Ib Economics Study Guide Pyszczek

IB
Economics Study Guides

Assessment Outline - SL
EXTERNAL ASSESSMENT (3 hours) 80%

Monday May 2, 2016
Paper 1 (1 hour and 30 minutes) 40%
An extended response paper (50 marks)
Assessment objectives 1, 2, 3, 4

Section A
Syllabus content: section 1Microeconomics
Students answer one question from a choice of two. (25 marks)

Section B
Syllabus content: section 2Macroeconomics

Tuesday May 3, 2016
Paper 2 (1 hour and 30 minutes) 40%
A data response paper (40 marks)
Assessment objectives 1, 2, 3, 4

Section A
Syllabus content: section 3International economics

Section B
Syllabus content: section 4Development economics

Completed March 2016

INTERNAL ASSESSMENT (20 teaching hours) 20%
This component is internally assessed by the teacher and externally moderated by the IB at the
end of the course.

Students produce a portfolio of three commentaries, based on different sections of the syllabus
and on published extracts from the news media.

Maximum 750 words x 3 (45 marks)

IB Economics City Honors School 2015-2016
Basic Definitions

Social Science and Economics

Social Science is defined as a branch of science that studies the society and human behavior in it,
including anthropology, communication studies, criminology, economics, geography, history,
political science, psychology, social studies, and sociology.

Economics is the branch of social science that deals with the production and distribution and
consumption of goods and services and their management.
It is the study of how scarce resources are allocated to fulfil unlimited wants.

Microeconomics and Macroeconomics
Economics is usually divided into two main branches:

Microeconomics, which examines the economic behaviour of individual actors such as businesses,
households, and individuals, with a view to understand decision making in the face of scarcity and
the allocation consequences of these decisions.

Macroeconomics, which examines an economy as a whole with a view to understanding the
interaction between economic aggregates such as national income, employment and inflation.

Economic growth is the increase of per capita gross domestic product (GDP) or other measure of
aggregate income. It is often measured as the rate of change in GDP. Economic growth refers only
to the quantity of goods and services produced.

Economic development typically involves improvements in a variety of indicators such as literacy
rates, life expectancy, and poverty rates. It is a measure of welfare in the economy. Human
Development Index (HDI) is one of the most commonly used development measure.

Sustainable development is a pattern of resource use that aims to meet human needs while
preserving the environment so that these needs can be met not only in the present, but also for
future generations. Economic development that meets the needs of the present without
compromising the ability of future generations to meet their own needs.

Free Goods and Economics Goods

Free goods are what is needed by the society and is available without limits. The free good is a
term used in economics to describe a good that is not scarce. A free good is available in as great a
quantity as desired with zero opportunity cost to society.
Economics goods are consumable item that is useful to people but scarce in relation to its demand,
so that human effort is required to obtain it.

Economic Definition of the Four Factors of Production

Economic resources are the goods or services available to individuals and businesses used to
produce valuable consumer products. The classic economic resources include land, labor and
capital. Entrepreneurship is also considered an economic resource because individuals are
responsible for creating businesses and moving economic resources in the business environment.
These economic resources are also called the factors of production. The factors of production
describe the function that each resource performs in the business environment.

Land
Land is the economic resource encompassing natural resources found within a nations economy.
This resource includes timber, land, fisheries, farms and other similar natural resources. Land is
usually a limited resource for many economies. Although some natural resources, such as timber,
food and animals, are renewable, the physical land is usually a fixed resource. Nations must
carefully use their land resource by creating a mix of natural and industrial uses. Using land for
industrial purposes allows nations to improve the production processes for turning natural
resources into consumer goods.

Labor
Labor represents the human capital available to transform raw or national resources into
consumer goods. Human capital includes all able-bodied individuals capable of working in the
nations economy and providing various services to other individuals or businesses. This factor of
production is a flexible resource as workers can be allocated to different areas of the economy for
producing consumer goods or services. Human capital can also be improved through training or
educating workers to complete technical functions or business tasks when working with other
economic resources.

Capital
Capital has two economic definitions as a factor of production. Capital can represent the monetary
resources companies use to purchase natural resources, land and other capital goods. Monetary
resources flow through a nations economy as individuals buy and sell resources to individuals
and businesses.

Capital also represents the major physical assets individuals and companies use when producing
goods or services. These assets include buildings, production facilities, equipment, vehicles and
other similar items. Individuals may create their own capital production resources, purchase them
from another individual or business or lease them for a specific amount of time from individuals
or other businesses.

Entrepreneurship
Entrepreneurship is considered a factor of production because economic resources can exist in an
economy and not be transformed into consumer goods. Entrepreneurs usually have an idea for
creating a valuable good or service and assume the risk involved with transforming economic
resources into consumer products. Entrepreneurship is also considered a factor of production
since someone must complete the managerial functions of gathering, allocating and distributing
economic resources or consumer products to individuals and other businesses in the economy.
Three Basic Economic Questions

As an entrepreneur and as an economic agent, there are three basic economic questions you
should ask when deciding how to use scarce resources:

What to produce?
How to produce?
For whom to produce?

What to Produce?

In a true command economy, what to produce is determined by a central economic authority. In a
true free market, what to produce is determined by individual choices. However, most nations fall
somewhere between a true command economy and a true free market and production is
determined by a mixture of central planning and individual choices.

For example, in the United States, while the production of some foodstuff is determined by supply
and demand, others, such as sugar and milk, are subsidized by the government.

All businesses must decide what to produce given limited resources. While a society must decide
how much food and shelter to produce to satisfy the population, a business must decide how much
of each goods or services to produce.

Because of scarcity, by producing A, you must forgo the production of B, thus incurring an
opportunity cost. You choose to produce, hopefully, the product or service that brings the highest
benefits relative to costs. However, as the organization gets bigger and more complicated and as
the number of choices increases, so will the difficulty in answering this question.

How to Produce?

There are many ways to produce a good or service of equal quality. As an entrepreneur, it is
important to have a clear understanding of all your alternatives. Should the business produce all
the goods and services it sells by itself or will it bring in outside contractors? Should the
production take place domestically or should it be outsourced to another country? Should the
production be labor intensive or capital intensive?

For Whom to Produce?

All goods and services are produced for somebody to consume. In a free market, who gets what is
determined by who is able to afford what at a price determined by supply and demand. As an
entrepreneur, this question should be addressed in the same line of thought as "what to produce?"
Who are your customers? Will your targeted customers be able to afford the product? Are there
enough of them to support your business?

4 Factors Examples

Papa Johns Pizza

Land: Retail Locations/Kitchens/Stores

Labor: Hourly and Salaried Workers, per diem delivery drivers.

Capital: Ovens, Boxes, Utensils (pans, spatulas, etc.), Point of Sales equipment, Ingredients, etc.

Entrepreneur: Papa John Schnatter, Founder CEO

Coca-Cola Softdrinks

Land: Factories, Bottling Plants, Floor Space at the Retail Market

Labor: Hourly and Salaried Workers

Capital: Ingredients, Bottling Supplies (Aluminum & Plastic), Packaging, Delivery Vehicles, etc.

Entrepreneur: John Pemberton, Founder. Today; CEO and Board of Directors

3 Basic Questions Examples

What to produce: Automobiles; SUVs, sports cars, sedans, coupes?

How to Produce: Factory, USA or Overseas? Union or Non-Union

For Whom to Produce: How expensive do you make the vehicle? Chevrolet, Buick or Cadillac

What to produce: TAG Heuer; Timepieces

How to Produce: Factory and handmade, Switzerland

For Whom to Produce: sports, casual and dress watches and customers

What to produce: New Era Hats

How to Produce: Factory, USA or Overseas? Union or Non-Union

For Whom to Produce: MLB Hats, NFL Hats, NBA Hats, NHL Hats, Casual Hats, Comic Hats

Section 1: Microeconomics
1.1 Competitive markets: demand and supply (some topics HL only)
1.2 Elasticity
1.3 Government intervention (some topics HL extension, plus one topic HL only)
1.4 Market failure (some topics HL only)
1.5 Theory of the firm and market structures (HL only)

The purpose of this section is to identify and explain the importance of markets and the role played
by demand and supply. The roles played by consumers, producers and the government in different
market structures are highlighted. The failures of a market system are identified and possible
solutions are examined.

The concepts learned here have links with other areas of the economics syllabus; for example,
elasticity has many applications in different areas of international trade and development.

What is Market
Market is a place where buyers and sellers meet. In economics, the concept of a market is any
structure that allows buyers and sellers to exchange any type of goods, services and information.
The exchange of goods or services for money is a transaction.

Features of a market
Market participants consist of all the buyers and sellers of a good who influence its price. There
are two roles in markets, buyers and sellers. The market facilitates trade and enables the
distribution and allocation of resources in a society. Markets allow any tradable item to be
evaluated and priced. A market emerges spontaneously or is constructed deliberately by human
interaction in order to facilitate the exchange of goods and services

What is demand?
Demand is defined as want or willingness of consumers to buy goods and services.
In economics willingness to buy goods and services should be accompanied by the ability to buy
(purchasing power) and is referred to as effective demand.

Law of demand
The law of demand is an economic law that states that
consumers buy more of a good when its price decreases and less when its price increases, ceteris
paribus.

It states that when price increases, the amount demanded will fall and when prices fall, the
amount demanded will rise.

Rationale of the law of demand
There are two reasons for a fall in demand when the prices increase.

Income effect: People feel poorer. As the price of a good rises the purchasing power of people to
buy that good will fall. This is known as income effect.

Substitution effect: Some people might shift to cheaper alternatives/substitutes once the price of
a good rise, thus leading to a fall in demand for that good.

Straight line (linear) demand curve

A straight line demand curve will have a different elasticity at each point on it.
The price elasticity of demand can also be measured at any point on the demand curve.

If the demand curve is linear (straight line), it has a unitary elasticity at the midpoint. The total
revenue is maximum at this point. Any point above the midpoint has elasticity greater than 1, (Ed
> 1).

Here, price reduction leads to an increase in the total revenue (expenditure). Below the midpoint
elasticity is less than 1. (Ed < 1). Price reduction leads to reduction in the total revenue of the firm.
Now the question arises, why does a straight line demand curve have different elasticity at each
point? The value of PED falls as price falls.

The reason is that low priced products have a more inelastic demand than high priced products,
because consumers are not that price sensitive when the product is inexpensive, Similarly the
value of PED is higher when the prices increase because consumers are more sensitive to price
change when the good is expensive. A mathematical explanation can be given as follows. As we
seen in diagram below

Movement along the demand Curve:

Extension of demand
Extension of demand is the increase in demand due to the fall in price, all other factors remaining
constant.

Contraction of demand
Contraction of demand is the fall in demand due to the rise in price, all other factors remaining
constant.

Shift in the demand curve
Usually demand curves are drawn based on the assumption except for price all other factors
remain the same. But there might be instances when demand may be affected by factors other
than price. This will result in the change in demand although the price will remain the same. This
change in demand may cause the demand curve to SHIFT inwards or outwards.

Shift of demand curve OUTWARDS shows an increase in demand at the same price level. It is
known as INCREASE IN DEMAND.

Shift of demand curve INWARDS shows that less is demanded at the same price level. It is known
as a FALL IN DEMAND.


Factors affecting demand
Change in peoples income: More the people earn the more they will spend and thus the demand
will rise. A fall in income will see a fall in demand.

Changes in population: An increase in population will result in a rise in demand and vice versa.

Change in fashion and taste: Commodities or which the fashion is out are less in demand as
compared to commodities which are in fashion. In the same way, change in taste of people affects
the demand of a commodity.

Changes in Income Tax: An increase in income tax will see a fall in demand as people will have
less money left in their pockets to spend whereas a decrease in income tax will result in increase
of demand for products and services because people now have more disposable income.

Change in prices of Substitute goods: Substitute goods or services are those which can replace
the want of another good or service. For example margarine is a substitute for butter. Thus a rise
in butter prices will see a rise in demand for margarine and vice versa.

Change in price of Complementary goods: Complementary goods or services are demanded
along with other goods and services or jointly demanded with other goods or services. Demand for
cars is affected the change in price of petrol. Same way, demand for DVD players will rise if the
prices of DVDs fall.
Advertising: A successful advertising campaign may affect the demand for a product or service.
10
Climate: Changes in climate affects the demand for certain goods and services.
Interest rates: A fall in Interest rate will see a rise in demand for goods and services.

What is Supply?
Supply refers to the amount of goods and services firms or producers are willing and able to sell in
the market at a possible price, at a particular point of time.

Law of Supply
It states that when the price of a commodity rises, the supply for it also increases.
The higher the price for the good or service the more it will be supplied in the market. The reason
behind it is that more and more suppliers will be interested in supplying those good or service
whose prices are rising.

11
Movement along the Supply Curve

Extension of supply
It refers to the increase in supply of a commodity with the rise in price, other factors remaining
unchanged.

Contraction of supply
It refers to the fall in supply of a commodity when its prices fall, other factors remaining
unchanged.

12
Shift in Supply Curve

When factors other than price affect the supply it results in the shift of supply curve. The supply
curve may move inward or outward.

A shift of supply curve outwards to the right will mean an increase in supply at the same price
level.

When the supply curve moves inwards to the left it means that less is being supplied at the same
price level.

13
Factors affecting Supply

Price of the commodity: A rise in price will result in more of the commodity being supplied to the
market and vice versa.

Prices of other commodities: For example if it is more profitable to produce LCD TVs then
producers will produce more LCD TVs as compared to PLASMA TVs. Thus the supply curve for
PLASMA TVs will shift inwards i.e. a fall in supply.

Change in cost of production: Increase in the cost of any factor of production may result in the
decrease in supply as reduced profits might see producers less willing to produce that commodity.

Technological advancement: Improvement in technology results in lowering of cost of
production and more profits for the producer and thus more supply of that commodity.

Climate: Climate and weather conditions affect the supply of commodities especially agricultural
goods.
Equilibrium
Equilibrium is a point of balance or a point of rest. A more complex definition is
Equilibrium is a state in market where economic forces are balanced and in the absence of
external influences the (equilibrium) values of economic variables will not change.

It is the point at which quantity demanded and quantity supplied is equal. Market equilibrium, for
example, refers to a condition where a market price is established through competition such that
the amount of goods or services sought by buyers is equal to the amount of goods or services
produced by sellers. This price is often called the equilibrium price.

In the graph below the point at which the demand curve meets the supply curve is the equilibrium
price.

14
Equilibrium is self righting

It means that if we try to move away from the equilibrium situation it will revert back to its
original position, if there is no external disturbance.
Figure below explains the concept.

In this diagram the equilibrium price is P* and the quantity supplied Qe. However, the prices have
been increased to P2. As the price has increased it will lead to more suppliers entering the market
and supply increasing to Qs. At the same time, a increase in price to P1 will lead to a fall in demand
(as per the law of demand) i.e. Qd. This will create an excess supply situation. Now the suppliers
will find it difficult to sell their goods and they will have to reduce their price to attract more
consumers. This will go on till the price again reaches its initial level i.e. P*. Hence the situation is
self righting if the prices are raised without any external reason.
Similarly, in the figure below

15

We can see that the prices have been artificially reduced from P* to P1. This leads to a fall in
supply from Q* to Qs (as per law of supply). As the prices fall from P* to P1, people can afford to
buy more of that good and demand increase from Q* to Qd. Again an excess demand situation is
created. In order to get the most out of this situation the suppliers will start increasing their price.
On the other hand demand will start falling as the prices increase. This will all continue till the
prices settle at equilibrium price i.e. Pe. Hence we can say that equilibrium is self-righting

Movement to a new equilibrium

The equilibrium price remains unchanged till the demand and supply curves retain their position.
The moment there is a shift in any of the components, a new equilibrium will be formed.

Effect of change in Demand and Supply

Demand
Supply
Equilibrium price
Equilibrium quantity
Increase
Decrease
Unchanged
Unchanged
Unchanged
Unchanged
Increase
Decrease
Rise
Fall
Rise
Rise
Rise
Fall
Rise
Fall
16
Affect of Change in Demand on equilibrium

If there is a shift in demand, it will lead to a movement along the supply curve and a new
equilibrium point will be achieved.

In figure 1, There is equilibrium at point E, where the price is Pe and quantity supplied is Qe.
There is a shift in demand from D1 to D2. At price Pe, it will lead to a 'excess demand' situation (F).
In order to cope with excess demand the suppliers will start increasing the price and more will be
supplied. On the other hand as the prices increase, demand will start to fall. This phenomenon will
continue till a new equilibrium stage is reached at point G. Now the Price will be P1 and quantity
supplied at that point will be Qe1. Hence it has resulted in an increase in price and quantity
demanded.

The opposite will happen if there is a shift of demand curve to the left. The price and quantity
demand will fall.

17
Affect of Change in Supply on equilibrium

In figure 2, the equilibrium point is E with Pe as the equilibrium price and Qe as the quantity
demanded. Now there is a rightward shift in supply curve to S2 i.e. supply increases. This will lead
to a excess supply. Producers will find it difficult to find consumers and will have to reduce their
prices to clear their inventories. As the prices fall, more people will be interested in buying the
product. This will continue till equilibrium is achieved at G. There will a price fall from Pe to Pe1
and Qe to Qe1. The result is lower equilibrium price and lower equilibrium quantity.

Price Elasticity of demand
The responsiveness of quantity demanded, or how much quantity demanded changes, given a
change in the price of goods or service is known as the price elasticity of demand.

Price Elasticity of demand (PED)=
% change in quantity demanded

% Change in price

Negative sign
The mathematical value which is derived from the calculation is negative. A negative value
indicates an inverse relationship between price and the quantity demanded. However, the
negative sign is ignored.

18
Range of PED
The value of PED might range from 0 to ?
Lets take a look at various types of PED.
Perfectly Inelastic demand

In this case the PED =0 That means, any change in price will not have any effect on the demand of
the product. Or in other words, the percentage change in demand will be equal to zero. It is
hypothetical situation and does not exist in real world.
Perfectly elastic demand In this case the PED =?

The demand changes infinitely at a particular price. Any change in price will lead to fall of demand
to zero. It is hypothetical situation and does not exist in real world.
However Normal goods have value of PED between 0 and ?.

These can be classified as Inelastic demand When a product has a PED less than 1 and greater than
0, it is said to be have an inelastic demand. The percentage change in demand is less than the
percentage change in price of the product.

Demand for a product is said to be ELASTIC if the percentage change is demand is more than the
percentage change in price.
The value of PED is more than 1.

19

When there is a smaller percentage change in quantity demanded as compared to the percentage
change in its price, the product is said to price INELASTIC.
The value of PED is less than 1.

20

Applications of Price Elasticity of Demand

Examine the role of PED for firms in making decisions regarding price changes and their effect on
total revenue.

Firms give a lot of importance to PED while setting prices for their products. A firm will be more
willing to increase the price of a product, which has a more inelastic demand because it will lead to
an overall increase in their revenue. With an increase in price of the product, the demand will not
fall in the same proportion and this end up in more revenue for the firm. On the other hand a firm
seeking to increase its revenue and having elastic demand for its product should not increase its
prices because it will lead to a fall in their revenue. As the price increase there will be a more than
proportionate fall in sales, thus pulling down the overall revenue of the firm.

Explain why the PED for many primary commodities is relatively low and the PED for manufactured
products is relatively high.

The PED for primary commodities is relatively low due to the fact that they have very few
substitutes whereas manufactured products have a relatively high PED because of the existence of
many substitutes. For example, the PED for cow leather (primary commodity) is relatively lower
than a genuine cow leather shoe (manufactured product). The reason being there is no or very few
substitutes for leather as a raw material for producing shoes. However, leather shoe may have
many substitutes in the form of sheep leather and other types of artificial leather shoes available
in the market.

Examine the significance of PED for government in relation to indirect taxes.

