Study Guide

Table of Contents
Page
Section 1: Introduction to Economics 1

Section 2: Microeconomics. 5
Section 3: Macroeconomics 32
Section 4: International Economics.. 49
Section 5: Development Economics.. 61
Resources.. 69
Section 1: Introduction to economics

The purpose of this section is to introduce the basic terminology and concepts of
economics. Students are encouraged to consider what markets and governments can and
cannot do. This section of the syllabus gives them an early opportunity to begin to
explain economic phenomena through the use of diagrams, data analysis and the
evaluation of economic material. This section is intended to make students aware of the
role of economics in real-world situations. Even at this initial stage teachers and
students should consider the application of economic theories to developing countries,
since development economics is integral to the course.
Definitions of social science and economics:
o social science: the study of various topics which all share the common theme of
human behaviour
o economics: the study of how to best allocate scarce resources among competing
uses
Definitions of microeconomics and macroeconomics
o microeconomics: study of individual behaviour in the economy; study of the
components of the larger economy (details)
o macroeconomics: study of aggregate economic behaviour; study of the economy
as a whole (big picture)
Definitions of growth, development, and sustainable development
o growth: increase in real output from one period to another
o economic growth: increase in output (real GDP); an expansion of production
possibilities
o economic development: qualitive measure of a countrys living standard that
includes factors such as education and health; often measured by the Human
Development Index
o sustainable development: development that meets the needs of the present
without compromising the ability of future generations to meet their own needs
o example: developing nations and cities without the opportunity cost of the
environment
Positive and normative concepts
o positive concepts: based on theories which can be tested by looking at past data;
concern what is, was, or will be: assertions about the world
o normative concepts: based on opinion; not testable; solved by voting (in
democracies, normally)
Ceteris paribus: the assumption that nothing else changes
Scarcity: the fact that available resources are insufficient to satisfy all desired uses
thereof
factors of production: land, labour, capital, and
management/entrepreneurship
o factors of production: resource inputs used to produce goods and
services, e.g. land, labour, capital and management/entrepreneurship
o land: all natural resources
o labour: skills and abilities to produce goods and services
o capital: final goods produced for use in further production
o entrepreneurship: assembling of resources to produce new or improved

products and technologies
payments to factors of production:
o rent: to pay for land
o wages: to pay for labour
o interest: to pay for capital
o profit: to pay for management
Choice
utility: the enjoyment from goods/services; first consumption of good/service is
most enjoyable, the following times never achieve that same amount
ex: Carnitas burritos in one sitting:
the first is good, the second is ok, the third is eh, fourth is I feel
really sick, fifth is ewww, gross!...
opportunity cost: most desired goods/services that are forgone in order to obtain
something else
free and economic goods
o free goods: goods that are without an opportunity cost (applicable in
theory)
o economic goods: goods that have an opportunity cost
production possibility curves (or production possibilities frontier): the
maximum that can be produced with existing resources and technology; a curve of
productive efficiency
diagrams showing opportunity cost, actual and potential output
opportunity cost diagram
Example above: opportunity cost is the shoe the supply of shoe being
given up so as to produce more televisions.
Actual and potential output Diagrams
Production Possibility Frontier
Oranges
C
B
A
Clothing
Point B: potential output

Points A, B, or C could be actual output
diagrams showing economic growth and economic development
Economic Development
Economic development
would entail that an economy
PPF2
is better able to provide the
N2
necessary goods/services.
NecessitiesEconomic Growth
Thus, an increase in the PPF
from PPF1 to PPF2 occurs,
Rationing systems
N1
PPF
with the amount of Luxuries
1
basic economic questions
Economic
growth
would
remaining
same
(though
What to produce?: decision made of what mix
of
goodsthe
and
services
entail
that
an
economy
is
it
can
change),
and
the
should be produced for the optimal mix
producing
amount
of Necessities
How to produce?: decision based on the means
in which
amore
good will be
Necessities
goods/services.
changing
from
N1 toThus,
N2. an
produced, considers
L not only efficiency, but social values as well
increase inofthe
For whom to produce?: decision regarding the recipients
thePPF from
Luxuries
N
PPF
to
PPF
occurs, with the
1
2
goods/services that have been produced
amount
of Necessities
Mixed economies: economy that uses both market signals
(e.g. price
signal) and
remaining
the
same (though
PPF
2
non market signals (e.g. government directives) to allocate goods and resources
it
can
change),
and the
private good: goodPPF
or service whose consumption by one person excludes
1
amount of Luxuries changing
consumption by others (e.g. one carnitas burrito)
L1 to Ldoes
2.
L2
public good: a good orLservice
whose
consumption byfrom
one person
not
1
exclude consumption by others
Central planning versus
free market
Luxuries
o Centrally planned: resources and production is controlled by
government group of leaders; centrally planned markets allow the
government to determine what is produced, how and for whom.
o example: Communist Russia
o Free market: resources and production is controlled by individuals;
allocation of resources, what, how and for whom, is left to the forces of
supply (production) and demand (consumers)
economies in transition: economy transition from a centrally planned market to
a free market
example: The Peoples Republic of China
Section 2: Microeconomics
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
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.
2.1 Markets:
Definition of markets with relevant local, national and international

examples
market: any institution or mechanism that brings together buyers

(demanders) and sellers (suppliers) of a particular good or service
Ex: fish market (local), U.S. Stock exchange (national), Fed
(international).
Describe the following perfect competition, monopoly, oligopoly as different

types of market structures, and monopolistic competition, using the
characteristics of the number of buyers and sellers, type of product and
barriers to entry.
Perfect competition: a market in which no buyer or seller has market power.

A perfect competitive industry has distinguishing characteristics, such as
many firma, identical products, and low entry barriers.
Monopoly: a firm that produces the entire market supply of a particular

good or service.
Oligopoly: a market in which a few firms produce all or most of the market
supply of a particular good or service.
Monopolistic competition: a market in which many firms produce similar

goods and services but each maintains some independent control of its own
price.
Demand:
Demand: the ability and willingness to buy specific quantities of a good at

alternative prices in a given period of time, ceteris paribus.
Law of demand (with diagrammatic analysis): the quantity of a good

demanded in a given time period increases as its price falls, ceteris paribus.
Quantity
D1
As demand moves
P1 from D1 to D2, the
price drops from P1
to P2 while quantity P
increases from Q1 to
Q2.
D2
P2
Q1
Q2
Determinants of demands:
Tastes desired for this and other goods.
Income of the consumer.
Other goods availability and prices
Expectations for income, prices, and tastes.
Numbers of buyers
Price
Fundamental distinction between a movement along the demand curve

and a shift in demand:
D1
P1
D2
P2
Q1
Q2
Quantity
Movement: the price of

the good goes from D1
to D2, as price goes from
P1 to P2 and quantity
from Q1 to Q2; no new
curve is formed.
5
Price
Shift: the demand curve

moves either to the right
or to the left, there is more
quantity demanded (Q1 to
Q2) at the same price, P.
P
HL Extension topic
Exceptions to the law of demand (upward-sloping demand curve)
ostentatious (Veblen) goods: goods that are bought as a display of wealth,

for ostentatious or snobbery reasons
D1
D2
the argument is that as price rises, some people buy them because they
Q1
Q2
are more expensive
(demand increases), and buy less if they are cheaper
(demand decreases)Quantity
role of expectations: if the expectation for a good/service is that the price

will be cheaper in the future, then the amount demanded decreases; likewise,
if the expectations for a good are that the price will be greater in the future,
then the amount demanded will increase.
Giffen goods: special type of inferior good that forms a large part of total
expenditure, therefore demand increases when prices increase.
Supply:
supply: the ability and willingness to sell (produce) specific quantities of a

good at alternative prices in a given time period, ceteris paribus.
Law of supply (with diagrammatic analysis): the quantity of a good

supplied in a given time period increases as its price increases, ceteris
paribus.
Price
S2
P2
P1
As the supply curve

moves from S1 to S2,
price increases from
P1 to P2 and quantity
increases from Q1 to
Q2.
S1
Q1
Q2
Quantity
Determinants of supply:
Factor costs
Technology
Profitability of alternative pursuits
Expectations
Number of sellers.
Effects of taxes and subsidies on the supply curve:
S2
S2
P2
Price
P1
S1
Taxes: the money that

industries have to pay the
government in relation to
the amounts of goods and
services produced.
As the production cost
increases, the quantity
supplied decreases (S1 to
S2), causing there to be an
increase in price (P1 to P2)
and a decrease in quantity
(Q1 to Q2)
Q1
Q2
Quantity
Subsidies: amount of money

the government pays to
industries to produce more
goods at a lower cost.
The diagram shows the
impact of subsidies on the
supply curve: as the
production cost is lower, there
is a greater quantity supplied
at a lower price.
S11
S
Price
S22
S
P1
P2
Q
Quantity
Movement along supply curve vs. shift on the supply curve:
In a movement along a
supply curve supply stays
on the same curve but
changes from point S1 to S2,
meaning that there is a
greater quantity supplied at
a higher price (P2 instead of
P1)
Price
S2
P2
S1
P1
SS1
1
SS2
2
Price
Q1
Q2
Quantity
P1
P2
Q1
In a shift in supply, the

curve moves from curve S1
to S2. The quantity supplied
either increases (as
illustrated) or decreases,
resulting in a lower price
and increased quantity
supplied (as shown) or
otherwise.
Q2
Quantity
Equilibrium: when the quantity supplied is equal to the quantity demanded

for a good/service. It is where the supply curve intersects with the demand
curve.
Price
Equilibrium
Diagrammatic analysis of changes in demand and supply to show the
adjustment to a new equilibrium:
Price
S
Quantity
P2
E1
P1
E2
D1
Q1
Q2
D2
DAs a result of a shift in demand

(from D1 to D2), the point of
equilibrium (where the Supply
and Demand curves intersect)
shifts from E1 to E2. Relative to
the initial equilibrium, prices at
equilibrium are higher than they
were initially (P1 to P2) and
quantity has increased (Q1 to
Q2).
Quantity
10
S1
S2
P2
E1
Price
E2
P1
D
Q1
Q2
Quantity
As a result in a shift in
supply (from S1 to S2), the
point of equilibrium moves
from E1 to E2, indicating
that the price of this
good/service has decreased
from P1 to P2 and the
quantity demanded has
increased from Q1 to Q2
(when operating at
equilibrium)
Price controls:
Maximum price: price ceiling, prices cannot go above this price

Causes: government
Consequences: shortages
Minimum price: price floor, prices cannot go under this price.

Causes: government
Consequences: surplus
Price support/buffer stock schemes:

Buffer stock: when the community decides to take and store part of the
supply in case of an emergency. For example U.S. government storing oil
apart n case of an emergency need for oil in the country.
Commodity agreements: when producers of commodities co-operate

together in an attempt to introduce more stability into the commodity market
2.2 Elasticities:
Price Elasticity of demand:
Formula: PED = (% change in quantity demanded) / (% change in price)
Definition: measurement of the response of consumers to a change in price.
Values of elasticity: the possible values of PED are from infinity to zero (
to 0). All of the values of PED are negative because demand curves are
always downward sloping.
11
Diagrams:
Determinants of price elasticity of demand:

Necessities vs. Luxury: necessities are goods that are critical for our
everyday life and therefore are regarded as necessary, for example
toothbrush or toothpaste. Demand for these goods tends to be relatively
inelastic. Luxury goods are the goods we would like to have but are not
likely to buy them unless there is a raise in our income or a big decrease
in prices. Demand for these goods tends to be relatively elastic.
Availability of substitute: a substitute good is a good that is substituting
or replacing another one, when the price of the first good increases
(resulting in decreased demand due to the unchanging prices of other
goods, a determinant of demand), the demand for the other good
increases. The greater the availability for substitute goods is, the higher
the price elasticity of demand is.
Relative price: the price of one good in comparison to the price of other
goods. The price elasticity of demand declines as price moves down the
demand curve.
Time: the long-run price elasticity of demand is higher than the short-run
price elasticity of demand.
Cross-elasticity of demand:
Definition: the percentage change in the quantity demanded for one good
compared to the percentage change in the price of another good.
Formula: CED = (% change in demand for good x) / (% change in price of

good y).
Significance of sign with respect to complements and substitutes:

A positive answer for cross elasticity implies that the goods are
substitutes for each other. An answer of +1 implies they are perfect
substitutes. An answer of less than 1 means they are substitutes but less
than perfect.
Thus, a negative answer implies that the goods are complements, i.e.,
they are consumed together. The greater the value of cross elasticity then
the stronger the relationship is.
12
Think of oreos and milk; theyre consumed together and therefore are
complements.
Income Elasticity of Demand:
Definition: the percentage change in demand for a good compared to the

percentage change in income.
Formula: IED = (% change in quantity demanded) / (% change in income)
Normal goods: good for which demand rises when income rises.
Inferior goods: good for which demand decreases when income rises
Example: secondhand cars.
Price Elasticity of Supply:
Definition: measurement of the responsiveness of the quantity supplied to a

change in price.
Formula: PES = (% change in quantity supplied) / (% change in price)
Possible range of values:

