ECONOMICS

Economics
John Hearn
ISBN 978-1-84516-970-1
9 781845 169701
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© ifs School of Finance 2012
ISBN 978-1-84516-970-1
Author information
John Hearn is an academic economist and member of the senior faculty of the ifs
School of Finance. He has taught at undergraduate and postgraduate level. He has
written many books on all aspects of economics, runs workshops that introduce
economics to bankers.
Contents
1 Economics and the economic problem 1

2 Markets and the theory of price 11
3 The theories of the firm 61
4 Market imperfections and market failure 87
5 Understanding and using national income statistics 107
6 The theory of the circular flow of income 121
7 Problems of imbalance and instability in the economy 137
8 Money, banking, monetary policy, financial
stability and the Bank of England 159
9 Government spending, taxation, borrowing and
fiscal policy 179
10 International trade 199
Index 225
© ifs School of Finance 2012 v

vi © ifs School of Finance 2012
Topic 1
Economics and the economic
problem
‘It is an economic axiom as old as the hills that goods and services can be
paid for only with goods and services.’
Nock (1943)
In this topic we will cover the following:

u the economic problem without which there would be no subject to study;
u the mix of mechanisms used to allocate resources throughout the world

today and in the past;
u the importance of the market mechanism in relation to both the type of
product and the political system under which it operates;
u the functions that markets carry out in a capitalist system; and
u the degree to which governments become involved in mixed economies.
1.1 Introduction
Economics studies the way in which resources that are scarce are allocated to the
production and exchange of goods and services for the consumer. One of the most
quoted definitions of the subject is by Lionel Robbins (1932, p15), who wrote in
his ‘Essay on the Nature and Significance of Economic Science’ that
‘Economics is the science which studies human behaviour as a relationship
between ends and scarce means which have alternative use’.
1.2 The economic problem
1.2.1 Not to be confused with economic problems

It is important not to confuse economic problems such as unemployment and
inflation with the economic problem. The economic problem is basic to all human
societies and problems such as inflation and unemployment are just symptoms of
a deeper underlying problem. Simply stated, the economic problem is that there
is not enough to go around. If there was enough to fully satisfy everyone’s needs
© ifs School of Finance 2012 1

1: Economics and the economic problem
and wants, then it would not be necessary to have an allocative mechanism and
the subject of economics would not exist.
1.2.2 Scarcity
In economics the term scarcity takes on a more precise meaning than that in
common usage. When, in a free market, a price would be paid for a resource or
product then scarcity is said to exist. The economist identifies scarcity when there
is not enough to satisfy everyone’s demand, ie supply is scarce relative to potential
demand.
When a product is produced and consumed freely in a market economy then it

is assumed that scarcity does not exist. For example, a person may swim in the
sea or sunbathe at zero price. These benefits are freely available partly because
the products available are not scarce and in some cases because ownership rights
have not been established, or, if established, have not been exercised. Another
example would be breathable air, which is free above water, but scarce and
therefore commands a price under water. Most products from which consumers
derive satisfaction are relatively scarce and therefore command a price in a market
economy.
1.2.3 Choice
Given a limited ability to obtain resources both consumers and producers must
choose between various alternative products. In order to build simple theoretical
models, it is assumed that people make rational decisions. It would be very
difficult to build economic models on the assumption that people make irrational
decisions unless they are Predictably Irrational, which is the title of an
interesting book by Dan Ariely (2008) and a basis for more advanced studies in
economics. In the case of the rational consumer, a decision will be made to buy
the product that gives the most satisfaction per unit of money spent. In reality,
consumers may be affected by impulse, lack of information and wrong information
so the most we can say is that most people will make rational decisions most of
the time.
In a command economy, a central authority takes responsibility for directing
resources and, in theory, will aim to maximise welfare in the society it controls. In
reality this task is made difficult by the sheer size of the undertaking, which tries
to match the sum of individual demands, and to direct resources to that supply
when they have only incomplete information.
1.3 Free goods and economic goods

We have noted that most resources are relatively scarce, with some resources
being more scarce and others being less scarce. Also we have noted that some
resources, although limited in supply, are in sufficient quantity not to need an
allocative mechanism. These are then referred to as free goods. As all production
requires the use of resources that have alternative uses, the free good is usually a
free gift of nature that has no cost of production and that is in sufficient supply to
satisfy all demand at no price to the consumer and at no cost to the producer. In
consequence, many natural resources do not qualify as their supply is not adequate
2 © ifs School of Finance 2012

Different political systems for allocating resources
to satisfy demand without an allocative mechanism. Hence, solar heat and salt
water are free goods, but gold and silver are not.
All other products produced and consumed are by definition economic goods and,
in a free market, demand exceeds supply for economic goods at zero price and
therefore they need an allocative mechanism to ration resources; in other words,
to decide who gets what and for how much.
1.4 Resource allocation

The allocative mechanism for rationing out scarce resources varies from one type
of economy to another.
In a free market products are distributed through a price mechanism. For example,
given the demand and supply of a product per time period a market clearing
price will prevail. If demand for the product rises then, in pursuit of self-interest,
suppliers will raise price and increase output to raise their profits. The higher price
will force some consumers out of the market until the price settles at a level where
the quantity demanded equals the quantity supplied.
In a command economy, the central authority faced with limited resources will have
to choose between allocating resources to one or other product. It is a dangerous
misapprehension to think that in command economies, or indeed in any economy, a
government can produce anything or everything without having to make choices. It
is worth restating that the economic problem applies equally to all types of political
economy.
1.5 Different political systems for allocating

resources
1.5.1 A capitalist free market

At this extreme there is a minimalist government whose responsibility is to create a
framework of rules that will protect freedom of contract and private property rights
while promoting flourishing markets that prevent the development of powerful
groups like monopolistic suppliers and monopsonistic buyers. This type of
economy is often referred to as ‘laissez-faire’, which is loosely translated as leaving
the economy alone from government interference. Producers are free to buy, own
and hire non-human factors of production, but, since the abolition of slavery, they
can only hire and fire labour. If firms have a relatively small share of the market
producers will be price takers and have less influence in the marketplace than
consumers.
Consumer sovereignty will determine what is produced, who produces it
and how it is produced. If the producer is not responsive to changing consumer
demand, then the firm will go out of business.
The interaction of producers and consumers will result in an efficient allocation
of resources as prices ration out scarce resources. Adam Smith’s invisible hand of
competition will harness the self-interest of the individual so that society benefits
from the pursuit of profit. The producers can only become better off by satisfying
the demands of consumers.

1.5.2 A command economy

At the other extreme a command economy tries to alleviate the economic problem
by total planning. This is usually based upon a centralised or a collectivist structure.
The state, which is all the people, owns the means of production as well as the
other significant trappings of wealth such as housing. Incomes are received for
work, but not for ownership.
Production will be under the direction of a central authority. Quotas will be

established for productive units and these may be based upon previous targets and
anticipated changes in demand. The profit motive and self-interest are eliminated
from the productive process.
Consumption is likely to be controlled by workers receiving vouchers that can be
used for access to part of planned output, incomes may be established based upon
people’s perceived needs and there may also be some limited choice.
One of the main aims of a command economy is to achieve an equitable distribution
of scarce resources. For this reason, it will not be possible for free markets to exist.
However, if the consumer is to be given some freedom of choice, then prices may
be fixed at an agreeable level and shortages and surpluses can be used to
signal planned expansions and contractions in output. The problem of temporary
shortages can be dealt with by rationing to ease the unfairness that could result.
1.5.3 A mixed economy

In reality a laissez-faire economy fails to live up to the ideals of market perfection
as powerful groups can distort an efficient allocation of resources. In a command
economy a similar problem exists, but this time it is a failure in the command
mechanism. This has led many countries to adopt a mixture of free markets and
state intervention.
If everything was ideal, then the government side of a mixed economy
would remove the less acceptable features of a laissez-faire free market:
u the instability of trade cycles that take the economy through recoveries into
booms and then through recessions into depressions;
u being caught in a stagflation where the economy is not growing and inflation
is endemic;
u the development of markets where producer sovereignty replaces consumer

sovereignty and industries are dominated by a few large firms who can make
excessive profits;
u the significant inequalities of income and wealth that have always characterised
capitalist economies; and
u the external costs and benefits in both the production and consumption of
goods and services that lead to an inefficient allocation of resources as products
that have substantial external benefits are under-consumed in a free market,
while those that have significant external costs are over-consumed.

The free market side of a mixed economy would also remove the less acceptable
features of a command economy:
u the lack of incentive in pursuit of collectivist ideals that limits rewards and
restricts competition at the level of the individual and the firm;
u other characteristics that do not allow the price mechanism and profit motive
to distribute and redistribute resources in the most efficient way at little or no
cost to the economy, as would happen in a free market;
u allowing shortages to develop as prices are not used to ration resources. Often
the rationing mechanism means waiting in a queue and wasting time in what is
essentially a counter productive activity; and
u that one of the main reasons for establishing a command economy was to
remove the inequalities of income and wealth. The resulting situation is often
referred to as the paradox of equality. Having removed private property rights,
then people can be said to equally own the wealth of the country. However, in
reality, the wealth of the country is often restricted to a powerful, political elite.
Also there is a difference between having an income that entitles you to buy
goods in well-stocked shops and an income that can only be used when you
come to the front of a very long queue.
1.5.4 Rationalising economic intervention
1.5.4.1 Introduction
Philosophers of political economy often argue a case for the mixed economy
based upon the observed weaknesses identified above at the extremes of political
organisation. In addition to this there is a strong argument for intervention based
upon the observation that there are various types of economic good, some of which
have characteristics that would allow them to be allocated through a marketplace,
while there are other goods that are as important but that do not have the
characteristics that would allow a marketplace to function effectively. At one
extreme there is the economic good that is referred to as a public good while
at the other extreme there is a private good. Between these two extremes are
goods with different characteristics and different requirements to allocate them
efficiently.
1.5.4.2 Types of economic good

The public good
A pure public good is necessarily collectively consumed. It is non-rival and
non-excludable. A person using it does not deny anyone else its use, while a firm
producing it cannot determine who receives the benefit as it is equally available to
everyone who wants it. Examples of public goods are not common. The oft-quoted
examples are street lighting, water purification, the prevention of contagious
disease, and law and order, including internal and external defence.
As consumers demand public goods but no one is prepared to pay for them as
they cannot use them exclusively, there is a very strong case for a third party
(government) to compulsorily remove money from people (tax) to finance their
purchase. However, it is an interesting point of debate that it may or may not
be efficient for government organisations to produce the public good. In certain

situations it may be better if they just manage the consumption of the product. For
example, much of the production side of the National Health Service is supplied
by the private sector.
The private good

At the other extreme is the pure private good, which, if it is consumed by one
person, cannot be consumed by anyone else and, if it is provided for one person,
cannot be made available to anyone else. Therefore it is completely rival and
excludable. Some examples of private goods would be food, drink, clothing, train
tickets and petrol.
The quasi-public good
A quasi-public good may have the characteristics of being non-rival and
non-excludable in the present, but have the potential to be rival and excludable
in the future. For example, parks and beaches may be free to use for everyone, in
which case they have the characteristics of a public good; at least up to the point
where they become congested or they may be fenced off and a fee charged for
entry. Often it depends upon whether there are private property rights or whether
private property rights have been exercised. A good example of this is the Internet.
Tim Berners-Lee invented the World Wide Web, but never exercised property rights
over his invention, leaving it free for anyone to use.
The club good
This is an interesting product because it has the characteristics of a public good
inside an organised group within the community, but it has the characteristics
of a private good with respect to the rest of the community. Inside a cinema, a
classroom, a lecture hall, the product provided is available to all and one person
cannot exclude another from using it. However, outside the room it is rival and
excludable.
The merit good
The most commonly used examples of merit goods are the health service and
education. In the past, they have been provided freely to consumers as have
public goods, but they should not be confused with each other as merit goods
are private goods that are rival and excludable but that also have an additional
characteristic, which is that their consumption produces external benefits for
society that are greater than the private benefits received by the consumer. For
example, it is argued that there are significant external benefits to society of having
a healthy, well-educated workforce. In the case of education, it is argued that a
child’s ability to benefit from education does not necessarily coincide with their
parents’ willingness and ability to pay for that education. It is usually argued that
information failure brings about resource misallocation as these products would
be under-consumed in a marketplace and therefore something needs to be done
to increase consumption and production of these products over and above what
would take place in a free market.
The demerit good
These products, which include cigarettes, alcohol and gambling, are private goods
that have the opposite characteristics from merit goods in as much as, at a free
market price, they will be over-consumed in terms of efficiency. This is because they
impose external costs on society that are not covered by the price of the product.
Again, there is information failure as people are not aware of the potential damage
they are doing to themselves and to society when they consume these products.

1.5.4.3 A role for government

The fact that we have identified a range of different economic goods provides
a rationale for government intervention. Firstly, it is generally agreed among all
economists that the public good needs to be purchased by a third party and
financed by a compulsory tax as there is no marketplace for these products
and consumers have a free ride. In recognition of this, and in most countries,
governments provide internal and external defence as well as law and order and a
framework of rules and regulations to protect individuals and society from abuse
by powerful groups. They may also consider that it is part of governments’ role to
correct information failure by providing advisory bodies, labelling foodstuffs and
putting warnings on cigarettes and alcoholic beverages.
In addition to the public good there is also the public bad. For example, global
warming and depletion of the ozone layer affects everyone, and no one person can
be excluded from their effects, as one person suffering from the problem does not
reduce the suffering of other people.
Other than what is described above, which mainly finds agreement among
economists, there are other reasons given for intervention about which there is
more disagreement and debate. Economists can make out a theoretical argument
for subsidising merit goods to increase their consumption, but it becomes more
difficult to provide them free to all consumers and maintain an efficient allocation
of resources. Also an indirect tax on demerit goods to reduce their consumption
may benefit society and there is a strong case for transferring tax revenues from
demerit goods to subsidies on merit goods.
Past this point, the debates get more vigorous and polarised. On one side are
those academics who think that the provision of public goods is sufficient while
others argue that the state should, to a greater or lesser degree, control all trade.
The search for an optimum allocation of resources is hindered by the difficulty
in measuring external costs and benefits and the fact that they can be found in
almost every trade. Earlier it was suggested that clothing is a purely private good.
However, people do not wear clothes just to keep warm. They dress to impress,
they may dress to offend or to show support for a particular group or to highlight
their need to be conventional or unconventional. This has led some people to
suggest that these externalities should be removed by requiring people to dress
in a uniform way, eg school uniform or in Chairman Mao’s China.
Other questions that need to be asked are whether capitalist economies are
inherently unstable and require governments to use their fiscal and monetary
policies to maintain long-term economic stability. Or is it that the very attempts by
governments to create stability using macroeconomic policies are the very cause
of economic instability?
1.5.4.4 Cost−benefit analysis

As soon as governments become involved in the provision and/or consumption of
products then they need a way of measuring their performance. In this situation, a
cost−benefit analysis may be used to assess the advantages and disadvantages of
rival schemes in order to establish quantitatively which schemes should be given
priority.
There are, however, problems in as much as many of the calculations that are
included in the measurement of total costs (private costs + external costs) and total
benefits (private benefits + external benefits) are based upon value judgements.
Decisions have to be made about which of the many externalities are to be taken

into account and which are to be left out. Also there are difficulties in deciding
whether externalities are good or bad in the context of society not only as it is,
but also as it will be in the future. Cost−benefit analysis can offer an estimate at
quantifying issues only once a framework has been established.
For example, suppose a new motorway is proposed and assessed for consideration.
The private costs will be calculated as the money costs of employing the productive
factors required to build and maintain the motorway. The private benefits could be
estimated fairly precisely if revenue were collected at toll points. However, if the
road is free to use, then it would be more difficult to identify the amount drivers
would be willing to pay to use the motorway. However, even this is relatively simple
compared with the task of estimating external costs and benefits.
These costs could include the destruction of certain environmental assets, the
peaceful nature of certain villages now subjected to the noise of large lorries and
the disruption to local wild life. To be weighed against this will be the additional
benefits of safer travel, protection of environmental assets and less noise and
exhaust pollution along the routes that will be relieved of congestion.
It is the task of cost−benefit analysis to estimate these matters in money terms

once the assumptions and framework have been established. This preceding
statement highlights a major criticism of cost−benefit analysis, namely that the
total costs can exceed the total benefits or vice versa, depending upon what
is included or excluded in the analysis. Some more cynical economists have
suggested that any project can be given the go-ahead or abandoned as the result
of what is included in the analysis and of the money value given to such intangibles
as human life, the peace of the countryside and a short, but less attractive, journey
to work.
1.5.4.5 A cautionary note

There is a lot of evidence to suggest that total government control of an economy
does not provide an efficient allocation of resources. The break-up of communist
controlled Eastern Europe is an example. Arguably the most difficult thing to do in a
modern command economy is to match supply and demand. At the other extreme,
an anarchist free market capitalist economy would not produce public goods in
sufficient quantity and this would lead to no collective internal and external defence
and a tendency towards the law of the jungle where the strong survive and the weak
are unprotected.
This leads to the tentative conclusion that some mix of government intervention
and free markets is essential in a modern economy. However, the most
perplexing question is how mixed the mixed economy should be? It is
very tempting for an interventionist economist to notice all the imperfections
of the marketplace and argue for more government involvement. In contrast,
those economists who back the free market cast doubt on governments’ ability
to acquire the knowledge necessary to improve upon the market. They are also
concerned that democratic governments give more weight to short-term political
horizons than to long-term economic stability. Their suggestion is that the most
effective government policies are those that ease entry into markets and confirm
property rights. They further argue that even external nuisances like noise and
other pollutions are more effectively dealt with by making producers legally liable
for them and by identifying property rights that can be traded on markets, rather
than by limiting them by government control and cost−benefit analysis.

Opportunity cost: A real measure
1.6 Opportunity cost: A real measure

Throughout the whole course, opportunity cost is a very important concept. It is
the real measure of the foregone alternative at both the level of production and
consumption. For example, if resources are used to build a hospital then they
cannot be used to build a school, or if a person buys one car then they forgo the
opportunity to use that money to buy another car of equal value. It removes any
misunderstanding that may result from money illusion and nominal changes in
price that are not real. It tells the producer that when resources are used to make
this product, then other things cannot be produced. In the same way, the consumer
is informed that the cost of buying one product is being unable to buy another.
All the time that products and productive factors are scarce in economic terms, they
will have an opportunity cost. So far we have identified one good that is not scarce,
namely the free good. This is the only good that does not have an opportunity
cost of production or consumption. All economic goods have an opportunity cost
of production. Most economic goods have an opportunity cost of consumption,
unless they are offered free at the point of consumption. The table below illustrates
this relationship.
Table 1.1
Type of good Opportunity cost Opportunity cost
of production of consumption
Free good No No
Public good Yes No
Merit good Yes No*
Demerit good Yes Yes
Club good Yes Yes
Private good Yes Yes
* Only if it is offered free at the point of consumption.
For the economy as a whole opportunity cost is often illustrated using a production
possibility boundary. This boundary separates all the output of the economy into
two groups. One is consumer goods and services that are in final demand and the
other is capital products that are a produced means of production used by firms
in their production process.

Figure 1.1
In Figure 1.1, the boundary AB is the maximum output for an economy at one point
in time when all resources are fully utilised. If X ’Y ’ represents the current level of
output of these two groups of products then the opportunity cost of producing
more consumer products represented by a move from Y ’ to Y 2 is a reduction in the
production of capital products from X ’ to X 2.
Summary
u This topic has introduced many of the important concepts that are the
foundation of economics.
u The economic problem is fundamental to economics and should not be

confused with other problems in economics.
u The extent to which you are free to choose what is produced and consumed is
dependent upon the political system adopted.
u To understand the reasons for economic intervention, it is necessary to identify
the different types of economic good that exist in an economy.
u To allocate resources efficiently there is a role for government, but the degree
of intervention is an area of much debate.
u To avoid money illusion it is necessary to both understand and use opportunity
cost analysis.
References
Ariely, D. (2008) Predictably Irrational: the hidden forces that shape our decisions. London: Harper
Collins.
Nock, A.J. (1943) Memoirs of a superfluous man. New York: Harper and Brothers.
Robbins, L. (1932) Essay on the nature and significance of economic science. London: Macmillan &
Co.Ltd.

Topic 2
Markets and the theory of price
‘Man is the only creature that consumes without producing.’

Orwell (1945)

u individual demand and market demand (we will leave aggregate demand to
a later topic);
u how to use the concepts of utility, indifference curves, budget lines and
elasticity of demand;
u the supply functions of the firm and the industry;
u market pricing, shifts and movements in demand and supply curves; and
u how the market creates consumer and producer surpluses.
2.1 The theory of demand
2.1.1 Demand and demand aggregates

In economics demand refers to effective demand, which means that the desire
to make a purchase is backed by the willingness and ability to pay a price in order
to possess the product. Therefore demand is what one is able and willing to buy
at a given price, not what one would like to buy if one could afford it. In a mixed
economy, like the UK’s, the demand for public and merit goods, which are provided
free, is made effective by a legal right rather than by money.
The theory of demand studies the relationship between quantity demanded and
price, and what follows aims to give a scientific analysis of why people usually, but
not always, buy more units at a lower price and vice versa. Theories of demand that
relate to the smallest economic unit will be looked at under consumer theory.
These variables will be aggregated when looking at the market demand for a
product and then later in the course further aggregated to include all of the demand
in an economy.

2: Markets and the theory of price
2.1.2 The concepts used in demand analysis
2.1.2.1 Utility and utility maximisation

Utility is defined as the satisfaction that is derived from the consumption of a
good or service. In everyday speech, utility is synonymous with usefulness and
the word is usually associated with legal or ethical judgements. For example, the
abuse of drugs would not be considered as useful. However, no such judgements
are made by the economist as everything that is wanted is considered useful and
the fact that someone is prepared to pay to acquire and consume a good or service
is sufficient and necessary proof of its having utility.
Consumer theory is based upon the assumption that individuals are acting
rationally if they aim to maximise the utility they derive from the products they
consume. This means that consumers will buy more of a product if they anticipate
that their total satisfaction will be increased as a result of that purchase. Consumers
will also arrange their pattern of expenditure to maximise this satisfaction.
In reality most individuals will admit to purchasing something or other that has
given them no satisfaction or less satisfaction than an alternative product. This
is usually explained in terms of imperfect knowledge, pressure of advertising and
changed circumstances. In spite of this it is generally accepted that the assumption
of utility maximisation applies to most people most of the time.
2.1.2.2 The law of diminishing marginal utility

The process of maximising utility is constrained by an economic law that states
that, over a specific period of time, and assuming that the consumption of other
products is fixed, the utility derived from consuming successive units of a product
will add less to the rising total and may even, at some point, reduce total utility.
The law produces a total utility schedule that is rising and a marginal utility
schedule that is falling. Marginal utility is the addition to total utility derived from
consuming one more unit of the product. In theory the rational consumer with
perfect knowledge would only consume additional units of a product if they were
to add more to total utility. However, in reality it is possible that marginal utility
could turn into marginal disutility. This implies a misjudgement on the part of the
consumer as consumption has not fulfilled expectations. For example, a passion
for strawberries may lead to a level of consumption that eventually causes the body
to reject additional quantities and total utility is reduced.
The two diagrams below show total utility rising by ever decreasing amounts as
marginal utility falls. Figure 2.1 is derived from Table 2.1, which assumes it is
possible to measure utility in terms of units of satisfaction. For example, the first
unit consumed gives ten units of utility, the second eight units and so on.
Table 2.1
Units consumed Marginal utility Total utility
1 10 10
2 8 18
3 4 22
4 2 24
5 0 24
6 -1 23

The theory of demand
Figure 2.1
Marginal Utility
10
0
1 2 3 4 5 6
-2 Units consumed
Total Utility
24
21
18
15
12
0 Units consumed
1 2 3 4 5 6
2.1.2.3 Can utility be measured?

It may seem strange to be asking this question after we have constructed diagrams
based upon theoretical measurements of utility. The answer is that in reality it is not
possible to measure utility in any meaningful way that allows comparison between

one consumer and another. For example, you would be quite safe if you offered
your most treasured possession to the person who would gain most utility from its
use. It is not possible in any objective way to prove that one person will gain more
usefulness from a product than another. It cannot be said that, because two people
pay the same price for a product, they will derive the same utility. This can more
clearly be seen by looking at the concept of opportunity cost. An individual will
measure the money spent on one item in terms of the utility that can be derived
from an alternative product. The alternative forgone will vary from one person to
another dependent upon tastes, preferences and income. It is generally accepted
in economics that the last pound spent by a person on low income will derive them
more utility than the last pound spent by a person on high income.
Although it is difficult to make comparison between one consumer and another it is
easier to rank products for each individual consumer. In fact the choice made by a
consumer reflects the expected utility that will be derived from each unit of money
spent. This is a point that we will look at in more detail when the equilibrium of
the household is analysed.
2.1.3 The paradox of value

Confusion arose from the failure to distinguish clearly between total and marginal
utility. This led some early economists to the following apparent contradiction. Why
were people prepared to pay high prices for non-essential goods like diamonds
when they spent little or nothing on essential goods like water? The confusion was
generated by looking at the marginal utility of the last diamond and the last drop
of water consumed. The answer was found by looking at relative scarcity and the
total utility derived from each product. Figure 2.2 estimates a consumer’s marginal
utility schedule for both products.

Figure 2.2
Marginal Utility Schedule for Diamonds

Marginal
Utility
MU1
Q1 Quantity consumed
Marginal Utility Schedule for Water

Marginal
Utility
Quantity consumed Q2
The first unit of water consumed derives much higher utility than the first diamond.
However, the relative scarcity of diamonds leads to a high price so a buyer may
stop consuming at Q 1 with a high marginal utility and a low total utility. If we
assume that water is offered at no price then it will be consumed up to Q 2 where
marginal utility is zero but total utility is high. In general this distinction can be
made between high priced luxuries and low priced necessities. Luxuries have low
total utilities and high marginal utilities while necessities have high total utilities
and low marginal utilities.
2.1.3.1 The shape of an indifference curve

The law of diminishing marginal utility tells us that increased consumption of the
same product will add successively less to total utility, ie total utility will rise more
slowly and may even begin to fall as more units are consumed. If we assume
that a person consumes two products X and Y and that a preference for a certain

combination of both products has been revealed, then in order to achieve the same
utility from a combination that has one fewer X the consumer will substitute more
than one Y. The removal of a second X will then cause the consumer to substitute
a further increasing amount of Y to maintain the same utility. This relationship is
characterised by an indifference curve as illustrated by the diagrams in Figure 2.3.
Figure 2.3
In the first case the removal of one Y requires increasing amounts of X to sustain
the same utility while in the second case the removal of one X requires increasing
amounts of Y to do the same. The indifference curve joins together all the points
where different combinations of two products give rise to the same total utility,
and therefore consumers are indifferent to which combination they consume.
The shape of the indifference curve is governed by the hypothesis of a diminishing
marginal rate of substitution (MRS). This can be illustrated in Figure 2.4 by
constructing an indifference curve from the statistics in Table 2.1.

Table 2.2
1 2 3 4 5 6
Bundle Y X ∆Y ∆X MRS (4/5)
1 36 5
2 30 6 -6 1 -6
3 24 8 -6 2 -3
4 18 13 -6 5 -1.2
5 12 23 -6 10 -0.6
6 6 45 -6 20 -0.3
Figure 2.4
The indifference curve drawn in Figure 2.4 shows that in order to remain on the
same indifference curve, ie derive the same total utility, a reduction from 36Y to
30Y is compensated for by a rise from 5X to 6X. This means that the consumer is
willing to accept 6 fewer Y for 1 more X at a marginal rate of substitution (MRS) of
-6. A further reduction of 6Y will, however, require an increase of 2X to remain on
the same curve at an MRS of -3. The MRS continues to diminish, as illustrated in
column 6, to the point where 20X is required to compensate for a reduction from
12Y to 6Y at an MRS of -0.3
2.1.3.2 The indifference map

The indifference curve in Figure 2.4 is one of many curves that illustrate different
combinations of two products that give rise to the same total utility. Curves nearer

to the origin than in Figure 2.4 will join together combinations that give rise to
lower utility, while curves to the right and further away from the origin will be ones
about which the consumer is indifferent at higher levels of total utility.
It is important to remember when drawing a map of indifference curves, as

illustrated in Figure 2.5, that there can be no point of intersection between curves
closer to or further away from the origin. If two curves did intersect it would
mean that a consumer could achieve higher utility from consuming less of both
products. This explanation seems so obvious that it is not necessary to dwell upon
it. However, the indifference curves are used in a number of economic models and
quite often a careless drawing illustrates that the rule has been forgotten.
Figure 2.5 An indifference map
2.1.3.3 The budget line: What is it?

The consumer is a constrained maximiser. This means that maximising satisfaction
can only occur given certain constraints and limitations. The constraint is imposed
by an income that creates a limited ability to buy products. The budget constraint
line is a useful analytical tool in the construction and interpretation of demand
models. In order to simplify the analysis it is assumed that a consumer has the
choice of only two products. The diagram below, Figure 2.6, shows the maximum
combinations of X and Y that can be bought given an income constraint of £100
and a price for Y of £2 and for X of £1.

Figure 2.6 A budget line
50
40
Y 30
20
10
0 X
10 20 30 40 50 60 70 80 90 100
The slope of the budget line identifies the opportunity cost of buying X in terms of
Y or Y in terms of X, ie 1X forgone allows ½Y to be purchased or 1Y forgone allows
2X to be purchased. This may be written as a ratio of the prices of X and Y (PX and
PY) ie:
PX 1
Opportunity cost of X = = Y
PY 2
or
PY 2X
Opportunity cost of Y = =
PX 1
2.1.3.4 Shifts in the budget line: Opportunity cost constant

The opportunity cost and therefore the slope of the budget line will remain
unchanged when income changes. For example, a rise in income to £200 will shift
the budget line upwards parallel to itself illustrating that the consumer can now
afford more of both products, ie 100 units of Y or 200 units of X. If income falls to
£50 then the budget line will shift towards the origin parallel to itself illustrating a
lower maximum of either 25 units of Y or 50 units of X. In each case the opportunity
cost of consumption is unchanged. Figure 2.7 identifies the different budget lines.
This same parallel shift in budget lines would occur if absolute prices changed
while relative prices were unchanged. For example, if income was £100 but the
price of X fell to 50p and Y to £1 then the new budget line would be the same as if
income had risen to £200. Also a price rise to £2 for X and £4 for Y would produce
a budget line the same as if income had fallen to £50. In all cases the slope is
unchanged, ie:
0.5 1 2
= =
1 2 4

Figure 2.7 Budget lines: Parallel shifts
100
80
Y 60
40
20
0 X
20 40 60 80 100 120 140 160 180 200
2.1.3.5 Shifts and pivots in the budget line: Opportunity cost

variable
We have seen that a change in income causes a parallel shift in the budget line
as relative prices are unchanged. However, if income is held constant and relative
prices change, then the slope of the budget line will change. If only one price
changes, then it will pivot around one point. For example, if the original budget
line was price of X = £1 and price of Y = £2 with an income constraint of £100,
then a change in the price of Y to £1 will cause the budget line to pivot from its
position on the X axis to a new position on the Y axis as 100 units of Y can now
be purchased. This is illustrated in Figure 2.8.
Figure 2.8
Y 100
80
60
40
20
0 X
20 40 60 80 100
This change has brought about a change in the opportunity cost of consuming 1Y
from ½X to 1X.

On the same diagram it is illustrated what would happen to the slope of the budget
line if both prices changed by different proportions. In this case the price of Y
changes to £1.25p and that of X to £2 leading to maximum purchases of 80Y and
1.25 X 50 X
50X. The opportunity cost of consuming 1Y is now or 0.625X
2 80
2.1.4 Consumer theory
2.1.4.1 Using demand curves

A person buys a product because it yields utility or satisfaction. As more of
any good is bought the total utility is likely to increase, but the increase is not
in proportion to the increase in consumption. This is explained by the law of
diminishing marginal utility.
The individual demand function establishes a relationship between the
price of a product and the quantity demanded. This relationship can be
illustrated by reference to Figure 2.9 and Table 2.3. It is assumed that a person
has only £50 to spend on one product and that total utility increases with each
successive purchase.
Table 2.3
Price Quantity demanded
£50 1
£25 2
£10 5
£5 10
Figure 2.9
50
40
30
Price
20
10
D
0
1 2 3 4 5 6 7 8 9 10
Quantity Demand
As we assume that the rational consumer maximises utility, then more purchases
will be made as the price falls and fewer purchases as the price rises owing to the
expenditure constraint. This is an illustration of the simplest demand curve.

The construction of the individual demand curve becomes more complex if we

assume that a person has a choice of two products. Table 2.4 sets out the marginal
utility a consumer would receive from purchasing successive units of two products
X and Y. Each product costs £5 to buy and the expenditure constraint remains at
£50.
Table 2.4
Units consumed Marginal utility Marginal utility
of X (MUX) of Y (MUY)
1st 20 15
2nd 18 12
3rd 16 10
4th 14 8
5th 12 6
6th 11 5
7th 10 2
8th 4 1
9th 3 0
10th 1 0
The question is: how will the consumer maximise utility in this example? The
answer is by buying 7X and 3Y. This expenditure pattern will give rise to 138 utils
(units of utility). No other expenditure pattern can achieve this total. To work this
out you could proceed in an iterative way, ie the first X gives the highest utility (20).
The second unit of X gives an additional utility of (18) and so on. Alternatively you
could search for an expenditure pattern that spends all the money and equates the
utility of the last pound spent on X and Y, ie:
MUX MUY 10
= =
PX PY 5
In each case the additional utility derived from the last pound spent is two utils.
In theory it is usual for calculations to be doctored so that the marginal utility
per pound spent can be equated for all products consumed. However, in reality
it is recognised that utility will be maximised when a consumer comes closest to
equating marginal utility per pound spent.
The analysis is made more complex by assuming different prices. Suppose the price
of X rises to £10 and the same expenditure constraint remains. The consumer will
then rearrange purchases in order to maximise total utility. The search for a new
expenditure pattern may be made easier if it is recognised that the doubling of
price X has halved the utility that can be derived from each £ spent on product X.
The new expenditure pattern will be 3X and 4Y. Once again:
MUX MUY 16 8
= = = and total utility is maximised at 99 utils.
PX PY 10 5
The rise in price of X has led the consumer to reduce consumption from 7X to 3X.
This can be represented by a movement down the demand curve as illustrated in
Figure 2.10.

Figure 2.10 Demand curve for product X
12
10
6
Price
4
2
D
1 2 3 4 5 6 7 8 9 10
Quantity Demand
As well as identifying a movement along the demand curve the use of two products
can illustrate the difference between a movement and a shift in the demand
function. The normal shape for an individual demand curve will be downward
sloping from left to right and therefore one can deduce that the curve for product
Y will be similar. Further to this it can be seen in conjunction with Table 2.4 that
the increase in price of X has increased the demand for Y as the consumer has
rearranged the pattern of expenditure by substituting Y for the more expensive X.
This represents a shift in the demand curve for Y as more is now being demanded
at the same price. This is illustrated in Figure 2.11.
Figure 2.11 Demand curves for product Y
Price
10
2 D1
D
Quantity Demand
1 2 3 4 5 6 7 8 9
The examples above illustrate how the individual demand curve for a product
can be constructed. A further point to note is that the total market demand for a
product is simply the horizontal summation of all the individual demand functions.

2.1.4.2 Using indifference curves and budget lines
Figure 2.12
10 b
Good Y
6
4
E
B Good X
2 4 6 8 10
The example used in section 2.1.4.1 can be explained using indifference curves
and budget lines. Figure 2.12 incorporates the budget line bb, which is drawn
on the assumption that a consumer has £50 to spend on two products X and
Y, which cost £10 and £5 respectively. The budget line is a frontier along which
different combinations of X and Y can be bought given the price and expenditure
constraints. This frontier is a divide between combinations of X and Y that are
achievable and those that are not. Position E represents the chosen pattern of
consumption consistent with Table 2.4 in section 2.1.4.1, ie 4Y and 3X.
Suppose that the consumer’s expenditure constraints rise to £100 as represented

below, in Figure 2.13.

Figure 2.13
20 b1
18
16
14
12
Good Y
10
4 E
2
b1
0
2 4 6 8 10 12 14 16 Good X
The consumer can now move from position E to a point on the new budget line to
b 1b 1. In order to identify the new position, reference will be made to Figure 2.14.
Figure 2.14
In comparison to position E any combination that has either more X and no fewer
Y or more Y and no fewer X will be preferred. This means that any point in the
shaded area above and to the right of E will be preferred to E and E will always

be preferred to any point in the shaded area below and to the left. Position E
is one combination of X and Y about which the consumer is indifferent. These
combinations must lie in the blank areas below and to the right and above and to
the left. The indifference curve II passes through E and joins together all the points
between which the consumer is indifferent. The shape incorporates a diminishing
marginal rate of substitution (Table 2.1), which is illustrated by observing that the
movement from F to G involves the same loss of Y as from E to F but requires a
larger gain in X to keep the consumer on the same indifference curve.
On the indifference curve II each point yields the same total utility to the consumer.
However, as explained previously, there is a whole map of indifference curves
each negatively sloped and convex to the origin. The indifference curves that pass
through points above and to the right of E, eg I 1I 1, link up combinations X and Y
that yield higher levels of satisfaction whereas those below I 2I 2 yield lower levels
of satisfaction.
Having now identified the budget line and characterised consumer tastes in an
indifference map, their combination provides a solution to the consumer choice
problem. The consumer who wishes to maximise utility will select a consumption
pattern on as high an indifference curve as possible consistent with the budget
line. This means that there is an indifference curve tangential to the budget line
bb at position E as illustrated in Figure 2.15.
Figure 2.15
20 b1
18
16
y
14
12
I
10 b
Good Y
4 E z
2
b I b1
0
2 4 6 8 10 12 14 16 Good X
Also there will be an indifference curve tangent to b 1b 1 between points Y and

X. To find the exact position where £100 spent would maximise utility we can
return to Table 2.4. The answer is that the indifference curve I 1I 1 in Figure 2.16 is
tangential to b 1b 1 where 6Y and 7X are consumed. The consumer would then be
in equilibrium at E, achieving 157 units of utility.

Figure 2.16
20
18
16
14
12 I1
Good Y 10 I
8
6 E1
4 E 1
I
2
I
0
2 4 6 8 10 12 14 16 18 20 Good X
2.1.4.3 Concluding point

Given our assumptions and the law of diminishing marginal utility, the preceding
explanation of consumer equilibrium brings together utility theory and indifference
analysis. The point where the consumer maximises total utility is both where there
is equality between the utility derived from the last pound spent on each item and
where the indifference curve is tangential to the budget line.
2.1.5 Market demand
2.1.5.1 The normal product demand curve

The total demand for an individual product is referred to as the market demand.
It is the horizontal sum of each individual demand curve and its normal shape
is downward sloping from left to right, ie negatively sloping, as illustrated in
Figure 2.17.

Figure 2.17
Price
P2
P1
Q2 Q1 Quantity
The uneven distribution of income in a country like the UK means that as the price
falls more consumers will be able to enter the market. Also each consumer will gain
more utility per pound spent as the price falls and is therefore likely to increase
consumption as purchases are rearranged to maximise utility.
2.1.5.2 Movements along the demand curve

If the first thing that changes in the relationship between price and quantity
demanded is price then this will be represented by a movement along the demand
curve. This is illustrated in Figure 2.17 by the price change from P 1 to P 2. The
diagram shows that at a higher price consumers will demand less and at a lower
price they will demand more. Although it may seem obvious to state this, it is worth
reminding ourselves how useful it is to translate diagrams into words. There are two
reasons for always trying to do this. Firstly, it helps those who have difficulty with
abstract mathematics, and secondly, it reminds those who are good at mathematics
that their analysis should lead to a convergence between theory and reality rather
than the divergence that has bedevilled some economic theory.
Usually a change in the costs of production will cause producers to test the market:
raise the price to recover a rise in costs or lower the price to increase sales if costs
fall or revenues are expected to rise. Each of these changes in price will provoke a
change in the quantity demanded and cause a movement along a constant demand
function.
2.1.5.3 Shifts in the demand curve

A movement along a demand curve occurs as the result of a change in price whereas
more or less of the product demanded at the same price constitutes a shift in the
demand curve. This is illustrated in Figure 2.18 where P 1 is consistent with two
levels of demand represented by D 1 and D 2 and two levels of output at Q 1 and Q 2.

Figure 2.18
This prompts the question: what causes a shift in the demand curve? Over time
the real income of consumers may rise. This will occur for the average consumer
if a country is experiencing economic growth. Also consumer tastes may change
especially when new products come on to the market; or previously suppressed
demand may be released by a change in borrowing restrictions. The introduction
of new ways of buying and selling, such as the use of credit cards, has made
loans more easily available and many people, because of the convenience, have
taken out loans even though rates of interest are higher than other comparable
forms of borrowing. Advertising campaigns have been known to have considerable
impact on shifting demand curves. Indeed commercial television, newspapers and
Internet sites finance their activities on little else. Finally it should be noted that,
although our analysis requires price to remain constant, a change in the price of
other products may cause consumers to shift their demand to or away from the
product in question.
2.1.5.4 Normal goods, inferior goods and perverse demand

curves
A normal good has two distinguishing features. Firstly the demand curve is
downward sloping from left to right, indicating what will happen to demand if
price changes and showing the inverse relationship between price and quantity
demanded. Secondly the normal relationship between a change in income and the
quantity demanded of a product is that an increase in income will increase the
demand for the product or in certain cases leave demand unchanged. It will not,
however, cause demand to fall. It is this second feature of a normal good that
distinguishes it from an inferior good.
An inferior good is a product of relatively low or inferior quality that has a superior
alternative. All inferior goods exhibit a perverse relationship between
changes in income and quantity demanded. However, it is common to identify
two types of inferior good only one of which responds perversely to a change
in price. They can be distinguished by the relative strength of the income effect
of a price change. Both types of inferior good illustrate a substitution effect that

increases demand as the price falls. This occurs because a price fall raises the
utility per pound spent. As well as having a substitution effect, the price change
will raise or lower spending power by changing real income. Only one type of
inferior good has a strong enough negative income effect to more than counteract
the substitution effect and reduce overall demand for the product when price falls.
Indifference curve analysis is the best way of distinguishing between the types of
inferior good.
Inferior goods
Inferior good with a normal demand curve
Figure 2.19
In Figure 2.19 the X axis identifies the quantity of an inferior good that can be
purchased with a given income while the Y axis identifies the quantity of other
goods that could be purchased. Y 1X 1 is the chosen pattern of consumption. If the
price of X falls the budget constraint line AB will pivot to AB 1 as more of the inferior
good can now be purchased. There will be both an income and a substitution effect
of this price change. To remove the income effect the new budget line is moved
towards the origin parallel to itself until it is tangent to the old indifference curve
II. The consumer will now purchase the combination Y 2X 2 substituting more X
for less Y as the utility derived from every pound spent on X has increased while
that of Y remains unchanged. If the income is now reintroduced its effect on the
inferior good is negative, ie a rise in income will lead to a fall in demand. This
means that the quantity of X consumed will be to the left of X 2: how far to the left
depends upon the relative strength of the income effect. In this case it will not be
strong enough to move to the left of X 1 and will lie between X 2 and X 1 at X 3. This
is illustrated in Figure 2.19 where the fall in price from P 1 to P 2 causes a rise in
demand from Q 1 to Q 2.

Inferior good with a perverse demand curve
Figure 2.20
Figure 2.20 is similar to Figure 2.19 in as much as the isolation of the substitution
effect leads to more of the inferior good being consumed X 1 to X 2 and less of the
other good Y 1 to Y 2. The difference lies in the relative strength of the negative
income effect. In this case the income effect changes the pattern of consumption
to X 3Y 3 where less of the inferior good is consumed as the result of the price
change. This is represented in Figure 2.10 by a perverse demand curve that slopes
upward from left to right as the fall in price has led to a fall in demand.
The inferior good with the perverse demand curve is referred to as a Giffen good,
named after Sir Robert Giffen who is credited with first reporting that the poor
during the nineteenth century consumed more bread when it rose in price and
less when it fell. Giffen goods refer to commodities of a relatively low quality
that form a significant part of the expenditure in subsistence societies. The most

quoted examples are the staple foodstuffs: potatoes, rice and bread. This unusual
relationship is explained by saying that as the price of staple foodstuffs falls,
so poorer people realise a significant increase in their spending power. This rise
in real income will encourage them to purchase higher quality foodstuffs such
as meat and dairy products. These purchases will reduce the demand for staple
foodstuffs as consumers redistribute their diet in favour of the more expensive
and desirable foods. Alternatively when the price of bread rises this reduces the
amount of real spending power and so the demand for meat and dairy products is
reduced. In order to complement the diet then more of the cheaper foodstuffs will
be purchased and consumed. This effect can still be observed today in the world’s
poorest countries.
Other perverse demand curves
Conspicuous consumption goods
Another type of product, which manifests a perverse relationship between a change
in price and quantity demanded, is the conspicuous consumption or status symbol
good. Products of this type have ‘snob’ appeal and can be used to display wealth.
Although there are many goods that can fit into this category to a greater or lesser
extent, some of the best examples are those that have low production costs and
could be sold profitably at a low price, but, because demand increases as price
rises, are more profitably sold at higher prices. If the prices of goods like perfume
and designer clothes are raised then they take on an exclusive character that can
increase demand. Similarly, if the price of the product is reduced then demand
may fall as the good loses its exclusive character and therefore its ability to display
wealth.
Many manufacturers have taken advantage of the fact that a new exclusive label
or a distinctive wrapping coupled with a higher price has increased demand for
their product. As the UK has found it more and more difficult to compete with the
mass production and standardisation of products from other parts of the world so
survival has meant going upmarket to produce exclusive products that satisfy the
demand for variety rather than similarity.
Conspicuous consumption has taken on a more bizarre characteristic in rich
societies where display of wealth does not produce the required ‘one-upmanship’.
In these societies individuals may derive status from the conspicuous destruction
of goods. A similar though more acceptable act is one of conspicuous benevolence
where rich persons give away large amounts of their wealth.
The speculative good
A perverse relationship between price and quantity demanded can be illustrated
when price instability and expectations of future price changes provoke
speculation. This seemingly perverse behaviour by buyers occurs in markets over
certain unstable ranges of price change. One often-quoted example of this type of
market is the Stock Exchange. Usually a rise in share prices will encourage buyers
into the market if they expect that share prices will continue to rise. The aim is
to buy when share prices start to rise and sell when prices reach their highest
in order to make a profit or capital gain. In Stock Exchange parlance this rising
market is described as a ‘bull’ market. Alternatively in a ‘bear’ market falling share
prices usually reduce the quantity demanded as potential buyers expect the trend
to continue. The aim is now to sell when prices start to fall and buy back when
prices reach their lowest.
A similar situation develops in societies that are experiencing inflation − a rise
in the average level of prices − or deflation − a fall in the average level
of prices. In an inflationary society consumers are encouraged to bring forward

purchases even though the price of a product is rising because they expect the
price to continue rising. Alternatively, in a society that is experiencing deflation
expectation that prices will continue to fall and that the same products can be
purchased in the future at lower prices will cause purchases to be put back.
2.1.6 The elasticity of demand
2.1.6.1 Price elasticity of demand
2.1.6.1.1 Introduction
So far it has been stated in an imprecise way that normal demand curves slope
downward from left to right. This could mean that a small change in price brings
about a relatively large change in demand or that a large change in price brings
about a relatively small change in demand. For many reasons it is necessary to
be more precise and establish an exact relationship between a change in price
and a change in the quantity demanded. This is done by calculating an elasticity
coefficient. The elasticity coefficient measures the responsiveness of a change in
demand to a change in price. Theoretically this relationship is precise and relatively
easy to calculate, while in reality the inclusion of many more variables than just
price and demand make it impossible to identify with the precision implied by
theory.
2.1.6.1.2 Point elasticity
A simple way to understand elasticity is to recognise the fact that each point along
a demand curve has an elasticity that can be measured using a ruler. Figure 2.21
illustrates this point.
Figure 2.21

The elasticity of any point along the line AC can be calculated by measuring the
distance from a given point to the X axis and dividing by the distance from that
point to the Y axis. For example, position B is equidistant from both axes and
therefore has an elasticity value of 1:
eg Elasticity of B = BC = 1
BA
Also Elasticity of A = AC = (infinity)

0
And Elasticity of C = 0 = 0
CA
This means that if a straight line demand curve is drawn to touch both axes as with
AC then the elasticity value will fall from infinity at point A to 0 at point C passing
through 1 at point B.
The same rule applies when the demand function is not a straight line as in
Figure 2.22.
Figure 2.22
AF
Elasticity of A = => 0
AE
BH
Elasticity of B = =< 1
BG
In this case a tangent is drawn from the point in question to each axis to allow
measurement. The tangent from point A produces an elasticity value that is greater
than 1 and is therefore described as elastic while point B produces a value that is
less than 1 and is therefore described as inelastic. The line that is tangent to the
curve DD has the same elasticity at the point where they touch.
The preceding analysis illustrates the point that, given price and demand details, it
would be possible to draw, measure and calculate an elasticity coefficient. It would
not, however, economise on the use of time as it would be quicker to use one of
the algebraic formulations set out below.