PED hold a lot of significance for government while deciding indirect taxes on goods and services.
Government uses taxes to reduce the use of demerit goods in the economy. For example they
might increase taxes on cigarettes. Cigarettes are habit forming or addictive and have inelastic
demand, thus, even a high increase in indirect taxes will not lead to a fall in the consumption of
21
cigarette smoking. Thus overall revenue of government will increase without drastically harming
the cigarette manufacturing industry and employment. Moreover, it might lead to some fall in
cigarette consumption due to increased prices.

Cross price elasticity of demand (XED)
Cross elasticity of demand is the effect on the change in demand of one good as a result of a change
in price of related to another product.

In economics, it is denoted by the symbol XED. The formula for cross elasticity of demand is

Cross elasticity of demand =
% change in quantity demanded of good X

% Change in price of good Y

In XED it is important to have the positive/negative sign in front of the value.
If the value of XED is positive, this means that the two goods being considered are substitute
goods.

Close substitutes have high positive value. Example: butter and margarine.
If two goods are complements, an increase in the price of one will lead to a reduction in the
demand for the otherthe XED is negative.

Very close complements have a lower negative value.
If two goods are unrelated, a change in the price of one will not affect the demand for the other
the XED is zero.

The Income Elasticity of Demand (YED) measures the rate of response of quantity demand due to
a raise (or lowering) in a consumers income.

Income elasticity of demand=
% change in quantity demanded

% Change in Income

Normal goods: an increase in income leads to an increase in consumption, demand shifts to the
right. Thus YED is positive for normal goods.

Inferior goods: Income elasticity is actually negative for inferior goods, the demand curve shifts
left as income rises. As income rises, the proportion spent on cheap goods will reduce as now they
can afford to buy more expensive goods. For example demand for cheap/generic electronic goods
will fall as people income rises and they will switch to expensive branded electronic goods.

22
Distinguish, with reference to YED, between necessity (income inelastic) goods and luxury
(income elastic) goods.

Basic or necessity goods have a low income elasticity i.e., 0 < ? < 1. Quantity demanded will not
increase much as income increases (income elasticity for food = 0.2)

Luxury goods have high income elasticity i.e. ? > 1. Quantity demanded rises faster than income.
For restaurant meals income elasticity is higher than for food, because of the additional restaurant
service.

In different types of economies, the demand for goods and services are determined by the income
elasticity. As economies grow, firms will want to avoid producing inferior goods. The reason being
as income increases more and more people will switch from inferior goods to superior goods.

Price Elasticity of Supply =
% change in quantity Supplied

% Change in price

Elasticity = 0: if the supply curve is vertical, and there is no response to prices.
Elasticity = ?: if the supply curve is horizontal.

Supply is price elastic if the price elasticity of supply is greater than 1, unit price elastic if it is
equal to 1, and price inelastic if it is less than 1.

Supply is Price Elastic when the percentage change in quantity supplied is more than the
percentage change in Price of the commodity. PES is more than 1.

23

Supply is Price Inelastic when the percentage change in quantity supplied is less than the
percentage change in Price of the comoditity. PES is less than 1.

24
Types of Price elasticity of Supply

Unitary Price Elasticity of Supply

Perfectly price elasticity of supply

25

Infinite price elasticity of Supply

Price Elasticity of Supply
Price elasticity of supply is a measure of the responsiveness of quantity to a change in price. In
other words, it the percentage change in supply as compared to the percentage change in price of
a commodity.

Factors affecting Price Elasticity of Supply

Time: In the short run firms will only be able to increase input of labor to increase supply of
commodities may not be able to increase the supply in response to the price change but the
supply change will be little because other factors of production may not be increased in the same
proportion and may limit the supply. However, in the long run a firm will increase the input of all
factors of production and thus the supply becomes more price elastic.

Availability of resources: If the economy already using most of its scarce resources then firms
will find it difficult to employ more and so output will not be able to rise. The supply of most of
goods and services will therefore be price inelastic.

Number of producers: More producers mean that the output can be increased more easily. Thus
supply is more elastic.

Ease of storing stocks: If goods can be stocked with ease and have a long shelf life, the supply will
be elastic, otherwise inelastic. For example perishable goods such as fresh flowers, vegetables
have comparatively inelastic supply because it is difficult to store them for longer periods.

Increase in cost of production as compared to output: In cases where there is a significant
increase in cost of production when output is increased, supply is inelastic. This is because
26
suppliers will have to have to do a significant investment in order to increase the output. It will
take time and some suppliers may be hesitant in doing so.

Improvement in Technology: In industries where there is a rapid improvement in technology,
the PES of such goods will be more elastic as compared to industries where there is not much
improvement in technology.

Stock of finished goods: In industries where there are high inventories/stocks of finished goods,
the suppliers can easily supply more as the price rises. Thus, the PES for these goods will be
elastic.

Consumer Surplus
Consumer surplus measures the
difference between total benefit of consuming a given quantity of output and the total
expenditures consumers pay to obtain that quantity.

the shaded area OCDE; total expenditures are given by the rectangle OBDE. The difference, shown
by the triangle BCD, is consumer surplus.

27
Producer Surplus
Producer surplus can be defined as
The difference between the amount that a producer of a good receives and the minimum amount
that he or she would be willing to accept for the good.

The difference, or surplus amount, is the benefit that the producer receives for selling the good in
the market.

Producers' surplus exists when actual price exceeds the minimum price sellers will accept.

Here, total revenue is given by the rectangle OBDE, and total costs are given by the area OADE. The
difference, shown by the triangle ABD is producer surplus.

28
Community Surplus
is the welfare of society and it is made up of a consumer surplus plus a producer surplus. It exists
when it is impossible to make someone better off without making someone else worse off.

When the consumer surplus is equal to producer surplus
It exists when the market is in equilibrium, with no external influences and no external effects.

Market is said to be socially efficient and community surplus is at its maximum.

29
Allocative Efficiency

Allocative efficiency is when resources are allocated in the most efficient way from society's point
of view. In other words the market is said to be socially efficient.

Allocative efficiency exisists where Community Surplus (consumer surplus and producer surplus)
is maximized.
At equilibrium where demand is equal to suppy, community surplus is maximised.

Indirect taxes
An indirect tax is a tax collected by an intermediary i.e. seller, from the person who bears the
ultimate economic burden of the tax i.e. consumer.
It is imposed on expenditure. In simple terms, it is a tax which is imposed on goods and services
sold. It is usually added to the cost of the good or service and charged from the ultimate consumer.
The seller will then file a return to the government on all the taxes he has collected from the
consumer.

Examples are sales tax and excise duty

30

Reasons for imposing taxes
The main reasons for government imposing taxes can be
To generate Government revenues: excise duties on beers, wines and spirits are price
inelastic in demand, so tax price increases by levying specific alcohol and tobacco taxes
raise consumer expenditures as a whole on these categories and therefore taxation
revenues;
To discourage consumption: Government might use taxes to discourage consumption of
certain demerit goods such as cigarettes.
To alter the pattern of consumption: Government might use direct taxes a a mean to alter
the consumption patter of its population. Certain goods can be made more price attractive
through lower taxes while goods which have high marginal social cost can be made
expensive through taxation.

Distinction between specific and ad valorem taxes
Specific tax is a flat rate of tax whereas ad valorem tax is a percentage tax.
Ad valorem literally the term means according to value. It is imposed on the basis of the
monetary value of the taxed item.
A specific tax is when specific amount is imposed upon a good, for example $10 on each
mobile phone sold; whereas ad valorem tax is expressed as a percentage of the selling price
e.g. 12% of the sales.
The amount of specific tax changes in the same proportion as the quantity sold increase,
whereas, in ad valorem the tax collected is more at higher prices then at lower prices.

Consequences of imposing indirect tax
Imposition of tax results in three economic observations.
Incidence: Incidence of tax means the party who actually pays the tax.
Government revenue: the amount of tax government will receive as revenue
Resource allocation: the amount of fall in quantity demanded and produced created by
the tax.

31
Incidence or tax burden

When a tax imposed on a good or service increases the price by the amount of the tax, the burden
of the tax falls on consumers.
If instead it lowers wages or lowers prices for some of the other factors of production used in the
production of the good or service taxed, the burden of the tax falls on owners of these factors.

If the tax does not change the products price or factor prices, the burden falls on the owner of the
firmthe owner of capital.

If prices adjust by a fraction of the tax, the burden is shared. The incidence of tax will be shared
between the consumers and producers, depending on the price elasticity of demand (PED) for that
product (which we will discuss later).

If we assume that the burden is equally shared by both the consumers and the producers then the
size of square CYZPe is equal to PeZXP1. This means the incidence of tax is equally distributed by
both the consumer and producer.

32
Government revenue
Putting taxes on goods and services generates revenue for the government.
Figure below shows the shaded region as tax revenue for government i.e. CYXP1. The implication
will be a fall in output from Qe to Q1 and thus the consumption and production of the commodity
will fall.

Tax incidence and price elasticity of demand and supply
Incidence of indirect taxes on consumers and firms differs, depending on the price elasticity of
demand and on the price elasticity of supply. Lets study individual cases.

Scenario 1: When PED is greater than PES
Where PED is greater than PES, it implies that consumers are more sensitive to price changes as
compared to suppliers. Thus the incidence of tax will be more on the suppliers because if too much
burden of tax is passed on to the consumers then the demand will fall drastically. Therefore, this
time the price paid by buyers barely rises; sellers bear most of the burden of the tax.

33
Scenario 2: When PES is greater than PED

When the supply curve is relatively elastic, the bulk of the tax burden is borne by buyers. This is
because PED as compared to PES is elastic, which means; consumers are not that price sensitive
and will not reduce their consumption even if the prices rise. Because the PES is elastic, suppliers
will stop the supply if the cost of production goes up. Therefore, buyers end up getting higher
burden of tax.

Scenario 3 : PED is equal to PES
In this case both the producer and consumer will share equal burden of tax.

What are subsidies?
A subsidy is a form of financial assistance paid by the government to a business or economic
sector.

Why subsidies are given?
Subsidies might be given to
Lower the cost of necessary goods which might affects a major part of population. Example,
subsidies given to essential food items and oil (in India).
Guarantee the supply of merit goods, which the government thinks consumers should
consume.
Help domestic firms become more competitive in the international market, also known as
protectionism.

34
Effect of subsidy
Subsidy reduces the cost of production. Thus the supply curve for the product shifts vertically
downwards by the amount of subsidy provided.

Impact of subsidies on Producers
Subsidies are monetary benefits provided to the producer by the Government on account of
production of certain commodity. Subsidies lead to increase in producer revenue. Due to subsidy
the supply curve (S-subsidy) will shift vertically downwards by the amount of subsidy. This
reduces the cost of production and more is now being supplied at every price. Through the
diagram, we can see, initially the market was at equilibrium with Qe being supplied & demanded
at Price (Pe).

Government provides subsidy WZ per unit.
Producers lower their prices to P1 Increase output till a new equilibrium is reached at Q1
The producer will however not pass all the subsidy benefit to the consumer.
Initial producer revenue was OPeXQe which now increases to ODWQ1.

35
Impact of subsidies on Consumers

Consumers will now consume more of the product due to lower prices. Consumers pay less as the
prices fall from Pe to P1, however, they end up consuming more from Qe to Q1. It is difficult to say
by how much the consumer expenditure will increase or fall as it will depend on their relative
saving and extra expenditure.

Impact of subsidies on Government
Government will end up paying a subsidy of P1DWZ. Obviously, this will involve an opportunity
cost. Government will have to forego investments in other sectors of the economy in order to
provide subsidy. At the end of the day, the burden usually lies on the taxpayer.

36
Subsidies and Elasticities

The impact of subsidies on consumers will depend on the relative price elasticity of demand and
price elasticity of supply.

Scenario 1: When PED is elastic relative to PES
The consumers do not benefit from a great fall but, because their demand is relative elastic, they
increase their consumption by a significant amount.

Scenario 2: When PED is inelastic relative to PES
Consumption of the product is increased and so is the revenue of the producer.
The consumer benefit from a relatively large price fall, but their demand is relative inelastic, their
consumption does not increase by a great amount.

37
GOVERNMENT INTERVENTION IN MARKET PRICES

Maximum Price or PRICE CEILINGS

In some markets, governments intervene to keep prices of certain items higher or lower than what
would result from the market finding its own equilibrium price.

A price ceiling occurs when the government puts a legal limit on how high the price of a product
can be. In order for a price ceiling to be effective, it must be set below the natural market
equilibrium.

It is also known as maximum price.
Rent control is an example of a price ceiling, a maximum allowable price. With a price ceiling, the
government forbids a price above the maximum. A price ceiling that is set below the equilibrium
price creates a shortage that will persist.

For the price that the ceiling is set at, there is more demand (Q2) than there is at the equilibrium
price. There is also less supply (Q1) than there is at the equilibrium price, thus there is more
quantity demanded than quantity supplied i.e. shortage.

Impact of Price ceiling

Inefficiency: Inefficiency occurs since at the price ceiling quantity supplied the marginal benefit
exceeds the marginal cost. This inefficiency is equal to the deadweight welfare loss.

Existence of black market: Due to demand exceeding the supply, there will be buyers who will
be willing to purchase the good at a higher price. This will lead to existence of black market.

How can government correct this situation?
Subsidies may be offered to the firms to encourage the production of such goods. However it
involves an opportunity cost to the government as they might have to divert funds from other
activities.

Government may also consider the option of producing the goods by themselves.
38

Government may also release previously stored inventory of such goods to ensure that there is no
shortage in the market, however, it might not be possible for all the goods, for example, perishable
goods.

All these options will lead to the shift of supply curve to the right and thus forming a new
equilibrium at Pmax

Minimum Prices or Price Floor
A minimum allowable price set above the equilibrium price is a price floor. With a price floor, the
government forbids a price below the minimum Price Floors are minimum prices set by the
government for certain commodities and services that it believes are being sold in an unfair
market with too low of a price and thus their producers deserve some assistance.

Government might set Minimum prices
To raise incomes for producers such a farmers and protect them from frequent fluctuations in
the commodity market.
39
To protect workers and ensure that they get a enough wages to sustain a reasonable standard of
living.

Examples of price floors
In many countries governments assist farmers by setting price floors in agricultural markets.
Setting Minimum wages for certain occupations is also an example of price floors.

Consequences of a price floor
As seen from the diagram. The equilibrium price for a particular good is Pe and the Quantity
demanded is Qe.

The government thinks that it is too low for that good thus they set up a minimum price for a good
Pmin.

This will lead to a fall in demand to Q1 and increase in supply to Q2, thus creating excess supply or
surplus.

Government can eliminate the surplus by buying the excess supply at the minimum price. This will
result in the shifting of demand curve to the right, thus creating a new equilibrium at Pmin.

The Government may store it or sell it abroad. However, both these options have consequences.
Buying the surplus and storing it will cost an opportunity cost for the government as they have to
divert funds from other important areas and exporting it other countries may be considered as
dumping.

What is Market Failure?
In a market where there is equilibrium, the resources are allocated in the best possible manner
and there is 'allocative efficiency'.
Allocative efficiency is when situation where Marginal cost is equal to Marginal revenue.

40
However, this is not possible in the real world. Market failure exists when the resources are not
allocated efficiently. Community surplus is not maximized and thus there is market failure. From a
community's point of view, producer surplus is not equal to consumer surplus.

Market failure is thus caused by
Abuse of monopoly power
Lack of public goods
Under provision of merit goods
Overprovision of demerit goods
Environmental degradation
Inequality in distribution of wealth
Immobility of factors of production
Problems of information
Short termism

Externalities
Externalities are a loss or gain in the welfare of one party resulting from an activity of another
party, without there being any compensation for the losing party.

This activity can be due to consumption or production of a good or service.
If the third party suffers due to this activity then it is known as negative externality.
When the third party gains from this activity is it known as positive externality.

Marginal Private Benefit is the benefit which is derived by private individuals in the
consumption of a good or service.

Marginal Private Cost is the cost of producing, specifically marginal costs, which are incurred by
private individual while producing a good or service.

41
Marginal Social Cost is the total cost to society as a whole for producing one further unit, or
taking one further action, in an economy. This total cost of producing one extra unit of something
is not simply the direct cost borne by the producer, but also must include the costs to the external
environment and other stakeholders.
The market demand and supply curves therefore reflect the MPB and MPC accruing to buyers and
sellers.

When there is no externality then the intersection MPB (demand) curve and MPC (supply) curve
determine the equilibrium price. The price and quantity reflected at this point are socially
optimum level of production or consumption and the market is said to have allocative efficiency.
i.e. MPC=MPB.

At this point the consumer surplus is equal to the producer surplus.
However, this is usually not the case in real world. The production or consumption of goods and
services do produce externalities and thus the concept of Marginal social benefits and Marginal
social costs comes into being.
MSB=MPB+Externality
MSC=MPC+Externality
Types of Externalities

Externalities can result either from consumption activities or from production activities

There are four types of Externalities
1. Negative externality of Production
2. Negative externality of Consumption
3. Positive externality of Production
4. Positive externality of Consumption

Negative Production Externalities
Negative production externalities are the side-effects of production activities. As a result an
individual or firm making a decision does not have to pay the full cost of the decision. Pollution
created by firms due to production activities is an example of negative production externality.

In an unregulated market, producers don't take responsibility for external costs that exist--these
are passed on to society. Thus producers have lower marginal costs than they would otherwise
have and the supply curve is effectively shifted down (to the right) of the supply curve that society
faces. Because the supply curve is increased, more of the product is bought than the efficient
amount--that is, too much of the product is produced and sold. Since marginal benefit is not equal
to marginal cost, a deadweight welfare loss results.

42

The diagram illustrates negative production externality.
The supply curve given by MPC reflects the firms private costs of production and the marginal
social cost curve given by MSC represents the full cost of production to society. The vertical
difference between MPC and MSC represents negative externality. Therefore for each level of
output, Q1, social costs given by MSC are greater than the firms private costs by the amount of
externality.

The optimal production quantity is Q*, but the negative externality results in production of Q1.
The deadweight welfare loss is shown in blue.

Corrective Negative Production externalities
In order to correct negative externality of production and to bring down the production to the
optimal level, government can intervene through the following options:

Legislation and regulations
Government can pass legislations to prevent or reduce the effects of production externalities.
These legislations will lower the quantity of goods produced and bring it closer to the optimal
quantity Q* by shifting the MPC curve upward towards the MSC curve. It might include legislations
to
Limit the emission of pollutants by setting limits to the extent of pollutants produced by a
firm.
Limit the production to a certain level.
Force polluting units to install technologies which reduce emissions.

Putting Taxes
Government may impose a tax on the firm either on per unit of production or per unit of
pollutants emitted. These will lead to a shift of MPC curve upwards towards the MSC curve and
thus reducing output and bringing it closer to socially optimal level i.e. Q*. The diagram below
shows the impact of taxes

43

Tradable permits
Tradable permits are a cost-efficient, market-driven approach to reducing greenhouse gas
emissions. A government must start by deciding how many tons of a particular gas may be emitted
each year. It then divides this quantity up into a number of tradable emissions entitlements -
measured, perhaps, in CO2-equivalent tons - and allocates them to individual firms. This gives
each firm a quota of greenhouse gases that it can emit over a specified interval of time. Then the
market takes over. Those polluters that can reduce their emissions relatively cheaply may find it
profitable to do so and to sell their emissions permits to other firms. Those that find it expensive
to cut emissions may find it attractive to buy extra permits.
Trading would continue until all profitable trading opportunities had been exhausted.

Tradable permits will result in firms to lower the quantity of goods produced so that it equals Q*
and to raise the price of the goods.

44
Negative Consumption externalities

Negative consumption externalities occur due to consumption of certain goods and services.

Example, smoking. By smoking in public places, the consumer is creating negative externalities, in
the form of passive smoking, for non-smokers. Other examples include using fossil fuels that
pollute atmosphere, playing loud music and disturbing neighbors, discarding garbage in public
places.