For the great majority of cases price elasticity of supply has a positive
value because supply curves slope upwards. However there is an
exception to this. It can be argued that when people sell their labor for
wages they will increase the amount of time they are prepared to work up
to a point. Beyond that point they would prefer to have more leisure
time, so that as the hourly wage increases they can reduce the hours work
and still retain the same level of income. In this case we see that initially
the supply curve slopes upwards but then later it slopes backwards on
itself.
Determinants of price elasticity of supply:

The amount costs rise as output rises if costs rise quickly as production
rises demand tends to be inelastic.
The time period immediate perfectly inelastic, short run inelastic,
long run elastic.
Availability of substitutes in production the easier it is to switch from
producing one good to another the more elastic supply is.
Applications of concepts of elasticity:
PED and business decisions: the effect of price changes on total revenue:
From price elasticity we can determine what will happen to total revenue
if prices rise or fall. However of greater concern to business is profit.
Profit is calculated by subtracting total costs from total revenue. Demand
curves and price elasticity do not yield information on costs
Cross-elasticity of demand: relevance for firms

Firms are interested in knowing if their good(s)/service(s) have cross
elasticity of demand (and to what extent), in order to consider the
13
impacts that lowering the price of another good/service will have on the
original good(s)/service(s)
Ex: Coca-Cola is considering whether or not to lower the price of its

Sprite brand. Theyll want to know Sprites PED (if the price cut will
increase/decrease total revenue) and if the price cut will come at the
expense of Coke (meaning that people are buying more Sprite instead
of buying Coke)
Firms also need to know this in considering merges, so they can lawfully
comply with anti-trust laws (U.S.) and have their merges approved.
Ex: Coke and Pepsi are strong substitutes, meaning that any merge
between the two would reduce competition (and therefore violate
U.S. anti-trust laws). However, a merger for products that not similar
would have minimal effects on competition, and thus would be
approved by the government.
Significance of income elasticity for sectoral changes (primary >

secondary > tertiary) as economic growth occurs
HL Extension
Flat rate and ad valorem taxes

specific flat rate tax: specific tax amount that is imposed upon a good
e.g. 1 Swiss franc on a bottle of whisky
percentage (ad valorem) tax: tax amount that is expressed as a percentage
when the price of a good changes the tax going to government

changes automatically
e.g. 15% of selling price
this is especially important during times of inflation, rather than
an increasingly smaller percent of spending as a tax
during times of inflation, the value of money decreases,

meaning that a constant rate for taxes would result in the
government receive money of less value, and it continues to
get smaller
Incidence of Indirect Taxes and Subsidies

o Indirect tax: a tax imposed on spending
o incidence of tax: division of indirect taxes and subsidies between buyers
and sellers
basically: who pays how much of the tax (buyers or consumers)
14
Diagramatic Analysis and Representation:

Effect of Imposing Flat Rate Tax
S after tax
Price
S before tax
P2
P1
D
Q2
Q1
Quantity
o indirect taxes and subsidies have effects on:
incidence of the tax: equally shared between buyers and sellers

because buyers and sellers previously exchanged at equilibrium
therefore buyers are paying a greater amount, but sellers are also
losing a greater amount (in taxes)
revenue: government revenue increases, because of the tax thats
been imposed, but if its revenue is based on the demand for the
good (and demand for that good has decreased from its original
demand curve) then revenue decreases
resource allocation: quantity demanded and produced of good has
fallen
this could be viewed as a hardship for consumers and

producers (because price has increased and quantity
demanded has decreased) or as beneficial if good/service
has some perceived harm
For an example: see pg 111 of Glanvilles Economics from a Global Perspective

Note: subsidies are considered to be a negative tax; therefore it is treated as
the opposite of those effects listed above
Implication of elasticity of supply and demand for the incidence (burden) of

taxation (note: Qd stands for quantity demanded)
Perfectly Inelastic Demand:

Incidence of tax falls on consumers. Price has risen by amount of the
tax, producers get the same Qd as before
Government revenue is large because Qd has not fallen at all
Resource allocation is unaffected because Qd is unchanged.
Perfectly Elastic Demand
15
Incidence of tax is on sellers. Tax has to be deducted from original price

Government revenue is small because large fall in demand as a result of
imposed tax
Resource allocation is significantly affected because of major decline in
trading with fall in production from Q1 to Q2
Perfectly Inelastic Supply

Incidence of tax falls on producers, where they receive price minus
whole amount of tax. Consumers pay same price as before.
Government revenue is large because of no fall in Qd or in area
Resource allocation remains unchanged because Q sold remains
unchanged
Perfectly Elastic Supply

Incidence of tax falls upon consumers as price increases by amount of
tax
Government revenue is relatively small
Resource allocation is likely to change considerably
2.3 Theory of the firm:
Cost Theory
Types of costs: fixed costs, variable costs (distinction between short-run

and long-run)
Fixed costs (FC): costs that do not vary with output; they must be paid
regardless of output
E.g. rent on a building; price of machinery
Diagram pg 399 in Economics by McConnell and Brue and

illustrated below (two different methods of illustrating)
Variable costs (VC): a cost that varies with the output level; they
increase when output increases and decrease when output decreases
(though the increase in cost is not always equal to the increase in output,
therefore just because output increases by 1-unit does not mean that
variable costs will increase by one unit)
in the long run, all costs are variable costs
E.g. payments for materials, fuel, power
16
http://william-king.www.drexel.edu/top/Prin/txt/Cost/cost2a.html
Total, average and marginal costs:

Total cost: sum of fixed cost and variable cost at each level of output
At zero units of output, TC=FC
Then for each additional unit of production, TC increases by same

amount as VC
Average cost:
Average fixed cost: AFC
TFC
where TFC is total fixed cost and
Q
output is Q.
AFC is fixed cost regardless of output, therefore when output
increase, it declines (or appears to) because it is spread out over
a larger output. On the other hand, if output decreases then the
AFC appears to increase because it is spread over a smaller
output
Average variable cost: AVC
TVC
where TVC is total variable cost
Q
and output is Q
At very low levels of output production is relatively inefficient
and costly because the firms plant is understaffed and therefore
average variable cost is relatively high; as output expands, greater
specialization and better use of capital equipment yield more
efficiency (variable cost per unit of output declines); as more
variable resources are added, point of diminishing returns is
reached and each input unit does not increase output by as much
as preceding inputs (so AVC eventually increases)
Diagram pg 400 from Economics by McConnell and Brue
Marginal cost: extra, or additional , cost of producing one more unit of
output
17
MC
change in TC
change in Q
where TC represents total cost and change in Q
represents the change in the quantity being produced.
Note that change in total cost and change in total variable cost
associated with each additional unit of output are always the same
Accounting cost + opportunity cost = economic cost

Accounting cost: costs that have a monetary value
e.g. raw materials, energy, rent, interest, wages
opportunity cost: the cost of goods/services measured by the alternative

that is forgone (the next best option)
Short-run: time period where at least one factor of production is fixed
Law of diminishing returns

States if some inputs are increased whilst at least one other is fixed then
whilst the extra output produced by each extra unit of input may at first
increase it will reach a point where it will diminish
Diminishing returns occur because each additional unit of input has less
and less of the fixed input to combine with
Ex: field with 1 worker increases its labor supply to 2 workers, then
3, etc at some point, it will reach a point where there will be too
many workers and the workers will begin to crash into each other or
something else will happen resulting in a decreased amount of output
being produced.
Total product, average product, marginal product

Total product: total quantity, or total output, of a particular good
produced
Average product: average amount produced by the variable factor
Calculated as: average output per worker= total output/number of

workers
May increase until point of diminishing returns, in which the
average output per worker falls
Marginal product: the extra output produced by the last worker
When its rising, or greater than the average, it pulls up the average
When it is less than the average, it pulls it down
When marginal output=average output, average will not change
18
Short-run cost curves: as firm expands, its average costs fall to the bottom
of the U shaped curve, and then begin to climb as a result of diminishing
returns. The firm then moves into another short run situation, and then
another.
Diagram 2:29 page 127 of Glanvilles Economics from a Global Perspective
Long-run: time period when all inputs can be changed; no fixed factors at all
Economies of scale: reductions in the average total cost of producing a

product as the firm expands the size of plant (its output) in the long run; the
economies of mass production
Diseconomies of scale: increases in the average total cost of producing a

product as the firm expands the size of its plant (its output) in the long run.
Long-run cost curves: consists of all the short run periods as a firm
expands; is the track of all the SRAC curves as the firm grows
Diagram 2:28 page 126 superimposed upon 2:29 (or look up online)
Revenues: the product of the quantity of good or services it sells (Q) and the
price of the good or service (P)
Total revenue: TR=P*Q

can also be represented bye the area under demand curve (see diagram)
diagram 2:41 with explanation
TR can also be graphed against output
Diagram 2:42 with explanation
Marginal revenue: the change in total revenue that results from the sale of 1
additional unit of a firms product
TR
equal to Qsold where TR is total revenue and Q is quantity of the

product sold
in short, it is the extra revenue by selling one more of something
Average revenue: total revenue from the sale of a product divided by the
TR
quantity of the product sold (demanded); mathematically illustrated as Qd

where TR is total revenue and Qd is quantity demanded.
Profit: TR-TC where TR is total revenue and TC is total cost
Distinction between normal (zero) and supernormal (abnormal) profit

Normal profit: profit that must be earned by a firm to cover its
opportunity cost
19
it will just keep the firm in the industry
Supernormal profit: any extra profit (after normal profit has accounted
for)
Due to the extra profit, there is incentive for others producers to enter
the industry to gain part of this profit
Profit maximization in terms of total revenue and total costs, and in

terms of marginal revenue and marginal cost
Profit maximization in terms of TR and TC: considers profit by
looking at the difference in equation TR-TC; when the difference is
greatest the point with the greatest profit is reached (profit maximization)
Profit maximization in terms of MR and MC: considers profit by
comparing MR and MC
Profit maximization assumed to be the main goal of firms but other

goals exist (sales volume maximization, revenue maximization,
environmental concerns)
profit maximization is assumed to be the main goal of firms, but other
goals exist which can alter profit maximization
sales volume maximization: to achieve the greatest possible level
of sales rather than the maximum profit
revenue maximization: to achieve the greatest possible amount of
revenue rather than maximum profit
environmental concerns: to achieve sustainable development such
as increasing the production or technology of a nation without
inflicting further harm onto the environment.
E.g. of alternative goals to profit maximization:
The Body Shop previously proceeded to use many

animal-friendly measures which prevented them from
maximizing profit
Perfect Competition: (page 153 of Glanvilles Economics from a Global

Perspective) a market structure in which the decisions of buyers and sellers
have no effect on market price.
Assumptions of the model:

Very large numbers of independently acting sellers, often offering their
products in large national or international markets.
Ex: markets for farm commodities; the stock market; the foreign
exchange market
20
Standardized (identical or homogeneous) product is produced by purely

competitive firms meaning that as long as price is the same, consumers
will be indifferent from which buyer to purchase from; also firms make
no attempt to differentiate their products or engage in other forms of nonprice competition
Price takers: no individual firm can exert significant control over
product price, therefore the only option is to adjust to it meaning that the
individual competitive producer is at the mercy of the market
Free entry and exit for new firms and existing firms. No significant
legal, technological, financial or other obstacles prohibit new firms from
selling their output in any competitive market
Demand curve facing the industry and the firm in perfect competition
Demand curve is horizontal, indicating perfect price elasticity for the
industry/firm
Profit-maximizing level of output and price in the short-run and longrun

Profit Maximizing in Short Run
Only can occur by adjusting the output
This can be determined by the method of comparing total revenue

and total cost or comparing marginal revenue and marginal cost
Profit Maximizing in Long Run
Consumer tastes increase (demand shifts upward) creating a larger

economic profit which draws more firms to enter the market (supply
increases)
Firms leave the market (supply decreases):
The profit maximizing level of output is where MC = MR.
The possibility of abnormal profits/losses in the short-run and normal

profits in the long-run
Abnormal profits/losses are only possible in the short run
Normal profits occur during the long run
Shut-down price, break-even price

Shut down price: (in the short run) should occur when price is below
average variable cost
Costs are produced due to the difference, rather than profits
21
Break even price: (in short run) when price is greater than average
variable cost
Profits are produced, rather than costs
Definitions of allocative and productive (technical) efficiency

Allocative efficiency: apportionment of resources among firm and
industries to obtain the production of the products most wanted by
society (consumers); the output of each product at which its marginal
cost and price or marginal benefit are equal
Productive (technical) efficiency: production of a good in the least
costly ways; occurs when production of takes place at the output at
which average total cost is a minimum and marginal product per dollars
worth of input is the same for all inputs
Efficiency in perfect competition: perfect competition is both allocatively

and productively efficient. However, it is dynamic efficient, in the sense that
products can't be differentiated and no new technology can be produced. In
the long run, no firm will have any profit to spend on research and
development
Monopoly
Assumptions of the model

Single seller where a single firm is the sole producer of a specific
good/service
No close substitutes in which if a consumer chooses not to buy the
product/service they do without it (there are no other options)
Price maker the monopoly controls the total quantity supplied and thus
has control over its price.
Blocked entry due to the barriers of entry which may be economic,
technological, legal or another type
Nonprice competition
Sources of monopoly power/barriers to entry

