

15. Dental bills in Toothache City rose again last year. The City Council
is considering placing a ceiling on fees that dentists can charge for
teeth cleaning. The supply and demand curve for teeth cleaning is
given in this table below.
Problem Table: demand and supply for teeth cleaning
Demand Supply
Price Quantity Price Quantity
$65 100 $65 190
$60 120 $60 180
$55 140 $55 170
$50 160 $50 160
$45 180 $45 150
$40 200 $40 140
A. Find the equilibrium price and quantity for teeth cleaning in
Toothache City.
B. The City Council passes a price ceiling ordinance, setting the
maximum price at $40 per cleaning. Use the supply and
demand analysis to determine the effects of the price control.
16. Draw a graph showing the demand curve and the supply curve of
personal computers. How would your graph be affected by ⎯
A. A rise in the price of software?
B. A rise in the price of electric typewriters?
C. A fall in the price of desktop printers?
D. An expected increase in next year’s PC prices?
E. A 10 per cent sales tax on computers?
F. A fall in income tax?
17. Which of the following are likely to have a positive cross-elasticity of
demand?
A. Fishing rods and fishing permits
B. Imported rice and domestically produced rice
C. Taxi and bus fares
D. Beer and wine
E. Cars and tyres
F. Cameras and films.
18. Suppose for health reasons, a tax is placed on tobacco consumption,
with the objective of reducing the demand for cigarettes. The
cigarette industry objects to this tax and argues that since the price
elasticity of demand is very low, the only effect of the tax will be an
increase in government revenue. Use diagrams to illustrate and
analyse this situation. What other measures could the government use
83
Module 1
to achieve itts objectives??

19. Imagine thatt you are resp
ponsible for running a buus company and a you
have access to the follow
wing informaation about thhe elasticitiess of
demand for bus travel:
• Income elaasticity = - 0.4
0
• Own-pricee elasticity = -1.2
• Cross-pricce elasticity with
w respect to rail fares = +2.1.
How might this
t informattion be of use to you in ccircumstances when
your companny is running
g a service thhat is currenttly taking a lo
oss?
20. You have beeen hired as an a economicc consultant bby OPEC and
d given
the followinng statistics sh
howing the world
w demannd for oil:
Price Quantity deemanded

(dolllars per barrrel) (milllions of barrels per day
y)
10 60,0000
20 50,0000
30 40,0000
40 30,0000
50 20,0000
A. Whaat is the totall revenue-maaximizing priice?

B. Statte explicitly all
a assumptioons and qualiifications thaat
undeerlie your annswers.
21. The Bustraeen Company is one of fivee firms that m manufacture washing
machines. The
T five firmss are all abouut the same ssize, have
approximateely equal marrket shares, anda produce very similarr
products. Buustraen sells approximateely 200,000 w washing macchines
per annum. TheT company has engageed a market rresearch consultant
to provide esstimates of thhe price elassticity and crooss-elasticity
y of
demand for its product. These
T estimaates have just been receiv ved and
they are listeed as followss:
• The pricce elasticity of
o demand foor Bustraen’ss washing machines:
-1.85.
• The crosss elasticity of
o demand foor Bustraen’ss washing machine:
m
0.45 vis-à-vis any on ne of the otheer firms’ machines.
• The pricce elasticity of
o demand foor all washinng machines (if
( all
prices chhanged togetther): -0.55.
A. Expplain what Bu ustraen shoulld expect to hhappen to itss sales if
it were to raise prices
p by 10 per
p cent and no other firm m
channged its pricee.
B. Expplain what Bu ustraen shoulld expect to hhappen to itss sales if
one of its rivals were to raisee its price byy 10 per cent,, ceterus
paribbus.
84
C. Explain what would happen if Bustraen raised its price by 10

per cent and all other firms did the same.
22. You have just bought a company that publishes cookbooks. You
consulted your in-house economist. The conversation goes like this:
• He tells you that the elasticity of demand for your cookbooks is -
2.4.
• Then you tell him that you want to maximise sales revenue.
• He tells you that you should raise the price of the cookbooks.
• Then you tell him that you are investing the first month of his pay
rise in lottery tickets to improve your business chances. Explain
your reaction.
23. The price of Goods A and of Goods B is $10, and both goods have a
quantity demanded of 100 units per week. When the price of Goods A
falls to $9, the quantity demanded rises to 200 units per week.
However, the price of Goods B must fall to $8 in order to achieve
sales of 200 units.
A. In the price ranges given, which good has a more elastic
demand?
B. Use the total revenue test to confirm that both goods face
elastic demand curves.
C. Verify your answer by calculating the price elasticity
coefficient for Goods A and Goods B.
24. If Goods X’s producer wishes its demand to increase, which of the
following scenarios is the most preferred, given that the cross-price
elasticity coefficient for Goods X (to a change in Goods Y’s price) is -
0.7 and the cross-price elasticity coefficient for Goods X (to a change
in Goods Z’s price) is +0.7 Goods X’s income elasticity coefficient is
-0.7.
A. Thanks to unexpected prosperity; the price of Goods Y
increases.
B. Because of an unexpected recession; the price of Goods Y
increases.
C. Thanks to unexpected prosperity, the price of Goods Y
decreases.
D. Because of an unexpected recession; the price of Goods Z
increases.
E. The price of Goods Y increases; the price of Goods Z
increases. Explain your answer.
85
Module 1
Asseessment answeers
1. A. Positive, B. normativ
ve, C. positivve, D. normattive.
2. A. The answ om a countryy to the next. Therefore, it is
wer varies fro
sensitive to your choice of local areaa.
B. Just remeember that op
pportunity coost reflects thhe forgone
alternative.
C. If the resoource is non-renewable, the cost shouuld reflect th
he
forgone valuue. Thereforre, it should be
b factored in.
D. Again it depends on your
y choice.
3. C.
4. C.
5. C.
6. B.
7. B.
8. A.
9. The price coontrol had caaused long quueues and exxcess demand d (prices
too low). Thhe removal ofo the control caused the excess demaand to
push the price upward, perhaps
p as hiigh as P1. Thhe supply of food in
the short runn would be fixed
fi (verticaal); little timee is availablee for
producing more.
m In the long
l run, suppply would reespond to thee rising
price. More food (S′) wo ould be produuced, new S′′short crossing g Slong
and D at A.
Consumers lost and prod

ducers gainedd in the shorrt run.
10. Although deemand D hass increased, supply

s has inncreased by more.
m
86
11. Main determinants of demand and supply of rented apartments are

average income of consumers, price of owner occupied housing units,
taste, expected future prices, expected future changes in the economy,
demographic factors, cost of construction, location, etc.
Setting a maximum rent causes: (a) apartment owners to lose, (b)
existing renters to gain, (c) future renters to face a difficult time
finding decent rental units.
12. A. the supply curve shifts to the right.
B. movement along upward.
C. movement along downward.
D. the curve shifts to the right.
E. the curve shifts to the left.
F. the curve shifts to the right.
G. movement along upward.
13. A.
14. A. $400,000.
B. 600,000 (litres).
C. public buys 150,000 litres. The government ends up buying the
remaining 450,000 litres.
D. it has created inefficiency and waste (deadweight loss) to the
society. Taxpayers have to pay a lot more to keep farmers happy.
E. 150,000 litres.
F. the latter plan works better for consumers. since they pay less even
though they buy the same quantity (150,000 litres) in either case.
15. A. P = $50, Q = 160
B. This causes development of an excess demand of 60 (200−140).
A price ceiling generates a shortage.
16. A. demand shifts back (left) (substitutes)
87
Module 1
B. demand shifts
s right (ssubstitutes)
C. demand shifts
s right (ccomplementss)
D. demand shifts
s right
E. supply, not
n demand, shifts
s to the left,
l or demaand shifts to the
t left
by 10%
F. demand shifts
s left
17. B, C and D. The productt pairs in eacch case are suubstitutes.
18.
Governmentt revenue froom taxation is i representedd by the areaa

P2BCP3. If the
t industry isi correct andd the price ellasticity of demand is
low (steep demand
d curvee), the effectt on the quanntity consumeed will
be minimal while the goovernment revvenue will bbe large. The question
is whether or
o not this obj
bjection is valid for all poossible price ranges.
r
In the long run,
r educatinng the public about the haazards of smo
oking
will be moree effective.
19. The price elasticity is hig gh (elastic deemand). Low wer your pricce and
expand yourr market sharre. This wayy your revenuue will rise. Your Y
cross elasticcity is high to
oo. Rail is a substitute,
s cuutting the priice will
lure customeers (riders) away
a from raail to your buusiness. Yourr service
is considered inferior baased on the neegative incom me elasticityy. Take
advantage ofo economic downtimes,
d y will prossper.
you
20. A. Based onn these numb bers, revenuee is maximizeed at $1,200,,000
correspondinng to P2 = $3
30 and P = $440. There is more than on ne price
associated with
w this reveenue. Howevver, at P = $330, revenue iss
climbing, whereas
w at P=$40 it is declining. Thereefore, it mustt have
peaked betwween $30 and d $40,000 – not
n shown heere.
88
B.
A U shape (quadratic TR function) is assumed. Also, it is assumed

that oil price can increase by smaller increments than $10.
%ΔQx
21. A. EP = = −1.85
%ΔPy
Therefore, if P is raised by 10%, %∆Q (Sales) should drop by %∆Q =
−1.85 x 10% = −18.5%.
% ΔQ x
B. EC = = .45
% ΔPY
Therefore, if its rival raises its price by 10% , Bustraen’s sales should
rise by %∆Q = 10 x .45 = 4.5%.
C. If all other firms raise their price at the same time as Bustraen’s,
sales drop by 5.5% [(10% x (−.55)].
22. You tell your economist he is WRONG and that he knows nothing
about the link between elasticities and revenue. Where the demand is
elastic (−2.4), a decrease (not an increase) in price will increase total
revenue.
⎛ 10 − 9 ⎞
23. A. A, because a 10% ⎜ ⎟ drop in price causes an increase in
⎝ 10 ⎠
⎛ 200 − 100 ⎞
quantity demanded of 100% ⎜ ⎟ in case of A, whereas in
⎝ 100 ⎠
⎛ 10 − 8 ⎞
case of B, it takes 20% ⎜ ⎟ drop in price to bring about the
⎝ 10 ⎠
same change (100% increase in quantity).
B. Total revenue (A) = $10 x 100 = $1,000 rising to $9 x 200 =

$1,800.
Total revenue (B) = $10 x 100 = $1,000 rising to $8 x 200 = $1,600.
%ΔQ 100
C. E PA = = = 10
%ΔP 10
89
Module 1
100
E PB = =5
220
24. A. not prefeerred. As PY increases QX
X falls (negaative cross ellasticity
= −0.7); X and
a Y are com mplements.
B. not preferred, for the same reasonn.
C. preferredd. As PY dro
ops, QX risees.
D. preferredd. As PZ incrreases, QX rises
r (substituutes as evideent by a
positive crosss-elasticity.
E. If the twoo prices rise by
b the same proportion, nnothing will happen
to sales of X.
X The impacct on X depennds on whichh increase is larger. If
PZ rises by more, the salle of X increeases and vicce versa.
90
Module 2
Production, Costs and Profit, and

Market Structure
Introduction
In this module, we will examine the relationship between input prices and
choice of technology in order to maximise efficiency. You will be
introduced to the definitions of economics cost and profits. We will
explain implications of opportunity cost and define the relationship
between marginal cost and per unit costs. For production in long run, we
will explain the concepts of economies of scale and diseconomies of
scale. You will also explore break-even analysis.
In terms of market structure, you will first explore the output decision of
a competitive firm, its decision to shut down, relationship between short-
run market conditions and long-run market entry / exit adjustment. Then
we will introduce types of imperfectly competitive markets, starting with
a monopoly market. We will explain monopoly output and price
determination, price discrimination of a monopoly and social costs of a
monopoly. Another imperfectly competitive market to be introduced is
the monopolistic market. Lastly, oligopolistic models and the concept of
prisoners’ dilemma and its application on oligopoly will be discussed.
Upon completion of this module you will be able to:
• give examples of the role of input prices in the choice of

technology.
• explain the particular meaning of cost and profits in economics.
• distinguish between production in the short run and the long run.
Outcomes
• distinguish between historical and incremental costs.
• explain some implications of opportunity cost.
• define the relationship between marginal cost and per unit costs.
• describesome goods subject to (a) economies of scale and (b)
diseconomies of scale.
• find the break-even level of output for a simple product.
• critique the reasoning given by managers of a competitive firm
about how much to produce.
91
Module 2
• infer econnomic princip

ples from an in-depth business news story
announcinng a competiitive firm’s decision
d to shhut down.
• explain thhe relationshiip between short-run marrket conditio
ons and
long-run market
m adjusstment.
• describe the
t types of imperfectly
i c
competitive m
markets.
• describe how
h a monop poly determiines the quanntity to produ
uce and
the price to
t charge.
• explain why
w a monopo
olist chargess different priices to differrent
customerss.
• identify thhe social costts of monopooly.
• describe monopolistic
m cally competiitive market structure.
• compare outcome
o und
der monopoliistic competiition and perrfect
competitioon.
• name the chief markett structures thhat occupy thhe spectrum
between perfect
p comp
petition and monopoly.
m
• articulatee the conceptt of prisonerss’ dilemma aand state how
w it
applies too oligopoly.
• explain what
w an oligop polistic moddel is and disttinguish betw
ween
correct annd incorrect descriptions
d of the way ddifferent
oligopolisstic models operate.
o
Term
minologyy
Breaak-even Given n the companny's fixed andd variable co ost, how
anallysis: many units of a paarticular prodduct does a company
c
have to
t sell to covver all its costs of producttion? It
is also
o calledcost-vvolume-profi fit analysis.
T erminology
Eco nomies of Firm experiences
e a fall in the llong run averrage
scale: total cost
c as a resuult of its expaansion.
Eco nomies of Cost-ssaving occurrs when it is ppossible to produce

p
pe:
scop two orr more produucts togetherr at a lower per-unit
p
cost th
han for each product sepaarately
Marg
ginal product: Extra output produuced when ann additional worker
is hireed. Marginal product is calculated by dividing
the chhange in totall product (∆Q
Q) by the chaange in
the ammount of laboour employed (∆L).
Mon
nopoly: Mono opoly consistts of a single seller of a product
that has no close substitutes;
s thhus the produuct is
highlyy differentiatted from the products of all
a other
92
firms
Monopolistic Monopolistic competition consists of more firms

competition: with slightly differentiated products.
Oligopoly: Oligopoly consists of a relatively small number of

firms whose products are typically differentiated
from each other through some combination of
product design, promotional efforts and place of
sale.
Opportunity cost: The cost of something is what you give up to get

it. The opportunity cost of an item refers to the
cost of all those things that must be forgone to
acquire that item.
Price A firm selling the same product to different

discrimination: customers for different prices even though the
costs of producing for the two customers are the
same.
Production: The process of transforming a set of resources into

a good or service that has economic value.
Pure competition or Pure competition consists of many firms producing

perfect competition: identical products in an environment of full
information –all firms know where to buy the
cheapest inputs, and all consumers know where to
buy the cheapest products.
Production, Costs and Profit

Introduction
Production is the process of transforming a set of resources into a good or
service that has economic value. Resources used in production are known
as inputs. Remember that natural resources, capital resources, and human
resources are the three economic resources used in production. Inputs for
most businesses include all three of these factors of production. Output is
the result of this production, the quantity of a good or service that is
produced.
Businesses and the industries in which they operate fall into one of three
sectors depending on the type of production: primary, secondary, or
service (also known as ‘tertiary’). The primary sector includes industries
that extract or cultivate natural resources, such as mining, forestry,
fishing and agriculture. The secondary sector involves fabricating or
processing goods, and includes manufacturing and construction, among
other industries. Finally, the service sector includes trade industries (both
93
Module 2
retail and wholeesale) such ass banking and insurance, and the new w
infoormation induustries. Desppite the differrences betweeen these threee
secttors, they all follow the saame producttion principlees.
Cho
oice of tecchnology
In producing
p a certain
c good or service, businesses
b caan typically choose
c
from
m several proocesses usingg a different combinationn of inputs. A labour-
intensive processs employs more
m labour and
a less capittal to producce a
certain quantity of output. Conversely, a capital- inteensive processs uses
morre capital andd less labour to produce the
t same quaantity of outp put.
Supppose you havve started a small

s compaany, ‘Simple Diapers,’ wiith
$100,000 you haave saved. YouY rent a buiilding to usee as a factory, and buy
a suupply of mateerials. Beforee hiring workkers or buyinng sewing maachines,
you discover thaat you can make
m 1,000 ‘SSoft Diapers’ a day by using one
of five
fi possible production processes,
p eaach involvingg a different
commbination of workers
w and machines.
Thee combinationns of labour and capital employed

e in each processs are
showwn in Table 2.1. Five diffferent technniques of prodducing 1,000 0 diapers
are available.
a Teechnique A iss most labouur- intensive since it requiires
morre workers annd fewer macchines (10 unnits of labouur and two un nits of
capiital) to produuce 1,000 diaapers per dayy. However, iinputs can allso be
subsstituted for one
o another. If I labour beccomes more eexpensive, fiirms can
adoppt labour-savving technolo ogies; that iss, they can suubstitute capiital for
laboour. They cann automate assembly
a linees by replacinng human beeings
a can substtitute capital for land wheen land is scarce.
withh machines and
Techhniques B, C,C and D are increasingly more capitaal- (and less labour-)
l
intensive. Technnique E is thee most capitaal-intensive, requiring on nly two
unitts of labour but
b 10 units of o capital.
T
Technique Units ofC
Capital (K) Units oofLabour (L
L)
A 2 10
B 3 6
C 4 4
D 6 3
E 10
1 2
Tab ble 2.1Inputss required to produce 1,000

1 diapers by means of
alteernative tech
hnologies
Howw does a busiiness decide which produuction processs to use? Ow wners

whoo want to earrn as much prrofit as possiible should trry to maximiise the
busiiness’s produuctive efficieency, which means
m makinng a given qu uantity
of output
o with thhe least costlly mix of inpputs. Selectinng the most efficient
e
94
process, therefore, depends both on the quantity of each input used and
on the prices of these inputs.
Use the following information for the next two questions. Each technique
produces the same amount of output.
Technique Units of Capital Units of Labour

Study skills A 2 15
B 5 8
C 9 3
D 14 1
1. The price of both labour and capital is $1 per unit. What is the
optimal production technique: A, B, C, or D?
2. Which production technique is the most labour intensive: A, B,
C, or D?
Solutions:
1. Technique C is best (least cost). The total cost is $12.
2. Technique A uses more units of labour than any of the other
techniques.
What are costs?

To determine what a cost is, you must begin with the firm’s objective. Let
us find the seemingly obvious answer to what costs are by focusing on
your diapers business. It is conceivable that you started your firm because
of an altruistic desire to provide nearby families of infants with diapers.
More likely, however, you started your business to make money.
Economists normally assume that the goal of a firm is to maximise profit,
and this assumption works well in most cases.
What is a firm’s profit? The amount that the firm receives for the sale of
its output (diapers) is called its total revenue. The amount that your firm
pays to buy inputs (fabric, absorbent filler, workers, sewing machines,
etc.) is called its total cost. You get to keep any revenue that is not needed
to cover costs. We define profit as a firm’s total revenue minus its total
cost. That is,
Profit = Total revenue − Total cost.
Your objective is to make your firm’s profit as large as possible. To see

how a firm goes about maximising profit, we must consider fully how to
95
Module 2
meaasure its totall revenue and

d its total cosst.
Totaal revenue iss the easy parrt: it equals thhe quantity oof output thee firm
prodduces times the
t price at which
w it sellss its output. IIf you producce 1,000
‘Sofft Diapers’ and sell them at $1 a diaper, your totall revenue is $1,000.
$
Thee measuremennt of your firrm's total cosst, however, is more challlenging.
In thhe example given

g above as in Table 2.1,
2 your totaal cost would d depend
on the
t choice off the Techniq que (A to E), which in turrn depends onn the
com
mbination of the
t two inpu uts and the prrices of the innputs. However,
therre is more to this than can
n be seen in the
t first instaance.
Opportunity costs
c
Wheen measuringg costs, econ nomists alwaays use the cooncept of opp portunity
costt. The cost off something is what you giveg up to geet it. The opp portunity
costt of an item refers
r to all th
hose things that
t must be forgone to acquire
a
that item. Whenn economists speak of a fiirm’s cost off production, they
incluude all the opportunity costs of makinng its outputt of goods an nd
servvices. When you
y close do own your bussiness of makking diapers for a
weeek to go on a fishing trip, the amount of income thhat you forgo o by
susppending yourr operation teemporarily would
w be a reeal cost to yo
ou, the
opportunity costt. For econom mists, this coost is as real aas the out-off-pocket
expeenses associaated with you ur fishing acctivities.
Firmms face two types

t of costts: explicit coosts and impllicit costs. Exxplicit
costts are paymennts made by a business too other businnesses or peo ople
outsside of it. Expplicit costs are
a also referrred to as acccounting costts
becaause they incclude all the costs that apppear in the bbusiness acco ounting
recoords. These costs
c include such items as a payments made for wo orkers,
builldings, machinery and maaterials. In coontrast, impllicit costs aree
estim
mates of whaat owners giv ve up by beinng involved with a busin ness – the
opportunity costt of pursuing g this course of action oveer another. Im mplicit
costts relate to thhe resources provided
p by the owners. This distincttion
betwween explicitt and impliciit costs highllights an impportant difference
betwween how ecconomists and accountantts analyse a bbusiness. Eco onomists
studdy how firmss make produ uction and prricing decisioons. Becausee the
deciisions are based on both explicit and implicit costts, economistts
incluude both whhen measurin ng a firm’s coosts, economic costs. By contrast,
accoountants keepp track of thee money thatt flows into aand out of firrms. As a
resuult, they measure the expllicit costs buut often ignorre the impliciit costs.
Thee difference between

b econ
nomists and accountants
a is easy to seee in the
casee of ‘Soft Diaapers’ factorry. When youu give up thee opportunityy to earn
monney as a mannager, your acccountant wiill not count this as a cost of your
diappers businesss. Because no ws out of thee business to pay for
o money flow
this cost, it neveer shows on the
t accountannt’s financiaal statements.. An
econnomist, howeever, will count the forgoone income aas a cost becaause it
willl affect the deecisions you make in youur diaper bussiness. For exxample,
if yoour wage as a manager of a T-shirt prroducing com mpany rises from
f
$100 to $200 peer day, you might
m decide that running your diaper business
96
is too costly and choose to shut down the factory in order to become a
full-time manager.
Economists define as opportunity cost the value of any sacrificed

opportunity that results from some course of action, even if no outright
monetary payment is made. Thus, the economic costs encountered by a
business are all the opportunity costs involved in production and include
both explicit and implicit costs. Therefore, for ‘Soft Diapers,’ the explicit
costs of producing 1,000 diapers per day based on, let us say Technique
A, are $210 – two units of labour ($5 per hour) and 10 units of capital
(priced at $20 an hour of machine work).
The implicit costs consist of two components:

1. The opportunity cost of the capital investment that you have tied
up in this business.
2. The opportunity cost of your own time as the owner manager of
the firm that you have established.
As for the first cost, you might estimate that, rather than making diapers,
you could deposit your $100,000 in a bank account and earn $30 a day.
Another implicit cost would be the wage that you as the owner of the firm
sacrifice by working as the manager of your company. You might
estimate the value of your work as $100, which is what you would earn
by working for someone else. The sum of these two costs ($30 + $100),
or $130, represents the opportunity costs for ‘Soft Diapers’. Therefore,
Economic costs Explicit costs Implicit costs

= +
$340 $210 $130
Distinguishing between relevant and irrelevant cost

In analysing the cost of a particular question, economists recommend that
only those relevant to the decision at hand should be considered. A cost is
deemed relevant if it will be affected by the choice of alternatives being
considered in a decision. Costs not affected by the outcome of a decision
are considered irrelevant. Two commonly used ways to determine which
costs are relevant are the criteria called respectively sunk versus
incremental and the fixed versus variable.
A sunk cost, sometimes referred to as historical cost, is a prior

expenditure that is not affected by any decision concerning a future
course of action. Based on the definition of relevant cost, sunk cost is
clearly irrelevant. The opposite of sunk cost is incremental cost. This is
considered to be relevant because it is defined as a cost associated with
any decision about a future course of action. Fixed cost is the cost that
does not change with the level of question or output. A variable cost is
one that does change with the level of question or output. Fixed cost is
normally, but not always, considered irrelevant, while variable cost is
97
Module 2
conssidered relevvant.
For example, Mother’s Day falls on the weekendw andd the owner of o the
locaal fruits and vegetable
v maarket buys 1000 rose bouqquets for $5 each.
e The
ownner figures thhere is enoug gh local demaand to sell alll 100 at $10 each to
makke a reasonabble profit. Ho owever, the estimate
e turnns out to be wrong.
w
By mid-afternoo
m on, 40 bouqu uets remain unsold.
u Whatt should be done?
d At
this stage, the $55 that was paaid for the floowers is irrellevant. It is a
histoorical or sunnk cost. It can
nnot be retrieeved. A decission to sell thhe rest of
the roses
r at a lowwer price shoould be indeppendent of thhe price paid d for the
bouquets - sunk. In fact, if th he owner muust pay to havve the unsold d
bouquets pickedd up for comp posting, it might
m be worthh giving awaay any
unsoold flowers.
Eco
onomic pro
ofit
Wheen economicc costs are su
ubtracted from
m total revennue, the exceess is
known as econoomic profit.
If thhis gives a neegative figure, the busineess faces a neegative econoomic

proffit, or a loss. The daily ecconomic proffit of ‘Soft DDiapers’ remaains
wheen you have calculated
c to
otal revenue and
a subtracteed economicc costs
fromm it. If 1,000 diapers soldd at a price of $1 each, thhen the total revenue
r
gainned by produucing is $1,00 00 ($1×1,0000). When thee economic costs
c of
$340 are deducted, we get an n economic profit
p of $6660 ($1,000 − $340):
Ecoonomic profiit To
otal revenue Econnomic costs
= -
$660 $1,000 $340
98
Your brother has a plot of land that has three alternative uses: R, S, and T.
The revenue from each use is $5, $6 and $8, respectively. The accounting
cost of each use is zero.
1. The opportunity cost of using the land for use S is —
Study skills
A. $5, the value in use R.
B. $8, the value in use T.
C. $1, the difference in value between use R and S.
D. $2, the difference in value between use T and S.
2. The economic profit of using the land for use S is —

A. -$8, the value in the use T.
B. $8, the value in the use T.
C. -$2, the difference in value between use T and S.
D. $2, the difference in value between use T and S.
3. The local vegetable and fruit vendor can sell as many cantaloupes as
he wishes at the market price of $2 each. Total cost to him of carrying
each cantaloupe is $0.50. He chooses to sell 10 cantaloupes. He is
making —
A. a total economic profit of $15.
B. a total economic profit of $20.
C. a normal profit of $15.
D. a normal profit of $20.
Solutions:
1. B. Opportunity cost is the value of the highest (next-best)
alternative: Use T.
2. C. Economic profit is total revenue (which for Use S is $6) minus
total costs. Accounting costs are zero, but economic opportunity
costs are $8 (the revenue from Use T).
3. A. Total profit is total revenue less total cost. For the vendor,
total revenue is $20.00 and total cost is $5.00. Therefore, the
difference is an economic profit of $15.00.
Time as a factor in the determination of relevant cost

The time period in which a firm’s cost structure is being considered is
very important in determining which costs are relevant to a particular
business decision. In the economic analysis of cost, the time factor is
handled by dividing time periods into two basic types: the short run and
the long run. Remember that this distinction was also used in the analysis
99
Module 2
of suupply and deemand and price elasticityy. In the shoort run, we asssume
therre are certainn resources su uch as land, factory
f spacee, and machiinery that
cannnot be changged within the time periodd allowed. The cost of ussing
thesse resources is i either sunk k or fixed. Thhus, there wiill always bee certain
costts that are irrrelevant to a short-run deccision. Longg-run analysiss
assuumes there iss enough time for manageers to vary thhe costs of uttilising
all their
t resourcees. Consequeently, all longg-run costs aare either inccremental
or variable
v and therefore
t releevant to a paarticular businness decision
n.
Produ
uction in the
t shortt run
Thee previous secction showed d that short run
r is the perriod during which
w
quanntities of onee or more of a business’s inputs cannot be varied. In
mannufacturing, companies
c usually
u cannoot adjust the qquantity of
macchinery they use or the sizze of their faactories on a short notice. In
agriiculture, therre is typically
y an additionnal quantity thhat cannot bee varied
– thhe land availaable for farm
ming. Inputs thhat cannot be adjusted in n the
shorrt run are knoown as fixed d inputs. Inpuuts that can bbe adjusted are
a
known as variabble inputs. Ty ypically, variiable inputs iin the short run
r
incluude the labour and materrials a busineess uses in prroduction. Fo or
exam mple, as the owner of ‘So oft Diapers,’ you are connsidering adju usting
your current prooduction of 1,000 packs (10 diapers per pack) a daay. You
havee already bouught three seewing machinnes and cannnot acquire more m
withhout a considderable delay y. Hence, thee three machiines represen nt a fixed
inpuut for your buusiness in the short run. However,
H yoou can change the
nummber of workkers you emp ploy, so labouur representss a variable innput in
the short run.
Total, average and marg

ginal product
To increase
i prodduction of a certain
c goodd or service, a business must
m
empploy more off all variable inputs includding workerss. The result is a rise
in tootal product, which is thee overall quanntity (Q) of ooutput associated
withh a given workforce. Thee employmennt of labour is a convenient
meaasure of a com mpany’s scale of producttion, since laabour is a varriable
inpuut in making virtually all products. However, busiinesses also use u other
variiable inputs, such as natu ural resourcess or semi-proocessed goodds. Once
agaiin, let us lookk at ‘Soft Diapers’. Say you
y conduct a few experiiments to
see what happenns to total pro oduct for youur business w
when the num mber of
worrkers employyed is changeed but the num mber of sewwing machinees - three
– remains constaant.
Coluumns 1 and 2 of Table 2.2 show thatt as the numbber of workerrs

incrreases, total product
p increeases until thhe fifth workeer is hired. In
n
addiition to total product, twoo other conceepts are impoortant when you are
anallysing produuction in the short
s run. Avverage produuct is the quaantity of
outpput producedd per worker and is foundd by dividingg total producct (Q) by
the quantity of labour (L) em mployed. Marrginal product, in contrasst, is the
extrra output produced when an additionaal worker is hhired. Margin nal
prodduct is calcullated by diviiding the chaange in total pproduct (∆Q) by the
100
change in the amount of labour employed (∆L). (The symbol ∆ is the

Greek capital letter ‘delta,’ which signifies a change in some variable.)
(1)Labour Total (2) (Q/L) (3) Average Product (4) Marginal
Product (L) (Packs of diapers (∆Q/∆L) Product (Q)
Workers per day perday) (Packs of diapers (Packs of
perday) diapersperday))
0 0 0
1 480 480 480
2 1,000 500 520
3 1,350 450 350
4 1,600 400 250
5 1,700 340 100
6 1,650 270 -50
Table 2.2 Production in the short run
Columns three and four of Table 2.2 list the marginal and average
products for ‘Soft Diapers’. When you employ three workers, the
workforce’s average product is 450 packs of diapers per day (1,350
diapers, three workers). If a fourth worker is added, the marginal product
of this worker is 250 packs, which comes from subtracting the old total
product (1,350 packs) from the new total product (1,600 packs), and
dividing the difference by the change in the workforce from three to four:
Total product (Q) 1,350

Average product = = = 450
Number of 3
workers (L)
Change in total
product (∆Q) (1,600 –1,350)
Marginal product = = = 250
Change in (4-3)
workforce (∆L)
Note that marginal product peaks when the second worker is hired and
becomes negative at the same point that total product begins to drop.
Meanwhile, average product peaks at twoworkers.
Diminishing marginal returns

The marginal product values in Table 2.2 reflect a law that applies to
production in the short run. According to the law of diminishing marginal
returns, at some point – as more units of a variable input are added to a
fixed input – the marginal product will start to decrease since the new
units of the variable input (for example, workers) are being added to an
101
Module 2
incrreasingly scaarce fixed inp

put (for exammple, land). F For the law of
o
dim
minishing marrginal returnss, consider what
w would hhappen if you u used a
flow
werpot to groow food. If thhe law of dimminishing maarginal return ns were
falsee, then, as yoou used moree labour, the total producct of food groown in
the flowerpot woould rise at a faster and faster
f rate unntil the world
d’s entire
foodd supply couuld be provided from this single pot. T The absurdity y of this
concclusion sugggests that the law of diminnishing margginal returns must be
corrrect.
The th
hree stagees of pro
oduction
Thee total producct for ‘Soft Diapers’
D is shhown in the ttop graph of Figure
F
2.1, and its margginal productt and averagee product aree shown in thhe
botttom graph. Both
B graphs can
c be divideed into three ranges. In th he bottom
grapph’s first range, marginall product risees as more w
workers are addded.
In thhe top graph’s first rangee, total produuct rises at a hhigher and higher
h
rate, giving the curve
c a posittive slope thaat gets steepeer. During thhe second
rangge, marginal product begins to fall buut is still posiitive. Total product
p in
this second rangge continues to rise but att a lower ratee, so that the curve
becoomes flatter. In the final range,
r margiinal product falls below zero
z and
total product deccreases. Poin nts in this lasst range will never be choosen by
the business.
b
Figu
ure 2.1
Notice that as thhe number off workers inccreases withinn stage I, thee
marrginal producct increases. The first worrker has a m
marginal product of
102
480, whereas the second worker has a marginal product of 520 packs of
diapers. This property is called increasing returns. As the number of
workers increases beyond stage I (stages II and III), the marginal product
decreases (law of diminishing or decreasing returns). The second worker
has a marginal product of 520 diapers, the third worker has a marginal
product of 350 packs, and the fourth worker has a marginal product of
250 packs of diapers. This property is called diminishing marginal
product. As the number of workers increases, additional workers have to
share equipment and work in more crowded conditions. Hence, as more
and more workers are hired, each additional worker contributes less to the
production of diapers. Increasing and diminishing marginal product are
apparent in both figures, depicted in Figure 2.1.
Use the following table to answer the next three questions.

Labour Total Marginal Average
(workers) Product Product Product
Study skills 0 0 — —
1 15 — —
2 32 — —
3 48 — —
4 60 — —
5 — 10 —
6 — — 13
1. Total product, if six workers are employed, is —

A. 70 units of output.
B. 73 units of output.
C. 78 units of output.
D. 86 units of output.
2. Average product, if five workers are employed, is —

A. 10 units of output.
B. 12 units of output.
C. 14 units of output.
D. 15 units of output.
3. Diminishing returns set in with the worker.

A. first
B. second
C. third
D. fourth
103
Module 2
Solu
utions:
1. C. Totall product is average
a produuct times thee number of workers
w
(13 x 6).
2. C. With 4 workers, total
t productt is 60 units. The fifth wo
orker
adds 10 more units to
t make a tottal of 70. Aveerage producct is total
product divided by the
t number of o workers (770/5).
3. C. The marginal
m products of the first, secondd, and third workers
w
respectivvely are 15, 17, and 16. The
T decline bbegins with thet third
worker.
The prroduction
n function
n to the total-cost
t t curve
Firmms incur costts when they buy inputs to t produce thhe goods and d services
that they plan too sell.In thism
module, we will
w examine the link betw ween a
firm
m’s productioon process an nd its total coost. In the shoort run, just as
a
busiinesses use fixed
f and varriable inputs, they face coorresponding g fixed
and variable cossts. Fixed cossts, or total fixed
fi costs, (T
TFC), do nott change
wheen a businesss changes its quantity of output
o since these costs relate
r to
fixeed inputs suchh as machineery and land.. Variable coosts or total variable
v
costts, (TVC) in contrast, relaate to variablle inputs, whhich change when w a
busiiness adjusts the quantity y produced. TheT most impportant variaable costs
are wages
w and payments for materials ussed in producction, whereaas the
typiical fixed cosst is the cost of machinerry. Total costt (TC) is the sum of
all inputs, both fixed
f and varriable, and iss found by addding fixed anda
variiable costs att each quantity of output.
Cossts and produuction are two o sides of thee same coin. A firm’s tottal cost
refleects its produuction function, whereas the firm’s suupply curve,
disccussed in the last chapter,, is a reflectioon of its costts relationshiips. To
see how these reelated measu ures are derivved, considerr the examplee in
Tab ble 2.3. This table presents cost data ono your neighhbour – the T-shirt
T
prodducer. From data on a firm’s total cosst, we can deerive several related
meaasures of cost which will turn out to be b useful wheen we analysse
prodduction and pricing
p decissions in futurre chapters.
Youur neighbour’s total cost can

c be divideed into two ttypes. The fix xed
costts, which do not vary with the quantitty of output pproduced, are
incuurred even iff the firm pro
oduces nothinng at all. Youur neighbourr’s fixed
costts include thee rent she pay
ys because thhis cost is the same regarrdless of
howw many T-shiirts she produ uces. Similarrly, if she neeeds to hire a full-
timee bookkeeperr to pay billss, regardless of the quantiity of T-shirtts
prodduced, the boookkeeper’s salary is a fixed cost. Thhe second collumn in
Tabble 2.3 showss your neighb bour’s fixed cost, which in this exam mple is
$100.
Her variable cossts, which chhange as the firm

f alters thhe quantity of output
prodduced, includde the cost of materials suuch as fabricc, thread, ink
k, and
104
labour. The more T-shirts she makes the more material she needs to buy.
The third column of the table shows the variable cost. The variable cost is
zero if she produces nothing, $56 if she produces one bundle (each
bundle consists of 10 units) of T- shirts and $106 if she produces two
units and so on.
A firm’s total cost is the sum of fixed and variable costs. In Table 2.3,
the total cost in the fourth column equals fixed cost plus total variable
cost. While marginal cost is based on changes in a business’s total
product, per-unit costs are expressed in terms of a single level of output.
These costs are related to a business’s fixed costs, variable costs and total
costs. Hence, there are three separate types of per-unit costs: average
fixed cost, average variable cost and average cost.
105
Module 2
(11) (2) (3) (4) (55) (6) (7) (8)

Quaantity Total Total Averrage Averagee Average
Total Marginal
of Ouutput Fixed Variable Fixeed Variablee Total
Cost Cost
[Q] (Tens Cost Cost Cost Cost Cost
of units) [TC] [MC]
[TFC] [TVC] [AF
FC] [AVC] [ATC]
0 100 0 100
1 100 56 156 1000.00 56.000 156.00 56
2 100 106 206 500.00 53.000 103.00 50
3 100 154 254 33.33 51.333 84.67 48
4 100 205 305 25.00 51.255 76.25 51
5 100 263 363 200.00 52.600 72.60 58
6 100 332 432 166.67 55.333 72.00 69
7 100 416 516 144.29 59.422 73.71 84
8 100 519 619 122.50 64.877 77.37 103
9 100 646 746 11.11 71.777 82.88 127
10 100 801 901 100.00 80.100 90.10 155
Tab
ble 2.3 Meassures of total and averagge cost
• Averagee fixed cost (AFC)
( is the fixed cost peer unit of outtput,
which you
y derive by y dividing thee business’s fixed costs (TFC)
( by
its total product (Q)..
• Similarlly, average variable
v cost (AVC) is thee variable co
ost per
unit of output,
o which
h you derive by dividing the businesss’s
variablee costs (TVCC) by total prooduct (Q).
• The aveerage fixed, average
a variaable, and aveerage total co
osts are
found inn columns fiv
ve, six, and seven.
s
Wheen three bundles are prod duced, the buusiness’s fixeed costs of $100 are
diviided by the tootal product, giving an avverage fixed cost of $33.33 per
bundle. Similarlly, the $254 variable
v costts at this leveel of productiion are
diviided by threee bundles of T-shirts,
T resuulting in an aaverage variaable cost
of $51.33.
$ Let us
u observe thee calculationns:
106
Fixed costs (TFC) total product

Average fixed cost (AFC) =
(Q)
$154
$33.33 per batch (of 10 shirts) =
3 shirts
Variable costs (TVC) total product

Average variable cost (AVC) =
(Q)
$254
$51.33 per batch (of 10 shirts) =
three shirts
Average total cost (ATC) (or simply ‘average cost’) is the business’s total
cost per unit of output.
Average cost is the sum of average fixed cost and average variable cost at
each quantity of output. Therefore, for example, in column seven, when
the T-shirt maker produces three bundles (units) of T-shirts, the average
fixed cost is $33.33 and the average variable cost is $51.33, giving an
average total cost of $84.66.
Average total Average fixed Average variable

cost (AC) cost (AFC) cost (AVC)
= +
84.66 33.33 51.33
Although average total cost tells us the cost of the typical unit, it does not
tell us how much total cost will change as the firm alters its level of
production. The last column in Table 2.3 shows the amount that total cost
rises when the firm increases production by one unit of output. This
number is the marginal cost. For example, if your neighbour increases
production from two to three (units) of T-shirts, total cost rises from $206
to $254, so the marginal cost of the third (unit) of T-shirts is $48.
(Change in total cost) ∆TC 305-254

MC = = = = 51
(Change in quantity) ∆Q 4-3
As will be even clearer in the next chapter, your neighbour will find the
concepts of average total cost and marginal cost extremely useful when
deciding how many T-shirts to produce. Keep in mind, however, that
these concepts do not actually give your neighbour new information
about her costs of production. Instead, the average total cost and the
marginal cost express, information that is already contained in her firm’s
total cost. Average total cost tells us the cost of a typical unit of output if
107
Module 2
total cost is divided evenly over

o all the units
u produceed. Marginal cost tells
us thhe increase in total cost that
t arises froom producinng an addition nal unit
of output.
o
Cost curves an
nd their shapes
s
Grapphs of the coost data in Taable 2.3 are presented
p in Figure 2.2 and
a
enabble us to see the pattern of
o change of the differentt measures of cost as
outpput increasess. They also help
h us to vissualise the im mpact that marginal
m
costt has on the average
a variaable and averrage total costs. Using eitther the
dataa in Table 2.3 or the grapphs in Figuree 2.2, we cann observe thee
folloowing about marginal co ost’s impact on
o average vvariable cost:
Figu
ure 2.2
In previous
p studdy sections, graphs
g of suppply and demmand proved useful
wheen you were analysing thee behaviour of markets. S Similarly, grraphs of
averrage and marrginal cost heelp you analyyse the behavviour of firm ms.
Figuure 2.2 graphhs your neig ghbour’s costts using the ddata from Taable 2.3.
a measures the quantitty the firm prroduces, and the
Thee horizontal axis
verttical axis meaasures margiinal and averrage costs. Thhe graph sho ows four
curvves: average total cost (AATC), averagge fixed cost (AFC), averaage
variiable cost (AV VC) and marrginal cost (MMC).
Thee cost curves shown here for your neigghbour’s T-sshirt compan
ny have
som
me features thhat are comm
mon to the cost curves of mmany firms in
i the
econnomy. Let uss examine th
hree features in particular:
• The shaape of margin
nal cost.
• The shaape of averag
ge total cost.
• The relaationship between marginnal and averaage total costt.
Wheen no shirts are

a produced d, the denom
minator of the average fixeed cost
form
mula is zero, meaning thaat average fixxed cost is ann infinitely high
h
nummber. Averagge fixed cost then falls as the businesss’s total prodduct
incrreases, since the denominnator in the formula
fo rises.. Therefore, the
t
averrage fixed coost curve hass a negative (downward)
( slope which becomes
flattter as output rises.
108
Your neighbour’s average total cost curve is U-shaped (saucer-shaped).

To understand why this is so, remember that average total cost is the sum
of average fixed cost and average variable cost. Average fixed cost
always declines as output rises because the fixed cost is spreading over a
larger number of units. Average variable cost typically rises as output
increases because of diminishing marginal product. Average total cost
reflects the shapes of both average fixed cost and average variable cost.
At very low levels of output, such as one or two bundles per hour,
average total cost is high because the fixed cost is spread over only a few
units. Average total cost then declines as output increases until the firm’s
output reaches six bundles of T-shirts per hour, when average total cost
falls to $72 per bundle. When the firm produces more than six bundles,
average total cost starts rising again because the average variable cost
rises substantially.
The bottom of the U-shape occurs at the quantity that minimises average
total cost. This quantity is sometimes called the minimum efficient scale
of the firm. For your neighbour’s company, the efficient scale is six
bundles. If she produces more or less than this amount, her average total
cost rises above the minimum of $72.
Now that you have scrutinised the impact that marginal cost has on
average variable and average total cost, you may wonder about the
behaviour of marginal cost itself. Why does economic analysis assume
that marginal cost decreases and then, at some point, starts to increase as
more of a good or service is produced? To answer this question, we need
to review a concept referred to in economic theory as ‘the returns to a
variable input’.
In the short run, a firm must work with a certain fixed quantity of
resources or inputs such as land, factory or office space, machinery and
equipment. As additional amounts of variable inputs such as labour hours
and raw materials are combined with the fixed inputs, more output is
produced. At first, additional units of the variable inputs are assumed to
result in increasing amounts of additional output (also called marginal
product). However, eventually, the additional inputs are expected to
result in decreasing or diminishing marginal product. We can see this
with a simple numerical example.
Suppose one person, working with a fixed amount of factory space and
machinery, produces 100 units of output. Now suppose further that this
person is joined by another worker. The two of them working together as
a team produce 250 units of output. From the standpoint of the additional
output contributed by each worker, the marginal product of the first
worker is 100 and the marginal product of the second worker is 150. This
is an example of increasing returns to the variable input, labour. As the
two workers are joined by still more people, sustained effort to work as a
team may cause the marginal product of the additional workers to
continue increasing.
At some point, however, the marginal product resulting from the

additional workers will start to diminish because of the limits imposed by
109
Module 2
the fixed inputs..
To explain
e the relationship between
b returrns to variabble input and
marrginal cost, we w have exten nded the exaample in the pprevious paragraph
intoo the schedulee of numberss shown in Table
T 2.3. In this examplee, we
assuume that laboour is the onlly variable innput in this eexample, and d the firm
payss W (Wage rate) r per houur to employ each workerr. Thus, the wage
w rate
is, inn fact, the chhange in total variable coost if one worrk hour is hirred.
How wever, when the firm hirees ∆L workers, total variaable cost is (Wage(
rate × ∆L). Recaall that the ch hange in outpput resulting from the additional
worrker is each person's
p marg ginal productt. Therefore,, we can say that:
C
∆TVC Waage rate × ∆L Wage rate Wage
W rate
MC
C = = = =
∆Q ∆Q ∆Q/∆
∆L MPL
Theerefore the reelationship beetween margginal cost andd return to th

he
variiable input caan be presentted as follow
ws:
1. When a firm experieences increassing returns tto its variable input
(when itts marginal product
p increeases), its maarginal cost will
w
decreasee.
2. When a firm experieences decreasing (diminishing) return ns to its
variablee input (whenn a firm’s maarginal produuct decreasess), its
marginaal cost will in
ncrease.
3. When a firm experieences constannt returns to a variable innput
(when itts marginal product
p neithher increases nor decreasees), its
marginaal cost will be constant ovver the rangee of output prroduced.
Shift in short-rrun cost curves

c
Thee cost curves shift with chhanges in tecchnology or cchanges in reesource
ological leveel that allowss more output to be
pricces. An increaase in techno
prodduced from the
t same inpu uts or resourrces moves thhe cost curvees
dowwnward. If thhe technology y requires moore capital, a fixed input,, then the
averrage total cosst curve movves upward ata low levels of output annd
dowwnward at higgher levels ofo output.
On the
t other hannd, a decreasse in the pricee of the fixedd factor of
prodduction moves the averag ge fixed costts (AFC) andd average totaal cost
(AT
TC) curves doownward butt leaves the average
a variaable cost (AV
VC) and
marrginal cost (MMC) curves unchanged.
u A decrease inn the price off a
variiable factor of
o production
n moves the AVC,
A ATC, and MC currves
dow
wnward but leeaves the AF FC curve rem main fixed orr unchanged.
110
Cost curves shift if —

a. technology changes
b. the prices of factors of production change
Study skills c. marginal product changes.
A. only a
B. only b
C. a and b
D. a and c
Solution:
Discuss your answer with your tutor.
Production in the long run

The long run is the period in which quantities of all resources used in an
industry can be adjusted. So, even those inputs that had been fixed in the
short run – such as machinery, buildings, and cultivated land – can be
adjusted in the long run. Because all inputs can vary in the long run, the
law of diminishing marginal returns no longer has the same importance as
in the short run. In this section, we review the various ways a firm can
take advantage of this flexibility to reduce its costs in the long run.
Economies and diseconomies of scale

The term ‘economies of scale’ is defined as the decrease in the unit cost
of production as a firm increases all its inputs of production. This
phenomenon is illustrated in Figure 2.3.
In this figure, we see that the average total cost curve, labelled ‘Plant 1,’
represents a certain amount of capacity. At its most efficient point, a firm
with this plant capacity is able to produce Q1 units of output at a unit cost
of ATC1. ‘Plant 2’ represents a greater production capacity because it is
positioned to the right of Plant 1. In addition, it is located on a lower level
than Plant 1, signifying that over a certain range of output, the larger
plant is able to produce greater amounts of output at a lower average cost
than the smaller one, i.e., the unit cost of ATC2.
111
Module 2
Figu
ure 2.3
Sommetimes ‘economies of sccale’ is used interchangeaably with thee term

incrreasing returrns to scale. Increasing
I reeturns to scalle is a long-term
2
phennomenon inndicating thatt the firm’s output
o growss at a rate thaat is
fasteer than the growth
g rates of
o its inputs. For examplee, a 100 per centc
incrrease in inputts results in more
m than 1000 per cent inncrease in ou utput, say
200 per cent. In this case, as the firm exppands, the peer-unit cost drops.
d
Thee following are the main causes
c of ecoonomies of scale.
Divvision of laabour and specialisa

s ation
As Adam
A Smithh illustrated more
m than tw
wo centuries aago, increasees in the
scalle of production and work ker specialisaation can go hand in hand.
Perfforming feweer tasks allow ws workers tot become m more efficient at their
jobss. As a resultt, Smith conccluded that quantities
q of ooutput tend tot rise
morre quickly thaan the number of workerrs producing them. The im mpact of
the division of laabour is just as prevalentt today in labbour-intensivve
prodduction. For example, if a very small restaurant w where workerrs do
everrything expaands, then wo orkers can beegin to speciaalise in eitheer food
prepparation or seervice, thus making
m both sets of workkers more effficient in
the tasks
t they doo.
Speecialised cap
pital
In most
m manufaccturing indusstries, a greatter scale of pproduction iss
assoociated with the use of sp pecialised maachinery. If a car manufaacturer
raisees the quantiity of all its inputs,
i for exxample, capittal equipmen
nt can
havee more speciialised functiions, so that it performs ffewer tasks more
m
efficciently than before.
b
Not every firm benefits

b from
m all these facctors when itt increases itts scale
of production.
p F example:
For
2
Noot to be confuused with retu
urns to variaable input, whhich is a short-term
phennomenon.
112
• Firms that have a high level of debt will usually not be able to
borrow at the lowest possible interest rate.
• Size may not always offer the firm a cost advantage. Firms that
are very large may become bureaucratic and inflexible, with
management coordination and control problems.
• Oversized firms experience a disproportionate increase in staff
and indirect labour.
The resulting increase in these types of cost may cause the average total
cost to rise.
These are reasons for diseconomies of scale, or decreasing returns.