In negative consumption externality, the MPB is not reflecting social benefit and thus MSB lies
below MPB. The vertical difference between MPB and MSB is the negative externality. The optimal
level of consumption is where MSB=MSC i.e. Q*. However the negative externality is being ignored
and thus there is an over consumption of the goods at Q1.

Correcting negative consumption externalities

Advertising: Government can using persuasive advertising/awareness campaigns to alert the
consumers and influence them reduce their consumption. This will lead to a shift of MPB curve to
the left thus reducing the gap between socially optimal level of consumption Q* and Q1.

Legislations and regulations: Government can also pass legislations or impose fines on certain
activities which create nuisance for the societies. Many countries already have banned smoking in
public places.

Imposing indirect taxes: By putting taxes on the production of goods that cause negative
consumption externalities, government can reduce the supply. By putting taxes, the supply
curve(MSC) will shift upwards to MSC+tax. This will reduce the gap between Q* and Q1.

Positive Production externalities
These are positive externalities created due to production of certain goods and services. Examples
include, when firms train their employees which result in better manpower or invest in research
and development and succeed in developing new technologies which benefits the society.
45

Due to the fact that positive externality is produced, the MSC lies below the MPC. The diagram
below illustrates positive production externalities. As we can see that the social optimal level of
production of these goods should be Q* , however there is under-allocation of resources and thus
there is output is at Q1.

Corrective positive production externalities
Subsidies can be provided to firms, which produce these goods. The effect will be the lowering of
MPC and thus the MPC will more downward to MSC. This will increase the output to a level Q2
near to the socially optimal level Q*. The price will also fall from P1 to P2.

Positive consumption externalities
Positive consumption externalities occur when there is a positive externality created by the
consumption of certain goods.
Examples include consumption of education and health care. Both these will lead to more
productive workforce and hence high rate of economic growth for the society.

46

As the diagram illustrates, the MSB lies above the MPB and the difference between the two
consists of positive externality. The socially optimal level is where MSB=MSC i.e Q*, however, due
to under-allocation of resources the output/consumption is at Q1.

Corrective Positive consumption externalities

Subsidies
By giving subsidies to the producers of the good with the positive externality will result in
increasing supply and shifting the supply curve downwards. This will lead to MSC curve shifting to
MSC+subsidy which means high output/consumption at socially optimal level Q* and at lower
prices from P1 to P*.

Advertising
Through positive advertising government can persuade consumers to increase their consumption
and thus lead to a shift of MPB to the right i.e. increase in demand. If the MPB curve shifts enough,
it will coincide with MSB and Q* will be produced and consumed.

47

Unit 2: Macroeconomics
The purpose of this section is to provide students with the opportunity for a detailed examination
of the major macroeconomic issues facing countries' economic growth, economic development,
unemployment, inflation and income distribution. The economic strategies available to
governmentsdemand-side policies, supply-side policies, direct interventionare introduced
and evaluated. These policies are applicable to almost all areas of macroeconomics, international
economics and development economics.

Macroeconomics deals with the economy as a whole; it examines the behavior of economic
aggregates such as aggregate income, consumption, investment, and the overall level of prices.

Aggregate behavior refers to the behavior of all households and firms together.
We can use macroeconomic analysis to:
Understand why economies grow.
Understand economic fluctuations.
Make informed business decisions.

Lets start with a simple model of how economy works.

48
Circular Flow Diagram

The economy is divided into two sectors i.e. households and firms
The households provide factors of productions (land, labour, capital and enterprise) to the firms.
The firms in return pays the factors of production (wages, rent, interest and profit).

The firms produce goods and services which are consumed by the household. The households
spend money on purchasing the goods and services produced by the firms (consumer
expenditure).

The clockwise flows of goods and services through these markets are balanced by counter
clockwise flows of payments. Households make payments for the things they buy in product
markets. Firms make factor paymentswages, interest payments, rents, royalties, and so onin
exchange for the labour services and other resources they buy.

49

Financial Institutions
This sector consists of all those institutions that are engaged in the borrowing and lending of
money, acting as the intermediaries between those who save, and borrowers of money.
Financial institutions are needed for individuals and firms to be able to undertake saving and
investment. They perform the function of mobilising savings for investment.
Savings: leakage; Investment: injection

Government
Households in this model are required to pay taxes. When the government receives these taxes
they then spend them (government spending) on building roads, paying soldiers, and teachers and
so on. In this model the total amount of expenditure is equal to consumption plus investment plus
government spending.

50
GDP and GNP

Gross Domestic Product (GDP) is the value of final goods and services produced within a
country in a given period. It is the total of all activities in a country, regardless of who owns the
productive asset.

Gross National Product (GNP/GNI) is the market value of all products and services produced in
one year by labour and property supplied by the residents of a country.
Unlike Gross Domestic Product (GDP), which defines production based on the geographical
location of production, GNP allocates production based on ownership. It is the total income that is
earned by a country's factors of production regardless of where the assets are located.

Thus GNP=GDP + (incomes earned from assets abroad-Incomes paid to foreign assets operating
domestically)

51
Nominal GDP & Real GDP

The raw GDP figures are called the Nominal or Current GDP. When comparing GDP figures from
one year to another, it is desirable to compensate for changes in the value of money i.e., for the
effects of inflation or deflation. The GDP adjusted for changes in money-value in this way is called
the Real GDP.

For example, suppose a country's GDP in 2000 was $100 million and its GDP in 2010 was $300
million; but suppose that inflation had halved the value of its currency over that period. To
meaningfully compare its 2010 GDP to its 2000 GDP we could multiply the 2010 GDP by one-half,
to make it relative to 2000 as a base year.
The result would be that the 2010 GDP equals $300 million one-half = $150 million, in 2000
monetary terms. We would see that the country's GDP had, realistically, increased 50 percent over
that period, not 200 percent, as it might appear from the raw GDP data.

GDP Deflator

GDP Deflator=
Nominal GDP
Real GDP
X 100

GDP per capita
GDP per capita is the value of all final goods and services produced within a country in a given
year divided by the average population for the same year.

Comparisons of national wealth are also frequently made on the basis of nominal GDP, which does
not reflect differences in the cost of living in different countries. However, GDP per capita is often
considered an indicator of a country's standard of living and often used as an economic
development indicator.

Output methods
52
It is the Market value of all final goods and services calculated during 1 year. In other words, add
up the value of all goods and services produced in the country.
There are three stages in calculating it.

First, the Gross Value of domestic output in various economic activities is estimated

Second, the value of intermediate consumption, i.e., the cost of material, supplies and services
used to produce final goods or services is determined.

Finally, intermediate consumption figures are deducted from Gross Value to obtain the Net Value
of Domestic Output.
Income method

In this methods GDP is derived by adding up all income i.e. wages and salaries, profits, rent and
interest.
Expenditure method

All expenditure incurred by individual during 1 year.
GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net
Exports (X M).

Y = C + I + G + (X - M)
To derive GDP using the expenditure approach, we must look at each of the separate components
of expenditures and then add them together. These components are consumption expenditures,
investment, government expenditures, and net exports.

Consumption is spending by households on goods and services. Goods include household
spending on durable goods, such as automobiles and appliances, and non durable goods, such as
food and clothing. Services include such intangible items as haircuts and medical care.

Investment is the purchase of goods that will be used in the future to produce more goods and
services. It is the sum of purchases of capital equipment, inventories and structures.

Government Purchases include spending on goods and services by local, state and central
governments. It includes the salaries of government workers as well as expenditures on public
works.

Net Exports equal the foreign purchase of domestically produced goods(exports) minus the
domestic purchases of foreign goods (imports). The net in net exports refers to the facts that
imports are subtracted from exports.

53
Business Cycle

The business cycle is the cycle of short-term ups and downs in the economy. The Alternating
periods, of economic growth and contraction. The main measure of how an economy is doing is
aggregate output

Aggregate output is the total quantity of goods and services produced in an economy in a given
period.

Explanation of Business Cycle
A recession, contraction, or slump is the period in the business cycle from a peak down to a
trough, during which output and employment fall.

A depression is a severe reduction in an economy's total production accompanied by high
unemployment lasting several years

An expansion, or boom, is the period in the business cycle from a trough up to a peak, during
which output and employment rise.

Ups and downs of the Business Cycle
Peak: at the peak of the business cycle, Real GDP is at a temporary high.
Contraction: A decline in the real GDP. If it falls for two consecutive quarters, it is said the
economy to be in a recession.
Trough: The Low Point of the GDP, just before it begins to turn up.
Recovery: When the GDP is rising from the trough.
Expansion: when the real GDP expands beyond the recovery.

54
Evaluating National Income Statistics

Economists find it especially valuable as an overall indicator of a nation's economic performance.
But it is important to realize that GDP has significant weaknesses.
The following points make GDP figures unreliable to get a true picture of an economy's health:

It includes only the value of goods and services traded in markets, it excludes nonmarket
production, such as the household services of homemakers discussed earlier. This can cause some
problems in comparing the GDP of an industrialized country with the GDP of a highly agrarian
nation in which nonmarket production is relatively more important.

It also causes problems if nations have different definitions of legal versus illegal activities. For
instance, a nation with legalized gambling will count the value of gambling services, which has a
reported market value as a legal activity. But in a country where gambling is illegal, individuals
who provide such services will not report the market value of gambling activities, and so they will
not be counted in that country's GDP. This can complicate comparing GDP in the nation where
gambling is legal with GDP in the country that prohibits gambling.

Furthermore, although GDP is often used as a benchmark measure for standard of living
calculations, it is not necessarily a good measure of the well-being of a nation. No measured figure
of total national annual income can take account of changes in the degree of labor market
discrimination, declines or improvements in personal safety, or the quantity or quality of leisure
time.
Measured GDP also says little about our environmental quality of life. Other nations, such as China
and India, have also experienced greater pollution problems as their levels of GDP have increased.

While making international comparisons, statistics may be converted at official exchange rates
which will not necessarily reflect purchasing power. Another problem arises due to the fact that
different countries have different conventions for calculating national income.

Nonetheless, GDP is a relatively accurate and useful measure of the economy's domestic economic
activity, measured in current dollars. Understanding GDP is thus an important first step for
analyzing changes in economic activity over time.

Green GDP

Traditional measurements of performance, such as gross domestic product (GDP), account for
economic development but do not accurately reflect human or environmental well-being. Since
the 1990s several new metrics have been proposed, including green GDP, which attempts to
provide a more accurate accounting that considers both the positive transactions that benefit
well-being and the negative economic activities that diminish it

Gross Domestic Product (GDP) almost completely ignores our environment. Even worse, actually,
GDP often includes the environment on the wrong side of the balance sheet. If we first pollute and
55
then pay to clean up the mess, both activities add to GDP. Environmental degradation frequently
looks good for the economy. In that regard, GDP is a poor welfare measure.

The green gross domestic product (green GDP) is an index of economic growth with the
environmental consequences of that growth factored in. Green GDP monetizes the loss of
biodiversity, and accounts for costs caused by climate change.

Aggregate demand (AD)
Aggregate demand is the total spending on goods and services in a period of time at a given price
level.

On the horizontal axis, real GDP is measured. For our measure of the price level, we use the GDP
price deflator on the vertical axis. The aggregate demand curve is labeled AD.

Components of Aggregate Demand

Consumption is spending by households on goods and services. Goods include household
spending on durable goods, such as automobiles and appliances, and non durable goods, such as
food and clothing. Services include such intangible items as haircuts and medical care.

Investment is the purchase of goods that will be used in the future to produce more goods and
services. It is the sum of purchases of capital equipment, inventories and structures.

Government Purchases include spending on goods and services by local, state and central
governments. It includes the salaries of government workers as well as expenditures on public
works.

56
Net Exports equal the foreign purchase of domestically produced goods(exports) minus the
domestic purchases of foreign goods (imports). The net in net exports refers to the facts that
imports are subtracted from exports.

Aggregate Demand Formula

AD=C+G+I+(X-M)

Why AD curve slopes downwards
There are economywide reasons that cause the aggregate demand curve to slope downward. They
involve at least three distinct forces:

The real-balance effect: The change in expenditures resulting from a change in the real value of
money balances when the price level changes, all other things held constant; also called the wealth
effect. A rise in the price level will have an effect on spending.

Interest rate effect: One of the reasons that the aggregate demand curve slopes downward:
Higher price levels increase the interest rate, which in turn causes businesses and consumers to
reduce desired spending due to the higher cost of borrowing.

The open economy effect: One of the reasons that the aggregate demand curve slopes
downward: Higher price levels for an economy result in foreign residents desiring to buy fewer
exports, while local residents now desire more foreign-made goods, thereby reducing net exports.
This is equivalent to a reduction in the amount of real goods and services purchased in the
economy.

57
Changes in AD
Movement along the AD curve is caused due to the change in price level in the economy.

Any non-price-level change that increases aggregate spending (on domestic goods) shifts AD to
the right. Any non-price-level change that decreases aggregate spending (on domestic goods)
shifts AD to the left.
Increase in any components of AD will result in the shift of AD curve to the right and a fall in the
value of any component will result in the fall of AD and the AD curve will shift to the left.

58
Factors Causing Change in Components of AD

Change in Consumption
A change in consumption is caused by any of the following factors
Changes in income: Income increases consumption increases and vice versa.
Changes in interest rates: Fall in interest rates will make borrowing money cheaper.
Consumers will now be tempted to take loans and purchase goods and services.
Consumption will rise. On the other hand if the interest rates increase, borrowing becomes
expensive. Consumers will be more tempted to save rather than spend. Consumption will
fall.
Changes in wealth: A rise in house prices or the value of stock and shares makes a person
feel wealthy. Consumers feel more confident and tend to spend more .
Changes in consumer confidence: Higher consumer confidence is likely lead to increased
consumption.

Change in Investment
Interest Rates: If interest rates are low firms will find it easy to borrow funds for
investment. Investment increase when interest rates fall.
Changes in National Income: If the national income increases, firms will have to invest
further to increase output (induced investment).
Technological change: Regular changes in technological front demand firms to invest in
order to keep up with the changes and remain competitive.
Business Confidence: The economic environment in an economy is a major factor in
determining the investment level. When an economy is showing signs of healthy growth,
firms will have positive expectation and will invest in expanding their facilities and to meet
higher demands in the future. During troughs firms will be more conservative in their
investments and thus AD will be affected.

Change in Government Expenditure
Government Expenditure depends on
Macroeconomics objectives: If the government is considering increasing employment
then it might increase its spending on public projects.
Condition of the economy: During phases of slow economic growth, government is more
likely to increase its spending in order to stimulate the economy.

Changes in net exports

Exports are domestic goods bought by foreigners. Exports will rise when
Foreigners income rise
Exchange rate of the exporting country is falling.
The economy follows a more liberal trade policy i.e. free trade increase
Inflation rate in the economy is comparatively lower than its trading partners.

59
Imports are the goods bought from foreign country. Imports will rise when
Domestic income rises. This is because people will increase their consumption and thus
imports will increase.
Exchange rate of the importing country increase. Now it becomes cheaper for the country
to purchase from outside as their currency is stronger than their trading partners.
If the economy is following a liberal trade policy i.e. free trade increases.
Inflation rate is high

Aggregate supply (AS)
Aggregate supply is the total amount of goods and services that all industries in the economy will
produce at every given price level.

Short run and Long run in Macroeconomics
Short run is the period of time during which the nominal prices of resources, particularly labour
(wages) do not change in response to the changes in price level.
Long run is the period of time in which the nominal prices of all resources, including the price of
labour (wages), change so as to reflect fully any change in the price levels.

Short Run AS (SRAS) curve
AS curve is similar to a microeconomic supply curve. It is upward sloping and hence has a positive
relation between price level and amount of output.

Movement along the SRAS
A change in price level will lead to a movement along the SRAS curve.

60
Shift of SRAS
Any factor changes other than price level will lead to a shift in SRAS. A rightward shift of SRAS
means an increase in Aggregate supply at any particular price level. An leftward shift of SRAS
signifies a decrease in Aggregate supply for any particular price level.

Factors causing a shift of SRAS
Any factor which causes a change in the cost of production will result in a shift of SRAS curve.
These factors are
Changes in wages: Wages constitute a major part of the cost of production. As wages increase the
cost of production increases and thus the SRAS will move leftward.
Price of raw material: An increase in price of raw material will result in the cost of production
going up and thus the SRAS will shift to the left.
Change in Taxes: Increased taxes add to the cost of production and thus SRAS moves leftwards.
Changes in Subsides: If subsidies are provided, this will result in the lowering of cost of
production and increase Aggregate supply. Thus SRAS will move rightward.
Change in price of imports: An increase in price of imported components will lead to a increase
in price of goods which use a lot of imported components. This will lead to a fall in AS
Long run AS curve
There are two major views relating to the shape of the LRAS. The different beliefs about the shape
of the LRAS curve lie at the basis of controversies about appropriate policies to be followed by
governments.

61
THE NEW-CLASSICAL VIEW (MONETARIST OR FREE MARKET VIEW)

These economists argue that the LRAS curve does not respond to changes in AD in the long run
and is determined completely independently of demand.
According to New classical economist the economy operates at full level of output. Potential
output of economy depends on productivity of factors of production rather than price level.

The LRAS curve is vertical at potential GDP, or full employment level of real GDP. This indicates
that an expansion of AD will always lead to demand-pull inflation and will not, in the long run, lead
to growth in output and thus employment.
The new-classical economists argue that national output may only be increased by adopting
supply-side policies to shift the LRAS to the right.

62
THE KEYNESIAN VIEW (INTERVENTIONIST VIEW)

The shape of the curve that is known as the Keynesian LRAS shows three possible phases.

63
Low unemployment
Another macroeconomic objective of the government is to maintain a low level of unemployment
in the economy.

Unemployment refers to the number of unemployed people, defined as all people above a
particular age, who are not working and who are actively looking for a job.

Underemployment refers to all people above a particular age who have part time jobs when they
would prefer to have full time jobs or have jobs that do not make full use of their skills and
education.

Unemployment rate= unemployed workers/total labor force

Cost of unemployment
Costs to the economy
Unemployed labor means utilized factors of production. This will result in lower output for
the economy.
Long periods of unemployment would lead to deskilling of labour which will in return
reduce potential output.
Unemployment leads to greater disparities in the distribution of income.

Costs to the government
Unemployed people will not pay taxes as they dont have any running income. This will be a
loss of tax revenue to the government.
Unemployment benefits given out by the government to support the unemployed will
result in extra burden on the government exchequer moreover, there is an opportunity cost
involved as these funds could have been utilized for other development purposes.

Costs to society
Higher unemployment leads to increased crime and vandalism. Moreover, there is a cost to
the government of dealing with social problems resulting due to unemployment

Costs to individuals
There are personal costs for the unemployed in terms of stress-related illness and family
problems (family breakdown) caused by the strain of being unemployed.
In order to meet daily expenses, an unemployed person may result in increased
indebtedness

64
Types and causes of Unemployment

Disequilibrium Unemployment

Cyclical or Demand Deficient unemployment
Cyclical unemployment exists when individuals lose their jobs as a result of a fall in aggregate
demand (AD). The fall in AD, in the economy, results in the fall in real output and thus
unemployment. It is called also known as demand deficient or
Keynesian unemployment.

Cyclical unemployment through a diagram
As we can see in the AD/AS diagram, the fall in AD to AD1 will result in a fall in the Real output
(Y1).
This will force the firms to reduce their output and hence reduce their workforce from ADL to
ADL1. However, due to wage stickiness it is less likely that real wages will fall (as seen in the
labour diagram). Therefore, the wages instead of coming down to W1 will remain at We. This will
create a surplus situation where the aggregate demand for labour will be at a and the aggregate
supply of labour will be b.

Wage stickiness: The firms may not be able to reduce the wages may be as a result of the following
reasons:
They dont want to create discontent among the workers by reducing their wages
Trade unions may not allow the wages to go down.
Labor contract may deter the firms to reduce the wages.

65
Equilibrium Unemployment

Structural unemployment
Structural unemployment occurs when certain industries decline because of long term changes in
market conditions. These structural changes in the economy might lead to fall in demand for
certain sectors of the economy. This is usually common in developing countries where primary
sector generally reduces in size and secondary sector and tertiary sector might gain more
importance. Change in technology is also one of the major reasons for structural unemployment,
whereby certain kind of jobs become obsolete. Changes in consumer taste or preference may also
be a cause of structural unemployment

Structural unemployment may worsen if there is
Occupational immobility occurs when there are barriers to the mobility of labor between
different industries and occupations.
Geographical immobility exists when there are barriers to people moving from one area to
another to find work.

Frictional Unemployment
Frictional unemployment occurs when people leave their jobs and are unemployed while they are
looking for a new job, or just having a break from working.

Seasonal Unemployment
Unemployment attributable to relatively regular and predictable declines in particular industries
or occupations over the course of a year, often corresponding with the climatic seasons.

66
Equilibrium unemployment through a diagram

Here, we can see what is called equilibrium unemployment represented by the arrows between
point a and point b. Equilibrium unemployment is the term which means the situation is that the
labor market is in equilibrium but there are still people who are not at work (represented by the
arrows between points a and b.)
This is what would realistically be considered as full employment, since there will always be
people who are unwilling or unable to take available jobs, causing the official rate of
unemployment (calculated by) to be above zero, which is not a realistic reachable goal.

The meaning of inflation, disinflation and deflation

What is inflation?
Inflation is a rise in the general level of prices of goods and services in an economy over a period
of time.

When the general price level rises, each unit of currency buys fewer goods and services.
Consequently, inflation also reflects erosion in the purchasing power of money.

What is disinflation?
Disinflation is a decrease in the rate of inflation a slowdown in the rate of increase of the general
price level of goods and services over a period of time.
For example if the annual inflation rate for the month of January is 5% and it is 4% in the month of
February, the prices disinflated by 1% but are still increasing at a 4% annual rate.

What is deflation?
Deflation is a decrease in the general price level of goods and services.
Deflation occurs when the inflation rate falls below 0%.

67
Calculating Inflation
Rate of inflation is measured by calculating the percentage price increase in goods and services
over a period of time.
Inflation is measured through a Price Index. The economists monitor the price changes of a
collection of goods & services over a period of time.
There are different Price Indices that can be used, the most popular are:
Consumer Price Index (CPI) measure the price of a selection of goods and services for a
typical consumer.
Producer Price Index (PPI) measures the prices for all goods and services at the
wholesale level. It is like the consumer price index but it is measuring the prices the
producers have to pay.
Price index consists of

A basket of goods
It contains goods and services from various sectors of the economy. There prices are monitored
over a period of time.

Base year
This is the first year with which the prices of subsequent years are compared. The price of each
commodity is given the value of 100. The base year chosen is a typical year in the sense that there
is neither very low or very high inflation, nor any extraordinary occurrences like wars.

Weights
Some commodities are more important in the economy as compared to other commodities. To
find out the true effect of inflation, weights are added to different products and services according
to their importance in the society. A product, which has a more serious affect, is given a higher
weight. For example food products, which form a staple diet of the society, are assigned more
weightage than luxury products (perfumes). As the pattern of consumers spending changes over
time so the Price Index will have to change the weights assigned to different commodities.

Natural rate of unemployment
The natural rate of unemployment is the unemployment rate that occurs in even a healthy
economy. That's because workers are always coming and going, looking for a better job, and often
they are unemployed until they find that better job.
The Natural Rate of Unemployment is the rate of Unemployment when the labor market is in
equilibrium. The natural rate of unemployment is caused by a combination of frictional
unemployment and structural unemployment.
The reason why the natural rate can change over time (or differ across countries) is because of
changes or differences in economic policies that impact frictional unemployment (the ease with
which firms can layoff workers, the ability and incentive for laid-of workers to find jobs, the
adequacy of job retraining programs, the ease with which unemployed workers can link up with
firms that have job vacancies) or structural unemployment (technological changes that impact
industries, the education and retraining programs available to support workers in obsolete
industries, the level of inter-generational mobility (how does the layoff affect the education and
income prospects of the laid-of worker's children).
68

Policies to Lower the Natural Rate
Lower minimum wages: Helps reduce the job losing rate. If we think about it from the firm's
point of view. During times of hardship, a firm may not have to let workers go if they can pay them
a little bit less. This does not mean that the minimum wage is bad. As a society, we may be entitled
to set a wage that is adequate for taking care of basic needs and set up a safety net for those who
are unable to find jobs at that wage.

Better information: Set up job finding centers that allow workers to find potential matches,
quickly and efficiently. Helps increase the job-finding rate.

Better training of workers: This can help in both reducing the job losing rate and in increasing
the job finding rate.

Remove disincentives to work: Excessive unemployment benefits, strong labor market
regulations, although improving the quality of life of the employed can bring about high
unemployment through reductions in the job finding rate because of shortfalls in both labor
supply and labor demand. Once again this does not mean that unemployment benefits or
regulations that enhance worker's bargaining power with the employers are a bad thing - it is
important to find the tradeoff between providing enough unemployment benefits to provide a
safety net and providing so much that you are effectively providing a disincentive to gain
employment.

Reductions in payroll taxes: Social Security is paid partly by the employer and partly by the
employee. Lower payroll taxes may help reduce unemployment by reducing the cost of hiring
workers and by increasing incentives for people to return to work.

Consequences of inflation
High inflation rate may result in the following adverse effects on the economy:

Greater uncertainty: There may be greater uncertainty for both firms and households. Firms will
postpone their investment due to uncertainty in the market. This will result in negative
implications on the economic growth in the economy.

Redistributive effects: High rate of inflation will affect people who have constant incomes, such
as retired people, students, and dependents. Moreover, rise in prices of essential commodities
(food & clothing) will affect the poor segment of the society as they spend a major part of their
income on these good. This will lead to increased inequality in the economy.

Less saving: High rate of inflation will have an adverse effect on the savings in the economy. As
people spend more to sustain their present standard of living, less is being saved. This will result
in less loanable funds being available to firms for investment.

Damage to export competitiveness: High rate of inflation will hit hard the export industry in the
economy. The cost of production will rise and the exports will become less competitive in the
international market. Thus, inflation has an adverse effect on the balance of payments.
69

Social unrest: High rate of inflation leads to social unrest in the economy. There is increase
dissatisfaction in among the workers as they demand higher wages to sustain their present living
standard. Moreover, high rate of inflation leads to a general feeling of discomfort for the
household as their purchasing power is consistently falling.

Interest rates: The Central Bank might use monetary tools to control high inflation rate by
increasing interest rates. This will increase the cost of borrowing and will have a negative effect on
both consumption and investment.
Shoe leather cost refers to the cost of time and effort (more specifically the opportunity cost of
time and energy) that people spend trying to counter-act the effects of inflation, such as holding
less cash and having to make additional trips to the bank.

Menu cost is the cost to a firm resulting from changing its prices

Consequences of deflation
Consistent fall in the general price level in the economy (deflation) might not be good news for the
economy. Long term deflation will lead to:

Cyclical unemployment: Deflation usually happens to due to a fall in Aggregate Demand in the
economy. This will lead to businesses cutting the output levels which will result in
retrenchment/laying off of workers. Moreover, if consumers delay spending in anticipation of
falling prices economic activity falls, unemployment increases.

Bankruptcies: As the value of money is increasing, it becomes difficult for debtors to repay the
load. Moreover, during deflation firms will be having lower profits due to falling prices and will
find it difficult to meet their liabilities. This might lead to greater number of bankruptcies.
Businesses see profits fall; as they do so dividends and investment returns fall and so share prices
fall.

Deflationary spiral: Consistent fall in prices may trigger deflationary spiral. As firms make less
profit, this leads to less profits, they might not be willing or able to invest which will have negative
implications on the economic growth. Moreover, as firms cut cost by lay off workers, there is less
income for the households and the aggregate demand might fall. Due to a fall in consumer and
business confidence the economy might fall into a deflationary spiral.

The principle problem of deflation is that it leads to a rise in the real value of debt. In the early
stages low interest rates and low prices encourage borrowing but as the real weight of the
borrowing is recognized so borrowing is reduced.
It is sometimes difficult to control deflation and Monetary policy can prove ineffective when
interest rates (nominal) are already low.

70
Types and causes of inflation

Demand Pull inflation
This type of inflation results due to the increase in Aggregate demand in the economy. The
movement of aggregate demand from AD1 to AD2 results in an increased average price level in the
economy i.e. P1 to P2.

Demand pull inflation is caused due to the changes in the determinants of AD. Whenever, any of
the components of AD (i.e. consumption, investment, government spending and net exports) will
increase, this will result in an increase in aggregate demand.

Cost Push Inflation
Increase in cost of production will result in cost push inflation. As the cost of production increases,
the firms will reduce supply. The aggregate supply will shift to the left, from SRAS1 to SRAS2. This
will result in an increase in the average price level in the economy. Real output will fall.

71
Cost Push inflation is mainly caused due to the following factors:

increase in wages (wage push inflation)
increase in cost of raw materials
increased cost of imported components (import-push inflation)

Inflationary Spiral
It is self-sustaining upward trend in general price levels due to interaction of demand pull and
cost push inflation. It is also known as Wage price spiral. High cost of living prompts demands for
higher wages which push production costs up forcing firms to increases prices, which in turn
trigger calls for fresh wage increases ... and so on.

Monetarists view of inflation
As per monetarists (new classical economists) inflation is caused due to the excessive supply of
money in the economy. According to monetarists an increase in money supply results in higher
aggregate demand from AD1 to AD2. Monetarists assume the economy to operate as full
employment level of output, thus, any increase in AD is purely inflationary.

72
Government Policies to control Inflation

Government uses a number of policies to deal with the different types of inflation. These are:

Demand Side policies-to control demand pull inflation

Deflationary fiscal policy: This involves an increase in taxes and lowering of government
spending. Increasing taxes will result in lower disposable income for household and thus less
consumption. Moreover, increased taxes will result in lower profits for firms and thus less
investment by firms. All these factors will lower the AD in the economy.

Deflationary monetary policy: It involves rising of interest rates and reducing money supply.
Higher interest rates mean higher loan and mortgage repayments. This will deter households and
firms to borrow, leading to fall in consumption and investment respectively.

Supply side policies-to control cost push inflation
It includes all those policies which aim at improving the efficient supply of goods and services.
These might include:
Privatization
Imparting training and improving the education level of the workforce resulting in higher
skills.
Increase competition in all industries by removing entry barriers, thus leading to more
efficiency.

Exchange rate policies to control imported inflation
This involves increasing the value of currency to reduce imported inflation. Increase currency rate
will also lead to fall in demand for exports (component of AD).

Causes of economic growth
The following factors can help to achieve economic growth

Capital accumulation
Investment in capital equipment that is used by people at work is the key to economic growth.
These resources will enable the workforce to produce consumer goods more efficiently.

Technological Progress
Improvement in technology will lead to more goods being produced from available resources. The
country will have achieved a higher gross domestic product.

Improvement in quality of human resources
Improving the quality of existing workforce can lead to increased productivity and hence optimum
utilization of resources. The quality of human resource can be improved with education, training
and healthcare.

Research and development
Discovering new sources of natural resources will add to the total output of the country.
73
Illustrating Economic growth using a PPC diagram

In case when the economy is operating with a deflationary gap. This means that the economys
resources are not being fully utilised.

Point a indicates a point where the economy is operating inside the PPC. With the economy
achieving economic growth it would be equivalent to the movement from a to b.

Economic growth can also be achieved by increasing the potential output. This is achieved through
supply side policies.

As illustrated by the diagram the outward shift in the PPC signifies the increase in full employment
level of output.

74
Illustrating Economic Growth using a AS/AD diagram

An economy operating below full employment level of output can be illustrated by the diagram.
Where the gap between Y1 and Yf signifies deflationary gap.

The movement of AD to the right (or increase in Aggregate Demand) will result in filling up of the
deflationary gap and the economy will achieve full employment level of output. This is known as
economic growth.
Economy can also achieve economic growth in the long term by increasing the potential output by
increasing the efficiency of its factors of production. This can be illustrated by the movement of
LRAS to the right. i.e. LRAS1 to LRAS2. This is achieved by governments supply side policies.

75
Consequences of economic growth

Positive
Broadly speaking economic growth will result in the increase in living standard of the
population.
Increase in GDP (more precisely, GDP per capita) will result in the increase in the standard
of living of its population.
Greater income results in higher tax revenue for the government which can be spend of
merit and public goods, again a higher living standard.
An important factor which leads to economic growth is technology. Improved technology
results in making our lives easy and comfortable.
Economic growth leads to higher level of education and health service. This will result in a
better social structure with a more stable political setup.

Negative
Economic growth may not necessarily reflect the quality of life of the population. People
may have more material gains at the cost of sacrificing leisure time and neglect of personal
relationships.
Economic growth leads to structural change in the economy, which might result in
structural unemployment and income inequalities
Environment may suffer due to high level of economic activities. High emissions of
greenhouse gases are usually associated with economies achieving rapid economic growth.

Poverty
What is poverty?
WHO (World Health Organization) defines poverty as:
Poverty is associated with the undermining of a range of key human attributes, including health. The
poor are exposed to greater personal and environmental health risks, are less well nourished, have
less information and are less able to access health care; they thus have a higher risk of illness and
disability.

http://www.who.int/topics/poverty/en/

One of the problems with discussing poverty is clarifying what it means and how it can be defined.
Poverty is generally divided into two types, absolute or extreme poverty and relative poverty.

Absolute poverty
Absolute or extreme poverty is when people lack the basic necessities for survival. For instance
they may be starving, lack clean water, proper housing, sufficient poverty clothing or medicines
and be struggling to stay alive. This type of poverty is most common in developing countries.

76
Relative poverty
As per European Commission, people are said to be living in poverty if their income and resources
are so inadequate as to preclude them from having a standard of living considered acceptable in
the society in which they live.

Because of their poverty they may experience multiple disadvantages through unemployment, low
income, poor housing, inadequate health care and barriers to lifelong learning, culture, sport and
recreation. They are often excluded and marginalized from participating in activities (economic,
social and cultural) that are the norm for other people and their access to fundamental rights may
be restricted.

Causes of poverty
Unemployment or having a poor quality (i.e. low paid or precarious) job as this limits
access to a decent income and cuts people off from social networks;
Low levels of education and skills because this limits peoples ability to access decent
jobs to develop themselves and participate fully in society;
The size and type of family i.e. large families and lone parent families tend to be at
greater risk of poverty because they have higher costs, lower incomes and more difficulty
in gaining well paid employment;
Gender - women are generally at higher risk of poverty than men as they are less likely to
be in paid employment, tend to have lower pensions, are more involved in unpaid caring
responsibilities and when they are in work, are frequently paid less ;
Disability or ill-health because this limits ability to access employment and also leads to
increased day to day costs;
Being a member of minority ethnic groups and immigrants/undocumented migrants as
they suffer particularly from discrimination and racism and thus have less chance to access
employment, often are forced to live in worse physical environments and have poorer
access to essential services;
Living in a remote or very disadvantaged community where access to services is worse.

Consequences of Poverty
Poverty has far reaching consequences on the society. People suffering from poverty will generally
have a low standard of living. They are not able to afford education and lack access to health care
and education. This will lead to a low quality of human capital and thus compromise economic
growth.

Poverty takes a toll on poor childrens development. For example, poverty causes malnutrition
which would affect the development of a childs mental thinking and healthy body.

Poverty may also lead to political instability and lead to increased risk of war, mass emigration of
population and terrorism.

77
Role of Taxation in promoting equity

What is a tax?
Tax is a fee charged ("levied") by a government on a product, income, or activity.

Why taxes are imposed?
There are different reasons for imposing taxes.
To finance government expenditure. One of the most important uses of taxes is to finance public
goods and services, such as street lighting and street cleaning.
To reduce consumption of goods that creates negative externalities.
To control the amount of imported goods i.e. tariffs
Used as a part of fiscal policy to control aggregate demand in the economy.
To control income inequality.

Types of taxes

Direct Taxes
It is a tax paid directly to the government by the persons on whom it is imposed.
EXAMPLES
Tax imposed on peoples income-Income tax
Tax on wealth wealth Tax
Tax on firms profits.- corporate tax

Indirect Taxes
Indirect tax is a tax collected by an intermediary (such as a retail store) from the person who
bears the ultimate economic burden of the tax (such as the consumer). The intermediary later files
a tax return and forwards the tax proceeds to government with the return.

Indirect taxes are generally included in the price of goods and services, so are less obvious to
those paying the taxes than direct levies. Thus indirect taxes are also known as expenditure tax or
consumption based tax.

EXAMPLES
GST (Goods and service tax)
VAT (Value added tax)
Consumers are charged a percentage of tax while purchasing a good/service and then the
seller pays the tax collected to the Government.

Other measures to promote equity
The governments also undertake expenditures to promote income equity. These include

Subsidies
Provide directly, or to subsidize, a variety of socially desirable goods and services. These include
health care services, education, and infrastructure that include sanitation and clean water
supplies.

78
Transfer payments
Government provide various kind of assistance to low income groups in the society. The objective
is to support them in maintaining a reasonable standard of living and to lower inequality. These
payments are given directly to these groups in the form of monetary help. Examples include Social
Security, unemployment compensation, welfare, and disability payments.

Categories of taxes
Taxes can also be classified on the basis of their nature. A tax system/structure may be

Progressive
A tax system where the tax liability increases with the increase in the income. The idea is to charge
more tax from high income earners and low tax from low income earners. This tax system is based
on the principle of equality.
Example
Income tax slabs 2012-2013 for General taxpayers
Income tax slab (in Rs.)

0 to 2,00,000
2,00,001 to 5,00,000
5,00,001 to 10,00,000
Above 10,00,000
Tax
No tax
10%
20%
30%

Regressive
This percentage of tax decreases as the income increases. In terms of individual income and
wealth, a regressive tax imposes a greater burden on the poor than on the rich there is an
inverse relationship between the tax rate and the taxpayer's ability to pay as measured by assets,
consumption, or income.
Regressive taxes amount to a large share of governments income. They are also used to
discourage the use of demerit goods. However, indirect taxes promote income inequality.

Examples
Indirect taxes are regressive in nature. For example, if Jane has $10 and John has $5, a tax of $1 on
a purchase would result in a different percentage of total income applied to taxation, 20% for John
and 10% for Jane. Thus, a tax that is fixed to the value of the good/service would likely, in effect,
result in a higher burden of taxation to people with less money.

Proportional Tax
A proportional tax is one that imposes the same relative burden on all taxpayersi.e., where tax
liability and income grow in equal proportion. In simple terms, it imposes an equal burden
(relative to resources) on the rich and poor. Proportional taxes maintain equal tax incidence
regardless of the ability-to-pay and do not shift the incidence disproportionately to those with a
higher or lower economic well-being.

79
Fiscal Policy -The government budget

According to Encyclopedia Britannica:
Government budget, forecast by a government of its expenditures and revenues for a specific
period of time.

In national finance, the period covered by a budget is usually a year, known as a financial or fiscal
year, which may or may not correspond with the calendar year.
As mentioned above, the government budget has two aspects, the revenue and the expenditure.

The role of fiscal policy
Fiscal policy refers to government policy that attempts to influence the direction of the economy
through changes in government taxes or through some spending.
The two main instruments of fiscal policy are government spending and taxation.
Changes in the level and composition of taxation and government spending can impact on the
following variables in the economy:
Aggregate demand and the level of economic activity.
The pattern of resource allocation.
The distribution of income.

AD=C+G+I+(X-M)

As we can see in the above equation that G (Government Expenditure) is a component of AD, it can
be used by Government to influence AD in the economy. The government can use expansionary or
deflationary fiscal policy to get the desired results. Lets discuss each policy in detail.

Expansionary fiscal policy
Expansionary fiscal policy is used to increase the Aggregate demand in the economy. If the
economy is having a deflationary gap, the government can use expansionary fiscal policy to reduce
the gap or totally eliminate it.
Now, what is deflationary gap?
Deflationary gap is the difference between full level of employment and the actual level of output
of the economy. We can see in the diagram below, that the economy is operating a level a below
the Yf (full level of employment).

80

The consequence is that due to deflationary gap all the resources of the economy are not being
used in the optimum level and they are idle. This results in unemployment and low level of output.
This is not desirable for any government. In order to reduce/eliminate the deflationary gap, the
government uses expansionary fiscal policy.

Government will either increase its spending or reduce taxes (or both) in order to stimulate the
aggregate demand. Increase Government spending will result me more projects being funded by
the government and thus employment and output will increase. Even a lower tax rate will result in
more disposable income for households and encourage consumption.

Increased G and C will lead to higher AD. However, this might also lead to higher prices/inflation
in the economy.

Contractionary fiscal policy
Contractionary fiscal policy involves the reduction of government spending and increase taxes as a
measure to control inflation/AD in the economy. With reduced government spending, the AD will
fall and thus reduce pressure on the economic resources and the average price level in the
economy will come down. Similarly, increased taxes will take away the excess disposable income
from the households and result in a fall in AD. Contractionary fiscal policy is thus used to reduce
the inflationary gap.

But, what is inflationary gap?
Inflationary gap is when the Aggregate demand exceeds the productive potential of the economy.
As we can see through the diagram, the economy is operating at a level above the full employment
level of the output. Due the limitation of the economy to fulfill this increased demand the average
price level in the economy increases resulting in inflation.

81

In this case the government can use contractionary fiscal policy to control inflation and bring
down the AD.

Evaluating Fiscal Policy
Fiscal policy is a powerful tool in the hands of the government. Fiscal policy can promote long
term economic growth by increased government spending different sectors of the economy. With
a careful planning of expenditure on capital goods in the economy i.e. infrastructure, better
education and health systems, government can considerably improve the potential output in the
economy. Better education and health will also result in improved human capital. Thus, improving
the very basic factors of production available in the economy.

Moreover, a skilled labor force supported by a strong infrastructure will create a positive
environment for firms to invest. The economy will find it easy to attract foreign capital. All these
factors will lead to an increased economic growth.
Central Banks
Central Banks are charged with regulating the size of a nations money supply, the availability and
cost of credit, and the foreign-exchange value of its currency. Central bank Regulation of the
availability and cost of credit may be designed to influence the distribution of credit among
competing uses. The principal objectives of a modern central bank in carrying out these functions
are to maintain monetary and credit conditions conducive to a high level of employment and
production, a reasonably stable level of domestic prices, and an adequate level of international
reserves.

Function of a Central Bank
A central bank usually carries out the following responsibilities:
Implementation of monetary policy.
Controls the nation's entire money supply.
The Government's banker and the bankers' bank ("Lender of Last Resort").
Manages the country's foreign exchange and gold reserves and the Government's stock
register;
Regulation and supervision of the banking industry
82
Setting the official interest rates- used to manage both inflation and the country's exchange
rate - and ensuring that this rate takes effect via a variety of policy mechanisms

Monetary Policy and the Economy

Monetary policy is the process by which the government, central bank, or monetary authority of a
country controls the supply of money, availability of money, and cost of money or rate of interest,
in order to attain growth and stability of the economy.
Monetary policy is generally referred to as either being an expansionary policy, or a
contractionary policy.

An expansionary policy increases the total supply of money in the economy and is traditionally
used to combat unemployment in a recession by lowering interest rates. Lowered interest rates
encourage the household and the firms to increase their consumption and investment
respectively. This will shift the AD to the right and result in higher real output and more
employment.

83
Contractionary policy decreases the total money supply and involves raising interest rates in
order to combat inflation. The result will be that investment will fall, and consumption will fall. All
of these changes will shift the AD to the left.

It is argued that an increase in the money supply causes an increase in the rate of inflation.
Maintaining a low and stable inflation is one of the main macroeconomic objectives of the
Government. Government does so by controlling the supply of money to the economy. This policy
is known as monetary policy.
Monetary policy in any country is usually controlled by the Central Bank of that country. The
Central bank alters the interest rates in the economy after assessing the inflationary pressures in
the market.

Monetary Policy tools
Central Bank has three tools of monetary policy:
Open market operations
Open market purchases: The central bank buys government securities to increase the
monetary base.
Open market sales: The central bank sells government securities to decrease the monetary
base.
Open market operations have a number of advantages:
They are under the direct and complete control of the central bank
They can be large or small.
They can be easily reversed.
They can be implemented quickly

Discount loans
When a bank receives a discount loan from the central bank, it is said to have received a loan at
the discount window. The Central Bank can affect the volume of discount loans by setting the
discount rate:
A higher discount rate makes discount borrowing less attractive to banks and will
therefore reduce the volume of discount loans.
A lower discount rate makes discount borrowing more attractive to banks and will
therefore increase the volume of discount loans.
84
Discount lending is most important during financial panics:

When depositors lose confidence in the financial system, they will rush to withdraw their
money.
This large deposit outflow puts the banking system in great need of reserves.
The central bank stands ready to supply these reserves by making discount loans. In such
situations, the central bank acts as a lender of last resort.

Changes in reserve requirements
The portion (expressed as a percent) of depositors' balances banks must have on hand as cash.
This is a requirement determined by the country's central bank. It affects the money multiplier;
changes in the required reserve ratio can lead to changes in the money supply. This is also
referred to as the "cash reserve ratio" (CRR).

What are supply side policies?
Supply-side policies are those government policies, which aim at positively affecting the
production side of an economy by improving the institutional framework and the capacity to
produce (that is, by changing the quantity and/or quality of factors of production).

In short it involves all measures taken by the government for improving the productive potential
of the economy.

Supply-side policies may be market-based or interventionist and that in either case they aim to
shift the LRAS curve to the right, achieving growth in potential output.

85

Interventionist supply-side policies

Investment in infrastructure
Improving information and investing in infrastructure will facilitate the firms to produce more
and at a more cost efficient manner. Better infrastructure attracts more investment both domestic
and foreign. In the short run increase government expenditure on infrastructure will lead to rise
in AD and will fuel inflation, however in the long run it will lead to greater efficiencies and output
thus shifting the LRAS to the right.

Investment in human capital
This involves investment in education and training which will raise the levels of human capital.
This will, in the short-term, impact on aggregate demand as consumption of certain goods will
increase, but more importantly will increase LRAS as labor becomes more skilled and efficient.

Industrial policies
Through various industrial policies focus the government encourage firms to move to areas of
high unemployment.
These measures might include subsidies or tax concessions for firms which move, the provision of
facilities and improved infrastructure in the depressed area, the siting of government offices in the
depressed areas and the prevention of firms expanding in the prosperous ones.
This will have a short-term impact on aggregate demand but, more importantly, will increase
LRAS.

Investment in new technology
These policies encourage research and development, which will enhance efficiency and output. It
will have a short-term impact on aggregate demand, but more importantly will result in new
technologies and will increase LRAS.

Market-based supply-side policies
86

Policies to encourage competition
Competition leads to increased efficiency and eliminates market failure. Government can adopt
various strategies to reduce its control over market and encourage competition. This includes
Deregulation: The reduction or elimination of government power in a particular
industry, usually enacted to create more competition within the industry.
Privatization: The transfer of ownership of property or businesses from a
government to a privately owned entity. It leads to greater efficiency as it is thought to
come from the greater importance private owners tend to place on profit maximization as
compared to government, which tends to be less concerned about profits.
Trade liberalization: This involves the removal or reduction of restrictions or
barriers on the free exchange of goods between nations. Trade liberalization ultimately
lowers consumer costs, increases efficiency and fosters economic growth.
Anti-monopoly regulations can avoid monopolies being formed and thus stimulate
competition among firms, leading to greater efficiency.

Labor market reforms
These include reducing the power of labor unions, reducing unemployment benefits and
abolishing minimum wages in order to make the labor market more flexible (more responsive to
supply and demand).

Incentive-related policies
Personal income tax cuts are used to increase the incentive to work, and cuts in business tax and
capital gains tax are used to increase the incentive to invest.

Evaluation of supply-side policies
The strengths and weaknesses of supply-side policies
Time lags: Supply side policies generally take time to implement and show results in the long run.
For example, improving the quality of human capital, through education and training, is unlikely to
yield quick results.

These policies have an ability to create employment as more jobs are created in various fields such
as education, technology and health care. Moreover, these jobs are long term and sustainable.

Supply side policies have the ability to reduce inflationary pressure in the long term because of
efficiency and productivity gains in the product and labor markets.

Supply-side policy is very costly to implement and have severe impact on the government budget.
For example, the provision of education and training is highly labor intensive and extremely
costly. The government has to carefully plan these spending over a period of time. In the short run
market oriented supply side policies such as reducing in income and corporate taxes can reduce
governments main source of revenue, however in the long run size of the economic growth would
be significant enough that the increased government revenue from a faster growing economy
would cause overall revenue to increase.

87
Effect on equity: Many supply-side measures have a negative effect on the distribution of income,
at least in the short-term. For example, lower taxes rates, reduced union power, and privatization
have all contributed to a widening of the gap between rich and poor.

Effect on the environment: Supply side policies lead to more economic growth. However, it can
lead to exploitation of natural resources and environment if environmental regulations are
relaxed thus creating negative externalities of production.

Opposition: Power of labor unions, reducing unemployment benefits and abolishing minimum
wages can lead to wide spread discontent among the labour force in the economy. Thus
governments are usually hesitant in taking these steps. Moreover, these might also lead to
worsening of working conditions in the long run which will affect labor productivity.

Section 3: International economics
3.1 International trade (one topic HL extension, plus one topic HL only)
3.2 Exchange rates (some topics HL extension)
3.3 The balance of payments (one topic HL extension, plus some topics HL only)
3.4 Economic integration (one topic HL extension)
3.5 Terms of trade (HL only)

The purpose of this section is to encourage candidates to understand why countries trade, the
problems involved and how these problems are addressed. Students need to understand how
exchange rates affect international trade. The international trade theory introduced in this section
should be related to real-world examples.

What is Free Trade?
Free trade is a system of trade policy that allows traders to trade across national boundaries
without interference from the respective governments.

Reasons for Free Trade
Domestic Non-availability: A nation trades because it lacks the raw materials, climate, specialist
labor, capital or technology needed to manufacture a particular good. Trade allows a greater
variety of goods and services.
Cost effectiveness: It is cheaper to buy from other countries rather than producing themselves.

Benefits of Trade
Lower prices for consumers: When there is free trade, consumers can free to buy goods from the
producer who is willing to sell at the lowest prices. Hence consumers gain from lower prices.

Greater choice for consumers: With free trade, consumers have access to variety of goods and
services from different producers across the globe. This means more choice.

Ability of producers to benefit from economies of scale: Producers have access to a larger
market thus they can produce more at lower cost and benefit from economies of scale.

88
Ability to acquire needed resources: Through free trade producers can not only sell in a large
market but also gain from purchasing from suppliers across the world.
More efficient allocation of resources: When there is free trade, the most efficient producers get
the opportunity to produce due to their cost efficiency. This leads to productive efficiency.

Increased competition: In free trade producers from different regions can compete with each
other in terms of price, quality and variety. Increased competition leads to efficient allocation of
resources.

Source of foreign exchange: Free trade involves the transaction of goods and services between
nations. In order to purchase goods from abroad (imports), we need foreign currency. This is
possible through exporting of goods to other countries.

Free Trade diagrams

89
Exports & Imports

Exports are the movement of goods or commodities out of the country.
Imports are the movement of goods or commodities into the country.

Visible Trade
Visible trade involves trading of goods which can be touched and weighed. Examples include trade
in goods such as Oil, machinery, food, clothes etc.

Visible Trade consists of
Visible exports: Selling of tangible goods which can be touched and weighed to other
countries.
Visible imports: Buying of tangible goods which can be touched and weighed from other
countries.

Balance of trade
It is the difference between the value of visible exports and value of visible imports of a
country.
If the value of visible exports is more than visible imports the country will have a Surplus
balance of trade.
If the value of visible imports is more than visible exports the country will have an
Unfavorable balance of trade.

Invisible trade
Invisible trade involves the import and export of services rather than goods.

Examples include: services such as insurance, banking, tourism, education.

If a UK student comes to Singapore to study, it would be invisible export for Singapore as it is
earning foreign exchange by providing educational services.

If a Singapore citizen travels to UK for a holiday. It will be invisible import for Singapore and
invisible export for UK.

Balance of invisible trade
It is the difference between the value of invisible exports and value of invisible imports of a
country.

Absolute advantage
A country has an absolute advantage over another in producing a good, if it can produce that good
using fewer resources than another country.

For example if one unit of labor in Australia can produce 80 units of wool or 20 units of wine;
while in France one unit of labor makes 50 units of wool or 75 units of wine, then Australia has an
absolute advantage in producing wool and France has an absolute advantage in producing wine.

90
Australia can get more wine with its labor by specializing in wool and trading the wool for French
wine, while France can benefit by trading wine for wool.

Examples

Example 1
Country A can produce one widget using one unit of labor.
Country B can produce one widget using two units of labor.

Country A has an absolute advantage over Country B in producing widgets.

Example 2
Country A has 100 units of labor. It uses 20 to produce 80 units of Parachutes, and 80 to produce
20 units of Barbie dolls.

Country B has 100 units of labor. It uses 40 to produce 100 units of Barbie dolls, and 60 to produce
20 units of Parachutes.

If the countries maximized their potential, Country A could produce 400 units of Parachutes, and
country B could produce 250 units of Barbie dolls. Through trade, the two countries would achieve a
more efficient allocation of resources and increase their prosperity.

Comparative advantage
The theory of comparative advantage states that a country should specialise in the production of
good or service in which it has lower opportunity cost and it should import commodities which
have a higher opportunity cost of production.

Example
Suppose for example we have two countries of equal size, Northland and Southland. Both produce
and consume two goods, Food and Clothes. The productive capacities and efficiencies of the
countries are such that if both countries devoted all their resources to Food production, output
would be as follows:
Northland: 100 tons
Southland: 200 tons

If all the resources of the countries were allocated to the production of clothes, output would be:
Northland: 100 tons
Southland: 100 tons

Assuming each has constant opportunity costs of production between the two products and both
economies have full employment at all times. All factors of production are mobile within the
countries between clothing and food industries, but are immobile between the countries. The
price mechanism must be working to provide perfect competition.

Southland has an absolute advantage over Northland in the production of Food. Both countries are
equally efficient in the production of clothes. There seems to be no mutual benefit in trade
91
between the economies. The opportunity costs shows otherwise. Northland's opportunity cost of
producing one ton of Food is one ton of Clothes and vice versa. Southland's opportunity cost of one
ton of Food is 0.5 ton of Clothes. The opportunity cost of one ton of Clothes is 2 tons of Food.
Southland has a comparative advantage in food production, because of its lower opportunity cost
of production with respect to Northland. Northland has a comparative advantage over Southland
in the production of clothes, the opportunity cost of which is higher in Southland with respect to
Food than in Northland.

To show these different opportunity costs lead to mutual benefit if the countries specialize
production and trade, consider the countries produce and consume only domestically. The
volumes are:

Food
Clothes
Northland
50

50
Southland
100
50
World Total
150
100

Production and consumption before trade
This example includes no formulation of the preferences of consumers in the two economies
which would allow the determination of the international exchange rate of Clothes and Food.
Given the production capabilities of each country, in order for trade to be worthwhile Northland
requires a price of at least one ton of Food in exchange for one ton of Clothes; and Southland
requires at least one ton of Clothes for two tons of Food. The exchange price will be somewhere
between the two. The remainder of the example works with an international trading price of one
ton of Food for 2/3 ton of Clothes.

If both specialize in the goods in which they have comparative advantage, their outputs will be:

Food
Clothes
Northland
0

100
Southland
200
0
World Total
200
100

Production after trade
World production of food increased. Clothing production remained the same. Using the exchange
rate of one ton of Food for 2/3 ton of Clothes, Northland and Southland are able to trade to yield
the following level of consumption:

Food
Clothes
Northland
75

50
Southland
125
50
World Total
200
100

Consumption after trade
92
Northland traded 50 tons of Clothing for 75 tons of Food. Both benefited, and now consume at
points outside their production possibility frontiers.

Assumptions in Example 2
Two countries, two goods - the theory is no different for larger numbers of countries and
goods, but the principles are clearer and the argument easier to follow in this simpler case.
Equal size economies - again, this is a simplification to produce a clearer example.
Full employment - if one or other of the economies has less than full employment of factors
of production, then this excess capacity must usually be used up before the comparative
advantage reasoning can be applied.
Constant opportunity costs - a more realistic treatment of opportunity costs the reasoning
is broadly the same, but specialization of production can only be taken to the point at which
the opportunity costs in the two countries become equal. This does not invalidate the
principles of comparative advantage, but it does limit the magnitude of the benefit.
Perfect mobility of factors of production within countries - this is necessary to allow
production to be switched without cost. In real economies this cost will be incurred: capital
will be tied up in plant (sewing machines are not sowing machines) and labor will need to
be retrained and relocated. This is why it is sometimes argued that 'nascent industries'
should be protected from fully liberalized international trade during the period in which a
high cost of entry into the market (capital equipment, training) is being paid for.
Immobility of factors of production between countries - why are there different rates of
productivity? The modern version of comparative advantage (developed in the early
twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin) attributes
these differences to differences in nations' factor endowments. A nation will have
comparative advantage in producing the good that uses intensively the factor it produces
abundantly. For example: suppose the US has a relative abundance of capital and India has
a relative abundance of labor. Suppose further that cars are capital intensive to produce,
while cloth is labor intensive. Then the US will have a comparative advantage in making
cars, and India will have a comparative advantage in making cloth. If there is international
factor mobility this can change nations' relative factor abundance. The principle of
comparative advantage still applies, but who has the advantage in what can change.
Negligible Transport Cost - Cost is not a cause of concern when countries decided to trade.
It is ignored and not factored in.
Assume that half the resources are used to produce each good in each country. This takes
place before specialization
Perfect competition - this is a standard assumption that allows perfectly efficient allocation
of productive resources in an idealized free market.

Limitations of Theory of Absolute Advantage
The theory is based on unrealistic assumptions:
Factors of production are immobile and fixed
Technology is fixed
There is perfect competition
Resources are fully employed
Imports and exports balance each other
93
There is free trade

Cost of Transportation has been ignored
The theory does not allow structural changes in an economy
May result in too much specialization:

For example agricultural goods are subject to strong price fluctuation which might lead to
unstable export revenue for an economy

Protectionism
Policy of protecting domestic industries against foreign competition by means of tariffs, subsidies,
import quotas, or other handicaps placed on imports. The chief protectionist measures,
government-levied tariffs, raise the price of imported articles, making them less attractive to
consumers than cheaper domestic products. Import quotas, which limit the quantities of goods
that can be imported, are another protectionist device.

Methods of Protectionism
Tariffs
A tariff is a tax on foreign goods upon importation. Tariff rates vary according to the type of goods
imported. Import tariffs will increase the cost to importers, and increase the price of imported
goods in the local markets, thus lowering the quantity of goods imported.

94
Impact of Tariffs
Tariffs lead to higher prices for imports and thus Imports fall
Domestic consumers have to pay higher prices and buy less.
Domestic producers gain, as they get higher prices and sell larger quantities. As we can see
in the diagram domestic production increases from 0Q1 to 0Q2. Moreover their revenue
increases from PwQ1 to Pw+TQ2
Higher domestic production leads to increased domestic employment.
Government now gains from tariff revenues, which can be represented by e in the diagram
Tariffs are regressive in nature and thus worsen income distribution.
Exporting countries lose due to fall in exports.

Quotas
An import quota is a type of protectionist that sets a physical limit on the quantity of a good
that can be imported into a country in a given period of time. This leads to a reduction in the
quantity imported and therefore increases the market price of imported goods. Quotas, like
other trade restrictions, are used to benefit the producers of a good in a domestic economy at
the expense of all consumers of the good in that economy.

Effects of Quotas
Domestic production increases from 0Q1 to 0Q1+Q3Q4.
Domestic consumption fall from 0Q2 to 0Q4
Imports fall from Q1Q2 to Q1Q3
Consumers end up paying more. Before quota was imposed they were paying Pw, but
now they are paying Pw+Quota
Domestic producers gain as they sell more at higher prices (Pw+Quota)
95
Domestic employment increases as domestic production rises.

Government gets quota revenues
Domestic society is worse off due to decrease in consumption and production by less
efficient producers
Exporting countries lose revenue
Quotas result in global misallocation of resources as goods are being produced by
inefficient producers.
J and K represents the dead weight loss of welfare to the society, as J represents
production by inefficient producers and K represents the loss of consumer surplus.
Subsidies
Government subsidies (in the form of lump-sum payments or cheap loans) are sometimes given to
local firms that cannot compete well against foreign imports. These subsidies are purported to
"protect" local jobs, and to help local firms adjust to the world markets.

Effects of Subsidies
Consumption of the good is not affected. Consumption remains at Q3.
Taxpayers lose as the tax revenue collected is being used for subsidies
Domestic producers gain as the production increases from 0Q1 to 0Q3.
Employment increases as more is being produced domestically.
Exporting countries are worse off
Global misallocation of resources as inefficient producers are now producing goods.

96
Administrative Barriers
Countries are sometimes accused of using their various administrative rules (eg. regarding food
safety, environmental standards, electrical safety, etc.) as a way to introduce barriers to imports.

Embargo
An embargo is the prohibition of commerce and trade with a certain country, in order to isolate it
and to put its government into a difficult internal situation, given that the effects of the embargo
are often able to make its economy suffer from the initiative.

Anti-dumping legislation
Supporters of anti-dumping laws argue that they prevent "dumping" of cheaper foreign goods that
would cause local firms to close down. However, in practice, anti-dumping laws are usually used
to impose trade tariffs on foreign exporters.

Arguments in favor of protectionism

Infant industry argument: It is argued that government should go in for protectionist measure to
protect infant industries, or else they will not get an opportunity to survive due to international
trade.

Efforts of a developing country to diversify: Developing countries need to protect industries in
which they want to diversify.
Protection of employment: Protecting domestic industries also means protecting domestic
employment.

Source of government revenue: Tariffs form a good source of revenue for governments.

Strategic arguments: it means use of a tariff to protect military capability. The idea is, to consume
the goods of our country to promote the national industry and so, in the case of war we don't have
to buy the products in a foreign country and our industries have the capacity to produce all the
goods that our country need. We want tariffs to reduce the dependence on international
resources.

Means to overcome a balance of payments disequilibrium: High imports as compared to
exports might lead to severe balance of payments issues. Government might resort to
protectionist measures such as tariffs and quotas to restrict import and thereby control the
balance of payment disequilibrium.

Anti-dumping: Dumping is when manufacturers export a product to another country at a price
either below the price charged in its home market. This harms the domestic industry and
employment. The importing country might resort to protectionist measures such as tariffs to
control dumping of these goods.

97
Arguments against Protectionism

misallocation of resources: It leads to global misallocation of resources, as it supports inefficient
producers and in certain cases (tariffs and quotas) consumer surplus is scarified.

The danger of retaliation and trade wars: Continuous protectionist measures by a country
might lead to retaliation of other countries and they might also put protectionist measures on the
imports.

The potential for corruption: Putting administrative controls might also lead to corruption.

Increased costs of production due to lack of competition: Constant protection to the domestic
producers and lack of competition propagates inefficiency and lack of initiative to control cost.

Higher prices for domestic consumers: As we can see due to tariffs and quotas domestic
consumers end up paying more.

Increased costs of imported factors of production: Imported goods become expensive which
might also lead to imported inflation.

Reduced export competitiveness: Continuous protection to domestic industries (such as
subsidies) might make them inefficient in terms of cost and technology. In the long run they might
become uncompetitive in the exports market.

Freely floating exchange rate
Exchange rate is the rate at which one countrys currency can be exchanged for another countrys
currency.

Floating Exchange Rate
Floating exchange rate system means that the exchange rate is allowed to fluctuate according to
the market forces without the intervention of the Central bank or the government.

APPRECIATION AND DEPRECIATION
The exchange rate for any currency usually fluctuates. When the value of the currency goes up as
compared to other currency it is known as appreciation. When the value of currency falls as
compared to other currency it is known as depreciation.
Usually the exchange rates are determined by the demand and supply of that currency in the
international market.

Demand for any countrys currency on the foreign exchange market is determined by demand for
that countrys exports of goods and services and by changes in foreign investment in that country.
This is because when foreigners buy another countrys exports of goods or services they must pay
for these in the currency of the exporting country.

In the same way Supply of any countrys currency on the foreign exchange market is determined
by that countrys imports of goods and services and by its investment in other countries.
Thus when the demand for a currency rises its price goes up and it becomes costlier.
98

As we can see in the diagram as the demand for $ from UK increases it price in terms of goes up
from .62 to .63.

Similarly, we can see that the supply of dollar in the market increases which forces its price down
from .63 to .62.

99
What causes the fluctuation in currency value?

Changes in the imports and exports of the country: An increase in exports of a country will
lead to an increase in demand for the currency and thus the value rises.

Changes in Interest rate: Higher interest rate will attract more foreign investors to invest in the
country and thus the demand for currency will rise, resulting in appreciation in value of the
currency.

Changes in Inflation rate: Higher inflation rate will make the country uncompetitive in the
international market. The exports will fall resulting in decreased demand for the currency and
hence lower value.

Rise in domestic income relative to incomes abroad: currency depreciates.

Investment opportunities: if bright lead to appreciation.

Speculative sentiments: Individuals and institutions invest in currency markets with the sole
intention to get short term gains. This is quiet like investing in stock exchange. Whenever a
currency is going strong, people will invest more in an expectation to gain from it. This fuels the
demand for that particular currency and it appreciates further.

Global trading patterns: if strong global presence in trade then the currency appreciates.

Changes in relative inflation rates: high inflation rate leads to exports becoming less
competitive in international market

Effect of exchange rate changes
Exchange rate fluctuation effects countrys inflation rate, employment, economic growth and
current account balance.
Lets see how

Scenario 1- Currency depreciates
A depreciation in exchange rate should lead to a rise in demand for exports and a fall in demand
for imports the balance of payments should improve,
Exports will improve, this will lead to more output, more employment will be created thus
economic growth will be achieved. However, exports is a component of AD, an increase in exports
will lead to the shift of AD to the right and might also lead to inflation. The economy might also
suffer from imported inflation as imports are now expensive due to depreciation of your
currency.

Scenario 2 Currency appreciates
An appreciation of the exchange rate should lead to a fall in demand for exports and a rise in
demand for imports the balance of payments should get worse.
When exports fall, real output will fall which leads to unemployment. Economic growth is
compromised and the economy may suffer from deflationary gap.
100
However, The volumes and the actual amount of income and expenditure will depend on the
relative price elasticity of demand for imports and exports.

Government Intervention in the exchange rate
Fixed Exchange Rate
A fixed exchange rate system refers to the case where the exchange rate is set and maintained at
same level by the government irrespective of the market forces.

The diagram below shows a fixed exchange rate

REVALUATION AND DEVALUATION
It refers to official changes in the price of a currency in a fixed exchange rate system.
Devaluation is when the price of the currency is officially decreased in a fixed exchange rate
system.
Revaluation is the official increase in the price of the currency within a fixed exchange rate
system.

Managed Exchange Rate
A managed exchange rate occurs when there is official intervention by a government or an agency
such as the Central Bank to determination the value of a countrys exchange rate. Through such
official interventions it is possible to manage both fixed and floating exchange rates.

For example,
The Federal Bank may decide to enter the foreign exchange market as either a buyer or seller to
stabilize any short-term fluctuation in the value US$. To limit a fall in the value of US$
(depreciation) the Fed will buy US$, and to prevent a rise in the value of US$, the central bank will
sell US$ in the market.
Such intervention by the central bank is known as a dirty float, or more correctly a managed
float.
101
Other Government actions and their effect

Expansionary monetary policy (MS) causes an increase in GNP and a depreciation of the
domestic currency in a floating exchange rate system in the short run.

Contractionary monetary policy (MS) causes a decrease in GNP and an appreciation of the
domestic currency in a floating exchange rate system in the short run.

Expansionary fiscal policy (G, TR, or T) causes an increase in GNP and an appreciation of
the domestic currency in a floating exchange rate system.

Contractionary fiscal policy (G, TR, or T) causes a decrease in GNP and a depreciation of the
domestic currency in a floating exchange rate system.

In the long run, once inflation effects are included, expansionary monetary policy (MS) in a full
employment economy causes no long-term change in GNP and a depreciation of the domestic
currency in a floating exchange rate system. In the transition, the exchange rate overshoots its
long-run target and GNP rises then falls.

A sterilized foreign exchange intervention will have no effect on GNP or the exchange rate in the
AA-DD model, unless international investors adjust their expected future exchange rate in
response.

A central bank can influence the exchange rate with direct Forex interventions (buying or selling
domestic currency in exchange for foreign currency). To sell foreign currency and buy domestic
currency, the central bank must have a stockpile of foreign currency reserves.

A central bank can also influence the exchange rate with indirect open market operations (buying
or selling domestic treasury bonds). These transactions work through money supply changes and
their effect on interest rates.
Purchases (sales) of foreign currency on the Forex will raise (lower) the domestic money supply
and cause a secondary indirect effect upon the exchange rate.

Consequences of overvalued and undervalued currencies
Overvalued Currency

Advantages
Downward pressure on inflation i.e. imported goods will be cheaper
More imports can be bought
High value of currency forces domestic producers to improve their efficiency to be more
competitive in the international market.

Disadvantages
Overvalued currency will make exports uncompetitive in the international market which
will hurt the export industries
102
Imports are relatively cheaper to buy due to overvalued currency. Consumers will go in for
more imports which will damage to domestic industries

Undervalued currency

Advantages
If currency is undervalued, the exports will be cheaper and they will grow leading to
greater employment in export industries
Undervalued currency will make imports expensive for consumers, they will divert to
domestic goods and thus employment in domestic industries will increase.

Disadvantages
As discussed earlier undervalued currency makes imports expensive which also leads to Imported
inflation i.e. all the products using imported components/raw material will become expensive
thus effecting the general price level.

What is Balance of Payments?
Balance of Payments is an accounting record of all monetary transactions between a country and the
rest of the world

Important Points
BOP is a record which countries use to monitor all international monetary transactions at a
specific period of time.
All trades conducted by both the private and public sectors are accounted for in the BOP in
order to determine how much money is going in and out of a country
If a country has received money, this is known as a credit, and, if a country has paid or
given money, the transaction is counted as a debit.
Usually, the Balance of Payments is calculated every quarter and every calendar year.

Components of Balance of Payment
Balance of Payment is classified into three categories. These are:

The Current Account
It includes
Trade in goods: visible account
Trade in services: invisible account consists of transport, tourism and insurance etc.
Net Income flows: Income flows consist of wages, interest and profits flowing into and out
of the country.
Current transfers of money: Government contributions to and receipts from international
organizations and international transfers of money by private individuals and firms.

The Capital Account
It records flow of funds, into the country (credits) and out of the country (debits),
associated with the acquisition or disposal of fixed assets
Transfers of financial assets by migrants
103

The Financial Account
It records the flow of money in and out of a country because of:

Investment (direct and portfolio)
Records primarily long term investments like:

Direct investments if a foreign company invests money from abroad in one of its branches or
associated companies a country. (Any profit from this investment will be recorded as income
outflow on the current account)

Portfolio investment- changes in the holding of paper assets, such as company shares. E.g. If an
Indian buys shares in an overseas company, this is an outflow of funds i.e. Debit item

Other Financial Flows
It consists primarily of various types of short-term monetary movement between a country and
the rest of the world. E.g. Deposits by overseas residents in banks in the country and loans to India
from abroad are credit items.
Deposits by Indians in overseas banks and loans by Indian banks to overseas residents are debit
items.
Short term monetary flows are common between international financial centres to take advantage
of differences in interest rates and changes in exchange rates.

Flow to and from the reserves
Every country holds reserves of gold and foreign currencies. Central bank sells some of the
reserves to purchase Rupee in the foreign market. It does so in order to support the rate of
exchange. Drawing on reserves represents credit item in the balance of payment accounts. Money
drawn from the reserves represents an inflow of the BOP.
The surplus elsewhere in the balance of payments can be used to build up the reserves i.e. debits.

Balance of Payment can be favorable or unfavorable (deficit)

Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should
balance. But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has
a deficit or a surplus and from which part of the economy the discrepancies are stemming.

104

Current Account Deficits and Exchange rate
The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and current account deficit dividends.

A deficit in the current account shows the country is spending more on foreign trade than it is
earning, and that it is borrowing capital from foreign sources to make up the deficit. In other
words, the country requires more foreign currency than it receives through sales of exports, and it
supplies more of its own currency than foreigners demand for its products. The excess demand for
foreign currency lowers the country's exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to generate sales for domestic
interests.

Implications of a persistent current account deficit

Exchange rate: As discussed earlier, a persistent current account deficit will lead to a fall in the
value of the domestic currency.
Another way is to draw on reserves, however if the reserves are run down to rapidly, it may cause
a crisis of confidence and foreign investment may withdraw suddenly. Persistent current account
deficits will also lead to depletion of foreign exchange reserves.

Indebtedness: If the combined balance is a deficit, then it would have to be covered by
borrowings from abroad or attracting deposits from abroad. It might mean paying more interest.

Increase in Interest rates: With a falling exchange rate, the government might have to take more
serious monetary measures such as increasing the interest rates. This will attract foreign
currency, however, the higher interest rates means compromising the Aggregate Demand in the
economy.

Another alternative is to attract foreign investments. However, it leads to greater outflows in
interest and dividends in the future.

Methods to correct a persistent current account deficit

Expenditure switching policies
These are policies implemented by the government that attempt to switch the expenditure of
domestic consumers away from imports towards domestically produced goods & services.
Devaluating currency: Fixing the domestic currency value at a lower price and thus making
exports more attractive. Moreover, imports will become more expensive, thus diverting
consumption to domestic goods.

However, expensive imports will lead to imported inflation
Protectionist measures: Reducing imports by levying tariffs and setting up quotas.

105
Expenditure reducing policies

These are policies implemented by the government that attempt to reduce overall expenditure in
the economy, so shifting the AD to the left.

Deflationary fiscal policies: Increasing taxes and reducing government spending.
Deflationary monetary policies: Increasing Interest rates.

However, contractionary fiscal and monetary policies will lead to fall in Aggregate Demand, which
is not desirable. This will result in compromising economic growth and higher unemployment.

Supply Side policies
The main objective of the supply side policies is to improve the quantity and quality of factors of
production. By achieving efficiency in the production of goods and services, the economy can
improve its international competitiveness and increase its exports. This would include
Improvement in technology
Improving the education and skill level of its workforce
Providing better infrastructure
Privatization
Deregulation

All of the above measures will also attract foreign investment in the economy, which will lead to
inflow of foreign currency and improve balance of payment.
Supply-side policy can provide a highly effective policy framework for long term improvement in
competitiveness and current account performance. The main problem is that supply-side policy
may take decades to work and is not a quick-fix.

Current Account Surplus
A current account surplus occurs when the countrys exports are more than its imports. This is a
desirable condition, however it has its own problem associated with it.

A surplus in the long run will lead to the appreciation of the countrys currency which will reduce
its export competitiveness.

Lower domestic consumption: Relatively stronger currency will induce people to go in for
imported goods, thus harming the domestic consumption and investment. In the long run, it will
harm the domestic industry and increase unemployment.

What is economic integration?
Economic integration refers to trade unification between different states by the partial or full
abolishing of customs tariffs on trade taking place within the borders of each state.

This is meant in turn to lead to lower prices for distributors and consumers (as no customs duties
are paid within the integrated area) and the goal is to increase trade.

106

What is a trade agreement?
A trade agreement is a contract/agreement/pact between two or more nations that outlines how
they will work together to ensure mutual benefit in the field of trade and investment.

Trade agreements are often regional, involving only a relatively small number of countries.

Trade agreements are either bilateral, involving only two countries, or multilateral, involving
more than two countries.

What is a trade bloc?
A trade bloc is a type of intergovernmental agreement, where regional barriers to trade, (tariffs
and non-tariff barriers) are reduced or eliminated among the participating states.

Types of trade blocs
Preferential Trade agreement
A preferential trade agreement, is a trading bloc that gives preferential access to certain products
from the participating countries.

107
This is done by reducing tariffs but not by abolishing them completely. A PTA can be established
through a trade pact. It is the first stage of economic integration.

Free Trade Areas
A free-trade area is a trade bloc whose member countries have signed a free-trade agreement (FTA),
which eliminates tariffs, import quotas, and preferences on most (if not all) goods and services traded
between them.

However they are free to trade with countries outside of the free trade area

108
Customs Union
An agreement among countries to have free trade among themselves and to adopt common
external barriers against any other country interested in exporting to these countries

Examples:
European Union
East African Community (Kenya, Uganda, Tanzania]
Mercosur [ Brazil, Argentina, Uruguay, Paraguay and Venezuela]

Common Market
A type of custom union where there are common policies on product regulation, and free
movement of goods and services, capital and labour.
Best known example is EU
All common markets and economic and monetary unions are also customs unions

Economic & Monetary Unions
A common market with common currency
Where more than two countries use the same currency.
Example Euro

Advantages of single currency
Reduces the level of transaction cost.
When trading among each other the countries need not worry about possible exchange rate
fluctuations.
It is easier to make price comparisons between countries.
Greater FDI is attracted because of reduced transactions costs, reduced uncertainty and the
large size of single currency market.

109
Disadvantages of single currency

Individual countries lose the ability to set interest rates.
Individual countries cannot depreciate or devalue its currency value.
Huge cost involved such as physical changing, reprogramming computers, producing new
price lists etc.

Complete Economic Integration
Individual countries have no control of economic policy, full monetary union and complete
harmonization of fiscal policy.

Evaluation of Economic integration
Greater size of the market
Potential for exports
Greater efficiency
More choice
Lower prices for consumers
Increased foreign investment
Greater political stability
Free trade among members but discriminatory policies against non-members which might
not lead to global economic integration.

110
Trade Creation and Trade Diversion

Economic integration results in trade creation and trade diversion. Trade creation leads to
advantages while trade diversion is not desirable from an economists point of view.

Trade Creation
Trade creation takes place when domestic consumers in member countries import more goods
from other members as import prices fall due to a removal of tariff and quotas; production will
shift to lower cost producer.

In the above diagram, when Thailand and Malaysia form a trading bloc, Thailand will remove
tariffs from Malaysian imports. Trade will go to more efficient Malaysian producers. The blue
shaded regions shows that world efficiency wil be regained as now more efficient producer is
producing the good and there are lower prices which lead to regaining of consumer surplus.

Increased income resulting from specialization & benefits of scale can further this by creating
increased demand for imports from non-member countries.
Initial effects are the increase in consumer welfare resulting from more goods and lower prices,
while the long-run effects include enhance competitive advantage and increasing specialization.

111
Trade Diversion
When a customs union is created and tariffs differentials between members and non-member
result in trade flows being diverted toward higher cost producers.

In the upper image, once the UK joined the EU, it had to place tariffs on the Palm Oil that it used to
import from Malaysia at lower prices. The trade now is diverted to EU nations in spite of the fact
that they are inefficient in producing palm oil.
The blue shaded regions show a loss in efficiency due production by inefficiently European
producers. Moreover, the prices for consumers have increased from Pm to Peu which results in
loss of consumer surplus.

In other words, lower cost imports from outside the union have been replaced by high cost
imports from within the union.

World Trade Organization
The WTO is an international entity established on January 1st 1995, that sets the rules for global
trading and resolves disputes between its member countries, it now counts with 149 members.

Functions of the WTO:
To administer WTO trade agreements
To be a forum for trade organizations
To handle trade disputes among members countries
To monitor national trade policies
To provide technical assistance and training for developing countries
To cooperate with other international organizations

112
The last round of negotiation is the Doha round. The program called the Doha Development
Agenda, covers many areas such as: agricultural tariffs, non-agricultural tariffs, trade and
environment, anti-dumping, subsidies, competition policy, transparency in government
procurement, and intellectual property. On July 2006, this round was suspended since the
members could not reach an agreement based on two key concerns: First, he EU and the US are
being urged to reduce their agricultural subsidies to improve market access for developing
countries exports. Second, the more developed countries want the larger developing countries
such as Brazil and India to lower their barriers to imports of manufactured goods.

Is the WTO a success or a failure?
There are several benefits that member countries gain from this organization:
The system helps to promote peace in the world
Freer trade cuts the cost of living for the majority of consumers
Trade raises income and stimulates economic growth
Freer trade provides more choice of products and better quality products
The system encourages good government
Disputes are now handled constructively at forums
Rules make life easier for everyone. Small countries have an equal say and gain from
collective bargaining with the larger countries.

However, there is some criticism to consider:
In reality, many important decisions get made in informal negotiations between small
groups of the wealthier nations. Hence, many of the WTOs developing countries members
are often excluded from decision-making negotiations; apart from the fact that many of
such countries cannot afford to participate in all negotiations and send their
representatives.
The WTOs General Agreement on Trade and Services includes a long list of services that
should be privatized (childcare, sewage, garbage disposal, park maintenance, care for the
aged and postal services), which is not well seen in developing countries where the
majority of the poor population would not be able to afford for such services.
It is argued that WTO treaties are unfairly biased towards the interest of multinational
corporations and the rich nations. For example: rich countries being allowed to maintain
high import duties and quotas on certain products from developing countries; increasing
non-tariffs barriers against developing countries; intellectual property rights banning
developing countries from incorporating technology that originates in developed countries;
etc.
It is claimed that in the quest for free trade, issues of health, safety at work, and
environmental protection are too often ignored to the great detriment of health, safety, and
the environment, at the forums.
Opponents of globalization, and in particular those opposed to the growing power of
multinational corporations, argued that the WTO infringes upon national sovereignty and
promotes the interests of large corporations at the expense of smaller local firms struggling
to cope with import competition.

113
Section 4: Development Economics

The main purpose of this section is to provide students with the opportunity to understand the
problems faced by developing countries, and to develop an awareness of possible solutions to
these problems.
Throughout the course, students are introduced to several important concepts in development
economics and, in particular, to the fundamental distinction between economic growth and
economic development established in macroeconomics section. This important distinction needs
to be re-emphasized at the beginning of this section.

Given the dynamic nature of the international economy, it is problematic to group countries into
clearly established categories such as developed, developing, newly industrialized countries
(NICs) and transition economies. However, students should understand current terminology and
be aware that similarities and differences exist within different categories. It is important for
teachers to help students find relevant examples of the different categories of countries.

Economic growth
Economic growth is the increase of per capita gross domestic product (GDP) or other measure of
aggregate income, typically reported as the annual rate of change in real GDP.

Economic growth is primarily driven by improvements in productivity, which involves producing
more goods and services with the same inputs of labor, capital, energy and materials.

Economic Development
Economic development is the increase in the standard of living in a nation's population with
sustained growth from a simple, low-income economy to a modern, high-income economy. Also, if
the local quality of life could be improved, economic development would be enhanced. Its scope
includes the process and policies by which a nation improves the economic, political, and social
well-being of its people.

Sources of economic growth in economically less developed countries
Natural factors
Improving the quality of human capital through education and training
Improving the quantity physical capital
the development and use of new technologies that are appropriate to the conditions of the
economically less developed countries
Improving the Institutional factors such as banking system, legal system, education system,
political stability etc.

Common characteristics of economically less developed countries
Low standards of living, low GDP per capita, low incomes, inequality, poor health,
inadequate education
Low level of productivity
High rates of population growth, High birth rates and dependency burden
High and rising levels of unemployment and underemployment
114
Substantial dependence on agricultural production/primary sector

Prevalence of imperfect markets i.e. Lack of banking, legal system, adequate infrastructure,
imperfect information.
Dominance by developed nations and dependence in terms of international relations.

Sources of economic development
Education leads to more gender equality, improved levels of health
Health care coupled with education facilities improve the quality of workforce, leading to
increase in productivity
Infrastructure :better facilities and services such as roads, transport, communication
Political stability

Poverty Trap
Some countries there may be communities caught in poverty trap (poverty cycle) where poor
communities are unable to invest in physical, human and natural capital due to low or no savings;
poverty is therefore transmitted from generation to generation, and there is a need for
intervention to break out of the cycle.

The diagram below illustrates a poverty trap

In order to escape the poverty trap, it is argued that individuals in poverty must be given sufficient
aid so that they can acquire the critical mass of capital necessary to raise themselves out of
poverty. This theory of poverty helps to explain why certain aid programs which do not provide a
high enough level of support may be ineffective at raising individuals from poverty. If those in
115
poverty do not acquire the critical mass of capital, then they will simply remain dependent on aid
indefinitely and regress if aid is ended.

Diversity among economically less developed nations
Economically less developed countries differ enormously from each other
Resource endowment may differ.
Historical background: Most have been colonized.
Geographic and demographic factors
Ethnic and religious breakdown
Structure of industry: some may heavily depend on primary sector while other may not.
Per capita income levels may differ in these countries.
Political structure : These countries might be having different political structure, Some may
be having democracies, monarchies, military rule, single party states and so on.

International development goals
The Millennium Development Goals (MDGs) are eight international development goals that were
officially established following the Millennium Summit of the United Nations in 2000, following
the adoption of the United Nations Millennium Declaration. All 193 United Nations member states
and at least 23 international organizations have agreed to achieve these goals by the year 2015.
The goals are:
Eradicating extreme poverty and hunger,millennium development goals
Achieving universal primary education,
Promoting gender equality and empowering women
Reducing child mortality rates,
Improving maternal health,
Combating HIV/AIDS, malaria, and other diseases,
Ensuring environmental sustainability, and
Developing a global partnership for development

116
Measuring Development - Single Indicators

GNI per capita
GNI per capita (also GNP per capita) is the gross national income, divided by the midyear population.

GNI is the sum of value added by all resident producers plus any product taxes (less subsidies) not
included in the valuation of output plus net receipts of primary income (compensation of
employees and property income) from abroad. GNI, calculated in national currency, is usually
converted to U.S. dollars at official exchange rates for comparisons across economies, although an
alternative rate is used when the official exchange rate is judged to diverge by an exceptionally
large margin from the rate actually applied in international transactions.

To smooth fluctuations in prices and exchange rates, a special Atlas method of conversion is used
by the World Bank. This applies a conversion factor that averages the exchange rate for a given
year and the two preceding years, adjusted for differences in rates of inflation between the
country, and through 2000, the G-5 countries (France, Germany, Japan, the United Kingdom, and
the United States). From 2001, these countries include the Euro area, Japan, the United Kingdom,
and the United States.

GDP per capita (current US$)
GDP per capita is gross domestic product divided by midyear population.

GDP is the sum of gross value added by all resident producers in the economy plus any product
taxes and minus any subsidies not included in the value of the products. It is calculated without
making deductions for depreciation of fabricated assets or for depletion and degradation of
natural resources.

GDP per capita, PPP (current international $)
GDP per capita based on purchasing power parity (PPP). PPP GDP is gross domestic product
converted to international dollars using purchasing power parity rates.

An international dollar has the same purchasing power over GDP as the U.S. dollar has in the
United States. GDP at purchaser's prices is the sum of gross value added by all resident producers
in the economy plus any product taxes and minus any subsidies not included in the value of the
products. It is calculated without making deductions for depreciation of fabricated assets or for
depletion and degradation of natural resources.

See more information on Health Indicators
http://data.worldbank.org/indicator/NY.GDP.PCAP.PP.CD/countries/1W?display=map

117
Composite Indicators
Human Development Index
The Human Development Index (HDI) is a summary measure of human development. It measures
the average achievements in a country in three basic dimensions of human development: a long
and healthy life (health), access to knowledge (education) and a decent standard of living
(income). Data availability determines HDI country coverage. To enable cross-country
comparisons, the HDI is, to the extent possible, calculated based on data from leading
international data agencies and other credible data sources available at the time of writing.

A composite index that brings together three variables adopted in 1990 developed jointly by
Amartya Sen and Mahbub ul Haq.
Long and healthy life ; life expectancy
Improved education; adult literary
Decent standard of living; GDP per capita
Category
High Human development
Medium human development
Low human development
HDI Value
.800 and above
.500 -0.799
Less than .500

Other composite indices
Gender Inequality Index
The Gender Inequality Index (GII) reflects womens disadvantage in three dimensions
reproductive health, empowerment and the labour marketfor as many countries as data of
reasonable quality allow.

The index shows the loss in human development due to inequality between female and male
achievements in these dimensions. It ranges from 0, which indicates that women and men fare
equally, to 1, which indicates that women fare as poorly as possible in all measured dimensions.
The health dimension is measured by two indicators: maternal mortality ratio and the adolescent
fertility rate. The empowerment dimension is also measured by two indicators: the share of
parliamentary seats held by each sex and by secondary and higher education attainment levels.
The labour dimension is measured by womens participation in the work force. The Gender
Inequality Index is designed to reveal the extent to which national achievements in these aspects
of human development are eroded by gender inequality, and to provide empirical foundations for
policy analysis and advocacy efforts.

More information at http://hdr.undp.org/en/statistics/gii/

Inequality-adjusted Human Development Index (IHDI)
The Inequality-adjusted Human Development Index (IHDI) adjusts the Human Development Index
(HDI) for inequality in distribution of each dimension across the population. The IHDI accounts for
inequalities in HDI dimensions by discounting each dimensions average value according to its
level of inequality. The IHDI equals the HDI when there is no inequality across people but is less
than the HDI as inequality rises. In this sense, the IHDI is the actual level of human development
118
(accounting for this inequality), while the HDI can be viewed as an index of potential human
development (or the maximum level of HDI) that could be achieved if there was no inequality. The
loss in potential human development due to inequality is given by the difference between the
HDI and the IHDI and can be expressed as a percentage.

More information http://hdr.undp.org/en/statistics/ihdi/

Multidimensional Poverty Index (MPI)
The Multidimensional Poverty Index (MPI) identifies multiple deprivations at the individual level
in health, education and standard of living. It uses micro data from household surveys, and
unlike the Inequality-adjusted Human Development Indexall the indicators needed to construct
the measure must come from the same survey. Each person in a given household is classified as
poor or nonpoor depending on the number of deprivations his or her household experiences.
These data are then aggregated into the national measure of poverty.

The MPI reflects both the incidence of multidimensional deprivation, and its intensityhow many
deprivations people experience at the same time. It can be used to create a comprehensive picture
of people living in poverty, and permits comparisons both across countries, regions and the world
and within countries by ethnic group, urban or rural location, as well as other key household and
community characteristics. The MPI builds on recent advances in theory and data to present the
first global measure of its kind, and offers a valuable complement to income-based poverty
measures. The 2011 Human Development Report (HDR) presents estimates for 109 countries
with a combined population of 5.5 billion (79% of the world total). About 1.7 billion people in the
countries covereda third of their entire populationlived in multidimensional poverty between
2000 and 2010.

More information at http://hdr.undp.org/en/statistics/mpi/

Domestic factors and economic development
The following factors contribute to economic growth:

Education and health
Education is one of the most important domestic factors in any country. Not only does it provide
benefits to the educated individuals; it also brings benefits to society. The workforce as a whole
will be able to produce more than it previously could, but that is not all. Increased level of
education improves communication and sparks social debate, which may help to reform the very
foundations of society. Because of the all-important role of education in achieving development,
the U.N has made universal enrolment in primary education one of its Millennium Development
Goals to be achieved by 2015.

Improving healthcare in less-developed countries is another key in achieving economic
development. Better healthcare means that the quality of the labour factor of production
improves, and that the country can potentially produce more. However, one of the most important
aspects of improved healthcare is perhaps a reduction in child mortality. Studies show that a
reduction in child mortality reduces the long-term need to have many children, as the certainty of
them surviving to adult age increase. A reduction in child mortality is, in itself, a very significant
119
factor in achieving development since it means that parents have more resources to spend per
child, and this increases their quality of life.

The use of appropriate technology
Appropriate technology is technology suitable for use with the factor endowments of particular
developing countries. The factor endowments of developing countries are labour intensive.
Whereas in more developed countries, technology is mainly used in production in order to save
firms from having to hire more workers, this would not be appropriate in developing countries as
it would only add to unemployment rather than increase the productivity of each worker. Instead,
appropriate technology would be such technology that makes use of the labour surplus in order to
increase production.

Access to credit and micro-credit
The limitations of the formal financial sector and the informal financial sector in providing
financial services, especially credit, encouraged the micro-credit program to evolve. Micro credit is
an enabling, empowering, and bottoms-up tool to poverty alleviation that has provided
considerable economic and non-economic externalities to low-income households in developing
countries. Credit creates opportunities for self-employment rather than waiting for employment
to be created. It liberates both poor and women from the clutches of poverty. It brings the poor
into the income stream. Given the access to credit under an appropriate institutional structure and
arrangement, one can do whatever one does best and earn money for it.

The aim of microfinance is not just about providing capital to the poor to combat poverty on an
individual level, it also has a role at an institutional level. It seeks to create institutions that deliver
financial services to the poor, who are continuously ignored by the formal banking sector. It is
believed that the poor are generally excluded from the financial services sector of the economy so
micro financing Institutions have emerged to address this market failure. By addressing this gap in
the market in a financially sustainable manner, an micro financing institution can become part of
the formal financial system of a country and so can access capital markets to fund their lending
portfolios, allowing them to dramatically increase the number of poor people they can reach.

The empowerment of women
In the past decades, the health and education levels of women and girls in developing countries
have improved a great deal--in many cases they are catching up to men and boys. But no such
progress has been seen in economic opportunity: women continue to consistently trail men in
formal labor force participation, access to credit, entrepreneurship rates, income levels, and
inheritance and ownership rights. This is neither fair nor smart economics: Under-investing in
women limits development, slows down poverty reduction and economic growth.
A host of studies suggest that putting earnings in womens hands is the intelligent thing to do to
speed up development and the process of overcoming poverty. Women usually reinvest a much
higher portion in their families and communities than men, spreading wealth beyond themselves.
This could be one reason why countries with greater gender equality tend to have lower poverty
rates.

For example, studies show that when income is in the hands of the mother, the survival
probability of a child increases by about 20 percent in Brazil, and in Kenya, a child will be about 17
120
percent taller, because mothers will invest more of their income in health and nutrition. In sub-
Saharan Africa, agricultural productivity could be raised by as much as 20 percent by allocating a
bigger share of agricultural input to women.

Income distribution
The view that that improved equality can help sustain growthhas become more widely held in
recent years. The main reason for this shift is the increasing importance of human capital in
development. Now that human capital is scarcer than machines, widespread education has
become the secret to growth. "Broadly accessible education" is both difficult to achieve when
income distribution is uneven and tends to reduce "income gaps between skilled and unskilled
labor."

A 2011 note for the International Monetary Fund by Andrew G. Berg and Jonathan D. Ostry found a
strong association between lower levels of inequality and sustained periods of economic growth.
Developing countries (such as Brazil, Cameroon, Jordan) with high inequality (during the years
being studied) have "succeeded in initiating growth at high rates for a few years" but "longer
growth spells are robustly associated with more equality in the income distribution."
It is said that high levels of inequality might damage long term growth by amplifying the potential
for financial crisis, discourage investment with political instability, making it more difficult for
governments to make difficult choices in the face of shocks, such as raising taxes or cutting public
spending to avoid a debt crisis.

Inequality is associated with lower level of human capital formation (education, experience,
apprenticeship) and higher level of fertility, while lower level of human capital is associated with
lower growth and lower levels of economic growth. Inequality is associated with lower levels of
taxation which in turn are associated with lower level of economic growth
Inequality in the presence of credit market imperfections has a long lasting detrimental effect on
human capital formation and economic development.

The political economy approach, developed by Alesian and Rodrik (1994) and Persson and
Tabellini (1994), argues that inequality is harmful for economic development because inequality
generates a pressure to adopt redistributive policies that have an adverse effect on investment
and economic growth.

International Trade and Economic Development

Trade problems facing many economically less developed countries

Dependence on developed economies

Developing nations are highly dependent on the advanced or developed nations in terms of:
Income dependence: A majority of the exports of developing nations go to the developed
nations.
Dependence on Technology: Most imports of developing nations originate in the
developed countries (medicine, new machines). Trade among developing nations is minor.
121
Primary products
Exports of developing nations are primary products (agricultural goods, raw materials, and fuels).
Some countries export drugs and low tech military goods to gain international currencies. Shares
of manufactured exports tend to be less than 10% among African countries.

Price volatility of primary products
The fluctuations of commodity prices remain a central issue for developing countries. Often the
collapse of commodity prices spells disaster for developing countries, since exports are needed for
obtaining essential imports. But also, high commodity prices, particularly of food and energy, may
be a significant problem for least developed countries (LDCs) creating food and energy shortages.

Labor intensive exports
Exports of manufactured goods tend to be labor intensive (such as textiles). The absolute value of
manufactured goods produced by the developing nations is low.
The rise in manufactured goods in developing nations is due to a handful of newly industrializing
countries (NICs) such as Korea, Taiwan, and Singapore until 1980s. However, these countries have
lost their export markets to China, which has emerged as an industrial giant in the 1990s.

Over-specialization on a narrow range of products
In most of the least developed and other low-income countries, primary products - incorporating
low levels of processing - continue to account for the bulk of both national production and exports.
Given the changing structure of world trade described at the beginning of this paper, it is not
surprising that most of the countries that have participated little or not at all in global integration
are primary commodity-dependent countries with relatively small and highly inefficient
manufacturing sectors. As a result, these countries are especially vulnerable to external (or
domestic) shocks and are generally viewed as having limited growth prospects.

Trade strategies for economic growth and economic development

Import substitution
The import substitution approach substitutes externally produced goods and services, especially
basic necessities such as energy, food, and water, with locally produced ones. By doing so, local
communities can put their (hard-earned) money to work within their boundaries. Import
substitutes are meant to generate employment, reduce foreign exchange demand, stimulate
innovation, and make the country self-reliant in critical areas such as food, defense, and advanced
technology.

Protectionism and subsidies to domestic industries will encourage inefficiency in the sense that
domestic firms do not need to compete with other firms on the world market. There will thus be a
loss of consumer welfare, both because the products produced domestically will be more
expensive, and also because the government will have to levy higher taxes in order to finance the
subsidies. Consumer welfare will also be reduced due to a more narrow range of choices.
Furthermore, a policy of import substitution will not go unnoticed by other countries, and they
will thus retaliate by using protectionist measures of their own.

122
Export promotion
This involves promoting exports industry. By promoting exports the economy can earn valuable
foreign exchange which can be used to funding economic development projects. This can be
achieved by improving the competitiveness of domestic firms and making use of the countrys
specific factor endowments. Most products produced by less developed countries are primary
commodities. Even if the prices of such products are competitive, the export revenue is still
unlikely to pay for the costs of imports.

Trade liberalization
Trade liberalization refers to the reduction or complete removal of protectionist measures that
prevent free trade. This includes for example tariffs, quotas and subsidies to domestic producers.
Many developing countries suffer from the protectionist measures used by the more developed
countries as this reduces the competitiveness of their exports. For example, both the United States
and the European Union offer substantial subsidies to farmers who produce agricultural products.
This is to ensure that the European countries remain self-sufficient in terms of food production.
However, it also means that the relatively cheap agricultural imports from e.g. African countries
appear, by comparison, expensive. Many developing countries are therefore heavy critics of the
protectionist measures which they argue act as a major constraint on worldwide economic
development.