Economies of scale: firms that are producing small amounts are not able
to enter into the industry due to their inability of mass production
Legal barriers (by government)
Patent: the exclusive right of an inventor to use, or to allow another

to use, her or his invention
Patents aim to protect the inventor, but also provide the inventor
with a monopoly position for the life of the patent
22
Licenses: prevents other firms from entering (because certain

qualifications must be met, and there is a scarcity in the amount of
licenses) and thereby altering the price and profit
E.g. Cab drivers in most large cities need to have one of a limited
number of municipal licenses; the restriction of supply creates an
economic profit for cab owners and drivers, which means that
new cab drivers cannot enter the industry and drive down prices
and profits.
ownership or control of essential resources: where one firm owns all the
nearby essential resources and other firms are unable to produce due to
the inability to get the necessary resources
pricing and other strategic barriers to entry
slashing prices so that other firms are unable to compete
increasing advertising so that other good/service are less desirable or

so that that firms good/service is more desirable
Natural monopoly: an industry in which economies of scale are so great

that a single firm can produce the product at a lower average total cost than
would be possible if more than one firm produced the product
Demand curve facing the monopolist

Contain only one demand curve for the industry and for the firm
(because the firm is the industry)
Demand curve is downward sloping, with demand increasing as price
decreases, signifying three things:
Marginal revenue is less than price, meaning that no matter how the
price changes, the change that shall be created in marginal revenue
makes this action more costly (and less efficient) than otherwise
Monopolist is a price maker, meaning that they establish the price of

a good/service because they control total output
Monopolist sets prices in the elastic region of demand, because if

they were to set prices in the inelastic region they would have to
lower price and increase output (thus costs) which would yield a
smaller profit
Profit-maximizing level of output

At point at which MR=MC because the marginal revenue is covering all
marginal costs and therefore there is no cost overflowing and not being
paid off.
Advantages and disadvantages of monopoly in comparison with perfect

competition
23
Advantage/Disadvantage (of
Monopoly)
Advantages/Disadvantages (of Pure

Competition)
not always highest price

(because high price can result
in decrease sales and total
revenue)
no new entrants to alter price,
change in supply or eliminate
economic profit
Greater likelihood of
economic profit
Less likelihood of economic profit
Also greater likelihood of

economic cost
more security because less likelihood of

economic cost
Efficiency in monopoly
Monopoly is inefficient since output is less than that required for
achieving minimum ATC and because the monopolists price exceeds
MC
This is because MR curve lies below demand curve and maximized

profit occurs when MR=MC
(See diagram page 447 in Economics by Collen and Brue)
Monopolistic Competition

Relatively Large Number of Sellers
Small market shares where each firm has a small percentage of the
total market (therefore limited control over market price)
no collusion the presence of relatively large number of firms ensures

that collusion by a group of firms to restrict output and set prices is
unlikely
independent action there is no feeling of interdependence among the

firms; each can determine its own pricing policy without considering
the reactions of rival firms; basically a change in price in one firm
will have nearly no effect on another firm and therefore trigger no
response.
24
Differentiated Products (often promoted by heavy industry), with

varying differences
Easy Entry to, and Exit from, the Industry
Due to:
Few economies of scale
Low capital requirements
Short-run and long-run equilibrium

Short run equilibrium yields a profit or a loss depending on the demand
for the good/service. This is measured at the point of output when
MR=MC.
Long run equilibrium yields only a normal profit because firms can leave
and enter when they so desire (during times of loss or profit) and they act
accordingly.
Product differentiation
Differentiated Products (often promoted by heavy industry), with varying
differences which may include:
Product Attributes
E.g. personal computers
Service
E.g. grocery stores that stress the helpfulness of its clerks who
bag groceries and carry them to the customers car.
Location
E.g. a small local grocery with a small range of products at a high
price, which is preferred to the large grocery store because of its
proximity to the customer
Brand Names and Packaging

E.g. different brands of aspirin: Bayer, Anacin, Bufferin
Some Control over Price

This is due to the product differentiation, but it is very limited
because there are so many other substitutes available.
Efficiency in monopolistic competition

long run equilibrium yields neither productive nor allocative efficiency
25
productive efficiency not realized because production occurs when

average total cost exceeds minimum average total cost
allocative efficiency not realized because product price exceeds the

marginal cost
in short, under allocation of resources and excess productive capacity

occurs
e.g. cities with an abundance of small motels and restaurants all
which operate well under half capacity.
Oligopoly

A few large producers
Homogeneous or differentiated products (are produced)
Control over price, but mutual dependence each firm can set their own
price and levels of output to maximize profit, but it must consider how
its rivals with react to any change in price, output, product
characteristics, or advertising.
e.g. in deciding on its advertising strategy, Burger King will consider

how McDonalds will react
Entry barriers similar to economies of scale in monopolistic competition
E.g. economies of scale (for certain industries, such as aircraft,

rubber, copper); patents; availability of capital or necessary resources
Mergers may create oligopolies by combining two ore more competing

firms thus increasing their market share and allowing the new firm to
achieve greater economies of scale
Measures of industry concentration
Concentration ratio: reveals the total output produced and sold by an

industrys largest firms. When the largest four firms in an industry
control 40% or more of the market, that industry is considered
oligopolistic
However, the shortcomings of this method lie in the inability to
analyze and understand the:
Localized markets
Inter-industry competition
World trade
26
Herfindahl index which illustrates the market power by giving

greater weight to larger firms and less weight to smaller firms (by
squaring the different percentage market shares).
Collusive and non-collusive oligopoly

Collusive oligopolies occur when firms decide to cooperate with rivals
E.g. cooperating in terms of prices on good/service resulting in an

increased profit for both firms
non-collusive oligopolies are classified as independent
Cartels: a group of producers that typically creates a formal written

agreement specifying how much each member will produce and charge
E.g. OPEC
Kinked demand curve as one model to describe interdependent behavior

Occurs because of a possible reaction by other firms due to a price
change in a rivals product. In diagram, demand is highly elastic above
the going price, P0, but much less elastic or even inelastic below that price
D1
MC1
Price
MC2
D2
Quantity
Importance of non-price competition (advertising)

Advertising can provide the consumer with useful information and
introduce them to new products. In the long run, it can reduce long-run
average total cost by enabling firms to obtain economies of scale
However, it can also bring negative effects if the information

presented is incorrect or misleading, and can be a barrier for smaller
firms because they are unable to incur the large advertising costs. It
can also be canceled by another advertisement, such as if a rival fast
27
food chain is advertising their similar product and no increase in

sales occurs.
Theory of contestable markets

Contestable market: a market with low barriers of entry and exit
Due to the nature of oligopolies, firms are able to enter when the profits
seem favorable (abnormal profits), and leave when these abnormal
profits end (and normal profits are resumed).
The theory of contestable markets is used to defend firms with
established monopolies to say that they may have a monopoly, but the
market is contestable due to low barriers of entry and exit
Price discrimination
Price discrimination: selling of a product to different buyers at different

prices when the price differences are not justified by differences in cost.
E.g. movie theatre and golf course fares at varying prices; discount
coupons redeemable at purchase (which some use and some dont)
Reasons for price discrimination

to increase its profit (in a monopoly) by attracting consumers whose
demand is more elastic (and therefore are less likely to demand the
following good/service)
E.g. Discount coupons redeemable at purchase: allows price

discounts to most price-sensitive customers who have elastic demand
(meaning that because of the discount they will go buy the
product/service or buy more)
Necessary conditions for the practice of price discrimination

Monopoly power meaning that the seller must be a monopolist or possess
some degree of monopoly power (some ability to control output and
price)
Market segregation meaning that the seller must be able to segregate
buyers into distinct classes, each with different willingness and ability to
pay for the product (demand)
Normally based on different elasticities of demand
No resale meaning that the original purchaser cannot resell the product or
service. If resale were possible, buyers in the low-price segment of the
market could easily resell in the high-price segment causing a
competition in the high price segment (which would undermine the
monopolists price-discrimination policy).
28
Possible advantages to either the producer or the consumer

Producer: able to increase total revenue and economic profit by
appealing to a wider market
Consumer: under certain circumstances (e.g. price discrimination when
buying in bulk, the good/service is cheaper than otherwise) consumers
are able to benefit by getting more good/service for their money
2.4 Market Failure:
Definition: an imperfection in the market mechanism that prevents optimal

outcomes. Market failure implies that the forces of supply and demand havent
led us the best point on the production possibilities curve. The four specific
sources of market failure are public goods, externalities, market power, and
equity.
Reasons for market failure:
Positive and negative externalities:

Externality: cost (or benefits) of a market activity born by a third party
the difference between the social and private cost of market activity.
Price or Cost
Negative externality: when social cost exceeds private cost.
Price or Cost
Price
Social Cost exceeds private costs by the

amount of external costs (negative
externality) Production decisions based
on private costs alone will lead to point
B, where private costs are MC = MR. At
point B, the rate of output is Qp. To
maximize social welfare, we equate
social MC and MR, as at point A. Only
Qs of output is socially desirable. The
failure of the market to convey the full
costs of production keeps us from
B
attaining
this outcome.
Private Marginal
cost
Positive Externality: when private cost exceeds social cost.

Private Cost exceeds social costs by the
Social Marginal amount of external costs (externalities).
Production decisions based on social
cost
costs alone will lead to point B, where
Price
A
B MC = MR. At point B, the rate of
Qp Qssocial
Quantity
output is Qs. To maximize private
welfare, we equate private MC and MR,
Social Marginal
as at point A. Only Qp of output is
cost
socially desirable. The failure of the
market to convey the full costs of
production keeps us from attaining this
outcome.
External cost
External cost
Private Marginal
cost
Quantity
Qs Qp
29
Note: this is not the only way to diagram an externality. Externalities can also
be diagrammed on the basic supply-demand diagram with the positive
externality resulting in a lower cost of a good/service and a negative externality
resulting in a higher cost of a good/service (at the equilibrium point).
Short-term and long-term environmental concerns, with reference to

sustainable development:
Short term environmental concerns:
Organic pollution: disposal of organic wastes from toilets and

garbage disposals.
Thermal pollution: an increase in the temperature of waterways

brought by the discharge of steam or heated water.
Long term environmental concerns:
Acid rain: sulfur dioxide (SO2) is an acrid, corrosive, and poisonous

gas secreted by burning high-sulfur fuels such as coal. As a
contributor to acid rain, it destroys vegetation.
Smog: nitrogen oxides (NOx) are principal ingredients in the

formation of smog that damages human view, lung system, and also
vegetation. Automobile emission account for 40% of urban smog.
Greenhouse effect: humans and nature exhale too much carbon

dioxide (CO2) that the earths oceans and vegetation can no longer
absorb it all. The destruction of rain forests, which also absorbs CO2,
contributes to the greenhouse effect.
Sustainable development: is a process of developing (land, cities,

business, communities, etc) that "meets the needs of the present without
compromising the ability of future generations to meet their own needs"
according to the Brundtland Report, a 1987 report from the United
Nations. One of the factors which it must overcome is environmental
degradation but it must do so while not forgoing the needs of economic
development as well as social equity and justice.
Lack of public goods:

Pure public goods are both non-rivalries and non-excludable, some
people will be able to enjoy the benefits of the public good without
paying a share of its cost (free rider problem). Government tends to
provide the good and service and attempts to impose inefficient systems
of charging such as tolls or entry fees.
Underprovision of merit goods:
30
A merits good is a private good with positive externalities and underproduced. Government can subsidize production or use advertising to
increase demand.
Overprovision of demerit goods:

Demerit goods are rivalries, excludable private goods with negative
externalities. They tend to be overproduced. They could be banned, or
negative advertising used to discourage use or be taxed heavily.
Abuse of monopoly power:

By raising prices and lowering output, firms can increase producer
surplus at the expense of consumer surplus.
Possible Government responses:
Legislation:
Government is regulating the market by voting and applying new laws.
Through regulation, they determine that a certain level of production can
be reached before production must stop/decrease.
E.g. regulation of drugs.
Direct provision of merit and demerit goods:

Government is increasing the market supply of both merit and demerit
goods.
Taxation:
Tax is equal to the value of the gap between marginal social and private
costs: MSC = MPC + externality tax.
Subsidies:
Government can also help the industry by giving firms subsidies (see
definition before) to help them increase the market supply.
Tradable permits:
Firms purchase the right to pollute the environment. The principal
advantage of pollution permits is their incentive to minimize the cost of
pollution control.
Extension of property rights:

People are given rights to pollution free air; countries in Africa can give
property right over big game animals to local villages.
Advertising to encourage or discourage consumption.
31
Section 3: 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.
Section 4 deals with external equilibrium. Income distribution is introduced here in section 3 but is
addressed in greater detail in section 5.
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.
3.1 Measuring national income
Circular flow of income: The circular flow of income diagram illustrates how
income produced by production does not return completely return to the households
due to the spending of an economy as a whole.
Leakages
Businesses
Injections
Savings: savings causes
peoples money not to
be spent on goods and
services.
Taxes: taxes are
deducted from
peoples and
businesses incomes
causing money not
to be spent on goods
and services.
Imports: imports
are purchases made
to foreign countries
causing money to
leave the country.
Investments: Businesses
may invest for new factories
or equipment to increase
production.
Government: the
government may spend an X
number of dollars for a
specific business project to
create economic activity.
Exports: exports are goods
and services sold to foreign
countries, which will help
bring money into the
economy.
Households
Methods of measurementincome, expenditure and output

Measure of income:
32
Adds up all the sources of income in the domestic economy.