2.1.6.1.3 The algebra

Let us start by referring to a simple demand schedule.
Table 2.5
Price Quantity demanded per time period
60p 200
40p 400
Table 2.5 shows that at a price of 60p 200 units of a product are demanded. When
the price falls to 40p then demand rises to 400 units.
The coefficient of price elasticity of demand C is an arithmetic relationship between
the change in price and the change in quantity demanded. Two formulae have been
used to calculate this coefficient:
Table 2.6
Either C = AP × ∆Q
AQ × ∆P
Where AP = average price
∆Q = change in quantity demanded
AQ = average quantity
∆P = change in price
Or C = percentage change in quantity demanded
percentage change in price
The elasticity of a normal demand curve is a negatively sloped line, ie a rise in price
will lead to a fall in demand and vice versa. This means that either calculation will
produce a negative answer. You may be told to ignore the direction of movement
and assume that all changes are positive or that a negative may be placed in front
of the equation, as above, to produce a positive answer.
Usually either formula can be used to calculate elasticity, and the choice would
be governed by the form in which the statistics are available. However, as will
be shown, different calculations can produce different answers. With reference to
Table 2.5 and using the average method:
50 × 200
C = = 1.66
300 × 20
When the price goes up:
50%
C = =1
50%
When the price goes down:
100%
C = =3
33.3%
The fact that, in this case, answers can vary between 1 and 3 needs some
explanation. In this example we are working over a large price range from 60p
to 40p. In terms of point elasticity the price 60p on the demand curve would be
closer to the Y axis and infinity while 40p would be closer to the X axis and zero.

The other calculation takes the average of the points between 60p and 40p and
produces the answer 1.66. This same answer can be obtained using the percentage
method if the percentages are calculated by taking the change in price or quantity
and dividing by the average of the prices or quantities before multiplying by 100,
eg the percentage change in quantity demanded is:
200
× 100 = 66.66%
300 (average)
while percentage change in price is
20
× 100 = 40%
average
Therefore 66.66% = 1.66

40%
2.1.6.1.4 The graphs
Figure 2.23

In Figure 2.23 there are two demand curves D and D 1 in A and B respectively. One
of the demand curves has a uniform elasticity over the entire price range while the
other demand curve has a different elasticity at each point. The untrained eye will
almost certainly choose A for the uniform elasticity and B for variable elasticity.
However, if you have read point elasticity you will know that each point on demand
curve D 1 in B is equidistant from each axis (as shown by the tangents) and therefore
has an elasticity of 1, while the elasticity value for D in A is continually falling as
we move down the curve from left to right towards the X axis. The demand curve
D 1 in B produces the mathematical shape described as a rectangular hyperbola.
With this demand curve, D 1, the percentage change in price is the same as the
percentage change in quantity demanded as prices move up or down.
As well as the rectangular hyperbola there are two other shapes that have uniform
elasticities. These are represented in Figure 2.24 as the perfect cases.
Figure 2.24
Perfectly Inelastic Demand Curve
Price
D
Quantity
Perfectly Elastic Demand Curve
Price
P1 D1
Quantity

The perfectly inelastic demand curve D identifies a situation where the quantity
demanded remains constant irrespective of price changes. This produces an
elasticity calculation that is 0. The perfectly elastic demand curve D 1 identifies
a price P 1 at which demand is infinite. At any price below P 1 demand will remain
infinite while at any price above P 1 there will be no demand for the product. This
produces an elasticity value that is infinite.
2.1.6.2 Expenditure and price elasticity

If it is only necessary to describe a demand curve as elastic, inelastic or of unitary
elasticity then it is probably quicker to look at how expenditure changes as the
price changes. In the case of the rectangular hyperbola, which has a constant
demand elasticity of 1, the amount spent remains unchanged as the price changes.
Figure 2.25 shows that £30 is spent on the product irrespective of price.
Figure 2.25
If the amount of money spent falls when price falls then the curve will be inelastic.
Figure 2.26 shows that the rectangle represented by Price × Quantity Demanded
falls from OP 1AQ 1 to OP 2BQ 2 as price is reduced.

Figure 2.26
When the price falls and the amount of money spent rises then the curve must
be elastic. Figure 2.27 shows that the rectangle represented by PxQ rises from
OP 1AQ 1 to OP 2BQ 2 as the price is reduced.
Figure 2.27
Price
P1 A
B
P2 D
lost
gain
Quantity
Q1 Q2
If there is an equal percentage change in the price and the amount spent then the
curve must be perfectly inelastic as illustrated in Figure 2.28 where the rectangle
increases or decreases in size by the same proportion as the price.

Figure 2.28
Price
P2
P1
Quantity demanded
Q1
All of this means that, given a schedule such as that set out in Figure 2.25, it is
possible to identify where the demand function is elastic, inelastic and unitary by
filling in column 3 rather than by making the calculation.
Price per tonne (£) Quantity Total expenditure

demanded (tonnes)
4 7,000
8 5,000
12 4,000
16 3,000
20 1,800
24 500
Often it is assumed that a reduction in price leads to more sales and higher revenue.
Our analysis of the relationship between elasticity and expenditure shows that, in
the normal case, a reduction in price will lead to more sales. However, increased
sales may cause expenditure to rise, fall or remain the same dependent
upon the price elasticity of demand.
2.1.6.3 Reality and price elasticity

Before prices and product taxes are changed knowledge of price elasticities is
essential to producers and governments. The problem is that it is not possible to
predict elasticities with certainty and many prices have to be adjusted on a trial and
error basis. In reality the best that can be achieved is estimates of price elasticity,
usually based upon analysis of previous price adjustments. The precise elasticity
will never be known until after the price has changed and even then it is not easy to

identify the change in demand that has occurred as the result of the price change
from that which has occurred as the result of an increase or a decrease in demand
at the same price, ie a shift in the demand curve in response to a change in some
factor other than price.
For the producer, profit maximisation may occur when prices are raised or lowered,
depending on the degree of price elasticity. For a government concerned with
making adjustments to indirect taxes such as excise duties, price elasticity will
determine whether an increase in tax will result in a rise or fall in revenue. It
should not be assumed that a rise in product tax will automatically lead to a rise in
tax revenue. This mistake has been made in the past by governments. The more
inelastic the demand curve the more successful the product tax as this means that
people do not respond much to the price increase. Trial and error has shown that
the greatest potential for raising revenue in the past has been with necessary and
addictive products such as petrol, alcohol and cigarettes. There is, however, no
guarantee that this will continue into the future.
Improved estimates of elasticity can come from uncovering the factors that
determine the price elasticity of demand. A government will look to products whose
demand will not be much affected by increased costs and prices. We have already
noted that addictive products such as alcohol and tobacco are good revenue
earners. The smoker or the drinker will moan when the Chancellor raises the tax on
these items and swear never to smoke or drink alcohol again. Within a few weeks
this is forgotten. In the case of petrol the product is essential to transport and has
no obvious substitutes. Taxes on all these products have a political advantage in
that government can justify the tax by saying it is trying to discourage smoking
and drinking as well as conserving energy.
Another characteristic of these items is that they have a short product life and
therefore cannot be easily stored. In the past and in the case of household durables
the government was not successful when it imposed a higher rate of VAT on
certain ‘luxury’ items such as televisions and washing machines. Demand for these
products was relatively elastic because they had longer product lives. Potential
consumers put back purchases of new and replacement products and there was
an increase in repairs and in the sale of second-hand machines that extended their
product life.
For the private firm a similar analysis applies, although greater emphasis needs to
be placed upon the degree of competition and possible alternatives. In the case of
petrol it may be perceived by a government as being relatively inelastic in demand
while to the firm it is relatively elastic. If any individual petrol station raises its price
then demand will fall quickly as it seems that motorists will travel many miles to
get 0.1p off a litre of petrol.
2.1.6.4 Cross elasticity of demand

It is recognised that a change in the price of one product may have an effect on
changing the demand for another product. For example, two products may be
in competitive demand. This means that a rise in the price of one product will
increase the demand for the other product. Butter and margarine, pork and beef,
and peaches and nectarines would fit into this category. Cross elasticity of demand
measures the responsiveness of quantity demanded of one product to a change in
the price of another product or products. The following formula is used:
Percentage change in demand for X
Cross elasticity of demand =
Percentage change in price of Y

In this case the calculation would be a + −

+ or − either of which would produce
a positive answer. It is a necessary condition of substitute products that they
have positive cross elasticity, ie both changes are in the same direction. However,
positive cross elasticity is not sufficient to identify two products as substitutes for
each other as the changes may have been related by chance. For example, if the
price of nappies rose at the same time as the demand for airline tickets increased
it would be stretching the imagination to suggest that they were in competitive
demand.
Alternatively, it may be that products are in complementary demand or derived

demand. Complementary demand links the demand for two products at the same
stage in the production process. For example, the demand for DVDs is linked to
the demand for DVD players, in the same way as the demand for cars and petrol.
Derived demand links the demand for two products at a different stage in the
production process. For example, the demand for steel by firms is influenced by
the demand for cars by consumers, or the demand for jam influences the demand
for sugar. In each of these cases the cross elasticity calculation will product a
negative answer: either a + −
+ or − .
Again it is a necessary though not sufficient condition of products in
complementary and derived demand that they have negative elasticity. The chance
factor must still be taken into account.
Products that are not related produce a zero or infinite calculation. If the demand
for one product changes while the price of the other product is unchanged then
change
the answer would be infinity: or if the demand was unchanged when price
0
changed then the answer would be zero, ie 0 .
change
2.1.6.5 Income elasticity of demand

This is the degree of responsiveness of quantity demanded to a change in income.
It can be calculated by the equation:
Percentage change in quantity demanded
Income elasticity of demand =
Percentage change in income
The relationship between quantity demanded and income could be as illustrated
as in Figure 2.29.

The theory of supply
Figure 2.29
Consumption Positive Zero Negative
Income
Demand for the normal good will rise as income rises producing a positive
calculation. For the inferior good the income elasticity of demand will always be
negative as a rise in income will lead to a fall in the quantity demanded.
Normal goods that are described as necessities will have low income elasticities
that tend towards 0. These products will be consumed in similar quantities at all
levels of income, ie basic foodstuffs. In contrast, demand for luxuries will produce
income elasticities with higher numerical values.
An understanding of this concept is important for firms who are making long-term
projections about changes in demand for their product and changes in real income.
It may well be that many UK manufacturers missed the point that increasing real
income creates a demand for more expensive higher quality products.
2.2 The theory of supply
2.2.1 Supply and supply aggregates

As with demand there is a small unit for which we can derive a supply function.
It is the firm that is a legal entity of production distinguished from others by
ownership. A collection of firms producing the same or similar products derives
an industry function, while the addition of all the productive units in an economy
produces an aggregate supply function that will be further investigated later in the
macroeconomic section of the course.
2.2.2 In the short run

Time periods on the supply side of the economy relate to the amount of time
required to change output. In the short run the producer is always constrained by

at least one fixed factor of production while all the other factors of production may
be variable.
In order to understand the supply function it is necessary to look at four cost
functions and how they change as output expands. They are:
Average total = Total cost

cost Total output
Average fixed = Total fixed cost
cost Total output
Average = Total variable cost
variable cost Total output
Marginal cost = The additional cost of producing one more unit of output
Fixed costs are those costs of production that remain when the firm is not
producing anything, and are unchanged up to the point of full capacity utilisation,
eg rent and rates; while variable costs only occur when a firm starts to produce,
and then they vary with the number of units produced, eg labour and raw materials.
Having identified the cost function, it is the concept of increasing marginal returns
and the law of variable proportions that determine the shape of the curves used to
identify the supply function for a firm.
In the short run variable factors, such as units of labour, can be added to fixed
factors, such as a factory, and it is likely that, through specialisation of function
and division of labour, the addition to total output (marginal output) will at first
rise. It is, however, not definite. What is certain, and is therefore granted the status
of an economic law, is that when additional units of a variable factor are added to
a fixed factor then, at some level of input of the variable factor, the addition to
output will begin to diminish. Hence the law of variable proportions is also referred
to as the law of diminishing marginal returns.
It is important to note that the concept of increasing marginal returns and the law
of variable proportions are about output in the short run. However, they obviously
have implications for the costs of production. Because fixed costs remain the same
at all levels of output up to the point of full capacity, these fixed costs per unit must
always fall, on average, as output expands. If we made the assumption that the
additional costs of employing factors is constant, then falling average costs plus
increasing marginal returns must bring down average or unit costs of production.
However, as output expands the fall in average fixed costs becomes weaker and
diminishing marginal returns set in. This means that the normal shapes for average
and marginal cost curves are as illustrated in Figure 2.30.

Figure 2.30
Note that when unit costs fall and then rise the marginal cost (MC) curve must
intersect the average cost (AC) curve at its lowest point. This is a mathematical
rule for average and marginal numbers derived from the same set of figures.
2.2.3 In the long run

The shapes of the cost curves are further confirmed in the long run when, by
definition, all the factors of production are variable and there is no fixed factor
constraining expansion. What were fixed costs in the short run vary in the long run
as the firm changes its capacity. Two further theories are introduced at this stage:
economies and diseconomies of large-scale production.
Economies of scale exist when a firm grows larger, and factors inside and outside
the firm cause the unit or average costs of production to fall. Internal economies of
scale result from technical issues such as increasing dimensions where doubling
the size of each dimension increases the volume by eight times; or marketing
economies where advertising costs are spread over larger volumes; or financial
economies where larger loans can be negotiated at lower interest rates; or
management economies where a larger firm can be managed by a similar sized
group of people to that employed by a small firm. Outside the firm the very fact
that it is large may lead to external economies of scale. A local college may offer
training courses, governments may offer to improve the local infrastructure or a
component supplier may move nearby to take advantage of reduced transport costs
and delivery times. All these things can reduce the firm’s costs and are outside its
control.
However, all good things come to an end, and at some point a growing firm
comes up against diseconomies of scale. Internally, these are usually the difficulties
involved in co-ordinating the production process, controlling and communicating
with a larger workforce and maintaining the morale of the workers, especially
when they feel only a small cog in a large engine and do repetitive and boring jobs;
and larger firms often find it harder to control their costs. External diseconomies
may result from more firms growing in the area and competing for and ultimately
forcing up the price of labour. Roads may become congested and rents may
increase, all outside the control of the firm. Again, all the evidence suggests that,

under normal circumstances, the long run cost curves will look the same as the
short run curves illustrated in Figure 2.30. The only difference will be the scale of
the productive process. In fact, the long run average cost curve will be an envelope
around many short run cost curves as illustrated in Figure 2.31.
Figure 2.31
SRAC5 LRAC
SRAC1
£
SRAC2 SRAC4
SRAC3
Output
Also note that each short run cost curve (SRAC) is tangential to the long run cost
curve (LRAC) but only SRAC 3 is tangent at its lowest point to the lowest point on
LRAC. This is because points of tangency always have the same slope.
A final point to note is that not all firms grow large as some firms cannot achieve
significant economies of scale and therefore reach the optimum size (the lowest
point on the average cost curve) at a relatively low level of output.
2.2.4 The firm’s supply curve

In order to construct a firm’s supply curve it is necessary to make some simplifying
assumptions and to use a model that includes the curves set out in Figure 2.32.

Figure 2.32
Firstly we will assume that a firm aims to maximise profits (we will question this
assumption later in the course). Secondly we will assume that the firm can sell
unlimited amounts of its product for a single price. This means that the marginal
revenue it receives for selling one more unit is equal to the price. Thirdly we note
that a firm maximises profit when marginal cost (MC) = marginal revenue (MR) and
MC is rising.
All of this means that in Figure 2.32 the MC curve above average total cost (ATC) is
the long run supply curve for the firm. It is maximising profit at all prices between
P 2 and P4. The average cost curve in the diagram is the average total cost curve
that is made up of average fixed costs (AFC) + average variable costs (AVC). The
gap between ATC and AVC along the MC curve is part of a short run supply curve
for the firm. Although P 1 is a loss minimising position, a firm will continue to
produce for a short period of time as long as it can cover its variable costs. Think
of variable costs being labour and fixed costs being rates due at the beginning
of the financial year. If the firm cannot pay its labour, it will cease production as
would happen at a price Po; however, it can carry on production for a little longer
at P 1 until the next round of fixed costs becomes payable and then the firm will
close down if there has been no improvement.
Therefore MC above ATC is the long run supply function and MC above AVC is the
short run supply function.
2.2.5 The industry supply curve

Individual firms in a market economy are assumed to stay in production as long
as it is profitable to do so. In a competitive market it is generally agreed that each
of many similar firms cannot influence market price and consumer sovereignty
prevails.
At a given market price there will be a number of firms willing to supply the product.
In reality it is likely that some firms will be more efficient and others will be less

efficient in terms of their lowest attainable unit cost of production. As the price
rises so each firm will find that its marginal revenue exceeds its marginal cost and
it will maximise profit if it expands output. Also other firms who are less efficient
may now find it profitable to enter this market. The opposite will happen if the
market price falls.
The industry supply curve is therefore made up of the horizontal sum of all the
firms’ output at each prevailing market price. The normal shape for an industry
supply curve is upward sloping from left to right (a positive slope), ie the more
consumers are willing to pay for a product, the more producers are prepared to
offer for sale, as illustrated in Figure 2.33.
Figure 2.33
£ S
P2
Price
P1
Quantity supplied
Q1 Q2
2.2.6 Shifts and movements in supply curves

If the first thing that happens in a marketplace is a change in price and this change
brings about a change in output, then this will be represented as a movement
along a supply curve as illustrated in Figure 2.33. Alternatively, if the first thing
that happens in the marketplace is a change in the quantity supplied then this will
be represented by a shift in the supply curve, outwards or to the right if supply
increases and inwards or to the left if supply decreases. This may be easier to
understand if you remember the following: more or less supplied at different
prices is a movement; more or less supplied at the same price is a shift.
Shifts may occur as the result of variable weather in the agricultural industry,
technical progress, changes in costs of production or changes in indirect taxes or
subsidies.

2.2.7 The elasticity of supply
2.2.7.1 Measuring price elasticity of supply

We have stated that a supply curve will be upward sloping from left to right, but,
as with demand, it is possible to measure the elasticity precisely by calculating the
relationship between a change in price and the change in supply.
The algebra is the same formula used for demand and now adjusted for supply, ie:
Percentage change in quantity supplied
Coefficient of supply elasticity =
Percentage change in price
Graphically there are three uniform shapes, two of which are obvious and illustrated
below in Figure 2.34.
Figure 2.34
Price
S2
P1 S1
Quantity supplied
The first curve S 1 is described as perfectly elastic and has a mathematical value
that is infinite. It means that at P 1 and above there is an infinite supply of a product
and below P 1 there is no supply.
As an extreme case, this is unrealistic. However, the perfectly inelastic curve S 2
that has a value of 0 is possible as many products are unique, eg the Mona Lisa,
and cannot be increased as the price rises. Also theatres and sports arenas have a
fixed seating capacity that cannot change as price changes.
The third uniform shape is the unitary supply curve. Surprisingly, any straight line
that passes through the origin of the graph has the same percentage change on
each axis as illustrated in Figure 2.34. There is a proof using similar triangles if
you are interested.

Figure 2.35
Otherwise, any straight line that would intersect the horizontal axis has inelastic
supply over the range illustrated and any straight line that would intersect the
vertical axis has an elastic supply curve as illustrated in Figure 2.36.
Figure 2.36

2.2.7.2 Factors affecting supply elasticity
Figure 2.37
Price
S1 (VSR) S2 (SR) S3 (LR)
P2
P1
Quantity supplied
Q1 Q2 Q3
Figure 2.36 shows that if the price rose from P 1 to P 2 then, in the very short
run, when it is not possible to change any productive factors, the supply curve is
perfectly inelastic. In the short run, when it is possible to change all but one factor,
then the supply curve will show a positive elasticity. Finally, in the long run the
elasticity will adjust fully to the fact that all productive factors are variable.
In the short run

Supply elasticity will be affected by the amount of spare capacity a firm has up
to the point of full capacity, the level of stocks held, the access to unemployed
resources and the law of variable proportions.
In the long run

The supply elasticity will be affected by changes in process, internal and external
economies and diseconomies of scale and the level of spare capacity in the
economy as a whole, and the access to relevant skills.
Products in joint supply

There are a number of examples of products that are supplied together, eg beef
and cowhide, lead and zinc, and wooden furniture and sawdust. If there is an
increase in demand for beef, it is likely that the price will rise and more will be
supplied. However, this will shift the supply curve for cowhide to the right and
lower its price.

2.3 The elementary theory of price
2.3.1 Equilibrium price and output

It is the interaction of supply and demand in a free market that determines the
market price. By drawing supply and demand curves on the same graph, it is
possible to identify an equilibrium price and output where the quantity demanded
by consumers is equal to the quantity supplied by producers. This is identified at
PoQo in Figure 2.38.
Figure 2.38
Price
Surplus S
{
P2
>>
>>
P0
>>
>>
P1
{
Shortage D
Quantity
Q1 Q0 Q2
Should the price be lower, as with P 1, then a shortage, Q 2 - Q 1, will develop in the
marketplace as demand exceeds supply. At this price, forces will be set in motion
to move the price back towards equilibrium. Producers will seize an opportunity to
raise price and make more profits, while at the same time this action will reduce
consumer demand.
If the price is set too high as with P 2 then a surplus will develop, Q 2 - Q 1, and
firms will be forced to lower price to eliminate this surplus. This is what is meant
by market forces.
2.3.2 Changes in supply and demand functions

So far we have explained shifts and movements in terms of either a demand or a
supply curve. Now that we are looking at the interaction of supply and demand,
we need to recognise another important connection: a shift in either the supply or
the demand curve will bring about a movement along the other curve.

The elementary theory of price
Figure 2.39
S1
Price
S2
P2
P3
P1
D2
P4
D1
Quantity
1 2 3 4
Q Q Q Q
In Figure 2.39 the equilibrium P 1Q 1 is where S 1 and D 1 intersect. If more is

demanded at each and every price D 1 will shift to D 2 and a movement along the
supply curve S 1 will produce a new equilibrium at P 2Q 2. Looking at the diagram
you can read off the various shifts and movements that take place as more or less
is demanded or supplied at each and every price.
2.3.3 Producer surplus and consumer surplus

Figure 2.40 illustrates an equilibrium price at PQ. The area represented by ABP is a
consumer surplus that is defined as the difference between the maximum amount
of money consumers are willing to pay for a product, which is illustrated by the
demand curve D, and the amount that they actually pay as the market produces a
single price that benefits those people who would have paid a higher price.
At the same time, the producer also makes a surplus represented by the area
PBC. This surplus is revenue received by the producer over and above the amount
required to bring forth that quantity of the product to the market and is therefore
extra revenue to the producer.

Figure 2.40
2.3.4 Market distortions
Up to this point there have been a number of assumptions made that describe a
competitive marketplace, ie lots of firms accept a market price that is determined
by many competing consumers. The perfectly competitive marketplace will be
described in the next topic. However, there are many imperfections in the
marketplace, some of which will be described to help bring a little more reality
into this analysis.
2.3.4.2 A price set too low: Development of a black market

For many reasons a price can be set below the market price. An example would be
FA Cup Final tickets where, in order to reward the loyal supporters of the clubs in
the final, prices are not as high as they could be for a showpiece final. Similarly,
where there is a limited space in a stadium used for a music concert, the price
that will fill the venue is not known in advance and the last thing the promoter and
performer want is a half-full stadium, so if they err it is then on the side of a price
that is too low as illustrated in Figure 2.41.

Figure 2.41
Price S
P1
P2
D
Quantity
Q1 Q2
Where there is a ground or stadium capacity, the supply of tickets for the event is
perfectly inelastic. If P 2 is below the market clearing price (P 1) then a shortage of
tickets will exist Q 2 - Q 1. This shortage is a necessary condition for the development
of a black market. However, for a black market to exist a second condition needs
to be in place and that is that some people must have access to some of the tickets
that they can resell at any price the market will bear. Therefore the cheapest cup
final tickets may resell for thousands of pounds.

2.3.4.3 Price too high: Development of a surplus
Figure 2.42
Price
P1
Quantity
1 2
Q Q Q
If price is fixed at P 1 a surplus will develop as Q 2 is supplied and Q 3 is demanded.

This has happened in the agricultural industry where output is likely to fluctuate
owing to weather conditions. The government may intervene, because of the
perceived importance of self-sufficiency, and stabilise market prices. This will stop
the bankruptcies that occur particularly during good harvests when price is forced
down below costs. In this situation the surpluses need to be resold in markets that
do not affect local prices, stored at a cost or destroyed. A humorous depiction, that
you may like to look up, of what can happen in this situation is described in Joseph
Heller’s Catch 22 (p45 Corgi edition) when he introduces Major Major’s father.
2.3.4.4 Maximum and minimum pricing policies

It is important to note the difference between the effect on the market of a price that
is fixed too high or too low as opposed to the use of maximum or minimum pricing
policies. For various reasons, such as trying to control inflation, the government
may impose a maximum price on an industry or a minimum price if, for example,
it was trying to protect employment.

Figure 2.43
If the maximum price is below the equilibrium price, as in diagram 2, Figure 2.43,
then Q 3 will be demanded and Q 2 will be supplied at P 2. Shortages will develop.
In contrast, if the maximum price is set above the equilibrium price then the free
market price P 1 will prevail as no firms will have the incentive to raise price above
the market price.
Similarly, if the minimum price is above the equilibrium as in diagram 1,
Figure 2.43, then Q 2 will be demanded and Q 3 supplied at P 2. This will lead to
a surplus in the marketplace. However, if the minimum price is below the market
equilibrium then the equilibrium price P 1 will prevail as no firms will need to charge
less than the market price.

Therefore, in this example, distortions only occur on one side of the equilibrium,
ie too high for a minimum price and too low for a maximum price.
2.3.5 The cobweb theory: A dynamic theory of price

This approach takes price theory from the simple static interpretation so far
undertaken to a more realistic analysis in an ever-changing world. The cobweb
theory is usually applied to agriculture and it uses a static model, but introduces a
time lag between decision and execution and an output total that is variable. The
time lag is one year between the decision to increase supply and the extra supply
coming on to the market.
This is illustrated in Figure 2.44 if we assume that a bad harvest produces Q 1 when
Q 3 was the intention. In the current year price will rise to P 1 and P 1 will induce a
higher level of output next year at Q 2. Assuming no more shocks, you can follow
the bold points on the curves until you eventually disappear into the equilibrium.
Figure 2.44
Price
P1
Quantity
1
Q Q 2
Summary
u In a free market economy market forces act to allocate resources and distribute
products.
u The theory of consumer behaviour assumes that people are rational and will
attempt to maximise usefulness from every product they purchase.
u The law of diminishing marginal utility, indifference curve theory and budget
lines are used to explain how consumers react in different situations.

Summary
u The sum of individual demand produces a market demand for products that is
normally downward sloping from left to right.
u There are, however, some interesting exceptions that produce perverse demand
curves.
u The elasticity of demand functions can be measured and can provide a useful
insight into the impact of price changes on the quantity demanded by the
consumer and the revenue received by the producer.
u Supply functions for firms and industries can be constructed with the help
of, and reference to, the law of variable proportions and economies and
diseconomies of scale.
u Supply elasticity varies considerably between the short run, when at least one
factor of production is fixed, and the long run, when all factors are variable.
u Together, supply and demand curves produce market prices for products.
u Simple static models of markets produce equilibrium prices and outputs for
products.
u Moving closer to reality, we have identified a number of market distortions that
can be applied to various product markets.
References
Orwell, G. (1945) Animal Farm. London: Secker and Warburg.

Topic 3
The theories of the firm
‘The world is full of willing people; some willing to work; some willing to let
them.’
Frost (1958)

u perfect competition;
u monopoly;
u monopolistic competition;
u oligopoly;
u how useful these theories are in understanding pricing and output;
u the discussion over whether monopoly or competition allocates resources
more efficiently;
u an alternative theory of contestable markets;
u a critique of the profit maximising assumption; and
u private v. public ownership.
3.1 The theory of perfect competition
3.1.1 Assumptions
3.1.1.1 Many competing buyers and sellers

There are many competing producers so that no one firm can become dominant
and it is not possible for a monopoly or one firm industry to develop. Also there
are many competing customers so that it is not possible to form a monopsony or
single buying unit.
3.1.1.2 Homogenous product

It is assumed that all products are identical so that there are no discriminating
features between products other than price.

3: The theories of the firm
3.1.1.3 Perfect knowledge

Consumers have perfect information regarding the price and availability of
competing products; while, in order to make entry into the industry viable,
producers must know what costs and what profits are being achieved by all other
potential and actual competitors.
3.1.1.4 Free entry into and exit from the industry

There must be no cost barriers to entering or exiting from the industry. This means
that when profits increase firms will be attracted into the industry and when losses
occur firms will leave the industry.
3.1.1.5 Perfect mobility of productive factors in the long run

All productive factors, including enterprise, must be equally available to all firms,
perfectly mobile in an occupational (job to job) and geographical (place to
place) sense, so that they can move out of less rewarding activities towards more
rewarding activities as market signals indicate.
3.1.1.6 No time or transport costs

To complete the analysis, it is usual to assume that there are no additional time
or transport costs to the producer or consumer, although identical transport costs
would create the necessary identity.
3.1.1.7 Price takers

In the long run all firms take the market price as they cannot influence it by their
actions.
3.1.1.8 Theory and reality

In real life the conditions described above may never apply or may never apply
simultaneously. It must be emphasised that the assumptions of perfect competition
are primarily an analytical device to reach a certain level of basic understanding.
Once this elementary level is mastered then it becomes possible to develop more
complex models that more closely reflect the real world.
Ask yourself why the foreign exchange market and the markets for cereals are
often considered closest to examples of perfect competition.
3.1.2 Assertions
3.1.2.1 Profits
In economics various types of profit are strictly defined and necessary to explain
the various theories of the firm. When the total revenue a firm receives is greater
than its costs, then the surplus is defined as an excessive profit. This is because
a normal profit is considered to be the opportunity cost of enterprise, ie the
minimum amount of profit required by the entrepreneur to stay in that line of

The theory of perfect competition
business. Without that reward the entrepreneur would move to an alternative

business.
Abnormal profits, which are by definition not normal, cover two levels of profit.
The term is used to describe the excessive profit already described (sometimes
referred to as super-normal profit) as well as subnormal profit, which is a level
of profit that is not sufficient to keep a firm in business in the long run.
A final point to note is that profits may just be referred to as short run profits,
which could be subnormal and cause firms to leave an industry or excessive and
attract firms into an industry; or the profits may be described as long run profits,
which are normal and just sufficient to maintain the current level of firms in the
industry.
3.1.2.2 Profit maximising

A firm can produce at many levels of output that are profitable, but usually it is
assumed that there is only one level of output where profits are at a maximum.
This leads to the profit maximising rule: it is a necessary condition for profit
maximisation that output is where the marginal cost (MC) of producing the last
unit of output is equal to the marginal revenue (MR) received from selling that last
unit. However, to make the rule sufficient it is necessary to add that MC must be
rising as illustrated in Figure 3.1 where Q 2 is profit maximising even though Q 1
completes the necessary rule.
Figure 3.1
MC
MR
Output
Q1 Q2
3.1.2.3 Long run and short run

In the long run a firm will stay in business as long as its total revenue is equal to or
greater than its total costs, ie it is making at least normal profit. However, in the
short run a firm may be making subnormal profits or even be loss-making and still

stay in business. This rule states that a firm can remain in business in the short
run as long as its total revenue is equal to or greater than its total variable costs.
The reasoning behind this is that a firm must cover variable costs such as wages
or it will immediately cease production. However, certain fixed costs like rent and
rates may not need to be paid until next year and so the firm will eventually close
down when it comes to paying next year’s fixed costs.
3.1.3 The demand curve for a perfectly competitive firm

Each very small firm in a larger industry produces only a very small proportion of
the total output of that industry. In addition to this, the range of output over which
the firm can be profitable is relatively small and therefore no one firm can change
output sufficiently to influence the market price of the product. The result is that
each firm faces a perfectly elastic demand curve (D) as illustrated in Figure 3.2.
Figure 3.2
P D, MR, AR
Quantity
As each firm can sell all its output at the market price, its demand curve is the
same as the additional revenue (MR) received from selling one more unit and the
same as its average revenue (AR), since total revenue divided by the quantity sold
will be equal to the price at all levels of output.
3.1.4 The supply curve for a perfectly competitive firm

Because of a number of limiting assumptions the firm in perfect competition only
has a short run supply curve. This is because, in the long run, there is only one
point of equilibrium where the firm is making normal profits. There are, however,
many points of equilibrium that can occur in the short run when the firm is making
excessive or subnormal profits. This means that the supply curve is the marginal
cost curve above average variable cost (AVC) as illustrated in Figure 3.3.

Figure 3.3
3.1.5 The profit maximising equilibrium
3.1.5.1 In the short run
Figure 3.4
In Figure 3.4 there are two short run equilibriums. P 1Q 1 is a loss minimising
equilibrium where the firm will stay in business over the short run because it is
covering its variable costs. P 2Q 2 is an excessive profit-making equilibrium where
the shaded area represents the excessive profit. Neither equilibrium is stable and

forces will be set in motion that will shift the firm’s demand curve towards a stable
position, ie existing firms will leave the industry if they are making less than normal
profit and new firms will enter the industry if existing firms are making more than
normal profit.
3.1.5.2 In the long run
Figure 3.5
If firms are making excessive profits then new firms will be attracted into the
industry and each individual firm’s share of the market will contract and its demand
curve will shift downwards. If firms are making losses or subnormal profits then
firms will leave the industry and those left will find their demand curves shifting
upwards. Only at one point, where the demand curve is tangential to the average
cost curve, will each firm be making normal profit and this is the long run stable
equilibrium for a perfectly competitive firm. At this point MC = AC = MR = AR =
price.
3.1.6 Marginal and intra-marginal firms

As a point of interest, there is a weakness in the argument regarding identical firms
who make identical decisions at the same point in time. Taken literally, it means
that when the industry is loss-making all firms will make a decision to leave the
industry at the same time. For the theory to explain actions as so far described it
is necessary for firms to leave the industry one at a time. One way of explaining
this is to assume that there are slight variations in the cost of enterprise and only
the marginal firm is in long run equilibrium while other firms are slightly more
profitable and these are referred to as intra-marginal firms.

3.1.7 Perfect competition and efficiency

At this point, it is necessary to introduce two types of efficiency, namely allocative
efficiency and productive efficiency.
Allocative efficiency occurs when a firm produces where P = MC. It means that
the price a customer is willing to pay to buy the last unit produced is equal to
the additional cost of using resources to produce that last unit. Figures 3.4 and
3.5 illustrate that a perfectly competitive firm is allocatively efficient in both the
short run and the long run. This is also described as bringing about an optimal
allocation of resources.
Productive efficiency occurs when a firm is producing at the lowest point on its
average cost curve. This occurs in perfect competition only in the long run as
illustrated in Figure 3.5. In the short run the profit maximising or loss minimising
equilibrium is to the right or to the left of the productively efficient point as
illustrated in Figure 3.4.
3.1.8 The perfectly competitive industry
Figure 3.6
£
S
P1
D
Quantity
Q1
For the perfectly competitive industry, equilibrium is the same as the one we
constructed for a marketplace in the previous topic. Two points of interest need,
however, to be explained. The first is the difficulty some people have with
understanding how the horizontal sum of each firm’s perfectly elastic demand
curve can produce a downward sloping demand curve for the industry. The
explanation is that the range over which output would vary for each firm in the
short and long run is significantly smaller than the change required to affect the
market price. The second is that, for the supply curve to be upward sloping from
left to right, it must be assumed that all firms face rising costs as the industry

expands. If they faced constant costs then the supply curve would be perfectly
elastic or if they faced falling costs then it would be downward sloping from left to
right.
3.2 The theory of monopoly
3.2.1 Introduction
At the other extreme from a perfectly competitive industry is the theoretical
extreme of an industry with only one firm in it. As the monopolist has complete
command over the supply of a product, it is a price-maker rather than the
price-taker of perfect competition. However, the monopolist has no power to
dictate demand and the consumers are many as under perfect competition. The
monopolist can, however, discover the nature of demand and offer a quantity of
the product that can produce excessive profits in the short and long run.
In reality there is a difference between a monopoly and having monopoly power
as the government considers any firm that has more than 25 per cent control of
a market as having a degree of monopoly power and being therefore liable to
investigation by the Competition Commission to determine whether the firm is
abusing its monopoly position.
3.2.2 Barriers and the creation of a monopoly
Monopolies depend for their existence on barriers to entry into the industry.
Without these barriers the excessive profits of the monopolist would sooner or
later attract new competing firms who would enter the industry and erode the
profits. For the purpose of analysis, the creation of barriers can be described
in two main groups. Firstly there is the natural or spontaneous monopoly that
occurs without any deliberate action on the part of the producer. Secondly there
is the deliberate monopoly where producers or governments consciously aim to
exclude competition. It is mainly in this second group of monopolies that a further
important distinction can be made between monopolies that are set up to benefit
the consumer and the producer; and monopolies that are set up with the expressed
aim of making excessive profits at the expense of the consumer. This further
distinction is particularly important in formulating policy in the ‘national interest’.
In the one case, a monopoly can be encouraged in a controlled way, while in
the other case the monopoly can be broken up or encouraged to produce in the
national interest.
3.2.2.2 Natural monopoly

The geographical distribution of natural resources is very uneven and the known
deposits of some materials are concentrated into very small regions, eg nickel,
gold, diamonds, etc. Where the known deposits are highly concentrated in a given
area there is a great incentive for producers to form a monopoly in order to
manipulate supply. Of a similar nature is the potential for monopoly in certain

The theory of monopoly
regions that give their name to products that are unique because of local soil and
climatic conditions, eg wines, champagne, whisky, coffee, tea, etc.
So far the examples above of natural monopolies are of nature, but there are
other monopolies that are given the same status as they do not occur deliberately.
Another group of examples is caused by the technical barriers that are created by
economies of scale. When firms are already operating on a vast scale making
use of large indivisible units of capital such as in tyre manufacture, oil processing,
chemical plants, then it is almost impossible for new firms to enter, start business
in a small way and then expand to a competitive size. This is because they cannot
compete with the already existing larger firms that have much lower unit costs of
production.
A third group of natural monopolies may be local monopolies that gain their
advantage when protected by the prohibitive cost of transporting competing
products into a particular region. Also it is possible that a firm may remain the
sole provider of a product through the ignorance of potential competitors.
3.2.2.3 Deliberate monopoly

In the public sector of the economy or from the public sector, monopolies have
been created that are arguably in the national interest. In the past the monarchy
granted firms monopoly status and even today firms receive royal patronage.
Government protects a firm’s invention from competition for 16 years under the
Patent Act. Public utilities have been granted monopoly status, while legislation
has created monopolies of marketing and distribution, particularly in agriculture.
In the private sector the desire for greater profits has encouraged firms to try to
become monopolies through a process of contrived scarcity or anti-competitive
practices. These may involve tied outlets for retailers, subsidiary companies set
up to be loss-making and force competitors out of the market or persuasive
advertising programmes designed to strengthen a company’s uniqueness. Finally,
mergers and takeovers will reduce the number of competitors. For example, the
big four retail banks now supply 77 per cent of personal current accounts in the
UK (ICB, 2011).
3.2.3 The monopoly model
3.2.3.1 Preliminary considerations

Cost curves for a monopoly are the same shape as in other theories of the firm.
It is the monopoly revenue curves that are different when compared with perfect
competition. The firm is the industry, since there is only one firm, and therefore
the demand curve is a normal downward sloping curve from left to right. As the
demand curve shows how many units are demanded at each and every price it is
also the average revenue curve. However, since the price must be lowered to sell
more units, the addition to revenue (ie marginal revenue) is less than the average
revenue as illustrated in Table 3.1.

Table 3.1
Price Sales Total AR MR
revenue
10 1 10 10 10
9 2 18 9 8
8 3 24 8 6
3.2.3.2 The profit maximising equilibrium
Figure 3.7
To satisfy the profit maximising rule, output is where MC = MR at Q and price is

determined on the demand curve at P. The difference between AC and AR is the
excessive profit that is recorded in Figure 3.7 as the shaded area PABC. Also note
that there is no linear relationship between market price and quantity supplied
so there is no supply curve under monopoly. Because the long run equilibrium is
stable, the only difference between the long run and the short run is what may
happen to the cost structure of the monopolist.
3.2.3.3 The monopolist and efficiency

As shown in Figure 3.8 the profit maximising equilibrium does not produce equality
between price and marginal cost so there is no optimal allocation of resources
under monopoly. For equilibrium to occur at P 1Q 1 where price = marginal cost
the firm would no longer be profit maximising. Also in the diagram, the profit
maximising equilibrium is to the left of the productively efficient level of output
(lowest point on the AC curve). However, it should be noted that just by chance
it could be that the MR curve passes through the intersection of MC and AC and
therefore productive efficiency could exist in this unique position under monopoly.

The theory of monopoly
Figure 3.8
3.2.3.4 The monopolist and price discrimination

For the sake of this analysis we will consider two types of price discrimination.
The first type is discrimination between units sold to the same buyer, an example
of which would be rail travel at different prices at different times of the day. The
second type is discrimination between buyers such as cinemas charging discounted
prices to pensioners and full prices to other people.
A single price monopolist can become a discriminating price monopolist if it is

possible clearly to separate the market into segments and stop any resale of units
between the different parts of the market. It is easier to separate the market for
services than for goods and this segmentation can occur as the result of:
u different times
u transport costs
u quotas and tariffs
u age of the consumer
u gender of the consumer and

u national boundaries.
The advantage of price discrimination is that the monopolist can start to absorb
the consumer surplus to increase revenue. In fact a perfectly discriminating
monopolist can absorb the entire consumer surplus as the producer is able to
charge the full price that each consumer is willing to pay. This is illustrated in
Figure 3.9.

Figure 3.9
MC
P
B AC
C
AR
Pn
A
MR, D
Quantity
Q
It is interesting to note that, because all of the consumer surplus is removed and
each unit is sold at the highest possible price between P and PN, then the demand
curve is the marginal revenue curve (MR) and the profit is the area between AC and
AR at PnABC.
A final point of interest is that the word discrimination often has bad connotations
but it is possible for the process of price discrimination to benefit the economy
as it could bring forward the production of a good or service that, given a single
price, would not be viable to produce.
Suppose that, in the days before the NHS was set up, a GP in a poor rural area with
only a few rich patients could not cover costs by charging a single price. This is
illustrated in Figure 3.10 by the fact that the AC curve is always above the AR curve
and therefore a single price P is loss-making.

The monopolistically competitive model
Figure 3.10
AC
B
P
A
C
AR
MR
Quantity
However, if the GP can charge the richer patients more then, as long as the
triangle PDA is larger that ABC, the GP can remain in business and treat all patients
irrespective of their income.
3.3 The monopolistically competitive model
3.3.1 Introduction
Between the two extremes of monopoly and perfect competition there must be
industries that comprise many firms and others with only a few firms. In theory
these two groupings are separated into those industries where there are too many
firms to make any form of collusion viable, and those industries where there are
only a few firms, like the retail banking industry, where collusion is possible. In the
case of too many firms we have a supporting theory of monopolistic competition
and too few firms will be looked at under oligopoly.
3.3.2 Characteristics
Confusingly, both monopoly and competition are used together in naming this
type of industry. The reason is that each firm has many competing firms producing
products that are similar but not identical, and each firm, at least, monopolises a
legal entity that is its proprietary name and has probably worked hard to create a
brand image that makes it slightly different from its competitors.
So in this industry there are many firms producing similar but differentiated
products. Barriers to entry and exit are very low or even non-existent, and, because

there is some product differentiation, each firm faces a downward sloping demand
curve rather than a perfectly elastic demand curve. In fact, the more successful the
firm is at creating a brand image, the less elastic will be its demand curve and vice
versa.
There will also be price competition between firms, each firm being able to charge
a slightly higher price than in a perfect market because of brand loyalty and the low
price elasticity that this entails. Each firm’s costs will be higher than in a perfect
market because of the need to advertise and market its brands, and these higher
costs will be passed on to the consumer in higher prices. Chamberlin (1933) said
that this is the price paid by the consumer for having choice among brands.
3.3.3 Profit maximising equilibrium in the short run

To simplify things it is possible to use the monopoly equilibrium in Figure 3.8
as short run equilibrium for firms in monopolistic competition. In a monopoly
situation barriers to entry can sustain this equilibrium into the long run; however,
because the diagram shows an area of excessive profits, this cannot happen in
monopolistic competition. New firms will be attracted into entering the industry
and as they join so the demand curve and the marginal revenue curve shift to the
left. For the monopolistically competitive firm the demand curve that is to the right
of a point of tangency will shift to the left and any demand curve to the left of that
point will shift to the right as illustrated by the arrows in Figure 3.11.
Figure 3.11
ATC
AVC
D1
D
Quantity
3.3.4 Profit maximising equilibrium in the long run

In the long run the equilibrium position under monopolistic competition will
be stable only when the firm is making normal profits. This means that the
demand/average revenue curve must be tangential to the AC curve as in
Figure 3.12.

The oligopoly model
Figure 3.12
When you draw this diagram it is often difficult to get MC to cut MR directly below
the point of tangency. In order to avoid this problem, always draw the curves in
the following order: AC, MC, AR; then mark on P and Q and last of all draw in MR.
3.3.5 The monopolistically competitive firm is inefficient

Both long run and short run firms in monopolistic competition are productively
inefficient as profit maximising equilibrium always settles at a point to the left of
the lowest point on the average cost curve where unit costs are falling. Sometimes
you will find this referred to as firms producing with excess capacity where
capacity output is the productively efficient level of output at the lowest point on
the average cost curve.
Also the firm is not allocating resources efficiently as the point described above
brings about a non-optimal allocation of resources, where price is greater than
marginal cost and the firm is maximising profits. Also note that in the long run
any position other than this equilibrium would be loss-making for the firm.
If we compare monopolistic competition with perfect competition then, for the
industry as a whole, the horizontal sum of all the firms’ output will produce a
higher price and a lower output for the monopolistically competitive industry.
3.4 The oligopoly model
3.4.1.1 A few firms

There is no definition of few in this sense. Usually it is taken to mean few enough
to be able to manage collusive actions. There is a loose relationship between the

capacity output of a firm and the total market demand. Suppose a firm reaches
the lowest point on its average cost curve when 50 per cent of the total market is
satisfied. This is likely to lead to a duopoly situation with two firms in the industry.
If a firm reaches this same point when 25 per cent of the market is satisfied then
it is likely to be an oligopoly with four firms and so on.
3.4.1.2 Barriers to entry

The economies of scale implied in the last section will automatically act as a barrier
to new firms entering the industry. Other barriers may be large set-up costs, large
fixed costs, large advertising budget or a proliferation of brands controlled by one
firm. Some firms have been found using aggressive and even illegal techniques to
keep competitors out of the market.
3.4.1.3 A kinked demand curve

Although there is no accepted diagram for the oligopolistic firm, it is generally
agreed that each firm faces a demand curve that is kinked at the prevailing market
price. Since there are only a few firms in the market, each firm is big enough to
notice the actions of others and to have its actions noticed by them. This means
that each firm formulates its pricing policy on the basis of what it thinks the other
firms will do and how they will react if it changes its price.
Figure 3.13
P1
P2
D Quantity
Q1 Q Q2
If PQ represents the current market price then it is argued that if the firm raises its
price to P 1 it will lose a lot of orders, Q 1, as customers shift to the other firms. In
other words, demand is very elastic so total revenue falls. In contrast, if it lowers
its price, P 2, then competitors will lower their price rather than risk a considerable
loss of sales. This means that demand will be relatively inelastic and that revenues
will once again fall as there will only be a small increase in demand to P 2. This fear

The oligopoly model
of a fall in revenue, whether prices are raised or lowered, pushes firms towards
some form of collusion. The price in this model is sticky and tends to stay at the
point of the kink; for this reason, price competition is not usually a feature of
oligopoly.
3.4.2 Types of oligopolistic behaviour
3.4.2.1 A basic dilemma

Oligopolists motivated by profits have the incentive to come to some sort of
agreement that would see them acting like a monopoly by restricting their output
and raising price to make excess profit. However, they are also in competition
with each other and face a situation where it is actually against the law to make
agreements that may restrict competition.
We have pointed out that oligopolists face a sticky price situation as they have no
incentive to raise or lower price as either change is going to lose revenue. This
means that oligopolists may become heavily involved in non-price competition, eg
expensive marketing campaigns, special offers, free gifts, loyalty bonuses, etc.
Before the practice was outlawed, petrol companies used to agree the petrol pump
price and compete strongly in the ways described above. When it became illegal to
entertain covert agreements, they used to announce price change in the press to
be introduced in the future and wait to see if other firms would follow. If they did,
the price change stuck; if they did not, then the price change was never introduced.
Collusive agreements of one sort or another between oligopolists tend to support a
higher level of prices across the firms. Non-co-operation tends to push the average
level of prices lower.
3.4.2.2 Does game theory provide a solution to oligopolistic

pricing?
The two by two matrix in Table 3.2 provides some insight into oligopolistic pricing.
Table 3.2
Firm Y
Comply Cheat
Firm Z Comply A B
Cheat C D
Suppose in a duopoly firms Y and Z have the opportunity to make an agreement to

restrict output and raise their prices and then they have the choice of complying
with that agreement or cheating on that agreement providing us with four possible
outcomes represented by A, B, C and D. These outcomes are influenced by the fact
that each firm has the incentive to persuade the other firm to comply while itself
choosing to cheat on the agreement. The reason is that cheating on the agreement,
as long as the other firm complies, produces even larger profits.

Let us look at the four possible outcomes:

u Position A represents an outcome where both firms observe the agreement to
restrict output and raise price resulting in excessive profits to each firm.
u Position B means that firm Y has persuaded firm Z to comply with the agreement
while at the same time cheating on the agreement. The profits of firm Y will be
even greater and firm Z will receive less profits and may even make a loss.
u Position C reverses the position in B as it is now firm Z that is cheating and firm
Y that is complying.
u Position D represents a situation where both firms cheat on each other while
unsuccessfully trying to encourage the other firm to comply. The result will
bring down profits to a normal level in the long run.
The conclusion of the game is interesting because it implies that the risk of the
other firm cheating will push the firms towards equilibrium where both firms will
make normal profits. In fact it may look more acceptable if we replace ‘comply’
and ‘cheat’ with ‘co-operate’ or ‘compete’. Also this analysis suggests that as long
as there is more than one firm in the industry competition will prevail and remove
any excessive profits.
3.5 Monopoly v. competition
3.5.1 The discussion

So far it has been asserted that firms in perfect competition are more beneficial
to society than monopolies. The more competition, the greater the benefit,and
the less competition, the more chance that the consumers’ position will be
weakened. However, even though UK and US legislation is based on this assertion,
it does require further analysis that may weaken the simple separation between
competition and monopoly that is described above.
3.5.2 In favour of competition
3.5.2.1 Efficiency
We have already shown that perfect competition brings about allocative efficiency
in the short and long run as price = marginal cost. Also we have shown that
productive efficiency occurs in the long run as firms produce at the lowest point
on the long run average cost curve. If all the assumptions of perfect competition
hold, then Pareto (after Vilfredo Pareto, 1848−1923) optimality will exist as there
is an optimal distribution of products to consumers and an optimal allocation
of resources to production.
3.5.2.2 Variety
Competition produces a greater variety of products for consumers to choose
among. Although in perfect competition this choice only refers to who produces the

Monopoly v. competition
product, under monopolistic competition there will also be variety among a range
of similar brands, designs and qualities of products offered up in the marketplace.
3.5.2.3 Profitability
In the long run excessive profits are eroded and firms will be left with normal
profit, ie the minimum level of profits required to keep them in business. In the
short run any excessive profits will produce a market signal that draws resources
to that part of the market where they will be most useful to society.
3.5.2.4 Consumer sovereignty

Competitive markets will produce what consumers want and, as consumer tastes
change, so adjustments to prices and profitability will draw resources away from
the less desirable product towards the more desirable product and consumer
demand will be satisfied.
3.5.2.5 More produced at a lower price

The competitive industry will end up producing more at a lower price than the
monopolistic industry that will be producing less at a higher price. The diagram
in Figure 3.14 shows that output for the perfectly competitive industry would be
P 1Q 1 while the introduction of a marginal revenue curve under monopoly produces
equilibrium at P 2Q 2.
Figure 3.14
S(MC)
P2
P1
AR
MR
Quantity
Q2 Q1

3.5.3 In favour of monopoly
3.5.3.1 Removing the given cost assumption

When perfect competition and monopoly are compared, as in Figure 3.14, there is
a given cost assumption. This means that, when a perfectly competitive industry
is transformed, the monopoly inherits the same cost structure. However, in reality,
one of the main motivations for growing larger is that the firm can benefit from
economies of scale. This means that it is unreasonable to assume given costs and,
if we remove this assumption, then it is possible, in a monopoly, that the costs will
move down sufficiently to produce a lower price and a higher output as illustrated
in Figure 3.15.
Figure 3.15
S - S 1 represents the reduction in costs caused by removing the given cost

assumption and P 2Q 2 is the monopoly price and output.
3.5.3.2 Dynamic efficiency

So far two types of efficiency have been identified: allocative efficiency and
productive efficiency. However, a third type of efficiency can be introduced into
the argument and it is related to how costs behave over time. Perfectly competitive
firms make normal profits over the long run and it is difficult to set funds aside
for research and development (R&D). In contrast the excessive profits of the
monopolist mean that it is more likely to complete R&D programmes and be
more innovative than competitive firms, especially if the government is offering tax
breaks on such activity. R&D is very important in, for example, the pharmaceutical
and electronic industries. This means that the firm with excessive profits is likely to
see a reduction in its costs over time that means it will be more dynamically efficient
than competitive firms. Even though the monopoly will remain productively and
allocatively inefficient in a comparison at any point in time, it is likely to become
more efficient over a period of time.

Do firms maximise profits?
3.5.3.3 Is there more consumer choice under monopoly?

Arguably, there is more real choice when a firm monopolises a market as could
be illustrated by the British Broadcasting Corporation (BBC) when it monopolised
the airwaves. In this situation it offered a variety of programmes that catered for
mainstream and minority interests. More competition over the airwaves produced
more radio stations, but initially all of them produced a similar programming of
popular music interspersed with popular current affairs and news items. However,
it can be argued that the existence of competition in recent years has forced the
BBC to improve the range and quality of its programmes.
3.5.4 Concluding points

We have shown that the three main arguments for competition, namely lower prices
and higher output, efficiency, and choice can be challenged. However, in both the
UK, with the Competition Commission, and the USA, with anti-trust legislation, we
can see that the assumption is that small competitive businesses are good while
large oligopolies and monopolies create a producer sovereignty that is damaging
to the economy and may be against the interests of consumers.
3.6 Firms in contestable markets

So far, the productive side of the economy has been described as being more or
less competitive dependent upon the number of firms in the industry. However, an
alternative theory suggests that the critical factor is the degree of contestability,
not the number of firms in the industry.
Markets are considered to be more contestable when there are fewer sunk costs,
which are the costs of setting up a business that cannot be recovered in the
normal course of events and that would be lost when the firm leaves the industry.
The theory implies that a perfectly contestable market has no sunk costs and
is therefore freely open for firms to enter. This means that, even if industries
contain only a few firms and as long as actual entry is possible or potential entry is
anticipated, then firms will be forced to keep their price low and will achieve only
normal profits. Theoretically, even a monopolist could be in a contestable market.
If this is the case then just the threat of a new entrant into the industry may be
sufficient to keep price and output at levels that sustain normal profits.
Between them contestable market theory and game theory indicate that in almost
all types of industry a level of real or potential competition will remove excessive
profits in the long run.
3.7 Do firms maximise profits?
3.7.1 Is it a realistic assumption?

So far it has been assumed that firms are solely motivated to make as much profit as
possible. There are, however, convincing arguments that question the assumption
that firms aim to maximise profit and produce at a level of output and set a price
that will equate marginal revenue and marginal cost.

3.7.2 Sales maximisation

The larger the firm, the more likely there is to be a separation between the
owners of the firm and the management of that firm. The obvious example is
the public joint stock company, where the owners are the shareholders who
take no part in management and the managers are paid employees. Here it is
likely that the majority of shareholders are unaware of the objectives set and
of the strategies chosen to achieve those objectives, and whether or not these
include profit maximisation. At the same time, managers can justify increasing
their salaries as the firm grows larger and they become responsible for more
employees and a greater turnover. This means that, as long as the shareholder
is satisfied by a certain minimum level of profit, the managers will push to expand
the company revenues without thinking too much about the effect on profits.
Figure 3.16 illustrates the point.
Figure 3.16
Pr1
Profits
Pr2
Total profits
Q1 Q2 Sales
The point at which profits are maximised is Pr 1Q 1 whereas if the shareholder

accepts a level of profits at Pr 2Q 2, where sales are much higher, then the firm will
be much larger and managers’ salaries will be justifiably higher.
In the past bankers’ bonuses have tended to be linked to the turnover of the
business and are therefore revenue driven. A solution may be to link bonuses to
the profitability of the bank: when the shareholder dividend increases, then so
does the bonus, and, since there can be large fluctuations in the performance of
banks (especially during a financial crisis), some suggest that bonuses should be
paid on the basis of average profits and losses over several years and not simply
of one year.
Firms that have recognised this problem have given their managers shares, thus
making them into shareholders, and linked a considerable proportion of executive
remuneration to the dividends paid out by the company.

Should firms be owned publicly or privately?
3.7.3 Satisficing
Professor Herbert Simon suggested a satisficing theory that started from the
assumption that there is no unique equilibrium that explains a firm’s action but
that firms may have many different goals. Aiming for these goals means taking
into account the claims of other stakeholder groups as well as shareholders,
eg employees, customers and society as a whole. Thus firms may be willing to
accept lower profits:
u for environmental reasons;

u for ethical reasons;
u to reward customer loyalty;

u to hide the potential for profits from potential competitors;
u to avoid exposure as an exploitative company;
u because the information is not available to identify a profit maximising position;

u because the firm is satisfied by its current level of profits;
u to avoid becoming a takeover target; and/or

u because in reality most firms are happy to approximate rather than expect to
achieve in an ever-changing environment.
3.7.4 Cost-plus pricing

In the 1930s Charles Hitch and Robert Hall looked at firms in and around Oxford
and concluded that costs plus a rigid mark-up was how prices were established.
This became known as cost-plus pricing where firms identified their average cost
of production and added a conventional mark-up. In this theory prices tend to be
fairly stable and only adjust to changes in costs.
3.8 Should firms be owned publicly or privately?
3.8.1 The case for public ownership
3.8.1.1 Public goods and merit goods

As public goods are non-rival and non-excludable, they would not be produced
in a free market. Known as collective consumption goods, they need a third-party
mechanism before they can be produced for the benefit of the community. The
provision of merit goods such as health and education has taken place under public
ownership where arguably the state can take advantage of significant economies
of scale and offer the product at subsidised or zero prices dependent upon the
perceived needs of the consumer. Now, parts of the health and education services
are provided by private firms, and there is a big debate over the role and extent of
the private sector in the provision of these services.

3.8.1.2 Natural monopolies

Public utilities such as electricity, gas and water are likely to become natural
monopolies. To avoid them being used to produce monopoly profits, the state
has, in the past, argued that they should be under state control. More recently
they have been privatised but with a watchdog to control many of their decisions,
the most obvious being pricing policy.
3.8.1.3 Duplication
A natural monopoly, which is operated by one firm, avoids duplication of
infrastructure. For example, once railway lines have been laid down it would not
be economically viable for a competitor to lay down another set of lines nearby.
Therefore the owner could take advantage of the near monopoly situation. This
is why there is a stronger argument for the state to control the rail network even
though the argument is not quite as strong for the competitive users of the line.
3.8.1.4 Externalities
Arguably, once an industry is taken into public ownership it becomes free from
the profit motivation and can take into account the greater good. This means that
external costs and benefits, which are ignored by the private firm, can be taken
into account by the publicly owned company.
3.8.1.5 Declining industry and job protection

It may be that changes in the marketplace, incompetent management, union
problems, foreign invention and innovation make a once great industry
uncompetitive. Arguably this happened to car manufacturing, steel and
shipbuilding in the UK. In the private sector, these industries would decline and
close down, having an impact on firms supplying the industry and communities
dependent upon them. State ownership could breathe new life into the industry,
allowing it to invest and regenerate. This would also save jobs and reduce the
welfare payments that would need to be paid out to compensate for job losses and
unemployment. Recently, partial nationalisation of RBS and LBG saved many jobs
in the banking industry.
3.8.2 The case for private ownership
3.8.2.1 Competition and market forces

Competition makes firms responsive to customer demands. It also imposes a
discipline on costs and encourages invention and innovation. Over time, resources
will be much more efficiently allocated in free markets.
3.8.2.2 Free from political constraints

Under public ownership, decisions may be made from a background of politics
rather than economics. Inefficient rail lines may be kept open because they run
through marginal constituencies, or the firm may be forced to buy more expensive
resources from the UK against its better judgement when the same resources can
be imported more cheaply.

Summary
3.8.2.3 No longer a drain on the public purse

The evidence from state ownership in the past has identified a considerable drain
on taxpayers where losses have been written off and inefficient processes have
been preserved.
3.8.3 An inconclusive conclusion

The case for public or private ownership is a continuing point of discussion. Even in
the case of public goods, it can be argued that they could be collectively financed
with taxpayers’ money, but do not need to be provided by a public enterprise.
Equally, where marketplaces exist, there are inefficiencies that seem to be possible
to overcome with state ownership. Any analysis of public or private ownership
needs to recognise that there are inefficiencies in the marketplace as well as
inefficiencies in government and a judgement needs to be made about the most
efficient way we can deal with the problem of asymmetric information where
one side has more information than the other.
Summary
u Many firms in the industry producing identical products is the basis of perfect
competition.
u At the other extreme, a one firm industry produces a theory of monopoly.
u Between these two extremes there are many firms in an industry producing
similar but not identical products (monopolistic competition) and an industry
with a few large firms producing similar or differentiated products (oligopoly).
u Perfect competition is generally thought to be the most efficient model for an

industry, and monopoly the least efficient.
u However, remove some assumptions from the theories that cover more
competition and less or no competition, and the debate becomes less clear-cut.
u A theory of contestable markets offers a different approach to analysing firms
in an industry.
u The assumption of profit maximisation may not be as universal as the models
suggest.
u Given market imperfections, there may be a place for public ownership of

productive assets?
References
Frost, R. (1958) The world is full of willing people, some willing to work, the rest willing to let them.
In: Prochnow, H. V. (ed) (1958) The new speaker’s treasury of wit and wisdom. New York: Harper
and Brothers.

Topic 4
Market imperfections and market
failure
‘In the leadership countdown there was one serious minus: I was not trained
in economics.’
A. Douglas-Home, Prime Minister (1963−64)

u the difference between imperfection and failure;
u what makes an economy efficient or inefficient;
u how information failure and asymmetric information misallocate resources;
u how public goods produce failure;
u how merit goods produce imperfection;
u the difference between equality and equity;
u whether market dominance is good or bad for the economy;
u whether factors need to be mobile; and
u whether the government should intervene in the economy.
4.1 Introduction
No market is efficient: they all have imperfections and sometimes the degree
of imperfection is sufficient to bring about total market failure. For example,
public goods, by their very definition, are not traded in a marketplace so for
them the market fails. In general, market imperfection is used to describe less
serious events, while market failure is used to describe the more serious events
that disturb, distort or eliminate trading in marketplaces.
4.2 Relevant efficiencies and inefficiencies
4.2.1 Efficiency
The economic efficiency of a firm is usually described in terms of productive
efficiency and allocative efficiency. Productive efficiency can be described in

4: Market imperfections and market failure
two ways: either the relative efficiency of one firm compared with another, or the
absolute efficiency of one firm’s level of output compared with other possible levels
of output for that firm.
Figure 4.1 shows two firms that have different average cost curves. Relative to
firm B, firm A is productively efficient at all levels of output, while a comparison
of the different level of output for firm A shows that the quantity Q 1 is the most
productively efficient level of output as it is the lowest average cost of production
that firm A can achieve.
Figure 4.1
Firm A Firm B AC1

AC
Output
Q1
For a firm to be allocatively efficient the level of output it produces must equate
price and marginal costs. This means that consumers are willing to pay a price
equal to the additional cost of producing one more unit. Again this can be
illustrated by looking at the two firms in Figure 4.2 where firm A is profit
maximising while firm B has set a price that will just cover its average cost of
production.

Relevant efficiencies and inefficiencies
Figure 4.2
Equilibriums exist in both diagrams, ie supply equals demand, but in both cases
resources are inefficiently allocated. At the output level Q 1 firm A is efficient
because the price is above the marginal cost of producing the last unit. In the
case of firm B the price P 2 produces an output at Q 2 where the price is below the
marginal cost of production. In this example the use of resources could become
allocatively efficient if they were shifted from firm B to firm A. If firm A expanded
output to Q 3 then its price would fall to P 3 and an equilibrium would equate price
and marginal cost. If, at the same time, firm B contracted output and released
resources to firm A, then at Q4 price would rise to P4 and again P = MC.
Distributing resources efficiently and allocating them efficiently to consumers is
described as Pareto efficiency. When this happens it is not possible to reallocate
resources in any way to make one person better off without making another person

worse off. Therefore it would not be productively efficient if one more product could
be produced without reducing the production of other products, or it would not
be allocatively efficient if a consumer could consume more without someone else
consuming less.
For the economy as a whole, Pareto efficiency exists when it is producing anywhere
along its production possibility boundary.
Figure 4.3
A
Consumer
goods B
D C
Capital goods
Points A, B and C are all Pareto efficient while point D, inside the boundary, is
inefficient as a movement towards the boundary means more of all products can
be produced. It is possible to use all resources and not be on the boundary if these
resources are not being used efficiently. On the boundary all resources are being
used in the most efficient way.
4.2.2 Inefficiency
So far inefficiency has been identified as a situation where firms are not producing
and consumers are not consuming in the most efficient way. Consumers would
not be efficient if they were irrational and not trying to maximise utility from their
chosen pattern of consumption. For the firm there are two types of inefficiency:
these are x-inefficiency and y-inefficiency.
X-inefficiency exists when a firm’s average cost curve is not at the lowest attainable
level. It may be the result of a lack of competition that has given rise to shoddy
work practices. Arguably, this may happen when a firm has a level of monopoly
power and it may occur in both the private and the public sector of the economy.
In either sector, management and workers may become careless in their attitude
towards minimising the unit costs of production.

Externalities
Y-inefficiency occurs when a firm with significant market power and little
competition has become lax about the market opportunities that exist and has
not recognised the potential of new customers or the fact that a different market
price might see an increase in profits. There are similarities with x-inefficiency in
that they are both based upon a level of incompetence and can occur in the public
or private sector of the economy. However, it could be possible for a firm to be
only x- or y-inefficient as one deals with an attitude towards costs, while the other
is concerned with potential revenues.
4.3 Externalities
4.3.1 Definitions
Externalities are third-party or spillover effects that the firm does not pay for,
but that are absorbed by others. There is never a contract to pay for external costs
or benefits. If there was, then they would have been internalised and no longer
exist as external costs or benefits.
Externalities can occur as the result of either production or consumption. For
example, a factory discharging toxic smoke is a production externality while a
person smoking in a confined space is a consumption externality.
External costs are sometimes referred to as negative externalities, while external
benefits are positive externalities. The total costs of production are made up
of private costs, which are such things as payments to the factors of production,
plus external costs, and the total is often referred to as the social cost to society.
Similarly with benefits, the private benefits, which can be recorded in the price
a consumer is willing to pay, plus the external benefit is equal to the total or
social benefit to society.
4.3.2 Externalities and resource misallocation
4.3.2.1 External costs

If a product has external costs then it will produce equilibrium with overproduction
and consumption of the product, as illustrated in Figure 4.4.

Figure 4.4
S1 (MPC+MEC=MSC)
Price S (MPC)
{ External cost
P1
D (MPB)
Output
1
Q Q
In the marketplace equilibrium will occur at PQ where marginal private costs (MPC)
= marginal private benefits (MPB). If external costs are represented by the vertical
distance between S and S 1 then an optimal allocation of resources to society will
occur where MSC = MPB at the position P 1Q 1. This means that the difference
between Q and Q 1 is the overproduction of this product.
4.3.2.2 External benefits

If a product only has external benefits then it will produce equilibrium with
underproduction and consumption of the product, as illustrated in Figure 4.5.

Externalities
Figure 4.5
£ S (MPC)
P
{ External benefit
P1
D1 (MPB+MEB=MSB)
D (MPB)
Output
1
Q Q
In the marketplace the equilibrium will be PQ where marginal private costs (MPC) =
marginal private benefit (MPB). If the external benefit is represented by the vertical
distance between D (MPB) and D 1 (MSB) then an optimal allocation of resources will
occur where MSB = MPC at Q 1. As this is not an equilibrium position, action will
need to take place to create an optimal allocation of resources where one option
is to manipulate the price down to P 1. On this occasion the difference between Q 1
and Q is the underproduction that occurs for this product.
4.3.3 Creating an optimum allocation of resources
4.3.3.1 Using taxes and subsidies

In order to create a socially optimal level of output for products with externalities,
it is necessary to equate the marginal social cost and the marginal social benefit. A
simple solution, if all information is known, is to use indirect taxation or subsidies,
as illustrated below in Figures 4.6 and 4.7.

Figure 4.6
Figure 4.6 illustrates how an external cost can be internalised by placing an indirect
tax on the product that is equal to the value of the external cost. This would change
the equilibrium from PQ to P 1Q 1 and decrease the output of this product to an
optimum level represented by Q 1.
Figure 4.7
Figure 4.7 illustrates an external benefit equivalent to the distance between MPB
and MSB. If a subsidy equivalent to this amount is put on this product then the MPC

Information failure and asymmetric information
curve will be shifted downwards by this value, producing equilibrium at P 1 and a

socially optimal output at Q 1.
Of course, the above will provide a perfect solution if there is perfect information.
Although it is relatively easy to value private costs by looking at those costs paid
out by the firm and private benefits by looking at the revenue taken in from selling
the product, it is not easy to put a value on external costs and benefits. A simple
example of this would be a firm discharging waste into a river; the waste then
creates an unpleasant smell, but at the same time feeds the fish and increases
fish stocks. The local ramblers might consider this an external cost while the local
fishermen consider it an external benefit. If it is not possible to value externalities
with any certainty, then it is not possible to know what level of subsidy or indirect
tax to place on the product. Nevertheless, this has not stopped high indirect taxes
being placed on cigarettes and alcohol arguably to counteract the harmful external
costs, and subsidies placed on education and the arts to encourage consumption.
4.3.3.2 Other ways of counteracting externalities

Rules and regulations have been established to increase the consumption of
products with external benefits. Raising the school leaving age has increased the
demand for education. Alternatively a reduction in the number of places where a
person can smoke has reduced the external costs from passive smoking.
The need for firms to buy pollution permits before they can discharge waste has
reduced pollution as well as transforming an external cost into a private cost.
In some countries public ownership of productive assets is used to increase the
production of beneficial products and reduce production and consumption of
harmful products.
4.4 Information failure and asymmetric

information
4.4.1 What is asymmetric information?

Information failure takes place when information is asymmetric. This means that
on one side of the transaction there is more knowledge than on the other side. It is
possible that both sides of a transaction have insufficient information to conduct
an efficient trade while on other occasions both sides may have all the relevant
information. As a rough rule it is more likely that information will be asymmetric
when the product being sold is complex. For example, in financial markets a lot of
products are difficult to fully comprehend. These include derivatives and various
financial products that put people’s capital at risk without their full knowledge.
Even something relatively simple like payment protection insurance was the source
of a lot of mis-selling because many consumers did not understand the product
they were buying.
As well as a situation where the information about products is overly complicated
and requires specialist knowledge, it may be that consumers have little idea of the
real benefits to themselves of products such as education, keeping fit and other
health related options. Often, if something purchased now requires judgement
about the future, it will create uncertainty, ie how much should one contribute to
a pension or to life assurance?

Bearing in mind that it is very unlikely that there is perfect information in the real
world, it follows that information is, to a greater or lesser degree, imperfect. Given
this statement, the next question to ask is how much additional help do consumers
and producers require to make an efficient decision? Should a third party be
involved in decisions about car insurance, car safety, pornography, drugs, the
level of education a parent should finance, guarantees and extended guarantees,
the speed limits on various roads and the need for cyclists to wear helmets?
4.4.2 Overcoming asymmetric information

Third-party intervention, to deal with the problem of an uneven distribution of
information, is usually carried out under the direction of government. It could be
involved with the provision of information by labelling products, taking out adverts,
providing information leaflets, allowing access to NHS Direct. Alternatively, laws
could be reinforced to control the distribution of drugs, protect customers against
faulty products, ensure employees in the various professions are sufficiently
educated and trained, and enforce compulsory attendance at school.
As has already been explained, the use of taxation and subsidy can adjust
the price of a product, and that price alone may be sufficient to encourage
or discourage consumption. The very high price of cigarettes seems to be
discouraging consumption of this damaging product, but there is also the added
problem of dealing with addiction for this and some other products. Alcoholism
is another damaging problem, as is overeating, and it may be that the desire
to consume fast-food and chocolate is damaging people’s health without their
knowledge.
4.5 Public goods and market failure
Public goods are a good example of a market that fails. There are people willing
to consume these products and firms who can produce these products but there
is no mechanism in a free market that can allocate resources to these products.
The reason is that these products have the characteristics of being non-rival and
non-excludable. This means that if a person consumes this product they do not
reduce the quantity available for other people to consume. Also, if firms offer this
product to one person they cannot stop other people from using the product.
Street lighting, law and order, the availability of a fire brigade, and some roads are
public goods that cannot stop free-riders. These are people who do not purchase
the product but cannot be stopped from consuming the product. People will buy
lights to place in their garden or at the entrance to their property because, placed
here, they are private goods. However, they will not pay for lights in a street that
may only be a few metres from their property. Often, whether a product is a public
good or not depends upon property rights. If stretches of the countryside are not
owned by any person or group of people, or if they are judged common land,
then they will be non-excludable. However, if they are pleasant places to visit then
they may become more congested and therefore they are not non-rival as people
compete for space. Often these locations are referred to as quasi-public goods.

Merit goods/demerit goods and market imperfections
4.5.2 Making public goods available to the public

Almost everyone will agree that the public goods so far identified are necessary.
They are collective consumption goods that we all need but are not willing to buy
because of the free-rider problem. It is therefore necessary for a third party to
become involved and there is general acceptance that this should be a government
working on our behalf. Again, as was pointed out in an earlier topic, the controversy
is over whether government should just buy the product on our behalf or whether
it should buy the product as well as producing the product for us, eg it could buy
street lighting from a private company or supply it through council employees.
In the past, governments have become involved in providing the product as well
as buying the product. There is some measure of agreement that governments
are not efficient providers of products as too much money becomes absorbed
in bureaucracy and administration. Therefore questions need to be asked.
Establishing the law is a role for government, but enforcing the law may not be in
certain cases. For example, paying for a prison service is a government role, but
could prisons be more efficiently run by private companies?
This debate will run and run, but it should not be confused with almost total
agreement that governments have to finance the public good. Therefore the next
issue is how it should be financed and the simple answer is through taxation. In
the UK the tax system is progressive (although we may question this later in the
course) and designed on an ability to pay principle, ie those who earn the most
contribute a higher proportion of their income to tax. The alternative is a system
based upon the benefit principle that people should be taxed in line with the benefit
they receive, which outs them, in effect, only one step away from being charged
for the public goods they use.
4.6 Merit goods/demerit goods and market

imperfections
4.6.1 Definitions and characteristics

A merit good is a product that has rival and excludable characteristics and therefore
should not be confused with a public good. However, when left to a free market,
it is likely to be underconsumed. This is because individuals may not be aware of
the intrinsic benefits of the product to themselves and they do not account for the
external benefits to society of its consumption. Also they may not be able to afford
to buy these products that will benefit themselves and society. The usual examples
are the NHS and education. Individuals may not realise the benefits to themselves
of keeping healthy in the present in order to benefit them in the future and they
may not realise the impact on their future income. Also a healthier, well-educated
workforce is likely to benefit society by increasing its productivity and reducing its
reliance on welfare payments.
A demerit good is a product that again has rival and excludable characteristics,
but this time, if it is left to a free market, it will be overconsumed. This is because
consumers may not be aware of the potential damage to themselves and society
of overconsumption; or, if aware, they may not be able to reduce consumption
through addiction to the product. Examples of demerit goods include cigarettes,
alcohol and gambling. A person who gets pleasure from smoking may not fully
realise the chance that they are considerably reducing their life span, may increase

their health costs that will have to be paid through the NHS, and could damage
other people through passive smoking.
4.6.2 The case for supplying merit goods free to the

consumer
As merit goods are private goods by their nature, the case for supplying the
consumer with a product they would buy is weaker than the case for supplying
public goods free. However, although health and education would be provided in
a free market, the argument for some level of intervention is based upon the fact
that they would not be provided at a socially optimal level. The fact that a person
may not be able to, or be prepared to, buy a vaccination against an infectious
disease may endanger other people. Also, the distribution of human capacity to
benefit from education may not coincide with the income required by the parent
to fully utilise that capability.
Although the preceding argument is relevant, it is not conclusive evidence for

intervention. Many countries do not support education and health in the same
way that the UK does. The amount of money per head of the population spent
on health in the USA is considerably greater than the UK. This may be a good
argument for privatising the health service or it may be the very opposite, namely
that asymmetric information in the medical profession means that many people
are persuaded in a freer market to pay for treatments that are not necessary and
insurance companies are deceived into paying more for treatments that are cheaper
in a more regulated system. Also, it could be that the NHS is more efficient at
taking advantage of economies of scale that are not available to a more fragmented
market in the USA where millions of people have no health care at all and so the
distribution of an essential product is not equitable.
As an economist, one final issue to consider is whether the cost of education

and health should be totally offset by the taxpayer or whether a subsidised price
should be entertained as a fairer price. This argument hinges upon the elasticity of
demand for the product. If the elasticity is high between the subsidised price and
zero, then more resources will be wasted in terms of efficiency. If the elasticity is
low then fewer resources will be wasted, as illustrated in Figure 4.8.

Merit goods/demerit goods and market imperfections
Figure 4.8
In A and B, P 1Q 1 represents the equilibrium given a subsidised price and Q 2 is

the output at zero price. With a more elastic demand the gap between Q 1 and Q 2
in A is significantly greater than the gap in B. Also in A the gap between MC and
output at Q 2 is significantly greater than in B. Therefore the case for supplying
merit goods free is enhanced if elasticity is low or if demand can be rationed by
some other relevant criteria.
4.6.3 The case against supplying products free to the

consumer
This case is built around the fact that an economic good provided free will bring
about a non-optimal allocation of resources. This is because consumers who

maximise utility will consume the free good up to the point where marginal utility
is zero. At this point the marginal cost of producing the last unit is likely to be
relatively high and certainly higher than zero. This will bring about inefficiency
because scarce resources will have to be used in order to produce goods and
services that will give very low additional utility. The consumer who pays a price
will stop consuming them at a much higher level of marginal utility. Resources will
have been taken from products that would give rise to higher marginal utility and
be used to supply products that would give rise to much lower marginal utility.
The total utility of all households will be lower than it would have been if a price
was charged for the good that is offered free to the consumer. A price would have
reduced its consumption and released resources to produce goods and services
that give rise to a much higher marginal utility.
A final point to consider is the fact that these products are being provided on
the assumption that their market is imperfect and the assertion that government
can improve the situation. This assertion has been questioned by a number of
economists who argue that the inefficiencies of government far outweigh those
of the marketplace. These criticisms are based upon observations of the large
bureaucracy required to provide a free good and an idea that the election cycle
and the vote motive make government susceptible to small but powerful lobbies
and cause them to be wasteful in pursuit of the short-term expedient of success at
the ballot box rather than long-term economic efficiency and stability.
4.7 Issues of equality and equity
4.7.1 Definitions
Equality refers to a distribution of resources that gives equal shares to everyone
and is unrealistic in any type of economy, although it may be talked about as an
ideal in a socialist economy and may be seen as an achievable aim in a communist
economy. In contrast, equity is about fairness, and what is judged to be fair is a
matter of value judgement and therefore requires a normative rather than positive
analysis in economic terminology. Here, normative refers to people’s perception
of how things should or ought to be while positive refers to how they are or will
be.
Both issues of equality and equity tend to be discussed because economies exhibit
a profound uneven distribution of income and wealth. Income is a flow of earnings
over time and is often divided between earned income from wages and salaries
and unearned income from the ownership of assets. Wealth is a stock of assets
that is owned or available to people at any one point in time. Wealth could be all
kinds of property and obviously tends to be built up over a lifetime.
4.7.2 The unequal distribution of income and wealth: A

problem or not?
The observed uneven distribution of income and wealth is considered by some
economists to be the result of market imperfections. In a capitalist economy the
supply and demand for labour tends to produce a very uneven distribution of
income. This is illustrated in Figure 4.9.

Issues of equality and equity
Figure 4.9
£ Opera star
W1
Q1
£ Rock star
S
W2
Q2
Here, the opera singer has more skills and is therefore in inelastic supply compared
with the number of potential rock stars. The demand for rock stars is significantly
higher, producing a much higher wage W 2 compared with W 1. However, a relatively
high demand for labour does not ensure a high wage. Again it is dependent upon
the interactions of supply and demand. The demand for refuse collectors and
shop workers is relatively high, but the wage is relatively low as the supply of
people available to do this job is relatively high and elastic. In contrast, the demand
for surgeons is relatively low, but the supply is also very limited and therefore
produces a high wage. The uneven distribution may be considered equitable under
some circumstances even though it produces significant inequality; or it may be
considered unfair if the high wage results from what is perceived to be an unfair
manipulation of the conditions for supplying labour, and this may then be judged
to be a market imperfection.

The uneven distribution of wealth tends to result from inheritance, age and luck in
the case of winning the National Lottery. Again, a lifetime of savings by one person
may be considered a fair reason for producing an unequal distribution of wealth
while inheritance may be considered unfair and therefore a market imperfection.
In comparison, the distribution of wealth has been much more uneven than the
distribution of income and this has led to misleading statements in support of
redistributive policies. An example of this is the statement that the distribution
of wealth is very uneven and therefore we need policies designed to redistribute
income. People’s standard of living is very much determined by their income,
although it is recognised that there is a wealth effect of owning property and that
people generally feel better off as the value of their assets increases and vice versa.
Also, wealth derives a small proportion of total income. Apart from this, attention
to issues of fairness and equality is needed to look carefully at how income is
distributed.
4.7.3 More or less redistribution of income and wealth

In 1975 Lord Diamond’s ‘Royal Commission on the Distribution of Income and
Wealth’ showed that the top 10 per cent of income earners, after tax, received a
little above 20 per cent of the total UK income, while the top 10 per cent owned
67 per cent of the wealth. The Institute of Fiscal Studies reported that by 2010 the
post-tax income of the top 10 per cent had increased to 28 per cent while the top
10 per cent of wealth ownership has fallen to 53 per cent of total wealth.
There is a simple economic argument in favour of redistributing income, namely
that one pound taken away from a rich person causes them to lose less utility than
is gained by the poor person who receives one additional pound. Therefore the
total utility of the population must rise if redistribution from the rich to the poor
takes place.
Against this argument is the view that increasing marginal rates of tax above a
certain point has damaging effects over time. It may encourage more tax evasion
and avoidance. It may encourage taxpayers to move to other countries where tax
rates are lower. It may have a disincentive effect and discourage people from
working harder, reducing motivation to innovate and increase productivity.
Overall there is a general consensus that, up to a point, redistributive policies
benefit the economy and that past that point they can damage the economy. The
problem is that it is not possible to identify where the tipping point is and how it
may change over time.
4.7.4 Redistributive policies

In the UK the aim is for taxation to be progressive and redistributive as those
people who earn the most pay the highest proportion of their income in tax. Social
security payments are redistributive in as much as they are available to people on
low incomes through either means testing, where the low income is identified, or
indicator testing, where target groups are identified as most in need of help as they
are likely to include a majority of poorer people, eg old-age pensions. Because they
are paid to everyone in the target group they are cheap to administer, but they are
also paid out to people who do not need the benefit. There are also benefits that
are paid out in kind. These are often linked to the NHS where the poor will get free
prescriptions and eye tests among other things.

Factor immobility and regional problems
Income has faced the brunt of the progressive tax system, but, over the years,
various wealth taxes have been discussed and the UK has come close to making a
decision that would shift the balance of taxation away from income towards wealth.
However, the change has not been introduced for a number of reasons. Firstly, it is
difficult to distinguish the source of wealth, eg capital gains, inheritance, gambling,
high income or saving, and then to decide if they should all be treated equally.
Secondly, a wealth tax could have disincentive effects on capital accumulation and
adversely affect economic growth. Thirdly and perhaps most damningly, is that the
more successful the tax is at raising revenue and redistributing wealth, the more
it destroys the tax source. This does not happen in the same way with income as
there is always more income following on. Income is a flow rather than a one-time
valuation of assets.
4.8 Market dominance

Here we will make a brief mention of market dominance, as we have already
established much of the theory in the previous topic. The simple argument was that
the more competitive the industry, the more likely it is that it will be responsive to
consumer demand and produce efficiently, while an industry with a few dominant
firms will be less responsive to the consumer and more likely to control supply so
that the firms can make excessive profits and create an imperfect market. In these
markets the role of advertising and branding is to maintain a dominant position
in the industry. Where there are a few large, competing firms their competitive
advertising takes up a large proportion of the budget. This is considered to be an
imperfection and a waste of resources as most adverts in this category do not tell
consumers what they really want to know, ie price, reliability, what a product can
do and, more importantly, what it cannot do. Instead the advert is concerned with
reinforcing the brand image and maintaining the product in the forefront of the
consumer’s mind.
Competitive advertising tries to create an image in the consumer’s mind that there
are no competitors, ie ‘Beanz meanz Heinz’. This means that when you go to the
supermarket you will not even notice that there are many competing brands of
baked beans and will miss the opportunity to consume Branston baked beans,
which, in the author’s opinion, are by far and away the best baked beans.
In the past, the government, having noticed that more than 80 per cent of the cost
of washing powder was spent on advertising, decided to sponsor an unbranded
washing powder at a fraction of the price. Unfortunately, it was not successful as
very few people purchased it, preferring to stay with their more expensive branded
option.
Having concentrated on the market imperfections caused by dominant firms, you
need to be reminded that there is another side to the argument. We have already
suggested the possible advantages of a monopoly compared with a competitive
industry and we need to add that firms may be dominant because they are
dynamically efficient and can produce the product consumers want, helped by
economies of scale, at a price that satisfies the consumer.
4.9 Factor immobility and regional problems
4.9.1 Definitions and characteristics

If all the factors of production were perfectly mobile, then resources would be
allocated more efficiently. However, they are not perfectly mobile and this tends to

manifest itself in a range of problems, the most obvious of which is the imbalance
between regions of the UK. The fact that unemployment, activity rates, wage levels,
output per capita and growth rates vary considerably from region to region results
from imperfect mobility. Here, perfect mobility would iron out these differences
over time.
Of the three main productive factors − land, labour (including enterprise) and
capital − it is labour that causes the greatest strain on mobility. Natural resources
and capital move relatively freely to where the economic return is greatest. For
reasons that will be looked at, labour is not as responsive.
When looking at labour it is necessary to identify two necessary requirements of
mobility. They are occupational (vertical) mobility, which requires people to move
between the various labour markets to equalise net advantage, and geographical
(lateral) mobility, which requires labour to move freely throughout the country.
Also, if we wanted to deal with imbalances across the world, we may like to consider
whether these mobilities should be analysed across international boundaries as
well as across the regions of one country.
The economic importance of mobile labour results from the fact that economies
are dynamic and therefore forever changing. A change in tastes, new inventions
and innovations, and new discoveries will cause a continual restructuring of
economic activity. This means that economists are concerned not only with the
total size of the labour force and its efficiency, but also with its mobility. To
maintain and improve efficiency all productive factors must be sufficiently mobile
to accommodate the changes that take place in the economy. This includes mobility
from one place to another and from one occupation to another. However, in reality,
frictions exist within the labour force that slow down its mobility.
4.9.2 Frictions and lateral mobility

People are creatures of habit. They become attached to their own neighbourhood
and are often reluctant to move to new areas. As people become older so they seem
to be more immobile. Parents are reluctant to disrupt their children’s education
and many people do not want to risk the break-up of families and friendships
by moving to another area. The many disadvantages of moving may even cause
people to choose welfare benefits and unemployment rather than job searching in
new areas.
What has been said so far implies that labour must be mobile to accommodate
changes in the economy, but this does not apply to all labour. It is only necessary
for a proportion of the labour force to actually move in order to complete the
necessary restructuring. It is suggested that there is always a more mobile element
of the labour force comprising young, intelligent and more adaptable persons.
Problems start to arise for several reasons when the proportion of labour required
to complete restructuring is larger than the more mobile element. This could occur
if the changes are quick: the faster the rate of economic growth, the more changes
are required. Labour frictions may have been reinforced by government action,
for example propping up a declining industry; and a flood of changes may come
later if government is forced to reverse this policy. Also, if the industrial decline is
concentrated in a small area where there are no alternative forms of employment,
then many additional jobs may be lost in firms that supply the industry and also
the local service industry.

Factor immobility and regional problems
4.9.3 Frictions and vertical mobility

If one unit of labour is a perfect substitute for another then many frictions
associated with occupational mobility would not exist. In reality there are two
main problems.
Firstly, human resources need to be trained and will probably reach a peak of
efficiency before depreciating with age. The specialisation of function limits the
range of industries that can use a certain skill. Over time, changes in the economy
will lead to some skills becoming redundant while new skills are demanded. A
problem of retraining will exist as the older members of the workforce find it
difficult to adjust and acquire new skills.
Secondly, the abilities of labour are unevenly distributed throughout the workforce.
Only a limited number of people have the ability to become top-class footballers,
mathematicians, linguists and steeplejacks. This means that an increase in demand
for certain skills will not necessarily bring forward an increase in supply. Arguably,
this problem is aggravated by the existence of artificial barriers raised to protect
certain types of job. These barriers range from the more necessary to the less
necessary. Qualification barriers are used to protect professional associations.
These barriers can be of two types. One protects the customer from being abused
by unqualified and unskilled persons. The other is an attempt to protect the present
members of the association from new entrants who are probably as well qualified
but who may erode the earning capacity of present incumbents. For example
accountancy has changed from a profession that asked for GCSE competence in
maths and English to a profession that requires a degree qualification. No doubt
the customers are the best judges of whether the qualification barrier protects
members’ earning capacity or improves the quality of accountants. Also, trade
unions have been known to support closed shops, enforce long training periods
and impede new entrants into a labour market.
4.9.4 Removing mobility frictions

If the choice was between starvation and mobility then the workforce would be
considerably more mobile than it is today, and herein lies a problem: a civilised
society will want to protect its members from the genuine hardship that can come
with unemployment. However, in doing this, it can also reinforce the frictions
already described.
As the UK has moved from a more laissez-faire economy to one with more
intervention by the state, the actions of its governments have tended to reduce
labour mobility. As this problem has become recognised, there have been attempts
to reverse this process and improve mobility. Firstly, there have been attempts
to improve lateral and vertical mobility by various schemes such as financial
inducements to labour in the form of removal and disturbance allowances. There
has also been job retraining and more widespread advertising of job vacancies
using similar skills in the same place or the same skills in different places.
A second approach, which is politically more difficult to pursue, is the removal
of some of the more artificial barriers that have been erected to protect certain
jobs. These may include unnecessary qualification barriers in the professions and
restrictive practices on the part of the unions. Also, welfare benefits could become
more selective and the government needs to be careful not to index-link benefits at
the same time as it tries to hold down wages to remove some inflationary pressure.
The result of this would be that more people would become better off out of work
than in work.

4.10 Economists and government intervention

Welfare economists tend to be interventionists who see an important role for
government in correcting market failure, whereas free market economists cast
doubt on the ability of government to acquire the knowledge necessary to improve
upon the market. They would like to limit the government’s role to easing the entry
of firms, products and productive factors into the marketplace. Arguably, this can
be done by reinforcing property rights and creating a level playing field of rules
and regulations that promotes fair competition.
In allocating resources more efficiently and removing market imperfections, the
government may be considered successful if it promotes public goods, increases
the consumption of merit goods and decreases the consumption of demerit goods,
manages externalities, provides more information, prevents market dominance
and encourages greater fairness.
Alternatively, the government may be considered a failure when it develops
unnecessary bureaucracy, reduces information to the consumer, misprices external
costs and benefits, provides incorrect information, abuses its dominant position
in the economy and generally wastes resources by increasing the misallocation of
resources.
Summary
u Markets are imperfect and sometimes fail, meaning that an efficient solution is
required.
u Public goods definitely need government intervention, while merit goods may
need intervention.
u Products with significant externalities need to be considered for some degree
of intervention.
u Efficiency needs to be balanced with equity.

u There is a difference between greater equity and greater equality.
u Significant market imperfections exist because of factor immobility.

u Governments can fail as well as markets, so decisions need to be made about
the most efficient way to allocate resources.

Topic 5
Understanding and using national
income statistics
‘Society is comprised of two great classes; those who have more dinners
than appetite and those who have more appetite than dinners.’
Chamfort (1795)

u measuring national income;
u the national income identities;
u important definitions;
u problems of using and interpreting national income statistics;
u the usefulness of national income as a measure of performance over time,
or as a comparison between countries; and
u other ways of measuring standards of living.
5.1 The relevance of national income statistics

For an economist looking at the performance of an economy, it is necessary to
measure meaningful aggregates. The yearly activity that takes place in an economy
can be measured by looking at people’s income, or what people spend, or their
contribution to output. If these numbers change from one year to the next then
this tells us something about the performance of the economy.
As we have already identified, income is not the same as wealth, and a measure
of a nation’s wealth would add up to the value of all the assets owned by the
people of the country. A separate, but similar, measure is to look at the nation’s
capital stock. This will be less in value than the nation’s wealth, as all capital is
wealth, but not all wealth is capital. In fact, capital is that component of wealth
that is capable of producing more wealth. For example, a car used for social and
domestic purposes would be wealth, while a car used as a taxi service would be
capital.
5.2 The national income identities

Over a given period of time the same total can be arrived at from three different
starting points.

5: Understanding and using national income statistics
The value of the output of the economy is added up to produce a national output
or national product. In macroeconomic modelling this national product is usually
given the symbol Q.
This output is produced by productive factors and the income received by these
factors can be added together to produce a national income total that is usually
given the symbol Y.
The income received by productive factors is then spent on the product of the
economy and therefore it is possible to add up the same total from the expenditure
side of the economy where total expenditure is represented by the symbol E.
As these are three ways of adding up the same total, they produce the national
income identities:
Total output = Total income = Total

expenditure
Or
Q = Y = E
We now need to identify more precisely exactly what is being measured.
5.3 Important definitions
5.3.1 Gross numbers

Gross national income (GNI) adds together income received by the factors
of production where labour receives wages, land receives rent, capital receives
interest, and enterprise receives profits. Sometimes this is referred to as earned
income + unearned income.
More commonly economists refer to the output measure of the economy as gross
national product (GNP). This figure values the output produced in the UK plus
any value derived from owning productive assets abroad minus any value lost
from UK assets owned abroad. The difference between inward and outward flows
of profit and interest produces a positive or negative number that is referred to
as net investment income or net property income. Usually the gross total is
increased by net property income, but there is no reason why this should be the
case, and for many less developed countries whose assets are owned by foreign
countries the net property income number is negative.
A truer measure of domestic output and income is achieved by removing the net
property income figure from the national statistics such that:
Gross national income - Net property income = Gross domestic income (GDI)
Or
Gross national product - Net property
income = Gross domestic product (GDP)

Important definitions
Of the definitions above the most commonly referred to in economics is gross

domestic product or GDP.
5.3.2 Net numbers

In order to maintain the productive capacity of the economy it is necessary to
replace capital, the produced means of production, as it is used up, worn out or
becomes obsolete over time. This is known as the depreciation of capital and
it can lose its value through wear and tear or because a newer form of capital is
more efficient and makes the previous capital lose its value or become obsolete. It
is important to know if the net national product is growing as this tells us whether
we are replacing our worn out and obsolete machinery. If GNP is rising while NNP is
falling then the longer-term effect on the economy is likely to bring about a decline
or slowing down in economic activity.
To sum up this point GNP - Depreciation of capital stock = Net national
product (NNP). In the same way GNI - Depreciation of capital stock = Net
national income (NNI). To add a little confusion to this, it is usually the case when
a reference is made to national income that it is referring to net national income,
not gross national income. This is for the same reason as described above, that
NNI is a better measure of the long-term economic viability of an economy.
It is not usual to refer to net domestic product, but, if it was, then it would observe
the same rule of removing capital depreciation from GDP.
5.3.3 Gross and net numbers measured in different

ways
Any of the numbers described above can be measured in one of three different
ways. They can be measured at market price, which includes the indirect tax
component in the price but excludes any subsidy, or they can be measured at
factor cost, which excludes the indirect tax component but includes any subsidy.
There is a problem from year to year in making real comparisons using the above
numbers because it is not possible to tell whether the numbers are growing
because of inflation or because of a real increase in output. In order to identify
real changes in output it is usual to measure the above aggregates at constant
prices. This means that the same products are measured at the prices prevailing
in one specified year. This removes the inflationary element from the total and
means that any changes that take place are identifying real changes in output.
5.3.4 More about nominal, real and index numbers

The real economy grows as more products are made. As the only way to make
clear comparisons over time from aggregate numbers is to give them the value of
a currency it is necessary to separate real changes from nominal changes.
If the national income figures are measured from year to year at market prices,
then the changing nominal value tells the analyst very little. It is quite easy for
the real economy to contract while the nominal measure grows by small or large
increments. For example if inflation was 100 per cent and there was no change
in output then the real economy is unchanged while the nominal value of that
economy has doubled.

A GDP deflator is often used in national income accounts. It is:

Nominal GDP
× 100 = GDP deflator
Real GDP
Or
1655 T
× 100 = 113.356 T = trillion
1460 T
Therefore
Nominal GDP
× 100 = Real GDP
GDP deflator
In order to make comparisons between numbers meaningful it is often the case
that index numbers are used. For example, if you wanted to identify the rate of
inflation it would be necessary to:
1. Identify the change in price of every product (impractical).

2. Calculate an average change in all those prices (impractical).
3. Account for any changes in the pattern of consumption (impractical).

As all of the above are not practical, then the following things need to be done:
1. Choose a small basket of representative products.
2. Identify the percentage change in price and add to or subtract from an index
number that is usually 100 in a base year.
3. Allocate weights to the index numbers that represent the importance/proportion

of total expenditure on this product.
Why choose an index number of 100? The simple answer is to avoid negative
numbers arising in the future. An index number could be 10, but this increases
the risk of moving into negative territory in a few years. The index number 100 will
remain positive for a much longer number and when it moves too far away from
100 then it is rebased back to 100 and starts again.
An example of using index numbers to measure inflation assumes that there are
only three products.
Year 1 Year 2
Product A B C A B C
Price (£) 5 15 50 10 18 35
Price − − − 100 20 −30
change
(%)
Index 100 100 100 200 120 70
number
The average index number for the base year 1 is 100. This changes to 130
(200+120+70÷3) in Year 2 and this means that the average unweighted price
rise is 30 per cent.

Problems of using and interpreting national income statistics
Inflation of 30 per cent is based upon the assumption that price changes have not
changed the pattern of consumption that was equally distributed between each
product, ie one-third of expenditure on each.
Let us suppose that 30 per cent of expenditure was on product A, 20 per cent
on B and 50 per cent on C in both years. Then weights can be allocated in those
proportions 3.2.5. In this case the statistics will change to:
Year 1 Year 1
Product A B C A B C
Price (£) 5 15 50 10 18 35
Price − − − 100 20 −30
change
(%)
Index 100 100 100 200 120 70
number
Weight 3 2 5 3 2 5
Weighted 300 200 500 600 240 350
index
number
Weighted average index number Year 1 1000 ÷ 10 = 100

Weighted average index number Year 2 1190 ÷ 10 = 119
Having weighted the products the rate of inflation has been adjusted down from
30 per cent to 19 per cent. The main reason for this is that the product that went
down in price was the most heavily weighted product and this brought down the
average.
The change in the index of retail prices can be used to show changes in the value
of money. Compared to the base year money has fallen in value by 16 per cent.
This is calculated from:
Previous year 100
× 100 = = 84% of its former valuer
Current year 119
Index numbers are used for a lot of similar sets of numbers in economic analysis
where it is the target to give current values relative to a previous year or years.
5.4 Problems of using and interpreting

national income statistics
5.4.1 Money values

It is relatively easy to add up all the values that have been accounted for in money.
It is much more difficult to value products that are not traded. For example, if you
employ a window cleaner then output increases; if you clean your own windows
then the impact on output is the same, but there is no record. In the same way,
all ‘Do It Yourself’ projects, vegetable gardens, and housework is not recorded.

There are some attempts to value things that are not recorded, an example being
imputed rent, which estimates the rent that would be paid by house owners if
they actually rented the property they own. Overall self-provided products are
all part of the economy’s output but no money is transferred and there is only
knowledge of these things taking place, but there is no record of, and, in most
cases, no requirement to make this information available.
5.4.2 The black economy

This is the illegal or underground economy. Here trade takes place, but there is no
record of the events. Cash-in-hand jobs are conducted so as not to leave a paper
trail and to allow people to evade taxation as well as live as illegal immigrants.
A significant proportion of the workforce is self-employed and this creates many
opportunities to work without any official recognition. A common argument used
by the tax evader to justify actions is that the person is happy to pay tax on the
money they earn during a normal working week, but if they choose to work in the
evenings or at weekends they do not feel they should pay tax, especially as they say
they would not work at these times if they had to pay tax. There is some indication
of a value to the black economy when one looks at the difference between the
expenditure measure of national income and the income measure.
In the past it has been estimated that up to about 10 per cent of the UK economy
is hidden from official statistics, while other countries like Greece have estimates
nearer 30 per cent. Before they joined the EU Italy was classed as one of the
poorest European countries from official statistics. However, if the black economy
was taken into account, it was judged by some to be one of the richest.
5.4.3 The quality of products

Changes in the quality of products both in terms of improvement and deterioration
can be missed by national income figures. Over recent years there has been
considerable improvement in the quality of computing products and, arguably, a
significant deterioration in the provision of education and health care. In the case
of education and health care, the situation is further masked by the fact that, in
some people’s judgement, the amount of money spent has significantly increased
at the same time as the quality of the service has decreased.
5.4.4 Double counting

When constructing aggregated statistics it is necessary to be careful and not
count the same item twice. For example, when a firm buys in raw materials and
components in order to make a final product, these inputs will already have been
recorded as being produced. Therefore it is only the value added in the next stage
of the production process that should be added to the accounts in order to avoid
double counting.
5.4.5 Externalities
By definition external costs and benefits are third-party effects that are not
accounted for in the normal course of business. Also the value of these external
costs and benefits is often a matter of judgement and there may not even be

Can national income statistics be used to compare living standards over time in the same country?
agreement about whether the event in question is a cost or a benefit to society.

For example, global warming may be considered a benefit to those people who
live in harsher climates, while it may be a cost to those people living in an
area that may be at risk of flooding. Overall, national income statistics will
underestimate standard of living given positive externalities and overestimate
it given negative externalities.
5.4.6 Imperfect information

Because of mistakes in form filling and as the result of not telling the truth over
events that may cause more tax to be paid, there are likely to be underestimates
of income output and expenditure. This is why estimates are made to account for
errors and omissions in official statistics.
5.5 Can national income statistics be used to

compare living standards over time in the
same country?
5.5.1 What is standard of living?

National income statistics are often used to reflect living standards and changes
in living standards, but they can only go so far and in certain cases can be
misleading. In simple terms, the standard of living includes both characteristics
that are quantifiable, as in goods and services consumed, and also unquantifiable,
such as low stress levels, pleasant climate, attractive scenery, etc. However, the
fact that national income statistics are used for comparison requires us to look at
their limitations and how they may be overcome.
5.5.2 Population size and per capita income

If we looked at national income statistics for the last 50 years, they would tell us
very little unless we refine them. To have any real meaning, the national income
statistics, and the size of the population that shares that income, must be analysed.
In the UK the first official census was taken in 1801. Before then indirect sources
such as the Domesday Survey and poll tax accounts would have to have been
used. However, over the last 50 years statistics for population have become more
accurate and have to be divided into the national income statistics to produce a
measure of per capita income.
5.5.3 Collection of statistics

It should be noted that the efficiency with which national income and population
statistics have been collected has changed over time. In their current form national
income statistics have only been compiled in the UK since 1941 and, as we have
already pointed out, their collection is not always precise as there are incentives
for people not to provide them correctly and mistakes are also made.

5.5.4 Changes in the value of money

Nominal national income changes are meaningless in terms of telling us anything
about real changes in the economy. Given 5 per cent inflation per year, the nominal
national income would double in a little over 13 years. In the decade of the 1970s
the economy grew by less than 10 per cent in real terms while the nominal national
income grew by more than 100 per cent. All of this means that a deflator needs to
be used to eliminate the impact of any inflation or deflation that has taken place
over the relevant period being analysed. At this point, measures would now be per
capita real measures.
5.5.5 Balance of payments disequilibria

To make it even more realistic, a number similar to that of the inflation adjustor
has to be included to account for significant disequilibria on the current account
of the balance of payments. A current account deficit means that the value of
imported goods and services is greater than the exported goods and services and
this tends to raise living standards above trend, while a current account surplus
depresses living standards below trend.
5.5.6 Distribution of income and wealth

Over time, the distribution of income and wealth changes and, even without a
change in national income, this will change the standard of living. A more equal
distribution of income will bring about a higher average standard of living than a
less equal distribution of income. Also a country’s wealth distribution and amount
are not illustrated in yearly income statistics, although a proportion of that income
will have been derived from accumulated wealth. However, the accumulation of
wealth over many centuries means that standards of living today will be higher
without any measurable changes in national income. Also, and even though it
cannot go on forever, the UK’s large current account deficit on the balance of
payments has been partly offset by selling some of the UK’s wealth to foreigners,
ie properties in and around London. Foreigners are required to supply much needed
foreign currency to buy sterling to buy the UK asset.
5.5.7 Consumer and capital goods

In the present the consumption of consumer goods and services is a major
determinant of living standards. In contrast, the production of capital goods does
not raise the standard of living in the present. In fact, at a full employment
level of resource use, the opportunity cost of producing capital is consumption
foregone. However, producing capital in the present is likely to boost economic
growth and raise living standards in the future, except if it is a certain type of
unproductive capital, as defence expenditure on weapons is often described. In
this case, standard of living is lowered in the present to product capital that will
not raise living standards in the future. There are, however, two possible exceptions
to this: if a wartime invention has a peaceful use, i.e. radar and nuclear fission; or if
the fact that a country has all these weapons is sufficient to stop another country’s
aggressive intent that may threaten or actually damage living standards.

Can national income statistics be used to compare living standards between different countries?
5.5.8 Changes in working conditions

Over time, factory conditions will have become cleaner, safer and more pleasant
working environments. Health and safety legislation will have improved working
life. The number of hours worked and compulsory holidays will have changed. Also
what is measured in income statistics is pecuniary benefit, and there may well
have been considerable changes in non-pecuniary benefits that have added to
job satisfaction and therefore a person’s standard of living.
5.5.9 Yearly comparisons

It is important to compare years that are not exceptional in any way. For example,
national income statistics have only been collected in their current form since 1941.
However, a comparison between now and 1941 would not be a particularly useful
comparison as a lot of national income in 1941 would have been derived from
the production of munitions and therefore standard of living and consumption of
goods and services will have been suppressed.
5.6 Can national income statistics be used

to compare living standards between
different countries?
5.6.1 A common unit for comparison

In addition to relevant points already made under the previous headings, there
is the problem of comparing national income statistics derived from Japan in
yen or India in rupees or America in dollars with aggregate numbers in sterling.
Having accounted for differences in population size, the obvious step is to convert
currencies to a common unit using exchange rates. However, as we will see when
we look at exchange rates in more depth in Topic 10, they very rarely equalise
spending power between countries and it is this comparison that is needed if we
are going to compare standards of living. In order to compare purchasing power
parities it would be necessary to take a basket of goods in London worth £1,000,
go to New York and buy the same basket of goods in dollars, go to Japan and buy
the same basket in yen and then convert the currencies into a common unit. As
we will then see, the purchasing power parity rate of exchange will be different to
the actual foreign exchange rate of each currency. For example, the exchange rate
with the dollar may be £1 = $1.5, but the same £1,000 basket of goods may have
been purchased for $1,200 making the purchasing power parity £1 = $1.2.
5.6.2 Forex traded currency

A rough and ready comparison could be made using foreign exchange rates, but
even this is made more difficult where a country’s currency is not traded on the
Forex. The less developed a country is, the more likely its currency is to be only for
domestic use and the only way to make comparison would be through a purchasing
power parity calculation.

5.6.3 Different methods of collection

Between countries there are significant differences in the way statistics are
collected. Some are more efficient than others. Some are more comprehensive
while others make greater use of sampling. For many years the national income
of Russia has been calculated using goods only and taking no account of services
that are provided.
5.6.4 Large variations in the distributions of income

and wealth
Although it would be possible to make a per capita calculation between countries,
the average income per head will not inform us of how that income is distributed.
It may be that a small elite receive a very high proportion of the national income
while the rest of the nation lives at subsistence levels. In terms of economic welfare
analysis, two countries with the same income per head can have significantly
different distributions of income and therefore very different average and actual
standards of living. Also, as has already been pointed out, wealth is a stock of
value at one point in time and this will give older established countries a much
greater wealth effect than newer countries.
5.6.5 Productive capital, unproductive capital and consumer

products
As the standard of living depends mainly on the availability of consumer goods
and services and the value of national income does not distinguish between capital
and consumer goods, then significant differences may be hidden. This is further
aggravated when the capital is unproductive in the sense that it is part of a nation’s
defence or part of its attacking capability that will bear no economic fruit in the
future. If we compare Switzerland, which commits a very low proportion of its
national income to external defence, with the UK, which commits a significantly
greater proportion to this form of unproductive capital, then we will see that
standards of living are very different even if other aggregates are the same.
5.6.6 Different gifts of nature

In some countries a number of natural resources may be provided at zero price and
therefore not figure in national income statistics. Heat from the sun is available in
abundance on the Equator, but is very costly in Iceland. While rainwater is free in
the UK it is relatively scarce in the counties of the Middle East and therefore water
commands a price there. In addition to this, different scenery and climate will have
different effects on living standards throughout the world.
5.6.7 Different political situations

The type of political situation in a country may have significant effects on living
standards, as may the stress levels, levels of unemployment and other types of
disruption that occur in a country. Also, the way that various groups within a
population are dealt with can affect living standards and real things like growth

Other measures of economic welfare and living standards
rates. The ways in which women are treated in terms of education and opportunities
to contribute to the economy mean that some countries are missing out on an
efficient use of the productive factor, labour.
5.7 Other measures of economic welfare and

living standards
5.7.1 Introduction
As we have seen, there are considerable difficulties in using national income
statistics to measure and compare standards of living. In consequence, there are
several other ways that statistics are put together to allow a more meaningful
comparison.
5.7.2 The human development index (HDI)

This was developed by the economists Mahbub ul Haq and Amartya Sen for the
United Nations in 1990. It uses three main indicators, which are:
u real GDP per capita measured in US dollars at a purchasing power parity rate;
u life expectancy at birth as an indicator of the health and longevity of a

population; and
u educational attainment measured by a two-thirds weighting on adult literacy

and one-third on an enrolment ratio for students at three levels of schooling.
The table above shows the top ten countries with Ireland at number seven. This
compares with the UK, which is at 27. Also note that the bottom ten is dominated
by countries in Central and West Africa.
5.7.3 Measure of Economic Welfare (MEW) and Index of

Sustainable Economic Welfare (ISEW)
In 1972 economists William Nordhaus and James Tobin introduced MEW, which
took real GDP and made adjustments to it by including a positive value for leisure
time and unpaid work and a negative value for environmental degradation caused
by production and consumption.
Friends of the Earth took MEW further and produced their own index, ISEW, which
took out defence spending and what they judged to be the more harmful effects
of economic growth.
MEW = Real GDP + Leisure time + Unpaid work - Environmental degradation

ISEW = Private expenditure + Public expenditure - Defence spending +
Unpaid work - Environmental degradation

Table 5.1 2011 Human Development Index

Very high human development
Rank HDI
New 2011 Change Country New 2011 Change
estimates compared estimates compared
for 2011 [1] to new for 2011 [1] to new
2011 data 2011 data
for 2010 [1] for 2010 [1]
1 − Norway 0.943 ↑0.002
2 − Australia 0.929 −
3 − Netherlands 0.910 ↑0.001
4 − United States 0.910 ↑0.002
5 − New Zealand 0.908 −
6 − Canada 0.908 ↑0.001
7 − Ireland 0.908 ↑0.001
8 − Liechtenstein 0.905 ↑0.001
9 − Germany 0.905 ↑0.002
10 − Sweden 0.904 ↑0.003
11 − Switzerland 0.903 ↑0.002
12 − Japan 0.901 ↑0.002
13 ↑(1) Hong Kong 0.898 ↑0.004
14 ↓(1) Iceland 0.898 ↑0.002
15 − South Korea 0.897 ↑0.003
Low human development

173 − Zimbabwe 0.376 ↑0.012
174 − Ethiopia 0.363 ↑0.005
175 − Mali 0.359 ↑0.003
176 − Guinea-Bissau 0.353 ↑0.002
177 − Eritrea 0.349 ↑0.004
178 − Guinea 0.344 ↑0.002
179 − Central African 0.343 ↑0.004
Republic
180 − Sierra Leone 0.336 ↑0.002
181 − Burkina Faso 0.331 ↑0.002
182 ↑(1) Liberia 0.329 ↑0.004
183 ↓(1) Chad 0.328 ↑0.002
184 − Mozambique 0.322 ↑0.005
185 − Burundi 0.316 ↑0.003
186 − Niger 0.295 ↑0.002
(United Nations, 2011)

Summary
5.7.4 Other measures

These include a variety of happiness and misery indices. The misery index,
developed by Robert Barro, is interesting because it relates misery to stagflation
in as much as it adds together the rate of inflation and the rate of unemployment.
For the UK this peaked in the mid 1970s, but has been rising again since the credit
crunch of 2009.
Summary
u This topic has shown how national income statistics are constructed and how
the accounting identities are produced.
u Working with raw data makes it necessary to refine statistics so that the
differences between national and domestic, and gross and net, and among
market price, factor cost and constant cost are known.
u Creating index numbers from raw data aids comparison.
u A variety of further adjustments allow the data sets to be used for comparison
over time and across the world in terms of standards of living and economic
welfare.
References
Chamfort, S. R. N. de (1795) Pensées, maximes, caractères et anecdotes. London: Deboffe.

Topic 6
The theory of the circular flow of
income
‘[T]he ideas of economists and political philosophers, both when they are
right and when they are wrong, are more powerful than is commonly
understood. Indeed the world is ruled by little else.’
Keynes (1936, p. 384)
u constructing a basic economic model for the economy as a whole;
u developing that model into a more complex but more realistic

representation of an economy;
u identifying equilibrium positions where the economy is using its resources

fully and at less than full employment’
u using the AD/AS and W/J models to illustrate an economy in various states
of equilibrium; and
u considering the relevance of the consumption function, multiplier and
accelerator in economic modelling.

6: The theory of the circular flow of income
6.1 The basic circular flow model
6.1.1 Symbols used in this topic
Y = National income
C = Consumption
MPC = Marginal propensity to = ∆C
consume ∆Y
∆ = Change in
APC = Average propensity to C
consume Y
W = Withdrawal
S = Savings
M = Imports
T = Taxation
J = Injections
I = Investment
X = Exports
G = Government expenditure
AD = Aggregate demand = C + I + G + X − M
K = Multiplier 1
MPW
MPW = Marginal propensity to
withdraw from the circular
flow
MPM = Marginal propensity to import
MPS = Marginal propensity to save
MPT = Marginal propensity to pay
tax
AS = Aggregate supply
6.1.2 The flow of income
6.1.2.1 A two sector model

Y is a continuous flow of income that is often cut off at specific periods of time
when measuring national income totals. Consumption (C) is a continuous flow
within Y.
A very simple model of the economy has two components, as in Figure 6.1.

The basic circular flow model
Figure 6.1 Two sectors
Households provide productive factors to the firms who produce the products that
satisfy consumer demand: these are real flows. Revenue is received from selling the
products and income is received by the households for providing the productive
factors: these are money flows.
6.1.2.2 A three sector model

In reality not all the income that is earned is spent.
Figure 6.2 Three sectors
In Figure 6.2 it is recognised that the income that households do not use
for consumption is recycled through financial markets in the form of savings,
borrowing and asset purchases. By acting as intermediaries between those with
surpluses and those with deficits, financial institutions return savings to borrowers
in the household sector. Also, surplus income may go through financial markets
to purchase assets that transfer ownership of wealth and capital from sellers to
buyers, or savings (S) may be borrowed by the firms to invest in new plant and
machinery.
At this point, we need to recognise that the word ‘investment’ has two different
meanings, one used in finance and the other used in economics. In financial
markets customers whose surplus income is channelled into the market may buy
savings products or investment products. Savings products have their nominal

value guaranteed whereas investment products transfer the ownership of assets,

whose value can go up or down, from one owner to another. In contrast, in
economics the term investment (I) refers strictly and only to the purchase of
capital/produced means of production.
This means that, in the simple Keynesian circular flow diagram, unspent income
is referred to as savings and it is assumed that firms borrow this for investment
in the economic sense. This means that the circular flow in a three sector model
would be stable if savings = investment or S = I.
6.1.2.3 A four sector model

We take one step closer to reality when we add government to our model. As
illustrated in Figure 6.3, we now have a government that removes taxation (T)
from households and firms and returns it in the form of government expenditure on
such things as public and merit goods. If we assume that all taxation = government
expenditure (G), then the model will be balanced, whereas if there is an imbalance
between G and T then financial markets may once again be involved in recycling
deficits and surpluses to produce the balance G + I = S + T.
Figure 6.3 Four sectors
6.1.2.4 A five sector model

Economic models so far constructed are referred to as closed economy models
and our final step towards reality is to recognise that there are now no closed
economies in the world where all trade is internal, but we have economies that
are open to the rest of the world and therefore engaged in international trade as
illustrated in Figure 6.4.
Here, flows of income, products and assets flow in and out of each of the other
sectors and the result when imports (M) and exports (X) are in balance is: G + I + X
= S + T + M.

Models of equilibrium in the circular flow
Figure 6.4 Five sectors
6.2 Models of equilibrium in the circular flow
6.2.1 Preliminary considerations
6.2.1.1 Aggregate demand and aggregate supply

In microeconomics we have looked at the relationship between supply and demand
for individuals and markets. If we add all these markets together, then we are
looking at a supply and demand model for an economy in its entirety. On the
one side we have aggregate supply, which is the total supply of products over a
given period of time, and on the other side we have aggregate demand for those
products and a function for aggregate demand, which is made up of the following
components:
AD = C + I + G + X − M
It is the interaction between aggregate demand and aggregate supply that
produces a circular flow of income that we can interrupt at certain periods in
time to construct national income statistics. Further to that we have shown that
there are injections into the circular flow in the form of G + X + I and withdrawals
or leakages from it in the form of T + M + S.
6.2.1.2 Autonomous and induced change

The variables described under the previous heading can either change
autonomously and affect national income, or they can be induced to change by
a change in national income.
Consumption and consumption functions
It is important to note that consumption is a continuous flow and not something

that enters and leaves the circular flow of income as do withdrawals and injections.
However, it can have significant effects on the economy as it is by far and away
the largest component of the aggregate demand function. Therefore autonomous

changes in consumption, which may result from changes in the distribution of

income, changes in attitude to savings, changes in access to credit, changes
in the age composition of the population, or changes in the wealth effect, can
have considerable effects on the economy. Equally, changes in income caused by
changes in other variables can bring about induced changes in consumption. For
example, a rise in economic growth, employment and income will in turn lead to
higher consumption.
It would be very useful to predict how these changes will affect the economy and
these predictions will depend very much upon which theory of how consumption
and income are related is closest to the truth.
Keynesian economists predict that rising incomes reduce the marginal propensity
to consume and raise the marginal propensity to save, where marginal propensity
means the proportion of any additional income that will be spent or saved. In
the same way, high income earners have lower marginal propensities to consume
and low income earners have higher marginal propensities to consume. If this is
correct then changes in income tax rates will have different effects when targeted
at different income groups.
There is a permanent income hypothesis that was popularised by Milton Friedman
and that assumes that people have a perception of permanent income that
influences their actual consumption. Therefore, if a change in income is not
perceived as permanent then consumption will not change. In this case a change in
income tax rates will take some time to affect consumption as people will initially
consider it to be a temporary rather than a permanent change.
Popularised by Franco Modigliani and others, the life cycle hypothesis assumes
that consumption is planned over a lifetime so as not to pass on debts to
future generations. This means that the age structure of a population will
have considerable effects on consumption. Younger people will be financing
consumption through borrowing but will at some point in the future be consuming
smaller proportions of their income as they start to repay debt.
Most consumption functions do recognise a distinction between the short-run and

the long-run effect on consumption of a change in income. Figure 6.5 shows that
a change in income Y 1 to Y 2 raises consumption from C 1 to C 2 in the short run
and from C 1 to C 3 in the long run.
Figure 6.5

Models of equilibrium in the circular flow
Savings and investment

Savings functions are very much the corollary of the various consumption
functions. For Keynesians the marginal propensity to save increases with income.
Alternatively, and until they are perceived as permanent, changes in income have
little effect on savings, or, over a lifetime, savings habits will change with the age
profile.
Investment is usually described as a decision that is autonomous and often related
to policy or strategy changes by firms and governments and therefore not affected
by changes in income. In contrast, induced investment is a response to changes in
income. Here, the assumption is that there is a fairly consistent ratio of capital to
output and if output (income) increases then investment in capital will be induced
to change in order to maintain the same ratio.
Taxation and expenditure

Autonomous changes in tax rates take place almost every year in the Budget and
are related to new plans and strategies. Tax revenues are induced to change,
particularly as the result of changes in economic growth rates. Governments often
get themselves into trouble as the result of anticipating growth and expecting an
increase in tax revenue that they then plan to spend even before it has occurred.
Then if it does not occur debts unexpectedly increase.
Similarly, changes in government expenditure are autonomous as plans and
strategies change, but are induced by unexpected changes in the economy. For
example, a rise in unemployment will commit government to spend more money
on welfare benefits.
Imports and exports

Imports can result from autonomous decision-making or they can change as
national income changes. For a country like the UK, a rise in income usually
increases imports and very often the marginal propensity to import. The demand
for exports can be induced by changes in the foreign exchange rate or they can be
considered to be autonomous in relation to changes in UK income as, in fact, they
are induced by changes in income in foreign countries.
6.2.2 The AD/AS model

As you are now familiar with supply and demand functions, it is expected that
using your summation to produce aggregate functions will help improve your
understanding of how an economy functions.
Once again, we need to consider two main and conflicting theories about how
this model should be constructed. In both cases there is no debate about how
the aggregate demand curve is constructed. It will be the same in each diagram.
The difference is in the assumed shape for the aggregate supply curve. The main
difference is between Keynesian economists and free market monetarists.
In Figure 6.6 the aggregate supply curve is horizontal up to a point where it
becomes vertical. This means that there is a range over which aggregate demand
can change and it will have no effect on average price, but it will expand GDP
as illustrated by Ye→Ye 1. However, there is a point where the economy has
fully utilised its resources (Keynesians refer to this as full employment) and any
further attempt to expand demand can only lead to inflation. Keynesians accept

Figure 6.6 Extreme Keynesian
that equilibrium can occur at less than full employment of resources and that
the economy may need some fiscal and/or monetary stimulation to shift the
aggregate demand curve from AD to AD 1 and increase the GDP. Keynes recognised
that economies may tend towards full employment but he also recognised that
economic shocks could force economies into long and sustained periods of less
than full employment. His response to this was that ‘in the long run we are
all dead’(Keynes, 1923, p.80) and he therefore suggested that immediate action
by government could alleviate the problem by moving the economy towards full
employment over a much shorter period of time.
A less extreme depiction of the Keynesian approach is represented in Figure 6.7.
Figure 6.7 Less extreme Keynesian
Here it is recognised that there is a range over which real GDP can be expanded but
that there is a trade-off with higher inflation. In Figure 6.7 a shift in the aggregate
demand curve from AD to AD 1 will increase the real GDP from Ye to Ye 1, but at the
cost of a rise in the average level of prices from AP to AP 1.
At the extreme opposite end of the Keynesian model is a free market monetarist
model that is represented in Figure 6.8.

The withdrawals/injections model
Figure 6.8 Free market monetarist
Here, the aggregate supply curve is considered to be vertical, meaning that

manipulating aggregate demand upward will have no long-term effect on output
although it will change the nominal GDP by raising the average level of prices
at which the same level of output trades. There is recognition that there may be
short-run effects of shifting the aggregate demand curve, but over the long run the
only effect will be on the average level of prices. The AS curve being vertical needs
some further explanation, especially as this may occur at what is an unacceptably
high level of unemployment. In this diagram Ye also represents the natural level of
employment at which the economy will settle, given all the factors prevailing in that
economy. Further to this, once the economy is settled in this position, any increase
in aggregate monetary demand will only impact on the average level of prices, not
on the real economy. Two issues raised by this, which we will look at in more
detail in Topic 7, are that this natural level of employment is not an unchanging
point, as it will vary over time as things change, and that it will also constitute
different proportions of total employment in different countries depending on the
relevant institutional factors. Ask yourself the question: if one country pays very
high welfare benefits to the unemployed and another country makes no welfare
payments, in which country will the natural level of employment be higher?
If we look at both extreme models of equilibrium, then we note an important
assertion regarding government policy. If the Keynesians are correct, then the
levels of employment and real GDP can be managed using demand side policies
such as monetary policy, fiscal policy and exchange rate policy. If the free
market monetarists are correct, then these demand side policies cannot be used
proactively to manage the economy and should only ever be used reactively to
accommodate real growth in the economy. Further to this, if the government is
unhappy about the natural level of employment then the only thing to do is to
analyse what is causing the aggregate supply curve to be in that position and to
think how that position could be shifted to the right: another issue we will consider
in more detail in Topic 7.
6.3 The withdrawals/injections model

Another useful model, which takes a slightly different perspective on the same
equilibrium process, is the withdrawals/injections model. Here we look at nominal
national income on the horizontal axis so that a movement along this axis could
be the result of real or inflationary changes. Figure 6.9 identifies the basic model.

Figure 6.9
Here the equilibrium Ye occurs where injections into the circular flow of income
are equal to withdrawals. As we have seen earlier, there are three matching pairs of
withdrawals and injections, ie savings and investment, taxation and expenditure,
and imports and exports.
The withdrawals function changes as nominal income changes. This is because it
is likely that an increase in income will increase the marginal propensities to pay
tax, to save and to purchase imports. However, the injections function is parallel
to the horizontal axis showing that changes in nominal income do not change the
value of each injection. This assumption can be questioned in as much as we are
assuming that government expenditure, investment and the purchase of exports
are unaffected by changes in income. This is obviously a realistic assumption in
terms of exports as their demand is determined by the changing income in other
countries and changes in the foreign currency price of UK products. It is a little
less realistic to assume this for government expenditure and investment, although
we have already identified that decisions in these areas may be autonomous as
investment decisions and government expenditure are planned over longer time
horizons and are likely to be unaffected by levels and changes in current income.
We have, however, also noticed that there is an induced element of change in
these variables, but in order to keep the model simple to analyse, we will ignore
any induced effects and consider injections to be unrelated to changes in Y.
A further point to note is that the withdrawals function starts to rise at some point
along the horizontal axis as people will not be able to allocate any of their income
to savings or taxes until they have, at least, reached a level of subsistence.
Given Figure 6.9, we can see that any shifts to the right or left for the withdrawals
function or up and down for the injections function will produce a higher or lower
level of nominal national income, which may or may not be a real change in the
economy.
6.4 The multiplier
6.4.1 Definition and preliminary considerations

This is a coefficient that measures the number of times an injection into or a
withdrawal from the circular flow of income raises or lowers the total income of

The multiplier
that economy. In a more abstract way it is described as a proportionality that

calculates the result of an exogenous event (a variable from outside the system)
and how it affects an endogenous event (a variable inside the system).
The multiplier was introduced into the mainstream of economics by Keynes and
his followers in the 1930s and has subsequently been refined and argued about
by many economists, including Paul Samuelson and, more recently, Robert Barro.
As with many theories in economics, it is difficult to predict the size of the multiplier
with any accuracy, and arguably its most important contribution to economics is
the recognition that a change in a withdrawal or an injection is likely to have a
greater change on nominal and/or real income than the size of the initial change.
As a Keynesian concept, and given the assumption of fixed prices, the changes are
recognised as real; however, we should interpret the change on the assumptions
that prices may vary and that the effect may be real, nominal or shared between
output and prices.
6.4.2 The multiplier round: An iteration

If we assume an autonomous injection of investment into the economy and make
some simple assumptions for the marginal propensities to withdraw from the
circular flow of income then the multiplier would look like this:
Table 6.1 The multiplier round

100m investment injection (£s) 50m
MPT 25m 12.5m
75m change in 37.5m
income
MPS 10m 5m
65m change in 32.5m
consumption
MPM 15m 7.5m
50m to start the second round 25m to start the third round
The total effect, keeping all the same assumptions, and stopping where the effect
becomes insignificant =
100 + 50 + 25 + 12.5 + 6.25 + 3.125 + 1.563 + 0.871 + 0.391 + 0.196
So far we have got to 199.806, but if we continue then eventually we will reach
200m, showing that the multiplier in this example is 2.
6.4.3 The algebraic formulation

The symbol K represents the multiplier and can be calculated working backwards
by identifying the change in income and dividing by the original change. Therefore
for the previous multiplier round:
∆Y 200
K = = =2
∆J 100

You may come across models that only have one withdrawal, as the original
Keynesian calculation had, in terms of the marginal propensity to save. If saving
was the only withdrawal in the previous example, then the multiplier is:
1 1 1
K = = = = 10
(1 − MPC) MPS 0.1
If we add in tax then the multiplier is:
1 1 1
K = = = = 2.857
MPS + MPT (0.1 + 0.25) (0.35)
If we add in imports then the multiplier is as it was in the previous example:
1 1 1
K = = = =2
MPS + MPT + MPM (0.1 + 0.25 + 0.15) (0.5)
6.4.4 The graphical formulation

For those who prefer the graphs to the algebra, we can use the withdrawals/injections
diagram to explain what we have just calculated.
Figure 6.10
The diagram shows that the slope of the withdrawals function is determined by the
value of the withdrawals, ie 0.5 and the ∆Y = 200 and the ∆J = 100 and therefore
∆Y = 2 .
∆J
A further point to notice is that the shallower the slope for W, the bigger the
multiplier; and the steeper the slope, the smaller the multiplier. For example, if
there was only one savings withdrawal then the previous example would show
a multiplier of 10: see Figure 6.10. Given an injection of 100, and the shallower
slope, income rises by 1000.
Also remember that a shift in either curve in either direction will produce a
multiplier effect. Expansionary multipliers are usually described as upward shifts
in J, but a rightward shift in W will have a similar multiplier effect.

The paradox of thrift
6.4.5 The balanced budget multiplier

It is often assumed that, if the government moved from one balanced budget
situation to another by increasing expenditure and taxation by the same amount,
then the upward and downward multiplier effects would cancel each other out.
However, this is not the case as the balanced budget multiplier always has a value
of 1 and not zero. A few simple numbers can illustrate this. Suppose from one
balanced budget situation the government increases expenditure and taxation by
£10m. If we assume that the marginal propensity to consume is 4/5 and therefore
that the marginal propensity to withdraw is 1/5, then:
1 1
k = or =5
1− 4 1
5 5
An increase in G of £10m will have an upward multiplier effect of £10m x 5 =
£50m.
An increase in T of £10m will reduce consumption by 4/5T as 1/5T would have
been withdrawn. Therefore the downward multiplier effect will be £10m x 4 =
£40m.
The overall effect will be a positive net multiplier effect of 1; as would any
calculation using any MPW/MPC numbers.
6.5 The accelerator

The accelerator is often confused with the multiplier, but there is a clear separation
between them as this is a theory about how investment responds to changes in
national income, while the examples of the multiplier are about the effect on
national income of a change in investment.
In its simplest form, the accelerator theory of investment is expressed as I = f (∆Y),
ie investment is a function of a change in national income. In this situation, we
are referring to investment induced by changes in income rather than autonomous
investment having a multiplier effect on national income.
As an example, assume that there are 1,000 units of capital in an economy and
each year 100 or 10 per cent have to be replaced because of capital depreciation.
Suppose that the national income doubles over one year. In order to maintain a
fixed capital/output ratio then investment in one year will have to rise from 100
units to 1,100 units. This will cause an acceleration in output before the capital
investment settles back to 200 replacement units each year or 10 per cent of 2,000.
The accelerator theory is used as part of the Keynesian analysis of economic
instability and, alongside the multiplier, it is used to explain how cycles of more
and less economic activity may follow one another.
6.6 The paradox of thrift

An apparent contradiction about the way that savings may impact on the circular
flow of income is offered by the paradox of thrift.
In the past individuals were often encouraged to save or be thrifty with the
expectation that this would increase their wealth and future income. Alternatively,

they were discouraged from being spendthrift (overspending a personal budget)

as this would lead to lower incomes in the future and the possibility of personal
bankruptcy.
Bearing in mind the action of thrift we can investigate, by using our

withdrawals/injection model, what may happen if everyone decided to increase
the proportion of their income that they were going to save.
In Figure 6.11, this is shown as a shift to the left in the withdrawals function from
W to W 1.
Figure 6.11
This collective decision to increase savings would reduce the national income
equilibrium from Y to Y 1. This leads to the conclusion that, other things being
unchanged, the more frugal or thrifty households are, the lower will be the level
of national income and, by association, the level of employment; or, put the other
way, unemployment will rise. In contrast, the more spendthrift households are, the
higher will be the levels of national income and employment.
Arguably the analysis produces the conclusion that the more responsible people
are with their finances, the more damage they will do to the economy, and the
more irresponsibly they act, the greater will be the benefit to the economy.
As this conclusion may give a wrong impression, we need to question this paradox
further. One weakness in the argument is that it relies on the level of injections
being autonomous and therefore independent of the volume of withdrawals. This
is most unlikely and it would be quite reasonable to expect that an increase in
savings would lower the rate of interest and that this in turn would encourage more
borrowing to buy both consumer goods and carry out investment expenditure. This
investment expenditure should lead to higher levels of real income in the future,
while increased borrowing to buy consumer goods should help offset the reduction
caused by increased savings. However, if people borrow amounts that they cannot
afford to repay, the banking system and the economy can get into trouble. In such
a case, a large part of current consumption is being financed by future incomes
that have not yet been earned and, in some cases, may never be earned.
However, having said all that, the reaction of the Bank of England to the credit
crunch of 2009 was to lower rates of interest and call for increased borrowing,
which, by 2012, had not been forthcoming as more people seemed to be paying
down debts and protecting themselves from a recession. These actions are argued,
by some, to be the reasons why the UK recession continued into 2012.

Summary
Summary
u Understanding the circular flow of income is fundamental to understanding the
macroeconomic management of the economy.
u The circular flow of income has three main injections into the flow and three
matching withdrawals.
u Useful equilibrium models are the aggregate demand/supply model and the
withdrawals/injections model.
u The models are based on different assumptions about the role of manipulating
aggregate demand and its effect on economic activity.
u There are several important functions that help explain changes in the economy:
the main ones being the consumption function and the savings function.
u The multiplier and accelerator effects of changes to injections into and
withdrawals from the circular flow are important in understanding whether
targets are likely to be achieved.
u A paradox is an apparent contradiction and thrift provides such a paradox for
the economy as a whole.
References
Keynes, J.M. (1923) A Tract on Monetary Reform. Chapter 3. London: Macmillan & Co. Ltd.
Keynes, J.M. (1936) The General Theory of Employment, Interest and Money. Chapter 24, concluding
notes, p. 384. London: Macmillan & Co. Ltd.

Topic 7
Problems of imbalance and instability
in the economy
‘Much money makes a country poor for it sets a clearer price on everything.’
Herbert (1640)
u the main problems of imbalance and instability in the form of

inflation, deflation, unemployment, business cycles and current account
disequilibria;
u economic growth as both a cause of instability and a solution to many

economic problems;
u the way in which inflation and deflation distort markets and mask economic
signals;
u the waste of resources when they are unemployed, particularly labour; and
u the debate among economists about cause, effect and solutions to these
problems.
7.1 Inflation
7.1.1 Inflation and different types of inflation

By definition, inflation is a rise in the average, absolute or general level of prices.
This is important and needs to be distinguished from a change in relative prices.
The easiest way to do this is to recognise that relative prices can change without
changing the average price, eg:
Product Price Year 1 (£) Price Year 2 (£)

A 20 18
B 10 12
Prices have changed but the average is still 15 in year 2.

Or, a change in average prices can occur without a change in relative prices, eg:

7: Problems of imbalance and instability in the economy
Product Price Year 1 (£) Price Year 2 (£)

A 20 24
B 10 12
Here the average has gone up from 15 to 18, but relative prices are still the same
as the price of product A is twice as much as product B. Obviously it would be easy
to illustrate a change in relative prices and a change in average prices at the same
time.
Although this may seem to be just a matter of semantics, it is, in fact, very
important. This is because there can be some falling prices during a period of
inflation and some rising prices during a period of deflation. The only fact that
distinguishes them is the change in the average.
A point that we will consider in the next topic is the fact that, over recent years, the
Bank of England’s explanations of why inflation is above target focuses on those
prices that have gone up most as if they are the cause of the inflation, whereas it
is possible that they are just the prices that went up the most and that the cause
of inflation was the event that caused the average to change.
Having defined inflation, we need to note that it is often described by the rate at
which the average level of prices is rising over a given period of time.
Creeping inflation is described as a rise of just a few per cent a year. This can
be a necessary and useful thing, as we will analyse in the next topic, or it can be
a rather pernicious event that has damaging and unforeseen effects. For example,
a rate of just 5 per cent inflation a year reduces the value of money by half in 13
years and 62 days.
Accelerating inflation is self-explanatory and even more worrying for an
economy as it suggests that things are not under control and could get worse
and may even signal the beginning of hyperinflation.
Hyperinflation is when price rises are out of control. They may be rising by
hundreds of thousands of per cent over shorter and shorter periods of time.
There is a well-known story of how, in Germany, in 1923 a person had to take
a barrow loaded with money to the shops. The first stop was to buy some bread
and the person foolishly left the barrow-load of money outside the shop. When he
came out of the shop, the barrow had been stolen. However, the money was still
there. Hyperinflation had led to money having little or no value and it was the real
product that attracted the thief. Hyperinflation was running so high in Germany
that between June and October 1923 prices rose by 5,882,352,900 per cent. There
are many examples of hyperinflation over the last 100 years, the latest of which
has been observed in Zimbabwe. Hyperinflation usually leads to the collapse of the
currency and the downfall of the ruling regime.
One final point to note is that, when reference is made to the rate of inflation rising
or falling, it is, in both cases, referring to prices that are rising. The only difference
is that the reference to inflation falling is a reference to inflation rising more slowly
than previously, ie the rate of inflation has fallen to 3 per cent this year compared
with 5 per cent last year.

Inflation
7.1.2 The causes of inflation
7.1.2.1 Keynesian causes

As far as Keynesian economists are concerned there are two causes of inflation:
one occurs only at the full employment level of output for the economy, while the
other can occur at any level of economic activity.
Demand pull inflation occurs when aggregate demand grows past the full
employment or capacity output of the economy. It may occur as the result of an
increase in any of the injections into the circular flow or a reduction in withdrawals
from the circular flow. In either case, the growth in demand is faster than the
growth in output and so the average level of prices rises.
Cost push inflation can occur alongside demand pull inflation at full employment,
but it also stands alone as the cause of inflations that occur at less than full
employment. As there are many examples of inflation when the economy is working
at less than full capacity, it is those prices that are rising quickest that tend to be
analysed as the potential cause. Often this analysis comes down to an observation
of rising costs of production. These may be the result of high wage costs, higher
raw material prices, energy costs or they may be associated with a fall in the foreign
exchange rate and a rise in import prices. Often those costs that are likely to have
an effect on all, or most, firms, such as energy costs, commodity prices or a falling
exchange rate, are highlighted as the main cause of cost push inflation.
7.1.2.2 The monetarist cause

Monetarist economists such as Milton Friedman and Friedrich Hayek discount cost
push inflation as a logical fallacy and argue that there can only be one cause of
inflation and that this is too much money chasing too few goods. They argue that
changes in costs will change relative prices, but they cannot change the average
level of prices unless there is a monetary expansion that is greater than the growth
in real output, ie people cannot pay more money for the same or more goods at
higher prices if the money does not exist to allow them to do this. However, it
is possible that a contraction in real output could create a situation where there
is excess monetary demand in the economy, but this is a very rare occurrence in
history and so it is observed that almost every inflation has been preceded by a
monetary expansion that was faster than the rate of growth in the real economy.
In any monetised economy, an increase in the average level of prices is by definition
an increase in the amount of money used in the average purchase. Monetary
demand is made up of a quantity of money multiplied by the speed in which
it circulates through the economy and between them these two variables must
determine any inflation or deflation that takes place.
7.1.3 The effects of inflation
7.1.3.1 Redistribution of income

Inflation reduces the value of people’s money income. However, some groups in
society are better at protecting the real value of their incomes than others. The
more powerful groups in society are likely to get pay increases at or above the rate
of inflation. These are often the members of strong trade unions in industries where

they can threaten effective industrial action, the top of the employment hierarchy
and various professional organisations. Those who lose out are the members of
weaker unions, people at the bottom of the employment hierarchy and individual
workers who are not members of unions. As long as inflation continues, it is likely
that there will be winners and losers in the various labour markets.
7.1.3.2 Redistribution of wealth

Wealth is held in many forms, some of which are, at one time or another, good
hedges against inflation. However, there is one way of holding wealth that will
definitely be damaged by inflation and that is hoarding cash. Nearly as bad as
hoarding cash are cash deposits that receive no interest or interest at less than 1
per cent. In 2011 it was necessary to achieve a rate of return on cash in excess of 5
per cent, otherwise the value of the cash asset was depreciating. During the 1970s
those people who were best protected against inflation, which reached nearly 30
per cent pa, were property owners. During the current inflation, which started in
2010, property prices have not protected wealth and so some of the better forms
of protection have been gold, rare metals, precious gems, antiques and works of
art. As a rough rule of thumb, during periods of inflation try not to hold cash or
cash valued contracts and look for tangible assets as, even if you do not need a
wheelbarrow (see section 7.1.1), its value may be better preserved when compared
to cash.
7.1.3.3 Redistribution from creditors to debtors

When inflation rates are higher than nominal interest rates, ie real rates are
negative, there is generally a loss in value to people in credit as the real value
of their surpluses fall, while debtors find that the real value of their debts have
also fallen. The biggest debtor in the UK is the government; and if it is able to
borrow at rates below inflation, then it will benefit by some of the value of its debt
being inflated away.
7.1.3.4 Adjustment to foreign exchange rates

What happens to the rate of exchange between currencies depends upon relative
rates of inflation between countries. If we assume that the UK has a higher rate
of inflation than its trading partners, then the exchange rate will fall, lowering the
price of exports in terms of foreign currency and raising the price of imports in
domestic currency. Only if the rate of inflation is lower than its trading partners
will sterling rise in value against its competitors. These changes in exchange rates
will take place if we assume, other things being equal, that all other variables such
as interest rates remain unchanged.
7.1.3.5 Adjustment to economic growth rates

If the inflation rate becomes volatile and seemingly out of control, then it will
damage the rate of economic growth as price signals will stop acting efficiently to
reallocate resources and investment decisions are likely to be held back as firms
lose confidence in the way the economy is being managed. The higher the rate of
inflation, the more likely it will damage growth prospects. Economic growth rates
slowed significantly during the 1970s when inflation peaked at just under 30 per
cent pa. The average growth rate during the 1970s was 0.6 per cent pa against a
5 per cent target set by government in 1970 and a 3.2 per cent average rate of
growth during the 1960s when there was no government target. Also during the

Inflation
recession, after 2009, growth rates have been significantly lower than expected
and inflation has remained stubbornly above its 2 per cent CPI target.
7.1.3.6 Adjustment to standards of living

Not everyone loses out during a period of inflation. As has already been described,
redistributions take place so some people become better off as others become
worse off. Also expectations of future growth rate rises are not realised if actual
growth rates are suppressed during periods of high and volatile inflation.
7.1.3.7 Social and political disorder

Lower than expected economic growth and faltering rates of investment can be
associated with higher levels of unemployment. Even a rate of inflation that has
been only a few points above target since 2009 has not seen any reduction
in unemployment, which has remained stubbornly between 8 per cent and 9
per cent measured by claimant count. As unemployment tends to be unevenly
distributed, it can lead to hotspots of disruption, vandalism and crime. All of these
impose economic costs on society. Often very high rates of inflation have been
last-gasp attempts by governments to remain in power and, although there is
no conclusive evidence, it has been suggested that high rates of inflation have
promoted the growth of more extremist political groups and toppled governments.
Most governments see inflation as something that needs to be controlled if their
political power is to remain intact.
7.1.3.8 So what are the benefits of inflation?

In an ideal world the best of all situations is a zero rate of inflation. In this
situation, relative prices can work unhindered to allocate and reallocate resources
as consumer patterns of expenditure change and as economic growth offers new
and better products to the market.
However, zero inflation is impossible to achieve unless the Bank of England has
total control and perfect information about current and future rates of growth. We
will see under the next heading that the smallest change in average prices in a
downward direction is damaging to an economy and needs to be avoided at all
costs, and the cost of doing this is to concentrate on maintaining a low rate of
inflation such as the current Bank of England inflation target of 2 per cent pa.
A very low rate of inflation will have effects that can be described as causing
minimal damage, but they can also avoid the even more damaging risk of deflation
as well as provide sufficient buoyancy to prices to encourage markets to be dynamic
and responsive: and so, if there is a good side to inflation, that is it.
7.1.4 Ways to control inflation

If inflation exists, then there is an imbalance between aggregate monetary
demand and aggregate supply. This can be described as too much aggregate
demand or too little aggregate supply. Bringing the two aggregates into line can
result from constraining aggregate demand or boosting aggregate supply. Also the

solution to unwanted inflation will very much depend upon whether the monetarists
or the Keynesians are correct.
7.1.4.2 The Keynesian way

If the Keynesians are right, then there are solutions that are different depending
upon whether the cause is cost push or demand pull.
When inflation occurs at full employment, then the economy is described as
being in a condition of over-full employment and the Keynesians will look to fiscal
policy solutions that may entail budgeting for a surplus or monetary policies that
may require interest rates to rise. More of this will be explained in Topics 8 and 9.
Alternatively, if the economy is at less than full employment equilibrium and
the inflation is described as of a cost push type, then solutions to keep costs from
rising can be used. In the past, and particularly in the 1970s, the government
adopted prices and incomes policies to control the rate of inflation. A rather crude
attempt was to put a limit on the rate that prices could be adjusted upwards by a
firm, while another was to try to keep down labour costs by imposing a nominal
limit on wage increases.
Again, for reasons that will be explained in more detail later, these were not
successful. Almost all prices have an element of imported costs and these could
not be controlled from the UK. Also trade unions put up a strong defence of their
members’ nominal wages by threatening and carrying out industrial actions that
both imposed costs on society and forced the government to break its self-imposed
limits, especially when the union was powerful and was producing an essential
product.
There are two elements of imported prices: they may be raised, by the foreign
seller, in a foreign currency, or they may rise in the domestic currency as a result
of a fall in the exchange rate. Ideally a government could intervene and try to
maintain a higher value for its currency that would keep imported prices lower, but
this becomes impossible if the economy is already running a large current account
deficit on its balance of payments: see Topic 10.
7.1.4.3 The monetarist way

Monetarists see only one solution to inflation, which is to stop the money supply
from growing faster than the rate of growth in output. This means that the Bank
of England is the main player in terms of inflation control. As the money supply is
controlled by the Bank using the price of money or the quantity of money, all it has
to do is to make sure that monetary demand grows just a little bit faster than the
rate of economic growth. As a crude example, the Bank could expand monetary
demand by 5 per cent and, if the growth in real GDP is 3 per cent, then inflation
will be 2 per cent-ish.
7.1.4.4 Index-linking
Some economists argue that inflation is inevitable and therefore suggest that the
best thing to do is to control the harmful redistributive side effects by index-linking,
which automatically adjusts nominal contracts to real values, ie if inflation is 5
per cent then incomes are adjusted upward by 5 per cent to maintain their real
spending power. The main criticism of this is that it would be difficult to do for
all private sector contracts, as this would not allow prices to adjust to changing
circumstances in the marketplace. However, the same argument does not apply to

Deflation
public sector contracts and perhaps index-linking of public sector contracts would
be a partial solution to the inflation problem.
7.2 Deflation
7.2.1 Terminology
There is a problem with the term ‘deflation’ as it is the opposite of two words,
namely inflation and reflation. When it is the opposite of inflation it means a
fall in the average level of prices. However, when used to mean the opposite of
reflation, which in turn is being used to mean an expansion in demand side policy,
then deflation means a contraction in demand side policy. This leads to a problem
when a contractionary demand side policy exists alongside inflation, which, in
a Keynesian world, could occur with cost push inflation. At this point we have
created a situation where deflation is the opposite of reflation, but occurs alongside
its other opposite, which is inflation. Therefore we look to someone to invent
another word to be either the opposite of inflation or reflation and therefore remove
the current dilemma. Until that happens we are going to consider that deflation
means a fall in the average level of prices and note that when Keynesians refer
to deflationary policies they are probably referring to what monetarists would call
anti-inflationary or less inflationary policies.
7.2.2 The cause of deflation
7.2.2.1 Shortages of monetary metal

During the eighteenth and ninteenth centuries, and before governments took
control over managing monetary demand, it was relative shortages of monetary
metals that caused the average level of prices to fall. Discoveries of gold tended
to come in a rush and monetary demand grew faster than the real economy thus
causing inflation. However, as output continued to expand so it would grow faster
than gold and the average level of prices would fall. At the time that the prices of
products, traded with gold, were falling, the value of gold was rising, so it became
more profitable to search for more gold and instigate another gold rush. This is
why the nineteenth century particularly produced cycles of deflation followed by
inflation.
7.2.2.2 Credit crunches and a little bit more

During the twentieth and twenty-first centuries central banks have taken control
over monetary demand. Events outside the control of the central bank can cause
credit crunches: these may be wars, natural disasters, political disasters and
economic disasters and, arguably, the reaction of the central bank, which may deal
with the problem or which may make the problem worse. The last big deflation
in prices in the UK occurred after the 1914−1918 War when the Bank of England
made a decision to return to the pre-war gold standard and underwent what turned
out to be a damaging monetary contraction that caused deflation for most of the
1920s. In the USA a major deflation occurred after the Wall Street Crash in 1929 and
caused a prolonged depression during the 1930s. In 2009 there was a significant
risk of deflation after the collapse of Lehman Brothers and the subprime mortgage

crisis. However, the Bank of England took action by initiating a quantitative easing
programme and, at least, avoided deflation, although it may have caused more
inflation than it expected. We will discuss more about this in Topic 8.
7.2.3 The results of deflation
7.2.3.1 Redistribution of income

A period of deflation increases the value of money so that any persons or groups
of people who can maintain their income level become better off while anyone
whose income falls may become worse off if the income falls faster than the rate
of deflation or no better off if it keeps pace with deflation. As with inflation, it is
probably the weak and disorganised who become worse off and the strong and
organised who become better off.
7.2.3.2 Redistribution of wealth

Now anyone holding their assets in cash or cash contracts becomes better off while
people holding assets that fall in price become relatively worse off.
7.2.3.3 Redistribution from debtors to creditors

The value of debts and savings will both increase, meaning that savers become
better off while debtors become worse off as they will have to repay debts that
have increased in value in real terms.
7.2.3.4 Adjustment to the foreign exchange rate

If we are the only country deflating, then export prices will fall and become more
competitive such that the likely rise in demand for exports will produce a current
account surplus on the balance of payments, or at least reduce the deficit, as well
as causing a rise in the exchange rate. In contrast, if all countries are deflating,
then a country that is deflating least will find the value of its currency falling relative
to the other currencies.
7.2.3.5 Adjustment to economic growth

Deflation has a damaging effect on economic growth as it depresses demand at
current prices and forces price down. A fall in price usually damages profits initially
and this will impact on investment and job creation. Falling prices and profits, talk
of recession, and depression generally cause a loss of business confidence and a
‘batten down the hatches’ mentality among business people.
7.2.3.6 Adjustment to standard of living

There will be redistributive effects as already described and there will be pockets
of unemployment because, as prices fall, it is necessary for firms to reduce their
wages bill. If the labour force tries to resist this adjustment, then it is likely to lead
to bankruptcies and a proportion of people becoming unemployed in those firms
that survive. All the main deflations so far described have been associated with
significant rises in unemployment.

Deflation
7.2.3.7 Social and political disorder

As with damaging high rates of inflation, so it is with damaging low rates of
deflation. As deflation manifests itself through unemployment, so we see the
development of a discontented underclass, a rise in the drug culture and an
increase in vandalism, theft and many other crimes.
7.2.3.8 Are there any benefits from deflation?

Overall, the answer is no. As already described, there will be some who benefit
as others lose, but even getting close to deflation by moving towards zero sets in
motion a range of undesirable economic consequences.
7.2.4 Ways to control deflation
7.2.4.1 Pre-Keynesian
Before the 1939−1945 War the classical argument for solving the problems of a
deflation was to let the market make the adjustments. As prices fall, so wages
and other incomes will fall. Any rise in unemployment will increase the supply of
available labour and put downward pressure on wages. Eventually the market will
adjust to lower prices with lower wages and full employment will return.
7.2.4.2 Post-Keynesian
Events have not been quite as the theory described. Economies took a long time
to come out of a deflation and this caused Keynes to suggest that we cannot wait
for the market to solve the problem as ‘in the long run we are all dead’(Keynes,
1923, p. 80). To solve the problem more quickly the government would need to
be proactive rather than just reactive as it had been in the past.
Keynes had noted that, during periods of time when prices were falling and
unemployment was rising, government revenues contracted and so government
spent less money. Also people tended to delay purchases and increase cash
balances as the value of their money was rising. Governments were then acting
in a pro-cyclical way if they reduced their expenditure as tax revenues fell and
so they were actually aggravating the deflation. Keynes therefore argued that,
during a period of time when there was a natural tendency for the economy to
deflate, governments should act in a counter-cyclical way to reverse direction
and so increase their spending and budget for a deficit. This would remove the
deflation and stabilise the economy as well as absorb some of the idle resources.
This process could then be reversed when the economy was inflating too fast by
running a budget surplus.
7.2.4.3 The monetarist way

Monetarists focus on the contraction in monetary demand that occurs during a
period of deflation. Part of this is illustrated above where a slow-down in the
velocity of circulation of money occurs when deflation starts as people are inclined
to hold back on non-essential purchases. At this time, and through monetary not
fiscal policy, the Bank of England would be encouraged to boost the money supply
and stabilise aggregate monetary demand. In essence, the solution is the same as
that for controlling inflation, namely managing monetary demand so that it grows

slightly faster than the expected growth in real GDP leading to a low (circa 2 per
cent) and stable rate of inflation.
7.3 Unemployment
7.3.1 Separating unemployment from deflation

Unemployment is a damaging waste of idle resources in the economy. Most
commonly, unemployment is associated with periods of deflation. Two examples
of this were after the 1914−1918 War when there was a deflation in the UK and
a rise in unemployment, and in America, and subsequently other countries, after
the Wall Street Crash of 1929. This close link has led some economists to think of
deflation and unemployment as almost synonymous. This view has been reinforced
by the fact that, at low rates of deflation, unemployment begins to rise while at low
rates of inflation there may even be stimulation to economic activity and more jobs
may be created. However, as inflation accelerates and becomes more volatile, so
unemployment also begins to rise. This could be seen during the hyperinflation in
Germany after the 1914−1918 War, during the inflation in the UK in the 1970s and
during the rising inflation that occurred in the UK after 2009. Also unemployment
has been seen to rise during periods of disinflation (slowing the rate of inflation)
as noted in the UK during the 1980s.
So, from what has been said above, we can see that unemployment can occur
during periods of very low deflation, rising and volatile inflation, as well
as disinflation, depending upon what other factors come into play at the same
time. For this reason we are separating the terms unemployment and deflation
and freeing ourselves from the policy view that every time unemployment rises,
the government needs to pursue reflationary policies that could be, given our
analysis, exactly the wrong thing to do.
7.3.2 More important concepts
7.3.2.1 Full employment

Ideally, full employment can be thought of as 0 per cent of the working population
unemployed. However, in a dynamic economy we need to recognise that there are
always going to be people unemployed as the economy changes over time and as
some industries expand while others decline. Therefore it could be argued that
the best situation is one where the number of people unemployed is equal to the
number of job vacancies.
In Keynesian economics, full employment was an achievable high level of
employment consistent with a stable economy. In the 1940s the economist William
Beveridge reported to the government that full employment was consistent with
a 3 per cent level of unemployment. During the 1960s this rate was realistically
considered to be between 1.5 per cent and 3 per cent of the workforce unemployed.
As unemployment has grown, so other numbers have been chosen politically to
represent full employment or what has been described as the fullest or a fuller
level of employment.
Whatever the chosen number, it is important to Keynesian economists that there
is a full employment level of output that they believe is achievable given the right

Unemployment
mix of sound economic policies. Given that assertion, then any number that is
not consistent with the chosen number must be an under-full employment level
of output while any high level of employment associated with an overheating or
rapidly inflating economy must be an over-full employment position.
7.3.2.2 The natural level of unemployment and NAIRU

Other economists believe that, when prices are stable, any economy will settle
at a level of unemployment that is determined by market forces and a range of
institutional factors peculiar to each country in question. This idea has been further
developed into the NAIRU or non-accelerating inflation rate of unemployment.
Between 1997 and 2005 the Bank of England was successful at maintaining the
rate of inflation close to 2 per cent while unemployment was relatively stable
around 5 per cent. This would then have been considered to be the UK NAIRU. The
actual natural rate will vary from country to country and from time to time mainly
as the result of changes in institutional factors on the supply side of the economy.
Ask yourself which country will have the lowest natural rate of unemployment if we
compare one country that has very generous welfare benefits for the unemployed
with another country that has no welfare benefits for the unemployed.
7.3.3 Types, causes and possible solutions to unemployment
7.3.3.1 Important note

It is necessary to understand that unemployment, although it is expressed in
one number, is not a homogeneous grouping of people who are all unemployed
for the same reason. Therefore it is very unlikely that one solution will cure all
unemployment. Some types of unemployment may be easier to solve than others
and there may not be any practical solution to other types of unemployment. Let
us then look at each of these types in alphabetical order.
7.3.3.2 Casual unemployment

This occurs in labour markets where work is irregular and often affected by the
weather. Building work is one example where certain jobs cannot be carried out
when it is too cold or too wet. It would be difficult to think of a general policy to
cope with this type of unemployment and one may expect that builders would have
a number of jobs on the go, some inside and some outside, and be able to move
between them as the weather dictates.
7.3.3.3 Cyclical unemployment

As the name suggests, this is related to an economic cycle where recession and
depression will be associated with rising levels of unemployment. Economists have
seen solutions to this by using counter-cyclical policies to flatten the amplitude
of the cycle (work in the opposite direction to the cycle). Keynesian demand
management policies were designed to deal with this problem.
7.3.3.4 Demand-deficient unemployment

This is similar to cyclical unemployment but more inclusive is the idea that any
level of unemployment above a certain level must be the result of there not being

sufficient aggregate demand in the economy to employ these people. Again, a

policy to boost demand may involve fiscal or monetary policy.
7.3.3.5 Disguised unemployment

One of the main unemployment measures is a register of those people claiming
unemployment or welfare benefits. Those who are out of work but not claiming a
benefit are, to all intents and purposes, still unemployed. The partner of someone
who is working may be considered, or consider themselves, to be unemployed but
because they chose not to register they will not be counted. It is probably not
necessary to search for a solution here as such people have chosen their position
and are not likely to be in need.
7.3.3.6 Export unemployment

A decline in orders from export markets is likely to lead to unemployment in
domestic firms supplying these markets. There is very little that can be done
to influence export markets directly, although one can improve marketing, and
governments may choose to finance trade delegations. However, as we will see
in Topic 10, it is possible to make export prices more attractive by allowing the
domestic currency to decrease in value against foreign currencies.
7.3.3.7 Frictional unemployment

This is said to exist when jobs are available in one area of the economy while
people are unemployed somewhere else, or where unemployed people do not have
the right skills to fill the jobs that are available. Here there are opportunities to
try to improve the mobility of labour such that people move more easily from one
area or one skill to another, or to give incentives to entrepreneurs to move their
jobs to where people are without work.
7.3.3.8 Poverty trap unemployment

There are a significant number of people who get caught in the poverty trap
because if they took a job they would be worse off than if they remained
unemployed. This happens when there is an implicit marginal tax/welfare effect in
excess of 100 per cent when they go to work, ie there is a range of income over
which, if they earned £1 more, they would lose welfare benefits worth £1 and also
pay tax at 22 per cent, giving them an overall loss, from earning £1, equal to £1.22.
Various ideas have been put forward to deal with this problem, but governments
have been reluctant to carry out what would be a significant restructuring of the
tax and benefit system.
7.3.3.9 Regional unemployment

As the name suggests, this type of unemployment gets its name from observing
that total unemployment is very unevenly distributed around the economy. More
worrying is the fact that the numbers of people in these pockets of unemployment
remain stubbornly high. Solutions to this problem will require further analysis to
try to find out into which other category of unemployment this group best fits.

Unemployment
7.3.3.10 Search unemployment

Sometimes this type of unemployment is included as frictional, but there is a clear
separation in as much as there are people who register as unemployed while they
are between jobs, ie they have left one job to take up another job in the near future.
It could be possible to remove this category from the statistics by not recording
these people as unemployed until they have been out of employment for a certain
period of time, eg three months.
7.3.3.11 Seasonal unemployment

This is similar to casual unemployment, but it is regular and associated with the
seasons rather than with the weather. There is no demand for people to take on
the role of Father Christmas in any other month than December. Equally, deckchair
attendants are more likely to be employed in the summer, although global warming
may increase opportunities to extend their employment.
7.3.3.12 Structural unemployment

As the name suggests, this is the result of some significant change in the structure
of the economy usually brought about by the decline of a large industry. In the
past the UK has suffered such declines in coal mining, steel making, shipbuilding
and car manufacture to mention just a few. Often this is localised or regionalised
and there are local effects on support services, leaving behind significant levels of
unemployment that will not easily be absorbed into other labour markets.
7.3.3.13 Technical unemployment

As capital replaces labour through technical innovation so labour becomes
unemployed and often the skills used by that labour becomes obsolete. Further
to this, much of the labour may find it difficult to take on the new skills that
will allow it to be re-employed in another labour market. Here policies aimed at
retraining and developing more viable skills may ease the problem.
7.3.3.14 Unemployables
In the past, a number of people have been thought of as unemployable because
of mental or physical disabilities. It also includes the chronic unemployed who do
not know how to get a job. However, over more recent years considerable efforts
have been made, particularly by charities, to create forms of employment that can
include a much wider category of people who, at one time, may have been thought
of as unemployable.
7.3.3.15 Voluntary unemployment

There are people who choose not to work and are able to live without working.
These may include tramps, beggars and homeless people; or they may be rich
people who can live off an inheritance or who receive sufficient income from owning
assets. Again, charities do a good job of trying to deal with the problem at the
bottom end of the social scale illustrated above.
7.3.3.16 Concluding point

The fact that we have identified 15 relatively distinct categories of unemployed
people makes it clear that it would be foolish to believe that there is one catch-all

solution to unemployment. It also suggests that it may be necessary to look to the

supply side of the economy for solutions rather than the demand side, which is a
blunt tool that can only focus on unemployment in general, instead of targeting a
particular type of unemployment.
7.3.4 Is there a relationship between inflation and

unemployment?
From a long series of empirical data, Professor A. W. Phillips established a
relationship between the level of employment and the rate of change in
wages. Much as expected, it showed that when unemployment was high, the
rate of change in wages was low or even negative. In contrast, when the level of
employment was high and there was little unemployment, wages tended to be bid
up by employers and their rate of change was positive and rising.
For those economists who accepted a cost push cause of inflation, this was
sufficient proof that there must be a similar relationship between the level of
employment and the rate of inflation and so they developed the functional
relationship seen in Figure 7.1 as a model of how the economy may function.
Figure 7.1
Inflation
+
%age of labour employed
0% F 100%
Deflation
Position F represents the level of unemployment/employment that is consistent

with stable prices. Any higher level of employment could only be sustained with
inflation accelerating and employment approaches 100 per cent. If the average level
of employment falls below F, then a deflation will result. This model underpinned
much government policy during the 1960s but was found to be waiting in the
1970s.
The model predicted rising employment and rising prices of falling employment
and falling prices. It did not, however, predict that rising prices and falling
employment could occur together, and so when this combination, which has

Fluctuations in economic activity
become known as stagflation, did show up it was thought that the Phillips
relationship no longer applied.
Supporters of the Phillips curve did suggest the possibility that the level of
unemployment at which prices are stable had been shifting, as illustrated
in Figure 7.2, from F to F 1, and governments, in order to achieve their full
employment target, were raising aggregate demand and moving up the shifted
curve from F 1 to G.
Figure 7.2
Inflation
G
+
%age of labour employed
0% F1 F 100%
Deflation
-
As these two trends were occurring simultaneously so they produced rising prices
at a higher level of unemployment. They further suggested that, if the economy
could be stabilised at F 1, then the old Phillips relationship would reappear, but, all
the time the shift from F to F 1 was being frustrated by a pull to G, the economy
would remain in a state of stagflation.
7.4 Fluctuations in economic activity
7.4.1 Introduction
In the nineteenth century periods of inflation were followed by periods of
deflation. During the twentieth century fluctuations became much more irregular
and cycles of activity have been recorded that include a range of indicators of
changing activity, but not necessarily all the expected indicators all the time. For
example, a period of stagflation will have depression characteristics in terms of
unemployment, but boom characteristics such as inflation.

7.4.2 Regular cyclical events

The most common of these is referred to as the trade cycle. It includes four phases,
as described below:
u Depression is characterised by high unemployment, falling prices, declining
incomes (profits, wages, rents and interest) and weak investment.
u Recovery from the low described above often starts in the capital goods sector
as firms see opportunities to grow their business. Demand begins to rise, jobs
are created and all incomes begin to rise.
u Boom is when the economy reaches a full utilisation of resources and pressure
builds on prices that begin to rise at faster rates.
u Recession occurs when costs rise and squeeze out profits causing firms to rein
back on their investment plans and start laying off surplus productive factors.
Eventually this reaches a depression and the cycle repeats itself.
7.4.3 Irregular fluctuations

These irregular fluctuations lead economists to describe economic activity in
terms of cumulative movements where a momentum builds up with multiplier and
accelerator activity. These changes lead to tops and bottoms or peaks and troughs
from which a reversal of direction or a turning point is recognised. There is a lot
of interest in cycles from the point of view of financial institutions that recognise a
link between those turning points and asset prices. This creates an opportunity to
buy into a rise and sell at the top or to sell at the top and buy back at the bottom.
There are longer cycles that are analysed by economists. The Kondratief cycle is
analysed over a period of 50 years whereas it is more usual to look at business or
trade cycles over 5 to10 or 10 or 20 years.
7.4.4 Theories of cyclical events
7.4.4.1 Under- or overproduction

This theory sees a change on the supply side of the economy as an instigator of
change. Going back to the nineteenth century, agriculture would have taken up a
larger proportion of real GDP and output was very variable depending on weather
and various crop diseases. A significant change could signal a move towards boom
or depression.
7.4.4.2 Business confidence

This may be jolted by real events or rumours and uncertainties about the future
and create a mass response. The 2009 credit crunch had such an effect and has
arguably created a long period of recession.
7.4.4.3 Keynesians
As described in Topic 6, the multiplier and accelerator theories explain how one
event can have a multiple or accelerating effect on national income and these would

Economic growth
be recognised as the beginnings, and reinforcements, of fluctuations in economic

activity.
7.4.4.4 Monetarists
Monetarist economists refer to a cycle of events starting when either the money
supply/monetary demand grows faster than output or when it contracts without
a corresponding contraction in output. This will cause either inflation or deflation
in prices, which will in turn cause other changes in the economy. As we have
already stated, a small deflation may bring about recessionary effects while a
small expansion may provide the economic buoyancy to kick-start the economy.
However, it has also been pointed out that events that cause inflation to rise, or
become unstable, will have similar damaging effects to that of inflation.
Monetarists are also keen to link cyclical events to the election cycle as
governments tend to become overzealous with expansionary zeal just before an
election with an initial effect that may seem beneficial, but that tends to be reversed
soon after the election.
7.5 Economic growth
7.5.1 Economic activity over time

We have described how fluctuations in economic activity occur over time. If we
analyse a series of peaks and troughs in terms of changes to real GDP, we notice
that a peak tends to be a little higher than the last peak and a trough not quite as
low as the last trough. In other words, despite this instability, there is an underlying
trend, over most years, when the economy is growing in real terms.
7.5.2 What is economic growth?

The definition of economic growth supported in this text is ‘an increase in the
productive capacity per capita over time’. In order to proceed with this view, it
is necessary to make a clear distinction between a growth in output owing to
the increased use of existing capacity, ie using up unemployed resources, and an
increase in our ability to produce more as a result of a growth in capacity. This can
be illustrated by reference to Figure 7.3.
If the economy is producing at point X, then a movement from X to Y will raise
income and possibly living standards, but it is not economic growth. It is just an
increase in use of existing resources. However, given a population constraint, if
the production possibility boundary moves out from AB to A 1B 1 then this is an
increase in the productive capacity per capita. Therefore a move from Y to Z is
economic growth.
7.5.3 Why is economic growth desirable?

Over the next 45 years, if the economy grows by 2.5 per cent pa then, on average,
its citizens could be 3 times better off than they are today. This average is on the
conservative side of estimates if we compare it with the last 100 years. Continuing

Figure 7.3
Consumer
goods
A1
A Z
Y
B B1 Capital goods
economic growth has raised expectations that people’s real income and standard
of living will grow over time and most children will expect to be better off than
their parents. In almost every country of the world there is widespread acceptance
of the view that a fairly rapid rise in personal prosperity is possible and it can only
happen for all people if the world economy grows.
The desirability of economic growth is recognised in both the individual and
the collective sense. Central authorities would be able to provide better social
provision, better education, better town planning and more facilities for recreation
as well as reduced tax rates. The individual would find more scope for real wage
increases that render the possibility of more extensive purchases of consumer
goods and services, longer holidays and even shorter working hours coupled with
this higher spending power.
Economic growth offers the prospect of reducing poverty without having to make
some people worse off. A redistribution of income may improve the welfare of
the poorer sectors of society at the expense of the better-off, but it is a once and
for all gain. Economic growth enables all to gain and if redistribution policies are
adopted at the same time then the less well-off could gain without making anyone
else worse off.
7.5.4 Sources of economic growth
7.5.4.1 Invention and innovation

By far the greatest source of economic growth has taken place as the result
of inventions and subsequent innovation. Invention is often the product of the
scientist taking the form of a new technique, new material, new machine or a
whole new way of doing things, usually developed under experimental conditions.
Not all inventions lead to economic growth, as they may not be economically viable.
The road from invention to the commercial production process is undertaken by
the innovator. Sometimes the inventor and the innovator are the same person, but
in most cases they are not, as each has a very different and specialised function.
In a capitalist economy the innovator is usually known as the entrepreneur.

Economic growth
7.5.4.2 Improvements in the quantity and quality of

productive factors
An increase in the quantity of labour on its own is not likely to lead to economic
growth unless that labour has economically useful skills. More capital investment is
a precondition of growth, but it is not sufficient on its own to guarantee growth. A
higher rate of investment in one country does not necessarily mean that growth will
be higher than other countries. The structure of investment may be as important
as its total volume. For example, investment that takes the form of a piecemeal
modernisation of an industry with an out-of-date structure may be less effective
than the same amount of investment devoted to building a new industry. Difficult
to comprehend is the fact that investment of the wrong type may be obsolete
(have no value) when it is new if someone else has invested in a new and more
cost-effective way to produce something. The productive factor land, ie the free
gifts of nature, can cause an economy to grow as the result of a new discovery
of oil, gas, precious metals, etc, but its presence in a particular country does not
always guarantee growth.
Although quantity is important, it is the quality of resources and their rate of
change that is more likely to support economic growth. This is why education,
training, health and motivation are important for labour and enterprise, as without
them we are not going to produce the inventors, innovators and efficient workers
of the future.
7.5.4.3 Resource allocation

Where a country is able to direct a major part of its new investment to industries
with high growth potential, it will achieve higher growth rates than a country that
finds itself obliged to allocate a large part of its investment to declining or static
industries in an attempt to alleviate problems of structural unemployment. Often
this is a problem in democracies where votes tend to attract political decisions
towards saving things that are in decline. In a command economy, like China,
decisions are made much more quickly with no concern about a voting population.
In some industries a reallocation of resources from small to large scale will lead
to significant increases in productivity. These economies of scale become possible
as the size of the market grows and techniques of distribution are improved. In a
similar way, it is important to know your market and your competitors and not try to
compete when you have a significant disadvantage. For example, more developed
countries find it very difficult to compete in labour intensive industry where newly
developing countries have significant labour cost advantages. Often the solution is
to move to the top end of the market and leave mass production and standardised
products to the low labour cost countries. The UK has found it particularly difficult
to compete in the mass produced car market, but is doing very well at the top end,
eg Rolls Royce, Jaguar, Lotus and Formula1 cars.
Of critical importance in the question of resource reallocation is the problem of
mobility of productive factors, especially labour. As pointed out in an earlier topic,
a rapid rate of economic growth calls for a high degree of mobility. New and
improved methods of production can only be fully utilised by a labour force with a
high degree of adaptability that is prepared to undertake retraining and ready to
accept changes in traditional working practices.
7.5.4.4 Capitalism and the profit motive

History supports the view that those countries that have embraced free markets,
private property rights and the profit motive have grown much faster than those

countries that moved down the road of state control of the factors of production.
Even a country like China, which has very little political freedom, but has adopted
the capitalist model, is growing at a much faster rate than ever before.
7.5.5 The costs of economic growth
7.5.5.1 Opportunity cost

We have already described why economic growth is desirable and it is important
to balance this statement by looking at the costs of economic growth. Any
self-respecting economist recognises that support for growth policies depends
upon a situation that weighs up both the benefits and the costs. The first cost to
look at is the opportunity cost of allocating resources to economic growth, and
that is what is forgone as the result of pursuing growth. The answer is that, in
order to produce capital goods, it is necessary to forgo producing products for the
consumer. This means that the pursuit of growth lowers living standards in the
present, but is likely to achieve higher living standards in the future. Notice that
your own investment in education requires a reduction in current consumption and
the promise of greater opportunities in the future.
7.5.5.2 Personal costs

A rapid rate of economic growth is dependent upon a continuous stream of new
techniques and products. Machines and production methods will be subject to a
fairly rapid rate of obsolescence. The same is also true of labour as the changes,
which make economic growth possible, also make labour redundant. This brings
about disruption and unpleasant breaks in working life. As people get older so
they are less likely to be able to change at precisely the time they are required so
to do. In consequence, demands on the National Health Service increase as people
seek solace in legalised drugs and the productive factor, labour, is underutilised
and unable to accept or cope with change.
7.5.5.3 External costs

The social costs of production and consumption include a number of damaging
effects. Rising incomes lead to more cars being bought and this in turn leads
to more pollution and more congestion. The production process is likely to lead
to more industrial pollutants and together these costs will impose damage on the
environment both nationally and internationally. This leads us to the next question
and the next heading.
7.5.6 Are there limits to economic growth?
7.5.6.1 The doomsday case

There are obviously limits to economic growth rates but the interesting question
is whether there are absolute limits to economic growth.
Some economists suggest that there is an absolute limit and indicate that we are
currently very close to it. They suggest that the desire to grow will lead us all into

A satisfactory and sustainable balance of payments position
a growth-induced doomsday brought about by accelerating demand for a limited

amount of natural resources.
The doomsday scenario is being caused by accelerating population growth and a
worldwide desire to raise living standards. Over the next 50 years these economists
predict that many important non-renewable resources will become exhausted.
There will be damage to the ozone layer, global warming, the flooding of low-lying
areas and increased pollution of the atmosphere, rivers and oceans. Growth will
turn from positive to negative and the only way people will be able to become
better off will be to take resources away from other people.
Although they do not expect it to happen they suggest the problem can be
avoided by international co-operation to cut back on natural resource use, bring
net investment closer to zero, clean up the environment and cut the birth rate.
7.5.6.2 A reply to doomsday

This line of thinking does have its opponents. They suggest that the doomsday
case is based upon weak assumptions that ignore the possibilities of technical
progress, new resources being discovered, old resources being rendered usable
by new techniques, the substitution of non-renewable resources by renewable
resources and synthetic products, and a slowing down of population growth.
Other economists argue that invention, innovation and rising incomes will mean
that we can allocate more resources to cleaning up the environment and, if it is
allowed to work properly, the price mechanism will ensure that, as resources
become scarce, prices will rise and make it profitable to utilise other resources
and search for substitutes. They even go on to suggest that global warming has
been overestimated and what little there is may create more benefits than costs to
the world economy.
7.6 A satisfactory and sustainable balance of

payments position
This is the fourth main macroeconomic target of government and it will be looked
at in more detail under Topic 10. However, at this point we will just identify the
problem and suggest briefly ways it could be overcome.
In an international trading world with many domestic currencies each economy

looks to its external balance as a measure of its long-term ability to remain a
sustainable economy. As we have seen with the circular flow of income, some of
our currency is withdrawn from this flow when we buy foreign products and assets
and also other financial transactions cause income to flow out and back into the
circular flow.
As a person’s account needs to be sustainable and their current income needs

to balance over the long term with current expenditure without running up
unserviceable debts, so a country’s external position is very similar. To buy
the products of other countries we need to earn their currency from selling
our products to them. An imbalance between us and any one other country is
unimportant as long as there is a broad balance on all the value of exported
products and imported products.
If there is an imbalance on the current flows of income and expenditure to finance
flows of imported and exported products, then wealth, savings and borrowings

will have to be used to establish an overall balance on the accounts. As with a

person borrowing to continually overspend a budget, the international situation
can become unsustainable at current exchange rates and given current policies.
It is therefore the case that, as we move towards a more unsustainable position,
actions will have to be taken to re-establish a more satisfactory position for our
balance of payments. This will be looked at in more detail in the last topic.
Summary
u There is no disagreement about what is meant by inflation but there is much
disagreement about how it is caused and whether, and how, it should be
controlled.
u Deflation happens and can be even more damaging than inflation, so much so
that countries actively risk inflation to avoid the risk of deflation.
u Although deflation causes unemployment, it needs to be recognised that
unemployment can also be caused by inflation and disinflation.
u As there are many types of unemployment, there cannot just be one solution to
the unemployment problem.
u In theory, fluctuations in economic activity over time can be managed. In reality,
it has not been easy to achieve success at eliminating these fluctuations.
u As economies fluctuate from high points to low points, so something else is

going on in the economy that is causing it to grow, and whether that growth is
desirable or sustainable is a further point of debate.
References
Herbert, G. (1640) Outlandish Proverbs. London: Humphrey Blunden.
Keynes, J.M. (1923) A Tract on Monetary Reform. Chapter 3. London: Macmillan & Co. Ltd.

Topic 8
Money, banking, monetary policy,
financial stability and the Bank of
England
‘There is no subtler, no surer means of overturning the existing basis of

society than to debauch the currency. The process engages all the hidden
forces of economic law on the side of destruction and does it in a manner
which not one man in a million is able to diagnose.’
Keynes (1919, p. 235)

u understanding money and how its role has developed and changed over
time;
u the relationship between the demand for, and the supply of, money;
u how the Bank creates cash and banks create money − the credit multiplier;
u intermediation and the role of banks; and
u the Bank of England’s role in providing both monetary policy and financial
stability.
8.1 Money and its value
8.1.1 Before money and the difficulties of barter

As soon as people began producing surpluses over and above their own
subsistence requirements, they had a surplus to exchange. The process of
exchanging one product for another was known as barter and it had four main
drawbacks. Firstly it required a double coincidence of wants, ie if you had a surplus
to trade you needed to find someone who had a surplus of what you wanted and,
in turn, wanted what you had on offer. Secondly if you had a large valuable item
to trade and only required a small less valuable product, then you needed your
product to be divisible, but not all products can maintain their value when they are
divided up. Thirdly many products are perishable and cannot be stored for future
exchange. And finally there is no standard unit of account, so multilateral trade is
difficult to value.
8.1.2 Early forms of money

The origins of money can be found in generally accepted products that could store
value, were divisible and therefore became a crude unit of account. A person could

8: Money, banking, monetary policy, financial stability and the Bank of England
now make a trade for something they did not want but could hold on to for a trade
sometime in the future. These early forms of money were usually either useful or
ornamental. Examples of early money were hides, furs, tea, salt, shells and, as
Adam Smith (1776) found in Newfoundland, dried cod.
8.1.3 The characteristics of an efficient money

The economist F. A. Walker wrote in his book, titled Money and published in 1883,
that money is ‘that which passes freely from hand to hand in full payment for
goods, in final discharge of indebtedness, being accepted equally without reference
to the character or credit of the person tendering it and without the intention on
the part of the person receiving it to consume or enjoy or otherwise use it than by
passing it on sooner or later in exchange’.
To be efficient money needs a variety of characteristics. As already stated, it needs
to be generally acceptable, fairly durable, recognisable, divisible into smaller units,
portable, scarce but not too scarce, and relatively stable over time, although with
the ability to increase as the output of the economy expands.
Early forms of money had some but not all of these characteristics: tea was
susceptible to deterioration, salt to dampness and cowrie shells were used as
money in China until they were found in abundance in the Indian Ocean. The
first commodities that became universally acceptable as money were the monetary
metals silver and gold.
8.1.4 Modern forms of money

Coins are nothing more than definitive amounts of metal whose value is guaranteed
by the issuing authority. As a marketing exercise for the monarchy, coin issue soon
became the responsibility of the state. This gave monarchs, in financial straits, the
opportunity to earn money by offering to mint metal into coinage and also to make
money by debasing the coinage. Henry VIII debased the precious metal in coins so
much that during the period 1543−47 only one-seventh of the value of the coin
was retained after four years. This meant that the King and other debtors could
pay off their debts more easily. However, there came a point where merchants
demanded more coins to make up the original amount of silver; hence inflation
and merchants would often bite coins to make a judgement about the precious
metal content.
As we will see in the next section, notes had their origins in the receipts for gold
and even today they include a promise to the bearer on the note that originally
meant it can be turned back into gold. Today the promise is somewhat empty,
although it is possible to replace an old note with a new note.
Today coins and notes make up cash, which is still only a very small proportion of
the total amount of money used to trade products and assets. The main forms of
money transfer are cheques, credit and debit cards, and other forms of electronic
transfer. Although the majority of transactions are not, and could not, be made
with cash, they are all made with something that is a proxy for cash and it is
assumed that each proxy is a claim on cash. However, all claims on cash cannot
be satisfied as there is only about 3.6 per cent of all money, in the form of cash,
in the UK (2012).
Over time an interesting change in the characteristics of money is that early forms
of money had two characteristics, ie a value in use and a value in exchange

Money and its value
as a commodity, eg gold. Modern forms of money, however, only have a value in

exchange and no value in use if you discount the way in which films depict people
breaking into other people’s houses using a credit card.
8.1.5 Important definitions and distinctions

In order to comprehend a lot of monetary theory it is important to understand
the difference between money and cash. Money is everything that can be used in
trade as defined by F. A. Walker. Cash is only a very small proportion of that total
as it is tangible notes and coins. The easiest way to identify this distinction is to
remember that all cash is money, but not all money is cash.
In some definitions of money there are components that do not quite fit into the
Walker definition of money as they are not immediately usable. These are referred
to as near money as they are assets that require some small change before they
can be used to settle a transaction, ie they may have to be shifted from a deposit
account in a bank to a current account.
A further distinction to make is between money and legal tender. Any means
of payment that a debtor can legally compel a creditor to accept is termed legal
tender. All notes issued by the Bank of England are legal tender in the UK but not
in other countries. Coins up to a specified amount are legal tender. Can you think
why 1p, 2p, 5p and 10p are legal tender but more than £1’s worth of 1ps and 2ps
is not and more than £5 of 5ps and 10ps is not? This means that the most common
forms of money, the cheque and the credit card, are not legal tender, but are used
legally to make purchases.
8.1.6 The functions of money

Modern money is defined as having four functions and these should not be
confused with the characteristics of an efficient money.
u The first function is that it acts as a medium of exchange that is acceptable
to both parties in a transaction.
u The second function is that it acts as a unit of account that allows a person to
make quick and easy comparisons of price and value.
u The third function is that, while it is held, money acts as a store of wealth.
It is this function that is particularly damaged by inflation and may even be
destroyed by hyperinflation.
u The last function is that money acts as a standard of deferred payment, ie
it measures debt. This means that its value must remain relatively stable over,
at least, short periods of time, so that the days of grace given before a debt is
finally settled will be acceptable to both parties. Again, this standard of deferred
payment will be affected by inflation at varying rates.
8.1.7 The demand for money

A proportion of a person’s wealth may be held in the form of money, and this
demand to hold one’s own assets in the form of money was separated by Keynes
into three motives.

The first motive was the transactionary demand for holding money. People will
hold money in the form of cash or cards, to draw on their bank deposits and
complete daily transactions, and they will also have a profile for topping up their
access to money for transactions, usually based upon the period of time over which
they are paid, ie weekly or monthly.
Most people will carry more money than they require for daily transactions just in
case the unexpected happens. This was referred to as the precautionary demand
for money. Together, transactionary and precautionary demands are known as
active balances, while the third motive, described below, is referred to as an idle
balance.
There is a speculative demand for money that is sometimes confused with using
money to earn a rate of interest. This is not correct as the speculative demand
is holding on to money in the hope that prices will fall and the value of money
therefore increases. The often quoted example is holding on to money when it is
expected that interest rates are likely to rise. If interest rates do rise, then asset
prices will fall and, relative to the price of these assets, the value of money will
have risen. Perhaps an easier example to comprehend is that if you ask for money
rather than a present at Christmas, then you will hope to be able to buy that same
present at a lower price in the January sales. You are therefore speculating with
money.
An important point is not to confuse the demand for money with the demand for
loans. When you are choosing to hold your own assets in a liquid form, then that
is demand for money. When you borrow money from someone else, then that is
demand for loans.
8.1.8 The supply of money

In the UK there are two main components of money supply. The first is core
money, which is the cash that is printed and minted under guidance from the
Bank of England. The second is money that is created by banks when they lend
money to people. This second element is under the control of the Bank of England
and both elements will be looked at in more detail later in this topic.
8.1.9 The liquidity preference theory

This theory was referred to by Keynes (1936) in The General Theory of Employment
Interest and Money. It is a theory of interest rate determination based on the supply
and demand for money. In Figure 8.1 these two functions create an equilibrium rate
of interest.
The three motives for demanding money described above produce a liquidity
preference curve that is downward sloping from left to right. As interest rates
rise, the opportunity cost of holding money increases so demand falls, while at a
lower rate of interest the opportunity cost of holding money falls so demand rises.
The supply of money is, however, perfectly inelastic as its supply is determined
by Bank of England policy often to influence interest rates rather than to react to
them. This means that its policy will shift the supply function to the left or right
when it wants to raise or lower interest rates. However, as the supply curve shifts
to the right it comes up against a liquidity trap. At this point, interest rates cannot
go any lower and therefore idle money balances increase.

Money and banking
Figure 8.1
Supply of money
Rate of
interest
Demand for money

} Liquidity trap
Q Quantity of money
The liquidity trap occurs when people become indifferent about holding cash or
assets and increase their speculative balances in anticipation of a rise in rates and
therefore a fall in asset prices.
8.2 Money and banking
8.2.1 The roots of banking

In the seventeenth century just after the English Civil War, goldsmiths in London
were finding the jewellery business difficult. In order to store their gold they
had well-protected vaults and they saw a market opportunity as people who held
surpluses, mainly in the form of gold, needed to store them safely. From this
situation one can trace through the probable sequence of events that turned a
goldsmith into a bank and money into a fractionally backed currency.
Initially, goldsmiths charged people to look after their gold and the depositor
received a receipt bearing the amount of gold held at the goldsmith’s.
People holding goldsmiths’ receipts could purchase goods, assets, and settle
debts by using their gold deposit. This meant that they could remove their
gold, if necessary mint it into coins, and complete the transaction: or they could
countersign the goldsmith’s receipt and transfer the ownership of the gold to a
third party.
As confidence grew in the goldsmith’s receipt so people were happy to use the
receipt to trade, and the goldsmiths recognised the opportunity to improve this
aspect of their business by giving the depositors multiple receipts of different
denominations, ie instead of one receipt for a deposit of £100 worth of gold the
goldsmith could offer 8 x £10, 2 x £5 and 10 x £1. This was the beginning of notes

being introduced into the monetary system. However, at this point no new money
had been created as all notes issued were 100 per cent backed by gold.
A respected goldsmith now held quantities of gold that no one used, as notes were
being passed from person to person and gold ownership was being transferred.
At the same time the goldsmith observed that there were respectable people who
needed to borrow some money so why not expand the business by lending out
some of this surplus-to-requirement gold?
Most of the people who borrowed gold from the goldsmith did not want to see
or use the gold; they were quite happy to accept a goldsmith’s note, which they
could then use to conduct trade. At this point in time there were now more notes in
circulation than there was gold to back them, and this was very significant because
our early bankers had now created new money as they started to lend out gold to
borrowers.
The lending side of the business now took over as the main income-earning assets
for goldsmiths. As their note issue expanded so there would soon be a significant
excess of notes in circulation to gold deposited in the vaults of the goldsmiths.
Through experience, goldsmiths would know that, as long as they kept a fraction
of all the notes issued in the form of gold, to satisfy everyday demand for gold,
then confidence in the emerging banking system would be sustained.
Any overzealous goldsmith who created too many notes would find that the
business had a liquidity crisis, ie was unable to satisfy the demand for gold. A
probable solution to this would be for the business to be quickly absorbed by
other more reputable goldsmiths in order to avoid a run on all of the banks.
The country now had a banking system financing the expansion of trade by creating
new money and a necessary confidence in a gold standard, which means that
every person holding goldsmith receipts knew that they could get access to their
gold whenever they wanted it, and, as long as they did not all want it at the same
time, they could see and hold their gold whenever they chose.
8.2.2 Intermediation and modern banking
8.2.2.1 The surplus and deficit sectors

In the economy there are those people who have income in excess of their
expenditure and those who have expenditure in excess of their income. This was
recognised in the early development of banking and it is the basis of modern retail
banking, which offers a service to those with surpluses that allows the bank to
recycle those surpluses to the deficit sector. A rate of interest is set to attract the
lender and a higher rate of interest is charged to the borrower. The difference
between the two covers the costs of running the bank and hopefully produces
a profit for the owners of the bank. In this process the bank acts as a principal
and has separate contracts with the lending side and the borrowing side of the
business. This means that there is no contact, legal or otherwise, between those
people who lend money to the bank and those who borrow from the bank. This is
called financial intermediation.
8.2.2.2 The benefits of intermediation

Intermediation breaks down the barriers of geographical location. Without banks
it would be difficult for people with surpluses in one part of the country to find

Money and banking
potential borrowers in other parts of the country. To a certain extent this has been
broken down by peer-to-peer lending websites on the Internet.
It would be very unlikely that a person with a surplus to save will have exactly the
right amount to satisfy a borrower. It is usually the case that the average deposit
is relatively small compared to the average loan and banks can solve this problem
by aggregation, ie they can add up many small deposits to make a much larger
loan.
Similarly, there is likely to be a mismatch between the amount of time a person
wants to set aside a surplus for saving and the term of a loan. A loan to cover a
mortgage on a property would typically be for 25 years whereas a savings term
is likely to be much shorter. Maturity transformation means that a bank can
overcome this mismatch.
There are significant economies of scale that reduce the costs of lending through
the process of intermediation. Finding a borrower, verifying their creditworthiness,
keeping a check on their debt servicing record and enforcing any breach of contract
would involve a very high proportion of costs to the value of a loan and this is
considerably reduced by a bank carrying out many loans to customers.
Lending money to a person you do not know creates significant exposure to risk.
Banks can take away the individual’s risk and transfer it to themselves; and then,
in ways that we will identify in the next headings, they can carry out a risk
transformation that mitigates most, but not all, risks from lending.
8.2.2.3 Risks and risk mitigation

Default risk (credit risk) is the possibility that a person taking out a loan cannot
meet the interest charges and/or cannot complete the final repayment. Banks can
mitigate this risk by carrying out credit checks, and, asking for collateral as with
mortgages where the bank holds the deeds to the property and has the right to
sell the property to recover unpaid debts. This risk can also be diversified by banks
lending to lots of potential borrowers knowing that there may be a small proportion
of defaults, but that their bad debts can easily be written off against profits from
the majority of the other transactions.
Asymmetric information creates a variety of risks. This is when one party to
the transaction has more information that the other party. For a bank lending,
this risk can manifest itself through the principle of adverse selection. A
potential borrower may request a loan for a relatively risky undertaking, but have
the incentive not to disclose all the relevant information and put a lot of effort
into making the loan seem safe to the potential lender. Again, this risk can be
somewhat mitigated by a credit scoring system, but even then the action will only
be observed if it is a repeat rather than a first attempt at getting the loan.
Another aspect of asymmetric information is the moral hazard that can result from
a situation where once the money is lent it may be used for a different, riskier
reason than was originally intended. To a certain extent, banks can mitigate this
risk by getting their legal departments to draw up contracts designed to limit this
type of risk. Risk associated with asymmetric information can also be seen from the
other side and means that the customer of the bank will have less information and
be mis-sold a product if not all the relevant information is disclosed. Customers
who were sold payment protection insurance (PPI) without a full understanding of
the product and why they needed it have been compensated after an investigation
by the Financial Services Authority.

8.2.3 The conflict between liquidity and profitability for

banks
The main commercial banks in the UK are public limited companies that are owned
by shareholders. These shareholders receive their rewards from the dividends paid
out from the profits made by the banks. The most profitable assets a bank can
hold are longer-term loans such as mortgages that are totally illiquid (cannot be
turned into cash) until the final repayment date. Therefore, to satisfy shareholders,
a bank would like to hold the least amount of liquid assets and preferably no cash,
as cash does not earn any income, and make as many long-term loans as possible
to customers.
In contrast, the customers of the bank who have made deposits and taken out
loans want to know that they have access to cash on demand or at relatively short
notice. In order to satisfy this customer demand, the bank must hold cash (till
money), but, as we have already pointed out, cash earns no income for the bank.
So the more a bank satisfies customer demand by holding on to liquid assets, the
less profit it will make to satisfy the demands of its shareholders.
In order to solve this conflict, a bank’s assets will comprise an amount of cash
thought to be necessary to satisfy everyday demand, some assets that are very
liquid and could be turned into cash at short notice and finally high earning illiquid
assets. In the 1960s banks were required to hold 8 per cent of all their assets in
cash, a further 20 per cent in liquid assets like treasury bills with a maximum of
90 days to maturity, and 72 per cent of higher income earning assets.
8.2.4 The difference between liquidity and capital adequacy

As we have seen in the previous section, banks need to manage their liquidity to
ensure customer demand for cash is satisfied and to maintain overall confidence
in the banking system. The problem of a loss of confidence in a bank came with
Northern Rock in 2007 when it was finding difficulty sourcing funds and the Bank
of England stepped in to provide liquidity. This led to concern about the bank’s
viability and customers started to queue to withdraw cash. It was necessary to
avoid the systemic risk that probably would have occurred if the bank had failed
and so the Bank of England concluded that the Northern Rock bank should be
nationalised and taken into state control. At that point in time the bank was judged
to be illiquid, but solvent. Solvency is a reference to a bank’s longer-term ability to
remain in business and continue to make a profit. It is a situation where the value
of the bank’s total assets is greater than the value of its total liabilities (excluding
its capital). To judge solvency it is necessary to look at a bank’s capital, which
is basically a cushion against the possibility of losses from the various risks a
bank is exposed to. The capital adequacy ratio is a measure of the amount of
core capital a bank holds relative to its risk weighted assets. Core capital includes
mainly equity capital or shareholder funds, and this is regulated internationally
by the Accords of the Basel Committee on Banking Supervision. Over time,
these have changed but the 2012 Basel III Accord requires banks to hold 6 per
cent of their risk weighted assets in tier 1 core capital. It is therefore important
not to confuse liquidity, which is the bank’s ability to satisfy everyday customer
demand for cash, with capital adequacy, which is the ability to cover itself against
market risk when, during difficult times, the market may turn down for a period of
time and profit reductions and even losses may occur.

Money and banking
8.2.5 The loanable funds theory of interest rate determination

We have identified the liquidity preference theory of interest rate determination that
looks at the relationship between the supply and demand for money. An alternative
theory of interest rate determination is the supply and demand for loans.
Figure 8.2
Figure 8.2 illustrates an equilibrium rate of interest at r 1. The supply of funds

to this market comes from people’s decisions to save, which increase as interest
rates rise, and the demand for loans, which increases as interest rates fall. If
people are supplying funds to the market that cannot be lent on, then interest
rates will fall to attract borrowing and discourage saving. Similarly, if the demand
for loans increases then the rate of interest will rise to encourage more saving and
discourage borrowing until a new equilibrium is achieved.
8.2.6 The ISLM model of interest rate determination

So far we have two models for interest rate determination and in his review of
Keynes General Theory entitled Mr Keynes and the Classics John R. Hicks (1937)
compressed the four curves and two diagrams into two curves and one diagram,
as illustrated in Figure 8.3.
As income rises so savings increase and therefore the interest rate must fall to
bring forward an increase in investment. This gives us the downward sloping IS
(investment = savings) curve. In contrast, a higher level of national income will
increase the quantity of active balances required for transactions and precautions.
Given a fixed supply of money (perfectly inelastic and determined by the Bank
of England) there will be less available for speculative purposes. Therefore, to
reduce demand to the smaller quantity available, the interest rate must rise. The
LM (liquidity preference = supply of money) curve now shows all the combinations
of income and interest rates that will equate the supply of and demand for money.
The intersection of the two curves at R 1Y 1 shows the general equilibrium condition
where investment equals savings and the demand for money equals the
supply of money.

Figure 8.3 The ISLM model
Rate of LM
interest
r1
IS
Income
y1
8.2.7 The structure and level of interest rates

Anyone who observes financial markets will notice that interest rates on different
financial products and assets are not all the same, and, as well as being different,
they may also move up or down together. As we will see later the Bank of England
is the main driver determining the level of interest rates. By raising and lowering its
Bank Rate all other interest rates will tend to rise and fall accordingly. However,
the structure created by individual interest rates will be determined by the acronym
RAT. R is the risk involved in the loan, A is the amount of the loan and T is the
term of the loan. So a large unsecured riskier loan will have a high interest rate
attached whereas a small secured less risky loan will have a lower interest rate.
8.2.8 Asset management or liability management of the

bank balance sheet
In the early days of banking the structure of the balance sheet was described as a
process of asset management. The bank would accept deposits from customers
and use these as a basis to structure the assets that it held, including the loans it
had made, in order to make banking a profitable business. Given a relatively stable
level of savings the business of banking grew slowly, constrained by the level of
savings available in the economy.
At the end of the 1980s deregulation in the City of London and the USA, and the
growth of wholesale financial markets, led to banks building their asset portfolio
by accepting deposits from customers, taking loans from the interbank market
(loans between banks) and the securitisation of assets (selling bundles of assets,
previously on the banks balance sheet, to investors in order to fund further
expansion). This was referred to as liability management of the balance sheet as
banks lent money first and then found funding in the wholesale markets. It allowed
banks to expand their business much faster or, as some would say in the case of
Northern Rock, too fast.
Since the financial crisis of 2008/09, banks have been unable or more reluctant
to access the wholesale markets in search of funds and there seems to be a shift
back towards asset management of balance sheets once again.

Money and banking
8.2.9 Do banks create money?

The simple answer to this question is yes. We have already seen that, as soon as
goldsmiths started to lend out money based upon the gold that was deposited in
their vaults, there was more value in the notes in circulation than value in the gold
that backed them up. It was at the point at which they started lending that money
was created. Today the core from which money is created is no longer gold, but
it is the cash that has been minted and printed by the Treasury and the Bank of
England. People make deposits of cash in banks and this legal tender is used as
a base from which banks can create loans for customers. Once a loan is created
then the money supply has increased and this money can now be used time and
time again in trade.
8.2.10 Money supply and monetary demand

The total supply of money in the UK economy can be illustrated using two
concentric circles, as in Figure 8.4.
Figure 8.4
credit money
cash
velocity
The core is cash, but by far the greatest proportion of money supply is made up
of loan deposits, which are here referred to as credit money. To understand how
the money supply can be turned into monetary demand we need to understand the
velocity of circulation of money. Money supply is a stock while monetary demand
is a flow that is measured over time and it will exceed money supply by the number
of times the average unit of money is used over a specified time period.

8.2.11 The bank credit multiplier

There is a relationship between the size of the core money (cash) and the total size
of the money supply. It can be determined by the customers’ demand for cash and
be a judgement of the banks, or it has been, in the past, a ratio imposed upon the
banks by the Bank of England. If the ratio is a consistent ratio, then any chance in
the core of cash will have a multiple effect on the total money supply.
Once the ratio is established then it is easy to calculate the multiplier effect of any
change in the base using the formula:
1
Bank credit multiplier =
core ratio
If banks are required to hold 10 per cent of all their assets in cash then:
1
= 10
10
100
In the past the ratio has been 8 per cent:
1
= 12½
8
100
or 12½ per cent
1
=8
12½
100
In each example a change in the base changes the total money supply by 10 times
or 12½ times or 8 times. Also it is important to note that when the base changes
by 1 and the total by 10, given a multiplier of 10, the amount of credit money
created is 10 - 1 (already changed) = 9.
To understand this fully we can create a balance sheet for a bank based upon a new
deposit in cash of £10m and a requirement to keep a 20 per cent cash base. To
simplify this even more, we will assume that there is only one bank in the economy
with many branches and no cash drain to the public when a new cash deposit is
made at a bank.
Let us assume that someone who, up to now, has not trusted banks decides to
take £10m in cash that was previously hoarded to the bank, and opens a deposit
account. The first thing that happens to the balance sheet is that both assets and
liabilities change by £10m, as shown in Table 8.1.
Table 8.1
Liabilities Assets
£10m deposit £10m in cash
It is this process of double entry of events on the balance sheet that allows the
money supply to expand. So in order to maintain a cash ratio of 10 per cent the
bank can now create £90m of loans so the balance sheet will now be as in Table 8.2.

Money and banking
Table 8.2
Liabilities Assets
£10m deposit £10m in cash
£90m loan deposits £90m in loans
The total value of assets is now £100b and 10 per cent of those assets are in cash.
Although it is easy to follow through a simple example using one bank with
many branches and no cash drain to the public, all the same principles apply
in a multi-bank economy and, if there is a cash drain into idle balances, then the
credit multiplier will be reduced accordingly.
8.2.12 Banking crises old and new

Banking crises have existed as long as we have had banks. The main reason for
this is that the whole system is based upon confidence − if anything shakes that
confidence then customers start withdrawing their deposits in the belief that their
bank may fail.
As soon as goldsmiths started to lend out gold and people were happy to hold their
receipts as money, there were more receipts in circulation than gold to back them.
This meant that, if everyone with a claim on gold wanted to exercise that claim
at the same time, there would not be enough gold to satisfy all claims. Exactly
the same thing applies today except that core money is cash not gold. So when
customers of Northern Rock were concerned that the bank may fail, they started
taking out their deposits in cash and electronic transfers that eventually drained
their cash base such that Northern Rock could not satisfy the demands without
getting liquid funds from the Bank of England.
Looking back, it is fairly easy to grasp that a banking system does not require gold
to function efficiently. Equally, it does not require cash to function: all it needs is
people’s confidence in the fact that the units of money created by bank lending
will maintain stable prices and facilitate a steady growth of trade over time.
In theory, paper money can create the necessary stability to facilitate trade better
than any other system based upon a commodity like gold. However, because it
has no inherent value, paper money is likely to be abused by those who manage
it, as well as being vulnerable to any crackpot theory about how it should be
used. So in the next headings we will ask the question: is quantitative easing just
another crackpot theory; has it saved the UK economy from financial disaster; or
is it just about to create a disaster of its own? The main problem about a banking
system based on confidence is that one seemingly small, inconsequential loss of
confidence as the result of some minor problem can cause a systemic problem as
the loss of confidence spreads throughout the banking system. Not even the most
prudent and solvent bank can deal with the problem of more than a few per cent
of people asking to remove their deposit from the bank in cash. We will now look
at what most people think is the solution to a potential crisis of confidence, which
is for a country to have a central bank to look after all the private banks in the
economy. Before we do that, it is interesting to note that if you look up ‘List of
banking crises’ in Wikipedia, http://en.wikipedia.org/wiki/List_of_banking_crises,
there are 4 listed for the eighteenth century, 11 listed for the nineteenth century,
13 listed for the twentieth century and 9 listed for the first 11 years of the
twenty-first century.

8.3 Banking and the Bank of England
8.3.1 History
The privileges of the Bank of England came from William III’s desire for England to
become the dominant naval power in the world at a time when no one would lend
him the £1.2m he needed to build a navy. However, he was the king and he decided
to encourage finance for his plan by offering a group of potential subscribers the
opportunity to be incorporated under the name of the Governor and Company
of the Bank of England. They were given exclusive access to the government
and its finances and were allowed to be the only supplier of bank notes that were
issued against the government bonds used to raise the £1.2m.
So in 1694 the Bank of England was established as the government’s banker and
debt manager, and it has held this position ever since. It remained a private bank
until 1931 when it was subordinated to HM Treasury and was finally nationalised
in 1946.
Up to 1997 the Bank of England was very much the junior partner while the
Treasury was the senior partner. The Treasury directed government policy with
its main focus on using fiscal policy to manage aggregate monetary demand while
the Bank of England accommodated the Treasury policy in the way it pursued its
monetary policy and exercised control over the financial sector. However, in May
1997 the Bank of England was given independence to pursue its own monetary
policy and given the responsibility for maintaining stable prices. Currently this
target is a yearly inflation rate of 2 per cent with a fluctuation of 1 per cent either
side before the Bank has to write an open letter to the Treasury explaining why
the target has been missed. Monetary policy is managed by the Monetary Policy
Committee (MPC), which comprises nine members (five Bank employees and four
co-opted members). At monthly meetings they decide on the direction of monetary
policy.
In October 1997 the Financial Services Authority (FSA) was set up to take over
regulatory responsibilities from the Securities and Investment Board and also to
manage the regulatory side of banking and a wider range of financial services.
However, after the 2008/09 financial crisis and with a new government in power,
plans were put forward to abolish the FSA and return some powers to the Bank
of England. This led to the setting up of the Financial Policy Committee (FPC)
within the Bank of England, whose objective is to identify, monitor and suggest
actions to avoid systemic risk in the UK financial system.
As of 2012, the Bank of England is tasked with price stability through its MPC and,
once its powers have been formally established, financial stability through its FPC.
The role of each will now be looked at in more detail.
8.3.2 Managing monetary policy
8.3.2.1 A reminder
In order to achieve its inflation target, the Bank of England needs to manage
the money supply and the overall level of aggregate monetary demand. The total
money supply is made up of two important aggregates. The first is core money,
or cash, which is a very small (less than 5 per cent) proportion of the total. The

Banking and the Bank of England
rest of the money supply is made up of credit money that was created by bank
lending. Both components of the money supply are linked in their size to the credit
or money multiplier. The bank therefore has two options if it wants to control
the total level of monetary demand. It can either control the amount of cash at
the base or it can control the amount of bank lending that determines the size of
credit money that has been built up on the foundation of cash.
8.3.2.2 Managing credit money

If you remember the two concentric circles that make up the money supply, then
it is the outer larger circle that is being controlled here and, to a certain extent, its
size can be managed irrespective of what is happening to the cash core.
In the past, there were two ways in which bank lending could be controlled. The
first was by imposing a credit ceiling on bank lending. The Bank could instruct
banks to keep lending to the level of the previous year or let it expand by say 5 per
cent maximum. Although this technique is still available, it is not used currently
as the only techniques being used at present are the manipulation of interest rates
and the use of QE.
Between 1997 and 2009 interest rates were used, to the exclusion of any other
techniques, for managing monetary demand. If the Bank wished to push interest
rates up in order to discourage borrowing, it would raise the Bank Rate. The Bank
Rate is the 14 day gilt repo rate and it is the rate at which the Bank lends to the
commercial banks. It therefore underpins and transmits to all other interest rates
in the economy. The general rise in interest rates will limit the net amount of
credit money that is created and this would slow the rate of growth of aggregate
monetary demand. Although this is not a precise science, the Bank can continue
to raise rates until it judges it has had the desired effect.
Alternatively, the Bank can lower its rate and so encourage all interest rates to
follow it down. This will encourage banks to lend out more money and expand
aggregate monetary demand. There is a potential problem with this process and
it has manifested itself in the years 2010 to 2012. Without any government
intervention, there is a market rate of interest as we have noted using liquidity
preference theory, loanable funds theory or the combination of both in the ISLM
model. This means that actions by the Bank may move away from what would be
a free market result. An economic analysis of what might happen is illustrated in
Figure 8.5.
If the market rate of interest is r and the Bank of England raises interest rates
to r 1 then more funds will be supplied than are demanded in the marketplace.
Alternatively if the rate is lowered to r 2 then more funds will be demanded than
are supplied.
The Bank of England has been criticised for moving too far away from a market rate
and disconnecting itself from the marketplace. The current Bank Rate (June 2012)
is 0.5 per cent, but the level and structure of interest rates in the market for loans
is much higher because banks have added significant risk premiums given the
uncertain state of the economy. So Bank Rate seems to be having little effect other
than allowing some banks to access cheap loans to support themselves through
difficult times.
Also the Bank seems to be in a difficult situation in as much as the rate of inflation
has been considerably above its target of 2 per cent for the last two years and
theory tells us that the Bank Rate should be raised to dampen down inflation.
However, the Bank is also worried about the current stagflation and does not want

Figure 8.5
Rate of surplus of funds S

interest
}
r1
r2
}
shortage of funds D
Loanable funds
Q 1 Q Q
2
to create the wrong signal, or make borrowing even more expensive, by raising
interest rates during a recession.
8.3.2.3 Managing cash

Before 1997 the Bank had a number of options for managing the amount of cash
in the economy and therefore the total level of monetary demand, given a known
bank credit multiplier. The main technique was open market operations. The
Bank would increase some of the cash in the financial system by buying back
government debt or it would reduce the amount of cash by selling government
debt.
Bankers hold accounts at the Bank of England that allow an easy transfer of
payments to settle debt between banks, ie the Bank is acting as a banker to
the bank. In the past, the Bank of England could choose to transfer some cash
into a special deposit that could no longer be included as part of a bank’s cash
balances. Although no longer used, this option is still available to the Central Bank.
Another technique for controlling cash that was used in the past was a request by
the Bank to the banks to hold a fixed proportion of their total assets in cash. In
the 1960s this was an 8 per cent request. In the 1970s banks were asked to hold a
reserve ratio, 12.5 per cent, which included short-term assets that could easily be
turned into cash at short notice.
The latest attempt by the Bank to manage cash in the financial system is the use of
quantitative easing (QE). After the financial crisis of 2007/08/09 the Bank was
concerned about a shortage of liquidity in the banking system and a contraction
in monetary demand that may have brought about a deflation in prices and a
depression in the economy. In March 2008 the Bank reduced Bank Rate to 0.5 per
cent and still felt that more was required to sustain monetary demand so it adopted
an asset purchase scheme. The scheme is similar to the expansionary side of open
market operations in as much as the Bank will inject cash back into the economy
by buying back government debt. By May 2012 the Bank had purchased £325b of
government debt from the private sector and effectively printed cash to that value.

Banking and the Bank of England
In July 2012 the Bank announced a further £50b of QE taking the total to £375b.
The upside of this is that deflation was avoided, but the downside seems to be that
inflation is continuing to be above target, though there is much debate among
economists over the real cause of that inflation. Monetarists explain its cause as
excessive QE while Keynesians argue it was mainly an imported cost push inflation.
There is, however, no debate about the observation that QE is a one-way
expansionary process and, as yet, it has not been considered to be part of a scheme
to manage the overall level of cash in the economy. As yet, banks have tended to
build up their liquid reserves of cash and have been criticised for not increasing
their lending by as much as the government hoped. However, we can imagine a
situation when bank lending will expand more quickly and it is possible that the
expansion in credit money could fund a higher than expected rate of inflation.
At this point it may be necessary for the Bank to use a quantitative tightening
scheme to dampen down the prospect of a runaway inflation.
At this point it may be helpful to open up the debate for discussion and look at
the conflicting theories about how monetary policy should be used to manage the
UK economy.
8.3.3 Conflicting theories
8.3.3.1 A Keynesian approach to monetary policy

For Keynesian economists the main way to manage the economy is to use fiscal
policy and adjust its use to the desired level of economic activity: budget deficits
to remove spare capacity, budget surpluses to stop the economy from overheating
and have a balanced budget when full employment has been achieved. Monetary
policy plays an accommodating role and should be there to reinforce the actions of
fiscal policy. The evidence of previous Keynesian expansions of the economy has
seen fiscal and monetary expansions occurring together. The fiscal stimuli that
have taken place since 2009 have seen accommodating expansion in monetary
demand with low rates of interest and QE.
Arguably, the end of 2011 and the beginning of 2012 have almost seen the Bank
of England adopt a more aggressive go-it-alone policy of monetary stimulation.
This involved £125b of QE at a time when the government was highlighting fiscal
austerity. Several members of the Monetary Policy Committee, including Adam
Posen and David Miles, have argued that there is a spare capacity in the economy
that can be alleviated by a much more proactive monetary policy. This is Keynesian
demand management with a proactive monetary policy rather than the previously
seen accommodating policies. The Keynesian approach to managing the economy
will be considered in much more detail in the next topic.
8.3.3.2 A monetarist approach to monetary policy

To understand the monetarist approach to monetary policy it is necessary to look
at Milton Friedman’s key propositions of monetarism and Irving Fisher’s Quantity
Theory of Money (1911).
Friedman (1970, p. 22) said in his IEA occasional paper 33 ‘There is a consistent
though not precise relation between the rate of growth of the quantity of money
and the rate of growth of nominal income [. . .] Today’s income growth depends
on what has been happening to money in the past. What happens to money today

affects which is going to happen to income in the future.’ The relationship between
changes in the money supply and inflation is important because change in the
money supply always precedes inflation and, with a time lag of between 12 and 24
months, it is often difficult for the layman to be convinced of the relationship. If
one thing happened today and the impact was immediate, it would be much easier
to comprehend.
Irving Fisher (1867−1947) is credited with the quantity equation, sometimes
referred to as the Fisher equation, which underpins the monetarist philosophy.
It is expressed by the function MV = PT where M is the stock of money and V is its
velocity of circulation over a given time period. On the other side of the equation
P is the average level of prices and T is the volume of transactions over the same
time period. Together MV is equivalent to aggregate monetary demand and PT is
equivalent to nominal national income. Now if we follow through a sequence of
changes it is fairly easy to understand the policy implications.
Suppose M increases and, given an assumption about a natural level of
unemployment, the effect is a rise in the average level of prices. Rising prices
may encourage people who are worried by inflation and bring forward purchases
and this will increase the velocity of the circulation of money. Together this rise in
monetary demand may further aggravate inflation. This analysis tells us that if an
expansionary monetary policy is pursued then the effect is likely to be inflationary.
There is, of course, the opportunity for an expansionary monetary policy not to
lead to inflation and this is if the real economy is growing. Suppose economic
growth takes place and therefore increases the number of potential transactions
over a given period of time. To avoid a deflation in prices monetary demand will
need to expand to accommodate more transactions at the same average level of
prices.
Monetarists will suggest that this is the main and only role of monetary policy,
ie to expand the money supply in line with the growth in output in the economy.
However, because the rate of growth in output is not precisely known, the policy
implication is that monetary demand needs to grow at a slightly faster rate than
the expected rate of economic growth in order to avoid any risk of deflation. This
is why a 2 per cent inflation target is an efficient target for monetarist economists.
The next thing to point out is that monetary policy in this monetarist analysis is
benign, ie it cannot be used to close capacity gaps in the economy or to encourage
any real activity. All it does is avoid the problems that would be caused by deflation
or volatile inflation if it were to be mismanaged. Monetary policy is part of an overall
policy to create a level playing field for the competitors in that economy and to
allow relative price signals to work and efficiently reallocate resources.
Here monetary policy is likened to the referee in a game of football. The referee
cannot improve the game of football by their actions. They can, however, make
the game worse by their mistakes. It is the same for the Bank of England: if it gets
things wrong, it can damage the economy; but if it gets things right, then it cannot
improve the economic situation.
8.3.4 Managing financial policy

As we have already noted, in 2013, and after the passing into law of the Financial
Services Bill, the Bank of England will be taking over the role of managing
financial stability from the soon-to-be disbanded Financial Services Authority. With
a structure very similar to it and some of the same members, the interim Financial
Policy Committee (FPC) of nine members is charged with the responsibility

Summary
of managing macroprudential regulations for the financial system as a whole

and microprudential regulations for individual financial firms. A third body,
the Financial Conduct Authority, will take over the role of regulation and
supervision of the conduct of banking business but this will not be directly under
the Bank of England.
At the macro level the FPC is concerned with assessing risks across the financial
system as a whole to avoid any systemic problems affecting the financial sector
and the economy as a whole. This may involve looking at capital and liquidity
requirements over the whole sector and, at the micro level, the Prudential
Regulation Authority will be responsible for each firm in the financial industry.
Working alongside the Basel Committee, the FPC is looking at capital adequacy
requirements and suggesting the set up of a counter-cyclical capital buffer to see
financial institutions through a downturn, and also a leverage ratio (capital to total
liabilities) that will stop firms increasing their risk exposure relative to their ability
to absorb losses. It will also look at ways of influencing the amount of lending
carried out by banks and at ways in which market structures might be altered in
order to make them safer.
As we have noted before, capital requirements are necessary to maintain the

solvency of a bank while liquidity requirements are also essential to maintain the
confidence of the customer and, at the time of writing, the interim FPC is looking
at ways to reduce liquidity risk.
Summary
u Understanding how early forms of money developed, and what money has
become in a modern economy, is basic to understanding how an economy
functions.
u It is important to separate the characteristics of money, the functions of money,
the demand for money, the supply of money and the price of money.
u Theories of interest rate determination require you to look at liquidity

preference, loanable funds and the ISLM model.
u Understanding the events that changed goldsmiths from gold depositories into
bankers is still relevant to understanding a modern retail bank.
u Money transmission, intermediation and risk mitigation are the main functions
of modern banks.
u There is an inherent conflict between maintaining liquidity and being profitable
that must be overcome before a bank can be successful.
u Banks do create money, and when they create too much a banking crisis may
be on the horizon.
u Banking crises can be a systemic problem that can develop from a relatively
small event that causes customers to lose confidence.
u The Central Bank is there to steer through the choppy waters of monetary and
financial instability and its role still seems to be a work in progress, made more
difficult by the conflicting theories of monetarism and Keynesianism.

References
Fisher, I. (1911) The Purchasing Power of Money. New York: Macmillan.
Friedman, M. (1970) The Counter-revolution in Monetary Theory, Institute of Economic Affairs,
Occasional Paper No. 33.
Hicks, J.R. (1937) Mr Keynes and the Classics: a suggested interpretation, Econometrica 5(2), pp.
147−159.
Keynes, J.M. (1919) The Economic Consequences of the Peace. London: Macmillan & Co. Ltd.
Keynes, J.M. (1936) The General Theory of Employment Interest and Money. London: Macmillan &
Co. Ltd.
Smith, A. (1776) The Wealth of Nations. London: W. Strahan and T. Cadell.

Topic 9
Government spending, taxation,
borrowing and fiscal policy
‘We have the experience of many countries to demonstrate that unbalanced

budgets are the initial cause of collapse.’
Keynes (1923)

u the different views on how the economy functions;
u the government’s budget in terms of spending and taxation;
u government borrowing and the national debt;
u the Keynesian approach to fiscal policy; and
u the monetarist approach to fiscal policy.
9.1 Extreme views

Free market monetarists tend to think that a capitalist economy has self-regulating
tendencies that will move it to full employment at a stable level of prices. In a free
market private inventiveness motivated by profit will produce a reasonable rate
of economic growth. The government has only to maintain a level playing field
for competing firms and the economy will function efficiently. Monetary policy
can control monetary demand and the budget will be balanced. Arguably, it is
monetary and fiscal mismanagement that disturbs the economy’s self-regulation
and many economic problems result from politically misguided attempts to assist
the self-regulatory process.
At the other extreme, Keynesian interventionist economists believe that a
free enterprise economy has weak self-regulatory powers and can settle down
into prolonged periods of depression, or progress through volatile fluctuations in
an economic cycle. Also, as the result of the restrictive practices of industries
dominated by a few large firms and of consumers who have their needs and
wants manipulated by advertising, the economy will not produce a satisfactory
growth rate of national income. In addition to this, powerful trade unions, powerful
oligopolies and large foreign firms may cause cost push inflation that cannot be
blamed on monetary mismanagement. To prevent volatility and stagflation and
promote full employment and economic growth, the government must use its
fiscal policy supported by monetary and exchange rate policy.
We have looked at monetary policy and we will now focus on the second extreme
view as we look at intervention through fiscal policy.

9: Government spending, taxation, borrowing and fiscal policy
9.2 The government’s budget
9.2.1 The role of government in public finance

We have already identified the fact that government needs to intervene in the
provision of public goods and may need to intervene in the provision of merit
and demerit goods. The government needs to protect stakeholders, promote fair
competition and sustain a social policy that particularly looks after vulnerable
members of society. From year to year, it needs to set aside sufficient funds to
finance its current expenditure and, at least, the capital expenditure required
to sustain the current level of services. On top of this it has four main macro
targets for growth, employment, inflation and the balance of payments and
all of this requires funding. For the fiscal year 2012/13 the government planned
to spend £527.4b centrally and, when combined with local government, a total
of £712.6b. The government describes its overall policy as being necessary to
maintain external security, internal security, social security and economic
security and progress.
9.2.2 Taxation

There are four principles of taxation that were first laid out by the
eighteenth-century economist Adam Smith (1776) in his book The Wealth of
Nations. They still apply today, although they have been slightly varied over time.
They are:
u equity, ie a person contributes taxation in proportion to their relative income;
u certainty, ie the tax should not be arbitrary, but clear and certain to the
taxpayer;
u convenience, ie the tax should be levied in a manner, and at a time, convenient
to the taxpayer; and
u economy, ie it should take the minimum amount of tax required to maintain
the highest level of government service.
There are two categories of taxation in the UK. They are direct taxes and indirect
taxes. Direct taxes are those levied on income and wealth and the burden of
such taxes falls upon those upon whom they are levied. The indirect taxes are
sometimes referred to as expenditure or purchase taxes. The incidence of these
tax changes is usually shared between producer and consumer dependent upon
the elasticities of supply and demand for the product in question. All taxes are
collected by HM Revenue and Customs (HMRC).
The effect of taxation on income and/or expenditure can be described as
progressive, proportional or regressive. A progressive tax is one that takes
an increasing proportion of a person’s income as their income increases. A
proportional tax always takes the same proportion of a changing income, while
a regressive tax takes a smaller proportion of a person’s income as it rises.
Direct taxes are often set up to be progressive, while expenditure taxes tend to be
regressive. An important point to note is that a regressive tax will still take more

The government’s budget
tax from a person as their income and/or expenditure rises − it is just that the tax
take will be proportionately less of their rising income.
9.2.2.2 The advantages and disadvantages of the principal

direct taxes
Income tax is a progressive tax so the burden of payment falls more heavily on
those people who are more able to pay. The tax therefore has a redistributive
impact, from rich to poor, and an overall welfare benefit to society. The revenue
from income tax is a high proportion of the total tax take. It is difficult to evade
under the Pay As You Earn scheme and it can be fairly precisely estimated. If the
rate of tax on high income earners is considered punitive, then it could provide a
disincentive to work as the high marginal rate means little additional reward, and
leisure becomes relatively more attractive. Also high marginal rates encourage tax
evasion, which is illegal, and tax avoidance, which is legal. Tax avoidance also
brings about resource misallocation as a whole army of tax consultants make their
living by offering advice on how to avoid paying tax. It was reported in June 2012
that a K2 named tax avoidance scheme, run out of Jersey, allowed self-employed
people earning over £1m pa to pay only 1 per cent of their income in tax. Schemes
like K2 are regularly closed by HMRC only for a new loophole to be found by another
tax consultancy. It is thought that high income earners traditionally save a higher
proportion of their income and therefore a progressive tax may reduce the total
amount of savings that can be recycled into investment projects. At worst, the high
marginal rates of tax may drive high income earners to live in foreign countries
where tax rates are lower. Overall, this has two damaging effects on the economy
as it reduces spending in the economy as well as reducing the total tax take.
Corporation tax is levied on the profits of a firm. It raises a considerable
amount of revenue and, because it is a tax on profits, it does not affect costs
or prices and therefore will not have any effect on output and employment. The
potential disadvantages of this tax include a reduction in profits available to the
firm and therefore potential dividends. This, in turn, may reduce enterprise and
investment incentives. If UK rates are considerably higher than other countries,
then international companies will be able to avoid the tax by shifting profits to
foreign countries and recording losses in the host country. Also it may encourage
firms to transfer more of their potential profits into costs, rather than leave them
exposed to the tax authority.
Inheritance tax is levied on transfers of wealth, which can be the estates of the
deceased, gifts made within seven years of death and other lifetime chargeable
transfers. It raises a lot of money that helps to keep down other rates and, arguably,
only penalises those who have not contributed to the value of the asset. It also helps
bring about a more equitable distribution of wealth. This tax has been criticised in
as much as it taxes nominal gains as well as real gains in value. Also, if it is a form
of capital that is being taxed, such as a farm or a business, then the business may
have to be broken up to pay the tax bill and this could be counterproductive as it
is the opposite to the advantages of economies of scale.
Capital gains tax is a tax on the increase in value of an asset at the point in
time when it is disposed of. It mainly affects higher income earning groups, since
they are the people who buy and sell most assets, and is therefore redistributive
of wealth. Changes in value, when assets are disposed of by a company, are
index-linked, but this is not the case for individuals and therefore the tax can
be levied on nominal gains rather than on real gains. There is also a point of
criticism where certain gains are considered taxable and other similar gains are
not. For example, buying a share and selling it at a higher price in the future is
taxable while gambling on which way a share index may move is not taxable.

Other direct taxes include National Insurance contributions and the taxes derived
mainly to finance local government, which are council tax and business rates.
9.2.2.3 The difference between tax rates and tax revenue

It is often thought that raising the rate payable on a direct tax will increase the
revenue received by HMRC. However, the evidence does not always support this
statement. The American economist Arthur Laffer used a curve in his teaching
that he claims was developed in the fourteenth century by Ibn Khaldun and later
referred to by Keynes, but his name has become associated with this curve, hence
the Laffer curve is shown in Figure 9.1.
Figure 9.1
Tax
revenue
Income tax rate

0% 100%
On the horizontal axis a 0 per cent tax rate will raise no income as will a 100 per
cent tax take that gives no one incentive to work. However, as tax rates start to
rise so does the tax revenue until it reaches a point T 1 where the tax revenue is
at its highest. After T 1 the tax revenue falls as people become disillusioned by the
higher rates and this creates a disincentive to work, tax avoidance, evasion and
emigration.
Laffer suggested that many large government high tax countries had tax rates
above T 1. Anyone living in the UK in the 1970s noticed income tax rates rise to
98p in the £1 (83 per cent highest marginal rate on earned income + another
15 per cent if the income was unearned) and then noticed rich mobile people
moving abroad for tax reasons. These people included motor racing drivers, rock
stars, actors, etc. The result was that when Margaret Thatcher came to power in
1979 there was the political double whammy of being able to cut taxes and raise
government revenue/expenditure. Ronald Regan seemed to have done the same
in the USA at the same time. The danger, however, is that if you keep cutting taxes
there comes a point when you pass T 1 again and, this time, if you cut taxes and
plan to spend more money on the tax windfall, then you may suddenly find yourself
with a large borrowing requirement to finance.

9.2.2.4 The advantages and disadvantages of indirect taxes

Indirect taxes raise a high proportion of the total revenue received from taxation.
They are useful in managing certain parts of the economy, especially when they
can be set at different rates. For example, VAT (value added tax) at 20 per cent
can also be zero-rated on specific goods and services, eg certain foodstuffs and
exports, and excise duties can be placed independently on particular items. If a
government wants to discourage smoking, drinking and gambling it can raise a
price through an excise duty to help reduce consumption. The difference between
VAT and excise duty is that one is a percentage and the other is a nominal amount
of money, which means that they will shift the supply curve differently: parallel in
the case of an excise duty and an ever larger nominal amount for VAT, as illustrated
in Figure 9.2.
The excise duty on petrol has been used both to encourage a reduction in our
import bill and to help save a non-renewable resource. Another advantage of
changes in indirect taxes is that they can be immediate whereas direct tax changes
take time to implement. Also indirect taxes are relatively simple to collect and
difficult to evade. A final and less convincing argument in favour of indirect taxes
is that there is an element of choice about paying the tax as you only pay when
you choose to buy the product.
The disadvantage of indirect taxes is that they are regressive. As the same rate of
tax is paid by all income percentiles, it becomes a heavier burden on poorer people
as they contribute a higher proportion of their income in tax. When differential
rates of indirect tax are used, the number of products on which higher rates can
be placed is limited by the elasticity of demand for the product. An indirect tax
placed upon a product with a relatively elastic demand curve could bring about
a significant reduction in demand that actually reduces the tax take and raises
unemployment. This is why differential rates are often placed, through excise duty,
on addictive products or products with no, or only a few, substitutes. Also, at a
time when government may be concerned about the rate of inflation, a rise in
indirect taxes can register a one-off impact on prices. A final point to consider is
the difficulty of identifying the party or parties upon whom the incidence of an
indirect tax change falls. At the extreme of a perfectly inelastic demand curve the
incidence of tax will fall entirely on the consumer as illustrated in Figure 9.3,
or on the producer as illustrated in Figure 9.4 with a perfectly elastic demand curve.
In reality the downward sloping demand curve will share the tax between the
producer and the consumer with more coming from the consumer if the curve is
relatively inelastic and vice versa. In Figure 9.5 the consumer will pay the difference
between p and pı, and the rest of the ∆T will be paid by the producer.
As well as VAT and excise duties the other main indirect taxes are stamp duty
on property transfers and motoring taxes such as fuel duty, vehicle excise duty,
vehicle licensing and congestion charges.
9.2.2.5 Taxation/benefits, the poverty trap and reverse

income tax
A lot of people are unemployed because they receive more in benefits than their
take home pay from any work they could have done. Also a lot of our poorest
people have an implicit rate of tax in excess of 100 per cent. This is made up of
a standard rate of tax paid at 20 per cent plus the loss of £1 benefit for each £1
the person earns. In order to jump over the poverty trap a poor person will often
have to find a job that will give them a considerable rise in their salary. One way to

Figure 9.2
£ VAT
S1
} ∆VAT
Quantity
£ Excise Duty
S1
S
} ∆ED
Quantity
overcome this problem is a reverse or negative income tax. It uses the mechanism
by which tax revenue is collected to provide financial assistance. For example,
suppose a person starts paying tax after they have earned £10,000. If a reverse
income tax of 50 per cent was then introduced a person receiving no income would
receive 50 per cent of £10,000 = £5,000. If a person earned £6,000 they would
have their income topped up by 50 per cent of the additional £4,000 they had not
earned, giving them £8,000. This system means that at no point will a person be
worse off by working and therefore reverse income tax eliminates the poverty trap.
The advantages of this system are that it helps the poor in the most direct way and
treats them as responsible adults rather than as wards of the state. It gives low
income people an incentive to help themselves. It would cost less than the present

Figure 9.3
Figure 9.4
welfare programme by managing it through HMRC and it would remove much of a

very cumbersome and wasteful welfare system.
The disadvantages are that it would require a total reorganisation of the tax system.
It would remove special consideration for various groups in the benefits system
and it would cause a significant amount of unemployment in the civil service.

Figure 9.5
S1
Price S
P1
P
} ∆T
Q1 Q Quantity
9.3 Borrowing and the national debt
9.3.1 Definitions
Almost every year the government overspends its budget, and it runs up a
borrowing requirement. Economists may refer to this as a budget deficit while
the government accounts refer to it as the public sector net cash requirement
(PSNCR). On the relatively rare occasion that the government runs a surplus on its
budget, it will be referred to as a budget surplus and it can be used to fund public
sector debt repayment (PSDR).
The national debt (public debt) is the government’s accumulated debt, which
started, under William III’s monarchy, with the setting up of the Bank of England,
in 1694. A yearly PSNCR will add to the nominal value of the national debt while a
year of PSDR will reduce its nominal size. There have only been 4 years in the last
40 years when the government’s accounts registered a surplus, ie 1987 to 1990.
The national debt usually grows nominally year on year except when there is
a PSDR. However, it can go up or down in real terms depending upon what is
happening to the rate of inflation. For example, if the national debt grew nominally
by 5 per cent, but the rate of inflation was 10 per cent, then the real size of the
national debt would have actually contracted in spite of a rise in its nominal size.
9.3.2 The national debt
9.3.2.1 Funded/long-term debt and floating debt

The funded debt is what increases when there is a budget deficit. It is alternatively
known as the long-term debt. Although the distinction is not precise, the floating

Borrowing and the national debt
debt is very short-term debt that covers a mismatch between expenditure and
tax revenue. There are certain times of the year when there are large inflows of
tax revenue, but expenditure tends to be relatively smooth throughout the year.
Temporary shortages of funds are usually covered by issuing treasury bills that
have 90 days to maturity. They are considered very liquid assets and are usually
held by retail banks as a buffer to their holdings of cash.
The long-term debt is funded by non-marketable debt that is sold through NS&I
and has to be held to maturity, and marketable debt that includes:
u short-dated stock, up to 5 years;
u medium-dated stock, 5 to 15 years;

u long-dated stock, over 15 years; and
u undated stock with no redemption date.
9.3.2.2 The holders of national debt

The Bank of England has significant holdings of the national debt, much of which
backs the issue of legal tender banknotes. This has increased significantly during
the £325b QE programme that returned cash to the economy by buying back
government debt. Most of the rest of the debt held in the UK is with financial
institutions such as banks, building societies, insurance companies and pension
funds. In 1990 about 10 per cent of the national debt was held overseas. By 2010
about 35 per cent of the debt was held by foreign governments and overseas
investors. This does have implications for the balance of payments that will be
discussed later.
9.3.2.3 Is the size of the national debt a problem?

Written like this £1,000,000,000,000, a trillion, looks like a large number. The
national debt grew to over 1 trillion early in 2012 and is expected to grow, perhaps
reaching £1.5 trillion by 2016. To understand whether this number is a problem, it
is better to look at the ratio of national debt to GDP. Over the last 100 years national
debt has risen. It was 290 per cent of GDP in 1946 but this was an exceptional year
after the 1939−45 War. In 1992 it was 34 per cent of GDP. The 1997 incoming
Labour government set themselves a rule that the national debt should stay below
40 per cent of GDP and they kept to this until the crisis of 2008/09 when a
series of fiscal stimuli caused the 1 trillion number to become 64.2 per cent of
GDP (excluding financial interventions) by January 2012. The National Institute of
Economic and Social Research has estimated that servicing the debt will rise to
£50.7b per annum by 2013/14. Put into context, this will be about £6b more than
our total defence budget of £44b.
Economists are split down the middle about whether or not this is a problem.
Those who think it is not a problem claim that having nearly reached 300 per cent
of GDP in 1946, and survived financially, we should not bother about 64+ per cent.
They point out that it is just a transfer of expenditure between the surplus and
deficit sector and the burden is contained to the generation of people doing the
borrowing. They also point out that the real size of the debt falls as the result of
inflation and that a 5 per cent rate of inflation, on its own, would halve the value
of the debt in just over 13 years. Also we need to understand that it is part of an
expansionary fiscal policy that will cause the economy to expand and grow and
that this will raise more tax revenue and cut the real and nominal size of the debt.

Those economists who think it is a problem suggest that both the yearly deficit and
the accumulated debt are not stimulating the economy − they believe that these
factors are the cause of the problem by crowding out private sector investment and
drawing resources away from a more efficient private sector that promotes growth,
to a less efficient public sector that stifles growth. They point out that inflating away
debt creates unconstitutional redistributions of income and wealth that damage the
weaker sector of the economy. They also separate holders of the debt and suggest
that 35 per cent held overseas requires a drain to foreign countries with both
service charges and repayments and this weakens the pound and the balance of
payments accounts. A final point is a disagreement over whether debt transfers
a burden to the next generation. If we look at say £1b of debt financed by 40
year bonds (or, as is being suggested, 100 year bonds), the money is spent on
resources today and the servicing of that debt continues on for another 40 years
before final repayment. As a teacher of economics, I always apologise and thank
my students for their future financing of my current spending.
A very good measure of whether the size of the debt is approaching dangerous
levels is the willingness of investors to buy government bonds at various rates of
interest. Long before a government reaches an absolute debt limit, in terms of
its ability to meet interest charges, the experienced investors will lose confidence.
The price of bonds will fall and interest rates on government debt will rise. Today
this process is aggravated by the credit rating agencies that will downgrade a
country’s debt and could even push the value of its debt towards junk status. This
has happened in Greece and is beginning to happen in the other PIIGS countries:
Portugal, Ireland, Italy and Spain. So a country needs to stop its fiscal debt to GDP
ratio from becoming so high that it will lose the confidence of the markets and be
unable to fund its debt.
9.4 Who bears the opportunity cost of government

spending?
A new government programme cannot be undertaken without someone bearing
the cost, although there are some economists who believe that, if the government
undertakes a programme of spending at less that full employment, then there
is some scope to expand production using unused resources and therefore the
alternative at this level of production is not forgone, although as we will see there
is still an opportunity cost caused by a reduction in private consumption and private
investment.
If the government programme is financed by an increase in taxes the current

taxpayers bear the cost of having their purchasing power reduced. If the
expenditure is financed by borrowing from households and firms then the
reduction in spending power for current consumption or investment is felt by
those who lend their money to government rather than choose an alternative form
of savings or investment product that will reward them for their loss of liquidity.
People who do not buy government debt do not bear any of the real cost of the
government’s activity.
If expenditure is financed in a way that causes inflation (printing money to the value
of unsold debt and/or QE), then the rise in prices will mean that those groups who
cannot maintain the real value of their income and wealth will lose out. In a sense,
inflation is a hidden tax on money and the good thing for government is that it
can buy the resources before the prices rise because of the lagged relationship
between printing money and the ensuing inflation.

A Keynesian approach to fiscal policy
As far as opportunity cost is concerned, inflationary finance and tax are similar,
although the identity of groups forced to cut back purchases is likely to be different.
Under a tax-raising regime the government can have a considerable influence
over the distribution of the tax burden. However, given inflationary finance, the
government bids up prices and leaves it to the market to determine those groups
who will have to forgo an alternative.
Once the government spending programme has been completed, if the cost was
financed by taxes or inflation then the cost is fully paid and the resources can be
transferred to other uses. But if the spending was financed by borrowing then a
burden still remains after the activity has been completed. It is still necessary to pay
interest each year to the bondholder and eventually to repay the bonds when they
reach maturity. As the interest payments and eventual redemption of the bonds
are made from current tax revenue, it is the taxpayer who, at that time, will bear
the alternative forgone. The original transfer has not been reversed: in return for
bearing the original reduction in consumption and investment bondholders receive
additional income and taxpayers who are not bondholders bear a net reduction.
Also there is an opportunity cost to this country when debt is held by foreigners,
as interest payments to them and final repayment will give them a claim on the
resources of the UK economy.
An interesting point to conclude with is that it is always the taxpayer who pays
for government spending. The only difference is between whether it is the current
taxpayer or, whether through borrowing, interest charges and final redemption, it
is deferred to future taxpayers.
9.5 A Keynesian approach to fiscal policy
9.5.1 The budget and fiscal policy

It has already been seen how the government’s budget is used to redirect resources
into particular areas of the economy. Before the 1939−45 War there were budgetary
policies and strictly no Keynesian fiscal policies. This means that the pre-1945
budgets were pro-cyclical, ie if the economy was moving towards a recession or
depression unemployment would rise and incomes would fall so that revenue from
taxation also fell, and a government focused on balancing its budget would also
cut its expenditure. The opposite would occur if the economy was moving through
a recovery period towards a boom as revenue would rise and spending could
increase. Government budgets therefore reinforced the trend or, as Keynes pointed
out, made a bad situation even worse. Before the influence of Keynesian ideas,
governments were considered powerless and had to accept cyclical fluctuations in
the economy.
After Keynesian ideas were accepted by governments we see the introduction of
fiscal policy where the budget is seen as a way of managing the overall level of
aggregate demand to stabilise the economy at full employment. The Keynesian
approach was a change from pro-cyclical to counter-cyclical actions through the
government’s budget, by which government fiscal policy could work against the
trend of the cycle to bring it back to a more acceptable level.
Fiscal policy developed out of a Keynesian interpretation of the way the economy
functions. This analysis is based on the assumption that the economy has a
productive potential that can only be reached when all available units of labour
are employed and the economy at full employment equilibrium. Further to this, it

is assumed that the government can manipulate aggregate monetary demand to

achieve this full employment equilibrium. Without intervention by government it is
felt that the economy can come to rest at levels of economic activity that are less
than full capacity. These are referred to as under full employment equilibriums
and they occur when there is a deflationary gap in the economy. This deflationary
gap is not just determined by what is happening to prices (see deflation), but it
also takes on a wider range of characteristics that tends to focus on the level of
unemployment. Alternatively, the economy could have an inflationary gap that is
excessive monetary demand at the full employment level of output. This range of
potential problems can be managed in a Keynesian way as described in the next
headings.
9.5.2 A budget deficit and a deflationary gap

By definition, this is a situation where the government’s yearly budget shows that
spending exceeds the revenues it receives, mainly from taxation. It would be
appropriate to use this type of policy if the economy was underperforming and
judged to be producing at a level of economic activity below full employment, ie
the economy was in a state of under-full employment equilibrium. To deal with this,
Keynesians would suggest either a reduction in taxation, with no corresponding
reduction in expenditure, or an increase in expenditure with no increase in
taxation. This is illustrated in Figure 9.6, using the withdrawals injections model
of the economy.
Figure 9.6
W
£ W1
J1
} deflationary gap
J
Real GDP
Ye Yf
Ye represents an under-full employment equilibrium and Yf is a full employment

equilibrium. The deflationary gap is illustrated by the required distance between

A Keynesian approach to fiscal policy
J or W that needs to be closed by policy action. The government could choose to

increase expenditure and shift J to J 1 or reduce taxation and shift W to W 1. Note
at this point that the distance between Ye and Yf divided by the distance between
J and J 1 or W and W 1 is the multiplier. Usually, but not always, in this situation
the government will choose to boost spending as the impact on the economy is
slightly more predictable, as a reduction in tax requires additional assumptions
about the marginal propensities to save and import. This means that a fraction
of the £1 the consumer has available to spend on domestic consumption will be
withdrawn as tax falls, but that £1 of government expenditure can be fully spent
on the domestic economy.
9.5.3 A budget surplus and an inflationary gap

This time the assumption is that the economy is already at its full capacity, but
nominal national income is rising because excess demand at full employment is
causing demand pull inflation. At this point in time the appropriate policy is to
produce a yearly budget surplus either by increasing taxation without any rise in
spending or a cut in spending without any fall in taxation. This is illustrated in
Figure 9.7 where either J or W can be used to close an inflationary gap.
Figure 9.7
W1
£
W
} J
inflationary gap
J1
Yf Ye Nominal national income

Here Ye is an over-full employment equilibrium and the inflationary gap needs to

be closed by shifting J to J 1 by cutting government expenditure or W to W 1 by
raising taxation. Again the calculation for cutting expenditure is easier to predict
than the impact of raising taxes.
9.5.4 Balanced budgets and neutral budgets

If the economy is at full employment equilibrium then the government will be
required to balance its budget from year to year, but also to be aware that moving
from one balanced position to another will have a balanced budget multiplier effect
of 1.
The term neutral budget first appeared in the 1970s to cope with an intellectual
and political dilemma. In a simple Keynesian analysis of the relationship between
employment and inflation, the economy would risk rising inflation at full
employment or no inflation or even deflation at a rising level of unemployment.
Therefore if unemployment is rising it is a signal for a budget deficit and if inflation
is rising it is a signal for a budget surplus. Problems arose during the 1970s
when both inflation and unemployment rose to unacceptable levels together. The
situation was described as a period of stagflation and the Keynesians were able to
reconcile the problem by arguing that the inflation was of a cost push type and
that the unemployment was an indicator of an under-full employment equilibrium
that required a budget deficit. In contrast, monetarists pointed out that inflation
must be the result of too much demand in the economy and, as it was rising and
volatile, it was distorting labour markets, masking market signals and also causing
unemployment to rise. Therefore, if anything, it was necessary to run a budget
surplus and get aggregate monetary demand moving in line with the change in
real GDP. In political circles this academic confusion was partially hidden at budget
time by referring to the budget not as a deficit or a surplus, but as a neutral
budget, which is a budget that is broadly similar to the previous year’s budget with
no major changes. This means that, if last year’s budget was a deficit, this year’s
budget will be too. Technically, this terminology could be applied to a succession
of surplus budgets. It is interesting to note that in 2012 the budget was once
again described as a neutral budget by some commentators as the government
was still planning for another large budget deficit. However, as the planned large
deficit was slightly less than the previous year’s in both 2011 and 2012, other
economists have referred to them as austerity budgets.
9.6 A monetarist approach to fiscal policy

It has already been stated that monetarists consider monetary policy as an
important way of managing a free market, capitalist, non-interventionist economy.
The money supply needs to grow at a rate that is slightly faster than the rate of
growth of real GDP and the price of money (rate of interest) needs to be responsive
to market signals. Monetarists describe monetary policy as the proactive policy,
while fiscal policy has to be reactive and accommodate all the monetary targets.
Therefore fiscal policy should not be changed to impose pressure on, or make it
difficult to achieve, the chosen monetary targets.
As an example, let us assume that inflation is running significantly above target
and that therefore monetarists would argue for a tightening of monetary policy
where money supply growth is slowed down and interest rates are not on the low
side of market rates. In order to accommodate this, it would not be wise to be
running a large budget deficit that requires interest rates to be on the high side of

The demand management debate and an introduction to supply side policies
market rates in order to sell government debt, lest it may encourage a quantitative
easing programme that would mitigate against tighter controls over money supply
growth.
In summary, monetarists want an active monetary policy and accommodating fiscal
policy, while Keynesians want exactly the opposite, which is an active fiscal policy
and an accommodating monetary policy.
9.7 The demand management debate and an

introduction to supply side policies
9.7.1 The debate

The Keynesian side of this debate argues that managing aggregate demand can
manage the level of economic activity in the economy and any level of under-full
employment can be manipulated towards full or, at least, a more acceptable level
of employment. Policies are formulated on the assumption that there can be
a situation of deficient aggregate demand. Figure 9.8 illustrates how aggregate
demand can be increased from Ye towards Yf by manipulating aggregate demand.
Figure 9.8
The other side of the debate accepts, as Keynes himself did, that the destruction
of aggregate demand after the 1914−18 War caused unemployment to rise and
economic activity to decline, while the fiscal expansion towards the 1939−45
War recreated many jobs and stimulated economic activity. However, a level of
aggregate demand that is not compensating for some previous contraction causes
the argument of the Keynesian interventionists and the monetarist free marketers
to diverge.
At the other end of the spectrum the argument is that the economy settles at a
level of economic activity consistent with many factors in the economy, none of
which are to do with manipulating aggregate demand. For these economists the
AS function, in the long run, is vertical as illustrated in Figure 9.9.

Figure 9.9
Average
level of AS AS1
prices
AP2
AP1
AD1
AD
Real GDP
Ye Yf
The diagram shows that any proactive shift in aggregate demand to the right
will cause the average level of prices to rise from AP 1 to AP 2. Therefore, if it is
considered that the level of unemployment is unacceptably high, the only option is
to cause changes that will shift the aggregate supply curve to the right and close
the gap between Ye and Yf. If this happens it will be necessary to have a reactive
or accommodating expansion in aggregate demand AD to AD 1 to stop the average
level of prices falling from AP 2 to AP 1 and a potentially damaging deflation being
set in motion.
9.7.2 Introducing supply side policies

As is suggested above, the only opportunity to raise the level of economic activity
and employment is to shift the supply curve and this requires supply side policies.
Here the aim is to improve the workings of the market, increasing both competition
and incentive, thus adding to the supply potential of the economy. There are three
main policy groupings.
The freedom of the market to function more efficiently can occur as the result
of deregulation and the removal of restrictive legislation, rules and regulations.
Promotion of competition and curbing monopoly power, both in product markets
and labour markets, can increase the flexibility required in markets to make a
quick response to changing market signals. The privatisation of firms, the removal
of barriers to the flow of capital and the reinforcing of private property rights again
have been used to encourage a better market response to a changing economy.
A second grouping is tax reductions, profit related pay, employee share ownership,
wider share ownership and more encouragement to start up businesses and add
private incentives that may shift the aggregate supply curve to the right.

The 2008 financial/economic crisis
Thirdly a greater awareness of cost effectiveness brought about by reductions

in National Insurance contributions, improvements in the quality of labour, and
invention and innovation may help to increase the output of the economy.
A final point to note is that a reduction in tax rates to promote incentives is a
supply side policy as long as it does not change the balance between taxation and
government spending. If, however, it is part of a package to reduce the overall level
of taxation, but keep spending constant, then it becomes part of a fiscal policy.
9.8 The 2008 financial/economic crisis

In the early years of the new millennium, fairly loose monetary and regulatory
policies in the USA fuelled a boom in property prices and what became known
as the subprime lending problem. Mortgages were granted to people who could
not afford to service them on the assumption of the lender that, even if some
mortgages failed, the rising value of the property would act as sufficient collateral
to protect the lending institution. Mortgage lending expanded rapidly as bundles
of mortgages were sold on as securitised assets all over the world and the inflow of
funds was used to support further rounds of mortgage lending. These securitised
asset bundles contained some very safe assets, some not too safe assets and some
that became known as toxic assets.
When interest rates rose, the subprime borrowers could not afford the higher
payments and began to default on their loans in large numbers. This led to an
increase in properties for sale as well as a fall in demand and therefore a fall in
property prices. As the asset bubble started to implode so it became clear that
some banks and institutions were overexposed, although it was not quite clear
which banks had the potential problems. The inter-bank lending market began to
shrink as banks stopped lending to each other for fear that their loan may not be
repaid.
Northern Rock, a UK bank that had grown strongly by securitising bundles of
mortgages, relied excessively upon the inter-bank market for its funding and, when
it found this source of funds drying up, it had to go to the Bank of England as a
lender of last resort. This sparked a run on the bank that eventually led to its
being nationalised in February 2008. At that time Northern Rock did not have any
toxic assets on its books, but it was damaged by rumour and significant liquidity
problems.
In the USA there were rumblings of a significant problem and various financial
institutions were given financial support until Lehman Brothers was allowed to fail
in September 2008 by a Federal Reserve that had come to the view that, as far
as bailouts were concerned, enough was enough. On the day Lehman Brothers
collapsed all inter-bank lending stopped and a lot of bank lending was cut back.
As we know, bank lending is the main component of aggregate monetary demand
and governments around the world seemed to go into panic mode. After a G20
meeting in March 2009 there was general agreement that all member countries
should introduce a Keynesian fiscal stimulus package to avoid their economies
slipping into depression.
In the UK the 2009/10 fiscal year produced a budget deficit of £179b, which was
added to a national debt that stood at £743b. At the same time, what would have
been known, in the heyday of Keynesian economics, as a loose accommodating
monetary policy was adopted with quantitative easing programmes in the USA, the
eurozone and the UK. In 2009/10 £200b of money was created in the UK through
the QE programme. The fiscal expansion has continued with the national debt now

more than £1 trillion in 2012 and QE has grown to £325b. Unfortunately, only
one problem seems to have been solved and that is that the UK avoided deflation.
However, economic growth has been almost non-existent, unemployment remains
at just under 10 per cent of the workforce, and inflation has been above target
for three years, up to the time of writing (June 2012). At this time the UK was
facing a sovereign debt crisis in terms of servicing the debt and the actual size of
the debt, which is still growing at a rate that puts the UK credit rating at risk as
the national debt is likely to grow to £1.5 trillion by 2016. The UK problem is not
unique, though, as similar problems are being felt throughout the eurozone with
many countries threatened with having to exit the eurozone and re-establish their
own currency and manage their own monetary and fiscal policies.
9.9 Opposing solutions to the problems

facing the UK economy
9.9.1 The Keynesian solution

The focus of Keynesian economists is on low/no growth, high unemployment, cost
push inflation and a sovereign debt crisis that will begin to diminish as soon as
the economy starts to recover and grow more rapidly. So they are encouraging
policymakers to ignore inflation, which they say is mainly an imported/commodity
problem that is unrelated to UK monetary policy, and concentrate on more
aggressive spending targeted on the growth areas of the economy. At the same
time, tax cuts will help this expansion and the budget deficit needs to be ignored
in the short term. Do not worry if our credit rating is downgraded, continue the QE
programme and keep interest rates as low as possible to support an expansionary
demand side policy is the Keynesian mantra.
9.9.2 The monetarist solution

As far as the monetarist economists are concerned, the current problem is caused
by too much money chasing too few goods, hence inflation, and too much
government expenditure crowding out the private sector of the economy and
employing people in jobs for which there is no market demand. Overall the
fiscal stimulus programme has created jobs inefficiently in the public sector and
destroyed a potentially more efficient allocation of resources and source of growth
in the private sector.
The solution is to have a monetary policy that allows the money supply to expand
at a slightly faster rate than the growth in output, preferably by reintroducing open
market operations rather than QE. This will also allow the Bank Rate to rise and
reconnect with real rates of interest in the financial sector. In order to get fiscal
policy under control, it is necessary to reduce public expenditure as quickly as
possible with a view to achieving a balanced budget within two years. We then
need to instigate a balanced budget rule that enshrines in law a situation where all
future governments must balance their budget over a three-year term and reduce
the national debt to below 40 per cent of GDP with no lower limit. This effectively
removes the failed and ineffective Keynesian fiscal policy from ever being used
again to stimulate aggregate demand and distort the economy.

Summary
Summary
u The government’s budget is essential for an efficient modern economy to
function effectively.
u Taxation should be equitable, certain, convenient to the payee and economical
in the way it consumes resources.
u A balance of direct and indirect taxes should be used to minimise any damage
to the economy and maximise the opportunity to continually raise more funds
as the economy expands and grows.
u It is essential to recognise both the impact of yearly borrowing by government

and the burden created by the accumulation of this national debt.
u The size of the national debt can reach an absolute debt limit beyond which
government finances will begin to collapse and the economy to suffer.
u Fiscal policy is an essential part of Keynesian demand management policy.
u There is an alternative view and much debate about the way fiscal and demand
side policies, including monetary policy, can be used to manage the economy.
References
Keynes, J.M. (1923) A Tract on Monetary Reform. London: Macmillan & Co. Ltd.
Smith, A. (1776) The Wealth of Nations. London: W. Strahan and T. Cadell.

Topic 10
International trade
‘It requires a considerable act of imagination to see through the veil of money
and to realise that what society really wants of the shopper is not money, but
the service which was performed to earn it. It requires an even greater act of
imagination to apply this principle when the goods bought are produced in
a foreign country.’
Pearce (1970)

u the importance of opportunity cost ratios in understanding the difference
between the gains from trade and the terms of trade;
u the reasons for protection from free trade;
u the structure and the importance of balancing international payments;
u fixed and floating exchange rates and how they are determined; and
u the international organisations charged with managing the world economy.
10.1 The gains from trade and the terms of

trade
10.1.1 The importance of opportunity cost ratios

To understand the gains from international trade it is necessary to become familiar
with opportunity cost ratios. Once you have calculated the opportunity costs, then
it is easy to identify:
u who has absolute advantage in which product;
u if any country has a comparative advantage only;
u which country should specialise in which product;
u the limits to exchange; and
u where the terms of trade must lie for both countries to benefit from trade.
At this point we can remind ourselves that an opportunity cost measure gives us
a real measure of the forgone alternative. In this case, if we are looking at

10: International trade
production, then it tells us how much of one product must be given up if we want
to produce more of another product.
10.1.2 The difference between absolute advantage and

comparative advantage
Suppose that, given equal amounts of productive factors, each of two countries A
and B allocates half of its productive capability to product X and half to product Y,
as illustrated in the table below.
Table 10.1
Country/product X Y
A 100,000 80,000
B 60,000 90,000
It can immediately be seen that country A can produce more of X than can country
B and so country A has an absolute advantage in X. Similarly, country B has an
absolute advantage in producing Y.
To calculate the comparative advantage we need to use the opportunity cost. To
work out the opportunity cost for each product in each country, we place Y/X
for product X and X/Y for product Y and this will give us the opportunity cost of
producing 1X and 1Y in each country, as illustrated below:
Table 10.2
Country/product X Y
A 4/5Y 5/4X
B 3/2Y 2/3X
Having calculated the opportunity cost horizontally we now look vertically to

compare these numbers and see which country has the lower opportunity cost for
producing each product. As we would expect from the raw numbers in Table 10.1,
country A has the lower opportunity cost for producing X (4/5Y is lower than 3/2Y)
and country B has the lower opportunity cost for producing Y (2/3X is lower than
5/4X). As observed in Table 10.1, country A has an absolute and a comparative
advantage in producing X while country B has these advantages in producing Y.
If we change the numbers slightly it will be more difficult to see from the raw
numbers what the relative situation is. However, as soon as we have worked out
the opportunity costs it will be clear.
Table 10.3
Country/product X Y
A 100,000 80,000
B 60,000 50,000
The raw numbers in Table 10.3 show us that country A has an absolute advantage
in producing both X and Y as, given the same amount of resources, it can produce
more of both products than can country B.

The gains from trade and the terms of trade
Table 10.4
Country/product X Y
A 4/5Y (24/30Y) 5/4X (25/20X)
B 5/6Y (25/30Y) 6/5X (24/20X)
However, if we reduce each opportunity cost fraction to its smallest common

denominator we can see that all the opportunity costs are different and this is
enough information to tell us that each country must have a lower opportunity cost
in one of the products. If we look at the numbers in brackets, which show common
denominators, then we can see that country A has a lower opportunity cost in
product X (4/5Y is lower than 5/6Y) and that country B has a lower opportunity
cost in product Y (6/5X is lower than 5/4X). This means that, although country
A has an absolute advantage in the production of X and Y and country B has an
absolute disadvantage in both, country B does have a comparative advantage in
the production of Y.
A final tweak to the numbers produces a situation where country A has an absolute
advantage in the production of both X and Y and there is no comparative advantage.
If you work out the opportunity cost ratios in Table 10.5 you will see why. In this
situation it is not possible to rearrange resources to achieve any gains from trade.
Table 10.5
Country/product X Y
A 100,000 80,000
B 90,000 72,000
10.1.3 The theory of comparative advantage

The theory states that, if opportunity cost ratios are different between countries,
it will always be possible to rearrange resources to increase output and benefit
from trade. This theory applies to internal trade comparisons between firms and
international trade between countries.
The theory of comparative advantage shows that relative absolute advantage is
irrelevant and that the best way to reinforce this point is to use an example where
one country has absolute advantage in both products but opportunity costs are
different.
Table 10.6
Country/product X Y
A 10 20
B 200 120
Total 210 140
In Table 10.6 we have chosen numbers for what can be produced if you use 50
per cent of your resources on each of two products that, at first glance, do not
seem to fit the theory as there is such a difference between what country A can
produce given the same resources as country B. The table shows that country A
can only produce 10X and 20Y while country B can produce 200X and 120Y. The
first question to answer is: are opportunity costs different?

Table 10.7
Country/product Opportunity cost Opportunity cost
of producing 1X of producing 1Y
A 2Y 1/2X
B 3/5Y 5/3X
We have shown in Table 10.7 that opportunity costs are different. We can also see
that country A has a lower opportunity cost and therefore should specialise in Y
while country B should specialise in X. The easiest way to prove gains from trade is
to rearrange resources so that there is an increase in the totals produced of both
products. Before specialisation the total amount of X produced is 210 and of Y is
140.
There are many ways to prove this point, one of which is described below.
If we allocate all resources in country A to producing product Y, then output will
double to 40, while country B produces 2 more X and 12 fewer Y. The totals have
both increased, as illustrated in Table 10.8, from 210X to 220X and 140Y to 148Y.
Table 10.8
Country/product X Y
A 0 40
B 220 108
Total 220 148
10.1.4 The limits to exchange and the real terms of trade

Opportunity cost ratios are important in illustrating the limits between which trade
can take place and be beneficial to both countries. This means that the actual terms
of trade (see below and in the next section) will lie somewhere between those two
outer limits.
In the previous example, and by its own efforts, country A could have produced 1Y
or 1/2X and therefore would not choose to specialise in Y, unless it could receive
more than 1/2X in trade. Equally, country B could have produced 1X or 3/5Y and
therefore would not choose to specialise in X unless it could receive more than
3/5Y in exchange.
Therefore if specialisation is to benefit both countries, the rate at which 1X trades
must lie between 3/5 and 2Y; or the same thing written from the perspective of
1Y is that trade must occur between 1/2X and 5/3X. If trade were to take place on
either of these limits, then only one country would benefit and the other country
would not benefit. If trade were to take place outside these limits, then one country
would gain from trade and the other country would lose.
The final rate at which a quantity of X would trade with a quantity of Y is known as
the real terms of trade. These terms of trade are determined by the conditions of
supply and demand for each product in both countries relative to the price changes
that occur at different rates of exchange. There would be a market clearing price
that would clear the total market for each product.

Free trade v. protection
10.1.5 The official terms of trade

In international trade, products have prices that are determined by the interaction
of supply and demand and therefore a country’s official terms of trade are
measured by the formula below:
Index number for the average price of exports
Terms of trade = × 100
Index number for the average price of imports
A rise in the terms of trade is described as a favourable movement because,
given the same sales revenue from selling exports, a country could finance the
purchase of more imports. Similarly, a fall in the terms of trade means that fewer
imports can be purchased from the same value of export sales and is described as
an unfavourable movement.
The terms favourable and unfavourable are, however, misleading under certain
circumstances. For example, a favourable movement in the terms of trade means a
relative rise in the price of a country’s exports. However, if this was not associated
with a rightward shift in the demand curve, ie foreigners demanding more at the
same price, and if the demand for exports was elastic, then there would be a fall
in the demand for exports that would reduce the total sales revenue from foreign
countries and, in turn, reduce our ability to buy imports.
Similarly, if there was an unfavourable movement in the terms of trade, then relative
export prices would be falling and, with an elastic demand curve for exports and
no leftward shift in the demand curve, there would be a more than proportionate
increase in demand for exports and an increase in total revenue from abroad, and
in our ability to buy imports.
Favourable movements in the terms of trade will tend to have favourable effects on
a balance of payments and unfavourable movements will tend to have unfavourable
effects when demand curves are relatively inelastic.
For the UK it is thought that the competitive nature of demand for our exports
creates elastic demand and therefore the conditions described above will produce
an unfavourable effect on our balance of payments account if the terms of trade
move favourably. Thus a country like the UK will tend to benefit more when the
terms of trade move unfavourably, ie when export prices fall and import prices
rise.
10.2 Free trade v. protection
10.2.1 Introduction
It has already been shown by the theory of comparative advantage that there
are benefits to countries if they specialise in the products for which they have
lower opportunity costs of production and trade with each other. Many economists
argue that, in theory, the world economy would be most efficient if there was
totally free trade and market forces allocated resources. However, in reality, the
world’s trading model is a complex interaction of national economies that have
erected trade barriers against all countries, some countries, all products or some
products. A country uses these barriers to limit the volume or value of products
being purchased from other countries. It does this to protect its economy from
foreign competition and so the barriers as a whole are known as protectionism.

10.2.2 The main methods of protection

Tariffs are used to raise the price of imports either by a specific amount or by a
percentage addition to the price of an import. Quotas are a limit on the number
of products that can be imported from a foreign country, or a number of countries,
often related to the product of a particular industry. In the past the UK has used
quotas on the import of cars.
Less obvious forms of protection can be used. For example, subsidising the
production costs of domestic firms will make them more price competitive when
compared with imports. Forcing the exchange rate down below a market rate will
lower the price of exports and raise the price of imports, both of which will benefit
domestic producers (see the Marshall-Lerner condition).
Legislation and quality controls can be used to the advantage of local producers
and the disadvantage of importers. The Japanese have used a variety of less obvious
ways of protecting their producers. In the 1970s, they placed differential tax rates
on cars such that the slightly narrower Japanese car went into a lower tax band than
the similar imported car that was in a higher tax band. Also, in Tokyo, preferential
parking was given to people driving Japanese cars. In the UK ‘Buy British’ campaigns
have been used. A Japanese car company responded to such a campaign in the
1970s by putting a ‘Buy Blitish’ sticker in the back of its cars. A new campaign
called Dopios has been set up in Greece to encourage Greeks to buy local products
during the 2012 crisis; ‘dopios’ means ‘local’ in Greek.
10.2.3 The case for protection

There are some good economic reasons for protection and some others that
make less economic sense. There is a strong case for reacting to unfair trading
practices by other countries. One of these practices is dumping, which is selling
products in another country at below the costs of production perhaps to get rid
of an unwanted surplus, or just to earn foreign exchange, or to try to damage a
competitor in another country. Foreign countries may be unfairly subsidising their
export industries or imposing restrictions on imports or they may have introduced
unfair or overlong testing procedures to slow the flow of imports. A country may
feel it is necessary to protect itself against a large exploitative monopoly supplier
or a very powerful group of suppliers such as the Organisation of the Petroleum
Exporting Countries (OPEC), which fixes crude oil prices. Illegal drugs and products
that may threaten national security provide another category for protection.
Most economic textbooks quote the example of the infant industry case. This
is where a start-up industry in, for example, a less developed country is unable
to compete with more mature industries in other countries. As yet, it will not
have grown sufficiently large to benefit from economies of scale and the argument
suggests that its home market is protected from competing imports while it secures
a domestic foothold and grows to a level where it can become competitive. At this
point, it can be released into the market as the protection is taken away.
Not quite so convincing an argument, but a similar one, is used for senile
industries (such as the UK car industry in the 1970s and 1980s) that have grown
old and uncompetitive. It is argued that they should be protected for a period of
time while they regenerate, re-skill, re-equip, invest in new plant and machinery
and therefore become competitive once again. Other less convincing economic
arguments include protecting essential industries, protecting employment and
providing a source of revenue for government.

Supranational organisations
10.2.4 The case against protection

Protecting infant and senile industries may remove the incentive for these
industries to become competitive and, although it is easy for politicians to impose
protective measures for electoral reasons, we need to recognise that it becomes
very difficult to remove this protection once it has been imposed. This is because it
can be perceived as benefiting the domestic economy and, once removed, it gives
an advantage to foreign firms. It is an example of a moral hazard if infant firms
fail to grow up and if senile industries argue for more time. Moral hazard means
that the firms will not take the necessary steps to become efficient because they
know they can rely on government protection. This can mean that the misallocation
of resources caused by protection becomes a permanent inefficiency rather than
just a temporary readjustment.
Protection ignores the benefits of the theory of comparative advantage and reduces
consumer choice as well as raising the cost of living. It also raises the risk of
retaliation as foreign countries try to protect themselves against the damage done
to their economies by your protective measures. In the 1980s it was reported that
the UK put a restriction on importing £10m of Indonesian shirts and trousers.
Indonesia retaliated by cancelling £150m of aerospace and scientific instrument
orders and denied the UK an opportunity to tender for a further £500m of business.
Protection cannot be practised against the imports of vital raw materials, eg fuel
and metals, especially when a country is not endowed with these resources. Equally,
a country cannot erect protectionist measures against other countries that are in
the same free trade bloc, eg the European Union.
Introducing import controls may direct attention away from the real economic
problem that is causing the current account of the balance of payments to be in
deficit and encouraging the government to look for a temporary fix. It is likely
that a long-term fix to UK problems may require a change to the way in which
macroeconomic policy is carried out.
10.3 Supranational organisations
10.3.1 Introduction
In almost any type of political structure, there is tremendous pressure to move
away from free trade towards protected trade. This pressure gains momentum
when economic times are hard. Questions are asked such as:
u Why should we produce goods and services for people in other countries?
u Why should we sell lots of products to countries who buy very little from us?
u Surely we should protect our domestic industry and employment ahead of
purchasing imports?
u How will we survive during a war if we buy all our food from other countries?
u Other countries are making it difficult to sell our products to them so why
should we not do the same to them?

u We do not agree with the human rights policy of this country so why are we
trading with them?
u Aren’t countries where labour is cheap and children are exploited destroying
our manufacturing base?
And so it goes on. It is not, therefore, surprising that over the centuries a
very complex trading model has developed with significant levels of protection
enshrined in domestic policies. Over time, the situation has been made worse by a
process that ratchets up levels of protection as one country sees another trying to
gain an advantage. It has even been suggested that each country’s relative position
in a free trade model is little different from the current situation, with trade barriers
surrounding each country.
At the same time, there has been a competitive increase in protective barriers and a
realisation that we all might be better off if we can reduce some of these barriers.
Unilaterally it would be a very difficult thing to instigate so what has tended to
happen is that some international organisations have been tasked with trying to
persuade countries into reducing tariffs, while in other cases groups of countries
have come together to free up their trade against each other.
In 1948 the General Agreement on Trade and Tariffs (GATT) was established.
Its brief was to reduce or, wherever possible, remove both tariff and non-tariff
barriers to trade. In 1995 GATT was absorbed into the World Trade Organization
(WTO), which has a wider brief to regulate the world trading environment while
continuing to push for fewer restraints on international trade.
10.3.2 A customs union

In 1957 the Treaty of Rome established the European Economic Community
(EEC) comprising 6 original members who were joined in 1973 by the UK and
subsequently by 20 other countries. Although it had greater expectations, it was
originally set up as a customs union.
A customs union refers to a group of countries that remove trade barriers between
themselves and establish a common external barrier between themselves and
the rest of the world. This was, and a customs union usually is, a movement towards
freer trade. In this case, two actions supported this move. The first was free trade
between countries, while the second was to choose a common external barrier
based upon the least restrictive barrier previously present in a member country.
This meant that the overall level of tariffs was reduced by this action.
The advantages of setting up a customs union are that the market size that each
firm can access is increased, which this may lead to significant economies of
scale. The theory of comparative advantage can play out in a larger arena and
have an immediate effect on reallocating resources more efficiently, while over the
longer term more competition should have a beneficial impact on enterprise and
efficiency.
The obvious disadvantages of a customs union are that the benefits are not likely to
be distributed evenly. In general, countries located nearer the geographical centre
will receive more benefits, particularly as the result of cheaper transport costs in
reaching the outskirts of the market. Also, some industries in some countries may
not survive the increased competition.
The overall impact of setting up a customs union is likely to be a net trade
creation, but this will be the result of both trade creation and trade diversion
(destruction), as illustrated in Figure 10.1.

Figure 10.1
The diagram shows the supply and demand curves for a country that, initially, does
not trade internationally. The equilibrium price determined by domestic supply and
demand is PD.
Suppose international trade takes place behind a tariff such that the supply curve
becomes horizontal at S 1 and price PT. At this price OQ 3 will be demanded from
domestic producers and OQ4 minus OQ 3 will be imported from abroad.
Suppose that country A joins a customs union and a common external tariff is
agreed that causes the price to fall to PC where the original supply now becomes
horizontal at S 2. Domestic production will now fall from OQ 3 to OQ 2 and imports
will increase to OQ5 minus OQ 2. The net trade creation is from OQ4 to OQ5 and
the trade diverted is a reduction in domestic trade from OQ 3 to OQ 2.
On this diagram it is assumed that, if there is totally free international trade, the
supply curve would become horizontal at S 3 with a price of PF. Total demand for
this produce will be OQ6 of which OQ 1 would be produced domestically.
In summary, the change from tariffs in country A to a customs union would produce
a net trade creation and a lower market price. However, it should be noted that
if the customs union were set up from a position of free trade, then the opposite
would happen.
10.3.3 A customs union for less developed countries

The arguments for setting up a customs union among a group of less developed
countries are the same as described above, with one additional consideration.
Economic groups of countries in the more developed world, as exemplified by
the European Union, are much stronger and more powerful than any individual
country, let alone any less developed country. A certain amount of this imbalance
in power can be redressed if the less developed countries get together and form a
customs union. As a group of countries, they would be able to protect themselves
a little more from the powerful more developed countries. An example of a special

problem created within the European Union that inflicts damage on less developed
countries is the EUs Common Agricultural Policy (CAP).
10.3.4 A European Union problem: The CAP
The CAP was fully implemented in 1968 and has cost the EU countries exceptionally
large amounts of money ever since. ‘The policy has been shaped with an
astounding neglect of fundamental economic rules about the efficient use of
scarce resources in market-oriented economies’ (J. B. Donges, ‘What is wrong
with the European Communities?’, 11th Harold Wincott Memorial Lecture, 1981).
Agriculture attracts intervention as it is arguably a country’s most basic and most
important industry and also one of the most unstable as the result of the whims
of nature. To protect themselves against instability caused by volatile prices and
particularly by overproduction and low prices, all countries have policies to ensure
a steady supply of foodstuffs.
10.3.4.2 The arguments for the CAP

As there was not a free market for agriculture in any of the EU’s member countries,
the setting up of a union created the opportunity to produce a unified policy. A
system of minimum price guarantees for about 90 per cent of farm produce was
introduced, with variable import levies and export subsidies, to stabilise prices in
the market and to make them competitive in the world market. The result was that
prices in the union fluctuated less, which is of benefit to farmers and arguably
of most benefit to inefficient or high cost farms and farming countries. Overall,
the price support system did encourage a considerable growth in the agricultural
industry.
10.3.4.3 The arguments against the CAP

A minimum price guarantee tends to err on the side of a price that is too high.
Figure 10.2 shows that surpluses are likely to occur repeatedly, with little hope
of selling them off in the future. Over the years, many ‘mountains’ and ‘lakes’ of
food and wine were created as a result of the CAP. The problem of storing excess
supplies led to converting food into animal fodder, dumping on world markets
and destroying crops. Overall, prices in the union tend to be higher than world
prices and consumers do not have access to cheaper products from outside the
EU. All of this misuses taxpayers’ money and wastes resources. Consumers suffer a
reduction in real income and higher taxation, and the CAP is particularly regressive
for the poor who spend a greater proportion of their income on food.
As well as the internal harmful effects there are external harmful effects
as Third World farmers are denied access to EU markets at competitive prices.
Arguably, the use of export subsidies to get rid of excess supplies is tantamount to
dumping on world markets, as the fixing of EU prices is likely to worsen fluctuations
in prices around the world.
10.3.4.4 A solution
There have been substantial reforms of the CAP over recent years, but an economist
might suggest that there was always an easy answer and that was not to interfere

Figure 10.2
Prices
S
surplus
}
P1
D
Quantity
Q2 Q Q1
with the price mechanism. Instead, let prices clear markets to avoid any surpluses
or deficits. A tariff on imported products could be used to add some measure of
protection and a policy could be developed that directly supports farm incomes
and does not interfere with prices. Arguably, this is the best way to manage the
allocation of resources for private goods.
10.3.5 A single European market

The establishment of a single market is one stage further on from the customs
union described previously. All the rules of the customs union apply plus, in the
case of the European Union, an additional number of collective agreements. These
included freedom of movement for productive factors with no hold-up at customs.
Commercial laws are standardised across the EU, as are rules for quality control
and open tender for all public contracts. Also, in the case of the EU, a single
currency was created and, by 2012, 17 of the 27 EU member states had joined.
This was partially achieved with some early success, but also with considerable
doubts, such that those members of the EU who did not join the eurozone looked
at the situation in 2012 and considered their decision not to join a wise one. More
about the eurozone will be analysed under foreign exchange.
10.3.6 A free trade area

An alternative to a customs union that still moves towards freer trade is the free
trade area. An example is the European Free Trade Area (EFTA), which includes
Iceland, Norway, Lichtenstein and Switzerland. It is different from a customs union
in that, although free trade takes place between the countries, they each maintain
their own external barriers against the rest of the world.

As there is no common external tariff there is the problem that countries outside
the free trade area could choose to export to the country with no, or a low,
barrier and then once inside the free trade area it could re-export to other member
countries. In order to avoid this happening, it is necessary to have a re-export tariff.
For example, if country X had a 50 per cent tariff on one product while country
Z only has a 20 per cent tariff, then a 30 per cent re-export tariff is necessary in
country Z to stop products entering the free trade zone and breaching country X’s
tariffs.
10.4 The balance of payments
10.4.1 Some important definitions

Balance of payments: This is the difference between the total payments into and
out of a country measured in the domestic currency over a given period of time.
Balance of payments current account: This is usually referred to as the current
balance and is the difference between the total value of goods and services
exported and imported over a given period of time.
Visible balance of trade: This is the difference between the total value of goods
exported and imported over a given period of time, eg oil and cars.
Invisible balance: This is the difference between the total value of services
exported and imported over a given period of time, eg banking and tourism.
Capital account: Since the introduction of the new accounting rules in 1998, this
account has shrunk and now is only a small component of the balance of payments.
It includes mainly transfers of fixed and non-financial assets.
Financial account: This includes transfers of financial assets including direct

investment, portfolio investment and financial derivatives. It also includes official
flows of currency, mainly to and from the foreign exchange reserves held by the
Bank of England.
Official financing: This is that part of the financial account that offsets the positive
or negative currency flows generated by other parts of the balance of payments
accounts.
Net errors and omissions: Overall, the net balance on the balance of payments
is zero; therefore, if the statistics do not show this, there must have been mistakes
and so an estimate of the errors and omissions is included to produce a zero
balance.
Exports or imports FOB: This means free on board and it is the value of goods,
excluding any costs of insurance and freight.
Exports or imports CIF: This measure includes the cost of insurance and freight.

The balance of payments
In 2010 the various accounts produced the following balances (The Pink Book
2010):
£millions
Visible balance -98,462
Invisible balance 58,778
Other current account transfers -2,958
Current balance -36,726
Capital balance 3,708
Financial account balance 41,517
Net errors and omissions -8,499
10.4.2 Why does the balance of payments always produce

a zero balance?
The simple answer is that we are dealing with an accounting identity such that any
positive or negative currency flows that result from the movements on component
accounts will be offset by official financing. For example, if there is a current
balance deficit of -£35b, a capital surplus of £5b, and a surplus on the financial
account excluding official financing of £20b, then the deficit will produce a -£10b
currency flow that will be matched by £10b of official financing. This is usually
the running down of foreign exchange revenues, but the gap could be plugged by
borrowing from abroad or by running down domestic gold reserves.
In the opposite direction, a positive currency flow will produce an equal and
opposite negative number for official financing. This negative number will match
an increase in foreign exchange reserves, loans to other countries or an increase
in gold reserves.
There is also another zero balance to consider on a worldwide scale: if we ignore
all official financing then countries will either have deficits or surpluses on their
balance of payments. Since one country’s deficit is a surplus for one or more other
countries then the sum of all these imbalances for all countries must produce a
zero balance.
10.4.3 Equilibrium and disequilibrium on the current

balance
Statistically, every month there will, at least, be a temporary disequilibrium on the
current account of the balance of payments. This is because a zero balance would
be very improbable. In fact, the current account would be described as being in
equilibrium if the value of the monthly surpluses and deficits cancelled each other
out. This means that a temporary imbalance is not a problem.
In contrast, a persistent deficit each month would tend to indicate a problem
because the country is not selling enough exports to be able to finance its purchase
of imports. In the short term, this imbalance is not necessarily a problem as other
flows may be offsetting this shortage of foreign currency. Reserves may be run
down, or foreign countries may be buying UK assets and therefore supplying

necessary currency to the foreign exchange market. However, over the longer
term this persistent deficit highlights a problem as countries will not have infinite
supplies of foreign currency reserves or assets to sell to foreign buyers and
therefore some form of corrective measures may be considered or may just take
place.
Although a persistent surplus on the current account may not be perceived to
be as much of a problem as a deficit, it is still an imbalance. This persistent surplus
means that the country can afford to buy more foreign products and it is not taking
advantage of this, and it also means that other countries are in a persistent deficit.
This will put pressure on surplus countries to carry out some corrective action. A
current example (2012) of this is the USA putting pressure on China to act in a
way that will eliminate, or at least reduce, its large and persistent current account
surplus.
The UK economy has a persistent deficit on its current account so you may be
forgiven for answering a question about disequilibrium by focusing on deficit,
but remember that if the word disequilibrium is used you should analyse both: a
persistent surplus and a persistent deficit.
As we will see further on in this topic, currencies that float against each other on
the foreign exchange market have an inbuilt corrective mechanism for dealing
with persistent disequilibrium. The currency of a country in deficit will tend
to depreciate as the deficit reduces the demand for a currency relative to its
supply. This will lower the price of exports making their sale more attractive and
competitive in terms of other currencies. A persistent surplus will tend to cause
the currency to appreciate as the demand for the currency will increase relative
to its supply. This means that import prices will now become more attractive in
terms of the domestic currency.
An alternative way to manage a currency is for it to be fixed in terms of one or
more currencies and, if this is the case, then there are four possible options for
dealing with persistent disequilibrium. They are:
u devaluation of the currency, ie moving it from a higher fixed point to a lower

rate of exchange;
u revaluation of the currency, ie moving it from a lower fixed point to a higher
rate of exchange;
u deflation of domestic demand (here the term deflation is used in the Keynesian
sense as reducing aggregate demand, not lowering the average level of prices);
and
u reflation of domestic demand by using expansionary demand side policies.
Which policy is chosen will very much depend upon the current level of economic
activity and whether, as the Keynesians would describe, the economy is at:
u full employment,
u under-full employment, or
u over-full employment.
And, for the purpose of this analysis, it will be assumed that the sum of the
demand elasticities for imports and exports is greater than one. The reason for
this is explained by the Marshall-Lerner condition towards the end of this section.

A persistent surplus at under-full employment will require a reflation of

domestic demand that will increase output and employment, increase the demand
for imports, and redirect some potential exports into the home market.
A persistent surplus at over-full employment will require a revaluation of the

currency that will relieve the pressure on demand for domestic products through
lower import prices and higher export prices.
A persistent surplus at full employment will require a mix of revaluation
to correct the current account imbalance and a little reflation to maintain full
employment.
A persistent deficit at under-full employment will require a devaluation to
reduce the price of exports, raise the price of imports, and boost demand for
domestic products.
A persistent deficit at over-full employment will require a deflation of demand

to control inflation, reduce demand for imports, and switch some unsold domestic
products into export markets.
A persistent deficit at full employment will require a mix of devaluation

to correct the current account imbalance and a little deflation to maintain full
employment.
Finally, it should be noted that small imbalances could be tackled by
microeconomic policies that may involve adjustments to taxes or tariffs. This
happened in an attempt to reduce the demand for oil imports to the UK in the
1970s.
10.4.4 Can a country run a persistent disequilibrium on

its current account?
The theoretical answer is no, although it does seem that reality contradicts this
answer, as China and Japan have run surpluses for long periods of time and the UK
and USA have run deficits for similar periods. For example, UK history over the last
25 years shows that there was a small surplus on the current account in 1998 and
some very large deficits for the other years, reaching a deficit of £36.8b in 2010
(Office for National Statistics). Let us then look at why the theoretical answer is no.
For a country to run a persistent deficit on its current account it would require
unlimited supplies of gold and foreign currency, or it would need to have the
ability to borrow from the rest of the world indefinitely, or it would need to have an
unlimited wealth of assets that it was prepared to sell to rich foreigners. Of these
three options, the UK has probably survived in deficit by transfers of ownership of
assets to citizens and groups of citizens in other countries. This has meant that
surpluses on the financial account have offset deficits on the current account, at
least up to now.
A persistent surplus is less of a problem, but it still is a problem, despite the
fact that some countries seem to consider a current account surplus as a measure
of economic success. The reasons it is a problem are that standards of living in
the country with a surplus are lower than they otherwise could be and that the
surplus is someone else’s deficit. This means that the country in deficit may argue
that the other currency is undervalued and needs to be revalued or allowed to float
upwards in order to level the playing field for international trade.

The fact that those countries that have persistent deficits also have currencies
that are floating down in value suggests that deficits can be sustained over longer
periods than if the countries were trying to maintain a fixed rate of exchange.
Another point to take into account is that a persistent deficit on the current account
may not just be an overvalued exchange rate − it may be an indication of a more
deep-seated problem that needs to be addressed. For example, it may be that a
country running a large fiscal deficit over a number of years is causing itself several
problems such as inflation and slow growth and also causing an imbalance on the
current account, which could therefore be solved if the problem of the fiscal deficit
was addressed.
10.4.5 Disequilibrium and the Marshall-Lerner condition

The Marshall-Lerner condition states that the sum of the demand elasticities for
imports and exports needs to be greater than unity 1 for a devaluation to improve
the current account of the balance of payments. If the sum is equal to unity, then
a change in the rate of exchange will leave the balance unchanged in percentage
terms, and if the sum is less than unity then a devaluation will worsen the balance
and, under these circumstances, it is a revaluation of the currency that will improve
the balance.
For example, Table 10.9 shows us what will happen if a country devalues its
currency by 3 per cent and the sum of its elasticities adds up to unity.
Table 10.9
A devaluation of 3%
Price elasticity Price change Change in Change in
demand £ revenue
Exports
0.3r Domestic output +1% +1%
prices unchanged
in sterling, 3%
depreciated in
foreign currency
Imports
0.6r Import prices rise -2% +1%
3% in sterling
Given a price elasticity for exports of 0.3r, then the formula for elasticity tells us
the impact on demand (X) of a change in price. For exports:
X
0.3 r = therefore X = +1% as export prices fall
3%
For imports:
X
0.6 r = therefore X = -2% as import prices rise
3%
The 3 per cent fall in export prices in foreign currency increases demand by 1
per cent and therefore there is a 1 per cent increase in sterling revenue as prices
measured in sterling have not changed. However, the 3 per cent rise in the sterling

price of imports has reduced demand by 2 per cent, but raised revenue in sterling
by the same 1 per cent, leaving the balance unchanged in percentage terms.
To take this point a little further, let us construct Table 10.10, which includes
elasticities that add up to less than unity, but include the same 3 per cent
devaluation.
Table 10.10
A devaluation of 3%
Price elasticity Price change Change in Change in
demand £ revenue
Exports
0.3r 3% less in foreign +1% +1%
currency
Imports
0.3r 3% higher in -1% +2%
sterling
In the last column you can see that revenue from selling exports has risen by 1 per
cent, but that expenditure on imports has risen by 2 per cent thus worsening the
current account of the balance of payments.
One additional point that needs to be taken into account is the fact that changes are
shown in percentages, and their effect on the total value of exported and imported
goods and services will only be the same in real numbers if the totals were the
same to start with: eg if the totals were both 100, then the balance would be 100 -
100 = 0. Suppose they both increased by 10 per cent then the totals would be 110
and the balance 110- 110 = 0. However, if the export total was 100 and the import
total 200 the balance would be 200 - 100 = 100. Here a 10 per cent increase would
cause the balance to grow as 220 - 110 = 110.
10.4.6 The J curve effect

A devaluation or a depreciation of a currency may have a J-curve effect on revenue
and expenditure, as illustrated in the diagram below. Put simply, this shows that
things get worse before they get better.
Immediately after a fall in the value of the currency, the current balance worsens.
This is because imports will go up in price immediately and for a period of time
it will not be possible to reduce demand as most contracts of sale will have been
agreed. A similar situation will occur for exports as their prices will go down and
orders will be completed at lower prices. The immediate impact is to worsen the
current balance. However, over time, the lower prices for exports are likely to
increase sales and the higher prices for imports will reduce sales. Over time, and
given a favourable Marshall-Lerner condition, it is likely that the current account
balance will improve.

Figure 10.3 A currency depreciation
+
Change
in 0 time
current
balance
10.5 Foreign exchange
10.5.1 The theory of exchange rates
10.5.1.1 Purchasing power parity (PPP)

The earliest theory of exchange rate determination was that the rate of exchange
will settle at a point that will equalise spending power between economies. If
this did not happen, then it was argued that price differences would promote
trade across international borders until equilibrium was re-established. On the
face of it, the argument seems sound but for two apparent weaknesses. Firstly
real exchange rates do not actually equalise spending power and, in most cases,
are significantly different from a PPP rate. It may be possible to argue that this
is because of interference in foreign exchange markets by government. But there
is a second more powerful argument, and this is that not all items consumed
in one country are tradable between countries, ie we can distinguish between
tradables and non-tradables. This may be because of such things as different
tastes, perishability, transport costs, etc. This means that the supply and demand
for currency, in foreign exchange markets, is determined by only those goods,
services and assets that cross international borders. Those products that are
only consumed domestically may have different prices and also be a significant
proportion of any PPP calculation.
10.5.1.2 Market exchange rates

Do not be confused by the fact that it is two demands that determine the supply
of and demand for a currency. The demand for a currency is determined by the
demand for exports and the supply of a currency is determined by the demand
for imports.
Given this information, the price of a currency will be determined by the interaction
of supply and demand, as illustrated in Figure 10.4.

Foreign exchange
Figure 10.4
PQ is the market clearing price and it is important to note that the vertical axis is
labelled with a currency other than sterling. The only way a currency can be priced
is in another currency. In this case, dollars have been used.
There is also one other complication that needs to be addressed, in the case of
currencies as opposed to products, and that is the elasticity of demand for the
product from which the demand for the currency is derived.
The supply curve illustrated in Figure 10.4 is constructed on the assumption that
the demand for imports is elastic, therefore when the price of imports goes down,
more currency will be provided to buy more products.
Referring back to Topic 2 on elasticity, you will find that if the demand for imports
is unitary then the same amount of currency will be provided to buy more products
at lower prices and the supply curve, as illustrated in Figure 10.5, will be inelastic.
Even more interesting is the fact that if demand for imports is inelastic, then if the
price of imports goes down, less currency will be supplied to buy more imports and
in this case the supply curve will be upward sloping from right to left, as illustrated
in Figure 10.5 by S 3.
Figure 10.5

Changes in the equilibrium rate of exchange between currencies will result from
shifts in either the supply or demand curve for the currency at each and every
price. Things that are likely to trigger a shift in the curves are factors that cause
different reactions in different countries.
Changes in world prices will affect countries differently as will different rates of
inflation, economic growth and different policies. Changes in the markets for
individual products can affect exchange rates, particularly when the product is
a major import or export. One other significant change in the conditions of supply
or demand can result from changes in interest rates, especially when the change
is unilateral and brings about a difference from other and previous rates. There is
an enormous amount of surplus money in the world looking for a place for savings
and investments and the flow of funds in this area is significantly greater than the
total amount of goods and services traded over the same time period. If interest
rates in the UK are just 0.25 per cent above those in America, there is likely to be
a significant shift in demand for sterling to buy UK assets. So, other things being
equal, an increase in UK interest rates will cause an increase in the exchange rate
of sterling against other currencies, and vice versa.
10.5.2 Fixed or floating rates of exchange
10.5.2.1 The difference between a fixed and a floating

currency
It is actually not possible for the government to fix the price of a currency. All they
can do is influence the price of a currency by buying or selling the currency.
It should be noted that both fixed and floating exchange rates have their prices
determined by market forces and that the only difference between them is that a
totally free float involves no intervention buying and selling by the Bank of England
or another central bank. A fixed system is only fixed in the sense that government
overtly states that it will intervene in the markets to buy and sell currency to
maintain a target or par value for that currency. As the market determines the
price of the currency, so it is likely to move either side of the par value and this is
the signal for the Bank to intervene before it reaches a specified limit. In the past,
sterling was fixed at $2.40 but it allowed rises up to $2.42 and down to $2.38.
When the currency starts to get too close to its upper limit, the government,
through the Bank of England, will supply currency to the market and buy foreign
currency. When the rate is falling too low, the Bank will use up its foreign exchange
reserves to buy sterling and bring its price back up. Alternatively, or at the same
time, the Bank can change interest rates so as to achieve the desired movement in
the exchange rate (see above).
In fact, in most countries that have a floating currency, the float is not totally
free. The float is usually managed covertly so as to avoid any unexpected large
or volatile changes in currency price. Here, the government is intervening so the
float is described as a managed float or even a ‘dirty float’ because no target, or
preferred rate, has been announced.
10.5.2.2 The case for fixed rates

When people are thinking about buying foreign products, and when decisions are
made, there may be a considerable time before the order is complete. Just think

Foreign exchange
about buying your foreign currency for next year’s holiday. The time lag between
decision and execution can expose a person to considerable exchange rate risk
under a floating system. This can almost be eliminated under a fixed exchange
system so that a person can expect to maintain an agreed price in sterling over
a period of time. It is therefore argued that fixed exchange rates, by removing
exchange rate risk, provide more certainty and stability and therefore promote
business and international trade.
It has been argued by some economists that while governments are trying to
maintain a fixed exchange rate they will be discouraged from allowing domestic
demand and the money supply to expand too rapidly. They are therefore forced
into maintaining a stable currency and a low rate of inflation and both of these
would be considered preconditions for faster growth and more employment. This
argument has gained support even from people who praise the virtues of a floating
rate in an ideal world, but would settle for a fixed exchange rate as a second-best
solution in a world of irresponsible government management of the money supply
and fiscal policy.
10.5.2.3 The case for floating rates

There is a strong argument to support the view that the free market does its
best and therefore should be left alone to adjust exchange rates. Economies
are dynamic, things change and it is therefore necessary for different market
conditions to be reflected in different market prices and the exchange rate is no
exception. Although it is possible to revalue or devalue a fixed position, it is not
easy, whereas a floating price for currency will allow day-to-day adjustments. This
will then change the relative price of imports and exports to reflect changes in the
supply and demand conditions of a marketplace.
Information is available to predict precisely if a fixed exchange rate is at risk of
either revaluation or devaluation. A continuing and large current account deficit
is a measure of an overvalued currency that has only one way to adjust, which is
down. If speculators sell the currency, they will make money when the devaluation
occurs as they can buy back at the lower price or they will lose nothing if the
currency value is maintained. This is known as a speculators’ paradise as they
cannot lose. They are either right or they are not wrong. On the other hand, a
floating rate creates minute-by-minute adjustments to rates that mean currencies
will not become obviously over- or undervalued, thus removing the opportunity for
large speculative gains.
10.5.3 The eurozone and the single European currency

In 1999, a number of EU countries went one stage further than a fixed exchange
rate by adopting a single currency, the euro, to replace their own domestic
currencies.
The advantages of doing this included an efficiency gain from removing exchange
rate risk. There was also a cost advantage in as much as it would no longer be
necessary to trade in the currency before trading in the product for eurozone
members. The single currency would remove artificial restrictions to free trade
caused by different currencies and therefore bring about a more efficient allocation
of resources. Traders would be certain of eurozone prices and be able to sign
contracts without hidden risks. Arguably, the euro would create more stability and
transparency for prices as well as removing any opportunity to speculate in those
currencies absorbed by a single currency. Monetary policy would then be managed

by one central authority, the European Central Bank, which removes any political
influence on central banks in the way they manage monetary demand.
Against these arguments, some economists saw a risk of putting monetary controls
in the hands of a single central bank that may not act to serve the interests of all,
but concentrate on satisfying the demands of the more powerful countries. Initially
a problem existed in terms of the rate of exchange on entry into the union. A
decision had to be made, bearing in mind that once the decision had been made
that value would be locked into the euro. Arguably, Germany and France went in
at too high a rate and suffered recession, while Ireland and Spain went in too low
and underwent boom conditions.
Since its inception, a bigger problem has manifested itself as countries have come
together in terms of monetary harmony, but have pursued policies that have
imposed a fiscal disharmony on the eurozone and that have resulted in the poorer
countries owing money that they are unlikely ever to be able to repay. In fact, this
problem has become so big that at the time of writing (June 2012) there is every
chance of the eurozone breaking up or, at least, a few of the smaller and/or weaker
economies, like Greece and Portugal, leaving the union.
Even those countries that remain in the eurozone have a longer-term problem if
they grow at different rates to their competing other eurozone members. They
will no longer have the opportunity to manipulate their own monetary policy
and affect everyone a little bit by causing inflation. Instead they will be left with
unemployment taking on the burden of adjustment and this tends then to affect a
few people rather than a lot.
10.5.4 The foreign exchange market (Forex)

Traders, tourists, investors and public bodies need to exchange currencies and the
Forex market facilitates this activity. There are many operators in the market, a
uniform product (currency) and a quick response to price differences that has led
some economists to use this market as a close approximation of a near perfect
market. Each currency can be bought and sold at the current prevailing price (the
spot market) or at a price determined today but paid in the future (the forward
market).
When the world was made up of currencies and fixed exchange rates, the Forex
market was a spot market dealing in current deals at today’s price, for delivery
today. However, when the world’s main currencies floated against each other in
the early 1970s, the Forex market developed to compensate for a loss of certainty
about future prices for traded currencies. As we have already noted, firms prefer
to be protected from exchange rate risk and, to facilitate this, the Forex market
developed from just being a spot market into a market that allowed traders to
buy forward at rates agreed today. This forward market allowed a trader to buy
currency today for delivery in the future at a fixed price. This did not remove all
exchange rate risk as the price agreed today could be considerably lower in the
future, but it did provide certainty.
As well as fixed forward deals, it was possible to buy FX options. These meant
that, for a small down payment known as an option premium, a person could buy
the option to buy a currency in the future at a fixed price. This option could then
be exercised if its price was better than the market price on the day of expiry of
the option; or ignored if this price was not favourable, in which case the option
premium would be forfeited.

International organisations and international trade
10.6 International organisations and international

trade
10.6.1 Introduction
Because international trade takes place in a multilateral way rather than in a
bilateral way, it has become important for organisations outside any one country
to oversee, manage, discipline and develop international rules and regulations,
not only to see fair play, but also to protect the less powerful economies from
the more powerful countries and groups of countries. Some of those important
organisations are described below. The first and second are concerned with the
monetary policies of all countries, the third acts as a banking intermediary for the
world’s surplus and deficit sectors, and the last looks at creating a free and fair
trading situation for the world economy.
10.6.2 The International Monetary Fund (IMF)

In July 1944 a conference at Bretton Woods, the US, set up a gold exchange
standard whereby the main trading nations fixed their exchange rates to the dollar
and the USA fixed the price of gold at $35 per ounce. This meant that all countries
had access to gold through their central banks and only they could exchange
dollars for gold.
At the same time the IMF was established to stabilise exchange rates and assist
with the reconstruction of the international payments system after the 1939−45
War. It was recognised that countries may have temporary problems in maintaining
international liquidity and the IMF allowed them special drawing rights (SDRs) for
foreign currency. Also, if a currency became significantly over- or undervalued the
IMF would be involved in managing a revaluation or devaluation of the currency.
By 1972 most countries had moved away from fixed rates to floating currencies.
This meant that the role of the IMF changed to one of examining the
economic policies of member countries and assessing their overall macroeconomic
performance. Since the credit crunch of 2008/09 and the problems of the euro and
various eurozone countries, the IMF has been in the background producing reports
offering advice and providing emergency funding.
Overall, the IMF is now involved in more of a surveillance role, looking not only
at balance of payments and currency problems, but also at the appropriateness
of economic policies for achieving growth, stable prices and high levels of
employment.
10.6.3 The Bank of International Settlements (BIS)

The BIS is an organisation that has all the main central banks as members. One of
its important aims is to harmonise monetary policies and keep them transparent.
Underneath this umbrella it has two main targets. The first is to regulate capital
adequacy and, through its Basel Committee on Banking Supervision, it has been
involved in establishing three Basel Capital Accords that aim to keep banks solvent
by creating rules for how much capital, mainly in the form of shareholder funds,
they should hold as a proportion of their total risk weighted assets. The second
target is to look at banks’ liquid reserves and therefore their ability to manage

customer liability. Banks need to always be able to satisfy customer demand for
cash and therefore, to avoid the systemic risk of a run on the banks, they must
hold sufficient cash reserves.
10.6.4 World Trade Organization (WTO)

Although not set up until January 1995, the WTO absorbed the General Agreement
of Trade and Tariffs (GATT) and widened its brief. The GATT had been established
in 1946 and was the sole body looking after the development of international trade.
The role of GATT and now of the WTO is to try to promote as much free trade as
possible given the position it has inherited. It is concerned with promoting fairness
and transparency in multilateral trade and the removal of bilateral agreements
between countries that show favouritism to one country rather than all countries.
Wherever possible, the WTO is concerned with reducing both tariff and non-tariff
barriers to trade.
Since 2001 the WTO has concerned itself with negotiating under the Doha
Development Rounds to promote and protect the less developed countries from
being discriminated against, particularly in agricultural trade. It sees the process
of globalisation as one that must include all nations and give the poorer nations
equal and fair access to markets in more developed countries. This means reducing
barriers and, in the case of the EU’s Common Agricultural Policy, removing import
levies and export subsidies. The target is to ensure that comparative advantage
determines who produces what and not to protect inefficient producers from
competition.
10.6.5 The World Bank

Established in 1944, the World Bank is exactly what its title describes, and that is an
intermediary on an international scale. It is concerned with channelling funds from
the rich surplus countries to the poorer deficit countries. The World Bank comprises
two main institutions, which are the International Bank for Reconstruction and
Development (IBRD) and the International Development Association (IDA).
The IBRD was originally set up after the 1939−45 War to promote reconstruction
and development in war-torn countries. However, its brief today is to promote
development in middle income and creditworthy poor countries. It provides loans
to governments and to enterprises that have a sovereign backed guarantee of
repayment. It issues triple A rated World Bank bonds to finance its operations and
it can therefore raise funds and make loans at favourable rates.
The World Bank recognises that there is another rank of countries below those that
can access funds through the IBRD and it is the IDA, which focuses on the poorest
countries that would not be considered creditworthy and could not raise loans in
international markets. It is funded by donations from richer countries. In the past,
the USA and the UK have been the biggest contributors. IDA funds are used mainly
to promote primary education, basic health and sanitation and an infrastructure
that will be the foundation for growth and future prosperity.
Since 2000 the World Bank has focused its attention on the Millennium
Development Goals for:
u eradicating extreme poverty;
u achieving universal primary education;

Summary
u promoting gender equality;

u reducing child mortality;
u improving maternal health;
u combating HIV/AIDS, malaria and other diseases;

u ensuring environmental sustainability; and
u developing a global partnership for development.
Summary
u The theory of comparative advantage states that international trade makes us
all better off on average.
u Favourable movements in the terms of trade are likely to have unfavourable

effects on the UK balance of payments.
u Protecting ourselves from free trade may be an advantage under certain

circumstances.
u Customs unions benefit the world economy when they are a move towards freer
trade.
u The Common Agricultural Policy of the EU is arguably a waste of scarce
resources.
u Overall, the balance of payments always balances − it is the imbalance on the

current account that is of most concern.
u Devaluations and depreciations in the external value of a currency may be

successful, but this is not always the case, as the Marshall-Lerner condition
proves.
u A strong case can be made out for either a fixed or a floating exchange rate
system.
u As a point of discussion one can question whether massive international flows
of products, currencies, assets and funds need international organisations to
manage them.
References
Pearce, I.F. (1970) International Trade. London: Macmillan.


Index

Index
A C
Abnormal profit, 3.1.2.1 Capital account, 10.4.1
Absolute advantage, 10.1.2 Capital adequacy ratios, 8.2.4
Accelerating inflation, 7.1.1 Capital depreciation, 5.3.2
Accelerator theory, 6.5, 7.4.4.3 Capital gains tax, 9.2.2.2
Advertising, 4.8 Capital goods, 5.5.7
Aggregate demand, 6.2.1.1, 7.1.4.1, 9.7 Capitalism, 1.5.1, 1.5.3, 7.5.4.4
free market monetarist model, 6.2.2, Cash, 8.1.4, 8.1.5
9.7.2 Cash economy, 5.4.2
Keynesian model, 6.2.2, 9.7.1 Cash management, 8.3.2.3
Aggregate supply, 6.2.1.1, 7.1.4.1 Cash ratio, 8.2.11
Allocative efficiency, 3.1.7, 4.2.1 Casual unemployment, 7.3.3.2
Alternative foregone, 2.1.2.3, 10.1.1 Central banks, 7.2.2.2
Asset management, 8.2.8 Centralism, 1.5.2
Asymmetric information, 3.8.3, 4.4.1, Choice, 1.2.3
4.4.2, 8.2.2.3 Circular flow of income theory, 6.1
accelerator theory, 6.5
B aggregate demand and supply model,
Balance of payments, 7.6, 10.4, 10.4.1 6.2.2
deficit, 10.4.3 five sector model, 6.1.2.4
disequilibria, 10.4.3, 10.4.4 four sector model, 6.1.2.3
Marshall-Lerner condition, 10.4.6 multiplier theory, 6.4
surplus, 10.4.3 the paradox of thrift, 6.6
zero balance, 10.4.2 three sector model, 6.1.2.2
Balance of payments current account, two sector model, 6.1.2.1
10.4.1 withdrawals/injections model, 6.3
Balance of payments disequilibria, 5.5.5, Club goods, 1.5.4.2
7.1.4.2 Cobweb theory, 2.3.5
Balanced budget multiplier, 9.5.4 Coins, 8.1.4, 8.1.5
Bank credit multiplier, 8.2.11 Collectivism, 1.5.2, 1.5.3
Bank of England, 7.1.4.3, 7.2.2.2 Command economy, 1.2.3, 1.4, 1.5.2,
Bank Rate, 8.2.7, 8.3.2.2 1.5.3
history, 8.3.1 Comparative advantage, 10.1.3, 10.2.4,
monetary policy, 8.3.2 10.3.2
national debt holdings, 9.3.2.2 Competition, 3.1
Bank of International Settlements (BIS), oligopoly model, 3.4.2.1
10.6.3 Competition Commission, 3.2.1
Bank Rate, 8.2.7, 8.3.2.2 Conspicuous consumption goods, 2.1.5.4
Banking Consumer goods, 5.5.7, 5.6.5
crises, 8.1, 9.8 Consumer theory
intermediation, 8.2.2 demand curves, 2.1.4.1
liquidity: profitability conflict, 8.2.3 indifference curves and budget lines,
money creation, 8.2.9 2.1.4.2
nationalisation, 8.2.4 Consumers
origins of, 8.2.1 budget constraints, 2.1.3.3
Barro, Robert, 6.4.1 equilibrium, 2.1.4.2
Barter, 8.1.1 rational behaviour of, 2.1.2.1
Basel Accords, 8.2.4 sovereignty, 1.5.1, 3.5.2.4
Basel Committee on Banking Supervision, Consumption, 6.2.1.2
8.2.4, 8.3.4, 10.6.3 Consumption foregone, 5.5.7
Beveridge, William, 7.3.2.1 Contestable markets, 3.6
Black market, 2.3.4.2, 5.4.2 Contrived scarcity, 3.2.2.3
Boom, 7.4.2 Core money, 8.1.8, 8.3.2.1
Budget deficit, 9.3.1, 9.3.2.1 Corporation tax, 9.2.2.2
Budget gap, 9.5.2 Cost functions, 2.2.2, 2.2.3
Budget lines, 2.1.3.3, 2.1.4.2 Cost push, 7.1.2.1, 7.1.4.2, 7.3.4
constant opportunity costs, 2.1.3.4 Cost-plus pricing, 3.7.4
variable opportunity costs, 2.1.3.5 Credit crunches, 7.2.2.2
Budget multiplier effect, 9.5.4 Credit money, 8.3.2.1, 8.3.2.2
Budget surplus, 9.5.3 Credit risk, 8.2.2.3
Business confidence, 7.4.4.2 Creeping inflation, 7.1.1

Index
Cross elasticity of demand, 2.1.6.4 E

Currency exchange, 10.4.3 Economic cycles, 7.4
deflation and, 7.2.3.4 irregular fluctuations, 7.4.3
exchange rates, 5.6.1 Keynesian theories, 7.4.4.3
Forex traded currency, 5.6.2 monetarist theories, 7.4.4.4
inflation and, 7.1.3.4 regular cyclical events, 7.4.2
Current account deficit, 5.5.5, 7.1.4.2, theories, 7.4.4
10.4.4 Economic goods, 1.3, 1.5.4.2, 2.1.5.4, 4.5,
Current account surplus, 5.5.5, 10.4.4 4.6
Customs union, 10.3.2, 10.3.3 government role in allocation, 1.5.4.3
Cyclical unemployment, 7.3.3.3 non-optimal allocation, 4.6.3
opportunity cost, 1.6
D Economic problem, the, 1.2
Debt Economic welfare, 5.7
deflation and, 7.2.3.3 Economies of scale, 2.2.3, 3.2.2.2, 3.5.3.1,
inflation and, 7.1.3.3 10.3.2
the national debt, 9.3.1, 9.3.2, 9.3.2.3 Effective demand, 2.1.1
Default risk, 8.2.2.3 Efficiency, 4.2.1
Deficit sector, 8.2.2.1 monopolies, 3.2.3.3, 3.5.3.2
Deflation, 2.1.5.4, 7.2 monopolistically competitive model,
benefits, 7.2.3.8 3.3.5
causes, 7.2.2 Pareto optimality, 3.5.2.1
currency, 10.4.3 perfect competition, 3.1.7, 3.5.2.1
definition, 7.2.1 Elasticity of demand, 2.1.6
effects, 7.2.3 Elasticity of supply, 2.2.7, 2.2.7.2
gap, 9.5.2 Employment, 6.2.2, 7.3.2.1
monetarist controls, 7.2.4.3 Employment equilibrium, 7.1.4.2, 9.5.2,
post-Keynesian controls, 7.2.4.2 9.5.3
pre-Keynesian controls, 7.2.4.1 Entry barriers, 3.2.2.1, 3.4.1.2
unemployment and, 7.3.1 Environmental issues, 7.5.5.3
Deliberate monopolies, 3.2.2.3 Doomsday case, 7.5.6.1
Demand curves, 2.1.4.1 Equality, 4.7.1
interaction with supply curves, 2.3.2 Equilibrium price. see Market clearing price
oligopoly model, 3.4.1.3 EU Common Agricultural Policy (CAP),
perfectly competitive firms, 3.1.3 10.3.3, 10.3.4, 10.6.4
Demand pull, 7.1.2.1, 7.1.4.2 euro, the, 10.5.3
Demand schedules, 2.1.6.1.3 European Free Trade Area (EFTA), 10.3.6
Demand theory, 2.1 European Union, the, 10.3.5
consumer theory, 2.1.4 Common Agricultural Policy (CAP),
elasticity of demand, 2.1.6 10.3.3, 10.3.4, 10.6.4
market demand, 2.1.5 eurozone, 10.5.3
paradox of value, 2.1.3 Excessive profit, 3.1.2.1
utility, 2.1.2 Exchange rates, 5.6.1
Demand-deficient unemployment, 7.3.3.4 deflation and, 7.2.3.4
Demerit goods, 1.5.4.2 fixed, 10.5.2.1, 10.5.2.2
definitions, 4.6.1 floating, 10.5.2.1, 10.5.2.3
interventionism and, 9.2.1 inflation and, 7.1.3.4
and market imperfections, 4.6 market exchange rates, 10.5.1.2
Depreciation, 5.3.2, 10.4.3, 10.4.6 Marshall-Lerner condition, 10.2.2
Depression, 7.3.3.3, 7.4.2 purchasing power parity, 10.5.1.1
Devaluation, currency, 10.4.3 Excise duty, 9.2.2.4
Diamond-water paradox, 2.1.3 Expected utility, 2.1.2.3
Direct taxes, 9.2.2, 9.2.2.2 Export unemployment, 7.3.3.6
Diseconomies of scale, 2.2.3 Exports, 6.2.1.2, 6.3, 10.1.5, 10.2.2. see
Disguised unemployment, 7.3.3.5 also International Trade
Disposable income, 6.2.1.2 cost of insurance and freight (CIF),
Doha Development Rounds, 10.6.4 10.4.1
Doomsday case, 7.5.6.1, 7.5.6.2 demand and supply, 10.5.1.2
Double counting, 5.4.4 free on board (FOB), 10.4.1
Dumping, 10.2.3 Externalities, 4.3, 5.4.5
Dynamic efficiency, 3.5.3.2 definitions, 4.3.1
Index
Externalities continued HM Treasury, 8.3.1

and resource misallocation, 4.3.2 Human development index (HDI), 5.7.2
Hyperinflation, 7.1.1
F
Financial account, 10.4.1 I
Financial Conduct Authority, 8.3.4 Imperfect information, 2.1.2.1, 5.4.6
Financial Crisis 2008, 9.8 Imports, 6.2.1.2, 10.1.5, 10.2.2, 10.2.4.
Financial Policy Committee (FPC), 8.3.1, see also International Trade
8.3.4 cost of insurance and freight (CIF),
Financial Services Authority (FSA), 8.3.1 10.4.1
Fiscal policy, 9.1 demand and supply, 10.5.1.2
demand management policy, 9.7.1 free on board (FOB), 10.4.1
Keynesian approach, 9.5 Income distribution, 1.5.3, 4.7.1, 4.7.2,
monetarist approach, 9.6 4.7.3, 4.7.4, 5.5.6
supply side policy, 9.7.2 deflation and, 7.2.3.1
taxation, 9.2.2 inflation and, 7.1.3.1
Fisher, Irving, 8.3.3.2 Income elasticity of demand, 2.1.6.5
Fixed exchange rates, 10.5.2.1, 10.5.2.2 Income flows, 6.1.2
Floating exchange rates, 10.5.2.1, 10.5.2.3 consumption rates and, 6.2.1.2
Foreign exchange market (Forex), 5.6.2, models of equilibrium, 6.2.1
10.5, 10.5.2, 10.5.4 Income tax, 9.2.2.2, 9.2.2.5
deflation and, 7.2.3.4 Index numbers, 5.3.4
inflation and, 7.1.3.4 Index of Sustainable Economic Welfare
Free goods, 1.3 (ISEW), 5.7.3
Free markets, 1.5.1 Index-linking, 7.1.4.4
'Free rider' problem, 1.5.4.3, 4.5.1, 4.5.2 Indifference curves, 2.1.4.2
Free trade, 10.2.1, 10.3.2 Indifference maps, 2.1.3.2
Frictional unemployment, 7.3.3.7 Indirect taxes, 9.2.2, 9.2.2.4
Friedman, Milton, 6.2.1.2, 7.1.2.2, 8.3.3.2 Inefficiency, 4.2.2
Funded debt, 9.3.2.1 Infant industries, 10.2.3, 10.2.4
Inferior goods, 2.1.5.4
G Inflation, 2.1.5.4, 6.2.2, 7.1.1
Game theory, 3.4.2.2 adjuster, 5.5.4
General Agreement on Trade and Tariffs benefits, 7.1.3.8
(GATT), 10.3.1, 10.6.4 causes, 7.1.4.2, 7.3.4
Gold, 7.2.2.1, 8.1.4, 8.2.1, 8.2.12 effects, 7.1.3
Gold standard, 8.2.1 gap, 9.5.3
Goldsmiths' notes, 8.2.1 index-linking, 7.1.4.4
Government Keynesian causes, 7.1.2.1
economic targets, 9.2.1 Keynesian controls, 7.1.4.2
expenditure, 6.2.1.2, 9.4 monetarist causes, 7.1.2.2
interventionism, 4.5.2, 4.10 monetarist controls, 7.1.4.3
role in public finance, 9.2.1 Information failure, 4.4.1, 4.4.2
Gross Domestic Product (GDP) deflator, Inheritance tax, 9.2.2.2
5.3.4 Injections function, 6.3
Gross National Income (GNI), 5.3.2 Innovation, 7.5.4.1
Gross National Product (GNP), 5.3.2 International Bank for Reconstruction and
Growth, 7.5.2 Development (IBRD), 10.6.5
absolute limits to, 7.5.6 Interest rates
benefits of, 7.5.3 Bank Rate, 8.2.7, 8.3.2.2
costs, 7.5.5 ISLM model, 8.2.6
deflation and, 7.2.3.5 liquidity preference theory, 8.1.9
inflation and, 7.1.3.5 loanable funds theory, 8.2.5
peaks and troughs, 7.5.1 policy, 8.3.2.2
sources, 7.5.4 structure and level, 8.2.7
Intermediation
benefits, 8.2.2.2
H surplus and deficit sectors, 8.2.2.1
Happiness index, 5.7.4 International Development Association
Hayek, Friedrich, 7.1.2.2 (IIDA), 10.6.5
HM Revenue and Customs, 9.2.2 International Monetary Fund (IMF), 10.6.2

Index
International trade, 10.5 M

customs union, 10.3.2, 10.3.3 Marginal firms, 3.1.6
EU Common Agricultural Policy (CAP), Marginal propensity to consume, 6.2.1.2
10.3.4 Marginal propensity to save, 6.2.1.2
European Single Market, 10.3.5 Marginal utility, 2.1.2.2, 2.1.3, 2.1.3.1
foreign exchange market, 10.5 Market adjustment, 7.2.4.1
free trade, 10.2.1 Market clearing price, 1.4, 2.3.1
Marshall-Lerner condition, 10.4.5 in a capitalist free market, 1.5.1
opportunity cost ratios, 10.1.1, 10.1.4 Market demand, 2.1.5
protectionism, 10.2.1, 10.2.2, 10.2.3, Market distortions, 2.3.4
10.2.4, 10.3.1 Market dominance, 4.8
terms of trade, 10.1.5 Market exchange rates, 10.5.1.2
Interventionism, 1.5.4, 1.5.4.3, 4.5.2, 4.10, Market failure
9.1 merit goods and, 4.6
merit goods, 4.6.2, 9.2.1 public goods and, 4.5
Intra-marginal firms, 3.1.6 Market imperfections
Invisible balance, 10.4.1 asymmetric information, 4.4.1
ISLM model, 8.2.6 efficiency, 4.2.1
externalities, 4.3
J inefficiency, 4.2.2
J curve effect, 10.4.6 inequalities in income and wealth, 4.7
labour force immobility, 4.9
K market dominance, 4.8
Keynes, John Maynard, 6.2.2, 6.4.1, Marketable debt, 9.3.2.1
7.1.2.1, 8.3.3.1, 9.1, 9.5, 9.9.1 Marshall-Lerner condition, 10.2.2, 10.4.3,
Kondratief cycle, 7.4.3 10.4.5
Maturity transformation, 8.2.2.2
Measure of Economic Welfare (MEW), 5.7.3
L Medium of exchange, 8.1.6
Labour force. see also employment; Merit goods, 1.5.4.2, 3.8.1.1
unemployment definitions, 4.6.1
investment leading to growth, 7.5.4.2 interventionism and, 4.6.2, 9.2.1
mobility, 4.9, 7.5.4.3 and market imperfections, 4.6
skills and training, 4.9.3 Millennium Development Goals (MDG),
working conditions, 5.5.8 10.6.5
Laffer curve, 9.2.2.3 Misery index, 5.7.4
'Laissez-faire', 1.5.1, 1.5.3 Mis-selling, 8.2.2.3
Law of diminishing marginal utility, Mixed economy, 1.5.3, 1.5.4.5
2.1.2.2, 2.1.3.1, 2.1.4.1 Modigliani, Franco, 6.2.1.2
Law of variable proportions, 2.2.2 Monetarism, 8.3.3.2, 9.6, 9.9.2
Legal tender, 8.1.5 Monetary contraction, 7.2.2.2
Lehman Brothers, 7.2.2.2, 9.8 Monetary policy, 8.3.2
Lending, 8.2.2 interest rates, 8.3.2.2
Liability management, 8.2.8 Keynesian approach, 8.3.3.1
Life cycle hypothesis, 6.2.1.2 monetarist approach, 8.3.3.2
Liquidity, 8.2.3, 8.2.4 Monetary Policy Committee (MPC), 8.3.1
Liquidity preference theory, 8.1.9 Money
Living standards, 5.5 characteristics, 8.1.3, 8.1.5
cross-country comparisons, 5.6 demand for, 8.1.7, 8.2.10, 8.2.11
deflation and, 7.2.3.6 functions of, 8.1.6
inflation and, 7.1.3.6 modern forms, 8.1.4
reflected in human development index origins of, 8.1.2
(HDI), 5.7.2 Money creation, 8.2.9
reflected in national income statistics, Money illusion, 1.6
5.5 Money supply, 7.1.4.3, 8.1.8, 8.2.10
Loanable funds theory, 8.2.5 interest rates and, 8.1.9
Long run production, 2.2.3 Money values, 5.4.1, 5.5.4
Long run profit, 3.1.2.1 Monopolies, 1.5.1, 3.2
Long-run profit maximising equilibrium, vs. competition, 3.5
3.1.5.2, 3.3.4 consumer choice and, 3.5.3.3
Long-term debt, 9.3.2.1 cost curves, 3.2.3.1
Index
Monopolies continued Overproduction, 7.4.4.1

deliberate monopolies, 3.2.2.3 Ownership, 3.7.2
economies of scale, 3.5.3.1
efficiency and, 3.2.3.3, 3.5.3.2 P
natural monopolies, 3.2.2.2, 3.8.1.2 Paper money, 8.1.4, 8.2.12
and price discrimination, 3.2.3.4 Paradox of equality, 1.5.3
profit maximising equilibrium, 3.2.3.2 Paradox of thrift, 6.6
Monopolistically competitive model, 3.3 Paradox of value, 2.1.3
characteristics, 3.3.2 Pareto efficiency, 3.5.2.1, 4.2.1
efficiency and, 3.3.5 Peaks and troughs, 7.4.3
profit maximising equilibrium, 3.3.3 Pecuniary benefits, 5.5.8
Monopsonies, 1.5.1 Peer-to-peer lending, 8.2.2.2
Moral hazard, 8.2.2.3, 10.2.4 Per capita income, 5.5.2, 5.6.4
Motoring taxes, 9.2.2.4 Perfect competition, 3.1
Multiplier theory, 6.4, 7.4.4.3 assertions, 3.1.2
algebraic formulation, 6.4.3 assumptions, 3.1.1
balanced budget multiplier, 6.4.5 consumer sovereignty and, 3.5.2.4
graphical formulation, 6.4.4 demand curve, 3.1.3
the multiplier round, 6.4.2 efficiency and, 3.1.7, 3.5.2.1
industry, 3.1.8
N marginal and intra-marginal firms, 3.1.6
National debt, 9.3.1, 9.3.2, 9.3.2.3 vs. monopolies, 3.5
holdings, 9.3.2.2 producing variety, 3.5.2.2
National income statistics, 5.1, 5.4 profit maximising equilibrium, 3.1.5
collection methods, 5.5.3, 5.6.3 profitability, 3.5.2.3
comparing living standards, 5.6 supply curve, 3.1.4
gross numbers, 5.3.1 Permanent income hypothesis, 6.2.1.2
measurement, 5.3.3, 5.3.4 Perverse demand curves, 2.1.5.4
net numbers, 5.3.2 Phillips curve, 7.3.4
reflecting living standards, 5.5 Point elasticity, 2.1.6.1.2
Natural monopolies, 3.2.2.2, 3.8.1.2 Political disorder, 7.1.3.7, 7.2.3.7
Natural resources, 5.6.6 Political systems
Near money, 8.1.5 capitalist free market, 1.5.1, 1.5.3
Negative externalities, 4.3.1, 4.3.2.1, 5.4.5 command economy, 1.2.3, 1.4, 1.5.2,
Net errors and omissions, 10.4.1 1.5.3
Net property income, 5.3.2 international, 5.6.7
Net trade creation, 10.3.2 mixed economy, 1.5.3, 1.5.4.5
Neutral budget, 9.5.4 Population statistics, 5.5.2
Nominal numbers, 5.3.4 Positive externalities, 4.3.1, 4.3.2.2, 5.4.5
Non-accelerating inflation rate of Poverty trap, 7.3.3.8, 9.2.2.5
unemployment (NAIRU), 7.3.2.2 Precautionary demand, 8.1.7
Non-marketable debt, 9.3.2.1 Price discrimination, 3.2.3.4
Non-pecuniary benefits, 5.5.8 Price elasticity of demand, 2.1.6.1
Non-price competition, 3.4.2.1 estimates and predictions in, 2.1.6.3
Normal goods, 2.1.5.4 expenditure, 2.1.6.2
Normal profit, 3.1.2.1 expenditure and, 2.1.6.2
Northern Rock, 8.2.4, 8.2.12, 9.8 Price elasticity of supply, 2.2.7, 2.2.7.2
Price theory, 2.3
O changes in demand and supply, 2.3.2
Official financing, 10.4.1 the cobweb theory, 2.3.5
Oligopolies, 3.4 equilibrium price and output, 2.3.1
characteristics, 3.4.1 market distortions, 2.3.4
pricing behaviour, 3.4.2 maximum and minimum pricing policies,
Open market operations, 8.3.2.3 2.3.4.4
Opportunity cost, 1.6, 2.1.2.3, 7.5.5.1, 9.4 surplus and, 2.3.3, 2.3.4.3
budget line shifts, 2.1.3.4, 2.1.3.5 Principle of adverse selection, 8.2.2.3
international trade, 10.1.1, 10.1.4 Private ownership, 3.8.2
Optimal allocation of resources, 3.5.2.1, Producer sovereignty, 1.5.3
4.3.3 Product quality, 5.4.3
Output, 2.2.2, 2.3.1 Production costs, 2.2.2, 2.2.3
Production possibility boundary, 1.6

Index
Productive efficiency, 3.1.7, 4.2.1, 7.5.4.2 Senile industries, 10.2.3, 10.2.4

Profit, 3.1.2.1 Shareholders, 3.7.2
banks, 8.2.3 Short run production, 2.2.2
competitive markets, 3.5.2.3 Short run profit, 3.1.2.1
maximisation, 3.1.5.1, 3.1.2.2, 3.2.3.2, Shortages, 1.5.2, 1.5.3
3.1.5.2, 3.7.1 Short-run profit maximising equilibrium,
Progressive tax, 9.2.2, 9.2.2.2 3.1.5.1, 3.3.3
Proportional tax, 9.2.2 Smith, Adam, 9.2.2
Protectionism, 10.2.1, 10.2.2, 10.2.3, Social disorder, 7.1.3.7, 7.2.3.7
10.2.4 Social security payments, 4.7.4, 7.3.3.5,
Public goods, 1.5.4.2, 3.8.1.1, 4.5.1 7.3.3.8, 9.2.2.5
Public ownership, 3.8.1 Solvency ratios, 8.2.4
Public sector debt repayment (PSDR), 9.3.1 Specialisation, industry, 10.1.4
Public sector net cash requirement Speculative demand, 8.1.7
(PSNCR), 9.3.1 Speculative goods, 2.1.5.4
Purchasing power parity, 5.6.1, 10.5.1.1 Stagflation, 1.5.3, 8.3.2.2, 9.5.4
Stamp duty, 9.2.2.4
Q Standard of deferred payment, 8.1.6
Quantitative easing, 7.2.2.2, 8.2.12, State benefits, 7.3.3.5, 7.3.3.8, 9.2.2.5
8.3.2.3, 9.8 Store of wealth, 8.1.6
Quasi-public goods, 1.5.4.2 Structural unemployment, 7.3.3.12
Supply curves
the firm, 2.2.4
R industry, 2.2.5
Real numbers, 5.3.4 interaction with demand curves, 2.3.2
Recession, 7.3.3.3, 7.4.2 perfectly competitive firms, 3.1.4
Recovery, 7.4.2 shifts and movements, 2.2.6
Redistributive policies, 4.7.4 Supply side policy, 9.7.2
Redundancy, 7.5.5.2 Supply theory, 2.2
Reflation, 7.2.1, 7.3.1 cost functions, 2.2.2
currency, 10.4.3 elasticity of supply, 2.2.7
Regional unemployment, 7.3.3.9 firms' supply curves, 2.2.4
Regressive tax, 9.2.2, 9.2.2.4 industry supply curves, 2.2.5
Regulation, 8.3.4 in the long run, 2.2.3
Resource allocation, 1.4, 1.5, 3.5.2.1 in the short run, 2.2.2
cost-benefit analysis, 1.5.4.4 Supranational organisations, 10.3
economic growth rates and, 7.5.4.3 Surplus, 1.5.2, 2.3.3, 8.2.2.1
government role, 1.5.4.3
non-optimal allocation, 4.6.3
optimal allocation, 3.5.2.1, 4.3.3
T
Pareto efficiency, 4.2.1 Taxation, 4.5.2, 4.7.4, 6.2.1.2, 9.2.2
Resources avoidance, 9.2.2.2
choice, 1.2.3 direct taxes, 9.2.2.2
economic goods, 1.5.4.2 evasion, 5.4.2, 9.2.2.2
natural resources, 5.6.6 government spending and, 9.4
scarcity, 1.2.2 indirect taxes, 9.2.2.4
Revaluation, currency, 10.4.3 rates, 9.2.2.3
Reverse income tax, 9.2.2.5 revenue, 9.2.2.3, 9.2.2.4
Risk, 8.2.2.2, 8.2.2.3 Technical unemployment, 7.3.3.13
Royal Commission on the Distribution of Terms of trade, 10.1.5
Income and Wealth, 4.7.3 Theories of the firm
contestable markets, 3.6
monopolies, 3.2, 3.5
S monopolistically competitive model, 3.3
Sacrificing theory, 3.7.3 oligopoly model, 3.4
Sales maximisation, 3.7.2 perfect competition, 3.1, 3.5
Samuelson, Paul, 6.4.1 private ownership, 3.8.2
Savings and investment, 6.2.1.2 profit maximisation, 3.7
Scarcity, 1.2.2, 3.2.2.3 public ownership, 3.8.1
Search unemployment, 7.3.3.10 sacrificing theory, 3.7.3
Seasonal unemployment, 7.3.3.11 Total utility, 2.1.3, 2.1.3.1
Self-provided products, 5.4.1 Trade barriers, 10.2.1, 10.3.1, 10.3.2
Index
Trade cycles, 7.4.2

Trade quotas, 10.2.2
Trade tariffs, 10.2.2
Trade unions, 7.1.3.1, 7.1.4.2
Transactionary demand, 8.1.7
Treasury bills, 9.3.2.1
Treaty of Rome 1957, 10.3.2
U
Underemployment equilibrium, 6.2.2,
7.1.4.2
Underproduction, 7.4.4.1
Unemployables, 7.3.3.14
Unemployment, 7.3, 7.3.1
deflation and, 7.3.1
non-accelerating inflation rate of
unemployment (NAIRU), 7.3.2.2
types of behaviour, 7.3.3
wage rates and, 7.3.4
Unit of account, 8.1.6
Utility, 2.1.2.1
indifference curve, 2.1.3.1
indifference map, 2.1.3.2
law of diminishing marginal utility,
2.1.2.2
marginal rate of substitution, 2.1.3.1
measurements of, 2.1.2.3
opportunity cost, 2.1.2.3
V
Value added tax (VAT), 9.2.2.4
Visible balance of trade, 10.4.1
Voluntary unemployment, 7.3.3.15
W
Wage rates, 7.3.4
Wall Street Crash 1929, 7.2.2.2, 7.3.1
Wealth distribution, 1.5.3, 4.7.1, 4.7.2,
4.7.3, 4.7.4, 5.5.6
deflation and, 7.2.3.2
inflation and, 7.1.3.2
Withdrawals function, 6.3
Working conditions, 5.5.8
World Bank, 10.6.5
World Trade Organisation (WTO), 10.3.1,
10.6.4
World War I, 7.3.1
Z
Zero balance, 10.4.2
Zero inflation, 7.1.3.8

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Economics

The ifs School of Finance is a registered charity, incorporated by Royal Charter.

ifs School of Finance

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© ifs School of Finance 2012

1 Economics and the economic problem 1

© ifs School of Finance 2012 v

In this topic we will cover the following:

u the mix of mechanisms used to allocate resources throughout the world

u the degree to which governments become involved in mixed economies.

1.2 The economic problem

1.2.1 Not to be confused with economic problems

© ifs School of Finance 2012 1

When a product is produced and consumed freely in a market economy then it

1.3 Free goods and economic goods

2 © ifs School of Finance 2012

1.4 Resource allocation

1.5 Different political systems for allocating

1.5.1 A capitalist free market

© ifs School of Finance 2012 3

1.5.2 A command economy

Production will be under the direction of a central authority. Quotas will be

1.5.3 A mixed economy

u the development of markets where producer sovereignty replaces consumer

4 © ifs School of Finance 2012

1.5.4 Rationalising economic intervention

1.5.4.2 Types of economic good

© ifs School of Finance 2012 5

The private good

6 © ifs School of Finance 2012

1.5.4.3 A role for government

1.5.4.4 Cost−benefit analysis

© ifs School of Finance 2012 7

It is the task of cost−benefit analysis to estimate these matters in money terms

1.5.4.5 A cautionary note

8 © ifs School of Finance 2012

1.6 Opportunity cost: A real measure

© ifs School of Finance 2012 9

u The economic problem is fundamental to economics and should not be

10 © ifs School of Finance 2012

‘Man is the only creature that consumes without producing.’

In this topic we will cover the following:

u the supply functions of the firm and the industry;

2.1 The theory of demand

2.1.1 Demand and demand aggregates

© ifs School of Finance 2012 11

2.1.2 The concepts used in demand analysis

2.1.2.1 Utility and utility maximisation

2.1.2.2 The law of diminishing marginal utility

12 © ifs School of Finance 2012

2.1.2.3 Can utility be measured?

© ifs School of Finance 2012 13

2.1.3 The paradox of value

14 © ifs School of Finance 2012

Marginal Utility Schedule for Diamonds

Marginal Utility Schedule for Water

2.1.3.1 The shape of an indifference curve

© ifs School of Finance 2012 15

16 © ifs School of Finance 2012

2.1.3.2 The indifference map

© ifs School of Finance 2012 17

It is important to remember when drawing a map of indifference curves, as

Figure 2.5 An indifference map