Decreasing returns occur when a business expands inputs to a product’s
production by a certain percentage but sees output rise by a smaller
percentage. For example, a 100 per cent expansion in all inputs may lead
to its output rising by only 75 per cent. In terms of Figure 2.3, this can
expect the ATC associated with bigger plants to shift up and to the right.
Figure 2.4 shows how short-run and long run costs are related. The long-
run average-total-cost curve is a much flatter, saucer-shaped curve than
the short-run average-total-cost curve. In addition, all the short-run curves
lie on or above the long-run curve. These properties arise because of the
greater flexibility firms have in the long run. In essence, in the long run, a
firm gets to choose which short-run curve it wants to use. However, in the
short run, it has to use whatever short-run curve it chose in the past.
Figure 2.4 also shows a long-run average cost curve reflecting both
economies and diseconomies of scale as well as constant returns to scale.
When long-run average total cost declines as output increases, there are
said to be economies of scale. When long-run average total cost rises as
output increases, there are said to be diseconomies of scale. When long-
run average total cost does not vary with the level of output, there are said
to be constant returns to scale.
Figure 2.4
Expressing this differently, assume that our firm (say, a car-making
113
Module 2
commpany) expannds its assem mbly plant thrree times. Eaach time, it faaces a
diffe
ferent short-ruun average cost
c curve forr each plant size. With eaach
expaansion of thee plant, the cuurve shifts too the right, ddemonstrating g the
effeects of the inccreased outpuut. When thee plant is firsst expanded, the
shorrt-run averagge cost curvee falls from ATC
A 1 to ATC C2. This shiftt results
fromm economiess of scale or increasing
i reeturns to scalle. Remembeer that
averrage cost is found
f by diviiding total coost by the quuantity of outtput.
With economiess of scale, ou utput rises moore rapidly thhan the total cost of
inpuuts, so that avverage cost falls
f as the sccale of produuction expand ds.
With the secondd plant expan nsion, the shiift of the shorrt-run averag
ge cost
curvve (from ATC C2 to ATC3) reflects constant returns to scale. Ou utput and
the total
t costs off inputs rise at
a the same rate
r when thee plant is exp panded
this second timee, so the averrage cost curvve moves hoorizontally ass the
outpput of cars rises. With thee final plant expansion,
e thhe company’’s short-
run average costt curve not only shifts to the right butt also rises (ffrom
ATC C3 to ATC4).. This shift reeflects disecoonomies of sscale. Since thet
plannt’s output iss rising less rapidly
r than the
t total costt of input cossts, the
averrage cost currve rises as th he productionn of cars conntinues to inccrease.
Connstant returnss to scale aree what you might

m expect – the middle of the
teeteer-totter haviing at its hig
gh end, econoomies of scalle (increasing
g returns
to sccale) and at its
i low end, diseconomie
d es of scale (deecreasing retturns to
scalle). Constant returns to sccale usually result
r when mmaking moree of an
item
m requires reppeating exactly the same tasks used too produce prrevious
I objective terms, constant returns too scale occurr in a
unitts of output. In
busiiness that exppands inputss a given perccentage and sees output rise
r by
the same percenntage. The flo owing table, Table 2.4 suummarises th he causes
of economies off scale and diiseconomies of scale.
R
Reasons for ecconomies of sccale R
Reasons for diiseconomies of
o scale
• Speecialisation in thhe use of labour and • Disproportionate rise in transporrtation

cappital. coosts.
• Indiivisible nature of
o many types of
o • Inpput market impeerfections (e.g., wage
cappital equipment.. rattes driven up).
• Prooductive capacitty of capital equuipment • Maanagement cooordination and control
c
risees faster than puurchase price. prooblems.
• Ecoonomies in mainntaining inventoory of • Disproportionate rise in staff andd indirect
replacement parts and maintenannce labbour.
personnel.
• Discounts from bulk purchases.
• Low
wer cost of raising capital funds.
• Sprreading of prom
motional and ressearch-
andd-development costs.
• Mannagement efficiiencies (line and staff).
Tab
ble 2.4
114
Economies of scope
In the long run, it is also possible for managers to identify ways to take
advantage of economies of scope. This cost-saving phenomenon occurs
when it is possible to produce two or more products together at a lower
per-unit cost than for each product separately. A key factor in this form of
cost savings is the sharing of a company’s fixed cost by multiple
products. For example, certain electronic stores that normally sell TVs,
VCRs, DVD players and computers are now selling CDs, videos, DVDs
etc. These latter products are displayed on racks that occupy otherwise
unused floor space in the stores. The use of this retail establishment’s
excess capacity in this manner reduces the average total cost of selling
each product.
Another way that a company can utilise economies of scope is to produce

goods or services that require similar skills and experience. For example,
when Pepsico expanded into the snack and fast-food business, it was able
to utilise its background in one type of fast-moving consumer item (soft
drinks) to another (chips, tacos and fried chicken). The product
development, channels of distribution and marketing know-how are very
similar in these two product groups.
The learning curve

As pictured in Figure 2.5, the learning curve shows that a firm’s unit cost
decreases as its total cumulative output increases. Its rationale is that you
improve with practice. Over the long run, as a firm produces more of a
good or service, its workers are expected to get better at what they are
doing. This increase in labour productivity will then decrease the unit
cost of production. But other people besides the direct labour involved in
the production process are also expected to improve with practice. For
example, researchers may find less-costly substitutes for raw materials
currently used; engineers may develop more efficient production
processes or product designs.
Figure 2.5
The learning curve has played an important part in the strategic approach
115
Module 2
calleed learning-ccurve pricing g. This approoach advocattes that a firm

m should
set its
i price at a relatively low level to stiimulate dem mand, even th hough
therre is the possibility that itt will earn minimal profitt or even incu
ur a loss
at thhe outset. Thhe greater dem mand will acccelerate the learning effeects that
accoompany the higher
h accummulated volum me of production. As thee
commpany’s costss are broughtt down the leearning curvee, the compaany will
startt to become profitable.
p
Break-even anaalysis
Whaat is to be doone about tho ose costs thatt are not relevant to a deccision?
Afteer all, even iff they are ign nored, they must
m still be ppaid for. How wever,
this,, in fact, is thhe logic of deesignating a cost as irreleevant. By deffinition,
an irrrelevant cosst is one that must be incuurred, regarddless of the
alterrnative seleccted by the deecision makeer. The questtion of how this t cost
is reecovered is a separate issue altogetherr. To understtand this asp pect of
the problem,
p wee can turn to a commonlyy used techniqque called brreak-
evenn analysis.
Breaak-even anallysis is perhaaps the most widely usedd application of the

conccept of relevvant cost. You u will find innformation oon this subjecct in
books on finance, accounting g and marketting as well aas economiccs. This
anallytical techniique addresses the basic question:
q “HHow many un nits of a
partticular produuct does a com mpany have to sell to covver all its cossts of
prodduction: that is, to 'break even?” Anoother name foor break-even n
anallysis is cost-vvolume-profi T label desscribes the break-
fit analysis. This
evenn problem more
m explicitly. That is, giiven the commpany’s fixed d and
variiable cost, hoow much volu ume does it have
h to sell tto break even
n?
Morreover, once it passes thee break-even point and beecomes profiitable,
w much profit will it earn as its volum
how me increases??
Supppose your prrofessor deciides to open a seafood stoore. How maany

kiloograms of seaafood per mo onth must he sell to breakk even? To answer
this,, we first divvide his montthly costs intto their fixedd and variablee
commponents. Fixxed cost is prresented as a total figure,, while the vaariable
costt is shown onn a per-unit basis.
b Variabble cost per uunit is also referred to
as average
a variaable cost (AV
VC):
Variable C
Cost per Unit
Total Fixxed Cost
(Average Variable Cost or AVC)
Rent $ 1,200 Averagee wholesale price peer kilogram of

seafood $ 3.00
Utilitiees $ 400
Wagees $ 2,350
Interest payment on loann $ 1,500
Insuraance $ 400
Misceellaneous $ 150
Total $ 6,000
Tab
ble 2.5Month
hly cost of operating
o a seafood
s storre
116
To find the break-even point, we use the following equation:

TFC
QBE =
P – AVC
Where QBE= The break-even quantity of product sold
TFC = Total fixed cost
P = Selling price of the product
AVC= Average variable cost of the product
P – AVC= ‘Contribution margin’ per unit of product sold
that must be incurred, regardless of the alternative selected by the

decision maker. The question of how this cost is recovered is a separate
issue altogether. To understand this aspect of the problem, we turn to
break-even analysis.
Figure 2.6
The logic of break-even analysis is very straightforward. The amount by

which the selling price exceeds the average variable cost is called the
‘contribution margin’ per unit of product sold. When the amount of
product sold reaches the point where the total contribution margin covers
all the fixed costs of a product, the firm breaks even. The break-even
concept can also be shown graphically. In Figure 2.6, the break-even
point occurs when the firm’s total cost line crosses the total revenue line.
Although our example is quite simple, we do not want to imply that

break-even analysis applies only to small and uncomplicated business
operations. To be sure, larger and more complex businesses might have a
more difficult time dividing their costs into fixed and variable
components, particularly when fixed and variable costs have to be
determined for many different products. But no matter how complicated
117
Module 2
the situation, theere still remaains the basicc concept of generating enough
salees so that the contributionn margin covvers fixed cosst.
For the total reveenue TR = 32.5Q and tottal costs TC = 120 +12.5Q where
Q reepresents thoousands of un
nits, determinne the break--even level of
o output
as well
w as the coontribution margin.
m
S
Study skills Solu
ution:
Setting TR
R =TC, Q = 6.
6 Contributtion marginn = P- AVC = 32.5
– 12.5 = 20.
Hint: TC = TFC (= 120) + TVC (=
( 12.5Q).
Lim
mitations of
o break-evven analysis
Thiss review of break-even
b annalysis shoulld give you a good idea of o how
the knowledge
k o a firm’s fix
of xed and variaable costs caan help in thee making
of certain busineess decisionss or in the annalysis of parrticular
mannufacturing or o marketing strategies. However,
H as uuseful as thiss
techhnique can bee, it is still su
ubject to several shortcom mings. First, break-
evenn analysis seelects only on ne price for a particular pproduct and then
t
procceeds to deteermine how much m a firm has to sell att this price to
o break
evenn. In order too consider the possibility of different amounts dem manded
by consumers
c att different prices (the pricce elasticity oof demand), a whole
scheedule of prices and break k-even pointss would havee to be constrructed. In
otheer words, breeak-even anaalysis determ mines how muuch a firm wiith a
giveen price and cost structurre needs to seell in order too break even n.
How wever, it does not providee any indicattion of how m many units itt will
actuually sell. Seccond and mo ore importantt, this analyssis assumes th hat a
firm
m’s average variable
v cost is constant. In
I certain cirrcumstances,, it is
quitte possible foor a firm’s av verage costs to either deccrease or incrrease as
morre of a good or o service is produced. To T explain whhy, the next studys
secttion guides you
y through the t economicc analysis off short-run co ost.
Activvity 2.1
Whyy are many firms
f likely to
o experiencee economies of scale up to
t a
certaain size and the diseconoomies of scalle after somee point beyon
nd that?
Activity
118
Market Structure
Introduction
Terms such as ‘monopoly’ and, less often, ‘oligopoly’ appear in
thoughtful discussions of business and global economics and you
probably have working definitions of these words in your vocabulary.
However, you may not know a great deal about the economic behaviour
that distinguishes one of these market types from another, nor how these
and other classic market models shed light on the types of pricing or
production decisions that confront you at work. The purpose of this study
section is to acquaint you more closely with these predictive models. The
practice you gain in applying their principles will give you a perspective
on pricing, market entry, market departure, implicit collusion and other
decisions made by firms in today’s business world.
Market structure
Traditional price theory delineates four basic market forms:
1. Pure competition.
2. Monopolistic competition.
3. Oligopoly.
4. Monopoly.
Pure competition consists of many firms producing identical products in

an environment of full information – all firms know where to buy the
cheapest inputs and all consumers know where to buy the cheapest
products. Firms operating in pure competition are called price takers
because the price of their product is determined by the market forces of
demand and supply. Excess demand for the product will drive the market
price up and excess supply will drive the market price down. Since all
firms are selling exactly the same product and consumers have full
information about all firms’ prices, a firm will sell nothing if it raises its
price above the market price. Conversely, the firm has no incentive to
reduce its price below the market price since it is small relative to the size
of the market and can sell all that it wants to at the market price.
The other three market forms are characterised by product differentiation

and by an environment of incomplete information. In fact, lack of
information may be one of the bases for consumers’ differentiating
between the products of rival suppliers.
1. Monopolistic competition consists of many firms with slightly
differentiated products.
2. Oligopoly consists of a relatively small number of firms whose
products are typically differentiated from each other through
some combination of product design, promotional efforts and
place of sale.
119
Module 2
3. Monopooly consists of o a single seeller of a product that hass no

close suubstitutes; thu
us the producct is highly ddifferentiated
d from
the prodducts of all other firms.
Firmms operating in monopoliistic competiition, oligopooly and monopoly

are called
c price makers becaause they cann adjust the pprice of theirr product
up or
o down to puursue their objectives.
o Inn monopolistiic competitio
on and
oliggopoly, the firm’s ability to set prices derives from m the differen
ntiation
of itts product. Each
E firm can
n raise its pricce to some eextent withou
ut losing
all its customerss, since the reemaining cusstomers belieeve that the product
p
is worth
w g asked. In a monopoly, the firm can set its
the extrra price being
ownn price becauuse there are no direct com mpetitors.
Key asssumptio
ons used in the miicroeconomic theory of thee firm
Theere are two keey assumptio ons used in thhe economicc theory of firrms that
you should revieew before loo oking at priccing and outpput decision-making
in thhe four typess of markets.
1. The firmm’s primary objective
o is the
t short-runn maximisatio on of
profit. This
T may not, however, be b the case foor oligopoly, where
time horrizons typicaally extend beyond the shhort run. High h short-
run proffits may indu
uce the entry of new com mpetitors to caause a
more coompetitive market
m for thee firms later iin the plannin
ng
period.
2. The oppportunity cosst of producinng a particulaar good or seervice is
includedd in the cost of doing bussiness – econnomics costs..
In analysing
a a fiirm’s pursuitt of short-runn profit, the eeconomic theeory of
gers must adddress three bbasic questions:
the firm posits thhat its manag
1. Should our company y be in this business?
b In oother words, should
it be selling this partticular produuct at all?
2. If so, hoow much sho
ould we prodduce?
3. And if we o set the pricce, what pricee should we charge?
w are able to
Thoose firms opeerating in perrfectly compeetitive markeets cannot seet their

ownn price. Thereefore, this qu
uestion does not apply too them.
The ou
utput deccision of a firm in a perfecttly compeetitive maarket
In economic anaalysis, the typ pe of markett in which a ffirm is comppeting
dictates its abilitty to determiine its price. In the extrem
me case of peerfect
com
mpetition, thee managers of o a firm havee no power too set price. They
T
musst sell their product at thee price determ mined by thee market forcces of
suppply and demaand and can only decide how much ooutput to prod duce.
A perfectly com mpetitive marrket consists of numerouss sellers, andd no one

firm
m can set the price by con ntrolling the supply
s of output. At the opposite
o
extrreme, a sellerr without com
mpetition couuld control thhe price by keeping
k
120
the supply at a level relative to demand so that it would support the

desired price.
In a perfectly competitive market, there is no way sellers can exercise any

product differentiation. They all sell a standardised product. Any attempt
by a seller to raise the price would simply result in a complete loss of
customers to other suppliers because all are selling the same product.
To calculate potential profits, firms must combine their cost analyses with
information on potential revenues from sales. The goal of a firm is to
maximise economic profit. As you remember, normal profit is the return
that a firm’s owner could obtain in the best alternative business.
Economic profit is a profit that a firm earns in excess of normal profit. If
a firm cannot sell its product for more than its cost to produce, it will not
be able to sustain. However, if the market gives the firm a price that is
significantly greater than the cost it incurs to produce one unit of its
product, the firm may have an incentive to expand its output. Large
profits might also attract new competitors into the market.
Figure 2.7 shows a typical firm in this industry. The price $10 is
determined by the interaction of many suppliers and demanders. The firm
can sell its products only at this price, no less and no more. If the firm
chooses to charge a higher price, given that its rivals are selling the same
product, it will lose all its customers. The firm should not sell its product
at a lower price, either; this strategy would have made sense if the firm
had some of the capacity and the size to meet the needs of the customers
lured from other firms, but it does not. These perfectly competitive firms
are small; selling for less is not practical. Therefore, a perfectly
competitive firm faces a demand curve that is horizontal at the market
equilibrium price. In other words, the demand is perfectly elastic.
Figure 2.7
Table 2.6 supports this analysis. Suppose your ‘Soft Diaper’ business,
discussed in section 2.1, was so successful that you decided to use your
experience to expand your product line into adult clothing –men’s shirts.
Column 1 in the table shows different quantities of shirts sold by this new
business that is named ‘Men’s Shirt Company’. For a price taker – a
perfectly competitive firm – the quantity sold varies while the price
remains constant ($10 in this example). Total revenue in column three is
121
Module 2
obtaained by mulltiplying pricce by quantityy. Average rrevenue in coolumn

fourr is obtained by dividing total revenuee by the quanntity of outpuut sold.
Thee most imporrtant informaation here is given
g by marrginal revenu ue, which
is thhe change in total revenue caused by a one-unit chhange in quaantity.
For example, whhen output in ncreases from
m four to fivee, total reven
nue
incrreases from $40
$ to $50, so the marginnal revenue iss $10 ($50 –$40).
–
As also
a illustrateed in the diag gram, the firm
m’s equal avverage and marginal
m
prodducts are in turn
t equal to the market price:
p MR = AR = P. Theerefore,
the firm demandd curve is alsso its averagee revenue currve (AR). Bu ut, in this
casee and only inn this case, th
he firm’s demmand curve iss also its MR
R curve.
(1)) Quantity (2) Price (3) Total (4) Averaage (5) Marginal
Sold
d (Q) Shirts (P) per Revenue (TR Revenue ((AR = Reveenue MR =
per day shirt = P×Q) TR/Q)) ∆TR/∆Q
∆
4 $10 $400 $10
5 $10 $500 $10 $10
6 $10 $600 $10 $10
7 $10 $700 $10 $10
Tab
ble 2.6 Men’’s shirt comp
pany
Outtput decisions: Shorrt-run proffit maximissation

Youu are now in a position to o put costs annd revenue toogether to fin nd the
outpput at which profit is max ximised. As discussed
d eaarlier, the sho
ort run is
a peeriod of time in which eacch firm facess a constraintt: its fixed in nput
(cappital) or its giiven plant. Furthermore,
F the number of the firms in the
induustry is also fixed.
f But many
m things can change inn the short ru un, and
the firm must bee prepared to o react to them
m: e.g., its prrice pattern over
o the
courrse of the year.
Loook carefully ata the Figuree 2.8. Once again

a we havve the whole industry
ngle represenntative firm oon the right. Again
(maarket) on the left and a sin
the current markket price is $10. To restatte the basic qquestions intrroduced
at thhe outset of this
t section – should this firm be in buusiness and if i so,
howw much of thiis product shhould the firm
m produce? T To answer thhese
quesstions and otthers, one needs to have the
t firm’s coost functions.. The two
impportant curves are the marrginal cost (MMC) and aveerage total co ost
(ATTC) curve.
Youu can answerr ‘How much h to produce??’ by recallinng the short-rrun profit
maxximising conndition, MR = MC. As ouutput increasees, MR is con nstant
becaause the pricce is constantt (price takerr) whereas, M
MC eventuallly
incrreases. If the additional profit associatted with anoother unit of output
o
(MR R) exceeds thhe additionall costs associiated with thiis unit of outtput
(MC C) – that is, MR
M > MC th hen profit inccreases. Conttrarily, if MRR < MC,
thenn the extra reevenue from selling an addditional unitt will fall sho
ort of the
extrra cost incurrred to producce it and proffit decreases.. Therefore, if MR =
MCC, profit is maaximised.
122
Figure 2.8
Now let us extend Table 2.6. In the extended table, Table 2.7, which
retains three columns, Q, TR, and MR — there are more observations and
also three new columns: Total Cost (TC), Marginal Cost (MC), and
Economic Profit (TR-TC) as follows.
(1) (2) (3) (4) (5) (6) (7) (8)
Quantity Total Average Marginal Marginal Economic
Price (P) Revenue Revenue Revenue Total
Sold (Q) Cost (MC) Profit(TR–
per shirt (TR) (AR) (MR) Cost (TC)
Shirts (∆TC/∆Q) TC)
(P×Q) (TR/Q) (∆TR/∆Q)
4 $10 $40 $4 $20 $20

$10 $3
5 $10 $50 $5 $23 $27
$10 $5
6 $10 $60 $6 $28 $32
$10 $8
7 $10 $70 $7 $36 $34
$10 $13
8 $10 $80 $8 $49 $31
$10 $20
9 $10 $90 $9 $69 $21
Table 2.7 Men’s shirt company
Table 2.7 illustrates how as the company increases its output from four to
five and to six and so on, marginal revenue remains at $10 while
marginal cost increases from $3 for the fifth unit to $5 and all the way to
$20 for the ninth unit. For the earlier units, because marginal revenue is
greater than marginal cost, profit increases. Up to the seventh unit, (MR =
P)> MC and profit increases. In fact, for the seventh unit, profit increases
by $2 since MR is greater than MC by $2. At the eighth unit, however,
diminishing returns push MC above MR and total profit drops (MR= P
=RM10< MC = $13). Therefore, the profit maximising level of output is
unit number 7. Column eight shows that profit increases from $20 to the
maximum of $34 at the seventh unit, and from that point onwards, there
is a descending trend.
Note that in the short run, there are three possible profit outcomes. If P
(MR) > ATC, the Shirt Company makes economic profit. If P < ATC, the
company makes a negative economic profit or an economic loss. If P =
123
Module 2
ATC C, then the fiirm makes noormal profit and zero ecoonomic profiit. This
latteer situation we
w referred to
o earlier as thhe break-eveen level of ou
utput.
Twoo of these cases are illusttrated below in Figure 2..9, panels (a)) and (b).
Figu
ure 2.9
In Figure
F 2.9, paanel (a) the firm
f earns economic proffit whereas in
n panel
(b) the
t situation is one of eco onomic loss.
1. Complete thhe following table, using the given infformation. The price
of the produuct is $6 per unit.
u
Q TC TR MC
C MR
Study skills
S 0 5 — — —
1 9 — — —
2 12 — — —
3 16 — — —
4 21 — — —
5 28 — — —
2. Referring to the table above, what is the profit-m

maximising ou
utput
level?
A. three units.
B. fourr units.
C. five units.
D. two units.
3. At the profitt maximising

g level of outtput in this taable, the firm
m will
make a totall economic profit
p of —
A. 24
B. 30
C. 2
D. 3
124
Solution:
1. TR: 0, 6, 12, 18, 24, 30.
MC : 0, 4, 3, 4, 5, 7.
MR: 0, 6, 6, 6, 6, 6.
2. B. The fourth unit is the last unit for which MR exceeds
MC.
3. D. At four units, the difference between total revenue ($24)
and total cost ($21) is the largest. Therefore, economic
profit of $3 is the highest that can be achieved.
The short-run supply curve

A perfectly competitive firm’s MC curve is indeed the representative of
alternative levels of output that the firm would be willing to supply at
different prices: to be exact, it is the firm’s supply curve. However an
option exists for the firm to temporarily shut down if it is unable to cover
either its fixed or its variable costs. To understand this point better,
remember that when a firm shuts down, it avoids variable costs while
continuing to incur its fixed costs, which are unavoidable in the short run.
Production becomes pointless when a firm is unable to cover either fixed
or variable costs. Therefore, if the firm’s total revenue falls below its total
variable costs, the firm should shut down. To state the point differently,
the firm should shut down if its price falls below its average variable
costs (P < AVC).
The shut down point for the firm is defined as a situation where the firm’s
total revenue is exactly equal to its total variable costs, or its price equals
its AVC. The minimum point of AVC is the firm’s shut down point, a
point at which the firm revenue just covers its variable costs. At prices
greater than the minimum AVC, of course, total revenue will be greater
than total variable costs and the firm should produce, since it can cover
not only its variable but also part of it fixed costs.
Thus, a firm’s supply curve is the portion of its MC curve that lies above
the minimum point of AVC.
Choose the right answer:
125
Module 2
1. A firm makees an operating loss if —

A. Pricce is less than
n average varriable total cost.
B. Pricce is less than
n average tottal costs but ggreater than average
Study skills
S variable cost.
C. Pricce is less than
n average varriable cost.
D. Pricce is less than
n average fixxed cost.
n the short ruun, then —

2. If the firm shhuts down in
A. Totaal revenue will
w be zero, and
a total costt will be zero
o.
B. Totaal revenue will
w be zero, but
b total fixedd costs will still
s have
to be
b paid.
C. Totaal revenue will
w be zero, but
b total variaable costs wiill still
havee to be paid.
D. Totaal profit will be zero, andd total costs w
will be positiive.
Solu
utions:
1. C. Variable costs are the oness that are acctively incurrred
during the firm’s operation.
o
2. B. In thhe short run
n, fixed costts have to bee incurred,
unrecooverably
Outtput decisions: Long
g-run optim
misation
In thhe short run, a firm deciddes whether to t produce orr not and also if the
deciision is to produce, how much
m to prodduce. In the llong run, thee firm
facees less constrraint. Rememmber, long ruun is a time fr frame in whicch an
exissting firm cann change thee size of its fiixed input (pplant) – there are no
fixeed inputs – orr to decide to
o leave the inndustry to avvoid losses. By
B a
simiilar token, inn the long run
n, new firms can enter the industry in n pursuit
of profits.
p
As indicated
i earrlier, in the sh
hort run, a fiirm might facce three diffeerent
posssibilities: maaking an econ nomic profit,, taking an ecconomic losss or
breaaking even. InI the long ru un, however,, a perfectly ccompetitive firm,
desppite its short--run situation n, cannot eithher run an ecconomic proffit or an
econnomic loss. Indeed,
I the only
o outcomee in the long run for a perrfectly
com
mpetitive firm m is one in which
w the firm
m makes norm mal profit.
An industry
i in which
w firms are
a making an a economic profit in the short
run adjusts in twwo different ways.
w First, the
t number oof firms in thhe
induustry increasees. Second, the
t existing firms
f expandd to take advantage of
the profit.
p Entryy by new firm
ms is a rationaal decision bby investors who
w
resppond to markket incentivess (signals) prrompted by aan economic profit.
Meaanwhile, economic profitt also serves as the incenttive (signal) to the
exissting firms too expand theiir existing opperation.
126
The presence of short-run losses prompts a different set of rational

responses. First, the number of firms in the industry decreases as some
existing firms exit. Second, the existing firms contract the scale of their
business.
Figure 2.10 illustrates the long run equilibrium for a perfectly

competitive firm.
Figure 2.10
1. A competitive profit maximising firm will enter a market if:

A. Price exceeds minimum average cost.
B. Revenue exceeds variable costs.
Study skills C. Revenue exceeds fixed costs.
D. Price exceeds minimum marginal cost.
2. All the following statements, except one, are true of long-run

equilibrium in a competitive industry. Which is odd one out?
A. The marginal firm is making zero profit.
B. The marginal firm’s price is equal to average cost.
C. All firms determine output by equating price and marginal
cost.
D. Industry demand is not perfectly elastic.
3. Use the following figure to answer the following questions.
127
Module 2
4. If the markeet price for sh t firm shoould produce _____

hirts is $10, this
shirts and caan earn .
A. 70, and $1,500.
B. 80, and $1,500
0.
C. 110, and $1,100
D. 80, and $800.
5. If the markeet price is $15
5, this firm produces
p shirts an
nd can
earn economic prrofit.
A. 100, and $1,500
0.
B. 100, and $1,100
0.
C. 50, and zero.
D. 100 and zero.
Solu
utions:
1. A, becaause only in this
t case is thhe economicc profit positiive.
2. D. Induustry demand d is not perfeectly elastic oor horizontal. This is
the kindd of firm (priice taker) whhose demandd is perfectly elastic).
3. D. Traccing the price $10.00 to
o the interseection with MC.,
you finnd the quanttity to be 1000 and total revenue $8
800.
4. D. Totaal cost is eq
qual to total revenue at this price leevel.
Again first find wh
here P crossses MC.
128
Figure 2.11
The short-and long-run dynamics of perfect competitiveness provide us

with three key lessons for managers in a highly competitive market
environment.
1. The reason the market price is high enough for firms to earn an
economic profit is that the demand is high, the supply is low, or
some combination of both. By now, smart managers have their
firms established in such markets. This, however, requires the
entrepreneurial skill of taking a risk before the competition
enters the market.
2. When firms within the industry make economic profit, other
firms will enter in order to invest and reap the benefits of the
opportunities. This movement, as we have seen, increases the
supply and drives the price down. Economic profits will
gradually disappear. Therefore, no firm can remain complacent.
3. Since perfectly competitive firms within an industry sell
homogenous (identical) products, there is no strategy in
competing on the basis of product differentiation. Therefore,
advertising is not an option. The only way a firm under perfect
competition can maintain profit is through keeping its costs as
low as possible.
Price makers (imperfect competition)

All firms seek to obtain and expand market power, and many firms have
some degree of such power. A minority of firms have significant market
power and account for a large portion of the market, if not the entire
market. To understand the market system, you need to know how the
system functions when individual firms possess significant market power.
Let us proceed by looking at monopoly. Next in the logical sequence is
monopolistic competition, and you will conclude this study section by
finishing the sequence and analysing oligopoly.
Monopoly
At the extreme opposite of a perfectly competitive market is one in which
there is one seller of a particular product or service. When a firm is
identified as a monopoly, it has considerable power to determine its price
and output level. Such monopolies as public utilities are sanctioned by
governments. Government and laws also provide companies with a
monopoly for the duration of the patent on a particular product.
Sometimes, circumstances allow a firm to enjoy temporary monopoly.
For example, there may be only one store in a shopping mall that sells
gourmet coffee. Whenever a firm has a monopoly in a particular market
or markets, the economic theory states that it still must adhere to the MR
= MC rule to maximise its short-run profit. Because it is a price maker
rather than a price taker, we can no longer say that its price is equal to its
marginal revenue. In a nutshell, a monopoly is an industry that produces a
good or service for which no close substitute exists. There is only one
129
Module 2
suppplier that is protected

p from competitioon, one way or another.
Youu can best unnderstand thee relationshipp between a m monopolist’ss price

and its marginall revenue by using the annalysis of pricce elasticity
pressented earlierr. Recall the graphs repreesenting the ddifference beetween a
perffectly compeetitive firm annd industry. While the deemand faced d by the
induustry was dow wnward slop ping, the firm
m faced a perrfectly elasticc
(horrizontal demaand curve). InI this case, however,
h thee monopolistt is the
w a demannd curve that is
induustry itself — one seller. Therefore, with
dowwnward slopiing, the firm's marginal reevenue line llies below itss demand
line.
We can show hoow a monopo oly (a hairdreesser, for exaample) would

procceed to pricee her product by combininng its cost strructure with the type
of demand
d and marginal
m revenue curve shown
s in Tabble 2.8.
(1) (3) (4)
(5)
(
Quuantity Sold (2) Total Averagee
Marginaal Revenue
(Q)) Hairstyles Price (P) Revenue TR Revenue A
AR
MR (∆∆TR/∆Q)
per day (P×Q) (TR/Q)
1 $10 $100 — —
2 $9 $188 $9 $8
3 $8 $244 $8 $6
4 $7 $288 $7 $4
5 $6 $300 $6 $2
6 $5 $300 $5 $0
7 $4 $288 $4 -$2
8 $3 $244 $3 -$4
9 $2 $188 $2 -$6
10 $1 $100 $1 -$8
Tab
ble 2.8 Haird
dressing bussiness
Tabble 2.8 showss that total reevenue, colum

mn three, reaaches a peak k between
unitts five and sixx. Marginal revenue, coluumn five, is initially positive, up
to thhe sixth unit,, and subsequ mes negative.
uently becom
Note that averagge revenue, column

c four, is equal to pprice. Figuree 2.12
illusstrates these relationshipss.
130
Figure 2.12
Table 2.8 also shows an important difference between perfect

competition and monopoly. A monopolist’s marginal revenue is always
less than its price. The reason is that in order for the monopolist to sell an
extra unit of output, the firm must cut its price, and the price cut applies
to all units sold – the additional unit as well as all previous units.
However, the addition to revenue from selling the extra unit is less than
the price charged. In order to see this point, consider the following
diagram, Figure 2.13. This figure shows the demand curve represented in
Table 2.8.
Figure 2.13
As you can see, when the prices are $7 and $6 respectively, total revenue
is $28 and $30 respectively. Marginal revenue is, however, $2. In order to
131
Module 2
incrrease its sale by one unit from four to five, the moonopolist mu ust lower
its price
p from $77 to $6. Howwever, the revvenue generaated is less th han the
pricce charged. The
T gain from m selling the unit is the diifference bettween the
two shaded rectaangles. The seller
s gains the
t checked aarea and losees the
hatcched area. Thhe loss is equ
ual to 6 × (5 − 4) = $6, wwhile the gain n is 4 × (7
− 6)) = $4. Thereefore, the nett (extra or maarginal) gainn is 6 − 4 = $2
2, which
is loower than thee price charg
ged $6.
In a monopoly,w
which statem
ment applies?
A. The marrket demand curve is aboove and steepper than the marginal
m
revenuee curve.
Study skills
S B. The marrket demand curve is the same as the marginal rev
venue
curve.
C. The marrket demand curve is aboove and paralllel to the maarginal
revenuee curve
D. The marrket demand curve is aboove and flatteer than the marginal
m
revenuee curve.
ution:
Solu
D. The margginal revenuee curve has the
t same inteercept as dem
mand but
its slope is twice as mucch.
Sho
ort-run pro
ofit maximisation
Noww that you haave considereed the revenuue side of a m monopoly firrm, we
can find out how w a monopoliist maximisees its profit. F Figure 2.14 shows
the same revenuue conditionss as in Figuree 2.13. The pprofit-maxim mising
monnopolist will wish to expaand output unntil marginall costs rise to o equal
marrginal revenuues. You notiiced in the laast section that the margin nal
reveenue curve asssociated witth a negativee sloping lineear demand curvec has
the same verticaal intercept on the graph and a twice thee slope of thee demand
curvve. Figure 2..14 presents the market demand
d curvee (D) faced by
b the
monnopolist and the correspo onding margiinal revenue (MR) curve..
Supperimposed on o these are the cost curvees of the monnopolist – th he short-
run average costt (ATC) and marginal cost (MC) curvves. The proffit-
maxximising monnopolist prod duces up to thhe point wheere marginal cost per
unitt rises to meeet the falling marginal revvenues. This point occurss at
outpput level Qm. Notice that every unit too the right off Qm has a maarginal
costt greater thann its marginaal revenue; thherefore it wiill not be prooduced.
Connversely, eveery unit to thee left of Qm costs
c less thaan it earns
(maarginally or inncrementally y); it thereforre will be prooduced and sold.
s The
firm
m’s profits caan be visualissed as the recctangle PmAB BC.
132
Figure 2.14
From a management viewpoint, the important implication of the

monopoly model is that a firm in a position of monopoly in selling a good
or service should not charge the highest price. Furthermore, we know that
the right price is the one that helps equate the firm’s marginal revenue
with its marginal cost. In doing so, the firm will earn the maximum profit.
Monopoly in the long run

In a monopolised industry, as in a perfectly competitive one, losses and
profits provide incentives for exit and entry. If the monopoly is suffering
losses in the short run, it will continue to operate as long as it can cover
its variable costs. In the long run, however, it will leave the industry
unless it can find a scale of operations at which its full opportunity costs
can be covered.
If the monopoly is making profits, others will wish to enter the industry
in order to earn more than the opportunity cost of their capital. If such
entry occurs, the monopoly’s position shown in Figure 2.14 will change,
and the firm will cease to be a monopoly.
In order for positive monopoly profits to lead to the entry of new firms
into the industry, these new firms must be able to enter the industry. This
leads us to a discussion of entry barriers: impediments that prevent entry
by other firms to the industry. These may be either natural or created. If
monopoly profits are to persist in the long run, effective entry barriers
must prevent the entry of new firms into the industry. Natural entry
barriers typically arise as a result of economies of scale. When the long-
run average cost curve is downward sloping over a large range of output,
big firms have significantly lower cost per unit than small firms.
Natural barriers give rise to natural monopoly. Natural monopoly occurs

when one firm can supply the entire market at lower average total cost
than two or more firms can. This situation arises when the demand limits
sales to a quantity at which economies of scale exist. Electrical power
133
Module 2
trannsmission is a natural monnopoly – a siingle set of ppower lines serving

s a
giveen region willl always be cheaper thann two. Figure 2.15 showss such a
situaation. Here the
t demand curve
c for elecctricity is D and average total
costt is ATC.
Figu
ure 2.15
Anoother type off natural barriier is setup cost.

c If the firrm could oveercome
its costs
c of enterring the mark ket, developiing its products and estab blishing
suchh things as itts brand imag ge and its deaaler networkk – which is typically
t
huge – then its entry
e into thee market could prove successful and
proffitable. Howeever, this is usually
u not thhe case and nnormally thee
incuumbent firm will be free of this threatt.
As discussed
d earrlier, many entry
e barrierss are created by consciou
us
government actiion and are th herefore conndoned by it. Patent laws,, for
instaance, may prrevent entry by conferrinng on the pateent holder th he sole
fo a specific period. The best
legaal right to prooduce a certaain product for
exammple is the case
c of pharm
maceutical coompanies.
Monopoly versus perfeect compettition

In teerms of welffare and efficciency, monoopoly does pooorly relativee to
perffect competittion. A mono opoly makes economic prrofit by charrging a
highh price. Therrefore, consu
umers and moonopolists tennd to have
diammetrically oppposed standp points on thee desirabilityy of a monopoly.
Thiss section disccusses the faact that there is more to thhis issue than
n just
simpply a redistriibution of inccome. In the process of thhis transfer of
o
incoome from connsumers to th he firm, therre will be a nnet loss.
Youu are well preepared now to

t see the im mpact on pricee and quantitty of a
monnopoly by coomparing them with pricee and quantitty in a perfecctly
com
mpetitive marrket. To do thhis, considerr what wouldd happen if a perfectly
com
mpetitive marrket were trannsformed intto a monopoly. The mark ket
dem
mand and suppply curves for
fo the bottledd-water induustry are show wn in
Figuure 2.16. Reemember thatt the supply curve
c is the ssame as the MC
M cost
curvve under perffect competittion. In this case,
c we are assuming a
134
horizontal MC curve. Equilibrium for a competitive market occurs at the

intersection of these curves, point A. If the industry becomes one large
company, the market demand curve remains the same despite the change
in the market structure.
With the transformation to a monopoly, the demand curve for the entire
market becomes the business’s demand curve. There is a significant
change, however. Now that the business is a monopolist, its price (given
by the demand curve) and its marginal revenue are no longer equal.
Instead, the marginal revenue curve falls below the demand curve, as was
the case before.
Next, consider supply. Recall that a perfect competitor’s supply curve

shows the quantity of output supplied by the business at each possible
price and is represented by a portion of the marginal cost curve. In turn,
the market supply curve is the sum of all supply curves of businesses in
the market. After the change to a monopoly, production facilities remain
the same as before: inputs originally owned by the perfectly competitive
producers are now in the hands of one business. When the monopolist
combines the cost figures for these various facilities, it finds a marginal
cost curve that is merely an extension of the perfectly competitive supply
curve shown in Figure 2.16.
The bottled-water monopoly’s profit-maximising output occurs where the

new marginal revenue and marginal cost curves intersect, point B. At this
output level, the price is found at point C on the demand curve. Thus,
with the transformation from perfect competition to monopoly, bottled
water becomes more expensive, (Pm versus Ppc), and fewer bottles, (Qm
versus Qpc) are produced.
Figure 2.16
Allocative efficiency
As you see, monopoly status restricts output and sets a higher price than
perfect competition, so it moves wealth from the consumers to the seller.
135
Module 2
Theerefore, from the perspecttive of fairneess and equityy, the society

y is
better off with perfectly
p commpetitive induustries than m
monopolies.
Howwever, whethher monopoly y is inferior to
t perfect coompetition fro
om the
persspective of effficiency is a different matter.
m
Figu ure 2.16 cann be employeed again to illlustrate this ppoint. Underr perfect
com
mpetition, connsumers pay Ppc for each unit bought.. The maxim mum price
that consumers area willing to o pay for eacch unit is derrived differen
ntly. It is
show wn by (the height
h of) the demand currve (D), whicch measures the value
of thhe good to thhe consumerss. The value minus its priice is consum mer
surpplus. In terms of Figure 2.16,
2 consum mer’s surpluss is representted by
the triangular
t area TAPpc– thhe area betweeen the pricee line and thee demand
curvve.
Wheen the monoppoly replaces perfect com mpetition chaarging a high her price,
Pm, consumer suurplus is redu uced to the shhaded patternned with diam mond
shappes. The monnopoly gainss in the form of higher prrofit – shown n with
strippes. But is thhe monopolisst’s gain equaal to the conssumer’s loss? Again,
if thhe gain by thee seller had been
b equal too the loss to tthe buyers, you
y could
view w the monoppoly practice of charging a higher pricce and restriccting
quanntity as mereely redistribu utive. But theere is more too this. A closser look
at Figure
F 2.16 shows
s that th
he loss to the consumers iis greater thaan the
gainn to the monoopolist. Som me of the lossees to the buyyers are accru ued to
the seller as depicted by the square patterrn. While thiis represents a loss to
the consumers, it i is not a losss to the socieety as wholee since the loss to one
grouup is offset byb the gain off the other. TheT net gain (or loss) equ uals zero.
How wever, the rest of the losss in consumeer’s surplus, ccaused by th he

monnopoly’s resttriction of ouutput, is lost. The total losss resulting from
f the
lower monopolyy output is th he shown by the t grey trianngle. This arrea is
alsoo referred to as
a the deadwweight loss too the society,, which meassures the
allocative inefficciency assocciated with thhe monopolisstic practice.
Use the followinng diagram (m market for icce cream) to answer the following
f
quesstions. Initiallly this indusstry is perfecctly competittive and fixed
d cost is
equaal to zero.
Study skills
S
1. If the ice creeam becomes a monopolyy, the monoppolist will ch harge a

price of per ice creaam and produuce cones off ice cream.
136
A. B dollars and L cones

B. B dollars and K cones
C. F dollars and K cones
D. F dollars and L cones
2. If the ice cream becomes a monopoly, the monopolist’s profit is equal
to —
A. ABC
B. BFGC
C. CGH
D. GHKL minus BFGC
3. If the ice cream becomes a monopoly, the loss in social welfare is
equal to—
A. ABC
B. BFGC
C. CGH
D. GHKL minus BFGC
Solutions:
1. B. A perfectly competitive industry would produce L and charge
F dollars. The monopolist will reduce output to K and will raise
the price to B.
2. B. The monopolist will reduce output to K, will charge B
and will face an average cost of F. Its profit is price minus
average cost times quantity, or BFGC.
3. C. The area CGH is the loss in consumer’s surplus not
gained by the monopolist.
Price discrimination
As you have analysed the behaviour of monopolies so far, there has been
an assumption that the monopoly charges the same price to all customers.
In some circumstance, however, a firm may be able to sell the same
product to different customers for different prices even though the costs
of producing for the two customers are the same. This practice is called
price discrimination. Before looking at such behaviour, note that price
discrimination is not possible when a good is sold in a competitive
market. In a competitive market, there are many firms selling the same
good at the market price. No firm is willing to charge a lower price to any
customer because the firm can sell all it wants at the market price. And if
any firm tried to charge a higher price to a customer, that customer would
buy from another firm. For a firm to discriminate in its pricing, it must
have some market power.
There are numerous examples of price discrimination. Movie theatres
137
Module 2
charrge different prices for diifferent custoomers: lowerr price for stu udents
and senior citizeens or to thosse who attendd in the afterrnoon and on n certain
weeeknights verssus weekendss, etc. Anothher form of prrice discrimiination
sets different priices for diffeerent quantitiies (volumes). Examples of this
typee would incluude bulk buy ying: the largger the order,, the larger th
he
disccount. Another form of prrice discrimiination occurrs when a firm m
charrges a differeent price for each unit solld and chargges each conssumer the
maxximum price that he or sh he is willing to pay for thhat unit.
Thee first and moost obvious lesson is that price discrim mination is a strategy
for a profit-maximising mon nopolist. In other
o words, bby charging prices to
diffe
ferent custommers, a monop poly can incrrease its proffit. In essencce, a
pricce-discriminaating monopo olist charges each custommer a price clloser to
willlingness to paay than is poossible with a single pricee. The second d lesson
is thhat price disccrimination requires the ability
a to separate custom mers –
geoggraphically or o sometimess by age or inncome – according to theeir
willlingness to paay.
1. The followinng is an exam

mple of pricee discriminattion: True/ Faalse?
A monopolist charges a higher price for its daytimme customerrs than

its night-tim
me customers because the cost of prodduction is greeater
Study skills
S during the day’.
d
ution:
Solu
1. False. Price
P discrimiination is thee practice of charging diffferent
prices foor reasons no
ot associatedd with costs.
Soccial benefits of mono

opoly
Monnopoly yieldds neither alloocative nor productive
p effficiency as compared
c
to competitive firms.
fi Howev ver, in certainn cases, a moonopolist maay incur
either higher or lower unit co ost than that incurred by competitive firms.
Theere are two reeasons why costs
c may difffer, namely (1) economiies of
scalle, and (2) tecchnological advance
a in thhe long-run.
138
Economies of scale
When economies of scale are extensive, a large number of competitive

firms, producing at the minimum efficient level, may not be able to meet
the market demand. In this situation, an industry of one or two firms
would have a lower average total cost than would the same industry made
up of several competitive firms. At the extreme, a single firm or a natural
monopoly might be able to attain the lowest long-run average total cost.
For example, extensive economies of scales always display in some firms
relating to new information technologies such as computers, notebooks,
computer software and Internet services. As these firms have grown, their
long-run average total costs have decreased because of greater use of
specialised inputs, the spreading of product development costs and
learning by doing. This has substantially reduced the average total costs
of the firms.
Invention and innovation
Monopolists can lower their costs through the discovery and

implementation of new technology in the long run. If monopolists are
more likely than competitive firms to develop more efficient production
techniques over time, then inefficiency of monopoly might be overstated.
Moreover, monopolists may seek technological advance to restrict new
firms enter into the market. In this situation, technological advance is
important to the maintenance of monopoly.
Government policy toward monopoly

Collusion is an agreement made by few firms or producers to charge the
same price or otherwise not compete among each other. In the United
States, for example, government policies with respect to monopoly and
collusion are embodied in the antitrust laws. Antitrust laws are laws
and/or regulations aimed at eliminating collusion and promoting
competition among firms. Anumber oflaws have been implemented to
regulate the behaviour of monopolies.
1. Antitrust laws and antitrust enforcement
The first law regulating monopolies in the United States was the
Sherman Act (1890), which was designed to encourage competition
and avoid the formation of monopolies. The Sherman Act is aimed to
regulate firms that had combined to form trusts. Trusts enabled firms
to collude. After the Sherman Act was passed, trusts disappeared, but
the term ‘antitrust laws’ continues to be used to refer to laws aimed
to eliminate collusion among firms. To address loopholes in the
Sherman Act, Congress passed the Clayton Act (1914) and the
Federal Trade Commission Act. Under the Clayton Act, a merger is
prohibited or defined as illegal if its effect tends to cause
“substantially to lessen competition, or to tend to create a monopoly.”
The Federal Trade Act established the Federal Trade Commission
(FTC), which was given rights to monitor and regulate unfair
business practices.
139
Module 2
140
3. Mergers: The trade-off between market power and efficiency
The U.S. federal government regulates mergers because if firms gain

market power by merging they may incur inefficiency of the market
by raising prices and reducing output. In particular, the government is
most concerned with horizontal mergers, which are mergers
between firms in the same industry. Vertical mergers are between
firms at different stages of production of a good.
4. The Department of Justice and Federal Trade Commission
merger guidelines
The Economics Section of the Antitrust Division of the Department

of Justice was established in 1973 to evaluate the economic
consequences of proposed mergers. Subsequently, merger guidelines
were developed by the Department of Justice and the FTC in 1982.
The guidelines made it easier for firms proposing a merger to
understand whether the government would allow the merger. These
guidelines focus on three main issues, namely market definition, the
measure of market concentration, and merger standards.
5. Regulating natural monopolies
If a firm is a natural monopoly, competition will not play its role of

forcing prices down to the level where the firm earns zero economic
profit. Policy makers usually set prices for natural monopolies. To
achieve economic efficiency, regulators may require that the
monopoly charge a price equal to its marginal cost. However, this
strategy has a weakness when the firm’s average total cost curve is
still falling when it crosses the demand curve. If the firm charges a
price equal to marginal cost, price will be less than average total cost
and the firm will suffer a loss. Hence, the policy makers will set the
price equal to the level of average total cost so that the natural
monopoly will break even.
Monopolistic competition
Monopolistic competition is a cross between perfect competition and
monopoly. It has most of the characteristics of a perfectly competitive
firm: a large number of sellers, fairly easy entry and exit into and out of
markets, and knowledge of market participants about the prices being
offered by the sellers. A key characteristic that makes it monopolistic is
the ability of sellers to differentiate their product. For example, brand
names, packaging, advertising, location, etc. all help a product appear to
be different from the competition. This differentiation enables a firm to
charge a higher price than its competitors, if it so desires.
In monopolistic competition markets, the firm must choose a price

knowing that the consumer has many close substitutes to choose from. If
the price is too high, in view of the consumer’s perception of the value of
the differentiating features of the firm’s product, the consumer will
purchase a competing firm’s product instead. Thus the monopolistic
141
Module 2
commpetitor mustt expect a rellatively elasttic demand reesponse to chhanges in

its price
p level. Yet
Y at the samme time, it exxpects to be aable to changge price
withhout causing any other firrm to retaliatte and consequently, with hout
caussing a change in the geneeral price levvel in the marrket. This is possible
p
becaause the firmm is one of many
m firms, annd it expectss the impact of
o its
actioons to be sprread imperceeptibly over all
a the other firms, giving g no one
firm o react to the initial firm’ss price chang
m any sufficieent reason to ge.
In other
o words, monopolistic
m c competitionn can changee price up an nd down
withhout experienncing the exttreme responnse of pure coompetition. ForF price
incrreases it will suffer loss of
o sales, but this
t loss is noot total as it would
w be
for the
t pure com mpetitor. Likee a monopolyy, the monoppolistic comp petitor
can adjust the prrice upward or downwardd to the levell that maxim mises its
proffits. Howeveer, similar to the pure commpetitor, the monopolistic
com
mpetitor has many
m rivals in
i the short run,
r compounnded by the free f
entrry of new firmms in the lonng run.
Monnopolisticallyy competitiv ve markets arre found wheere a large nu umber of

venddors gather tot sell similarr products too a gathering of potential buyers.
Thee weekly fruit and vegetab ble market inn some comm munities may y be
charracterised as monopolistiic competitioon. Similarlyy, the gatherin ngs of
artissans selling souvenirs
s and other goodds in tourist rresorts act lik
ke
monnopolistic competitors. Other
O examples of monoppolistic comp petition
are small retail businesses
b su
uch as floristts, pharmaciees, restaurantts and
dry cleaners. For instance, so ome Chinesee restaurants try to offer food
f
from
m different reegions of Ch hina. The neigghbourhood pharmacist triest to
get to
t know all his
h or her cusstomers by name.
n
Sho
ort-run pro
ofit maximisation
Figu ure 2.17 shoows the case of a profit-m maximising m monopolisticaally
commpetitive firmm within the industry.
i Thee demand annd marginal revenue
r
curvve are similarr to those in monopoly, represented
r bby d and mr
resppectively. Thhe industry deemand curvee is given by D. The firm’s
demmand curve iss obviously flatter
f than thhe industry’s demand currve since,
for instance,
i a drop in the prrice charged by b a firm inccreases the qu uantity
demmanded by ass much as thee firm, with its i elastic dem mand curve, is able
to luure away som me of the cusstomers of otther firms. H However, for the
induustry as a whhole, the resp ponse of the quantity
q to thhe same pricee cut
cannnot be as muuch (there is lower
l price elasticity)
e sinnce the indusstry
incluudes all selleers (firms), inncluding all those who loost customerss and the
one that gained mostly
m at thee expense off others.
142
Figure 2.17
The situation of a representative firm in monopolistic competition is

depicted in Figure 2.17. Since the demand curve has a negative slope, the
marginal revenue curve must lie below the demand curve, having twice
the slope and the same intercept point. The monopolistically competitive
firm maximises its profits at the price and output level where marginal
revenue equals marginal costs. Thus, price will be set at P1 and quantity
at Q1; profits are shown as the area P1ABC.
Nothing, however, guarantees that a firm in a monopolistically

competitive industry will earn economic profits in the short run. Figure
2.18 shows what happens when a firm with the same cost curves faces a
weaker market demand. Even though the firm follows the rule of profit
maximisation by setting marginal revenue to marginal costs, it might face
an economic loss. The loss is shown by the rectangle P2DEF – the striped
area.
Figure 2.18
143
Module 2
1. Unlike a moonopolist, a monopolistic

m ally competiitive firm —
A. can earn positivee economic profit
p in the sshort run butt not in
the long
l run.
Study skills
S B. has a downward
d sloping marrginal revenuue curve.
C. can never cover its minimum
m average cost in the long
g run.
D. mayy sell to many
y buyers.
2. In monopoliistic competiition, when profits

p are beeing maximissed, the
price —
A. equaals marginal revenue.
B. exceeeds marginaal cost.
C. is leess than marg
ginal revenuee.
D. equaals marginal cost.
3. The monopoolistically co ompetitive firrm's demandd curve will be b
elastic than that of the peerfectly com
mpetitive firmm. The
monopolistically compettitive firm’s demand curvve will be do ownward
sloping, the market demand
d curvve in perfect ccompetition.
A. morre, like.
B. morre, unlike.
C. less, like.
D. less, unlike.
utions:
Solu
1. A. Easyy entry into th
he market wiill compete aaway any sho
ort-run
econom
mic profits.
2. B. To maximise
m profits, MR = MC.
M Because price exceed
ds MR, P
exceedss MC.
3. C. Giveen product differentiati

d ion, the degree of
substituutability willl be less thaan it is in peerfect comppetition.
The maarket deman nd curve is downward
d ssloping in th
his
market structure, whereas
w the firm's demand curve iss
horizonntal in perfeect competittion.
Lon
ng-run opttimisation
In analysing
a moonopolistic co ompetition, our
o key assum mption is thaat entry
and exit are freee in the long run.
r Firms caan enter the iindustry wheen there
are profits
p to be made and deepart when thhey face ecoonomic lossess.
Theerefore, the difference
d bettween this sittuation and tthe one facedd by a
puree monopoly is i that the mo onopolistic competitor
c caannot expectt to earn
an economic
e proofit indefiniteely. As soon as other firm
ms notice thaat it is
posssible to earn an economicc profit in a particular
p maarket, they will
w
quicckly try to move
m in. Theirr entry will cause
c the demmand curve facing
f
our representativve firm to deecrease (shiftt to the left) bbecause the
144
newcomers will be taking a certain amount of its business away. This

shift continues until profits are eliminated, when the demand curve slips
to the average total cost curve. Graphically, this is the point at which the
demand curve and the average total cost are tangent (that is, the point at
which they just touch and have the same slope). Figure 2.19 shows a
monopolistically competitive industry in long-run equilibrium. At Q* and
P*, price and average total cost are equal and there are no economic
profits or losses. Note that tangency occurs at the profit-maximising level
of output, where marginal revenue is equal to marginal cost.
A different sequence occurs if a monopolistically competitive firm starts

with losses, but the market will arrive at the same long-run equilibrium.
Suppose that there are too many video stores in a small town and none of
them is able to make a profit. Eventually, there will be a shakeout: some
firms will be forced to leave. Therefore, for the remaining firms, the
market share (demand) increases and their demand curves will shift to the
right. These shifts will continue until the losses for the surviving firms are
eliminated. Graphically, it means a tangency between demand and
average cost curve and the same long-run equilibrium as develops when a
firm starts in a profit-earning position.
Figure 2.19
145
Module 2
Use the diagramm to answer th he followingg questions. This diagram

m depicts
a moonopolisticallly competitiive firm.
Study skills
S
146
1. In the short run, the profit-maximising output level is —

A. OA.
B. OB.
C. OC.
D. OD.
2. In the short run, the profit-maximising price is —
A. OE.
B. OF.
C. OG.
D. OK.
3. In the short run, this firm will earn a total economic profit of —
A. OA×OG.
B. OA×OK.
C. OA×GK.
D. OA×EK.
4. In the long run, this firm’s demand curve will shift to the and
become more
A. right, inelastic.
B. right, elastic.
C. left, inelastic.
D. left, elastic.
5. In the long run, this firm’s marginal revenue curve will shift to the
and become more _
A. right, inelastic.
B. right, elastic.
C. left, inelastic.
D. left, elastic.
Solutions:
1. A. This is the output level where MR = MC.
2. D. Use the demand curve to determine price.
3. C. Total economic profit equals (P -ATC) x Q.

4. D. Each firm will lose some of its market share as firms
enter the industry. Demand will become more elastic
because of the larger number of substitutes.
5. D. The reason is that as more firms enter the industry, each
firm’s market share drops (there is a reduction in the
147
Module 2
demandd faced by eache individdual firm). T

Therefore, thhe
firm’s demand
d andd marginal revenue
r currves will falll (shift
to the leeft). Also, with
w a largerr number off firms now w
operatinng in the industry, the demand
d currve faced byy each
firm is more elastic. Each has less controol and hencee its
marginal revenue curve
c will also
a becomee flatter or more
m
elastic.
The firrm in an o
oligopolyy
Thee determinatioon of price, output
o and profit is not as simple in an
a
oliggopolistic maarket as in thee three other types of maarket. Firms in
i an
oliggopoly mightt sell a standaardised produuct: steel, a mmicrochip prrocessor,
alum minium, chem micals such asa hydrochlooric acid; papper products and so
on. They might also sell a diifferentiated product suchh as soft drin nks or
carss. The key chharacteristic distinguishin
d ng this markeet and the othher three
is thhe relatively small numbeer of competing firms. Thhere is no rulle in
econnomic theoryy for the min nimum numbber of firms thhat qualify a market
as an
a oligopoly.
Reggardless of hoow few firmss there are inn a market annd what perceentage of
marrket share is held
h by the top firms, thee most imporrtant implicattion for
firm
ms in an oligoopoly is that the pricing practices
p in thhis type of market
m
are named
n by a condition
c nown as mutuual interdepeendence. This means
kn
m set its prrice on the baasis of its cossts, demand elasticity
that each firm must
and of the anticiipated reactio mpetitors. In other words,, just
on by its com
folloowing the MR
M = MC rulee may not bee enough to m maximise pro ofit.
Anoother crucial feature of olligopoly is thhe existence of barriers to

o entry.
Unlike monopollistic compettition, oligoppoly involvess various barrriers to
the entry of new
w firms, with variation froom industry tto industry.
Oliggopolists are typically pu

ulled in two different
d direections:
1. The inteerdependencee of firms maay make them m wish to co ollude
with eacch other. Unlless the law prohibits
p it (aas is usually the
case), thhey tend to get together and
a act as a single seller or o
monopooly to maxim mise their joinnt profits. At least expliciitly, most
of the time firms do not collude, partly from fear of criminal
charges and partly because
b of thee lack of trusst discussed below.
b
2. Alternattively, they will
w be temptted to compeete with theirr rivals to
gain a bigger
b share of
o industry profits
p for theemselves. Thhe two
policies, however, arre incompatiible. The moore fiercely fiirms
competee to gain a biigger share of
o profits, thee smaller thesse shares
will be. Competition wn the price aand hence will drive
n drives dow
down thhe potential profits.
p
Priccing underr oligopolyy

Wheen firms undder oligopoly y engage in collusion, theey are agreein ng on
pricces, market shhare, advertising expendiiture, etc., too reduce the
148
uncertainty they face and to banish the spectre of competitive price-

cutting or retaliatory advertising, both of which could reduce total
industry profits.
Cooperative or collusive mechanisms

A formal (explicit) collusive agreement is called a cartel. The cartel will
maximise profits if it acts like a monopoly: if the members behave as if
they were a single firm. Figure 2.20 illustrates a cartel.
The total market demand curve is shown with the corresponding market
MR curve. The cartel’s MC curve is the horizontal sum of the MC curves
of its members. Profits are maximised at Q1 where MC = MR. The cartel
must therefore set a price of P1 (at which Q1 will be demanded).
Figure 2.20
Having agreed on the cartel price, the members will then divide the
market among themselves.
Each member would be given a quota. The sum of all the quotas must add
up to Q1. If the quotas exceeded Q1, either there would be output unsold
if price remained fixed at P1 or the price would fall.
In many countries, cartels are illegal, as they are depicted by the

government as a means of driving up prices and profits and thereby as
being against the public interest.
Where explicit collusion is illegal, firms may simply break the law, or get
round it. Alternatively, firms may stay within the law but still implicitly
collude by watching each other’s prices and keeping theirs similar. Firms
may implicitly agree to avoid price wars or aggressive advertising
campaigns.
Another form of implicit collusion occurs when firms set the same price
as an established leader. The leader may be the largest firm: the firm that
dominates the industry. This is known as dominant firm price leadership.
149
Module 2
Alteernatively, thhe price leadeer may simplly be the firm m with the lo
owest
costt, known as low-cost
l pricce leadershipp or, one thatt has emerged d over
timee as the mostt reliable onee to follow: the one that iis the best baarometer
of market
m condittions. This iss known as barometric
b firrm price lead
dership.
In thhese scenarioos, regardless of the type of leadershiip, one firm leads
l the
wayy and will be followed wiithin a relativvely short tim me by all or most
m of
the other firms. The price leaader is the firrm that is wiilling to take the risk
of being
b the firstt to adjust prrices, but thiss firm has ussually a good
d reason
to exxpect that otther firms will follow suitt.
Non
n-cooperaative (Comp
petitive) mechanism
m m
Colllusion (impliicit or expliccit) is not the only reason for every co ompetitor
charrging the samme price. In fact,
f one impportant modeel of competiition in
oliggopolies is the model thatt explains whhy mutual intterdependencce leads
to thhe same pricee being charg ged among competitors:
c the kinked demand
d
curvve. The kinkeed demand curve
c model shows that iff firms expecct rivals
to match
m a price cut but not price
p increasses, then theyy are unlikely
y to
channge price or quantity.
Figu
ure 2.21
Figu ure 2.21 illuustrates the esssential aspects of this thheory. Noticee that at
the given
g price P*,
P the demaand curve is kinked
k in thee sense that its slope
is noot continuouus. The portio on of the demmand curve aabove the price is
mucch more elasttic than the portion
p beloww the price. T This is becauuse each
commpetitor anticcipates that iff it increasedd its price, noone of the othher
commpeting firmss would follo ow. If this is indeed the case, the firm m that has
raiseed its price stands
s to losee a consideraable amount oof market sh hare
(theere being an elastic
e deman nd curve). Thhe lower porrtion of the kinked
k
demmand curve iss rather inelaastic because each compeetitor is assum med to
anticipate that thhe lowering of o its price would
w bring aabout retaliattory price
reduuctions from the other co ompetitors.
Thee main intent of lowering prices in an oligopoly is to gain markket share

at thhe expense of the other co
ompetitors. If m lowers its price,
I every firm
none would gainn very much market sharee. In fact theey may all ennd up
150
selling about the same amount as before but at lower price unless their
price cuts help to stimulate total market demand. This would depend on
the price elasticity of the industry demand.
The upshot is that the kinked demand curve helps to explain why firms in
an oligopolistic market tend to charge the same price. However, the
kinked demand curve model does not explain how the market price
around which the kinked curve lies is actually determined.
The price stability can be shown by drawing in the firms’ marginal

revenue curves. The marginal revenue curve appropriate to this demand
curve has two different segments. The upper segment relates to the elastic
portion of the demand curve, while the lower segment relates to the
inelastic portion of the demand curve. At quantities below Q*, the MR
curve corresponds to the flat (elastic) part of the demand curve, starting
from the same point where the demand curve intercepts the vertical axis:
A. At quantities greater than Q*, however, the MR curve corresponds to
the steep (inelastic) portion of the demand curve and starts at C. To see
how this is constructed, imagine extending the steep part of the demand
curve back to the vertical axis.
This and the corresponding MR are shown by the dotted lines in Figure
2.20. Therefore, you will note that there is a vertical discontinuity in the
marginal revenue curve, shown as the gap CD.
Other important models of competition, discussed below, explain

instances when oligopolists cannot cooperate (collude), implicitly or
explicitly. The nature of competition, however, varies from industry to
industry.
• When firms produce homogenous products and/or are committed
to producing a given amount of output, as in the case of
industries where fixed costs are high and changing capacity is
very expensive, there is quantity or Cournot competition. An
example of this situation is the steel industry.
• When they produce differentiated products and/or the cost of
increasing capacity is low, competition takes the form of price
competition or Bertrand competition. Airlines belong in this
category.
Oligopoly and the prisoner's dilemma

Strategic situations form the subject matter of game theory. Formal game
theoretic modelling is beyond the scope of thiscourse. However, there is
one very simple game theoretic structure that captures the basic oligopoly
incentive problem very well: the prisoner’s dilemma. Consider a two-firm
industry (a duopoly) in which firms may charge either a high (collusive)
price or a low price. Note that this setting is different from the Cournot
model in two aspects. First, firms are choosing price rather than quantity.
Second, their choice is discrete in that they have only two prices to
choose from. In the Cournot models, firms can choose any one of a large
number of possible quantities. Despite these differences, however; the
151
Module 2
inceentive structuure of this gaame is similaar to the Courrnot model.
Let us assume thhat oligopolists can engagge in two diffferent strategies:

highh prices, which we will reefer to as a cooperative
c strategy, and low
pricces (a non-coooperative strrategy). If booth firms coooperate or chaarge high
pricces, both firm
ms do well, esssentially shaaring in monnopoly profitts. If one
firm
m charges a high
h price and
d the other does
d not, the defector takees most
of thhe sales in thhe market and
d does very well
w but the other firm do oes very
poorly. If both firms
f charge lower pricess, both make modest proffits. This
payooff structure is illustrated
d in the followwing box or matrix, know wn as a
pay--off matrix.
As indicated
i in Table
T he first elemeent in each cell is Firm l’s profit
2.9, th
(or payoff);
p the second elem ment is Firm 2’s2 profit. Coombined proffits are
highhest under thhe strategy off mutual coopperation (colllusion). In th his case,
eachh will earn a profit of 50. However, iff, Firm 1 believes that Firrm 2
intends to charge the collusiv ve price, thenn Firm 1 hass an incentivee to
defeect, for by chharging a lowwer price, it can
c raise its pprofit from 505 to 100.
Furtthermore, evven if Firm 1 believed thaat Firm 2 wass likely to deefect,
thenn the best straategy would be to defect also, becausse by doing so s Firm 1
getss 30, while iff it remains trrue to the agreement, it wwill get nothiing.
Simmilar reasoninng applies to Firm 2. Thuus, for each fi firm, no matteer what
the other does, its best strateegy is to defeect – charge llow prices. A
strattegy that is best
b no matteer what the riival does is rreferred to ass a
domminant strateggy. It is likelyy, that mutuaal defection wwill be the outcome
evenn though the firms could earn significcantly more bby colluding g. The
outccome of the mutual
m defecction strategyy is called Naash equilibriium;
giveen the strateggy chosen by y the rival, eaach firm is dooing the bestt it can.
Firm 2
Hig
gh price L price
Low
Highh price 50,50 100, 0

Firrm 1
Low price 0, 100 30,30
Tab
ble 2.9
Thee original verrsion of the prisoner’s

p dillemma dealt with two susspects in
a criime rather thhan two firms. In the origginal version,, each prison
ner was
induuced to confeess (defect) in
i the hope ofo getting a liighter sentennce even
thouugh both susppects would do best if neeither confesssed. If firms (or
prisoners) had too make singlle, once-and--for-all choicces, it is hard
d to
believe they wouuld do anyth hing other thaan defect. If, however, thhe
interaction betwween the firmms is repeatedd, the chance is much bettter of
mainntaining coooperation. In a repeated game, there iss an incentive to
coopperate if the firms believe that cooperration in thiss period will bring
forthh cooperation from the riival in the neext period, w
while defectioon today
willl induce defeection by the rival next peeriod. Thus, cooperation may be
mainntained in a repeated gam me, althoughh if one firm bbelieves it may
m not
152
be around next period, or if the one-period gains from defection are very
high, then defection will result.
It is fortunate for consumers that oligopoly situations include the aspect

of prisoner’s dilemma as this maintains reasonably vigorous levels of
competition even when only a few firms are involved. We cannot say in
general how much competition is enough, but, as indicated above, even
industries with only a few firms can be highly competitive. There are
many alternative theories of how oligopolies behave.
Pricing strategies in imperfectly competitive markets

Limit pricing
Market theory reveals that monopolists set profit-maximising prices

where MR = MC. At this optimal price level, the monopolists will
maximise their profit level. In practice, markets are dynamic and
monopolists must remain sensitive to the possibility of entry by new
competitors. In some circumstances, it make sense for monopolists to
forego higher short-run profits if pricing moderation will forestall
competitors’ entry and boost long-run profitability. In this situation,
monopolists may implement a pricing strategy called limit pricing to
retard the entry of new competitors. Limit pricing is a competitive
strategy to set a less-than-optimal price (where MC = MR) in an effort to
deter market entry by new competitors.
Network externalities
Affinity programmes for restaurant dining and flyer programmes for the
airlines reflect the fact that many firms are always able to create a
customer lock-in effect that produce long-run benefits. Customer lock-in
effects are close-linked with network externalities that yield to significant
first-mover advantages. Network externalities refer to the advantages of
production tied to widespread adoption of a physical or economic
standard. In the railroad industry, for example, customers are linked using
railroad rights of way with a consistent gauge of track. The benefits of a
consistent physical network are so important that trains could not run if
different railroad companies required different gaugesof track.
Market penetration pricing
Market penetration pricing is a strategy of setting very low initial prices

to create a new market or enlarge market share in a well-developed
market. The main purpose of this pricing strategy is to benefit a critical
mass of customers, create good network effects and establish a viable
market or business. For example, in the computer software market,
Microsoft is well-known to have sold initial versions of PC-based
software programsat promotional prices in order to attract a large base of
enthusiastic customers. Once a large customer base is created, Microsoft
increases prices to gain higher profit margins as switching computer
software becomes more difficult or costly once use has become
widespread throughout a firm or organisation.
153
Module 2
Advvertising
A fiirm in a monnopolistic maarket with a differentiated

d d good is req quired to
ensuure that its cuustomers knoow how its good
g is differrent from its
commpetitors, eveen when the difference
d iss marginal. O
One of the strrategies
is too use advertissing and packaging. Firmms in monopoolistic compeetition
spennd huge amoounts in adveertising to enssure that cusstomers appreeciate
and value the differences bettween their owno goods annd those of their t
commpetitors. Addvertising in magazines,
m n
newspapers, television, raadio and
the Internet
I are the
t main chaannels for proomoting theiir goods or prroducts.
Onee of the mainn objectives ofo advertisingg is to providde a signal to

o
conssumers of a high-quality
h product or create
c a brandd name for thheir
prodduct. In geneeral, a brand name gives information
i tto customerss about
the quality of a product,
p and is an incentiive to the prooducer to achhieve a
highh and consisttent quality standard.
s Advvertising andd brand namee benefit
the customers inn terms of pro oduct differeences and quality and enaable a
better product chhoice to be made.
m
Activvity 2.2
Thinnk of three different
d prodducts or serviices and estim
mate roughlyy how
manny firms are there
t in the market.
m Identtify whether ‘the market’’ is local,
natioonal or internnational. In what
w ways doo the firms ccompete in eaach of
the cases
c you haave identifiedd?
Activity
154
Modulesummary
You have reviewed the production function which is governed by the law
of diminishing marginal returns in the short run that results in the
marginal product curve that is hill-shaped. The total and average product
curves are also hill-shaped because of their connections with changes in
Summary marginal product. Marginal cost is inversely related to marginal product.
The marginal cost curve is shaped like the letter ‘J’. Average fixed cost
has a negative slope and is flatter at higher output levels. Average
variable cost has a saucer-shaped curve that reaches its minimum where it
crosses the marginal cost curve. The curve for average cost is saucer-
shaped and reaches a minimum where it intersects the marginal cost
curve. Economic cost includes the opportunity cost of all the factors of
production and a normal rate of return for the owners of the firm. A
business could have increasing, constant, and decreasing returns to scale.
The long-run average cost curve is saucer-shaped reflecting ranges first of
increasing, then constant and finally decreasing returns to scale.
You have also seenthat a perfectly competitive individual firm has no

control over its price. In the short run, a perfectly competitive firm
should produce if its product price exceeds its average variable costs. In
perfect competition, free entry and exit ensure that an individual firm in a
long-run equilibrium situation makes neither economic profit nor loss. A
natural monopolist is a monopolist whose ATC is declining over the
entire relevant range of market demand for which economies of scale
exist. A monopolist can make an economic profit that will not be
competed away in the long run. Production of a monopoly is undesirable
from the point of view of the society because the monopolist causes a
deadweight loss to the society. Price discrimination is the practice by a
monopolist for reasons not associated with the cost conditions. Market
structure of monopolistic competitive industry is a cross between a
monopoly and perfect competition. To understand oligopoly industry, it
is important to relate to concepts of cartel, collusion, Prisoner’s Dilemma
and Cournot competition.
In the following study units, you will be looking at economy in aggregate

of national income, inflation, unemployment, business cycle, aggregate
demand, aggregate supply and their equilibrium.
155
Module 2
Assig
gnmentt
1. What is the relationship
r among a firm
m's total reveenue, profit, and total
cost? How are
a they relatted?
2. Give an exam mple of an opportunity

o c that an accountant might not
cost
count as a coost. Why would
w the accountant ignoore this cost?
A
Assignment
3. How and whhy does a firm m's average-total-cost cuurve differ in the short
run and in thhe long run?
4. Define econnomies and diseconomies of scale andd explain why

y they
might arise.
5. Production processes
p maay be labour--intensive or capital-intennsive. To
achieve prodductive efficiiency, what criterion
c musst a firm app
ply in
choosing thee production process to produce
p a cerrtain quantity
y of
output?
6. Which costss—economicc costs or acccounting costts—include both b

explicit costts (payments to those outside the busiiness) and im
mplicit
costs (opporrtunity costs owners sustaain by runninng the busineess)?
7. How do economists meaasure profitabbility?
8. What is the name

n of the market struccture when onne firm supp
plies the
entire markeet?
9. What does thhe demand curve

c facing the firm in pperfect compeetition
look like?
10. What does thhe demand curve

c facing the firm in im
mperfect com
mpetition
look like?
11. How is the marginal

m curv
ve drawn in relation to thhe demand cu
urve in
imperfect coompetition?

r between the demand faciing a monop polist and
the industry demand with hin which thhe monopolisst operates?
13. Is it true thatt compared to

t perfect com
mpetition, m
monopolies prroduce
more outputt and charge higher pricess?
14. How can firm

ms continue to earn puree profits in thhe long run?

r between the elasticity off the monopo
olist's
demand andd how much its i price exceeeds marginaal cost?
156
Assessment
157
Module 2
Usee the followinng information for the neext two questtions. You arre
makking plans too establish a car
c wash bussiness. Your research hass isolated
fourr distinct meethods of production, eachh of which w
will produce the
t same
Assessment
A num
mber of cleann cars.
Technique Units of Capital Units of Laabour
A 2 20
B 4 15
C 6 11
D 8 8
1. If the hourlyy price of a unit

u of capitaal is $60 and the hourly wage
w is
$6, which production
p technique shouuld you chooose in order to
t
minimise coosts; A, B, C, or D?
2. Which is the most labou

ur-intensive method
m of prroduction: A, B, C, or
D?
3. Use the folllowing table for this quesstion.

Number of nal
Margin Totaal Averaage
Workers Produ
uct Produuct Produuct
1 12
2 16
3 14
4 13
5 10
A. Com
mplete the to
otal product and
a average pproduct colu
umns.
B. Witth which worrker do diminnishing returrns occur?
C. Graaph the marg
ginal and averrage productt curves.
4. ‘When margginal product is decreasinng, average pproduct is co

onstant.’
Is this statem
ment true or false? Why??
5. Your friendd operates a variety

v store that providess an annual revenue
r
of $480,0000. Each year he pays $25,,000 in rent ffor the store,, $15,000
in business taxes, and $3350,000 on products
p to sell. He estimmates he
could put thhe $80,000 hee has investeed in the storre into his friend’s
restaurant business
b insteead and earn an annual 200 per cent prrofit on
his funds. He
H also estimmates that he and
a his familly could earn n a total
annual wagee of $90,000 0 if they workked somewhere other thaan the
store.
A. Callculate the total explicit costs
c and totaal implicit co
osts of
runnning the variiety store.
B. Whhat is the acco
ounting profi
fit of the variety store?
C. Whhat is the econ
nomic profitt?
158
D. In what way is economic profit superior to accounting profit

as an indicator of the overall performance of this business?
Given the advantages of economic profit as a performance
indicator, explain why the concept of economic profit is not
often used in accounting.
E. Should your friend consider closing down this business?
Why?
6. Identify each of the following short-run costs as either variable or

fixed:
A. Depreciation charges for a construction firm.
B. Lumber costs for a pulp-and-paper producer.
C. Property insurance for a restaurant.
7. How does the law of variable proportions (decreasing returns to

scale) differ from the law of diminishing returns to labour?
8. Distinguish between economies of scale and scope.
9. Daily production for Pot-Works, a flowerpot maker, varies with the

number of workers employed, as shown in the table below.
Short-run Production for Pot-Works
(2) (3) (4)

(1)
Labour Total Product Marginal Product Average Product
(pots/day) (pots/day) (pots/day)
0 0
1 100
2 280
3 510
4 560
5 540
A. On one graph, draw the total product curve. On another

graph, draw the marginal product and average product
curves. Explain the relationships between these curves.
B. On your graphs, identify the ranges where marginal product
rises, where marginal product falls and is positive, and where
marginal product is negative.
10. Suppose Honda’s total cost of producing four cars is $225,000 and
its total cost of producing five cars is $250,000. What is the average
total cost of producing five cars? What is the marginal cost of the
fifth car?
11. How do returns to scale influence the size of businesses in certain

industries?
159
Module 2
12. All of the foollowing, exccept one, aree true of the ccompetitive
model.Whicch is the odd d one out?
A. Marrginal revenu
ue equals maarket price.
B. Thee firm cannott raise the maarket price w
without losing
g all its
custtomers.
C. Thee firm can sell as much ass it wants at the market price.
p
D. Thee firm is a price taker.
E. Thee firm faces a downward--sloping dem
mand curve.
13. When the demand curvee facing the firmf is downnward sloping
g,
marginal revvenue is lesss than price because:
b
A. the firm can selll more units without lowering its pricce.
B. the firm can onlly sell more units
u by lowering its pricce.
C. a veery large num
mber of firmss are produciing essentiallly the
sam
me product.
D. if thhe firm raisess its price, it loses all its customers.
E. the firm is behaving as a price taker.
14. A pure monnopoly is best defined as a firm—

A. sellling a producct for which there
t are no close substitutes.
B. makking short-ru
un economic profits.
C. withh a degree off market pow
wer.
D. withh a downwarrd-sloping deemand curvee.
E. all of
o the above.
15. Which of thhe following is not a barriier to entry?

A. pateent rights.
B. ownnership of prrivate properrty.
C. the possession of ment franchise.
o a governm
D. substantial econ
nomies of scaale.
16. A monopoliist who is pro

oducing wheere MR is lesss than MC should—
s
A. incrrease producction.
B. reduuce price.
C. reduuce production.
D. produce where price
p is equaal to marginaal cost.
17. The profit-m

maximising monopolist
m m decide aall of the folllowing
must
except—
A. outpput level.
160
B. price level.
C. the wage level.
D. the combination of inputs.
18. A monopoly is currently maximizing profits. We can conclude that—

A. it is maximising total revenue and minimising total cost.
B. it has reduced the difference between marginal revenue and
marginal cost to zero.
C. it is maximising total revenue and marginal revenue.
D. D. it is producing at a point in output where marginal
revenue equals average cost.
19. A natural monopoly is usually regulated to produce an output level

such that—
A. P=MC.
B. MR=MC.
C. P=ATC.
D. MR = ATC.
Use the diagram below to answer the next six questions.
20. When perfectly competitive industry becomes a monopoly, price will

_____________ and quantity will _______________
A. fall to E, fall to G.
B. fall to E, rise to H.
C. rise to F, rise to H.
D. rise to F, fall to G.
21. With a profit-maximising monopolist, the net loss of social welfare is

shown by area—
A. BDF.
B. BAC.
161
Module 2
C. EAB
BF
D. DCE.
22. To preservee the monopo

oly, this firm
m would be w
willing to spen
nd up
to—
CE.
A. FBC
B. BA
AC.
C. FBA
AE
D. ABDC.
23. If this indusstry was initiially perfectlyy competitivve and then became
b a
monopoly, thet amount of o consumer surplus transsferred to thee
monopoly is shown by the t area—
A. DBC.
B. ABC.
CE.
C. FBC
D. BA
AE.
24. If this indusstry were perrfectly compeetitive, consuumer surpluss would

be shown byy the area—
A. ABC.
B. DCE.
AE.
C. FBA
D. FBC
CE.
162
Assessment answers
1. Technique Total Cost
A 2 x $60 + 20 x $6 = $240
B 4 x $60 + 15 x $6 = $330
C 6 x $60 + 11 x $6 = $426
D 8 x $60 + 8 x $6 = $528
Therefore, A is the least expensive technique and hence it is to be
chosen. A is the least costly because labour is much cheaper than
capital.
2. Clearly A is the answer. This is compatible with the answer to the

previous question.
3. A.
Number of Marginal Total Average
Workers Product Product Product
1 12 12 12
2 16 28 14
3 14 42 14
4 13 55 13.75
5 10 65 13
B. With the third worker MPL begins to diminish.
C. Diagram
4. False. When MP is decreasing, AP could be rising or falling.
5. A. Explicit costs = $25,000 + $15,000 + $350,000 = $390,000

Implicit costs = ($80,000 x 0.2) + $90,000 = $106,000
B. Accounting Profit = TR – Explicit costs = $480,000 - $390,000
= $90,000
C. Economic Profit = TR – Total costs (explicits + implicits) =
163
Module 2
$480,0000 − ($390,,000 + $106,000) = −$166,000

D. Econoomic profit iss superior in that it is obtaained after alll costs,
includding opportun nity costs of time and cappital, are accoounted
for. Anny business decision
d should be basedd on this notion.
Econoomic profit iss hard to meaasure becausee the forgonee
alternaatives (opporrtunity costs)) are normallly difficult too
pinpoiint with accu uracy, as theyy are market--driven and tend
t to
fluctuaate. It is true that sometimmes an effortt to determinne
opporttunity costs could
c be subjjective.
E. Yes. My
M friend will be better offo working ffor someone else and
deposiiting the capiital investmeent in a finanncial institutio
on
insteadd.
6. A. fixed
B. fixed
C. variable
D. fixed
7. The law off decreasing returns
r is a loong-term pheenomenon; thhe law of
diminishingg returns to labour
l is shorrt-term. The former occuurs when
all inputs arre flexible an
nd changed ata the same tiime, whereass the
latter is cauused by keeping capital fiixed while chhanging labo
our.
8. Economies of scale arisse when averrage cost of pproduction decreases
as the levell of productioon increases.. Economies of scope arise when
the cost of producing
p tw
wo products jointly
j is lesss than the co
ost of
producing them
t separattely.
9. A.
Sho
ort-run Production for Pot-Workks
(2) (3) (4)

(1)
Labour Total Prodduct Marginal Product Average Product
P
(pots/daay) (pots/day) (pots/d
day)
0 0 0 0
1 100 100 100
2 280 180 140
3 510 230 170
4 560 50 140
5 540 -20 108
164
Diagrams:
B. MP rises between 0 and the third unit of labour. It falls with

unit 4 and becomes negative with unit 5.
Total cos t $250,000

10. Average total cost = = = $50,000
5 5
Marginal cost of 5th unit = 250,000 −225,000 = $25,000.
11. When firms face increasing or constant returns to scale they can
expand while taking advantage of falling or constant costs. In the
former, decreasing average costs enable the firm to drive
competitors out of the market and capture a bigger share of the
market. This way the firm grows in size to become one of the small
number of remaining firms(if not the only one). Industries such as
auto, chemical, and pharmaceutical fall into this category.
12. E is the answer. A perfectly competitive firm faces a flat demand

curve.
13. B
14. E
15. B
16. C
17. C
18. D
19. C
165
Module 2
20. D
21. B
22. C
23. D
24. B
166
Module 3
The Macroeconomy:Aggregate
Demand and Supply
Introduction
In thismodule, we will first discuss the concept of Gross Domestic
Product (GDP) and different approaches of measuring GDP as a
measurement of national economy activities, people’s income and well-
being. You will examine the differences between GDP and Gross
National Product (GNP) as well as nominal GDP and real GDP. You will
also learn how unemployment rate, GDP deflator and Consumer Price
Index (CPI) are determined.
Then we will examine the changes in economic forces that result in

fluctuations in economic and business activities including determinants of
aggregate demand and aggregate supply and impacts of shifts in
aggregate demand and supply to economic fluctuations.
At the end of this module you will be able to:
167
Module 3 The
• define Grooss Domesticc Product (G

GDP).
• account foor the differeent approachhes to measurring GDP.
• distinguissh between nominal GDP
P and real GD
DP.
O
Outcomes • state how the unemplo
oyment rate is
i defined annd describe how
h it is
determineed.
• explain thhe definition and construcction of the G
GDP deflatorr and the
Consumerr Price Index x (CPI).
• describe some
s predicttable interacttions among demand, agg
gregate
productionn and incom
me.
• state the characteristic
c cs and determ
minants of thhe components of
aggregatee demand.
• state the conditions
c in
n which demaand equilibriium is likely in goods
and financcial markets..
• list the deeterminants of
o aggregate supply.
s
• describe in
i what way the labour market
m differss from the prroduct
market.
• state whatt is meant by
y general equuilibrium.
• explain soome aspects of

o output dettermination iin the short run
r that
differ from
m those whicch prevail in the long runn.
• define reccessionary an
nd inflationarry gaps.
• comment on the effectts that governnment policyy tends to hav
ve in the
short-run versus its lon
ng-term effects.
• state, in general
g termss, how shifts in aggregatee demand or supply
can cause booms and recessions.
r
Term
minologyy
Con sumer price A meaasure of the price
p level thhat considerss the
indeex (CPI) price of
o a list of sppecific goodss and servicees
purchaased by a typpical househoold at curren nt prices.
T erminology
Deflator: An av
verage of the prices of all goods in thee
econo
omy, weighteed by the quaantities of tho
ose
goodss that are actuually purchassed.
Grosss domestic Total income earnned domestically. It includdes

prod
duct: incom
me earned dom mestically byy foreigners, but it
exclud
des income earned
e by domestic resideents on
168
foreign ground.
Gross national Total income earned by nationals. It includes the

product: income that nationals earn abroad but it does not
include the income earned within a country by
foreigners.
Inflation rate: The percentage of change in the price level is

called inflation rate. The measure of inflation most
frequently cited is the CPI (Consumer Price
Index).
Marginal Propensity The additional consumption spending generated by

to Consume (MPC) an additional amount of disposable income. Value
of MPC is assumed to take a value less than unity.
Marginal Propensity The additional household saving generated by an

to Save (MPS) additional amount of disposable income.
Exchange rate: The value of one nation’s currency in terms of

currency of another nation.
Measures of Economic Question

Introduction
Section 3.1 of Module 3 is designed to increase the accuracy and power
of your economic vocabulary by spelling out the strict meaning of
economic measurement terms that you encounter often in business
reading. Exercises help you to grasp and remember distinctions between
similar kinds of measures and indices. You will also have a chance to
reflect on certain problems of aggregation such as those which arise in the
measurement of a nation’s productivity when many of its passport holders
are employed outside its boundaries.
Management and measurement
Business managers normally make decisions specific to their department

or part of the firm. These decisions usually take into account the concerns
of the company as a whole and, at times, are subject to wider industry or
market conditions. But how do you describe and measure such
conditions?
In this section, we will focus on the main measures of economic

questions. Fluctuations in economic questions set the conditions within
which the market, industry and company must operate, and these
measures reflect those fluctuations. There are many measures and
indicators of overall (macroeconomic) questions such as the number of
people with jobs, the total income of persons, the output of factories, the
169
Module 3 The
totall quantity off goods and services prodduced in the eeconomy, thee
unem mployment rate,r the conssumer price index,
i retail sales, housinng
statiistics, etc. Suuch measuress are regularlly reported inn newspaperrs and
televvision and raadio news. At
A the least, well-equipped
w d business an nd public
secttor managers must undersstand these economic
e inddicators in orrder to be
ablee to make infformed busin ness decisionns. The follow wing pages focus
fo on
the main
m measurres of econom mic questionns to provide you with a working
w
know wledge of ecconomic indiicators.
Gro
oss domesstic producct (GDP)
GDP P is the mostt comprehensive measuree of economiies and a bro oad
meaasure of peopple’s income and well-being. The growth in real GDP G is
hencce a measuree of the growwth of peoplee’s real incom mes and thereefore the
pacee of improveement in livin ng standards.. Differencess in growth rates
r
prodduce large diifferences in living standaards betweenn countries. Much
M of
maccro economiccs is about try ying to undeerstand the caauses of grow
wth and
the reasons
r for persistent
p diffferences in growth
g rates and income levels
betw
ween countries.
GDP P can be viewwed from eitther the demaand side or thhe supply sid de. On
the demand
d sidee, it provides insight into the interactioon of the varrious
deciision-makingg sectors of thhe aggregatee economy (hhouseholds; business
b
firm
ms; governmeent entities; and
a foreignerrs). A compeetent manageer
recoognises that these
t nts constitute the market ddemand that a firm
elemen
facees.
The supply of gooods and serv vices requirees firms to brring togetherr the
factoors of producction, particu
ularly labourr and capital,, and to emplloy the
bestt available technology in order to prodduce output that meets deemand.
As a manager, youy need to be b aware of thhese limits aand any ongo oing
channges in themm to manage your
y resourcees efficientlyy.
Sommetimes econnomic growth h is rapid andd at other tim

mes it is slow
w. There
are even
e occasioons when thee economy sttops growingg and actually y shrinks
for a period. A rapidly
r growiing economyy is one in whhich people enjoy
rapidly rising livving standard ds and in whiich good jobbs are easy to o find. In
a sloow-growing or shrinking g economy, liiving standarrds decline an nd
unem mployment becomes
b a seerious probleem.
Uneemploymeent rate
The labour markket performan nce is measuured by a num mber of indiccators
incluuding the unnemploymentt rate, the em
mployment raate and the
ployment ratte is the key and the mostt-
partticipation ratee. The unemp
watcched indicatoor. At times when
w the unemploymentt rate is high,, a
persson may takee a long time to find a jobb. Today, thee rapid pace of
o
techhnological chhanges and thhe onslaught of globalisaation are resp
ponsible
for the
t widespreead displacem ment of workkers.
Althhough unempployment is a permanent feature of ecconomic life, it

som
metimes becom One such time was the
mes an extreemely seriouss problem. O
period of high unnemploymen nt and rapid contraction
c tthat occurred
d in the
170
late 1920s and the 1930s throughout the world known as the Great
Depression, which was to a great extent, the result of the collapse of the
international financial system as well as mutual adoption by many
countries in the West of high-tariff policies. In the West, we also
witnessed other periods of high unemployment and stagnation in the early
1980s and the early 1990s although these were less severe than earlier in
the century. The economic slump of the early1980s was primarily caused
by a combination of a second oil price increase from OPEC (the
Organization of Petroleum Exporting Countries) and the anti-inflation
policies of the central banks of the developed oil-importing nations. The
slowdown of the early 1990s perpetuated itself in Japan for at least ten
years with a widespread impact in Asia.
Recently, dating back to 1997, the economies of major economic powers

in Asia – Korea, China and Indonesia – have suffered serious financial
and economic crises, as have many in Latin America and subsequently
the economy of Russia as well.
Business decisions are increasingly made in an international context – the

global economy is becoming increasingly borderless – so that
macroeconomic thinking necessarily becomes broader to consider the
international trade and finance flows that affect business. It is not enough
for a manager to take into account the conditions that affect the domestic
economy. Furthermore, attempts by governments to stimulate growth and
employment have often resulted in inflation and balance of payments
crises.
Even when societies do achieve growth, it is often short-lived. This is

especially true in developing countries where – for historical, sociological
and economic reasons – governments take the central role not only in
initiating stimulating economic packages but also in implementing them.
In the absence of a reliable tax system, governments of developing
countries often wind up financing their growth strategies by creating
inflation.
In those nations that rely on regular tax channels for financing their
growth strategies, the outcome is typically high foreign and domestic
debts and the ensuing current account crises. As discussed in Module 1,
these have prompted the governments of developed as well as the
emerging economies such as India, Indonesia and Brazil. to reformulate
their economic policies around the basic principles of greater emphasis on
market mechanisms (less government intervention) and a stable
macroeconomic framework.
In light of the discussion above, it is no surprise that governments have

set the following as goals of macroeconomic policy:
• Sustained income growth.
• Low unemployment.
• Mild fluctuations.
171
Module 3 The
• Price staability.
• Exchangge rate stabillity.
• Balancee of trade surp
plus.
Measu
uring eco
onomic peerformance: Output and in
ncome
The output of “thhe economy””, aparticularr nation’s prooductive cap pacity,
excllusive of unppaid work consists of millions of diffeerent goods. We
coulld report howw much of eaach good the economy prroduced: 1,40 00,362
com
mputers, 1,650,562,382 metres
m of fibree-optic cablee, 13,220,490
0 bottles
of beer,
b and so forth.
f Such data
d may be useful
u for somme purposes, but they
do not
n provide us u with the in nformation we w want. If neext year the output
o of
com
mputers falls byb 10 per cen nt, the outpuut of cable gooes down by 2 per
centt, and the outtput of beer rises
r by 3 per cent, has tootal output goone up or
dowwn? And by howh much?
We need a single number thaat summarisees these outpputs of the ecconomy.

But how do we add a up the co omputers, caable, beer andd millions off other
prodducts producced in the ecoonomy? We do d this by addding the mo oney
valuue of all the final
f goods and
a services produced
p (thhose that are not used
to make
m other gooods and servvices) to arriive at a single number thaat
encaapsulates thee production of the econoomy.
The most comm mon measuress of productioon of aneconnomy are Gro oss
Dommestic Produuct (GDP) and Gross Natiional Producct or income (GNP).
GDP P and GNP refer
r to produ
uction duringg a particularr time period
d, which
we usually
u take to be a year or a quarter of a year. Thhey are the fllow of
new
w products duuring the yeaar (or the quaarter) and aree measured inn the
currrency of the local
l econom
my.
GDP versus GNP

G
GDP P is total income earned within
w the coountry. It inccludes incom
me earned
dommestically by foreigners, but
b it excludees income eaarned by dom mestic
residdents on foreeign ground. This total vaalue of goods produced would
w
alsoo measure thee total value of domestic residents’ (nnationals’) in
ncomes,
but only if
mestic workerr had a job inn another couuntry.
1. No dom
2. No foreiigner had a job in the dom
mestic econoomy.
3. All machines and factories used were ownedd by domesticc
residentts or nationalls (residents of
o a nation).
Howwever, since some incom me is receivedd from individuals owning capital

equiipment in othher countriess, GDP is nott a perfect m measure of tottal
dommestic incomee. Thus, statiisticians alsoo compute ann alternative measure,
m
the gross
g national product (G GNP). GNP is total incom me earned byy
ome that nationals earn aabroad but it does not
natioonals. It inclludes the inco
incluude the incom me earned within
w a counntry by foreiggners. The difference
betw
ween GDP annd GNP is, th herefore, knoown as “net iinvestment in ncome
from
m non-residennts”.
172
Most countries pay more attention to GDP than to GNP for measuring
their aggregate economies. For the purpose of stabilising employment, we
are interested in a broad measure of job-creating within the nation. GDP
is that measure. For evaluating trends in the standard of living of many
nations, including the OECD (Organization for Economic Cooperation
and Development) nations, GNP is more appropriate. Despite a possible
gap between GDP and GNP, possibly arising from either foreigners
owning some capital equipment operating within the nation or nationals
being in debt to foreigners, we simplify by ignoring the difference
between them (and focus only on GDP) within this course.
There are three different ways to think about and measure GDP.
Statisticians can measure either:
1. The production of each industry agriculture, mining,
manufacturing, etc.
2. The income that this production generates wages, salaries, profits,
etc.
3. The expenditure on the goods and services produced spending by
households, firms, governments, etc.
To see how GDP can measure all these things at once, we must discuss
national accounting, the accounting system used to measure GDP and
many related statistics.
If a Malaysian company in Brazil employs a Malaysian citizen, the

income that he/she earns is:
A. Part of Malaysian GDP and Brazil’s GNP.
Study skills B. Part of Malaysian GDP and Brazil’s GDP.

C. Part of Malaysian GNP and Brazil’s GNP.
D. Part of Malaysian GNP and Brazil’s GDP.
Solution:
D. Since it is income by a Malaysian national abroad, it is part of the
Malaysian GNP. However, since she contributes via a Malaysian firm
(a foreign firm to Brazil), it is also part of Brazil’s domestic
production, GDP.
Income, expenditure and the circular flow

Imagine an economy that produces single good, bread, from a single
input, labour. Figure 3.1 illustrates all the economic transactions that
occur between households and firms in this economy.
173
Module 3 The
Figu
ure 3.1 An economy
e pro
oducing a single good w
with a single input
Thiss figure illusttrates the flo

ows between firms and hoouseholds in an
econnomy that prroduces one good g or prodduct, bread, ffrom one input,
laboour. The inneer loop repressents the flow ws of firms sselling the brread they
prodduce to houseeholds. The outer loop reepresents thee correspondiing flows
of money:
m houseeholds pay th he firms for the
t bread, annd the firms payp
wagges and profitt to the households. In thhis economy, GDP is both h the
totall expendituree on bread an nd the total inncome from the productiion of
breaad.
Value added and interm

mediate go
oods
Seveeral difficultties arise wheen output is measured.
m Leet us exploree two of
them
m. Suppose a farmer prod duces $5 worrth of wheat,, which he seells to a
bakeer. The bakerr exerts $20 worth of effo fort to turn thhe wheat into
o bread,
whicch she sells for
f $25. At th he end of thee day, what hhas been prod duced?
The answer is juust $25 worth h of bread. But
B if we ask the farmer and a the
bakeer to report thheir output for
f the day, thhe farmer sayys, “I producced $5
worrth of wheat,”” and the bak ker says, “I produced
p $255 worth of brread."
A sttatistician whho naively addds these num mbers might think that th
here has
beenn $30 of outpput in the ecoonomy. The statistician iss led astray by
b
counnting the whheat, which iss not a final good
g but rathher an interm
mediate
goodd that disapppears after it is used to prroduce the brread. There are
a two
wayys to avoid thhis measurem ment pitfall:
1. Ask the farmer and the
t baker to report
r the vaalue of their sales
s of
final gooods to consu
umers. The baaker reports $25 and the farmer
reports $0
$ because his
h wheat is not
n a final goood.
2. Ask the farmer and the
t baker to report
r the coontribution of each
made to the total. Th
he farmer repports $5 wortth of wheat anda the
orth of effortt, for a total vvalue of $25 worth of
baker reeports $20 wo
output.
We call the bakeer’s contribu

ution to outpuut his/her vallue added, which
w the
bakeer calculates by subtractiing his/her coosts, $5, from
m his/her rev
venue,
$25. The baker’ss value added is thus $200. The farmerr’s value add ded is $5:
in ouur example, the farmer had
h no costs. When businnesses report their
174
output to the government, they subtract their costs, so they are reporting
value added. The government then sums the value added by all businesses
to arrive at GDP.
There are many examples of intermediate goods e.g., wheat whose value
should not be double-counted when output is computed. Other examples
are oil, shipping and advertising.
For businesses to know what to report as their contributions or value

added, they have to know how much of their costs they should subtract
from their revenues. Thus, the government must define “intermediate
goods” quite explicitly. Officially, an intermediate good or service is one
that is used up in the production of other goods or services during the
same period in which it was produced. The key phrases in this definition
are “used up” and “same period”. Let us see how these concepts clarify
which goods are intermediate and which are final.
A farmer who grows barley sells some of it for $1 to a miller. The miller
turns the barley into flour and then sells the flour to a baker for $3. The
baker uses the flour to make bread that he sells for $5 to an economist,
who eats the bread. What is the value added by each person? What is
Study skills GDP?
175
Module 3 The
Solu
ution:
The farmerr’s value add ded is $1.000, as she staarts from scrratch.
The miller’’s contributiion (value added)
a is ($33.00 -$1.00 =
$2.00). Thee baker’s co
ontribution isi ($5.00 - $$3.00 = $2.0 00). The
value of GDDP is the su
um of the vaalues added ($1.00 + $2 2.00 +
$2.00 = $5..00), which is equal thee value of thhe final pro oduct
(bread).
Severaal measu
ures of inccome
The national acccounts includ de other measures of incoome that difffer
slighhtly in definiition from GDP and GNP P, and econoomists and the press
often refer to theem. You can measures of income
n see how thee alternative m
relatte to one anoother by startting with GD
DP and subtraacting variouus
quanntities. First, to obtain GNNP from GD DP, we subtraact the net income of
foreeigners who own
o factors of o productionn employed ina country:
GNP = GDP
G − Net Income
I of Fooreigners.
GDP P and GNP area gross measures of an economy beecause of the gross
inveestment firmss’make on neew capital annd additions tto inventoriees. The
capiital stock inccreases becau
use of investm ment and deccreases becau use of
deprreciation. Thhe total additiions to the caapital stock iin a given peeriod are
calleed gross inveestment. Thee change in thhe capital stoock equals grross
inveestment minuus depreciatio on and is callled net invesstment. To ob btain net
natioonal productt (NNP), we subtract the depreciationn of capital,th hat is the
amoount of the ecconomy’s sto ock of plant, equipment aand residential
strucctures that wear
w out durin ng the year:
NNP = GNP
G − Deprreciation.
In thhe national accounts,

a dep
preciation is called
c the cap
apital consum mption
allowances. Sincce the deprecciation of cappital is a costt in producin
ng the
outpput of the ecoonomy, subtrracting depreeciation showws the net ressult. For
this reason, somme economists believe thaat NNP is a bbetter measurre of
econnomic well-bbeing.
The next adjustm ment in the national

n accounts is for inndirect busineess taxes
suchh as sales taxxes and subsiidies. These taxes
t place a wedge betw ween the
price that consum mers pay forr a good and the price thaat firms receiive.
Because firms never
n receive this tax weddge, it is not ppart of their income.
Oncce we subtracct indirect buusiness taxes from NNP, we obtain a measure
calleed national income:
i
Nationaal Income = NNP

N − Indireect Business Taxes.
Natiional incomee is a measurre of how muuch everyonee in the econo

omy has
earnned.
GDP P data are, inn practice, ussed not only as a measuree of how mucch is
beinng produced but also as a measure of the welfare oof the residen nts of a
counntry. Econom mists and polliticians talk as if an increease in real GDP
G
176
means that people are better off. In reality, GDP data are far from perfect.
Most of the difficulties of' measuring GDP arise because some outputs do
not go through the market. Examples are volunteer activities, housework,
and do-it-yourself home improvements. In the case of the government
sector, we already noted that production is valued at cost. This is because
much of government output is not sold in the market, nor is there a simple
technique available that would make it possible to estimate the value of
government output. How would we measure safety from criminals as the
value of output that police expenditures are supposed to produce?
Potential GDP
You saw that GDP measures how much the economy actually produces.
But the economy is generally capable of producing more than it actually
does. Another measure, potential GDP, indicates what the economy could
produce if labour and machines were fully used up. Although it is true
that actual GDP usually falls short of its potential, sometimes it could
exceed it. This happens when the rate of utilisation of the labour force and
that of other factors of production exceeds their normal rates. Strong
upward fluctuations are called boom, and downwards ones are called
recessions. Severe downturns are referred to as depressions. The last
depression, called the Great Depression because of its length and depth,
began in 1929. The economy did not fully recover from it until four years
later. There is no technical definition for a boom, but there is one for a
recession; a recession is said to have occurred when GDP falls for at least
two consecutive quarters.
The economy’s fluctuations are sometimes called business cycles but the
term “cycle” suggests a kind of regularity that cannot be found between
one downturn and the next. Economists have seen patterns repeat often
enough to have given a name to the bottom of a recession (a trough) and
the top of a boom (a peak). However, we also know that as little as two
years and as much as ten can elapse between one and the other.
Net national product (NNP) is equal to

A. GDP minus consumption of fixed capital.
B. GNP minus consumption of fixed capital.
C. Personal disposable income plus net interest payments.
Study skills
D. Personal income plus net interest payments.
Solution:
B. The difference between gross and net is what is known as personal
consumption allowances or depreciation. NNP is obtained from GNP
not GDP.
Real versus nominal GDP

Both GDP and GNP, as discussed above, are valued at market prices, the
prices paid by the final user. There is, however, one problem with using
money as a measure of output: the value of one dollar changes over time.
177
Module 3 The
Choocolate bars, books, moviie tickets andd cars cost m more today thaan they
did ten
t years agoo, whereas co omputers cost less. We uuse prices nott only
becaause they aree a convenien nt way of maaking comparisons but also
becaause prices reeflect how co onsumers vaalue differentt goods. If thhe price
of ann orange is twice
t that of an apple, it means
m an oraange is worth
h twice
as much
m at the margin
m as an apple. Anothher way of saaying this is that one
dollar does not buy
b as much as it did ten years ago. W We do not waant to be
mislled into belieeving that thee output is hiigher when iin fact only th he price
leveel has risen. To
T keep the comparisons
c of different years straigh
ht,
econnomists adjuust GDP for changes
c in thhe average level of pricess.
Unaadjusted GDP P is known as a nominal GDPG (RMYt). The term real GDP
(Yt) is used for innflation-adju usted GDP figures, whichh are true yeaar-to-
yearr measuremeents of what the t economyy actually prooduces. To caalculate
real GDP, econoomists take th he nominal value
v of GDP P, the moneyy value of
all thhe goods andd services prroduced in thhe economy aand divide it by a
meaasure of the price
p level. Thus,
T real GDDP is definedd by the equaation:
Real GD
DP = Nominaal GDP/ Pricce level
If, for
fo instance, nominal
n GDP has risen 5 per cent in the past yearr but
prices have also increased by
y 5 per cent, then real GDDP is unchan nged. If
nomminal GDP haas risen 5 perr cent in the past year butt prices havee
p cent, real GDP has acttually decreaased.
incrreased by 6 per
Phaases of thee businesss cycle

Business cycles reflect the flluctuations inn the growthh of real GDP P. A
busiiness cycle is the periodiic but irregullar up-and-doown behavio our of
totall production and other measures
m of ann economy. B Business cyccles have
fourr phases, nam
mely: expansion, peak, reecession, andd trough. Thee
expaansion phasee is the period d during whiich real GDP P is increasin
ng. A
peakk is the higheest level of reeal GDP yet attained. A ppeak is a turnning
poinnt between ann expansion and a recession. After acchieving a peeak, real
GDP P usually turrns into recesssion, that is,, a period durring which real GDP
decrreases for at least six mon nths. Finallyy, a trough is the temporarry low-
poinnt in real GD
DP and it is a turning poinnt between a recession an nd an
expaansion.
Supppose nominaal GDP increased by 5 peer cent in 20001 (over its previous
p
yearr). Given thiss information
n, can we sayy:
A. The agggregate price level (the GD
DP deflator) increased in
n year
2001.
Study skills
S
DP increases in year 20011.
B. Real GD
C. Both thee aggregate price
p level annd real GDP rose in year 2001.
D. More information is necessary too answer thiss question.
178
Solution:
D. Nominal GDP is equal to real GDP multiplied by price. Therefore,
it is not clear from the available information which of the two
elements of nominal GDP is behind the 5% change, or whether
perhaps both are.
Price indexes and inflation

In macroeconomics, the price level is the average level of prices
measured by a price index. For example, in Canada, two main price
indexes that are used today are the Consumer Price Index and the GDP
Deflator.
The consumer price index (CPI)

The CPI is a measure of the price level that considers the price of a list of
specific goods and services purchased by a typical household at current
prices. The nation’s statistics agency typically starts with this “basket” of
purchases and calculates this year’s CPI by expressing the cost of the
basket in the current year as a percentage of the cost of that same basket
in the base year. The CPI is the weighted average of price movements of
several thousand goods and services grouped into several hundred
categories. More precisely:
value of fixed basket in current prices
CPI = × 100
value of fixed basket at base year prices
where the value of the basket represents total expenditure on (or the cost
of) the basket in any period, month or year. The base year is an arbitrary
year employed by the nation’s statistics agency that, depending on the
agency’s approach, its targets and its feasibility, normally changes once
every five to ten years.
Implicit GDP deflator

Economists generally tend to prefer measures of the inflation rate that are
broader than the CPI. The broadest such measure is the implicit GDP
deflator (sometimes called just the GDP deflator for short). The GDP
deflator is an average of the prices of all goods in the economy, weighted
by the quantities of those goods that are actually purchased. The
computation of the price deflator is simple. It is equal to nominal GDP as
a percentage of real GDP (expressed in the currency of the base year):
Nominal GDP
GDP deflator = × 100
Real DGP
The deflator, then, is highly inclusive. Another main difference between
the CPI and the deflator is that the CPI is a fixed-basket index whereas
the deflator is a variable-basket index.
Expressed in terms of a time period, the GDP deflator in year t (Pt) is
defined as the ratio of nominal GDP to real GDP in year t: Pt = RMYt/Yt.
The GDP deflator gives the average price of all goods and services
179
Module 3 The
incluuded in GDP
P.
Bothh the GDP deflator and th
he CPI can be
b used to calculate the in
nflation
rate.
Inflation rate
The percentage of o change in the price levvel is called tthe inflation rate. If
the price
p level riises from $200 per good too $22 per goood over a perriod, the
inflaation rate forr the period is
i 10 per centt. If the pricee level falls from
f $20
per good to $18 per good, th he inflation raate is -10 perr cent; that iss, there is
a 100 per cent defflation. The measure
m of innflation mosst frequently cited by
the media
m is the CPI:
CPIIt – CPIt-1
Innflation rate = × 100
C t-1
CPI
An alternative
a on can be callculated by rreplacing the CPI
raate of inflatio
withh the deflatorr.
he table beloow, compute Northton’s nominal

1. From the datta given in th n
and real GDP for the currrent year, itss CPI, and itss rate of inflaation
from the basse year.
Da
ata from Noorthton
Study skills
S Price Quantity
Item Base
B Currrent Base Current
Rubberr ducks 1.00 1
1.25 1000 100
Beach towels 9.00 6
6.00 122 14
2. Use the folloowing inform
mation to:
A. Calcculate the ratte of inflationn between 19997 and 2001.
B. Calcculate the ratte of inflationn between 19998 and 1999
9.
C. Calcculate the ratte of inflationn between 20000 and 2001.
P deflator
GDP
19977 100.0
19988 101.7
19999 102.4
20000 105.0
20011 107.1
Solu
utions:
1. Nominaal GDP is equal to Pricce x Quantitty. For the current
c
year, it is (100 x $1.25 + 14 x $6.00 = $2209). Real GDPG is
(100 x $1.00
$ + 14 x $9.00 = $226).
$ The CCPI is calcu
ulated by
dividingg the currennt outlay onn a fixed bassket by the outlay
o
on the same
s baskett in the basee year:
CPI = (1100 x $1.25 + 12 x $6.000)/(100 x $1.000 + 12 x $9
9.00) =
197/2088 = .947 (or 94.7
9 as the CPI
C should bee multiplied by b 100).
180
Inflation rate is [(94.7 – 100)/ 100] x 100 = 5.3%. Remember that

the CPI for the base year is, by convention, equal to 100.
2. A. 7.1%. You can do this simply by taking the difference

between the base year price index (100) and the price index
in 2001 (107.1 -100) x 100).
B. This and the next part cannot be found as readily as the
first part of the question. Inflation in 1999 is [(102.4 -
101.7)/101.7] x 100 = .688%.
C. [(107.1 -105)/105] x 100 = 2%
Unemployment statistics
In most countries, unemployment data are collected by their respective
statistics agencies, which survey a representative mix of households and
ask each whether a member of the household is currently seeking
employment. The unemployment rate is the ratio of the number seeking
employment to the total labour force:
Number of unemployed
Unemployment rate = × 100
Labour force
Labour force = Number employed + Number unemployed
Problems with unemployment statistics

Some economists believe that the statistics agencies’ unemployment
surveys provide too high an estimate of the true unemployment rate.
These statistics typically come from the labour force survey conducted by
the agency in charge. Based on the survey questions, each working age
individual is placed into one of three categories: employed, unemployed
and not in the labour force. The main difference between an unemployed
individual and one who is not in the labour force is that the latter is
deemed not actively looking for a job. Some workers who do not have
jobs may have in fact abandoned hope of finding one. They are referred to
as discouraged workers. Statistics will not count them as unemployed,
thus will provide an underestimate of the number that would choose to
work if a job were available.
The sharp focus on the unemployment rate by economists, policy makers
and the media is, to a degree, misguided. As discussed above, some of
those classified as not in the labour force are in fact discouraged workers.
These workers would typically take a job if offered it even though they
are not looking for one. This is why economists sometimes focus on the
employment rate. Employment rate is the ratio of employment to working
age (adult) population:
Number of employed
Employment rate = × 100
Adult population
Finally, the fraction of the working age population that is employed or
seeking employment is called the labour force participation rate, which
181
Module 3 The
is thhe ratio of labbour force to

o population. Because of discouraged workers,
the labour
l force participationn tends to decline in recessions:
Laabour force
Particiipation rate = × 100
Adullt populationn
Use the informattion provided

d below to annswer the following quesstions.
Civilian population 30 millionn
S
Study skills Employeed 15 millionn
Unemployed 1.5 millioon
A. Whaat is the size of the labouur force?

B. How
w many indiv
viduals are ouut of the laboour force?
C. Calcculate the un
nemploymentt rate.
Solu
ution:
A. Labour force = em
mployed + unnemployed = 15 = 1.5 = 16.5
million.
B. 30- 15.55 = 14.5 miillion are ouut of labour force for a variety
of reasoons.
C. 1.5/ 16..5 = .909 orr 9.09%.
Aggrregate Demand
D d, Aggregate
Supp
ply and Econom
mic Flu
uctuatio
on
Introduction
Describing the regular
r patterrns that econnomies experrience as they
y
fluctuate over timme is easy. Explaining
E w causes thhese fluctuattions is
what
morre difficult. Inndeed, comp pared with thhe topics you have studiedd up to
noww, the theory of economicc fluctuationss remains conntroversial. This
T
secttion developss a model thaat most econoomists use too explain sho ort-run
fluctuations in economies.
Mosst business decisions

d are short-run deeterminationss and most arre made
undeer conditionss of uncertainnty. These unncertainties ttypically refllect
shorrt-term fluctuuations in economic dem mand in respoonse to the im mpact of
the business
b cycle. These fluuctuations, inn turn, represent the reacttion of
m basic economic deccision makers – househollds and busin
the most nesses –
to thhe economic conditions that
t prevail at a a particularr time.
182
This section describes changes in economic forces that result in

fluctuations in economic and business activities, in both the short and
long run. You must have realised that it is not possible for managers to
anticipate the exact behaviour of the economy all the time, nor do most
managers need to track fluctuations scientifically. Specialists can do this.
However, a competent manager should not only be aware of the effects of
the short-term economic fluctuations on her business but also be sensitive
to current economic conditions.
For example, suppose a manager, say of a chain of upscale department

stores, is to order its line of summer designer clothing several months
ahead of time. Since the demand for the dresses will be affected by the
economic conditions prevalent at that future time, it is necessary for the
manager to foresee those economic conditions. Naturally, the manager
should combine the forecasted future conditions with prevailing economic
conditions. Two points emerge:
1. The manager needs to be proactive.
2. The future is uncertain and forecasts are not always accurate.
Should the manager expect a buoyant economy and instead it weakens,

the stores will be stuck with expensive dresses they cannot sell. On the
contrary, if she looks for a lacklustre economy and, in fact, it grows
strongly, the stores will miss out on sales that could have been made.
Thus, misjudging the economy’s strength can prove to be a costly error.
However, while managers are not to be blamed for economic
misforecasts, which are normally done by a third party, to avoid
unpredictable consequences they should take measures to avoid all-or-
nothing strategies.
From a policy point of view, economic forces that affect the demand and
supply of goods and services as well as labour also affect the demand and
supply of credit. Such changes in turn will set influence the central bank’s
monetary policy as central bankers respond to those situations. Again,
while firms and households cannot prevent certain policy measures from
being taken by authorities, they should be prepared to revise their
decisions accordingly.
1. The business cycle describes

A. the change in the standard of living across countries.
B. the change in potential GDP over time.
Study skills C. the behaviour of real GDP over time.
D. the behaviour of GNP over time.
2. The business cycle is defined as
A. the period of time during which the unemployment rate is
rising.
B. the period of time during which the inflation rate is rising.
C. persistent growth in potential GDP.
183
Module 3 The
D. irreggular ups and

d downs in production
p annd jobs.
Solu
utions:
1. C
2. D.
Aggreegate dem
mand and
d its comp
ponents
Whaat is the connnection betw
ween price, GDP,
G levels of spending and
a real
outpput in an econnomy? In thee case of inddividual markkets, the expllanation
can be given in terms
t of dem
mand and suppply. First, w we will look at
a how
the concept
c of demand can be
b applied to the economyy as a whole to see
the relationship
r between the general pricce level and ttotal spending in the
econnomy, whichh is known ass aggregate demand
d (ADD).
Rem member that total

t spendin
ng on an econnomy's goodds and servicees is the
summ of four com mponents: con nsumption, investment, ggovernment
purcchases and neet exports. The
T primary groups
g respoonsible for th
his
spennding are houuseholds, buusinesses, govvernments annd foreignerss. Total
spennding in an economy,
e adjjusted for changes in the general price level,
is reeferred to as real expendiitures and is calculated w
with the use of
o the
GDP P price deflaator.
Thee aggregatte demand

d curve
Agggregate demaand can be exxpressed in a table knownn as the aggrregate
mand schedulle or on a graaph known ass the aggreggate demand curve
dem
D). Figure 3.2 and Table 3.1 show ann aggregate ddemand schedule and
(AD
an aggregate
a dem
mand curve.
Reaal GDP Dem manded

Price Level
L
(B
Billions of doollars)
520 1000
440 1100
360 1200
280 1300
200 1400
120 1500
40 1600
Tab
ble 3.1
As indicated
i in Table
T 3.1, ou
utput demanded and the pprice levels are
a
inveersely relatedd.
Pricce and quantiity demanded d of a single product havee an inverse

relattionship: as price
p rises, quantity
q demaanded decreaases, and vicce versa.
The same can bee said for gen neral price leevels and reaal aggregate
expeenditures althhough for different reasoons. The quanntity demand ded of a
184
certain product can be explained by the price of that product but the story
is different for the aggregate output. As the general level of prices
increases, less real output is bought for three reasons:
1. The real value of financial assets such as bank accounts and
bonds, decreases – the wealth effect. As a result, households feel
less wealthy so they reduce their consumption spending.
2. Net export spending decreases as foreigners spend less on
domestic exports –real exchange rate effect.
3. To these reasons, one can add the less-intuitively obvious
channel of interest rates. A rise in the price level tends to lower
the rate of interest that in turn tends to encourage investment
spending – theinterest rate effect.
Just as with a demand curve for a single product, the price variable
is placed on the vertical axis of the graph,and the output variable
isplaced on the horizontal axis.
Figure 3.2
As discussed in Module 1, this relationship can be represented by a key

equation as follows:
Y (GDP) = C + I + G + (X − M) (1)
This relationship represents aggregate demand: the sum of personal

consumption expenditures, C, residential investment plus businesses
(nonresidential) investment, I, government expenditures, G, and net
foreign expenditures or net exports, (X – M), which is exports minus
imports, on the goods and services produced in the economy.
Consumption consists of purchases of non-durable goods such as food

and fuel; consumer durable goods such as cars and services such as travel
and banking.
Investment consists of additions to capital stock or real capital formation

– not to be confused with financial investment. There are three elements
contained in investment:
1. machinery and equipment investment
2. residential and office investment
185
Module 3 The
3. additionns to inventorries.
Govvernment speending consissts of currentt spending (oon goods and d

servvices) such ass health and education. Note
N that partt of governm ment
spennding belonggs to consum mption and thee other part tto the investm
ment
cateegory. For exxample, goveernment spennding on infraastructure su uch as
roadds belongs inn the investmment categoryy, whereas sppending on seervices
suchh as civil servvants’ salariees, belongs inn the consum
mption categoory.
How wever, spendding on educaation and ressearch and deevelopment, which
are to
t be regardeed as investm ment, are curiiously treated as current
(connsumption) spending.
s
Exports comprisse spending byb foreignerss on domestically producced goods

and services andd are thereforre added to aggregate
a dem
mand (includ ded in
GDP P). Imports are,
a of coursee, the opposiite: domestic spending on n foreign-
prodduced goods and servicess. They are thherefore subttracted (exclluded)
from
m aggregate demand.
d
Chaanges in aggregate
a demand
d
There are other factors
f besiddes the price level that cann influence total
t
spennding. Howeever, these faactors (aggreggate demandd factors) chaange
totall spending att all price lev
vels. In otherr words, theyy shift the agggregate
demmand curve.
Wheen factors othher than pricce level affecct any of thesse componennts, they,
in tuurn, affect thhe entire real expendituress (demand) sschedule and
d hence
causse the aggreggate demand curve to shifft.
Suppose, for exaample, that due

d to an incrrease in goveernment purcchases,
the aggregate
a deemand curve shifts to the right, as shoown in Figurre 3.3,
fromm AD1 to AD D2. This changge is known as an increasse in aggregaate
demmand. Similarrly, a decreasse in anotherr componentt of real expeenditures,
suchh as exports, causes a deccrease in totaal expenditurres. This decrrease in
aggrregate demannd is represeented by a shiift in the agggregate demaand curve
to thhe left, AD3. Aggregate demand
d factoors can be cattegorised by the
spennding compoonent they im mmediately affect.
a As we consider eacch in
turnn, we must asssume that alll other aggreegate demandd factors and d the
price level remaain constant.
186
Figure 3.3
Consumption and its determinants

Personal consumption expenditure, or simply consumption, is the
component of aggregate demand that represents spending by households
on goods and services. Consumption spending constitutes the largest
component of economies, accounting for a bit more than two-thirds of
GDP of Canada, for example.
A key notion in all of macroeconomics views consumption as the core of

aggregate demand. The other components, in one sense or another,
facilitate consumption. Business investment spending ultimately provides
the capacity to produce consumer goods.
Exports are produced to exchange for imported consumer goods.

(Although this may not be the intention of the exporters, it is still true in
the end). It can even be argued that government spending ensures an
environment within which “the pursuit of happiness” can take place.
One of the most basic relationships in economics is that between income

and consumer spending. In The General Theory of Employment, Interest,
and Money, the basis for modern macroeconomics, John Maynard Keynes
noted:
1. Consumer spending tends to increase as income increases.
2. The increases in spending are less than the full increase in income
(some of the increased income is saved).
These two aspects of the aggregate income-spending relationship are

presented in Equation (2) and Figures 3.4. Figure 3.4 contrasts real
personal consumption expenditures (C) with real disposable income
(income after taxes). Real disposable income (YD) equals real GDP (Y)
minus taxes (T).
C = a + b (Y − T) (2)
Since figures for 1960 became available, data inspection confirms the
following relationship for a country such as Canada:
C = 0.54 + 0.85 YD (3)
187
Module 3 The
Figu
ure 3.4
Thiss result indiccates that for every $1 inccrease in afteer-tax incomee,

individuals spennd 85 cents (ssaving the reemaining 15 ccents). One can c
conffidently statee that the equuation (2) is a quite accurrate descriptiion of the
real world’s connsumption-in ncome relatioonship. A com mparison bettween the
geneeric equationn (2) and the estimated eqquation (3) suuggests that a = 0.54,
the vertical
v interrcept, and b, the slope of the functionn, equals 0.855.
Perssonal consummption and saaving are twoo uses of disposable inco ome.
Thuus, consumer spending is decided wheen householdds determine how
mucch to spend or
o save. The constant
c term
m, 0.54, is unnimportant. ItI does,
howwever, highligght the fact th
hat changes in factors othher than disp posable
incoome, discusseed below, affffect the posittion of the cuurve, whereaas
channges arising from GDP (Y) ( and hencee YD disposaable income cause
movvement alongg the curve. Conventional
C lly, b is referrred to as ma
arginal
proppensity to consume (MPC C), which is defined
d as thhe change in C
brouught about byy a given chaange in YD
Marrginal Prop
pensity to Consumee (MPC)
The Marginal Propensity
P o Consume (MPC) is thhe fraction off a
to
channge in dispossable incomee (Yd) that is spent on connsumption (CC). In
otheer words, MPPC is also defined as the additional coonsumption spending
s
geneerated by an additional am mount of dissposable incoome, and the value of
MPC C is assumedd to take a vaalue less thann unity. MPC
C can be calcculated as
folloows:
C
Change in co
onsumption ΔC
MP
PC = = < 1
Change in dispo
osable incom
me Δ Yd
Marrginal Prop
pensity to Save (MPS)
An alternative
a too spending iss saving by households.
h Saving (S) iss the
amoount of dispoosable income that househholds do not spend on thee
conssumption of goods and seervices. The marginal proopensity (MP PS) is
defined as the addditional hou
usehold savinng generatedd by an additiional
amoount of dispoosable income.
188
Change in saving ΔS
MPS = = < 1
Change in disposable income Δ Yd
Hence, the marginal propensity to consume (MPC) plus the marginal

propensity to save (MPS) for any people will equal to one, namely MPC
+ MPS = 1.
For example, if a $40,000 increase in income stimulates consumption

spending by $32,000. Then, the marginal propensity to consume is 0.80.
ΔC 32,000
MPC = = = 0.80
Δ Yd 40,000
Since MPC + MPS = 1, then MPS = 1 - 0.80 = 0.20.
This suggests that for every additional $1 in disposable income,

consumers will consume $0.80 of their additional disposable income and
will save $0.20.
1. When a consumer realises extra income in a household and spends

the extra income, it is called the:
A. Average propensity to save.
Study skills B. Marginal propensity to consume.

C. Average propensity to consume.
D. Marginal propensity to save.
2. The marginal propensity to save is:

A. Consumption divided by real disposable income.
B. Saving divided by real disposable income.
C. The change in saving divided by the change in real
disposable income.
D. The change in consumption divided by the change in real
disposable income.
Solutions:
Discuss your answers with your tutor.
Assuming that taxes (T) are 25 per cent of national income, (T = 0.25Y),
and MPC is 0.85, calculate the increase in T, C and S (saving) if Y
increases by $1.
Study skills
189
Module 3 The
Solu
utions:
1. B
2. C
3. For every $11 increase in Y (GDP), thhere is an inccrease of 75 cents
c in
real disposabble income——25 cents takken away as taxes. Of 75 5 cents,
85% goes too consumptio on (MPC = 0.85),
0 which iis about 63.77 cents
(0.85 x 75 cents) and thee remaining, 25%, goes too personal saaving,
which is 21.3 cents (.25 x 75).
Dissposable in
ncome
The most signifiicant determiinant of conssumer spendiing is the lev vel of
dispposable incomme (YD). Thee economy’ss total dispossable income may
channge as a resuult of changess in population or changees in disposaable
incoome per houssehold. High her income taaxes, for exammple, decreaase
household dispoosable income and hence consumer sppending. As a result,
aggrregate expennditures drop, shifting thee aggregate ddemand curvee to the
left.
Wealth
Weaalth and incoome are quitee different. Inncome consissts of earning gs
receeived over timme, wealth iss made of finnancial and reeal assets. Real assets
(succh as houses and appliancces) and finaancial assets ((such as stoccks and
bondds) are meassured at a parrticular time.. We have alrready consid dered the
weaalth effect – the
t effect of the
t price level on the reaal value of weealth,
whicch then influuences consu umer spendinng. Factors otther than pricce level
can also affect wealth
w and, inn turn, consuumer spendinng. For exam mple, if
stocck prices jum
mp, household ds who own stocks enjoyy increased wealth.
w
As a result, thesee householdss will probabbly spend moore of their disposable
d
incoome. Aggregate demand will w increasee, and the agggregate demaand
curvve will shift to
t the right. Conversely,
C an increase iin consumer debt
meaans that households lose wealth.
w Housseholds reduce spending as a
resuult – aggregatte demand deecreases.
Con
nsumer exxpectationss
Connsumer expecctations influ
uence the dem mand for a siingle product.
Sim
milarly, these expectationss can affect aggregate
a demmand by chaanging
geneeral consumpption pattern
ns.
If coonsumers exppect prices to o rise – for example,

e because of a nattural
disaaster, or a waar – they willl spend moree now and savve less. As a result of
highher consumerr spending, aggregate
a demmand increasses and the aggregate
a
demmand curve shhifts to the riight. Likewisse, if consummers expect thheir
incoomes to rise soon,
s they aggain spend more
m and savee less. Aggreegate
demmand increasees.
Inteerest ratess
Because households often bo orrow to purcchase durablle goods such h as cars
and furniture, chhanges in reaal interest rates can affectt their purchaasing
190
decisions. If the real interest rate falls, consumers are more likely to
borrow in order to buy big-ticket items. Therefore, consumer spending
rises and the aggregate demand curve shifts to the right. Conversely, a
jump in the real interest rate has the opposite effect because consumer
spending falls, aggregate demand decreases, and the aggregate demand
curve shifts to the left.
As a conclusion, changes in wealth (not triggered by price changes),

expectations and interest rates cause a shift in the AD curve whereas
changes in price cause a movement along the curve.
Investment and its determinants

As discussed earlier, investment within GDP comprises three major
components: residential construction, non-residential fixed investment
and change in business inventories. These are widely varied in terms of
the decision makers, the types of spending and the influences that affect
the decision-making process. Moreover, evidence suggests that these
spending components are highly cyclical. In fact, they represent the most
cyclically sensitive components of aggregate demand.
Non-residential fixed investment is the most conventional form of

investment spending. It is about business managers making decisions to
spend to increase a firm’s capacity for producing other goods or to cut
spending in order to contract capacity. Although residential construction
is consumer spending, a house is different from other types of consumer
spending in that it is such a major expenditure and such a long-lived asset
that it is considered investment in capital rather than merely a purchase to
be consumed in the near term. The change in business inventories is a
necessary expenditure to carry on business.
Business managers increase or decrease their holdings of inventories in

anticipation of an economic expansion or contraction, respectively.
Nonresidential fixed investment

Investment represents spending on projects where earning a profit is
anticipated. The investment component of aggregate demand is limited to
planned investment, which excludes unintended changes in inventories.
As already suggested, non-residential fixed investment conforms to the

commonly held notion of investment. It consists of spending for
structures (plants, office buildings and commercial buildings) and for
equipment: industrial machinery, office machinery (from computers to
desks to pencil sharpeners), transportation equipment (cars, trucks, ships,
and aircraft), and tools. These represent the capital goods used to produce
goods. Capital goods are factors of production that are purchased with a
large outlay up front but that yield a stream of income over an extended
period.
The usual textbook discussion of investment refers to an inverse
191
Module 3 The
relattionship betw ween investm ment and inteerest rates. Thhe typical arrgument
holdds that interest rates repreesent the oppportunity cosst (foregone rate
r of
retuurn) of tying down
d moneyy in a specific investmentt project. Thee higher
interrest rates aree, the higher the foregonee alternative (opportunity y costs)
and the lower thhe desire to in nvest in that project.
Alteernatively, thhe impact of interest ratess on investmeents is vieweed from

the perspective
p o costs of bo
of orrowing. Cllearly, rising borrowing costs
c tend
to discourage invvestment.
How wever, the relationship beetween invesstment and innterest rates is i far
morre complex. It I is not the level of intereest rates alonne that determ mines
inveestment but rather
r the lev
vel of interestt rates relativve to the ratee of
expeected return on investmen nt, with the interest
i rate bbeing viewed d as a
bencchmark. Thiss gives substtance to an im mportant behhavioural
charracteristic: buusinesses invvest in increaased plant annd equipmentt only if
theyy can envisioon increased profits
p as a result.
r Investm ments are no ot made
simpply because interest
i ratess are low.
Ressidential constructio
on
Manny factors inffluence invesstment in ressidential consstruction. Inttuitively,
you would put innterest rates high on the list l and you w would be rigght. Other
important influeences are inco ome prospeccts and emplooyment cond ditions.
Cleaarly, favouraable to the ho ousing markeets are markeet conditions that are
charracterised byy low and fallling interest rates as welll as a businesss cycle
that is in an upsw wing. The hiigher the inteerest rate is, tthe greater th
he cost of
carrrying a mortggage. A $100 0,000 mortgaage costs $8,0000 per yearr if the
interrest rate is 8 per cent butt $10,000 perr year if the iinterest rate is
i 10 per
centt. As the inteerest rate risees, the cost off owning a hhome rises an nd the
demmand for new w homes falls. An improvement in thee general health of the
econnomy causess the demand d for housingg to rise.
Chaange in bu
usiness invventories
Business investm ment is not reestricted to spending
s on ffixed capital--
strucctures and eqquipment butt also includes stocks of raw materialls, goods
still in productioon and finished goods reaady for sale. These inventtories are
heldd by manufaccturers, whollesalers, retaiilers, and farrmers and rep present
the businesses
b thhey need to carry
c out succh as bricks, m
mortar and to ools.
Inveentory managgement is a vital

v concernn to business managers whow
deteermine the innflow to inventories. Becaause the inveentories havee to be
paidd for and finaanced until th
hey can be soold, their buyying has a prrofound
effect on the com mpany’s costts.
Partt of these cossts is the carrrying cost off inventories that is influeenced by
the level
l of interrest rates. If interest
i ratess are high andd expected to o rise,
c of carryying inventorries, given the level of salles, tends to rise and
the cost
the firm
f will wannt to reduce its inventoryy level. Manaagers must allso pay
attenntion to curreent sales trennds in coordiinating their buying (ordeering) of
prodducts for futuure sale. Inveestment in innventories is related to thee
retaiilers’sales exxpectation, which
w in turnn is related too present salees trends.
192
If sales have been strong, then sales in the near future probably will
continue to be strong, and inventories will be increased. If sales have been
faltering, a firm will probably wish to curtail future orders, relying on
existing inventories to meet future sales.
Therefore, the behaviour of investment in inventories can be summarised

as follows: it rises as the expected sales increase but falls as interest rates
increase.
This discussion can be summarised with an equation relating investment

I, sum of all of its components, to the real interest rate r:
I = 1(r) (4)
Figure 3.5 shows this investment function. It slopes downward, because

as the interest rate rises, the quantity of investment demanded falls.
Figure 3.5
When studying the role of interest rates in the economy, economists

distinguish between the nominal interest rate and the real interest rate.
This distinction is relevant when the overall level of prices is changing.
The nominal (or market) interest rate is the interest rate that is usually
reported in the financial press: it is the rate of interest the investors pay to
borrow money. The real interest rate is the nominal interest rate corrected
for the effects of inflation. A full discussion of the relationship between
the real and nominal interest rates is postponed until Module 4. At this
stage, it is sufficient to know that investors’ decision to invest or not, and
how much, is sensitive to the inflation-adjusted (real rate) cost of
borrowing.
Investment demand curve
A drop in interest rates increases investment and hence aggregate

demand, giving rise to a shift in the aggregate demand curve to the right,
whereas an increase in interest rates does the opposite. A change in
business expectations, either optimistic or pessimistic, can affect the
position of the investment demand curve. If businesses anticipate that
profits will increase, the investment demand curve shifts to the right,
causing an increase in aggregate demand. Conversely, if businesses
anticipate that profits will drop, the investment demand curve shifts to the
193
Module 3 The
left, leading to a decrease in aggregate deemand.
Goverrnment pu
urchasess
Govvernment purrchases are th he third com
mponent of the demand for goods
and services. Thhe governmen nt buys heliccopters, compputers and th
he
servvices of goveernment employees. It buuys library boooks, builds schools
s
and hospitals, annd hires teach
hers and docctors.
These purchasess are only one type of govvernment speending. The other
typee is transfer payments
p to households
h s
such as welfaare for the po
oor and
the government
g pension payments for thee elderly. Unnlike governm ment
purcchases, transffer paymentss are not madde in exchannge for some of the
econnomy’s outpuut of goods and a services.. Therefore, tthey are not included
in thhe variable G.
G Transfer payments, how wever, do afffect the demmand for
goodds and servicces indirectly y. Transfer payments
p are the oppositee of
taxees: they increease househo olds’ disposabble income just as taxes reduce
r
dispposable incom me. Thus, an n increase in transfer
t paymments financced by an
incrrease in taxess leaves dispoosable incomme unchanged. We can no ow
revise our definiition of T to equal
e taxes minus
m transfe
fer payments..
Dispposable incom me, Y − T, inncludes bothh the negativee impact taxees and
the positive
p impact of transfeer payments..
A riise in such goovernment pu

urchases as highway
h connstruction, foor
exammple, causess an increase in aggregatee demand whhile a fall in
goveernment purcchases causees a decrease in aggregatee demand.
Net exxports
As seen
s earlier, net exports can
c vary withh changes in the price lev vel. For
exam mple, a drop in the Malay ysian price leevel increasees net exports
becaause Malaysiian exports area made cheeaper in the rrest of the wo orld and
imports are madde more expeensive in Mallaysia. As a rresult of this foreign
tradde effect, a chhange in the price
p level innfluences tottal spending as a
movvement of thee aggregate demand
d curvve.
Otheer factors succh as changees in incomess in foreign ccountries, cu

urrency
movvements (the rate of exch hange), and changes
c in traade instrumeents (for
exam
mple, tariffs)) cause an ov
verall changee in net exporrts. Then agg gregate
mand changess at all pricess: again theree is a shift in the aggregate
dem
dem
mand curve.
Forreign incom
me
Connsider two coountries, Mallaysia and thee United Staates. Supposee
Mallaysia is the home
h countrry and the U.S. the foreiggn country. Suppose
t U.S. Americans will be
incoome rises in the b able to buuy more prod ducts as a
resuult: not only U.S.-made
U products but also
a those maade in Malay ysia. As a
resuult, Malaysia’s (net) expo
orts to the U.S. will rise, tthereby increeasing
Mallaysia’s aggregate deman nd. Conversely, a fall in thhe U.S. income will
reduuce Malaysiaan net exportts, thereby deecreasing Maalaysia’s agg gregate
dem
mand.
194
Exchange rates
An exchange rate is the value of one nation’s currency in terms of
another currency. The value of the Malaysian ringgit, for example, can be
expressed in any other currency but is usually compared with the U.S.
dollar. Therefore, the exchange rate can show how many U.S. cents are
needed to buy one Malaysian ringgit. A rise in the value of the Malaysian
ringgit – for example, from 65 to 70 cents U.S. currency – means more
American currency is needed to purchase Malaysian funds. In this
example, Malaysia’s currency becomes more expensive for Americans to
purchase. At the same time, American currency becomes cheaper for
Malaysians to purchase since more of it – 70 cents as opposed to 65 cents
– is given in exchange for one Malaysian ringgit.
If the Malaysian ringgit goes up in value this way, exports from Malaysia
become more expensive for Americans. Therefore, a product priced at
RM1 in Malaysia costs not 65 cents in American funds but 70 cents. At
the same time, American products imported into Malaysia fall in price
when expressed in Malaysian currency. One Malaysian ringgit now buys
American products with an American price of 70 cents, whereas earlier
the same ringgit could buy American products with an American price of
only 65 cents.
Because of the impact of exchange rates on prices, net Malaysian exports

fall when the Malaysian ringgit goes up in value, causing aggregate
demand to decrease. A drop in the value of the Malaysian ringgit has the
opposite effect: net exports rise, thereby increasing aggregate demand.
Trade policies
Most industrial nations trade in environments characterised by trade
restrictions such as tariffs and quotas and other administrative restrictions.
In this setting, net exports and therefore aggregate demand will be
affected by trade liberalisation initiatives whether on bilateral bases
between two countries, multilateral bases within a regional trade
agreement, or on a broader basis such as the World Trade Organization
(WTO). For example, a reduction in general level of tariffs causes the
aggregate demand curve to shift to the right, whereas instituting new
barriers does the opposite.
Though aggregate demand comprises consumption, investment,

government spending and net exports (exports less imports), keeping
matters simple at this stage means you must assume a closed economy:
i.e., one that conducts no foreign trade. Despite the importance of world
trade, the closed economy assumption is not unrealistic. It approximates
the position of the larger industrial countries or blocs such as Japan, the
U.S. and the E.U., because the larger the economic entity, the lower the
ratio of trade to GDP. A full discussion of the economy in a global
context will be covered in Module 5.
195
Module 3 The
Moneyy and agg

gregate demand
d
We shall now tuurn our attenttion to the roole of money and how it affects
a
aggrregate demannd and the prrice level. Agggregate dem mand traces thet
relattionship betwween output demanded annd the price. The importaance of
the role
r of moneey in this disccussion arisees from (a) thhe fact that virtually
v
all economic
e traansactions in an industriall economy innvolve the usse of
monney and (b) an a important link betweenn money andd interest ratees is
imbedded in the aggregate demand
d relatiionship and ffeeds into thee link
betw nvestment. A full grasp off this link is a
ween interestt rates and in
prerrequisite to understanding
u g of the demand side of tthe economy and
therrefore how thhe economy’s general equuilibrium is aattained.
Money, intereest rates and the pricce level

Suppose we defiine money ass the stock of notes and ccoins held by y the
publlic, plus depoosits in comm mercial bankks. If people do not have enough
monney, they cut spending in an attempt to t add to theiir money ballances. If
theyy feel they haave too much h money, theey go out andd spend it on goods,
equiities or bondds etc., in an effort
e to reduuce their monney stock. Thhis link
betwween desiredd money balaances and agggregate spendding is a majjor focus
of atttention in thhis analysis. Furthermore
F e, when centrral banks injeect more
monney into circuulation, as deefined below w, banks can llend more eaasily
sincce the supplyy of credit froom which loaans are extennded has incrreased.
Thiss has an easinng impact on n lending ratees and the coost of borrow
wing falls.
Therefore, an inncrease in sup pply of moneey into the ecconomy by loowering
the borrowing
b raates tends to stimulate sppending and hence to incrrease
aggrregate demaand. The latteer, in normal circumstancces, in turn, will
w
incrrease producction. It also puts
p pressuree on prices.
A fuull discussionn of the role of money annd monetary policy and th he

aggrregate demannd curve is done
d in the laast section, w
where we will
exammine how thee tools of mo onetary policcy can shift aaggregate dem mand
and whether policy makers should
s use thhese tools forr that purposee. At this
poinnt, however, you should haveh some iddea about whhy the aggreg gate
demmand curve sllopes downw ward and whaat kinds of evvents and policies
can shift this currve. This secction will alsoo briefly disccuss how finnancial
marrkets functionn and how deemand and suupply of monney (financiaal assets)
interract to bring about equiliibrium in thaat market.
Thee money market

m
Thee demand forr money
Connsider now what

w determin nes the amouunt of moneyy people wan nt to hold.
If, for
fo some reasson, people were
w to feel thatt they hadd too much money
m and
if thhey decided to
t spend partt of their monney on other financial asssets such
as bonds
b and equuities or goo
ods and servicces, this wouuld have a drramatic
impact on the levvel of aggreg gate demandd. Note that mmoney is
convventionally and
a strictly defined
d as thee sum of cashh, or more
o the central bank) as weell as
apprropriately cuurrency (billss and coins of
bankks deposits.
196
Individuals typically hold a combination of various forms of financial

assets. We can call this a portfolio of assets. In their portfolio, they hold a
certain amount of currency on hand, a balance on deposit in the bank, and
other forms of assets. The decision to hold this amount of currency
(money) is influenced by availability of money substitutes such as credit
cards and automatic bank teller machines. The impact of these on the
amount of cash people demand is mostly noticed during the transitional
period within which the public is in the process of utilising these new
facilities and adapting to the new environment. Once the period of
transition has passed, no further noticeable change should be observed.
People hold money for a variety of reasons. At this stage, however, a

unique and indisputable reason is that, unlike other assets such as bonds
and stocks, money can be used to buy the goods and services on a
shopping list. How much money people choose to hold for this purpose,
given the availability of credit cards and other similar facilities, depends
on the level of their average income, the price of those products, and the
interest rate.
1. Income. The richer you are, the more money you are likely to
hold in absolute terms, even though the proportion of your total
assets held as money may fall. Individuals hold currency to
finance daily transactions. They use bank accounts to cover such
items as monthly credit card charges, telecommunications bills,
and other bills which fall due for payment on a regular basis.
Companies require money for much the same reasons.
2. The price level. The higher prices are, the more money the typical
transaction requires and the more money people will choose to
hold in their wallets and cheque account. When prices fall, people
reduce their demand for money when embarking on a shopping
spree or allocating a bigger share of their portfolio to financial
assets. Note the close link between the price level and aggregate
demand implicit in this explanation.
3. The interest rate. No interest is paid on currency and deposits
often receive only a token rate of return. Higher interest rates,
therefore, increase the opportunity cost of holding money and
reduce the demand for it.
The supply of money
Money supply is defined as the sum of currency in circulation plus public

deposits with financial institutions. This definition, however, changes
depending on the type of deposits included in it. Therefore, there are
several types of money supply that central banks monitor. Some serve
specific purpose and include only a limited number of deposits while
other definitions of money consist of a wider spectrum of deposits,
including saving deposits, term deposits, money market mutual funds, and
foreign-currency-denominated deposits. A full discussion of this subject
appears in Module 4 under the section on Financial Markets, Monetary
and Fiscal Policy.
Figure 3.6 shows the elements of the money market. The nominal interest
197
Module 3 The
rate (i) is measurred on the veertical axis and the quanttity of money y on the
horiizontal axis. The demand d for money is i representedd by a downward
slopping curve, Md.
M The logicc behind this is that higheer interest rattes
incrrease the oppportunity costt of holding money
m and ttherefore deccrease the
quanntity of moneey demanded d. This curvee is also referrred to as thee
liquidity prefereence curve.
Supply of moneyy, as discussed above, is determined by the centraal bank.

Reggarded as an exogenous
e variable
v – a factor
fa whose value is deteermined
outsside the systeem money su upply (stock)) is representted by a vertiical line
in thhis space, Mss. The logic behind
b this iss that the quaantity of mon
ney in
circulation is inddependent off the rate of interest.
i Equuilibrium in th
he
monney market iss achieved when
w Md = Ms,
M point E1.
Figu
ure 3.6
Otheer variables, such as inflaationary expeectations andd credit card

techhnology also affect the deemand for mooney but we will ignore them t for
noww in order to avoid
a unneceessary complications.
Acccording to thiis mechanism m, the interesst rate adjustss to the levell in

whicch the demannd for money y is equal to the supply. T To better und derstand
howw this mechannism works, assume that initially the interest rate is at a
ferent level – say, i2. This figure show
diffe ws that at i2, thhe demand for
f
monney is equal to
t i2A. The money
m supplyy is equal to i2 B.
Therefore, moneey supply is greater

g than money demaand excess su upply of
monney. This is the
t case becaause at a highher interest raate, the oppoortunity
costt of holding money
m is so high
h that thee central bankk makes morre money
avaiilable than thhe amount individuals wiish to keep inn circulation..
m fall to baalance demaand and supply.
Therefore, the innterest rate must
Connversely, if thhe interest raate is below the
t equilibriuum level, peo
ople will
wannt to hold moore money than the quantity available, and the inteerest rate
musst rise to balaance demand d and supply.
The following Tables3.2

T and
d 3.3 summaarise the poinnts made on this
t topic
so far.
fa
198
A lower price level increases real wealth, which encourages

1 The wealth effect
spending on consumption.
A lower price level reduces the interest rate by increasing
The interest rate
2 the real value (purchasing power) of money in the hands of
effect
the public that, in turn, encourages spending on investment.
The real exchange- A lower price level causes the real exchange rate to
3
rate effect depreciate, which encourages spending on net exports.
Table 3.2 Factors that cause the aggregate demand curve to slope
downwards
Shift to the right Shift to the left

1 Shifts arising A change in consumption due An event that makes
from to an increase in wealth consumers spend less, e.g.:
consumption unrelated to a change in the • A tax hike
price level, e.g.:
• A stock market decline
• A stock market boom
• A tax cut
2 Shifts arising Events that make firms invest Events that make firms
from investment more at a given price level, invest less at a given price
e.g.: level such as:
• A fall in interest rates due • A rise in interest rates
to rising money supply due
• An increase in optimism • A decrease in money
about future expected supply an increase in
profits pessimism about future
expected profits
3 Shifts arising An increase in government A decrease in government
from purchases purchases on goods and
government • of goods and services, services, for example
purchases such as: greater • A cutback in the
spending on health and allocated budget
education
• highway construction
4 Shifts arising An increase in net exports due An event that reduces
from net to: spending on net exports at a
exports • A boom experienced by a given price level.
major trading partner
• An exchange-rate
depreciation
• A change in trade policy
characterised by, for
instance, reduced tariff
barriers
Table 3.3 Factors that cause a shift in the aggregate demand curve
199
Module 3 The
1. Which of thee following events

e wouldd shift the agggregate dem
mand
curve to the left?
A. A deecrease in tax
x rates
S
Study skills B. An increase
i in government
g s
spending
C. An exchange
e ratte appreciatioon
D. A faall in the pricce level
ution:
Solu
C. A and B cause
c a righttward shift, whereas
w D caauses a moveement
along the cuurve. An exchhange rate apppreciation m
makes domesstic
exports morre expensive and hence reeduces aggreegate demand d.
Outpu
ut, aggreg
gate supp
ply and itss components
Gross domestic product meaasures both exxpenditure aand output. TheT
prevvious sectionn viewed the expenditure approach as aggregate demand.
d
On the
t other hannd, output reppresents the production oof the goods and
servvices that are demanded. Now
N let us tuurn our attenntion to the ro
ole of
prodduction.
Thee aggregatte supply curve

c
Let us look at thhe elements th
hat make up supply. Thee supply side of the
econnomy (produuction) consists of two eleements:
1. Input markets: Conssist of labourr, capital and raw materiaals.
2. The production funcction: A technnological rellationship thaat relates
inputs too output while the manneer in which thhey are combbined is
the technnology.
At thhe microeconomic level,, this is a vitaal manageriaal concern disscussed

in Module
M 2. Froom a macroeeconomic perrspective, hoowever, the
avaiilability and growth of thhe factors of production
p ddetermine thee
poteential for groowth by the overall
o econoomy.
The aggregate suupply curve shows combbinations of rreal output (Y Y) and

the price
p level (PP) which are consistent with
w the equillibrium in th he
prodduction side of the econo omy. Figure 3.7 shows diifferent aggregate
T price on the vertical axis
suppply curves. The a of the agggregate supply
vel. This conntrasts with thhe industry supply
curvve is the geneeral price lev
curvves in Modulle 1, where th he price of thhe industry’ss output is on
n the
verttical axis. Thhe industry su
upply effect arises
a becausse the price ofo the
induustry’s outpuut is defined relative
r to prrices in otherr sectors. Alll other
prices are assum med to remain n constant. Inn the case off the aggregatte supply
curvve, the general price level is defined relative
r to prrices of produuctive
factoors such as labour.
Youur intuition may

m tell you thatt the pricee level and reeal output should be
directly related, giving the agggregate suppply curve a ppositive slop
pe. At
highher price leveels in the eco
onomy, businnesses are enncouraged to produce
200
more, whereas at lower prices businesses may not be able to make a profit
or break even in the short run, so they reduce output. Indeed, this is
typically the situation, in the short run. A rise in the general price level
relative to nominal wages has a positive effect on aggregate supply and
the aggregate supply curve will be positively sloping.
Contrarily, if one believes that the price of labour (and other productive
factors) is linked to the general price level – because, let us say,
employees demand higher pay to compensate for inflation – there can be
no relative price effect and the aggregate supply curve will tend to be
vertical. This is regarded as a long-run situation.
In conclusion, a vertical aggregate supply curve shows that a given level

of real output, Yn, is consistent with many possible price levels. A
positively-sloped supply curve shows that a rise in the price level from
P1to P2, is consistent with a rise in output from Yn to Y2 — the short-run
aggregates supply curve is upward sloping. This line of reasoning, as you
will see, has important implications for macroeconomic policy.
Figure 3.7
A key distinction here is between actual GDP (output) and natural or

potential GDP (Yn), where natural GDP represents the output of goods
and services that would be produced if the unemployment rate were at its
natural, or normal, rate. The natural level of output is the level of
production toward which the economy gravitates in the long run.
The notion of natural output or full-employment output needs some

clarification. The concept of the normal (natural) unemployment rate does
not, however, imply zero unemployment, nor does “natural level of
output” imply the maximum output. A term that economists have used in
the past is “full-employment unemployment rate”. You may wonder at
economists’ tolerance for apparent nonsense. Today, the term “natural
rate of employment” has replaced this contradiction in terms, paired with
“natural output” for productivity.
201
Module 3 The
Dettermination of naturaal level of output
Figu
ure 3.8
Twoo steps are innvolved in deetermining thhe natural levvel of GDP, Yn. The
firstt is to determ
mine the naturral level of employment,
e Ln and the second, to
readd off the leveel of output from
fr the prodduction functtion. Naturall level of
empployment is thet employm ment counterppart of naturaal output. The natural
leveel of employm ment is by deefinition attaained when thhe labour maarket
cleaars – where demand
d and supply
s cross each other aas seen in Figgure 3.8.
Alsoo determinedd at this interrsection poinnt, indicated iin Panel (a), is
equiilibrium real wage. Secon nd, having determined eqquilibrium off
empployment (Ln) and equilib brium real waage, you cann read off the level of
outpput from the production function,
f Pannel (b). The pproduction fu
unction –
morre correctly thhe short-run production function – inndicates the level
l of
outpput that can beb produced by each leveel of labour innput, assumiing it is
commbined with a fixed capitaal stock (K), technology aand other facctors.
Thuus, it shows thhat an outputt of Yn can bee produced bby the input of o
laboour, Ln.
The equilibrium m real wage in n Figure 3.8 is representeed by (W1/P1). Note

that the real wagge is the ratio
o of the markket or nominnal wage (mo onthly or
weeekly pay), W,, to the price level, P, whhich in this eqquilibrium arre
assuumed to be W1and P1, respectively. Thhe real wagee, W/P, is a measure
m
of thhe purchasinng power of workers’
w incoome. The reaason behind having
h
the real
r wage apppear on the vertical
v axis in the panel (a) is that bo
oth
worrkers – who area behind th he supply of labour
l curvee – and firms – which
are behind
b the demand for laabour curve – behave ratiionally. They y
calcculate, bargaiin and decidee if and how much to work on the bassis of the
real wage, not thhe nominal money
m wage. In technicall jargon, all market
m
partticipants are assumed
a to be
b free from money illusiion.
202
Short-run versus long-run aggregate supply curve

The distinction is often drawn between the long-run aggregate supply
curve (LRAS), which is vertical, and the short-run aggregate supply curve
(SRAS), which is upward- sloping, as seen in Figure 3.7. The proof of
this, however, is provided by Figure 3.8. A rise in prices could lead to
higher output if (nominal) wages did not change, or in other words, if
wages were sticky. As shown in Panel (a), when the price increases to P2,
the amount of labour employed increases to L2. Corresponding to this
rise, as shown in panel (b), is an increase in output to Y2. Therefore, a new
equilibrium point is reached at output Y2 and price P2. The increase in
price has brought about an increase in output. Put differently, a change in
price has a real effect on that the quantity of output produced, in the short
run. Tracking the effects of different price levels and joining the points
together produces an upward-sloping SRAS curve.
The wage stickiness in the analysis might be present because the rise in
price was unanticipated or due to fixed-term pay deals. Employees might
require time to absorb the implications of the rise in price and may react
more slowly than firms do to the new price level. For these reasons, price
changes can have real effects on output and employment in the short
term.
The existence of rigidities and short-term wage stickiness may be

intuitively acceptable as a working assumption of how the labour market
operates in the short run. But such irrational behaviour cannot be
sustained indefinitely. Eventually, employees will respond in a rational
manner. Therefore, you might query how long it will take them to
respond. The length of the short run is not generally agreed upon; it is
likely to vary from country to country, and even from region to region.
Changes in aggregate supply

As discussed above, the short-run aggregate supply curve is an upward-
sloping function of price. However, other factors in addition to the price
level can influence real output. These factors change real output at all
price levels. In other words, they shift the aggregate supply curve. Once
again, as we examine each in turn, we must assume other factors remain
constant (ceteris paribus).
Input prices
Aggregate supply assumes steady input prices for the businesses that are
producing the output. Changes in input prices – an increase in wages, for
example, or increased prices for imported raw materials give rise to a rise
in production costs. These changes can occur frequently over brief
periods of time. When a rise in the price of an input pushes up production
costs, businesses reduce their real output and the short-run aggregate
supply curve shifts to the left. Note, however, that unless input price
increases happen to be long-lasting, no changes will happen to the
economy's potential output. That is, the long- run aggregate supply curve
203
Module 3 The
rem
mains unchangged.
Connversely, if thhe price of an

n input decreeases, producction costs faall.
Businesses then raise their reeal output, caausing the agggregate supp ply curve
to shhift to the rigght.
Ressource supplies
Oveer the long teerm, supplies of resourcess in an econoomy, especiaally

humman and capittal resources, tend to grow w. With anyy such increasse,
busiinesses produuce more reaal output at every price leevel. In otherr words,
morre inputs over the long ru un increase agggregate suppply as well as
a the
econnomy’s potenntial output. The reverse is also possiible. With a long-run
l
reduuction in the amounts of any a resourcee, businesses will producee lower
real output at alll prices, thereeby causing a long-run ddecrease in ag
ggregate
suppply which is accompanied by a reduction in the ecconomy’s po otential
outpput. In such cases,
c both thhe long-run and
a the shortt-run aggregaate
suppply curve shiift.
Technological knowledge
k
Onee of the most important reeasons the ecconomy todaay produces more m
thann it did a genneration ago is
i that our tecchnological kknowledge has
h
advaanced. The innvention of thet computerr and Interneet, for instancce, has
allowwed us to produce more goods and seervices from m any given am mounts
of laabour, capitaal, and naturaal resources. A technologgical innovatiion raises
prodductivity: thhe same amou unt of econom mic resourcees can producce more
real output at evvery price levvel and hencee can shift thhe long-run
aggrregate-supplyy curve to th he right.
Govvernment po
olicies
Govvernment pollicies can also influence aggregate

a suupply through h their
effects on the buusiness envirronment in ann economy. F For example, suppose
that taxes rise foor businessess and househoolds. Becausse the after-taax
retuurns on supplying econom mic resourcess are reducedd, businesses and
households mayy reduce the resources
r theey supply at eevery price level. As
a ressult, real outtput falls, cau
using a long--run decreasee in aggregatte supply.
Connversely, low wer taxes may y encourage businesses aand households to
incrrease their suupply of econ nomic resourrces, leading to a rise in real
r
outpput and a lonng-run increaase in aggregaate supply.
Govvernment reggulations such h as environmmental and ssafety standaards,

typically raise peer- unit costss for some buusinesses whhile lowering
g it for
otheers (especiallly those that have been addversely affeected by lax
reguulations). Hence, more reegulation cauuses some buusinesses to produce
p
less and, at the same
s time, otther businessses to producce more outp
put at
everry price levell. Therefore, the effect onn aggregate ssupply is am
mbiguous.
Thiss continues too be a controoversial issuee.
Factors causing
g the short-rrun aggregaate supply curve to slop
pe
upw
wards
‘Sticckiness’: Th
he sticky wag
ge and the prrice theory
204
Because nominal wages are slow to adjust (sticky) in the short run, long-
term employment contracts affect changes in product prices experienced
by firms. These price changes do not immediately translate to changes in
money wages.
The sticky price theory regards the slow adjustment in prices as the cause
of the upward sloping supply curve because of the implicit agreement
between vendors and their customers or because of large costs of
adjusting the price. For example, newspapers do not adjust their prices
periodically, despite economic conditions.
Wage stickiness
Wage impact Cost of hiring Effect on production
When the . . . then the real …pushing costs of …therefore, forcing the firms
price level wage (W/P) rises hiring labour to to hire less labour and produce
falls firms higher and, less goods and
A rise in P …so that the real …reducing firms’ …causing firms to hire more
has the wage (W/P) falls, costs of hiring and produce more.
opposite labour and…
effect
Price stickiness
Effect on
Demand impact Revenue impact
production
Change in economic Reduced Less revenue to Reducing sales and
condition other than price purchasing firms production
power
Change in economic Increased More revenue to Increasing sales
condition other than price purchasing firms and production
power
Table 3.4 Stickiness factors causing the short-run aggregate

supplycurve to slope upwards
With prices being sticky in the short run, a change in economic condition
which reduces the overall purchasing power of buyers will cause a drop in
sales and production, whereas an opposite situation will have a positive
effect on sales and production in the short run.
The imperfect information theory
Both firms and workers may in fact base their decisions on incomplete
information or misperceptions in the short run. Firms may misinterpret
market signals. That is, they may temporarily mistake a general increase
or decrease in the overall price (P) for a change in the price in individual
markets (relative to other markets). Workers may also misinterpret the
situation. Since they tend to notice a change in their (nominal) wage
before they notice a change in the price level, they may mistake the
205
Module 3 The
form
mer for a chaange in their real
r wage annd act accorddingly.
Tech
hnological chaanges
Shiftts arising from
m inputs:
In
nput Mechanism S
Shift
Capital Chaanges in capital Increassed volume of ggoods and servvices
stocck of the econom
my causess a rightward shhift in the aggregate
affecct labour supply curve; decreassed volume cauuse a
prodductivity leftward shift.
Natural Chaanges in supply With a rise (fall) in thee supply of natuural
Resoources resourcces the aggregaate supply curvve shifts to
the righht (left).
Laboour Chaanges in labour An incrrease in the sizee of the labour force
forcee size increasses the supply oof output of the economy
— a rigghtward shift in the aggregate supply
curve — and vice verssa.
Tab
ble 3.5 Factoors causing a shift in thee long-run aaggregate su
upply
curvve
Factors causing
g a shift in the
t short-run
n aggregate supply curvve
The short-run agggregate supp

ply curve shiifts arise from
m:
• The sam me factors thaat caused a shhift in the lonng-run aggreegate
supply curve.
c If the long-run agggregate supplly curve shiffts to the
right (leeft), the shortt-run aggregaate supply cuurve shifts along with
it to the right (left).
• Changess in people’ss expectationns of the pricee level. The short-run
s
supply ofo goods andd services also shifts withh changes in
expectattions of the price
p level, which
w in turnn depends on
perceptiions of wages and prices.. An increasee (decrease) ini the
expectedd price level causes a left
ftward (rightwward) shift in
n the
short-ruun aggregate supply curvee.
Gen
neral equillibrium
Lonng-run equilibbrium occurss when aggreegate demandd and supply y are put
togeether (Figuree 3.6). You thhen obtain thhe equilibriumm price and income
leveels in the ecoonomy at Ynan E At that point E, national
nd P, point E.
expeenditure equals national income
i and also
a equals nnational outp put. This
is where
w N howeveer, that the shhort-run and long-run
AD croosses LRAS. Note
w each othher. By the time the econ
equiilibrium poinnts coincide with nomy has
reacched this longg-run equilib
brium, there will
w have beeen adjustmen nts in
percceptions, wagges and pricees so that thee short-run agggregate supply
curvve crosses thiis point as well.
w
206
Figure 3.6
Short-run macroeconomic equilibrium and business cycles

The business cycle occurs because aggregate demand and short-run
aggregate supply fluctuate but the money wage rate does not adjust quick
enough to keep the actual GDP at potential GDP. Figure 3.7 shows two
types of short-run macroeconomic equilibrium.
Panel (a) shows an above-full-employment (over-employment)

equilibrium situation. This type of equilibrium is a short-run
macroeconomic equilibrium in which actual GDP, Y2, exceeds potential
GDP, Yn. The amount by which actual GDP exceeds potential GDP is
called an inflationary gap, (Y2 − Yn) > 0. As the name suggests, this gap is
poised to create inflation. This gap occurs either because the economy has
experienced a boom or because actual GDP, while growing, has grown
faster than potential GDP.
Panel (b) shows a below-full-employment (or underemployment)

equilibrium situation. A below-full-employment (underemployment)
equilibrium is a short-run macroeconomic equilibrium in which actual
GDP falls short of potential GDP. The gap between actual GDP and
potential GDP is called a recessionary gap, (Y1 –Yn) < 0. As the name
suggests, this occurs either because the economy has experienced a
recession or because actual GDP, while growing, has grown more slowly
than potential GDP.
207
Module 3 The
Figu
ure 3.7
Adjjustments in the long

g run
An important
i quuestion that arises
a is whetther the econnomy can forrever
prodduce in excesss of its poteential GDP ass illustrated iin Figure 3.88 Panel
(a) — or stay beelow that poteential, as in Panel
P (b). Arre there forcees that
brinng actual GDP back to its potential (natural) level?? These quesstions
needd to be addreessed before we can tacklle policy impplications. Reemember
that when the ecconomy movees along its SRASS curve, the price levvel
channges while thhe wage leveel remains unnchanged. Thhis, thereforee, causes
an adjustment
a inn the real wag ge, W/P, whiich in turn teends to entaill further
adjuustments.
Connsider panel (a)

( in Figuree 3.8, which represents
r ann over-emplo
oyment
equiilibrium situaation, point B,
B and an infflationary gapp of (Y1−Yn)
maggnitude. At point
p B relativ
ve to A, pricee has risen w
while the nom
minal
wagge remained constant.
c Theerefore, workkers have exxperienced a fall in
the buying
b poweer of their waages while thhe firms’ proofits have inccreased
from
m the reducedd real cost off workers. Evventually, woorkers will demand
d
highher (money) wages; firmss, anxious to maintain theeir employm ment and
outpput levels, wiill meet those demands. If I firms do not raise mon ney wage
ratess, they will either
e lose woorkers or endd up hiring leess productiv
ve ones.
As the
t money wage
w rate risees, the short-rrun aggregate supply curvve shifts
leftw
ward from SRRAS1 toward ds SRAS2 andd this producees a sequencee of new
equiilibrium posiitions. The ecconomy movves up along its aggregate
demmand curve, AD
A 1, as show wn by the arroowheads in tthe figure, ass actual
GDP P decreases and
a the pricee level rises.
208
Figure 3.8
Eventually, the money wage rate would have risen by the same
percentage as the price level. At this time, the aggregate demand curve
AD1 intersects SRAS2 at a new long-run equilibrium, point C, where actual
GDP is equal to potential GDP once again.
In contrast, panel (b) represents an underemployment equilibrium

situation, point B’, and a recessionary gap of (Yn – Y2) magnitude. At B’
relative to A’, price has fallen while money wage stayed constant. The
lower price level has increased the purchasing power of wages (real
wage) and decreased firms’ real costs. Eventually, the slack in the
economy will lead to a falling money wage rate: workers anxious to
maintain their jobs and the unemployed, anxious to find a job, will give in
under pressure. The short-run aggregate supply curve will then shift
rightward to SRAS2. Eventually, the aggregate demand curve (AD1) will
intersect SRAS2 at a new long-run equilibrium, point C’, where actual
GDP is equal to potential GDP once again.
Causes of economic fluctuations

The model of aggregate demand and aggregate supply gives you the basic
tools you need to analyse fluctuations in economies. At this stage, let us
examine two basic causes of short-run fluctuations and then, in the next
unit, you can refine your understanding of how to use these tools.
Shifts in aggregate demand

Figure 3.9 shows an economy in long-run equilibrium. As expected,
equilibrium output and the price level are determined by the intersection
of the AD curve and the LRAS curve, shown as point A. The short-run
aggregate-supply curve passes through this point as well, indicating that
perceptions, wages and prices have fully adjusted to this long-run
equilibrium.
209
Module 3 The
Suppose that a series

s of disapppointing eaarnings depreesses the stocck market
and a wave of peessimism sud ddenly hits thhe economy.. Because off these
evennts, many peeople lose connfidence in the
t future andd alter their plans.
p
Houuseholds mayy cut back on n their spendding and delaay major purcchases,
firm
ms may put offf buying new w equipmentt, or people m may sell equuities in
ordeer to hold moore of their wealth
w in the form of monney.
As result
r of thesse developmeents, the aggrregate demannd for goodss and
servvices will be reduced becaause of a droop in both coonsumer spen nding and
spennding by firm ms. As shown n in Figure 3.9,
3 the aggreegate-deman nd curve
shift
fts to the left from AD1 to o AD2. In thee short run, thhe economy moves
alonng the initial short-run ag ggregate-suppply curve, SR RAS1, from point
p A
to point B, wherre output is reeduced from m Yⁿ to Y2, annd the price level
l fall
fromm P¹ to P². Thhe gap shown n by (Yⁿ – Y2) indicates a recessiona ary gap.
Althhough the em mployment efffect is not shhown in the figure, firmss respond
to loower sales annd production n by reducinng employmeent. Thus, thee
pesssimism that caused
c the sh
hift in aggreggate demand is, to some extent,
e
self--fulfilling: peessimism abo out the futurre leads to fallling incomees and
risinng unemployyment.
Figu
ure 3.9
In thhe absence of
o any action by policy-m makers, a no-aaction or han nds-off
stannce, the recesssionary gap will force thhe price level to fall. Eveentually,
expeectations willl adapt to thiis new realityy of rising unnemploymen nt and
slowwing econom my. Perceptions, wages annd expected pprices will alll be
revised downwaard, causing a shift in the short-run agggregate- sup pply
curvve to the righht towards SRRAS2, in the above figuree. Over time,, the
econnomy will appproach poin nt C, where thhe new aggreegate-deman nd curve
(ADD2) crosses thhe long-run aggregate-suppply curve.
The economy, inn this case, hash remediedd itself over a period of tim me. In
the new
n long-runn equilibrium m, point C, output is backk to its naturaal level.
Even though thee wave of pesssimism reduuced aggregaate demand, the t price
leveel has fallen sufficiently
s (to
( P3) to offfset the shift iin the aggreg
gate-
dem
mand curve.
Alteernatively, faaced by the reeality of econnomic hardship in the

receessionary perriod, the period that it takkes for the ecconomy to move
m from
B too C in Figuree 3.9 — and the fact that the transitionn towards loong-run
210
equilibrium may be long and painful for the economy and the
unemployed, policy makers may choose to take action to accelerate the
recovery instead of waiting for the system to remedy itself. This action
typically takes the form of increasing money supply or government
spending.
If policy makers can act with sufficient speed and precision, they can
offset the initial shift in aggregate demand by increasing money supply or
government spending to move the aggregate demand curve back to AD1
and bring the economy back to point A.
Shifts in aggregate supply

As we know, a shift in the aggregate supply curve arises from a change in
supply of factors of production (inputs) or technology. For example, let us
consider an economy in its long-run equilibrium. Suppose that suddenly
some firms experience an increase in their costs of production due to an
increase in the price of raw materials. A standard textbook example in the
19th century was a crop failure due to bad weather; in the 20th century, the
rising price of oil triggered by an oil cartel such as OPEC. The 21st
century example may return to such environmental or seismic disasters as
an earthquake under a microprocessor plant complex.
What is the macroeconomic impact of such an increase in production

costs? For any given price level, firms now want to supply a smaller
quantity of goods and services.
Thus, as Figure 3.10 shows, the short-run aggregate-supply curve shifts

to the left from SRAS1 to SRAS2.
Figure 3.10
In the short run, the economy moves along AD1 to point B, where output
of the economy has fallen from Yn to Y2 and the price level has risen from
P1 to P2. Because the economy is experiencing stagnation (falling output)
and inflation (rising prices), such an event is called stagflation.
What should policymakers do when faced with stagflation?

Unfortunately, there are no easy choices. One possibility is to do nothing.
211
Module 3 The
In thhis case, the output of goods and servvices remainss depressed at a Y2 for
a whhile. Eventuaally, howeveer, the recessiion will remeedy itself as
percceptions, wagges and pricees adjust to thhe higher prooduction cossts. The
prevvailing periodd of low outp put and highh unemploym ment puts dow wnward
presssure on workkers’ wages. Lower wagees, in turn, inncrease the quantity
q
of output
o supplieed. Over tim
me, the short-rrun aggregatte-supply currve shifts
backk toward SRA AS1, the pricee level falls, and the quanntity of outpu
ut
apprroaches its natural
n level. In the long run,
r the econnomy returns to point
A, where
w the agggregate-demmand curve crrosses the lonng-run aggreegate-
suppply curve. Inn this case, po
olicymakers make the chhoice of main ntaining a
low price level ata the cost off temporarilyy lower outpuut and employ oyment.
Alteernatively, poolicymakers who control money suppply and government

spennding as welll as taxes miight attempt to t offset som
me of the effeects of
the shift
s in the shhort-run agg gregate- suppply curve by sshifting the
aggrregate-demannd curve. Th his possibilityy is shown inn Figure 3.10 0. In this
casee, changes inn policy shift the aggregatte-demand cuurve to the riight to
AD2, exactly enoough to prevent a shift inn aggregate suupply from affecting
a
outpput. The econnomy movess to point C. OutputO remaains at its natu
ural
leveel, but the priice level rises from P2 to P3. In this caase, policymmakers are
saidd to accommoodate the shift in aggregaate supply beecause they allow a the
incrrease in costss to affect thee level of prices permaneently. Policym makers
makke the choicee of maintain ning a constaant level of reeal output annd
empployment at thhe cost of a permanently
p y higher pricee level.
212
Modulesummary
This modulehas offered the basic definitions for understanding of GDP,
GNP, CPI and unemployment. You have learnt the calculation of national
income and the contrast of nominal and real GDP.
Summary You have also reviewed the concepts of aggregate demand, aggregate
supply and their equilibrium. Business cycle is the formation where
output and expenditures follow a cycle of expansions and contractions.
In the followingmodules, you will be looking at money, financial

institution system, monetary policies, fiscal policies, Phillips Curve,
inflation and unemployment.
213
Module 3 The
Assig
gnmentt
1. Define Grosss Domestic Product
P (GD
DP).
2. Explain the difference beetween nomiinal GDP andd real GDP.
3. What does thhe unemploy
yment rate measure?
m Briefly explain how it is
calculated.
A
Assignment 4. What is the GDP
G deflato
or and how iss it calculatedd?
5. What is the Consumer
C Prrice Index (C
CPI) and how
w is it calculaated?
6. Why should we be conceerned about an
a increase in the unemp
ployment
rate? Brieflyy explain.
7. Increases in the rate of in
nflation can have
h a numbber of negativ
ve
effects on thhe economy. Briefly explaain two (2) oof them.
8. What compoonent of aggrregate demannd is related to disposable
income?
9. What does marginal
m prop
pensity to coonsume repreesent?
10. What are thee key determ
minants of invvestment spennding?
11. Explain the marginal
m pro
opensity to coonsume (MP
PC) and the marginal
m
propensity too save (MPS
S). Prove thatt why MPC + MPS alway ys equals
1.
12. What is the role
r of exchaange rates in determiningg aggregate demand?
d
Which compponent of AD
D is influenceed?
13. Explain whyy AD is a dow
wnward-slopping functionn of the price level.
14. What factorss cause a mo
ovement alonng the AD currve; what facctors are
responsible for
f a shift in that curve?
15. Why is potenntial GDP in
ndependent of
o the price leevel?
16. What curvess, AD, SRAS and LRAS, are
a the determ
minants of ou
utput
(GDP) and the
t price in th
he short run??
17. What is the determinant
d of price in thhe long run — AD, LRAS
S or
SRAS?
18. What is staggflation?
19. What is the link
l between
n money marrket and aggrregate deman
nd?
20. What are thee causes of business
b cyclees?
21. What is monney supply? How
H might it i be controllled by the
authorities? What forces in the econoomy tend to bbring moneyy supply
and money demand
d into equilibrium??
214
Assessment
1. Consider an imaginary economy that produces only three goods:
steak, eggs and wine. Information on the quantities and prices of each
good sold for two years is given below.
Assessment 1997 2001

Output
Steak (kgs) 10 7
Eggs (dozens) 10 13
Wine (bottles) 8 11
Price
Steak (per kg) $9.10 $11.50
Eggs (per dozen) $1.10 $1.30
Wine (per bottle) $6.00 $6.50
For this hypothetical economy, calculate each of the following:

A. Nominal GDP.
B. Real GDP in constant year 1997 dollars (i.e., 1997 is the base
year).
C. GDP deflator.
D. The percentage of change in real GDP and the GDP deflator
between year 1997 and year 2001.
2. On the basis of your analysis in question 1, was nominal GDP in year

1997 greater than, less than or equal to real GDP in year 1997? If the
values for nominal and real GDP in year 1997 are different, explain
why this is so.
3. Suppose you are provided with the following information about an
economy that consists of just three firms.
STEEL COMPANY LOBSTER COMPANY
Revenues from sales $400 Revenues from $200
sales
Expenses (wages) $340 Expenses (wages) $160
Profits $60 Profits $40
CAR COMPANY
Revenues from sales $1,000
Expenses
Wages $500
Steel purchases $400
Profits $100
215
Module 3 The
A. Usinng the final goods

g approaach, what is tthe GDP?
B. Calcculate the vaalue added foor each of thee three firms.. Based
on your
y calculattions, what iss the GDP ussing the value-added
apprroach?
C. Whaat are the tottal wages (whhat is the labbour income)) in this
econnomy? Whatt are total proofits in this eeconomy? Giiven your
calcculations and
d using the inncomes approoach, what iss the
GDP P?
D. Commpare the lev
vels of GDP obtained in pparts (a), (b) and (c).
Whiich of these approaches
a y
yields the higghest and sm
mallest
leveel of GDP? Explain.
E
E. Based on your analysis,
a whaat percentagee of GDP is allocated
a
to: (1)
( labour inccome and (2)) profits?
4. Suppose nom minal GDP in year 2000 increased byy 7 per cent (over
( its
level in yearr 1999). Baseed on this infformation, w
what happeneed to the
rate of inflattion (as meassured by the GDP deflatoor) and real GDP
G
growth betw ween year 199 99 and year 2000?
2 Explaain.
5. Use the infoormation prov
vided below to answer thhe following
questions.
Real GDP
G (in
Nominal GDP
G GDP deflatorr
G
Year million
ns of year
(m
millions ofdollars) (
(1997 = 1.0)
1992 dollars)
d
1996 839,331
8 0.9889
1997 885,022
8 885,022
1998 0.9996 919,770
1999 975,059
9 1.0009
2000 1,0
055,604 104.6000
A. Whaat was nomin nal GDP in year
y 1998? W
What was thee GDP
defllator in year 1997?
B. Usinng the GDP deflator
d (where 1997 = 11.0), calculatee real the
GDP P for the rem
maining yearss.
C. Usinng your calcu ulations in part (B), comppare the leveels of real
GDP P with the leevels of nomiinal GDP forr each year. What
W
doess this compaarison suggesst about pricees in that yeaar
(relaative to year 1997)?
D. Expplain why eco
onomists foccus on real raather than nom
minal
GDP P when analy
ysing the levvel of an econnomy.
6. What sectorrs are least afffected by a downturn?
d
7. Identify the impact of eaach of the folllowing trendds on aggreg
gate
demand. In each
e case, drraw a graph tot show the eeffect on thee
o the equilibbrium price level and
aggregate deemand curvee as well as on
real output.
A. Connsumers beco ome more coonfident abouut the prospects for
outpput growth in
n the econom
my.
216
B. Interest rates rise.

C. Political pressure causes an increase in tax rates on
households earning high incomes.
D. Oil prices rise everywhere.
E. The local currency rises in value against the currency of the
trading partners.
8. Assume that your economy has the following aggregate demand and
supply schedules:
Real GDP
Real GDP Supplied Price Level in the
Demanded (billions
(billions of dollars) short run
of dollars)
520 120 100
440 140 110
360 160 120
280 180 130
200 200 140
120 220 150
40 240 160
A. In a figure, draw the aggregate demand and short-run

aggregate supply curve.
B. What are the short-run equilibrium values of real GDP and
the price level in your economy, based on this information?
C. If your economy is capable of producing $220 billion at its
potential, what is the size of the output gap? Is there a
recessionary gap or inflationary gap? Draw the long-run
aggregate supply curve.
9. Using the aggregate supply relation, explain how each of the
following events will affect the price level and output. Make sure you
explain the relevant shifts in the supply relationships, if any, first.
A. 10 per cent increase in wages.
B. 5 per cent increase in the price of a key raw material.
C. Increase in technology
10. Suppose Y>Yn.
A. What type of an output gap does this represent?
B. What does this mean for prices and GDP in the future?
C. What will happen to the expected price next year?
D. What will happen to nominal wages next year?
11. Answer all parts of question 10 if Y<Yn.
12. Assume the economy is initially operating at Yn. Now suppose the
Central Bank increases money supply.
217
Module 3 The
A. Usee a graph of AD-SRAS

A too illustrate thhe initial equiilibrium
situaation.
B. Whaat are the initial effects of
o the increasse in money supply
s
on P,
P M/P, intereest rate, and GDP? You m may find it useful
u to
skettch a money market diagrram in the baackground fiirst.
C. Doees Y return to
o Yn? And if so,
s what does this suggesst about
the price
p and thee expected prrice?
13. Explain whaat happens too money dem
mand and bonnd demand as a result
of each of thhe following events:
A. A 100 per cent in
ncrease in reaal GDP.
B. A reeduction in in
nterest rates.
14. Use the spacce provided below
b to answer this queestion.
A. Howw much mon ney do individduals hold att the initial in

nterest
rate (i)? Show th
his in the graaph.
B. Supppose there iss a reduction in the moneey supply. What
W
effeect will this have
h on the money
m supplyy curve and on
o the
interrest rate? Shhow this effecct graphicallyy.
C. At the
t initial inteerest rate of i, what has hhappened to the
t
actuual quantity of
o money?
D. Whaat must happ
pen to the intterest rate to restore equillibrium?
E. As i changes, wh
hat happens to money deemand?
F. Howw much monney do individduals hold att this new intterest
rate? Compare your
y answer here
h with yoour answer to o part
(A)..
218
Assessment answers
1. A. Nominal GDP in 1997 ($Y) = $9.10 x 10 + $1.10 x 10 + $6 (8)
= $150
In 2001: $Y = $11.50 (7) + $1.30 (13) + $6.50 (11) = $168.90
B. Real GDP in constant 1997 dollars: Y = $9.10 (7) + $1.1 (13) +
$6 (11) = $144.
C. GDP deflator in 1997 = base year = 1 by definition.
GDP deflator in 2001 = $Y/Y = $168.9 = 1.17

$144
D. % change in Y = −4%. % change in the deflator is 17%.
2. Nominal GDP and real GDP in 1997 are the same since we use the
same prices to calculate both figures (base year).
3. A. The final product of steel is 0 since steel is not a final good.

The final product of the lobster company is $200, and the final
product of the car company is $1000. GDP = $200 + $1000 =
$1200.
B. Value added for steel is $400. Value added for the lobster
company is $200. Value added for the car company is $1000 =
$400 = $600. GDP = $400 + $200 + $600 = $1200
C. Total wages are $1000. Total profits are $200. GDP is $1000 +
$200 = $1200.
D. All three approaches to GDP yield the same value.
E. Labour share is 83%, profit’s share is 17%.
4. Without more information, we can say nothing about inflation rate

and real GDP. Nominal GDP can change because of changes of
either one or both.
5. A. $Y (1998) = $91609.92 million (919,770 X .996)

The deflator is = 1
B. Y (1996) = $839,331 million, Y(1999) = $966,361.74, in 2000
(Y=$1,009,181)
C. Where the deflator is less than 1 (prior to 1997), real GDP is
greater than nominal GDP. Where it is greater than 1 (after
1997), real GDP is less than nominal, and where the deflator is
equal to 1 (in 1997), real and nominal GDP are equal.
D. Because nominal GDP incorporates changes in price and
quantity and therefore does not offer useful information from
the perspective of the study of growth and business cycles.
6. The sectors that are less sensitive to changes in income are least
219
Module 3 The
affected by a downturn.. That includdes food induustry (agricu

ulture),
governmennt-regulated industries, low-price transportation, basic
b
services andd necessitiess.
7. ght, AD'. Price and GDP rise.

A. AD shhifts to the rig
B. AD shhifts to the lefft, AD''. Pricce and GDP fall.

C. AD shhifts to the lefft same as b. P and GDP
P fall.
D. AS shiifts to the lefft, no shift inn AD. Price iincreases, GD
DP falls.
E. AD shhifts left as in
n c. Price andd output fall.
8. A.
B. P = 1440, GDP = 20
00
C. Output gap = 220 −200
− = 20, a recessionaryy gap.
9. A. AS shiifts to the lefft. Cost risess and hence pprice level rises.
GDP falls.
f
B. AS shiifts to the lefft (the same as
a part a). Prrice rises. GDP
G falls.
C. AS shiifts to the rig
ght. GDP inccreases and pprice falls.
10. A. Inflatioonary gap.

B. Price rises,
r GDP faalls back to Yn.
C. Expected price willl rise next yeear, because of inflationaary
pressuure.
D. Nominnal wages wiill rise to catcch up with thhe increases in price.
11. This is the opposite

o of 10.
1
A. Deflationary gap.
B. Price falls,
f GDP rises to return to Yn.
220
C. Expected price will fall.

D. Nominal wages will fall.
12. A.
B. AD shifts to the right, P rises, M P increases initially, interest

rates drop and GDP increases.
C. Yes, Y returns to Yn since in the next period Pe (expected price)
increases (money wage increase), SRAS shifts back and the
economy returns to Yn.
13. A. A 10% increase in GDP causes demand for bonds and demand
for money to increase.
B. Money demand rises, bond demand falls.
14. A
A. At the initial level of i, Md is equal to Ms (point A).

B. The Ms curve shifts leftward to Ms'.
C. At the initial interest rate (i1), there is an excess demand for
money (AB).
D. The interest rate must rise to i2 to restore equilibrium.
E. As the interest rate rises toward i2, Md diminishes (a movement
along the Md curve), to meet M s' at C.
F. Md = Ms at the new equilibrium interest rate i2 . As Ms
decreases, so does Md.
221
Module4
Mod
dule4
Goveernment Macro
oeconomic
Policcy
Introduction
In thhis module, we
w will first discuss monnetary and fisscal policy caategories
of sttabilisation policies.
p We will examinee the functioons of moneyy and
bondds, and relatiionship betw
ween bond prrices and inteerest rates. We
W will
alsoo examine mooney supply components, monetary ppolicy and
mecchanisms thatt changes mo oney supply and interest rates.
We will look intto the influennce of fiscal policy, the cconcepts of budget
b
balaance and natiional debt, an
nd relationshhip between ddebt and defificit.
We will also foccus on the co oncept of infllation and itss determining

g factors
togeether with “ddemand-pull”” and “cost-ppush” types oof inflation as well as
conttrols of the money
m supply y that leads to
t inflation. T
The responsee of
nomminal interestt rate to inflaation and variious costs associated with
h
inflaation and its danger will also be introoduced.
Nexxt, we will discuss labourr force participation rate, unemploymment rate,

typees of unemployment and the definitioon of full empployment. Laastly, the
impact of minimmum wage law ws and the reelationship bbetween inflaation,
unemmployment and
a the Phillips Curve wiill be elaboraated.
Upoon completioon of this mod

dule you willl be able to:
• make a fuunctional disttinction betw

ween money aand bonds.
• explain thhe determinan
nts of moneyy demand and bond demaand.
• state the relationship
r between
b bonnd prices and interest rates.
O
Outcomes • name the components of money suupply, and giive their funcctions.
• describe the
t mechanissms by whichh the central bank changees
money suupply and inteerest rates.
• layout thee implication
ns when the central
c bank’s states an ex
xplicit
inflation target.
t
• discuss thhe practice off monetary policy.
• describe how olicy influences the economy differen
h fiscal po ntly from
monetary policy.
222
• explain the concept of the budget balance and the national debt.
• outline the relationship between the debt and deficits.
• describe how inflation is measured and how it affects nominal and
real income.
• explain what factors determine inflation.
• distinguish between the states of inflation respectively labelled
“demand-pull” and “cost-push”.
• describe the causal chain happening with controls of the money
supply that leads to inflation.
• explain how the nominal interest rate responds to the inflation rate.
• distinguish between a one-time increase in the price level and
inflation.
• explain the various costs that inflation imposes.
• explain the danger of deflation.
• describe how the official unemployment rate is derived, the
different types of unemployment and the definition of full
employment and natural rate of unemployment.
• distinguish among the participation rate, unemployment rate and
non- employment rate.
• illustrate, with an example, the impact of minimum wage laws on
the unemployment rate.
• outline the concept of the trade-off between inflation and
unemployment.
• analyse what is behind the Phillips Curve.
Money: Anything that is generally acceptable as a means of

payment.
Reserve ratio: Regulation that sets the minimum reserves each

commercial bank must hold.
Terminology
Crowding out: Expansionary fiscal policy causes interest rates to rise,
thereby reducing investment spending.
223
Module4
Finanncial Maarkets, Monetaary and

d
Fiscaal Policyy
Introduction
Stabbilisation pollicy attemptss to influencee the amountts spent and produced
p
in ann economy. The T goal of such
s a policyy is to keep tthe economy as close
as possible
p to itss potential ou
utput while maintaining
m pprice stability
y.
Stabbilisation pollicies fall intoo two categoories; monetaary and fiscall policy.
Thiss section starrts with the taask of explorring the com mplex and
circuumscribed reelationship between
b monnetary policy (its tools, itss conduct
and its goals) annd interest rattes as well ass the econom my. Although h
monnetary policyy has already been discussed in the coontext of inflaation, the
detaails of such policy
p and itss relation witth interest rattes have yet tot be
fullyy examined.
Then you will exxamine the other

o tool of stabilisation policy: the fiscal
f
policy. Fiscal poolicy involvees changes inn the governm ment budget:
expeenditures, taxxes, transferss, subsidies and
a so on. Thhe issue of th he budget
deficit and debt is at the hearrt of fiscal poolicy. Governnments whose hands
are tied
t because of mounting g national debts and persiistent budgett deficits
are not
n able to use
u fiscal poliicy as an effeective tool off stabilisation n and,
therrefore, must rely
r entirely on monetaryy policy.
Moneyy
Deffinition and
d functions of moneey
Monney is anythiing that is geenerally accepptable as a m
means of paym ment.
Monney serves thhree separatee functions inn any econom my. It providees:
• A means of paymentt (exchange)).
• A store of (value) pu
urchasing power.
• measure of value)
A unit (m v of account.
Meaans of payment
The most importtant function n of money iss that it acts aas a means of
paym ment whenevver items aree bought and sold. Withouut money, marketm
partticipants musst trade one product
p for another,
a a trannsaction kno
own as
bartter. Barters are
a costly meeans of carrying out a trannsaction in th hat they
requuire double coincidence
c of
o wants betw ween both paarties. For ex xample, if
an economist
e wiishes to get a haircut, he or she shouldd be able to find
f a
hairr stylist who at the same time
t wishes to
t listen to a lecture in
econnomics.
Monney overcom mes these prob blems. The benefits

b of m
money as a means
m of
exchhange are farr-reaching: with
w it, people can minim mise the time they
hom they cann buy and sell. Thereforee, the use
spennd finding otthers with wh
224
of money not only facilitates transactions of goods and services but also
raises living standards.
Store of value
Money’s second function is providing a safe and accessible store of value

(wealth). Money is normally an attractive store of purchasing power
during the period between the time it is earned and the time it is spent.
There are both benefits and drawbacks associated with holding wealth as
money. Money’s major advantage is its liquidity, or the ease with which it
can be turned into a means of payment. Assets are liquid when they can
be quickly turned into money with little loss in value. All financial assets
are liquid to some degree, but none as much as money, which is perfectly
liquid by its very nature.
Recall, however, that for any economic choice, there is an opportunity

cost. In this case, the cost of holding wealth in the form of money is the
income sacrificed by not holding it in some other form. For example,
someone who holds wealth by stashing thousands of ringgit under his/her
mattress is sacrificing the income the wealth could earn if it were
converted into a stock or bond. As a result, people hold wealth as money
when the benefits of liquidity outweigh the income that could be earned
by holding it in another form.
Unit of account
Money also provides buyers and sellers with a unit of account, or pricing
standard that allows all products to be valued consistently against a
common measure. In other words, it provides a point of comparison
between various forms and types of automobile, spinach or economics
lectures.
The supply of money

The supply of money is made up of currency and deposits with financial
institutions.
Currency
Currency includes paper notes and coins such as currencybills, issued by

the central bank.
Deposits
Deposits can be classified according to the conditions of their use. In

general, the access the depositor has to his or her funds determines the
interest rates paid on deposits. By and large, deposits are money too
because they can be converted into money to settle debts.
There are several types of deposits. Some deposits give depositors

immediate access to their money. They are called demand deposits and
take the form of current and personal chequing accounts. This form of
deposit is almost as liquid as money. Another popular form of deposit is
225
Module4
know wn as savingg or notice deeposits, fromm which the ddepositor maay

officcially withdrraw funds on nly after givinng notice to tthe financiall
instiitution. In prractice, most banks waivee the right to require such h notice.
Notiice deposits typically pay y a higher ratte of interestt but limit or exclude
cheqque writing. This distincttion, howeveer, has lost itss relevance in most
counntries as new
wly introduceed saving acccounts have bbecome as acccessible
as chhequing accoounts. A term m / fixed depositaccount iis another fo orm of
depoosit that entittles the holdeer to a higheer rate of inteerest. A contrractual
conddition of placcing funds in n a term depoosit is that thhe depositor does
d not
withhdraw from that
t account for a specifieed period of time.
Equuation (1) bellow defines the

t money suupply in a geeneric form:
Ms= CU
U+D (1)
wheere CU standds for currenccy in the hands of public,, D, deposits with

bankks, and Ms foor the money
y supply.
Cleaarly, since thhere are severral types of deposits,

d therre are also seeveral
diffe
ferent measurres of money y. One comm monly used m measure know wn as
M1,, defines it ass including:
1. notes annd coins held
d by the publiic (CU), andd
2. demandd deposits witth deposits-taaking instituutions.
The definition of money can n be broadeneed to includee a greater ran

nge of
finaancial assets. For examplee:
M2 = M1 pllus some notiice deposits (personal or business).
w a wider range of financial institu

M3 = M2 pllus deposits with utions
and a broadeer definition of deposits.
These definitionns differ from

m one countryy to the next. However, you y need
not grapple withh fine distincttions. It is suufficient to saay that the bo
orderline
betw
ween money and non-mo oney assets iss arbitrary.
Creddit cards andd debit cards (also knownn as bank cards), though veryv
popuular in most countries, do o not constituute money. A credit card d is a
monney substitutee, as is the deebit card. Thhey enable peeople to purcchase
prodducts but they are not meeans of paym ments. For exaample, once money
has been transferred from yo our bank accoount to that oof the vendorr to
whoom you preseented your deebit card, thee card ceases to function as
monney. In other words, the card
c is not a medium
m of eexchange thaat can be
passsed on from one
o person to o another.
Thee demand for moneyy

As discussed
d in Module 3, money
m is dem
manded for reeasons primaarily
relatted to the first two functiions of moneey: medium oof exchange and store
of value.
v The folllowing motiives are idenntified for dem
manding mo oney:
226
1. Transactional: Money demanded for regularly scheduled

transactions (purchase of goods and services, etc).
2. Precautionary: Money demanded against emergencies.
3. Speculative (motive) demand for money: Money demanded as a
source of security against risks in bond markets.
The first two motives are directly related to the role of money as a
medium of exchange whereas the last motive is related to the role of
money as a store of value.
As discussed earlier, the main cost of holding money is the added income
it could have earned if it had been converted into a higher-paying asset
such as a bond. The added income is the rate of interest that is the
measure of the forgone alternative (the opportunity cost).
Bonds
Focusing on the basic mechanism by which interest rates are determined,
let us simplify by considering bonds as the sole alternative to money. The
main distinguishing features of bonds as opposed to money are:
1. Money does not yield return (interest) whereas bonds do.
2. Money can be used for transaction but bonds cannot.
Bonds are formal contracts that set out the amount borrowed, by whom,
for what period of time, and at what interest rate. Most bonds promise to
pay an agreed-upon interest rate per period for the duration of the bond
and also to pay back the bondholder the principal of the bond at its
maturity. Bonds are also attractive assets because they can be easily
bought and sold before their term has ended. This way, they offer
liquidity as well as relatively high rates of return in exchange for the risk
associated with changes in bond prices. Therefore, for individuals who
hold wealth, bonds offer the likeliest alternative to holding money for
individuals who have a favourable view of the trade-off between bonds’
higher rates of return and higher risk. Bonds are the most popular way for
governments and large business to raise funds.
There is a vast array of interest rates just as there is a wide range of credit
instruments. Table 4.1 presents annual average rates for a number of the
Government of Canada’s key interest rates. The rates in this table show
interest on short and long-term instruments.
227
Module4
Maturityy Rates
2 yeear 3.87
3 yeear 3.94
5 yeear 3.98
10 year
y 4.09
3
Lonng term (30 year)
y 4.18
Tab
ble 4.1 Government of Canada
C bencchmark bon
nds yields
(Deccember 2007)
Apaart from diffeerences in theeir maturity (their

( term uuntil they exp
pire)
bondds also vary in their extennt of followiing characterristics.
1. Default risk: The risk that the loaan will be paaid back at alll or on
time. Thhe greater thiis risk, the hiigher the “rissk premium””
includedd in the interest rate. Loans of similarr maturity can be
classifieed according to their risk with the riskkier ones earnning
higher innterest rates.. Governmennt bonds of m major industrrialised
countriees tend to be free of defauult risk. The contrasting side
s of
corporatte bonds, wh hich is regardded as risky, is that they offer
o a
higher risk premium m.
2. Inflationn expectationns: The mostt important component off interest
t inflation expectation premium. Innflation –the loss of
rates is the
purchasiing power –iis the greatesst enemy of iinterest-beariing
wealth. For examplee, average 5 per p cent inflaation per yeaar over a
five-yeaar period meaans that the purchasing
p power of the principal
p
paid bacck after the five
fi years is only
o 78.4 perr cent of whaat it was
at the beeginning of the
t loan. Thee following section discussses the
concept of the Fisheer relationshipp. Accordingg to that relattionship,
since thee future inflaation rate is not
n known w with certaintyy at the
time thee loan is mad de, the premiuum reflects tthe inflation
expectattions of the lender
l and boorrowers (Noominal rate ofo interest
real ratee plus the exppected inflatiion rate.)
Youu can obtain a better grasp p of differennt interest ratees by examin

ning
som
me of the featuures that diffferent rates have
h in comm mon and usin ng those
featuures which distinguish
d th
hem from eacch other. A sstarting pointt is to
recoognise that innterest rates are
a expressedd in percentaage and basiss points.
In addition, there are 100 basis points in each percenttage point off interest.
3
urce: Bank of Canada
Sou C
228
Now let us be more specific about the way the bond market works in the
economy. We have assumed that bond markets determine the interest rate
on the bonds. More precisely, bond markets typically determine not the
interest rate but rather the price of bonds. The interest rate can then be
inferred from the price. Let us look at the relation between interest rates
and price more closely.
Let the bonds be one-year bonds that promise a payment of $100

annually. Such bonds, when issued by most governments and promising
payment in a year or less, are called Treasury bills or simply T-bills.
Thus, you can think of the bonds in your economy as one-year T-bills.
Let their price today be RMPB, where B stands for “bond”. If you buy the
bond today and hold it for a year, the rate of return on holding the bond
for a year is equal to ($100 - $PB)/$PB(what you get for the bond at the
end of the year minus what you pay for the bond today, divided by the
price you paid for the bond today). Thus, the interest rate on the bond is
defined by:
i $100 - $PB
= (2)
$PB
For example, if $PBis equal to $95, the interest rate will be equal to
$5/$95 or 5.3 per cent. If $PBis $90, the interest rate will be 11.1 per cent.
Therefore, the higher the price of the bond, the lower the interest rate.
Equivalently, if we are given the interest rate, we can infer the price of the
bond. Reorganising the formula above, the price of a one-year bond is
given by:
$PB $100
= (3)
(1 + i)
The price of the bond is equal to the final payment divided by 1 plus the
interest rate. Thus, if the interest rate is positive, the price of the bond is
less than the final payment. Moreover, the higher the interest rate, the
lower the price today. When newspapers write that “bond markets went
up today”, they mean that the prices of bonds went up and therefore
interest rates went down.
Typically, bonds with maturities of more than one year offer a fixed rate
of return known as a coupon rate. For example, suppose you purchased a
$1,000 bond with an interest rate (coupon rate) specified as 6 per cent per
annum. In this case, you are guaranteed an annual interest payment of $60
until the bond matures, at which time you, or whoever else holds the
bond, will recover your principal, $1,000 as well.
229
Module4
Supppose a bond pays $1,000 in one year.. If the price of the bond is $750
todaay, we know that the interrest rate on this
t bond is:
A. 7.5 per cent
c
S
Study skills B. 15 per cent
C. 25 per cent
D. 33 per cent
Solu
ution:
D. ($1,000 – $750)/ $750 = .33 or 333%
Financcial systeems
Noww that you caan define the functions money
m serves,, you are in a position
to coonsider the system
s in whhich it operates as well ass the supply of
o
monney. The mosst important elements of financial sysstems are fina ancial
interrmediaries. Financial
F inttermediaries are primarilyy deposit tak
kers,
bodiies that acceppt funds provvided by savvers and lendd these funds to
borrrowers.
For the deposit-ttaker, the dep posits it acceepts and owees back to sav
vers are
its liiabilities andd the funds itt lends to borrrowers, and which borro owers
owee the deposit--taker, are itss assets. Thesse institutionns make a pro ofit by
payiing lower intterest rates on deposits thhan they charrge on loans..
Financcial interm
mediariess
Depposit-takers fall
f into two categories:
c c
commercial bbanks–which h in some
counntries are knoown as charttered banks –and – near baanks. The oriiginal
manndates of the two categoriies were disccrete as the ffollowing parragraphs
sugggest. In realitty, the dividiing lines are more blurredd. Recent changes in
mosst countries’ banking law ws mean that commercial
c banks now conduct
c
operrations in a much
m wider range
r of servvices includinng insurancee and
secuurities. Otherr recent legisslative changges have allow wed mergerss among
nearr banks so thhat most tradiitional barrieers between ddeposit-takin ng, trust,
insuurance and innvestment baanking (securrities) operations have vaanished.
Com
mmercial banks
b
Bannks are the baackbone of th he financial system.
s Theyy receive fun nds from
peopple and firmss and use theese funds to make
m loans aand to buy boonds.
Unliike other depposit-takers, these instituttions are typpically alloweed to sell
a wiide range of financial serrvices. What makes them m different froom other
finaancial intermeediaries is th
hat they receiive those funnds by offerin
ng
cheqquable depossits that allow w depositors to write cheeques or get cash
c on
demmand, up to ann amount eq qual to the account balancce. For this reeason,
thesse accounts are
a also called d demand deeposits.
230
The balance sheet of banks is given in Figure 4.1. On the asset side are
cash reserves, loans, and bonds, whereas on the liability side are deposits.
While deposits are liabilities to banks, they are assets to depositors.
Banks
Assets: Liabilities:
Cash reserves Deposits

Loans and bonds
Figure 4.1
Near banks
In contrast to commercial banks, near banks have more specialised
financial services. The most important are trust companies, mortgage and
loan companies, credit unions and other forms of government as well as
private savings and loan associations.
Trust companies, for example, administer various types of accounts,

including estates and trust funds. Nowadays, they also compete with
commercial banks by taking deposits and granting loans, mainly to
households.
In addition to deposit-takers, there are other types of financial specialty

institutions such as insurance companies and investment dealers.
Insurance companies offer policies to their clients and use the funds to
buy various types of income-producing financial assets. Investment
dealers buy and sell financial securities such as stocks and bonds for their
customers.
Cash reserves
Why do financial institutions hold reserves? On any given day, some
depositors withdraw cash from their chequing accounts while others
deposit cash into their accounts. Since there is no reason for the inflows
and outflows of cash to be equal, a bank must keep some cash on hand. In
the same way, on any given day, what a bank owes to other banks (as a
result of cheques written by people with accounts at this bank) may be
greater or smaller than what other banks owe to this bank (as a result of
cheques received and deposited by people with accounts at the bank).
Thus, for both reasons, banks want to keep some reserves even if they are
not required to do so.
Under the laws of some countries, banks are required to hold reserves as a
percentage of their deposits. These reserves are known as required
reserves (or legal reserves): the minimum amount of reserves that banks
by regulations must hold against deposits. In these situations, the central
banks tend to alter required reserves to influence the money supply. A
more detailed description of how changes in these reserves can affect the
money supply will follow below.
231
Module4
Fraactional resserve bankking system

The foregoing description
d off cash reserves gives youu the context from
whicch to infer what
w a fractional reserve banking
b systeem might be. In this
systtem, banks doo not hold th he whole of thheir total depposits as reseerves but
rathher a fraction called the reeserve requirrement (r.r.) ratio. This ratio is
deteermined by a combination n of governmment regulation and the central
bankk policy. Reccently, somee countries arround the woorld such as Canada,
C
havee repealed thhe system of reserve requuirements. Deespite this, banks will
holdd reserves as assurance th hat they will not run shorrt of cash.
For our purpose here, take th he reserve rattio as given aand examinee what
fractional-reservve banking means
m for the money suppply. Let us su uppose
that all banks wiithin the natiion have and maintain a rreserve ratio of 10 per
centt. This meanss that they keeep 10 per ceent of their ddeposits in reeserve
and lend out the rest. Now leet us consoliddate assets annd liabilities of all
bankks within thee nation to make
m the folloowing T-accoount, Figuree 4.2.
All banks
(in billions of dolllars)
Assets: Liabilities:
L
Cashh
$110
Reseerves:
osits:
Depo $100
Loaans and
$990
Bonnds:
Figu
ure 4.2 Conssolidated ba
anks’ T-Account
On the
t left-handd side of the T-account
T arre the bank’ss assets of $100
billiion, consistinng of $10 billion cash resserves held ppartly in theirr vault
and partly in thee form of dep posits with thhe central bannk and $90 billion
b in
bondds or in the form
f of loanss. On the righht-hand side of the T-acccount are
bankks’ liabilitiess of $100 billlion, made of deposits thhey owe to th heir
depoositors. The assets and liaabilities balaance exactly.
Notiice that in thhis situation, the reserve/ddeposit ratio is 10/100 = 0.10 (or
10 per
p cent), whhich is the fraaction of theiir deposits w we have assum med
bankks hold in the form of cash on averagge. More impportantly, thee figure
showws that for evvery dollaroff cash reservves on hand, bbanks have been
b able
to coollectively crreate $10 of deposits, or for their $100 billion of reeserves,
$1000 billion of deposits.
d Theerefore, bankks seem to haave been ablee to
creaate deposits and
a hence, crreate money supply.
Recall that the money

m supplyy equals currrency plus deeposits. Thuss, when
bankks hold only a fraction off deposits in reserve, bannks create mo oney.
They do this by using the am mount not helld in the form m of reservess. Since
onlyy 10 per centt is, the remaaining 90 per cent is lent oout or investted in
bondds. When baanks lend outt money, theyy open new aaccounts for the
borrrowers from which they can c withdraw w. In this casse, they have
232
collectively created 10 times more money than was initially available to

them.
The banking (money) multiplier

When banks hold $100 billion in deposits for $10 billion reserves, the
reserve ratio is 10 per cent (10/100). The banking multiplier just turns this
idea around. If the banking system as a whole holds a total of $10 billion
in reserves, it can have only $100 billion in deposits. In other words, if rr
is the ratio of reserves to deposits for all banks, 10 per cent in this case,
then the ratio of deposits to reserves in the banking system (that is, the
banking multiplier) must be 1/rr, 10.
Suppose the sum of all deposits in local banks is $400 billion and the
combined amount of cash reserves on hand in this economy is $20
billion.
Study skills 1. The reserve ratio in this case is:

A. 20 per cent
B. 10 per cent
C. 5 per cent
D. Cannot be calculated.
2. The banking multiplier is

A. 20
B. 10
C. 5
D. Indeterminate
3. The total amount of money that banks in this economy can
collectively lend out is
A. $400
B. $380
C. $20
D. $5
Solutions:
1. C. You calculate the reserve ratio by dividing total reserves ($20)
by total deposits ($400), 20/400 = 0.5 or 5%.
2. A. The multiplier equals 1/rr = 1/.05 = 20.
3. B. The T-account apparatus reveals that the sum of assets must be
equal to liabilities. Since liabilities total $400 billion (deposits),
total assets must be $400 billion, too. With reserves pinned at $20
billion, the residual (loans) must be $380 ($400 -$20).
233
Module4
Centraal bank
Fouur responsibillities are ofteen mentionedd for central bbanks. Thesee are:
1. Issue cuurrency. Thiss refers to suppply notes annd coins into
o the
econommy according to certain guuidelines andd objectives.
2. Act as thhe banker to commerciall banks. In thhis capacity, the
t
central bank
b holds deposits
d for commercial
c bbanks as commmercial
banks doo for the pub
blic. These deeposits at thee central ban
nk enable
commerrcial banks to o make paym ments to one another. Morre
importanntly, central banks act as the lender oof last resort by
b
extendinng short-term
m loans to baanks that mayy be in a cred dit
crunch.
3. Act as thhe banker to the governm
ment. The cenntral bank, in
n this
capacityy, manages thhe governmeent bank accoount, which is
i held
with thee central bank
k, and handlees its debt.
4. Control money stockk, which is thhe most impoortant task off the
central bank.
b The deecision by thee central bannk concerning
g the
money supply
s is refeerred to as monetary
m poliicy.
At present,
p curreencies issued
d by central banks
b are refferred to as fiat
fi
monney –money that has no in ntrinsic valuue. Central baanks no long ger link
theirr respective currency
c to precious
p mettals such as ggold, so curreencies
havee no intrinsicc value. A fiaat is an orderr or a decree..
The balance sheet of the cen

ntral bank in this
t economyy is shown in
n Figure
4.3.
Central Bank
B
Asssets: Liabilities:
L
Goveernment
Cuurrency &
bondss,Loans H = CU +R
baanks
to bannks,
deeposits,
Goovernment
Internnational
deeposits
reservves
Figu
ure 4.3 Centtral bank’s T-Account
T
As shown
s in Figgure 4.3, the central bankk’s assets aree primarily
goveernment bonnds that it hollds in its porttfolio, its loaans (advancees)
mosstly to banks,, and internattional (officiial) reserves. Its liabilities are
prim
marily currenncy and bank ks’ deposits. The
T sum of ccurrency whiich is
heldd partly by thhe public andd partly by baanks in the foorm of cash –in– the
vaullt as well as banks’
b depossits –is knowwn as the cenntral bank mo oney. The
last item on the liability
l sidee is the goverrnment depossits.
234
The central bank controls central bank money, which is more commonly
known as monetary base or high-powered money:
H = CU + R (4)
where CU stands for currency, R for banks’ reserves, and H for high-
powered money.
A quick comparison between equation (4) and the money supply equation
— equation (1):
Ms = CU + D — reveals that:
1. The size of money supply (Ms) is a multiple of the high-powered
money (H) because (though their first term on the right-hand side,
CU, is the same) their second term is different:
D versus R,
where D is a multiple of the R (D/R = 1/rr).

2. The central bank controls only part of the money supply directly.
That is currency (CU). Its controls of the rest of money supply –
deposits (D) –are indirect. Commercial banks, not the central
banks, decide how much shall be made in loans and therefore
how much to create in deposits. However, the central bank can
influence banks’ decisions in this regard by changing banks’ level
of cash reserves or by altering the interest rate, which influences
bank’s incentive to make more or less. Banks make more and
keep less idle cash when the interest rate rises and make fewer or
smaller loans when the interest rate falls. In the latter case, banks
are willing to sacrifice the (small) return –low opportunity costs –
in favour of larger liquidity (idle cash).
Monetary policy
You have seen already that a change in the quantity of money affects
aggregate demand and the economy. The central bank has the power to
increase or decrease the volume of the currency in the economy and
therefore, is responsible for monetary policy. This makes the central bank
an important institution able to exert profound influence on the economy.
Tools of monetary policy

Open-market operations
Think of your economy as having a market where people buy and sell
bonds in exchange for money so that those who want to increase the
proportion of bonds in their portfolio buy bonds and those who want to
decrease it sell bonds. In an equilibrium, the interest rate is such that the
demand for bonds is equal to the supply of bonds or equivalently, the
supply of money is equal to the demand for money, and the equilibrium
condition, as shown in Figure 4.4 holds.
235
Module4
Figu
ure 4.4
Now w, think of thhe central ban

nk as changing the stock of money in n the
econnomy by buyying and selliing bonds inn the bond maarket. If it waants to
incrrease the stocck of money,, the central bank
b buys boonds and payys for
themm by creatingg money. If iti wants to deecrease the sttock of moneey, the
centtral bank sellls bonds and removes froom circulation the money y it
receeives in exchhange for the bonds. Suchh operations aare called oppen
marrket operations, because they
t take plaace in the “oppen market” for
bondds.
Connsider now thhe effects of an open purcchase of government bon nds –an
openn market opeeration in wh hich the centrral bank incrreases the sup
pply of
monney (an expannsionary monetary policyy). In such a transaction, the
centtral bank buyys bonds in th he bond marrket and payss for them by y creating
monney. As it buyys bonds, thee demand forr bonds goess up and thuss the
price of bonds goes
g up. Equiivalently, thee interest ratee on bonds goes
dowwn. In terms ofo Figure 4.4 4, the injectioon of moneyy into the eco
onomy
therreby, causes a rightward shift
s in the money
m supplyy curve to Ms’ and
the interest
i rate drops to i2.
Wheen, instead, the

t central baank wants to decrease thee supply of money,m it
doess an open maarket sale off government bonds (contrractionary monetary
m
poliicy). This leaads to a decreease in their price,
p and thhus to an incrrease in
the interest
i rate. In this case,, Ms would shhift to the lefft and the intterest
rate would rise along
a the Md curve.
From m the doublee bookkeepin ng perspectivve, an open m market operattion

leadds to equal chhanges in asssets and liabiilities. Suppoose the centraal bank
buys $1 million worth of bon nds from com mmercial bannks. This cau uses the
amoount of bondss the central bank holds to t rise by $1 million that it pays
for by
b increasingg banks’ cash h reserves byy $1 million. Figure 4.5
illusstrates this siituation.
236
Central Bank Banks
Government Bank’s reserves Government

bonds + $1m (R) + $1m bonds - $1m
Reserves (R)
+$1m
Figure 4.5
When the central bank purchases bonds, it pays for it by raising banks’
cash reserves by equal magnitude. Recall that cash reserves are assets to
banks while liabilities to the central bank. Banks facing a net increase of
cash reserves are now in a position to expand their lending operation. In
light of the banking multiplier discussion earlier, we know that for every
available dollar of reserves banks can potentially extend several times in
loans. In this case, if rr is assumed to be 0.10, banks can collectively lend
$10 million and hence increase the money supply by that amount.
Reserve requirements
Reserve requirements influence how much deposits the banking system

can create with each ringgit of reserves. An increase in reserve
requirements means that banks must hold more reserves and, therefore,
can lend out less of each dollar that is deposited. As a result, the reserve
ratio goes up, the banking multiplier goes down, and the money supply
decreases. Conversely, a decrease in reserve requirements lowers the
reserve ratio, thereby increasing the banking multiplier and the money
supply.
The central bank rate
Central banks typically act as bankers to the commercial banks. As you

saw in the previous section, these banks hold deposits at the central banks
which are part of their reserves. In situations where banks face an overall
cash shortfall that they cannot cover by borrowing from other banks, or in
cases where an individual bank faces a negative balance vis-à-vis other
banks, they resort to borrowing from the central bank. The rate of interest
that central banks charge commercial banks for these loans is called the
discount rate in some countries. In Canada, it is known as the bank rate.
The central bank can alter the money supply by changing the discount
rate. An increase in the discount rate by the central bank reduces the
quantity of reserves in the banking system by discouraging banks from
borrowing reserves from the central bank, which in turn reduces the
money supply. Conversely, a lower discount rate encourages borrowing
from the central bank increasing the quantity of cash reserves and hence
increasing the money supply.
237
Module4
Supppose you aree given the foollowing infoormation aboout your econ nomy.
w commerrcial banks tootal $100 billlion. Banks’ reserves
Publlic deposits with
are $5
$ billion, tw
wo-thirds of which
w is in deposits
d withh the central bank.
b
Therre are $10 biillion notes and
a coins outtside bank (inn the hands of o the
S
Study skills publlic).
Calcculate:
A. The highh-powered money.
m
B. The monney supply.
C. Banks’ reserve
r ratio.
Solu
utions:
A. High-poowered moneey (H) = Currrency in hannds of public (CU) +
banks’ reserves(R),
r or H= $10 + $5 = $15.
B. Ms = CU
U + D = $10
0 + $100 = $110.
C. R/D = 5/100
5 = 0.05 = 5%.
Transm
mission mechanis
m sm of mo
onetary po
olicy
dy discussed at some lenggth how chan
Thiss study sectioon has alread nges in
monney supply annd interest raate affect thee economy. F
Figure 4.6 usees the
aggrregate demannd-aggregatee supply moddel to illustraate this effectt
diaggrammaticallly.
Figu
ure 4.6
Assuume the centtral bank con nducts an opeen-market opperation in which

w it
buys governmennt bonds from m the public (including thhe banks). Th his
incrreases the mooney supply and
a lowers thhe interest raate. This is sh
hown by
a rigghtward shift
ft in the Ms cu
urve to Ms’ and
a an adjusttment in the interest
i
( The loweer interest ratte stimulatess investment as
rate to i2, panel (a).
conssumers, enjooying a lowerr cost of borrrowing, buy more and larrger
houses and firmss spend moree on new maachinery and equipment, and so
on. As
A a result, the
t quantity ofo output dem manded, at thhe given pricce level,
incrreases and thee AD curve shifts
s to the right
r to AD2, panel (b).
238
The short-run impact of this expansionary monetary policy is an increase

in the level of output, represented by Y2, and a surge in price, P2. Of
course, this adjustment entails subsequent changes in price and output
beyond the short run. At the next stage, SRAS1 begins to shift to the left,
reflecting an upward pressure on nominal wages. In the long run, the
economy reverts to LRAS, settling at Point C’, where AD crosses LRAS.
Figure 4.7 illustrates a policy appropriate to the above analysis but in a

situation where the economy starts from a recessionary gap instead, (Y1 –
Yn) <0. An expansionary monetary policy could be designed to shift the
aggregate demand curve by exactly the right amount to cross the SRAS
along LRAS curve, point B. This would be the final (long-run)
equilibrium situation where the economy will settle in.
Figure 4.7
How much extra aggregate demand is needed?
To be effective, the expansionary (counter-cyclical) monetary policy,

shown in Figure 4.7 requires accurate information on the current level of
GDP (Y1) and on the gap between it and potential GDP, (Y1 - Yn).
Identifying the size of the gap, however, involves painstaking research
and good judgement. It can be a hazardous exercise. A thorough and
accurate job requires large econometric models of the economy
comprising many equations to estimate these curves and their parameters
first.
Objectives of monetary policy

Most central banks around world have shifted their focus to price stability
as their main objective. Price stability is defined as the sustained absence
of both inflation (prices rising too fast) and deflation (falling prices).
One would hope that the decline in inflation has been associated with a
demonstrable improvement in economic efficiency and social stability.
Many experts believe that it has, and for good reason. However, causality
is never simple in economics. Low inflation does not guarantee good
economic performance, nor does every high-inflation country grow
slowly. In the latter instance, growth occurs despite inflation not because
239
Module4
of itt. Price stabillity certainly

y assists econnomic growthh, while depaartures
from
m price stabillity never acttively help too improve ecconomic
perfformance.
Induustrial countrries experien nced relative price stabilitty in the 199

90s while
extrremely high rates
r of inflaation prevaileed in parts off Latin Amerrica,
Turkkey and the emerging
e maarket econom mies of the foormer Soviet bloc.
Highh inflation haas damaged these econom mies and hass distorted the
busiiness environnment.
Manny economiees have introd duced successsful counterr-inflationary y

proggrammes durring the past decade. Arggentina’s inflation reached d nearly
5,0000 per cent inn 1989 but, following
f its stabilisationn programmee, it fell to
3 peer cent. Bolivvia, Chile andd Israel provvide other exaamples of su
uccessful
stabbilisation.
The monetary auuthorities in the euro areaa, New Zealaand, Canada and the
Unitted Kingdom m are formallly committedd to maintainning stable prrices.
Mosst other counntries have a strong publicc commitmeent to keeping g
inflaation low althhough less fo
ormal targetss are set. Theese countriess have
founnd price stability an essenntial elementt in a healthyy business
enviironment.
Defl
flation, too, can
c be a majo
or problem as Japan’s expperience in th
he past
decaade demonstrrates.
n only meaans avoiding the costs

It is sufficient too say that pricce stability not
of innflation but also
a the costss of deflationn, which in fafact could be far
greaater. A stablee domestic prrice system helps
h to ensuure that intern
national
exchhange is condducted on the basis of a correct
c knowwledge of pricces and
alterrnatives.
Ingrredients of a successful price stability program
mme
The control of innflation invo olves a broadd spectrum off economic policies.
p
It is more than a mere econo omic slogan. It requires political comm mitment.
An informed
i pubblic opinion is also impoortant. For exxample, Germ many’s
succcessful anti-iinflation strattegy has been supported by the popullar
averrsion to inflaation. Furtherrmore, centraal banks shouuld be largely
indeependent of political
p conttrol. The eviddence indicaates that
indeependence raather than maanagement byy politicians is the optim mal
strattegy for low inflation. Poolitical controol may lead tto policies su uch as a
pre--election cut in interest raates (to help the
t electoral prospects off the
incuumbent partyy), which resu ults in higherr inflation att a later stagee. Many
counntries have acknowledge
a d this dangerr and are respponding by measures
m
to inncrease the autonomy
a of the monetaryy authorities.
Cenntral banks allso need a cleear statement of their pollicy objectivee.

d be to mainttain price staability. Central banks,
Ideaally, this objeective should
as thhe guardians of monetary y policy, mayy be asked too carry out un npopular
taskks. In Canadaa, for instance, the Bank of
o Canada haas effectively y
commmunicated itts policy objectives to the public by ppre-announciing its
courrse of action. Furthermorre, it has set a clear and eexplicit targett range
240
for inflation, 1 per cent to 3 per cent, and has made every effort to keep
the rate of inflation at the mid-point of this inflation target range. Another
example is the European Central Bank (ECB). Twelve European counties,
known as Euro 12, are guided by the monetary policy of the ECB with its
unqualified objective of price stability and elaborate guarantee of
independence.
Budget deficits, debts and fiscal policy

Budget deficits, excessive government debt, and high taxes have recently
become an almost universal focus of concern. Thirty years ago,
governments worried much less about these matters. Management of
public finances, in the sense of balancing the books and keeping debt
levels under control, was considered a rather pedestrian exercise. Fiscal
policy was judged primarily in terms of its success in dampening
economic fluctuations and maintaining full employment. In recent times,
this counter-cyclical function of public finances has been downplayed.
Keynesian economics, from which the era of fiscal activism drew its
intellectual sustenance, has declined in prestige. Fiscal balance has
replaced fiscal activism as the conventional target of fiscal policy.
In general, governments can affect spending and output levels in an

economy through two sets of instruments. The first, discussed above, is
clearly monetary policy. However, governments can have an extensive
impact on the economy through taxation and government purchases.
Because a government’s annual budget sets out what the government will
tax and spend, the budget becomes an instrument of stabilisation policy.
Such a policy is called fiscal policy –fiscal meaning budgetary. The 12-
month period to which the budget applies is called the fiscal year.
Governments apply fiscal policy during any part of the business cycle.
During a recession, government action is geared towards increasing
spending and output in the economy –expansionary fiscal policy. Such a
policy involves increasing government purchases, decreasing taxes or
both. In contrast, during an inflationary boom, the concentration is geared
towards restraining spending and output –contractionary fiscal policy,
which involves decreasing government spending and increasing taxes.
Rememberthe goods market equilibrium market condition from Module3,

Y = C + I + G in a closed economy. An expansionary fiscal policy
increases aggregate expenditures and hence output either (a) by
increasing G, which increases aggregate expenditure (right- hand side)
directly, or (b) by decreasing taxes, which also increases aggregate
expenditures, but indirectly via C or perhaps I, or (c) both. Contractionary
fiscal policy works in the opposite direction.
Discretionary versus automatic policy

As we have seen, fiscal policy involves adjusting government purchases
or taxes. These actions are intentional; laws must be passed and budgets
brought down. Because it is up to a government’s discretion to take these
241
Module4
actioons, fiscal poolicy is know

wn as discretionary policyy. In contrast, some
stabbilising forces are automa atic. That is, they do not iinvolve the direct
d
invoolvement of government
g decision-maakers.
For example, traansfer paymeent programm mes to indiviiduals by thee

goveernment suchh as unemplo oyment beneefits and welffare paymentts as well
as established taaxes such as progressive
p income taxess, act as auto
omatic
stabbilisers in bussiness cycless. In a periodd of contraction, net tax reevenues
(taxes minus trannsfers and su ubsidies) deccrease whereas during a period
p of
expaansion, net taax revenues increase. As a result, speending and ag ggregate
demmand are stim mulated in a downturn
d andd suppressedd in an upswiing,
therreby helping to smooth ou ut the busineess cycle.
Thee multiplier effect

The multiplier effect is the magnified
m im
mpact of any sspending chaange on
aggrregate demannd. It is the change
c in speending multiiplied by a ceertain
valuue to give thee resulting ch
hange in aggrregate demannd.
Suppose actual GDP G was$1,050 billion and

a potentiall GDP $1,100 0 billion.
At first
f sight, it might
m appearr that a $50 billion
b injecttion of goverrnment
spennding would close the gaap. But this iss incorrect. A According to the
theoory of the muultiplier, aggrregate demannd would inccrease by a multiple
m
of thhe initial injeection. To see this, suppoose the goverrnment, in view of
this gap, were too spend an ex xtra $50 billiion on roads. The initial injection
i
of $50 billion inncreases the economy’s
e output by $500 billion and the
incoome of emplooyees and su uppliers of materials
m by $50 billion. Suppose
theyy, in turn, savve 20 per cennt ($10 billioon) of their inncome and sppend
(connsume) 80 peer centof theiir income ($440 billion) onn cars or new w houses.
Thiss gives a booost to the car industry andd the construuction industrry, and to
theirr employees and shareho olders. The ouutput of the eeconomy hass
expaanded by anoother $40 billlion and the income in coonstruction and a
carssector has alsso increased by $40 billioon. Next, supppose the em mployees
and shareholder of these secttors spend 800 per cent off their income, (0.80
× $440 billion = $32 a save 20$$($8 billion).. This $32 billion
$ billion) and
noww constitutes income for somebody
s else who is asssumed to speend 80
per centand savee 20 per centt and so forthh.
We see that the initial

i spending impulse of $50 billioon has generaated
furthher spendingg of $40 billioon and $32 billion,
b for thhe total of $122
billiion after threee steps (roun
nds), as well as $18 billioon saving ($110 billion
+ $88 billion). Buut the process has by no means
m endedd.
Thiss descriptionn of the multiiplier presentts an intuitive and much

n reality is a complex proocess. For on
simpplified versioon of what in ne thing,
accoount should beb taken of “leakages”
“ frrom income iinto taxes an
nd
saviings as well as,
a in an open n economy, into imports. Any given purchase
madde by the govvernment hass an initial efffect, a seconndary effect, and so
on.
As the
t example illustrates, th he inclinationn to spend annd the inclinaation to
savee or otherwisse withdraw funds
f from the
t economy both determ mine the
multtiplier effect.. These facto
ors are summmarised by thee concepts of
242
marginal propensity to consume and marginal propensity to save or more

generally marginal propensity to withdraw.
As discussed earlier, Marginal Propensity to Consume (MPC) is the

effect on domestic consumption of a change in income. In effect, MPC
answers the question: “If income increases this amount, how much extra
will be spent on domestic goods and services?” MPC is defined as the
change in consumption on domestic products as a proportion of the
change in income.
Now that the multiplier effect has been seen in action, we will give it a
numerical value. The spending multiplier is the value by which the initial
spending change is multiplied by to give the total change in output –that
is, the shift in the aggregate demand curve. This multiplier effect
continues even after this first round and definitely does not stop at the
third round. Once all these effects –a process that continues until the last-
round effect is negligible –are added together, the total impact on the
quantity of goods and services demanded can be much larger than the
initial impulse from higher government spending.
Figure 4.8 illustrates the multiplier effect. The increase in government

spending of $50 billion initially shifts the aggregate-demand curve to the
right from AD1 to AD2 by exactly $50 billion. But when consumers
respond by increasing their spending, the aggregate-demand curve shifts
further to AD3.
Figure 4.8
The additional shifts in the aggregate demand curve i.e., from AD2 to AD3
are the result of the subsequent increases in consumer spending.
Therefore:
Total increase in spending = Initial increase in G + Sum of all subsequent

increases in C.
Or,
Total change in output = Initial change in G × Spending multiplier
243
Module4
For a given initial increase in n G, the biggger the seconnd term on thhe right,
the bigger
b the ovverall effect on output (thhe left-hand sside) and thee greater
the multiplier.
m Since the sizee of the changge in C (secoond term on thet right)
is deetermined byy MPC, we can c conclude that the biggger MPC, thee greater
the impact
i of fisscal policy on
n the econommy. Put differrently, the smmaller
the marginal
m proopensity to saave (withdraw wal), the largger the multiiplier.
Matthematics hellps determin

ne the magnittude of the sppending multtiplier in
a well as thee subsequent effects
this case, which incorporatess the initial as
on GDP:
G
Multipliier = change in GDP/ chaange in G = 11/(1-MPC).
The importance and relevancce of this conncept can be appreciated by

recaalling the hyppothetical sceenario in whhich your ecoonomy faced a
receessionary gapp of $50 billiion.
Baseed on our unnderstanding of the conceept of the muultiplier, we can c now

concclude that in order to closse this gap of $50 billionn, the governm ment
needds to inject a mere $10 biillion insteadd of $50 billion. The reason for
scaling down thee amount so far is that thhe magnitudee of the multiiplier (1/
(1-00.8)) is 5 andd, therefore, an
a injection of
o $10 billionn brings abou ut an
initiial increase of
o output by $10
$ billion plus
p the subseequent increaases in
conssumption speending of $4 40 billion for the overall eeffect of $50 billion.
A successful
s expansionary fiscall policy
An expansionary
e y fiscal policcy or fiscal sttimulus is deesigned to inccrease
aggrregate demannd by increassing governm ment expenditure or transsfer
paym ments, or deccreasing in taaxes (or com mbination of aall three actions) to
elim
minate a recesssionary gap p. As shown in i the figure below, the in nitial
equiilibrium is att real GDP of $12 trillionn and a price level of 100 0. Since
poteential GDP ($$13 trillion) is more thann real GDP att this point, there
t is a
receessionary gapp. In dealing with this ecoonomic probblem, the gov vernment
or auuthority can use expansio onary fiscal policy.
p The iinitial increase in
aggrregate demannd from the cut c in taxes or o hike in traansfer paymeents or
goveernment exppenditure is reeinforced byy the multipliier effect. Th he
aggrregate demannd curve (AD D) shifts righhtward from A AD0 to AD1. Real
GDP P rises so it equals
e potenttial GDP ($113 trillion) annd the price level
l
incrreases, to 1100, as indicateed in the samme figure.
244
A successful contractionary fiscal policy
Contractionary fiscal policy is a fiscal policy designed to decrease

aggregate demand by decreasing transfer payments or government
expenditure, or an increase in taxes (or a combination of all three actions)
to eliminate an inflationary gap. As shown in the figure below, the initial
equilibrium is at real GDP of $14 trillion and a price level of 110. Since
real GDP exceeds potential GDP ($13 trillion), there is a recessionary
gap. To solve the inflationary effect, government can use contractionary
fiscal policy. The initial decrease in aggregate demand from the cut in
government expenditure or transfer payments, or hike in taxes is
reinforced by the multiplier effect. The aggregate demand (AD) curve
moves leftward from AD0 to AD1. Real GDP decreases so it equals
potential GDP ($13 trillion) and the price level falls to 100.
Effect of a tax cut

The multiplier effect can be applied to the other tools that governments
245
Module4
use: taxes. Recall that tax cu uts can be useed to expandd the econom my. Lower
taxees leave housseholds and businesses
b w more funnds to spend and
with
inveest. In this caase, the initiaal spending sttimulus of thhe tax cut is
multiplied by thee spending multiplier,
m orr the reciproccal of MPS, which
w is
alsoo equal to (1/(1-MPC). Th he result is ann increase inn total outputt, shown
as a shift in the aggregate
a deemand curve..
In contrast to goovernment pu urchases, a taax adjustmennt has a smaller initial

effect on spendinng. In our prrevious exam mple of the goovernment sp pending
multiplier, a $100 billion increase in goveernment purchases caused d GDP to
rise by ($10 × 5 = $50) to clo ose the recesssionary gap.. The important point
is thhat the initiall impact of a change in G,
G say $10 billlion, on aggregate
expeenditure (C + I + G), is equal to $10 billion.
b In coontrast, the in
nitial
effect of a tax cuut of equal magnitude
m ($110 billion) iss less than $110
billiion. The reasson is that chhanges in taxees influence spending, C, C by first
channging consum mers’ disposable income by $10 billioon. Howeverr, since
MPC C is always less
l than onee –0.80 in thiis example –consumption n
spennding and heence aggregatte expendituures only rise by (0.80 × $10 $ =
$8), which is cleearly less thaan $10.
The effect of a taax change caan be summaarised in matthematical terrms

simiilar to those which
w show the effect off a change inn governmentt
spennding. The innitial change in spending on domesticc items that results
r
from
m a change inn taxes (T) iss found by multiplying
m thhe marginal
proppensity to consume by th he size of the tax change, and this prod duct is
thenn multiplied byb the spend ding multiplieer (1 /(1-MPC)) to derivee the
overrall shift in thhe aggregatee demand currve. And sincce this spendding
channge is in the opposite direection to the tax change iitself, the exp
pression
is prreceded by a negative sig gn.
Totaal change in output = Inittial change inn spending × Spending multiplier

m
-(M
MPC × changee in T) × (1/ (1−MPC))
The multiplier iss an importan nt concept inn macroeconoomics becau use it

show ws how the economy
e cann amplify thee impact of chhanges in sp pending.
A smmall initial chhange in connsumption, innvestment, ggovernment purchases
p
or net
n exports ennd up having g a large effecct on aggregate demand and a
therrefore, on prooduction of goods
g and serrvices. It is bbecause of th
he
ampplified impaccts that policy y-makers muust pay close attention to events
suchh as the possibility of reccession amonng our tradingg partners an nd the
posssibility of a stock-market
s t boom or craash.
1. When an ecoonomy facess an inflationary gap, a suuitable fiscal policy is

to:
A. increease governm
ment expendditure.
Study skills
S B. decrrease taxes.
C. decrrease government expendditure.
D. decrrease the quaantity of monney.
2. Which of the following is

i NOT an exxample of a fiscal stimulus?
246
A. increase in government expenditure on goods and services

B. increase in transfer payments
C. decrease in taxes
D. increase in taxes
3. If the economy is in equilibrium with real GDP less than potential
GDP, there is _____ gap and a fiscal policy that _____ is suitable.
A. a recessionary; increases potential GDP
B. a recessionary; increases aggregate demand
C. an inflationary; decreases aggregate demand
D. an inflationary; increases aggregate demand
Solutions:
1. C
2. D
3. C.
1. Suppose C = 200 + 0.75 YD. The multiplier in this economy is equal

to:
A. 0.75
Study skills B. 0.25

C. 4
D. 1.33
2. If, in this same economy, the government spending increases by $10

million, then GDP will increase by
A. $40 million
B. $10 million
C. $7.5 million
D. $2.5 million
3. If, in this economy, taxes fall by $10 million, GDP will increase by
A. $40 million
B. $10 million
C. $7.5 million
D. $30 million
Solutions:
1. C. The multiplier is equal to (1/(1- MPC) = (1/ (1-0.75) = 4.
2. A. The initial change in aggregate spending is $10 million (=
change in G) in this case, which is to be multiplied by the
spending multiplier, 4. Therefore, GDP rises by $40 million.
247
Module4
3. A. The initial
i changee in aggregatte spending iis $7.5 millio
on (=
change in
i T x MPC ) in this casee, which is too be multiplieed by the
spendingg multiplier, 4. Thereforee, GDP rises by $30 million.
The crrowding-o
out effectt on investment
The multiplier effect seems to t suggest thhat when the government spends
$10 billion on rooads and brid dges, the resuulting expanssion in aggreegate
demmand is necesssarily largerr than $10 billlion –in factt, it was $50 billion in
our previous exaample. Howeever, there is an effect thaat works agaainst this.
Whiile an increasse in governm ment purchases stimulatees the aggreg gate
demmand for goodds and servicces, it also caauses the inteerest rate to rise,
r in
turnn reducing invvestment speending and choking
c off aaggregate demmand.
The reduction inn aggregate demand
d that results
r whenn a fiscal expansion
raisees the interesst rate is called the crowdding-out effecct on investm
ment.
The logic behindd this pattern n is that, as thhe spending increases, deemand
for money
m rises to enable thee spenders too finance theiir new expen nditures.
Assuuming that thhis is a pure fiscal policyy –no changee in the moneey supply
is innitiated by thhe central bannk –an excess demand foor money dev velops
and the interest rate
r rises. Th his rising cosst of borrowing, in turn, reduces
r
the demand
d for residential
r an
nd business investment
i inn goods. In other
o
worrds, as the inccrease in gov vernment purrchases lifts tthe demand for
goodds and servicces, it may allso crowd ouut investmentt.
Thiss implies thaat the previou us illustrationn in Figure 44.8 lacks the element
reprresenting the crowding-ou ut effect andd its tendencyy to lessen th
he impact
of fiiscal policy. Two shifts are
a representeed accuratelyy: the AD cu urve
shift
fts from AD1 to AD2 (duee to the initiaal impact of tthe increase in i G) and
from
m AD2 to AD D3 (due to thee subsequentt changes in C C). To these,, we need
to addd a third shhift in the opp
posite directiion, in order to account fo or the
crowwding-out efffect.
ure 4.9 below

Figu o an expansiionary fiscal policy in
w illustrates the impact of
two alternative situations.
s Paanel (a) assum
mes the econnomy is in an n
unem
mployment (underemplo
( oyment) situaation and in ppanel (b) in a full-
empployment situuation.
248
Figure 4.9
An increase in government spending shifts the AD curve from AD1 to

AD4. This shift is a net of three effects.
1. The initial impact of G,
2. the subsequent impacts on C, through the marginal propensity to
consume (the multiplier effect), and
3. the crowding-out effect on investment.
The first two effects tend to reinforce each other, pushing the AD curve to
the right, whereas the third effect tends to work in the opposite direction,
pushing the AD curve to the left.
In panel (a), the economy moves directly from point A to point B, settling
at full employment. In panel (b), the economy initially surpasses its
potential in the short run, C. In the long run, as nominal wages will rise in
response to the inflationary pressure, the SRAS curve will shift shifts up
to SRAS2, and the economy will return to long-run equilibrium at point
D.
Government budgets
The annual statement of the expenditures and tax revenues of the
government makes up the government budget. Therefore, fiscal policy is
the use of the federal budget to achieve macroeconomic objectives such
as full employment, sustained long-term economic growth, and price
level stability.
The government’s budget balance is equal to its revenues minus its

outlays. That is,
Budget balance = Revenues – Outlays,
where outlays consist of expenditures on goods and services (G), transfer

payments such as welfare benefits, and debt interest charges, which are
payments of interest on previously accumulated debt.
When revenues exceed outlays, the government has a budget surplus. If

outlays exceed revenues, the government has a budget deficit. If revenues
equal outlays, the government has a balanced budget.
Deficits and debts

The government borrows to finance its deficit. Government (public) debt
is the total amount of government borrowing. It is the sum of past deficits
minus the sum of past surpluses. When the government has a deficit, its
debt increases. Evidence indicates that governments of most countries,
developed or otherwise, have consistently failed to balance their annual
budgets over the last couple of decades. This failure has resulted in
ballooning public debts.
249
Module4
Deficit = change in debt,

d
or
Debt (inn 2002) = Deebt (in 2001) + Deficit or surplus (in 2002)
2
To discover
d the fiscal stancee, it is sufficieent to say thaat we need to
o delve
deepper and find out what, if any, extra diiscretionary m measures thee
authhorities have taken in resp ponse to the situation–thaat is, deconsttruct the
budgget balance so
s that the cy yclical (recesssion or boom m) componen nt is
isolaated from thee structural component.
c
The lim
mits of po
olicy activism
We have seen hoow monetary y and fiscal policy
p can afffect the econ
nomy’s
aggrregate demannd for goods and servicess. These theooretical insig ghts,
howwever, raise some
s importaant policy quuestions. Shoould policymakers use
thesse instrumentts to control aggregate deemand and sttabilise the economy?
e
If soo, when? If not,
n why not??
The world econoomy is often subject to thhe effects of unexpected eventse –

natuural disasters, political orr economic happenings, oor speculativee
rum
mours. Eventss such as thesse have oftenn been responnsible for larrge
channges in outpuut, unemploy yment and innflation. If monetary and fiscal
policy can be ussed to stabilisse the econom my, then sureely these too
ols should
be used
u to offsett the harmfull effects of ecconomic flucctuations. Th
his is the
casee in favour off using moneetary and fisccal policy to stabilise thee
econnomy.
Keyynes, in his book Generall Theory of Employment,

E Interest and
d Income
empphasised the key
k role of aggregate
a dem
mand in expllaining shortt-run
econnomic fluctuuations. Keyn nes claimed that
t the goveernment shou uld
activvely stimulatte aggregate demand wheen aggregatee demand app peared
insuufficient to maintain
m prodduction at its full-employm ment level. At
A the
timee Keynes wroote the book, the world’ss major econoomies were in i the
middst of the Greeat Depressioon. It is no wonder,
w then, that the Keyynesian
propposal to use policy
p instru
uments to lesssen the severrity of econoomic
dowwnturns proveed popular. Keynes
K (and his many folllowers) wass a strong
advoocate of usinng policy insttruments to stabilise
s the eeconomy.
Now wadays, how wever, the sco ope appears tot be very cirrcumscribed for using
fiscaal policy to stimulate
s eco
onomies in thhe traditionall sense of tak
king
actioon that would widen bud dget deficits. Having faceed mounting deficits
and debts, the majority
m of go
overnments of o developedd and develop ping
counntries have been
b pressureed to introduce strict meaasures that haave led to
a coonservative approach
a to fiscal
fi policy. Unfortunateely, the progrress
madde under the newn conserv vative approaach seems to have lost mo omentum
for now,
n partly because
b of th
he recent ecoonomic slowddown but largely due
to thhe fallouts off the Septemb ber 11 eventt at the Worldd Trade Centter in
New w York and, more
m recentlly, by large-sscale accountting frauds by
b major
US corporationss,such as Enrron and Worlld.com.
250
Furthermore, the new conservative perspective on policy activism can be

explained under time lags. The argument against active monetary and
fiscal policy is that these policies affect the economy with a substantial
lag.
As we have seen, monetary policy works by changing interest rates,

which in turn influence investment spending. But many firms make
investment plans far in advance. Thus, most economists believe that it
takes at least six months for changes in monetary policy to have much
effect on output and employment. Morever, it takes anywhere between 18
and 24 months for monetary policy to have it full impact on the economy.
Therefore, critics of stabilisation policy argue that because of this lag, the
central bank should avoid fine-tuning the economy.
Fiscal policy suffers from long lags as well. However, there are major
differences in the structure of the lags in fiscal versus monetary policy:
1. Monetary and fiscal policy have differential impacts on aggregate
demand; fiscal policy, at least a change in government spending,
affects aggregate demand directly whereas monetary policy has
an indirect effect on it. As such, fiscal policy tends to have a
shorter execution lag.
2. Monetary policy lags are substantially shorter from the
perspective of implementation, implementation lag.
Implementation lags in fiscal policy are largely attributable to the
political process. A fiscal policy typically requires an Act of
parliament, budgetary preparation and presentation before the
policy takes effect, whereas monetary policy does not. Therefore,
while the overall length of the policy lags may be similar in both
policies, the composition of them is different.
Other arguments against fiscal, not monetary policy activism can be

explained under inefficiencies of a growing public sector and private-
sector reactions.
Inflation and Unemployment

Introduction
This section first explores the effects of a trend of rising prices, how the
trend is measured, and how it often hurts most those who can afford it
least. Such an exploration pulls together the tools you have already
acquired, namely the aggregate demand–aggregate supply model. The
next step is to consider how the two most-watched economic indicators,
inflation and unemployment, are related. You will then examine
unemployment in detail in terms of how it is measured, its causes, and its
costs, not only for individuals but also for the entire economy.
251
Module4
Inflatio
on
Moddule1 introduuced the concept of a pricce index andd how statistical
agenncies go abouut employing g this index (or
( indices) tto measure in nflation.
A brrief recapitullation of the basic conceppts sets the sttage for a stu
udy of
inflaation.
Onee key price inndex is the Consumer

C Priice Index (CPPI). The CPII is the
tool most comm monly used to o measure overall changes in price in a
reprresentative baasket of conssumer produucts. Anotherr important price
indeex is the GDP P deflator–a broader meaasure of averrage price. Th
his index
is foound by dividding the nomminal value of GDP by thhe real GDP. The
speccific differennces betweenn these two have already bbeen discusssed and
needd not be repeeated.
Inflaation, as introduced in Module

M 1, is a general incrrease in the prices
p of
goodds and servicces in the enttire economyy over time. T To measure inflation
rate, we calculatte the annuall percentage change in the price level. For
exam n in year 20002 is calculatted as follows:
mple, the rate of inflation
CPI2002 – CPI2001
2
Inflaation rate(20022) = × 1100
CPI2001
Thiss equation shhows the con nnection betw ween the inflaation rate and the
price level. If thee price level is rising, thee inflation raate is positivee. If the
price level rises at a faster raate, the inflattion rate will rise. In addiition, the
highher the new price
p level is, the lower thhe value of m money and th he higher
the inflation
i ratee.
Cau
uses of infflation
Dem
mand-pull inflation
An inflation
i thatt results from
m an initial inncrease in agggregate dem
mand is
calleed demand-ppull inflation.
Suchh inflation caan arise from

m any factor that
t increasees aggregate demand,
d
suchh as:
• An increease in the money
m supplyy.
• An increease in goverrnment expenditures.
• Increasees in exports..
• An increease in consu
umers’ and innvestors’ willlingness to buy.
b
Suppose that lasst year the price level in the

t economy was P1 and the t real
GDP P was at its potential
p leveel, Yn. Figurre 4.10 illustrrates this situ
uation.
At thhis long-run equilibrium point, point A, the aggreegate demand d curve
(AD
D1) crosses thhe short-run aggregate
a suupply curve, SSRAS1, and the t long-
run aggregate suupply curve, LRAS. Now w suppose thaat this year, thet
aggrregate demannd curve incrreases to AD D2, say due too an increase in
252
consumers’ optimism. Assuming no change on the supply side of the

economy, and therefore, no changes in SRAS and LRAS, new
equilibrium (short-run) levels of the price and real GDP are found where
the new aggregate demand curve (AD2) intersects the short-run aggregate
supply curve at point B, with P2 and Y2 at its coordinates. Graphs show a
jump in the price level of (P2 - P1)/P1 per cent and a surge in the level of
income. Furthermore, unemployment falls below the natural rate.
Figure 4.10
Of course, this is not the end of the process of the adjustment. The reason
is that GDP cannot remain above its potential value forever. Furthermore,
with unemployment below its natural rate, there will be a shortage of
labour. In this situation, the money wage rate begins to rise. As it does,
short-run aggregate supply decreases and the SRAS1 curve starts to shift
leftward. The price level rises further and real GDP begins to decrease.
With no further change in aggregate demand –the aggregate demand
curve remains at AD – this process ends when the short-run aggregate
supply curve has shifted to SRAS2. At this time, the price level has
increased to P3 and real GDP has returned to potential GDP of Yn, the
level from which it started.
Demand-pull inflation can be also sparked off by excessive growth of

money supply as well as excessive government budget deficits. For
example, the government might try to stimulate demand in order to
achieve a reduction in unemployment. As demand expands, demand in
labour markets and goods markets increases, driving up wages and prices.
Also, the deficit could affect the liquidity base of the economy, in effect
increasing the money supply, temporarily lowering interest rates, and
giving an additional boost to the economy.
Cost-push inflation
An inflation that results from an initial increase in costs is called cost-

push inflation. The two main sources of increases in costs are an increase
in the money wage rate and an increase in the price of raw materials.
At a given price level, the higher the cost of production, the smaller the
253
Module4
amoount that firm ms are willing g to produce. Therefore, if the money y wage
rate rises or if thhe price of raaw materials (for examplee, oil) rises, firms
f
decrrease their suupply of good ds and servicces. Aggregaate supply deecreases,
and the short-runn aggregate supply
s curvee shifts leftward.
Let us trace the effects

e of succh a decreasee in short-runn aggregate supply
s
on thhe price leveel and outputt. Again, assuume a similaar set-up as in
n the
prevvious figure seen
s in Figure 4.11.
Starrting from lasst year’s long g-run equilibbrium, point A, let us assu ume that
this year the OPEC nations increase
i the price
p of oil bby cutting pro
oduction.
The short-run agggregate supp ply curve shiifts to the lefft, SRAS2. At
A point
B, thhe price leveel rises and output
o of the economy fallls, a combin nation we
referred to earlieer as stagflattion.
Figu
ure 4.11
Money supplyy and inflaation

If eaach of us woke up today with twice as
a much monney as yesterd
day, two
thinngs could happpen:
1. we could spend som me of the extrra money on goods and seervices to

celebratte our good fortune,
f whicch would cauuse the price level to
rise, or
2. we mighht invest partt of the moneey in governm ment bonds or o

similar financial
f asseets. In this caase also, the resultant surrge in
asset priices would confer upon thhe public a ppositive weallth effect
that wouuld in turn bo
oost demandd for goods annd services. Hence,H
prices would
w be driv
ven up –assum ming fixed pproduction.
Ultimately, if the level of ou utput remaineed unchangedd despite thiss surge in

demmand, prices would
w be risiing to the samme extent as the nominall supply
(stocck) of moneyy –doubled –and – the initiial equilibriuum would be restored
withh prices and the
t nominal income beinng twice as m much as they were
origginally. In thiis situation, people
p are willing to holdd all the 100 per cent
incrreased supplyy of money because
b r purchasinng power of the
the real
publlic has remaiined unchang t doubling of the moneey supply.
ged despite the
Now w, one needs to hold twicce as much money m as befo
fore, since thee price of
254
everything has doubled. This explains why inflation cannot continue

without a sustained increase in the money stock and why continued
excessive increases in the money stock are invariably followed by
inflation.
In Module3, the chain of causation can be sketched within the aggregate

demand and aggregate supply framework. This framework shows that the
long-term impact of the increase in the money supply may be different
from its short-run impact. In the short run, a rise in the money stock
causes higher prices, but it also leads to more output. The output effect
occurs because of short-term rigidities, reflecting employees’ inability to
respond instantaneously to the decrease in the real wage caused by the
increase in the price level. In the longer term, pay levels catch up on
inflation and, over time, they will respond more quickly to it. The
economy then approximates more and more closely to the vertical
aggregate supply.
However, for the current purpose, our focus will be only on the long-term
implications. To conduct a long term analysis, we can employ a theory
referred to as the Quantity Theory of Money. This theory is constructed on
the basis of the highly simplified equation:
Ms.V = P.Y
where Ms = the money supply; V the velocity of circulation of money

(the number of times money changes hands); Y = the real GDP; and P =
the general price level.
The equation holds that the nominal GDP (P.Y) is determined by the
quantity of money in circulation and by the velocity of the money.
Strictly speaking, the ultimate determinant of money supply is the central
bank. The velocity is determined by institutional factors such as habits of
payments and receipts –the frequency of receiving the monthly income,
which could be weekly, biweekly, monthly – as well as the technological
factors such as credit cards, debit cards and automatic bank teller
machines. For example, as credit cards are used more widely by
individuals, the less cash they need to hold and therefore the greater is the
rate of turnover of money – money has to work harder because less of it is
being held.
For a given velocity, the equation suggests that as the central bank
increases the quantity of money in circulation, the nominal GDP on the
right-hand side increases. Assuming that in the long run, the economy is
at its full employment level of GDP (Y = Yn) and that full employment of
GDP is constant, a direct link is established between changes in Ms and
changes in P. An increase in Ms results in an increase in P of equal
proportions –one for one. This can also be expressed in percentage terms.
Other things being equal (notably, the velocity of circulation and trend
growth in income), the higher the growth of money supply, the higher the
rate of inflation. Hence, the popular description of inflation is too much
money chasing too few goods.
255
Module4
The quantity theeory of moneey is a usefull start to a theeory of inflattion, but

it leaves many questions
q unaanswered. It oversimplifiees the causall
interractions betwween money supply and real r output. IIt places all the
t
empphasis on mooney supply without
w explaaining the ecconomic and social
factoors which deetermine how w and why money
m supplyy should be allowed
a
to inncrease. A fuully-fledged theory
t of infflation wouldd also have to
o explain
the determinants
d s of velocity of circulatioon and to probe more careefully the
justiification for assuming thaat it remains constant.
Thee inflationaary processs

As already
a discuussed, the quuantity theoryy of money teells us that inn order to
trannslate a one-tiime increasee in the generral price leveel into a sustaained
inflaation, moneyy supply has to rise on a sustained
s bassis. The mon netary
authhorities must assent to a continuously
c y rising moneey supply. A political
deciision might beb taken that the short-runn costs of reffusing to vallidate the
inflaation –costs of
o civil strifee, unemploymment and dissruption –aree greater
thann the econommic costs of in nflation. We will proceedd with the following
expllanation.
The oil crisis in 1973 betweeen the oil-im mporting counntries ended with w
highh inflation raates. For exam
mple, up to 1973,
1 Britainn’s inflation rate
r had
onlyy been margiinally higher than Germaany’s. After 11973, Britain n’s
inflaation rose to more than double
d Germaany’s. The B British authorrities
deciided to validaate the inflattion, whereass in Germanyy, the authorities
madde clear theirr intention noot to validate it, and Germ man employeers and
tradde unions respponded by keeeping tight curbs on pricces and nom minal
incoomes.
For Germany, thhis means, in n terms of Figgure 4.11, a movement from

f
poinnt A to B, wiith the generaal price rising moderatelyy from P1 to P2. The
deciision not to inncrease the money
m supplly dampenedd inflationaryy
expeectations andd moderated pay claims. This made itt easier to cu urb
inflaation. Howevver, to achievve this, theree was a price that German
ny and
Germ mans had to pay: higher unemploymeent and loweer GDP.
Conntrastingly, inn Britain, moonetary validdation causedd the price lev vel to
rise to P3 while preventing
p th
he unemployyment probleem that Germ many had
to faace. In termss of Figure 4.11,
4 the situaation in Britaain can be caaptured
by a movement from A to B followed byy a movemennt to C, the laatter
movvement beingg the result ofo monetary validation.
v
An important
i coonclusion draawn from this analysis is that inflation n and
unemmployment offer
o authoritties a menu ofo choices. Innflation, it seeems, is
the cost
c to be boorne by trying g to keep uneemploymentt down;
unemmployment appears
a to bee the price off keeping infflation down.. This
implies a trade-ooff between inflation
i andd unemploym ment that
policymakers caan take advan ntage of.
256
Inflation, unemployment and the Phillips curve

The aggregate demand–aggregate supply model focuses on the price level
and real output (GDP). Although one can work out what happens to
inflation and unemployment using these two variables (price and GDP),
there is great appeal in a more direct approach to studying inflation and
unemployment. Such an approach is called the Phillips Curve. In essence,
the Phillips Curve is based on the aggregate demand–aggregate supply
model but focuses instead on inflation, which is calculated from the price
level changes, and unemployment, which can be linked to output via an
inverse relationship. However, in the same way that the aggregate
demand–aggregate supply model distinguishes between the short- and
long-run adjustments, we define the Phillips curve for both frameworks: a
short-run curve (SPC) versus a long-run Phillips curve (LPC).
A formal link between output and unemployment can be established

through a relationship known as Okun’slaw. Okun’s Law provides a
precise relationship between the rate of change of output and the
unemployment rate. Accordingly, when output of the economy grows
beyond a certain normal rate, which tends to vary from country to
country, the unemployment rate drops.
Short-run Phillips curve

The Phillips curve shows the combinations of inflation and
unemployment that arise in the short run as shifts in the aggregate
demand curve move the economy along the short-run aggregate supply
curve. As we saw earlier, an increase in aggregate demand gives rise, in
the short run, to a larger output and a higher price. Larger output means
greater employment and thus a lower unemployment rate while the higher
price implies higher inflation. Therefore, inflation and unemployment
move in opposite directions in the short run.
In Figure 4.12, the link between the aggregate demand–aggregate supply

model, panel (a), and the Phillips curve, in panel (b), is highlighted. The
equilibrium points A and B in panel (a), correspond to A’ and B’ in panel
(b), and U1 and U2 are the unemployment rate counterparts of output level
of Y1 and Y2. Initially, the price level (price index) is equal to 104 and
this, assuming that the previous year’s price level coincided with the base
year (P =100), puts the inflation rate at 4 per cent per year. This is shown
by point A’.
257
Module4
Figu
ure 4.12
Noww assume thaat aggregate demand

d curvve increases (shifting outt) to AD2,
pushhing up the price
p a GDP Y2. Correspondding to these changes,
to 107 and
the unemployme
u ent rate is low
wered to U2, while the innflation rate is
i raised
to 7 per cent (using the samee base year). This analysiis suggests th hat the
upwward movemeent from poin nt A to B, aloong the SRA
AS curve, corrresponds
to a similar movvement from point A’ to B’ B along the SRPC curvee.
milarly, a dow
Sim wnward moveement along the SRAS cuurve that brin ngs
abouut a lower prrice level and d a lower reaal GDP refleccts a downwaard
movvement alongg the SRPC that t brings abbout higher uunemploymeent and
loweer inflation.
The position of the

t trade-offf line (SRPC)) is determinned by (a) thee
expeected inflatioon rate and (bb) the naturaal unemploym ment rate thaat are
assuumed held coonstant. Simiilarly, the position of SRA AS is determmined by
the expected
e o output. If eeither factor changes,
pricce and the naatural level of
SRP PC will shift.. An increasee in inflation expectationss as well as an
a
incrrease in the natural
n rate of unemploym ment causes tthe SRPC to shift to
the right
r in the same
s way thaat an increasee in the pricee expectation
ns and a
fall in Yn would cause a shifft in SRAS too the left.
The long-run Phhillips curve shows the reelationship between inflation and
unem mployment whenw the actu ual inflation rate equals tthe expected inflation
rate. The long-ruun Phillips cu urve, LRPC,, is vertical aat the naturall
unem mployment rate,
r Un, as iss the long-runn aggregatedd supply curvve
verttical at Yn, ass seen in Figuure 4.13.
Figu
ure 4.13
Connsequently, thhe relationsh

hip between LRPC
L and SRRPC is the mirror
m
imagge of that beetween LRAS S and SRAS.. The long-ruun aggregate supply
258
curve told us that any anticipated price was possible at the natural level of
output: actual GDP equals potential GDP. In the same way, the long-run
Phillips curve tells us that any anticipated inflation rate is possible at the
natural unemployment rate.
When the expected price level changes, the short-run aggregate supply
curve shifts upward, but the long-run aggregate supply curve does not
shift. Similarly, when the expected inflation rate changes, the short-run
Phillips curve shifts up, but the long-run Phillips curve does not shift.
Therefore, for every long-run curve there is a family of short-run curves,
each associated with a different expectation level.
Costs of inflation
Why are high inflation rates bad? If you ask the typical person that
question, he or she will tell you inflation robs people of their purchasing
power of their earnings.
However, inflation means not only increasing prices but also expanding
nominal incomes as well. The effect on households’ purchasing power
depends on which is greater, the inflation rate (the rate of increase in the
average price) or the increase in nominal income.
If a household’s nominal income increases steadily every year but

inflation is at a higher rate, the household suffers from losses of
purchasing power. If, in contrast, the same household has a nominal
income that increases at roughly the same rate as inflation, the household
maintains its purchasing power. Therefore, whereas some households
may feel the full impact of inflation on living standards, others may have
the impact cushioned by income adjustments. Of course, others may even
benefit from inflation because their nominal income rises more quickly
than inflation.
Since most people earn their incomes by selling their services, such as
their labour, inflation in incomes goes hand-in-hand with inflation in
prices. Thus, inflation does not in itself reduce people’s real (purchasing
power) income. The damaging aspect of inflation for society is that it
redistributes (income) wealth among individuals in an arbitrary way. The
winners are often those with substantial economic resources, while the
losers are usually those least able to withstand a drop in purchasing
power.
Redistribution effect of inflation

Inflation tends to redistribute income (or wealth): some households lose
while others win. The biggest losers are those whose income is not fully
indexed. When workers’ incomes are automatically increased by the rate
of inflation, these are called fully indexed incomes. In this case, nominal
income rises at the same rate as prices, so real income stays the same.
Other people may receive incomes that are only partially indexed or not
indexed at all (fixed). These are typically fixed income earners:for
example, pensioners. Fixed incomes are those that stay at the same
259
Module4
nom
minal dollar amount
a and do
d not change in responsee to inflation n. The
winnner in this caase is the gov
vernment, whhich has colllected from thet public
morre valuable taaxdollars, before prices roose, to returnn them to thee public
withh less valuable dollars at a later date (when
( prices have risen). In other
worrds, a reducedd real (after-inflation) fixxed income too pensionerss implies
equaally reduced real fixed paayments (cossts) to the goovernment.
How wever, goverrnments tend to adjust thee loss of incoome of fixed--income

earnners to inflatiion with a formula knownn as COLA ((cost of livin ng
adjuustments). Inn practice, theese measuress are partial iindexation
(adjustment) andd their effectt is that incom
mes rise morre slowly thaan the
inflaation rate.
Anoother redistribbutive effectt of inflation is on borrow wers and lend ders.

Wheen a lender leends funds ata an interest rate that is nnot adjusted for
f
inflaation, the lennder may losee out. In thiss case, the wiinner will be the
borrrower who haas borrowed more valuabble moneyonnly to return less l
valuuable moneyaat a later datee.
To illustrate
i thiss, we need to
o distinguish between twoo types of intterest
ratess, discussed briefly in Module3.
1. The nom minal (markeet) rate of interest, the intterest rate exp
pressed
in moneey terms in daaily financiaal reports andd bulletins at your
bank. Foor example, you
y borrow $100,000
$ forr one year froom a
bank to start a business. Assumee the borrowiing rate is 10 0 per cent
per annuum. At the en nd of the yeaar, you must pay back thee
principaal ($100,000)) plus interesst (0.10 × $1000,000 = $10 0,000),
for a tottal of $110,00
00 ($100,0000 + $10,000)).
2. The reall interest ratee: the real coost of borrow
wing to you (o or the
real retuurn to the bannk). This is too be measureed at a rate of
o interest
that corrrects for the inflation ratee.
The real rate of interest

i is roughly equal to the nominnal interest raate minus
the rate
r of inflation.
Real intterest rate = Nominal

N inteerest rate − IInflation ratee
Noww return to thhe same exam mple but this time, assumme that the inflation
rate is 4 per centt in the year you borrow money for your businesss. In this
casee, the real cosst of borrowiing to you annd hence the real rate of return
r to
the bank
b (real innterest rate) is 6 per cent––the 10 per cent nominal interest
rate minus the 4 per cent ratee of inflationn. The real innterest rate reeflects
the fact
f that becaause of inflattion, the fundds lent (the pprincipal) hav ve less
purcchasing poweer at the end of the one-yyear term thaan they did att the time
the loan
l was maade. Thereforre, your bankk receives $10,000 (10 peer cent)
in nominal intereest at the end d of the year, but only $66,000 (6 per cent)
c in
real interest. Sim milarly, your real cost of borrowing
b iss $6,000 and not
$10,000.
Alteernatively, wew can write this

t equationn to show thaat the nominaal rate of
interrest is the suum of the reall rate and thee inflation raate.
260
Nominal interest rate = Real interest rate + Inflation rate
This way of looking at the equation is very useful because it shows in

order for a lender, for example, to maintain a constant real rate of return
(real interest rate) on his or her wealth, he or she must adjust its nominal
lending rate (nominal interest rate) one for one to the changes in the rate
of inflation. Once the nominal interest rate has been agreed upon, it is
fixed. Therefore, lenders try to anticipate the rate of inflation for the loan
period and build it into the nominal interest rate. This rate built into the
nominal interest rate is known as the inflation premium. Lenders,
therefore, determine what real interest rate they desire and add an
inflation premium to determine the nominal interest rate.
The adjustment of nominal rate of interest to the expected (anticipated)

inflation rate is called the Fisher Effect, named after American economist
Irving Fisher (early 20th century).
What happens if the inflation rate turns out to be higher than lenders
anticipated? Suppose, in our previous example, the lender expects that the
inflation rate to be 4 per cent in the current year. If the lender wishes to
earn a real rate of return of 6 per cent he or she must then set the nominal
rate at 10 per cent per year (real rate (6 per cent) = nominal rate (10 per
cent) – expected inflation rate (4 per cent)). Now suppose the inflation
rate turns out to be 7 per cent instead of 4 per cent. As a result, the bank
actually receives only 3 per cent real interest –that is, the 10 per cent
nominal rate minus the 7 per cent inflation rate. This is substantially less
than the 6 per cent real interest rate the bank had anticipated.
Therefore, because the inflation rate is higher than anticipated, the real
interest rate is lower than the desired real interest rate, and lenders are
worse off while borrowers are better off. Borrowers, indeed, return less
valuable dollars to lenders. Conversely, if the expected rate of inflation
turns out to be less than the expected one, the losers and winners will be
reversed – lenders lose while borrowers gain.
If the nominal rate of interest is 6 per cent and the expected rate of
inflation is4 per cent, then the real interest rate is:
A. 2 per cent
Study skills B. 10 per cent
C. –2 per cent
D. actual inflation rate is equal to expected rate.
Solution:
A. The real rate of interest is equal to the nominal minus the rate of
inflation (6-4 =2). D is wrong because there is not enough
information to determine if the expected and actual inflation rates are
equal.
261
Module4
Oth
her impacts of inflation
Sho
oe-leather co
osts
Incrreases in the inflation ratee cause increeases in the nnominal interrest rate.
Faceed by this inccrease in thee opportunityy cost of monney, individu uals
reduuce their holddings of real money balannces to econnomise on holding
cashh. Cash is, off course, subjject to a greaater deterioraation than altternative
asseets that at leaast provide so
ome kind of monetary
m retturn. Individu uals, still
in need of cash to t finance theeir regular trransactions bbut hold less money,
musst make moree trips to the bank. Note that t individuuals’ spending habits
and monthly exppenditures arre not alteredd. The only thhing that hass altered
is thhat they hold less money and hence thhey have to vvisit their ban nk more
freqquently. Thesse trips reducce leisure andd/or time speent working, and are
referred to as shoe-leather co osts.
Tax distortions
Incrreases in inflaation can inccrease the efffective tax raate on consum

mers
throough a processs called bracket creep byy pushing thhem into high her
incoome-tax bracckets as their nominal income increasees. If, for insstance,
the increases
i in individuals’ nominal income are due to higher inflation –
theirr pay chequees rising onlyy to keep up with the risinng cost of livving –
this will reflect only
o an increease in nominnal income aand not an in ncrease in
conssumers’ reall income. However, unlesss the incomee tax system is fully
indeexed, these inndividuals will
w end up in a higher taxx bracket and d will,
inevvitably, pay higher
h taxes. This changee would not ooccur in a fully
indeexed tax systtem because the tax brackket would noot change wh hen the
nomminal incomee did. Increasses in inflatioon also affectt capital gainn taxes,
evenn though the real value of the taxed asset
a has not changed. Th he same
logic applies agaain.
Con
nfusion and money illussion
As inflation
i incrreases, decisiion making becomes
b morre challengin
ng, and
certaain computattions becomee more difficcult. Higher iinflation tendds to
massk the real eaarnings of inddividuals. Evvidence suggests that risin
ng
earnnings, salariees, wages andd other sourcces of incomee are more likely to
be mistaken
m for increases in real income in an enviroonment of hig gher
inflaation than in one of lower inflation.
Inflaation variabiility
Anoother problem m with inflatiion is that offten, as inflattion rises, it becomes

b
morre variable tooo. It is the variability thaat makes lendding and borrrowing
morre risky. Onee implication is that bond holding beccomes riskierr.
Inflaation tax
If innflation is so bad, why do

o the central banks of these countries choose
to prrint so muchh money that its value is certain
c to fall rapidly oveer time?
The answer is thhat the govern nments of thhese countries are using moneym
creaation as a wayy to pay for their
t spendinng. When thee governmen nt wants
to buuild roads orr pay salariess to civil servvants, for exaample, it firsst has to
262
raise the necessary funds. Normally, the government does this by levying
taxes such as income and sales taxes. In countries with well-developed
financial markets, the government can raise funds by borrowing from the
public by selling government bonds. A third option, widely used in
developing countries, however, is for the government to pay for its
spending by simply printing the money it needs.
When the government raises revenue by printing money, it is said to levy

an inflation tax. The inflation tax is not exactly like other taxes, however,
because no one receives a bill from the government for this tax. Instead,
the inflation tax is more subtle. When the government prints money, the
price level rises and the ringgit in your wallet are less valuable. Thus, the
inflation tax is like a tax on everyone who holds money.
The benefits of inflation

The recent experience with several deflationary situations in countries
such as Japan has reminded us of an important fact that deflation can be
more dangerous than inflation. To understand this point, recall the Fisher
equation, (real interest rate = nominal inflation minus expected inflation).
When the inflation rate becomes negative (deflation), the real rate of
interest rises. The problem with a scenario such as this becomes more
evident when lower, and not higher, interest rates are desired as in when
central banks wish to jump-start the economy or calm the financial
markets down.
To appreciate this point, note that central banks can change nominal
interest rates, not real rates –at least not directly. The study of business
cycles of the last several decades points out that central banks facing
recessions have counted on negative real interest rates in order to give the
economy a boost. This is achieved by lowering the nominal interest rates
below the rate of inflation. The problem arises, however, when the rate of
inflation is zero or below zero: deflation. In such circumstances, not only
are central banks unable to bring about a negative real rate of interest
because the nominal rate cannot fall below zero, but also the deflation
rate will be the only driving force behind the real rate of interest and
hence the health of the economy.
Therefore, in instances where negative real interest rates are desired but
cannot be achieved via lower nominal interest rates –since nominal
interest rates cannot fall below zero –central banks may have to resort to
higher inflation rates. However, if the inflation rate is stuck at zero per
cent and lower, the real interest rate will never become negative and
economic recovery may never start.
Unemployment
Unemployment is one of the two most serious macroeconomic problems,
the other one being inflation, that affects people rather directly. For most
people, the loss of a job means a reduced living standard and
psychological distress. It is no surprise that unemployment is a topic of
263
Module4
heatted debate am
mong politiciians, academ
mics and meddical practitio
oners.
Tab ble 4.1 below w, shows the rate of unem mployment –tthe percentag ge of the
laboour force uneemployed –in n several couuntries. The ffigure suggessts that
therre is always some
s unemplloyment. Thiis is true eveen when the economy
e
is att natural leveel of output (full employmment). This ffigure does not
n
incluude the size of unemploy yment at full employmennt or you wou uld see
that this varies from
fr a countrry to the next. A historicaal sequence would
w
show w you that thhe natural ratte of unemployment doess not stay con nstant
withhin a given country eitherr.
Country Unemp
ployment Rate
R (%) (20002)
Ausstralia 6.3 (Maay)
Belggium 10.4 (M
May)
Brittain 5.2 (Aprril)
Cannada 7.7 (Maay)
Spaiin 11.4 (M
May)
Sweeden 2.0 (Aprril)
USA
A 5.8 (Maay)
Euroo area 8.3 (Maay)
(Sourrce: The Econom
mist, July 2002)
Tab
ble 4.1
Economists studdy unemploy yment to idenntify its causees and to help

p
improve the pubblic policies that
t affect the unemployeed. Some pollicies
suchh as job-trainning programmmes, help peeople to findd employmen nt. Others
suchh as employm ment insurannce, alleviate some of the hardships th hat the
unem mployed face. Still, otherr policies afffect the prevaalence of
unem mployment inadvertently
i y. Laws manddating a highh minimum wage,w for
instaance, are widdely thought to raise unem mployment aamong the leeast
skillled and expeerienced mem mbers of the labour
l force.. By showing
g the
effects of variouus policies, ecconomists heelp policymaakers evaluatte their
options.
In thhis section, you

y begin your study of unemployme
u ent by looking at
som
me of the relevvant facts that describe unemploymen
u nt, including
g why
therre is always some
s unemplloyment andd what determ mines its leveel. The
probblems associated with un nemploymentt are usually categorised into two
grouups: the longg-run and sho ort-run probleems. The lonng-run
unem mployment problem
p refeers to the natuural rate of uunemploymen nt, a
normmal state of unemployme
u ent that an ecconomy tends to in the lo ong run.
The short-run prroblem is asssociated withh cyclical uneemployment: year-to-
yearr fluctuationss in unemplo oyment arounnd its naturall rate.
264
The labour force survey

Statistical agencies around the world keep track of their respective
workforces through a monthly survey of labour force participation. These
households are a random sample of the labour force population, which
includes all residents of the country above certain legal age (15 in
Canada) with some exceptions that tend to vary from one country to the
next. The labour force is made up of those who either have jobs or are
actively seeking employment. By its definition, the labour force leaves
out those who have given up looking for a job, as well as full-time
homemakers who, while they work, do not do so in the formal job market.
The official unemployment rate

The answers to survey questions enable statistical agencies to place each
adult in each surveyed household into one of three categories:
• employed
• unemployed
• not in the labour force.
A person is considered employed if he or she spent most of the previous

week (or weeks) working at a paid job. A person is unemployed if he or
she is on temporary layoff looking for a job, or is waiting for the start date
of a new job. A person who fits neither of the first two categories, such as
a full-time student, homemaker or retiree, is not in the labour force.
Labour force = Number of employed + Number of unemployment
Number of unemployed
Unemployment rate (%) = × 100
Labour force
Another valuable piece of information that statistical agencies tend to

produce from their labour survey is the labour-force participation rate.
The participation rate measures the percentage of the total adult
population that makes up the labour force.
Labour force
Participation rate (%) = × 100
Adult population
265
Module4
Assuume that in the

t year 2002 2, the size off the local aduult populatio
on is 40
million, 25 milliion people were
w employeed, and 3 milllion were
unem
mployed. Baased on this innformation:
Study skills
S 1. The size of the
t labour fo
orce is
A. 25 million
m
B. 28 million
m
C. 40 million
m
D. 3 miillion
2. The unemployment rate is:

A. 2 peer cent
B. 7 peer cent
C. 10.77 per cent
D. Cannnot be calcu
ulated from thhis informatiion.
3. The particippation rate is
A. 70 per
p cent
B. 62.55 per cent
C. 12 per
p cent
D. Nonne of the above.
Solu
utions:
1. B. Laboour force = un
nemployed + employed ((3 + 25 = 28)).
2. C. Unem mployment raate is the ratiio of the num
mber of unem
mployed
to the laabour force (3
3/28).
3. A. The participation
p n rate is the raatio of the lab
abour force to
o adult
populatiion (28/40).
Draawbacks of the officiial unemplloyment raate

Because of the wayw the officcial unemployyment rate iss calculated, it may
eitheer understatee or overstatee the true levvel of unemployment. Criitics of
this official rate point primarrily to the following factoors:
undeeremploymeent and discouraged workkers.
Und
deremploym
ment
The official unem mployment rate

r makes non distinctionn between part-time
and full-time em
mployment, nor n does it reflect the apppropriateness of the
worrk. While somme part-time workers preefer part-timee work, otherrs favour
full--time work iff it were available.
Furtthermore, in some circum mstances, som me workers m may have to work at

jobss that do not fully utilise their
t skills annd educationn. This is a ty
ypical
probblem in deveeloping counttries, especiaally in the puublic sector anda
266
though less prevalent in developed countries such as Canada, it is still

apparent. The most important example is that of a reasonably large
number of highly educated recent immigrants to Canada who have been
unable to quickly secure a job that matches their skills and education.
Discouraged workers
Discouraged workers are those who, after a period of searching for a job
unsuccessfully, have given up looking. The official unemployment rate
does not consider them unemployed because they are not actively looking
for a job. They are, in fact, not considered part of the labour force. In
other words, they are non-employed but not unemployed (or jobless).
Anatomy of unemployment
How do people become unemployed? How do they end unemployment?
These are two of the most important questions that motivate the study of
the labour market. Here we try to address these and other questions.
In a typical labour market, the following characteristics can be observed:

1. Large variations in unemployment rates across age groups.
2. Large variations in unemployment rates across regions in large
and diversified countries, especially those subject to disparate
impacts in different regions.
3. Each month, substantial movement of individuals in and out of
unemployment –either to employment or out of the labour force,
most of those who have become unemployed in any given month
remaining unemployed for only a short period of time.
4. Much of the unemployment rate representing people who will be
unemployed for a long period of time.
The unemployment pool

Any time there is a given number or pool of unemployed people, there are
flows in and out of the unemployment pool.
Workers may become unemployed for one of the following reasons:

1. Loss of a job through dismissal, layoff or closing down of a firm,
followed by searching for another job. A layoff means that the
worker was not fired and will return to the old job if demand for
the firm’s product recovers.
2. Quitting a workplace and searching for another job.
3. Entering or re-entering the labour force to search for a job.
Individuals may end a spell of unemployment if they:

1. Are hired or (in the case of laid-off persons) recalled.
2. Withdraw from the labour force by stopping to look for a job and
thus, by definition, leave the labour force.
267
Module4
Uneemployment is rising wheen more peopple are enteriing the pool than
leavving. Thus, other things being
b equal, increases
i in qquits and lay
yoffs
incrrease unemplloyment as does
d an increaase in the floow of new enntrants
into the labour market.
m For a country succh as Canadaa, job loss acccounts
for about
a half off new unempployment. Vooluntary sepaarations, new w entrants
and re-entrants into
i the labou
ur force togeether accountt for the otheer half.
As illustrated
i in Figure 4.14 4, there are allways discouuraged workeers who
leavve the labour force from the t unemployyment pool w while some find
f a job
or arre recalled. There
T is alwaays a percenttage of employed persons who
becoome unemplooyed or laid off, while annother group leaves the laabour
forcce permanenttly (into retirrement) or tem mporarily (oon maternal leave, for
exam mple). Finallly, at any poiint, some inddividuals whoo are out of the
t
laboour force go directly
d to em
mployment by b ending a lleave of abseence, etc.,
and some join thhe unemployment pool inn search of a job.
ure 4.14 (Laabour markeet dynamicss)

Figu
Typ
pes of unemploymen
nt
Wheen examiningg unemploym ment, you caan distinguishh among fourr types:
fricttional, structuural, cyclicall, and seasonnal.
Fricctional unem
mployment
Worrkers who arre temporarily y between joobs or have bbegun lookin ng for
theirr first jobs arre experienciing frictional unemploym ment. There are
a
alwaays people whow are enterring the labouur force for tthe first time or who
havee quit their joobs in searchh of a new annd better onee. The size off this
typee of unemplooyment varies from one country
c to thee next and deepends
on thhe labour maarket instituttions, custom ms, labour law
ws and manp power
and employmentt policies. No onetheless, the,
t frictionall unemploym ment is a
permmanent featuure of the labo our market.
Stru
uctural unem
mployment
Anoother type off unemploym ment arises larrgely from sttructural chaanges in
the economy.
e Sttructural uneemployment isi due to a m
mismatch betw ween
peopple and jobs.. Unemployeed workers caannot fill thee jobs that aree
avaiilable. This tyype of unem
mployment occcurs primariily because of o
268
changes in technology and the phenomenon of globalisation that tend to

introduce sectoral shifts and workplace demands for new skills.
Sometimes, distance may be responsible for this type of unemployment: a

skilled person may possess the required qualifications for an available job
but the work site location may keep them apart. In this case, the job
remains vacant and the individual remains structurally unemployed from
lack of willingness or inability to relocate.
Because of these changes, workers lose out; they are displaced. Consider
a worker who loses her job in manufacturing because of applications of
robotics. She might not yet have the skills for operating the robots in
order to stay in manufacturing, nor might she have the necessary skills for
the expanding service sector, if she chooses to leave the manufacturing
industry. In the same way, an unemployed fisherman living in a remote
village cannot easily take advantage of employment opportunities
elsewhere. Because gaining new skills, moving to obtain work elsewhere
and developing new industries in a region all take time, structural
unemployment can persist for long periods.
Cyclical unemployment
Cyclical unemployment is primarily caused by fluctuations in spending; it

is demand- driven. A car worker, for example, may work overtime in
periods of strong consumer demand for cars but be laid off when the
economy weakens.
Seasonal unemployment
In some industries agriculture, fishing, construction, and tourism, for

example –work is seasonal, with unemployment rising during winter
months and some workers becoming seasonally unemployed during
spring and summer. Clearly, in many resource-or tourism-based
economies, seasonal unemployment can be significant.
Full employment
The notion of full employment (or the natural level of employment) plays
a central role in macroeconomics and also in macroeconomic policy. This
section starts by discussing the theory of the natural rate and then turns to
examining estimates of the rate.
Defining full employment is a tricky task. Full employment is the highest

reasonable expectation of employment for the economy as a whole –a
natural unemployment rate. Natural rate of unemployment consists of
frictional and structural unemployment but traditionally excludes cyclical
unemployment. This rate also excludes seasonal unemployment, which is
already omitted from the official unemployment rate.
Determinants of the natural rate
The natural rate of unemployment depends on following factors:

1. The organisation of the labour market, including the presence or
269
Module4
absence of employm
ment agenciess, youth empployment serv
vices and
the like.
2. The dem mographic makeup of thee labour forcee: e.g., the in
ncrease in
the nummber of houseeholds with tw
wo paid worrkers or a chaange in
the birthh rate or migrration.
3. The avaailability of unemploymen
u nt compensaation that tend
ds to
affect thhe ability and
d desire of thhe unemployeed to keep loooking
for a bettter job.
4. The pacce and the dirrection of tecchnological cchanges.
5. Minimuum wage laws that affect the employaability of teen
nagers
and worrkers with few
w employablle skills.
Incrreases over thhe past few decades

d in booth the actuaal and the nattural
unem mployment rates
r represen nt worrisomee trends. How w can a counntry
reduuce its naturaal rate of uneemployment??
Red
ducing the natural rate of
o unemployyment
a time, there are peoplee who quit thheir jobs in seearch of another.
At any
Thiss is one reasoon why econ nomies alwayys experiencee some
unem mployment –job– search. Job search iss the processs of matching g workers
withh appropriatee jobs. If all workers
w and all jobs weree the same so o that all
worrkers were eqqually well su uited for all jobs,
j job seaarch would no ot be a
probblem. Laid-ooff workers would
w quicklyy find new joobs that weree well
suiteed for them. However, in n fact, workeers differ in thheir tastes an
nd skills,
jobss differ in theeir attributes and informaation about joob candidates and job
vacaancies is dissseminated slo owly among the many firrms and housseholds
in thhe economy. Therefore, some s unemployment is innevitable.
Fricctional and sttructural unemmployment area inevitable simply beccause the

econnomy is alwaays changing g. For instancce, 100 yearss ago, the big
ggest
sourrces of emplooyment in a country suchh as Canada w were the primmary
secttor (agricultuural, mining, fishing, etc.)) and manufaacturing. Todday, the
servvice sector coomprises the largest emplloyers in the Canadian ecconomy,
captturing near 70
7 per cent off total emplooyment. Receent estimatess for
Cannada indicate that the mismatch betweeen availablee jobs and peeople
seekking employm ment explainns the unempployed plightt of roughly one
o out
of eight jobless persons
p in th
he labour poool.
Publicc policy
The fact that fricctional and sttructural uneemployment cannot be avvoided is
no reason
r for coomplacency. There are sevveral steps thhat governments can
takee to reduce thhe natural ratte of unemployment. For instance, thee faster
infoormation spreeads about jo ob openings and
a worker aavailability, the
t more
rapidly the econnomy can maatch workers and firms. B Better and mo ore
efficcient governm ment manpower and empployment cenntres can facilitate
f unemployyed workers to find a
job search by redducing the tiime it takes for
job and hence heelp reduce th he economy'ss natural ratee of unemployment.
270
Another public policy would be public training programmes, which aim

to ease the transition of workers from declining to growing industries and
to help disadvantaged groups escape poverty. This way, the government
can help reduce the structural component of the natural rate of
unemployment.
Unemployment insurance
It is possible that the existence of the unemployment insurance
programmes may have an effect on the unemployment rate. The effect of
such programmes on unemployment rate depends on the replacement
ratio. Replacement ratio is the ratio of the unemployment compensation
(to be paid while unemployed) to after-tax income (while employed). The
higher the ratio, the less urgent it will be to have a job. The presence of
unemployment benefits allows longer job search by raising the
replacement ratio and reducing the urgent need to take a job. A related
point is that in the absence of unemployment benefits, some people might
not be in the labour force. But in order to collect unemployment
compensation, they have to be in the labour force, looking for work even
if they do not really want a job.
In general, substantial evidence suggests that unemployment benefit

programmes tend to increase the participation rate as well as the average
duration of unemployment, so they help increase the rate of
unemployment. This does not imply, though, that unemployment
compensation should be abolished. Individuals need time to conduct a
reasonably long job search if the economy is to allocate people efficiently
among jobs. It would not make sense to put a skilled worker in an
unskilled job the moment she loses her previous job, just because the
worker cannot afford to search. Thus, even from the viewpoint of
economic efficiency, zero is not the ideal level of unemployment benefits.
Beyond that, society may be willing to give up some efficiency so that
unemployed people can maintain a minimal standard of living. What is
appropriate is a scheme that will create less incentive for firms to lay off
labour while at the same time ensuring that the unemployed are not
exposed to economic distress. This is obviously a tough and controversial
issue.
Minimum wages
Although minimum wages are not the predominant reason for
unemployment, they have an important effect on certain groups with
particularly high unemployment rates. Figure 4.15 reviews the basic
economics of a minimum wage. When a minimum-wage law forces the
wage to remain above the level that balances supply and demand, it raises
the quantity of labour supplied and reduces the quantity of labour
demanded, compared with the equilibrium level, giving rise to a surplus
of labour. Because there are more workers willing to work than there are
jobs, some workers are unemployed.
In Figure 4.15, Ld is the quantity of labour demanded, Ls is the quantity

of labour supplied, and (Ls - Ld) is the size of the surplus. Note that the
271
Module4
porttion (L* - Ld) represents displaced

d ( s - L* )
woorkers, while the portion (L
is thhe increased number
n of jo
ob seekers motivated
m by hhigher wagess.
Figu
ure 4.15
Minnimum-wage laws are jusst one reasonn why wages may be too high.
h
There are two otther reasons why wages may
m be kept above the
equiilibrium leveel:
1. Unions and collectiv
ve bargainingg.
2. Efficienncy wages.
Uniions and collective

c bargaining
b g
A unnion is a worrker associattion that barggains on behaalf of its mem mbers
(workers) with employers
e ov
ver a wide raange of issuess, including wages
w
and working connditions. Uniion membersship, definedd as a percenttage of
the non-agricultu
n ural labour force,
f tends too be differennt in different
counntries (Swedden is at the high
h end withh 75 per centt and the U.S S. at the
low end, with 166 per cent). Furthermore,
F the proportiion of union
memmbership (unnionisation raate) tends to also vary froom one sector to the
nextt. In industriaal countries, the manufaccturing sector has one of the
highhest unionisaation rates wh hereas the seervice sector tends to be ata the low
end..
Colllective bargaaining is the process by which

w unionss and firms agree
a on
the terms
t of empployment. Ev vidence sugggests that in m most countries where
therre is a strong tradition of collective baargaining andd where unioons are
deepply rooted, unions
u have enabled
e unionnised workerrs to enjoy a
conssiderably higgher wage lev vel than that of their nonn-unionised
counnterparts.
Resservation wage
w and efficiency wage
For workers whoo are engageed in the job search
s proceess, reservatiion wage
is thhe wage at which
w acceptin
ng a job offeer has as mucch appeal to workers
w
as reejecting it to stay unemplloyed and prrolong their job search peeriod. At
this wage level, the cost to workers
w of remmaining uneemployed, wh hile
conttinuing their job search, isi equal to thhe benefits off not acceptinng a job
offeer. Therefore, workers wo ould be indiffferent towardds the choicee
betw ween acceptinng and not accepting a joob offer at thhis wage leveel.
272
Efficiency wage is the level above the reservation wage that firms pay
workers in order to:
1. increase the chances that productive workers will stay with the
firm, and
2. increase the cost to workers of losing their jobs if they are found
shirking.
This incentive reduces job turnover.
Costs of unemployment
As individuals, unemployed people suffer both from their income loss
and from the related social problems that long periods of unemployment
cause. Society on the whole loses from unemployment because output is
driven below its potential level.
As suggested by Okun’s Law, when the output of the economy grows

beyond a certain normal rate, which tends to vary from country to county,
the unemployment rate drops.
The typical adjustment pattern of labour use during a recession is as

follows.
1. Employers first adjust hours per worker –for example, by cutting
overtime –and only trim their workforce.
2. Layoffs and firings increase, increasing the flow into
unemployment. However, at the same time, quits decrease as
workers decide to hold on to their current job.
3. It is possible that during a prolonged recession, many of the
unemployed become discouraged and leave the labour force,
making the official unemployment rate lower than it would
otherwise be. As a result of all these effects, unemployment
changes usually lag behind output changes.
273
Module4
Modu
ulesummary
Thiss modulehas offered the basic
b for undderstanding thhe functions of
monney, definitioons of money y supply and the motives for holding money.
m
Youu have been introduced
i to
o various finaancial instituutions, system
m
partiicipants and the implemeentation of monetary
m and fiscal policiies.
Summary Govvernments use monetary policy
p to inflluence spendding and outp put
through interest rates, money y supply and reserves to bbanks for thee
ultim
mate objectivve of monetaary policy of price stabilitty. Governm ments use
eitheer expansionnary or contraactionary staabilisation poolicies to min
nimise
ups and downs inn the businesss cycle. Thee fiscal policy affects speending
and output throuugh taxes and d governmennt purchases.
Youu have also reeviewed the concepts of inflation,

i uneemploymentt,
categories of uneemployment, their impaccts and the w weaknesses off
unemmployment rate
r which do oes not take into
i account underemplo oyment,
discouraged worrkers, and disshonest answ wers given inn the labour market
m
survveys. You havve learnt thaat the short-ruun Phillips cuurve shows a trade-
off between
b unemmployment and a inflationn.
In thhe following study units, you will be looking at thhe open econ nomy
withh the componnents of balannce of payments accountts, exchange rates
regimmes, foreignn exchange markets,
m interrest rate paritty, internatio
onal trade
and trade policy.
274
Assignment
1. Explain how a decrease in government expenditures affects the
position of the aggregate-demand curve.
2. What are the major tools of monetary policy?
3. What are the popular monetary policy tools in your country?

Assignment
4. What is the banking multiplier?
5. What is the relationship between reserve ratio and the multiplier?
6. In what way can banks create deposits and money?
7. What are the major assets of the central banks?
8. What are the major liabilities of central banks?
9. Explain the term marginal propensity to consume.
10. What is the government spending multiplier?
11. Why is this multiplier greater than one?
12. What is the crowding-out effect?
13. What does the size of the crowding-out effect depend upon?
14. What are the automatic stabilisers?
15. What are a budget deficit and a budget surplus?
16. What are the two ways a government can finance a budget deficit?
17. What is meant by debt monetisation?
18. Who is helped and who is harmed by deflation?
19. What is the Quantity Theory of Money?
20. Why does a minimum wage have virtually no effect for skilled
workers?
21. Define the natural rate of unemployment and explain its

determinants.
22. What are the components of the labour force?
23. What does the reservation wage represent?
24. What does the efficiency wage represent?
25. Why do firms and workers care about real wages?
275
Module4
Asseessment
1. What is the theory
t of liqu
uidity preferrence? How ddoes it help explain
e
the downward slope of th he aggregatee-demand currve?
A
Assessment 2. Use the theoory of liquidity preferencee to explain hhow a decreaase in
the money suupply affectss the aggregaate-demand ccurve in a cloosed
economy.
3. The governmment spends $100 millionn on health ccare. Explain why

aggregate deemand mightt increase byy more than $$100 million..
4. Suppose that survey meaasures of connsumer confidence indicaate a

wave of pesssimism is sw weeping the country.
c If poolicymakers do
nothing, whaat will happeen to aggregaate demand? What should d the
central bankk do if it wants to stabilisee aggregate ddemand?
5. Give an exam overnment poolicy that acts as an autom

mple of a go matic
stabiliser. Exxplain how th
his policy woorks this wayy.
6. The Malaysiian economy y is in recessiion and has a large recesssionary

gap during thhe period off East Asian financial
f crissis erupted in
n mid-
1997. Descriibe what automatic fiscall policy mighht occur. Exp plain a
d be used thaat would not increase the budget
fiscal stimullus that could
deficit.
7. Explain how w each of the following developmentss would affecct the

supply of mooney, the demmand for mooney and the interest rate.
Illustrate youur answers with
w diagram ms.
A. The central bank
k buys bondss in open-maarket operatio
ons.
B. An increase
i in crredit card avvailability redduces the cassh people
holdd.
8. Suppose bannks install au

utomatic telleer machines oon every block and,
by making cash
c readily available,
a it reduces
r the aamount of mooney
people want to hold.
A. Assuume the centtral bank doees not changee the money supply.
According to thee theory of liiquidity prefeerence, whatt happens
to thhe interest ratte? What happpens to agggregate demaand?
B. If thhe central ban
nk wants to stabilise
s aggrregate deman
nd, how
shouuld it respondd?
9. Suppose the governmentt reduces taxxes by $20 billion. Also su uppose

that there is no crowding
g out of invesstment and thhat the marginal
propensity too consume iss 3/4.
A. Whaat is the initiaal effect of thhe tax reducttion on aggreegate
276
demand?
B. What additional effects follow this initial effect? What is the
total effect of the tax cut on aggregate demand?
C. How does the total effect of this $20 billion tax cut compare
with the total effect of a $20 billion increase in government
purchases? Why?
10. Is it possible, or advisable, for central banks to attempt fine-tuning for

monetary policy? If the answer is yes, what monetary measures could
be used to implement such a policy?
11. Discuss the ways in which a persistent budget deficit could lead to
inflation.
12. Respond to the following questions:

A. Discuss the effects of higher expected inflation on bond
markets.
B. Explain what the authorities might hope to achieve by raising
interest rates at an early stage of the upward cycle.
13. Suppose you are given the following information about your
economy. Public deposits with commercial banks total $600 billion.
Banks hold $6 billion deposits at the central bank and keep $6 billion
ringgit in notes and coins in the vault. There are $120 billion notes
and coins outside bank (in the hands of the public). Calculate:
A. The high-powered money.
B. The money supply.
C. Banks’ reserve ratio.
14. Discuss why high unemployment should be a matter of concern not

just for the unemployed but also for business.
15. What has inflation been in your country for the last decade? What
have been the determinants of this inflation?
16. Name a developing country that has experienced high inflation and
has been able to implement a successful stabilisation programme.
17. Sketch a diagram consisting of AD, SRAS and LRAS. Assume the
economy starts from a long-run equilibrium point, where all three
curves have a common intersection point.
A. Illustrate the initial effects of an event that increases the
aggregate demand curve.
B. Show what happens beyond the short run. How does the
economy adjust to the long-run equilibrium?
18. In the economy described in question 4,
277
Module4
A. Illusstrate the inittial effects off an event that may causee a cost-
pushh inflation.
B. Showw what happ
pens beyond the short runn. How does the
econnomy adjust to the long-rrun equilibriuum?
19. “Over time, long-run chaanges in aggrregate supplyy are the key y
determinantss of changes in real outpuut”. Evaluatee this statemeent,
using evidennce from the chapter.
20. An economyy with a natu ural rate of unnemploymennt rate of 6 peer cent
and an expeccted inflation
n rate of 5 peer cent a yearr has the folllowing
inflation andd unemploymment history:
Year Inflation ra
ate (%) U
Unemploym ent rate (%)
1998 9 4
1999 7 5
2000 5 6
2001 3 7
2002 1 8
A. Draww a diagram of the short--run and longg-run Phillip

ps curves
for this
t economy y.
B. Is thhis economy initially in loong-run equiilibrium? Wh
hy? Or
Whyy not?
C. If thhe governmennt pursues ann expansionaary policy thaat raises
inflaation from 5 per cent a yeear to 7 per ccent, what is the
channge in the un
nemploymentt rate? Why??
21. List the costts and the ben

nefits of inflaation.
22. Suppose the nominal ratee of interest is 3 per cent.

A. Calcculate the reaal rate of inteerest when innflation rate is
i equal
to: -5
- per cent, 0 per cent, 2 perp cent and 7 per cent.
B. Whaat happens to
o the real ratee of interest w
when inflatio
on rate
risess?
C. Whyy do you thin nk policy maakers may waant a negativ
ve real
rate of interest?
23. Use the information prov

vided below to answer thhe following
questions.
Civiliann population
n 3
30
Employyed 1
15
Unempployed 0
0.5
A. Whaat is the size of the labouur force?
278
B. How many individuals are “out of the labour force”?

C. Calculate the participation rate.
D. Calculate the unemployment rate.
24. Use the information provided below to answer questions 1 to 3
Civilian population 200 million

Employed 100 million
Unemployed 6 million
(a) The labour force for this economy is:

A. 100 million
B. 106 million
C. 194 million
D. 200 million
(b) The unemployment rate for this economy is:
A. 6/100 = 6 per cent
B. 6/106 = 5.7 per cent
C. 6/194 = 3.l per cent
D. 6/200 = 3 per cent
(c) The labour force participation rate is:

A. 100/200 = 50 per cent
B. 94/200 = 47 per cent
C. 94/100 = 94 per cent
D. 106/200 = 53 per cent%
279
Module4
1. The theory ofo liquidity preference
p is the theory oof demand forr money
in which thee determinants of liquiditty (money) annd alternativ ve forms
of financial assets, such as bonds, aree discussed. This theory holds
g of liquidity is inversely related to the rate of
that the publlic’s holding
n increase in the price levvel reduces th
interest. Acccordingly, an he real
t interest raate to increasse, which in turn
money suppply, causing the
tends to low
wer investmen a hence to lower the ag
nt spending and ggregate
demand.
2. When moneey supply deccreases, interrest rates risee and this cau
uses
investment spending
s and
d hence aggregate spendiing (demand)) to fall.
3. Any time the level of speending increeases, it sets iin motion a chain
c
reaction of further
f spend
ding, giving rise
r to the nootion of ‘spen nding
multiplier.’ Therefore $1
100m fresh spending
s on hhealth will bring
about furtheer spending by
b creating more
m income.
4. Aggregate demand
d decreeases as conssumers and iinvestors witthdraw
from the maarket. In ordeer to offset thhis, an increaase in money
y supply
(lower intereest rate) will be necessaryy. This will kkeep aggregaate
demand intaact.
5. The income tax system is i an example of an autom matic stabilisser.

When the ecconomy is sh hrinking and income and employmentt are
dropping, thhe governmen nt revenue frrom taxation (proportionaal to
income) droops to alleviaate the pressuure, and vice versa.
6. Discuss youur answers wiith your tutor.
7. Answers as follows:
A. Monney supply in
ncreases, inteerest rates drrop, and the demand
d
for money
m increases (from point 1 to 2).
B. Monney demand drops, intereest rates dropp. The lowerr interest

rate (i2) restoress money dem
mand to its orriginal level. Money
suppply stays uncchanged.
280
A. The interest rate decreases as a result of a fall in money
demand that has been caused by increased use of credit cards.
Investment spending, aggregate spending and aggregate
demand increase.
B. The central bank should reduce money supply to stabilise
aggregate demand.
A. The initial effect of a tax reduction of $20 billion is an
increase in the disposable income by $20 million and hence
an increase in consumption spending by (¾ x $20b) = $15b.
B. This causes a further increase in income and hence further
spending. At the end, aggregate demand will have risen by
the initial impact times the multiplier:
⎛ ⎞
⎜ $15 x 1 ⎟ = $60
⎜ 1− 3 ⎟
⎝ 4⎠
C. If instead the government spending rose by $20, the total
effect would be
⎛ ⎞
⎜ $20 x 1 ⎟ = $80 . This is the case because
⎜ 1− 3 ⎟
⎝ 4⎠
when the government expenditure increases by $20, the entire

increased expenditure enters aggregate spending ($20),
whereas when taxes decrease by $20, only ¾ of it ($15)
enters aggregate spending in the form of increased
consumption spending; the remaining ¼ of it ($5) is saved.
10. Fine tuning is typically dangerous because of: (a) the complex nature
of the economy, (b) information problem, and (c) lags in
effectiveness of monetary policy.
11. Persistent budget deficits lead to a growing national debt. Also,
281
Module4
unable to baalance their budgets,

b goveernments maay have to ressort to
which can lead to
printing monney to financce their deficcit, a tactic w
inflation.

A. Highher expected d inflation givves rise to ann increase in nominal
interrest rate. Bo
ond markets usually
u do not like high inflation
i
rates, but since higher
h nominnal interest raates increasee the
opportunity costt of holding money,
m the ddemand for bonds
b
incrreases.
B. Thee authorities might
m hope to
t pre-empt tthe possibilitty of a
futuure inflation.

A. Highh-powered money
m = currrency in circuulation plus banks
b
reseerves (120+12) = $132.
B. Monney supply = currency inn circulation pplus depositss with
bankks = (120 + 600)
6 = $720..
12
C. Reserve ratio = = 10% .
120
14. High unempployment meeans less outpput and (less demand for output,
since there is
i less incom
me). Profits diminish.
d Thhe firms’ sharre prices
in the stock market drop, making it more
m difficullt for the firm
ms to
raise funds or
o to borrow..
15. The answer depends on youry specificc example. TThere is no one

o single
answer. One thing that canc be said, however—fo
h or all possiblle
scenarios—iis that in all likelihood thhe resulting inflation wouuld be
related to high growth off money suppply.
16. Argentina
17. Answers aree as follows:

A.
Pricce and GDP rise

r when AD
D increases iin the short ru
un, point
B.
B. Beyyond that, thee expected prrice rises, SR
RAS shifts baack until
it reeaches LRASS at C (on ADD’).
282
18. Answers are as follows:

A. A cost-push inflation arises from a leftward shift in SRAS.
This change, caused by a greater wage demand of a rising
raw material price, gives rise to higher prices and lower GDP.
B.
In the next phases, SRAS shifts back toward its

originalposition.
19. True. Long-term growth is a function of technological changes.

Fiscal and monetary policy is not directly relevant.
20. Answers are as follows:

A.
B. Yes, because P = Pe and U=Un

C. Unemployment drops along SPC to B to 5%. More spending
triggers more business activity and more jobs.
21. Costs of inflation: Redistribution of income and wealth, to the

detriment of fixed income earners. Distortive effects on the
economy, causing misallocation of resources; investment suffers;
inflation tax. Benefits of (low) inflation may be viewed in terms of
its impact on the job market. At zero inflation rate, unemployment
may increase permanently.

A. r = 3 – (−5) = 8%; r = 3 – (0) = 3%, r = 3 – (2) = 1%, r = 3 −
7% = − 4%
B. It rises.
C. A negative real rate may be necessary to jump-start the
283
Goovernment Maccroeconomic Poolicy
econnomy.

A. 15.55
B. 14.55
15.5
C. = .51 = 51%
300
.5
D. = .032 = 3.2%
15.5

(a) B. (106 million))
(b) B. (6/106 ) = 5.7
7%
(c) D. (106/200)
( = 53%
5
284
Module5
The Open Economy

Introduction
Earlier study moduleshave simplified economic analysis by assuming a
closed economy but most economies are not closed. In the twenty-first
century, national economies are becoming more closely interrelated and
the notion of globalisation is increasingly accepted.
In this module, we will introduce balance of payment (BOP) accounts

where surplus in BOP will increase a country’s foreign exchange
reserves.
Then you will learn about exchange rate, its determinants and exchange
rates systems. A government’s monetary policy will influence the
exchange rates and hence aggregate demand. You will be introduced
channels of monetary policy in an open economy as opposed to a closed
economy.
Lastly, we will discuss about absolute and comparative advantage

theories, the advantages of participating in international trade and trade
policies which may favour free trade or protectionism.
Upon completion of this module you will be able to:
• definethe concept of the exchange rate.

• explainthe determinants of exchange rates.
• compareand contrast fixed and flexible exchange rates systems.
Outcomes • explainthe importance of foreign exchange reserves in a fixed
exchange rate system.
• distinguishthe short-run from the long-run determinants of the
exchange rates.
• explainhow monetary policy influences the exchange rates and
hence aggregate demand.
• outlinethe channels of monetary policy in an open economy as
opposed to a closed economy.
• compareand contrast the exchange-rate policies of devaluation
and revaluation.
285
Module5
• list policcies that cha

ange expendittures, and coontrast them with
expenditture-switchin ng policies.
• understaand the expenditure switcching policiees.
• list and elaborate onn the reasonss for which ccountries eng
gage in
internattional trade.
• distinguuish between absolute andd comparativve advantagee.
• name annd define som
me alternativve trade theories.
• explain how gains frrom trade are shared by ttrading partn
ners.
• extrapollate differentt types of trade policy froom current ecconomic
news events.
• state argguments in favour
fa and aggainst free trrade.
Abso
olute advantage: A couuntry has an absolute
a advantage when n it is
more efficient thann any other ccountry at producing
a prod
duct.
Currrent account: The cu urrent account summarises all foreign n

T erminology transaactions associiated with exxchange of goods
g
and seervices. It inccludes four tyypes of transsactions:
trade in
i merchandise, trade in services, flow w of
investtment incomee and transfeers.
Currrent account The cu urrent account of the balaance of paym

ments is
deficcit: in surpplus when a country expoorts more go oods and
servicces than it im
mports.
Exch
hange rate: The raate at which one currencyy is converted into
anotheer.
Mixeed economy: Certaiin sectors of the economyy are left to private

p
ownerrship and free market meechanisms, while
w
other sectors have significant ggovernment
ownerrship and govvernment plaanning.
Overrview
Prevvious study modules
m havee simplified economic annalysis by assuming a
clossed economyy but most economies are open. Our loocal econom my is
linkked to the restt of the world through tw wo broad chaannels: trade in goods
and services, andd finance. WeW export gooods and serviices abroad and a we
import goods annd services frrom abroad. We W also borrrow and lend d in
worrld financial markets.
m In fact,
f wenty-first ceentury, national
in the tw
econnomies are becoming
b moore closely innterrelated annd the notion
n of
286
globalisation –that we are moving towards a single global economy –is

increasingly accepted.
There are many degrees of engagement in international trade (exporting

and importing). A country whose exports and imports constitute a large
percentage of their GDP such as Canada, with its exports close to 50 per
cent of its GDP and its imports over 40 per cent of its GDP, are called an
open economy. Compared to Canada, the United States engages in
relatively little international trade. With exports and imports between 12
and 15 per cent of its GDP, the U.S. is a relatively closed economy.
The balance of payments accounts

The balance of payments is a record of the transaction of a country with
the rest of the world. Table 5.1 summarises the balance of payments for
Canada in 2001.
CANADA’S INTERNATIONAL BALANCE OF PAYMENTS,

2001 (MILLIONS OF DOLLARS)
Current Account
Goods and Services Account
Net Exports (Goods) 64,015
Exports 414,638
Imports 350,623
Net Exports (Services) -8,382
Exports 56,612
Imports 64,994
Net Investment Income -27,534
Receipts 34,990
Payments 62,524
Net Transfers 1,950
Receipts 7,024
Payments 5,074
Current Account Balance 30,049
Capital and Financial Account

Capital Account Net Flow 5,678
Inflow 6,482
Outflow -804
Financial Account Net Flow -26,596
Canadian Liabilities, Net Inflow 83,789
Canadian Assets, Net Outflow -110, 385
Capital and Financial Account Balance -20,918
Statistical Discrepancy -9,131
Change in Official Reserves -3,353
(Source: Statistics Canada: National Account (August, 2002))
Table 5.1
287
Module5
As you
y can see in i this table, the balance of payments is made up of two
majoor accounts: the current account
a as well
w as the cappital and finaancial
accoount. Moreovver, transactiions in these accounts aree divided intoo two
grouups: receipts and paymen nts. The receiipts represennt monetary inflows
i
to thhe Canadian economy, in ncluding bothh foreign purrchases of Caanadian
expoorts and infloows from forreigners wheen they buy C Canadian finaancial
asseets. Receipts are considerred positive, so they appeear with a plu
us (+)
signn in the accouunts.
Paym ments naturaally represennt monetary outflows

o from
m the Canadiian
econnomy. They include outlaays by Canaddians for foreeign importss and
foreeign financiall assets. Paym
ments are coonsidered neggative, so theey are
giveen a minus siign (−) in thee accounts.
Thee current acccount
The current accoount summarrises all foreiign transactioons associateed with

exchhange of gooods and serviices. The currrent accountt includes fouur types
of trransactions: trade
t in mercchandise (in other words, tangible gooods) as
welll as in three invisible
i item
ms: trade in services,
s flow
w of investm
ment
incoome and trannsfers.
Traade in good
ds (merchaandise)
The most signifiicant and obv vious compoonents of the current acco ount are
expoorts and imports of goods: visibles, ass they are knnown. Each year,
y the
peopple of a counntrysell a brooad range of merchandise
m e exports andd buy an
equaally broad raange of merch handise impoorts. In yearss when the
dollarvalue of exxports of visiibles outweigghs that of im mports of vissibles,
the current
c accouunt shows a positive
p merrchandise balance of trad de or a
n years when imports of ggoods outweiigh
tradde surplus. Inn contrast, in
expoorts, the currrent account shows a neggative merchaandise balan nce of
tradde or a trade deficit. Thesse transactionns are structuured on the basis
b of
the double
d bookk
kkeeping prin nciple. For exxample, if yoou sell a goodd abroad,
the proceeds
p from the sale will
w be treatedd as a receiptt (credit) in th
he
currrent account and will app pear with a poositive sign.
Traade in non--merchand
dise
The three remainning invisible componentts of the currrent account:: trade in
servvices, investm
ment income and transferrs are collectively known
n as non-
merrchandise trannsactions.
Servvices
Servvices includee tourism, traansportation (freight and shipping), in nsurance

and telecommunnication. Speending by forreigners on services offerred by
dommestic firms such
s as whenn foreign touurists travel inn acountry,
reprresents a servvice export th
hat creates ann inflow of ffunds from fo oreign
counntries. Conveersely, when n we travel ouutside our coountry, our sp pending
dered a service import thaat causes an outflow
in fooreign countrries is consid
of fuunds to foreiign hands.
288
Net investment income
Payments of income on investment in assets constitute this second

category of the invisible items in the current account. These incomes or
returns on assets (financial instruments) are in the form of interest (return
on bonds), dividends (return on stocks) and other forms of return such as
profits. The same double bookkeeping principle employed for goods
applies here too. For instance, for a Malaysian who holds a bond that was
issued by the United States government, any interest earned on that bond
is treated as a receipt (credit) in Malaysia’scurrent account, or a positive
figure. Conversely, payment to a German who owns a Malaysian
government bond is treated as a payment (debit) in the current accounts,
or a negative figure. Net income from assets refers to the difference
between these two items.
Transfers
The final item, “transfers”, refers to items such as foreign aid or a gift
from family members in one country to family members in another
country. When new immigrants to the country bring funds with them,
these funds are considered an inflow to the economy. In contrast,
government spending on foreign aid is considered an outflow.
Current account balance

The current account balance is the sum of the above items. When the
receipts in the country’s current account are lower than the payments, this
results in a negative net balance known as a current account deficit.
Conversely, when receipts on the current account outweigh payments,
there is a positive net balance, which is known as a current account
surplus. According to Table 5.1, Canada enjoys a current account surplus
of more than $30 billion in year 2002.
The capital and financial account

Table 5.1 shows another portion of the balance-of-payments statement
called the capital and financial account. Recently many statistical
agencies around the world have followed the lead of the IMF
(International Monetary Fund) to divide the capital account into capital
account and financial account. The financial account records direct
investment and portfolio investment while the capital account includes
items such as inheritances and trade in intellectual property. This division
is new and for simplicity, we will refer to these accounts together as the
capital account.
This account summarises the foreign transactions of financial assets

involving Canadian dollars. Suppose a foreigner buys a domestic
government bond or holds bank deposits valued in Canadian dollars.
These transactions are treated as ownership of financial of assets being
exported from home to abroad and therefore, are recorded as an inflow of
funds (receipts), marked with a positive sign, on the capital and financial
account. Conversely, a local investor’s purchase of stocks in a foreign
289
Module5
commpany is viewwed as an impport of owneership, so thee transaction is

conssidered an ouutflow, mark
ked with a neegative sign ((for paymentts) from
this account.
The current accoount transacttions discusseed above reffer to trade inn

currrently producced goods an nd services. Trade
T betweeen countries in
exissting assets iss recorded in
n the capital (financial)
( acccount. This account
recoords direct innvestment and portfolio innvestment w while the capiital
accoount includess items such as inheritancces and tradee in intellectuual
propperty. The most
m significaant transactions on the cappital accountt are
assoociated with the
t buying anda selling off stocks and bbonds. Thesee capital
flow
ws are often referred
r to ass financial innvestment annd can be divided into
portf
tfolio investmment and direect investmennt.
Porttfolio investtment
nancial assetss (of a company), stocks and

Thiss refers to puurchase of fin
bondds, when theese investmen nts do not coonstitute ownnership or controlling
interrest in the coompany that issued these assets. Notee that ownersship and
conttrol pertain too equity purcchase into a company,
c i.ee., shares (sto
ocks) of
that company, not its debt (b bonds). Thereefore, a purchhase of domestic
bondds by foreignners automattically belonggs to portfoliio investmen nt.
Direect investmeent
In contrast, direcct investmen

nt refers to puurchase of finnancial assetts that
givees rise to ownnership and controlling
c innterest of a ccompany. Thhere are
nummerous well-kknown exam mples of direcct investmentt.
Capitaal (financial) accou

unt balan
nce
Wheen receipts on
o the country y’s capital acccount exceeed payments,, the
capiital account balance
b is po
ositive and it is referred too as a capita
al
ficit. According to
accoount surplus;; the obversee is a capital account defi
Tabble 5.1, Canaada faces a coombined cappital-financiaal account defficit of
overr $20 billion.
Thee official seettlementss account

The final item inn the balancee of paymentts account is the official
settllements accoount, which records
r the chhange in offificial reservess.
Offiicial reservess are the government's hooldings of forreign currenccy.
Techhnically, offi
ficial reservess should be listed
l separattely, in this th
hird
accoount. Howevver, in some countries,
c off
fficial settlem
ment transactiions
appeear as part off the capital and
a financial account under the assetts. In
suchh a case, theyy would be put
p at the endd of the balannce of paymeents
accoount to illustrrate the balanncing role off official reseerves.
These transactioons arise from m foreign excchange intervventions by thet

centtral authorityy for the purp
pose of eitherr keeping thee exchange rate
r fixed
or managing
m it from
fr time to time. In otheer words, in oorder to pay for our
m either boorrow more from abroad than we
currrent account deficit, we must
lendd abroad or our
o official reeserves mustt decrease to cover the sh hortfall.
290
Balance of payments balance

It should be clear that the overall balance of payments must be zero.
Individuals and firms must pay for what they buy abroad. If you were to
spend more than your income, you would be obliged to finance your
deficit by selling assets or negotiating a loan. Similarly, if a country runs
a deficit in its current account, spending more abroad than it receives
from sales to the rest of the world, the deficit would need to be financed
by the sale of assets or borrowing abroad. Therefore, any current account
deficit must be financed by an offsetting capital account inflow. However,
the balance on the third account (the official settlement account) must
also be zero since the sum of the balances on all three accounts, including
the official settlement balance, always equals zero: that is:
Current account balance + Capital account balance

+ Official settlement balance = 0 (1)
A logical implication, if the third account item is positive, it means that

the central bank (monetary authority) has sold foreign reserves (a flow of
funds into the home country from the sale of these reserves). If this item
is negative, this means that the central bank (monetary authority) has
bought foreign reserves (a flow of funds out of the home country from the
purchase of these reserves). As indicated above, it is also customary to
lump the capital and the official balance together. This way, the capital
account would include not only the private transactions but also official
transactions.
In practice, another item statisticians need to be concerned about

isstatistical discrepancies. Because of data imperfection and errors and
omissions, the sum of balances on all three accounts will most likely not
equal zero. There may be many transactions for which there are no
records, or that the authorities are unable to directly measure, or there
may be funds that enter or leave the country illegally. Therefore,
statistical discrepancies enter the balance of payment account as a fourth
term such that:
Current account balance + Capital account balance

+ Official settlement balance + Statistical discrepancies = 0(2)
According to Table 5.1, these discrepancies, measured at more than $9

billion, explain why the sum of the current and capital account balances
do not add up to zero in year 2001.
Current account, lending and borrowing

As discussed above, a country that has a current account deficit has to
borrow from the rest of the world. Since at any point in time, many
countries tend to lend and borrow at the same time, a deficit country must
borrow more than it lends, becoming a net borrower. Similarly, a country
that enjoys a current account surplus is a net lender, lending more to the
rest of the world than it borrows.
291
Module5
Exchaange ratess
Anyy transaction that appearss in the balannce-of-paymeents accountss
invoolves tradingg domestic cu urrency for annother currenncy. When we w buy
foreeign goods annd services oro invest in annother counttry, we have to obtain
som
me of that couuntry’s curren ncy to make the transactiion. When fo oreigners
buy domesticallyy produced goods
g and seervices or invvest in their domestic
d
econnomy, they have
h to obtain
n some of thhe home counntry’s curren ncy. We
get foreign
f o domestic currency in the
curreency and foreeigners get our
foreeign exchangge market. Th he global market is made up of thousaands of
peopple: importerrs and exportters, banks and specialistts in the buyiing and
selliing of foreignn exchange called
c foreignn exchange bbrokers. In th he home
counntry’s sector of this mark ket, domesticc currency is exchanged for f major
currrencies such as the U.S. dollar,
d Japaneese yen, Euroopean euro and a other
interrnational currrencies.
The foreign exchhange markeet operates onn a daily basis. It opens on o

Monnday morninng in Hong Kong,K which isi still Sundaay evening in
n
Toroonto and New w York. As the
t day advaances, marketts open in Siingapore,
Tokkyo, Bahrain,, Frankfurt, London,
L New
w York, Monntreal, Torontto and
Vanncouver. The price at whiich one curreency can be eexchanged fo or
mply the rate of
anotther is calledd the foreign rate of exchaange, or sim
exchhange. Tablee 5.2 shows thet exchangee rate betweeen a selected number
of world
w currenccies and the U.S.
U dollar ($$).
E
Exchange Rates
R for 28/008/02
Country per US$ peer C$

Ausstralia 1.81 1.16
Brittain 0.65 0.42
Cannada 1.55 -
EUR
RO 1.02 0.65
Honng Kong 7.8 5.02
Japaan 118.16 76.07
Sweeden 9.28 5.97
Unitted States - 0.64
(Sou
urce: The Econoomist, August 28,
2 2002)
Tab
ble 5.2
As indicated
i in Table
T 5.2, th
here are manyy exchange rrates for a ceertain
currrency. Furtheermore, nomiinal exchangge rates or altternatively, market
m
ratees of exchangge between currencies, arre quoted in ttwo ways:
1. the num
mber of units of foreign cuurrency you ccan get for one
o unit
of domeestic currency
y, or
2. the nummber of units of domestic currency youu can get forr one unit
of foreiggn currency.
292
In August 2002, for example, the nominal exchange rate between the
Canadian dollar (C$) and the U.S. dollar (US$) was quoted as either
US$0.64 for one Canadian dollar, or, equivalently, C$ 1.55 for one US
dollar. In this unit, we define the nominal exchange rate as the number of
units of domestic currency you can get for one unit of foreign currency –
the second way – or equivalently, as the price of foreign currency in terms
of domestic currency. This rate will be denoted by E. Accordingly, for
Canada, E, in terms of U.S. dollars, is equal to 1.55 (and not 0.64).
Exchange rate determination

Exchange rates among foreign currencies change every day, indeed every
minute during the day. These changes are called nominal appreciations or
nominal depreciations, appreciations or depreciations for short. An
appreciation of the domestic currency is a decrease in the price of the
foreign currency in terms of the domestic currency. Given our definition
of the exchange rate as the price of the foreign currency in terms of
domestic currency, an appreciation corresponds to a decrease in the
exchange rate, E.
Similarly, a depreciation of the domestic currency is an increase the price

of the foreign currency in terms of a domestic currency, and thus
corresponds to an increase in E. It is customary in foreign exchange
markets to quote the value of every currency in terms of the U.S. dollar.
Therefore, appreciations and depreciations tend to be expressed in terms
of the U.S. dollar.
Foreign exchange market

Similar to any other market, the foreign exchange market (financial or
non-financial) can be characterised by demand and supply –in this case
by demand and supply of foreign currency. Figure 5.1 illustrates the
supply and demand for the foreign currency (U.S. dollars) in terms of
domestic currency (Canadian dollars) in the exchange market with the
exchange rate measured on the vertical axis as the domestic currency
price of foreign exchange.
Demand for foreign currency (exchange)

The demand for foreign currency, in terms of domestic currency, is a
relationship between the price of the foreign currency and its quantity
demanded in exchange for our own currency. The quantity of a foreign
currency demanded in the foreign exchange market is the amount that
traders plan to buy during a given time period at a given exchange rate.
However, the exchange rate is only one factor. The quantity demanded is
also determined by others including:
• Domestic and foreign interest rates.
• Domestic and foreign income.
• Domestic and foreign inflation rates.
293
Module5
• The exppected future exchange raate.
As is
i customaryy, we will cho oose the U.S. dollar ($) aas the foreignn
currrency. This reelationship can
c be expresssed in as a ccurve as show wn in
Figuure 5.1. As expected,
e thee relationshipp between thee price of thee foreign
currrency and thee quantity off it demandedd is an inversse one.
For example, if thet price of the

t U.S. dolllar rose againnst the local currency,
c
let us
u say Canaddian dollar, frrom C$1.55, per one (US S) $ to C$1.660, but
nothhing else chaanged, the quuantity of U.S
S. dollars thaat people plan
n to buy
in thhe foreign exxchange mark ket would deecrease. The reason for th he
demmand curve’s downward slopes can be understood bby considerin ng the
factoors behind thhis curve. Th
he demand foor a currencyy is derived from
fr the
demmand for its underlying
u elements. Peopple demand tthe U.S. dolllar
prim
marily becausse of their deemand for:
1. Americaan goods and
d services (A
American expports) and
2. Americaan financial assets
a a bank accouunts, bonds, stocks,
such as
businessses and real estate.
e
mand applies to dollars juust as it does to

Nevvertheless, thhe law of dem
anytthing else thaat people vallue.
For example, whhen the pricee of the U.S. dollar ($) drops (appreciation of
the local
l currenccy), there is an
a import efffect: foreigneers can purch hase
U.S.-made goodds and servicees more cheaaply. Apprecciation of thee local
currrency also aff
ffects the demmand for Am merican assetss. The strong ger the
locaal currency, other
o things remaining
r thhe same, the llarger the expected
proffit from buying American n dollars andd the greater tthe quantity of
Cannadian dollarss demanded.
For the two reasons we havee just revieweed, ceteris paaribus, whenn the
exchhange rate rises, the quan
ntity of the U.S.
U dollars ddemanded decreases
and when the exxchange rate falls, the quaantity of the U.S. dollars
dem
manded increaases.
Figuure 5.1 show

ws the deman U dollars in the foreign
nd curve for U.S.
exchhange markeet.
Figu
ure 5.1
294
According to Figure 5.1, the lower the rate of exchange (appreciation of

C$), the greater the demand for the foreign currency, as shown from the
downward-pointing arrow.
Changes in the demand for dollars

As indicated above, there are other factors besides the exchange rate that
influence the demand for a foreign currency, including domestic and
foreign interest rates, domestic and foreign income. While changes in the
exchange rate cause a movement along the demand curve, changes in
these factors cause the demand for the currency to shift. We shall examine
the impact of these factors in detail.
Interest rates
People and businesses buy financial assets to make a return. The higher
the interest rate that people can make on domestic assets compared to
foreign assets, the more domestic assets they buy. In analysing this issue,
we should be careful not to view each interest rate in isolation. What
matters in deciding which asset to buy is not whether domestic interest
rate (i) is high or low, or whether in fact in has risen or fallen, but rather,
how it compares with the foreign interest rate (i*). The critical question
then is: ‘What is the interest rates differential (i − i*)?’ For example, if
the foreign interest rate rises and the domestic interest rate remains
constant, the interest rate differential (i − i*) decreases. Similarly, if the
foreign interest rate stays constant while the domestic interest rate falls,
the interest rate differential (i – i*) decreases. The smaller this interest
gap (differential), the more attractive foreign assets are and the less
attractive domestic assets become. The smaller the gap, the greater the
demand for foreign assets and thereby, the greater the demand for foreign
dollars in the foreign exchange market. In terms of Figure 5.1, the
demand curve shifts to the right.
Incomes
When an economy grows, its GDP increases and investment prospects

become more attractive in that environment. The faster the (real) growth
of the economy, the greater the inflow of investment and hence the
greater the demand for foreign currency. Again, what matters in deciding
which asset to buy is how fast the domestic economy (Y) expands in
comparison with the foreign economy (Y*). This relates to the income
differential (Y −Y*). For example, if foreign income rises and domestic
income remains flat (no growth), the income differential decreases.
Similarly, if foreign income stays constant (no growth) while the
domestic economy shrinks (recession), the differential decreases. The
smaller this income gap (differential), the more attractive are the
prospects from investing in foreign economy and the greater the demand
for foreign currency, and vice versa. In terms of Figure 5.1, the demand
curve shifts to the right.
Inflation rates
When prices change, they tend to affect exports and imports. If, for
295
Module5
exam mple, domesstic prices risse at a faster rate than forreign prices (there
( is a
highher domestic inflation ratte relative to the foreign rrate), a counttry’s
prodducts becomee more expen nsive than fooreign produccts. Citizensw will,
therrefore, buy a lesser quantity of domesstic products and more fo oreign
(Am merican) prodducts, increassing the amoount of foreiggn currency
demmanded. (Theere is a rightw ward shift in the demand curve.) Agaiin, what
mattters in decidiing which prroducts to buuy is not wheether domestiic
inflaation rate is high
h or low, or whether ini it rises or ffalls, but rath
her how
it coompares withh the foreign inflation ratte. In other w words, ‘Whatt is the
inflaation rates diifferential?’
Excchange rate expectation
e s
Otheer things remmaining the same,

s the higgher the expeected future exchange
e
rate, the greater the demand for a foreignn currency (U U.S. dollars). To see
whyy, suppose yoou, a Canadiaan, are plannning to buy U US dollars sinnce you
are expecting
e thee U.S. dollarr to gain valuue in the nearr future (say,, a week).
Let us assume thhat you buy the t U.S. dollars at today’s rate of exchange of
C$11.55 and you are expectin ng the exchannge rate to rise to C$1.60 0. If your
preddiction turns out correct, you will selll your U.S. ddollars for Caanadian
dollars, at the ennd of the weeek to obtain C$1.60
C per eeach U.S. dolllar,
makking a gain of C$0.05 forr every U.S. dollard initiallly purchased
d.
The higher the expected

e futu
ure exchangee rate with otther things reemains
the same,
s the greeater the exp pected profit,, the greater iis the deman
nd for the
U.S. dollars. Aggain, in termss of Figure 5.1,
5 the demaand for the U.S. U
dollar shifts to thhe right.
In suummary, thee following events

e increasse the demannd for the forreign
currrency (U.S. dollars)
d and shifts
s the dem
mand curve rrightward fro om D$1
to D$2 in Figuree 5.1, and vicce versa:
• An increease in the fo
oreign interest rate (a deccrease in inteerest
differential).
• An increease in the grrowth of foreeign econom
my (a decrease in
income growth diffeerential).
• An increease in domeestic inflationn rate (an inccrease in infllation
differential).
• A rise inn the expecteed future excchange rate.
Sup
pply of forreign curreency (exch
hange)
The supply of thhe foreign cu urrency, in terrms of domeestic currency y, is a
relattionship betwween the pricce of the foreeign currencyy and its quaantity
suppplied in exchhange for ourr own currenncy. The quanntity of a foreeign
currrency supplieed in the foreeign exchangge market is tthe amount that
t
tradders plan to seell during a given
g time peeriod at a givven exchangee rate.
How wever, the exxchange rate is only one factor.
f The qquantity demaanded is
alsoo determined by other facctors includinng:
• Domestiic and foreig
gn interest rattes.
• Domestiic and foreig
gn income.
296
• Domestic and foreign inflation rates.

• The expected future exchange rate.
Again, choosing the U.S. dollar as the foreign currency, the supply
relationship can be expressed as a curve in Figure 5.2. As expected, the
relationship between the price of the currency and its quantity supplied is
a positive one.
People supply U.S. dollars in the foreign exchange market when they buy
other currencies. The reason for this is that U.S. dollars are supplied in
exchange for Canadian dollars to finance foreign purchases of either
Canadian goods and services or Canadian financial assets. When the price
of U.S. dollars rises, it will be cheaper for Americans to buy Canadian
goods, services and assets and hence to supply more U.S. dollars in
exchange for Canada dollars. Therefore, the supply of the U.S. dollar
rises as its price does. The law of supply applies to dollars just as it does
to anything else that people plan to sell.
Figure 5.2
The higher the exchange rate, with all else remaining the same, the
greater the quantity of dollars supplied in the foreign exchange market.
For example, if the price of the U.S. dollar rises from C$1.55 to C$1.60,
but nothing else changes, the quantity of U.S. dollars that people plan to
sell in the foreign exchange market will increase. The reason for the
supply curve’s upward slope can be understood if you consider the fact
that the supply of foreign currency is derived from the demand for
domestic currency, which itself is derived from demand for is underlying
elements. People supply the U.S. dollar in exchange for domestic
currency primarily because of their demand for:
1. domestic goods and services (domestic exports), and
2. domestic assets.
For example, when the price of the U.S. dollar increases (depreciation of
the Canadian dollars), the export effect occurs: it will be cheaper for
Americans to purchase Canadian goods and services. Depreciation of the
C$ also affects the demand for Canadian assets. The weaker the Canadian
dollar with other things remaining the same, the larger the expected profit
from buying Canadian dollars. Therefore, as the Canadian dollar
297
Module5
deprreciates, the demand for domestic currrency rises aas also does the
suppply of U.S. dollars
d that neeeds to be exxchanged forr it.
Chaanges in th
he supply of dollars
As indicated
i aboove, there aree other factorrs, besides thhe exchange rate, that
influuence the suppply of a foreign currenccy including ddomestic and d foreign
interrest rates, doomestic and foreign
f incomme, etc. While changes in n the
exchhange rate caause a movem ment along thhe demand ccurve, Figuree 5.2,
channges in thesee factors causse the demannd for the currrency to shifft. Let us
noww look at the impact of theese factors.
Inteerest rates
Recall that one of o the determminants of invvestment flow w is the interrest rate
diffe
ferential. If thhe foreign intterest rate risses and the ddomestic inteerest rate
rem
mains constannt, the domestic interest raate differentiial (i – i*) deecreases.
In thhis case, dommestic assets are relativelyy less attracttive than foreeign
asseets, causing thhe demand forf domestic assets to droop. This, in tu urn,
causses the demaand for domeestic currencyy (or the suppply of foreig gn
currrency) to fall. In terms off Figure 5.3, the supply ccurve shifts to the
left.
Inco
omes
Anoother factor thhat determinnes which asssets to buy iss the relative growth
of thhe domestic economy (Y) Y) in comparisson with foreeign income (Y*),
i.e., income diffeerential (Y − Y*). If the differential
d deecreases, thee
dommestic econom my becomes relatively leess attractive and the dem mand for
dommestic assets dwindles. Th his causes thhe demand foor domestic
inveestment oppoortunities to fall
f as well asa the demandd for domesttic
currrency, whichh is equal to the
t supply off the foreign currency in this t two-
currrency situatioon. In terms of
o Figure 5.33, the supplyy curve shiftss to the
left.
Inflaation rates
At any
a given ratte of exchang ge between domestic
d andd the foreign currency
n the price off domestic products relattive to
(the U.S. dollar)), increases in
foreeign (Americcan) productss means that Americans w will purchasee fewer
dommestic produccts, reducing their demannd for domesttic currency.. This fall
in thhe demand foor our currenncy corresponnds to a fall iin the supply
y of the
foreeign currencyy (U.S. dollarr), shown as a leftward shhift in the su
upply
curvve. Again, whhat matters in deciding which
w produccts to buy is how
h
dommestic inflatioon compares with the forreign inflation rate: the inf
nflation
ratees differential.
Excchange rate expectation
e s
Sim
milarly, the hiigher the exp pected future exchange raate, other thin
ngs
rem
maining the saame, the smaaller the expeected profit (in domestic
econnomy) and thhe smaller is the demand for domesticc currency (o or the
smaaller is the suupply of U.S. dollars). Aggain, in termss of Figure 5.2,
5 the
suppply curve shiifts to the lefft.
298
In conclusion, a drop in the interest rate differential; a relative slow-down

in the growth of the domestic economy; a rise in the inflation differential;
a rise in the expected future exchange rate; decreases the demand for the
domestic currency (decreases the supply of U.S. dollars); causes the
supply curve to shift leftward from S$1 to S$2. This is shown along the
arrow in Figure 5.2. The opposite will happen if the scenarios are
reversed.
Market equilibrium
Recall that in competitive markets, the forces of demand and supply bring
the market to an equilibrium point. Foreign exchange markets are no
exception. Figure 5.3 shows such a situation. When the government
allows the value of its currency to vary (fluctuate), markets for currencies
will move towards equilibrium where the quantity supplied equals the
quantity demanded and there is neither a shortage nor a surplus of a
currency. Such a system of exchange rates where the central bank allows
the exchange rate to be determined by the foreign exchange market is
referred to as a flexible (or floating) exchange rate system.
The demand curve is shown by D$ and the supply curve by S$ in Figure

5.3.
Figure 5.3
Foreign exchange markets around the world are brought together through
a worldwide computer network. Information flows from dealer to dealer
and the price adjusts second by second to keep buying plans and selling
plans in balance. Foreign exchange markets are indeed very efficient.
As discussed earlier, in efficient markets the price (the exchange rate in

this case) acts as a regulator. If the exchange rate is too high, there is a
surplus (excess of supply) of a currency. When the exchange rate is too
low, there is a shortage (excess demand) of a currency. For example, at
the exchange rate C$1.70, in Figure 5.3, (C$1.70 per US$1), there is a
surplus of U.S. dollars, whereas, at the rate of exchange C$1.50, there is a
shortage of U.S. dollars.
What happens is that when a surplus situation is faced –too many sellers
and not enough buyers –the rate is pressured down towards the
equilibrium point, C$1.60. Conversely, when there is a shortage of the
299
Module5
currrency –too many

m buyers and
a enough sellers
s – the rrate is bid up
p, along
the arrows
a show
wn in this figu
ure.
Chaanges in exchange
e rates
r
As we
w have seenn, several facctors can cauuse a shift in the foreign exchange
e
dem
mand and suppply curves. Let
L us examiine the impacct of some off these
factoors.
Suppose again thhat the homee country is Canada

C and tthe foreign economy,
its laargest trade partner,
p he U.S. Now suppose thatt Canadian economy
is th
expeeriences a lower inflation n rate than thhe U.S. As exxplored earlieer, this
has two effects on o the foreig gn exchange market.
m By mmaking domeestic
prodducts less exppensive com mpared to the U.S. produccts, (a) it reduuces the
demmand for U.S.. dollars –Caanadians buyy a lesser voluume of American
prodducts in favoour of Canadiian products –and (b) it inncreases the supply
of U.S.
U dollars since
s Americcans find Cannadian produucts more attrractive
hencce they increease their dem mand for Cannadian produucts. As a ressult, this
will increase theeir demand fo or Canadian dollars, whicch means an increase
in suupply of U.S S. dollars.
Figu
ure 5.4
Starrting from ann initial equillibrium pointt, point A, coorresponding to the

exchhange rate E1 (1.60) and quantity of thhe U.S. dollaar transacted d ($50
billiion), the lower inflation rate
r in Canadda causes thee demand currve to
shift
ft leftward froom D$1 to D$2 $ and the sup pply curve too shift rightw
ward
from A a result off these demaand-and-suppply changes, the
m S$1 to S$2. As
exchhange rate faalls to E2 (1.445), depictingg an appreciaation of Canaadian
dollars and the volume
v of traansactions faalls to 44 billion, point B.
The question thaat arises is why

w the exchaange rate som metimes exhiibits
volaatile behaviouur, given thaat the volumee of dollars trraded may barely
channge. The ansswer is that, as
a we saw eaarlier, the dem mand and suppply of
the foreign
f curreency are influ
uenced by thhe same set oof variables th
hat tend
to puush demand and supply in i opposite directions.
d
Reaal exchange rates
The previous secction, as illusstrated by Fiigure 5.4, tellls us only ab

bout
channges in the reelative price of the two currencies. However, to domestic
d
300
(Canadians) tourists thinking of visiting the U.S., the question is not only
how many U.S. dollars they can get for 1 C$, but also how many goods
their dollar will be able to buy. It does them little good to get more US$
per Canadian dollars if the U.S. dollar prices of goods in the U.S. have
increased proportionately. In the same way, an American firm thinking of
exporting to Canada needs to know not only the nominal exchange rate
but also the price in C$ of Canadian products with which it will have to
compete. This leads us to the construction of real exchange rates, the
price of Canadian goods in terms of American goods.
Consider the case of a McDonald’s Big Mac bought in Canada and a Big
Mac bought in the U.S. In 2002, a Big Mac costs US$2.30 in the United
States and in Canada, it costs C$2.90. The first step would be to convert
this price in US$ to a price in C$. In order to do this, we need the current
rate of exchange, which is assumed to be E = 1.60 (a US$ is worth
C$1.60), so the price of a Big Mac in Canadian dollars is calculated as
follows:
PUSUS × E = PCUS
US$2.30 × 1.60 = C$3.68.
Here the superscript denotes the country of origin and the subscripts
denotes the currency in which the price is measured, where the subscripts
of US and C denote the U.S. and Canada, respectively.
Therefore, the Canadian dollar price of a U.S. Big Mac in 2002 equals
C$3.68. The second step would be to compute the relative price of a Big
Mac (ratio of the price of the Big Mac) in the two countries:
Real exchange rate = q = PCUS/PCC (3)
q = C$3.68/C$2.90 = 1.269.
This equation tells us that, measured in a common currency, the U.S. Big
Mac costs 27 per centmore than the Canadian Big Mac.
But since the United States and Canada produce more Big Macs, we need
to construct a real exchange rate that reflects the relative price of all the
goods produced in the two countries. In order to do this, we must use a
combined prices index instead of an individual price, such as that of a Big
Mac.
Therefore, if Pcan and Pus are, say, the GDP deflator for Canada and the
U.S. respectively, and if E is the nominal exchange rate between C$ and
US$ (C$/US), then
q = E × Pus / Pcan (4)
where multiplying Pus by the exchange rate, E, gives us the price of

American goods in Canadian dollars, E × Pus, and the price of Canadian
goods in C$ is Pcan.
301
Module5
An increase
i in thhe relative prrice of domeestic goods inn terms of foreign
goodds is called a real apprecciation; a deccrease is callled a real
deprreciation. Thhe word real, as opposed to nominal, indicates thaat we are
noww referring too changes in thet relative price
p of goodds rather thann in the
relattive price off currencies. Given
G our deefinition of thhe real exchaange rate
as thhe price of fooreign goodss in terms of domestic goods, (q = E × Pus/
Pcan), a real apprreciation corrresponds to a decrease inn the real excchange
rate. Similarly, a real depreciation corressponds to an increase in q. q
1. Which of thee following events

e wouldd cause a reaal depreciatio
on of the
domestic currrency?
A. Redduction in E
Study skills
S B. Incrrease in E
C. Redduction in P* (foreign pricce)
D. Incrrease in P
2. Use the folloowing inform

mation to calculate the real exchange rate in
year 2001 annd year 20022. Has the reaal exchange rrate appreciaated or
depreciated??
Year E P P*
2001 1.6 1.2 1.5
2002 1.55 1.5 1.7
Solu
utions:
1. B. The real
r exchange rate is defiined as E x P P*/P, where * denotes
the foreign variable.
v Reaal depreciatioon requires thhat this ratio rise.
Only a rise in
i E can do this
t amongst these choicees.
2. q (2001)) = 1.6 x 1.5// 1.2 = 2, andd q in (2002)) = 1.55 x 1.7

7/ 1.5 =
1.75. Since q has fallen, the real exchhange rate haas appreciateed.
Excchange rate regimes
r
Undder a flexible (or floating)) exchange rate,

r the centtral bank allo
ows the
exchhange rate too be determinned by the fooreign exchannge market. In I
Figuure 5.4, we examined
e thee factors thatt influence thhe demand an nd
suppply and, therefore, the ex
xchange rate.
Flexxible exchangge rates offerr one main advantage:

a market forces quickly
m
elim
minate shortages or surpluuses so that inflows and ooutflows soo on match
eachh other. How
wever, flexiblle rates also have
h an impoortant disadvvantage.
Drammatic changees in exchange rates meaan considerabble risks for
busiinesses invollved in imporrting or expoorting.
Connsider, for exxample, a local importer of

o American--made produ ucts. If
mestic currency depreciatees suddenly, the price off the productss is
dom
pushhed up to thee point that th
he products become
b too eexpensive fo
or
dom
mestic consum mers and quaantity demannded decreasees. Domesticc
302
exporters and their suppliers face similar uncertainty. Suppose, for

example, our currency jumps up in value in relation to the American
dollar. The exporter who exports domestic products to the American
market finds that they become too expensive for the American market and
quantity demanded decreases. Because of these fluctuations, incomes and
employment in the import and export industries are harmed.
To avoid the uncertainty caused by flexible exchange rates, governments

often intervene directly in foreign exchange markets. Fixed exchange
rates offer the most striking option. In a fixed rate system, central banks
stand ready to buy and sell their currency (in exchange for foreign
currency) at a fixed exchange rate to make up for any excess supply or
demand arising from private transactions. Such purchases and sales are
referred to as exchange market intervention. In order to be able to ensure
that the rate stays fixed, it is obviously necessary to hold an inventory of
foreign exchange that can be sold in exchange for domestic currency.
Thus, central banks hold reserves of major (vehicle) currencies –mostly
U.S. dollars –and gold that can be sold for U.S. dollars and other
currencies for the purpose of exchange market intervention.
In case of an excess supply of the foreign currency (which is the

counterpart of an excess demand for domestic currency), the intervention
takes the form of the domestic central bank’s purchasing the foreign
currency (U.S. dollars) in exchange for its own currency. The excess
supply situation has translated into an increase in the official reserves
held by the central bank, which appears as a negative entry in the official
settlement account –a surplus in the balance of payments. Conversely, in
case of an excess demand for the foreign currency (which is the
counterpart of an excess supply of domestic currency), the intervention
takes the form of the domestic central bank’s selling the foreign currency
(U.S. dollars) in exchange for its own currency. The excess demand
situation has translated into a decrease in the official reserves held by the
central bank, which appears as a positive entry in the official settlement
account –a deficit in the balance of payments.
Figure 5.5 illustrates the case of a deficit. This occurs where the
exchange rate if fixed below the equilibrium level, E0. At this rate of
exchange, the central bank has to meet the excess demand by exchanging
foreign currency for domestic currency, Canadian dollars in this case.
303
Module5
Figu
ure 5.5
As shown
s in Figgure 5.5, therre is an exceess demand fo
for U.S. dollaars at this
fixed rate of excchange (Qd$ – Qs$) whichh, if not remooved, will result in an
incrrease in the exchange
e ratee towards its market valuue, E1. To preevent this
fromm happening,, the Central Bank of Cannada must inntervene by selling
s
U.S. dollars out of its inventories of reserrves in exchaange for its own
o
currrency, C$. Thhis interventiion causes thhe US dollar supply curvee to shift
righhtward. Note,, however, th his is an ongooing operatioon and, if neccessary,
interrvention has to continue.
The ability of a country

c to maintain
m the value
v of its cuurrency depeends on
its stock
s of foreiign exchangee reserves. Iff a country peersistently ru
uns a
deficit in its balaance of paymments, the cenntral bank wwill eventuallyy run out
of reeserves and will
w be unablle to continuue interventioon. The outco ome is
eitheer a realignm
ment of the fiixed value off the exchangge rate with the
t
marrket value, orr a serious cuurrency crisiss. In many wwell-known
deveelopments suuch as the fin nancial crisiss in Mexico iin the last decade and
morre recently inn Asia, South h America annd Russia, thee realignmen nt of the
locaal currency was
w accompan nied by a currrency crisiss.
Reaalignment of the fixed excchange rate takes

t two diffferent formss.
Devvaluation refeers to an offiicial decreasee in the valuee of the curreency (an
incrrease in E), vis-à-vis
v anotther currencyy: usually thee U.S. dollar, since
the dollar
d is the world’s mosst widely useed currency. D During the Gold-
G
Exchange Standdard (1944–1973), currenncies were deefined in term ms of
theirr gold contennt and as succh, a devaluaation was deffined against the U.S.
dollar and ultimaately againstt gold. Revalluation is thee opposite off
devaaluation. It reefers to an in
ncrease in thee value of the currency (aa
decrrease in E).
Undder flexible exchange

e ratees, interventiion is not reqquired. In a system of
cleaan floating, central
c banks do not intervvene in foreiign exchangee markets
and thus allow exchange
e ratees to be freelly determinedd. In this casse, the
officcial settlemeent account does
d not channge as no enttry is necessaary. In
pracctice, howeveer, the flexib
ble rate system m has not beeen one of cleean
floaating hut rathher than mana aged (dirty) floating.
f Undder managed d
floaating, central banks interv
vene by buyinng or sellingg foreign currrency,
thuss attempting to influence exchange raates.
304
Suppose the central bank sets a target range: a range that it will attempt,
by intervening in foreign exchange markets, to keep the exchange rate
within. Alternatively, suppose there is a minimum psychological level of
the exchange rate below which if the market rate falls, the market will
expect the central bank to intervene to prop up the currency. In either
case, the central bank will be dealing with a non-clearing level of
exchange rate and, therefore, in its pursuit of its objectives, it will either
face a surplus or a shortage of the foreign currency in foreign exchange
markets. In case of a shortage, the central bank will have to use its stock
of foreign currency reserves and in case of a surplus, it will have to add to
its stock of foreign currency reserves. Either way, these transactions will
appear as changes in the official settlement account.
The exchange rate and the aggregate demand curve

A full discussion of the aggregate demand side of the economy requires
that we incorporate the fourth component of aggregate demand, net
exports (X − M) as follows:
Y = C + I + G + (X − M) (5)
where the last term on the right-hand side, as you recall, represents the net
exports, NX, or the trade account balance. To have a better understanding
of how net exports affect the economy, first let us examine the
determinants of (X − M).
Current account
As you know, the current account balance (CAB) is defined as:
CAB = Net exports of goods and services

+ Net investment income + Net transfers. (6)
Fluctuations in net exports are the main source of fluctuations in the

current account balance. The other two items have trends, but they do not
fluctuate much. Therefore, you can study the current account balance by
looking at what determines net exports.
Net exports
The key determinants of exports and imports are the exchange rates (or
more precisely real exchange rates), domestic and foreign incomes. A
real exchange rate appreciation, for example, makes our exports more
expensive to foreigners and our imports cheaper to domestic consumers,
thereby decreasing our net exports. This decrease, in turn, has a negative
impact on the aggregate demand curve. Similarly, real exchange rate
depreciation–by making our exports cheaper and our imports more
expensive –causes aggregate demand to rise.
Changes in income also affect aggregate demand. An increase in
305
Module5
dom
mestic incomee increases our
o imports and
a hence redduces aggreg gate
dem
mand, whereaas an increasee in foreign income
i (by iincreasing ou
ur
expoorts) raises aggregate
a dem
mand.
From
m a differentt perspectivee, net exportss are determinned by the
goveernment buddget and private saving annd investmennt. To see ho ow net
expoorts are deterrmined accorrding to this view, we neeed to rearran
nge
equaation (1) as follows:
f
Y − C − G − I = NX
As we
w did in Moodule3, defin
ne disposablee income (YD
D) as incomee (Y)
minnus taxes (T):
YD = Y––T (7)
By substituting
s i the above equation
in
(YD + T)
T – C − G − I = NX
or,
(YD − C)
C + (T − G) − I = NX
Thiss can be writtten as
(Sp – I) + (T − G) = NX (8)
wheere (YD – C) is private (seector) savingg and we dennote it by Sp.. (Sp – I)

reprresent the priivate sector surplus
s or deeficit. If savinng exceeds
inveestment, the private
p secto l to other sectors. If in
or surplus is lent nvestment
exceeeds saving, the resulting g private secttor deficit wiill be financeed by
borrrowing from other sectors. (T − G) represents the government sector
surpplus or deficiit and is equaal to net taxees minus govvernment
expeenditures on goods and services. (T − G) is also reeferred to as
goveernment saviing, Sg. A po ositive Sg reppresents a goovernment seector
surpplus which iss to be lent ouut to other seectors, and a negative Sg
(govvernment defficit) must bee financed byy borrowing from other sectors.
s
Thiss equation shhows the relaationship betw ween the three balances.
Acccordingly, net exports equ ual the sum ofo the governnment surplus and the
privvate surplus. It is also truee that net expports plus deebt interest (aand other
smaall transfers) equals the cu urrent accounnt balance. T The question that
arisees is: “What is the relatio
onship over time
t betweenn net exports (or
currrent account balance) and d the governm ment budget balance?”
The answer is thhat generally, there is a teendency for tthe governmeent

budgget deficit onn the left-han
nd side of eqquation (8), too move togetther in
the same
s directioon with the trade
t deficit (or
( current account deficit), on
the right-hand
r siide. This, howwever, does not necessarrily imply eqquality
betw
ween the twoo, as the privaate-sector baalance could be either possitive or
negaative but only coincidenttally equal too zero. Nonettheless, observations
suppport the fact that there is a tendency for
f the currennt account too go into
306
a deeper deficit when the government budget goes into a deeper deficit.
Because of this tendency, they have been called twin deficits.
Substituting in equation (8), we obtain an alternative relationship as

follows:
S − I = NX (9)
where Sp + Sg = S denotes domestic (national) saving. Equation (9) tells

us that, in an open economy, the excess of domestic savings over
domestic investment must equal net exports. This relationship also helps
us understand why the two deficits in equation (8) are linked. We know
from the balance of payment equation, equation (1) that current account
and capital account (including the official settlement account) must offset
each other for balance of payments equilibrium. Therefore, equation (9)
can be interpreted in terms of trade in goods and services equalling capital
flows in terms of net lending or borrowing.
Net Foreign Lending = Trade Balance (10)
If domestic savings is greater than domestic investment, the excess

domestic savings is lent abroad (to foreigners), and if domestic savings is
less than domestic investment, the shortfall is borrowed from abroad.
Therefore, the left-hand side of equation (9) is equal to net foreign
investment, which is the amount that domestic residents are either lending
to or borrowing (on a net basis) from foreigners. Accordingly, another
way to look at the equilibrium condition is that net foreign investment
must equal the trade balance in equilibrium.
The key to understanding this link is the phenomenon of international

capital mobility. In today’s world, economies are linked through highly
mobile international capital. In the closed economy model of Units 3 and
4, we discussed three methods of financing a government deficit: raising
taxes, printing money and borrowing from the (domestic) public. In an
open economy framework, a fourth possibility emerges: borrowing from
abroad. High capital mobility or unrestricted capital flows allow
governments as well as the private sector to borrow directly in
international financial markets.
Interest rate parity

One of the most popular theories of exchange rate determination in the
short run is Interest Parity Theory. Consider two kinds of homogeneous
assets: a Canadian dollar asset (say a Canadian dollar saving deposit) and
a U.S. dollar asset (a U.S. dollar saving deposit). These two assets are
assumed alike in every respect (risk of default, tax treatments and other
regulatory and banking restrictions) except for their returns. For example,
suppose the Canadian dollar saving deposit in Toronto earns 5 per cent a
year and a U.S. dollar saving deposit in New York earns 3 per cent a year.
In this situation, capital should fly to Toronto since saving deposits in
Toronto pay 2 per cent (5−3) more return than those in New York. The
307
Module5
onlyy reason whyy all the monney in New YorkY does not fly to Toronto is the
posssibility of exchange rate changes
c in thhe future (whhile all the money
m is
depoosited in Torronto) in a diirection that might
m wipe oout the 2 perr cent
interrest advantagge that Toronnto has over New York.
Suppose people expect the Canadian

C dollar to deprecciate by 2 perr cent.
Thiss depreciatioon must be su ubtracted from m the 5 per ccent interest to obtain
t Americaans can earn by depositin
a retturn of 3 perr cent a year that ng funds
in a Toronto bannk. The expected depreciation of the C Canadian do ollar
worrks as a negattive return too American investors
i whoo will be con nverting
the Canadian
C prooceeds at thee time of withhdrawals intoo their own currency.
c
In thhis case, the two returns are
a equal, annd the situatioon is referredd to as
interrest rate pariity, which meeans equalityy between raates of interesst (3 per
centt deposit ratee in New Yorrk = 5 per ceent deposit raate in Toronto o minus
2 peer cent expeccted depreciaation of Canaadian dollar)).
Adjuusted for riskk of exchangge rate changges (exchangee risk), intereest rate
parity always prrevails. Fund ds move to geet the highestt return availlable.
Suppose that savving depositss in Toronto pay 5 per ceent return as opposed
o
to 3 per cent paid to similar deposits
d in New
N York. This time, how wever,
assuume that Cannadian dollar is expected to depreciatee by 1 per ceent. A
quicck comparisoon indicates that
t it is advaantageous too deposit mon ney in
Toroonto. Therefofore, funds flo
ow into Toroonto’s markeet. For the few w
secoonds that thiss opportunity
y lasts – a siggn that in effi
ficient markeets,
proffits disappearr very quicklly – the demaand for Canaadian dollarss rises
and the exchangge rate rises, causing
c it to appreciate uuntil the expeected
ratess of return arre equal.
Exchaange rate policy

Sommetimes goveernments inittiate a change in the exchhange rates to o affect
dommestic output and prices. ToT see how policymaker
p rs can use excchange
rate policy to diffferent ends, let us considder the followwing scenariios.
Hig
gh exchang
ge rates (lo
ow currenccy values))
A loow target ratee for our dommestic currenncy makes ouur exports ch heap and
imports more exxpensive. Thiis policy stim mulates expoort revenues and
a
inhibits import spending,
s theereby increassing net expoorts. Thereforre, by
initiiating a drop in the value of the currenncy, the centtral bank can
n help
incrrease net exports and hence aggregatee demand. Heence, raising g the
exchhange rate (ddepreciation)) serves as ann expansionaary policy. Bo oth real
outpput and emplloyment are boosted
b and any recessioonary gap thaat exists
is reeduced.
How wever, there are several problems

p in setting
s a highh exchange rate. First
is thhe danger of inflation. Th
his hazard is especially immminent if th he
econnomy is nearr its potentiall output, wheen shifts in thhe aggregatee demand
curvve primarily affect prices. Second is the
t chance thhat a country’s
tradding partners may respond d by raising their
t exchannge rates to maintain
m
theirr own exportt markets. When
W this happpens, currenncies return too their
origginal relative values, and the original policy
p achievves nothing.
308
Despite these risks, a policy of high exchange rates has sometimes been
pursued with success. In the past, for example, countries such as Taiwan
and South Korea have depressed the values of their currencies as a way of
encouraging export-driven growth. Evidence of this strategy was found in
their large holdings of foreign currency which resulted from the balance-
of-payments surpluses associated with a high exchange rate policy. More
recently, the evidence from Latin America indicates that Argentina,
which had until lately fixed its peso against the U.S. dollar, suffered a
tremendous economic crisis mainly because its exports were driven out of
competition by its strong currency relative to the currencies of its
immediate neighbours who had experienced significant depreciation
during the economic crisis of year 1997.
Low exchange rates (high currency values)

Setting a high target for the currency has the opposite effect. High
currency value targets (low exchange rates) make imports cheaper and
boost prices of domestic exports. Therefore, lowering the exchange rate
serves as contractionary policy by reducing net exports and decreasing
aggregate demand. This puts downward pressure on inflation as is well as
on real output and employment.
Nonetheless, using a low exchange rate as an anti-inflationary tool has its

problems. Not only will a low exchange rate policy cause a reduction in
output and employment, especially in exporting industries, but it will also
reduce the government’s foreign currency holdings.
Sooner or later, through continual balance-of-payments deficits, the

holdings are depleted. In this situation, countries sometimes attempt to
bolster their currency reserves by measures such as forcing citizens to sell
their foreign currency to the government rather than allowing them to
trade it privately. These laws produce underground foreign exchange
markets, with prices set at equilibrium levels determined by demand and
supply.
Monetary policy and exchange rates
As suggested by interest parity, an increase in the domestic interest rate

relative to those of other currencies causes our currency to appreciate.
This is because as domestic interest rates rise, demand for the foreign
currency drops while the supply of the foreign currency increases in the
foreign exchange market –where upon the exchange rate falls. Similarly,
when domestic interest rates fall relative to those in other countries, the
demand for foreign currency increases and the supply of foreign currency
decreases, forcing the exchange rate higher (depreciation of our
currency).
Interest rates themselves are normally determined by the demand for and
supply of money (see Modules3 and 4). However, it is the central bank
that influences the supply of money (and consequently the exchange rate)
through its monetary policy.
309
Module5
Therefore, if thee central bankk wishes to raise

r the valuue of its curreency, it
can force up inteerest rates ussing contractiionary moneetary policy.
Connversely, an expansionary
e y money poliicy of low innterest rates can
c be
appllied to depreciate the excchange rate. InI either casee, the centrall bank
influuences the cuurrency by ad djusting its equilibrium
e vvalue.
Thee exchangee rate in th

he long run
n: Purchassing power parity
The purchasing power parityy (PPP) theoory of the excchange rate states
s
that, in the long run, the nom minal exchange rate movees primarily as a
resuult of the diffference in priice level behhaviour betweeen two coun
ntries.
Undder this theorry, the nomin nal exchangee will appreciiate or depreciate to
the point
p where the average price
p of goodds, as measuured by somee overall
price index, willl be the samee when measured in a com mmon currenncy.
We can gain an understandin ng of PPP byy looking at tthis theory frrom the
persspective of a single good that is produuced in two ddifferent cou untries.
Recall the exam mple of a McD Donald’s Bigg Mac sold inn Canada and d in the
U.S. In that illusstration, we assumed
a thatt in year 20022, a Big Macc costs
US$$2.30 in the U.S.
U while itt was sold forr C$2.90 in C Canada. We also
assuumed that E = 1.60 (a US S$ is worth C$1.60)
C so that the Canad
dian
dollar price of a U.S. Big Maac equals C$$3.68 (US$2..30 × 1.60). The T
relattive price off a big Mac (rreal exchangge rate, q) equuals C$3.68//C$2.90
= 1.269. This eqquation tells usu that, meassured in a com mmon curren ncy, the
U.S. Big Mac coosts 26.9 per cent more thhan the Canaadian Big Maac.
Eviddently, the twwo monies do o not have thhe same valuue.
If, however,
h we were to calcculate the relaative Big Maac price using g 1.269
as thhe exchange rate, this relative price would
w be equual to 1. The situation
we have
h just desscribed is callled purchasiing power paarity, which means
equaal value of money.
m In thiss example, thhe PPP level of the nominnal
exchhange rate is the level thaat would makke the real exxchange ratee (the
relattive price) eqqual 1.
Thiss Big Mac standard impliies that the Canadian

C dollar is underv
valued by
26.99 per centandd therefore, PPP
P would prredict that thhe nominal ex xchange
rate would appreeciate 26.9 per
p cent: fallinng to 1.269.
t the Big Mac example, when you reelate PPP as a theory

Withh reference to
abouut the generaal level of priices in two economies
e ass opposed to the
relattionship betw
ween a singlee good, the PPP
P level of tthe exchangee rate is
the one
o that wouuld equate prrice levels in two countriees.
Marrket forces prrevent the ex xchange rate from moving too far from m PPP or
from
m remaining away from PPP P indefinittely. Howeveer, pressures to move
to PPP
P work slow wly. There area several reeasons for sloow movemen nt
towaards PPP. Thhe first reaso on is that marrket baskets ddiffer across
counntries. The seecond reason n for slow movement tow wards PPP is that
therre are many barriers
b to the movement of goods bettween countrries.
Somme are naturaal barriers –trransportationn costs are onne obvious ex xtra cost
–whhile others (taariffs, for exaample) are immposed by ggovernments.
Sommetimes movvement of fin nal goods is not
n enough: w workers and capital
310
would have to move. Third and probably of greatest importance, many

goods –land is the classic example –are non-tradable and cannot move.
The importance of current account

An unsustainable current account imbalance matters for a number of
different reasons. Each type of imbalance deficit and surplus creates its
own set of problems. However, a deficit tends to result in more immediate
and pressing problems than a surplus. Before we begin considering the
types of problem likely to confront a chronic deficit country, let us
examine what running a deficit implies.
A country with a current account deficit is absorbing more goods and

services from foreigners than it is earning from export of goods and
services to them. Therefore, a deficit signifies that a country is living
beyond its means. But does it make a difference how the current account
deficit is being used?
As it turns out, there are striking similarities between the case of a

government budget deficit and that of a current account deficit. Therefore,
the argument put forth here is similar to the one presented in the budget
deficit case.
If the deficit is used to purchase capital equipment that will enhance the
country’s future earning capacity, running a deficit might make good
economic sense. The deficit should then be financed by long-term capital
inflows through the public or private sectors. When the time comes for
the accumulated debt to be serviced and repaid, spending will have to fall
below the value of domestic production. However, if the deficit is used to
finance imports of consumers goods, running a deficit make no sense and
the deficit will become unmanageable and the growing debt may never be
serviced — and worse still, never be repaid. The problems associated
with a situation such as this can be presented in the following categories.
1. As the current account worsens, foreign indebtedness increases
and ‘country risk’ ratings are expected to increase. Country credit
ratings are compiled regularly by international banks and by
financial service companies. Highly indebted countries with poor
scores on credit ratings generally have to pay high rates of
interest for further credits. The more these countries rely on
foreign creditors, the greater is the country’s exposure to the
volatility of international capital markets. Furthermore, if the
creditors lose confidence in the debtor country, the supply of
capital can dry up regardless of the interest rate paid by the debtor
nation. There are numerous examples of such a collapse of
creditor confidence amongst heavily indebted developing
countries, such as Mexico, Indonesia and Brazil.
2. The loss of confidence can lead to excessively large devaluations
of the exchange rate, which involves both loss of real income and
inflationary repercussions that only add to the problems of the
deficit country. A best example to illustrate this would be Turkey.
311
Module5
3. Accumuulation of extternal debt may

m pose a seerious probleem from
the persppective of fo
oreign ownerrship. The boorrower’s deb bt
accumullation is the creditor’s deemand for asssets as collatteral.
Korea iss the best exaample of escalating exterrnal debt at nearly
n 50
per centt of its GDP in
i the 1990s..
Corrrective po
olicy options
Whaat can be donne to tackle the
t problemss of chronic ddeficits and
surppluses? The following
f secction discussses policy opptions availab
ble to
goveernments.
Recall equation (9): S – I = NX.

N Accordinng to this equuation, the
counnterpart of thhe current account deficitt, (NX< 0), iss the excess of
o
inveestment over savings, (S – I) < 0. Theerefore, to cuure this problem
eitheer (S − I) shoould decreasee or NX increease or both.. These policcy
options fall into two groups: expendituree-changing poolicies and
expeenditure-switching policiies.
1. Expend diture chang ging policies: These policcies tend to change
c
the aggrregate domesstic spendingg (C + I + G). They are in ncreased
in the prresence of a current accouunt surplus aand reduced by that
of a currrent account deficit. In thhis current caase, faced by
ya
current account
a deficcit, the goverrnment shouuld either incrrease the
domestic savings or reduce invesstment. But aas discussed earlier,
domestic savings consist of privaate savings (Sp) and goveernment
savings (Sg). In ordeer to encouraage private saavings, the
governm ment can incrrease the retuurn on savinggs by increassing
interest rates on savving accountss or by offeriing better taxx
treatmennt of retired saving
s depossits. Note thaat such policiies at the
same timme tend to diiscourage consumption. A An increase in
i the
general level of interrest rates alsoo tends to disscourage invvestment.
Furthermmore, increasses in busineess taxes andd/or consump ption
taxes mootivates less spending annd more savinng. To encou urage
governm ment savings (reducing thhe budget defficit), the gov vernment
should either
e reducee its expendittures or increease its taxess.
2. Expend diture switch hing policiess: In contrastt to expenditu ure
changinng policies, th
hese policies tend to channge the comp position
of the agggregate exppenditure direectly rather tthan its levell. For
examplee, faced by a current accoount deficit, tthe governm ment can
implemeent an expen nditure switchhing policy tthat discouraages
spendingg on importss in favour off domesticallly produced products.
Converssely, faced by y a surplus, the
t governm ment can emplloy an
expenditure switchin ng policy thaat encouragess spending on
importedd goods vis-àà-vis domesttically produuced productss. In
other woords, this typ
pe of policy tends
t to induuce consumerrs to
switch thheir spendinng from foreiggn to domesttic and vice versa.
v
Exppenditure swiitching policiies consist off exchange rrate policy:

revaaluation (apppreciation) an
nd devaluatioon (depreciattion) as well as
com
mmercial poliicy including g but not limiited to:
312
• Tariffs, which are similar to taxes typically on imports but

sometimes on exports.
• Quotas, which are quantitative restrictions on imported products.
• Export subsidies, which are the opposite of taxes.
• Dumping, the act of selling exported products to foreign markets
at a price below costs or below domestic prices.
The reality, however, is that these types of policies tend to create frictions
with the trading partners and are rarely an efficient way of rectifying a
balance of payment crisis.
Causes and implications of trade deficits
There are a few reasons that account for large trade deficits. First, a
country is growing more rapidly than the economies of its trading
partners. The strong growth of the country (means high growth of
income) enables the people to buy more imported goods and services.
Hence, the total volume of its imports is higher than its exports. Secondly,
the large trade deficits may be caused by the frequent rise of the oil price
in the international market. If a country imports a large proportion of its
oil, rising prices tend to aggravate trade deficits. Finally, the declining of
a country’s saving rate (measured as saving divided by total income) may
also contribute to the large trade deficits. For example, if saving rate is
decreased while the investment rate remains the same, or even increased,
then the difference or gap between saving rate and investment rate will be
met via foreign purchases of the country’s real and financial assets. This
leads to a large capital and financial capital surpluses. This is because the
foreign investors or savers are willingly financing a larger portion of their
investment, people of the country will be able to save less than otherwise
and consume more. Part of that added consumption spending is on
imported goods and services.
The large trade deficits should be of significant concern to the country.

Nevertheless, most researchers see both advantages and disadvantages to
trade deficits, as follows:
Increased current consumption
At the time a trade deficit is occurring, consumers of the country benefit.

A trade deficit means that the consumers of the country are receiving
more goods and services as imports from abroad than its exports. In this
case, domestic consumers are able to consume outside its production
possibilities curve. However, it is important to note that the increase in
current consumption may come at the expense of reduced future
consumption. If the trade deficits decline, the consumers may have to
consume less than before and may be less than they produce.
Increased indebtedness level
A trade deficit is considered not favourable because it must be financed

by borrowing from the rest of the world, selling off assets, or dipping into
313
Module5
officcial reserves. Recall that trade deficitts are financeed primarily by net
repaayments of fooreign curren ncies to a couuntry. Whenn the exports of the
counntry are not sufficient
s to finance its im
mports, the ccountry increeases
bothh its debt to people
p abroaad and the vaalue of foreiggn claims agaainst
asseets in the couuntry. Hence,, financing of the countryy trade deficiits has
yieldded a larger foreign accu umulation of claims againnst the country’s real
and financial asssets than the country’s claims againstt foreign asseets. For
exammple, in 2006, foreignerss have ownedd about US$22.5 trillion more m U.S.
asseets (such as laand, corporaations, stockss, bonds, loann notes, etc.) than
U.S. citizens andd institutionss owned in fooreign assetss. If the Uniteed States
wannts to regain ownership
o off these domeestic real andd financial asssets, it
will have to export more than n it imports at
a some futuure times. In this
t
situaation, domesstic consump ption will be lower as the United Statees will
needd to export more
m of its ou
utput abroad than it receivves as imporrts.
Internaational trrade
The rapid growtth of foreign trade and invvestment flows and the resulting
spreead of internaational busin
ness and markkets are part of a trend kn
nown as
globbalisation. Markets
M are no
o longer conntained withinn national
bounndaries. Every day you rely on peoplle from arounnd the world, whom
you do not know w, to provide you with gooods and servvices that you u enjoy.
Suchh interdepenndence is possible because people tradde with one another.
a
Somme countries such as Belg gium and Cannada are morre dependentt on
interrnational tradde whereas some
s show leess reliance oon trade (thee U.S.
and Japan). Nonnetheless, eveery country, regardless off its size, deppends to
som
me extent on other
o econommies and is innfluenced byy events outsiide its
bordders.
Why do
d countrries tradee?
The most straighhtforward an nswer to this question is thhat trade brin ngs
signnificant econoomic gains to o all parties engaged
e in itt. It increases
prodduction by alllowing speccialisation in products in w which a coun ntry is
commpetitive, it inncreases variiety for consumers and itt promotes
commpetition.
Speecialisation and trad

de
The most importtant gain from m internationnal trade is sspecialisation
n.
Withhout trade, a country wou uld have to produce
p everrything it connsumes
and be self-suffiicient. With international
i l trade, the saame country can
focuus on producing productss in which it is efficient, aallowing it to o
commpete in the expanded
e maarkets. The coountry’s incoome will incrrease as
a ressult of speciaalisation and
d increased exxports, whichh enables it tot import
prodducts from thhe rest of thee world. This increases thhe standard of living
of thhe nation sinnce the standaard of living is best meassured by the amount
of consumption and imports per capita, and a these, in turn, are also o driven
by specialisation
s n.
314
As the first step in developing a framework to analyse gains from

specialisation, let us look into the sources of these gains: absolute and
comparative advantage.
Absolute advantage
The easiest way to grasp the concepts of absolute and comparative

advantage is to consider the case of two trading partners; persons, firms
and nations. Accordingly, a person, a firm or a country will enjoy an
absolute advantage over another country in the production of a product if
it uses fewer resources to produce that product than the other country
does. Suppose a lawyer who practices law can use a secretary to prepare
her documents for her. The lawyer can type threepages per hour, while
her secretary can type 10 pages per hour. Also, suppose that the secretary
does not have the required training to practice law. Therefore, the lawyer
can do a better job in practicing law and the secretary can produce more
typed pages than the lawyer. The lawyer, thus, enjoys an absolute
advantage over the secretary in practicing law and the secretary has an
absolute advantage in typing.
If each trading partner specialises in the product for which it has absolute
advantage, everyone can benefit. The lawyer should specialise in
practicing law and the secretary in typing. This way, the volume of
production increases beyond the levels that would have been achieved if
each party were confined to self-sufficiency and forced to produce
everything. The gains from specialisation can be alternatively explained
in the context of productivity and saved resources. Since each partner can
produce one product more efficiently (using fewer resources than the
other), specialisation allows trading partners to save resources.
As indicated earlier, the principle of absolute advantage (and also

comparative advantage, to be explored in the following subsection) are
general enough to apply to all possibilities. Accordingly, two firms or two
nations can specialise in products that they have an absolute advantage in.
In fact, trade allows two nations to move out beyond their previous
resource and productivity constraints.
Comparative advantage
A country enjoys comparative advantage in a product when it can

produce that commodity or item at a lower cost relative to other products
–lower marginal cost –than other producers. Table 5.3 illustrates a
hypothetical case. Suppose there are two countries, Home (H) and
Foreign (F). Also, suppose that there are two goods produced by both
countries, wheat (X) and cloth (Y), and there is one factor of production
(labour). The number in each cell of the table below shows the amount of
(labour) work required to produce one unit of each product. As indicated
in the second column, two hours of work is required to produce one unit
(in cubic metres) of wheat in H compared to 20 hours in F whereas in the
third column, five hours of work is required to produce one (in metres)
unit of cloth in H compared to 10 hours in F.
315
Module5
X Y
Hom
me (H) 2 5
Foreeign (F) 20 10
Tab
ble 5.3 Labour content of
o one unit of
o output of X or Y
Acccordingly, H is more efficcient (producctive) than F in the produ

uction of
X: tw
wo labour hoours required d to produce one unit of X versus 20 hours.
h
Thuus, H has an absolute
a advaantage in X. On the otherr hand, note that H is
morre efficient thhan F in prod
ducing Y as well,
w five labbour hours veersus 10.
Thuus, H enjoys ana absolute advantage
a in Y. Hence it is possible for
f a
counntry to enjoyy an absolute advantage inn both goodss.
How m the 18th cen

wever, the paattern of trade, as we have learnt from ntury
Brittish economist David Riccardo, is not determined
d bby absolute
advaantage but raather by commparative advvantage. In thhis example, we can
showw H has a coomparative ad dvantage in X (wheat) w while F has a
com
mparative advvantage in Y (cloth).
The simplest waay of showing g the patternn of comparattive advantag ge is to

trannslate these numbers
n into opportunity costs. Recalll that the opp portunity
costt of producinng a product isi the foregoone alternativve –the amou unt of the
secoond product that
t needs to o be sacrificed to producee one unit of the first
prodduct. Therefoore, in this illlustration, thhe opportunitty cost of X is
i
meaasured in term ms of Y and the opportunnity of Y is m measured in terms
t of
X. Table
T 5.4 shoows these oppportunity coosts.
X Y
Hom
me (H) 2/5 = 0.4 5/2 = 2.5
Foreeign (F) 20/10 = 2 10/20 = 0.5
Tab
ble 5.4 Oppoortunity costts of X and Y
Acccordingly, thee opportunity y cost of X inn terms of Y in Home is 0.4. This

sugggests that in order to prodduce one uniit of X, Home must give up u 0.4
unitts of Y. The logic
l behind this is that too produce onne unit of X, the
counntry must addd twounits of o labour (woork hours). Thhis can be arrranged
by relocating
r tw
wounits of lab bour from thee other sector, Y. But, sinnce one
unitt of Y requirees five units of labour, reemoving two units of labo our from
Y caauses only a drop of 2/5 of Y The same logic applies to all.
o a unit of Y.
Therefore, the oppportunity co ost of Y in thhe home couuntry is 5/2 (2
2.5). For
Foreeign country, the opportu unity costs off X and Y aree 2 and 0.5,
resppectively.
w, we are in a position to establish comparative addvantages. Since

Now
Hom
me has a low
wer opportuniity cost in X (0.4) compaared to Foreiggn (2),
316
Home has a comparative advantage in producing X. Similarly, since

Foreign’s opportunity cost of Y is less than of Home, 0.5 versus 2.5,
Foreign has a comparative advantage in producing Y. Therefore, Home
will export X and Foreign will export Y. Of course, Home’s imports will
be Foreign’s exports and Foreign’s imports will be Home’s exports.
The pattern of international trade is determined by comparative

advantage.
Note that the above conclusion is reached despite the fact in our example
Home is assumed to have an absolute advantage in both X and Y. Thus,
as Ricardo showed us, the pattern of trade is not determined by absolute
advantage but relative advantage, otherwise Home would have been
found exporting both products and not just X. In other words, although
Foreign has an absolute disadvantage in both X and Y, its margin of
disadvantage (deficiency) is smaller in Y than in X and hence relatively
speaking, it has a relative (comparative) advantage in Y. Similarly,
Home’s margin of advantage in Y is smaller than that in X; therefore,
Home has a relative advantage in X.
The important point is that specialisation and trade can benefit all trading
partners; even those that may be inefficient producers in an absolute
sense. If markets are competitive and if foreign exchange markets are
linked to goods-and-services exchange, countries will specialise in
producing those products in which they have a comparative advantage.
Terms of trade
We have established the fact that both nations benefit from trade. A
question that arises is how the benefits of trade are shared between
nations. The answer is that distribution of gains depends on the
international price of products, theterms of trade. Terms of trade are the
international price of one product in terms of another product. Terms of
trade must be set in such a way that they are beneficial to both trading
sides or otherwise, there will not be an incentive to trade. In other words,
the rate at which a country will end up selling its exports for an imported
product must be at least equal to or better than the rate that country can
exchange the same two goods internally –its opportunity cost –in the
absence of trade. In terms of the example above, in order for Home to
export one unit of X, it must be able to import at least 0.4 units of Y;
otherwise, the trade is not beneficial to Home. The reason for this is that
in Home, one unit of X exchanges for 0.4 units of Y in the pre-trade
situation.
Similarly, in order for the foreign country to engage in trade, it must be

able to import one unit of X in exchange for at most twounits of Y –its
opportunity cost –or less, or otherwise, there will be no gains from trade
for it. Therefore, terms of trade consist of a range of prices that may be
acceptable to both sides. In our example, the limits of terms of trade are
as follows:
317
Module5
0.4 < terrms of trade < 2
or
0.4 < prrice of X in teerms of Y < 2
The actual termss of trade aree then set by the international demand d for
eachh product. Thhe closer the final internaational price is to Home’ss
maller the gaains from tradde for Home and the
oppoortunity costt (0.4), the sm
larger the gains for Foreign. Conversely, the closer thhe internation nal price
is too Foreign’s opportunity’s
o s cost (2), thee larger the ggains for Hom
me and
the smaller
s the gains
g for Foreign.
Refeer to the folloowing table to

t answer thee next two quuestions. Thee table
show
ws the possibble output lev vels from onne hour of labbour input.
Milk (Litrre) Banan

nas (Kilo)
Study skills
S Home 12 5
Foreign 4 6
1. According too the table, Home

H has
A. an absolute
a advaantage in millk.
B. an absolute
a advaantage in bannanas.
C. a coomparative disadvantage in both.
D. the potential
p to export
e both goods.
g
2. The opportuunity cost of one litre of milk
m in Homee is
A. 5/122 kg of banan
nas.
B. 12/55 kg of banan
nas.
C. 3 kgg of bananas..
D. 2 kgg of bananas..
Solu
utions:
1. A. Homme can simply y produce moore milk thann Foreign. Home has
an absollute disadvan
ntage in banaanas only, soo B is wrong.. A
country cannot havee relative advvantage in booth goods, an
nd thus C
and D arre wrong.
2. A. The opportunity
o cost
c of one liitre milk is thhe quantity of
o
bananass to be sacrifiiced. To prodduce one litree of milk, Ho
ome
needs 1//12 unit (hou
urs) of labourr work to be transferred from
f the
moving 1/12 hours of worrk from banaanas
other sector. But rem
causes a loss of 5/12
2 kg of banannas. Remembber that one hourh of
work in Bananas pro oduces 5 unitts, therefore,, 1/12 hours of
o work
producees 5/12 units.
318
The sources of comparative advantage

The sources of comparative advantage can be broadly categorised into
two groups. According to Ricardo –Ricardian theory of trade–the
existence of a country’s comparative advantage is explained by its
technological superiority: productivity. The alternative and more popular
explanation is the one advanced by two Swedish economists by the names
of Heckscher and Ohlin. Their theory is based on the concept of factor
endowments: the quantity and quality of labour, land and natural
resources of a country.
The Heckscher-Ohlin theorem of international trade explains the

existence of a country’s comparative advantage by its factor endowments:
a country has a comparative advantage in the production of a product if
that country is relatively well endowed with inputs used intensively in the
production of that product.
Factor endowments seem to explain a significant portion of actual world

trade patterns. This idea is simple. A country with a lot of good fertile
land per person is likely to have a comparative advantage in agriculture.
A country with a large amount of labour but little capital is likely to have
a comparative advantage in labour-intensive goods.
Comparative advantage, however, is certainly not the only reason that

countries trade. For instance, it does not explain why many countries both
import and export the same kinds of goods. Trade of this nature is known
as intra-industry trade — trade within the same industry — as opposed to
inter-industry trade — trade between industries — as explained under the
Ricardian and Heckscher-Ohlin theories of trade. Intra-industry trade
occurs as industries differentiate their products to please the wide variety
of tastes that exists worldwide. In fact, the bulk of trade amongst
industrialised countries is of intra-industry type. Automobiles serve as a
good example of a product that follows this pattern. A country such as the
US exports cars of large models with powerful engines, and at the same
time imports smaller and more fuel-efficient cars. Product differentiation
is a natural response to diverse preferences across economies.
In contrast to inter-industry trade which tends to occur under perfect

competition and conditions of constant costs, intra-industry trade requires
an environment of imperfect competition and decreasing costs
(increasing returns to scale). In reality, most manufacturing industries
such as cars, chemicals, petrochemicals and pharmaceuticalsare
characterised by increasing returns and monopolistic or oligopolistic
market conditions, which means there are advantages to producing large
quantities of output.
319
Module5
Swittzerland is faamous for waatches, whichh it exports. This specialiisation is

best explained by
A. the largee population of Switzerlaand, which prrovides many
y
Study skills
S potential watch makers.
B. Swiss stteel refineriess, which produce steel ussed in watch parts.
C. Swiss diiamond minees, as diamonnds are used in watch parrts.
D. economiies of scale in the watch industry.
320
Solution:
D. As the watch industry became established, an input supply

network developed within Switzerland. Also, existing watch makers
could teach their techniques to new workers. Both developments
lowered the cost of firm expansion or the cost to new firms.
Trade policy
Having covered the basic economics of international trade, you are now
prepared to think about trade policy more directly. The next step is to go
over the main instruments of trade policy. The most common objective of
trade policy is to restrict imports. Trade policies are forms of protection
by which some sectors of the economy are shielded from foreign
competition. Trade policies, sometimes called trade barriers or trade
obstacles, take many forms. The most common trade policies are tariffs,
export subsidies and quotas, but there are other forms as explained below.
A list of protective policies includes:

• Tariffs.
• Quotas (quantitative restrictions).
• Export subsidies.
• Government procurement policies.
• Administrative barriers to trade (red tape).
• Other regulations.
A tariff is usually a tax on imports, but sometimes on exports as well.

Import tariffs tend to act as a tax on imports. They restrict imports by
raising the domestic price of imported products. The objective of tariffs
may be primarily increasing revenue for the government or alternatively,
reducing foreign competition to protect domestic industries. Tariffs vary
by product and country of origin. Tariffs are most visible in
manufacturing sectors. Export subsidies are government payments made
to domestic firms to encourage exports and can also act as a barrier to
trade.
High-technology and aerospace industries that depend on intensive

research and development are prime examples of industries that rely
heavily on export subsidies. Agriculture is another example of an industry
that governments around the world tend to target this way. Farm subsidies
remain very much a part of the international trade landscape today. Many
countries, especially in Europe, continue to appease their farmers by
heavily subsidising exports of agricultural products.
The most common non-tariff barrier is the quota. A quota is a limit on the
quantity of imports and is usually implemented by means of licences.
These licences are obtained by importers from the government, normally
for a price (creating revenue) or governments grant them an allowance to
321
Module5
brinng in a speciffic number off units of gooods. Import qquotas can work
w in
two ways.
A goovernment can impose an n import quoota itself or itt can ask foreeign
prodducers to set their own vooluntary quotas, which arre known as
voluuntary exportt restraints (V
VERS). Now wadays, mostt quotas are foundf in
agricultural sectors and textiile industries. The differeence between n quotas
and VERs is thaat unlike ordiinary quotas, VERs do noot generate reevenue
for the
t governm ment, nor can they be giveen to domestiic importers.
Wheen it comes to t governmen nt procuremeent, most couuntries give

prefference to doomestic produ ucers. This means
m that a domestic govvernment
will give prefereence to a locaal supplier evven if a loweer price could
d be
obtaained elsewhhere. Such a policy
p createes an incentivve for domesstic
supppliers to quotte higher pricces than theyy otherwise w would. The extent
e to
whicch preferentiial purchasinng causes pricces to rise deepends on the level of
locaal competitioon.
The term adminiistrative barriers refers to t the cost off filling in forrms,
lininng up at customs offices, waiting to get
g permissioon to export, and all
the other
o adminiistrative proccedures that make
m it hardder (and moree costly)
to exxport rather than
t to produuce and sell locally. Whiile it is difficcult to
meaasure the effeects of adminnistrative barrriers to tradee, many smalll
busiiness people argue that su uch barriers are
a a seriouss impedimentt.
Quitte frequentlyy, regulationss seem to be focused on a non-trade objective

o
suchh as making sure the food d supply is saafe or makinng sure that monopoly
m
pow
wer is not abuused but in faact they oftenn serve to keeep foreign prroducts
out of the domesstic market.
Thee case for traade protectio
on
The gains in ecconomic weelfare associiated with specialisation n and

the law of com mparative adv vantage are generally
g largge enough to o make a
com
mpelling casee for free trad
de. Consequeently, it is common for
econnomists to opppose govern nment policiees that preveent trade. Thee
appaarent policy implication is
i that the beest policy is a policy of frree trade.
In other
o words, countries
c shoould not use tariffs, quotaas, preferentiial
proccurement pollicies, exportt subsidies orr other intervventions in
busiinesses assocciated with in
nternational trade.
t This iss, in fact, thee
presscription madde by Ricarddo, and this prescription iss widely accepted by
moddern econom mists.
How wever, a few complications persist. Fiirst, even if w we agree thatt free
tradde is the best policy for th
he world as a whole, it dooes not follow w that
everry country faaces a unilateeral incentivee to avoid traade barriers. In fact,
mucch of the inteernational con nflict over trrade policy reeflects an atttempt by
one country to gain
g from inteerventionist trade policy at the expen nse of
otheer countries. From the nattionalist pubblic interest ppoint of view w, it might
be defensible
d to pursue a pollicy whose principle
p effect is to transfer
beneefits from othher countriess. Nonetheless, particularr cases of traade
prottection can be defended with
w either ecconomic or nnon-economiic
arguuments.
322
Second, the prescription that free trade is the best policy does not hold
perfectly. Especially in the presence of economies of scale and imperfect
competition, there are potential benefits to be obtained from intervention.
The following is a list of rationales for trade policy.
1. Raising revenue.
2. Improving a country’s terms of trade through monopoly tariffs (to
exploit monopoly power in world markets).
3. Increasing employment.
4. Protecting a country’'s safety standards and shielding domestic
workers from imports produced by cheap foreign labour.
5. The ‘infant industry’ argument for protection.
6. Non-economic objectives (military or cultural objectives).
Tariffs have been traditionally the most popular tool of trade policy. In
recent years, however, this tool has lost its usefulness because of the
world economy’s progress towards further trade liberalisation both under
the World Trade Organization (WTO) and through the growing number
of regional trading blocs. Nonetheless, one reason for many countries,
especially developing countries, to employ tariffs has been its revenue
implication for the government. Tariffs generate revenue for governments
in the same way that taxes do.
By setting tariffs on imported products, a large country –a country that is

either the sole player or one of the small number of players in the world
market –can turn its terms of trade to its advantage. A major player, by
setting a tariff on its imports, reduces the world demand for that product
and hence reduces the price for the imported product, which in turn
increases the terms of trade.
Because imports are a withdrawal from an economy’s circular flow, they

have a dampening effect on total spending and output. Thus, a reduction
in the level of imports through trade barriers can potentially increase the
level of economic activity in a country and provide more jobs for
domestic workers. In reality, however, this may only be valid at the
sectoral level, not at the national level. That is, the increase in economic
activity may only materialise within the sector that has been boosted by
the government trade policy. In fact, evidence suggests that the projected
employment gain in the targeted sector may be offset by an employment
loss in other sectors that are paid less attention.
A related argument suggests that imports produced by cheap foreign

labour need to be blocked from entering an industrialised country in order
to protect the job ofdomestic workers. In its basic form, however, this
argument is flawed because it ignores the reason pertaining to the
differences among wage rates in various countries. Workers in countries
with a higher per capita GDP tend to earn more than workers elsewhere
because of their higher productivity. When average wages in various
countries are compared with these different productivity levels, workers
in industrialised nations still possess an advantage over low-wage foreign
323
Module5
laboour in many types

t of prod
duction.
An infant
i industtry is made of
o domestic producers
p thaat are young and far
fromm establishedd compared to t foreign com mpetitors. Thhese industriies are
inexxperienced annd often too small to be ablea to comppete on a glob bally
baseed volume annd scale. Theerefore, theirr governmentts may try to o protect
prodducers behind tariff barriers until theyy have maturred, gained
expeerience and thet necessary y scale of prooduction to bbe left alone. The
trouuble is that noormally goveernments havve difficulty in identifyin ng
prodducers that qualify
q for theese protectivve measures. Furthermoree, a
natioon’s efforts to
t help its owwn industriess are also couuntered by siimilar
meaasures by its trade
t partnerrs –trade retaaliation.
Amoong the mostt important non-economi

n ic arguments one can refeer to are
natioonal securityy and culturaal sovereigntyy.
Activvity 5.1
If soome countriees are so keen
n to reduce barriers
b to traade, why do many
m
otheers frequentlyy attempt to erect
e barrierss?
Activity
Trad
de agreemen
nts and trad
de liberalisattion
Tradde agreemennts and trade liberalisationn are two esssential mechaanisms

whicch can be used to increasse the rate off growth of w
world trade.
• Trade aggreements innvolve the reeduction/remmoval of tarifffs on
each othher’s goods between
b two countries. Itt also includees the
reductioon of bureauccracy by simpplifying impport/export
proceduures.
• Trade liiberalisation might involvve creating ffree-trade areeas. This
creates larger
l markeets, greater acccess to raw materials an
nd more
competiition. It also encourages
e t lowering of unit costss, thus,
the
allowingg firms to gaain economiees of scale. Lower prices and
greater choice
c also in
ncrease conssumers’ welffare.
Reg
gional trade agreementss
There has been a significant expansion of o regional traade agreemeents

acrooss the worldd economy ov ver the last tw
wo decades. Some of theese
agreeements are simply
s free-ttrade agreemments which iinvolve a red duction in
currrent tariff andd non-tariff import
i controols to liberalise trade in goods
g
and services betw ween countries. The morre sophisticatted regional trade
agreeements incluude regional rules on flow ws of investm
ment, coordin nation of
com
mpetition poliicies, agreem ments on enviironmental ppolicies and free
f
movvement of labbour.
Exaamples of reggional tradee agreementts are as follows:
324
• The Association of Southeast Asian Nations (ASEAN) Free

Trade Area (AFTA).
• The European Union (EU) –a customs union, a single market and
now with a single currency.
• The European Free Trade Area (EFTA).
• The North American Free Trade Agreement (NAFTA) – created
in 1994.
• The South Asian Free Trade Area (SAFTA) created in January
2006 and containing countries such as India and Pakistan.
• Mercosur – a customs union between Brazil, Argentina, Uruguay,
Paraguay and Venezuela.
• The Common Market of Eastern and Southern Africa
(COMESA).
Economic integration between countries
There are various versions of economic integration between countries. A

free trade area is a mild form of integration where countries agree to
remove tariff and non-tariff barriers between them to promote free trade
in goods and services. The North American Free Trade Area (NAFTA),
the European Free Trade Area (EFTA) and ASEAN Free Trade Area
(AFTA) are some of the examples. Table 3 summarises the different
stages of economic integration between countries.
No internal Common Factor and Common

Stage of economic Common
trade external asset economic
integration currency
barriers tariff mobility policy
Free trade area X
Customs union X X
Single market X X X
Monetary union X X X X
Economic union X X X X X
Table 5.5 Stages of economic integration between countries
Understanding World Trade Organization (WTO)
World Trade Organization (WTO) is the international organisation whose

primary role is to encourage trade for the benefit of member countries.
WTO currently has 153 members, of which 117 are developing countries
or separate customs territories. WTO activities are supported by a
Secretariat of some 700 staff, led by the WTO Director-General. The
Secretariat is located in Geneva, Switzerland. WTO is run by its member
countries or governments. All major trade decisions are made by the
membership as a whole, either by ministers (who usually meet at least
325
Module5
oncee every two years)

y or by their ambasssadors or dellegates (who meet
reguularly in Genneva).
The bulk of the WTO’s

W funcctions come from
f the 19886-94 negotiaations
calleed the Uruguuay Round an nd earlier negotiations unnder the Genneral
Agrreement on Tariffs
T and Trrade (GATT). The WTO is currently the host
to new negotiations, under th he ‘Doha Deevelopment A Agenda’ laun nched in
2001. WTO provvides a forum m for membeer countries tto negotiate trade
t
agreeements and to settle trad de disputes. Essentially,
E thhe WTO is a place
wheere member governments
g s try to sort out
o the trade iissues or pro
oblems
theyy face with eaach other. Heence, WTO was w born outt of negotiatiions, and
everrything the WTO
W does is the result off negotiations. For examp ple, when
counntries have faced
fa trade baarriers and wanted
w them lowered, thee
negootiations havve helped to openo markets for internattional trade. Once the
mem mber countriees negotiated d and signed the WTO aggreements, th he
agreeements provvide the legall ground rulees for internaational trade and
bindding governm ments to keep p their trade policies withhin agreed lim
mits.
Besiides, WTO alsoa providess a legal and institutional framework for the
implementation and monitorring of these trade agreem ments, as welll as for
settlling disputess arising fromm their interppretation and application. The
currrent body of trade
t agreemments compriising the WT TO comprised d of 16
diffe
ferent multilaateral agreem ments (to which all WTO members aree parties)
and two differennt plurilaterall agreementss (to which oonly some WTO
mem mbers are parrties).
Deccisions made in the WTO O are commonnly taken by consensus of o the

hest institutioonal body is the Ministerial
entirre membershhip. The high
Connference, whiich meets about every tw wo years. Morre specificallly, the
WTO's main acttivities are:
• negotiatting the reducction or elimmination of obbstacles to trrade
(import tariffs, otherr barriers to trade)
t and aggreeing on ruules
governinng the condu uct of internaational trade (for examplee,
antidum
mping, subsid dies or producct standards.)
• administering and monitoring
m the applicationn of the WTO O’s
agreed rules
r for trad
de in goods, trade
t in serviices and trade-related
intellecttual propertyy rights
• monitorring and revieewing the traade policies oof our membbers, as
well as ensuring
e tran
nsparency off regional andd bilateral traade
agreemeents
• settling disputes amo
ong our mem
mbers regardiing the interp
pretation
and application of th
he agreementts
• buildingg capacity off developing country goveernment officials in
internatiional trade matters
m
• assistingg the processs of accessionn of some 300 countries who
w are
not yet members
m of the
t organisattion
• conductting economiic research annd collectingg and dissemminating
trade daata in supportt of the WTO
O’s other maiin activities
326
• explaining to and educating the public about the WTO, its

mission and its activities.
The founding and guiding principles of WTO remain the pursuit of open
borders, the guarantee of most-favoured-nation principle and non-
discriminatory treatment by and among countries members, and a
commitment to transparency in the implemention of its activities. The
opening of national markets to international trade, with justifiable
exceptions or with adequate flexibilities, will encourage and contribute to
sustainable development, increase people’s welfare, reduce poverty, and
foster peace and stability. At the same time, such market opening must be
accompanied by sound domestic and international policies that contribute
to economic development according to each member's needs and
aspirations.
327
Module5
Modu
ule sum
mmary
In thhis moduleyoou learned:
Wheen currency is i not alloweed to vary (fixxed exchangge rates), theccentral
bankk must intervvene in the fo
oreign exchaange market tto preventthee
exchhange rate froom changing g. This is donne by the cenntral bank’sd
drawing
Summary on itts supply of foreign
f exch
hange reservees.A central bbank can inteervene in
the foreign
f exchange markett to smoothennfluctuationss in its nation nal
currrency. When this is done, the centralbbank is said to be involveed in
mannaging its currrency (manaaged float).
Net exports (the trade balancce) are equal to the goverrnment sectorrbalance
pluss the private sector
s balancce.In a worldd of freely flooating exchaange
ratess, problems relating
r to baalanceof payments are unnlikely to surrface.
Impending deficcits or surpluses,if not maatched by offfsetting capittal flows,
will bring about exchangeratte fluctuationns which willl neutralise the
threaatened imballance.
Exchhange rate flluctuations may,
m howeverr, raise difficculties for
theaauthorities noo less acute th
han the balannce of paymeents
diffiicultiesexperrienced by coountries withh a fixed exchhange rate reegime.
Facttors that shift
ft the demand d and supply curves for a particularcu urrency
and the equilibriium point aree inflation differences,intterest rates
diffeerences, incoome growth differences
d a exchangeerates expecttations.
and
Defiicit countriess can ease theeir balance of
o payments bby curbing
netggovernment spending
s or encouraging
e saving. Surpplus countries
cansstimulate impport demand and reduce the t surplus thhrough
expaansionarybuddget policies. These are referred
r to ass expendituree-
channging policiees.Expenditure-switchingg policies refe fer to price in
ncentives
designed toinducce a switch in n spending between
b tradeed and non-ttraded
gooddsand services. Two such h policies aree: commerciaal policy and d
exchhangerate changes.
The theory of coomparative ad dvantage proovides the rattionale for frree
tradee.Ricardo shhowed that bo oth trading partners
p couldd benefit
from
mspecialisatioon in the goo od in which they
t have thee
commparativeadvaantage.Comp parative advaantage hinges on the notiion of
oppoortunity costt.The Hecksccher-Ohlin thheorem buildds on the theo ory of
commparativeadvaantage by foccusing on thee different faactor endowm ments
ofcoountries.Tarifffs, quotas an
nd export subbsidies are examples of trade
t
barrriers.
328
Assignment
1. What is the exchange rate and how is it determined?
2. What are the influences of interest rates and the expected future
exchange rate on the demand for, and supply of dollars as well as the
actual exchange rate in the foreign exchange market?
3. How do purchasing power parity and interest rate parity affect
Assignment exchange rate expectations?
4. How can the Bank of Canada influence the foreign exchange market?
5. What is the current account and what is the capital account? What is
the relationship between these two accounts?
6. How is a current account deficit financed?
7. What is real exchange rate? How is it calculated?
8. What causes a real appreciation of a currency?
9. What are the long-run determinants of the exchange rates?
10. What is the purchasing power parity rate of exchange?
11. What is a “managed floating rates of exchange” system?
12. How does the central bank maintain a fixed exchange rate?
13. What is a devaluation? What is a revaluation? How are they different
from a depreciation and appreciation?
14. How does monetary policy influence the exchange rate, aggregate
demand and output?
15. What are expenditure changing and exchange rate switching policies?
16. What is comparative advantage?
17. Why does trade benefit all trading parties?
18. What are terms of trade and how are they related to the concept of
real exchange rates?
19. Name the trade barriers that are commonly used in your country.
20. List the advantages and disadvantages of trade protection.
329
Module5
Asseessment
1. In what wayys do importss affect your life? (Think of imported
d goods or
services thatt you have ussed recently.)
2. Which of thee following goods
g and seervices are traadable, and which
w are
not? In eachh case, explaiin your answ
wer briefly.
A
Assessment
A. Carss
B. Com
mputers
C. Hairrcuts
D. Resttaurant meals
3. Does your country’s

c currrent accountt show a deficit or a surpllus? How
about your country’s
c cappital accountt? What is thee situation like from
the perspecttive of the inddividual com
mponents of tthe current acccount?
Can you expplain your fin ndings?
4. For each trannsaction belo
ow, identify where it apppears on yourr
nt and whethher it is classiified as a receipt or a
country’s cuurrent accoun
payment:
A. A doomestic fabrric dealer buyys fabrics froom abroad.
B. A fooreign bank is
i paid intereest by your ggovernment.
C. A doomestic resid
dent spends her
h holidays abroad.
D. Youu send funds to relatives living
l abroadd.
5. For each trannsaction belo
ow, identify where it apppears in your
country’s caapital accoun
nt and whetheer it is classiffied as a receeipt or a
payment:
A. A fooreign compaany opens a chain of storres in your co
ountry.
B. Youur neighbour buys 1,000 Microsoft
M shhares on the New
N
Yorrk Stock Exch
hange.
C. An American
A pu
urchases a boond issued byy your goverrnment.
D. A fooreign giant media
m company takes ovver your natio
onal
new
wspaper.
E. Youu open an acccount in a Euuro-bank in U
U.S. dollars.
6. Consider thee following hypothetical
h economy.
330
Balance of Payments Accounts (in $millions)

Receipts Payments Balance
Current Account
Merchandise trade 183.4 323.6 _______
Trade in services 187.9 _______ + 90
Investment income 192.3 157.9 _______
Transfers _______ 24.5 + 32
Capital Account
Portfolio investment _______ 65.9 − 20
Direct investment 32.7 45.8 _______
Other capital flows _______ 15.2 + 22
A. Fill in the blanks.

B. Calculate the current account balance.
C. Calculate the capital account balance.
D. Does the balance of payments balance?
7. In Yorktonia, the foreign currency’s demand and supply schedules
are given as follows:
Quantity of US
Price of US dollars Quantity of US
Dollars Supplied
(in Yorktonia’s Dollars Demanded ($
($ billions per
currency) billions per year)
year)
0.1.70 75 35
0.1.65 65 45
0.1.60 55 55
0.1.55 45 65
0.1.50 35 75
A. Sketch the demand and supply of the US dollar curves based

on the information provided above.
B. If the exchange rates were flexible, what would the market
value of the U.S. dollar be in terms of our local currency?
C. If instead the government set a target exchange rate of
US$1.65, will there be an exceed demand or excess supply of
the U.S. dollar in terms of the local currency?
D. Does Yorktonia face a balance of payments surplus or deficit
at this target exchange rate?
331
Module5
E. Calcculate the “ch

hanges in offficial reservees” that woulld appear
in Yorktonia’s
Y balance
b of paayments accoounts.
8. For each of the following cases, draw w a demand aand supply graph
g to
show the efffect on the prrice of the U.S.
U dollar in terms of dommestic
currency:
A. A coontractionaryy monetary policy
p initiateed by the dom
mestic
centtral bank in which
w it raisees the domesstic interest rate.
r
B. Dommestic real ou
utput rises att a time whenn the real outtput in
the U.S.
U is fallinng.
C. Americans find your countryy a more attractive place to make
finaancial investm
ments.
9. Assuming thhat the only goods
g in the world are Home country
y’s textile
w and also assuming that
and French wine t in the hoome country,, the
price of a metre
m of cloth is H$5 (5 Home dollar). Determine the
t real
exchange raate (the price of foreign goods in term
ms of domestiic goods)
between Home and Fran nce when:
A. A French franc is
i worth H$00.20, and the price of a bo
ottle of
wine in France is
i 25 francs.
B. A French franc is
i worth $0.220, and the pprice of a botttle of
wine in France is
i 30 francs.
C. A French franc is
i worth H$00.25, and the price of a bo
ottle of
wine in France is
i 30 francs.
10. Home, whosse currency is
i H$, conduucted the folloowing transaactions in
year 2002:
Item
m ((Billions of H$)
H
Imports of goods and services 350
Exports of goods and services 500
Borrowingg from the resst of the worlld 60
Lending too the rest of th

he world 200
Increase inn official hold

dings of foreeign 10
currency
A. Calcculate the thrree balance of

o payments accounts ballances
(thee trade accounnt balance, current
c accouunt balance and
a
capiital account balance)
b for Home.
B. Based on this information, does
d Home’s central bank
k
interrvene in the foreign exchhange markett?
C. Doees this countrry face a defiicit or a surplus in its balance of
paymments? Why y?
332
11. Suppose that it takes five French francs to buy one Canadian
dollar, the price level in France is 1.2, and the price level in
Canada is 1.5.
A. What is the real exchange rate between Canada and France
(the price of French goods in terms of Canadian goods)?
[Hint: First, calculate the nominal exchange rate as the price
of a franc in dollars.]
B. What would happen to the real exchange rate if the dollar
rose to eight French francs?
C. Comparing your answers in parts (a) and (b), is this a real
appreciation or a real depreciation of the dollar? What is the
percentage?
12. Suppose that the interest rate in Home country (H) is 5 per cent,
the interest rate in Foreign country (F) is 1 per cent, the current
nominal exchange rate, H$ (Home dollar) price of a F$ (Foreign
dollar) is 0.01 and the expected nominal exchange rate next year
is 0.011.
A. How many H$ would a resident of Home country expect to
earn for each Home dollar invested in Foreign bonds for one
year?
B. Ignoring risk and transaction costs, should a Home resident
prefer to invest in Home or Foreign bonds?
C. What is the expected rate of appreciation or depreciation of
the Home dollar?
13. Under what circumstances could a country simultaneously have a
balance of trade surplus and a current account deficit?
14. How would you explain the rapid growth in capital account
transactions relative to merchandise trade transactions in recent
years?
15. What, if anything, does the fact that a country has a current
account surplus tell us about the strength of that economy?
16. How would you define balance of payments disequilibrium?
Discuss some of the economic forces that tend to automatically
restore the balance of payments to equilibrium.
17. What are some arguments that could be made for and against the
use of strategic trade policy?
18. Which of the following is correct? Tariffs and quotas are
economically inefficient because
A. The government does not collect any revenues under a tariff.
B. Imports rise, and this reduces the welfare of consumers.
C. Producers are saved from the pressure of foreign competition.
D. Domestic prices must be reduced.
333
Module5
334
Refer to the following table to answer three questions. The table

shows the possible levels from one day of labour input.
Wheat (cubic metres) Cloth (metres)

Home 12 6
Foreign 1 12
19. Home—
A. has absolute advantage in the production of cloth.
B. has an absolute advantage in the production of wheat.
C. has a comparative advantage in the production of cloth.
D. should export cloth to Foreign.
20. The opportunity cost of one cubic metre of wheat in Foreign is
A. 1/2 metre of cloth.
B. 2 metres of cloth.
C. 6 metres of cloth.
D. 12 metres of cloth.
21. Which of the following statements is wrong?
A. Foreign has an absolute advantage in wheat.
B. Home should export wheat to Foreign and import cloth form
Foreign.
C. The opportunity cost of wheat is twice as high in foreign as in
Home.
D. The opportunity cost of a metre of cloth in Home is one cubic
metre of wheat.
335
Module5
1. Imports aree important in
n that they arre consumer items that arre
produced ellsewhere. Consumption per capita iss the best measure of
well-being and the standdard of living of a nationn. Also, impo orts offer
not only prooduct variety
y for differennt tastes but aalso, at timess, better
quality thann those produ
uced domestiically.
2. Answers arre:
A. Traddeable.
B. Traddeable. Bothh A and B arre the same inn this respectt,
becaause transacttion costs andd barriers to trade are nott
insuurmountable.
C. C annd D are imp possible to trade since traansaction cossts of
travvelling to a diifferent counntry to get a hhaircut or din
ne, as
welll as transactiion costs of importing thee service of thet
hairrcutter and th
he restaurant meal, are prrohibitive.
3. The answerr is a function
n of your couuntry of choiice.
4. Answers arre:
A. Impport of fabrics is an imporrt of goods (ggoods or
merrchandise acccount) and iss a source of payment.
B. Thee payment off interest by the
t governmeent is a curreent-
accoount transacttion under the net flow off investment income
and is classified as a paymennt.
C. Travvelling abroaad is a servicce account traansaction and
da
paymment.
D. Sending funds to o relatives abbroad is a traansfer item an
nd
classified as a paayment.
5. Answers arre:
A. A fooreign compaany opening a chain of sttores in yourr country
is a foreign direcct investmennt and classifi
fied as a receipt, from
yourr perspectivee.
B. Thee purchase off 1,000 shares of Microsooft is a portfo
olio
trannsaction and a payment.
C. An American
A pu
urchasing your governmeent securitiess is a
porttfolio investm
ment and a reeceipt.
D. A fooreign takeov
ver of your newspaper
n is a foreign dirrect
inveestment and a receipt.
E. Opeening an acco
ount in a Eurro bank is a pportfolio inveestment
and a payment, from
f your peerspective.
6. Answers arre:
A. Currrent Account
336
Merchandise trade Balance (−$140.2) million

Trade in services Payments ($97.9) million
Investment income Balance ($34.4) million
Transfers Receipts ($56.5) million
Capital Account
Portfolio investment Receipts ($45.9) million
Direct investment Balance (−$13.1) million
Other capital flows Receipts ($37.2) million
B. Current Account Balance: + 16.2 million.
C. Capital Account Balance: −$11.1 million.
D. No. The gap, $5.1 billion, must be due to the changes in
official reserves transactions (not shown), assuming that there
are no errors or statistical discrepancies.
7. Answers are:
A.
B. E = $1.60
C. At 1.65 there will be an excess supply of US$, AB.
D. Yorktonia faces a surplus, at this rate of exchange, of $20
billion.
E. At 1.65 rate of exchange, the excess supply of $20 billion
will appear as (−20 billion) in the official reserves account.
8. Answers are:
A. As interest rates rise, capital flows into the domestic
economy from abroad, indicating an increase in supply of
foreign currency. This causes a decrease in the exchange rate
(an appreciation of domestic currency).
337
Module5
B. Thee increase in domestic

d outtput increasees demand fo or goods
and services by domestic ressidents, incluuding demand d for
imported goods and servicess (imports risse). This cau uses
dem
mand for foreeign currencyy to increase (a shift to th he right).
Thee decrease in foreign (Am merican) outpput decreasess foreign
dem
mand for our currency as Americans
A reduce their purchase
p
of our
o goods and d services (thhe supply currve shifts to the left).
Thee combination n of the two pushes E higgher (depreciiation of
homme currency)..
C. Foreeign (Americcan) capital flowing

f into your econom my
incrreases deman nd for your cuurrency, whiich is the sam
me as an
incrrease in the supply of the US dollar inn foreign excchange
marrkets. The ex xchange rate falls. This iss the same ass part (a).
E .P *
9. Real exchannge rate = where P and P* aree Home and French
F
P
prices respeectively, and
d E, as beforee, is the domeestic price off one unit
of foreign currency.
c
E.P * 0.2 x 25
A. Reaal exchange rate
r = = =1
P 5
.2 x30 6
B. Reaal exchange rate
r = = = 1 .2
5 5
.25 x30 7.5
C. Reaal exchange rate
r = = = 1 .5
5 5
10. Answers arre:
338
A. The Trade Account Balance = (500 −350) = + $150 billion

(surplus).
The Current Account Balance = Trade account balance + net
inflow of net investment income = $150 + 0 = $150 billion
surplus (there is no information on the latter here).
The Capital Account Balance = capital inflow (receipts) −
capital outflow (payments) = ($60) − ($200) = −$140 billion
(deficit). The Current Account Balance, including the
changes in holdings of reserves, = (60) − (210) = $−150
billion.
B. Yes. The increase in official holdings of foreign currency
(+10) indicates the central bank’s intervention.
C. Excluding the official holdings of foreign reserves, the
balance of payments is net of the surplus in the Current
Account ($150) and the deficit in the Capital Account
($−140) = $10. That is, it shows a an overall surplus.
11. Answers are:
A.
Pr ice of French goods ⎛ 1.2 ⎞ .24
= ⎜ ⎟ x no min al exchange rate (0.2) = = .16
Pr ice of Canadian goods ⎝ 1.5 ⎠ 1.5
B.
1 .2 1
1 .5
x( )
8
= .1
C. Canadian dollar has appreciated in real terms. This is so

because at given prices, the nominal exchange rate
appreciated (from $1 per ff 5 to $1 to 8 ff).
12. Answers are:
A. Home rate of return = 5%, Foreign rate of return = foreign
interest rate +
⎛ E e−E ⎞ .011− .01

⎜⎜ ⎟⎟ = .01+ = .11=11%. For every H dollar
⎝ E ⎠ .01
invested in foreign bonds you should expect 11% return
=11¢.
B. Foreign return, 11%, is greater than Home return, 5%,
therefore, Foreign bonds should be preferred.
⎛ E e −E ⎞
C. ⎜⎜ ⎟⎟ = 10% .
⎝ E ⎠
13. CA balance = Trade balance + net inflow of investment income.
Therefore, CA balance can be negative (deficit) despite a trade
surplus if the second term on the right-hand side shows a deficit
339
Module5
bigger thann the trade account surpluus.

14. The onslaugght of compu uterization teends to enhannce the freerr capital
movementss that have acccelerated soo rapidly in thhe last decad de. A big
part of the world
w now benefits
b from
m unrestrictedd capital floww far
greater thann the flow off trade in gooods and serviices. Investmment
opportunities are enormmous compareed to newly explored trad de
opportunities.
15. A current account
a surpllus is a sign of
o a clean billl of health. The
T
country shoowing a surplus need not borrow exteernally. All
internationaal payments are covered and there rem mains money y to lend
out.
16. When the sum of the cu urrent and cappital accountt surplus is different
d
from zero, payments
p do
o not match receipts
r and tthere is a neeed for the
central authhority to step
p in to bridgee the gap, a trransaction in
n the
foreign excchange markeet known as changes in oofficial reserv ves. This
happens, hoowever, when the exchannge rates are fixed or wheen the
central bankk aims to maanage its currrency. Undeer flexible rattes, the
movement of the exchange rates in response
r to tthe gap betw
ween
receipts andd payments (excess
( demaand/excess suupply of currrencies)
tend to elim
minate this gaap, restoring equilibrium in balance of o
payments.
mes difficultt to justify sttrategic tradee policies, sin
17. It is sometim nce they
assume prioor government knowledgge as to whichh industries and
firms show potential. Also,
A such poolicies are invvitation for
retaliation by
b the trade partners.
p Thiis is controveersial.
18. Discuss youur answer wiith your tutorr.
19. A. Home haas an absolutte advantagee in wheat.
20. D. (12 metrres of cloth).
21. A.
340
References and suggested course

readings
341
Module5
Balddassari, M.,, Mundell, R.

R & McCalllum, J. (1993). Debt, Deficits
D
and Ecoonomic Perfrformance. London:
L MccMillan.
Bannk Negara Malaysia.
M (2
2007). Montthly Statisticcal Bulletin
References
R Septembber 2007: Balance
B of Payment
P Neew Format.
Retrieved from
http://w
www.bnm.go ov.my/files//publicationn/msb/2006//7/pdf/v
iii_02.ppdf.
Bannk of Canadda. (2003). Bank
B of Cannada’s Semiiannual Rep
port.
Retrieved from httpp://www.baankofcanadaa.ca/en/presss/.
Barrrow, R. J. (1989). Ricaardian approoach to budgget deficits..
Journall of Econom mic Perspecttives, 3(2): 37-54.
Boaadway, R. & Stiglitz, J. (2001). Prrinciples of M
Macroeconomics.
New Yoork: W.W. Norton
N & Co.
C
Brannder, J. A. (1995).
( Govvernment Poolicy Towarrd Busines (3rd
(
Ed.) Etoobicoke: Wiley
W Canadaa.
Case, K. E., Faair, R. C., Sttrain, J. F. & Veall, M. R. (2002 )..
Principples of Micro oeconomicss (2nd Canaadian Ed.). DonD
Mills: Pearson
P Edu ucation Cannada.
Cheee, Y. H. (20006). Malayysians proteest against ffree trade ta
alks
with USS. Retrieved
d from FTA Malaysia
http://w
www.ftamalaaysia.org/arrticle.php?aaid=66.
Dorrnbusch, R.,, Fischer, S.., Startz, R.,, Atkins, F. & Sparks, G.
G
(2005). Macroecon nomics, (7thh Canadian Ed.). Toron nto:
McGraw w-Hill Ryerrson.
Euroopean Centtral Bank. (2
2003). The European
E C
Central Bank
Quarterrly Report. Retrieved
R fr
from http://w
www.ecb.in
nt/.
Euroopean Unioon. (n.d.). Organizationn for Econommic Cooperation
and Devvelopment (OECD).
( Reetrieved froom
http://w
www.oecd.org/.
Galbbraith, J. K.. (1950). Th
he Affluent Society.
S
Harmonndsworth:.P Penguin Boooks.
Gennting Groupp. (2007). Th
he Genting Story.
S
http://w
www.gentingg.com/histoory/index.htm
m
Hym
mans, S. H. (1970). Consumer durrable spendiing: Explanation
and prediction. Broookings Pappers on Ecoonomic Activvity, 2.
Inteernational Monetary
M Fu
und (IMF). (n.d.).
( Interrnational Fiinancial
Statisticcs. Retrieveed from
http://w
www.imf.org g/external/ppublicationss/index.htm..
Inteernational Monetary
M Fuund (IMF). (n.d.).
( Worlld Economicc
Outlookk Reports. Retrieved
R froom
http://w
www.imf.orgg/external/nns/cs.aspx?idd=29.
342
Keynes, J. M. (1936). General Theory of Employment, Interest and

Money, New York: Harcourt, Brace & Co.
Loveard, K. (2005). Malaysia: Turning the corner. Retrieved from
Global Finance, http://www.gfmag.com/archives/62-62-
july-2005/1551-features-malaysia-turning-the-
corner.html#axzz2IdLMt8ok.
Lovewell, M. (2007). Understanding Economics: A Contemporary
Perspective (4th Ed.). Toronto: McGraw- Hill Ryerson.
Mankiw, G., Kneebone, R., McKenzie, K. & Rowe, N. (2002).
Principles of Microeconomics (2nd Canadian Ed.). Ontario:
Thomson Nelson.
MTUC. (2002). MTUC campaign for a minimum wage of RM 900.
Retrieved from
http://www.mtuc.org.my/MINIMUMWAGE900.htm.
Netto, A. (2000). Minimum wage row splits workers, govt.
Retrieved from Indian-Malaysian Online,
http://www.indianmalaysian.com/minimum_wage.htm
Parkin, M. & Bade, R. (2001). Modern Macroeconomics (5th Ed.).
Pearson Education.
Sloman, J. and Sutcliffe, M. (2007). Economics for Business (4th
Ed.). London: Prentice Hall Europe.
Stiglitz, J. E. & Boadway, R. W. (1997). Principles of Micro-
Economics and the Canadian Economy(2nd Ed.). New York:
W.W. Norton & Co.
The Economist, London, England.
Wikipedia. (2007). List of minimum wages by country. Retreived
from
http://en.wikipedia.org/wiki/List_of_minimum_wages_by_c
ountry.
Wong, S. W. (2007). AirAsia to start flights to Chinese city from
July 15. Retrieved from The Star Online,
http://thestar.com.my/news/story.asp?file=/2007/5/28/nation
/17833247&sec=nation
Wood, J. (2003). Is Big Beautiful? Retrieved from CFO Asia,
http://www.cfoasia.com/archives/200309-01.htm.
World Bank. (2003). World Development Report. Retrieved from
http://www.worldbank.org/.
Young, P. K. Y. & McAuley, J. J. (1994). The Portable MBA in
Economics. Hoboken: Wiley.
343
Module5
344

C5 EcoEnviron

Uploaded by

Copyright:

Available Formats

You might also like

C5 EcoEnviron

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

C5 EcoEnviron

Uploaded by

Copyright:

Available Formats

COURSE MANUAL

C5 Economic Environment of Business

Open University of Mauritius

Open University of MauritiusMAURITIUS

Course designer Catherine Kerr, BEd

Course reviewer and revision Professor Choong Chee Keong

Instructional designer Pooja A. Nadkarni

Revision coordinator Prakash V. Arumugam, MA

Course editor Symbiont Ltd.

Getting around this course manual 5

Activity 1.1 ..................................................................................................................... 17

Consumer Surplus, Producer Surplus and Market Efficiency............................... 41

Diminishing marginal returns.............................................................................. 101

Activity 2.2 ................................................................................................................... 154

Net exports .......................................................................................................... 194

Financial systems ................................................................................................ 230

The official unemployment rate ................................................................. 265

Demand for foreign currency (exchange) .................................................. 293

Module summary .......................................................................................................... 328

About thiscourse manual

How this course manual is

The overview also provides guidance on:

We strongly recommend that you read the overview carefully before

The course content

• summarisebenefits of studying economic issues and describe

derations willl be time andd space– the time

Getting around this course manual

A complete icon set is shown below. We suggest that you familiarise

Activity Assessment Assignment Case study

Discussion Group Question Help Note it!

Outcomes Reading Reflection Study skills

Summary Terminology Time Tip

In thhis module, you

Theen we will revview commaand, laissez-ffaire and marrket econom mic

Upoon completioon of this module you willl be able to:

• discuss thhe efficiency of free markket competitiion.

Economics: The study of how individuals and societies choose

Income elasticity of The percentage of change in the quantity

Law of demand: The law of demand states that there is a negative

Law of supply: Relationship between the price of the product and

Marginal analysis: Marginal analysis refers to the benefit from a one-

Introduction to the Economic

Theere are four main

In thhe process off studying ecconomics, yoou will be aw ware of the

Econnomics is thee study of ho

Choosing more of one thing means having less of something else. In

The economic way of thinking

becausee a student is not able to do d these diffeerent things at

• “At the marggin” means making

Consider the following:

Economic environment of business

Macroeconomics is concerned with the economy as a whole. Thus it is

Miccroeconomiccs is concern ned with the individual

Whiich one of thhe following is

Havving acquiredd the knowledge of these external factors, how do o firms

Firms will be directly affected by the actions of government, since the

Economic factors constitute a wide range of factors from rising costs of

Thrree dominaant macroeconomic principless