Transfer payments (pensions, unemployment and welfare
benefits) are excluded: no good or service is produced for the
income.
Income includes:
Wages and salaries
Self-employed income
Profits: divided into dividends given to shareholders and
undistributed or earnings retained by the firm
Rent which includes the cost of raw materials and
intermediate inputs and imputed rent on any owner
occupied housing
Interest
Measure of expenditure:
This adds up all the spending in the economy: C + I + G + (X M)
It is called Gross Domestic Product (GDP) at market prices and
includes:
C: Consumption
I: Investment which includes:
o Planned investment in capital
o Unplanned increases in stocks or inventories
G: Govt. spending on goods and services. Because they are often
provided free of charge (no market value), they are valued as
cost.
X: Exports: the domestic economy receives the money
M: Imports: these must be subtracted because it is spending on
goods and services from outside the domestic economy.
Measure of output:
Adds up the values of a firms production:

The value of the firms output minus the value of inputs
Alternatively this method adds up the output of final goods and
services.
If $100 worth of goods and services has been produced (output
method) this must have generated $100 worth of income (income
method) for the various factors of production and will lead to
$100 worth of spending (expenditure method).
If spending by households is added up this will show the
spending at market prices. But this does not truly reflect income
earned by factors because of indirect (sales) taxes paid by firms
to government and subsidies received by firms from government.
Therefore:
Market price - indirect taxes + subsidies = factor cost.
Distinction between:
gross and net
33
GDP (gross domestic product): The total market value of all

goods and services produced in a nation in a given period.
NDP (net domestic product): The total market value of all goods
and services produced in a nation in a given period that is
adjusted to account for depreciation
calculated by subtracting depreciation from the gross
domestic product (GDP).
national and domestic
GNP (gross national product): The total market value of all goods
and services produced by a nation in a given period.
GDP (gross domestic product): The total market value of all
goods and services produced in a nation in a given period.
nominal and real
Nominal GDP: A GDP measurement that has not been adjusted
for inflation in a given year.
Real GDP: An inflation-adjusted measure of all goods and
services produced in a given year.
total and per capita
Total: The complete quantity per nation.
Per capita: divided equally among each individual or per unit of
population.
3.2 Introduction to development
Definitions of economic growth and economic development

Economic growth: occurs when production grows through the measure
of material things. Growth occurs even when individual standards of
living are falling because it is independent to the populations size. It can
be measured through the PPF curve to determine if a nation is producing
its optimal output compared from one period to another.
Economic development: the development of economic wealth of
countries or regions for the well being of their inhabitants. It is a process,
which believes that measurements through the HDI (Human
Development Index), which measures life expectancy, literacy rate, and
GDP per capita, will help provide incentives for innovation and for
investments so as to develop an efficient production and distribution
system for goods and service in the long run.
Differences in the definitions of the two concepts
Economic Growth
Economic Development
Increase in the capacity of an Increase
the
development
of
economy to produce goods/services
economic wealth of countries/regions
for the well being of their inhabitants
Can be measured in nominal terms Aims to develop an efficient
or real terms
production and distribution of
goods/services
Diagram with PPF or PPC (see Measured by Human Development
section 1 or 5)
Index
Gross Domestic Product (GDP) versus Gross National Product (GNP) as
measures of growth
34
GDP
Includes the value of final goods and
services produced by factories owned
by domestic households around the
world
Represented by formula:
GNP = GDP + Foreign investment
income investment income paid to
foreigners
GNP
Is limited to the value of final goods
and services produced within a
country
Represented by formula:
GDP= C + I + G + (X-M)
See above for explanation
In developing countries, tends to
exceed GNP
(meaning that factor payments to
foreigners exceed those received
from foreigners)
In industrialized countries, tends to

exceed GDP
(meaning that factor payments
received from foreign countries are
larger than what is paid to foreigners)
Limitations of using GDP as a measure to compare welfare between countries

Per capita income still ignores the distribution of income: there could be
a few rich people and large numbers of poor.
Non-market sector: goods and services traded in a barter or parallel
economy which are not reported as output or income. How do we
include them?
Future growth through capital goods: national income accounting does
not distinguish between the production of consumption and capital
goods:
Producing consumption goods leads to more today but less
tomorrow.
Production of capital goods involves less consumption today but
higher future growth and greater consumption in the future.
Externalities: pollution and the cleanup of pollution or increased traffic
congestion and the resulting increase in gas consumption can actually
lead to a rise in GDP even though the quality of life may have been
reduced.
Quality of life: pollution regulations or more vacation time can lead to a
fall in GDP but lead to an increase in the quality of life; how should we
adjust?
Government services: how do we value national defense or govt. medical
services? We count them at cost which may be too high or too low an
estimate.
Allowance for differences in purchasing power when comparing welfare

between countries:
35
Purchasing power parity: rather than use a single currency to compare,

currency is converted to PPPs which measure the actual purchasing
power of domestic income in terms of what it can buy within the country.
Alternative methods of measurement:
HDI (Human Development Index): best alternative because it considers

the well being of the inhabitants of a country through factors of
education, health, etc
EFI (Economic Freedom Index): more developed countries tend to have

more economic freedom
Energy Consumption: more developed countries tend to consume more

energy
CPI (Consumer Price Index): prices in lesser developed countries tend to

remain fairly stable and so consumption also remains stable and
unchanged
Problems of measuring development:
Accounting systems are different amongst countries. Many LDCs cannot

afford comprehensive systems and use a lot of guesswork or estimation
to fill the gaps.
Climate differences: some countries spend more on energy to heat or

cool houses and offices.
There may be considerable differences in the distribution of income, the

size of the non-market sector, the balance between consumption and
capital goods production and between production of consumer goods and
weapons for war
3.3 Macroeconomic models
Aggregate demandcomponents:
The total amount of goods and services demanded in the economy at a
given overall price level and in a given time period.
Aggregate Demand (AD) = C + I + G (X-M);
C = Consumers' expenditures on goods and services.
I = Investment spending by companies on capital goods.
G = Government expenditures on publicly provided goods and
services.
X = Exports of goods and services.
M = Imports of goods and services.
Aggregate supply:
Aggregate Supply: the total supply of goods and services is produced
within an economy at a given overall price level in a given time period.
Short-run: aggregate supply changes due to the determinants of
aggregate supply
Long-run (Keynesians model):
Potential (full employment) income is constant and is shown by a
vertical line, often called the Long Run Aggregate Supply curve
(LRAS).
36
If equilibrium is above potential or full employment income and

we get an inflationary gap (positive output gap).
Full employment level of national income: the level of total output attained
when unemployment is at a socially acceptable level.
Equilibrium level of national income: when short run aggregate supply is
perfectly elastic, any change in aggregate demand will feed straight
through to a change in the equilibrium level of real national output.
Inflationary gap: the amount by which aggregate spending at full
employment exceeds full-employment output.
Deflationary gap: a situation in which a country's national income falls well
below what its economy is capable of producing.
Diagrams illustrating trade/business cycle
http://www.quickmba.com/econ/macro/business-cycle/
3.4 Demand-side and supply-side policies
Shifts in the aggregate demand curve/demand-side policies

Fiscal policy: the use of government taxes and spending to alter
macroeconomic outcomes.
Interest rates as a tool of monetary policy: in the United States,
the Federal Reserve can only directly set the discount rate; it
engages in open market conditions to alter the federal funds rate.
In other nations, the monetary authority may be able to mandate
specific interest rates on loans, savings accounts or other financial
assets. By altering the interest rates under its control, a monetary
authority can affect the money supply.
37
Shifts in the aggregate supply curve/supply-side policies

Supply side policies attempt to shift the LRAS to the right far
enough to reduce inflationary pressures:
By focusing on incentives:
Taxes and subsidies are reduced to encourage
work, risk taking and investment
Unemployment benefits are reduced, raising the
opportunity cost of not working.
By increasing productivity of labor (Q/L rises):
Education and training will increase productivity.
Investment in capital will increase the K/L ratio.
By increasing the productivity of capital (Q/K rises):
through tax deductions for Research and Development:
firms are motivated to find ways to increase capital
productivity.
By reducing the costs of inputs:
Eliminating or reducing the minimum wage and
the strength of unions.
Lowering interest rates and thus lowering the
rental price of capital.
Providing incentives to find cheaper sources of
raw materials.
By reducing the power of big companies through antimonopoly regulation.
Strengths and weaknesses of these policies
Problems with Fiscal Policy
Fiscal policies attempt to reduce the suffering encountered
in a market system by providing assistance to the less
fortunate. The benefits are the counter-cyclical effects of
automatic stabilizers, but the costs include:
Disincentive to work: welfare and unemployment
assistance has encouraged people supported by the
govt. not to be productive by imposing a "tax" in
the form of a loss of social assistance for those
who go and work. This reduces the motivation to
look for a job, and shifts the LRAS to the left.
Increased taxes: the steady increase in taxes for
social security have increased business costs, this
has shifted the LRAS to the left.
More regulation: greater regulation of industry
protects firms from competition and leads to
inefficiency which shifts the LRAS to the left.
Substitution of capital for labor: there has been
greater social regulation such as labor protection
laws which have substantially increased the costs
of hiring employees leading to the substitution of
capital for labor which increases the natural rate of
unemployment (shifting the LRAS to the left).
38
Underground economy: higher tax rates have led

to disincentive problems and to a significant
proportion
of
economic
activity
going
underground.
Lags
o Discretionary policy often runs into
problems with lags:
o Recognition lag: it takes some time before
a gap is recognized.
o Legislative lag: it takes time to decide what
to do and if it requires a change in taxes or
borrowing, it takes time to get approval
from parliament.
o Implementation lag: it takes more time to
put the policy into effect.
The result is that stabilization policy or demand

management policy has often done more to
encourage fluctuations than to remove them.
Reversibility
Another problem is that policies put into effect

may be very difficult to reverse:
o If there were a recessionary gap, the
government may decide to cut corporate
taxes:
o After the usual lag, businesses start to
increase investment.
o By the time the investment shifts out the
AD curve, the economy may already have
recovered and the shift in AD may open an
inflationary gap.
o The problem then becomes one of trying to
reverse the policy.
It is extremely
unpopular to raise taxes when businesses
have become used to lower taxes.
To overcome this problem it has been suggested
that policies be made short run:
o The govt announces that the tax cuts will
only last for two years.
o This may help with investment, but many
consumers will simply absorb the increased
income into savings as a result of the
wealth effect.
39
Financing Government Expenditures

When govts attempt to increase G, they must
finance it somehow:
o They can raise taxes by the same amount
as G, but this would lead to a fall in
consumption and investment.
o They can borrow the money, but this leads
to a rise in interest rates and a fall in
investment:
o The demand for money shifts out, but the
supply of loanable funds does not change
so interest rates rise.
This is called the crowding out
effect because private businesses
wanting to borrow money now find
they have to pay more to borrow
and cut investment.
They can expand the money supply
(govt. borrows from the central
bank equivalent to printing money)
and use the money to finance the
increase in G, but this leads to
inflation.
The attempt to use fiscal policy to fine tune the
economy is no longer accepted as a valid
stabilization tool. Only where there are large
persistent gaps, particularly gaps associated with
recessions or depressions, is it generally agreed
that fiscal policy does have role to play in
restoring the economy to full employment.
Problems with Monetary Policy
In the long run, because the LRAS is vertical above the
full employment income level, the major impact of
monetary policy will be on the price level.
In boom times, the SRAS curve is very steep:
Shifts in the AD curve translate into large changes
in the price level and little change in income.
At less than full employment demand-side policy
can affect both price and income in the short run.
Rational expectations means that workers cannot
be fooled, there is no money illusion.
o Workers know that real wages remain
unchanged, and real income stays the
same.
o Govt. will be unable to reduce
unemployment below the natural rate even
in the short run.
40
Expectations can alter the speed at which

adjustment takes place. A change in the expected
rate of inflation will change aggregate demand:
o If inflation is expected to rise, consumers
will increase current buying
o If inflation is expected to fall, expenditures
may be delayed.
If the money supply is increased, and the AD
curve shifts out to the right, workers anticipate that
increasing the money supply will lead to higher
prices and they will demand higher wages right
away:
o The general expectation of an x percent
inflation creates pressures for wages to rise
by x percent and hence for unit costs and
the SRAS curve to shift in by x percent.
o As AD shifts to the right, the SRAS shifts
to the left.
Lags in Implementing Monetary Policy
The monetary transmission mechanism takes varying
lengths of time from 18 months to 3 years. While there is
still a recognition lag, there is no need for a legislative lag
as the govt. does not have to go to parliament to get
permission to change the money supply.
There is still an implementation lag.
o Open market operations lead only slowly to
changes in the money supply and interest rates.
o It takes time in companies to adjust investment
plans in response to changes in interest rates.
o It then takes time for investment to be put in place
and for the multiplier responding chain to lead to
changes in national income: Economists estimate
it takes 18 months on average for half the effects
to be felt in the economy.
Lags are long and unpredictable increasing the risk that
using monetary policy could lead to destabilizing effects.
The poor record of monetary policy as a short term
stabilizer has led to the introduction of a monetary rule
approach where the money supply would only be
increased by a set amount.
Some countries chose the rate as equal to the population
growth rate plus the growth rate in productivity.
Experience since then shows that there have been quite
sudden shifts in the liquidity preference function, also
known as the demand for money, which has made the
monetary rule approach less stable than had been hoped.
41
Most economists now believe that fiscal policy must be used to