The role of the WTO
The main objective of the WTO, the World Trade Organisation is to promote free trade among its
members. The current round of negotiations in the WTO is known as the Doha round negotiations,
but it has been suspended due to fundamental disagreement and failure to reach consensus
regarding issues relating to trade in relation to less developed countries. The main concerns were
that the United States and the European Union refused to abandon their subsidies on agricultural
products in order to increase the competitiveness of exports from developing countries. On the
other hand, large developing countries such as India and Brazil refused to get rid of their
protectionist measures levied against the import of manufactured goods. While most people agree
that such measures would do much to improve economic development, a compromise currently
seems beyond reach.

Bilateral and regional preferential trade agreements
By implementing different trading blocs is the hope that world trade, and thereby world output,
should increase. That is, it is hoped that trading blocs should result in trade creation and not only
trade diversion. A preferential trade agreement (PTA) is an agreement whereby the products from
one country become cheaper due to a reduction, but not abolition, of tariffs.

A bilateral PTA is an agreement between two parties, e.g. India and Nepal, while a multilateral or
regional PTA, as the name suggests, is an agreement involving several countries. Examples of the
latter include the Asia-Pacific Trade Agreement and the Latin American Integration Association. It
is believed that more agreements to promote trade with reduced protectionism, and eventually
completely free trade, will result in economic growth and eventually economic development as the
standard of living increases.

123
Diversification
One of the major problems that many developing countries face is their over-dependence on a
narrow range of agricultural products. As such, they are vulnerable to the volatile nature of the
prices of such products, originating in the fact that both price elasticity of demand and price
elasticity of supply for such products are low. If prices fall in one year, due to a good worldwide
harvest, the quantity demanded from any particular country would be reduced dramatically, and
the country would be unable to rely on other exports to make up for the loss.

Diversification involves broadening the range of goods and services that developing countries are
able to provide. For example, production of manufactured goods (i.e. industrialization) would both
reduce unemployment levels and enable the country to produce goods that, because they are
income elastic (link), would allow the developing countries to benefit from worldwide economic
growth. By doing so, the country would also be less vulnerable to volatile primary product prices
and instead be able to stabilize their export revenue.

Foreign direct investment
Foreign direct investment (FDI) is direct investment into production in a country by a company in
another country, either by buying a company in the target country or by expanding operations of an
existing business in that country.

Foreign direct investment is done for many reasons including to take advantage of cheaper wages,
special investment privileges such as tax exemptions offered by the country as an incentive to gain
tariff-free access to the markets of the country or the region.

Why do FDI expand to Less developed economies?
Less developed countries have huge untapped natural resources. Moreover, these countries lack
the capital investment and the technology to tap into these resources. This provides FDI with a lot
of opportunity to exploit these resources and earn high returns on their investments.
In recent years, FDI has been used more as a market entry strategy for investors, rather than an
investment strategy. Despite the decline in trade barriers, FDI growth has increased at a higher
rate than the level of world trade as businesses attempt to circumvent protectionist measures
through direct investments. With globalization, the horizons and limits have been extended and
companies now see the world economy as their market.

Additionally for investors, FDI provides the benefits of reduced cost through the realization of
scale economies, and coordination advantages, especially for integrated supply chains. The
preference for a direct investment approach rather than licensing and franchising can also been
viewed in terms of strategic control, where management rights allows for technological know-how
and intellectual property to be kept in-house.

Less developed countries usually have less stringent labour and environment laws. This provides
MNCs with an opportunity to lower their cost of production by taking advantage of these
loopholes.

Labor is usually cheaper and available in abundance in LDCs. The MNCs can considerably lower
their cost of production. This gives advantage to the MNCs to compete in the international market.
124
LDCs understand the importance of FDIs and have special policies to attract them. This might
involve tax holidays, provision of cheaper land and government support. All these factors make it
an attractive proposition for FDIs to invest in LDCs. examples include, tax holidays, Duty
exemptions and drawbacks, Export tax exemptions, Subsidized credits and Credit guarantees.
Some developing countries provide great promises in terms of being emerging markets. Brazil as
well as India and China are all markets with huge populations and growing incomes. As incomes
rise, the demand for all normal goods and services will increase, and there is thus potential for
substantial profits to be made by companies that manage to establish a presence in these markets.

Benefits of FDI
One of the advantages of foreign direct investment is that it helps in the economic development of
the particular country where the investment is being made. This is especially applicable for
developing economies. During the 1990s, foreign direct investment was one of the major external
sources of financing for most countries that were growing economically. It has also been noted
that foreign direct investment has helped several countries when they faced economic hardship.

An example of this can be seen in some countries in the East Asian region. It was observed during
the 1997 Asian financial crisis that the amount of foreign direct investment made in these
countries was held steady while other forms of cash inflows suffered major setbacks. Similar
observations have also been made in Latin America in the 1980s and in Mexico in 1994-95.
Resource transfer, in terms of capital and technical knowledge, is also a key motivator that
encourages inward FDI.

FDI allows the transfer of technologyparticularly in the form of new varieties of capital inputs
that cannot be achieved through financial investments or trade in goods and services. FDI can also
promote competition in the domestic input market.

Recipients of FDI often gain employee training in the course of operating the new businesses,
which contributes to human capital development in the host country.

Profits generated by FDI contribute to corporate tax revenues in the host country.
Foreign investment gives advantages in terms of export market access arising from economies of
scale in marketing of foreign firms or from their ability to gain market access abroad. Besides their
contributions through joint ventures, foreign firms can serve as catalysts for other domestic
exporters. In an empirical analysis, the probability a domestic plant will export was found to be
positively correlated with proximity to multinational firms

Foreign investment can aid in bridging a host countrys foreign exchange gap. Growth requires
investment and investment requires saving-whether domestic or foreign. Two gaps may exist in
the economy: insufficient saving to support capital accumulation to achieve a given growth target;
and insufficient foreign exchange to transform domestic to foreign resources. If investment
requires imported inputs, then domestic saving may not guarantee growth if the saving cannot be
converted to foreign exchange to acquire imports. Capital inflows help ensure that foreign
exchange will be available to purchase imports for investment.

125
Disadvantages of FDI
Loss of sovereignty by host nation.
MNC have their parent companies and shareholders in the country of origin. Repatriation
of profits by MNC to the parent country causes a flow of capital out of the developing
country. This might also lead to depletion of foreign exchange reserves with the host
country.
There is a chance of rise in inflation.
The country or industry that attracts foreign investment may become entirely dependant
for growth and increase the risk.
If the domestic companies are not competitive and efficient, they may suffer losses.
In absence of proper regulatory policies, MNCs might exploit the labour and natural
resources.
Foreign direct investment is an expensive and risky option for companies than licensing
and exporting. They face expropriation, political risk and currency inconvertibility.
Capital intensive technology, by the MNC, rather than labour-intensive technology limits
benefits to host country.
In very poor nations, MNCs may sometimes exert political control in other to suit their
vested interests. This might bring about political stability and chaos in the host nation.

Foreign aid
Foreign aid, the international transfer of capital, goods, or services from a country or international
organization for the benefit of the recipient country or its population.

Classification on the basis of origin
Government (official) aid
Aid organized by the government. It can

Bilateral aid is assistance given by a government directly to the government of another country.
This is usually the largest share of a countrys aid. It is often directed according to strategic
political considerations as well as humanitarian ones

Multilateral aid is assistance provided by governments to international organisations like the
World Bank, United Nations and International Monetary Fund that are then used to reduce
poverty in developing nations. In 2006-7, the Australian Government committed $400 million in
multilateral aid.

Non-government (unofficial) aid
Non-government aid is assistance provided by non-government organizations (NGOs) like World
Vision, the Red Cross and Oxfam. The money for this aid is mainly provided by public donations
from individuals and businesses. However, NGOs also receive some funding from government.

126
Classification on the basis of purpose

Humanitarian aid
This type of aid is traditionally extended to nations which are victims of natural disasters, such as
floods, famines and epidemics. This is short term aid and does not have to be repaid.
Humanitarian aid is per se non-political.

Traditional responses to humanitarian crises, and the easiest to categorize as such, are those that
fall under the aegis of emergency response:
material relief assistance and services (shelter, water, medicines etc.)
emergency food aid (short-term distribution and supplementary feeding programmes)
relief coordination, protection and support services (coordination, logistics and
communications).

But humanitarian aid can also include reconstruction and rehabilitation (repairing pre-existing
infrastructure as opposed to longer-term activities designed to improve the level of
infrastructure) and disaster prevention and preparedness (disaster risk reduction (DRR), early
warning systems, contingency stocks and planning). Under the Organisation for Economic
Cooperation and Development (OECD) Development Assistance Committee (DAC) reporting
criteria, humanitarian aid has very clear cut-off points for example, disaster preparedness
excludes longer-term work such as prevention of floods or conflicts. Reconstruction relief and
rehabilitation includes repairing pre-existing infrastructure but excludes longer-term activities
designed to improve the level of infrastructure.

Humanitarian aid is given by governments, individuals, NGOs, multilateral organizations, domestic
organizations and private companies.

Development aid
Development aid is financial aid given by governments and other agencies to support the
economic, environmental, social and political development of developing countries. It is
distinguished from humanitarian aid by focusing on alleviating poverty in the long term, rather
than a short term response.

Major part of the developmental aid comes from government sources as official development
assistance (ODA). The remaining comes from private organizations such as "Non-governmental
organizations" (NGOs), foundations and other development charities (e.g., Oxfam).

Financial Aid
The simplest form of capital inflow is the provision of convertible foreign exchange, but very little
foreign capital indeed comes to the underdeveloped world so conveniently. Financial aid is
further divided into various sub-forms, i.e.:
(i) Tied Aid: Tied aid is of two types:
Nation Tied Aid: is given to the recipient country on the condition that she will spend it in
the donor country to solve the BOP problems of that country and to stimulate exports, i.e., if
Pakistan is given aid by US and is asked to import raw materials or machinery from US only
then it is nation tied aid or resource tied aid.
127
Project Tied Aid: is given only for specific projects and the recipient country cannot shift it
to other projects.

(ii) Untied Aid: Untied aid is the aid which is not tied to any project or nation. It is, in all
respects, better than the tied aid because it offers more efficient use of foreign resources. It is
much desired because in the case of untied aid the recipient country is not bound to spend the
foreign resources on specific projects or in the donor country which may charge higher prices
than international market.

(iii) Grants: A grant is that form of foreign aid which does not entail either the payment of
principal or interest. It is a free gift from one government to another or from an institution to a
government. It is much desired because it increases the internal expenditures and generates
income. It is given on the basis of humanitarianism, especially in days of emergencies, earth
quakes, floods, wars, etc.

(iv) Loans: It is the borrowing of foreign exchange by the poor country from the rich country to
finance short-term or long-term projects. They are further sub-divided into two types:
Hard Loans: Hard loans are also called short-term loans. In order to finance industrial
imports they are given usually for a period less than five years, and they are paid in the
currency borrowed. It contains no concessional element but interest rate is usually lower
than the prevailing rate of interest in the international market.
Soft Loans: Soft loans are also known as long-term loans. Soft loans are made for 10-20
years and it is repaid in the currency of recipient country. Interest on these loans is lesser
than hard loans and often these loans invoice grace period. Concessional elements are
comparatively greater.

Commodity Aid
Commodity aid, in fact, is another type of tied aid, which relates to agriculture products, raw
materials and consumer goods. Under commodity aid, the donor country has much political
influence on the recipient country. Commodity aid may be received in cash form or in the form of
food grains:
In Cash Form: If it is received in cash form it may be more helpful because then a country
may buy more commodities from cheaper sources.
In Food Grain Form: It is a special type of commodity aid, which is given in the form of food
grains only.

Food Aid
There is more than enough food produced each year to feed adequately everyone on earth.
However, food is so unevenly distributed that malnutrition and hunger exist Food aidin the same
country or region where food is abundant.

Critics of food aid argue that it increases dependence, promotes waste, does not reach the most
needy and dampens local food production. Nevertheless, the food aid has frequently been highly
effective. It plays a vital role in saving human lives during famine or crisis, and if distributed
selectively, reduces malnutrition. Unfortunately, poor transport, storage, administrative services,
128
distribution networks and overall economic complex hinder the success of food aid programmes,
but the concept itself is not at fault.

Technical assistance aid
Technical assistance is designed to disseminate knowledge and skills rather than goods or funds.
Under this aid program, training facilities are provided by the donor countrys government and it
bears all the expenditures involved in the training of advisory technocrats. Technical assistance
from the donors point of view takes two main forms:
Through Recruitment: Technical assistance may be given through recruitment. Selected
people of recipient country are recruited in the donor country for service overseas, partly,
often largely, at the expense of the donor government.
Through Scholarships & Training Facilities: The second form of technical assistance is
scholarship and training facilities in donor country for foreign students (from recipient
country).

The Role of NGOs
The United Nations now describe a Non-Governmental Organization as a
Not-for-profit, voluntary citizens group, which is organized on a local, national, or international
level to address issues in support of the public good. Task oriented and made up of people with
common interests, NGOs perform a variety of services and humanitarian functions, bring citizens
concerns to governments, monitor policy and program implementation, and encourage participation
of Civil Society stakeholders at the community level.

NGOs have, since the end of the Second World War, become increasingly more important to global
development. They often hold an interesting role in a nations political, economic or social
activities, as well as assessing and addressing problems in both national and international issues,
such as human, political and womens rights, economic development, democratization, inoculation
and immunization, health care, or the environment.

However, in the developing world, the role of NGOs is often critical. In years of drought or famine,
the non-governmental organizations have been pivotal in providing food to those most
marginalized. NGOs often provide essential services in the developing world that in developed
countries governmental agencies or institutions would provide. Normally, NGOs provide services
that are in line with current incumbent governmental policy, acting as a contributor to economic
development, essential services, employment and the budget. In a wider approach, NGOs are also
the source and centre of social justice to the marginalized members of society in developing
countries or failed states. NGOs are often left as the only ones that defend or promote the
economic needs and requirements for developing states, often bringing cases to the International

Monetary Fund, World Trade Organization and World Bank. Developing nations and NGOs often
find allies in one another when opposing legislation, economic terms or agreements from global
institutions.

If the Millennium Development Goals are to be achieved in many of the developing, the role of
NGOs will have to be recognized by the international community. Their efforts are often more
129
effective than much bilateral aid. However, the role of NGOs has also been criticized, as many
international experts estimate that much of the work done by NGOs is not harmonized or tailor-
made to the countries preferences and peculiarities, causing the quality of aid to suffer.

Role of IMF and World Bank
International Monetary Fund [IMF]
The IMF was founded more than 60 years ago toward the end of World War II. The founders
aimed to build a framework for economic cooperation that would avoid a IMFrepetition of the
disastrous economic policies that had contributed to the Great Depression of the 1930s and the
global conflict that followed.

Since then the world has changed dramatically, bringing extensive prosperity and lifting millions
out of poverty, especially in Asia. In many ways the IMF's main purposeto provide the global
public good of financial stabilityis the same today as it was when the organization was
established. More specifically, the IMF continues to
provide a forum for cooperation on international monetary problems
facilitate the growth of international trade, thus promoting job creation, economic growth,
and poverty reduction;
promote exchange rate stability and an open system of international payments; and
lend countries foreign exchange when needed, on a temporary basis and under adequate
safeguards, to help them address balance of payments problems.

Key IMF activities
The IMF supports its membership by providing
policy advice to governments and central banks based on analysis of economic trends and
cross-country experiences;
research, statistics, forecasts, and analysis based on tracking of global, regional, and
individual economies and markets;
loans to help countries overcome economic difficulties;
concessional loans to help fight poverty in developing countries; and
technical assistance and training to help countries improve the management of their
economies.

The IMF collaborates with the World Bank, regional development banks, the World Trade
Organization (WTO), UN agencies, and other international bodies. While all of these organizations
are involved in global economic issues, each has its own unique areas of responsibility and
specialization. The IMF also works closely with the Group of Twenty (G-20) industrialized and
emerging market economies and interacts with think tanks, civil society, and the media on a daily
basis.

With the world's economies so closely connected, having an organization to help countries
prevent crises and resolve when they occur is more important than ever.

130
World Bank
The World Bank, formed in 1944, is like a cooperative, made up of 188 member countries. These
member countries, or shareholders, are represented by a Board of World Bank Governors, who
are the ultimate policymakers at the World Bank. Generally, the governors are member countries'
ministers of finance or ministers of development. They meet once a year at the Annual Meetings of
the Boards of Governors of the World Bank Group and the International Monetary Fund.

The World Bank seeks to
Promote the economic development of the world's poorer countries
Assists developing countries through long-term financing of development projects and
programs
Provides to the poorest developing countries whose per capita GNP is less than $865 a year
special financial assistance through the International Development Association (IDA)
Encourages private enterprises in developing countries through its affiliate, the
International Finance Corporation (IFC)

Since inception, the World Bank has expanded from a single institution to a closely associated
group of five development institutions. These are
The International Bank for Reconstruction and Development (IBRD) lends to governments
of middle-income and creditworthy low-income countries.
The International Development Association (IDA) provides interest-free loanscalled
credits and grants to governments of the poorest countries.
The International Finance Corporation (IFC) provides loans, equity and technical assistance
to stimulate private sector investment in developing countries.
The Multilateral Investment Guarantee Agency (MIGA) provides guarantees against losses
caused by non-commercial risks to investors in developing countries.
The International Centre for Settlement of Investment Disputes (ICSID) provides
international facilities for conciliation and arbitration of investment disputes.

Further reading
The IMF and the World Bank How Do They Differ?
http://www.imf.org/external/pubs/ft/exrp/differ/differ.htm

IMF official website http://www.imf.org

World Bank official website http://www.worldbank.org

Role of IMF and World Bank http://da-academy.org/imf_worldbank.pdf

The Functions of the IMF & the World Bank
http://blogs.law.uiowa.edu/ebook/sites/default/files/Part_1_2_0.pdf

Excellent articles on Aid and development http://www.guardian.co.uk/global-
development/poverty-matters+aid

131

Ib Economics Study Guide Pyszczek

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Ib Economics Study Guide Pyszczek

Uploaded by

Copyright:

Available Formats

IB

Economics Study Guides

Economic Definition of the Four Factors of Production

Three Basic Economic Questions

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

Straight line (linear) demand curve

Movement along the demand Curve:

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

Movement along the Supply Curve

IB Economics City Honors School 2015-2016

Shift in Supply Curve

IB Economics City Honors School 2015-2016

Factors affecting Supply

Equilibrium is self righting

IB Economics City Honors School 2015-2016

Effect of change in Demand and Supply

IB Economics City Honors School 2015-2016

Affect of Change in Demand on equilibrium

Affect of Change in Supply on equilibrium

Price Elasticity of demand (PED)=

% change in quantity demanded

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

Cross elasticity of demand =

% change in quantity demanded of good X

Income elasticity of demand=

% change in quantity demanded

IB Economics City Honors School 2015-2016

Price Elasticity of Supply =

% change in quantity Supplied

IB Economics City Honors School 2015-2016

Types of Price elasticity of Supply

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

Incidence or tax burden

IB Economics City Honors School 2015-2016

Scenario 2: When PES is greater than PED

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

Impact of subsidies on Consumers

IB Economics City Honors School 2015-2016

Subsidies and Elasticities

IB Economics City Honors School 2015-2016

GOVERNMENT INTERVENTION IN MARKET PRICES

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

Negative Consumption externalities

IB Economics City Honors School 2015-2016

Circular Flow Diagram

IB Economics City Honors School 2015-2016

IB Economics City Honors School 2015-2016

GDP and GNP

IB Economics City Honors School 2015-2016

Nominal GDP & Real GDP

Evaluating National Income Statistics