9781398308282CambEconsWorkBook AnswersFinal

Cambridge International AS & A Level Economics
Workbook answers
Cambridge Assessment International Education bears no responsibility for the example answers
contained in this publication.
1 Basic economic ideas and resource allocation

(Chapter 1)
Multiple-choice
1 B
2 D
Data response
1 a Human capital is an intangible asset including things like an employee’s experience
and skills and capabilities. In Ukraine, the 4% of firms planning to increase
investment in workforce training and development would be investing in the human
capital of their employees.
Physical capital, on the other hand, consists of human-made goods that assist in the
creation of other goods. An example of investment in physical capital would be when
a firm acquires items such as additional manufacturing equipment or machinery used
in the firm’s production processes.
b The extract suggests that environmental sustainability may only be obtained with the
opportunity cost of lower economic growth. This means that a sustainable
environment is a scarce resource and choices have to be made.
There is an opportunity cost associated with greater environmental sustainability

which may be fewer cars and lorries on the road, for example, which would reduce
the economic activity that creates the growth. Therefore, choices must be made over
whether a country should create the economic growth that provides housing and
food or be more concerned about the preservation of natural capital and the
sustainability of the environment.
c Labour productivity is defined as output per unit of labour input. The physical
product or output of a worker is partly determined by their physical and mental
health. If a worker suffers poor physical and mental health, they are less likely to
have the capability and motivation to produce greater levels of output. Hence poor
health can lead to reduced labour productivity.
Cambridge International AS & A Level Economics Workbook

© Adam Wilby, Mila Zasheva/Hodder & Stoughton Ltd
Cambridge International AS & A Level Economics Workbook Answers
The notion of production possibility refers to the maximum possible output

combinations of two goods/services or classes of goods/services that an economy
can achieve when all resources are fully and efficiently employed.
When the workers of a country suffer poor health – for example, through
malnourishment – the total output combinations that they can produce are limited
by their condition. This will lead to a lower production possibility compared to the
situation where workers are better nourished and in better health.
d A free good, such as the air within an ecosystem, is a good that does not suffer
scarcity and is available without limit. It can be consumed in as great a quantity as
desired without a choice being made to forgo alternative consumption. A free good
therefore has zero opportunity cost to society.
An economic good, such as the capital machinery used by an entrepreneur, does

have an opportunity cost. This is because an economic good has a degree of scarcity
and therefore an associated opportunity cost.
Essay style
2 A production possibility curve (PPC) shows the maximum possible output combinations
of two goods (or services) that an economy can achieve when all resources are fully and
efficiently employed. Such a PPC is used in the diagram below to illustrate the production
possibility of onions and sweet potatoes for an economy.
Consider the economy originally producing 300 tonnes of onions and 180 tonnes of sweet
potatoes. If the economy then reallocated scarce resources from onions to sweet potatoes,
to produce 250 tonnes of sweet potatoes (70 more tonnes), this would involve an
opportunity cost in terms of 50 tonnes of onions (300 – 250) that can no longer be produced.
The concave downward nature of the PPC means that if the economy were to continue to
increase its allocation of scarce resources to the production of sweet potatoes – for
example, to produce another additional 70 tonnes (to 320 tonnes) – the opportunity cost
2

would be the increasingly large amounts of onions that would need to be forgone (greater
than 50 tonnes) in order to produce the additional sweet potatoes. This illustrates, through
the use of a PPC diagram, the concept of increasing opportunity cost as resource allocation
changes.
2 The price system and the microeconomy

(Chapters 2–4)
Multiple-choice
1 B
2 A
3 B
4 D
5 A
6 C
7 A
8 C
9 C
10 B
Data response
1 a Income elasticity of demand is calculated using the formula:
% change in demand/% change in income
In 2024, the % change in demand is estimated at 9.4%.
In 2024, the estimated % change in income is:
(15,102.15 – 13,969.54) × 100/13,969.54 = 8.1%
Estimated income elasticity of demand = 1.16.
The income elasticity of demand is estimated to be greater than 1, which means that
as income increases, the demand for pea protein products is estimated to increase

by proportionately more. This means that pea protein products sold in China are
classed as a normal luxury good.
b Demand describes the entire relationship between the various quantities demanded
over a range of prices, while the quantity demanded is the amount demanded at a
given price.
Applying this to the extract, a shift in consumer preference towards healthy

preparations will lead to an increase in demand over the whole range of prices,
whereas a rapid increase in supply would lead to a reduced equilibrium price and an
increase in quantity demanded at the new lower price.
c Joint supply refers to a situation where the production of one good can deliver two
or more outputs.
An example would be the farming of yellow peas where the protein can be used in
the supply of meat substitutes and sports drink supplements.
d The extract states, ‘Globally the [pea protein] growth rate in demand is estimated to
be 12% a year’ and ‘Some bakery and confectionery preparations will also experience
a rapid increase in supply.’ These conditions will lead to an increase in demand for
and supply of pea protein. The impact on the market for pea protein is shown in the
diagram below.
With an initial equilibrium price and quantity of P0 and Q0, an increase in demand will
shift the demand curve to the right from D0 to D1 and an increase in supply will shift
the supply curve to the right from S0 to S2. The new equilibrium quantity will be Q2
which is an increase, and, in the diagram, the new equilibrium price is P0. However,
the actual new equilibrium price would be indeterminate.

The new equilibrium price will increase if the relative increase in demand is greater
than the increase in supply. However, the new equilibrium price will decrease if the
relative increase in supply is greater than the increase in demand. The final impact
will also depend on the relative price elasticities of both demand and supply.
e Substitute goods are goods that consumers regard as alternatives, where the
demand for one will fall if the price for the other falls. One example from the extract
is pea-protein-based meat substitutes which can be consumed as a substitute for
meat.
f Price elasticity of demand (PED) measures the responsiveness of the quantity

demanded of a good or service to a change in its price. Total expenditure on a
product is found by multiplying the product’s price by the quantity demanded.
Pea protein has price inelastic demand. If the price of an inelastic good is lowered,
the demand for that good is relatively unresponsive and increases by proportionately
less. The proportionately smaller increase in quantity demanded than the decrease in
price would result in reduced total expenditure on pea protein.
g Pea protein is produced from the yellow pea, which is an agricultural product. The
supply plans of firms producing pea protein will be affected by changes in natural
conditions, especially the weather. Unfavourable weather for growing yellow peas
will affect a firm’s ability to supply. In the case of adverse weather conditions, this
would interrupt the continuity, reduce supply and shift the supply curve to the left.
Essay style
2 a Consumer surplus is the value that a consumer gains from consuming a good or
service over and above the price paid. It is the sum of the differences between the
prices that consumers are willing to pay and the equilibrium market price.
The diagram below shows a market in equilibrium with demand D and supply S, with
equilibrium at E and price P and quantity traded Q. The initial consumer surplus at
this point is given by the triangle APE.

The introduction of a producer subsidy into this market will reduce the cost of
production and so will shift the supply curve to the right (S to S1), establishing a new
equilibrium at E1 with a new lower equilibrium price of P1 and greater quantity traded
of Q1.
As a result of the subsidy, the consumer surplus in the market has increased and is
now given by the (larger) triangle AP1E1.
The value of the consumer surplus increases because there is a new lower market
price of P1, but the price preferences of the consumers have not changed. This leads
to an increase in the sum of the differences between the prices that consumers are
willing to pay and the equilibrium price in this market.
The extent to which the consumer surplus will increase is largely dependent on size
and duration of the subsidy. The larger the subsidy, the greater the shift to the right
in the supply curve and the lower the new equilibrium price. If this subsidy and price
decrease are permanent then the increase in consumer surplus will also be
permanent, ceteris paribus.
b Knowledge of the value of price elasticity of demand (PED) allows a firm to predict
how a change in price will impact on the demand for its product and on its total
revenue. If the demand is relatively price elastic, due to the large number of
substitutes, the firm knows that it can decrease the price to increase the total
revenue because the quantity demanded will rise by a larger percentage. This
knowledge is useful for any firm that is considering altering its pricing strategy and is
concerned about total revenue.
The extent to which this might prove useful in reality depends on the accuracy of the
estimate of the PED. It can be difficult for firms to obtain accurate data and therefore

gain accurate PED estimates. The response of competitor firms in the market to the
price change is also important. These reactions are unknown to the firm. Therefore,
any impact on total revenue predicted from a price change and knowledge of the
PED may prove less accurate or useful if other firms also implement such a price
change.
Knowledge of the value of income elasticity of demand (YED) allows a firm to

predict how a change in income will impact on the demand for its product. A firm will
find this useful, assuming it knows whether its product is an inferior good (negative
YED) or a normal necessity or luxury good (positive YED), because it will be able to
anticipate an increase or decrease in demand. Furthermore, the absolute value of
the YED will help to predict the scale of the increase or decrease in the demand for
its product or service as income changes. This knowledge will help the firm to make
key decisions with respect to producing more luxury goods during periods of income
growth; or with falling incomes, firms might decide to produce more inferior goods.
The extent to which this knowledge might prove useful depends on the accuracy of
the calculation of YED. As with PED it can be difficult to obtain accurate estimates for
the YED value. Care must also be taken over the issue of whether the market
segment that a firm sells to is significantly affected by the change in income, which is
likely to be derived from a national average. This could mean predicted changes in
demand do not occur and the reactive decisions of firms may prove incorrect.
Knowledge of PED and YED will undoubtedly prove useful to the decision making of
firms so long as the data are accurate. It could be argued that the PED value is of
more use because it allows the firm to make proactive decisions regarding its
strategies whereas knowledge of the YED allows reactive decisions to be made to
changes in a variable that is out of the firm’s control.
3 Government microeconomic intervention

(Chapter 5)
Multiple-choice
1 B
2 A
3 D
4 A

Data response
1 a The Gini coefficient is a statistical measure that attempts to quantify the equality of
income distribution in a country. The coefficient measures the dispersion of income
among the members of a population.
In published data, the Gini coefficient is expressed as a percentage. A Gini value of

0% indicates a perfectly equal distribution of income within a population. A Gini
value of 100% represents perfect inequality when one person in a population
receives all the income, while other people earn nothing.
By comparing the Gini values of Mexico (48.2%) and Sweden (24.9%) it is possible to
conclude from one summary statistic that the inequality of income distribution in
Mexico is approximately twice that of Sweden.
b A progressive income tax can be said to create a fairer redistribution of income

because it imposes a lower tax rate on low-income earners compared to those with a
higher income. This means it is based on taxpayers’ ability to pay, resulting in a lower
percentage being taken from low-income earners than from those commanding high
incomes.
Additionally, this view would argue that the redistributive power of a progressive
income tax policy can be seen through the government raising increased revenues to
finance public expenditure. This would include spending on transfer payments,
health and education that tend to favour low-income households.
c An increase in transfer payments could allow the government to effectively alter the
final distribution of income. They comprise welfare payments made available
through the social security system including, for example, unemployment benefit,
child benefit and housing benefit (where available). The main aim of transfer
payments is to provide a basic floor of redistributed income or minimum standard of
living for low-income households.
However, government transfer payments do not boost production or economic

activity. For example, increasing unemployment benefits could arguably reduce
incentives to take paid work and redistribute income more effectively. This leads
some to argue that reducing transfer payments, thereby increasing the incentive to
work, and the opportunity cost of not working, could lead to a more effective
redistribution of income.
The reduction in transfer payments would be most effective at redistributing income

when combined with policies that ensure there is paid work available for those
unemployed who are incentivised to try to find it. This will be even more effective in
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redistributing income if the skill sets of the unemployed are addressed in order to
ensure that they have the skills to match the available jobs that they are incentivised
to seek.
Essay style
2 A minimum price involves a government imposing a price that is above the free-market
clearing price. In the case of the market for alcoholic drinks in Wales, the minimum price
of US$0.63 per unit of alcohol would represent an attempt to limit alcohol consumption
and improve the wellbeing of consumers.
The impact on the market of the minimum price is shown on the diagram below.
In this example the minimum unit price (US$0.63) for alcohol is above the free-market price
of PE and would increase the price of alcoholic drinks in the market. This, in turn, would
create an excess supply of QD to QS. This illustrates the contraction in the quantity demanded
from QE to QD and the extension in the quantity supplied from QE to QS.
Within this market there will be a reduction in the quantity of alcoholic drinks consumed,
which will effectively reduce the size of the market to QD and so help to reduce the adverse
effects of excessive drinking.
The extent to which the minimum price impacts on the market for alcoholic drinks will
depend upon a number of factors. These include the extent of the difference between the
free-market price (PE) and the minimum price imposed. The greater the difference, the
greater the impact on the market and the reduction in the quantity of alcohol consumed.
The impact of the minimum price on the market will also depend on the price elasticity of
demand for alcoholic drinks. The more price elastic the demand, the greater the reduction in
quantity demanded for any given price increase. However, due to the habit-forming nature

of alcoholic drinks, it may be that the quantity demanded is particularly price inelastic and
that consumers may not behave in strict accordance with rational economic theory.
4a The macroeconomy (Chapters 6 and 7)

Multiple-choice
1 C
2 C
3 D
Data response
1 a Gross domestic product (GDP) is the total market value of all finished goods and
services produced within a country in a set time period. It does not matter where the
producer originates from.
Gross national income (GNI), on the other hand, is a measure of a country’s income.
It is the value of all the income earned by a country’s residents and businesses. This
includes any income earned by nationals employed abroad and sent home as a
remittance.
The remittances sent home by Nepalese workers employed overseas will therefore
add to the measure of Nepal’s GNI but not its GDP.
b There are several pieces of evidence in the extract that suggest Nepal has taken the
Asian Development Bank (ADB) advice with respect to gross fixed capital formation.
First, Figure 1 shows that since 2016, gross fixed capital formation as a percentage of
GDP has increased substantially in Nepal from 33% in 2016 to 56% in 2019. Over the
same period, gross capital formation as a percentage of GDP in other (high-growth)
economies has decreased.
The president of Nepal has also actively sought investment from China in tourism
infrastructure, including transport, hotels and resorts and technological innovation.
This is clearly in line with the ADB guidance.
Finally, the 2020/21 budget in Nepal granted tax exemptions to the agriculture,
industrial and service sectors. This would increase the possibility of these sectors
increasing their gross capital formation as a result of the greater funds they are able
to retain. This too is in line with the ADB guidance.
10

c The circular flow model is a representation of the level of national income in an

economy that shows the movement of factors of production and goods and services
between sectors and the flows of payments in monetary terms that correspond.
Monetary flows in and out of the system in this model are referred to as injections
and leakages. A leakage occurs when money is not passed on but moves out of the
circular flow in the form of savings, taxation and imports. When a leakage flows out
of the system, the value of the money left in the system decreases. This represents a
contraction in national income.
In terms of the information provided, the tax exemptions from 25% to 75% for small
and micro enterprises in Nepal would constitute a reduction in the value of leakages
from the Nepalese circular flow of income. As the leakages decrease, so the value of
the circular flow will increase, representing an increase in national income in Nepal.
d The position of the long-run aggregate supply (LRAS) curve will be determined by the
decisions taken by profit-maximising firms about production levels at any given price
level.
Over the short run, the state of technology is assumed to be fixed. However, one
important influence on the position of the long-run aggregate supply (LRAS) curve is
the level of innovation and developments in technology. If the Nepalese president is
successful in securing Chinese investment in technological innovation in Nepal, this
could improve the efficiency with which other inputs are utilised. Such developments
can reduce firms’ costs and increase the amount of aggregate output that can be
produced. Over the long run this would shift the LRAS curve to the right.
e An increase in aggregate demand would shift the entire aggregate demand curve to
the right. This is illustrated for Nepal in the diagram below.
11

Consider the short-run position showing an original equilibrium with real GDP at Y0
and price level P0, with AD0 and SRAS. The planned increase in aggregate demand will
shift AD0 to AD1. The Nepalese economy will move to a new equilibrium position,
with a higher output level Y1 and a higher price level P1.
There is no guarantee that the new equilibrium will be at the full-employment level
of real GDP in Nepal. The full-employment level of output is the level at which the
economy is operating at its full potential capacity. It is entirely possible that Y1 is a
lower level than the full-employment level of real GDP (YFE). To reach YFE a greater
level of AD is required, illustrated by AD*. It is also possible in the short run that an
equilibrium above YFE is achieved, but this will be unsustainable.
Essay style
2 An increase in unanticipated costs such as that of electricity is known as an external
supply shock and will alter the position of the short-run aggregate supply (SRAS) curve.
The SRAS curve represents the combined output that firms are willing to produce at
different price levels in order to maximise profits.
The equilibrium in this model represents the price level and output level at which planned
aggregate supply equals planned aggregate demand and is shown in the diagram below.
Originally with AD and SRAS0 there is an equilibrium with a real GDP of Y0 and a price level of
P0. The increase in the cost of production caused by the increase in price of electricity used
by firms will influence the position of the SRAS curve. In the case of an increase in cost the
SRAS curve will shift to the left, from SRAS0 to SRAS1 in the diagram, which represents a
movement along the static AD curve.
This will cause a new equilibrium with a higher price level at P1 and a reduced level of real
GDP at Y1. The equilibrium level of output in the economy has decreased and therefore the
12

derived demand for labour to produce the output will have decreased. This would be
expected to lead to reduced employment in the economy.
The extent to which the increase in the price of electricity will shift the SRAS curve and
therefore have the impacts described here will depend on the proportion of the cost of
electricity in the overall production costs of firms. The greater the importance then the
greater the relative cost increase and the greater the shift in SRAS and impact on the price
level, real GDP and employment. The slope of the aggregate demand curve will also be a
consideration. The greater the price level elasticity of aggregate demand, the greater the
relative size of the reduced real GDP and reduction in employment, and the smaller the
increase in the general price level in the economy.
In the long run, the impact of a supply shock such as the unanticipated increase in electricity
prices will depend on whether the shock led to a temporary or a permanent change.
4b The macroeconomy (Chapters 8–10)

Multiple-choice
1 B
2 C
3 D
4 C
5 A
Data response
1 a An economist may wish to measure the rate of growth of the productive potential of
the economy. This would be illustrated by the rate of shift of the production
possibility curve over time or the rate of increase in long-run aggregate supply/the
full-employment level of output.
However, this is not what will be measured if the economist calculates the rate of
change of GDP in the economy. The rate of change of GDP will show the actual rate
of growth that the economy has achieved at a point in time. This may be constrained
by insufficient aggregate demand and will not reveal any growth in the productive
potential of the economy that the economist was attempting to measure.
b The travel and tourism industry contributes 21% of GDP to the Greek economy. In
2020, due to the Covid-19 pandemic, Greece stayed closed to all foreign tourism for
13

the beginning of the tourist season, which would lead to a reduction in demand for
tourism services. There would be a corresponding fall in GDP. If real GDP is below the
full-employment level, then unemployment will occur during the time when the
economy is adjusting back to its long-run equilibrium. This will be cyclical
unemployment in the Greek economy.
The tourism industry in Greece is ‘seasonal’ in any relatively normal year. The
demand for labour in the tourism sector will peak significantly in the summer
months. During the winter months of 2020 the demand for labour in Greece will be
significantly less because of the seasonal effects. This will give rise to seasonal
unemployment in Greece.
c The extract states that unemployment in Greece is measured by the International

Labour Organisation method. This is a measure based on the Labour Force Survey – a
survey of the population that identifies the number of people available for work, and
seeking work, but without a job. It then expresses the percentage of the workforce
who are without a job at a particular time.
d The extract reports that Greece’s CPI fell by 1.6% from a year earlier in June 2020,
following a 1.1% decrease in the previous month. It was the third consecutive decline
in consumer prices. This shows a quarter of deflation for the Greek economy.
Deflation is defined as a reduction of the general price level in the economy and
reflects an increase in the value of money over time.
Real GDP is equal to nominal GDP adjusted for inflation. The increase in the value of
money means that when nominal GDP is adjusted for the effect of the deflation in
the Greek economy, the value of real GDP will be greater than its nominal value.
e The increase in economic activity associated with actual economic growth (increasing
GDP) brings benefits but also brings costs. One clear and significant cost is pollution.
As the extract states, GDP per capita increased by 50% between 1990 and 2016, and
global trends for air pollution followed a similar upward trajectory. In particular,
Figure 1 shows that from 2014 to 2016 the rate of increase in air pollution was far
greater than the rate of economic growth.
As economic growth increases, inevitably industrial output, energy production and

transport will increase. These are among the contributors to the consequential
increase in air pollution. The problems associated with increasing air pollution are
those of poor health and restrictions on the quality of life.
It is also clear from Figure 1 that for individual countries it is possible to achieve
economic growth without the negative consequence of increased air pollution.
14

Norway, between 2014 and 2016, was able to achieve stable per capita economic
growth while significantly reducing its level of air pollution from almost 9 to below 8
PM2.5.
This can be achieved through strict regulation of production processes, taxation to

incentivise cleaner production methods and investment in sustainable energy
practices with particular application to the transport industry. However, not all
countries are willing and/or able to go to the lengths that Norway has to achieve its
outcome.
Essay style
2 a The quantity and quality of the labour force are key factors that can contribute to
increases in productivity and economic growth. A lack of skilled labour can affect the
overall productivity of the entire labour force. This subsequently impacts on a
country’s rate of growth of GDP per capita and its potential for future economic
growth.
The AD/AS diagram below shows an economy initially in equilibrium with AD0, SRAS0
and LRAS0 without unemployment and with a price level of P0.
If AD increases to AD1, there will be a temporary increase in real GDP to Y1 with a

price level of P1 as existing workers work overtime. However, this situation is
unsustainable and in time the economy will return to the full-employment level of
output at YFE but with a new higher equilibrium price level of P2.
The key point is that if there had been more skilled workers in the economy, capable
of greater productivity, then LRAS0 would have shifted to the right, representing
economic growth, and there would have been an increase in equilibrium real GDP.
Thus, it is the lack of skilled labour that has restricted economic growth.
15

One solution to skilled labour shortages is for governments to look abroad for skilled
workers. Offering higher wages for specific skills could encourage migration from
other countries to fill immediate skilled labour shortages and increase economic
growth. However, the quantity of migration is not under the direct control of the
domestic government and there will be times when such wage incentives will have
little impact.
The government could alternatively increase education and training in order to

increase the supply of skilled labour. This should raise the skill level and increase
productivity and economic growth, but there will be an opportunity cost and there
could also be a long period of skilled labour shortages because it will take time for
the labour market and educational institutions to adjust.
A combination of migration as a short-term fix to labour shortages and a longer view

of investment in the human capital of the domestic labour force would be the most
effective overall strategy.
b Inflation is the positive rate of change of the average price level in an economy over
a period of time and is calculated from the consumer price index. Inflation will have
consequences for consumers and firms in the economy, but the significance of these
consequences will depend on a number of factors.
As the rate of inflation increases, consumers, especially those on fixed incomes, will
find that they can purchase fewer goods and services. This is because the prices have
increased but their incomes have not, or have increased by less. There will also be a
negative consequence for consumers (and firms) who have savings. This is because
the real value of savings will reduce because the amount of goods and services that
they can purchase will be less.
Firms and consumers will both face greater uncertainty over current and future
prices. The consequence is that they will have to conduct more extensive and
intensive price research, which will cost more in terms of time and money. This will
especially be the case when making significant purchases. Some consumers may
even bring purchases forward in order to avoid further price rises.
Firms will find their revenue and profit may decrease as their costs increase and their
sales reduce. In the case of firms engaged in international trade, they may find their
goods becoming less competitive in overseas markets, again leading to falling
revenue and profit. Similarly, all firms may be affected by the now relatively cheaper
imports coming into the economy. In terms of labour costs, firms may face increasing
wage demands from workers anticipating further price rises and trying to protect
their real income. One of the most important consequences for a firm of rising
16

inflation is the degree of uncertainty it brings to the economy. This may affect
consumer confidence and consumers’ desire to purchase the firm’s products or
services.
The extent to which these consequences will have a significant impact on consumers
and firms will depend on a number of factors. The first is the extent to which the
inflation is anticipated. Anticipated inflation can be prepared for over a period of
time and thus the negative aspects somewhat negated. Moreover, if the increase in
inflation is stable, even within the government’s target rate, then this can actually
benefit firms and consumers as future nominal wage increases and consumer
expenditure can be better planned for.
If firms are suffering from unanticipated inflation but are able to cut some of their
costs of production, the overall consequence of the increase in inflation may not be
as severe. Similarly, if there is even greater inflation in the overseas market, the
increase in inflation in the domestic economy may not impact on export sales with
the same negative consequence.
In conclusion, while an increase in the rate of inflation has the potential to deliver
negative consequences to consumers and firms, if the increase is small, short-lived,
anticipated and stable then the negative consequences for consumers and firms will
be far less significant and the increase could even be beneficial over the short term.
5 Government macroeconomic intervention

(Chapter 11)
Multiple-choice
1 C
2 B
3 A
4 A
5 D
Data response
1 a A government budget deficit is a situation in which government expenditure exceeds
current government revenue. This may occur because the government has identified
expenditure needs that it deems important for the economy – for example, the
17

‘Emergency Economic Measures’ in Japan to cope with the Covid-19 pandemic. This
situation need not necessarily be a problem in itself.
The national debt is the accumulated stock of past public debt. The projected
national debt ratio for Japan of well above 240% of GDP in 2020 and 2021 means
that any additional budget deficit will add to the cost of paying interest on the
government’s debt. In Japan this debt repayment will become very high. This may
lead to higher taxes and lower government spending in the future, which could
adversely affect economic growth and living standards for many years. This makes
the projected national debt of Japan for 2020/21 potentially a larger problem than
the government’s budget deficit.
b Between 1975 and 1990 tax revenue and government expenditure in Japan did not
diverge greatly. This in turn led to a relatively consistent amount of national bonds
issued each fiscal year.
However, after 1990 Japan’s tax revenue situation deteriorated but government
expenditure continued on its upward trend. As the increase in expenditure was
greater than the tax revenue, the government needed to borrow more. This can be
seen from the increase in national bonds issued, which broadly speaking continued
from 1990 until around 2000 when government expenditure stabilised and even fell.
c A tax system is progressive when taxation takes a greater proportion of income from
higher income earners.
Sales taxes are regressive because they take a larger proportion of income from
lower income earners. The increase in the rate of sales tax from 8% to 10% in
October 2019 made the overall tax system in Japan more regressive and therefore
less progressive, ceteris paribus.
d The incentive effects produced by corporation tax deferrals for firms are an
important aspect of supply-side policy. Supply-side policies are designed to increase
aggregate supply through an increase in the quantity and/or quality of the factors of
production and so raise the productive capacity of the economy.
In 2020, the rate of investment had not decreased in Japan; rather there was a
deceleration in the pace of increase in firms’ fixed investment. The corporation tax
deferral will act as an incentive for firms to increase their investment further because
it will increase their post-tax profits. In theory, this will increase funds available to
fund capital investment, e.g. in new plant, factories and technologies. This will lead
to an outward shift of long-run aggregate supply (LRAS) as a country’s productive
18

capacity increases. The increase in aggregate supply will lead to a reduction in the
equilibrium price level in the economy.
However, there are conditions under which this will not necessarily be the outcome.
The confidence of firms is very likely to be low at this time and this will reduce the
size and speed of the increase in aggregate supply and therefore that of the price
level reduction. Moreover, corporation tax reductions will have the largest effects on
firms that are making a taxable profit. It is likely that firms’ profits will be lower than
usual at this time, so there will be a smaller increase in investment and aggregate
supply than at other times and therefore a smaller reduction in the equilibrium price
level in Japan.
Essay style
2 An expansionary monetary policy is intended to stimulate aggregate demand. As part of
an expansionary monetary policy, the interest rate can be reduced.
Reduced interest rates are likely to cause consumption to increase because it will be cheaper
for households to borrow money as less will need to be paid back in interest. Also, the
activity of saving will be less rewarding because the interest paid on saved funds is likely to
fall. This means that the opportunity cost of consumption falls and therefore consumption is
more likely to take place.
A reduction in the rate of interest is likely to increase investment. This is partly because the
opportunity cost of firms borrowing funds to invest falls. Moreover, firms may be
incentivised to invest because they expect to need to meet the increased consumption that
occurs as a result of the increased household borrowing.
Consumption and investment together represent a significant proportion of total aggregate

demand. Therefore, as consumption and investment increase, so does aggregate demand.
This increase in aggregate demand will lead to an increase in equilibrium real GDP in the
economy. This represents an increase in economic activity and should, therefore, be
accompanied by an increase in the derived demand for labour and an increase in
employment in the economy.
However, such an expansionary monetary policy aimed at increasing aggregate demand

would be far less beneficial in terms of increasing real GDP if the economy were already
close to (or at) full employment. In that case the major impact would be on the price level
rather than real output.
In terms of employment, it is not guaranteed that the increase in real GDP will drive an
increase in the demand for labour. In economies where there is sufficient capital available,
firms may expand their output through increased capital-intensive production, leaving
19

employment unaffected. It is also possible that the additional demand in the economy could
be accommodated through existing underemployed workers being invited to increase their
hours of work. In such a situation the expansionary monetary policy would not increase the
number of workers employed.
The conclusion is that expansionary monetary policy should only be used to stimulate
aggregate demand when there is sufficient slack in the economy to absorb the increase in
aggregate demand. The impact on employment will depend on entrepreneurs’ preferred
capital to labour ratio and the conditions in the labour market.
Part 6 International economic issues

(Chapters 12 and 13)
Multiple-choice
1 B
2 A
3 C
4 D
5 B
6 C
Data response
1 a Comparative advantage refers to an economy’s ability to produce goods at a lower
(opportunity) cost than that of trade partners. Raw material prices are similar when
sourced in global markets, wherever the location. This means that, once a firm is
established, labour costs are likely to be the main difference in manufacturing costs
between nations, and labour costs are also an important determinant of comparative
advantage.
The data in Table 1 show that China and India have the lowest manufacturing costs in
the world, primarily driven by low labour costs. The fact that China and India are also
reported to be the largest recipients (in Table 1) of foreign investment into their
respective manufacturing sectors in 2019 is evidence that the theory of comparative
advantage, driven by low labour costs, helps to explain the location decisions of
manufacturing firms.
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b One impact of import restrictions placed on South Korean exports by the USA and
India could be a reduction in aggregate demand because exports are a component of
aggregate demand. This could lead to a decrease in equilibrium real GDP and a
reduction in employment in the South Korean economy as a potentially vital source
of income is reduced.
The import restrictions could also lead to a reduction in the surplus on the current
account of the balance of payments of South Korea because South Korean exports
will fall in value compared to their imports.
The extent of the impact of the import restrictions will depend on the goods affected
and the relative importance of the USA and India as trade partners in value terms.
The extract states that almost 150 of the 210 import restrictions will be placed on
steel and chemicals. Neither of these individually accounts for more than 10% of
South Korean exports. Furthermore, neither the USA nor India is South Korea’s major
trade partner – this is China, the destination for over 25% of South Korean exports.
The conclusion is that, while these import restrictions will have some impact on the
South Korean economy as described, the impact will not be relatively so significant.
c One reason why the USA may have introduced the protectionist measures with
respect to South Korean steel imports is to protect jobs in the US steel industry.
It is possible that South Korea is able to produce steel more cheaply than the USA
and export it at a lower price into the US market, undercutting domestic producers.
This would lead to a reduction in demand for US-produced steel and also in the
derived demand for US steel workers. The protectionist measure of introducing a
tariff or quota, for example, would reduce this loss of US steel jobs.
d The demand and supply diagram below represents the US dollar (US$)/Indonesian
rupiah foreign exchange market.
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The initial equilibrium is at the exchange rate of e0 rupiah per 1 US dollar. The
economic uncertainty resulting from the Covid-19 pandemic led to the selling of the
currencies of a number of emerging economies, such as Indonesia, and an increase in
the purchase of more stable currencies, particularly the US dollar, perceived as a less
risky ‘reserve currency’.
This would lead to a rightward shift of the demand curve for the US dollar in the
rupiah/US$ market, from D0 to D1. This represents an increase in demand for the US
dollar.
The result is that the value of the US dollar would appreciate to a new equilibrium
value of e1 rupiah per 1 US dollar.
e One important factor to have contributed to the current account surplus in South
Korea could be an undervalued exchange rate. The IMF has calculated the South
Korean currency (won) to be undervalued by as much as 12% in recent years. An
undervalued currency means South Korea’s trade partners will need less of their
currency to purchase a won. This will make South Korean exports more competitive
and make them appear cheaper to foreigners. This will increase demand for exports,
making a current account surplus more likely.
A second factor could be linked to the increasing saving propensity of households in

South Korea. The result of increased saving is likely to be reduced consumption,
including a reduction in the purchase of imports. This will also make a current
account surplus more likely.
22

Essay style
2 Expansionary policy seeks to encourage economic growth. Expansionary fiscal and
monetary policy is intended to boost business investment and consumer spending by
injecting money into the economy.
Expansionary fiscal policy includes tax cuts, transfer payments and increased government
spending on projects such as transport improvements. These are designed to increase
aggregate demand as the government’s strategy puts more money into the economy than it
is taking out.
Expansionary monetary policy works by decreasing short-term interest rates or expanding

the money supply faster than usual. The easier access to domestic funds will both stimulate
domestic spending and attract an inflow of financial capital from overseas, which will result
in an appreciation of the domestic currency.
While the expansionary policies may work to increase real GDP, the increase in aggregate
demand will put upward pressure on the overall price level. This will reduce the
competitiveness of the exported goods while imports become less expensive to domestic
residents. Similarly, the appreciation of the domestic exchange rate will make domestic
exports more expensive and imports appear relatively cheaper. The combined effect of this
decrease in exports and increase in imports could be a deterioration in the current account
of the balance of payments.
The extent of the negative effect on the balance of payments depends on the price elasticity
of demand (PED) of the exports and imports. If the combined PED of imports and exports is
greater than 1 (relatively elastic) then the negative effect on the balance of payments will be
greater. However, if the combined PED is less than 1 (relatively inelastic) then there will be a
reduction in the current account deficit.
The conclusion is that the combined impact of the expansionary policies will be a
deterioration in the current account of the balance of payments unless the combined PED of
exports and imports is inelastic.
7a The price system and the microeconomy

(Chapters 14–16 and 20)
Multiple-choice
1 B
2 C
23

3 A
4 B
5 D
6 B
7 A
8 C
9 B
10 A
Data response
1 a Marginal utility is the change in total utility or satisfaction from consuming an extra
unit of a good – in this case, takeaway food such as pizza slices. Traditional economic
theory states that the marginal utility from each additional pizza slice eaten by a
consumer will diminish as more is consumed.
With less satisfaction gained from each additional pizza slice consumed, the rational
consumer will be prepared to pay less for each of these additional slices. This reveals
that as the quantity demanded increases, the price the consumer is willing to pay for
each additional slice will decrease. This means that the demand curve for takeaway
pizza slices will be downward sloping from left to right.
The limitations of this theory are revealed when we consider the ease with which
utility can be valued or measured. There is no objective way to achieve this and
therefore this limits the usefulness of the theory, especially when attempting to
compare individuals’ relative utility derived from pizza consumption. Also, the
analysis relies on the rationality of consumers when making their pizza consumption
choices. This too cannot be fully relied upon.
b An indifference curve reveals the combinations of two goods that give equal utility to
a consumer, while a budget line represents the boundary of an individual’s
consumption set, given the amount available to spend and the prices of the goods.
A consumer will maximise utility by consuming on the highest indifference curve

possible subject to their budget constraint. On the diagram below, representing
takeaway food and bottles of cola as the other good, this will be at point A.
24

Takeaway food has been categorised as an inferior good by the Adam Smith Institute.
When the price of takeaway food increases, less takeaway food can be consumed,
and the budget line will pivot inwards from BL0 to BL1.
The movement from point A to point C (on the notional budget line) represents the
substitution effect of the price change, which is a reduction in the quantity consumed
of takeaway food. The movement from C to B represents the income effect on an
inferior good, showing an increase in the consumption of takeaway food as income
falls.
The negative substitution effect is greater than the positive income effect and
therefore the price increase of takeaway food leads to an overall reduction in its
consumption.
There are two fundamental limitations to the use of indifference curve analysis in
this context. The first is that it is not practically possible to map the indifference
curves of a consumer, so these are actually theoretical constructs that cannot be
observed.
The second is that indifference curve analysis, in this context, relies on the
assumption of rationality and consistency of behaviour on the part of the consumer.
Neither of these can be relied upon in reality, thus creating a considerable further
limitation of indifference curve analysis.
c There are two aspects to productive efficiency. One involves selecting the most cost-
effective possible inputs. This is known as cost efficiency. The other involves making
the best possible use of those inputs to produce as much output as possible. This is
known as technical efficiency. Once these two conditions are satisfied, productive
efficiency can be achieved.
25

If Just Eat Takeaway and Grubhub are able to organise their newly merged firm to
satisfy these conditions, they will achieve productive efficiency whereby they operate
at minimum average cost. Operating at minimum average cost will increase their
profit potential, which will generate the chance to reinvest in their operations,
leading to high-quality growth.
While productive efficiency is concerned with the fixed set of existing resources that
Just Eat Takeaway and Grubhub have to work with, dynamic efficiency goes one step
further by considering the effects of innovation and technological progress on
productive efficiency in the long run. Attaining dynamic efficiency for Just Eat
Takeaway and Grubhub will involve undertaking investment in research and
development in the meal delivery sector, which means their services can be carried
out more efficiently in the future. This research and development activity will
generate the chance to reduce costs and develop new services, leading to further
‘high-quality and profitable growth’.
d In order for markets to allocate resources efficiently, consumers need to have access
to and receive full and accurate information about market conditions and the
products they consume.
Takeaway food is deemed a demerit good and is likely to be overconsumed because

of imperfect information. The consumption of takeaway food creates several
external costs, of which the consumer is unaware, due to the presence of imperfect
information.
It is the fact that the consumer of takeaway food is unable to process the long-run
health problems they could face from a poor diet which creates overconsumption of
the demerit good.
e Allocative efficiency is achieved when a market is producing the appropriate bundle

of goods in accordance with consumer preferences. This will be at the point where
the market price equals marginal cost.
When considering whether the meal delivery market is achieving allocative

efficiency, it is important that all costs are accounted for. This includes the private
cost of firms like Just Eat Takeaway and Grubhub, but also any external cost of their
activity. Meal delivery is traditionally made using motorised vehicles that create
polluting emissions. These emissions are an external cost because it is paid for by
third parties rather than the meal delivery firm or consumer. It is therefore not
accounted for in the market price.
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This provides evidence to suggest that the meal delivery market will not achieve
allocative efficiency because the market price of a delivered meal will not equal the
true marginal cost.
f A monopoly can be said to exist when one firm is able to dominate a market in terms
of either the price charged or the quantity traded. A monopoly firm will be able to
utilise its market power to disadvantage consumers by restricting output, leading to
a higher market price than would have been the case in a competitive market. This
activity will lead to an inefficient allocation of resources, which is market failure.
g Market failure occurs when the free market misallocates resources, resulting in a
suboptimal outcome. This can be the result of a divergence between marginal
private cost and marginal social cost.
The market cost and price of food deliveries include the private costs of Just Eat
Takeaway and Grubhub. However, the marginal external cost of the motor vehicle
pollution of each delivery is difficult to estimate but would be somewhat in excess of
the simple private costs of Just Eat Takeaway and Grubhub. Therefore, when the
market price only reflects the private cost of manufacture, the price is considerably
less than the cost to society.
The commercial delivery decisions of Just Eat Takeaway and Grubhub are based on
their own costs. This will lead to a misallocation of resources because they will
overproduce their deliveries based on a marginal private cost that is lower than the
marginal social cost. The increased demand for the services of Just Eat Takeaway and
Grubhub during the Covid-19 pandemic would lead to them being responsible for a
greater market failure than previously.
It is worth noting that the reduction in the movement of other polluting road vehicles
in areas with significant lockdown during the Covid-19 pandemic is likely to mean
that the overall market failure of this nature is reduced.
h The polluting journeys made by the vehicles of food delivery service firms create
externalities which mean the social cost of their activity is greater than the private
cost. The deadweight welfare loss of such an externality is the loss in social welfare
that arises when the existence of the externality moves a market away from its
optimum position.
The diagram below shows the extent of the deadweight welfare loss.
27

If the firm considers only its private costs (MPC), then the equilibrium in the market
will be at E2 with a price of P2 and quantity of Q2. The existence of significant
externalities would lead to the marginal social cost curve (MSC1) being above the
marginal private cost curve and there would be a significant deadweight welfare loss
shown by the triangle AE1E2.
The sharing of technology between Just Eat Takeaway and Grubhub, such as that
reducing the delivery distances travelled to service the same number of customers,
will reduce the external costs created by the firms from the operation of their
business, as their emissions decrease. This will shift the marginal social cost curve to
the right, from MSC1 to MSC2 towards the marginal private cost curve MPC.
The impact will be to reduce the size of the deadweight welfare loss shown by the
now smaller triangle BCE2.
i Organic growth occurs when a firm grows internally, by reinvesting its own profits
and developing the existing resources and markets of the firm. Human capital is a
measure of the economic value of an employee’s skill set.
The investment in the skill sets of the workforce at Grubhub would enable the
existing workforce to work more efficiently. Grubhub is likely to grow organically as a
result because a more efficient workforce will be able to process the needs of a far
greater number of customers with new more innovative products and services. This
will increase Grubhub’s reputation and growth as it works towards restoring its 50%
share of the US meal delivery market.
j The price elasticity of demand for the food delivered by Just Eat Takeaway and
Grubhub is greater than 1. This is price elastic demand.
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Total revenue is found by multiplying the price charged by the quantity demanded.
If there is a decrease in the price of food delivered by Just Eat Takeaway and
Grubhub, with price elastic demand there will be a proportionately larger increase in
the quantity of the food demanded and delivered. This will lead to an increase in
total revenue for the food company.
This will therefore also lead to an increase in the total revenue earned by Just Eat
Takeaway and Grubhub because they are receiving a fixed percentage price of a
volume of sales that has a greater total value than before the price decrease.
However, this does not necessarily mean they will enjoy an increase in profit. The
discussion here is about total revenue and we know nothing of how the costs of Just
Eat Takeaway and Grubhub will behave as the quantity of deliveries increases. We
would need this information before we could comment on the impact on total profit
of Just Eat Takeaway and Grubhub, which would be calculated by total revenue
minus total costs.
k Limit pricing is a pricing strategy used by an incumbent firm which involves setting its
price so low that it makes it difficult for new firms to enter the market and make a
profit. This pricing strategy could be used to deter the entry of new firms or
expansion of fringe firms in the market, protecting and growing the position of the
incumbent firm.
In 2019, Just Eat was operating as a technical monopoly in the food delivery market.
The limit price strategy would involve Just Eat charging a price lower than the
estimated average cost of potential entrant or fringe firms. The outcome would be
that Just Eat could protect and grow its market share without competition from
these rival firms. This would require Just Eat to be willing to sacrifice profits in the
short run to prevent their entry.
l A merger is a process that unites two existing firms which agree to form a new
company combining the assets of both. When the two existing firms are at the same
stage of production in the same market, as in the case of Just Eat Takeaway and
Grubhub, this integration is said to be horizontal in nature.
The advantage of the merger with Grubhub for Just Eat Takeaway relates to the
increased size of its operation. This is now the largest food delivery firm outside of
China with more than 70 million active customers who place close to 600 million
orders a year, giving the new larger firm a much more secure market share.
The larger scale of the merged operation will increase their combined access to
economies of scale. These may arise through discounted bulk buying opportunities or
29

the combined managerial efficiency of two independently successful firms. The

merged firm believes it can benefit from sharing technology to increase efficiency
and reduce the delivery distances. This is an advantage because the economies of
scale gained will allow the average cost of production to fall and profits and
productive efficiency to increase.
The new larger firm is also able to make efficiency savings by streamlining duplicated
tasks between the two firms in the short term. Over the longer term it can expand
operations as a new larger firm by consolidating further or by continuing to grow at
an increased organic rate. This is illustrated in the extract where it is reported that
‘Analysts have said that consolidation in the meal delivery industry is long overdue as
companies have to spend huge amounts of money to gain, service and retain their
customers.’
The extent to which the merger will be an advantage to Just Eat Takeaway will
depend on a number of factors. The streamlining of the duplicated tasks must be
quick and effective. If the duplicated tasks are allowed to continue for too long, this
will lead to X-inefficiency and a loss of profit. Moreover, the merger will involve the
integration of the two firms’ cultures, which, unless addressed quickly, can cause
inefficiencies.
In conclusion, the merger will be of considerable advantage to Just Eat Takeaway,

especially because Grubhub is also a successful firm. However, the process needs to
be managed effectively to ensure the maximum benefit is derived.
Essay style
2 External growth can occur through both vertical and conglomerate integration. Each has
its own specific advantages depending on the firms’ objectives. Each also has its
potential disadvantages that the expanding firms must be aware of.
Vertical integration involves firms joining together in the same industry but at different
stages in the production process. It is termed ‘forward vertical integration’ when the firm
joins with another business closer to the customer, such as the owners of a tea plantation
purchasing a tea processing firm. The growth is termed ‘backward vertical integration’ when
the firm integrates with another business further from the customer, such as Amazon.com
buying a book publishing business.
External growth achieved through vertical integration can lead to some economies of scale
in the areas of shared business practice. This could lead to a somewhat lower average cost of
production. Vertical integration is particularly preferable if control of the supply chain is
important to the firm. For example, an aircraft manufacturer might purchase a component
30

supplier. This is important because it ensures certainty and continuity of supply for the
business while controlling quality and costs of key inputs vital to the firm.
The major disadvantage of vertical integration, which can make it less attractive, is the
potential for diseconomies of scale, leading to increasing average costs of production.
Diseconomies of scale might result from corporate cultural differences where the different
objectives and operational practices of the two firms lead to inefficiencies. Diseconomies of
scale could also result from communication problems between the extended departments of
larger firms potentially operating with different home languages in different time zones. This
could result in inefficiency, wastage and ultimately higher average costs of production,
leading to reduced profitability.
External growth can also be achieved through conglomerate integration. This occurs when
two or more firms in different industries join together. For example, Associated British Foods
owns SPI Pharma (pharmaceuticals) and the retail clothing firm Primark.
Conglomerate integration would be preferred if the firm was concerned with a broader
reduction of risk. This is because operating in more than one industry or economy means
there is the possibility for the business to be successful across its operations even if one of
its markets is in the declining phase of its economic cycle. There is also the possibility of
transferring skills and knowledge between markets. This is because transferable practices
from one industry may bring cost reductions and efficiencies when applied in another
industry within the same organisation. These efficiencies are sometimes termed ‘economies
of scope’.
Less popular than vertical mergers, conglomerate integration has the major disadvantage
that the company may need to shift its focus from its core business activity. This could be
detrimental to the overall performance and profitability of all of the conglomerate
enterprises, thus detracting from overall efficiency. Conglomerate merger could also be less
preferred if too little is known of the market of the potential takeover and too high a price is
paid to acquire the target firm. This creates a disadvantage not experienced in vertically
integrated merger. Similarly, in a conglomerate merger it is difficult to merge different
cultural values and working practices. These differences are more pronounced than in a
merger between firms in the same industry.
The extent to which one of these methods of external growth is preferred over the other will
depend on a number of factors. The preferred method will depend on the capacity of the
business in terms of operations and management. If risk diversification is the objective but
there is little experience of this within the existing firm, vertical integration may still be the
preferred route to growth.
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Conglomerate merger is often regarded as riskier in the short run, making finance more
difficult to obtain. If the finance is not obtained on favourable terms, this may cause
difficulty for the profitability of the business in the longer run. This may lead to a preference
for expansion through vertical integration.
The impact of regulation is also important in determining the preferred expansion route.
Aggressive vertical integration may attract the attention of the competition regulator, which
can seriously restrict the activities of expanding firms in one industry or sector. This may lead
to a preference for conglomerate merger instead, which is less likely to suffer the same
scrutiny.
In conclusion, the objectives of the owners will be a key factor in selecting their preferred
method of external growth. However, their preference for growth, either through vertical or
conglomerate merger, will need to be informed by, and may even need to be directed by,
the other considerations discussed here.
7b The price system and the microeconomy

(Chapters 17–19)
Multiple-choice
1 C
2 C
3 B
4 D
5 C
6 C
7 A
8 D
9 C
10 B
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Data response
1 a One fixed cost in the extract is the rickshaw rental charge paid by the drivers who
rent their vehicles. One variable cost is the payment for the fuel they use in order to
operate their rickshaw.
b The law of diminishing returns states that, as the rickshaw manufacturer adds
increasing amounts of a variable factor input, such as labour, to a set of fixed factors,
the marginal output of the firm will at first increase. As this process continues, the
marginal output will reach a maximum. Then, as the quantity of labour is increased
further, while all other factors of production are still held constant, the marginal
output will decrease and continue to do so.
Assuming the rickshaw manufacturer can purchase each additional unit of labour for
the same wage rate, then initially, as additional workers are responsible for
additional marginal product, the marginal cost of the additional output will fall.
However, in the phase where the additional worker is responsible for a reduction in
the marginal product, the marginal cost of the additional output will increase.
Thus, the shape of the rickshaw manufacturer’s marginal cost curve is such that it will
first fall, reach a minimum and then rise, as output increases. This shape is
determined by the fundamental nature of the law of diminishing returns.
c The expansion in output of a rickshaw manufacturer, as suggested by the extract for

the years to 2024, may result in higher average costs of production. The source of
the increase in average cost could be related to control issues.
For one of the larger firms such as Bajaj Auto, as the expansion takes place it
becomes more difficult for the management to monitor the work of their employees
as closely as previously. The result could be a fall in productivity as it becomes
increasingly difficult to coordinate all aspects of production. Hence Bajaj Auto could
incur extra costs and the average cost of producing a rickshaw could increase.
However, diseconomies of scale are not certain to occur. In fact, a much smaller firm
such as Scooters India may actually gain economies of scale as it expands. This would
result in a decreasing average cost as it produces more rickshaws. Such economies of
scale could derive from the average cost saving from the bulk purchase of materials
as output expands.
In conclusion, it really depends where the firm is operating in relation to its own
minimum efficient scale (MES). It is possible that a large-scale rickshaw manufacturer
such as Bajaj Auto will have large fixed costs, meaning the expansion could result in
further economies of scale within its MES range, rather than diseconomies of scale.
33

d Barriers to entry are factors that make it more difficult, or even impossible, for new
firms to enter a market. The existence of barriers to entry makes the market less
competitive. The greater the barriers to entry, the less competitive the market.
One barrier to entry that will determine the degree of competition in the rickshaw
manufacturing market in India is the extent of the economies of scale of the
incumbent firms. The larger existing manufacturing firms such as Bajaj Auto and
Piaggio could be expected to have achieved significant economies of scale and
correspondingly low average costs of production. Hence potential market entrants
would find it difficult to compete on price and would be less likely to enter the
market. This is especially the case if the incumbent firms adopt a strategy of limit or
even predatory pricing.
A second issue for potential entrant firms is that of legal barriers. This involves the
need to meet safety criteria that ensure the rickshaws produced will meet the
regulations of the Indian authorities. The cost of compliance with such standards,
which are becoming increasingly strict in relation to emissions for example, may
deter potential market entrants who feel they may not be able to afford the cost of
meeting the standards. The result will be a less competitive market.
e The key characteristics required for a market to conform to the structure of

monopolistic competition are a large number of suppliers capable of being price
makers and a large number of independent buyers, all of which are relatively small in
terms of market power. There need to be low barriers to entry and exit, and some
product differentiation between the profit-maximising suppliers.
The rickshaw taxi hire market in Delhi conforms to this model to a large extent. There
are many profit-maximising rickshaw drivers who all offer a very similar service. This
means competition is high and the concentration rate is low. In the main, drivers are
able to alter the price they charge somewhat for a journey in line with the card rate.
The service they offer is differentiated by the power, relative comfort and fuel of
their vehicle. The cost of entry to the market is reasonably low because rickshaws
can be rented for a monthly fee by the drivers rather than an outright purchase
being made. There are a large number of buyers in the market and at times the
demand for the services of a rickshaw is greater than the supply.
To some extent the rickshaw taxi hire market in Delhi does not conform to the
market of monopolistic competition. This is because the process of obtaining and
renewing a driver’s operating licence can sometimes be difficult, making entry into
the market more restricted. For the drivers who cannot obtain a monthly rental
agreement, there is a considerable initial cost in the purchase of the rickshaw.
34

Moreover, a second-hand petrol rickshaw is becoming increasingly difficult to sell

because of the increasingly tough government regulation of such vehicles. This
presents a considerable barrier to exit which is not a characteristic of the model of
monopolistic competition.
f An oligopoly is a market structure where a few large firms dominate the market. The
extent of the dominance can be quantified through the concentration ratio.
The concentration ratio in an industry is a measure of the percentage market share

of the n largest firms in the industry and can give an indication of the type of market
structure. The three-firm concentration ratio for the rickshaw manufacturing market
in India is 92.1%.
A three-firm concentration ratio of 92.1% is relatively high and consistent with the
market dominance of a few large firms and therefore oligopoly.
The rickshaw manufacturing market in India can also be classed as an oligopoly

because it is characterised by significant barriers to entry: for example, the
considerable sunk costs associated with setting up in vehicle manufacture and the
extent of the economies of scale enjoyed by incumbent firms such as the relatively
large Bajaj Auto and Piaggio.
The rickshaw manufacturing market in India can further be classed as an oligopoly

because it satisfies the condition of product differentiation and non-price
competition. The rickshaw drivers engage in non-price competition through the
promotion of the benefits of using their particular rickshaw: for example, its comfort
or the lack of environmental damage caused by its fuel system.
g The rickshaw manufacturing market in India could be classed as an oligopoly. This is

based on Table 1, which shows the market is dominated by a few large
manufacturing firms with a relatively high three-firm concentration ratio of 92.1%.
One representation of the equilibrium position of a firm operating under conditions

of oligopoly is the kinked demand curve model that can be seen in the diagram
below.
35

A profit-maximising firm such as Bajaj Auto will operate where MC = MR. This will
give an equilibrium output level for the firm of Q and a price of P. At the profit-
maximising level of output, the marginal cost will be MC. This is lower than the price,
resulting in allocative inefficiency.
Productive efficiency is achieved when production takes place at the minimum

average total cost (ATC). This occurs when as few scarce resources as possible are
used in production. As the diagram shows, this is not achieved because Q is not at
the minimum ATC.
In terms of dynamic efficiency, this is theoretically possible in the model of oligopoly;

indeed, it is arguably likely. The supernormal profits earned by firms such as Bajaj
Auto and Piaggio mean they are able to invest in the ‘designing and development of
more efficient and affordable e-rickshaws’ rather than compete on price. This means
allocative and productive efficiency could be improved over the longer term as the
improved e-rickshaws that consumers want are provided and their average cost falls.
h In the strict sense, a contestable market is one in which there are no barriers to entry
or exit and the incumbent firms can make only normal profit.
In theory, legally, the rickshaw taxi hire market is contestable because any potential
rickshaw driver has the right to acquire an appropriate vehicle and apply for an
operator’s licence to work in the market.
The option for potential drivers to hire their vehicle greatly reduces the initial cost
involved in entering the market. Brand loyalty is not a particular issue in the rickshaw
taxi hire market and there is a pool of potential drivers waiting to take the
opportunity to enter the market when allowed. This degree of actual and potential
36

competition keeps the prices and profits lower than they otherwise might be. The
rickshaw taxi hire market therefore does possess some of the characteristics of a
contestable market.
However, there is the possibility of a potential driver not obtaining an operator’s

licence. Also, if a potential entrant driver cannot access a vehicle rental agreement
then there are relatively high start-up costs for the individual, even with the
government’s financial incentives. These create potentially significant sunk costs.
There is also the issue of incumbent drivers potentially operating a limit/predatory
pricing policy that would allow them to restrict the entry of new drivers and maintain
above normal profit.
It appears that the rickshaw taxi hire market has limited contestability. The extent to
which the market is contestable depends upon the extent of the barriers to entry
and the size and market power of incumbent drivers. The larger these two factors,
the less contestable the market will be.
Essay style
2 An increase in competition from new entrants into the renewable energy market will
lead to reduced market share and demand for individual incumbent firms, as supply in
the industry increases. This will lower the profit-maximising price of firms in the industry.
Profit-maximising incumbent firms will be in equilibrium at a price above their minimum

average cost. The greater competition and lower price will mean the firms will want to lower
their average cost, moving it closer to their marginal cost and thus achieving greater
productive efficiency. The firms will be motivated to do this in order to maintain profits in
the face of falling prices and to retain existing customers or continue to attract new
customers.
Allocative efficiency occurs when firms produce the service that consumers demand while
charging a price that equals the marginal cost of producing renewable energy. Allocative
efficiency is likely to increase because, in order to survive in the more competitive renewable
energy market, the incumbent firms need to provide the precise products that the consumer
is demanding. This will involve them selling their energy at a price closer to their marginal
cost. In order to achieve this effectively, firms must also remove any organisational slack in
their operations in order to reduce their X-inefficiency.
The greater competition in the market could also lead to dynamic efficiency gains. Energy-
producing firms will need to invest in greater research and development in the renewable
sector in order to develop and market the more innovative products or more efficient
production processes. This will lead to greater future allocative and productive efficiencies.
37

Finally, if the increase in competition is taking place because the entire renewable energy
industry is growing, there will be benefits to all renewable energy-producing firms due to
external economies of scale with an associated reduction in long-run average cost.
It is, however, possible that the increased competition will not lead to gains in efficiency.
This could be the case if one renewable energy-producing firm has a natural monopoly. In
this case and in the face of increased competition, possibly as a result of legislation, the
incumbent firm would not be able to gain such large economies of scale because its output
would decrease, which could reduce its productive efficiency. This could theoretically also
force its price up further above its marginal cost, which would move it away from allocative
efficiency.
There could also be a potential loss of dynamic efficiency in the long run. This would result
from the loss of long-run supernormal profits due to the increased competition. This would
leave less to reinvest in research and development activity and cause a loss in future
allocative and productive efficiencies.
Finally, the increased competition may result in energy firms trying to cut costs and hence
compromising health and safety standards and creating greater negative externalities. This
would create a misallocation of resources, with the firm operating at inefficient capacity
levels in the pursuit of greater profit, leading to greater pollution.
The extent to which there would be gains or otherwise in efficiency in the renewable energy
sector would depend on the scale of increased competition. It follows that, if there were just
a small increase in competition, this would have a much smaller impact on either increasing
or decreasing efficiency.
Some economists, such as William Baumol, would argue that it is not simply the level of
competition in the market but the threat of competition and therefore the contestability of
the market that will determine the behaviour and therefore the efficiency achieved by
incumbent firms.
In conclusion, the impact of competition (or the supposed threat of competition) can lead to
greater efficiency in the renewable energy market. The case where this is least likely to occur
is natural monopoly, where the impact on efficiency is likely to be most harmful.
3 A monopoly provider in a product market refers to a situation whereby one dominant

firm is the only provider or seller of a good in that market. The monopoly firm is assumed
to follow the objective of profit maximisation. The equilibrium position of such a
monopolist is shown in the diagram below.
38

The profit-maximising firm will produce where MC = MR with an output of Qm and a price of
Pm. This will lead to the monopoly being allocatively and productively inefficient. This is
because in the absence of a competitive incentive to produce at minimum average cost, the
monopolist will actually produce with an average cost of ACm. The result is that the
equilibrium marginal cost is below the equilibrium price and also below the equilibrium
average cost, which results in allocative and productive inefficiency.
The same lack of competitive incentives can lead to organisational slack and the emergence
of X-inefficiency for the monopolist. This can be compounded by low staff morale and
motivation, and management and communication problems across the large scale and
spread of the firm. The outcome is likely to be diseconomies of scale as the average cost of
production rises with output, leading to even greater inefficiency.
A monopoly provider in the product market need not always lead to such inefficiency. The
theory of natural monopoly can be used to explain how there are likely to be efficiency gains
associated with the kind of large-scale dominance of production enjoyed by a single provider
in a market.
A natural monopoly occurs in an industry where there are such substantial economies of
scale that only one firm is viable in the industry. In this case the supernormal profits of the
natural monopolist could be used to invest in research and development. This creates
dynamic efficiency gains.
These gains will be felt by the firm and therefore the industry and the consumer, as the
production processes and products improve such that it is possible for the monopolist to
reduce its price closer to the marginal cost, and the average cost also closer to the marginal
cost, such that the firm and therefore the industry move towards (but will not necessarily
achieve) allocative and productive efficiency.
39

The extent to which a monopolist remains inefficient in the absence of competitive pressure
will depend on the level of potential contestability and the threat of contestability. If the
threat were significant and real, the monopolist may be forced to behave as if the
competition actually existed, leading to greater allocative and productive efficiency.
The monopolist may also be subject to the governance of a regulator that requires price to
be set close or equal to marginal cost, for example, thus leading to allocative efficiency. This
would create difficulties for the natural monopolist, however, because its marginal cost is
below its average cost at all output levels, making a condition of price equal to marginal cost
unprofitable and requiring potentially inefficient subsidy payments.
In conclusion, an unregulated monopoly provider in the product market will lead to

significant inefficiencies. These inefficiencies could be reduced if the authorities are willing to
regulate the monopoly provider. They also depend on the extent to which the authorities
are willing to allow natural monopolies that may also require regulation.
8 Government microeconomic intervention

(Chapters 21–23)
Multiple-choice
1 C
2 D
3 C
4 A
5 C
6 D
7 A
8 B
9 C
Data response
1 a Government failure is a misallocation of resources arising from government
intervention to correct a market failure. In effect, the intervention causes a less
efficient allocation of resources and imposes a welfare loss on society.
40

The effect of the increased sales tax of over 20% imposed by the government in
Turkey can be illustrated through the demand and supply diagram below, using the
market for cigarettes as an example.
The increase in the sales tax is paid by the firm to the government while the
incidence of such a tax is shared by the consumer and by the seller. The sales tax
affects the supply curve, shifting it to the left. The outcome is a new higher
equilibrium price, moving from P0 to P1, and a lower quantity traded, moving from Q0
to Q1.
Once the tax is imposed, the government of Turkey would then be able to spend the
sales tax revenue on the provision of merit goods, such as health and education, that
would otherwise be underprovided in the free market.
However, allocative efficiency requires satisfaction of the condition that the

equilibrium price is equal to the marginal cost of production. The increase of a sales
tax in Turkey implies that the equilibrium market price will move (further) away from
marginal cost and therefore away from allocative efficiency.
This means that despite the tax revenue being used to correct one market failure,
the underprovision of merit goods, the increased sales tax causes the government to
create a misallocation of resources elsewhere, in the market of the sales tax. The
imposition of the sales tax is therefore the cause of government failure.
b The poverty trap is a situation in which an individual has no incentive to take a job or
work longer hours because the loss of benefits outweighs the gain from increased
earnings. Human capital refers to the stock of skills and expertise and other
characteristics that contribute to a worker’s productivity.
41

In the extract Jeffrey Sachs means that when individuals have a very low stock of
skills and expertise or other characteristics that contribute to their productivity, they
will generate a low marginal revenue product. This means the wage they can
command through taking (or increasing their) employment will be less than the
benefit they forgo in terms of their lost transfer payments. Therefore, there is little
incentive to take paid work because the opportunity cost is too high. This consigns
such an individual to the poverty trap, from which they can never earn enough to
escape.
One government intervention from the extract to combat this outcome would be a
policy to raise the human capital of individuals in the poverty trap. This could be
achieved through targeted programmes to improve the health, education, skills and
nutrition of those individuals suffering in the poverty trap. This creates a problem for
the government, which recognises the need to provide economic protection for the
poor, while also wanting to provide incentives for individuals to work. Achieving the
correct balance between these two issues can prove difficult.
c As a result of the interventionist policies of the Turkish government, the more

educated workforce may be more skilled at their jobs and create less waste of
resources. This will help the move towards productive efficiency because, with fewer
resources used, the average cost of producing goods or of providing services will fall.
As average cost falls, productive efficiency is increased.
Equity, on the other hand, is more concerned with the way that resources are
allocated in a society and primarily with respect to the treatment of people in
society. One way to view equity would be the treatment of everyone in the same
situation in the same manner.
In the context of the question, as a result of the interventionist policy, the Turkish
economy could achieve technical and productive efficiency while producing on its
production possibility frontier. From this perspective, this would appear efficient.
However, at the same time we know from the article that considerable inequality
exists in Turkey, where the income of the richest quintile is 7.5 times higher than the
income of the poorest quintile. This means the Turkish economy contains sections of
the population struggling with significant relative poverty. This outcome does not
achieve equity and highlights the importance of the distinction between efficiency
and equity because government intervention could create an efficient but
inequitable resource distribution.
d The marginal revenue product (MRP) theory suggests that the demand for labour
depends on the marginal revenue product of a worker. MRP is calculated by
42

multiplying the marginal physical product (MPP) of labour by the marginal revenue of
the output that the labour produces.
The increase in productivity achieved by the more highly trained workforce in Turkey
will increase their MPP. As the MPP increases, so their MRP will increase. This will
lead to an increase in the demand for labour as labour is substituted for capital,
which will shift the industry demand for labour curve to the right as in the diagram
below.
The initial equilibrium wage rate and quantity of labour employed in the industry are
given by W0 and Q0. The increase in the demand for labour will shift the industry
demand for labour from LD0 to LD1. This will lead to an increase in both the
equilibrium wage rate to W1 and the equilibrium quantity of labour employed to Q1.
e The transfer earnings of labour are defined in terms of the minimum payment that is
required to keep the marginal worker in their present employment. For example, a
worker is likely to choose one job over another because the pay is better. By taking
the job, the worker forgoes the opportunity to work in the alternative employment.
The opportunity cost is seen in terms of this forgone alternative wage, which is a
measure of the transfer earnings of the worker.
If the wage in the alternative employment increases, this will increase the
opportunity cost to the individual of not working in the alternative job. This will also
increase the transfer earnings they require to remain in their current employment.
In any occupation, even those where all workers receive the same wage rate, the
transfer earnings could potentially be different for different workers. This is because
the transfer earnings are determined by the opportunity cost of the employment
43

that each worker has forgone. This is likely to be different for different workers, who
would have different alternative employment opportunities reflecting a variety of
different alternative wage rates.
f An increase in spending on education and training in Turkey will lead to an increase

in the supply of skilled labour to an industry. The increase in the supply of labour is
illustrated in the diagram below.
The original equilibrium in the industry is shown with labour demand LD0 and labour
supply LS0. This gives a quantity of labour Q0 and wage rate W0. The supply of labour
curve then shifts to the right from LS0 to LS1.
The newly increased supply of labour will lead to an increase in the equilibrium
quantity of labour employed to Q1, but a lower equilibrium wage rate of W1.
Essay style
2 An economy with a significant number of state-owned enterprises (SOEs) is one in which
the government is able to exercise considerable and somewhat unaccountable control
over its domestic factors of production. It could be argued that such an economy is
inefficient and would benefit from a programme of privatisation. This would involve the
transfer of resources from state ownership to private ownership and control.
Large SOEs tend to be inefficient and wasteful. They do not produce at the minimum of their
long-run average cost curve, making them productively inefficient. They charge a price above
their marginal cost of production, making them allocatively inefficient as well. Moreover,
because they have little economic incentive to innovate, they also lack dynamic efficiency
and exhibit X-inefficiency throughout their structures.
44

The issues around efficiency could be traced to the lack of accountability of those in charge
of the decision making within the SOEs. This could be seen as an example of the principal–
agent problem. Here, the end consumers are the principals, while the managers within the
SOEs are the agents. In this case the consumer has almost no (short-term) control over the
decision making, actions or motivations of the managers. This will lead to problems of waste
and X-inefficiency within SOEs that will further compound the issues preventing allocative
and productive efficiencies being achieved.
A further issue could be that SOEs present a financial drain on the state’s resources. They
might require large state subsidies and financial capital at below the rates that could be
obtained on open financial markets. This financial commitment has an opportunity cost as
these state resources could have been used elsewhere in the wider economy more
productively by the authorities.
The likely benefits of a programme of privatisation where the state-owned resources are
transferred to the private sector arise because the decision makers in private sector firms
would be accountable to their shareholders. This is likely to increase the drive to make a
profit. With this incentive the firms are more likely to cut costs and achieve, or at least move
further towards, productive efficiency.
Consumer welfare will also be enhanced because the price in a privatised enterprise is likely
to fall to reflect more closely the marginal cost of production. This would therefore move the
enterprise towards producing with allocative efficiency.
As the enterprise is now being operated in a more profitable and accountable manner, there
is also the likelihood of dynamic efficiency as the firm invests its supernormal profit in its
own product and process developments. This will lead to further future improvements in
productive and allocative efficiency.
The government will also face the double benefit of not only losing the cost of subsidising
the SOEs, but also raising significant sums of money from the sale of the SOEs and the tax
revenues generated from their profitable operation. This can then be used to finance public
expenditure elsewhere in the economy.
The extent to which the benefits of privatisation are likely to occur will depend on a number
of factors. Privatisation has been most successful in economies around the world when it
occurs alongside some form of regulation. This is because the newly privatised enterprises
could become natural monopolies and subject to the problems that the SOEs originally
suffered. A regulator could be appointed to ensure the operations are not exploitative in
terms of pricing, for example.
45

One potential limit to the operation of a regulator in this context is the possibility of
regulatory capture. This occurs when the industry has better information about its operation
than does the regulator. This may require the two to work too closely together in a
relationship that loses the rigour that the regulator should exercise.
If the process of privatisation creates a private monopoly, this may harm consumer interests.
However, if the market is contestable, there is greater scope for efficiency savings and
additional benefits associated with the market economy. The extent of the competition that
is viable will be dictated, however, by the availability of economies of scale in the industry.
In conclusion, the extent of the benefit of a programme of privatisation in an economy with

a significant number of large state-owned enterprises will really depend on the industry in
question. An industry like telecoms is typical of those where the incentive of profit can help
increase efficiency. However, if privatisation were applied to industries like healthcare, the
profit motive and ensuing efficiency gains would be significantly more difficult to manage.
3 External costs are those incurred by third parties when an activity takes place. External
costs cause a divergence between the private costs to individuals engaging in the
activity, and the social costs of the activity incurred by all of society. It is this difference
that leads to a misallocation of resources and market failure. In the case of a negative
external cost, this takes place through overproduction and overconsumption in the
market. The market failure referred to here relates to allocative inefficiency.
When applied to the market failure created by the emission of toxic fumes in a production
process, the associated misallocation of resources arises from the cost to third parties of the
emissions. These emissions create the negative externality and the allocative inefficiency
associated with an equilibrium whereby the price charged (or average revenue) is not equal
to the marginal cost of production. This is shown on the diagram below.
46

Unregulated firms will only take account of their own marginal private costs, shown by MPC,
but the firm’s production creates higher costs than this for society. These are the external
costs of the toxic fumes that the firm does not account for. The marginal social cost curve S
(MSC) represents the supply curve that includes these additional external costs.
The equilibrium in the unregulated market will be at Q1, and price will be P1. This is an
inefficient outcome for society, as it is clear that there is a divergence between the price and
the ‘true’ marginal cost that reflects all of the costs to society.
The marginal unit of the good sold imposes higher costs on society than the marginal benefit
derived from consuming it. There is overproduction. The optimum position is where the
marginal social cost equals the marginal social benefit at Q* with a price of P*. Less of the
good will be consumed, but also less pollution will be created, and society will be better off
than at Q1.
The externalities created by the production emissions lead to a welfare loss to society,
represented by the shaded triangle area on the diagram, which is equal to the cost of the
overproduction multiplied by the extent of the overproduction.
This outcome may prompt the government to attempt to regulate the polluting activity. This
may take the form of taxation paid by the firm. The extent of the taxation should exactly
match the external cost incurred by society of the emission of the toxic fumes. This would
raise the marginal private cost of the firm to the level of the S (MSC), thus reducing the
overproduction and allocative inefficiency in equilibrium.
Alternatively, legislation and regulations may be applied to the firm, forcing it to reduce its
emissions through cleaner production processes or placing a limit on the amount of the
polluting activity that is permitted. However the regulations are applied, the purpose of the
regulation would be to reduce the external cost.
The extent to which government intervention can be used successfully to correct market
failure created by toxic fumes will depend on a number of factors. The introduction of
taxation to encourage producers to decrease output and enable allocative efficiency may be
an imprecise intervention. This is because it is difficult to measure the precise value of the
external cost created by the toxic fumes. It is therefore difficult to be precise about the exact
taxation that should be applied.
Complex taxation regimes can also be costly to administer. These funds could have been
directed to alternative purposes by governments. This means governments will have to
make a value judgement when deciding whether to impose such taxation. Moreover, the
imposition of the taxation and the higher price paid by consumers may create market
failures of their own.
47

There is also the time factor to consider. An increase in taxation can sometimes take a long
time to have an effect on price and output. This can be due to inertia in the market on the
part of consumers, in adapting to the new price as a permanent feature.
The benefits of regulation may not be clear-cut, as there may be considerable costs and
problems of enforcement, or appropriate standards may not be set. Moving forward, there
would also be limited incentive for any improvement in toxic emissions levels once standards
have been met.
In conclusion, there may be unintended consequences of the regulation and it would be

extremely difficult to get the level of taxation exactly right. The effectiveness of the
intervention will depend upon the extent of the government failure that might arise and the
extent to which the various intervention measures are successfully imposed as part of an
integrated strategy.
9 The macroeconomy (Chapters 24–27)

Multiple-choice
1 B
2 C
3 C
4 D
5 C
6 D
7 D
8 B
Data response
1 a Investment is expenditure undertaken by firms to add to their capital stock. Induced
investment is that portion of investment that is caused by a change in output. In the
extract, as the South African economy recovers from recession, aggregate income
will begin to increase. This means firms must undertake investment in order to
expand their production capacity. This part of investment by South African firms is
induced investment, caused by changes in demand in the economy.
48

Autonomous investment, on the other hand, is investment that occurs for reasons
other than changes in output. One key determinant of autonomous investment is the
rate of interest, or the cost to a firm of borrowing money. If the rate of interest is
relatively high, firms may be discouraged from spending on investment goods. Also,
if the rate of interest is relatively high, there is a greater opportunity cost to the firms
of using their own retained profit in order to invest, again making them less likely to
undertake such autonomous investment.
However, the rate of interest is not the only determinant of autonomous investment.
Firms will also need to form expectations about the future performance of the
economy. For example, if the indications are that the South African economy, and
therefore the demand for South African firms’ products, will not grow, then this will
be an important influence on their current investment decisions. Increasingly, as
firms and economies become globally integrated, it is not just expectations with
respect to the domestic economy that are important but also those of major trade
partners. These can be more difficult to predict with the same degree of confidence.
b The multiplier refers to a process where an initial increase in an injection to the

circular flow of income has multiple impacts on real GDP. An injection into the
circular flow of income is an amount that is introduced from outside the system that
has not been passed on from within the circular flow system. One injection into the
circular flow comes in the form of additional government expenditure such as that
allocated in South Africa to learning and culture and to social development.
Whenever there is an increase in an injection into the circular flow of income, there
will be an increase in incomes in the economy. Whatever is not withdrawn from the
economy will cause a second round of additional spending and further increases in
economic activity. This is the multiplier process that causes the level of real GDP in
the economy to increase by more than the initial change in the injection.
The multiplier effect can be seen using the withdrawals–injections model. The
diagram below shows an economy in equilibrium at Y0, with total injections (J) equal
to total withdrawals (W). If the South African government increases spending to G1,
as in the article, then injections increase from J0 to J1, and equilibrium income goes
from Y0 to Y1. The effect of the multiplier is seen in the way that the increase in
income (Y1 − Y0) is greater than the original increase in injections (J1 − J0).
49

c The business cycle is a phenomenon whereby GDP fluctuates around its underlying
trend. An economy such as that of South Africa will be in the recession phase of the
business cycle when GDP is falling for two consecutive quarters. The move from the
recession phase into the recovery or growth phase can be assisted by certain factors.
The weaker value of the South African rand means exports will appear relatively less
expensive and therefore more competitive in overseas markets. Similarly, imports
into South Africa will appear relatively more expensive and so should fall. Net exports
are a component of aggregate demand (AD), so as net exports increase, AD should
also increase, raising equilibrium GDP and helping South Africa to move out of the
recession phase of its business cycle.
The extent to which a weaker currency will lead to an increase in the value of net
exports will depend on the price elasticity of demand for the exports and imports. So
long as the sum of the price elasticities of demand of the exports and imports is
greater than 1, the increase in net exports will have a positive impact on the trade
cycle recovery.
Consumption and investment are major components of aggregate demand. The

stimulation of consumption and investment from their current low level by the
reduction in the interest rate enacted by the South African central bank in March
2020 is expected to increase aggregate demand significantly. This will help the South
African economy to move from the recession to the recovery phase of its business
cycle.
The extent to which the interest rate reduction will impact on the recovery in the
business cycle depends on the size and method of the intervention. The interest rate
50

reduction may be too small or not last long enough. This may not create the
confidence required in the economy and may not increase consumption and
investment among South African households and firms. This would reduce the
impact of this factor on South Africa’s move from the recession phase of its business
cycle.
d Disequilibrium unemployment is unemployment that arises because the economy is

away from equilibrium, and this is likely to be associated with a negative output gap
characterised by a level of GDP below its full-employment value. This is the type of
unemployment referenced by the president of South Africa in his 2020 ‘State of the
Nation Address’.
The increase in government expenditure (G) in South Africa on learning and culture
and on social development would increase aggregate demand (AD) because G is a
component of AD. This would lead to multiple increases in the equilibrium level of
real GDP, moving the economy towards its full-employment level of output while
closing the negative output gap. The increase in real GDP would increase the derived
demand for labour, which would effectively reduce the level of disequilibrium
unemployment in South Africa.
One important assessment to make is to consider the extent to which the economy
of South Africa would have returned to equilibrium at the full-employment level of
output anyway without any intervention. This is the classical idea of how the
macroeconomy operates.
A second consideration with such intervention concerns the impact on inflationary

pressure in the economy of South Africa. The increase in AD could increase the
overall price level through demand-pull inflation without any long-run gains for the
economy.
e Frictional unemployment is always present in an economy – it is the result of time

mismatches between voluntary employment transitions as workers move between
jobs. Structural unemployment, on the other hand, is a longer-lasting form of
unemployment caused by fundamental shifts in an economy. It can occur because
workers lack the skills required or live too far from regions where jobs are available.
The data in Table 1 support the case that unemployment in South Africa is structural.
This is because 64.8% of those unemployed in South Africa have been so for more
than 1 year. This is far too long to be classed as a transition between jobs and is
indicative of structural problems in the South African labour market. Large-scale
mismatches are indicated between the skills held by unemployed workers and those
required for employment vacancies.
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The OECD average of those unemployed who have been so for more than 1 year is
25.8%. This is significantly less than the figure for South Africa, which is the second
highest in Table 1. The consequence for those unemployed workers in South Africa
could be serious in terms of their income, standard of living and wellbeing. This is
because Unemployment Insurance Fund (UIF) benefits are only available to workers
who contributed to the UIF while they worked. Employment in the informal sector of
the economy is not credited. In countries in which there is little social security
protection, the long-term unemployed may be forced to enter the informal
economy. This problem is widespread in some otherwise upper-middle-income
economies such as South Africa.
f One role of the South African Reserve Bank (SARB) referred to in the article is the
regulation of the financial sector. This function is important because it ensures the
efficient and prudent operation of the financial system in South Africa. An
unregulated financial sector could lead to unsustainable and inefficient lending as
witnessed in the period before the financial crisis of 2008.
A second role of the SARB referred to in the article is the implementation of the
government’s monetary policy. This includes setting an interest rate that delivers the
government’s preferred target rate of inflation. The execution of this role is
important because it helps to create the stable and confidence-inducing
environment that generates the sustainable long-term growth of the economy.
Essay style
2 Sustainable economic growth is one of the primary macroeconomic objectives of most
governments. Economic growth is commonly measured through an increase in a
country’s real gross domestic product (GDP). This measures the growth in the value of
goods and services produced in an economy over a period of time and can be referred to
as actual economic growth. Potential economic growth reflects an increase in productive
capacity. While the benefits of economic growth are easily recognised, there can also be
significant costs associated with an increase in economic activity.
During times of economic growth, it is likely that employment opportunities will increase.
This will bring benefits to workers in the economy through increased opportunities and a
greater wage potential. This is known as inclusive growth. The benefits of economic growth
will be felt by consumers as the variety, choice and quality of the goods and services that
they purchase increases. This will increase their material standard of living.
As employment increases, the government will have the benefit of a smaller welfare bill. This
is because there are fewer individuals claiming a range of benefits as a result of their poverty
and/or employment status. At the same time, the government will benefit from receiving
52

greater revenue from taxation, specifically from increased income tax, corporation tax and
sales tax receipts generated by the additional economic activity. The net benefit of the
reduced expenditure by the government and an increase in its revenue is that the
government is able to balance its budget more closely and is in a better position to invest in
public services and provide merit goods. For greater long-term benefits, it is important that
the economic growth is sustainable, which means that the economy grows at a rate that can
be continued in the present without harming the potential for growth in the future.
There are also costs associated with economic growth. These include the opportunity cost of
the inevitable shift in production from consumer to capital goods. This could reduce the
availability of some goods and consumer choice somewhat. There is also the environmental
cost to consider as pollution and congestion, for example, are likely to increase as the level
of production and economic activity grows.
One specific cost associated with actual economic growth is the way in which emissions of
greenhouse gases warm the planet. Sea levels are rising, and major climate change appears
imminent, to most informed observers. On a different level it is also possible that there are
costs of actual economic growth to individuals in an economy, such as increased stress levels
as growth brings pressure in the workplace.
It is apparent that economic growth will bring both benefits and costs. To be beneficial
overall the benefits must be more significant than the costs. The extent to which this will be
the case depends on a number of factors. If there is initially little spare capacity in the
economy, the growth may need to be achieved through a more significant loss of consumer
goods output. This is because scarce resources are required to produce more capital goods.
In such a situation, the economic growth is likely to be less beneficial overall.
In a similar sense, the greater the sustainability of the growth, the more beneficial it is likely
to be over the longer term. If non-renewable resources are used to depletion in a short-term
growth spurt, the chance of future generations achieving similar growth is reduced, as are
the longer-term benefits.
Actual economic growth is most beneficial when associated with an increase in aggregate
supply (AS). If the economic growth is purely a result of an increase in aggregate demand
(AD), this can bring the extra costs associated with increased demand-pull inflation. If,
however, AS is also increasing in an accommodating fashion, the dual benefit will be that the
sustainability of the growth will be increased, and the inflationary pressure reduced.
The manner in which the environmental and climate change costs associated with economic
growth are dealt with will help to determine the extent to which the benefits of growth
outweigh the costs. The additional pollution and congestion generated by economic growth
can both be effectively dealt with through interventionist regulation or market forces. The
53

benefits of growth are more likely to outweigh the costs when such issues are dealt with
effectively by the relevant authorities.
In conclusion, for economic growth to have the greatest positive impact on the wider
economy, the benefits of the growth must be equally and inclusively distributed among the
population. This will help to ensure the benefits outweigh any costs present. In a similar way,
for growth to have an effective net benefit across the economy, it must be occurring at a
faster rate than that of the increase in the nation’s population. Otherwise real incomes will
fall. The objective of sustainable economic growth remains at the heart of most
governments’ range of objectives. This would suggest that, on balance, the benefits of
economic growth outweigh the costs for most economies.
3 Quantitative easing (QE) is a monetary policy tool in which a central bank/monetary

authority purchases securities from the market in order to increase the monetary base
(or money supply) in the economy. Economic growth is commonly measured by an
increase in a country’s real gross domestic product (GDP). This measures the value of
goods and services produced in an economy over a period of time and can be referred to
as actual economic growth. Potential economic growth reflects an increase in productive
capacity.
QE works through the central bank creating electronic money, then using this to purchase
securities including government and corporate bonds from banks. As the commercial banks
sell these assets for cash, the banks increase their liquidity. This is a process that may also
reduce the interest rate, unless the liquidity trap has already been reached.
Theoretically, with greater liquidity, the commercial banks should be more willing to lend to
consumers to increase their consumption and firms to increase their investment. The
consumers and firms should also be more motivated to borrow at new lower rates of
interest. Effectively, this additional lending will be important for increasing investment and
consumer spending, which leads to an increase in aggregate demand (AD) in the economy
and the stimulation of economic growth.
One advantage of QE as a tool of monetary policy is that it can help to avoid deflation when
interest rates are already ineffectively low, as in the case of the major external shock of
Covid-19 that occurred in 2020. A further advantage of QE is that it can help to make the
country’s exports more competitive. The process of QE will keep interests rates lower than
they otherwise would be, which will lead to an outflow of ‘hot money’ from the economy
and a depreciation of the exchange rate. The new lower exchange rate will increase the
relative competitiveness of exports and of domestic goods relative to imports. The combined
increase in exports and decrease in imports will further increase AD in the economy and
stimulate economic growth.
54

There are, however, significant downsides to the process of QE in terms of creating

economic growth. There is the threat of increased inflation, especially when the central bank
creates new (electronic) money with which to purchase the assets from the banks. If the
process of QE increases the money supply faster than the growth in real output, this will
cause inflation because there is more money chasing the same number of goods. The
increase in inflation, if above the government’s target rate, could significantly reduce
confidence in the economy among consumers and firms. This could reduce the extent to
which they are motivated to increase their activity. This would reduce the economic growth
that they would have otherwise generated.
The effectiveness of a policy of quantitative easing in promoting economic growth will

depend on a number of factors. First, there is the possibility that if QE suppresses interest
rates to an artificially low level, capital market distortions will be created. This means that
otherwise inefficient firms are allowed to survive on cheap borrowed money. These so called
‘zombie firms’ will create longer-term inefficiencies in the economy, negatively affecting the
future growth potential.
The effectiveness of QE will also depend on the timescale under consideration. Due to the
dynamic nature of the macroeconomy, it is not at all clear what time lag will be in effect or
even the precise nature of the relationship between QE and GDP growth.
There is also the issue of whether the central bank should become a major holder of
government debt as created by QE. Moreover, there is the issue of the sustainability of
growth that becomes overly dependent on ‘cheap money’. It might be necessary to move
back to a more fundamentally ‘normal’ interest rate if future economic growth is to be
sustainable.
In conclusion, QE can be effective as a policy to promote economic growth when used

selectively and in conjunction with complementary policy options. It is particularly effective
when a liquidity trap occurs and cutting interest rates fails to increase economic activity and
growth because, despite low interest rates, banks are reluctant to lend and/or consumers
and firms are reluctant to borrow.
10 Government macroeconomic intervention

(Chapter 28)
Multiple-choice
1 B
2 D
55

3 C
4 B
5 A
6 B
Data response
1 a The short-run Phillips curve demonstrates a relationship first observed in the 1950s
between unemployment and inflation rates. The relationship shows that as the rate
of unemployment increases, the rate of inflation decreases. This relationship is
shown in the diagram below.
The trade-off between the variables exists because an increase in unemployment

leads to a surplus of labour that encourages a decrease in wage rates and a
subsequent decrease in prices. The implication is that there cannot be a
simultaneous reduction in unemployment and reduction in inflation in the short run.
The data on unemployment and inflation between December 2019 and March 2020
in Brazil conforms to this notion. This is because the rate of unemployment increases
from 11.63 million to 12.85 million while the inflation rate decreases from 4.31% to
3.30%. Thus, to some extent the short-run Phillips curve does explain the
unemployment and inflation situation in Brazil.
b Calculation:
(49.78 − 2.11) × 100/2.11 = 2,259.24%
56

Crowding out refers to the process by which an increase in government expenditure

increases the cost of borrowing such that private sector activity is reduced or
‘crowded out’. The increased government expenditure in Brazil between February
and June 2020 was substantial. However, interest rates were already low and falling
over the same period, so the likelihood of ‘crowding out’ occurring was very low. This
means that the increase in government expenditure would have a larger net impact
on real GDP.
c i A decrease in the interest rate (relative to that in other economies) is likely to

reduce inward foreign investment and encourage an outflow of ‘hot money’
currently resident in the economy. This will create downward pressure on the
exchange rate as the supply of the currency increases relative to demand.
ii The decrease in the interest rate reported for the Brazilian economy from 6%
to 2.5% between September 2019 and June 2020 occurred at the same time as there
was a significant appreciation of the Brazilian real from 6.0 BRL to 1 US dollar in
September 2019 to 4.8 BRL to 1 US dollar in June 2020. Therefore, there is no
evidence to suggest the relationship identified in question c i is evident in the article.
d The balance of payments records financial transactions between one country and the
rest of the world. One of the government’s macroeconomic objectives is to maintain
stability in the balance of payments because a surplus in the current account can
cause a deficit on the financial account and affect the operation of macroeconomic
policy and the value of the exchange rate. The achievement of the objective in
relation to the balance of payments may conflict with other macroeconomic
objectives such as the control of inflation.
The surplus in the current account of the balance of payments experienced by Brazil
for the majority of the period in question could be addressed by a loose monetary
policy of interest rate reductions. This could be used to reflate the Brazilian economy
and increase the number of imports to restore some balance to the current account.
However, such a correction of the surplus in Brazil’s current account of the balance
of payments could create a serious conflict with the government’s key
macroeconomic objective of maintaining stability in the price level. The reduced
interest rate may lead to an increase in aggregate demand (AD). As AD increases and
resources become increasingly scarce, there is likely to be an increase in the price
level through demand-pull inflationary pressure. The extent of the pressure on the
price level will depend on the size of the negative output gap. If there is significant
slack in the Brazilian economy, as is likely to be the case, then demand-pull inflation
is less likely to occur.
57

Essay style
2 Aggregate supply (AS) is the total supply of goods and services available in an economy.
Supply-side policies are designed to increase aggregate supply through an increase in the
efficiency of factor and product markets.
Supply-side policies which succeed in increasing the quantity or quality of the factors of
production will raise the productive capacity of the economy. Interventionist supply-side
policies are those that directly involve the government in attempting to influence conditions
of efficiency. An interventionist supply-side policy aimed at increasing human capital through
increased education and training is likely to have the impact of increasing skills and efficiency
and therefore labour productivity over the longer term. The result would be an increase in
economic growth and a reduction in inflation.
Investment in infrastructure, such as a major national rail construction project, is another

interventionist supply-side policy. This will lead to a more efficient use of the factors of
production through greater mobility and reduced transport times. This could also lead to an
increase in the potential capacity of the economy and cost savings that reduce the price
level.
A further interventionist supply-side policy is government investment in new technology

through research and development. This would allow firms to operate more efficiently and
produce greater output from a given set of inputs. This too would increase the productive
potential of the economy while potentially reducing the price level.
The effect of these interventionist supply-side policies on the macroeconomy is illustrated in

the diagram below, which incorporates the Keynesian approach to the long-run aggregate
supply curve.
58

The economy is originally in equilibrium at E1. The interventionist supply-side policies

analysed above lead to an increase in long-run aggregate supply from LRAS1 to LRAS2, which
moves equilibrium from E1 to E2. This results in economic growth, represented by an increase
in real GDP from Y1 to Y2, and a reduction in the equilibrium price level from P1 to P2. This
analysis provides evidence to support the statement that interventionist supply-side policies
enable a government to achieve multiple objectives simultaneously.
However, the effectiveness of interventionist supply-side policies in always achieving these

multiple objectives simultaneously is questionable and will depend on a number of factors.
Some supply-side policies, such as an increase in spending on education and training, may
take many years (if ever) to have an impact on productivity and so influence aggregate
supply. Some beneficiaries of the education and training may go to work overseas. This is a
particular problem if the skills learnt are being quickly superseded by new skills needed as
technology also advances rapidly. This means that any associated positive impact on
economic growth and inflation might never actually take effect.
Major infrastructure projects are notoriously expensive both in real terms and in terms of
the opportunity cost of the expenditure. In order to undertake some of these major supply-
side projects, taxation may need to be raised to pay for the policy. If the additional taxes
increase the costs of firms, this may lead to reduced incentives to produce and also to cost-
push inflationary pressure. This may reduce the effectiveness of the supply-side policy in
achieving multiple objectives simultaneously.
Finally, supply-side policies may have very limited impact on actual economic growth if the
economy is already operating with a (significant) negative output gap. This is because, with
considerable spare capacity in the economy and an existing demand deficiency, any increase
in productive potential following the implementation of interventionist supply-side policies
will add little to real GDP.
In conclusion, it is possible to show that interventionist supply-side policies do not always

achieve their multiple objectives of increased economic growth and reduced inflation
simultaneously. Inefficiencies can still exist that may require coordinated market-based
supply-side policies in order to fully exploit potential efficiency gains and achieve multiple
objectives simultaneously.
11a International economic issues

59

Multiple-choice
1 C
2 B
3 A
4 A
5 C
6 D
7 B
Data response
1 a The key fiscal policy measure that the authorities in India have undertaken to
stimulate economic growth is to reduce income taxation and increase government
spending. The proposed decrease in income taxation detailed in Table 1 would
increase disposable income. The increase in disposable income is greater for the
middle-income earners and is likely to increase household consumption expenditure
in India. This is a component of aggregate demand (AD), as is government
expenditure, which is also increasing by 12.7% according to the article. The combined
effect would be to increase AD and actual economic growth in the Indian economy.
India is already suffering a current account deficit on its balance of payments, as

reported in the article. The additional consumer spending would include an element
spent on imports; similarly, the increased government expenditure is likely to contain
some spending on imported raw materials or services. The effect, therefore, of the
fiscal policy measures would be to increase net imports, moving the current account
of the balance of payments in India into greater deficit.
The extent of the impact of the fiscal policy measures on the current account deficit
will depend on the marginal propensity to import in India, for both consumers and
the government. The greater the propensity, the greater the increase in the value of
imports. It is likely that the increasingly wealthy middle class in India would use their
increase in disposable income to import more luxury items of relatively high value,
such as gold, mobile telephones and consumer electronic goods, causing a greater
increase in the deficit on the current account of the balance of payments.
b The article reports that the current account of the balance of payments in India has
been in deficit for a number of years up to June 2020. This account goes into deficit
when money sent outwards exceeds that coming inwards. An expenditure-switching
60

policy would be one that encourages domestic residents to switch their expenditure
away from imports towards domestically produced goods. For India, a decrease in
the import of mobile telephones and consumer electronic goods in favour of
domestically produced items would help to reduce the current account deficit. One
way to achieve this would be through trade protection methods such as tariffs.
The issue with adopting any protectionist measure is retaliation. For an open and
outward-looking economy like India that arguably enjoys export-led growth, this
could be a seriously damaging issue in both trade and international relations terms.
An expenditure-reducing policy would encourage domestic residents to spend less.

This would move them away from the purchase of so many imported items such as
gold, through a reduction in domestic aggregate demand. This could be achieved
through increased income taxation, for example. For India, the resulting decrease in
imports would help to reduce the current account deficit.
The problem with adopting this approach in India is that the government is actually
undertaking expansionary fiscal policy with lower income tax rates in the pursuit of
economic growth. Expenditure reduction would hinder this and potentially lead to
higher unemployment.
c The financial account of the balance of payments records transactions associated

with changes in the ownership of a country’s foreign financial assets and liabilities.
India is expected to receive US$73 billion in foreign direct investment (FDI) in

2019/20. FDI occurs when overseas investors purchase assets in the domestic Indian
economy. The net flows of such foreign direct investment are one of the most
important categories of such transactions recorded in its financial account.
The current account of the balance of payments, however, is the place where any
income, paid overseas to the foreign owners of the assets, would be recorded. Hence
the FDI will create entries in both the financial and the current accounts of the
balance of payments of India over time.
d India is considering a renegotiation of its trade deals, with a particular focus on the
USA, the EU and the UK. The realignment will include the benefits of trade creation,
which are derived from the replacement of more expensive domestic production or
imports with cheaper output from a new partner within a new trade agreement.
However, the Indian government will also need to be mindful of the possible costs
associated with trade diversion. These occur through the replacement of cheaper
imported goods from existing trade partners by goods from a less efficient and more
61

expensive trading partner within a new agreement that has relatively high common
external tariffs.
e A monetary union is a situation in which countries in a comprehensive trade

agreement also adopt a common currency. One disadvantage to India of monetary
union would be the loss of sovereignty over its monetary policy decisions. Within a
monetary union there is usually a central banking institution that undertakes the
monetary policy for all economies in the union. This gives rise to the risk of
asymmetric shocks occurring. This could disadvantage India if the monetary response
did not align with its current economic circumstances.
Essay style
2 A competitive devaluation of an exchange rate occurs when one country deliberately
acts to lower – that is, devalue/depreciate – the external value of its currency in order to
secure a competitive price advantage in overseas markets. This can be achieved through
supplying its own currency in the foreign exchange market.
The strategy of a competitive devaluation is aimed at the reduction of a current account

deficit through increasing the quantity of exports and decreasing the quantity of imports.
The exports become cheaper because overseas buyers will require less of the importing
countries’ currency to purchase the exporting country’s goods or services. Similarly, a
competitive devaluation will also provide an advantage to the domestic economy by making
imports more expensive. The law of demand will then dictate that the quantity of exports
increases while the quantity of imports decreases.
Whether this strategy will lead to an improvement in the country’s current account deficit,
though, will depend on the responsiveness of the quantity demanded of exports and imports
to the change in their price. This will be determined by their price elasticities of demand.
The more price elastic the demand for exports, the greater the increase in their quantity
relative to their price decrease and therefore the greater the positive impact on the value of
the current account deficit. The more price elastic the demand for imports, the greater the
decrease in their quantity relative to their price increase and therefore, again, the greater
the positive impact on the value of the current account deficit.
In summary, there will only be an improvement in the current account of the balance of
payments if the sum of the price elasticity of demand for exports and imports is greater than
1. This is known as the Marshall–Lerner condition and it is this that appears to validate the
view expressed in the statement. If this condition does not hold then the relatively price
inelastic nature of exports means that there will be a relatively small increase in the volume
of exports as the exchange rate devalues. Additionally, the relatively price inelastic nature of
62

imports means there will be a relatively small decrease in import volumes as the exchange
rate devalues. The combined effect will lead to no improvement in the deficit on the current
account of the balance of payments.
The extent to which the view in the statement is valid will depend on a number of factors. In
the long run, if imported raw materials increase in price significantly, this could affect the
price competitiveness of exports and negatively affect the current account balance moving
forward.
The success of the strategy will also depend on the elasticity of the domestic supply of
goods. If this is relatively inelastic and domestic producers cannot increase output
sufficiently to meet the additional demand for exports, then the current account cannot
improve in the manner suggested in the statement.
While a competitive devaluation will make all exported goods cheaper, there is no guarantee
that consumers in overseas markets will be in a position to increase their consumption at
that time. This would not then help to reduce a balance of payments deficit on the current
account.
In conclusion, the impact of a competitive devaluation on the current account deficit is not
clear and will depend on a number of factors that are difficult to predict accurately. Higher
import prices will contribute to higher inflation, which may reduce any significant export
price advantages that might otherwise be expected. It is therefore not possible to state that
the success of a policy of competitive devaluation is ultimately determined by price elasticity
of demand.
3 Globalisation refers to the range of processes by which the world’s economies are
becoming more closely integrated. It is globalisation that allows goods or services to be
produced, distributed and exchanged anywhere in the world. The process will have an
impact on consumers, workers and the environment, some of which will be beneficial
and some of which will cause otherwise positive situations to deteriorate, or already
difficult situations to get worse.
Globalisation can have the impact of increasing the living standards of consumers in an
economy that engages in international trade. This results from increased specialisation and
trade which, through the law of comparative advantage, reduces costs and prices, leading to
increased welfare and choice for consumers.
Workers benefit from globalisation through the impact of an increase in the number of
‘location-independent’ transnational companies. This is because such transnational
companies are often encouraged by host governments to locate in areas of high
unemployment, bringing jobs, training and income to the unemployed workforce. Moreover,
63

workers employed in domestic export-orientated industries will also benefit from greater
employment opportunities.
It is possible that the increased ease with which international communications take place
under globalisation and the development of ideas sharing as an expected norm will lead to
environmental benefits. This is because the best practice in environmental safeguarding and
sustainability from around the world will be shared more readily in forums such as the
climate change summit meetings.
The extent to which globalisation is universally beneficial for consumers, workers and the
environment will depend on a number of factors. The extent to which consumers will benefit
from globalisation depends on the validity of the classical view of free-trade theory. There is
academic and empirical evidence which suggests that the benefits of comparative advantage
are not equitably shared, and globalisation can be detrimental to the standard of living of
some countries and some groups within countries.
The benefits to workers are also not necessarily universal. This is because, while increased
imports cause domestic job losses, there is no guarantee that these will be replaced by the
creation of additional jobs through additional export activity. Unemployment, relative
poverty and wage squeezes may follow and living standards fall, especially among lower-
skilled workers.
Moreover, footloose transnational companies can actually cause unemployment as they

move from country to country in search of lower costs of production and increased profits.
Moreover, workers may be exploited in terms of pay and conditions as their interests are
poorly represented and work regulations in some host countries are not of the standard
expected elsewhere.
The increase in economic activity generated by globalisation leads to increasing

environmental destruction and other negative externalities. These include the
environmental problems caused by congestion, pollution and increasing levels of
greenhouse gases from increased production. The notion that goods can be created
anywhere in the world, then distributed to end users anywhere in the world, inevitably
involves increased transportation. The external costs created by this transportation will not
necessarily be fully accounted for. This will lead to negative externalities that contribute to
climate change and a reduction in the health and wellbeing of third parties and ultimately
market failure.
In conclusion, despite some demonstrable gains in poverty reduction and increased levels of
economic growth and development, it is possible to show that globalisation is not universally
beneficial for consumers, workers and the environment. As a result of globalisation,
consumers may not benefit from cheaper and better-quality goods and services, and
64

workers may not obtain appropriate employment. The environment may also suffer from
increased resource depletion and degradation. It is not always possible to enforce the
regulations required in a global context to address the issues highlighted here. Climate
change agreements are a good example of this.
11b International economic issues

Multiple-choice
1 C
2 B
3 A
4 B
5 B
6 D
7 A
8 B
Data response
1 a Simon Kuznets hypothesised that as society develops, income inequality within
society increases and then falls. In early stage agricultural society there is income
equality because most people have very little income. As the economy grows and
develops, the wages of industrial workers rise faster than those of agricultural
workers, giving rise to income inequality. As the economy and society continue to
grow and develop, additional wealth is redistributed through government transfers
and access to education. Kuznets essentially argued that inequality in poor countries
is just a transitional phase, and once nations become economically developed,
inequality reduces.
This relationship is shown in the simple Kuznets curve below.
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There is some evidence in Table 1 to support the Kuznets curve. The Gini coefficient
measures the degree of income inequality in a country. The highest Gini coefficients
recorded in Table 1 are in the two sets of middle-income countries, ranging from
40.2 to 44.5, while those countries in the upper- or in the lower-income classification
have lower Gini coefficients. Nigeria, another lower-middle-income country, with a
Gini coefficient of 48.8, also fits with this specific set of data. However, the data
reported in the article are very limited.
b One hypothesis is that there is for any country an optimum population level for the
resources available. Under this argument, Nigeria would be seen as having too large
a population that is growing too rapidly. This will result in a number of
disadvantages.
First, a rapidly growing population could deplete resources more quickly, which
would reduce the opportunity for future growth in Nigeria.
Secondly, a rapidly growing population will increase the dependency ratio if the
rising population is due to an increase in the birth rate, as is the case in Nigeria. More
resources will have to be devoted to providing primary education and infant and
mother healthcare, and there will be fewer members of the household available to
take paid work.
Finally, an increasing population will lead to overcrowding and lower living standards.
This is especially the case if, as in Nigeria, the infrastructure development is
insufficient to keep pace with the population growth.
c The Gini coefficient is a commonly used measure of income inequality in a country. It

has a value between 0 and 1. The lower the value, the less the income inequality.
66

The article reports that the number of people living on less than $1.90 a day has had
been decreasing considerably. According to the most recent estimates, 10% of the
world’s population or 734 million people live on less than $1.90 a day. That is down
from nearly 36% or 1.9 billion people in 1990. This has helped to reduce the global
Gini coefficient from 65.7 in 1992.
The Covid-19 pandemic crisis will have a disproportionate impact on the poor,
through job loss, loss of remittances, rising prices, and disruptions in services such as
education and healthcare. This disproportionate impact will cause a rise in the Gini
coefficient as the income gap widens in countries where the more wealthy are less
affected, suffering less loss of income than the relatively poor.
d An increase in savings can help finance higher levels of investment and boost
productivity over the longer term. This is because if households save more, by
increasing their savings ratio, it enables the banks to lend more money to firms for
productive investment. With the correct levels of the savings ratio and the
productivity of capital, stable and sustainable growth can be achieved.
This approach assumes that a well-functioning financial system exists. The article
details the problems of banking in Nigeria, concluding that despite the efforts of the
central bank, the Nigerian banking system is yet to reach full stability. This means
that even if the savings ratio increased in Nigeria, which is unlikely given the extreme
poverty, there would be bottlenecks and liquidity shortages in the Nigerian banking
system. These problems would prevent the efficient channelling of savings to
investment.
The extent to which an increase in savings in Nigeria is likely to lead to an increase in

economic growth is also dependent on the short-term impact of the increase in
savings.
Over the short-term, a sharp rise in the savings ratio is likely to lead to a fall in
consumption, which can lead to a recession. This will be more so the greater the
percentage of consumption within GDP. A sustained reduction in consumption can
be a significant factor in economic stagnation. In such a situation, a sharp increase in
the savings ratio is less likely to lead to the anticipated increase in investment and
economic growth over the longer term.
Essay style
2 Gross domestic product (GDP) is relatively easy to measure and represents the value of
economic activity in an economy over time. Living standards are a more normative
67

concept, considering material and non-material aspects of the quality of life. Establishing
a causal link from increases in GDP to increases in standard of living has its difficulties.
Within any economy there are variations felt in the impact of growth created by an increase
in GDP. There will be those individuals in the economy who are unaffected, and in a wider
sense, whole regions of a country that do not benefit from an increase in the GDP. Larger
cities will traditionally benefit disproportionately from economic growth with more rural
areas left behind. Also, workers with the skills required in the growth sectors will see their
incomes increase while others will not. Those working in sectors that become less valuable
to economic growth could even suffer structural unemployment. This means that for regions
and individuals within the same economy, the increase in GDP growth could produce
regional deprivation and very different experiences in terms of the impact on their standard
of living.
The composition of the goods and services that lead to the increase in GDP and growth will
also be important in determining the impact on the standard of living. If more merit and
public goods are produced, material and non-material standards of living are likely to
increase. Similarly, but conversely, if more goods that create negative externalities or
demerit goods are produced, GDP will still be increased but the standard of living could
actually decrease. This is because these goods, which are worse for consumers than they
realise, are increasingly overconsumed.
The accuracy of GDP data and therefore growth rates could also create an issue. The
national income accounting calculations that produce a value for GDP come from vast
quantities of diverse economic data. In reality, these data can be subject to errors and
omissions and, in some cases, the deliberate misreporting associated with illegal economic
activity. This could lead to significant inaccuracies that result in the true growth figure for
GDP being quite different from that officially recorded, whereas the population of the
economy would experience the actual standard of living as it occurred. This means increases
or decreases in GDP will not necessarily lead to corresponding changes in the standard of
living.
Finally, if the increase in GDP is achieved through an increase in the hours worked, leading to
a poor work–life balance or reduced mental health and wellbeing, there could be an increase
in GDP but a lower standard of living.
The extent to which an increase in GDP will necessarily lead to an increase in living standards
will depend on a number of factors. Specifically, there is more likely to be an increase in the
living standard in an economy if the GDP growth is inclusive and sustainable.
The OECD defines inclusive growth as economic growth that is distributed fairly across all of
society and that creates opportunities for all. The particular group being considered and the
68

length of the time period will affect how likely it is to identify inclusive growth. This is
because, for certain groups, such as skilled, occupationally mobile individuals, living
standards are likely to increase quickly. In order for others to be included in the benefits, the
authorities must ensure that growth affects all parts of the economy geographically, and any
individuals unable to access new opportunities should be included in retraining or assisted
relocation in order to also increase their standard of living.
Welfare provision by the state can also help to increase standards of living when GDP
increases. If welfare provision by the state is extensive and increased in line with the
increase in GDP, the increase in the standard of living will be more inclusive for all.
For the increase in GDP to increase the standard of living, it also needs to be sustainable.
This means that the growth in GDP today must not compromise the opportunities for those
in the future also to increase their GDP. If the growth in GDP is part of a poorly managed and
uncertain boom-and-bust cycle, resulting from and in poor decision making, then this will
lead to inefficiency and unsustainable increases in GDP, and volatility in living standards.
The sustainability of the growth in GDP and living standards will depend on the extent to
which pollution, created through increased economic activity, is dealt with efficiently and
effectively by the appropriate regulatory authorities. Rigorous enforcement of the existing
standards would afford a greater link between increased GDP and an increase in living
standards over time.
In conclusion, while there is a link, it is not possible to say that an increase in GDP is
sufficient to cause an increase in the standard of living in an economy. Intervention is
required to ensure that any growth in GDP is both inclusively and sustainably managed by
the authorities to ensure that the widespread and long-term benefits are felt through an
increase in the standard of living throughout the population.
3 The Human Development Index (HDI) is a composite measure of the development of an

economy. It comprises developmental and economic criteria in its measure. The HDI
provides a value for the level of human development that can be used to provide a ready
numerical comparison of development between countries and over time.
One of the main attributes of the HDI is that it is a measure of development that uses
internationally accepted criteria. These measures include education, through the mean years
of schooling for an adult aged 25 and expected years of schooling for a pre-school child. This
provides a measure of development reflecting the opportunities offered by the degree of
exposure to education in the country. A measure of health is included in the HDI through life
expectancy at birth. This has the benefit of providing a measure of development reflecting
the standard of healthcare in the country. A measure of economic growth is included in the
HDI through real GNI per capita at purchasing power parity (PPP). This reflects access to
69

opportunities for higher standards of living and the human development that can stem from
them.
These three components all have an equal weight in the calculation of the Human
Development Index. The mean average of the three provides one overall value for the HDI of
a country of between 0 and 1. A higher value means a higher level of human development.
This is because the country is more successfully creating and providing opportunities for
human development. Countries often achieve a similar ranking in consecutive years (during
stable times), providing reliability in the value of the HDI calculation. In this way the HDI can,
therefore, be thought of as being used successfully to compare levels of development
between countries.
A key deficiency in the HDI calculation, in terms of measuring human development, is that
no account is taken of the negative impacts of economic activity on human development,
such as the external costs of production processes.
One further drawback of using the HDI to compare levels of development between countries
is that it fails to record the difference in access across the key indicators between gender
groups. This effectively masks the different life experiences of different members of the
population. In some societies the arrangements for access to health, education and
employment opportunities differ between the genders, for example. This leads to different
degrees of human development within the same economic environment. This will not be
captured by the basic HDI statistic.
Additional criticism of the HDI arises because there exists a range of readily available
indicators, such as those relating to access to sanitation or financial networks, that have an
impact on human development but are not directly included in the HDI calculations. This can
make the measure appear arbitrary when key factors are excluded that would impact on the
degree of human development recorded within a country.
The issue of inequality is not referenced within the HDI. This can be reasonably easily
measured and can be extremely important in determining access to choices and
opportunities that determine human development. Where there is greater inequality, it is
more likely that sections of the population suffer lower human development than the HDI
figure would suggest.
Alternative measures of development exist that go some way to addressing the

shortcomings of the HDI. The Gender Human Development Index, for example, measures the
access of each gender to the opportunities and choices afforded by the level of human
development in a country. The Measure of Economic Welfare (MEW) is a further example.
Like the HDI, the MEW includes a value for GNI, but it then makes various adjustments not
included in the HDI. These adjustments include a value for unrecorded or informal
70

production and crucially there are deductions made for negative externalities such as
environmental damage.
The Multi-dimensional Poverty Index (MPI) is another alternative measure of development.

The MPI uses the same broad criteria as the HDI but attempts to reflect the number of
deprivations faced by households across a broader range. Items comprised in the measure of
deprivation include access to electricity, clean water, sanitation and good cooking fuels.
These do not appear in the HDI measure.
In conclusion, the HDI is a useful composite indicator of economic development and

standards of living. However, as a complete measure of human development it has
significant shortcomings. There are both deficiencies in the measure when used for
comparative purposes and alternative measures that, if used together with the HDI, could
provide a more valid and holistic comparison of human development between countries.
71


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Cambridge International AS & A Level Economics

1 Basic economic ideas and resource allocation

There is an opportunity cost associated with greater environmental sustainability

Cambridge International AS & A Level Economics Workbook

The notion of production possibility refers to the maximum possible output

An economic good, such as the capital machinery used by an entrepreneur, does

Cambridge International AS & A Level Economics

2 The price system and the microeconomy

In 2024, the % change in demand is estimated at 9.4%.

In 2024, the estimated % change in income is:

(15,102.15 – 13,969.54) × 100/13,969.54 = 8.1%

Estimated income elasticity of demand = 1.16.

Cambridge International AS & A Level Economics

Applying this to the extract, a shift in consumer preference towards healthy

Cambridge International AS & A Level Economics

f Price elasticity of demand (PED) measures the responsiveness of the quantity

Cambridge International AS & A Level Economics

Cambridge International AS & A Level Economics

Knowledge of the value of income elasticity of demand (YED) allows a firm to

3 Government microeconomic intervention

Cambridge International AS & A Level Economics

In published data, the Gini coefficient is expressed as a percentage. A Gini value of

b A progressive income tax can be said to create a fairer redistribution of income

However, government transfer payments do not boost production or economic

The reduction in transfer payments would be most effective at redistributing income

Cambridge International AS & A Level Economics

Cambridge International AS & A Level Economics

4a The macroeconomy (Chapters 6 and 7)

Cambridge International AS & A Level Economics

c The circular flow model is a representation of the level of national income in an

Cambridge International AS & A Level Economics

Cambridge International AS & A Level Economics

4b The macroeconomy (Chapters 8–10)

Cambridge International AS & A Level Economics

c The extract states that unemployment in Greece is measured by the International

As economic growth increases, inevitably industrial output, energy production and

Cambridge International AS & A Level Economics

This can be achieved through strict regulation of production processes, taxation to

If AD increases to AD1, there will be a temporary increase in real GDP to Y1 with a

Cambridge International AS & A Level Economics

The government could alternatively increase education and training in order to

A combination of migration as a short-term fix to labour shortages and a longer view

Cambridge International AS & A Level Economics

5 Government macroeconomic intervention

Cambridge International AS & A Level Economics

Cambridge International AS & A Level Economics

Consumption and investment together represent a significant proportion of total aggregate

However, such an expansionary monetary policy aimed at increasing aggregate demand

Cambridge International AS & A Level Economics

Part 6 International economic issues

Cambridge International AS & A Level Economics

Cambridge International AS & A Level Economics

A second factor could be linked to the increasing saving propensity of households in

Cambridge International AS & A Level Economics

Expansionary monetary policy works by decreasing short-term interest rates or expanding

7a The price system and the microeconomy

Cambridge International AS & A Level Economics

A consumer will maximise utility by consuming on the highest indifference curve