restore the economy to full employment during a serious
recession or depression:
The labor market experiences sticky wages which means
wages fall too slowly
Weaknesses in the monetary transmission mechanism plus lags
mean that monetary policy is unpredictable
The Transmission Mechanism (applicable to both)
Fiscal policy operates directly on AD through changes in
G and T.
Monetary policy operates through adjustments in the
money supply which then lead to changes in interest rates
and investment before impacting on AD. Problems with
this transmission mechanism during depressions can make
monetary policy useless:
o Monetary expansion fails because banks hold
excess reserves rather than lend money.
o Interest rates may not fall because people may
hold money rather than invest in bonds (liquidity
trap)
o Firms may be afraid to invest: the MEI curve is
vertical, large changes in interest rates lead to only
small changes in investment.
Multiplier: the number by which a change in any component of aggregate
expenditures or aggregate demand must be multiplied to find the resulting change in
equilibrium GDP
change in real GDP

initial change in spending
Accelerator: The accelerator is a causal relationship between increases in aggregate

demand and national output(Q), and the resulting increase in net investment (I)
Calculation of multiplier:
in short says that an increase in output (as a result of greater consumer

income) results in an increase in investment ceteris paribus; this can also
act oppositely if output decreases (due to less consumer income, such as
in a recession) then a decrease in investment occurs
Crowding out: (part of fiscal policy) as a result of a recession in the economy,

fiscal policy (changing taxes/spending) is used to relieve the economy of GDP
below full employment which results in the govnerment needing to increase their
borrowing to finance the deficit (thus increasing demand) and causing an inflation
rate that crowds out some investment spending.
Diagram pg 225 of McConnell and Brue
3.5 Unemployment and inflation
Unemployment: A person who is able and willing to work yet is unable to find a
job is considered unemployed.
Full employment and underemployment
42
Full employment: the lowest level of unemployment that can be

sustained given the structure of the economy.
Underemployment:
inadequately
employed,
especially
employed at a low-paying job that requires less skill or training
than one possesses.
Unemployment rate: the percentage of people available in the labor force who are
considered unemployed when compared to the total labor force. The unemployment
rate can be calculated in this method:
Number of people unemployed x 100
Total work force
Costs of unemployment:
Loss of output to the economy
The unemployed could be producing goods and services, which
could have helped economic growth.
Loss of tax revenue
The unemployed people aren't earning income causing them to
be unable to pay taxes, which hurts the government.
Increase in government expenditure
The government has to pay more benefits to support the
unemployed.
Loss of profits
With higher employment, businesses are more likely to do better
and make better profits. If they make less profit because of
unemployment, they may have fewer funds to invest.
Types of unemployment
Structural: Unemployment resulting from changes in requirements of
available jobs. These changes simultaneously open new positions for
trained workers.
Frictional: Short periods of unemployment experienced by people
moving between jobs or into the labour market.
Seasonal: Unemployment due to seasonal changes in employment or
labour supply.
Cyclical/demand-deficient: Cyclical unemployment results from a lack
of job vacancies, and demand-deficient (Keynesian) unemployment is
unemployment caused by a fall of aggregate demand and no equivalent
fall in wages to restore equilibrium.
Real wage: If labor unions or minimum wages hold the real wage above
equilibrium, or if there is an economy wide rise in real product wages,
some firms will not be able to cover their labor costs and will shut down,
leading to unemployment.
Measures to deal with unemployment
Cyclical unemployment can be reduced with appropriate fiscal and

monetary policy.
Real wage unemployment can be reduced by not allowing inflation to

break out leading to the need to break entrenched inflation which can
create the problem in the first place.
Search (frictional) unemployment can be reduced by:

43
Reducing unemployment benefits.

Creating employment agencies to reduce the search time.
Study-work programs such as those in Germany (in which allows
half the students in high school to learn by working in a job
several afternoons per week)
Structural unemployment can be reduced through retraining and

relocation:
Older workers resist changes and are reluctant to admit that
innovations have destroyed the value of the knowledge and
experience that they already have. Employers tend to hire
younger workers who will learn the new skill faster.
(Extra Information)
In many industrialized countries, sunset industries and regions are
supported with subsidies. But agreements with industry to hire
un-needed (usually older) workers increases costs and makes the
industry even less viable and puts an even greater burden on
taxpayers.
In Sweden the state approaches firms in the sunrise area

and arranges for unemployed people from sunset
industries to enter into a training program which
eventually leads to a full time position. The govt. pays all
the labor costs during the training period.
In Japan, the govt. approaches companies with sunset

divisions and assists them in investing in new sunrise
divisions by paying for retraining of workers.
Large, sick, declining industries appear like a national disgrace.

However, at any point in time there are a number of new firms in
sunrise industries. The attempt by govt. to pick winners and
losers has proven to be a waste of money, and often inhibits the
real winners. A policy is needed that encourages private
initiatives and risk taking. Retraining and relocation grants make
movement easier and reduce structural unemployment without
inhibiting economic change and growth.
Definitions of inflation and deflation

Inflation: a rise in the general level of prices in an economy (an increase
in price level)
Deflation: a general decline in prices, often caused by a reduction in the
supply of money or credit. Deflation can be caused also by a decrease in
government, personal or investment spending. The opposite of inflation,
deflation has the side effect of increased unemployment since there is a
lower level of demand in the economy, which can lead to an economic
depression.
Costs of inflation and deflation
Costs of inflation: Increasing uncertainty may discourage investment
and saving. Panicky spending that tries to anticipate inflation has the
44
effect of increasing the velocity of money and the inflationary cycle.

Sudden spending also contributes to economic bubbles as demand (and
thus prices) increase drastically.
Redistribution of Wealth: Inflation tends to redistribute
wealth/income/purchasing power from those on fixed incomes,
such as people living off bond interest or a fixed pension, to those
whose income is based on market conditions (for example, wages
and company dividends, which tend to keep pace with inflation).
International trade: If the rate of inflation is higher than that
abroad, a fixed exchange rate will be undermined through a
weakening balance of trade.
Shoe leather costs: Because the value of cash is eroded by
inflation, people will tend to hold less cash during times of
inflation. This imposes real costs, for example in more frequent
trips to the bank.
Menu costs: Firms must change their prices more frequently,
which imposes costs, for example with restaurants having to
reprint menus, and stores having to re-price their goods.
Hyperinflation: if inflation gets totally out of control (in the
upward direction), it can grossly interfere with the normal
workings of the economy, hurting its ability to supply.
Costs of deflation:
When nominal prices are sticky (a situation in which a variable is
resistant to change) due to institutional factors then a monetary
deflation can lead to widespread bankruptcy. It is only after this
process allows certain institutional barriers to be broken (i.e.
contract commitments) that the downward price spiral can be
fully transmitted to other sectors.
Causes of inflation
Cost-push: Inflation where general level of prices rise (inflation) due to
increases in the cost of wages and raw materials. It develops because of
the higher costs of production factors decreases in aggregate supply (the
amount of total production) in the economy.
Demand-pull: when inflation increases because of a continual increase
in consumer demand. It is caused when consumers increase demand of a
scarce good causing the price to unavoidably increase.
Excess monetary growth: Inflation is caused by monetary theory to
only focus on money supply causing the supply of money to become
larger than the demand of money.
methods of measuring inflation
Consumer Price Index:

Examines the index by looking at price of a market basket of
some 300 consumer goods and services that are purchased by a
typical urban consumer and comparing it to the same market
basket in 1982-1984 then multiplies by 100. The rate of inflation
for a certain year is then found by comparing in percentage terms
that years index with the index in the previous year.
45
Mathematically illustrated as:

step 1: CPI=
price of the most recent market basket in the particular year
x100
price of the same market basket in 1982 - 1984
step 2:
rate of inflation=
given years CPI - CPI of the previous year

x100
CPI of the previous year
Producer Price Index (PPI):

Examines inflation by considering the market basket of various
indexes covering a wide range of areas affecting domestic
producers; the three main areas are: industry-based, commoditybased, stage-of-processing goods.
problems of the methods of measuring inflation
This gives it the ability to predict movement in the CPI

ahead of time
similar market basket must be available for comparison

because it is set up for the typical urban consumer it doesnt consider
many of the needs of those who do not fall into this category (CPI)
PPI excludes prices for imported goods, therefore it does not necessarily
detect producer prices for companies with operations in other countries.
In short run, PPI increases before CPI (being part of the earlier
procedure) therefore they are not in concurrence for short run, though in
long run they are.
Phillips curve: relates annual rates of inflation and annual rates of unemployment
(which are inversely related) for a series of years
Short-run
46
When the actual rate of inflation is higher than expected, profits

temporarily rise and the unemployment rate temporarily falls
Suppose the economy is at point A, The rightward shift in AD
is associated with rising output and a rising price level (to point
B, with a higher inflation and lower unemployment); the higher
ACTUAL inflation will eventually cause EXPECTED inflation to
rise as well. The increase in EXPECTED inflation shifts the
short-run Phillips Curve to the right (to SRPC2), and the
economy ends up at point "C". This cycle then can repeat again.
Long-run
There is no apparent long-run tradeoff between inflation and
unemployment
Unemployment has a tendency to return to its natural level at
point C and the economy has now faced a higher actual and
expected rate of inflation.
Natural rate of unemployment: the unemployment rate occurring when there is no

cyclical unemployment and the economy is achieving its potential output; the
unemployment rate at which actual inflation equals expected inflation
Non-Accelerating Inflation Rate of Unemployment (NAIRU)
Also known as full employment (see definition above)
3.6 Distribution of income
Direct taxation: a tax that cannot be shifted onto others. Income taxes and property
taxes are taxes that cannot be enforced upon others.
Indirect taxation: a tax that increases the price of a good so that consumers are
actually paying the tax by paying more for the products
E.g. fuel, liquor, and cigarette taxes
Progressive taxation: a tax that takes a larger percentage from the income of highincome people than it does from low-income people; most income taxes are
considered progressive taxes.
Proportional taxation: an income tax that takes the same percentage of income
from everyone regardless of how much an individual earns.
Regressive taxation: a tax that takes a larger percentage from the income of lowincome people than the income of high-income people including cigarette and gas
tax.
Transfer payments: a payment made to individuals by the federal government
through various social benefit programs, such as Social Security, welfare, and
veterans benefits.
Laffer curve: depicts the relationship between tax rates and tax revenues
Tax revenues decline beyond some point because higher tax rates
discourage economic activity, thereby shrinking the tax base (domestic
output and input)
47
Laffer Curve
Tax
rate
(%)
100
Maximum tax
return
Tax revenue ($)
Lorenz curve and Gini coefficient
good for illustrating the degree of income inequality; the area between
the diagonal and the Lorenz curve represents the degree of inequality in
the U.S. distribution of total income; this is measured numerically by the
Gini ratio- area A divided by area A + B.
In short, Lorenz curve illustrates the distribution of a populations
income
HL portion: http://www.lclark.edu/~bekar/Mankiw/ch33/notes.htm
48
Section 4: International economics

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.
4.1 Reasons for trade
Differences in factor endowments

O Each country has their own base of raw resources as well as other factors that
effect how they live and what they produce
E.g. weather.
Variety and quality of Goods
O Trade allows for more variety and a better quality of goods because some
countries produce different goods and others do a much better job.
Gains from specialization
O specialization increases total output because countries concentrate in producing
the goods they do well and buy the rest in the marketplace. The gain from trade
is increase world output and a higher standard of living in all trading countries
O (also covered in HL extension)
Political
O Trading helps establish relationships because you depend on each other for
goods.
Absolute and comparative advantage (numerical and diagrammatic
representations)
Absolute advantage: when a country can produce a good

with less resources than another
Comparative advantage: when a country has a lower
opportunity cost of producing that good
The model assumes that there are only two controls and
only two products, also that there are no transport costs and that there is
full employment
Country B
Country A
Production
of Food
Production
of Food
Production of
Machines
Production of
Machines
Country A has both a comparative and absolute advantage

over country B, with an opportunity cost ratio of 1:0.5 (approximately)
of food to machinery. Also, they can produce more goods with less
resources as illustrated by their greater PPF curve.
49
o opportunity cost is calculated by comparing the ratio of the production of

machines to the production of food (to find the opportunity cost of food) or
by comparing the ratio of the production of food to the production of
machines (to find the opportunity cost of machines)
o limitations of the theory of comparative advantage the model assumes
only one factor of production: labor which is used in fixed proportions in
producing products; also assumes that labor can be shifted from one
production to another; fails to consider communication costs and
international barriers of entry
http://www.kimep.kz/ICT/sld002.htm
Hartmut Fischer, Prof of Economics, Honorary Professor

KIMEP
4.2 Free trade and protectionism

Definition of free trade
free trade: no government intervention to constrain trade or alter trade patterns.

the unhindered flow of goods and services between countries, and is a name given
to economic policies and parties supporting increases in such trade.
concept refers to:
International trade of goods without tariffs (taxes on imports) or other trade barriers
(e.g., quotas on imports)
International trade in services without tariffs or other trade barriers
The free movement of labor between countries
The free movement of capital between countries
The absence of trade-distorting policies (such as taxes, subsidies,

regulations or laws) that give domestic firms, households or factors of
production an advantage over foreign ones.
Government protection of property rights to enforce the above

conditions
Open economy GDP= I + G + C + ( X-M) vs. Closed economy GDP = I + G + C
Free trade Consumer and Producer Surplus
Where there is no trade, the equilibrium will be at point B - a price level of OC and
output level of Q1. When there is free trade the world price is below the domestic
50
equilibrium price and equilibrium will be where the world price is equal to domestic
demand. This is at point D - an output level of Q2
*allows countries to consume beyond their PFF
Types of protectionism
ProtectionismGovernment policies fostering home industries by protecting them from
the competition of foreign goods, the importation of these being checked or discouraged
by the imposition of duties (tariffs) or otherwise.
Tariffsa tax ( duty ) imposed on imported goods.
A tariff is an indirect taxes imposed upon imports. They can be either specific (fixed
amount per good) or ad valorem (a % of the value). There are several reasons for the
imposition of tariffs. These include reducing imports and protecting domestic firms
from competition, reducing imports to reduce balance of payments deficits and raising
government revenue. As a result of the tariff, Supply follows S domestic until point M
(instead of point P, due to the imposition of a tariff) and then continues from M on S tariff.
Overall, the supply available changes from area DPJH to area EMLG.
Quotas a physical limit imposed upon the amount of a good that may be imported.
A quota is a physical limit imposed upon the amount of a good that may be imported.
This will have the effect of restricting the total supply to the domestic market. Supply
ends up following the curve ABC and then continues along S dom+q
Subsidies a government incentive given to producers so as to encourage production

(by decreasing the production cost, one of the determinants of supply)
51
If the government put a subsidy on a good, this will shift the supply curve
downwards by the amount of the subsidy (S1 to S2 in the diagram).
Voluntary Export Restraints (VERs) also known as Voluntary Restraint

Agreements (VRAs) countries voluntarily limit the amount of good(s) they export
into a country because they are afraid they will be forced to if they don't.
Administrative Obstaclesregulation for starting businesses and trading practices

require money and time.
Health and Safety StandardsFDA -Federal Drug Administration requires standards

to be met before it gives approval for the products to be sold.
Environmental Standardsregulation by government needs to be met by companies

costing them money.
Arguments for protectionism
Infant industry argument
Efforts of a developing country to diversify
Protection of employment
Source of government revenue
Strategic arguments
Means to overcome a balance of payments disequilibrium
Anti-dumping
Arguments against protectionism
Inefficiency of resource allocation
Costs of long-run reliance on protectionist methods
Increased prices of goods and services to consumers
52
The cost effect of protected imports on export competitiveness
Free Trade
Protectionism
- US could produce all the things it imports but it

would be very expensive and problems for lack of
resources. Its better to concentrate on our
comparative advantage( that refers to producing
that good for a less opportunity cost).
-Jobs taken away

-National Security
-Human Rights consideration
-Political
-Environmental
-Dependence
-Leakage
-Unfair advantage of poor countries
Unfair terms of trade-low prices for their stuff but
-have to pay high prices for our stuff
Wealthy countries get richer while poor get poorer.
-exports are cheap leading to inflation
-competition with domestic businesses
-dumping
--protection of infant industries
-perpetuating the problems such as young children
working
-US trade deficit worsen
-US should take care of our owns problems
-Universally accepted --Free Trade Helps

everybody
-trade expands Production Possibilities curve. We
have more stuff. Free trade unlimited supply of
goods
-if there is net exports were would be selling more
stuff thereby consuming less than we are producing
the US is net imports so we can have a higher
standard of living !!!
-Brings injection of hard currency ( currency
widely respected around the world)
* breaks down the cycle of poverty
-self sufficient
-unlike loans doesnt have to be paid back
-provides jobs
promotes good relationships between trading
counries, peace and friendship for all
4.3 Economic integration

Globalization: the integration of industry, commerce, communication, travel and
culture among the worlds nations
o generally referred to as the increasing integration of world markets for
capital, goods, and services
o a widening, deepening and speeding up of interconnectedness in all
aspects of contemporary social life from the cultural to the criminal, the
financial to the spiritual (Held and McGrew 1999: 2).
o In the industrialized countries, there is a fear that the forces of
technological change and geographical shifts in the location of economic
activities are transforming employment prospects in adverse ways,
particularly for the less educated and less skilled.
o The disparity between rich and poor countries widens and environmental
change continues.
o A hundred years ago only rare products such as spices and some basic
raw materials were involved in international trade. Today virtually
everything is involved.
o There is a new global division of labour:
Originally the DCs produced manufactured goods
The LDCs supplied raw materials and agricultural products, and
provided markets for some of the exports of manufactured goods
from DCs.
53
Trading blocs- Group of countries agree to trade with each other
Free Trade Areas (FTAs) two or more countries which have no tariff between
themselves but they have no common external tariff.
Customs Unionsconsists of two or more countries which have no tariff barriers
between themselves and a common tariff against the rest of the world.
Common Marketscustoms unions plus a union with free movement of production
factors, particularly of labour.
o E.g. European Union...
Trade creation and trade diversion
o trade creation: where trade is created by the formation of a customs union

o
where free trade is established within a zone and a tariff is placed on goods
from non-member nations
trade diversion: where trade is diverted from a more efficient producer to a
less efficient one by the formation of a trade agreement; under the natural
circumstance of a tariff being placed on goods from a non-member nation (of a
common market) the imports will generally come from the most efficient
producer, however with a trade diversion (and the establishment of free trade
with one or more nations) this natural pattern is changed
Obstacles to achieving integration

o
reluctance to surrender political sovereignty
This can refer to the fact that by integration the economy is no

longer isolated, but shared and therefore other political
tactics/procedures will also impact the economy
reluctance to surrender economic sovereignty
This can apply specifically if a government is reluctant to accept

foreign ownership (e.g. partial foreign ownership of German banks)
4.4 World Trade Organization (WTO)

Aims
The World Trade Organization was founded in 1995 to replace the General Agreement on
Tariffs and Trade (GATT). This multilateral organization aims to lower tariffs and non-tariff
barriers so as to increase international trade. The 146 member states meet in ministerial
sessions at least once every two years. NGOs and poor countries fear that further
liberalization of trade will only benefit rich countries. WTO negotiations favor the interests
of investors and neglect agricultural protectionism by rich countries. Critics often charge
that the WTO functions undemocratically and that it has opaque negotiation procedures that
harm the interest of the poor.
Success and Failure Viewed from different perspectives

O More than 140 countries are members and have agreed to several rounds of
tariff cuts. It also has developed a code of conduct relating to unfair trade
practices.
O The Kennedy Round was completed in 1967, the Tokyo round in 1986, and the
Uruguay round in 1995.
O The Uruguay round: negotiations began in 1986, agreement was reached in
1996:
O The agreement reduced non-tariff barriers, liberalized trade in services, reduced
domestic subsidies to agriculture, created better dispute settlement mechanisms,
and better copyright protection for intellectual property.
54
A current controversy surrounds the proposed Multilateral Agreement on

Investment (MAI) which would take a great deal of power away from
governments and give it to companies investing in a country.
International protest groups oppose the WTO, the World Bank and the IMF as
they feel they are dominated by leading industrialized countries, particularly the
US.
The most difficult areas facing the WTO in the future will be:
The reduction of agricultural subsidies in all industrialized countries
which should open these markets to LDCs
The establishment of a trade in services agreement
The integration of China which will strain trading systems as well as
impose new obligations on China to conform to WTO rules.
The development of a more equitable world trading system where the
power of developed countries is not imposed on LDCs through various
kinds of conditionality and trade-opening requirements.
Developed countries must operate a fairer system of access to their own
markets for poorer countries.
4.5 Balance of payments

Balance of Payments: summary record of a countrys international economic transactions in a
given time period.
Current Account = trade balance
+ unilateral transfer (ex. Grants, pensions)
+ US income from US overseas invest.
- US outflow for foreign US investment.
O balance of trade is exports - imports
O invisible balance- refers to services
Capital Account = foreign purchases of US assets - US purchases of foreign assets

+/ - US capital inflow/outflow
*CURRENT ACCOUNT BALANCE + CAPITAL ACCOUNT BALANCE = 0.
4.6 Exchange rates
Fixed Exchange Rates the exchange rates are fixed at a certain amount by having X
amount of US dollars worth X amount of gold. Its referred to as a gold standard.
Floating Exchange Ratesthe exchange rates go up and down according to market
supply and demand
o aka Flexible exchange rates - a system in which exchange rates are permitted to
vary with market supply and demand conditions.
Managed Exchange Rates a system in which governments intervene in foreign
exchange markets to limit exchange rate fluctuations; aka "dirty floats" . They usually
use Foreign account reserves or persuasion to convince other countries to change their
currency value.
Distinction between
o Depreciation and devaluation
Depreciation a fall in the price of one currency relative to another
Devaluationan abrupt lowering of value of a currency by government
o Appreciation and revaluation
Appreciation a rise in the price of one currency relative to another
Revaluation raises the official price of a currency by government.
Effects on Exchange Rates of
55
o
o
Trade Flow import relative to exports ; more exports means a stronger

currency, more imports means weaker currency.
Capital Flows/Interest Rate Changes If interest rates increase in a country
peple will want t deposit money in there because the long term return is better.
therfore the deman will rise and the currency will appreciate. Capital here
refers to investment which will also create demand for the currency.
Inflation means the overall average cost of goods/services has gone up.
People will want money where there is the lowest inflation so to keep its
value. And the opposite is true.
o
o
Speculation expectations !! If speculators anticipate an increase in the price

of a currency they will begin buying it, thus pushing its price up.
Use of Foreign Currency Reserves countries have currency reserves for
specific purposes to intervene by selling a type of currency to lower the value
or by buying to increase the value.
Ex. if the price of the dollar was increasing, central banks of other
countries who are worried, would sell dollars to increase the supply of
$ thereby, lowering the price.
Relative advantages and disadvantages of fixed and floating rates

Fixed
Floating
Advantages
1. Stable exchange rates provided a basis 1. Automatic adjustment of imbalances
for business expectations
2. Stability encourages increased trade
2. Reduced need for reserves in theory no
need for reserves at all
3. Reduced danger from exchange
3. Relative freedom to make internal economic
speculation
policy
4. Discipline is imposed on internal
4. Exchange rate changes smoothly
economic policy
5. Domestic price stability is endangered 5. May reduce speculation as rates move
by import price changes
freely up or down
Disadvantages
1. Large reserves are required
1. Increased uncertainty for traders
2. Internal domestic policy is largely
2. May increase speculation and overshooting
dictated by external factors
of long term exchange rates
3. No automatic adjustment danger of
3. Lack of discipline over the domestic
large changes in rates
economy
Advantages and disadvantages of single currencies/monetary integration: Stronger
countries tend to be dragged down by countries using inflationary policy in country,
because the countries with inflationary policy decrease the value of the currency.
However, weaker countries say that they have to live up to harsher standards imposed
on them because of the stronger countries holding the line. There is the advantage of
having one currency that can be used within a region, and so having to deal with fixed
exchange rates (such as China has with most of the world) is not an issue, but the value
of currency has to react to a much larger market with more consumers.
Purchasing power parity theory (PPP): To compare economic statistics across
countries, the data must first be converted into a common currency. Unlike
conventional exchange rates, PPP rates of exchange allow this conversion to
take account of price differences between countries. Recently purchasing power
parity exchange rates have been calculated comparing the cost of a common
basket of commodities in every country. By eliminating differences in national
56
price levels, the method facilitates comparisons of real values for income,
poverty, inequality and expenditure patterns
4.7 Balance of payment problems
Consequences of a Current Account Deficit or Surplus

o A current account deficit is a leakage because you import more than you
export. It means we can live beyond our means, our CPF is beyond our PFF.
That creates many problems and creates dependency on other countries for their
willingness to accept US dollars.
- Ex. Of surplus would be china, whose the opposite they export more
which allows them to have a better GDP and their currency value
would go up except their government is keeping it down.
(Extra Info) Excerpt from article on internet:

March 14, 2006
U.S. current account deficit breaks record at 7% of GDP

The Bureau of Economic Analysis (BEA) announced today that the current account deficit (i.e., the
broadest measure of the U.S. balance of trade in goods, services, and payments to the rest of the
world) soared to an all-time record level of $900 billion, at an annual rate, in the fourth quarter of
2005, an increase of $158 billion over the previous quarter. The U.S. deficit reached 7% of gross domestic
product (GDP), also a record share. For the year, the deficit was $805 billion, and increase of $137 billion,
or 20% over 2004. The growth of the deficit in the fourth quarter was caused by rapid growth in the deficit
on goods and services trade, and a large increase in unilateral transfers, which were temporarily reduced
by payments from foreign insurers for losses caused by hurricanes Katrina and Rita in the third quarter.
The deficit is expected to increase in the future due to growing consumer demand for imports, and rapid
growth in interest payments to foreign holders of U.S. government securities.
The U.S. trade deficit increased 17% in 2005, and 9% in the fourth quarter alone (see Trade Picture,
February 10, 2006). Rapidly rising oil prices and imports explained about two-thirds of the increase. But U.S.
trade deficits increased with every major area of the world, including China (34%), OPEC (18%), Africa
(15%), Europe (15%), Mexico and Canada (13% combined), Latin America (12%), and all Asian countries
besides China (5%). Note that the largest increase was with China, from whom the United States does not
import oil.
Although the U.S. dollar has fallen 11% in value since 2002q2, this decline has not been sufficient
to slow the trade deficit's growth. In fact, the past year actually saw the dollar gain 2% in value,
contributing to the ballooning trade deficit. Much more dollar depreciation will be needed to substantially
reduce or eliminate the deficit. The determination of Asian governments to prop up the dollar to promote
their export-led growth is the largest barrier to needed dollar adjustments.
The rapid growth of interest payments to foreign holders of U.S. Treasury securities has also
contributed to the growth of the deficit, and those payments will grow rapidly in the future for two
reasons. Not only are foreign holdings of U.S. treasuries expected to grow rapidly (see Soaring Federal
Government Payments to Foreign Lenders), but the interest rates paid on those securities are also expected to
increase. Foreign lenders have been financing more than 80% of the growth in the federal budget deficit,
and foreign holdings of treasury securities increased $108 billion in the fourth quarter of 2005 alone.
Total U.S. imports of goods and services hit $2.1 trillion in the second half of 2005 for the first time,
58% more than the $1.3 trillion in exports. To keep the trade deficit from widening further, the growth
rate of exports must exceed the growth rate of imports by 58%. In the absence of a dramatic and
sustained slowdown in U.S. growth, exports can grow more than half again as fast as imports only with a
substantial reduction in the value of the U.S. dollar. When the dollar rises in value, U.S. exports become
more expensive and import prices fall. Between 1995 and 2002, the dollar gained about 30% in value (see
chart). As a result, the U.S. trade deficit has grown from about 1.5% of GDP to 7.0%, which experts
believe to be far above a sustainable level. In order to reduce the deficit back to a sustainable level of less
57
than 3% of GDP, the dollar must fall by at least 30% to 40% to reduce export prices and achieve the
needed increase in export growth, relative to imports. A falling dollar will also help by raising import prices
and thus slowing import growth and increasing demand for goods produced in the United States.
The current account deficit indicates that the United States is purchasing about 7% more than it is
producing. It needs to import about $2.5 billion per day in foreign capital to finance this deficit. As
a result, the net U.S. international investment deficit reached $2.5 trillion in 2004 and likely exceeded $3
trillion at the end of 2005 (net international investment data for 2005 will be released on June 29). Foreign
central banks and other private investors held $2.2 trillion in U.S. treasury securities at the end of the
fourth quarter of 2005; foreign central banks held the sizeable majority (63%) of that government debt.
As long as the U.S. maintains sizeable current account deficits, net borrowing and payments to
foreign investors will continue to grow . The standard of living of future generations will be depressed
by the need to pay for today's heavy borrowing from abroad.
Methods of Correction
o Managed Changes in Exchange rates
o
Reduction in Aggregate Demand/Expenditurethere are different ways to

reduce demand, you can use fiscal policy you increase taxes and/or reduce
gov. spending; or monetary policy-decrease money supply and increase int.
rates; or supply side policies
change in supply-side policies to increase competitiveness ( supply side policies

to use would be: tax cuts, subsidies, encouragement of savings( savings+ lower
int. rates
tax cuts
subsidies
encourage savings [savings + lower int. rates = investment in future]
deregulation
human capital development [education & training]
reduce/illiminate discrimination
infrastructure
free trade
tax rebates wont work because its a one time deal people not to invest
o Protectionism/expenditure-switching policies
Consequences of a Capital Account Deficit or Surplus
o realize the a current account deficit is the same thing as a capital account
surplus. and a currenct account surplus is the same things as a capital account
deficit.
o a capital account deficit is that foreigners are buying more us assets than the us
is buying foreign assets. a big concern like the currency china situation they are
funding our debts and own more american assets causing concerns over
dependency. nationalism is also a factor.
Marshall-Lerner condition
o
the sum of price elasticity of exports and imports (in absolute

value) must be greater than 1 for currency devaluation to have a
positive impact in trade balance
illustrates when a devaluation of a currency occurs and how the balance

of payments will worsen before it improves
J-curve
(scanned picture from Orange Econ Book)
58
time is important in determining elasticity because it takes time for

traders to adjust and for producers to produce more
the diagram graphically portrays how given the situation of a deficit,
the devaluation of a currency can improve the balance of payments
when the country is running a deficit, the curve is constant
at point t1 the currency is devalued, which is followed by a
period of worsening them improving (Marshall-Lerner
condition)
4.8 Terms of trade
Definition of terms of trade:

o terms of trade: ratio of export prices to import prices.
Consequences of a change in the terms of trade for a country's balance of
payments and domestic economy Depending on whether to terms of trade are
good for a country or not then
The significance of Deteriorating terms of trade for developing countries
o If its an LDC it will probably have unfair terms of trade. That means that while
they are exporting inelastic, low price primary products they have to pay much
more for manufacturing goods from other countries, which tend to be elastic.
Developing becomes much harder because they are forced to pay more for less
while they make more goods for less money.
Measurement of terms of trade
Export prices are weighted in terms of importance (which is determined

by the percentage of total export expenditure on the good); this
weighted index is set to 100 in the base year, the reference point for
future changes
Import prices are then evaluated similarly and also set to 100
measured mathematically by the formula:
Index of Export prices 100
*
= Terms of Trade
Index of import prices
1
Causes of changes in a country's terms of trade in the short-run and long-run
in short run: day by day changes o a floating exchange rate will cause
the relative prices of exports and imports to change
these are dominated by capital movement and can be very large
in long run: movement of domestic prices which determines the trend

of exchange rates and terms of trade
domestic prices are determined by domestic inflation

rate and productivity
relative inflation rate is important for international
trade (i.e. whether domestic prices are rising more or
less quickly than those o fthe main trading partners)
if foreign inflation is higher the terms of trade will
worsen
in long run relative productivity also will determine domestic prices

move relative to foreign prices
higher productivity means lower prices
59
higher productivity countries will produce lower cost

goods than other and their export prices will rise less
quickly; exports will be relatively more attractive as
terms of trade fall
Elasticity of demand for imports and exports
LDCs tend to produce goods/services from the tertiary sector (e.g. raw
materials), whereas developed countries tend to produce goods/services
from the primary sector (e.g. education).
That considered, goods/services from the economy of an LDC tend to
have an elastic demand, whereas goods/services from the economy of a
Developed Country are likely to have an inelastic demand
In regards to imports and exports, because LDCs have goods/services
with an elastic demand, their goods/services will not always be
demanded, whereas a DCs goods/services will be demanded, thus
influencing the terms of trade and the DC is likely to have more
favourable terms of trade
60
Section 5: Development economics

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 section 3. 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.
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.
5.1 Sources of economic growth and/or development
Natural Factors: the quantity and/or quality of land or raw materials

O Land and raw materials are often scarce; how well the nation can use
their resources effectively for production will influence their GDP
growth.
Human Factors: the quantity and/or quality of human resources
O Human Capital: the knowledge and skills possessed by the workforce.
E.g. the high productivity of the US economy results from using
highly educated workers in capital-intensive production
processes.
Physical Capital and Technological Factors: the quantity and/or quality of
physical capital
O Physical capital refers to land, labour and factors of production. The
amount of capital is directly tied to achieving growth and/or
development because its a factor along with investment for an increase
in GDP.
Institutional Factors that contribute to development
O banking system: those who take on the central bank role in a nation
E.g. in the US- the Federal Reserve Bank can institute monetary
policy (the use of interest rates and money supply) to change
aggregate demand.
O education system: programs by which the population are able to get a
good education, thus increase human capital by providing greater
productivity and/or innovation, but also reducing the threat of structural
unemployment
E.g. better-educated and trained individuals (such as those who
have gone to college) can also run a business and country more
efficiently.
O Health care: gives people more opportunities to remain healthy, or get
treatment if ill; it results in people being able to live long and happier
lives, contributing to a higher quality of life (economic development)
61
Infrastructure: Defined as the transportation, communications,

education, judicial and other institutional systems that facilitate market
exchanges. Infrastructure reduces opportunity costs.
E.g. increasing productivity by transporting people to work
results in increased goods and at a lower cost. Therefore business
can save money and sell their goods at lower prices.
Other benefits are increasing trade and investment
through good environment incentives.
O Political stability: an unstable government is subject to corruption, wars
and change of leaders, which can lead to widespread poverty, unstable
interest rates and poor infrastructure.
These factors also correlate with the supply side policy levers for increasing
supply and therefore economic growth.
O
5.2 Consequences of growth
Externalities: costs (or benefits) of a market activity borne by a third party.

O E.g. a positive externality is education. The private costs are less than the
cost of it when you think of the total benefits that education produces
(see section 2 for diagrams)
Income Distribution: the differences in income in groups of the population
effect for whom goods and services are produced. As the income becomes more
equally distributed it shows how the standard of living is improving because
there isn't such a disparity between the rich and the poor.
Sustainability: development where consideration is given to the quality of life
of the future as well as of current generations.While you can have an increase in
GDP by cutting down trees, a natural resource, its unsustainable development
because you will need to stop and fewer trees causes environmental problems
and concerns. Economic growth is defined an increase in GDP per capita,
contrasting with development which means that there is an increase in the
quality of living. If a country wants both growth and development its directly
related to having sustainable development.
5.3 Barriers to economic growth and/or development
Poverty Cycle: low incomes low savings low investment low

incomes
Low
education/
skills
Low
productivity
/ low
paying jobs
Low/ no
growth
Low
income
Low
investments
Low
savings
62
Institutional and Political Factors

O Ineffective taxation structure e.g. regressive tax
Laffer Curve: as taxes increased (from fairly low levels), tax
revenue received by the government would also increase.
However, there would come a point as tax rates where people
would not regard it as worth working so hard. This lack of
incentives would lead to a fall in income and therefore a fall in
tax revenue. The logical end point is with tax rates at 100%
where no one would bother to work (because all their earnings
are being taken away) and so tax revenue would become zero.
Drawn on a diagram this gives the Laffer curve: T* represents the
optimum tax rate where the maximum amount of tax revenue can
be collected.
O lack of property rights: if there are no property rights for protection of
ownership and possession as belonging to legal individuals then what
incentive is there for developing new technologies? The individual
would not get the credit, and it could be claimed by everyone, so there is
no incentive.
O Political instability (see above)
O Corruption (see above)
O Unequal distribution of income
O Formal and informal markets i.e. the black markets which sell goods
illegally
O Lack of infrastructure
International trade barriers
O Overdependence on primary products: When LDCs concentrate on
producing and exporting primary products they are vulnerable to prices
decreasing because of over-supply. Primary products are characterized by
being low priced and inelastic.
O consequences of adverse terms of trade: unfair terms of trade results in
countries being unable to buy the exports they need because they are so
expensive.
e.g. some LDCs may require high levels of healthcare and
medication to combat the problems of high mortality, but they are
unable to purchase such goods because healthcare and doctors are
so expensive (and typical to developed nations)
O consequences of a narrow range of exports
O protectionism in international trade: e.g. Quotas, Tariffs, Subsidies
International financial barriers
O Indebtedness: countries wont want to let you borrow more money,
leaves you vulnerable to external shocks.
O non-convertible currencies: currencies that are not wanted because they
are unstable or not worth very much.
O capital flight: the movement of capital out of a country. Capital in this
63
case refers to investment; typical when inflation begins to occur or

political instability results in fear (or other similar expectations) for the
currency
Social and cultural factors acting as barriers
O Religion
O Culture
O Tradition
O Gender issues
5.4 Growth and development strategies
Harrod-Domar Growth Model: This model suggests savings provide the funds
that are borrowed for investment purposes. The model suggests that the
economy's rate of growth depends on: the level of savings and the productivity
of investment i.e. the capital output ratio
O The Harrod-Domar model was developed in the 1930s to analyze
business cycles. It was later adapted to explain economic growth.
Economic growth depends on the amount of labor and capital.
Developing countries have an abundant supply of labor. So it is a
lack of physical capital that holds back economic growth hence
economic development.
More physical capital generates economic growth.
Greater net investment (if there is no corruption or instability)
leads to more producer goods (capital appreciation), which
generates higher output and income. Higher income allows higher
levels of saving. Therefore, breaks the cycle of poverty.
Structural Change/Dual Sector Model:
O It was based on the assumption that many LDCs had dual economies
with both a traditional agricultural sector and a modern industrial sector.
The traditional agricultural sector was assumed to be of a subsistence
nature characterized by low productivity, low incomes, low savings and
considerable underemployment. The industrial sector was assumed to be
technologically advanced with high levels of investment operating in an
urban environment.
O The modern industrial sector would attract workers from the rural areas.
Industrial firms, whether private or publicly owned could offer wages
that would guarantee a higher quality of life than remaining in the rural
areas could provide. Furthermore, as the level of labor productivity was
so low in traditional agricultural areas people leaving the rural areas
would have virtually no impact on output. Indeed, the amount of food
available to the remaining villagers would increase as the same amount
of food could be shared amongst fewer people. This might generate a
surplus which could them be sold generating income.
O Those people that moved away from the villages to the towns would earn
increased incomes and this crucially generates more savings. The lack of
development was due to a lack of savings and investment. The key to
development was to increase savings and investment. Urban migration
from the poor rural areas to the relatively richer industrial urban areas
gave workers the opportunities to earn higher incomes and crucially save
64
more providing funds for entrepreneurs to investment.

A growing industrial sector requiring labor provided the incomes that
could be spent and saved. This would in itself generate demand and also
provide funds for investment. Income generated by the industrial sector
was trickling down throughout the economy.
Types of Aid
O Bilateral: one country to another
Multilateral: many countries to one country
O Grant Aid: provision of funds to developing countries without
repayment obligation on the basis of requests from the governments of
developing countries for their economic development and welfare
Soft loans: giving them a break, no interests or lower interests
O Official Aid: given by one government to another government
O Tied Aid: aid given with strings attached
E.g. possibly an agreement to vote on an issue in front of an
international council, or to trade x amount of goods/service with
said country
Export-led Growth/Outward-Oriented Strategies: Exports are good
injections in the economy. Leading to outward growth, an expansion of the
production possibilities curve.
Import Substitution/Inward-Oriented Strategies/Protectionism: substituting
imports with domestically produced goods; similar to protectionism, it supports
domestic industries (rather than favoring foreign industries) but can result in
higher prices for the consumer, and poorer foreign relations (because some sort
of protectionism is necessary so as to hinder/decrease the amount of foreign
goods/services being bought within the country)
Commercial Loans: short-term renewable loan used to finance a company's
immediate working capital needs.
Fair Trade Organizations: Fair Trade organizations provide critical technical
assistance and support such as market information, product feedback and
training in financial management. Unlike conventional importers, Fair Trade
organizations establish long-term relationships with their producers and help
them adapt production to changing trends.
O Note: The word "fair" can mean a lot of different things to different
people. In alternative trade organizations, "Fair Trade" means that trading
partnerships are based on reciprocal benefits and mutual respect; that
prices paid to producers reflect the work they do; that workers have the
right to organize; that national health, safety, and wage laws are
enforced; and that products are environmentally sustainable and conserve
natural resources.
Micro-Credit Schemes: Micro-credit is the name given to extremely small
loans made to poor borrowers. A typical micro credit scheme involves the
extension of an unsecured, commercial-type loan at interest to poverty stricken
borrowers.
O It is based on the recognition that the latent capacity of the poor for
entrepreneurship would be encouraged with the availability of smallscale loans and would introduce them to the small-enterprise sector. This
could allow them to be more self-reliant, create employment
opportunities, and, not least, engage women in economically productive
O
65
activities. Currently, there are estimated to be about 3,000 microfinance

institutions in developing countries. These institutions also help create
deeper and more widespread financial markets in those countries.
E.g. in China two women used their loans from the scheme to
build plastic greenhouses to grow vegetables all year round. They
repaid the first loans, and have even more ambitious plans for the
second loan they're going to take out: this time, their set on a
guest house, a car park -- even a restaurant. But the micro-credit
scheme, funded by UNICEF in China, does more than help
women on to the first, vital step of the economic ladder. It also
helps them gain friends, basic knowledge on how to improve
their health -- and, crucially, self-esteem.
Foreign Direct Investment: Investments by foreigners directly into another
country, which leads to stimulation of the economy where more people can be
hired and trained (therefore building the human capital in the country); it may
also result in building infrastructure. Negative aspects: nationalism in the
country causes the country to want to feel self sufficient and by accepting the
foreign investment, the country may feel less self sufficient; also the best paying
jobs tend to go to the foreigners running the investment and most profits tend to
go to the foreigners
O E.g. building a factory in another country.
Sustainable Development
5.5 Evaluation of growth and development strategies
Evaluation of the following in terms of achieving growth and/or

development
O Aid and Trade
Aid has advantages and disadvantages for countries. By giving
aid to LDCs the problem can be perpetuated because with that
money the government is not forced to do fix the problems
affecting the country. Also the money may not go to good use but
instead be used by these countries for their leaders own personal
use or to fund wars. Free trade is the best policy to achieve
growth and development. While its true that trade can have
negative outcomes the long-term benefits outweighs all that. Free
trade allows countries to use their comparative advantage to the
goods and services they are good at with other countries exports
that are needed. It expands the production possibilities curve. It
allows a country to also live beyond their means as with the
United States. Free trade is used effectively helps all sectors to
improve leading to long term sustainability and development.
What is better for a country to develop and/or grow economically, free trade or aid?
Aid is Good
Aid is Bad
-Mainline Injection
-Help the economy as a whole i.e. productivity,
build markets
-Innovation, Technology causes outward
-hard to get money

- a never ending process for more aid
-creates dependency
countries have to be nice for money
66
movement of PPF
-create peace and stability, end to the poverty cycle
-Increase standard of living
-money can go to the wrong places (such as

Dictatorship or individuals)
-no incentive to improve
-DEBT SERVICING making the payments for
interest rates.
-Nationalism is low
Free Trade is the Way !!
No trade
- US could produce all the things it imports but it

would be very expensive and problems for lack of
resources. Its better to concentrate on our
comparative advantage (that refers to producing
that good for a less opportunity cost).
-Human Rights consideration- perpetuating the

problems such as young children working
-Political
-Environmental
-Dependence
- LDC have primary products which have a low
price and are inelastic
-Unfair advantage of poor countries
Unfair terms of trade-low prices for their stuff but
have to pay high prices for our stuff
- crowding out of domestic businesses
-to some extent dumping (when a large quantity of
goods/services is injected into a market at an
artificially low price) is a threat
-Universally accepted --Free Trade Helps

everybody
-trade expands Production Possibilities curve. We
have more stuff. Free trade unlimited supply of
goods
-if there is net exports were would be selling more
stuff thereby consuming less than we are producing
the US is net imports so we can have a higher
standard of living
-Brings injection of hard currency (currency
widely respected around the world)
* breaks down the cycle of poverty
-self sufficient
-unlike loans doesnt have to be paid back
-provides jobs
promotes good relationships between trading
countries, peace and friendship for all
Market-led and Interventionalist Strategies:

While some people believe that the economy is self-adjusting
others do not, they believe that the economy is inherently
unstable. Thats the central conflict between the Classical
Economist and Keynesian. Whether government intervention
helps or is detrimental to the economy depends on what you
believe; there is evidence to contradict both sides. As in the Great
Depression, some believed that the economy would self-adjust
but it didn't happen. Also seen was that though the interest rates
were low, people had low expectations so the recession
continued. This shows how both policies don't have control over
the market, just some influence that can help. To some extent it
should be government intervention, which seeks to stabilize the
market when needed.
The role of international financial institutions
O the International Monetary Fund (IMF): deals mostly with the
financing part of helping LDCs develop, such as money set aside for
O
67
O
O
O
third world countries that need money to stabilize their currency.

Example is when the baht plunged in value, the IMF fund gave them
money but there were strings attached.
the World Bank: its mission is aimed to help developing countries grow.
It works hands on, by going to countries and trying to plan what would
work best to help that specific country attain growth. Provide lowinterest loans, interest-free credit and grants to developing countries for
education, health, infrastructure, communications and many other
purposes. It also works by promoting free trade.
private sector banks: are able to help other countries with loans if
needed and able.
non-governmental organizations (NGOs): the United Nations helps
many countries to develop and survive.
multinational corporations/trans-national corporations
(MNCs/TNCs): Companies such as MacDonalds, Ford, Coca Cola that
have companies in many nations. These companies provide jobs and help
with development to some extend because they build roads, buildings,
and better communication systems.
commodity agreements: Commodity markets are characterized by
instability and uncertainty. This uncertainty may arise due to fluctuations
in the market prices due to market conditions changing; changes in prices
due to changes in exchange rates and changes in foreign government
protectionist measures. Often producers (and sometimes consumers) of
commodities will co-operate together in an attempt to introduce more
stability into the markets. These agreements attempt to stabilize prices.
Indeed with most primary commodities they are used to prevent prices
from falling below certain levels. A production quota system such as the
International Coffee Agreement operated by the International Coffee
organization between 1962 and 1989 and a buffer stock system.
Other helpful definitions:

Poverty line: A level of income below which people are deemed poor. A global
poverty line of $1 per person per day was suggested in 1990 (World Bank 1990).
This line facilitates comparison of how many poor people there are in different
countries. But, it is only a crude estimate because the line does not recognize
differences in the buying power of money in different countries, and, more
significantly, because it does not recognize other aspects of poverty than the
material, or income poverty.
Privatization: The process of making state-owned enterprises private. Also
termed denationalization.
{as of 5/3/2006}
68
Resources:
1. Economics for International Students-- IB Syllabus
http://www.cr1.dircon.co.uk/TB/contents.htm
2. The Library of Economics and Liberty
Article on Fiscal Policy: http://www.econlib.org/library/Enc/FiscalPolicy.html#top
Article on Monetary Policy: http://www.econlib.org/library/Enc/MonetaryPolicy.html
3. Biz Ed Resources Diagram Bank, glossary, study skills (i.e. essay writing), links
to journals http://www.bized.ac.uk/reference/index.htm
4. Chronology of Money
http://www.ex.ac.uk/~RDavies/arian/amser/chrono.html
5. Global Articles, definitions and such. More Web resources:
http://www.globalpolicy.org/globaliz/websites.htm
6. www.google.com
7. Economics syllabus
http://peernet.lbpc.ca/economics/Assets/Notes-Section-1-Introduction-2004-06.doc
http://peernet.lbpc.ca/economics/Assets/Notes-Section-4-International-Standard-2004-0
8. Wikipedia/Wikibooks
http://en.wikibooks.org/wiki/IB_Economics:_Introduction_to_Economics
http://en.wikibooks.org/wiki/IB_Economics:_Microeconomics
9. Schiller, Bradley The Economy Today
10. Economics Syllabus (HL Material Notes)http://www.cr1.dircon.co.uk/TB/2/monopoly/contestablemarkets.htm
69

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Table of Contents

Section 1: Introduction to Economics 1

Section 1: Introduction to economics

o entrepreneurship: assembling of resources to produce new or improved

Production Possibility Frontier

Point B: potential output

Definition of markets with relevant local, national and international

market: any institution or mechanism that brings together buyers

Describe the following perfect competition, monopoly, oligopoly as different

Perfect competition: a market in which no buyer or seller has market power.

Monopoly: a firm that produces the entire market supply of a particular

Monopolistic competition: a market in which many firms produce similar

Demand: the ability and willingness to buy specific quantities of a good at

Law of demand (with diagrammatic analysis): the quantity of a good

Fundamental distinction between a movement along the demand curve

Movement: the price of

Shift: the demand curve

Exceptions to the law of demand (upward-sloping demand curve)

ostentatious (Veblen) goods: goods that are bought as a display of wealth,

role of expectations: if the expectation for a good/service is that the price

supply: the ability and willingness to sell (produce) specific quantities of a

Law of supply (with diagrammatic analysis): the quantity of a good

As the supply curve

Taxes: the money that

Subsidies: amount of money

Movement along supply curve vs. shift on the supply curve:

In a shift in supply, the

Equilibrium: when the quantity supplied is equal to the quantity demanded

DAs a result of a shift in demand

Maximum price: price ceiling, prices cannot go above this price

Minimum price: price floor, prices cannot go under this price.

Price support/buffer stock schemes:

Commodity agreements: when producers of commodities co-operate

Price Elasticity of demand:

Formula: PED = (% change in quantity demanded) / (% change in price)

Definition: measurement of the response of consumers to a change in price.

Determinants of price elasticity of demand:

Formula: CED = (% change in demand for good x) / (% change in price of

Significance of sign with respect to complements and substitutes:

Income Elasticity of Demand:

Definition: the percentage change in demand for a good compared to the

Formula: IED = (% change in quantity demanded) / (% change in income)

Price Elasticity of Supply:

Definition: measurement of the responsiveness of the quantity supplied to a

Formula: PES = (% change in quantity supplied) / (% change in price)

Possible range of values:

Determinants of price elasticity of supply:

Applications of concepts of elasticity:

Cross-elasticity of demand: relevance for firms

Ex: Coca-Cola is considering whether or not to lower the price of its

Significance of income elasticity for sectoral changes (primary >

Flat rate and ad valorem taxes

e.g. 1 Swiss franc on a bottle of whisky

percentage (ad valorem) tax: tax amount that is expressed as a percentage

when the price of a good changes the tax going to government

during times of inflation, the value of money decreases,

Incidence of Indirect Taxes and Subsidies

basically: who pays how much of the tax (buyers or consumers)

Diagramatic Analysis and Representation:

incidence of the tax: equally shared between buyers and sellers

this could be viewed as a hardship for consumers and

For an example: see pg 111 of Glanvilles Economics from a Global Perspective

Implication of elasticity of supply and demand for the incidence (burden) of

Perfectly Inelastic Demand: