Econ Intro PDF

Introduction to economics
A. Witztum
EC1002, 2790002
2011
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 100 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 4 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
A. Witztum MA, PhD (LSE), Professor of Economics, London Metropolitan University and the
London School of Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please use the form at the back of this guide.
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Published by: University of London
University of London 2005
Reprinted with minor revisions 2011
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Contents
Contents
Introduction ............................................................................................................ 1
Aims and objectives ....................................................................................................... 2
Learning outcomes ........................................................................................................ 2
About levels of knowledge............................................................................................. 2
Methods of writing ........................................................................................................ 3
About economics ........................................................................................................... 4
Structure of the guide .................................................................................................... 4
Reading ........................................................................................................................ 5
Online study resources ................................................................................................... 6
Working with others ...................................................................................................... 7
Examination advice ....................................................................................................... 7
Some basic mathematical tools ..................................................................................... 8
Technical preface .................................................................................................... 9
Learning outcomes ........................................................................................................ 9
Introduction .................................................................................................................. 9
Sets and specifications ................................................................................................... 9
Numbers .................................................................................................................... 11
A point in a plane ....................................................................................................... 13
Functions and graphs ................................................................................................. 14
Self-assessment .......................................................................................................... 21
Chapter 1: The study of economics ..................................................................... 23
Learning outcomes ...................................................................................................... 23
Reading ..................................................................................................................... 23
Economics as a theory ................................................................................................ 23
The fundamental economic problem ............................................................................ 28
Specialisation and trade .............................................................................................. 36
The shape of the PPF and the importance of marginal changes .................................... 39
Self-assessment .......................................................................................................... 42
Test your understanding .............................................................................................. 42
Answers ...................................................................................................................... 44
Chapter 2: Individual choice ................................................................................. 49
Reading ..................................................................................................................... 49
The role of demand .................................................................................................... 49
Rationality .................................................................................................................. 53
Preferences: the relationship individuals have with the world of economic goods ......... 56
Deriving demand for economic goods ......................................................................... 68
Market demand .......................................................................................................... 78
Self-assessment .......................................................................................................... 82
Answers ...................................................................................................................... 84
Chapter 3: Production and the behaviour of the firm .......................................... 93
Reading ..................................................................................................................... 93
Production functions .................................................................................................... 93
i
02 Introduction to economics
The behaviour of the firm........................................................................................... 102

Producer behaviour with respect to output ................................................................. 108
A numerical example ................................................................................................ 112
The firm as an organisation: a note ............................................................................ 114
Self-assessment ........................................................................................................ 117
Answers .................................................................................................................... 118
Chapter 4: Market structures ............................................................................ 125
Learning outcomes .................................................................................................... 125
Reading ................................................................................................................... 125
The basic principle of equilibrium in Economics ......................................................... 126
The determinants of market structure ........................................................................ 129
The model of perfect competition .............................................................................. 131
The monopolist ......................................................................................................... 135
Monopolistic competition ......................................................................................... 140
A note on strategic behaviour ................................................................................... 147
Self-assessment ........................................................................................................ 152
Answers ................................................................................................................... 155
Chapter 5: The market for factors ..................................................................... 169
Reading ................................................................................................................... 169
Capital, labour and distribution ................................................................................. 169
The demand for factors ............................................................................................. 172
Supply of labour ....................................................................................................... 180
Market equilibrium ................................................................................................... 185
Self-assessment ........................................................................................................ 187
Answers ................................................................................................................... 188
Chapter 6: General equilibrium and welfare economics ................................... 191
Reading ................................................................................................................... 191
Vertical and horizontal dimensions of general equilibrium ...................................... 192
Pareto efficiency in an exchange economy ................................................................. 208
A note on welfare economics .................................................................................... 216
Self-assessment ........................................................................................................ 217
Answers ................................................................................................................... 218
Chapter 7: Externalities and public goods ........................................................ 223
Reading ................................................................................................................... 223
Externalities and incomplete markets ........................................................................ 224
Public goods and their efficient provision .................................................................. 232
Information and incentive compatibility: a note ........................................................ 237
Self-assessment ....................................................................................................... 239
Chapter 8: Aggregation and the macroeconomic problem ................................ 241
Introduction .............................................................................................................. 241
The problem of aggregation ....................................................................................... 243
Chapter 9: The determinants of output .............................................................. 251
Reading ................................................................................................................... 251
Says Law and general equilibrium ............................................................................ 252
ii
Contents
Output and markets .................................................................................................. 260

Market imperfections and unemployment .................................................................. 264
Self-assessment ........................................................................................................ 272
Chapter 10: The goods market in the closed economy ...................................... 273
Reading ................................................................................................................... 273
Closed economy without a government ..................................................................... 273
The complete goods market: closed economy without a government........................... 284
Closed economy with government ............................................................................ 287
The IS representation of the goods market equilibria .................................................. 290
Self-assessment ......................................................................................................... 293
Answers .................................................................................................................... 294
Chapter 11: Money and banking ........................................................................ 299
Reading ................................................................................................................... 299
Introduction .............................................................................................................. 299
The demand for liquid assets .................................................................................... 302
The supply of liquid assets ......................................................................................... 303
Equilibrium in the liquid assets market ....................................................................... 306
Deriving the LM (the liquid assets market) ................................................................. 308
Chapter 12: General equilibrium, employment and government policy ........... 311
Reading ................................................................................................................... 311
The macro notion of general equilibrium ................................................................... 311
The algebra of macroeconomics general equilibrium ................................................. 313
The geometry of general equilibrium: IS LM ........................................................... 314
Some comparative statics ......................................................................................... 315
Internal debt financing .............................................................................................. 320
Borrowing from the central bank (printing money) ..................................................... 322
Chapter 13: Prices, inflation and unemployment ............................................... 327
Reading ................................................................................................................... 327
Prices and output ...................................................................................................... 327
The aggregate demand: yet another representation .................................................... 328
The problem with aggregate supply ........................................................................... 329
Inflation and the Phillips curve ................................................................................... 331
A price-level interpretation ........................................................................................ 336
Self-assessment ......................................................................................................... 337
Answers .................................................................................................................... 339
Chapter 14: The open economy .......................................................................... 347
Reading ................................................................................................................... 347
The national accounts for the open economy ............................................................. 347
The goods market ..................................................................................................... 348
Exchange rate determination and the money sector ................................................... 351
General equilibrium in an open economy .................................................................. 358
Self-assessment ........................................................................................................ 361
Answers ................................................................................................................... 364
iii
Appendix: Sample examination paper ............................................................... 385

Section A ................................................................................................................... 385
Section B ................................................................................................................... 387
iv
Introduction
Introduction
You are about to embark on the study of Introduction to economics.
Economics is a discipline which deals with the broad issue of resources
allocation. Within it, an ongoing debate is raging over the question of
how best to organise economic activities such that the allocation of
resources will achieve that which society desires. A debate which feeds
into political discussions in a way that exposes all members of society to
the consequences of economic analysis. The academic side of Economics
provides the concepts, tools of analysis and reasoning upon which such a
debate is based. To be able to understand the logic of an existing system
or the motivation behind the drive for its change one must possess a
reasonable understanding of economics as an academic discipline. Beside
the obvious benefits to society from having better informed citizens, such
an understanding can provide one with the ability to benefit most from
the system; an ability and drive which are naturally taken into account in
economic analysis.
To some of you, economics is not the main area of study and this
introductory course is just one of those things which you have to endure
in order to receive the academic qualification. May I remind you that
the purpose of an academic programme is not to tell you what various
things are. Instead, its aim is to help you develop academic skills, the most
important of which is a creative and critical way of thinking about almost
anything. The fact that not all students are therefore required to take
courses only in mathematics, logic and philosophy is merely an indication
that nowadays, we have a more sophisticated conception of what critical
and creative thinking means. We came to realise that different areas of
our interest have their own particular features which are necessary for the
development of relevant academic skills. Of course, studying mathematics,
logic and philosophy will not reduce ones critical abilities but they cannot
provide the entire scope of considerations which the social sciences demand.
Learning what things are will provide you with some knowledge but
will not provide you with the skill of analytical thinking. Therefore, the
academic programme has been carefully design to provide students of
the social sciences with the necessary exposure to the more fundamental
methods of analysis that will, we hope, equip you for life with an ability
to understand the broad dimensions of society, contribute to it and benefit
from it. The implications of this is that the course which you are now
beginning to study will sometimes appear intimidating. It is indeed a
complex subject. Still, it is our view (and experience) that with patience
and work everyone can gain the necessary command over it.
The purpose of this subject guide is to assist you in your endeavour
and to guide you through the labyrinth of material, levels of knowledge
and examination standards. There are, as I am sure you know, numerous
textbooks at the introductory level. However, most of them cater for
the American market with its unique characteristics and in particular,
the notion of general undergraduate studies. This is in contrast with
the British (and European) system where degrees are specialised. This
means that the level of knowledge, in economics, which is required of a
student by the end of their study is much greater than that which would
be required of them had they pursued a general degree. Consequently, the
1
spacing of that knowledge over three years requires a much more rigorous
introductory course than is offered by most textbooks. I would therefore
strongly advise against picking a single textbook and concentrating ones
effort on it. Instead, you should conduct your study along the lines and
recommendations of this subject guide. In it you will find a well-focused
organisation of the subject which will highlight those things which we
deem to be important. You will find, on each topic, references to readings
from a set of textbooks which will help you understand each topic through
the use of different methods of exposition. At the end of each topic
you will find worked-out past exam questions which will enable you to
enhance your understandings as well as help you prepare yourself for the
examination.
There are a few sections in the subject guide which are slightly more
difficult than others. They are there because we wish to cater for the
interested student as much as we would like to support the one who
is struggling. We believe that as time is an important factor in the
learning process, even the struggling student will reach the point in
time where they will wish to expand their knowledge. Naturally, as we
must distinguish between the process and learning from the process of
assessment, the sections in the guide which we deem difficult will be
clearly marked. If they are not essential for examination purposes, you
will be advised that you may skip the section and come back to it at your
leisure.
Aims and objectives

The aims of this course are to:
introduce students to an understanding of the domain of economics as
a social theory
introduce students to the main analytical tools which are used in
economic analysis
introduce students to the main conclusions derived from economic
analysis and to develop students understanding of their organisational
and policy implications
enable students to participate in debates on economic matters.
Learning outcomes
At the end of this course and having completed the Essential reading and
activities, you should be able to:
define the main concepts and describe the models and methods used in
economic analysis
formulate problems described in everyday language in the language of
economic modelling
apply and use the main economic models used in economic analysis to
solve these problems
assess the potential and limitations of the models and methods used in
economic analysis.
About levels of knowledge

In contrast with the breadth of some introductory textbooks,
Introduction to economics is much more focused. This means that
instead of getting acquainted with a little bit about a lot of things, we
2
Introduction
wish you to gain real command over fewer things. The key difference here
is between getting acquainted and gaining command. For the former,
one would normally need to know about economic concepts. To gain
command, however, we want students to know the concepts. Evidently,
there is a profound difference between studying for these two kind of
purposes.
To know about economics it is indeed sufficient to read about the
various economic concepts. Then, whenever you encounter them you
will understand what is meant by these concepts. Almost like being able
to recognise the meaning of words in a foreign language. But this, as I
am sure you will agree, is far from being sufficient in order to be able to
speak the foreign language. To achieve this, one would have to learn a bit
of grammar too. Most textbooks tend to teach the words which are used
in economics. We wish to teach you its grammar.
To know what the concepts are one must not only acquaint ones self
with the meaning of these concepts but one must also be able to use them.
This means that after learning about the concept, one must do as many
exercises as possible. Exercises, however, can sometimes be misleading.
A question like explain the meaning of concept A is not an exercise
question. An exercise is a problem where the student is expected to:
a. choose the right model, or concept, with which to deal with the problem
b. use the model, or the concept, to derive a solution to the problem.
In this subject guide, you will find such exercises. You will also be
provided with the answer. However, to make full use of the guide it is
recommended that before you examine our solution to the problem, you
try to solve it yourself. When you then compare your own solution to
the one which we propose, if they do not match, it is not sufficient for
you to say Oh, now I understand the answer. You probably have only
obtained what we may call passive understanding. To reach the level
of active understanding you must go over your own solution and try
to understand what it is that led you to answer the way you did. Only by
clearing away embedded misconceptions will the road be clear to learn the
new language.
Methods of writing
The essay-type or discursive writing is a method of exposition becoming
the getting acquainted approach. In such a format, one tends to write
about things and to describe them. For the other approach which
requires active understanding one would need to resort to a more
analytical form of discourse. A form of discourse where the student is
making a point or, to use a more traditional word from rhetoric, where
one is trying to persuade.
To think about writing in this way will help a great deal. It forces the
student first to establish what it is that they wish to say. Once this has
been established, the writer must find a way of arguing the point. To
make a point, as one may put it, basically means to know the answer to
the questions before one starts writing. It is my impression from past
examination papers that many students try to answer questions while
they are writing the answer. Any question normally triggers a memory
of something which one had read in the textbook. It somehow opens the
floodgates and students tend to write everything they know about the
subject with little reference to what the question is really about. This is
not what this course is all about. We want the student to identify the tools
3
of analysis which are relevant in each question; we want them to show us

that they know what these tools are; and, lastly, we want students to be
able to use the tools.
The examination questions are normally designed in such a way that
will allow the Examiners to view those different levels of students
understanding. Questions are written in a problem form which then
require that the student will be able to establish which framework analysis
is more appropriate to deal with which problem. In their exposition,
students are then expected to properly present this framework. Only then
are they expected to solve the problem within this framework. Although
some questions may have a general appeal, we do not seek general
answers. You must think of the examination as an exercise rather than a
survey.
About economics
Economics is a broad subject. A quick glance at some of the major
textbooks is sufficient to make even the bravest of students faint. Apart
from the scary geometrical and algebraic expositions, there is the issue
of quantity. The subject matter of economics appears to be so enormous
that one begins to wonder whether studying it is not just another form of
Sisyphean work.1
While it is true that the subject matter of economics is so broad it does
not follow that the study of it should become so laborious. What exactly
is economics? The answer is that economics is basically a way of
thinking. In the narrow sense of the word it is a way of thinking about
those things which are defined as economics activities. In a broader sense,
it is a method of thinking about all questions concerning the organisation
of society. The scope of the subject, therefore, may sometimes appear as
almost unlimited. However, the subject itself the principles of analysis
is very well defined and well under control.
The purpose of this course is to introduce the student to the fundamentals
of economics analysis. This means that what we are concerned with is
the study of the way economics think rather than the extent of what they
have said.
This subject guide will help you in this endeavour as I intend to highlight
the analytical points while spending less time on applying those
principles to various social issues. It is a kind of alternative textbook. The
precondition for passing the final exam is to have a good command of all
things which are presented in this subject guide.
Structure of the guide

With the exception of Chapters 1 and 6, you should start by doing
the suggested reading given at the beginning of each chapter. Then, you
should work through the relevant chapter in the subject guide, attempting
the questions and exercises throughout.
Each chapter begins by listing the main points of the issue being discussed.
You should always go back to this list after you have worked through the
chapter to ensure that you have a satisfactory understanding of each of
these items before you move to the next chapter.
You will, no doubt, find some parts of this subject guide slightly more
difficult than others. This is because we wish to cater for students at
all levels of ability. Naturally, as we must distinguish the process of
learning from the process of assessment, the sections in the guide which
4
1
Sisyphus, king of
Corinth, is a figure from
Greek mythology who
was doomed, for his
tyranny and wickedness,
to endless labour in the
underworld. He had to
roll uphill a heavy rock
which would always slip
from his arms to spin
down to the bottom.
Introduction
we consider difficult will be clearly marked. If they are not essential for
examination purposes, you will be advised that you may skip the section
and come back to it at your leisure.
When you have a good grasp of the discussed subjects, and the
corresponding readings, you should explore the textbooks in more depth.
Reading
Some of the larger economics textbooks reflect a mixed view of what an
introductory course in economics should look like. While providing the
fundamentals of economic analysis, they also try to show the scope of
the subject. This means that a lot of the material in these textbooks is not
really part of this subject, and rather serves to illuminate some of the ways
economic analysis can be used to look at society.
So the good news is that a great deal of what appears in some of the
books is of less interest to us. The not-so-good news is that as a language
and a method of analysis, logic (and hence mathematics) is an important
component of our subject. Still, most of the logical arguments can also be
presented in a less formal way. Therefore, although mathematics lies at the
heart of the subject, mathematical expositions are not an essential part of
learning the language of economics.
In short, the heart of the subject guide is the study of economic reasoning.
This means that the extent of the subject guide is much reduced, compared
to some of the more comprehensive textbooks. On the other hand, this
subject guide is more rigorous than some of the textbooks. You should
always carefully check your understanding of each step of the analysis,
you should never accept a proposition without understanding the logic
behind it.
Recommended reading
You are strongly advised to stick to one of the two textbooks listed below
for your additional reading. Only look at the other textbook if you find a
topic difficult and feel that the teaching style in the other book suits you
better. It is not important to read a huge amount beyond the subject guide,
but it is very important to really understand what you do read.
Lipsey, R.G. and K.A. Chrystal Principles of Economics. (Oxford: Oxford
University Press, 2007) eleventh edition [ISBN 9780199286416]
(referred to as LC).
Begg, D., G.Vernasca, S. Fischer and R. Dornbusch Economics. (New York:
McGraw Hill, 2008) tenth edition [ISBN 9780077129521] (referred to
as BFD).
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
Please note that there is a textbook which is based on the subject guide but
which goes well beyond it. It brings together the learning of the tools and
their practice through solved self-assessment exercises. The books details
are:
Witzum, A. Economics: An Analytical Introduction. (Oxford: Oxford University
Press, 2005) [ISBN 9780199271634].
5
Online study resources

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should receive your login details in your study pack. If you have not,
or you have forgotten your login details, please email uolia.support@
london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
Past examination papers and Examiners commentaries: These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
Recorded lectures: For some courses, where appropriate, the sessions
from previous years Study Weekends have been recorded and made
available.
Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library

The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
6
Introduction
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
Working with others

Group work is an important element of effective learning. Of course,
you can study the material on your own, but discussing problems and
insights with others is important for two reasons. First, it exposes you to
different ways of thinking about the same problem. Second, it forces you
to convince others about your own line of argument. The process of trying
to convince others will enable you to gain a much deeper understanding of
the material you are studying.
Even if there are not enough people around you who study the same
subject, it would still be useful if you could persuade at least one other
person to work with you. Try to explain to the other person what you have
been learning. If you succeed in teaching them economics, you will have
done very well.
Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this we
strongly advise you to always check both the current Regulations for relevant
information about the examination, and the VLE where you should be advised
of any forthcoming changes. You should also carefully check the rubric/
instructions on the paper you actually sit and follow those instructions.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
Many subjects, and their exams, require essay-type answers, in which one
tends to write about things and to describe them. For this course, the
approach is different, and you need to adopt a more analytical form of
discourse, which aims to persuade and to make a point.
Thinking about writing in this way will help you a great deal. It forces you
to think about what you want to say, as well as about how you will argue
your point. Making a point requires you to basically know the answer
before you start writing. It is my impression, from past examination
papers, that many students try to answer questions while they are writing
the answer. Reading a question normally triggers memories of things
which you have read in the textbook. This often leads students simply to
write everything down that is remotely connected to the question, with
little reference to the problem the question actually poses.
This is not what this course subject is all about. We want you to:
identify the tools of analysis which are relevant to each question
show us that you know what these tools are
be able to use the tools.
7
The exam questions are normally designed to allow the Examiners

to see those different levels of understanding. Questions are written
in a problem form, which requires you to be able to establish which
framework of analysis is most appropriate. In your answer, you are
expected to properly present this framework. Only then are you expected
to solve the problem within this framework. Although some questions
may have a general appeal, we do not seek general answers. You must
think of the exam as an exercise rather than a survey.
Some basic mathematical tools

Many students find the use of mathematics in economics intimidating.
There are no sound reasons for this. Although there is some use of
mathematical notation, the level of mathematical analysis which is
required is basic. Still, to ensure that technical problems do not create
unnecessary obstacles, we recommend that you should focus on clarifying
some basic concepts before going any further. These basic concepts
include:
what is a point in a plane
what is a function, a graph and a slope
the meaning of a derivative and tangency.
In particular, you must have a good understanding of slopes, as these
are the most important tool for understanding the geometrical expositions
of the subject. To assist you in reviewing these basic mathematical
concepts, the short technical preface introduces some of the most basic
mathematical and geometrical notions.
We recommend that you begin your study by reading this preface, together
with the following references from existing textbooks:
Thomas, R.L. Using Mathematics in Economics (1999) Addison Wesley, second
edition (Chapters 1 and 2).
Jacques, Ian Mathematics for Economics and Business (1999) Addison Wesley,
third edition (Chapters 1, 3 and 4).
Lipsey and Chrystal, (see the Recommended reading) also explains the
mathematical tools required to study this subject.
Do not continue until you are sure that these basic tools are
properly understood. When you are sure, continue to the
question below.
Question 1
Draw a plane figure with y on the vertical axis and x on the horizontal
axis. Plot the following points:
100
80
60
40
12
20
16
20
What is the slope of the line connecting all these points?

Write the equation which describes this line.
8
Technical preface
Technical preface
If you are not familiar with the language of economics, work through this
short preface before beginning the main part of the guide. Make sure that
you thoroughly understand what is being said, and how it is expressed in
economics terms. It will be particularly useful in helping you understand
the numerous formulas and figures that we use later on.
Learning outcomes
At the end of the chapter, you should be able to define and list examples
of:
sets and their enumeration
natural, integer and rational numbers
planes and xy-coordinates on a plane
functions, slopes and binding constraints.
Introduction
When we look around ourselves we see many individual things often
more than we can make sense of or communicate clearly to others. We
need to find effective ways to think about and describe all these things.
Listen to the scream of a hungry Neanderthal husband to his wife in the
cave: Dinner, dear!
For his wife to understand what he wants, they must both know exactly
what dinner means. She is unlikely to offer him a tree or a stone to eat.
She knows, as well as he does, that dinner refers to the kinds of things
that we eat at a certain time of the day. So instead of the poor wife
offering him a random selection of objects from sticks to dung, using the
word dinner brings the number of objects under consideration down to a
manageable number.
Dinner defines a certain group of objects within the complex world which
surrounds us. Of course, this group of objects varies across cultures, but
in all of them there will be one word to identify the set of objects from
which the meal is likely to be prepared.
Suppose now that dinner, or things we eat at this time of the day
includes only two objects: bread and eggs. Would the Neanderthal and
his wife consider 100 eggs as dinner? Probably not. She is more likely to
consider two slices of bread and one egg as an example of dinner. So it
is not enough just to group those things in the world to which we want
to relate. We must also be able to count, or enumerate, them. The two
fundamentals here are called sets and numbers.
Sets and specifications

Sets
A set is a collection of well-defined objects, which are called its
elements (or members).
What is the set, and what are the elements in the dinner example we have just used?
9
In economics, if X is an element or member of a set S, we write:

XS
The negation of this is:
XS
which says X is not part of the set S.
In slightly different terms, we could write the broadest definition of our
dinner set like this:
D = {X|X is edible}.
Put into words, this reads: the dinner set contains all things which are
edible (the vertical line in expressions like these means where or such
that or conditional on). This therefore says:
Dinner is all X such that X is edible.
But do we eat all things which are edible, or is our taste refined by custom
and culture?
Specifying a set
We can specify a set in two ways: either by enumeration (listing what is
in the set) or by description.
Examples of enumeration
A = {1, 2, 4}
or
B = {Romeo, Juliet}.
Here A is the set containing the numbers 1, 2 and 4 and B is the set
containing Romeo and Juliet. We have enumerated all the members.
In our dinner example, the set called dinner (D) may be enumerated like
this:
D = {Eggs, Bread}.
This does not tell us how many eggs, or bread, constitute a meal. However,
the wife not only knows what things might constitute the dinner set, she
also knows her husbands capacity.
Description Suppose that to eat more than 5 eggs in a meal is
considered dangerously unhealthy. To eat more than 10 slices of bread
might also be inappropriate. The meal set those meals that a good wife
will offer her Neanderthal husband will only contain those meals that
are healthy. Hence, the meal set, to which both husband and wife are
implicitly referring, is a subset of D, where D is the set of all possible
meals (including unhealthy meals). It is given by the expression:
M = {(E,B)|0 E 5, 0 B 10}.
Can you see what the letters M, B and E stand for in this expression?
Here (E,B) is a typical member of the meal set comprising Eggs (E) and
Bread (B). Put into words, M is the set of healthy combinations of E and
B such that there are between 0 and 5 eggs and between 0 and 10 slices
of bread. Clearly the set M is itself contained in, or is a subset of, the set D
(we denote this by M D).
10
Technical preface
Practise writing down some similar expressions for sets, for example: what will be the set
describing the guest list for your dinner party?
Here are some other examples of a descriptive way of writing a set, this
time a set of solutions to a mathematical problem:
C = {X|X2 25 = 0}.
C is the set of all the values of X that solve the equation X2 25 = 0. If we
add +25 to each side of the equation, the equation becomes: X2 25 +
25 = +25, which can be reduced to: X2 = 25.
The solution of this equation is the square root of 25 (which is either +5
or 5). In this case, we could have enumerated the set like this:
C = {+5,5}
Now consider the set L:
L = {Y |Y loves Romeo }.
L here is the set of all things that love Romeo. By enumeration, the set
may look like this:
L = {Juliet, Romeo, Romeos mother, Romeos dog, the girl next door, }.
For a description of a set to be meaningful, we must have an idea about
the range of the objects which might be included in the set. In our earlier
examples, we must know the possible values of the variables X and Y :
In C, the range of X is the set of all real numbers.
For L, the range of Y might be all of the characters in Shakespeares
play Romeo and Juliet.
For our meal set M, the range for E was all real numbers between 0 and
5 and for bread, all real numbers between 0 and 10.
Numbers
Natural numbers
Numbers are one of the means of describing a set. The most natural way of
using numbers is the process of counting. The numbers we use for counting
(two slices of bread, one egg et cetera) are called natural numbers.
The set of natural numbers is defined as:
= {1, 2, 3, 4, }
Natural numbers are therefore positive whole numbers. But how
will you count how much money you have in your bank if you are 200
overdrawn? Well, you are obviously the proud owner of a negative sum:
200. But while 200 is a natural number, 200 is not: it is whole, but
not positive. Perhaps you may dismiss your overdraft as being an unreal
number and a capitalist conspiracy.
Integers
To allow for circumstances where we want to consider negative numbers,
we define a new group of numbers called integers. These are all the
natural numbers and also their negative values. It also includes the
number zero, but we will not discuss this here.
The set of integers is defined as:
= {,3,2,1, 0, 1, 2, 3,}
11
However, the world around us is too complex to be depicted by integers

(whole numbers, whether positive or negative) alone. Rather, the world
seems to be continuous. Suppose that the distance between two points (say A
and B) is an integer (say 1 mile). Suppose that you live at A and your college
is at B. If there is a fast-food outlet halfway, does this mean that you cant
ever have lunch simply because there is no way of describing the distance
between your home, or college, and the fast-food outlet? Of course not, there
is a distance: it is real, and you can imagine yourself stopping at the fast-food
outlet. However, we cannot account for it in a world of integers. We therefore,
need to define yet another group of numbers, which can help us to depict the
world better. These are called the rational numbers.
Rational numbers
The set of rational numbers is defined as:
= {X/Y|X Y }.
Put into words, this says that is the set of fractions X/Y such that X is an
integer (which can be a negative number) and ( = and) Y is a natural
number. Thus the set of rational numbers could include any such numbers
as: 1/2, 1/15, 125/6000 or their decimal equivalents.
If the set contained all possible numbers which we might come across
in real life, we could stop here. However, in reality there are also numbers
that are not rational the number for example. We know that the area
of a circle with radius r is A = r2, and that when r = 1, the area of the
circle will be . This is real, but cannot be expressed as a rational number.
Similarly, 2 and Eulers Constant e are not rational numbers.
Real numbers
Not rational means that we cannot obtain the number as a fraction of
(or ratio between) integers and natural numbers. All real numbers
have a decimal expression (for example, 12/15 = 0.8, and 15/11 =
1.36363636). Rational numbers can be defined as real numbers whose
decimal expression terminates (as in 12/15) or else repeats itself over
and over again (as with 15/11).
For instance, 5/2 terminates (it is equal to decimal 2.5) and 22/7 repeats
itself (it is equal to decimal 3.142857 142857 142857). , however, neither
terminates nor repeats itself:
= 3.141592653589793
The set of all real numbers, , can be represented geometrically, by a
straight line, as in Figure 1:
Figure 1: The real number line.
We call this line the real number line, and it stretches from negative
infinity to positive infinity. However, we can also express sets in a
geometrical way.
12
Technical preface
A point in a plane
Sometimes, we define sets of objects across multiple dimensions. For
instance, our dinner from before contains more than one object. We said
that it contains both bread and eggs. If we can count bread and eggs in
terms of real numbers then the line which depicts the real numbers will
not be sufficient to describe the object called dinner. We will need two
lines: one to count bread, and another to count eggs. The set dinner can
therefore be written like this, with standing for rational numbers:
D = {(X, Y)|X Y }
Write out in words exactly what this expression means.
In words, dinner is a set comprised of X (the name for bread) which can
be counted by real numbers and Y (the name for eggs), which can be
counted by real numbers as well.
Dinner, therefore, is defined by two real number lines, as Figure 2 shows:
Figure 2: The (X, Y ) plane.
The intersecting axes X (horizontal) and Y (vertical) are the names of the
variables which are enumerated by real numbers. In our dinner case, X
stands for slices of bread and Y stands for eggs. To distinguish between
the name of the variable and a particular quantity of it, we use an index
number, denoted by a subscript. Hence:
X0 denotes a certain quantity of X
X0 units of X may mean 10 slices of bread
X1 will denote another quantity of X, which may or may not be the
same as X0.
We may add further quantities, called X2, X3 and so on.
But remember that in these expressions, the subscripts 0, 1, 2, 3 and so on do
not describe the magnitude of these quantities. They only identify them: it
may be better to think of them as the initial, 1st, 2nd quantities respectively.
The two lines of real numbers define what we call a plane. This plane (of
real numbers) is often denoted by 2 (meaning two sets of real numbers).
A typical point in this plane, say A in Figure 2, is defined as:
A = (X0, Y0)
This means that A is a combination of X0 units of X and Y0 units of Y.
Each point in the plane of real numbers has two coordinates. The first
one refers to variable X, the second refers to variable Y. This, in turn,
Coordinates: these are

always written in the
form (X, Y), so when you
see a form such as (5, 3)
you know that 5 is the
value of X, and 3 is the
value of Y.
13
divides the plane into four quadrants. The upper right-hand quadrant
contains elements like A where the coordinates of both variables are
positive numbers (including zero, which is both positive and negative at
the same time). The bottom right quadrant is where an element in the
plane has a positive X coordinate but a negative Y coordinate. The third
quadrants on the bottom left contains elements for which both variables
are assigned a negative number. In the fourth quadrant, X has negative
values while Y has positive values. In Figure 2, X1 is a negative number,
which is not very meaningful if X denotes slices of bread.
As far as our dinner is concerned, we can rule out any negative
consumption. We must, therefore, redefine the dinner set to account for
positive (including zero) consumption of both bread (X) and eggs (Y):
D = {(X, Y)|(X, Y) +2 }
where +2 depicts the positive quadrant in the real numbers plane.
So when our male chauvinist Neanderthal comes to the cave and yells
Dinner, dear, both of them know that he means positive quantities of
bread and eggs (the positive quadrant). However, while both of them
know what the components of a meal are, the actual composition can vary
considerably across cultures and fashions. In other words, what exactly a
meal is depends on where, and when, the Neanderthal story takes place.
At this stage, let us consider only the capacity limitations (which are
almost universal). To eat more than 10 slices of bread or more than 5 eggs
is considered dangerously unhealthy.
The subset called meal, which is a set contained in the set of all possible
dinners, contains the point (0, 0) but cannot go beyond point A due to
health reasons. Thus a meal cannot include more than 10 slices of bread
(X 10) or 5 eggs (Y 5). The set M, therefore, is contained in the
shaded area of Figure 3, including the edges:
M = {(X, Y)|0 X 10, 0 Y 5}
Figure 3: The set of possible meals depicted in the (X, Y ) plane.
Functions and graphs

So far, we have been dealing with how to conceptualise the world around
us. We examined some categories through the use of sets and we also used
the figures to show that sets can have a geometrical representation. We
have not begun, however, to introduce any kind of order to the world. We
have not, for example, discussed issues like causality.
Causality is a very difficult concept, and here we shall only deal with the
question of how to represent a causal relationship.
14
Technical preface
Graphs
Consider the development of a baby. There are many variables which
determine its development. How can we tell whether a baby is developing
properly? We might think about the two variables of length (height) and
weight. A baby may be growing taller, but at the same time not putting on
enough weight. Conversely, a baby may be gaining too much weight given
that it is not growing in length.
To have a balanced picture, we must observe how well the baby is doing in
both important dimensions of its growth. A tool that can help us do so is
the graph.
Both length and weight are enumerated by real numbers. Therefore,
the development of these two variables will have to be analysed in the
real numbers plane, 2. As we know that a negative weight, or length, are
meaningless numbers in this context, we can concentrate on the positive
quadrant of the real numbers plane, as in Figure 4.

Figure 4: A depiction of babies weight-length combinations.
Here X and Y denote length and weight of a baby respectively. We have

drawn three lines in the plane, to represent the expected growth rates of
babies that are relatively large (A), average (B), and relatively small (C)
at birth. Each line consists of a set of points in the positive quadrant which
have two coordinates each: one for length X and one for weight Y. The
graph lines define sets. In other words, the lines connect a large number
(actually an infinite number) of points with different values of X,Y.
From each of the initial points A, B and C, we may now move along
the relevant graph. As we do so, we depict a systematic increase in the
values of both variables. This suggests a connection between the weight
and length for which we believe the development of a baby is normal
given different conditions at birth. (We have omitted the important time
dimension, which would have complicated our story. We shall assume that
at least in one dimension the baby develops over time.)
The actual progress of any particular baby may not follow any of these
lines. We shall have to create a special graph for it. We can then relate the
actual development graph to the desired paths and determine how well
the baby is developing. This is the thick line labelled Actual.
The graph line, therefore, provides us with a set of points which
represent a certain relationship. This does not mean it is a causal
relationship. That is to say, it does not mean that the values of X (length)
15
determine, or explain, the values of Y (weight) nor that the values of Y

explain, or determine, the values of X. We simply use the graph to depict
the combination of length and weight which constitute our accepted view
of balanced growth.
In a similar way we could draw a line within the meal set M, which would
depict what one may consider a balanced diet (Figure 5).

Figure 5: A graph of all balanced diets.
Meals-that-do-not-kill (no more than 5 eggs and 10 slices of bread) are

captured by the shaded area in this figure, which represents the set:
M = {(X, Y)|0 X 10, 0 Y 5}
A balanced diet could mean a balanced consumption of protein (coming
from eggs) and carbohydrates (coming from bread). It implies a certain
correspondence between the amount of eggs and bread that one eats.
The heavy line in this figure depicts such a diet. Again, there is no causal
relationship, and the graph simply defines a certain set, the elements of
which are comprised of eggs and slices of bread.
Slopes and functions

Slopes
Consider the subset of balanced diets depicted by the line in Figure 6:
Y
(eggs)
F
3
2
1.5
1
0
B
A'
A
Figure 6: Balanced diets again.

16
10
X
(bread)
Technical preface
Here, the balanced diet is described by the straight line going from the
origin, the point (X = 0, Y = 0) or simply (0, 0), to point F where X =
10, Y = 5 (that is (10, 5)). What can we learn from this line, apart from
a detailed list of combinations of bread and eggs which are considered a
balanced diet? We can find the value of one thing in terms of its desired
relation to another (The desired outcome is a balanced diet).
Notice that according to the line, the following combinations of X and Y
(among others) constitute a balanced diet:
Slices of bread (X)
Eggs (Y)
As a point in the plane
A = (2, 1)
B = (4, 2)
C = (6, 3)
Suppose that we are consuming 2 slices of bread and 1 egg (point (2,
1)), and we now wish to increase our consumption of bread to 3 slices.
Worried about unbalancing our diet with the extra carbohydrate, we
would immediately want to compensate for it with some protein (and
cholesterol) so that our diet remains balanced. How many more eggs
should we consume?
We could easily take a ruler and set it vertically against the point X =
3 and find the corresponding coordinate of Y which will yield a point
on the balanced diet line. This will tell us how many eggs we can
consume with 3 slices of bread without breaking our diet. The answer
will obviously be to consume 1/2 an egg more (point A' in the above
diagram).
What if we were consuming 4 slices of bread and 2 eggs (point (4, 2)) and
we now want 1/2 a slice of bread more? We could repeat the exercise with
the ruler. But even without using the ruler, I can tell you that we would
need to consume 1/4 of an egg more.
If you repeat the exercise for any conceivable increase in the consumption
of bread from any conceivable point of consumption, you will be able
to derive a rule. Doing it in this way means following the logic of
induction (from the particular to the general). But we may also be able
to establish the rule by deduction (from the general to the particular).
What you want to find is how the change in the value (the number) of
one variable, say slices of bread, relates to the change in the value of the
other so that we are still in the set of balanced diets.
Let us consider for a moment the two extremes of the balanced diet line.
At the one end there is point (0, 0) which I shall call point O and at the
other end there is point F (for Full) where F = (10, 5). Between O and F,
the value of X changes by 10 and the value of Y changes by 5. Hence, dX
= 10; dY = 5.
The definition of the slope of a graph is:
which is, in fact, the tangent of the angle , tan (see Figure 7). It tells
us by how much Y has changed for a given change of X.
Notation: We usually
use the letter d (or its
Greek equivalents and
), to denote change.
Hence, dX means the
change in the value of
X. Between points A and
B in the above diagram,
the value of X changed
from 2 to 4. Hence, dX
= 2.
17
Y
(eggs)
F
dY
0
dX
10
Figure 7: The definition of a slope.
In our case, the slope of the balanced diet line (which is the tangent of
angle ) is:
In maths we may not be interested in the meaning of the number 1/2.

In economics, however, we give meaning to mathematics by assigning
significance to the various variables. In turn, this assigns meanings to
concepts like the slope. If you think carefully, the slope suggests 5 eggs
per 10 slices of bread. Or 1/2 an egg per slice of bread, which is the same
thing. It gives us some kind of an equivalence scale which is represented
by the special line of our balanced diet. One egg is equivalent, in our
balanced diet, to 2 slices of bread. The operational implications are that
if you wish to increase your consumption by 1 slice of bread, you must
add 1/2 an egg to your consumption of eggs in order not to deviate from
your balanced diet. If you want 2 eggs, you must add 4 slices of bread. If
you want 2.5 eggs, you will have to add 5 slices of bread and so on and so
forth.
If you look at points A, B and C in Figure 6, you will find that this
general rule (just like the rule of 1/2 an egg per slice of bread) applies
everywhere.
The reason for this is simply that the balanced diet line is a straight line.
The meaning of a straight line is that it has the same slope everywhere.
If you now choose any two points along this line you will find that the
change ratio of the variables always complies with what we have found:
half an egg as an equivalent to one slice of bread.
Functions
Having established a general rule which relates slices of bread X to eggs Y,
we may want to write the rule in a more explicit fashion. In other words,
we want to find a form that will provide a brief, and comprehensive,
description of the balanced diet line in the above diagram. That is to say,
we are searching for a function.
A function is a rule which assigns each element in one set to a unique
element in another set. In our case we have two sets. B denotes the set
containing various quantities of bread:
18
X
(bread)
Technical preface
B = {X|0 X 10}
E denotes the set containing the various quantities of eggs allowed:
E = {Y |0 Y 5}
The balanced Diet Function f(f stands for function, of course) is a rule
which assigns a value in E to each value in B (generally denoted by
f : B E.) In our case, both E and B contain real numbers so f is a real
numbers function and we can say that f : R R. So f is a mapping from
real numbers to real numbers It tells us how many eggs we can consume
with any possible quantity of bread.
We know that with 0 bread we may consume 0 eggs. But we also know
that for every extra slice of bread we must consume an additional 1/2 egg.
Hence we write:
You can now check this function by setting values for X and finding
whether or not the function yields a value of Y which corresponds to
what you would find if you had used a ruler. We can easily see now what
role the slope plays in this function. We know that for every change in X
(dX) we will need a change in the consumption of eggs (Y) to maintain a
balanced diet. We can therefore write:
Y
This means that if we increase the consumption of bread by 1 slice (dX =

1), the consumption of eggs (Y) will have to change by adding 1/2 an egg
(dY = 1/2).
Divide both sides by dX and we get:
which is exactly the slope of the line (the function).

The interpretation which we gave to the slope (as an equivalent scale) is
influenced by the nature of the variables as well as by the direction, or
sign, of the slope.
Our balanced diet concentrated on the balanced intake of carbohydrate
and protein. Increased consumption of food (in the dinner set M)
required a simultaneous increase in both variables. It is the fact that
the consumption of both bread and eggs had to be increased in order to
maintain a balanced diet that forced on us the interpretation whereby
1/2 an egg and 1 slice of bread are equivalent in some way. Equivalence
here is an expression of dependency. Whether we stay on our balanced
diet when we increase the consumption of one good depends on an
equivalent increase in the consumption of the other.
We say that a line has a positive slope whenever the signs of both changes
are the same. Here, staying within the boundaries of a balanced diet
meant an increase in both X and Y. As dX > 0 and dY > 0,
If instead, we thought of balanced diet in terms of calories, the picture

would be different. Let X and Y represent the same variables (that is, slices
of bread and eggs respectively) and suppose that there are 50 kilocalories
19
in a slice of bread and 80 kilocalories in an egg. Suppose too that a

healthy diet means a meal of 400 kilocalories. This is not the same as a
balanced diet: this time we are going to set a constraint of a maximum
of 400 kilocalories in total. The set H, of healthy meals, will be a subset of
our original dinner set D. Remember that we defined D like this:
D = {(X, Y)|X Y }
Constraints
The new healthy meal set obviously contains positive amounts of food
and is confined to the positive quadrant. However, it now has an additional
constraint since the amount of calories derived from the consumption of
bread (50 kilocalories per slice times the number of slices, namely, 50X) and
that derived from consuming eggs (80Y), should not exceed 400:
H = {(X, Y)|(X, Y) D : 50X + 80Y 400}
In words, the set of healthy meals contains all combinations of slices of
bread and eggs which are in the dinner set (i.e. the positive values of X
and Y), provided that the sum of their calories does not exceed 400.
Let us examine first where the constraint is binding. We want to find the
points where the number of calories allowed has been exhausted. That is,
to find the combinations of X and Y for which:
50X + 80Y = 400.
We are trying to find a rule which will describe the combinations of X and
Y for which we consumed the entire quantity of calories which is allowed.
The way we have written the constraint automatically reminds us of the
idea of a function. But this is a very strange function. To turn it into
something more familiar, we simply rearrange it:
50X + 80Y = 400
take 50X from both sides
80Y = 400 50X
divide both sides by 80
Figure 8 describes the function f as well as the set H, which is the shaded
area:
Y
(eggs)
5 calories constraint
0
Figure 8: A calories constraint.
20
X
(bread)
Technical preface
To draw the function, we must know at least two of the following three
things: the intercept with the X-axis, the intercept with the Y -axis, and
the slope. The intercept with the X-axis denotes the value of X when Y =
0, and the intercept with the Y -axis denotes the value of Y when X = 0.
It is easy to establish that if X = 0, Y = 5, i.e. the point (0, 5), and that
the slope of this function is (5/8). Note that this is a negative number.
Before coming back to the slope let us first draw the line using the two
intercepts. We know that (0, 5) is one point on the graph. We can also
easily establish the value of X when Y = 0:
What, then, is the slope of the Healthy Diet Constraint? Since the healthy
diet constraint is a straight line, the slope can easily be deduced from the
tangent of the angle in Figure 8, which is clearly 5/8.
Suppose that we increase the consumption of bread by 1 slice (dX = 1).
This means that we have added 50 calories to our consumption. To remain
on a healthy diet, we must reduce the consumption of eggs (Y). Given
that each egg has 80 calories, we will need to reduce this consumption by
5/8 of an egg.
If we change X (dX), we change the value of Y by the coefficient in front of
X. In the above equation it is (5/8):
hence
Once again, in economics we must think of the meaning of these concepts.

Here, the sign of the slope is negative. This means that the equivalence
scale suggests substitution. If we want more of one good (bread) we
must give up some of the other good (eggs) so that we stay within the
constraint of the healthy diet. In our case, the slope means that we must
give up 5/8th of an egg (Y) for every extra slice of bread (X).
One could say that the health price of a slice of bread is 5/8th of an egg!
Self-assessment
Before leaving this chapter, check that you can define the following
correctly, and give an example of the appropriate form:
sets and their enumeration
natural, integer and rational numbers
planes and xy-coordinates on a plane
functions, slopes and binding constraints.
21
Notes
22
Chapter 1: The study of economics

Learning outcomes
At the end of this chapter, you should be able to:
recall the logic of economic investigation
define the fundamental economic problem, and describe its immediate
derivatives: economic good, scarcity of resources, production
possibility frontier and the concept of efficiency, opportunity cost,
marginal opportunity cost, desirability, choice and the concept of price
opportunity cost.
Reading
LC Chapters 12.
BFD Chapters 12.
But read this chapter first!

You should read this introductory chapter before you read the
introductory chapters in both BFD and LC. (This is an exception to the
usual rule for this subject guide.) This chapter will give you a brief and
more focused introduction to the study of economics. We will look at
some of the underlying issues of knowledge in general, as well as at the
fundamental economic problem. You may find the following section
somewhat difficult. As we promised in the Introduction, it is therefore
optional. You may choose to delve straight into the subject matter of
economics, and start reading from Section 2.
Economics as a theory
Note: this preliminary section aims to highlight some basic difficulties
concerning economic theory. It is not compulsory and it does not include
examinable material. You may choose to skip it and come back to it later.
If you do so, please come back to it sometime in the future, as it will
widen your understanding of the subject.
What is economics all about?

The most general definition of economics is perhaps this: Economics is
the discipline studying the organisation of economic activities in society.
You may, at first, think that this is too much of an abstraction. After
all, how do questions like how much should be produced?, or what
determines prices? or how can I make money? relate to the general
problem of the social organisation of economic activities?
Broadly speaking, particular institutions created by society will have an
effect on the answer to the questions posed in the preceding paragraph.
The answers will depend, for example, on whether society wishes to
have competitive institutions as opposed to, say, cooperative structures.
They will also depend on whether decisions are made through a
decentralised system of decision-making (which does not necessarily
imply competition) or some form of hierarchy. Naturally, the system that
will emerge will be a reflection of what is commonly perceived as the
economic problem.
23
To complicate things, similar institutions may not necessarily reflect

similar perceptions of the economic problem. Likewise, similar
perceptions may not always produce the same kind of institutions. For
instance, Adam Smith was not the first one to point out the benefits of
the division of labour. He did so because for him, broadly speaking, the
economic problem was that of reproduction and growth. He asked how
society could organise its activities in order to produce as much surplus
(above what is needed for reproduction) as possible.
But forms of division of labour had been recommended before, as solutions
to entirely different problems. Plato, for instance, in his Republic,
suggests a division of labour as a means to create the just society.
However, while both of them considered the division of labour as
central to the ideal form of social organisation, their institutional
recommendations were very different indeed. In part, this can be
attributed to a fundamental difference in the way these two scholars
understood the world. In a brief and unsatisfactory way one can say that
the difference between Plato and Smith is that the former was a kind of
rationalist while the latter a kind of an empiricist. Plato felt that the way
we know about the world is by the power of our mind. Appearances may
be misleading. Smith, on the other hand, wrote in the tradition which
followed the principle that knowledge can only be acquired by means of
the senses and experience. Consequently, while both of them considered
division of labour, the latter attached it to decentralised decision making
based on private ownership of property while the former created a clearly
hierarchical system with communal ownership among those who make
decisions about what society should do, and private ownership among
those who provide society with its material wealth.
Put broadly, Smith felt that the division of labour must give rise to the
institutions of private property, the market and competition as a means
of coordinating economic activities. While Plato felt that division of
labour gives rise to communalism which should not be confused with
communism sharing and cooperation. Evidently, the answers to
questions like how much to produce?, what determines prices? and
how can I make money? are going to be fundamentally different in the
two systems. In the end, whatever it is that we are doing, the advice and
the recommendations of the economist are all derivatives of the same
principles which guide and direct the social organisation of economic
activities.
What is a Theory? The logic of economic investigation

The world around us seems complex and irregular. Human beings,
however, have always been drawn to the idea that there is some order in
this apparent chaos. We constantly try and extract order from the world
around us, forming a mental model of the world. Whether and how such
an orderly model relates to the real world are complex questions. At this
stage we shall concentrate on how we may create such an order.
Suppose that the political party governing a certain country wants
to devise a strategy for re-election. It turns to its analysts to ask for
recommendations. In order to advise the party in power, the analysts must
find out what makes people vote for the government. They distribute
questionnaires, asking people about their general dispositions and
economic circumstances. The questionnaires yield two rules:
1. Happy people vote for the government
2. Rich people are happy people.
24
Suppose that we
produce wheat. To do so,
we will need wheat for
seeds as well as for food
for the people who work
during the period of
production. Surplus is
the difference between
what has been produced
and what is needed by
way of seeds and food
to produce exactly the
same quantity of wheat
in the next year.
Notice that these assertions do not have to result from empirical evidence,
such as questionnaires. The analysts could have made these statements as
assumptions: statements that most people would be willing to accept
as being true.
To make these assertions, the analysts would need to explain what they
mean by happy and rich. Is happy a person who jumps up and down for
joy at least three times a day, or is it simply someone who is not looking
for a new job? Does rich mean having a lot of money, though with huge
debts to the Mafia, or perhaps having no debts at all? In other words,
there is a need to agree on what exactly it is we are talking about. This
initial stage of any theory is the definition of the subject matters under
investigation.
The first phase in building a theory, therefore, is to define the relevant
components which we believe are likely to influence the outcome.
Let us suppose that in some way our analysts clearly define the factors
they believe will affect the re-election of the party in power. These factors
are: Riches, Happiness, Government and Money. Adding to this our two
observations from above, we have the foundation of a theory:
Definitions
Rich people (denoted by R),
Happiness (denoted by H),
Government (denoted by G),
Money (denoted by M).
Axioms
1. Rich people are happy
2. Happy people vote for the government
What we now need is a rule of inference a method by which we can
enrich our understanding beyond the two axioms. Aristotelian Syllogism is
an example of such a rule of inference. It works like this:
Premise 1
All humans are mortal
Premise 2
Aristotle is human
Conclusion
Aristotle is mortal
In our voting analysis, this becomes:

Axiom 1
R is H
Axiom 2
H votes G
Conclusion
R (rich people) vote for G (the government)
We call such a conclusion a theorem:

Theorem
Rich people vote for the government (or, R vote G).
This is a system of logic. Axioms (premises) plus a rule of inference
define a logical system. The conclusions of logical systems are always
logically true, provided that there has been no mistake in the
application of the rule of inference. However, this does not mean that
these conclusions are also empirically true.
Axioms (or premises)

are the fundamentals of
our theory. In our story,
we learnt about them
from our questionnaires
(i.e. observations) but
as I indicated earlier,
we could have simply
assumed them as a form
of common wisdom.
In any case, we accept
axioms to be true
without looking for
further confirmation.
Later, we shall have
to ask ourselves what
exactly we mean by
true, but we shall not
be dealing with this
question here.
Empirical: something
that can be observed,
or more generally, that
relates to reality. The
word empirical comes
from the name of Sextus
Empiricus who, in the
3rd century AD, argued
that deductive reasoning
on Aristotelian lines
does not add anything
to our knowledge.
This is because it is
through knowing that
Aristotle is mortal that
we constructed the
first premise. Hence the
conclusion is embedded
in the assumption. The
question of whether
Sextus was right has
evoked a great deal
of debate over the
centuries.
25
There are, in fact, statements that may be logically true but cannot be
confirmed in reality.
A theory produces two types of statements, explanations and
predictions. Predictions can be confirmed by some sort of testing. In this
case, the theory is verifiable. Explanations, on the other hand, give reasons
for empirically observable facts. However, the fact that a theory produces
good predictions does not automatically confirm its explanation. In our case,
the following propositions can be derived from the above theorem:
Prediction
If you give people M, they will vote G
Explanation
People vote G because they have M.
In our theory, the prediction is that if we give money to people, the
government will win the election. This may be confirmed by observations.
We may find that throughout history people were given more money
before the election and the party in government had been re-elected. But
does this mean that people vote for the government because they have
been given more money? Not necessarily.
Suppose now that all elections throughout history took place during spring
time. Suppose too that there is a flower called eternum contentum
which blooms for a short period in the spring, producing a certain special
scent in the air which acts like a pacifying drug. Every spring, people act
as if they have been collectively intoxicated and are content and happy
whatever their circumstances. Can we still say that the empirical truth of
our prediction also confirms our explanation? Certainly not.
The problem is that causality is basically not observable. What we
normally see are two events occurring in a given sequence. But even if
B always comes after A, can we say that A causes B? Without further
information, the answer is that we can not. What we have observed is
simply a correlation, a systematic relationship in the occurrence of
events. However, both A and B might be caused by some other event
C , of which we are totally unaware. It is important not to confuse this
correlation with causality. This makes the explanatory content of a theory
often very difficult to assess.
Naturally, if we believe that the axioms of the theory are empirically true,
we may be more inclined to believe the explanations offered by the theory
(because we expect the logical structure to carry the empirical truth of
the premises over to the propositions). Conversely, if we dont believe the
premises are empirically true, the explanatory side of the theory becomes
questionable. Since the goal of a theory is usually its explanatory potential,
this can be a problem.
To a great extent, the problem of Normative and Positive economics
developed around these questions. Many believe that there are elements
in economics which are purely positive. Namely, that some of the
propositions generated by economic analysis are purely descriptive and do
not involve any value judgement. For instance, a statement like: increase
in demand will raise the price of a good seems to be an is statement. It
describes what is in the real world. Normative economics, taken narrowly,
relates to those parts of the theory which are judgemental. For instance,
consumers will be better off when firms have no monopolistic power is a
normative statement.
26
However, what exactly is meant by positive is highly debatable like

the questions surrounding our perceptions and our ability to observe.
Generally speaking, people tend to associate an is statement with what
is positive. But in our previous example we claimed that demand
increases when it is not obvious what exactly we mean by demand.
Once we understand what is meant by positivism we shall be able to see
immediately what is normative.
Here is an is statement:
John is tall.
This appears to be a statement of fact which would, generally
speaking, appear positive. Still, it isnt necessarily universally true. Among
short people John may be tall, but in a different environment, where the
average height is greater, he might not really be considered tall at all.
Therefore, a truly positive statement would be John is 2.12 metres tall.
This would be universally true (true in all situations), and would not
depend on the environment John is in.
Now suppose that the price level in an economy is a function of the
prices of five goods, and that each good has a different weighting in
our price level, depending on the relative amount of spending on that
good (the weights will add up to 1). If only one good is purchased and
everybody spends their entire income on it, its weight in the price level
function would be 1. A good that nobody consumes will have a weight of
0. Let i represent the weight of good i (i will be a number between 1 and
5), P be the price level in the economy, and pi the price of good i. Then the
price level P is given by:
P = 1p1 + + 5p5
where
1 + + 5 = 1
A change in the general price level will be the weighted sum of the
changes of individual prices in the price index. We denote a change in the
price by dp. Hence, the general price level will change according to:
dP = 1dp1 + 5dp5
Example 1
Let the goods and weights be given as follows:
Good
Weight (i)
bread
0.4
fuel
0.2
transport
0.1
holidays
0.1
health
0.2
Now, suppose that the prices of the various goods change in the following way:
bread
+20%
(hence, dp1 = 0.2)
fuel
+20%
(dp2 = 0.2)
transport
+10%
(dp3 = 0.1)
holidays
40%
(dp4 = 0.4)
health
+10%
(dp5 = 0.1)
Given the weights in the table, the general price level will then rise by 11%.
Work out how these individual price increases amount to an 11% increase overall.
27
How much of an is statement will it be if I say Prices have gone up by

11%? For families who never go on holiday, this will be far from the
reality of their lives. Moreover, if I now chose to change the weights of the
various goods, the statement prices have gone up by 11% will simply be
incorrect. But the reason it is incorrect is not its failure to describe reality.
The problem is that it is describing a subjective reality, based on the
consumption pattern of a particular person, which is their choice.
The crucial point here is that a choice was involved in the formulation
of this positive statement. Each particular weighing system reflects
someones conception of a good definition of a price level. Price here is
more an idea than a fact.
It is true that a statement like the price of bread has gone up by 20% may
appear as a more convincing positive statement. We all know exactly what
is meant by the price of bread, and we can observe that it has gone up by
20%. Nevertheless, this is a rather an empty exercise. While it is factually
true that the price in terms of money has increased, we must also ensure
that we interpret money and price correctly. Different definitions of these
terms might have very different implications for the meaning we associate
with a rise in money prices. Since it is this meaning that matters for a
positive theory, we again find that a positive theory crucially depends on
the choice of definition.
A normative statement is often seen as a statement reflecting a value
judgement, for example It is good that the price of bread has gone up
by 20%. The value judgement rests in the definition of good and bad,
which clearly makes this a normative, and hence subjective, statement.
Value systems are the result of individual choices. However, as we saw
above, the conceptual framework giving meaning to the statement the
price of bread has gone up by 20% is in itself a matter of choice.
This means that the standard distinction between normative and positive
statements, which is based on the difference between judgement and
description, might be difficult to make in an economic context. Economic
theory is full of judgemental descriptions. This implies that we have to be
careful when evaluating apparently positive statements, and also that
we should not dismiss blatantly normative statements as unscientific. After
all, we are all human.
This view of the influence of value judgements on positive economics
might seem to dismiss economics as a serious social science. However,
nothing could be further from the truth.
It is the strength and beauty of the social sciences that they combine
our natural social outlook with the way we form and understand the
institutions of society.
The fundamental economic problem

The first step in understanding economics is to form an idea of its
domain. In other words, what makes something a subject of economic
investigation? Alternatively, we can ask what constitutes an economic
good.
There may be different answers to these questions which, in turn, will
suggest different economic theories. Although it is important to consider
different definitions of economic goods, I will concentrate on what is
commonly referred to as the Neoclassical interpretation.
28
Definition 1
Everything which is both scarce and desirable is an economic good.
Scarcity is a very straightforward concept: there is a limit to how much of
the good is available. Note, however, that scarcity has both a spatial and
a temporal aspect. If a good is scarce in one place, while it is not scarce in
some other place, it will still be considered an economic good. Similarly,
if a good is scarce today, but not likely to be scarce at some point in the
future, it is considered an economic good today.
Desirability is a more complex concept. What do we mean when we say
we desire a good? One might argue that we should distinguish between
desiring a good because we need it, and desiring a good because we
want it. The fact that we dont distinguish between those two sources
of desirability is sometimes seen as a defect in neoclassical economics.
However, we shall ignore this problem throughout the course.
The third element in the above definition is the emphasis on both scarcity
and desirability. Consider the example of fresh air. We clearly need, and
hence desire, fresh air to survive. At the same time, air is generally seen
as not scarce. Therefore, air would seem to be not an economic good.
However, under water, fresh air is clearly scarce, and we are willing to
do (and pay) a great deal to have air when we have to go under water.
Therefore, air under water is an economic good. Similarly, pollution levels
in Paris rose significantly during a recent heatwave. People were willing
to refrain from using their cars in order to reduce pollution. Fresh air had
become scarce, and hence an economic good. People were willing to pay a
price for it by not using their cars.
Try to think of other circumstances in which fresh air might become a scarce, as well as a
desirable, commodity.
Leprosy, on the other hand, is scarce but also undesirable. So, leprosy is
not an economic good, and there is no price for it.
Modelling the economic problem

The definition of economic goods also gives us the definition of the
economic problem, which is:
How do we satisfy our desires, or wants, with scarce means?
The definition of the economic problem therefore involves the same
ingredients as that of economic goods: scarcity and desirability.
The next step is to ask ourselves what are the implications of this
definition. What can we learn from it that we cannot see by simply
staring at it? To do so, we must use our common sense until things get
too complex. After that we want to use tools which preserve the logical
truth of our initial intuition. We may not intuitively understand the
mechanism of our system but we can rest assured that it carries on the
logic of our initial observation. In the end, by looking at what the system
yields we may find an explanation which may then appear obvious to us.
Nevertheless, this will not make our system redundant as this apparent
intuition is only reasoning backwards from effects to causes. Constructing
such a system is what we call modelling and the logical language most
commonly used is that of mathematics.
29
To see what exactly is meant by all this, let us begin by modelling the
first component of the definition of economic goods: scarcity. This
model is called the production possibility frontier (PPF) or the
transformation curve. We shall see that it is the modelling of this basic
feature scarcity that generates the two most important concepts in
economic analysis: price and efficiency.
The production possibility frontier

We begin by setting the premises of our model. Consider an economy
producing just two commodities, X and Y. In order to produce these
commodities, we need a means of production, another economic
good which we call labour. Suppose that 1 unit of labour, say one hour
of labour, can produce either 2 units of Y or 1 unit of X. (Given that the
labour unit (measured in time) is divisible, any linear combination of the
two is also possible.) Suppose that there are 100 homogeneous units of
labour in the economy.
Definition 2
Homogeneity means that all units are identical.
The PPF denotes all combinations of output of X and Y which are possible,
given that the labour units are constrained to 100 (which is a direct
result of the scarcity of labour), and given the technology in the
economy. The technology tells us that each unit can either produce 2 units
of Y or 1 unit of X. Given the constraint and the technology, the following
table lists some possible allocations of labour to the production of the two
goods, and the resulting output of both goods.
Labour units in
production of X
Labour units in
production of Y
100
200
100
100
99
198
99
99
If all units of labour were engaged in the production of Y, they would

have produced 200 units of it (each one can produce 2 units of Y and
there are 100 labour units). As each unit can either produce 2Y or 1
X, total production will be 200 units of Y and zero units of X. If, on the
other hand, all labour units were engaged in the production of X, they
would have produced 100 units of X and zero units of Y. As labour units
are homogeneous which in the present context means that they are of
equal ability we can also allocate some units to X while allocating the
rest to Y. If 1 unit of labour is transferred from the production of Y to X,
the economy will lose 2 units of Y but gain 1 unit of X, and similarly the
reverse is true if we transfer 1 unit from the production of X to Y.
If we assume that units of labour are divisible (so that we can transfer any
fraction of labour time from the production of one good to the other) the
PPF of the economy will be the one depicted in Figure 1.1 below.
30
Figure 1.1: The production possibility frontier when output rises in proportion to
inputs.
Clearly, we cannot have negative quantities of economic goods. Hence,

the space of economic goods is restricted to the positive quadrant, where
the values of both X and Y are positive. This is the space depicted in
Figure 1.1, with X on the horizontal axis and Y on the vertical axis. Point
A, for example, depicts a bundle containing X0 units of commodity X and
Y0 units of commodity Y.
Look back to page 13 of the Technical preface if you are not sure what X0, X1, Y0 etc.
represent.
Point B, on the other hand, describes a bundle containing X1 units of X and
Y1 units of Y. Comparing X0 and X1, you can see that there are more units
of X in bundle A than there are in B. Similarly, there are more units of Y in
A than there are in B. Our desirability assumption means that people will
always want to have A rather than be content with B.
The curve (a straight line in this instance) connecting the point where
Y = 200 and the point where X = 100 is the PPF. The PPF separates what
is feasible from what is not. Since neoclassical economics assumes that we
desire to have more of everything, the PPF represents a constraint. We
can only have those bundles below or on the PPF (that is, in the shaded
area or its boundaries).
In Figure 1.1, A is just feasible, since it is on the PPF. B is feasible with
some units of labour left unused, and hence spare capacity.
31
We can express the PPF (the curve connecting point (X = 0, Y = 200)

with point (X = 100, Y = 0)) algebraically as well. It will have the
following form:
1. Y = 200 2X
When X = 0, Y = 200, and when Y = 0, X = 100.
We can derive this equation by looking at the production constraint in
this economy. We know that each labour unit can produce either 2Y or 1X.
In other words, a unit of Y requires 1/2 a unit of labour and a unit of X
requires 1 unit of labour. The total number of labour units available is 100.
Thus, the economy can produce any combination of X and Y that requires
up to 100 units of labour. This constraint on output is expressed in the
following way:
2. Y + X 100
Given that there is a constraint in the number of units of labour available,
the PPF denotes the maximum output of X and Y feasible for any possible
division of labour. Points beyond the curve are not feasible for the
economy. This means that if we want more of one of the commodities in
our bundle, we have to give up some of the other commodity. We say that
the constraint is binding.
The expression on the left of the in equation (2) tells us how many
units of labour are necessary to produce a particular level of X and Y. Any
combination of X and Y which satisfies (2) is feasible. Thus, (2) defines the
production possibility set (which is the shaded area in the Figure
1.1). So a combination of 50 units of Y and 50 units of X will satisfy (2)
and will be in the feasible set. To produce 50 units of Y when each unit of
Y requires 1/2 a unit of labour means that we will need 25 units of labour.
For 50 units of X, we will need 50 units of labour as each X requires a full
unit of labour. Together, therefore, we will need 75 units of labour, which
is much less than the 100 units we have at our disposal. On the other
hand, a bundle of 100 units of both X and Y is not feasible, as you will
realise.
What is the maximum output of X we can have together with 60 units of Y, when we
have 100 units of labour?
What is the maximum level of X we can produce if we want 80 units of Y and when we
have 150 units of labour?
32
Efficiency
Let us now have a closer look at what it means to be on the PPF.
Figure 1.2: Efficient versus inefficient allocations
At point B we produce 100 units of Y and 25 units of X. Equation (2) tells

us that this combination is feasible, but does not exhaust all available
labour units. The constraint in (2) is: Y + X 100. If Y = 100 and
X = 25 the economy is using only 75 units of labour (25 less than what
is available). Equation (2) then holds and B is feasible. At point A, on the
other hand, we produce 150 units of Y and 25 units of X. This combination
is feasible, and also exhausts all labour units that were available to the
economy.
We can draw a horizontal and a vertical line going through point A. These
lines will separate the space of commodity bundles into four separate
quadrants, labelled (i) to (iv).
Is it feasible to locate bundles in each of the four quadrants, and what kind of bundles
could they be for example, how many of the available units of labour would they use?
Note down your answers before reading on.
Clearly, producing less of one or both of the commodities in bundle A is
always feasible, and will yield a bundle in quadrant (iii). However, we will
not be using all available labour at such a point.
Bundles in quadrant (i), on the other hand, are not feasible. If they
were feasible, we could have moved from A by producing more of at least
one commodity, without having to give up some of the other commodity.
This would imply that we hadnt used all labour resources at A, which is
obviously not the case.
Bundles in quadrants (ii) and (iv) have more of one commodity, compared
to A, while having less of the other. This means that to get to a point in,
say, quadrant (ii), we have to give up some Y in order to have more X.
33
How much more X could we have if we gave up 1 unit of Y?

Recall that our production technology required one unit of labour for each
unit of X and a unit of labour for one unit of Y . Hence, an extra unit
of X will require that we forgo 2 units of Y. Bundles in quadrants (ii) and
(iv), where each extra unit of X is associated 2 or less units of Y, or each
extra unit of Y is associated with a unit of X or less, are all feasible.
We call points like A, which require sacrificing one commodity in exchange
for more of the other commodity, an efficient allocation.
Definition 3
An efficient allocation of means of production is one which yields a combination of
outputs where it is not possible to increase the output of one good without reducing the
output of at least one other good.
There are two separate distinct instances of efficiency in an economy,
and both will be very important in the chapters that follow. If, as in our
example, all economic goods are tangible goods, such as food or
clothes, the idea of not being able to have more of one economic good
without giving up some of another good is called productive efficiency.
If, on the other hand, the economic goods include intangible concepts
such as the well-being of individuals (clearly, both desirable and scarce
and thus an economic good), we refer to an efficient allocation as being
allocative efficient.
Definition 4
The set of all productive efficient allocations is called the production possibility
frontier, PPF.
This means that there are infinitely many productive efficient allocations
(all the points along the line depicting the PPF). The problem will now
be to choose one of these efficient allocations as the most desirable. Once
we have found this allocation, we have to investigate which institutional
structure (such as competitive markets, cooperatives or planning) will
be able to deliver this socially desirable allocation. We can have a first
look at the characteristics of such an allocation by conducting a closer
examination of the significance of efficiency.
Opportunity cost
Suppose that the economy is producing at point A. Is there any cost
associated with this choice? Assuming that we want more of everything,
choosing to produce 25 units of X means that we had to give up 50
potentially feasible units of Y. Conversely, the production of 150 units
of Y cost us 75 units of X, which we could have produced had we not
produced any Y at all. This cost which society pays for its choices is called
the opportunity cost.
Definition 5
The opportunity cost associated with a particular choice measures how much of the
best possible alternative had to be given up to make this choice feasible.
34
This opportunity cost can be interpreted as a general real price. Let

us examine the opportunity cost of a unit of X. At point A, we gave up
50 units of Y in order to be able to produce 25 units of X. On average,
therefore, the opportunity cost of a unit of X is:
Write down a similar opportunity cost formula for Y.

This opportunity cost, which we can think of as the real price of X, will be
the same wherever we choose to be on the PPF, since our technology is
linear and the labour force is homogeneous. This means that regardless of
how much X and Y we produce and regardless of which particular labour
unit we use to produce X, producing an extra unit of X would require
giving up 2 units of Y. An extra unit of X always requires the transfer of 1
unit of labour from Y to X. This unit of labour could have produced 2 units
of Y . Hence, the opportunity cost of X will be 2 units of Y per X. Notice
that this is exactly the slope of the PPF in Figure 1.2.
Let us review our progress so far by way of theorising. We started with
definitions of scarcity, desirability, economic goods, efficiency, the
PPF and opportunity cost. The very basic modelling of scarcity has thus
produced the following system:
Premise 1:
All the efficient allocations are on the production possibility

frontier.
Premise 2:
Only goods produced on the production possibility frontier

have an opportunity cost which is greater than zero.
Conclusion (theorem): Only goods which are produced efficiently have an

opportunity cost which is greater than zero.
In the presence of scarcity, there are two kinds of possible allocations of
resources. The first kind is an allocation where the feasibility constraint is
not binding (i.e. it is not on the PPF, but inside the feasible set). The
second kind of allocation is feasible, but the constraint is binding (i.e. we
are on the PPF).
Only allocations with a binding feasibility constraint are efficient,
meaning that the production of each unit of any good will have an
opportunity cost associated with it. Inefficient allocations mean that
there is no opportunity cost associated with the production of an extra unit
of any good.
There is a paradox here, because we all know that all economic goods
seem to have a price associated with them, even when there are clearly
productive inefficiencies. Paying the price of a good, which is normally
denoted in monetary terms, means giving up something else which we
could have purchased with this money. This seems to suggest that there is
an opportunity cost associated with all economic goods, regardless of the
efficiency of their production. How can we relate this empirical finding
notion to the theorem above?
35
We have to examine the definition of opportunity cost carefully. We

defined it as the cost of not using resources for the best alternative
production of another good. Recall point B in Figure 1.2. We produced
100 units of Y and 25 units of X. From equation (2), we know that this
means a total of 75 units of labour. Suppose now that we want an extra
unit of X. According to our production technology, we would need 1
unit of labour for 1 unit of X. If we transferred 1 unit of labour from
the production of Y to work on X, we will lose 2 units of Y. It appears
that the opportunity cost of 1 unit of X at B is 2 units of Y. This clearly
contradicts the theorem, which says that only efficient allocations have
an opportunity cost associated with them. B, as it is well inside the feasible
set, is obviously an inefficient allocation.
Try to work out what the answer to this puzzle is. Concentrate on the full definition of
opportunity cost.
Is the opportunity cost of X at B really 2 units of Y? Notice that the
definition of opportunity cost refers to those costs which arise from not
using resources in their best alternative.
If we choose to employ a worker who is currently producing Y, when
there are workers who do not produce anything, we clearly do not use
resources in the best alternative. So rather than transferring labour from
Y to X, we should use one of the currently unemployed units of labour to
produce more X, leaving the production of Y unchanged. In this case, the
opportunity cost of an extra unit of X in terms of Y would clearly be zero.
This does not change the fact that we still have to pay a positive price for a
good, regardless of whether the economy is currently producing efficiently.
However, we have to differentiate between paying some quantity of Y for a
unit of X (by using, for example, money, or through some other method of
exchange), and paying the opportunity cost.
Whats happening here is that when the price of X in terms of Y is greater
than the opportunity cost of Y, we are paying more than it really costs to
produce X. In such a case, we may say that the economy is inefficient. It
means that to get a certain quantity of X we must produce a sufficient amount
of Y to be able to afford it. But this sufficient amount will be more than is
really necessary to obtain the quantity of X we desire. Those resources which
are now employed in producing the extra quantity of Y required for paying
for X could have been used to produce more of both X and Y.
As both goods are desirable (and we want more of them), any allocation
where prices do not reflect the opportunity cost is inefficient. Indeed,
one of the most important problems facing economists is how to determine
which form of economic organisation will yield prices (or exchange rates)
which reflect the real cost of production, the opportunity cost.
Specialisation and trade

The main direct conclusion of the way in which we presented the economic
problem was that efficiency implies a well-defined cost for the production
of each unit of output (the opportunity cost). This, in turn, allows us to
examine performance in terms of efficiency by comparing actual prices with
opportunity costs. Whenever an economic system produces prices which
are the same as the opportunity cost, we may conclude that the system is
efficient. If this is not the case, we are paying too much for some goods and
too little for others. This, of course, suggests an inefficiency.
36
But there is another implication which arises from our modelling of

scarcity. This is the principle of specialisation and trade. If we accept
the definition of economic goods as those goods which are both scarce
and desirable, and that we have unsatiated wants,then it can be easily
established that it is always best for everybody to specialise and trade.
Best, here, means that everyone will be able to have more of everything
once they specialise and trade. I will demonstrate this point with an
example:
Consider two individuals (the heads of households I and II) who produce
all their life necessities by themselves. Assume that these necessities
include only two types of goods: food F and clothes C. Individual I can
produce, and consume, either 6 units of C or 2 units of F, or any convex
combination of these two extremes.
The circumstances of the second individual (II) allow him to produce, and
consume, either 6 units of C or 6 units of F, or any convex combination of
these two extremes. Mapping out the convex combinations of those points
will give us the PPF for each household:
A convex
combination of two
points with coordinates
(C0, F0) and (C1, F1) is
defined as a point (C,
F) such that C = C0
+ (1 )C1 and F =
F0 + (1 )F1, where
0 1. As we vary
between zero and 1, we
will map out the straight
line connecting the two
points.
Figure 1.3: Autarky (self-sufficiency): each household consumes exactly what it

produces.
Suppose now that the two individuals chose to be at points AI = (1, 3)

(producing and consuming 1 unit of food and 3 units of clothes) and AII
= (3, 3) respectively. The two individuals, therefore, have organised their
households in a productively efficient manner.
Notice that the opportunity cost (or price) of food in household I is 3
units of C per unit of F which is the slope of the PPF in the left diagram.
In household II, however, the opportunity cost (or price) of food is only
1 unit of C per unit of F (the slope of the PPF in the right diagram).
Conversely, the opportunity cost of clothes in household I is 1/3 of a unit
of F per unit of C while in household II it is 1 unit of F per unit of C.
We can summarise the position of each household under self-sufficiency as
follows:
Clothes (C)
Food (F)
Totals
II
II
II
Production
Consumption
Opportunity cost
1/3 F per C
1 F per C
3 C per F
1 C per F
37
Clearly, producing C in household I is cheaper than producing it in

household II. This is because the the opportunity cost of producing C in
household I is only 1/3 F per C, compared with 1 F per C in household II.
We would say that household I has a comparative advantage in the
production of C. Having a comparative advantage in producing a good
means that the opportunity cost of producing that good is lower than it is
in other households.
For exactly the same reason, household II has a comparative
advantage in the production of F.
Work out the opportunity cost of a unit of F produced by household II compared with
household I.
You can probably see that if every unit of C consumed by both I and II
had been produced in household I, while every unit of F consumed had
been produced at II, the total amount of F and C would have increased.
This could only happen if each household specialises in the production
of one good, and trades with the other to get its preferred consumption
bundle.
This is the end of autarky: what each of them produces is no longer
necessarily what they will consume. Given the PPF of each household,
household I will produce 6 units of C, while household II will produce 6
units of F. Suppose that each household will want to carry on consuming 3
units of C. This means that household II will have to buy 3 units of C from
I. How many units of F will they be willing to give up to obtain those units
of C?
We cannot establish the exact price that will emerge at this stage of the
course. However, we do know the limits of this price. Household I will not
be willing to buy F for more than 3 units of C per unit of F, because they
could have produced it themselves at that price if they hadnt specialised.
Similarly, household I will not be willing to sell F for less than 1 unit of
C, because this is their opportunity cost of producing C if they hadnt
specialised.
This means that the price of a good must be less than
its opportunity cost to the buyer, but greater than the
opportunity cost to the seller. Hence:
Sellers opportunity cost
Price
Buyers opportunity cost
1C per F
PF
3C per F
The exact price within this range will depend on the institutions of
exchange and the relative bargaining power of the two households. We
will deal with these issues later in the course. At this stage, suppose that
the agreed price is 2 units of C per F. This exchange rate between C and F
is depicted by the line with slope 2 in the two graphs in Figure 1.4.
38
Figure 1.4: Feasible sets after specialisation and trade, with an agreed price of
2C per F.
Both households now have consumption opportunities which they did not
have before (the shaded areas in the above figure). This means that trade
and specialisation can potentially benefit both households.
If the two households insist on consuming 3 C each, they will now be able
to consume more food (1.5 units of F compared to 1 unit of F for I, and 4.5
units of F compared to 3 units of F for II).
Here is a summary of the situation after trade:
Clothes (C)
Food (F)
Totals
II
II
Production
Consumption
1.5
4.5
Price
1/2 F per C
1/2 F per C
2 C per F
2 C per F
Evidently, both households are better off (assuming that having more of
all goods is indeed equivalent to being better off) after specialising and
trading.
The shape of the PPF and the importance of marginal

changes
Let us now suppose that labour is not the only means of production. We
need machines, as well as labour, to produce both X and Y. To keep things
simple, suppose that there is just one kind of machine, and that the use of
machines is measured in (homogeneous) machine hours. Let 1 machine
hour produce either 1 unit of Y or 2 units of X. Assume a total of 100
machine hours is available.
The production technology with respect to labour is exactly the same as in
the previous sections: One unit of labour produces either 1 unit of X or 2
units of Y, and there are 100 labour hours available. However, we cannot
produce X or Y by using just one of the means of production. We need both
labour and machine time.
39
According to the new technology we see that in order to produce one

unit of X, we would need one unit of labour and 1/2 a machine hour.
Similarly, to produce one unit of Y requires half a unit of labour and 1
machine hour.
We have now introduced a second constraint which affects our feasible
set. As before, we have a labour constraint, the L-constraint, which we
have explored above. We found that the feasible set resulting from the
labour constraint was given by equation (2):
Y + X 100
(2)
In exactly the same fashion as above, we can derive a similar feasible set
from the machine constraint, the M-constraint. It will have the following
form:
Y + X 100
(3)
As both labour and machines are needed for the production process of
both X and Y, both constraints have to be satisfied simultaneously. This
means that a pair of X and Y will be feasible only if equations (2) and (3)
are satisfied. Figure 1.5 depicts the space of economic goods with the
two constraints:
Figure 1.5: Introducing a second constraint.
Let us now look at point A again. The combination of 150Y and 25X
satisfies equation (2) (i.e. because there is are enough units of labour to
produce it). But it does not satisfy equation (3), the machine constraint:
Y + X 100
If Y = 150 and X = 25, the left-hand side totals (150) + (25/2) = 162.5
machine hours, and since we only have 100 machine hours available, it is
no longer feasible to produce this bundle.
40
So if we insist on producing 25 units of X, we will have to reduce our

production of Y in order to make it feasible. This means that we will have
to reduce Y until we reach the binding limit imposed by the the machine
constraint. Hence, according to (3), 25 units of X are feasible, provided the
production of Y does not exceed 87.5. This is given by point E.
Is E in Figure 1.5 a productively efficient point, given that there is labour which is not
being employed?
The answer is at the end of the chapter, on page 47. Dont look at it until
you have generated an appropriate answer yourself.
When we have the two constraints (labour time and machine time) the set
of feasible allocations becomes the shaded area in Figure 1.6. The overall
PPF will now be the kinked line starting at (0, 100) on the Y-axis, and
going to (100, 0) on the X-axis.
Let us now consider the effect of this change in the feasible set on
opportunity cost. In Figure 1.6 we consider two points. Point A is at (40,
80) and B is at (80, 40). Both A and B are productive efficient points, lying
on the PPF. What is the opportunity cost (or the real price) of an extra
unit of X at points A and B?
Figure 1.6: Marginal opportunity cost.
At A, the overall opportunity cost for the production of 40 units of X is 20

units of Y. The opportunity cost of producing one more X can be calculated
as the average cost: 20/40 = 1/2 a unit of Y per unit of X. If we now add
one unit of X we shall lose 1/2 a unit of Y. Here, as in the previous case,
the average opportunity cost was a good measure of the marginal
opportunity cost. We call the marginal opportunity cost the cost
which is associated with the production of the next, or the last, unit of
a good. So far we paid little attention to this as the average and the
marginal were very much the same. At point A in Figure 1.6 this is still
the case. But the importance of special attention to considerations at the
margin can be learnt through the examination of point B.
41
At B, if we follow the same principle (of the average) to derive the

opportunity cost per unit we shall get that the cost of one unit of X at B is
60/80 = 3/4 of a unit of Y per unit of X. This might lead us to believe that
the cost of an additional unit of X will be 3/4 a unit of Y. However, if we
do produce the extra unit of X we shall find that it had, as a matter of fact,
cost us 2 units of Y rather than 3/4 of a unit of Y. Namely, the cost of an
extra unit depends on how much we are already producing. Instead of the
average, we shall have to be more careful and look at what is going on at
the margins. The reason for that is the convex shape (towards the origin)
of the PPF in Figure 1.6. In Figure 1.2, for instance, we would not
have encountered such problems.
So why is the PPF convex towards the origin? The reason that we have
discussed above is the existence of multiple constraints. However, even if
there was only one factor of production to be considered, the PPF would
have been convex had we not assumed the homogeneity of that factor of
production. A third reason, not entirely unrelated to the previous ones is
the existence of diminishing marginal productivity. We shall discuss the
role of the latter reason in more detail as we go along.
How is the slope of the PPF changing with X? Looking at Figure 1.6,
we see that it is relatively flat for small values of X, while it is steeper for
larger values of X. That is to say, the slope increases with X in absolute
values. We call a curve which exhibits such a property convex to the
origin.
Why is the PPF convex to the origin? In the above example, the reason
was the existence of multiple constraints. However, we might have a PPF
that is convex to the origin even if we only have one constraint, or factor
of production. This could be due to some heterogeneity of the factor of
production (for example if the skills of some the people providing the
labour were greater than those of others). Convexity could also be due to
decreasing marginal productivity. We shall explore these reasons further
later in the course. However, this shows an important point in the study
of economics: This is economics, so we should always try to provide an
economic interpretation of mathematical concepts.
Self-assessment
Check your knowledge
Check back through the text if you are not sure about any of these.
Recall the logic of economic investigation.
Define the fundamental economic problem, and describe its immediate
derivatives: economic good, scarcity of resources, production
possibility frontier and the concept of efficiency, opportunity cost,
marginal opportunity cost, desirability, choice and the concept of price
opportunity cost.
Give an example of the Aristotelian syllogism (rule of inference),
homogenous goods and autarky.
Test your understanding

In this section, you will find a set of problems of the kind you will meet in
the exam. The answers follow on page 44.
If you want to really improve your knowledge, you should try to answer
the questions without looking at the answers. After you have answered all
42
If a curve is given by the

function Y = f(X), it is
convex to the origin
if and only if
f(X1) + (1 )f(X2)
f (X1 + (1 )X2)
for any values Y1 and Y2
and any such that
0 1. This
mathematical concept
has a simple geometric
interpretation. The PPF
in Figure 1.6 encloses
the shaded region,
which is the feasible
set. It is convex to the
origin if all points on the
line connecting any two
points on the frontier lie
within the feasible set. It
turns out that this is the
case if the slope of the
curve is negative and
decreasing with X.
the questions, compare your answers with someone else who is studying
this course. If there is no other student you can consult, choose a (patient)
friend or family member and try to explain to them the issues involved. It
doesnt matter if they dont know anything about economics: this will force
you to explain the subject in a way that will help you understand things
which you would not have understood otherwise. Only after all these trials
should you compare your answers with the answers in the book.
Question 1
An economy produces two goods, X and Y. It uses two means of
production, labour and capital. A unit of labour can produce either 1
unit of X or 4 units of Y (or any linear combination of the two). A unit
of capital can produce either 4 units of X or 1 unit of Y (or any linear
combination of the two). There are 100 units of each means of production.
a. Draw the production possibility frontier of the economy when the two
goods can only be produced by a mixture of both factors.
b. What will be the opportunity cost of X if the economy produces 50
units of X?
c. Given that the production technology is linear, will the opportunity cost
of X remain unchanged when we produce 90 units of it X?
Question 2
You are still in the economy given in question 1. Suppose that the discovery of
new production technologies allows the production of both X and Y by using a
single means of production (without a change in their respective productivity).
a. What will the production possibility frontier be now?
b. What will the opportunity cost of producing 50 units of X be? Would it
change if we produced 90 units of X?
Question 3
Robinson Crusoe can bake 10 loaves of bread in one hour or peel 20
potatoes. Friday can bake 5 loaves of bread in an hour or peel 30 potatoes.
If they believe in equality in consumption, would they specialise and
trade? If so, at what price will they exchange bread for potatoes?
Question 4
Developed countries get very little from trade with less
developed countries. The reason for this is that all means of
production in the developed world are capable of producing
much more than any of their counterparts in the less developed
countries.
Discuss this statement with reference to the model of specialisation and

trade as in question 3.
43
Answers
Question 1
a. This is a straightforward question which tests your understanding of
the principles behind the modelling problem of scarcity. You should
have produced a graph like Figure 1.7.
Figure 1.7: Modelling the PPF.
This could have been established by drawing each constraint according

to the available information (i.e. 100L can produce either 400Y or
100X, and C can produce either 400X or 100Y).
Alternatively, you could have set up the two constraint equations:
(Labour) X + 1/4 Y = 100
(Capital) 1/4 X + Y = 100
From the symmetry of the model, you can see that the two lines
intersect at (80, 80). The PPF is given by the heavy line in Figure
1.7, as both capital and labour (at fixed proportions) are required for
the production of each unit of X and Y.
b. When the economy produces 50 units of X, we are to the left of point A
above. The binding constraint is that of capital. Hence, the opportunity
cost (the slope of the PPF) is 1/4 unit of Y per X.
c. When we produce 90 units of X, we are to the right of point A above.
Hence, the opportunity cost of X is 4 units of Y per X.
Question 2
The conditions in this question are similar to those in question 1. There is,
however, a technological change.
a. We assume now that a change in technology allows us to produce X or Y
by using only one of the means of production (capital or labour) at their
initial productivity (i.e. 1 unit of L can do either 1X or 4Y, and 1 unit of C
can do either 4X or 1Y). If we produce only Y we can produce 400 units
by using 100L and an extra 100 by using 100K (500 altogether). When
we wish to have X as well we shall first transfer to its production the input
which has comparative advantage in producing X (i.e. capital).
44
Figure 1.8: The PPF with changed technology.
b. The opportunity cost of X at 50 or 90 will be the same. It will be one

quarter a unit of Y per X. If, however, we produced 401 units of X, the
opportunity cost of X becomes 4 units of Y per X.
Question 3
The following PPFs should be drawn for Robinson Crusoe (on the left)
and for Friday (on the right):
Figure 1.9: Robinsons and Fridays PPFs.
Clearly, Robinson has a comparative advantage in baking bread (his

opportunity cost for it is 2 potatoes per loaf). Friday has a comparative
advantage in potatoes (his opportunity cost for potatoes is 1/6 loaf of
bread). Hence, both should specialise and trade with each other.
If they want to be better off from a material point of view as well as pursue
other values like equality, the distribution which they should aim for is 5
loaves of bread and 15 potatoes each. Hence, the price of a loaf of bread is
3 potatoes and the price of a single potato is 1/3 of a loaf of bread.
45
Question 4
The crucial step in this question is translating the language of the question
into the language of our model.
The question states that developed countries are more productive than
less developed countries. In terms of the language of our model, this
means that each unit of the input (say, labour) in the developed country
can produce more units of either X or Y than a unit in the less developed
country. This means that the developed country has an absolute
advantage in production of either good. However, the crucial insight
thing is that each country will have a comparative advantage in the
production of some goods.
In order to translate the question into the language of our model, we
have to choose an example which will highlight these features. To keep
matters as simple as possible, we assume a world of just two countries,
producing two goods. There will be a single input, and its availability and
productivity in each country will be chosen to fit the question.
If, say, the developed country can produce 100 units of X or 100 units of
Y, its opportunity cost of producing 1 unit of X is 1 unit of Y, and vice
versa.
The less developed country can produce either 40Y or 20X (it is less
developed, and smaller too). Its opportunity cost of producing X is
thus 2 units of Y per X (which is more than the opportunity cost of the
developed country) but only 1/2 unit of X per Y (which is less than that
of the developed country). We can then draw the PPF of each country in
a diagram. The line connecting (0, 40) and (20, 0) will be the PPF of the
less developed country, while that connecting (0, 100) and (100, 0) will be
the PPF of the developed country.
Figure 1.10: The effect of specialisation and trade.
Let us assume that Y is a luxury good which is of no use to the less

developed country at this stage (say a fine malt whisky); X, on the other
hand, is an essential good like food.
46
Before trade, the less developed country will produce and consume as
much of the essential good X as possible. This means it will be at the point
(20, 0). Suppose that to begin with the larger economy consumes (and
produces) 40 units of Y and 60 units of X.
Now, allow specialisation and trade. If the larger economy wants to carry
on consuming 40Y, it would be better off buying them from the smaller
economy, since the smaller country has a comparative advantage in
producing Y. In this case, the larger country can transfer all its means
of production to X, where it has a comparative advantage. It can then
produce a total of 100 units of X. The larger country will have to transfer
part of this to the smaller country to pay for its consumption of Y.
As long as it pays the smaller country more than 1/2X per Y (which is
what it costs the smaller country to produce Y), the smaller country will
be better off. The larger economy, on the other hand, will not be willing to
pay more than 1 X per Y, as this is what it would have cost it to produce y
itself. Hence, the price of Y in terms of X (PY) can be expressed like this:
1/2 unit of X per Y <Py < 1 unit of X per Y
If the price happens to be, say, 3/4 X per Y (or 4/3 Y per X), then the
larger economy can will buy its 40Y at the price of 30X, leaving it with
70X. It will now be able to consume 40Y and 70X, whereas before trade it
could only consume 40Y and 60X. The smaller economy will also benefit
as well, as it will be able to increase its consumption of the essential good
X by specialising in Y, in which they have it has a comparative advantage.
It will now be able to consume 30 units of X (all of which now come from
the large economy) instead of 20.
Answer to question on page 41

Is E a productively efficient point, given that there is labour which is
not employed? Yes. This is a good example of the benefits of working
with definitions and theory rather than with intuition. According to our
definition, a productively efficient allocation is any allocation where
we cannot have more of one tangible good (a commodity)
without giving up another. At point E, this is the case. We cannot
have more of X without giving up some Y, because we do not have enough
machine hours. Evidently, productive efficiency does not imply
allocative efficiency. Society might well want to choose a point where
all means of production are fully employed, but our criterion of productive
efficiency is no longer sufficient to guarantee this. Later in the course, we
will see what institutional arrangements we need to reach such a point.
Now read
LC Chapters 1 to 2.
BFD Chapters 1 and 2.
47
Notes
48
Chapter 2: Individual choice

Learning outcomes
define the concepts of utility, equilibrium price, transitivity, marginal
utility, indifference points and indifference curves, income effect,
substitution effect, inferior and normal good completeness and gross
substitutes, price elasticity, and real income
derive utility and indifference curves
use utility and demand curves to analyse problems involving choice,
utility maximisation, substitution and income effects, and price
elasticity of demand.
Reading
LC Chapter 5, Chapter 3 pp.3844 and Chapter 4 pp.6574 and 7685.
BFD Chapter 5, Chapter 3 pp.4849 and Chapter 4 pp.6582.
The role of demand

Two main issues are normally discussed in the context of consumers
choice: utility and demand. Before plunging into details let us consider
for a moment why are these two concepts so closely related.
One of the most famous illustrations associated with the study of
economics is the following:
Figure 2.1: Supply and demand curves.
49
The vertical axis gives real number values to the price of this good (say, x).
The horizontal axis gives real number values denoting the quantities of the
good. The demand schedule (D) depicts the quantity demanded at each
possible price while the supply schedule (S) relates the quantity that will
be supplied at any possible price. There is one point (A) where at a given
price the quantity demanded equals the quantity supplied.
Embedded in this picture is a vision of economics which is very similar to
the Newtonian vision of mechanics. The world of economic interaction is
conceptualised as a world of opposing forces (demand and supply) which
are constantly drawn to a balancing point (equilibrium). It is therefore
obvious that we would like to examine how each of these forces operates.
Utility, in neoclassical economics, provides the explanation to how demand
operates.
However, the notion of a downward sloping demand schedule is very old
indeed. It is possible to find some evidence of it in Aristotle, St Thomas
of Aquinas and certainly among Classical economists like Smith, J.S. Mill
and Marx. However, none of the above connected the notion of demand
and utility in the same way as we do in neoclassical economics. For many,
the downward sloping demand schedule was more like a certainty like a
law than a derivative of a more complex structure. Why then, may you
wonder, do we need such a complex structure to derive something which
many people seem to agree about anyway?
There are two dimensions to the answer. First, although many people
may feel that demand schedules are downward sloping, such a schedule
cannot be constructed as an empirical fact. At any point in time we can
only establish what people actually do at a given price. If price changes
over time, people may act differently for numerous reasons including
reasons which are not at all connected to the demand for a particular
good. Put differently, to be completely certain that demand schedules
are downward sloping, we must be able to observe an individual, or
individuals, acting at two points in time where the only thing different is
the price. This is obviously impossible. We can try and estimate demand
schedules empirically but as a schedule, they do not really exist. Therefore,
we cannot be certain that demand schedules are always downward sloping
and we must be in a position where we can provide an explanation even if
we come across an estimated upward sloping demand. Secondly, there is
the question of the usefulness of our theory. As I argued earlier, economics
is a language with which we discuss social issues. This means that we
cannot only be interested in the prediction power of our theory. We must
also be able to interpret situations in a way that will allow us to judge
them.
A bridge too far?

For instance, consider the following story. The government considers
whether to build a bridge over a certain river. It orders a market research
where a demand schedule is being constructed (assume, for simplicitys
sake that the demand was constructed through a questionnaire where
people were asked how many times will they use the bridge at different
crossing prices). At the same time, it commissions an investigation into the
engineering side where it is discovered that given the size of the river, the
smallest bridge that could be built is of a capacity for T crossings per day.
The graphs overleaf captures these findings:
50
The easiest way to think

of this is as a survey,
where people are asked
how much of a good
they will consume at
different prices. There
are sophisticated
statistical methods of
estimating demand at all
prices which are based
on the levels of demand
at observed prices. In
either case, we must
always bear in mind that
this is an estimation
which is not the same
as observing demand at
any given price.
Figure 2.2: Demand and supply for bridge crossings per day.
The cost of the smallest bridge is C but demand and supply do not
intersect with a meaningful positive price. Ignoring now the implications
of the failure of demand and supply to meet, how can the government
pursuing the interest of the public form an opinion on whether it is
worthwhile building the bridge? If the only use of demand and supply is
to predict the price in a market then we will not be able to say anything
about whether or not the government should build the bridge. However, if
we understood the meaning of the area underneath the demand schedule,
we might have been wiser. But to make sense of that area we must derive
the demand schedule from a certain construct rather than assume it. We
shall come back to this point at the end of the chapter.
Alternatively, consider the following two scenarios:

Figure 2.3: Shifting the demand and supply schedules.
If we merely accepted the downward sloping demand schedule as a

premise (or axiom), thus completely disassociating it from utility or any
other explanation, we would still be able to predict exactly as we would,
had we derived demand from a more complex structure. In the left-hand
diagram we can predict that if demand for a commodity increased (a
shift to the right of the demand schedule: which means that the quantity
demanded at each price will be greater), without any other changes (like,
in supply) the new equilibrium price will be higher. But as demonstrated
in the right-hand diagram, we would also predict an increase in price
51
if supply fell (the supply scheduled moves to the left which means that
at any price, quantity supplied will be smaller). Considering only these
two changes, how can we, as economists, distinguish between these two
changes which produce a similar prediction with regard to the price but a
different prediction with regard to quantities? Can we judge the one to be
in anyway better outcome than the other? Can we advise the public and
government on the social implications of these two changes?
On the face of it, the answer is clear. In the case of an increase in demand,
price increased but so did the equilibrium quantity. In the case of a fall in
supply the increase in price was accompanied by a fall in the equilibrium
quantity. Hence, you may say, the change on the left is better than the
change in the right-hand diagram.
But this is not so obvious. Let us suppose that the fall in supply resulted
from an increase in wages. These would increase the cost of production
which means that a seller will sell less at any given price (we shall explore
this further in Chapter 3). If you then examine carefully the case of the
fall in supply you will find that while there is a fall in equilibrium quantity,
there is also an increase in wages. Surely the interest of workers as
members of the community cannot be ignored. In addition, it is clear that
in the left-hand diagram people buy more of the good but they also spend
more on it. What would this mean to the amount of money left for them
to spend on other goods? In the right-hand diagram consumers buy less
of the good but pay more for every unit. This could mean that they either
spend more or less on the good, would it make a difference had it been
more rather than less? If you go to a shop and you find that the price of
brown rice has gone up and you buy instead the cheaper white rice should
this be interpreted as a deterioration in you circumstances? In particular, if
at the same time, workers earn more money?
As for the increase in quantity in the case of increased demand, can we
say for sure that it is a better sign than the fall in quantity? Suppose that
the good in question is a certain fruit: Nonesensatioualis which is
growing only in one place in the world: the island of Neverland. It is
considered common food among the indigenous population and there is
an equilibrium at point A. One day, it was discovered that the fruit has
immense powers of sexual regeneration. All of Hollywood moved to the
island and the demand for Nonesensatioualis rose. As there are too
many rich-and-famous (rafs), the new equilibrium will beat a higher level
of both price and quantity. Does this mean that the indigenous population
is necessarily better off?
In short, it is difficult to make sense of what the two pictures tell us unless
we have further information about what they mean. Clearly one obvious
distinction between the two outcomes is that in the case of increased
demand, the area underneath both demand and supply increased. In
the case of fall in supply, the area underneath demand clearly fell. What
exactly happened to the area underneath the supply schedule is unclear.
But what does this mean?
Had we only assumed the shape of the demand schedule (as well as that
of the supply schedule) we cannot attempt any serious interpretation
of the areas underneath both the demand and the supply schedules. We
do have an explanation of the outcome (in the one case price increased
because of an increase in demand while in the other, price increased
because of a fall in supply) but as we have no explanation of what is
demand (or supply) we cannot make sense of the outcome.
52
Introducing utility
The use of utility to explain the demand schedule (as opposed to
assuming it)will provide an immediate and coherent interpretation of
what the area underneath the demand schedule means. It will also allow
us to investigate the relationship between what is happening in one
market and the rest of the economic arena. Production functions (or
technology) would be equally useful in explaining the supply schedule
(as opposed to assuming it) and subsequently, allow us to interpret the
area underneath it in a meaningful manner. In such a way, a prediction
of an increase in price will have completely different significance when
we are able to pour more content into those tools which we feel are the
nearest to what can be empirically observed or estimated.
There are many more important implications which can be derived
from the way in which we explain those simple tools at the heart of the
economics psyche. We shall later on see that the support for market
institutions is very much embedded in the utility interpretation of demand.
This means that the study of utility is very important indeed. It will
provide a useful means of making sense of economic outcomes as well
as provide a justification for a certain kind of organisation for economic
activities. At the same time, we must all be conscious of its role as a means
of interpretation rather than a confirmed empirical truth.
Rationality
Reading
BFD Chapter 5 pp.9297.
LC Chapter 5 pp.9296.
What is rationality?
Modern economics is based on characterising the behaviour of individuals.
There is no direct role for more abstract constructs like groups, classes or
nations. Economists see these as arising from individual motivation and
interaction. Hence, the most important foundation of modern economics is
the theory of individual behaviour and motivation.
Individual motivation and desires are very difficult subjects, and many
conflicting theories attempt to explain them. Economics has circumvented
this problem by asking a slightly different question:
Given a motivation or desire, how would individuals act to achieve it?
The answer is a simple one: they will choose the best means to achieve
that end.
This economic concept of rationality involves two assumptions:
Assumption 1: People know their desires and know the consequences of each choice
of means.
Assumption 2: People will behave in a consistent manner. By this we mean that if
people have two feasible options available and choose one over the
other, they should not, at a later date, choose the other option if both
are still feasible.
53
Consider the following example:
Figure 2.4: An example of individual rationality.
Think about an individual living in isolation. Each season, he can decide

how to split up his labour between two goods, X (tomatoes) and Y
(cucumbers). If he produces only X, he can produce 3 units per season;
if he specialises in Y, he can produce 6 units of that good. He can also
divide his time between the two goods, and produce a combination of X
and Y. Obviously the combinations that are available to him lie on a line
connecting the two extreme points (the solid line in Figure 2.4).
These conditions impose a constraint on what he can consume. Assume
now that what our individual is really interested in is . . . a SALAD! The
first element of rationality, as we defined it above, would therefore be
for him to choose the combination of tomatoes and cucumbers which
will produce the most of his favourite salad. He likes both tomatoes and
cucumbers but from what is available to him now he prefers point A,
where he produces 1.5 units of tomatoes (X) and 3 units of cucumbers
(Y), (Figure 2.4).
Why would choosing a point which is not on the constraint be irrational?
By implication, choosing A means that A is preferred over any other
available option.
One day, our farmers wife gets cross with him and hits him on the head.
As a result, our farmer discovers that his abilities have changed greatly.
With his labour he can now produce either 4.5 units of tomatoes (X) or
4.5 units of cucumbers (Y). (This is represented by the dashed line in
Figure 2.4.) Assuming that the hit on the head did not affect his tastes,
what combination of X and Y should he produce now?
Of course he could remain at point A and carry on producing exactly the
same salad as before.
54
If he moved to a point like B, we would say that our individual was not
rational. The reason for this is that he had already made a choice between
A and B. When he initially chose to produce A, B (like any other point
under the solid line) was equally available to him. By choosing A, the
individual is telling us that he prefers A to B. If now he chooses B when
A is still feasible, he would be telling us that now he prefers B to A. This
means that he is behaving inconsistently. Consequently, the only
rational options are to stay at A or to move to a point like C (which was
not available before) where he has a few cucumbers less but where he is
more than compensated for that loss by producing a lot more tomatoes.
A move to C would be consistent because it would mean that he is now
choosing a salad combination which is either as good as the one at A or
even more to his liking, but which was not available to him before.
Suppose for a moment that our farmer considers the salad at C to be just
as tasty as the salad at A. Suppose too, that his wife again hits him on the
head and his abilities (but not his tastes) change once more:

Figure 2.5: Individual rationality in changed conditions.
Now he can produce either 2.5 tomatoes (X) or 7.5 cucumbers (Y). Point A
is still feasible. Using the same similar line of reasoning as before, we can
say that it would be irrational to move to a point like D (because although
this options was available before, he rejected it and chose A instead), but
perfectly consistent to move to a point like E where though he consumes
fewer tomatoes, he can more than compensate by adding cucumbers.
As before, suppose that he considers the salad at E as tasty as the salad at
A (and by implication, as tasty as the salad at C). Figure 2.6 shows all
these developments together.
55
Figure 2.6: Rationality and revealed preferences.
We can clearly see that the implication of rationality and consistency

is that individuals will find points of equal taste arranged along a line
like the heavy curve in Figure 2.6. Using this simple implication of
rationality, we will now proceed and define this idea more precisely
through preferences and utility functions.
Preferences: the relationship individuals have with the

world of economic goods
Satisfaction and all that . . .
To analyse the way in which individuals behave when dealing with
economic goods (those scarce and desirable things), we must find out how
they relate to them.
Example 1
Imagine an old lady with a shopping basket standing in front of the butter and margarine
display. In her basket she already has a loaf of wholesome sliced bread. She is trying to
decide whether to buy butter or margarine or a bit of both. How will she choose?
In the late eighteenth and nineteenth centuries the school of Utilitarianism was quite
prominent in moral philosophy. According to this theory, people derive areal and
measurable degree of satisfaction (or happiness) from their existence, including from
their consumption of goods.
According to this belief, our old lady will choose the butter and margarine depending on
how much happiness or satisfaction they will give her. Perhaps we could find out what
she will do simply by measuring her pulse rate! If the idea of eating the entire loaf of
wholesome bread with thick layers of butter spread over it raises her pulse from 60 to 80
beats a minute, while the idea of having the same loaf of bread with margarine produces
a pulse of only 70, she will probably choose the butter.
The meaning of this is that our choices are based on some measure of
gratification. Suppose that next to the old lady stands an old man whose
pulse will rise to 100 if he buys the butter, but will stay at 60 if he buys
the margarine. Since there is only one pack of butter and one pack of
margarine left, we should presumably give the butter to the old man and
56
the margarine to the old lady. According to utilitarian theories, this would
maximise the total amount of happiness created, even if the old lady was
not entirely satisfied with this deal.
Work out how much total happiness is created:
a) if the old lady gets the butter and the old man gets the margarine; and
b) if it is the other way round.
If each bundle of economic goods produces measurable degrees of
satisfaction, we can easily compare any two individuals and choose a
distribution which gives the highest degree of overall satisfaction.
Unfortunately, one of the problems with utilitarianism is that there is no
clear way of quantifying different peoples feelings. So economists needed
a different way to explain how the old lady makes her choice. The solution
was the notion of preferences: if the old lady takes the pack of butter,
she is merely indicating that she would rather have wholesome bread
with butter than wholesome bread with margarine. So the issue is not
one of quantifying her pleasure but rather a question of ranking her
preferences.
If we treat the relationship between individuals and the world of economic
goods as a matter of ranking (idea being that when an individual is
confronted with two bundles A and B of goods, they will always say either
I prefer A to B, I prefer B to A or, I like A and B equally) we can consider
a much broader setof motivations. This, in principle, lends the theory an
important degree of generality which is much more appealing than the
narrow and intellectually unacceptable notion of measurable satisfaction.
Representing preferences
For the purpose of analysing the relationship which individuals have
with the world of economic goods, we may wish to begin with a more
straightforward and descriptive instrument. We may want to describe what
people might say when confronted with at least two bundles of economic
goods.
Let A and B be such bundles. An individual is bound to say either I prefer
A to B or I prefer B to A or I like A and B equally. Let us denote these
three possible statements by the following preference symbols:
A B means A is preferred to B
A B means indifferent between A and B.
This depiction of the attitude which people might have towards the world
of economic goods generates a great deal of analytical difficulty. It is true
that most of the time, people will be confronted with binary choices (like
the one between A and B). But what concerns us is not only the single
choice of a single individual but the simultaneous choices made by many.
Note that these signs

do not mean the same
as the greater than
(>) or the equal (=)
signs. This is important
in what follows. Instead,
they simply denote
preferences.
To that end, we must be aware of what our individual would do had they
confronted a different choice. If, say, a child is offered a choice between a
Train Set (TS) and the game Snakes and Ladders (SL) she might choose TS
(which means that she prefers TS to SL). However, when offered a choice
between TS and a Pottery Wheel (PW) she might choose PW (which means
that she prefers PW to TS). If now she is being offered a choice between PW
and SL she might choose SL, which means that she prefers SL to PW.
57
Write down the girls preferences using preference notation (A B et cetera).

What have we got here? TS is preferred to SL (TS SL); PW is preferred
to TS (PW TS) and SL is preferred to PW (SL PW). This means that if
the child goes into a toyshop where she is confronted with all the goods at
once she will have a logical problem: PW TS SL PW. Which toy will
she choose?
In other words, it is not sufficient to ask the individual to rank only two
bundles, we need to know their preferences with regard to all the other
bundles. That is, we want a complete ordering (ranking) over the whole
space of economic goods. However, people are highly unlikely to have such
a comprehensive knowledge of their preferences. We must therefore move
from this literal description of peoples attitude towards economic goods
towards a more abstract depiction of these attitudes.
Not surprisingly, moving from the simple binary choice problems to a more
abstract depiction of attitudes creates problems of its own, as we saw in
the case of the child having to choose between three goods. To resolve
this and other issues, we will have to make some assumptions about
individuals preferences.
The two most crucial assumptions involved here are those of completeness
and of transitivity. We touched on completeness in the example above:
it is the requirement for individuals to be able to give a complete ranking
of all bundles available to them, from most preferred to least preferred.
Completeness is both a technical and substantive assumption.
Technical because it is required for there presentation of preferences and
substantive because it is a departure from the description of indifferent
behaviour. On the one hand it is an important assumption which enables
us to use a continuous, real number function to represent preferences
(the utility function, more of which later). On the other hand, it is a
logical extension of the idea of individual choice. We are always able to
rank two or more things in order of preference, but in most cases, we
are not choosing between one thing or the other, but between complex
bundles of goods. The ranking of such bundles is a much more delicate
and complicated issue. We are necessarily assuming that our
economic individuals are able to perform such rankings.
The assumption of transitivity, in spite of having important technical
implications, is first and foremost a substantive one. Transitivity is one way
of introducing rationality into our analysis. By assuming that preferences
are transitive we exclude the possibility of the above-childs predicament.
Our childs preferences PW TS SL PW are inconsistent, since PW is
apparently preferred to itself. Had her preferences been consistent, they
would have satisfied transitivity: PW TS SL. This is what would have
occurred if the child had been offered a binary choice between PW and
SL: her preferences would have been PW SL. Preferences, one might say,
must reflect consistency. (This, one may argue, is the most fundamental
principle of rationality.)
To remind you, we abstracted from the simple depiction of what people
might say when offered a choice between two bundles, because it doesnt
allow us analytically to gain much insight. Our goal is to move to a more
powerful instrument, which is also easier to handle. One such instrument
is a real number function. This may be less intuitively representative
of the world of preferences, but real numbers are much easier to use. In
order to make the transition from preferences, which we denoted by the
preference sign to real number functions, we need the completeness
58
and transitivity assumptions, plus a few more technical assumptions.

Since we end up with a real number function, we can now replace the
preference sign with the more familiar greater than (>) sign.
The transition works like this: Consider a world of two economic goods, X
and Y. The space of all possible bundles of economic goods is the positive
quadrant of the plane, as shown in Figure 2.7:

Figure 2.7: The consumption space.
A point like A depicts a bundle which consists of X0 units of X and Y0 units

of Y. We write A as A = (X0, Y0). Similarly, B is a point where we have X1
units of X and Y1 units of Y (B = (X1, Y1)). The subscripts and so on are
ways of identifying different packages of X and Y. They do not indicate
the magnitude of X and Y.
We can work the process through like this:
1. Write down what people might actually say, for example: I prefer A to
B.
2. Write this down using preferences symbols: in this case A i B
(meaning: A is preferred by individual i to B).
3. Introduce the concept of weak preference: For two bundles A and
C, A C means I prefer or am indifferent between A and C. This
is actually a very small extension to stage 2 above, but makes the
transition to a real number function much easier to make.
4. Extend the ordering over the entire set of economic goods (so that
each individual can at all times rank all possible bundles). This means
that our completeness assumption must hold.
5. Assume that the above ranking is rational and therefore satisfies
transitivity.
6. We have now ranked all available consumption bundles in order of
weak preference: say, A B C. Now, we assign a real number to
each of these choices, with the property that numbers assigned to
weakly preferred choices are weakly bigger than those assigned to
non-preferred choices. Denote the number by U (for utility). Then,
we clearly have U(A) U(B) U(C). We are thus mapping from
preferences onto real numbers. We call this mapping the ordinal
utility function. Ordinal means that the function only tells us about
59
the order, or ranking, of the bundles. The magnitude of the numbers

has no significance.
Example 2
Consider two individuals 1 and 2, with U1 and U2 as their respective utility functions. If
U1(A) = 1000 and U1(B) = 20 we know that individual 1 prefers A to B (U1(A) = 1000 >
U1(B) = 20); if U2(A) = 100 and U2(B) = 20 we know that individual 2 also prefers A to B.
Remember that the actual numbers have no extra significance, it is only the inequalities
that matter.
If this is so, and if individual 1 has B and individual 2 has A, can we say that it is
desirable to ask individual 1 and 2 to swap their bundles?
A utilitarian might want such a swap on the grounds society should
maximise the total amount of utility. On this argument, the present
allocation of A to 2 and B to 1 gives us a total utility of U1(B) + U2(A) =
20 + 100 = 120. But if we give B to 2 and A to 1 the sum would change
to to U1(A) + U2(B) = 1000 + 20 = 1020. However, the magnitude of
these numbers means nothing whatsoever. The fact that 1s preferences are
represented by 1000 against 20 and 2s preferences are represented by 100
to 20 is insignificant. However, we cannot say such a thing. The only thing
we can say is that both individuals prefer A to B.
On the other hand, when we choose to allow numbers to represent the
strength of our preferences we have a different utility function which
is more than just a ranking: this function is called cardinal utility.
Naturally, in such a case, the comparison of utilities between the two
individuals would have been meaningful.
Properties of utility functions

The ordinal utility function, then, simply represents individuals
preferences over the space of economic goods. Let us now examine the
properties of the utility function that represent those preferences.
We will begin by looking at a point like A in Figure 2.8. From what we
haves aid so far about preferences, A immediately defines 4 quadrants
around the horizontal (X) and vertical (Y) axes in this graph:
Figure 2.8: Preferences.

60
Clearly A is preferred over all points in quadrant III (A B), because

at A, we have more of both goods, which must be at least as good as
being at B.
All points in quadrant I are preferred over A (C A).
The line connecting B and C goes through either quadrant II or
quadrant IV. Therefore, as we move from an inferior point (B)
to a superior one (C),we must go through a point where we are
indifferent between the two bundles (point D). All such points must
be either in quadrant II or IV.
As we explained above, a function u is said to represent these preferences
if A B implies that U(A) U(B). What other properties must such a
utility function possess? Remember that each bundle, such as A, actually
consists of certain amounts of various goods. In the graph above bundle
A consists of X0 units of good X, and Y0 units of good Y. We can then show
that:
u must be increasing in both X and Y : the more we have of either good,
the more preferred the bundle is.
Marginal utility
For a given level of, say, Y, we can define the marginal utility of good X
(MUX).Mathematically, this is defined as:
For a brief introduction

to the concepts of
marginal values and
derivatives, consult
LC, Chapter 2, section
Measuring marginal
values.
This construct is called the derivative of U with respect to X, keeping Y

constant at Y0. It tells us how utility would change if we changed X, while
keeping Y constant.
The form which we give to the utility function reflects our beliefs about
how people relate to the world of economic goods (i.e. their preferences).
Having defined the utility function, we can look at its implications.
Example 3
Assume that the consumption bundles among which our individuals have to choose
consist of two goods, bedrooms (A) and television sets(B). Let us say that the number of
bedrooms is 3. You will probably agree that a change from 0 television sets to 1 television
set represents a substantial increase in utility. On the other hand, if we already have 14
television sets and add a fifteenth one, the increase in utility is likely to be insignificant.
There are two elements to this story:
1. increases in utility as we increase consumption of one good (marginal
utility) will depend on how many units of that good we already
consume
2. the marginal utility will depend on how much of the other goods we
consume (if we have 30 bedrooms, the fifteenth television set might
come in quite handy...).
This example points to a more general property of utility functions, as
they are typically defined in economics: diminishing marginal utility.
For a given consumption of all other goods, utility will rise in diminishing
increments with an increase in one particular good.
61
du
d
d
Figure 2.9: Diminishing marginal utility.
Marginal utility, as we have shown above, corresponds to the derivative

of the utility function. The derivative of a function is the change in the
functions value for a given change in one of its variables. This, of course,
is called the slope of a function.
Consider Figure 2.9. It shows utility on the vertical axis, and the
consumption of X on the horizontal axis. The consumption of the second
good, Y, is held constant at Y0. Initially, we are consuming X0 units of good
X and Y0 units of good Y. If we now change our consumption of X by an
amount dX, utility would change by dU. The magnitude of dU will depend
on where the initial X0 is located.
How would the magnitude of dU change as we increase the initial X0?
Had the initial X been at X1, dU would have been much greater.
Note that there is a slight problem with the concept of marginal utility:
A little while ago, we said that utility should be viewed as ordinal,
and that the actual numerical values did not matter. What, then, is the
significance of the falling marginal utility? This issue would not arise if we
viewed utility numbers as actually depicting the intensity of an individuals
preferences.
Indifference points
As seen in Figure 2.10, when moving from a point such as B, which is
inferior to A, to a point such as C, which is preferred to A, we must pass
through a point D, where we have no preference between D and A. We are
indifferent between bundles A and D.
The points which we rank as equally preferable to A will lie on a
downwards sloping line, going through A (by definition, we are indifferent
between a bundle and itself) and D. Such a line must go through
quadrants II and IV.
The reason why we can make such an assertion is our assumption about
the continuity of preferences. That is, if we take the line connecting point
B with C, we can see that there are many bundles along it. We know that
at B, U(B) < U(A) and at C, U(C) > U(A).
62

Figure 2.10: Indifference points.

Figure 2.11: Differences in utility for different bundles.
Let , on the horizontal axis of Figure 2.11, be a bundle on the line

between B and C. On the left-hand side of the graph, = B; at the
other end of the diagram, = C. On the vertical axis, we can write the
difference in utility between point A and point : U(A) U(). This is
positive on the left-hand side, since U(A) > U(B), but negative on the
right-hand side, since U(A) < U(C). As we move gradually from B to C,
we move from a less preferred to a more preferred bundle. On our way,
we must cross the point where U(A) U() = 0. This is the point where
= D and it means that U(A) = U() or, that the individual is indifferent
between A and D. Ordinality is trivial here because both points A and D
give the same utility to the consumer.
The slope of the indifference curve

There are many indifference points in Figure 2.12, where the utility of the
bundle at that point is the same as the utility of point A. We now want to
characterise the location of all such points, and draw a curve connecting
them.
Consider point A again. If we give up one unit of good X, we shall lose the
utility of that unit, as specified by the marginal utility MUX. Hence, the total
change in utility will be dX MUX. If we change our consumption of Y at the
same time by an amount dY, our change in utility from that will be dY MUY.
63
dy
dx
U0
Figure 2.12: The slope of the indifference curve.
Therefore, if we give up X and increase Y, there will be a point where our

loss of utility from X will be fully compensated by the increased utility
from Y. At that point,
dX MUX = dY MUY
We know from geometry that the slope of a curve, in particular the
indifference curve, is given by (dY /dX). Hence, rearranging the above
equation, we find that the slope of the indifference curve is given at A by:
What does this equation mean? MUX /MUY will be a number, say 5. What
does this number represent? The answer to this is crucial, and you should
bear it in mind at all times. Say MUX = 10 and MUY = 2. Then the fact that
10/2 = 5 means that the individual would be willing to give up 5 units of
Y in exchange for 1 unit of X. As we have seen, by construction, she will be
neither better nor worse off as a result of this change.
In other words, the slope of the indifference curve at any point represents
the individuals willingness to pay for X in terms of Y, in other words
how much of Y he would be willing to give up in exchange for one
extra unit of X. It is also referred to as the MRS: the marginal rate of
subjective substitution. This means the same thing: if we were to
substitute the consumption of X for the consumption of Y, it refers to the
number of units of Y we could take away for an extra unit of X.
Going back to the cucumbers/tomatoes example in Figure 2.5, what are the three
different MRSs illustrated?
64
Figure 2.9: The shape of the indifference curve.
The shape of the indifference curve

Consider the points A and B in Figure 2.9, which lie on the same
indifference curve. As we mentioned above, the slope of the indifference
curve represents an individuals willingness to pay at a particular point.
At point A, the individual has only a few X, while she has plenty of Y.
Surely, at this point, X (being scarcer) is more precious to her than Y
(think back to our example of the bedrooms and television sets), and she
would be willing to give up quite a lot of Y in exchange for one more X.
Consequently, the slope of the indifference curve at A (the number of Y the
individual would be willing to give up for one more X) is very steep. At B,
on the other hand, our individual has plenty of X and only a few Y, so her
willingness to pay for one more X in terms of Y should be much lower: The
slope of the indifference curve is much flatter.
Such an indifference curve is called convex. As we move along the
indifference curve from the top left (where we have a lot of Y but little X)
to the bottom right (where the opposite is true), the marginal utility of X
will decrease (),while that of Y will increase ():
This is mathematically
inaccurate, but it is an
easier way of presenting
the argument.
This is mainly a result of the decreasing marginal utility of consumption,

as we discussed above.
Individual behaviour and the budget constraint

Reading
We have now defined what we mean by the desirability of economic goods

through the concept of utility functions. We now have to complete the
picture by adding scarcity to our world picture.
We introduce scarcity through the concept of a budget constraint. Let an
individual have a money income I. In her world, there are only two goods,
X and Y, and she has to choose a bundle consisting of those two goods.
If we denote the prices of goods X and Y by PX and PY respectively, the
65
individual can choose bundles (X, Y) such that the cost of those bundles is
at most I, the total of her income:
PXX + PYY I
We call this the budget constraint of the individual: her choice of
bundles is constrained by her income, or the budget she has available for
consumption. Clearly, if she chooses a bundle such that the inequality
above is strict (<), she will have some money left over. The curve
connecting all the bundles where she spends all her income (that is, when
the equation above holds with equality, (=)) is called the budget line.
The budget line, a bit like the production possibility curve, divides
the world of economic goods into what is possible and what is not. The
intercepts with the horizontal and vertical axis are the points where the
individual uses their entire income for the consumption of one good. In
such a case, the individual will be able to buy I/Pi units of good i (where i
= X, Y).
Figure 2.14: The budget line.
The slope of the budget line reveals yet another concept of exchange.
Recall that so far we have talked about two such concepts. First there
was the slope of the production possibility curve which represented the
opportunity cost, or the technological rate of substitution. As
technology is assumed to be given, this exchange rate between X and Y
represents the social cost. It tells us how many units of Y (or X) we really
need to give up in order to obtain one more unit of X (or Y).
The second concept of price, or exchange rate, was the subjective rate of
substitution, or what one is willing to pay for one unit of X (and Y). This
exchange rate was entirely dependent on individuals preferences.
Now we have the slope of the budget line which will give us the market
rate of exchange between X and Y, or the price of X in terms of Y (and
also the price of Y in terms of X). If we are consuming X and Y such that
our income is exhausted, we are said to be on the budget line. The total
spending on X (PX X) plus the total spending on Y (PYY) equals our income
(I) (for instance point A in the above diagram).
If we now choose to consume 1 less unit of X (dX = 1), how many more
units of Y will we be able to buy? If PX = 10 and PY = 5, then giving up
one unit of X will leave 10 which we can now spend on Y. Given that the
66
price of Y is 5, we will be able to buy 2 units of Y (denoting the slope

of the budget line by , dY = dX). In our case, the slope is: = PX/PY =
10/5 = 2, hence dY = 2.Therefore, the slope of the budget line reveals the
exchange rate between X and Y that will be available in the market.
Utility maximisation
Reading
Assuming that the individual always wants more of all economic goods, they
would want to choose the most preferred bundle from the set of feasible
bundles. We know that utility is increasing in both X and Y (see above). We
also know that each level of utility corresponds to a convex indifference
curve. Translating this into the language of the model we say that the
individual wants to maximise utility (i.e. to choose the most preferred
bundle) subject to the budget constraint (i.e. from the set of feasible bundles
that they can afford). Graphically it means to choose the highest indifference
curve possible.

Figure 2.15: Utility maximisation.
Given the shape of the indifference curve, the highest level of utility will
be achieved whenever the indifference curve is just tangent to the budget
line. This is because a higher indifference curve denotes a higher level of
utility. However, an individual has to be confined within their budget and
thus the maximum utility that can be attained is at the point where the
indifference curve is just tangent to the individuals budget line.
Note that tangency means that the slope of the indifference curve is
the same as the slope of the budget line at the point of tangency. So
a consumer chooses the optimal consumption bundle whenever their
subjective rate of substitution (MUX/MUY) equals the market rate of
exchange (PX/PY). In other words, the individual pays for a unit of X in the
market place exactly as much as they are willing to pay!
The utility maximising individual will therefore want to consume X0 of X
and Y0 of Y (point A in Figure 2.15 in the world of two economic goods.
A point like A represents an optimal choice because there is nothing
the individual can do within this framework that will bring a higher
level of utility (or a more preferred bundle). At A, the subjective rate
67
of substitution (MUX/MUY) is the same as the market rate of exchange

between X and Y, PX/PY.

Figure 2.16: Suboptimal bundles.
If the individual is at a point like B, the subjective rate of substitution is

lower than the market rate of exchange. The slope of the indifference
curve (MUX/MUY) is smaller than the slope of the budget constraint (PX/
PY). This means that at B if the individual gives up one unit of X, they
would need units of Y to regain the same level of utility as B. However, if
they do give up one unit of X, they can afford = + units of Y per unit
of X at market prices. This means that they will be better off exchanging
some X for Y. This will be true as long as the subjective rate of substitution
differs from the market rate of exchange. In technical terms, they will
exchange X for Y as long as the slope of the indifference curve differs from
the slope of the budget constraint.
At A, however, the subjective rate of exchange equals the market rate of
exchange. Hence, if the individual gives up one unit of X at A, they will
need more than units of Y per unit of X to be able to increase utility.
However, in the market place they will get precisely units of Y per unit
of X. Therefore, if their aim is to increase their utility, they will not change
their consumption bundle once they get to a point like A. Therefore, A is
the point where they maximise their utility given the budget constraint.
Deriving demand for economic goods

Substitution and income effects
Reading
Having explained how individuals are making their choices, we can now
establish the downward sloping demand curve in the plane of quantity and
price as a result of utility maximisation. Figure 2.17 depicts this analysis:
68

Y
YP
10
PY0
P x0
P x1
B
U1
D(PY0,I0)
P 1x
P Y0
P 0x
P Y0
X0
10
P0x
10
P1x
X1
X0
X1
Figure 2.17: Utility maximisation and the demand function.
At A, the price of X is given as P0X and, for a given price of Y (P0Y) and a
given income I0, the quantity of X that will be demanded is X0. To analyse
the impact of a change in the price of X alone on the quantity demanded
we have to keep the price of Y, as well as income, unchanged. We simply
set P1X(< P0X) as the new price and repeat the analysis above to reach point
B as the new optimal choice. At B, clearly, the quantity of X demanded is
greater than before. Plotting the price of good X against the demand for
good X on the right-hand side, we observe a negative relationship between
the two: The lower the price, the higher is the quantity demanded when
the individual maximises utility. The downward sloping demand curve is
now a conclusion rather than an assumption.
But now we have further insights into these changes. We can see that a fall
in the price of X will shift the budget constraint in Figure 2.18.

Figure 2.18: Changing the price of good X.
The shaded area represents a whole new range of opportunities (either

to consume more X or to transfer some spending to Y) which were not
feasible before. Thus, without a change in the individuals nominal income,
there seems to be a rise in their real income: there is an income effect.
Given that individuals find both the two goods desirable, a change in the
69
price of X (which brings about a change in real income) will generate a

change in the demand for Y too. We therefore have to ask how the effects
of the rise in the price of X will be distributed between the two goods.
Also, if the change in the price of X has an income effect, then many
government policies that change the price we pay for goods (like taxation
and subsidies) will make people feel either richer or poorer in real terms.
Assuming that such policies are also concerned with redistribution of
income, this is an important new insight that we could not have derived by
treating the downward sloping demand curve as a law.
At the same time, since individuals find both goods desirable, and can get
the same level of utility consuming different proportions of both goods,
we will also observe a substitution effect. Individuals are likely to
substitute away from the good that is now relatively more expensive (Y in
our example) to the one that is now relatively cheaper (X).
Can we distinguish the substitution effect from the income effect (in other
words between that much more of X that we buy because it is cheaper
now, and that much more of it that we buy because we feel richer)? Yes,
but first we must establish what we mean by real income. Look again at
Figure 2.18: it is evident that in terms of X alone there was a significant
rise in real income but in terms of Y alone there was no real rise at all. So
has real income gone up or not?
We will consider two approaches to this question. One, following Hicks,
suggests that the relevant measure for real income is utility. The other,
following Slutsky, points to the initial bundle as the reference point for
real income. Let us consider those two approaches in turn.
Hicksian income and substitution effects

According to Hicks, real income is measured in terms of utility. Hence, the
substitution effect can be established by looking at the individuals optimal
choice had they confronted the new relative price (the new exchange rate
between X and Y), while keeping utility at the initial level U0. This can be
achieved by finding the point of tangency of the new relative price with
the initial indifference curve, U0 (point C in Figure 2.19):

Figure 2.19: The Hicks substitution and income effects.
The move from A to C is what we may call the pure (or, sometimes, net)
substitution effect. It simply tells us how a utility-maximising individual
70
would respond to a new market exchange rate between X and Y if their

real income remained unchanged. Given the Hicksian definition of real
income, based on utility, the individual enjoys the same level of real
income at both A and C, because their utility is the same at these two
points.
Notice that the move from A to C is determined by the shape of the
indifference curve (which is the same as the utility curve). The reason
why an individual will consume more of X as the price of X (in terms of
Y) falls is that the market price at A for X is now less than they are willing
to pay for it. Evidently, the optimal behaviour for this person in such
circumstances is to buy more of X.
As the individual buys more of X (and also consumes less of Y), the
marginal utility of X will decrease while the marginal utility of Y will
increase. MUX/MUY is now smaller: as we have plenty of X and only a few
Y, the willingness to pay for X will be reduced until the individual gets to
the point where her willingness to pay is the same as what she is being
required to pay in the market place.
Hence, due to the convexity of the indifference curve, there is always an
inverse net-substitution relationship. In other words, because of diminishing
marginal utilities we will buy more of the good whose price has fallen.
Let us now consider the move from C to B. Naturally, as both A and C are
on the same indifference curve (meaning that they are at the same utility
level) and at B we are on a higher level of utility, the move from C to B
must be the income effect.
The move from C to B in Figure 2.19 can be brought about by a parallel
shift of the budget line caused by an increase in nominal income between
points C and B. However, there has been no change in nominal income,
so budget lines at B and at A are for the same level of nominal income.
Evidently, then, at C the income which can be associated with the initial
real income (U0) must be lower than the income at A. The difference
between income at C, (the amount of money needed to sustain the original
level of real income at the new prices) and income at A can be considered
as a nominal equivalent to the real income effect.
For instance, let I0 = 100, P0X = 10 and P0Y = 10. Point A in Figure 2.20
captures the initial position where the consumer chooses the bundle (5, 5).
Y
100
10
70
10
6
(Yo) = 5
(Yc) = 4.2
30
5
Xo
6 8
Xc
100
10
70
5
Figure 2.20: Hicksian income and substitution effects.
71
Now the price of X has changed to P1X= 5. The individual will move to
a new preferred choice point B above, where she consumes (8, 6).
Following Hicks, we want to isolate the substitution effect by looking at
what the individual would have chosen if she confronted the new relative
price at the original level of utility. Point C in Figure 2.20 is such a point,
where the individuals choice is, say, (6, 4.2). We can now calculate the
level of nominal income that would have been needed for her to be at
point C.
4.2 = 72
So the shift from C to B can be explained as an equivalent to a rise of

28 in income (from 70 to 100), if there was no substitution effect to be
considered (that is, if relative prices had not changed). Notice, however,
that there was no actual change in nominal income during the move from
A to B.
You may also have noticed that in this case, at point C the individual could
not consume the bundle which is depicted by A: the budget line which
is tangent to C lies below A. Naturally, this causes some unease with the
Hicksian definition of real income because it suggests that although the
consumer cannot consume her initial bundle any more, she still enjoys the
same level of real income.
The Slutsky analysis
In the Slutsky analysis, we simply ask ourselves what the individual would
choose if there were new relative prices but she is able to maintain her
present consumption. This will reveal the net substitution effect, since real
income (measured in terms of the ability to buy the initial bundle) remains
unchanged. This idea is illustrated by the use of an imaginary budget line
that goes through A but reflects the new price ratio, as in Figure 2.21.

Figure 2.21: The Slutsky analysis.
72
As the new budget line, with changed relative prices, goes through A, it
cannot be tangent to the indifference curve at A. Hence A can no longer
be considered as the optimal choice (because the subjective rate of
substitution in A is greater than the market exchange rate between X and
Y). The individual will choose to be at point C, which is on a higher utility
level.
To calculate the nominal equivalent to the real income effect we can now
simply ask how much money would be needed to consume the bundle at A
at the new prices. The answer here will be 75. This is because to consume
the bundle at A at the new prices we need money amounting to
P'XX0 + P0Y Y0 = 5 5 + 10 5 = 75
Therefore, according to Slutskys definition of real income, the nominal
equivalent to the income effect is only 100 75 = 25.
Think about these two different approaches. Will the substitution effect always be greater
under Slutskys definition of real income than under Hickss?
Normal and inferior goods

Having distinguished between the income and substitution effects, we
are now able to make a further distinction, that between normal and
inferior goods. We will show that a normal good is defined as a good
that has a positive income effect, while inferior goods have a negative
income effect.
It is because we have provided an explanation in the form of the
rational utility maximiser that we are able to distinguish:
a. between substitution and income effect, and
b. between inferior and normal goods.
If we had chosen to accept the downward sloping demand curve as a law
or axiom, rather than as the outcome of more fundamental processes, we
would not have been in this position.
Bear in mind that the net-substitution effect is always inversely related
to the change in the relative price (the market exchange rate between
the goods): the cheaper (in relative terms) a good becomes, the more we
consume of it. This, we established, is due to the nature of utility functions
and their indifference curves. Hence, any proposed distinction between
goods cannot depend on the net-substitution effect. It must, therefore,
depend entirely on the income effect.
In Figure 2.22, the price of X has fallen from P0X to P1X. Net-substitution
suggests that the individual will move from point A to point C. This is
always true, regardless of whether the good is inferior or normal.
73

Figure 2.22: Normal and inferior goods.
The move from the broken line at C to the new budget line requires a
parallel shift, which, as we saw, is equivalent to an increase in nominal
income. This, therefore, is the income effect. The increase in real
income means that the individual can now buy more of all goods. It
would be perfectly rational for the individual to choose to move to a point
B anywhere on the new budget line, where utility is higher.
There are now two main possibilities:
1. the individual moves to the right of point C (which means that as
income increases, the individual will want to consume more of X).
In this case we say that X is a normal good, whose consumption
increases with income.
2. the individual will choose to be on the left of C (which means that as
income increases, the individual will want to consume less of X).
In this case, we say that X is an inferior good, in the sense that the
consumption of X decreases as income increases.
Try to think of some examples of inferior goods, and explain why consumption of them
decreases with income.
The position of B, in the end, depends on where indifference curves
are, and which option will be chosen is entirely a matter of personal
preferences. Therefore, being an inferior or normal good is not an
intrinsic characteristic of a good. It is the way in which individuals
see them which makes us consider them as either normal or inferior.
We now have three possible effects that a change in the price of a good can
have on the quantity of it which will be demanded. Figure 2.23 offers a
summary:
74
Figure 2.23: Normal, inferior and Giffen goods and their demand schedules.
In the case of a normal good, net-substitution and the income effect seem
to be working in the same direction (A to BN). In the case of an inferior
good the income effect appears to work in the opposite direction to the
net-substitution effect. There are now two possibilities. Either:
i. the net-substitution effect is greater (in absolute values) than the
income effect (A to BI), or
ii. the net-substitution effect is smaller (in absolute values) than the
income effect (A to BG).
We distinguish the latter (ii) from the general group of inferior goods by
naming it a Giffen good. For example, Sir Robert Giffen observed that
an increase in the price of wheat led to an increase in the demand for
bread by nineteenth-century peasants. However, it is widely believed by
many that Giffen goods do not exist in practice as it is unlikely to be the
case that a negative income effect would be strong enough to offset the
substitution effect. As before, we can translate these price effects into a
demand function, on the right-hand side. We see that the demand for a
normal good will tend to be flatter than the demand for an inferior good.
The demand for an inferior good for which the net-substitution effect is
dominant continues to be downward sloping, while that of an inferior
good for which the income effect dominates (a Giffen good) is upward
sloping.
Complements and gross substitutes

Since we are defining our preferences over the entire space of economic
goods, decisions we make about one good will influence our decisions
about the other goods. Where there are two goods, choosing the quantity
of X also means choosing the quantity of Y. Therefore, the demands for the
two goods are interrelated.
Consider again the fall in the price of X as discussed above, but now, let
us concentrate on what happens to the quantity of Y demanded (Figure
2.24).
75
!

"
"
'

Figure 2.24: Complements and gross substitutes.
There are, in principle, two possibilities. Either:

i. B (the new optimal point) falls above A, which means we increase
the consumption of Y when the price of X falls, or
ii. B falls below A, in which case we reduce the consumption of Y as the
price of X falls.
Where the consumption of Y increases when the price of X falls (case i),
we say that X and Y are complements. A fall in the price of X suggests
that people will buy more of X (unless X is a Giffen good). If they also
consume more of Y, then, in a sense, the two goods go together, or are
complementing each other. Common examples of such goods are cars and
fuel. As the price of fuel falls, there will be greater use of private cars and
greater consumption of fuel.
In a case where the consumption of Y falls as the price of X falls, we say
that X and Y are gross substitutes. (We use gross to distinguish it from
the substitution which we discussed before). Again, a fall in the price of X
will lead to more consumption of X, unless it is a Giffen good.
If consuming more of X means consuming less of Y, we must feel that we
can substitute X for Y. A typical example can be the use of private cars
and public transport. When the price of public transport drops, people will
tend use their private car less and travel more on public transport.
A generalised demand function

Let us now summarise and generalise the derivation of demand that we
have pursued so far:
1. The desirability of economic goods presents itself in the form of
preferring more to less; a rational individual has consistent
preferences over the world of economic goods which can be
represented by a real number function called the utility function.
2. This means that individuals demand for all goods is determined
simultaneously.
76
3. The individual confronts scarcity in the form of a budget constraint.

4. A utility maximising individual will choose the bundle where their
willingness to pay equals the market price or exchange rate
between the goods.
Figure 2.25: Deriving demand.
The choice of both X0 and Y0 in Figure 2.25 reflects the individuals demand for X and Y.
5. The demand for X, therefore, depends on those parameters that
determine the position of point A.
6. Point A is determined by the utility function (which determines the
shape and position of the indifference curve), and the position of the
budget line.
7. The position of the budget line is determined by Income (I) and the
prices PX and PY.
8. Hence, demand is a function of the utility function, income,
and prices. We can write it as a function:
Xd = D(PX, PY, I, U)
and for given tastes (assuming no change in U):
Xd = D(PX , PY, I)
(Note that D is the demand function and Xd is the quantity
demanded).
9. The first and immediate property of this demand function is that it is
homogeneous of degree 0. This means that if we, say, doubled all
variables (PX , PY and I), the choice of X will remain unchanged, since
the position of the budget line is unaffected by such a change. (The
budget line is determined by the intercepts: I/PX , I/PY and the slope:
PX /PY .)
10. The quantity demanded of X is inversely related to the price of X if X is
a normal or non-Giffen inferior good.
77
11. The quantity demanded of X is directly (positively) related to the price

of Y if X and Y are gross substitutes and inversely related if X and Y
are complements.
12. The analysis can be generalised in the following way: if there are n
goods in the economy, denoted by (X1, . . . , Xn), the demand for good 1
will take the following form:
Xd1 = D(P1, . . . , Pn, I)
This D is homogeneous of degree 0 as well: everything we said about PX
holds here for P1; and everything we said about PY is true here for any
of the other prices.
Market demand
We have now derived the individual demand schedule through our
analysis of the rational utility maximiser, and found, as expected, an
inverse relationship between quantity demanded and price. Market
demand is simply the total quantity demanded. It is the sum of the
quantities demanded by each individual when their willingness to pay
equals the market price. The right-hand diagram is thus a summary of the
three diagrams to its left.
Technically, this is called horizontal summation. Figure 2.26 is a
geometrical presentation of this idea. It shows three individuals (which
could also be groups of individuals) and a total market demand (on the
right).

Figure 2.26: Market demand.
In this figure, X10 , X20 and X30 are the quantities demanded by each
individual at the price P0X, and XT0 = X10 + X20 + X30 is the total quantity
demanded in the market.
Demand price elasticity

Reading
Consider the demand schedule shown in Figure 2.27, which represents

the relationship between the quantity of X demanded and its price
(we assume all other prices and income are fixed). For the purpose of
our analysis, we can treat this either as the market demand, in which
case income is that of the entire population, or as the demand of a
(representative) individual.
78

Figure 2.27: Deriving demand price elasticity.
If the current price is P0X and the quantity demanded at that price is X0, then
total spending on X is P0X X0. This is both the consumers expenditure and
the producing firms revenue.
If the price of X falls to P1X and the quantity demanded increases to X1, total
consumer spending will now be P1X X1.
Geometrically, we can say that the total spending at point A is:
+
and at point B the total spending is:
+
The question we wish to investigate is what will happen to consumer
spending (or firms revenue) if the price of X falls. What factors influence
whether spending (revenue) changes in direct or inverse relation to the
change in price?
We begin by investigating the case when revenues (and spending)
decrease as the price decreases. Revenue at A will be greater than revenue
at B. Given our previous notation, this means that + > + .
Since is a common area, we need > for this direct relationship to
hold. But when is this the case? What exactly are these areas?
If the quantity demanded had stayed at X0 after the price has fallen from
P0X to P1X, the loss in revenues (or, from the point of view of the consumer,
the savings on purchases) would be . Therefore, we can write = dP X.
Similarly, represents the gains on the new sales (or the extra spending on
the added consumption). In other words, = dX P.
Hence, the inequality > holds if:
dP X > dX P
Note that both and are positive numbers. However, when dP > 0, dX
< 0. This is because the demand curve is downward sloping generally.
Hence, we are really looking at the absolute values of the changes.
Writing the equation in terms of absolute values and rearranging it, we find:
|dP X| > |dX P|
Dividing through by dP X we get
d
d
d /X
dP/ P
| | denotes absolute
values. Normally, when
dP < 0, dX > 0, but
geometrically we do not
have negative areas.
79
We see that > whenever is less than 1. This is called the price
elasticity of demand, and is defined as the proportional change in
quantity over the proportional change in price. Being less than unity
means that the proportional change in price (in absolute values) is greater
than the proportional change in quantity, and revenues (or consumer
spending) will change in direct relation to the change in price. Figure
2.28 depicts such conditions. It is easy to see that > (or || < 1).

Figure 2.28: Inelastic demand.
This means that a reduction in price will reduce consumers spending (and
firmsrevenues) on that good.
Similarly, Figure 2.29 depicts a typical case where < (|| > 1).
Figure 2.29: Elastic demand.
We can see from these two graphs that when || < 1, the demand curve is
quite steep, while when || > 1, it is quite flat. Another way of describing
this situation is that in Figure 2.28, the quantity demanded changes
relatively little for a given change in price (this is inelastic demand),
while in Figure 2.29 it changes a lot (this is elastic demand).
80
Example 4
Let us now return to the bridge problem posed at the beginning of the
chapter. To remind you, what we had there was a government having to
decide on whether to build a bridge in a case where demand and supply
do not intersect. Market research has produced the demand schedule
shown in Figure 2.30, and the engineering investigation produced a
bridge of minimum capacity of T crossings per day at a cost of C:
Figure 2.30: A bridge revisited.
Now that we have derived demand from utility we know that when an
individual chooses a quantity at a given price they are in a position where
(MUX /MUY) = PX/PY units of Y per X.
Suppose that crossing the bridge is X. So when an individual answers the
questionnaire by saying that they would cross 5 times a day if the price
was 10, it means that for a given price of other goods Y (say, 5):
(MUX/MUY) = PX /PY = 2 units of Y per X
Put another way, at 5 crossings a day, the marginal utility of crossing
(measured in terms of y which the individual is willing to give up) equals
2 units of y per crossing. As the price of Y is 5, in money terms this means
that bridge users are willing to pay (2 units of Y times 5 per unit =) 10.
These 10 denote the money value of the marginal utility from crossings at
the point where the individual crosses 5 times. If, then, the demand schedule
denotes a money value for the marginal utility of each crossing, adding up all
these marginal utilities(vertical lines from the X-axis to the demand schedule)
will give us the individuals total utility at a given price of Y.
This is not formally

accurate but it is
possible to show that
the demand can produce
a money approximation
for utility.
In other words, the area underneath the demand schedule gives us a

money value for the utility of a rational individual. Thus the total amount
of benefits generated by the bridge is the area trapped in the demand
triangle in Figure 2.31.
As we have identified the overall benefit B in money terms, the
government can examine whether this exceeds the overall cost (C) and
thus decide whether or not to build the bridge.
Of course, in reality the problem is more complex, as there are issues of
financing to be considered. Still, what I hope you were able to see is how
the use of utility functions helped us to analyse and evaluate the demand
schedule. This analysis enabled us to create a framework in which we can
81
Figure 2.31: The money value of utility.
gain further insights into the nature of demand. In the process, we found
that even when supply and demand do not intersect (as in the bridge
example), our interpretation of the area under the demand schedule, or
the money value of utility, enabled us to make an informed statement
about the desirability of building the bridge.
Self-assessment
Define the concepts of utility, equilibrium price, transitivity, marginal
utility, indifference points and indifference curves, income effect,
substitution effect, inferior and normal good completeness and gross
substitutes, price elasticity, and real income.
Derive utility and indifference curves.
Use utility and demand curves to analyse problems involving choice,
utility maximisation, substitution and income effects, and price
elasticity of demand.
Give an example of:
a case where changes in taste or fashion lead to an increase in both
supply and price
the formula for expressing preferences between three different goods
a Giffen good.

Try to answer the questions without looking at the answers. After you have
answered all the questions, compare your answers with someone else who
is studying this course. If there is no other student you can consult, choose
a (patient) friend or family member and try to explain to them the issues
involved. It doesnt matter if they dont know anything about economics:
this will force you to explain the subject in a way that will help you
82
understand things which you would not have understood otherwise. Only
after all these trials should you compare your answers with the answers in
the book.
Question 1
When the price of X is 3 and the price of Y is 3, an individual consumes a
bundle of X = 4, Y = 4. When the price of X has become 1 and the price
of Y 5, the individual chooses a bundle of X = 3, Y = 5. Therefore, the
consumer prefers (3, 5) over (4, 4). True or false? Explain.
Question 2
In a world of two goods, when the demand elasticity of good X is greater
than unity, X and Y must be gross substitutes and X is more likely to be a
normal good. True or false? Explain.
Question 3
A good is a normal good whenever the substitution and income effects
work in the same direction. True or false? Explain.
Question 4
The Slutsky substitution effect is always greater than the Hicksian
substitution effect. True or false? Explain.
Question 5
A company considers a package to help employees with the running cost
of their cars. It considers two options:
A. to offer a fixed amount of money towards the use of the car in addition
to a cost-free usage for the first X0 miles;
B. to participate in the actual cost of running the car (i.e. pay a certain
amount, a0, per mile used).
a. Let X represent mileage of car usage and Y all other goods. Draw each
of the options while analysing the individuals response to the proposed
change (i.e. discuss the income and substitution effects);
b. which of the two options will the employee prefer if the company
decided to spend the same amount of money under the two options?
c. will your answer to (2) change had option A included only free
mileage?
d. which of the two options would the company prefer if it aims at
achieving the same real income improvement at a lower cost?
Question 6
A telephone company charges its customers a fixed sum of T for the first
X calls they make in a given period. Every extra call is then charged at
the price of PX a call. The company would like to replace the existing
arrangement with a new one. It considers two alternatives:
A. abolish the fixed payment and charge a lower price for each call;
B. increase the number of calls allowed under the same fixed payment
and increase the price of every extra call.
Assume that customers always make more calls than are covered by the
fixed payment.
a. Draw the budget constraint confronting customers under the initial
scheme;
b. Draw option (A) and consider whether customers are likely to be better
83
or worse off. Can the company choose a price where customers are
equally well off as under the original scheme? What will happen to the
number of calls in such a case?
c. Draw option (B) and consider whether customers are likely to be
better or worse off. Had the option been designed in such a way as
to allow individuals to consume the number of calls they would be
able to consume under (A), will it be a better or worse option for the
consumer?
d. If you knew that most customers use the phone only slightly above
what is covered by the fixed payment, which of the schemes would you
recommend? How would you advise the company if this was not the
case?
Question 7
It is better to give the poor a subsidy for food rather than an
income supplement which they are likely to spend on other
goods and alcohol.
Suppose individuals consume only two goods, X, which is food and Y,

which is other goods (including alcohol), and that they have an income
of I.
a. Show the effects on consumption of paying a subsidy of s per unit of X
consumed;
b. Show the effects on consumption of paying income supplement of S;
c. Compare the effects of the two schemes assuming that government
spending on each individual is the same in both cases (this means that
if under the subsidy scheme the individual chooses Xs then sXs = S);
d. Comment on the statement.
Answers
Question 1
This is a question about choice. It could be analysed by the use of revealed
preference approach (for those students who are familiar with it) or by
simple utility analysis. Of course it is the latter which we expected to find:

Figure 2.32
84
We have the following situation: At point A, (4, 4), in Figure 2.32, if the
consumer is rational his choice will exhaust the following budget line:
P0X X0 + P0Y Y0 = 3 4 + 3 4 = 24
At B his income is obviously greater:
P1X X1 + P1Y Y1 = 1 3 + 5 5 = 28
However, he could have afforded point B on the initial budget line:
P0X X1 + P0Y Y1 = 3 3 + 3 5 = 24
which suggests that the individual chose A when B was available. So,
if anything, the individual prefers A over B. It is easy to see, using
indifference curve analysis, that the individual behaves irrationally by
choosing point B.
Question 2
In order to analyse the nature of X and its relationship with Y we must
investigate a change in the price of X. Suppose that the price of X fell. This
leads to the following diagram:

"
&

Figure 2.33
Using the information that the demand elasticity for X is greater than unity,
we can conclude that as a result of the fall in the price of X, spending on X
will rise. As nominal income is unchanged, spending on Y must come down.
As the price of Y too, remains unchanged, the quantity demanded of Y must
fall. This suggests that X and Y are gross substitutes. In the above diagram,
points on the new budget constraint where the consumption of Y has
decreased are indicated by the heavy line. We can see that such points are
likely to lie to the right of C, therefore X is more likely to be a normal good.
85
Question 3
False. A simple counter example like the case where income is given in
kind (as below) should be sufficient:

Figure 2.34
The individual gets income in kind: IK = (XK , YK). At A he sells some of his
endowment in X and buys some more Y. When the price of X falls, the new
budget line will have to go through his point of income (because he can
always choose not to trade). Substitution considerations will lead him to C
while the fall in real income will mean that the good is normal only if the
income and substitution effects work in the opposite directions.
Question 4
False. There are three components to this question:
a. The difference between Hicks and Slutsky definitions of real income.
b. Analysing the fall in the price of X and showing that the Slutsky
substitution effect is greater when utility functions are homothetic and
the good is normal (the left-hand side diagram below).
c. Analysing the fall in the price of X and showing that in the case of an
inferior good, the Hicksian substitution effect is greater.
Note: the reverse will be true if you analyse an increase in the price of X.

Figure 2.35
86
Question 5
This question combines both an analysis of the budget line and the
theory of consumer choice. In the latter part, the main analytic elements
are income and substitution effects.
a. An employee is offered by a company a package to help in the running
cost of his company car. There are two options:
1. A lump-sum payment (L) towards the use of the car as well as a
certain amount of free usage (measured in miles). This option is
captured in the left-hand part of Figure 2.36.
2. a subsidy per mile used. This option is captured in the right-hand
diagram of Figure 2.36.

Figure 2.36
In both cases the individual will increase the use of the car. In the case
of the lump-sum payment, there will be no substitution effect, since
the relative price doesnt change, while in the case of the subsidy there
will be both income and substitution effects.
b. To spend the same on the two schemes means that the amount of
money paid out to the individual according to their use of the car
should be the same as the money paid to them when the payment is
independent of that use. This means: a0 X0 = L.
87
Figure 2.37
In other words, the budget line under offer (1) must cross the budget
line under offer (2) at the point where the individual would choose to
be had he received (2). We can show this formally: at B
(option 2) (P0X a0 ) X0 + P0Y Y = I0
(option 1) P0X X0 + P0Y Y = I0 + L
P0X X0 + P0Y Y = I0 + a0 X0
a0 X0 = L
If the two offers are to be of equal money value, point B must be on

both budget lines.
It is evident that the individual will prefer option 1, since this
represents a higher level of utility.
c. The answer will not change, but the company will need to offer more
free miles.
d. If the company wants to achieve a certain real income improvement,
say U1, then it is easy to see that the cheapest option will be option 1:
Y
I0+L
P Y0
n
tio
Op
I0
P Y0
Option 1
B
U0
X0
Figure 2.38
88
As the budget line of option 1 is tangent to the indifference curve

upon which the choice of option 2 has been made, the choice under
option 2 (point B) will not be feasible had option 1 been finally offered.
Therefore, the money which the company will spend under option 1 to
achieve the same utility as under option 2 will be much reduced.
Question 6
This question has two major components. One is the budget constraint and
its possible shapes; the other, a comparative analysis of individuals
choice. It aims at showing how economists may use abstract frameworks
to provide practical recommendations.
The pretext is the pricing policy of a telephone company. As no
information is provided regarding differences in costs or the market
structure, it implies that the criterion for choosing a scheme is a different
one. From reading the question in its entirety, we can deduce that this is a
firm which is more concerned with its public image than with its position
in the market.
This is clearly an indifference curves analysis, simply because the main
question here is whether or not the customer (a representative individual)
will be better or worse off. The next step, therefore, is to translate the
question into the language of the model.
Here, the real jump is the transformation of the three pricing policies (the
existing one, (A) and (B)) into forms of budget constraints.
The initial budget constraint is drawn in Figure 2.39.
Figure 2.39
e. Figure 2.40 details the diagrams that should emerge. Scheme (A)
is drawn in the left diagram. Note that if consumers were initially
at P they might be worse off. Had they been initially at T they will
definitely be better off. In the right-hand diagram, it is shown how a
price can be set such that their utility remained unchanged (this is an
example of how at a point like P, individuals will not be made worse
off).
89

Figure 2.40
f. The general principle is depicted in the left diagram of Figure 2.41.

At point P,they will definitely be better off. Had they been initially at
point T they might be worse off. This is exactly the opposite of the
previous scheme. In the diagram on the right we can see the
circumstances where scheme (B) is designed in such a way as to ensure
the feasibility of the choice under scheme (A). It is clear from this that
in such a case, individuals would rather have scheme (B).
Figure 2.41
g. This requires a more general answer: had the consumers been initially
at point P on Figure 2.42, scheme (B) is likely to appeal to them
more. Had they been initially at point T, scheme (A) would be more
appealing. One must bear in mind that we have no information about
the costs of the two schemes. Assuming that they cost the same, the
company would want to appear as having the consumers benefit in
mind.
90
Figure 2.42
Note: this question is a good example how one can conduct a rigorous
discussion even when there is no single answer. This, to a great extent, is
what economics is all about.
Question 7
As in Question 6, this question has the same major components: the
budget constraint and the comparative analysis of individuals
choice. The pretext here is the famous problem of subsidising goods
or individuals. Here, the analysis is conducted from the point of view
of the affected individuals. Other social issues and the difference in
administration costs are neglected, since there is a complete lack of any
information regarding the cost side of the two schemes.
Just like in the previous question, the analytical framework is clearly an
indifference curves analysis, simply because the main question here is
whether or not are presentative individual will be better or worse off. The
next step, therefore, is to translate the question into the language of the
model through the transformation of the two policy tools into forms of
budget constraints.
a. and b. The diagram on the left of Figure 2.43 depicts the effects of a
subsidy (s) on the budget line and the possible consumption
of X. The diagram on the right depicts the effects of an income
supplement S on the budget line.
Figure 2.43
91
c. Here, the main test lies in interpreting the equal spending (i.e. sXs = S)
and the relative positions of the two budget lines:

Figure 2.44
Notice that sXs = S means that the income-supplement budget line will
always go through whichever choice the individual would have made
under the subsidy scheme.
d. Using Figure 2.44, we can use indifference curves analysis to show
that the income supplement will be preferred by individuals. Note that
the indifference curves which are tangent to the two budget constraints
will not be the same!
92
Chapter 3: Production and the behaviour of the firm
Chapter 3: Production and the behaviour

of the firm
Learning outcomes
define the concepts of productive efficiency, isoquants and iso-cost,
marginal and average product, constant returns to scale, transaction
costs, diminishing marginal return fixed and variable costs, the
relationship between marginal and average costs
use these definitions to give examples of increasing returns to scale, the
interrelation between marginal cost and returns to scale, homogeneous
production function, and profit maximisation with respect to output
and the firms supply curve
construct cost-functions and derive their relation to the production
function
use diagrams to analyse problems involving short-run and long-run
average cost schedule.
Reading
LC Chapter 6.
Production functions
Reading
LC Chapter 6 p.117.
Production is a process whereby the combined activity of various economic

goods creates another economic good. To simplify our explanations, we
will divide all goods used in the production of other goods into two
categories: Labour (L) and Capital (C). Capital denotes all non-labour
inputs, such as machinery and other physical assets..
In the real world, the L and C inputs are typically aggregates of various kinds
of labour, and various kinds of capital, but again we will simplify and assume
that there is only one kind of labour input and only one kind of capital input.
The process of production simply relates a set of quantities of inputs K
and L (factors of production) to a quantity of output, X. This can be
expressed as a function, X = f(K,L). The function gives the level of output
X for any combined level of capital and labour inputs.
From an analytical point of view, the production function is very much
the same as the utility function (see Chapter 2). In both cases, we use
economic goods to produce another economic good. The difference is that
in the case of the production function we produce tangible economic
goods, while in the case of utility (which is an abstract notion) we
produced a non-tangible economic good.
Since we assume that factors of production are scarce, and that the
output produced is desirable, we are interested in finding the optimal
combination of inputs that will produce the optimal amount of output a
state that we call productive efficiency.
Previously we have
used the letter C to
refer to Capital; from
here on we will use the
letter K, which is the
normal convention in
economics.
Contrast this with

utility functions,
where our goal was to
choose consumption
in such a way as
to maximise utility.
This corresponds to
allocative efficiency.
93
In order to find the state of productive efficiency, we first have to look

at the circumstances of production.
Suppose that a certain commodity X is produced by using labour and
capital. How does this production process work?
In Figure 3.1 we set the horizontal axis to denote the quantity of
labour (L) used (measured in work-hours) while the vertical axis denotes
quantities of capital (K) used (measured in machine hours).

Figure 3.1: Combinations of production inputs.
At A, the combination of L0 units of labour (measured in hours) and K0

units of capital (measured in hours) can produce X0 units of X, so X0 =
f(K0, L0). At any point in quadrant III, the combination of labour and
capital will yield less units of X than X0. All points in quadrant I suggest
combinations of inputs which yield X X0. There are points in quadrants
IV and II where the loss of output as a result of a fall in the level of one
input can be offset by an increase in the use of the other input (compare
this to our analysis of utility in Chapter 2).
Choose a point in the four quadrants at random. What can you say about output in the
quadrant you have pinned?
Put differently, we can increase the level of output if we increase one
or both inputs, just as we could increase utility if we increased our
consumption of one or more goods. However, as with utility analysis, this
implies two things about our production function: First, that technology
is continuous, and second, that the two inputs can be divided and
substituted at all levels. This means that when we move from a point
such as B in quadrant III to a point like C in quadrant I, output increases
continuously as we continuously increase both inputs. Hence, as at B X
X0 and at C X X0, there is a point like D where X = X0. This means that
all the other points of equal output (called isoquants) are located in
quadrants IV and II. Like indifference curves (see Chapter 2), they will
be located on a downward sloping line.
The assumptions of divisibility and substitutability are not as
straightforward as in the case of utility analysis. Divisibility simply means
that we can measure inputs in terms of their time contribution. If there
94
is divisibility, we can talk of any fraction of a unit that can affect output.
While some may have difficulties with this, we shall not consider it as a
serious problem. Substitutability is a much more difficult problem.
Consider linear production processes, and assume that we have three
different such production processes, or technologies: T1, T2 and T3. Each
technology requires different combinations of inputs in the production
process, as indicated by the slope of the rays through the origin.
Furthermore, assume that we cannot increase output by merely increasing
one of the inputs. We must use both and maintain the same proportions
between them. (This is called a Leontief-style production function.) So,
in the case of A in process 1, you need L10 units of labour and K10 units of
capital to produce 1 unit of X (Figure 3.2).

!
Figure 3.2: Production isoquants.
The isoquant is L-shaped because increasing only labour or capital

(points B or C) will not increase output. Many people think this is how
production technologies really look. But in such a case there is clearly
no substitutability between the means of production. If you want to
produce 2 units of X using process 1, you will need to move to a point like
D, where both labour and capital have been increased to L11.units of labour
and K11 units of capital. The fixed proportion between the two means of
production is captured by the ratio of capital to labour (K/L) which is
depicted by the slope of the ray from the origin. At both A and D.
However, if we take substitutability to mean that we can choose

combinations of technology, then we may be able to move closer to the
notion of substitutability. If points A and E represent the combination
of capital and labour required for the production of one unit of X under
technologies 1 and 2 respectively, point F represents the inputs required
to produce one unit of X by a combination of the two technologies. The
greater the share of technology 1 has in the production, the nearer F
will be to A. The greater the share of technology 2 in the production, the
nearer F will get to E.
95
If, in addition, we have technology 3 to consider, F ' depicts the level of

inputs required for the production of one unit of X with the combination
of technologies 2 and 3. As before, the more of technology 2 we use,
the nearer F ' will be to E. The more of technology 3 we use, the nearer
F F ' will be to G. If indeed we can mix technologies, we can see that the
levels of inputs required for the production of one unit of output are
arranged along the heavy curve in figure n, which may remind you of
the indifference curve. This means that if we have a very large number
of technologies available, the move from one technology to another can
constitute the notion of input substitutability.
Therefore, we would claim that while smooth functions may not directly
capture the nature of the production process, they nevertheless constitute
a good abstraction of it. We will obviously be looking for a function that
will be able to generate similar properties as the mixture of processes (i.e.
smooth isoquants which are convex).
Such a production function is given by X = f(K,L), where f is a realnumber, continuous and twice differentiable function.
Properties of the production function.
Figure 3.3: Properties of the production function.
a. It is increasing in L and K (): As we increase the amount of one or

both inputs used, output increases.
96
Figure 3.4: Marginal product.
b. The marginal product (MP) of Capital and Labour: Defines the increase
in output for a one-unit increase of a particular input, keeping the
other one constant:
at L0 for a given level of the other input (K)
We typically assume that the marginal product is increasing for low levels
of an input, but decreasing for high levels. This is referred to as increasing
and diminishing returns to a factor, respectively. This assumption yields
a graph as in Figure 3.4, which depicts the level of output attainable
for every level of one input (here, Labour), keeping the level of the other
input (here, Capital) constant
c. Isoquants: Combinations of K and L which yield the same level of
output are arranged on a curve going through regions IV and II in
Figure 3.3 above. This curve is called the isoquant, and is defined
for every level of output.
d. The slope of the isoquant is defined as dK/dL when X is
unchanged. If we change L by dL, output will change by dL MPL[HS1],
given property (b) above. In the same way, if we change K by dK,
output will change by dK MPK. Along the isoquant, the change in
output as a result of a change in K has to equal the change in output as
a result of a change in L. Hence:
dL MPL = dK MPK
which implies
We thus have to change the amount of K we use by this much to

substitute a unit of L for output to remain unchanged.
e. Diminishing marginal product: because of the diminishing MP.
In terms of Figure 3.5, this means that the slope of the isoquant is
getting flatter as L increases (and steeper as K increases).
97
Figure 3.5: The slope of the isoquant.
Returns to scale
Let X denote output. K and L denote the two factors of production, capital
and labour respectively, and f represents the production function:
X = f(L,K).
Returns to scale is a measure of how effective an increase in the scale
of operation would be.
Increasing returns to scale means that the proportionate increase
in output is greater than the proportionate expansion of operations.
Constant returns to scale means the increase in output is
proportionately the same as the increase in operations.
Decreasing returns to scale means that the proportionate increase
in output is less than the proportionate expansion of operation.
In the context of production functions, the scale of operation is
captured by the amount of inputs used. When we talk about changes in
scale we normally mean a change across all inputs. However, you will see
later on that the composition of inputs depends on their relative price, so
the scale of operation would normally relate to the price of the output.
Therefore, a change in scale does not alter the composition of inputs, it
only affects the level of their use. An increase in the scale of production
means that we have increased all inputs by a certain proportion. The
return of this change is measured by the proportionate increase in
output.
98

Figure 3.6: Increasing production and returns to scale.
In Figure 3.6, increases in scale are depicted by a movement along a ray

from the origin. The slope of such rays, in this diagram, represents a given
capital-to-labour ratio (K/L) (also known as the inputs composition).
As we move along such a ray, the levels of inputs is increased by the
same proportion (otherwise the inputs composition will change and we
will be doing more than merely expanding our operation) and output
(represented by the relevant isoquants) will rise too.
We began at point A in the above diagram. We may now wish to increase
the scale of our operation by a certain proportion, say ( > 1). We
therefore increase both Labour and Capital by such that KB = KA and LB
= LA. Clearly the input composition will remain constant, thus:
At point B, output too has increased. Let us suppose that XB = XA, which
means that output increased by . Whether or not there are increasing,
constant or decreasing returns to scale depends now on whether is
greater, equal, or less than .
A simple way to look at this issue is by examining functions which have a
special property: homogeneity. This can be defined as follows:
Definition 6
f (X1, , Xn) will be called homogenous of degree t if for all X1, , Xn in its domain
and for all , f (X1, , Xn) = tf (X1, , Xn).
99
A homogenous production function means that if we increase all

inputs by a certain proportion, the increase in output can be described
as a function of the increase in inputs. That is to say, can be written as
a function of , (), for instance in the function where, if we multiply
all inputs by , output will rise by = t. We can translate this into a
production function, since represents the proportional increase in
output:
f (L, K) = t f (L, K) = t x
If t = 1, it means that an increase in all inputs by a certain proportion
will increase output by the same proportion ( = t = ). This is the
property of constant returns to scale; it means that as we increase
the scale of our operation by increasing all inputs, output will rise by
exactly the same proportion as the increase in inputs.
If t > 1, it means that an increase in all inputs by a certain proportion
will increase output by a greater proportion ( = t > ). This is the
property of increasing returns to scale.
Finally, if t < 1, then output will increase by a lesser proportion than
the increase in inputs ( = t < ). This is the property of decreasing
returns to scale.
Generally, we assume that all types of returns to scale are present in the
process of production. We believe that increasing returns to scale are
likely at the first stages of production, at low levels of production, and
decreasing returns to scale will appear as output grows. This will often
be due to human factors, such as organisation (i.e. hierarchy) as well as
control as some of the reasons why any operation is bound to encounter
decreasing returns at some stage.
Note: returns to scale refers to a change in all inputs.
If we had increasing returns to scale throughout the production process, what do you
think the optimal number of firms producing a good would be? Why?
Figure 3.7 depicts the production function where the returns to scale
increases at the beginning and decreases towards the end. To make it
simple, suppose that V is a composite input, comprised of both labour and
capital in a certain. proportion. We thus get the relationship between the
level of (composite) input. and the level of output as shown.
Figure 3.7: A typical production function, derived from isoquants.

100
Notice (in the right-hand diagram) that at first, fixed increments in output.
require ever-decreasing increases in inputs (which means increasing
returns to scale). Later, one can see that fixed increases in output require
ever-increasing increases in inputs (in other words decreasing returns to
scale).
The corresponding points in the left-hand diagram depict the firms growth
of output when all inputs are increased by the same proportion, along the
ray through the origin. When production functions have the property of
homogeneity, this ray will also become the firms expansion path. This
path depicts all the optimal combinations of inputs with which one can
produce a chosen level of output for given factor prices. As both inputs
change here, this is called the long-run expansion path. We will
discuss the difference between long run and short run in a little while.
Returns to factor (marginal product)

By definition, if there is more than one factor of production, the
contribution of a single factor must be analysed when the other inputs are
held constant. Marginal product tells us how a change in a single input
affects output. If X = f (L, K), then the marginal product of labour is the
change in X (dX) that results from a change in L (dL) when K is constant.
MPL is thus defined by (dX/dL).
Can a function exhibit increasing returns to scale and diminishing marginal product at the
same time? Explain your answer.
Average product
We define the average product as the output per unit of input: AP = X/L.
Short-run

M
!

Figure 3.8: Short-run production functions.
In the short run we assume that not all inputs are variable, unlike the
case considered above, when we looked at the long-run expansion path.
In this case, where there are only two inputs, it means, for instance, that
the quantity of capital (K) is given and we can only change output by
changing the other input, labour. Figure 3.8 depicts the production
function when capital is fixed at a level K0.
101
At low levels of production, it is reasonable to suppose that any increase

in the variable input will add to output in increasing increments (i.e.
increasing marginal product). At a certain point the amount of the
variable input, relative to the fixed input, will increase so much that its
contribution to output will have to fall.
Thus, at first, the production function exhibits increasing MPL, and then
diminishing MPL. We can now clearly see that MPL = dX/dL will give us the
slope of the production function (on the right-hand side) for the short-run
case, where the amount of capital is fixed (Question: Why?). Up to point
M, the slope increases, then, it diminishes.
In the left-hand diagram, we can see the corresponding points of
production. These form what one may consider the short-run
expansion path. Along this expansion path the level of capital is fixed
and the only way to increase output is through increases in labour inputs.
Average and marginal product
M

Figure 3.9: Average and marginal product.
In the right-hand graph of Figure 3.8, the slope of the ray from the origin
to any of the three points A, B, C is of the form X/L. This is precisely the
average product of an input, the AP. We can see how it increases between
A and B and diminishes afterwards. At point B, where the slope (the AP), is
at its highest, the slope of the ray equals the gradient of f, and thus equals
MPL. Figure 3.9 depicts these relationships.
The behaviour of the firm

Firms have to make two decisions: how much to produce and which
technology to use (that is, what the input composition will be). The
choice of technology is, in principle, very similar to the way individuals
choose their consumption basket. The production function, which
determines the amount of output produced for given inputs, is similar to
the utility function faced by the consumer.
102
We generally assume that firms wish to maximise profit. (Whether this

is really the case and what the consequences might be if it was not, is an
interesting subject which we will not consider here.)
Consider the profit function:
= pX X c(X)
where pX X is the revenue from selling X units of a good, while c(X)
represents the cost of producing them. We shall assume at this stage that
prices (of product as well as inputs) are given (that is, determined by
exogenous factors).
This formulation of the profit function clearly shows how the choice of
quantity and technology affects the profit generated. The quantity chosen will
affect both the revenue and the cost, while the choice of technology will affect
only the cost. We will now separate the effects of the choice of technology and
of quantity in order to understand their impact on the profit function.
One way of separating the effects is to fix a total cost of production, c0, and
then to find the highest level of output which is feasible. This is depicted
in Figure 3.10.
Why would this maximise profit? (Consider the form of the revenue function.)

"
#

Figure 3.10: Profit maximisation: maximising output for given cost.
For a given level of cost c0, the firm can choose all combinations of labour
(L) and capital (K) that are within its budget constraint. The rate at
which the firm can substitute capital for labour is given by the market
exchange rate, which is the relative prices of capital and labour,
here defined as w0/r0 units of capital per labour.
The highest level of output which is now feasible is given by the highest
isoquant. The choice of input combinations is therefore determined at
the point where the isoquant (derived from the production function) is
tangential to the isocost (the firms budget constraint). At that point,
the slope of the isocost, which is the market rate of exchange between
capital and labour, is the same as the slope of the isoquant. The latter is
really the technological rate of substitution between capital and labour.
103
This solution implies that at the optimal point, the firm will gain no extra
profit by exchanging labour and capital at the margin. If the firm gives
up some labour, but wants to keep the level of output constant, then the
amount of extra capital needed will cost exactly the amount saved by
reducing labour, leaving the total cost of production unchanged. Point B in
Figure 3.10 is clearly not optimal. If the firm gave up one unit of labour
it would need units of capital to remain at the same level of output. But
in the market place, it can get ( + ) units of capital per unit of labour.
This means that the firm can improve its performance through market
operations, changing the technology it uses.
&
"

Figure 3.11: Long-run expansion paths.
For any given relative factor prices we can get the set of all points where
the firm is producing optimally. These points, captured in Figure 3.11,
are what we call the firms expansion path. It is a long-run expansion
path as all means of production vary in the process of expansion.
In the case where the production function is homogeneous, the expansion
path will be a straight line.
So far, however, we have only talked about the choice of technology (input
composition) which constitutes optimal choice. We have not yet dealt with
the question of how much X to produce. The answer to this depends on
the relationship between output (X) and the isocost lines. This relationship
is explored in the next section.
The cost functions

1. The general form of the cost function in our two inputs model is:
C(K,L) = wL + rK
where w and r are the market prices of labour and capital respectively.
We shall assume that these prices are fixed.
2. Long-run cost function: We assume all inputs to be variable in the long
run. When we discussed production functions, we assumed that low
levels of production exhibited increasing returns to scale. An increase
in output will require decreasing increases in inputs, and hence a
decreasing increase in cost. In Figure 3.12 this is the case between
104
the origin and point A. We assumed, when discussing production

functions, that at first, it is most likely that the process of production
will be characterised by increasing returns to scale, hence, an increase
of a unit of output will require a decreasing increase in inputs, thus, a
decreasing increase in cost. For the production function below, this is
the case between the origin and point A.
"

Figure 3.12: Production functions and the total cost curve.
For higher level of outputs (beyond point A), we assume the process
exhibits decreasing returns to scale. Every further increase in output
will require ever-increasing increases in inputs. This means that, for
fixed prices, the total cost of production will increase faster and faster.
See Figure 3.12 for the derivation of the total cost curve from the
production function.
3. Marginal costs: the change in total cost C that results from a change
in output X.
MC is therefore dC/dX. We can clearly see that this is the gradient
of the cost function in the above diagram. Notice that Marginal
Cost and Returns to Scale are inversely related. When there are
increasing returns to scale, there will be diminishing marginal cost.
The production of every extra unit of output will require decreasing
increases in inputs and thus, decreasing cost per extra unit.
105
4. Average costs: The cost per unit of output.

Again, as AC = C/X, we can see that average cost is the slope of the ray
from the origin to a point on the cost curve in the above diagram.1
Note from the figure

that MC is equal to
AC only at the point
where average cost is
at a minimum. Thus, the
marginal cost curve will
cut the average cost
curve at the point where
AC is at a minimum.
5. Short run: In the short run, one of the means of production is fixed (the
capital used to set up the production facility, for example) and its costs
are independent of the quantity produced, because we cannot change
the quantity of it that is used. The cost function, therefore, is divided
into two elements:
Fixed Costs (FC), and Variable Costs (VC), which remain a function of
output: VC(X). Hence, we define the Short Run Total Cost as:
SRC = FC + VC(X)
To see how the SRC function behaves, we only have to recall the shortrun production function. The short-run production function has the same
shape as the long-run production function, though for different reasons.
Translating it into a cost function repeats the argument we had for the
long-run. Assume that the amount of capital used is fixed, and that we
can only vary the amount of labour used in the production process.
Whenever marginal product is rising, the cost of an extra unit (the
marginal cost) will be decreasing. This is so because increased
productivity means that one would need less labour than one needed
before for an extra unit of output.
Therefore, the VC(X) part of the SRC behaves in exactly the same
way as the LRC, and has the same general shape. The only difference,
therefore, will be the position of the SRC. Figure 3.13 depicts the
relationship between the long- and the short-run cost functions:

*
&

&
'

1
1

!

!
"

*
Figure 3.13: Long- and short-run production and cost functions.
Given input prices w0 and r0, our long-run level of output X would have
been produced using a K/L ratio (representing a particular choice of
technology) according to the long-run expansion path, which connects
all points where the slope of the isocost lines is equal to the slope of
the isoquants (points such as A or B). If, say, K is fixed at K0 in the
short run, the short-run expansion path is given by the horizontal line
at K0. Clearly, only at point A (and, associated with it, an output level
X0) would the firm be able to use the same combination of K and L in
both the long run and the short run (so for this output level, the level
at which capital is fixed in the short run is exactly the level that would
have been chosen without such a constraint, i.e. in the long run).
106
At other levels of output, say a lower level such as X1, the combinations
of K and L used would be different in the long and short run, due to
the fixed amount of capital available. Given the shape of isoquants,
this means that the cost of producing X1 in the short run (at C) must be
higher than the cost of producing the same amount in the long run (at
B): C is on a higher isocost line than B.
Show that this holds true for output levels above X0 as well.
We can see the intuition behind this by noting that firms try to
maximise profits given a number of constraints, such as their available
technologies, input prices and the price they can charge for the output
they produce. If we now introduce an extra constraint (for example the
constraint that capital is fixed in the short run), it is clear that we are
not making the firms job any easier. That is, we cannot be lowering
its cost of production. At best (for an output level X0), the cost stays the
same; for other output levels, it will increase.
6. The relationship between long-run and short-run average cost (LRAC
and SRAC):

&

&

Figure 3.14: The derivation of SRAC and LRAC.
The top part of Figure 3.14 again shows the Long-Run and Short-Run
Total Cost functions. As before, we can find the average costs for each
level of output by calculating the slope C/X of a ray from the origin. Given
the shape and position of the SRC and LRC discussed before, we can see
107
that for any given level of output, the slope of the ray that reaches the SRC
must be at least as great as that of a ray reaching the LRC. Therefore, the
SRAC will be greater than or equal to the LRAC. Equality is achieved only
when the long run and the short run use the same input combinations.
Application
Let us analyse the effects of a fall in the wage rate on the long-run cost.

Figure 3.15: A fall in the wage rate.
Suppose we are producing X0 with a total cost of C0 (point A in the above

diagram). The slope of the isocost line is w/r. Now, as the wage rate
falls, the intercept of the isocost line (associated with the same total cost
as before, C0) shifts to the right along the L-axis. Point B depicts the new
optimal level of production at the current level of cost if all means of
production are variable. We see that for the same level of cost we can now
produce more of X.
In order to see what happens to the total costs at any level of output,
we must consider what the cost would be of producing optimally the
previous quantity of X (X0). The broken line at point C, on the same
isoquant as before, gives us this information. Clearly, this broken line,
which has the same slope as our new isocost line, reflects a lower cost than
that going through point A.
Hence, for any level of output, total cost will fall and so will the average
cost. As the marginal product of any of the inputs has not changed, it will
also cost less to increase output by a single unit of output at any level of
production.
Producer behaviour with respect to output

So far we have mainly looked at the question of how a producer will choose
the combination of labour and capital which will bring about maximum
profit for any amount of X he might intend to produce. In other words, we
have minimised the cost of producing some output X. Naturally, there is also
the question of how much to produce in the first place. To analyse this, we
simply have to rewrite the profit function and take a closer look at the role
of X (the level of output) in determining the maximum profit.
108
The producers problem will now be written as:

max (X) = R(X) C(X)
Our analysis of how to minimise the cost of production for any level of X
told us all we need to know about the cost function C(X). However, we do
not know much about the revenue function R(X).
The revenue each firm earns is simply the price of its output multiplied by
the quantity sold. Its general form is:
R(X) = pX(X)X
where pX(X) is the inverse demand function which the producer confronts.
In a perfectly competitive market where his choice of output does not
influence the price R becomes simply:
R = pXX
What is max per unit of X produced on production of 500 units when total R = 6,250
and total C = 3,975?
In general, a change in R can be broken down to dR = dPX +dXP, where
dPX is the loss of revenue on previous sales (if the price of X decreased)
and dXP is the gain on new sales at the current price. By now, this should
sound very familiar. If not, read again the section on the price elasticity of
demand.
We now want to know how revenue changes when we produce one more
unit of X. We call this change in revenue the marginal revenue and we
denote it by MR = dR/dX.
In the case of perfect competition, where the firms behaviour does not
influence the price, the sale of one more unit will increase revenue by the
price we get for that unit. In other words, the competitive firms revenue
will change according to the change in sales. The price will not be affected
by these changes. Hence:
dRPC = pX dX
If we divide this by dX, we get the marginal revenue:
Hence, the marginal revenue in the case of perfect competition is simply

the price of the output in the market.
For more general revenue functions, we can find the marginal revenue by
similar means. All we have to do is to take the derivative of the revenue
function, R(X) = pX(X)X, with respect to X. We find that:
where dP/dX is the derivative of the demand function. It shows how the
price will change if output is changed. As dP/dX <0, it is clear that MR(X)
< PX(X); that is, the MR(X) curve will normally lie below the demand
schedule.
Are there any situations in which this would not be true?
109
Now, if we multiply and divide dP/dX X by P/P, we can write:
where is the price elasticity of demand.

In a perfectly competitive market, the price elasticity of demand which the
individual producer confronts goes to infinity. Therefore:
Now that we have studied the revenue function, we can add it to the cost
function which we studied before. Recall that (X) = R(X) C(X). For a
firm in a perfectly competitive market, we can thus derive the following
profit function:

Figure 3.16: Cost, revenue and the profit function for a perfectly competitive
market.
The R function of a competitive industry has a constant slope, PX, which

is the firms MR (= dR/dX). The greatest distance between it and the cost
function is always where the gradient of C(X) (i.e. MC(X)) equals the
gradient of R (MR). However, there are two points where the distance is
the furthest. In the one case we will be minimising profit; in the other, we
will be maximising it. Therefore, although MR(X) = MC(X) is a necessary
condition for profit maximisation, it is not a sufficient one.
110
Instead of exploring the mathematics of second order conditions (which

would let us choose the output level which actually maximises profits),
let us take another look at the profit function. Clearly, what distinguishes
the profit maximisation point from the other optimal solution (albeit to a
different problem) is that profits are positive.
We can rewrite the profit function in the following way:
Clearly, for > 0, we need that PX > AC(X).

We can summarise our analysis so far in two principles which will guide
the behaviour of the firm:
1. The decision over how much to produce.
The answer is to produce such as quantity of X that:
MC(X) = MRc = PX
2. The decision over whether to produce at all.
The answer here is to produce as long as:
PX AC(X)
Hence, provided that condition (2) is satisfied (i.e. provided the firm is
willing to stay in the market), the supply of the firm will be guided by the
part of the MC(X) function which is above the AC(X) function. We shall
call this part the supply curve of the firm.
Note: You should pay attention here to the difference between the short
and the long run and the roles of both average cost and average variable
cost.
To complete the analysis make sure that you can use Figure 3.17 alone to explain the
two principles which constitute the firms behaviour.
Figure 3.17: The firms supply curve.
111
A numerical example
Production functions
Consider the production circumstances of a good X which requires only
one input (labour) for production. The technology available has the
following results:
L
TP = X
AP = X/L
MP = dX/dL
24
12
15
42
14
18
60
15
18
75
15
15
87
14.5
12
96
13.7
101
12.6
101
11.2
10
95
9.5
Figure 3.18 depicts how total product (TP), average and marginal
product (AP and MP) change with the change in input (L). You can also
see how they relate to each other.

Figure 3.18: TP, AP and MP: a numerical example.
Notice that as long as the marginal product is greater than the average
product, the latter is rising. This is because the marginal product describes
the contribution of the last unit of input. As long as this contribution
112
is greater than the average, the average will have to rise. In brief, what
you see is that the AP is at its highest when it is the same as the marginal
product. If the marginal product is diminishing, every extra unit of output
will require more and more inputs. Thus, the product per input will have
to fall. The reason why it does not fall immediately when marginal product
begins to fall is that the increases in output at the beginning were so great
that it takes a much sharper decline in productivity to change the direction
of the average product.
Cost functions
Suppose now that the production of X requires a licence which costs
1,130.
A labour unit costs 900 (for the duration of the production process). We
can therefore distinguish between fixed costs (FC) which are unaffected
by the level of output produced, and variable costs (VC), which reflect the
level of production. Together, these give the total cost (TC) of producing a
given level of output X:
TC = FC + VC
The average cost (AC) is simply TC/X. Naturally, average cost is the sum
of the AFC (= FC/X) and AVC (= VC/X). The marginal cost (MC) is the
change in cost per extra unit of output. Evidently, this change will depend
on the productivity of labour. The more productive labour is, the less
labour units will be required for the production of one unit of output.
For instance, one unit of labour may produce 9 units of X. Hence, one X
would require 1/9 units of labour. Note from the previous table that 9 is
the marginal product of the first labour unit. Hence, the amount of labour
required for the production of one unit is always 1/MP. As we pay W =
900 per labour unit, the cost of one unit of output will be [900 1/9] =
100. In general, therefore, we can write:
Given this information, we can calculate the cost functions for the firm:
L
TP = X
FC
VC
TC
AFC
AVC
AC
MC
1130
900
2030
125.6
100.0
225.6
100
24
1130
1800
2930
47.1
75.0
122.1
60
42
1130
2700
3830
26.9
64.3
91.2
50
60
1130
3600
4730
18.8
60.0
78.8
50
75
1130
4500
5630
15.1
60.0
75.1
60
87
1130
5400
6530
13.0
62.1
75.1
75
96
1130
6300
7430
11.8
65.6
77.4
100
101
1130
7200
8330
11.2
71.3
82.5
180
The general generation of the U shaped AC function is depicted in the

lower graph of Figure 3.19. Clearly, AC = AFC + AVC. Since FC is
unchanged as output increases, FC/X will be declining as X increases. Due
to diminishing Marginal Product, every extra unit of output will require
ever-increasing cost. Hence, VC/X is rising with output. For very low levels
of X, FC/X is a large number while VC/X is small. The shape of the AC will
thus be dominated by AFC. For large X, FC/X is almost zero. The shape of
AC will thus be dominated by AVC.
113

Figure 3.19: Cost functions: a numerical example.
Profit maximisation
Suppose now that the firm can sell a unit of X for 100. We shall also assume
that whatever the firm does, it will not affect the market price as the firm is
too small. Hence, the revenue of the firm is PXX and the marginal revenue
(the revenue of the last unit sold) will be the price PX. The following table
describes the situation of the firm under various levels of production.
TP
TVC
TC
MR
MC
AVC
AC
100
1130
130
100
900
900
2030
1130
100
100
100.0
225.6
24
100
2400
1800
2930
530
100
60
40
75.0
122.1
42
100
4200
2700
3830
370
100
50
50
64.3
91.2
60
100
6000
3600
4730
1270
100
50
50
60.0
78.8
75
100
7500
4500
5630
1870
100
60
40
60.0
75.1
87
100
8700
5400
6530
2170
100
75
25
62.1
75.1
96
100
9600
6300
7430
2170
100
100
65.6
77.4
101
100
10100
7200
8330
1770
100
180
80
71.3
82.5
Notice that profit is maximised (M = 0 and > 0) when MR = MC and

when P = MR > AC.
The firm as an organisation: a note

In everything we have said so far, we treated the firm as an abstract object,
a profit maximising agent. But as we all know, firms are nothing like this.
They are large-scale organisations involving a great number of people with
different skills, wants and background. Can we really say that the firm is
simply a profit maximising agent?
114
Since our purpose in using economics is to describe the world around us,
we have to be aware that the firm is a much more complicated structure
than the abstract notion of a profit maximiser might suggest. This does not
necessarily mean that our representation of those firms as simple profit
maximisers is not true: it might be a fairly good description of how firms
actually behave. Nonetheless, it is useful for us to spend some time looking
at how the organisation of a firm might influence (and be influenced by)
its economic environment.
There are two separate issues which we have to consider when we
examine the organisation of the firm. First, given the current structure of
corporations, where ownership is in the hands of shareholders who are not
the managers, it is not obvious that the managers would necessarily have
the interest of the shareholders close to their hearts.
There is little doubt that the shareholders would want the managers to
maximise profit. Most shareholders are not involved in the firm, and
they have no other consideration apart from profit maximisation. The
managers, on the other hand, are working in the corporation and must
consider the interests of other groups with whom they are in daily contact.
They are salaried, and so their earnings may be slightly less sensitive to
changes in the performance of the corporation than the income of the
shareholders would be (shareholders receive their income in the form of
dividends or of capital gains from selling shares).
Consequently, the shareholders, who have the power to appoint or sack
the managers, will face what is called the principal-agent problem. The
shareholders are the principals who want their agents (the managers) to
maximise profit. The managers have a great informational advantage over
the shareholders, who are less familiar with the issues associated with
running the corporation and are therefore susceptible to all kind of excuses
and stories which the managers can put forward to justify their actions
(and the subsequent reduced profit). The question for the shareholders,
therefore, is how to write a contract that would give the managers the
incentive to maximise profits. One of the most common incentives is some
form of performance-related pay, but whether this actually provides a
sufficient incentive for the managers is a different story.
The second and far more important issue is how the firm (or corporation)
evolved and how it might change. Put differently, why do we have
corporations in the first place?
These are very difficult and important questions to which all economists
must pay attention. Unfortunately, economic theory has not produced any
theories that would do justice to the importance of the question. If we
understood why corporations exist, we would be able to understand how
they operate, what will make them succeed and what will change them.
In this context, I would like to draw your attention to two approaches
to the problem. First we have the real evolutionary approach. This
approach examines how and why corporations have been formed over
the years. For instance, when comparing the evolution of Russian and
Indian village communities, some authors have found that while the
sense of kinship among Indian village communities has decreased, that
among Russian communities remains very strong. A possible explanation
for this phenomenon is that while Indian village communities are located
in relatively populated areas, the Russian villages were located in a vast,
much emptier area. This allowed dissenting groups of people to move
away from existing village communities and set up new ones.
115
The consequences of this difference for the evolution of the institution of

private property were immense. In India, the outcome was the emergence
of private ownership of land, while in Russia, the arable land had been
periodically redistributed and, as one scholar puts it, the village artificer, even
should he carry his tool to a distance, works for the profit of his co-villager
(Maine, H. (1987) The Early History of Institution, London, John Murray, p.81
though admittedly this was a long time ago). Along similar lines, though in
a much more complex setting, one can examine how corporations have been
formed. For instance, one must inquire why it is that the English bankruptcy
laws are so different from the American ones, and what consequences this
might have on the organisation of productive activities.
The second approach is basically trying to explain the corporation from an
analytical point of view. Recall that in Chapter 1 we discussed specialisation
and trade. We saw there that once people specialise, there will be a gap
between how much it costs them to produce a good and how much others are
willing to pay for it. Suppose that you specialise in potato production and you
come to the market once a week with your sack of potatoes. Suppose too that
you would like to find in the market, in return for your potatoes, a nourishing
breakfast. There is a very large gap between what you are willing to pay for
that breakfast and what it really cost to produce. However, if you wanted to
research the breakfast market thoroughly, you would need to invest a great
deal of time. You would need to visit all other producers in the community
and ask them about the properties of the goods which they produce. You will
need to study nutrition to create the bundle of goods which will constitute
your breakfast. During all the time you are researching into the question, you
are not selling potatoes and, if you have to go to the library in the village, you
will even be producing fewer potatoes. So matching your desires with what is
brought to the market will cost you a great deal.
If, instead, someone took on the role of entrepreneur, they would do
the work for you, finding out what you want and roaming the village to
discover whether the combination of goods can be produced, leaving you
to carry on producing potatoes. Alternatively, they may persuade someone
to produce the goods you want, so that next time you go to the market,
they will be there. Given the difference between what you were willing
to pay and what it costs others to produce, the entrepreneur can make a
profit. This is a case where the middle man is most important. Without
the entrepreneur, it would cost you much more to exchange potatoes for
breakfast. The entrepreneur could operate because they were cutting your
transaction cost. As long as this is possible, there will be room for an
organisation like the firm which will do this work for you.
There is an additional problem, however. If the job of the entrepreneur is
simply to sign contracts with various agents to provide a good at a lower
rate than that which the consumer is willing to pay, the source of efficiency
for the organisation is simply the contracts. So again we have the issue of
designing contracts that will create the incentive for the people connected
with the corporation to do their best. However, as contracts do not cover
all eventualities (they are incomplete), there will be instances where
the contract does not specify who is entitled to what, and the question of
ownership emerges.
We have thus come full circle: from explaining private ownership as a
social institution which developed from the crumbling tribal sense of
community, to finding that this institution holds the key to the life of the
corporation. Unfortunately, these areas of research have not yet come
together, but as you can see, there is still a lot to be done to develop the
language with which we discuss economic and social organisation.
116
Self-assessment
Define the concepts of productive efficiency, isoquants and iso-cost,
marginal and average product, constant returns to scale, transaction
costs, diminishing marginal return fixed and variable costs, the
relationship between marginal and average costs.
Use these definitions to give examples of increasing returns to scale, the
interrelation between marginal cost and returns to scale, homogeneous
production function, and profit maximisation with respect to output
and the firms supply curve.
Construct cost-functions and derive their relation to the production
function.
Use diagrams to analyse problems involving short-run and long-run
average cost schedule.
Give an example of:
increasing returns to scale
the inverse relationship between marginal cost and returns to scale
a homogeneous production function.

Question 1
Short-run average cost always lies above long-run average cost
except at one point. However, while it is clear that with a fixed
amount of one input the firm cannot expand along its long-run
expansion path, it can always use less of it and follow its longrun expansion path. Therefore, short-run average cost should be
exactly the same as long-run average cost up to a certain point.
a. Derive the long-run average cost schedule.

b. What is the difference between the short and the long runs?
c. Derive the short-run average cost schedule.
d. Comment on the above statement.
Question 2
a. Under which conditions will the long-run average cost and marginal
cost be the same?
b. Will the short-run average cost be the same as the long-run average
cost?
c. Will the short-run marginal cost be the same as the short-run average
cost?
Question 3
a. Explain, using diagrams, why the short-run cost function is tangent to
the long-run cost function at one point only.
b. Assuming upward sloping expansion paths, what will happen to the
level of output at which such tangency occurs, the higher is the level of
fixed capital? Does this mean that the level of capital which generates
117
the coincidence of the short-run and the long-run minimum average

costs is an optimal level of fixed capital?
c. Will the long- and the short-run average cost of a production process
which exhibits only increasing returns to scale (at the relevant section
of output) have similar U-shapes? Explain.
Answers
Question 1
a. Deriving long-run average cost. The key issues here are:
associating the shape of the long-run cost function with the relevant
properties of the production function; recognising that average costs
can be depicted by the ray from the origin; deriving the average cost
from the change in the slope of that ray from the origin. All of these are
in the domain of testing ones familiarity with various models.
b. Here, as in part (a), we need a simple exposition of material which is
covered in great detail in the present chapter. First, students should
demonstrate that they recognise the role of fixed costs in the distinction
between the long and the short run. An explanation of the short-run
cost curve and its position relative to the long-run curve is essential.
c. The derivation process should be explained carefully, where we
compare the ray from the origin (the average cost) which is associated
with the long-run cost curve with that ray which is associated with the
short-run curve.
d. Here, the more analytical part of the question begins. The statement
suggests that as we can always produce less with those means of
production which we have, there is no reason why producing less
than the level of output for which both short- and long-run cost
coincide, should cost more than it would if we could vary all means of
production.
The choice of framework here is crucial and, as you see below, it is the
firms optimal choice in the production factors plane:
Figure 3.20
118
Translating the question into the language of the model: It is

proposed in the statement that there is no reason why the firm should
not produce at point C (with the long-run optimal mix of inputs) as it can
always reduce the amount of capital it uses. Obviously, while it is true that
the firm can use less capital, it will still have to pay for the idle means of
production. If at B the short-run total costs are:
CB1 = r0K0 + w0LB1
at C they will be:
CC1 = r0K0 + w0LC1
As LC1 > LB1, the actual costs at C are higher than at B and the configuration
around point C is not really feasible. It is not necessary to construct the
argument in this formal way but as you can see it is clearer and shorter.
Question 2
This is a question about (i) a constant return to scale production function;
(ii) the relationship between the properties of production functions and
those of the cost functions; and (iii) the difference between the short and
the long runs.
a. The main points here are these:
an understanding of the properties of the CRS production function
and its significance for the derivation of the corresponding long-run
cost function with its constant slope and 0-origin
the derivation of the long-run average and marginal cost functions
as depicted in Figure 3.21.

Figure 3.21
You are expected to demonstrate that you understand the geometrical

representation of both the average and marginal cost in the left-hand
diagram.
b. and c. An understanding is required here that returns to scale is a longrun property of production and that it does not affect the short-run
principle of diminishing returns to factor.
119
Figure 3.22
The answers to (b) and (c) are self-evident from Figure 3.22.
Question 3
a. The issue here is a recurring one: why should the short-run cost lie
everywhere above the long-run cost except at one point only? I am
sure that many of you will produce here the familiar picture shown in
Figure 3.23.

Figure 3.23
But this merely constitutes a restatement of what needs to be

explained. We need an explanation for this graph, pointing out
that there is only one combination of inputs which is optimal in the
long run for each level of output. In the short run, one of the means
of production is fixed. Hence, there will be only one level of output
which will be produced using the same input mix in both the long and
the short run. At any other level of output, as the short run adds a
constraint, the cost of production will have to be higher.
The above diagram is fully acceptable if accompanied by a graphic
explanation in the L,K space, where students are expected to produce
the long-run and the short-run expansion paths (Figure 3.24).
120


&
&

#
#
*
'
'
'
&
&
&
Figure 3.24
b. We normally assume that the long-run expansion path is upward

sloping. The short-run expansion path is horizontal. It is easy to see
that there is only one level of output for which the choice of inputs
will be on both the long-run and the short-run expansion path
(point C above). In addition, we expect students to show why at any
other point, the short-run costs are higher than the long-run costs.
Comparing the long-run cost of producing, say, X0 (A) with that of the
short-run cost for producing the same level of output (B) will yield:
CA0 = r0 K0 + w0 LA0 < CB0 = r0K0 + w0 LB0
Hence, the short-run cost lies everywhere above long-run cost with the
exception of point C which is common to both expansion paths.
There are two elements to this section:
To show that the tangency between the long-run and the short-run
average cost curves occurs at higher levels of output the higher is
the level of fixed capital.
"
"
Figure 3.25
121
As in Figure 3.25, this should be fairly obvious (a move from A to B).

The second element is a much more important component in
this sub-question. It is the question whether the level of K which
produces a tangency between the long-run and the short-run
average cost curves at their minimum can be considered as an
optimal level of fixed capital.
Here, you are expected to demonstrate that you understand the
relationship between section (a) and the average cost curve. Ideally,
you are expected to produce diagrams as shown in Figure 3.26,
where you explain how the short-run average cost relates to the
long-run average cost.

Figure 3.26
In addition, we would like you to demonstrate that you understand

that at the minimum of long-run average cost, the short-run average
cost is at its minimum too.
The main part of the answer is the explanation of the significance of
producing at the minimum average cost. We expect you to say that
only if the objective of the firm is to fully utilise its resources will the
minimum average cost be an optimal solution. As such, it can be said
that the level of capital which facilitates production at this level of cost
in the short run can be considered as optimal. However, as this is not
really the objective function of the firm, producing a level of output
where the short-run average cost is tangent to the long-run average
122
cost at the minimum of both functions, doesnt have anything to do

with the concept of optimality.
c. This section is the more demanding part of the question, where we
expect students to produce the cost functions for the long run as well
as the short run in the case of increasing returns to scale. Figure 3.27
shows what should emerge.
Figure 3.27
While the long-run average cost will be falling, the short-run average
cost should have its normal U-shape as increasing returns to scale is a
long-run property of the cost function.
123
Notes
124
Chapter 4: Market structures

Learning outcomes
define the concepts of equilibrium, Giffen good, allocative and
productive efficiency, perfect competition, demand elasticity, strategic
behaviour, the prisoners dilemma
use these definitions to give examples of a perfectly competitive
market, a monopoly, monopolistic competition, licensing of its patterns
by a monopoly, completely elastic demand
use diagrams to analyse problems involving short- and long-run effects
of unit and lump sum tax on a competitive industry.
Reading
LC Chapters 7,8 and 9.
The last two chapters introduced two of the most fundamental concepts in
economics: supply and demand. We derived a theoretical underpinning for
both these functions, based on technology and preferences respectively. We
can now use these theories to look at the structure of a modern economy.
First, we have established that the central problem in modern economics
is how to reconcile the tension between scarcity and unsatiated wants.
The immediate consequence of modelling scarcity was the realisation of
the significance to economic analysis of efficiency (an allocation where
we cannot have more of one thing without giving up another) and
opportunity cost (price).
Hence, we began by concentrating on the behaviour of the atom of economic
analysis: the individual. We have assumed that individuals are rational in the
sense that they will behave in a consistent manner and that they will be trying
to obtain their most preferred outcome. In terms of economic goods, they
would wish to choose the bundle of goods which they prefer most.
Notwithstanding the qualifications we made in Chapter 3 section 3.4, we
chose to treat firms as another form of an atom. This is clearly not right as
firms, too, are a result of human interaction. Still, at this level of your studies,
we are trying to explore basic concepts rather than get a comprehensive
picture of the many dimensions to which economic analysis can be applied.
As the other fundamental feature of economics is that it adopts a balance
of opposing forces (equilibrium) view of human interaction, we have to set
up a clear counterforce to the aims of the individuals. The firm, as a profit
maximising agent, presented us with such a counterforce.
We have also
emphasised that unlike
other traditions in
the analysis of social
phenomena, modern
economics takes an
individualistic approach
to the analysis of social
organisation.
From the utility maximising behaviour of individuals we derived demand;

from the profit maximising behaviour of firms we derived supply. The
opposition of forces here is quite clear and is well depicted by the
traditional demand and supply analysis to which we referred at the
beginning of Chapter 2. It is now time, therefore, to investigate what
happens when these two opposing forces meet.
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The basic principle of equilibrium in Economics

The notion of equilibrium is a complex and intriguing concept. It was
borrowed from physics (in particular, classical mechanics), but what
exactly it means in economics remains somewhat obscure and contentious.
To be sure, it means some kind of a resting point, but what the forces are
which lead to it, is not so easy to ascertain.
We wont dwell on this problem, which isnt really within the scope of this
subject. We shall think of equilibrium in the most simple terms, as the
point where rational plans coincide. All agents in the system are rational
and strive, at all times, to achieve that which they deem most desirable,
given various constraints. If the system is then in a state in which not all
rational plans coincide (that is, if some of the agents would like to, and
could, change their position/allocation) this cannot be a resting point for
the system.
So far, we have explored two types of agents: consumers and producers.
The former choose quantities they want to buy and the latter choose
quantities they want to sell. Equilibrium here will simply mean that the
total quantity desired by consumers equals the total quantity producers
want to sell. What is it that determines those decisions? Evidently, it is the
price of the good.
In Figure 4.1 you will find again that most famous picture, which in the
eyes of many epitomises economics.
Figure 4.1: Demand, supply and the concept of equilibrium.
The demand function represents the quantities which individuals will want
to consume at various market prices (or more precisely, their willingness to
pay for each quantity of the good). Recall that such decisions are based on
equating the price one is being asked to pay with the price one is willing
to pay.
The supply function represents the quantities which producers are willing
to sell at various market prices. Recall that such decisions are based on
equating the price one receives with what it costs one to produce.
There is, as you can see, no dynamic behind this graph. Therefore, the
only thing we can say is that:
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1. At P 1X, the quantity demanded is greater than the quantity supplied; we

call such a situation excess demand.
2. At P 2X, the quantity demanded is less than the quantity supplied; we call
such a situation excess supply.
3. At P 0X, the quantity demanded equals the quantity supplied; we call
such a situation equilibrium.
For this to be a meaningful depiction of anything, we have to distinguish
between points A, B and C in the above diagram. Clearly, the difference
between A and points B and C is that at A, we have equilibrium. This
means that A is a resting point, where all rational plans are satisfied. The
quantity of X which individuals wanted to buy at the price P 0X (given the
prices of other goods) is exactly the same quantity which producers wanted
to sell at that price. Consumers wanted this quantity because the marginal
utility of X at X0, measured in units of, say, Y and multiplied by the price of
Y equals the money value of X (P 0X). Put differently, they wanted this quantity
because at the prevailing prices X0 is the quantity of X which maximises
utility. Producers, on the other hand, want to sell this quantity because at the
prevailing price of X, X0 is the quantity of X which maximises profit.
We can now see the meaning of resting point: at point A, prices are such
that consumers just want to consume what is supplied, and suppliers just
want to supply what is demanded. Neither group is interested in changing
its behaviour, the economy will rest at point A.
At B and C, on the other hand, the rational plans of consumers and
producers do not coincide. Rational consumers will fail (at B) to obtain in
the market the amount of good X they intended to purchase. At price P 1X,
the quantity which they want to buy which will maximise their utility is
X d1. The quantity which will maximise producers profits is X 1s . As X d1 X 1s >
0, some agents will not be able to find what they want in the market. As
a result, some of them might choose to act and, say, offer to pay a higher
price for the good. They thus prefer to have somewhat less of the good to
not having any of it at all.
At C, the opposite is true. At the price of P 2X, producers want to sell X 2s
because this is the quantity of X which will maximise their profit at the
given price of X (and at given prices of means of production). Consumers,
on the other hand, will only want to buy X d2, which is the quantity of X that
will maximise their utility (evidently, for their willingness to pay to be as
high as the price of X, their marginal utility of X must be high, too. This,
given the diminishing nature of marginal utility, will only happen at lower
levels of consumption). As X 2s X d2 > 0, some sellers will not be able to sell
the goods which they have brought to the market. This is when the Sale
signs come up in shop windows.
The fact that individuals have incentives to act differently than they
initially intended creates what we call a disequilibrium. The question
now is whether what they will do will bring about equilibrium or merely
make things worse.
The model itself does not give us any information regarding the actions
individuals will pursue when unable to fulfil their rational plan. We
therefore shrug our shoulders and tell stories. One such story is the one I
have mentioned above. Namely, when an individual comes to the market
place and is unable to purchase the quantity she wants to buy at the given
price, she might offer to pay a higher price, knowing that the seller will
sell to the highest bidder.
127
If a particular individual offers a higher price, the seller will wish to sell at
that higher price. At the higher price, all individuals the bidder included
will revise their rational plans and will want to buy a smaller quantity of
the good, as they are expected to pay more in terms of other goods.
Sellers, too, will revise their plans. At a higher price, they are willing to
produce more (and sell more), as long as the price they can obtain is greater
than or equal to the cost of the last unit produced (the marginal cost).
As a result, the quantity demanded declines, and the quantity supplied
increases. This is working in the right direction: since the initial quantity
demanded exceeded the initial quantity supplied the situation moves
towards equilibrium.
Similarly, if we had started at point C, where the quantity demanded is
less than the quantity supplied, sellers would now be in a position where
they cannot execute their rational plan. At the given price they will be left
with a quantity of the good which they intended to sell but failed to do so.
One seller may wish to attract the buyers and will therefore offer to sell
the goods for a lower price (i.e. a Sale). Naturally, other sellers will want
to offer even better Sales. As a result, the price will begin to come down.
This will bring about a revision of rational plans. Consumers will want to
buy more and sellers will want to sell less. Again, the dynamic of the story
appears to be working in the right direction: reduction of the difference
between the quantity demanded and the quantity supplied.
What we have assumed here about the dynamics of disequilibrium is that
prices will change (over time) in direct relation with the excess demand
(excess supply is simply a negative excess demand). At B excess demand
was positive and therefore price increased. At C, on the other hand, excess
demand is negative (i.e. excess supply) and the price changed in the same
direction as the sign of the excess demand (i.e. it fell). We can write the
price change in general as:
which means that the change in price over time is a function F of the
difference between the quantity demanded and the quantity supplied at
the prevailing price.
This mechanism of an automatic movement towards an equilibrium,
however, may not always work. Consider for a moment the demand for
a Giffen good. There are now two possible relations between the upward
sloping demand curve characteristic of a Giffen good and the upward
sloping nature of supply, as Figure 4.2 shows.
Figure 4.2: Demand and supply for a Giffen good.

128
Think about Figure 4.2 and work out what will happen if there was a disequilibrium (as
at point B ) in case (a) and in case (b). If the dynamic of disequilibrium leads us away from
equilibrium, does it mean that there is no equilibrium to the system?
The determinants of market structure

The two conflicting forces of demand and supply determine the
equilibrium quantity and price of a good. The mechanism through which
this is achieved is the market. Buyers and sellers meet in a market, and
the price is determined. The most basic question we need to ask about the
functioning of such a market is what factors might influence the outcome
of an encounter between buyer and seller. These include, among others:
1. the number of agents in the market
2. their information set and mobility
3. the nature of the product
4. entry and exit from the market.
We shall look at these factors in turn.
1 Number of agents
The number of agents refers to both buyers and sellers. Imagine yourself
walking into an empty shopping mall. You are the only customer around
and for several days there havent been any shoppers at all. Can you
imagine what will happen? Will you walk into a shop finding indifferent
sellers waiting for you to choose a good at the marked price?
Most likely your appearance in the mall will create quite a commotion,
as all sellers are trying to convince you to buy their goods. Your ability to
influence the price will be immense.
Alternatively, imagine a kiosk selling water in the middle of a desert. A
convoy of silk traders arrives who have not been able to find an oasis for
six days. What will happen now? Assuming that the six-day journey has
not affected the civility of the silk traders, will the water seller be able to
buy a silk dress for his daughter? Put differently, the power over price will
now rest with the seller.
There are many other possible combinations, but what should have
become clear is that the number of agents and the relative size of each
force in the market, is bound to affect the distribution of power over the
setting of the equilibrium price.
2 Information and mobility

Information is one of the most important factors influencing the outcome
of any interaction in the market. If you walk into a shop and examine the
new CD you wish to buy, whether or not you pay the cashier the price
marked on the CD depends on whether you know how much it costs
elsewhere. If you knew that exactly the same CD can be bought in the
next shop for 5 pence less, you will immediately walk into the other shop
(provided you are rational).
Notice that two things have influenced your action:
first, knowing about the price of the good elsewhere (information)
second, your ability to act on it (mobility).
129
While you are visiting the shop and about to purchase a CD at a price
of 7.75, someone calls you on the mobile phone to tell you that next
door, the CD can be bought at 7.70. You now have the information, but
whether this will influence the outcome of your trade (i.e. whether you
buy the CD at 7.75 or not), might depend on whether there is somebody
quite big waiting at the door, who is adamant that you should not act on
the information you have just received. Put differently, sometimes you may
have the information, but for various reasons, you may not be able to act
on it. Similarly, being able to act but not having the information will also
produce a different outcome from the original situation where you have
the information and you can act on it.
3 Nature of product
Imagine you are in the process of deciding what kind of new car to buy.
When you walk into a car-dealer showroom, you will probably meet
an elegantly dressed person who would like to communicate to you
through the way they are dressed that they are serious people who
not only understand their business, but are also truly ready to give you
any information you require. You examine a car and you are impressed.
Not only is this a make about which you recently read a very favourable
review, it also has air-conditioning, a CD player, a small shower unit and a
breakfast bar.
When you recover from the shock of hearing the price, you will say that
only yesterday you saw a similar car elsewhere at half the price. The
salesman will smile and quietly tell you to go ahead and purchase the
other car. The source of his confidence will be simply the knowledge that
consumers of other cars are not the same people who buy the car he is
selling. Put differently, when you think that the price of a BMW is too high,
you do not automatically buy a Skoda Fabia instead.
It is important to realise that sometimes there is more than one dimension
to a product: we arent just interested in a means of transportation, we
also attach value to specific brands of cars. In such a case, information
(and the ability to act) we might have on just one dimension of the
product might not influence the trade in the same way as information
about all dimensions. A BMW salesman knows that you have not come
to his shop to buy a means of transportation. The fact that you can easily
purchase cheaper means of transportation will have no bearing on the
outcome of the trade. However, if you tell the salesman that you have seen
a comparable Mercedes that is cheaper, you will find the smile wiped off
his face, and then that he will order some coffee for you.
To put this discussion in economic terms, we have to differentiate between
homogeneous goods (the classic example is grains of wheat) and
heterogeneous goods (such as cars).
4 Entry and exit

This determinant of market structure is closely linked to 1 the number
of agents in the market. When there is free entry and exit, we are likely to
have many buyers as well as many sellers. When, on the other hand, there
are some barriers to entry, the number of sellers, or indeed buyers, may
not be as large.
Behind this notion of entry and exit lies a very important component in the
analysis of market structures. This is the concept of barriers to entry.
Barriers to entry could be exogenous, like licence fees or very high set-up
costs, which may deter many from even contemplating joining the market.
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The other, more interesting types of barriers to entry are endogenous.

These barriers can be created through various forms of strategic behaviour
on the part of the incumbents. These can include price wars, R&D
investment (to facilitate a reduction in cost) and many others. Naturally,
entry conditions are bound to influence both the long-term and the shortterm nature of interaction between buyers and sellers.
List as many barriers to entry as you can think of. Dont forget the effects of state
intervention.
The model of perfect competition

Reading
LC Chapter 7.
Perfect competition is a model which aims to explore the most

fundamental properties of competition. To achieve this we must try and
eliminate all the possible influences described in the previous section. This
is not to say that we, as economists, think that this is how the world really
looks. Instead, it is an effort to understand what lies at the heart of the
idea of competition. We begin, therefore, by specifying the determinants of
an abstract notion of competition. We call it, perfect competition.
a. Number of agents: We assume a very large number of agents (both
buyers and sellers), so that no particular agent can affect the market:
Agents are small compared to the market size.
b. Information and Mobility: Perfect information and perfect mobility so
that the outcome cannot be attributed to any imperfections in those
factors.
c. Nature of Product: A homogenous product so that we cannot explain
the outcome by the differences in the goods themselves.
d. Free entry and exit.
There are two immediate conclusions:
C1 All agents are price takers.
C2 There will be a single price in the market.
C1 is quite straightforward. As there is a large number of agents, each
agent will feel that:
i. she can buy (or sell) whatever quantity she wishes; whatever fits
her rational plans cannot be significant when there are so many
other participants
ii. none of the agents can, on their own, change the market price.
C2 follows mainly from our assumption (b) about the information set
and mobility. The fact that everyone knows, at all times, the price of a
good everywhere in the market, plus the fact that everyone can actually
go and get the good from the cheapest seller, suggests that there must be
a single price: Sellers charging a higher price would find themselves with
no customers, sellers charging a lower price would attract all the buyers in
the market.
131
To analyse the case of the perfectly competitive industry, we must always

look, separately, at each individual firm and at the cumulative outcome
of all firms actions: the market. For simplicity of exposition, let us
assume that all firms are identical. In such a case, the analysis of perfectly
competitive industry should be as in Figure 4.3, where the diagram on
the left depicts a representative firm, and the one on the right depicts the
market.

"
"

"
"
"
'
)
"
"
Figure 4.3: Suppliers in a perfectly competitive market.
We begin with an analysis of the short run. As there are many agents, each
one is a price taker. The price taking behaviour by consumers is expressed
by the shape of the budget line. Recall that in Chapter 2, we derived the
demand schedule from the behaviour of rational agents. The budget line,
which captures the notion of scarcity, was a straight line. This means
that the slope of the budget line (PX/PY units of Y per X) was the same
regardless of how many units of X or Y the individual chose to consume.
When a consumer makes choices thinking that these choices will not affect
the price, the consumer is a price taker. Otherwise, the slope of the budget
line (i.e. the price of X in terms of Y) should change according to how
many units of X the individual intends to consume. Consequently, we may
say that the downward sloping demand is representative of the behaviour
of rational agents who are price takers.
On the side of the producers, we made a similar assumption regarding the
prices of inputs. Recall from Chapter 3 how we derived the cost functions
by relating optimal choice of inputs with different levels of output. In
both the short run and the long run, the expansion path of the firm was
dominated by the isocost function, where the price of labour in terms of
capital remained unaffected by the actual choice made by the firm.
On the left-hand side of the graph, we can see both the long-run and the
short-run cost function for given factor prices and, for the short run, for
a given level of fixed capital. In this case, we are examining a situation
where the fixed level of capital is such that the minimum of the shortrun average cost and the long-run average cost occur at the same level of
output. This is not at all necessary, but it will make the exposition simpler.
The supply curve in the market (the right-hand diagram in Figure 4.3) is
the sum of all the short-run marginal costs which are above the minimum
average variable cost. Although all agents are price takers, it is through the
dynamics of the group that prices are formed in the market. In our case,
there will be an initial equilibrium at P 0X, and each firm will sell X 0i units
of X where its SRMC (X 0i ) = P 0X which is what a profit maximising policy
132

"
"
requires. Altogether, the amount supplied to the market will be (nX 0i ) = X0

where n is the number of the firms in the market.
At this stage, as SRMC(X 0i ) = P 0X > SRAC(X 0i ), each firm is making profit
above the market rate of return to capital (r). This is the shaded area in
the left-hand diagram. In the long run, this opportunity to earn profits
which are above the market rate of return will draw more capital into the
industry and new firms will appear.
As firms enter the market, supply at any given price will increase. This
means a shift in the supply schedule to the right.
Figure 4.4: Above-normal profits and entry.
The entry of new firms will create excess supply at the initial price. In
such a case, the dynamic of the market will push the price down, as some
sellers fail to achieve the sales they intended. As long as firms enter the
market and they will do so as long as there are profits above the normal
the supply curve will carry on shifting to the right and the price will
carry on falling. The process will reach its conclusion at the point where
firms are maximising their profits but the profits which they get are no
more than the normal rate of profit. This is the point where the price
equals both the marginal and the average costs (Figure 4.4):
minAC(X 1i ) = MC(X 1i ) = P 1X
At this point, total cost AC(X 1i )X 1i = C(X 1i ) equals total revenues P 1X X 1i and
therefore, profits are zero.
AC(X 1i )X 1i = C(X 1i ) is the shaded rectangle in the diagram on the left of Figure 4.4.
Why?
This means that the firm, as a legal entity, does not retain any profits.
However, total cost includes the cost of capital, which is equal to the
market rate of return. This cost is the return the firm pays out to its
owners, the shareholders. Shareholders therefore earn the market rate of
return, which means that they are indifferent between holding shares in
this firm or in any other firm paying out the market rate of return.
At the new equilibrium, X1 = X1i (n + k) where k is the number of firms
which entered the industry. Notice that it would make very little difference
if we described the movement towards the minimum long-run average
cost along the short-run or the long-run marginal cost functions. In both
cases, existing firms will produce less as new entrants bring about a
further reduction in price. You will find, therefore, that the analysis of the
133
movement towards the long-run equilibrium is often conducted only on the

set of the long-run cost functions, ignoring short-run constraints. Whether
this is appropriate depends on what exactly you are trying to analyse.
Outline the short-run and the long-run effects on a competitive industry of an increase in
demand.
The significance of the perfectly competitive model

The main feature of competitive equilibrium (both in the short and in the
long run) is the principle of marginal cost pricing. What does this imply?
From the definition of economic goods through the principles of scarcity
and desirability, we established the concept of efficiency. What we really
meant is productive efficiency. Recall that being on the Production
Possibilities Curve (PPC) suggests that we cannot have more of one
good without giving up another. The PPC curve is the manifestation of
scarcity and it is from this that our concept of efficiency is derived. It
is an important concept in our analysis simply because scarcity is the
fundamental economic problem.
However, the PPC offers us an infinite number of productively efficient
points. We now have to choose one of the points from the set of points on
the PPC. Note that the concept of productive efficiency was derived using
only the principle of scarcity: we cannot have more of one thing without
giving up some of another thing. The choice of one of the points from the
PPC is referred to as the problem of allocation, and touches on our second
economic principle, desirability. Allocative efficiency tells us how
much of each good we should produce. This is a function of individual
preferences and utilities. We can thus say that we have an efficient
allocation if we cannot change the allocation of goods in such a way as
to make somebody better off without making somebody else worse off.
We hence see that efficiency is a very general concept: it means that we
cannot have more of one thing without giving up some of another thing.
In the case of productive efficiency, these things were the economic goods
produced in the economy; for allocative efficiency, these are the utilities,
or the satisfaction, of individuals in the economy.
In the context of a single industry (partial equilibrium analysis), the
utility or well-being of the agents is captured in terms of consumer
and producer surpluses. Agents wish to buy X. The demand schedule
tells us about their willingness to pay for each unit of the good. This
willingness to pay is nothing else but the slope of the indifference curve;
that is, it is the marginal utility of X measured in terms of the quantity of Y
that would be needed to compensate for a loss of a unit of X. In that sense,
the downward sloping demand schedule represents diminishing marginal
utility.
The meaning of Figure 4.5 is that individuals were willing to pay
PX(X1) for X1 units of X. In a competitive market, however, there is a single
price. Namely, the individual pays P 0X for every unit of X purchased.
Individuals, therefore, enjoy a pure gain which is the difference between
what they were willing to pay and what they actually ended up paying.
This benefit is called the consumer surplus. The triangle ABC depicts
these gains.
Producers too are members of society. Their gains too, matter to the
welfare of society. While individuals were willing to pay PX(X1) for X1 units
of X, producers were willing to sell it for MC(X1). They too gain from the
uniqueness of the competitive price as they will get P 0X. The difference
134
Figure 4.5: Consumer and producer surpluses.
between what they get and what they were willing to sell the quantity for is
called producer surplus.
The perfectly competitive industry yields an equilibrium price which always
equates MC with price (point A in the above diagram). Therefore, if the
surpluses of both consumers and producers can be thought of as scarce and
desirable, we can apply to them the concept of efficiency.
At A, it is clear, we can increase neither consumer nor producer surpluses
without reducing the other. In that sense, the perfectly competitive solution
is allocative efficient.
Is such an allocation also productively efficient? The answer is yes. As
long as the firm is producing on the marginal cost curve, it cannot produce
the last unit for less cost. In other words, resources are not misused.
Otherwise, we could have reorganised production in such a way that would
have reduced the cost of the last unit.
The monopolist
Reading
LC Chapter 8.
The monopolist is often seen as the exact opposite of perfect competition.

We should be cautious, however, with such an assertion. Recall that we have
found four determinants of market structures. To say that one structure
is the exact opposite of the other, we must be able to show that in all
four categories this is indeed the case. When we examine what exactly is
entailed in the monopolist market structure, we will find that it is only in
one dimension that a monopoly is the opposite of perfect competition. Not
surprisingly, for this is the most obvious difference between monopoly and
perfect competition, this dimension is the number of agents in the market.
We therefore change assumptions (a) and (d) from above to allow for a
market where there is a single seller and a large number of buyers. The
change in (d) (entry and exit) is required to facilitate this state of affairs.
We therefore assume that there are exogenous barriers to entry. Notice,
however, that all other assumptions about the nature of the product and
about information and mobility remain unchanged.
135
The analysis of the monopolist is in principle similar to the analysis of the

single firm in competition. The monopolist too maximises profits, which are
still the difference between revenues and costs:
= R(X) C(X)
As long as we do not specify any special conditions about the position of the
monopolist in the inputs markets, the cost function which the monopolist
confronts will be exactly the same as the one which the competitive firm
confronts. That is, it is a function which reflects the increasing returns to scale
at the beginning of production, which then turn into diminishing returns to
scale when the operation becomes increasingly complex.
Figure 4.6: Cost function for a monopolist.
The difference between the monopolist and the competitive firm is in the
Revenue function. Let us write the Revenue function in its most general form:
Rm(X) = PX(X)X
Note that PX(X) is simply the inverse demand function; it tells us how much
people are willing to pay for each quantity of X.
Px
P x0
dP
P x1
D()
dX
X0
X1
Figure 4.7: Demand function and marginal revenue.
136
How will revenue change, say, from point A to point B in the above
diagram?
At A the revenue is P 0X X0, at B it is P 1X X1. Clearly, as the price decreased,
the seller lost the area , which is the difference between the higher and
the lower price (dP) multiplied by previous sales. , therefore, is really dP
X. On the other hand, the lower price attracted more sales so the above
loss might be offset by new sales which are captured by the area . ,
therefore, is really the new price (P) multiplied by the additional quantity
which is now sold (dX).
Hence, the change in revenue will be the following:
dR = = dP X + dX P
where dP will have the opposite sign to dX (this is the inverse nature of
demand).
Marginal revenue (MR) is defined as dR/dX. Divide the above equation by
dX:
We see that MR is a function of the current price and the demand elasticity.
Geometrically, elasticity is simply the product of the inverse of the slope
of the demand schedule and the slope of the ray from the origin (Figure
4.8).

Figure 4.8: Linear demand and demand elasticity.
Consider for a moment the above linear demand function. The slope of the
function at A and at B is exactly the same. Yet, demand elasticity will be
different because of the ray from the origin. While (dP/dX)A = (dP/dX)B
(hence (dX/dP)A = (dX/dP)B), (P/X)A > (P/X)B. Therefore:
137
hence
||A > ||B
This suggests that demand elasticity, in absolute values, is diminishing as
output increases. Consequently, given its position in the MR function, MR
will be diminishing too. MR is thus the slope of the revenue function.
We can now add this function to the cost function to find the point where
the monopolist will be maximising profits:
Again, like in the case of the competitive firm, the point where profit is
maximised is where the slopes of the cost and revenue functions are the
same. Therefore, the monopolist too confronts the same two question as
the competitive firm:

Figure 4.9: Profit maximisation for the monopolist.
138
1. How much to produce?

Produce so much X so that:
MR(X) = MC(X)
Specifically, produce where:
2. Whether to produce?
The monopolist wants positive profits. Therefore, a similar condition
will apply here as applied in the case of perfect competition; namely,
produce as long as:
P > AC(X)
The final market configuration of the monopolist will therefore be as in
Figure 4.10.

Figure 4.10: Equilibrium for the monopolist.
The shaded area represents the profit above the normal. What does it
mean that the profits are above the normal?
Why does the MR function always lie below the demand schedule?
The inefficiency of the monopolist

The left-hand diagram in Figure 4.11 depicts the perfect competition
equilibrium. The right-hand diagram shows the monopoly market
structure. Recall that the demand schedule represents individuals
willingness to pay (or the marginal utility from the consumption of
different quantities of the good X) and that the area underneath the
demand schedule provides a money value for the overall utility of our
representative agent. Hence, the triangle ABC in both diagrams depicts
what we called the consumer surplus in the sense that this is part of
what the consumer was willing to pay, but ended up not having to pay.
139

Figure 4.11: Consumer surplus, producer surplus and the inefficiency of the
monopolist.
Put differently, this is the portion of their utility from consuming X which
they have not passed on to the producers.
Similarly, the marginal cost schedule represents, as it were, the sellers
willingness to sell. The difference between the price he gets for each unit
and the price for which they were willing to sell we called producer
surplus. We interpret both surpluses to be the benefits generated by the
market. If we now compare the two equilibria we can clearly see the way
in which the monopolistic market structure is inefficient.
We saw earlier that the competitive allocation is both productive and
allocative efficient. The solution was on the PPF and benefits have been
efficiently allocated in the sense that we cannot increase consumer surplus
without reducing producer surplus and we cannot increase producer
surplus without reducing consumer surplus.
In the case of the monopolist, we see that by moving from point M (which
is the monopolist allocation) to point C, both consumer and producer
surpluses can be increased. Hence, the monopolist solution is inefficient
in the sense that we can have more of one thing (benefits of either
consumers or producers) without giving up another (benefits to the other
group).
Note: Pay attention to the issue of price discrimination as discussed in:
LC Chapter 8.
Monopolistic competition
Reading
Our analysis so far has focused on two forms of market structure:

perfect competition and monopoly. They differed in only one of the basic
fundamentals which influence market structures, the number of agents.
In perfect competition, we had many buyers and sellers (facilitated by
the free entry assumption) while in monopoly, there are as many buyers
as there are in a competitive environment but only one seller. To explain
such a configuration in the long run, we assumed that there are barriers
to entry. This meant that although the monopolist enjoys profits above the
normal, other firms cannot enter the industry.
140
We now move to a point in between these two extremes regarding the

number of agents. Consider the case where there are many buyers, while
the number of sellers is considerably smaller than in perfect competition,
but greater than in a monopoly. In other words, we are looking at a
situation where a monopoly, in the short run, does not become a perfectly
competitive market structure once the barriers to entry have been removed
(in the long run).
To understand this point, let us begin by analysing the case where the
removal of barriers to entry does produce a perfectly competitive outcome.
Consider the following situation.
In the previous section we discussed the market configuration of a
monopolist without inquiring into the origin of his powers. One way by
which a firm can gain such monopolistic power is through innovations
which could constitute barriers to entry. By innovation we normally
mean a technological development that leads to a reduction in the cost
of production (notably, the marginal cost). This means that the firm
with the innovation can sell the good at a lower price than the minimum
average cost of the existing technology. Other firms that cannot access the
new technology, will be making losses and will have to leave the market.
Indeed, whether such innovations erect barriers to entry and drive out
existing firms depends on how available the new technology is to other
firms. In the world of perfect competition, we also assumed perfect
information, which implies that information is widely available. Hence,
technological developments cannot remain the exclusive right of those
who generated them. This, in turn, raises a serious problem of incentives.
Why would a perfectly competitive firm invest in R&D and innovate if this
does not result in sufficient gains for the firm? If we had an explicit dynamic
depiction of the model, we could argue that even if everyone has access to
the new technology, the gains made by the inventor depend on how quickly
other firms learn and understand the new information. If knowledge is
instantly disseminated, then no firm will have an incentive to innovate.
As you can appreciate, this could be a serious source of difficulty for the
competitive paradigm (think back to the PPF from Chapter 1).
Figure 4.12: Innovation and the production possibility frontier.
141
The position of the frontier depends on the stock of means of production

(i.e. how much labour and capital there is in the economy at a certain
point in time) and technology. Consequently, there are two ways in
which this frontier can be pushed outwards and the availability of goods
in the economy increased (this is what we call growth). Firstly, we can
increase the stock of means of production (notably, capital). Secondly, we
can change the production technologies available through technological
development. The former suggests that we produce more of both goods
with the same technology, while the latter is based on the ability to
produce more with the same stock of means of production. If we find that
the model of perfect competition implies a disincentive to innovate, we
may have a problem in discussing its efficiency. We saw in the previous
section that perfect competition yields a productive efficient allocation.
But if perfect competition will yield less growth, then it might not really be
efficient in terms of future possibilities.
One way of dealing with this incentive problem is to allow innovators
to enjoy the fruits of their invention through legislation. This is what
patenting laws are trying to achieve.
For further discussion

innovation in a
competitive environment
see Question 5 in the
self-assessment section
on page 155.
This yields a market with a single producer, whose monopolistic power

derives from access to a new technology. His exclusive access to the
new technology is protected by patenting law. This means that we have
effective barriers to entry as new entrants will only be able to use the old
technology (with higher marginal cost of production). The monopolist will
be able to lower the price below the new entrants minimum average cost
price and thus drive them out of the market.
Patenting is a way of overcoming the incentive problem in innovation.
It allows firms to enjoy the fruits of their innovation by protecting their
exclusive rights to the new technology generated. However, after a firm
has earned due returns, society may wish to spread the benefits of the new
technology more widely. One way of achieving such a redistribution is to
attach a fee to the continued registration of a patent.
Suppose that the monopolist is required to pay a fee to keep the invention
as a registered patent. In a way, this resembles the idea of using a lumpsum tax to try and rectify the inefficiencies of the monopolist. Paying a fee
to retain the exclusive access right to an innovation might render using a
new technology more expensive than using an older one without patent
restrictions. This would be a problem since it would stifle innovation, but it
might induce the monopolist to share the new technology with other firms,
if the monopolist in turn were able to raise licensing fees from other firms.

Figure 4.13: Patent registration fees in a monopoly.

142
In the left-hand diagram of Figure 4.13, we have the monopolist setup before the application of patenting fees. In the right-hand diagram,
we see the effect of charging patenting fees. Notice that the introduction
of registration fees constitutes a fixed cost element, as the fees are
independent of the level of production. Hence, the average cost curve
will shift upward but the marginal cost will not change at all. The cost of
producing an extra unit of X has not changed as a result of the fees. Had the
fees been dependent on output, marginal cost would have changed too.
As the fees are part of fixed cost, the increase in the average cost is falling
as output increases. If we produce only a few units of X, the fees per unit
F/x will be high and the average cost will increase a lot. As F remain
constant and X is increasing, F/x (the difference between the old and new
average costs) will be decreasing.
The fact that marginal cost remains unchanged means that there will
be no change in the profit maximising allocation. This suggests that
the inefficiency of the monopolist will remain the same, as we are not
getting nearer to the competitive allocation. The only direct effect of
the introduction of these fees will be a fall in the profit (the shaded area
in the diagrams). The fees thus transfer some of the monopoly profits
from producers to the government. Whether this transfer will be able
to compensate for the loss of benefits due to the monopolistic market
structure remains, at this stage, an open question.
With the introduction of registration fees, the monopolist may decide to
allow other firms access to its technology, provided they paid the firm a
user licence fee. What will now happen to the markets structure and what
will be its long-run equilibrium? Could it be worthwhile for the firm to
lose its monopolistic power?
When the monopolist allows other firms to use the new technology for a
fee, it will reduce its own cost and increase the cost of possible entrants.
Put differently, it facilitates a long-run situation where one firm (the exmonopolist) can make profits above the normal while others cannot.
The following market will emerge (Figure 4.14).

Figure 4.14: The monopolist and user licence fees.
The left-hand diagram in Figure 4.14 depicts the ex-monopolist. While

everyone is now using the same technology, they are paying a fee for this
use. The monopolist pays the government; the other producers pay the
monopolist. With every entrant, the monopolists average cost (AC) is
falling as part of its fixed cost is being paid by another firm. The minimal
rate that the monopolist will set is that rate at which its own AC curve will
end up lying below the entrants AC. Figure 4.14 depicts such a longrun configuration. Firms will enter as long as there are profits to be made.
How many firms will enter depends on the fees which the monopolist
charges the entrants. The optimal fee level for the ex-monopolist will be
143
the one that will generate a profit in the left-hand diagram which is greater
than or equal to the profits before other firms entered, when the burden
of the fees lay entirely with the monopolist. Naturally, when the patent
registration can no longer be renewed, more firms will enter and all firms will
have the same technology and the same fixed costs (if any). We then end up
with the normal competitive market allocation as described in section 4.3.
Notice that as other firms enter the market, the demand confronting each one
of them becomes completely elastic (a horizontal demand). The reason for
this is that if any one firm charges a higher price than the market rate, it will
lose all its customers, who will simply move to another firm. This assumes
that a single firm can, in principle, supply the entire market. If this was not
the case, the demand confronting each firm would not be completely elastic.
If a firm raises its price, it may lose many, but not all, its customers. Since
other firms will not be able to supply the entire market, equilibrium price will
increase. Put differently, the firm will be able to influence the market price.
However, this situation cannot be sustained. In the long run, other firms
will be able to adjust their production in such a way as to supply the entire
market. Consequently, the demand each firm confronts (in the long run) will
inevitably become completely elastic.
Indeed, the main difference between monopolistic competition and other
market structures lies in the type of demand elasticity which each firm
confronts. If the process of entry leads each firm to confront a completely
elastic demand, then no firm can exercise any monopolistic power. It cannot
raise its own price without losing its entire share in the market. In perfect
competition, the reason for this complete demand elasticity is that the
goods firms sell are identical. When we moved from perfect competition to
monopoly, we changed the number of agents as a determinant of market
structure. When we move to monopolistic competition, we change another
one of these determinants, the nature of goods in the market. For perfect
competition, we assume that all goods are identical, or homogeneous.
For monopolistic competition, we assume that the goods are somewhat
differentiated, or heterogeneous.
To fully understand this, let us go back to the monopolist and ask what
exactly will happen to it when new firms enter the market.
Figure 4.15: Monopolist demand schedule and new entry.

144
Initially, the monopolist is the sole producer and he confronts the demand
schedule shown in Figure 4.15. If he raises the price by dP, he will lose
dX, because people are willing to pay the higher price only for a smaller
quantity of X.
Suppose that the commodity which the monopolist produces is a simple
type of white bread.
If you were considering entering the market for carbohydrate consumption
given that there is a monopolist producing white bread, would you choose
to produce white bread too? The answer to this question is actually fairly
complex and we shall deal with some of the principles behind it in the
next section. At this stage we shall assume that as you know that there is a
demand for all sorts of carbohydrates you may choose to produce something
within this category that is slightly different say, wholemeal bread. What
will happen to the producer of white bread as you enter the market?
Among the people who want to consume carbohydrates, there are those
who are more health conscious than others. In addition, they may have
different tastes in carbohydrates which may have nothing to do with health
(some like white bread, some like brown bread). When there was only
one producer in the market, there was not much choice. If you wanted
carbohydrates, it had to be white bread. With the new entrants, some would
immediately shift from white bread consumption to wholemeal bread
consumption, even if the latter is not cheaper. In fact, some may shift to
wholemeal bread even if it is more expensive, simply because this is nearer
to what they really want to consume when buying bread.
At the same time, there are people who would never abandon white
bread even if there was a cheaper option of wholemeal bread available.
For them, life is not worth living if they cannot dip a piece of white bread
in their soup! Therefore, both kinds of bread have a following which
would remain loyal even in the face of a price differential. For them,
the commodity is not carbohydrates or bread, it is rather white bread
or wholemeal bread. This means that each of the firms can raise the
price without losing all their customers, unlike in the case of perfect
competition. Hence, the demand elasticity which they confront will not be
perfectly elastic, even when there is market entry. Each of these firms has a
certain degree of monopolistic power over some section of the market.

Figure 4.16: Monopolistic competition and new entry.

145
When the producer of wholemeal bread enters the market, the demand
confronting the producer of white bread, who until this point was the sole
producer of carbohydrates, will shift to the left. At any given price, some
customers will shift to the other good, even if the price of the other good
is higher. In addition, if the producer of white bread raises the price of the
good by the same dP as before, he will lose a much greater dX now than if
he was the sole producer in the market. What this means is that with the
entry of new firms, not only will the incumbents lose market share, they
will also confront a more elastic demand schedule.
If you think carefully about the meaning of elasticity you will realise that,
among other things, elasticity represents choice. The more choice you
have, the more elastic will be the demand confronting a single producer.
If the producer of our white bread increases the price he will first lose dX
according to the willingness to pay of all his loyal customers (the move
from A to B in the above diagram). However, some of his customers stayed
with him simply because for them, neither white bread nor wholemeal
bread is what they really like. Given the price of both goods, they will
consume that which is cheaper, where the price here is measured by the
monetary price (as well as by the disutility of not getting exactly what
they want). When the producer of white bread raises his price, some of
these people will shift to the wholemeal bread because this would now be
cheaper in terms of the money cost as well as the cost of not getting what
you really want (the move from B to C).
Consequently, we may conclude that as new firms enter the market, the
demand schedule confronting existing firms will move to the left and
become more elastic. As long as there is profit to be made, firms will enter
the market until the point where the demand schedule is tangent to the
average cost, as shown in Figure 4.17.
Figure 4.17: Equilibrium in monopolistic competition.
146
When the demand schedule is tangent to the average cost curve, price will
be equal to average cost. This is fairly obvious. At any other price, average
cost is greater than the price. This means that at any other price, the firm
will be making a loss. Hence, the profit maximising price must be the one
where the price equals average cost. At the same time, we know that profit
maximisation also requires equating marginal cost with marginal revenue.
So the long-run equilibrium in the monopolistic competition case will be at
the point where marginal revenue equals marginal cost, but price will be
greater than marginal cost and equals average cost.
Had there been no product differentiation, the demand schedule would
have become completely elastic and the long-run solution would have
been the same as in perfect competition (the tangency of average cost with
demand would have occurred at the minimum of the average cost). This
means that the difference between perfect competition and monopolistic
competition lies in the demand elasticity which firms confront in the
long run. In the case of monopolistic competition, firms have some
monopolistic power over some people even in the long run. This allows
them, in principle, to vary their price without losing their entire market
share if they raise the price or gaining the entire market if they reduce the
price. The extent of their monopolistic power can be measured in terms of
the deviation of the market price from the marginal cost.
A note on strategic behaviour

Reading
Up to this point, our analysis was dominated by a sort of passive

behaviour. All agents were rational utility (or profit) maximisers, but in all
the cases we have discussed, they made their choices assuming that their
own choice will not influence the choice of the other agents. However,
consider the case of monopolistic competition. There are only a few firms
in the market. It is unlikely that they will be ignoring each other when
they make their pricing decisions. Instead, they will be taking the other
firms behaviour, and their likely responses, into account. We call such
behaviour strategic.
Consider a simple example where there is a market with the following
inverse demand function for good X:
P(x) = X
Suppose that marginal cost of producing X is constant and equals zero,
with no fixed costs. The revenue function will then be:
R(X) = P(X)X = ( X)X = X X2
and the marginal revenue:
147
Figure 4.18 shows the demand for good X.

Px
pM
M
D()
P c= MC=0
MR
X
1
=2
C
c
X =
Figure 4.18: A simple demand function.
The competitive solution occurs at the point where P(X) = MC(X). As we

assumed MC to be zero, the competitive equilibrium is at the point where
P(X) = MC(X) = 0:
P(X) = X = 0
This means that XC = /. This point is denoted by the letter C in the
above diagram. Had there been a single producer (a monopolist) the
equilibrium would be at the point where MR(X) = MC(X). Again, as MC =
0, this condition becomes:
This means that XM = /2. This point is denoted by the letter M in the
above diagram.
Suppose now that there are two producers in the market. Had they
ignored each other and acted as monopolists (comparable to the case
of monopolistic competition), each of them would have produced the
monopolist output which is /2. As there are two such agents, the total
quantity of X brought to the market will be 2(/2) = /. But / = XC
which means that they will end up at point C, where both will make no
profits above the normal.
It is clear from the Figure 4.18 that if each firm produced a bit less,
they would both enjoy greater profits (the price will be above zero and
revenues, which in our case are equal to profit above the normal, will be
positive too). But how much will each of them produce? Everyone would
want the other on to produce less and himself more so that he gets the
greater share of the profit. Is there a possible solution to this situation?
Let us deviate from our story and discuss a similar situation, which is
captured by the famous prisoners dilemma. Two people suspected
of cheating in an examination were caught by the police and are held
in different cells. They cannot communicate with each other. Their
interrogators tell each of them that if they inform on the other, they will get
only 20 days in jail while the other will get 10 years. They also know that if
they both confess, each one will get only one year in jail. However, if they
keep silent, they will be tried on a minor offence for lack of evidence, and
will get a sentence of three months each. What should they do?
148
The following matrix captures all possibilities. The rows represent

the choices of individual 1 while the columns represent the choices of
individual 2. Each box represents the outcome where the left-hand number
is the outcome for individual 1 and the right-hand number is the outcome
for individual 2:
2
Confess
2
Do not confess
1
Confess
(1 year, 1 year)
(20 days, 10 years)
1
Do not confess
(10 years, 20 days)
(3 months, 3 months)
The question which individual 1 will ask himself is: what will be my best
response for each choice of action by individual 2?
If individual 2 chooses to confess, we must examine column 1.
If individual 1 responds to the confession by 2 by confessing as well,
the outcome will be that both will sit in jail for one year.
If, instead, individual 1 responded to 2s confession by not confessing,
he will get 10 years in jail.
Clearly, one year is preferred over 10 years and individual 1 knows that his
best response to individual 2s confession would be to confess as well.
But what if individual 2 chooses not to confess? Here we must examine
column 2 of the matrix.
If individual 1 responded to 2s refusal to cooperate with the police by
confessing, he will get only 20 days in jail.
If, instead, he chose not to confess, he would end up with three months
in jail.
Clearly, 20 days is preferred over three months and individual 1s best
response to individual 2s cooperation with the police would be to confess.
In other words, whatever individual 2 chooses to do, individual 1s
best response is to confess. We say in such a case that confessing is
a dominating strategy. Since the situation is completely symmetric,
individual 2 will reach exactly the same conclusion. Consequently, both
will choose to confess and will end up spending one year in jail each. This
equilibrium is called a Nash equilibrium and it represents each agents
best response to whatever the other agent might do.
However, one can clearly see from the above that there is a better solution,
from the individuals point of view, than the Nash equilibrium. This would
be the outcome in case both choose not to confess. The reason why this
is not an equilibrium is that each agent will have an incentive to renege
on the choice of strategy. Were you able to agree with your partner not
to confess, you will have an incentive to confess as this will reduce the
number of days in jail from three months to 20 days. As your partner is
likely to do the same, you will end up confessing anyway.
The above description of Nash equilibrium presupposes a form of
competitive behaviour and does not provide a full account of what might
happen if c-operation was possible. In this sense, the notion of Nash
equilibrium is a perfectly good method to resolve the problem of the two
producers with which we started.
We know that for a monopolist, profits will be maximised whenever output
equals (/2), which is where MR = MC = 0. The geometry of our story
149
suggests that this point will be reached at exactly half the market size.
Indeed, under competition, the output would have been (/) which is
exactly 2(/2).
Consider now the situation where, like in the prisoners dilemma, each
firm is conscious of the other (Figure 4.19). What would its best policy
be?
The simple answer to this will be that the best response to the choice of
output by the other firm will be to exploit the monopolistic power over
the remainder of the market as much as possible. Hence, if one firm was
first in the market and, as a monopolist, chose to produce X1 = (/2),
the second firms best response will be to behave as a monopolist on the
residual of the market at the point: X2 = ((/) (/2))/2, where (/)
(/2) is the residual of the market demand at the competitive price.

Figure 4.19: Best responses.
But if this is what firm 2 chooses to do, will firm 1 not change its choice?
Well, like firm 2, firm 1 wishes to maintain its monopolistic power over
the remainder of the market. This would mean that it too would want
to choose the quantity which is half the residual (where MR = MC = 0).
Hence, we can write the rule of best response for each firm. The rule is
to produce half the size of what is left of the market, given the choice of
output by the other firm. This would mean the following:
Figure 4.20 depicts these equations.
150
Figure 4.20: Best response functions.
The horizontal axis shows the quantity produced by 1, while the vertical
axis shows the quantity produced by 2. Had 2 produced nothing, X1 =
(/2) which is exactly the monopolist solution. If firm 2 increased its
output, the best response of firm 1 would be a lower level of output.
In particular, if firm 2 chose X 20 then the line denoted by R1 (response
function for 1) tells us what level of output will maximise 1s profit (1s
best response to X 20 ). This will be X 10. Inthe same way, we can construct
the response function of firm 2 (denoted by R2). Clearly, there is a pair of
strategies (output levels) where each agents strategy is the best response
to the other agents choice. This is the pair (X 11 , X 21 ). From the above
equations we are able to calculate these values:
For symmetry reasons this will also be the value of X1.

From what we know about the Nash equilibrium in the prisoners
dilemma, we may conclude that while the pair (X 11 , X 21 ) may be an
equilibrium, the two firms could have increased their profits if they had
cooperated.
One well-known example of such cooperation is the Oil Producing and
Exporting Countries (OPEC) cartel. Representatives of these countries
meet in order to decide, among other things, on the quantity of oil to
produce. By limiting it, they could keep the price sufficiently high to yield
a profit greater than that in competition, even though the quantity they
sold was lower. However, on many occasions, some of the countries which
were more in need of funds chose to slightly increase their output so as to
gain more from the higher price. The more countries that behaved in this
way, the less effective the cartel became.
As I said earlier, cooperation is a very broad and complicated field of
investigation. The present framework might not be the most insightful
one for analysis. However, I would like to draw your attention to a certain
gap that has arisen from our analysis of strategic behaviour. While the
Nash solution may not produce the highest profits for the agents, it is,
from a social point of view, preferred to the cooperative solution. This,
151
of course, does not mean that cooperation is an inferior form of social

organisation. What it does mean is that in a world of self-interested
individuals, competition may be a means by which these self-interested
desires are tamed. In the non-strategic analysis we could see that the longrun solution meant firms will make no profits above the normal. In the
strategic case, we observe a similar phenomenon. A conspiracy (which is
a form of cooperation) by agents to increase their gain at the expense of
others will be socially undesirable as well as unsustainable.
There is, however, a much more alarming conclusion which follows the
analysis in strategic behaviour. This is the conclusion that agents fail
to achieve that which they want. In the case of the prisoners dilemma
this is quite clear. The interests of the agents is to get to the box of (3
months, 3 months) which would have been obtained if both of them had
cooperated with each other and refused to confess. The fact that a
competitive behaviour brought them to a less desirable outcome suggests a
serious failure in the mechanism of competition.
In the non-strategic framework, firms want to maximise profits and they
achieve this outcome even in the long run, when the normal profit is that
maximum. But in the case of strategic behaviour, it is clear that firms did
not achieve the highest profits feasible. If the meaning of competition
is that it allows the achievement of the coincidence of wants through
decentralised decision-making, then Nash equilibrium has demonstrated
that this may not always be the case. The question is whether this is a
result of failure in the mechanism of markets or due to the absence of
markets in some goods. The answer to this question will be given in
further studies.
Self-assessment
Define the concepts of equilibrium, Giffen good, allocative and
productive efficiency, perfect competition, demand elasticity, strategic
behaviour, the prisoners dilemma.
Use these definitions to give examples of a perfectly competitive
market, a monopoly, monopolistic competition, licensing of its patterns
by a monopoly, completely elastic demand.
Use diagrams to analyse problems involving short- and long-run effects
of unit and lump sum tax on a competitive industry.

If you really want to improve your knowledge, you should try to answer
you to explain the subject in a way that will help you yourself understand
things which you would not have understood otherwise. Only after all
these trials should you compare your answers with the answers in the
book.
152
Question 1
a. Analyse the short-run and long-run effects of a unit tax on a
competitive industry.
b. Compare the effects of such a tax (in the short run and in the long run)
on a competitive industry confronting an elastic demand schedule (||
> 1) with an industry confronting an inelastic demand schedule(|| <
1). Examine the effects from the point of view of:
i) consumers
ii) producers
iii) the government.
c. The inefficiency of the unit tax can only be justified in a partial
equilibrium analysis. If we consider the economy as a whole, the deadweight-loss will be offset by the increase in demand for other goods.
Comment on this statement.
Question 2
The competitive market for new homes is in long-run equilibrium. Its
demand is comprised of two groups: first-time buyers and second-time
buyers.
a. Describe the long-run equilibrium paying attention to the distribution
of surplus between first-time buyers and second-time buyers.
b. Analyse the effects of an increase in labour costs on total output, each
firms output, the number of firms and prices in the short and in the
long run.
c. What will happen (in the case of (b)) to the capital to labour ratio, to
all consumers expenditures and to the expenditures of each group of
consumers?
d. Analyse the effects of a government subsidy for first-time buyers on the
total output, each firms output, the number of firms and prices in the
short and in the long run.
e. What will happen (in the case of (d)) to the capital to labour ratio, to
consumers?
Question 3
a. Analyse the short-run and the long-run effects of a lump-sum tax on a
competitive industry.
b. Compare the effects in (a) to those of a unit tax which raises the same
amount of revenue for the government. What will happen to the
number of firms remaining in the market?
c. While in the short run, the lump-sum tax is clearly efficient and the
unit tax is not, in the long run, both taxes are equally inefficient as the
burden of tax is shifted onto consumers. Comment on this statement
making a clear distinction between productive and allocative efficiency
and bearing in mind some general equilibrium considerations.
Question 4
Two groups of producers supply one competitive industry with a
commodity (say, X) which requires skilled labour. One group is located in
an underdeveloped area A with a high level of unemployment amongst
unskilled labour. The other is located in a relatively well-off area B where
there is not much unskilled labour.
153
The government would like to pursue a welfare to work policy and tries
to induce firms to hire and train the unskilled workers. To that end, the
government proposes to pay part of the wages for all workers in area A. To
prevent firms from moving their plants from area B to area A, only existing
firms in area A qualify for this subsidy.
a. Analyse the effects of the proposal on market price, output and
consumers spending. How will it affect output, profits and the number
of firms in each area?
b. What will be the effects of the proposal on the choice of technology by
firms in area A? Will the proposal achieve its aims?
c. Instead of forcing people to work for welfare, the government could
have achieved the same result by taxing wages in area B. Discuss this
statement while reviewing your answers to (a) and (b) above.
Question 5
A technological discovery has been made in one of the firms in a
competitive industry. On registering the discovery as a patent, the
inventing firm will have to pay registration fees. It could allow other firms
the use of the new technology, charging them a licence fee if they decide
to use it.
a. Beginning with a long-run equilibrium, describe the short-run effects
of the discovery prior to any patenting arrangements and before other
firms could use the new technology, on the industrys price and output
and on each firms output and profits.
b. What will be the short-run and the long-run effects of introducing a
patent registration fee on the inventing firm and a licence fee on all
other users of the new technology?
c. Could the licence fee be set in such a way that none of the other firms
will be willing to pay them? What will then happen to output and price
in the industry in the long run?
d. Allowing firms to patent their innovations works against allocative
efficiency. Even in a case like (b) above, the existence of licence fees
could even bring about an increase in price. This means that the
benefits of the innovation are not shared. Discuss this statement.
Question 6
The overall demand schedule for cigarettes has elasticity which is greater
than unity. The demand elasticity of heavy smokers is less than unity.
a. What will be the demand elasticity of the light smoker if the demand
for cigarettes is comprised of these two groups alone?
b. Analyse the effects on the total output, each firms output, the number
of firms and prices in the short and in the long run when the cost of
capital decreases.
c. What will happen (in the case of (b)) to the capital to labour ratio, to
consumers?
d. Analyse the effects on the total output, each firms output, the
number of firms and prices in the short and in the long run when the
government has a way of taxing only heavy smokers.
e. What will happen (in the case of (d)) to the capital to labour ratio, to
consumers?
154
Answers
Question 1
a. This is fairly straightforward:
The first point is the direct effect of the unit tax on a representative
firm. In our case, this should be a shift upwards of both the average
and marginal cost curves. Also, as it is a unit tax, the new minimum
average cost will intersect the new marginal cost at exactly the same
level of output as before the change. A short-run analysis would appear
as in Figure 4.21.

"
"
"

'

Figure 4.21
Notice that the supply curve shifts upwards. As a result, equilibrium

price will rise by less than the value of the unit tax, total output will fall
and each firm will be producing less while making losses.
In the long run, some firms will now leave the market (you should give
an explanation of why only some firms and not all at once). The price
will rise by the full value of the tax and each firm will produce exactly
as before the change. (See Figure 4.22.)

'

"
"

"

Figure 4.22
155
It is sufficient here to examine the situation by looking at the market

alone. The left-hand diagram depicts the elastic demand schedule while
the right-hand diagram deals with the inelastic one. A to B is the short
run. A to C is the long run (Figure 4.23).
dPc
dPp
D
X2
X1
X0
X2 X1 X0
Figure 4.23
b. In the short run:

i) Consumers: when demand elasticity is greater than unity (i.e. 1),
price will rise by less than if demand elasticity had been less than
unity. This means that the burden of tax, in the short run, is greater
on consumers when demand elasticity is less than unity than when
it is greater than unity.
ii) Producers: exactly the reverse is true.
iii) The tax raised with a greater demand elasticity will be smaller (as
the equilibrium output in the short run is smaller when demand
elasticity is greater than unity than when it is less than unity).
In the long run:
i) Consumers: In both cases the long run increase in consumer price
will be the full value of the unit tax. This means that the entire tax
revenues are coming now from what used to be consumers surplus.
ii) Producers: For those staying in the market, the tax will make no
difference. As a group, however, there will be more producers
leaving the market under the elastic demand schedule than under
the less elastic one. The reason, as before, is that the long-run
equilibrium output under the elastic demand schedule will be much
smaller than under the less elastic demand schedule.
iii) Same as in the short run.
c. For this part, we need to comment on the efficiency of taxes. It is clear
that in a partial equilibrium setting, there will be a dead-weight loss
from the unit tax (as well as the lump-sum tax). The increase in price
will have effects on demand for other goods which may offset (in utility
terms) the dead-weight loss in this model. Nevertheless, the reason
we know that the unit tax will remain inefficient is that even in the
long run, the price in the market for X no longer equals the marginal
cost. So, even if compensation of the dead-weight loss been feasible,
it would not have been possible to equate price to marginal cost the
benchmark of efficiency.
156
Question 2
In this question, we analyse markets when the composition of agents is
more complex. We have a market for new homes (which is a flow!), but a
clear distinction between first- and second-time buyers. We may assume
that the demand elasticity of first-time buyers may be less than unity and
that of second-time buyers, greater than unity. This is not a necessary
assumption, but we should qualify our answer using such information. We
could equally have assumed the opposite.
The following set of figures below depict the market with diagrams (left
to right) illustrating demand of first time buyers, demand of second-time
buyers and the market as a whole. Clearly the market demand schedule
should have an elasticity which represents the relative size of each group
of consumers.

Figure 4.24
a. The long-run equilibrium is at point A.

b. and c. There is an increase in the cost of labour.

'
'

"
"
&
#

Figure 4.25
157
The increase in labour costs will push up both average and marginal cost.
The output of each firm (and hence, the total output in the short run)
will fall. This, in turn, will push up the supply schedule in the market,
which will bring about a short-run increase in equilibrium price. Under the
assumptions we have made about demand elasticities, second time buyers
spending will decrease while first-time buyers spending will increase.
Overall spending depends on the total demand elasticity. If we had made
different assumptions about demand elasticities, the answer here would be
different, of course.
The capital to labour ratio will rise when labour becomes more expensive.
In the short run, when capital is fixed, the mix of capital and labour is
depicted by point B while in the long run, firms will move to a mix at point
C.
In the long run, some firms will leave the market. This will push supply
further to the left, leading to an increase in long-run equilibrium price.
Consumers spending will change further in the same direction as they did
in the short run.
d. and e. Subsidy to first-time buyers.

Figure 4.26
A subsidy to first-time buyers will shift their demand upwards. This means
that overall demand will shift upwards as well, but by a smaller amount.
Short-run equilibrium prices will rise and overall consumer spending
will increase. Spending by second-time buyers depends on their demand
elasticity. Assuming, as we did, that it is greater than unity, their spending
will fall. Direct spending by first-time buyers will fall as well (with the
assumption of a demand elasticity less than unity). The increase in overall
spending will come from the government.
In the short run, output will increase and firms will be making profits. Capital
158
to labour ratio will fall in the short run (point B) but will remain unchanged
in the long run (point C). Firms will enter the market in the long run, pushing
the supply schedule to the right. Assuming a horizontal long-run industry
supply, the price will fall back to its original level. This means that spending
by second-time buyers will go back to its original level. Direct spending by
first-time buyers will fall even more (assuming demand elasticity less than
unity) and overall spending will rise or fall according to the overall demand
elasticity. Each firms output remains unchanged relative to the initial position.
The capital to labour ratio also remains unchanged.
Question 3
a. This is fairly straightforward. The first point is the direct effect of the
lump sum tax on a representative firm. In our case, this should be a
shift upwards of the average cost curve alone. Also, as the marginal
cost remains unchanged, the minimum average cost will be at a higher
level of output. The distance between the new and old average cost is
given by T/X.
Figure 4.27 shows the short-run analysis.

Figure 4.27
Note that the Supply curve does not move. As a result, equilibrium
price will remain unchanged. Each firm will carry on producing as
before but they will now be making losses.
In the long run:

&

&
%
"
&
&

Figure 4.28
159
Some firms will now leave the market (an explanation is expected of
why only some firms leave the market, and why they will not do so all
at once). Supply will fall and equilibrium price will rise by more than
the average tax. Each of the remaining firms will now produce more
than before the tax.
b. This part of the question is considerably more difficult. The question
here is about comparing the lump-sum (L) and unit tax (U). To see
the relationship between the two tax systems in terms of the revenues
which they raise, let us begin by assuming a unit tax of size t and a
lump-sum tax (T) such that the revenue raised through each firm is
the same. This will be a convenient benchmark, which implies that the
number of firms remaining in the market will be the same under the
two schemes (for the overall tax revenues to be the same), as Figure
4.29 shows.
&
)
$
Figure 4.29
If each firm was to pay the same amount of tax under the lump-sum
scheme (T) as under the unit tax, then:
where X 0I is the representative firms pre-tax level of output, as well as

its long-run unit tax level of output. This means that the average lumpsum tax at this point of initial output must be the same as the unit tax.
Naturally, under a lump-sum tax each firm will produce more (X 1I ), so
the average lump-sum tax which such a firm will pay will be smaller.
The long-run outcome of a unit tax t is denoted by point B. That of
the corresponding lump-sum tax is shown by point A. In both cases,
there will be fewer firms in the market than before the tax. Under the
unit tax, each firm will produce as much as before and overall output
will fall. Under the lump-sum tax, each firm will produce more than
before the tax, but overall output will fall. Equilibrium price under
a unit tax will rise by the full value of the tax t, where each firm will
pay the government the amount tX 0I in tax. Under the lump-sum tax,
which generates the same overall revenue as the unit tax with the
same number of firms, price will rise by more than the average tax but
by less than the equivalent unit tax. Output under unit tax will fall by
more than under the lump-sum tax.
160
Generally speaking, we know that for the two systems to produce the
same tax revenues we must have:
TnL = tX 0i nU
where T is the lump-sum tax per firm; nL the number of firms
remaining in the long run with a lump-sum tax; nU the number of firms
remaining in the long run with a unit tax. Hence, the relative number
of firms depends on the level of tax per firm:
If the tax per firm under the lump-sum tax is greater than under a unit
tax, then nU > nL. The opposite is true if the tax per firm under the
lump-sum scheme is smaller than under the unit tax.
c. Here, we have to comment on the efficiency of taxes. It is clear that in a
partial equilibrium setting, there will be a dead-weight loss to the unit
tax as well as the lump-sum tax in the long run. The reason we know
that the unit tax will remain inefficient is that the price in the market
for X no longer equals the marginal cost, even in the long run. Hence,
had a full compensation of the dead-weight loss been feasible (through
increases in demand elsewhere), equating price to marginal cost could
not have been the benchmark of efficiency. In the case of the lump-sum
tax, the benchmark of efficiency (price equals marginal cost) has not
been violated even in the long run. There is room to believe that the
increase in price will cause increases in demand elsewhere which might
compensate for the apparent dead-weight loss.
Question 4
This question reviews the model of perfect competition, and gives some
indication of the possible practical relevance of the model.
The first feature of this case is that there are two groups of suppliers for
the same commodity X. Group A produces the good in an underdeveloped
area with high unemployment among unskilled labour. Group B produces
in a developed part of the community where there is no unskilled labour
unemployment. By implication, good X is produced by skilled labour
(hence there will be no difference in wages because of the difference in
the level of unemployment among unskilled labour). We begin with the
long-run equilibrium in the industry (Figure 4.30).
MC,AC
A=C
Figure 4.30
The government wishes to deal with the problem of unemployment in area

A by pursuing a welfare to work approach. It proposes to subsidise wages
in area A to allow firms to take on unskilled workers and to train them.
Assume, for simplicity, that the subsidy applies to the entire wage bill of
the firm rather than to specific individuals.
161
In addition, to prevent the movement of firms across regions, only existing

firms qualify.
a. The effects of the proposal on the industry are depicted in the above
diagrams. Both AC and MC of firms in A will shift downwards. We
cannot say whether the new minimum will be to the left or the right of
the previous one but this is unimportant.
In the short run:
In the first instance, the fall in MC in area A will bring about a shift
downward of the aggregate supply, depending on the market share of
area A. This will cause a fall in market price of X. We end up at point B
in the above diagrams where firms in A make profits and produce more
of X; firms in area B make losses and produce less. Consumer spending
will change according to demand elasticity. If the price elasticity of
demand is greater than unity, spending will increase, otherwise it will
fall.
In the long run:
In the long run, firms in area B will leave the market. This will shift the
supply to the left and cause an increase in market price. The process
will continue as long as there are losses in area B. When the price
returns to its original level, we will reach the new long-run equilibrium.
Now, there will be less firms in area B and they will all make normal
profits. Each firm in area B will produce as much as it did before the
implementation of the policy.
In area A, each firm will produce more (point C) than before the
change and they will all be making profits above the normal (which are
used for retraining).
The effect of the change on the choice of technology is shown in
Figure 4.31.
'
'
Figure 4.31
The change in relative factor prices will introduce a new, flatter longrun expansion path. As a firm in area A is now producing more, the
move is from A to C in the above diagram where more workers are
employed. Hence, the policy will achieve its aim.
162
b. Taxing wages in area B:
Figure 4.32
In the short run:

Taxes on wages in area B will lead to a shift upwards of both AC and
MC. This will cause the aggregate supply to shift upwards, the size of
the shift will depend on the relative share of area B in the market. The
equilibrium price will increase and consumer spending will change
according to the price elasticity of demand. Each firm in area B will
produce less and make losses.
Each firm in area A will produce more and make profits above the
normal.
In the long run:
Phase 1: In the long run, firms in B will leave the market and price
will rise until it equals the minimum of the new AC curve in area B. At
this stage, each firm in area B will produce more or less of X, depending
on how the minimum of new AC relates to the pre-tax function; and
each firm will make normal profits. There will be less firms in area B.
Phase 2 In area A, there are profits above the normal. Firms from area
B, therefore, will move their plants to area A. Hence, in the end, all
firms from area B will move to area A, supply will increase and we will
return to the original price and quantity. The only difference is that this
time, supply will come from area A only. There will be no tax revenues
for the government and there will be more job opportunities in area A.
However, this will push up the wages, as it will be more costly to hire
the unskilled labour. Consequently, MC will increase, which will lead to
an increase in price and a subsequent adjustment of consumer surplus.
Despite the increase in the wage bill, firms will not return to area B as
long as the tax liability is in place.
To some extent, the critics were right. Employment opportunities in
area A have increased without using government funds. However, the
cost of this change is perhaps greater than using taxpayer money to
subsidise area A. The cost is the devastating effects which such a policy
will have on area B.
Question 5
In this question, we examine some possible relationships between market
structures. We have a competitive industry where one producer has made
a technological innovation which must now be registered and paid for.
a. Beginning with the long-run equilibrium before the innovation, we
investigate the short-run effects of the discovery before it is registered
as a patent and before anyone else can access it (Figure 4.33).
163
Figure 4.33
The discovering firm (left-hand diagram) will be able to reduce both

its AC and MC of production. If the number of firms is very large, this
should have an infinitesimal effect on the aggregate supply unless, of
course, the discovery is such that allows the inventor to leave its mark
on the market.
We shall assume that this is a competitive environment where the
discovery is significant enough to influence the aggregate supply.
Hence, price will fall and while the inventor is making profits, other
firms will suffer losses (point B above). Had we assumed that the
inventor is too small, it would simply mean that the inventor will now
make profits above the normal while others will not: both stories are
acceptable at this stage;
b. When the inventor allows other firms to use the new technology for
a fee, its own cost will be reduced, while that of others will increase.
Put differently, it facilitates a long-run situation where one firm (the
inventor) can make profits above the normal while others cannot. The
market that will emerge is shown in Figure 4.34.

"
"

"
"

Figure 4.34
The left-hand diagram in Figure 4.34 depicts the inventor. While

everyone is now using the same technology, everyone is paying a
fee towards this use. The inventor pays the government, the other
producers pay the inventor. With every new user, the inventors AC
is falling. The minimal rate that the inventor will set is the rate at
which its own AC curve will end up lying below the others AC. The
above diagram depicts such a long-run configuration. Firms will swap
technologies or new firms will enter as long as there are profits to
be made. How many firms will enter depends on the fees which the
inventor will charge the users.
164
c. If the inventor sets a very high licence fee and his technology is such
that it can flood the market, it will create a monopolist situation.
Whether this is the preferred outcome for the inventor will depend on
the size of the profits it will make as a monopolist who has to pay the
full patenting fees (there will be no licence fees to offset these costs)
against the profit it can make in a case like (b); We have to show
how the inventor will set the price and quantity if it remains the sole
producer. We must be aware that the monopolist price might be higher
than the price charged by a competitive block using the old technology.
Nevertheless, they should then point out that given that the inventor
can engage in a price war, its new technology can become an effective
barrier to entry.
d. This is a question about the incentives which competitive firms have
to invest in R&D. If there had been no patenting right, the long-run
equilibrium suggests that firms will only have normal profits. In a
regime of perfect information, this would mean that the firm will have
neither the funds nor the incentive to engage in R&D. In a case like (b)
above we can see how the benefits of the invention are shared. After
all, even if other firms make normal profits, with the new technology,
market price will be lower than before. Hence, at least some of the
benefits from the invention are passed on to consumers directly.
Naturally, the problem hidden in this question is about how to reconcile
the commonly used static concept of efficiency, with its dynamic
consequences.
Question 6
In this question we tested students ability to analyse markets when
the composition of agents is more complex. Here we have a market for
cigarettes but a clear distinction between heavy and light smokers.
The demand elasticity of heavy smokers is less than unity and that of
light smokers, greater than unity. But the overall demand elasticity for
cigarettes is greater than unity.
a. The demand elasticity of the light smokers must be greater than unity.
b. and c.
A decrease in the cost of capital
The following set of diagrams depicts the market with diagrams (left to
right) depicting demand of heavy smokers, demand of light smokers and
the market as a whole:
165
S()
A
Px0
^
S()
B
C
HS
LS
D ()
HS
X0
D ()
HS
LS
X1
X0
D ( )
LC
X1
X0
X1
K
MCi ()
^
MCi AC ()
i
K0
x1
2
i
K0
Wo
ro
^
ACi ()
Px
P 1x
P 2x
x0
Wo
r1
X0
X2
Figure 4.35
We assume that the decrease in the cost of capital has an immediate

effect (i.e. it affects the short run). It is equally acceptable to make
the assumption that the change in the cost of capital will only have a
long run effect. When we assume that there are immediate effects, the
decrease in cost of capital will shift down both average and marginal
cost. The output of each firm (and so, the total in the short run) will
rise. This, in turn, will shift to the right the supply schedule in the
market which will bring about a short-run decrease in equilibrium
price. The spending by light smokers will increase while those of
heavy smokers will decrease. Overall spending in the market will
increase.
Capital to labour ratio will fall in the short run (when we cannot vary
capital) from A to B. In the long run, however, it will rise (to point C)
when capital becomes cheaper.
In the long run, firms will enter the market. This will push supply
further to the right bringing about a decrease in long-run equilibrium
price. Consumers spending will change further in the same direction as
they did in the short run.
b. and c.
Taxing heavy smokers
A tax on heavy smokers will shift their demand downwards. This
means that overall demand will shift downwards too but at a
lesser proportion. Short-run equilibrium prices will fall and overall
consumers spending will fall too. Spending by light smokers will
increase. Overall spending by heavy smokers (including taxes) will
rise.
166
X1
LR
In the short run, output will fall and firms will be making losses.
Capital to labour ratio will rise in the short run (from A to B) but will
remain unchanged in the long run (point C). Also, in the long run,
firms will leave the market and push the supply schedule to the left.
Assuming a horizontal long-run industry supply, the price will rise back
to its original level and so will the spending by light smokers. Heavy
smokers, however, will be spending more on cigarettes. Each firms
output remains unchanged relative to the initial position. Capital to
labour ratio, too, remains unchanged.
S LR
S()
C
B
t
0
Px
1
HS
HS
D t
HS
X1
HS
LS
X0
X0
Px
LS
D t ()
LS
X1
D ()
X1 X0
MCi
ACi ()
i
K0
A=C
ACi (x 1i )
P 0x
x 0i
P 1x
x 1c
B
i
X1 X0
Figure 4.36
167
Notes
168
Chapter 5: The market for factors

Learning outcomes
define the concepts of capital goods, market equilibrium, factors of
production marginal products of labour, marginal revenue product,
demand and supply of labour derived from behavioural models of
consumers and firms
explain why labour is not an economic good, why the scarcity of leisure
is fixed, the implications of the existence of more than one equilibrium
in the market
use diagrams to analyse problems involving factors affecting labour
market equilibrium.
Reading
LC Chapters 1011.
Capital, labour and distribution

Up to this stage, we have investigated how individuals and firms make
their decisions about the demand and supply of goods. In the analysis
of those decisions, we took two elements as given: the income of the
individuals, and the factor costs to producers. This chapter provides an
explanation for these factors. We will see that an individual receives
income as a result of selling their labour and possibly capital in factor
markets. Firms buy these factors of production, and the equilibrium of
supply and demand determines the prices for the factors.
You may see there is no obvious reason why we should discuss these factor
markets in a separate chapter. The principles of scarcity and desirability,
and the resulting concept of opportunity cost, apply in exactly the same
way as they did in the markets we already considered. Our entire Chapter
4 was devoted to how economic goods are priced under different forms
of market structure. Why, then, must we discuss the market for means of
production separately? There are three main reasons:
a. The reversal in the position of agents: in the factor market, firms
demand factors, while individuals supply them.
b. There are different types of means of production: capital goods (those
goods which are used in the production process) and labour.
c. The effects of market equilibrium on the distribution of income, which
are much more evident than in other markets.
Point (a) is not a matter of substance in itself. In a sense, we devote a
special chapter to factor markets simply in order to consolidate your
command over market analysis. However, at the same time there are some
basic differences between the derivation of demand in the markets for
final goods and the derivation of demand in markets for intermediate
goods, such as capital and labour. While both consumption and
production can be characterised as processes where agents use economic
goods to produce other economic goods, in the case of consumption the
produced economic good is a non-tangible good (utility) for which
there is not a clear market. By fixing the prices of all other goods, we
can derive the demand for a good for each individual such that their
169
consumption is optimal. A horizontal summation of these individual

demands will constitute the total market demand for that good.
In production, however, we use economic goods (factors) to produce
other economic goods which are clearly traded in the market. Hence,
when we derive the optimal behaviour of an agent, we have to maintain
optimality in both factor markets and the final goods market. We have
already encountered the tools we need to analyse this part of the course
in Chapters 2 and 4. Their combination, however, introduces some added
complexity, which will help us to better understand the mechanisms of the
market.
The different types of means of production (point (b)) and their
implications for our analysis are obviously a much more serious issue. We
typically distinguish between two types of means of production, or factors:
Capital goods and Labour. The concept of capital goods does not pose
any particular problem. They are simply goods which can be used either
for consumption or for production. Since we could have used them for
consumption, we can easily see that they are economic goods, and that the
concepts of scarcity and desirability apply. We would therefore expect
them to command a price in the market. Similarly, we can see such factors
of production as machine hours as economic goods as well, in the sense
that we could have used the machine for alternative desirable purposes,
potentially even for direct consumption.
Computers in the workplace can be used both for production and for consumption.
Can you see how?
Counting capital goods

The introduction of machine hours hints at a potential problem: machines
typically last for several periods of time, and are considered to be stock
for accounting purposes. This contrasts with the idea of a flow of goods,
which is used in demand and supply analysis. Put differently, at any point
of time there will be a certain number of machines, but the demand is not
really for machines but rather for machine hours.
Consider the following situation: You visit a foreign country, and need
a car as a means of transportation. Normally, you would rent a car (you
would rent the machine hours). However, there might be situations where
you might prefer to buy a car at the beginning of your visit, and sell it
at the end. Similarly, a firm might have the choice of either buying some
capital goods (such as their premises) or renting or leasing them.
Note that the durability of some goods (i.e. the fact that they have a life
span which covers more than one period) is not necessarily unique to
factor markets.
There are durable goods in the consumption market as well (it is easy to
find examples for this houses, cars, the so-called white goods (washing
machines, refrigerators, etc.), PCs and so on). Hence, while markets for
such goods do require special attention, they are not specific to factor
markets and are beyond the scope of this course. Here, when we talk
about capital goods, we will only consider the flow, or the use of these
means of production during a given period. Hence, the unit in which we
count capital goods will be a machine hour.
For labour as a good traded on factor markets, we have to consider two
issues: First, as with capital goods, we have to distinguish between stock
and flow. Secondly, we have to define what we mean by scarcity and
desirability of labour as a good.
170
Given the distinction between stock and flow for capital goods, it is easy to
see what these concepts mean for labour as a factor. Stock of labour would
correspond to an individual, and the flow of labour she could produce over
her lifetime, while the flow corresponds to the number of hours she has
worked. Since ownership of another human being is fortunately illegal,
we will define labour as a flow variable as well, namely as the number of
hours worked.
How do we determine the price of labour? Why should anybody want
to provide labour to a firm? Why dont we all just take it easy and do
nothing? The answer is simple: working provides us with an income,
which we can then use to purchase other consumption goods. However,
given that we want to consume as much as possible, and given that wages
increase the longer we work, why dont we all decide to work all the time?
Apart from issues of feasibility, we soon realise that time spent not working
has its own utility. Leisure, or the part of our day that we dont sell as
labour, is desirable (when else can we play with all the toys we were able
to afford from our wages?). Scarcity of labour follows immediately from
the fact that the number of hours in a day are exogenously given: there
are only so many hours available. Thus, we have all the ingredients for a
normal market, in which the good traded is working hours. We call the
price of working hours wages.
Income distribution and the reward for capital

Finally, we have to consider the issue of income distribution (point (c)).
All factors of production are ultimately owned by individuals. For labour,
this is obvious. Short reflection will convince us that the same is true for
capital. It is either owned directly by individuals (as for example with land
or buildings), or it is owned by a firm. However, the firm is itself owned
by individuals, through their shareholding equity. Hence, the return to
capital, or the price at which we sell machine hours, is ultimately paid out
to individuals.
Recall that when we wrote the cost function for a firm, we wrote w
(wages) as the return to labour and r (the interest rate) as the return to
capital. With zero profits above the normal in a competitive environment
this means that the national income is divided between a reward to work
and a reward to capital. This immediately creates an obvious tension
between labour and capital. There are basically two layers to this problem.
First, why should we reward capital at all? Secondly, with a single interest
rate in the economy, all capital is rewarded in exactly the same manner,
even if we allow for heterogeneous capital goods. Why should this be the
case?
Consider, for a moment, a plot of land on which stand two individuals.
Both of them have an initial stock of wheat seeds. One of them consumes
the whole lot, while the other chooses not to. To grow wheat, we need
both seeds and labour. The first person would not be able to grow wheat
of his own, since he does not have any seeds left. The second person, on
the other hand, has enough left for both planting new wheat, and for
feeding the two of them during the growing season. He could thus give the
first person some wheat, and the first person can then grow wheat using
his own labour.
Who, then, should get the yield of the field (note that the land does not
belong to anybody)? Should it be the worker who did all the work or
should it be the person who advanced the seeds (the capital)? The answer
is far from obvious and scholars (and politicians) have argued about this
endlessly.
171
Whatever one thinks it is important to bear in mind that even without

ownership of land there could be reasons to justify return to both worker
and capitalist. The return to work is obvious but the return on the capital
can be justified on the grounds of abstinence and also risk. For one, the
capitalist abstained from consuming that part of his stock which was used
for the production of the new crop. Secondly, while the worker entered
a contract whereby his return was agreed and guaranteed, the capitalist
could not have known for certain whether the field will yield any crops
at all. Hence, while the worker has a secured return, the return to capital
depends on nature.
If the return on capital is risky, and depends on nature, why should it be
that the rate of return on capital is just equal to the interest rate r? First,
note that the return on capital cannot be lower than the interest rate.
Why would an individual want to hold a capital good, and earn the return
associated with it, if he can get a higher return simply by putting his
money in the bank? He would simply try and sell the capital good. Hence,
any capital good yielding a rate of return lower than the interest rate will
not be held (or at least, not for long).
An analogous reasoning holds for rates of return higher than the interest
rate. If there are capital goods available which yield a higher return than
the interest rate, nobody would want to put their money in the bank, and
everybody would invest in the capital good with the higher return. Just
like in our discussion of supply and demand, this shifts the demand curve
for bank deposits, and the rate of interest paid on bank deposits would
increase. Hence, the interest rate r would increase.
What is the appropriate price for bank deposits?
The preceding paragraphs will give you an initial idea about factor pricing.
However, there are clearly more issues, which we cannot cover within the
scope of this course. For example, how do differing risks affect returns on
capital goods? Intuitively, we would expect riskier capital goods to pay
out a higher return, and indeed this is the case. For our present purposes,
however, we shall abstract from these issues, and simply see capital goods
as homogeneously paying a (risk-free) return of r.
The demand for factors

Reading
The demand for factors of production comes from the firm, the producing
agent. It can be derived as a result of the desire of the firm to maximise
profits.
Remember that the profit function is:
= R(X) C(X) = P1 (X)X wL rK
where L stands for labour and K for capital goods.
As we said in the previous section, the price of labour is wages (w) and the
price of capital is the interest rate (r). The aim of the firm is to maximise
profits. We must now inquire what that would mean for the choice of
inputs.
172
Consider a field of a given size where only wheat is grown. Suppose too
that only labour is required for the production of wheat. The table below
illustrates the technology of wheat production on this basis:
Units of labour
0
1
2
3
4
5
6
7
8
9
Wheat output (kg)

0
1100
2000
2750
3200
3600
3900
4100
4200
4200
How many workers will an owner of such a field wish to employ? He

would probably like to employ nine workers and pay none of them
anything. But people will only work for him if he agrees in advance to pay
them something, so the picture is slightly more complex.
We start by making some assumptions about the market for labour. The
assumption with which we will start is that it is a competitive market.
From what we have established earlier, this would mean that there is a
single price for labour in the market. In other words, all workers get the
same wage. Since we have diminishing returns to labour as a factor, you
should be able to see that we will again get a solution where the return of
the last factor employed is equal to its cost (the wage).
Diminishing marginal product means that the contribution of each worker
is different. As all of them get the same wages, some would contribute
more than they get, and some might contribute less than they get. Those
who contribute more will increase the landowners profit and those
who contribute less will reduce his profits. Let us therefore examine the
contribution made by the workers.

Figure 5.1: Returns to labour as a factor.
173
Figure 5.1 depicts the marginal product of workers (taken from the
table above) measured in wheat. As you should be aware by now, the area
underneath the marginal product curve denotes the total output. Hence, if
you look at four workers, the marginal product of the fourth worker is 450
kg of wheat (3200 2750). If we employed four workers the total product
will be the sum of all four workers contributions. The contribution of the
first worker (which is 1100 1 = 1100) is given by the first column in the
above diagram. The contribution of the second worker (900 1 = 900) is
the second column. Altogether total output will be the sum of these four
columns, which is nothing else but the sum of workers marginal product.
It is, therefore, 1100 + 900 + 750 + 450 = 3200, which is indeed the
output of four workers as given by the technology table above. Suppose
now that the wage level is 700 kg of wheat per worker. If we employed
one worker only, his contribution will be 1100 and what we must pay him
will be 700. This means that we shall have a profit of 1100 700 = 400.
Hence, it is worth our while to employ at least one worker. If we chose to
employ two workers we still have to pay them 700 kg each. We know that
the first worker will contribute (i.e. his marginal product will be) more
than he will be taking away (his wages). The second worker contributes
900 which is still more than he takes home. Hence, by employing two
workers we will have 400 kg profit on the first worker and 900 700
= 200 kg profit from the second worker (600 kg altogether). The third
worker contributes 750 kg so his contribution to profit is 750 700 = 50
kg. Figure 5.2, on the left-hand side, depicts the distribution of wages
and profits when wages are at 700 kg and we employ three workers.

Figure 5.2: Wage bills and profits.
The diagram on the right depicts the case of employing four workers.
As you can see, the contribution of the fourth worker is only 450 kg. As
we must pay him the going rate he will take away 700 kg in wages. Our
profits, which we have accumulated on the previous three workers will
now have to fall in order to pay the fourth worker the difference between
his contribution and his wages. As his contribution is only 450 and we
must pay him 700, our profits will have to fall by 250 kg.
Notice that the area between the marginal product line and the wage line
depicts our profit. It will therefore be maximised with three workers as the
difference between the fourth workers contribution and wages will have
to be deducted from the accumulated profit. In other words, employing
three workers will give us the profits of: (1100 700) + (900 700) +
(750 700) = 650 kg. The profit when employing four workers will be
(1100 700) + (900 700) + (750 700) + (450 700) = 650 250 =
400 kg.
174
Work out a table for all the different possibilities from 1 worker to 9 workers. What is the
total profit (or loss) if 9 workers are employed, all at 700 kg of wheat? What would the
wage rate have to be to make a profit with 9 workers? (Work this out by trial-and-error).
With a more general and smooth production function, the above situation
will look as follows:
L0
Figure 5.3: A generalised marginal product function.
If we employ L0 workers at wages of (which is wages in terms of the

good produced, like wheat in our story), total output will be the area
underneath the curve up to point A. Of this area, L0 is the total size of
the wage bill and the difference between this wage bill and total output is
profit. As is quite clear from the above, profits will be maximised whenever
we choose to employ workers up to the point where the marginal product
of the last worker is equal to their wages (point A). The reason for this is
the diminishing nature of return to factor. The unit labour before L0 has a
marginal product which is above the wage level, while the unit of labour
after L0 has a marginal product which is below the wage level. Up to that
point, profits are augmented if we employ more workers; after it, they
diminish.
What if there is more than one means of production? The answer remains
unchanged. Assuming interdependence in the production process (i.e.
that we cannot produce the good with only one means of production),
whether or not there is another factor of production does not alter the fact
that the area underneath the marginal product of any means of production
depicts total output. The difference in our analysis will be that the area
between the wage line and the marginal product will no longer depict
profits alone. Instead, it will be that part of our output which will be used
to pay the other means of production as well as profit. Hence, if in our
previous story employing three workers generates profit of 650 kg, but we
needed to hire tractor hours (capital) as well, then the profit will be 650
(the cost of capital). Nevertheless, the principle according to which labour
should be employed optimally remains unchanged.
175
We have already discussed the principles that will guide the firm in
choosing its optimal mix of means of production. These were that the
market rate of exchange between labour and capital would be the same as
their technological rate of exchange. Namely, w/r = MPL(K)/MPK(L) units
of capital per labour.
This is shown in Figure 5.4.
Figure 5.4: Optimal input mix.
But the demand for a factor is derived assuming the demand for all other
factors is fixed. In this case, the answer is very simple and straightforward.
If you only vary one means of production and the market for it is
competitive, you should employ as many units of that means of production
as you need to make its marginal product equal its per-unit cost.
If we produce good X with K and L, then this would mean that:
1. the wage (in terms of the good we produce) is = w/PX which is the
nominal wage (w) divided by the price of the good; and it must be the
same as the marginal product of labour for any given level of capital
(K):
We rearrange this as follows:

PXMPL(K) = w
which means that the money value of the marginal product (or the
marginal revenue product of labour) equals the nominal wages.
2. the return to capital (in terms of the good we produce) is = r/PX
which is the return to capital measured in terms of the specific good
produced; and it must be the same as the marginal product of capital
for any given level of labour (L):
Rearranging again:
PXMPK(L) = r
176
which means that the money value of the marginal product (or the
marginal revenue product of capital) equals the nominal return
to factors.
Notice that the two conditions which we have just set are perfectly
consistent with the profit maximising principle which guided our choice of
input mix:
which implies choosing a combination of labour and capital such that the
units of capital one would need to pay per unit of labour will be exactly
the same as the quantity of capital which is needed to substitute the
productivity of one unit of labour.
In the short run, the quantity of capital is fixed (see Figure 5.5). Hence,
every increase in labour input will cause a greater fall in productivity than
when an increase in labour is accompanied by an increase in capital.

)
Figure 5.5: When short-term capital is fixed.
The left-hand diagram depicts the firms profit maximisation

considerations in terms of both goods. The right-hand diagram depicts the
demand for labour in the short and in the long-run, assuming the price
of output is fixed (this allows us to look at the real wage and the physical
marginal product rather than the nominal wage and the marginal
revenue product).
We begin at A. When the quantity of capital is fixed, increase in labour will
produce a fall in productivity (as more people are using a fixed number of
machines), as depicted by the MPL(K0) curve in the right-hand diagram.
When there is a fall in the nominal wage w, real wages ( = w/PX) will
fall too, for a given output price. In the left-hand diagram, this means that
we should now follow a new expansion path. Since we cannot change
capital in the short run, we will now move production to point B, where
the short-run marginal cost equals the price. At that point, we use more
labour with the same initial level of capital. Hence, we move along the
marginal product curve, which corresponds to the initial level of capital,
from A to B.
177
If we are able to change the quantity of capital, then for the same price of
output we will move to point C, which is the new long-run optimal mix along
the new expansion path. However, at C we use more capital. This means
that the productivity of any labour input would now be different, as they
have more capital at their disposal. This means that the marginal product
curve will shift upwards. This means that the movement in the right-hand
diagram is from points B to C, on different marginal product curves, which
are also the short-run demand curves. The long-run demand for labour by
an individual firm will thus be crossing through different short-run demands,
representing different levels of fixed capital. Obviously, the long-run demand
for labour will be more elastic than the short-run demand for it.
Industry demand
Some of the textbooks point out that in factor markets, unlike the normal
goods markets we have described earlier, market demand cannot be
reached by the mere summation of the individual demand schedules.
The reason for this is that when, say, the nominal wage falls, the cost of
production of any unit of output will fall. Subsequently, both marginal
and average cost will fall and there will be a change in the market price. A
change in the market price will change the marginal revenue product
of labour, or, in the alternative approach, will raise the real wages.
Figure 5.6 captures this feature.

$

Figure 5.6: A change in nominal wages and the marginal product.
In the left-hand diagram, we conduct the analysis in terms of real wages.

In the right-hand diagram the analysis follows the more traditional
marginal revenue product approach. Both diagrams depict the
optimal conditions given by: the real wage approach:
and the marginal revenue product approach:

PXMPL(K) = w
This means that the left-hand diagram is measured in terms of the
produced good (i.e. in real terms) while the right-hand diagram is
measured nominally (in money terms). The benefit of the marginal
revenue product approach is that it allows the demand for factors
to come from agents in different industries, since the marginal revenue
product can be compared across industries. The real wage approach is
easier to explain, but if there is more than one industry demanding the
factor, we may run into serious problems defining the price index.
178
We begin at an initial equilibrium at point A and examine how the

comparative statics of a change in the wage level affect the individual demand
for factors differently than the industrys overall demand. When the nominal
wage (w) falls we will, for a given price of X, move to B in the short run. This
means that every firm will want to produce more X (as we have more labour
at B than we have at A but we have the same amount of capital).
We can also look at what the marginal cost of producing X will be when
labour is the only variable factor:
As nominal wage (w) falls, the marginal costs of X will fall as well. This
means that at any given price, each firm will want to produce more X so as
to satisfy the profit maximisation principle of marginal cost equalling the
price. Figure 5.7 depicts this situation:

!
Figure 5.7: A change in the wage rate and optimal production.
As each firm produces more, there is now excess supply in the market and
the price of X will fall in the short run. As the price of X falls, we know
from the analysis of the industry that each firm will produce less than it
did at B but more than it had done in A. Looking at the left-hand diagram
we can see that this would mean a rise in the real wage such that the
firm will move in the short run to point C instead of B. In the right-hand
diagram, the same story will be captured through the effect of the fall in
the price of X on the marginal revenue product. As the price of X falls, the
money value of the marginal product falls with it. The marginal revenue
product will move to the left and the short-run choice of the firm will be at
point C.
Both diagrams yield the same conclusion. When we take the short-run
considerations of the industry into account, the demand for a factor will
move from A to C as wages change, rather than from A to B. The reason for
this is the change in the market price. But in the case of the MRP approach,
this is not simply a move along a MRP curve: the curve itself shifts. This
means that we cannot simply summarise the MRP over all firms to get
industry demand for a factor. This stands in contrast to the real wage
approach, where the move from A to C is simply a move along the curve.
When we derived the demand for a good by an individual, we kept the
prices of all other goods fixed. If the price of a good falls, individuals will
demand more of the good. But this price change will affect the demand
for all other goods as well. For the market equilibrium, this means that
the price of all other goods will change, and this in turn will affect the
179
demand schedule for the good whose price had changed in the first
place. This means that we encounter the same issue of shifting demand
curves in individual demand analysis as we do here when we consider the
MRP approach. These issues are best dealt with in a general-equilibrium
framework, and we shall conduct our analysis of factor markets under the
assumption that the price of output stays fixed.
Supply of labour
Reading
The supply of produced goods like capital or raw material is basically

subject to the same principles of supply which we described in Chapters
34. There are, of course, the additional alterations needed to deal with
durable as well as exhaustible resources, but the fundamental principles
will not be any different. We shall therefore skip the discussion of the
supply of produced goods and concentrate on the most specific and
difficult means of production, labour.
Preferences
For labour to be an economic good it must be both desirable and scarce.
While this is very much the case from the point of view of producers, as
far as the labouring individuals are concerned its scarcity is evident but its
desirability is slightly more questionable. Do we like to work? Would we
prefer to work more and obtain more economic goods, or to keep the same
level of economic goods and do less work?
Alternatively, if we do like to work and labour facilitates greater
consumption opportunities, why do we not all exhaust ourselves? To
address those issues, economists chose to look at labour as a residual of
the decision-making process rather than the actual subject of it. To by-pass
the problem whereby labour may not be a desirable good for individuals,
we ask ourselves why people work, why they differ in the amount of work
they do and, sometimes, why they differ in their response to changes in
their wage. The answer we provide is that we work to earn and be able
to buy economic goods, but this does not make work itself an
economic good. Work, for us, is nothing more than the bundle of goods
which we can purchase with its returns. In addition, work comes at the
expense of our leisure which, in the eyes of many, is an obvious economic
good. We desire leisure and it is scarce. So leisure is an economic good,
while work is not.
Labour, then, becomes not a good in itself but a transformation
mechanism. That is, when we choose to have an extra hour in bed, we
forgo an hour of work, with the return of which we could have purchased
other economic goods. This implies that work in itself is meaningless to
us. We only consider it as a means of getting other economic goods and as
such, it constitutes the opportunity cost of the only activity which can be
construed as economic good: leisure.
In some ways, this is unsatisfactory. We have debased the notion of work
to something that is only done in order to achieve another goal, that of
consuming goods. This ignores many aspects of work, and may raise
serious problems in explaining our behaviour as that of rational agents.
Still, at this stage we are merely setting the framework and in future
studies you will be able to see that some attempts have been made to
address these shortcomings and problems.
180
Accepting a framework where labour is a residual, and the subject of

preferences is leisure, we must now examine how this affects our analysis.
When we described preferences and their representation by a utility
function we said that in order for preferences to be representable they
have to be complete. That is to say, at any point in time we can rank all
possible bundles (consumption combinations) of all economic goods. We
have now added an extra economic good called leisure which we will
denote by Le. Assuming that all other economic goods can be represented
by an aggregate good called X, we can now write the utility function
that will represent the preferences individuals have over the entire set of
economic goods as follows:
u(X, Le)
This function will have exactly the same properties as the utility function
defined in Chapter 2. There, preferences were defined over the world of
economic goods comprising two types of clearly tangible goods (X and Y).
We have not really changed anything concerning that function. In a sense,
what we have now is simply a function with one additional economic good
(i.e. u(X, Y, Le)), but as we wish to stick to two dimensions in our diagrams
we have substituted X and Y by one composite good representing all such
goods called X. Figure 5.8 shows those preferences in the new plane of
leisure and consumption.
MULe
MUx
Uo
Le
Figure 5.8: Preferences in consumption-leisure space.
Hence, utility is increasing when we have more of both goods

(consumption (X) and leisure) and there is a marginal utility of leisure,
which we assume to be diminishing. As in Chapter 2 there are indifference
points where we are equally satisfied with less consumption and more
leisure or more consumption and less leisure. Indifference curves are
convex and their slope is denoted by the subjective rate of substitution
MULe /MUX units of X per hour of leisure.
3.2 Scarcity (budget constraint)

What makes leisure different from produced goods is that its scarcity is
fixed. It is, so to speak, restricted by nature. As we measure leisure by the
hour, there are only 24 hours of fun to be had in every 24-hour day. If we
allow for the necessary six hours beauty sleep, we are left with a maximum
181
of 18 hours of leisure. This, as can easily be understood, has nothing to do

with the price of leisure. From what we said earlier, the opportunity cost
(and hence the price) of leisure is the consumption of other goods which
have been forgone by not using the same time to work and earn hourly
wages. If w is the money wage per hour then it follows quite simply that
the budget constraint which an individual confronts is the following:
PX x = w(L Le )
This means that the amount of money we spend on consumption cannot
exceed the amount of income we earn. The income we earn (in this world
where there are no assets apart from our natural gifts) is simply the product
of the hourly wage rate and the number of hours worked. The latter is the
difference between the natural length of the day and that part of it which
we wish to use for leisure. Consequently, labour gets into the picture as
being the residual of the decision to have leisure: L Le = L (labour). This
means that individuals supply of labour depends on their choice of leisure.
Rewriting our budget constraint will yield the following:
PX X + wLe = wL
which suggests clearly that just as PX is the price of X, so w (wages) is the
price of leisure.
Figure 5.9: The budget constraint in consumption-leisure space.
Notice that the intercept of the budget line with the leisure axis is fixed
by L and, unlike the case in Chapter 2, nothing can move it. In Chapter 2
the intercept was given by I/Pi (i = X, Y) which meant that a change in
the price of one of the goods would affect the quantity of that good which
an individual could purchase if they had chosen to use their entire income
to buy that good. In the above diagram, you can see that the amount of
leisure to be had cannot exceed L regardless of either the price of the other
good or the price of leisure itself. The slope of the budget line can be easily
understood if we start at L. If we choose to stay in bed all day, we will
be able to earn nothing and subsequently, we will not be able to buy any
quantity of the other good (X). Leaving home for one hour (moving to the
left on the leisure axis) will produce a wage of an hour (w) with which
we will be able to buy w/PX units of X. Hence, the slope of the budget
line, which represents the quantity of the other good which an hour of
labour can command, is what we call the real wage; it is the hourly wages
measured in terms of consumption.
182
Note, however, that while we mentioned real wage when talking about
the demand for labour, this is not the same concept as the real wage in the
supply of labour. In the case of demand, the producer wants to equate the
marginal product of whatever it is that he is producing with the wage he
pays workers in terms of the same product. If the producer is in the business
of nuclear waste management, the real wage which he is looking at is the
quantity of nuclear waste shifted by the last worker; surely the real wage
for the worker cannot be the same thing. For the worker, his real wage is the
amount of consumption goods which they can purchase. It is highly unlikely
that he will consider nuclear waste as part of his consumption bundle.
Nevertheless, for the sake of simplicity we shall assume that X is a
composite consumption good and PX is the consumption goods price index.
In the final chapter (in the macro section) we shall spend more time
discussing the possible implications of the difference between real wages
as cost (for the producers) and real wages as income (for the workers)
but we shall not discuss these issues any further here. To circumvent the
problem we shall assume that all prices, except wages, are fixed.
Behaviour
Apart from the difference in the nature of the budget constraint, there
is no difference between the way we analyse individual behaviour
in the context of tangible goods and in the context of leisure. Hence,
our individual will want to choose the most preferred combination of
consumption and leisure. Given the shape of indifference curves and
the fact that utility is increasing with an increase in both leisure and
consumption, such an optimal point is captured in Figure 5.10:

"
&

Figure 5.10: Optimality in consumption-leisure space.
The highest indifference curve (that is, utility) that is feasible within
the budget set is the one that is tangent to the budget constraint. At this
point (A), the slope of the indifference curve will be the same as the slope
of the budget line. This means that the subjective rate of substitution
between leisure and consumption will be the same as the market rate of
substitution. In other words, at A, we are willing to pay MULe /MUX units of
consumption good X per hour of leisure. This, at A, is the same as the slope
of the budget line which is the quantity of X we will pay per hour of leisure
we take. If we forgo one hour of work we will lose w/PX units of X.
183
Imagine you are playing golf and all of a sudden your mobile phone rings
and someone tells you that if you came to work for him for one hour
he will pay you 2,000. If the price of a holiday is 1,000, not going to
work for that hour and carrying on playing golf would have cost you two
holidays. If you already take four holidays, you may feel that you are
willing to pay two holidays for the pleasure of one extra hour on the golf
course. If you had had no holiday by the time the phone rings, you may
feel that paying two holidays for one hour of golf is a price which you are
not willing to pay. This would mean that the slope of your indifference
curve is less than the market price.
Formally, this problem takes the shape of:
and its solution is exactly point A in the Figure 5.10.
Deriving the supply of labour

Having established how rational agents choose their allocation of time, we
must examine now how the time devoted to work varies when the cost of
leisure (wages) change.

Figure 5.11: Deriving the supply of labour.
On the left of Figure 5.11 we have the choices individuals make in the
space of consumption and leisure. On the right we have the subsequent
supply of labour.
We begin at point A. When the real wage is 0 (which means that the
nominal wage is w0) the choice of leisure is L 0e and subsequently, the
choice of labour is L0 = L L 0e .
When the wage level falls to 1, the nature of the indifference curves and
the budget constraints suggests that we will choose a point like B where
we have more leisure (L 1e) and less work (L1). This makes sense: when the
opportunity cost of leisure is falling, we would like to have more leisure
and work less.
We now go back to A. When the wage level increases to 2, we can see
again that due to the specific nature of the budget constraint (regardless of
prices. We cannot have more than L hours of fun per day), we are likely to
choose a point like C. Here, again, we have more leisure than at A and we
work less. If we now vary wage levels continuously we will get a set of all
the optimal choices along the heavy curve in the left-hand diagram. The
mirror of this curve in the labour-wage plane depicts exactly how much
184
work the individual will want to supply at any level of wages.

How is it, you may wonder, that both a fall and an increase in wage levels
produced the same response in relation to the initial point A, namely that
we increase the amount of leisure we consume?
Unlike previous cases, where the price of a good represented only its
opportunity costs (in terms of other goods), the wage we earn is both the
price of leisure and a source of income. Hence, whenever the wage level
rises, leisure becomes more expensive but at the same time we earn more
money.
As a price, an increase in the wage level should make us reduce our
leisure as it is more expensive. As an income, an increase in the wage
level should make us want more leisure (if it is a normal good). So we
have conflicting forces at work and it is therefore not at all surprising that
the supply of labour is backward bending. At the lower end of wage levels,
income is very low, so the effect of the wage as a price of leisure will be
greater. When you have little to eat and someone offers you a raise, you
are unlikely to drop it all and run to the golf course. You are more likely to
see the opportunity of using work to alleviate your poverty and respond to
the increase in the wage level by working more.
At the other end, when your hourly wage is enormous, you are unlikely to
be impressed by a proposed increase in your hourly wage. You are more
likely to think to yourself, If I am paid more, Id better spend more time at
the golf course so that other people can see that I am a high flyer.
Market equilibrium
Given the shape of the supply of labour which we have derived in the
previous section, there is a potential problem in the analysis of competitive
outcomes. Consider the aggregate demand for labour based on the
marginal product of labour and the supply of labour which is based on the
simple horizontal summation of individuals supply curves:

Figure 5.12: Equilibrium in the labour market with a backward-bending supply

curve.
185
Figure 5.12 depicts a situation where the demand for labour intersects
the backward bending supply of labour twice. On the face of it, this may
cause a problem. As we explained earlier, it is important not to have too
many equilibria, or we may risk being able to explain everything while
actually explaining nothing. If we have a few equilibria, the first question
is whether they are equally meaningful.
As we explained at some length in Chapter 4, it is important not only to
identify the existence of equilibrium, but also to establish an idea of
its stability. Namely, as the real world is not really in any equilibrium
situation, we need the equilibrium point to tell us something about
the direction which the developments in the market will take. These
directions, it is assumed, are dominated by the position of the equilibrium
point. For such a point to be a meaningful reference point, we need to be
able to point at forces that will drive the market towards the equilibrium
point.
At this stage we have only recognised one such force: excess demand.
When quantity demanded exceeds quantity supplied, we assume that
prices will tend to rise. When quantity supplied exceeds the quantity
demanded, we expect prices to fall. If you examine both our equilibrium
candidates you will find that around point B, excess demand will drive
us away from that point. This means that if we were at B, this will be an
equilibrium provided that nothing rocks the boat. A small shock that
pushes wages down will create a situation of excess supply which will
push prices further down towards A. Any wage level above B and we are
in an excess demand regime that will push prices up. Put differently, there
are no market forces that can lead us back to an equilibrium at B, and it
does not constitute a stable equilibrium. Around A, the story is different.
If we are at any wage level away from A, market forces, through excess
demand, will move us back towards point A. This point, therefore, will be
the equilibrium point, even if it so happens that the demand cuts twice
through the supply.
But even when we have only one equilibrium there are two possibilities to
be considered.

Figure 5.13: Equilibrium considerations in the labour market.
On the left-hand side of Figure 5.13, the unique equilibrium lies on the
upward sloping part of the labour supply. In the right-hand diagram it lies
at the backward bending part of the labour supply. Consider the effect
of a wage tax on the competitive equilibrium in the labour market. From
what we said about the labour supply, we know that it mirrors all possible
choices of leisure and consumption. This means that, for example, the
186
introduction of a tax will have no direct impact on this curve. However,

the introduction of a wage tax creates a difference between gross and
net wages. The individual makes their choices on the base of net income.
However, to get, say n0 the gross wage must be higher. Namely, if our
individual received 0g then n0 = 0g (1 t), where t is the tax rate. This
means that for the individual to take home 0 and to choose to work L0 he
will have to get 0g as wages. When we apply this rule for every level of
leisure, we see that the effect of a tax on wages will be to shift the supply
schedule upward. The results of such an event on the equilibrium level of
labour supplied will depend on whether the equilibrium is on the upward
or backward sloping part of the labour supply.
As you can see, if the equilibrium is on the upward sloping part of the
labour supply, the equilibrium level of labour will fall. However, if the
equilibrium is on the backward bending part of the labour supply, the
effect of the tax will be to increase labour supply.
We usually make the assumption that labour supply is more likely to
be rising with wages at the point of equilibrium. Consequently, we can
see that a wage tax can create productive inefficiency in addition to the
allocative inefficiencies which we have already discussed in Chapter 4.
However, you can also see from the above analysis the delicacy of this
framework. It means that any analysis of the labour market requires
careful attention, and also explains why there are so many different
opinions regarding the effectiveness of various tax policies.
Self-assessment
Define the concepts of capital goods, market equilibrium, factors of
production marginal products of labour, marginal revenue product,
demand and supply of labour derived from behavioural models of
consumers and firms.
Explain why labour is not an economic good, why the scarcity of leisure
is fixed, the implications of the existence of more than one equilibrium
in the market.
Use diagrams to analyse problems involving factors affecting labour
market equilibrium.

Question 1
The fact that the supply of labour increases with wages (income) suggests
that labour is a normal good while leisure is an inferior good. Whenever
labour supply falls with increase in wages, the reverse is true. Comment
on this statement.
Question 2
Will the fact that workers are unionised have an implication for the
structure of the labour market?
187
Question 3
a. An individual has to use public transport to get to his workplace.
Employers do not pay for either the time or the money which the
individual spends on his way to work. Suppose that initially a workers
spends T0 hours a day commuting at a cost of C0. Show the initial
choice of labour in the plane of leisure and other goods.
b. What will happen to labour supply as the government allows public
transport to deteriorate (i.e., longer travel times at higher cost)?
Answers
Question 1
This question requires a detailed analysis of the supply of labour.
Let us first examine the case when we are on the upward sloping part of
the labour supply:
Le normal
AI
Cannot be to the left of B
AI
AN
A= A
LE
L2
SE
1
LE
LE
0
L
LE
Figure 5.14
As we move from B to A, the wage level rises. The substitution effect is

the move from B to C. It suggests that as leisure becomes more expensive,
we will want to have less of it. From C to A we have a pure income effect
(emphasised by the parallel shift of the budget line from C to A). As real
income increases, having more leisure than what we have at C will imply
that leisure is a normal good. A choice of less leisure as a response to an
increase in real income implies that leisure is an inferior good. In the end,
point A suggests that we will have less leisure than we had at B. This will
be consistent with leisure being either a normal (point AN ) or an inferior
good (point AI ).
Let us examine now the backward bending part of the labour supply.
We now describe the move from A to D. The substitution effect is the move
from A to C and it suggests that as leisure becomes more expensive, we
will want to have less of it. From C to D we have a pure income effect
(again, emphasised by the parallel shift of the budget line from C to D).
As real income increases, having more leisure than what we have at C will
imply that leisure is a normal good. A choice of less leisure as a response
to an increase in real income implies that leisure is an inferior good. In
the end, point D suggests that we will have more leisure than we had at A.
This can only be consistent with leisure being a normal good.
188
Figure 5.15
Question 2
Workers trade unions are a complex case for analysis. We do not yet
possess all the necessary tools of analysis through which the behaviour
of unions and their impact on the market can be properly analysed. The
intention of this question, therefore, is to test some basic analytical skills.
For instance, from what we have studied so far, it is clear that if workers
form a union they turn the labour market structure into a monopoly.
Assuming that the union has enough power to ensure that all its members
obey the rules, what might the union try and achieve?
So far we have analysed a monopolist in the context of profit
maximisation. However, this will not be applicable to the labour market.
A union is an organisation which seeks to maximise the benefits of its
members (excluding all discussions regarding power structures, control
and the like). A possible aim of a union could be to maximise the overall
wage bills (revenues), which are then distributed to members of the union.
In such a case, the following picture will emerge (Figure 5.16).
Figure 5.16
189
As long as there is a positive marginal revenue, sending an extra worker

into the market will cause excess supply and reduce the level of wages.
However, the loss of earnings by those who are already in the market will
be smaller than the gain in earnings by the new people at work. At the
point where marginal revenue is zero, an increase in the supply of labour
will bring down the wage level and increase total earnings such that the
level of total wages remains unchanged. Hence, the wage bill will be
maximised at the point where the marginal revenue equals zero.
The outcome of such behaviour will be to raise the level of wages (relative
to the competitive outcome) and reduce the amount of employment.
Whether this will be a successful policy depends on whether everyone is
a member of the union and whether the union can prevent agents from
trying to make gains for themselves at the expense of the group.
Question 3
This is a question about the position of the budget line, as shown in
Figure 5.17.

Figure 5.17
When the time it takes to go to work is unpaid and the cost of transport
are not covered by the employer, the budget line begins at a deficit if we
assume that transport to work is not part of the individuals consumption.
That is, before someone can use their earnings to purchase goods, they
have to use part of it to cover the cost of getting to work.
Clearly, the time it takes to get to work will reduce the availability of paid
hours (shift leftwards). The cost of commuting will put the individual in
the red if they do not earn enough (the shift downwards).
Longer travel time and higher cost of commuting will shift the budget line
further to the left and down. While at each level of wages individuals will
choose to have less leisure, this will not necessarily translate into more
work as the extra time is used for commuting.
190
Chapter 6: General equilibrium and welfare economics
Chapter 6: General equilibrium and

welfare economics
Learning outcomes
define the concepts of general equilibrium, horizontal and vertical
dimension, markets interdependence, the excess demand function,
equilibrium across final goods markets, Pareto efficiency, the offer
curve, the contact curve, and the Edgeworth box
use diagrams to analyse problems involving short- and longrun equilibria for an economy with two goods and one means of
production.
Read this chapter before starting the Readings listed below.
Reading
BFD Chapter 13.
General equilibrium is one of the most important aspects of neoclassical
microeconomic analysis. It serves as the ultimate test of the principles that
guide economic analysis. Microeconomic analysis has been based on the
principle of rational behaviour, but the most important aspect of it is the
concept of equilibrium. Rational plans of individuals can coincide in such
a way that no rational being will have the incentive to act so as to change
the outcome.
However, while the considerations (i.e. choices) of the rational individual
are made with reference to all economic goods (see the conditions
for utility representation of preferences in Chapter 2) the concept of
equilibrium which we have encountered so far had been constructed
with reference to a single good. It reflected the coincidence of rational
plans made by consumers and producers regarding a single good
while assuming that all other prices are fixed. Yet, as we have seen, the
demand for each good by each individual is dependent on the prices of
all other goods. Similarly, the quantity of labour supplied (which affects
the equilibrium level of wages and subsequently, income and the supply
schedule of all goods) is dependent on the prices of other goods. The test,
therefore, of the idea of harmonious rational interaction lies in showing
that even when we allow all prices to change, there will exist a set of
prices for which all rational plans across all goods and factors will
coincide. Showing this is the task of general equilibrium theory.
The existence of such an equilibrium is the prime driving force behind the
advocacy of a free market system. General equilibrium, if it exists, suggests
that a decentralised system with rational agents can work. However,
this is not entirely satisfactory, and there are various questions that can be
asked:
Is the rationality assumption descriptive (i.e. describing how people
behave) or functional (a means of getting testable propositions)?
Even if equilibrium exists, are there any processes of exchange which
lead us to this point?
191
What are the social implications of being at a point of general

equilibrium?
We shall entirely ignore the first and second questions because they are
outside the scope of the subject, but we will say something about the
third. Before that, however, we shall elaborate on the meaning of general
equilibrium.
Vertical and horizontal dimensions of general

equilibrium
The distinction between what I call vertical and horizontal dimensions
is not a distinction of substance. The horizontal dimension refers to the
relationship between equilibria across final goods markets, which are
connected directly through demand (and which one may call intermarkets equilibrium). By vertical I refer to the relationship between
markets which are connected through production (and which one may call
intra-market equilibrium). The reason I draw this distinction is to allow a
simpler analysis of the circumstances and meaning of general equilibrium.
Horizontal, or inter-markets equilibrium
We begin the analysis by examining how markets become connected
through consumer behaviour. To do so, we shall start with something
familiar: the partial equilibrium analysis as described in Chapter 4. We
shall assume that there are only two goods in the economy (X and Y).
Figure 6.1: Equilibria in two-goods markets.

In the left-hand diagram in Figure 6.1 we describe the equilibrium
conditions in the market for X while in the right-hand diagram we have
the equilibrium condition in the market for Y. At the price P 0X , the quantity
demanded of X (which is X0 units of X) is the same as the quantity of X
which producers will want to supply (because the marginal cost of X0
equals to the price of P 0X , assuming this price to be above the average
cost). Similarly, in the market for Y it is at the price of P 0Y that the quantity
demand (Y0) is exactly the same as the quantity supplied. The question
which will concern us here is whether the two equilibria are dependent on
each other and if so, how.
To make our life easy, we shall concentrate on the most obvious and direct
relationship between the two markets. In this case, as the two goods
are final goods, in the sense that none of them is used in the production
of the other, any direct relationship between them can only come from
consumption. To understand why the two goods are related, we need to
remind ourselves of how the demand for each good was derived. Recall
192
from Chapter 2 that the choice regarding how much X or Y the individual
will want to consume is determined simultaneously by the process of
utility maximisation (the choice of the most preferred bundle). This is
shown in Figure 6.2.

Figure 6.2: Utility maximisation and demand for two goods.
This means that the quantity of X (X0) which the individual wants to
consume at the price of P 0X is chosen together with the quantity Y0 of Y at
the price P 0Y . In addition, the decision regarding both X and Y had been
made at a given level of income (I0 ). Hence, the demand schedule in
each market depends on the price of the good itself, the price of the
other good, and income. In Chapter 2, when we derived demand for
good X, we changed only the price of good X, assuming that the price of Y
remained unchanged. But the actual price of each good is a result of the
equilibrium conditions in that goods market. This equilibrium, which we
call partial equilibrium, is only telling us how the price of one good is
being determined for any given price of the other good. It does not explain
how a change in the equilibrium condition in one market may influence
the equilibrium condition in the other market.
The fact that markets are related in such a close way may not be easy
to establish. One of the most obvious examples might be the market for
bonds and the market for shares. I am sure that you have heard people
argue many times that an increase in interest rates (which means a fall
in the price of bonds) will have a devastating effect on the price of
shares. Surely the reason one can make such statements is the belief in
the existence of a clear connection between the equilibrium condition
in one market and that in another. However, while in some cases these
connections may appear intuitively clear, in many cases they are not
obvious. Nevertheless, bearing in mind the nature of modern economics,
where individuals are sovereign, things have no intrinsic value. Whether
goods are related to one another in this world is a matter of consumer
choice.
193
To capture the idea of such interdependence, let us elaborate the

equilibrium conditions within each of the above markets, bearing in mind
that the demand for each good depends on the price of the other good. As
income remains unchanged throughout our analysis, we shall drop it from
our exposition.
We begin by examining the equilibrium in the market for X. The following
equation describes the demand for X which could be derived from a
consumers rational choices for any given price of Y:
X d = D X (PX , PY ) = a bPX + ePY
where the sign of e depends on whether the two goods are gross
substitutes or complements:
e>0
if X and Y are gross substitutes
e<0
if X and Y are complements
If the individual views the two goods as gross substitutes then an increase
in the price of the other good (Y) will produce an increase in the demand
for good X.
For ease of exposition, I shall conduct the discussion in general as well as
specific terms. Let us therefore suppose that a = 100, b = 3 and e = 1.
Hence:
X d = D X (PX , PY ) = a bPX + ePY = 100 3PX + 1PY
Try to draw this function on a separate sheet of paper assuming a certain price for Y, say
P Y0 = 5. To test your understanding, see what will happen to demand if the price of Y
increases to 6.
The supply of X, which is the inverse of the marginal cost of X, is given by
the following:
X s = SX(PX , w) = cPX dw = 2PX 4w
where c = 2 and d = 4. Note that an increase in the price of X will induce
producers to sell more, as the cost of the current last unit (the marginal
cost) will become smaller than the price. Given diminishing marginal
product (and rising marginal cost), profit maximising behaviour implies an
increase in output. As wages increase, the marginal cost of the current last
unit will be greater. This, in turn, will induce producers to sell less at any
given price.
Equilibrium in the market for X can now be easily calculated:
X d = DX(PX , PY) = a bPX + ePY = X s = SX(PX , w) = cPX dw
or:
100 3PX + 1PY = 2PX 4w
If PY = 5 and w = 5, we get:
100 + 5 + (4 5) = PX(2 + 3)
125 = 5PX
25 = P 0X
which is the equilibrium price in the market for X for a given price of Y (5)
and a given level of wage (5).
194

Figure 6.3: Partial equilibrium in a two-goods market.
The left-hand diagram depicts the equilibrium in the market for X which
we have calculated above. The right-hand diagram depicts the equilibrium
price of X had the price of Y been 10.
What would have been the equilibrium price of X had the price of Y been 15?
We can clearly see how the equilibrium price of X depends on the price
of Y. The market of Y is subject to similar influences by the price of X. We
must therefore develop a tool that will clearly relate the two prices. We
know that in equilibrium, quantity demanded equals quantity supplied.
Hence, there is no excess demand or excess supply in the market. In
Chapter 4 we showed that the notion of equilibrium was strongly related
to the notion of excess demand. When there is excess demand or excess
supply (which is just a negative excess demand) there will be someone
in the economy who is willing to pay more (or sell for less) than the
going price. In such a case, we do not have an equilibrium, as prices will
continue to change. Only when there is no excess demand (positive or
negative) will there be no incentive for anyone to alter the situation. All
rational plans will be fulfilled.
Let us examine the notion of excess demand more carefully. In the above
diagrams, we had well-defined demand and supply functions. In the lefthand diagram, quantity demanded is exactly the same as quantity supplied
when the price of X is equal to 25:
X d = D X(PX , PY )
X s = S X(PX , w)
= a bPX + ePY
= cPX dw
= 100 3PX + 1PY
= 2PX 4w
= 100 3 25 + 1 5
= 2 25 4 5
= 30 units of X
= 30 units of X
In the right-hand diagram, we can see that when the price of y increases to
10, excess demand will no longer be equal to zero for P 0X = 25:
X d = D X (PX , PY )
X s = SX(PX , w)
= a bPX + ePY
= cPX dw
= 100 3PX + 1PY
= 2PX 4w
= 100 3 25 + 1 10
= 2 25 4 5
= 35 units of X
= 30 units of X
195
As excess demand is the difference between the quantity demanded and

the quantity supplied we can write it as:
ED = X d X s = 35 30 = 5.
We can write the excess demand for X as a more general function. It will
have the following form:
ED X(PX , PY , I, w) = X d X s = D X (PX , PY , I) SX(PX , w)
In our case (ignoring income completely) this becomes:
ED X(PX , PY , w) = X d X s
= D X (PX , PY ) SX(PX , w)
= a bPX + ePY [cPX dw]
= a + ePY + dw PX (b + c)
= 100 + 1PY + 4w 5PX
This function is depicted in Figure 6.4.

Figure 6.4: Deriving the excess demand function.
The left-hand diagram depicts the equilibrium condition in the market

for X when the price of Y is 5 and w = 5. The right-hand diagram depicts
the excess demand for X at different prices of X for a given price of Y. On
the vertical axis, we have the price of X while the horizontal axis denotes
the level of excess demand. Therefore, when PX = 25, ED X = 0. When PX
= 30, the quantity demanded will be X d = 100 3 30 + 1 5 = 15,
the quantity supplied will be X s = 2 30 4 5 = 40 and thus, ED X =
15 40 = 25 (which means excess supply). When the price of X is 10,
however, X d = 100 3 10 + 1 5 = 75, X s = 2 10 4 5 = 0, and
ED X = 75 0 = 75.
As the focus of our interest is the relationship between the equilibrium
price of X and the price of Y, we now derive the effect of a change in the
price of Y on the excess demand function for X.
We start with the original situation where the price of Y is 5 and w = 5.
The equilibrium in the market for X will then be at the point where PX =
25, since excess demand for X will be equal to zero. We now increase the
price of Y to 10. The intuition is very clear. When the price of Y increases
and the two goods are gross substitutes, the demand for X will increase.
At the original price for X, there will now be excess demand, which will
lead to an increase in the equilibrium price for X. Graphically the excess
demand function for X will shift to the right, as shown by Figure 6.5.
196

Figure 6.5: The effect of a change in Py.
The excess demand at the new price PY = 10 will be 5 if the price of X

remains at 25, as we saw above. However, if the price of X now changes to
26, the new quantities demanded and supplied will be:
X d = D X (PX , PY )
X s = SX(PX , w)
= a bPX + ePY
= cPX dw
= 100 3PX + 1PY
= 2PX 4w
= 100 3 26 + 1 10
= 2 26 4 5
= 32 units of X
= 32 units of X
Hence:
ED X (PX , PY ) = ED X(26, 10) = 32 32 = 0
We thus find that the new equilibrium occurs at a higher price for X, and
that the excess demand schedule for X has shifted to the right as a result of
the increase in the price of Y. By inspecting the demand function for X, we
find that this is due to the positive coefficient e, indicating that X and Y are
gross substitutes. Had the goods been complements, e would have been
negative.
Repeat the analysis for e = 1. How will the excess demand function change as the price
of Y increases?
We can now show the relationship between the price of Y and the
equilibrium price of X, by finding the price of X which would result in the
excess demand for X being equal to zero, for every possible price of Y.
As we saw above, an increase in the price of Y will cause an increase in
the price of X for the case when X and Y are gross substitutes. Hence, a
relationship between PX and PY emerges (Figure 6.6).
We start with PY = 0. Given our specification of the demand functions,
the demand function for X would still be downward sloping for that price,
with a strictly positive demand for X. Using our previous calculations, we
can find the equilibrium price for X by setting excess demand equal to
zero:
197

Figure 6.6: The relationship between PY and the equilibrium PX.
X d = D X (PX , PY ) = a bPX + ePY = X s = SX (PX , w) = cPX dw

As PY = 0:
100 3PX = 2PX 4w
For w = 5, we find:
100 + (4 x 5) = PX (2+3)
120 = 5PX
24 = PX
In the general case, the equilibrium conditions mean that:
where P Xe is the equilibrium price in the market for X. It is easy to see that
even when PY = 0, P Xe will be positive. Hence, we start at point F in the
above diagram which depicts P Xe when PY = 0. We now want to see how
P Xe changes as PY increases. In other words, we are looking for the price of
X which will yield a zero excess demand for X for any given price of Y.
From our previous analysis we can see that when the price of Y was 5,
P Xe Was 25 (point G in the above diagram). For PY = 10, P Xe was 26
(point H in the above diagram). The slope of the ED X = 0 line is really
(dPY /dPX). From our numerical example, this slope is equal to 5: For a 5 point
increase in the price of Y, there is only a 1 point increase in the price of X.
In more general terms, from the equilibrium price equation for X (which
implies zero excess demand for X) we can see that an increase in the price
of Y will cause an increase in the price of X as long as e > 0. Hence, we
will have an upward sloping line to depict the combinations of PX and PY
for which there is zero excess demand in the market for X. An increase by
dPY units in the price of Y will increase the equilibrium price of X by (e/(b
+ c)). This can be arrived at by taking the derivative of P Xe with respect to
PY , where P Xe is given by
198
Hence:
In our example, this was equal to 1/5. As I pointed out above, the slope
of the ED X = 0 line is given by (dPY /dPX ). This is just the inverse of
(dPX /dPY ), which we just calculated as e/(c + b). Hence, the slope of the
ED X = 0 line is 1/(e/(b + c)) = (b + c)/e.
We can now repeat the same analysis for good Y. There will be similar
demand and supply functions, yielding a similar excess demand function
as for good X. We use a numerical example again to illustrate the concept.
Y d = D Y(PX , PY ) = f gPY + mPX
Y s = SY(PY , w) = hPY jw
= 90 2PY + 1PX
= 3PY 3w
where f = 90, g = 2, m = 1, h = 3 and j = 3. This yields an excess

demand function
ED Y(PX , PY , w) = Y d Y s
= D Y(PX , PY ) SY(PY , w)
= f gPY + mPX [hPY jw]
= f + mPX + jw PY (g + h)
= 90 + 1PX + 3w 5PY
The equilibrium price for Y can be derived from the zero excess demand
condition:
We again find that P Ye > 0 even if PX = 0. Diagrammatically, the

relationship between P Ye and PX is again an upwards-sloping line:

Figure 6.7: The EDy = 0 line.
Why is the intercept of the ED Y = 0 line on the PY axis?
199
As the price of X increases, demand for Y will increase, as the two goods
are substitutes. The price of Y will increase to maintain the zero excess
demand condition. Hence, the ED Y = 0 line is upwards sloping.
Does equilibrium exist?
We have markets for goods X and Y. For each of these markets, we
have established equilibrium conditions such that the excess demand is
equal to zero. The conditions were expressed in terms of the prices
of both goods. However, this only constitutes a partial equilibrium
analysis, since it only solves for equilibrium in one market at a time.
Since we are interested in the general equilibrium, we have to combine
both partial equilibrium conditions: We are trying to find a set of prices
(P X* , P Y*) such that both markets are simultaneously in equilibrium, which
will give us the horizontal dimension of general equilibrium. This means
that P X* = P Xe (P Y*), that is, that P X* is the price that sets the excess demand
for X equal to zero when the price of Y is P Y*. The same condition holds for
the price of Y.
To find this general equilibrium, we can combine the graphs for both
markets in one diagram. The intersection of the two lines, as shown in
Figure 6.8, will give us the general equilibrium.

Figure 6.8: General equilibrium in markets for X and Y.
The diagram indicates that a general equilibrium exists in both markets,

provided that the slopes of the two ED = 0 functions are such that the
functions intersect.
Finding the solution algebraically is also very straightforward, and will
give us the conditions for existence more explicitly. The two excess
demand functions have to be equal to zero at the same time. That is, we
are looking for prices of X and Y such that:
X d X s = a bPX + ePY [cPX dw] = 0
Y d Y s = f gPY + mPX [hPY jw] = 0
Rearranging this, we get:
(b + c)PX ePY = a + dw
200
(g + h)PY mPX = f + jw
This is a simple set of simultaneous equations: The two endogenous

variables PX and PY are functions of a set of exogenous coefficients (a, b,
c, d, e, f, g, h, j, w). Values of endogenous variables are determined within
the model, while exogenous variables are those components of the system
for which the values are already known.
Note the implications of this. It is not really the price of X which
determines the price of Y, or vice versa. Rather, both prices are determined
by the exogenous coefficients, which depend on tastes (variables a, e,
f, m), technology (c, d, h, j) and wages (if this had been a complete
model, wages, which are a price as well, would have been determined
endogenously as well).
Systems of simultaneous equations are easily solved using algebraic
techniques, for example the Cramer method. Solving the above equations,
we find that:
which means that the value of the endogenous variables is determined

only by the values of the exogenous variables. As long as the two
expressions on the right-hand side of the above equations are greater than
zero, there exists an equilibrium.
Use the different methods to calculate the equilibrium values of the prices of X and Y in
our numerical example.
Is the equilibrium stable?
In Chapter 4 we found that the existence of equilibrium is not sufficient
for our purposes. If there are no forces moving the system towards an
equilibrium, then the existence of an equilibrium is meaningless. Let us
briefly examine the stability of our system (Figure 6.9).

Figure 6.9: Stability of equilibrium.
201
Suppose that markets are not in equilibrium initially. We start at point A,

with prices P AX and P AY . For the market for X, P AY, implies an equilibrium
price for X, PXAE, which is higher than that currently prevailing in the
market: P AX < PXAE. This implies that there will be excess demand for X. This
excess demand will push the price for X up, and we move to the right of A.
Similarly, there is excess demand for Y as well. Hence, the price of Y will
be pushed to its equilibrium value (the upward arrow from A) while the
price of X will be pushed to the right towards its equilibrium value. As the
time path of these changes is not clear, let us assume that both prices will
change at a similar speed. This means that both prices will change in the
direction to which the third arrow is pointing. This direction is clearly the
one that will lead the markets to the general equilibrium solution.
Once you understand that the ED = 0 lines represent equilibrium values,
you can see that a similar principle will apply for any set of initial prices.
If we start at B, it is clear that for any given price of Y, the price of X will
be moving in the direction of its equilibrium value (i.e., to the left). The
price of Y will tend to its equilibrium value of any given price of X (which
is upwards). Again, the arrow in between represents that change in both
prices over time and it too, points towards the general equilibrium values
of both the price of X and the price of Y.
The vertical dimension of general equilibrium

We have looked at the interdependence between markets for final goods
up to now. The origin of this interdependence is the fact that consumer
preferences are defined over the whole set of economic goods. The price of
every good will influence the demand for all other goods. In the preceding
section, we have looked at the conditions under which an equilibrium
exists and is stable in such markets.
However, we have neglected the relationship between consumer income
and the supply of final goods. Consumer income derives from their supply
of factors to producers, in particular the supply of labour. This supply,
combined with the technology available, will ultimately determine the
equilibrium level of wages and return on capital. From this, we can find
the level of consumer income, as well as the marginal cost of production
and the supply of final goods. We have thus found another relationship
between markets, working through returns to factors of production. I refer
to this relationship as the vertical dimension of general equilibrium.
As I said earlier, there is no real substance to the distinction between the
vertical and horizontal dimensions. As individuals make simultaneous
decisions with regard to consumption and the supply of factors, the
equilibrium values of all prices (including prices for those goods which are
used in the production of others) are determined simultaneously. The aim
of distinguishing between the vertical and the horizontal dimension was
mainly to reduce the complexity of the analysis somewhat.
The vertical dimension of general equilibrium is the relationship between
the consumption decision and the supply of factor decision. This, in
turn, determines the availability of goods for consumption. This idea is
discussed in detail in Estrin and Laidlers Robinson Crusoe model. Here, I
will present a simple version of the same story.
Suppose that an individual lives on an island. In order to generate
consumption, he has to use his own labour. There is only one good which
can be produced on the island. The technology of its production is based
on labour alone and has the form of a normal production function,
202
X = f(L). There are, therefore, two economic goods on the island. One is
the good X and the other is leisure. The PPF and the indifference curves
for the individual producer/consumer are therefore as shown in Figure
6.10.

Figure 6.10: Robinson Crusoes PPF and indifference curves.
If the individual chooses to lie on the beach all day, he will have the
maximum level of leisure with zero consumption of the other good. If he
decided that lying on the beach is not what he wants and that he would
like to have some X, he will face the following situation. If he gives up 1
unit of leisure (dLe = 1 hour), he will be able to produce X according to the
productivity of his first hour of work (dX = MPL units of X). Hence, the slope
of the PPF, dLe /dx, equals 1/MPL units of leisure-hour per unit of X. As the
marginal product of labour is diminishing, the slope of the PPF becomes
steeper the more he works. In other words, his productivity is high when he
only works a few hours. An hour of leisure, therefore, forgoes a lot of X. The
opportunity cost for leisure is very high. Equivalently, the opportunity cost
of a unit of X is very low (as his productivity is high, he can produce a unit
of X in a fraction of an hour). On the other hand, if we have slaved in the
field the whole day, we will be tired and our productivity will be reduced.
Every extra unit of X will require an increasing fraction of our time which
could have otherwise been spent on the beach.
The other element of our story is the individuals utility function, which is
defined over X and leisure. Both of these are economic goods in the sense
that they are scarce and desirable. Hence, utility is increasing with more
of both goods and there are downward-sloping indifference curves, as we
discussed in Chapters 2 and 5.
The PPF constitutes a constraint on the individuals consumption. If he is
rational, he will choose the allocation of time between labour and leisure
in such a way as to maximise his utility from both X and leisure. This is
point A in the above diagram. At this point, the slope of the indifference
curve (which is his willingness to pay for X in terms of leisure, or,
equivalently, his marginal utility of X in terms of leisure) will be the same
as the slope of the PPF:
203
In Chapter 5, we established that a rational individuals choice with

regard to consumption and leisure will be such that the subjective rate of
substitution (his willingness to pay for the good in terms of leisure) will
be equal to the market rate of exchange between the two. Had there been
a market for labour and X, the price of leisure would have been the wage
level per unit of labour and there would have been a price for X. Hence,
optimal consumption would mean that:
This implies that:

w = PX MPL
This means that the nominal wage will be equal to the value of marginal
product. Again, recall from Chapter 5 that this is the equilibrium condition
in the labour market. We have thus established the general equilibrium
conditions for competitive markets along the process of production. The
consumer chooses his supply of labour and demand for consumption
according to the principle which equates the subjective rate of substitution
with the market rate of exchange. Producers will produce according to
the profit maximisation principle, equating marginal rate of technological
substitution with the market rate of exchange for factors.
Note that in our example, the individual was alone on his island. Hence,
there are no markets on which to trade X and labour. The wage level we
found above is an implicit one; it simply tells us the marginal utility of an
extra unit of X, and also the marginal product of the consumer-producer.
Combining the horizontal and vertical dimension:

the complete picture
Suppose that we have a two-goods economy (X and Y) which are
produced by a single means of production. What will be the conditions for
equilibrium across all markets and within the production relations of each
commodity?
We begin by summing up the conditions across goods. In each of the
markets for final goods, we have an excess demand function of the
following general character:
ED X = X d (PX , PY , I ) X s (PX , w, r) ED X(PX , PY , I, w, r)
ED Y = Y d (PY , PX , I ) Y s (PX , w, r) ED Y (PY , PX , I, w, r)
Clearly
= F(ED X)
P
X
= G(ED Y)
P
Y
The dynamics of these equations are assumed to be such that whenever

there is excess demand in a market, prices will rise, while whenever
there is excess supply (negative excess demand), prices will fall.
General equilibrium in both markets is then given by the following
diagram, as we saw before.
General equilibrium in the final goods market will then give us a set
of prices (P 0X , P 0Y ). Suppliers of the final good will use these prices to
determine the productive technology they use. Figure 6.12 gives the
picture that will emerge, economywide.
204

Figure 6.11: General equilibrium in the final goods market.

Figure 6.12: Equilibrium in production.
We have two goods, X and Y. Following our discussion earlier, the slope of
the PPF is given by MP YL /MP XL units of Y per X. This reflects the trade-off
between leisure and consumption consumers face, which will determine
the wage level and hence the marginal productivity of labour. This is
also part of the general equilibrium conditions, but drawing in only two
dimensions, X and Y, does not allow us to capture the equilibrium in the
third dimension, leisure.
There is, however, an alternative way of looking at general equilibrium
which will show us the relationship between all elements in the economy
simultaneously. We use the fact that in each separate market, both for
goods and for factors of production, supply and demand will be in
competitive equilibrium. This means that in each market,
205
1. prices are equal to marginal cost

2. the distribution of surpluses is efficient.
Property (a) implies that the competitive prices, i.e. the market rate
of exchange between X and Y, accurately reflect the true technological
circumstances of production. In geometrical terms, prices reflect the slope
of the PPF.
Let us show this relationship by looking more closely at the meaning
of the slope of the PPF. Suppose you take one labourer away from the
production of Y and reallocate him or her to produce X. The loss of Y (dY)
will be exactly the marginal product of that labourer in the production of
Y; the gains in X (dX) will be exactly the marginal product of that labourer
in X. Hence:
dY = dL MP YL
dX = dL MP XL
In our case, dL = 1. Since the slope of the PPF is dY/dX = MP YL /MP XL ,

marginal cost pricing implies that:
hence
The relationship with leisure is captured by the competitive nature of the

labour market. There is a single price for leisure, the going wage level w.
If the labour market is not competitive, different producers might have
faced different wage levels. In this case, the PPF would not reflect the true
marginal cost of production.
In our discussion of efficiency, we defined it as a general principle which
can be applied to any scarce good. We further distinguished between
productive and allocative efficiency. We produce efficiently when we
cannot increase the production of one good without producing less of
another. This means that we have to produce on the PPF.
Allocative efficiency was concerned with the distribution of surplus
between different groups in the economy. We established that the area
underneath the demand schedule represented consumer surplus, or
the welfare of consumers arising from the consumption of a particular
good. Similarly, we showed that the area above the MC represented
producer surplus. A competitive equilibrium represents an allocatively
efficient distribution of those surpluses, as we cannot increase the surplus
of one group without reducing that of another. When we apply this idea
of efficiency to utilities, we call the resulting solution under competitive
equilibrium Pareto efficient.
However, allocative efficiency measured by surpluses is a partial
equilibrium result. It is very difficult to move to a general equilibrium
insight from here, since we would have to balance consumer and producer
surpluses across many markets. If we want to look at allocative efficiency
in a general equilibrium setting with production, we will have to make
some simplifying assumptions. Namely, we have to define a social utility
function defined over X and Y. This social utility function will implicitly
rank all possible distributions of surpluses across the different groups in
the economy.
206
If such a social utility function exists, then we can show that competitive
prices reflect not only the social cost of production, derived from the PPF,
but the social subjective rate of substitution as well, which is derived from
the social utility function. The diagram below captures this idea.
MPL
MPL
PX
PY
RA
MUX
RA
MUY
Figure 6.13: General equilibrium with a social utility function.
Note that this is a generalisation of the idea of Robinson Crusoes island.

Instead of the utility of Robinson alone, we use the social utility function
of the whole economy to find the allocative and productive efficient point.
Note, however, that it is far from obvious that such a social utility function
actually exists. The discussion of possible utility functions is far beyond
the scope of this course, but you might want to think about some of the
possible forms it could take. For example, we might consider a social
utility function which is simply the sum of individual utilities (assuming
that these are comparable across individuals see Chapter 2. But if the
social utility function has such a form, then the social utility of having one
very satisfied person and many unsatisfied people might be the same as
giving the same to everybody. Shouldnt inequalities matter to society? But
if we introduce equality preferences into our social utility function, then
what should we do if one person suddenly becomes richer, or happier?
Should we take money away from him and redistribute to the others, so
equality is re-established?
As I said, discussions of such matters is far beyond the scope of this course.
However, the crude assumption of a social utility function enables us to
see the characteristics of a solution that is both productive and allocative
efficient. This would, for example, enable us to analyse the inefficiencies
arising from taxation.
Take the equilibrium in Figure 6.13, and introduce a per-unit consumption tax on good
X. The price of X would increase. What would happen to the equilibrium outcome? Would
society be better off?
207
Pareto efficiency in an exchange economy

In the previous section, we used an analytical construct, the social
utility function, to determine the allocative efficiency of a competitive
equilibrium. This construct is not necessarily intuitively obvious, and in
fact its existence has been questioned. In this section, we use a different
approach to allocative efficiency. We look at it at the disaggregated,
individual level by examining a simple exchange economy, where
individuals can trade their allocation of goods. This means that we abstract
from the productive side of the economy, and simply assume that there is a
stock of consumption goods already present in the economy.
Suppose that we have two individuals (1 and 2) and two commodities
(X and Y ). Suppose too, that each individual has his income in kind (i.e.
in goods). Thus, the bundles (X1 , Y1 ) and (X2 , Y2 ) represent the income
of individuals 1 and 2 respectively. Thus, individuals have a bundle
of consumption goods before they interact with other members of the
economy. They could always choose not to interact, or trade, with the
others, and simply consume their initial endowment of goods. The two
diagrams in Figure 6.14 depict the initial endowment (income) of each
individual at point A.
Figure 6.14: Indifference curves of two individuals in an exchange economy.
To make things easier, let us add numbers to our story. Let the initial
bundle for individual 1 be (X 1 , Y 1) = (10, 20) which means that he gets
his income as a bundle of 10 units of x and 20 units of y. Let (X 2 , Y 2) =
(40, 10). Altogether, there are X 1 + x 2 = 10 + 40 = 50 units of X in
the economy and y 1 + y 2 = 20 + 10 = 30 units of Y. Since the whole
economy consists of just the two individuals, it is clear that any final
consumption of either good cannot exceed this total initial endowment.
Suppose that both individuals have the same utility function
u(xi , yi ) = xi yI (which means that if i = 1 we are looking at individual 1
and if i = 2, this is the utility function of individual 2).
A general analysis of such a utility function will tell us whether individuals
would want to keep their initial endowment, or trade it for a more
preferred mix of the two. Recall that a choice of consumption is optimal
when the subjective rate of substitution equals to the market rate of
exchange:
208
What is the marginal utility of X in our case? Suppose that we have X0

units of X and Y0 units of Y. Our utility will be U(X0 , Y0 ) = X0 Y0 . The
marginal utility of X will be the increase in utility if we increase the
consumption of X by 1 unit. Let X1 = X0 + 1. Therefore: U(X1 , Y0 ) = X1 Y0
= (X0 + 1)Y0 . The marginal utility of the extra unit of X is the difference
between the utility after the change in consumption and the utility before
the change:
MUX = U(X1 , Y0 ) U(X0 , Y0 )
= X1 Y0 X0 Y0
= (X0 + 1)Y0 X0 Y0
= X0 Y0 + Y0 X0 Y0
= Y0
For this type of utility function, therefore, the marginal utility of X is our
consumption level of Y. By a similar type of argument, the marginal utility
of Y is X. Hence, the conditions for optimal consumption become:
At point A in the above diagrams, the utility from the initial bundle is as
follows: For individual 1 U(10, 20) = 200 and for individual 2, U(40, 10)
= 400.
Does this mean that individual 2 is better off than individual 1? If you are not sure about
your answer, please read Chapter 2 again.
Had the prices been PX = 4 and PY = 2, would individual 1 wish to trade?
The market rate of exchange between the two goods is PX /PY = 4/2 = 2
units of Y per X. At point A, individual 1 has 20 units of y and 10 units
of X. Y/X, which is the individuals rate of subjective substitution, equals
20/10 = 2 units of Y per X. Hence, as the marginal rate of subjective
substitution equals to the market rate of exchange, the individual will be
consuming at an optimal point and will not wish to trade.
Figure 6.15: Prices and marginal rate of substitution.
209
In the left diagram, the budget constraint at A is tangent to the slope of

the indifference curve. Hence, A would constitute a rational choice for
individual 1.
For individual 2, the story is slightly different. At A in the right-hand
diagram, Y/X = 10/40 = 1/4 units of Y per X. This is clearly less than the
market rate of exchange, which means that individual 2 is willing to pay
more for Y than it costs in the market place. For one unit of X, he is willing
to pay Y/X = units of Y. Hence, he is willing to pay 4 units of X per Y at
his initial endowment point. If the market rate of exchange is 2, individual
2 would like to trade, selling X and buying Y, moving to a point such as B.
As individual 2 is willing to pay so much more for Y than the current market
rate of exchange, it is unlikely that the market rate of exchange will remain
at 2. If the rate of exchange changes, however, individual 1 would like to
trade as well. How much would individual 1 want to sell or buy of X and
Y as the prices change? This will depend on his utility function. For the
present example, we know that the rule of optimal choice requires that:
Hence:
However, individual 1 has to be able to afford his consumption bundle,

too. For the purpose of exposition, imagine that trade happens in the
following way. If an individual decides he wants to trade, he sells his
complete initial endowment and then buys back the bundle he wants
to consume. This means that we can express the money income of this
individual as the proceeds from selling his initial endowment:
I0 = PX X 1 + PY Y 1
and his budget constraint when buying the bundle he wants to consume is
then given by:
I0 = PX X 1 + PY Y 1 = PX X1 + PY Y1
where X1 and Y1 on the right-hand side of the equation denote the
quantities he wishes to consume. Given that his income is in kind,
the equation shows that the individual can always afford his initial
endowment, by simply not trading. Thus, all budget lines will have to go
through point A.
From the budget constraint we can now extract y, given prices, initial
endowment, and consumption of X:
and add this to the optimality condition, where the marginal rate of
subjective substitution equals the market rate of exchange:
210
Hence, the optimal consumption level for x is a function of the individuals

income and relative prices. This is consistent with the parameters of
demand we discussed in Chapter 2.
Similarly we can get an equivalent equation for the optimal consumption
level for Y:
Because both individuals have the same utility function, everything we

said about individual 1 is also true for individual 2. Namely, we will have
the same corresponding equations to describe X2 and Y2.
We have now derived the optimal consumption level for both goods, which
depends on the individuals income, or endowment, and on relative prices.
(We have already encountered this in Chapter 2, where it was called the
individuals demand.)
Hence, we can now look at the optimal consumption levels for each
possible market exchange rate. In our example above, we saw that,
if the market exchange rate is PX /PY = 2, individual 1 does not want
to trade, while individual 2 wants to change his consumption bundle
from the original endowment. In fact, we can now calculate the optimal
consumption bundle for individual 2. Given the equations above, we find
that for PX /PY = 2, individual 2 will want to consume:
Think back to our discussion of excess demand earlier in this chapter.

We saw that a necessary requirement for equilibrium was that the total
quantity demanded was equal to the total quantity supplied for each good.
Equivalently, we require that excess demand for every good is zero. The
present exchange economy is a special case of this, since supply is fixed at
the initial endowment. Hence, excess demand is given by:
EDX = X1 + X2 (X 1 + X 2)
EDY = Y1 + Y2 (Y 1 + Y 2)
What will excess demand be for the case of PX /PY = 2? Adding up all the
numbers, we find that EDX = 17.5 < 0, while EDY = 35 > 0. Hence,
there will be positive excess demand for good Y, while there is negative
excess demand for good X. As we saw in our discussion of excess demand,
this will mean that the price of good Y will increase, while that of good
X will decrease. This, in turn, will decrease the market exchange rate for
good X in terms of good Y, PX /PY . This process will continue until the
excess demand in both markets will be equal to zero.
At what prices will the excess demand be equal to zero, leaving the whole
market in equilibrium? We could either solve the simultaneous equation
system given by the excess demand functions, or we can use an economic
argument, which is ultimately more instructive.
Since the price of X decreases, while that of Y increases, let us assume that
prices have changed to PX = PY = 3, implying that PX /PY = 1. What will
now happen to the choices of both our individuals?
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Figure 6.16: Consumption and endowments for PX/PY = 1.
Clearly, the initial endowment point A will no longer be optimal for either
individual. The slope of individual 1s indifference curve is 2 units of Y per X,
while the market price of X in terms of Y is only 1. Since individual 1 has to
pay less for X than he is willing to pay, he would choose to consume more X.
Similarly, individual 2s subjective rate of substitution is still 1/4 unit
of Y per X at A, so he will want to buy more units of Y. Both individuals
want to move to a point like B in the above diagram. Given our equations
for demand for each good, we can calculate these optimal consumption
bundles, just like in the case where PX /PY = 2. We find that
X1 = 15
X2 = 25
Y1 = 15
Y2 = 25
How would you verify that this is not yet the competitive equilibrium?
Even though this is not yet a competitive equilibrium, point B in the above
diagram depicts the consumption bundles, and hence the trades, both
individuals would have been interested in had the relative price of the
two goods been equal to 1. In fact, we can find such a point B for every
possible relative price. As the relative price changes, the budget constraints
will rotate around point A, and we will find new optimal points, as in
Figure 6.17.

Figure 6.17: The offer curve.
The curve connecting all such points is called the offer curve. Each
individual will have an offer curve which starts at the initial endowment
(where they do not wish to trade) and changes according to the change in
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the relative market price. A point on the offer curve will have the features
of point B above, telling us how much of each good individuals will want
to buy or sell. Notice that at each point on the offer curve (like B above),
each individual is maximising their utility.
We mentioned above that the existence of a general equilibrium in this
context depends on the excess demand for each good being equal to zero.
This means that the points on the offer curve corresponding to the general
equilibrium must be such that the amount of any good an individual is
willing to sell must be exactly equal to the amount the other individual
wants to buy at the prevailing prices.
In order to find this point, we make use of an analytical device called the
Edgeworth box, where we combine the initial endowment and offer
curves of both individuals in one diagram:

Figure 6.18: The Edgeworth box.
The bottom left end of the box represents individual 1s point of view,
while the point at the top right-hand side of the box represents individual
2s point of view. Point A, now, is the common initial point which we had
in our previous diagrams. It depicts the initial bundle of both individuals
when read from their respective corners. From the point of view of
individual 1, we can see that he has 10 units of X and 20 units of Y.
Individual 2 (from the top right) has 40 units of X and 10 units of Y. The
boundaries of the box determine the domain of trade: Its dimensions give
the total amount of both goods available in the economy (the supply).
In our case, there are altogether 50 units of X and 30 units of Y. Point A,
therefore, describes a certain initial distribution between the two agents.
Figure 6.19 depicts the two agents position when the relative price is 2.

Figure 6.19: Edgeworth box with relative price equal to 2.

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It is easy to see that individual 1 will not want to trade, while individual 2
will want to exchange X for Y. At the same time, it is also clear that all the
allocations trapped between the two initial indifference curves (the shaded
area) represent greater utility to both individuals (unlike point B, where
only individual 2 will be better off). This suggests that both individuals will
have an incentive to find a way to trade to move inside the shaded region.
Notice that the indifference curves of each individual are convex in the
opposite direction. Utility, too, is rising in opposite directions. Individual
1s highest utility is the top right-hand end of the box while individual 2s
highest utility is at the bottom left-hand end of the diagram.
Consider the case when the relative price is 1 (Figure 6.20).

Figure 6.20: The Edgeworth box with relative price equal to 1.
If individuals trade to their respective point B, each one will be made better
off. At A, individual 1s utility is U(10, 20) = 10 20 = 200. If he had his
way he would want to buy an extra 5 units of X and sell 5 units of Y. This
means that he will have 15 units of X and only 15 units of Y. Clearly, U(10,
20) < U(15, 15) = 225. You can do the same calculation for 2.
Indeed, you can easily verify that all the points within the shaded area
represent allocations where both individuals are on a higher indifference
curve. This is a reiteration of the point we made in Chapter 1 regarding
the notion of benefits from trade. For each initial position like A, there are
allocations where both sides can make gains.
Let us now examine the existence of the general equilibrium price where
all rational plans coincide (see Figure 6.21).

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Figure 6.21: The Edgeworth box and general equilibrium.

214

We start from A and draw the offer curve for each individual. These
offer curves containing the points B from Figure 6.21. However, there
is a unique point C where the offer curves intersect. This is clearly an
equilibrium point, since the amounts of X and Y individual 1 wants to
buy or sell are exactly those amounts that individual 2 wants to sell or
buy. Hence, if they go ahead and exchange at the price prevailing at C,
all rational plans will coincide. The price prevailing at C will be the line
connecting the initial position to the point of intersection, given our most
basic definition of a price: The slope of the line tells us how many Y were
exchanged with how many X. It is also the equilibrium price, because it is
on both individuals offer curves. This means that at this price, each one of
them has made an optimal choice.
Try to calculate this equilibrium using the equations we used to construct the offer curves.
As each individual is at an optimal position at C, the indifference curve is
tangent to the price line. Hence, the indifference curves of both individuals
are also tangent to each other. It is therefore clear that it is no longer
possible for both individuals to agree on a different allocation. At any
other point (say D or E) either individual 1 will be worse off (D) than at
C, or individual 2 will be made worse off at a point like E. As there will
always be at least one of the two agents who will refuse to move to a point
different from C through trade, there will be no further trade and C is the
final point of negotiation. We say that C lies on the contract curve.
Figure 6.22: The Edgeworth box and the contract curve.
Within the Edgeworth box, there are maps of indifference curves for
both individuals. This means that every indifference curve of individual
1 will have a corresponding indifference curve of individual 2 to which it
will be tangent at some allocation. The line connecting all such points of
tangency is called a contract curve, since every such point is final in the
sense that further trading will cease. At any point on the contract curve,
we can no longer move to a point where both agents are made better
off. Given our initial definition of efficiency, we can now say that when
we are on the contract curve, we cannot make anyone better off without
making someone else worse off. Thus, all points on the contract curve
are allocative efficient. Whether the contract curve is a straight line
or not, depends on the nature of individuals utility functions and their
relationship. We shall not explore this point at this stage of our study.
215
A note on welfare economics

Now that we have established the nature of general equilibrium in
competitive systems, we may wish to examine some of its implications.
One of these is fairly obvious: without any central authority and without a
need for collecting information from individuals, the system can reach an
equilibrium with a complete decentralised decision-making mechanism. By
equilibrium we mean that all the rational plans of the participating agents
coincide. But what is the meaning of this? The most important meaning of
such an equilibrium is embedded in our analysis in the previous section, as
Figure 6.23 shows.

Figure 6.23: General equilibrium and welfare.
For any initial position like A, there exists a price where all rational plans
coincide, generating a general equilibrium. Such a price will lead us to an
allocation which will always be Pareto efficient. This means that the
allocation which will emerge in the process of trade will be such that it
will not be possible to make anyone better off without making someone
else worse off. Furthermore, all participating agent will be at least as
well off as they were before trade, since they always have the choice of
not trading. The implications of this are enormous. If no one is losing
from free trade, what reason could there be for anyone to oppose the
introduction of free-trade institutions?
Obviously, this is a very difficult issue. At this stage I only wish to draw
your attention to the word free. Freedom in this theory is merely the fact
that everyone is rational and is free to act within their constraints. What,
you may wonder, should be the rational choice of an individual who has
no money nor any assets? I would rather not say. I would only like you to
be aware of the pitfalls of the theory as well of as its achievements. This
analysis has been well defined, but at no stage have I suggested that it is
descriptive in nature. Even the concept of rational behaviour is open to
dispute. Therefore, one should have proper understanding of the meaning
of rationality before one accepts the implications of the theory.
There is yet a stronger reason within the theory to support the
mechanism of decentralised decision-making, deriving from the question
of social choice.
Suppose that social values suggest that the allocation which is most
socially desirable is allocation S in the above diagram. Clearly, this
allocation lies outside the set of Pareto efficient allocations where
216
both our agents are made better off than at their initial no-trade position.
However, the theory suggests that we can reach every point on the
contract curve through a lump-sum redistribution. Since the socially
desirable allocation S is on the contract curve, it will be a competitive
equilibrium.
The implications of this proposition are even stronger. They seem to imply
that competitive equilibrium concepts are completely independent from
social distributive issues. If all possible desirable distributions can be
reached by competitive means, competition is above morality and valuefree.
Again, this statement needs to be examined more carefully. Though this is
an immense topic, let me pick out one simple aspect for your deliberation.
In Figure 6.23, there exists a point E which denotes an equal distribution
of goods. Naturally, what is meant by equality is far more complex than
equal distribution but I believe that the idea of equal distribution of goods
is not so outrageous in the literature on equality. Yet, in spite of the very
long history which equality has in the social psyche of many nations, an
allocation like E may not be on the contract curve. Put differently, equality
may prove to be Pareto inefficient. Could it become a point of social
choice?
If the answer is yes, then it is clear that the proposition according to which
the socially desirable outcome can always be reached by competitive
means is no longer true. If the answer is no, does this mean that things are
socially desirable only if they are Pareto efficient?
I will not even begin to discuss these issues. The purpose of this section is
merely to point out the richness as well as difficulties which the model of
general equilibrium produces.
Self-assessment
Define the concepts of general equilibrium, horizontal and vertical
dimension, markets interdependence, the excess demand function,
equilibrium across final goods markets, Pareto efficiency, the offer
curve, the contact curve, and the Edgeworth box.
Use diagrams to analyse problems involving short- and longrun equilibria for an economy with two goods and one means of
production.

Question 1
Assume an economy with two goods (X and Y) and one means of
production (say, labour). All markets are perfectly competitive:
a. Describe the short-run and the long-run market equilibrium of a typical
competitive industry (say, the market and industry for commodity X).
217
b. What is the relationship between the efficiency conditions of

competition in the markets for X and Y, and social efficiency as
captured by the production possibility frontier? (Hint: do not analyse
the labour market but simply assume a unique, and fixed, wage level.)
Does this mean that competitive markets are efficient only in the long
run?
There is now a technological improvement in the production of X:
c. What would happen to the real price of X in terms of Y if the two goods
were gross substitutes?
d. Would your answer be the same if the two goods had been
complements?
e. Are both your answers to (c) and (d) consistent with analysing the
change within the framework of the production possibility frontier?
Question 2
What will be the effect on general equilibrium prices of X and Y (where X
and Y are gross substitutes) of an increase in the demand for X?
Question 3
What will be the effect on general equilibrium prices of X and Y (when X
and Y are complements) of a decrease in the demand for X?
Answers
Question 1
This is a question which combines competitive equilibrium with the
general equilibrium dimension of cross-industry analysis. We assume here
an economy with two goods and one means of production (labour):
a. An initial description of a typical competitive industry in both the short
and the long runs (see Chapter 4).
b. Here you are expected to explain the relationship between marginal
cost pricing and allocative efficiency in the sense that if all markets
priced at marginal cost (with labour as the only means of production),
relative market prices will reveal the true social cost (the slope of the
production possibility frontier):
hence:
Obviously, efficiency is independent of the considerations of long run

versus short run.
Now the question becomes slightly more complex: There is a
technological improvement in the production of X and we have to
analyse the general equilibrium implications for the relative price of X
in terms of Y.
218
c. and d.
The choice of framework
As the question deals with relative prices in a world of two goods, this
is clearly a general equilibrium question. The question is about crossmarkets equilibrium (a horizontal notion of general equilibrium).
The tool of analysis which is required here is that of excess demand
functions. Ideally, we should show how to construct the ED functions
for both cases of gross substitutes and complements.
This, however, is less significant than getting the models right.
Figure 6.24
The left-hand diagram depicts the case of gross substitutes, while the
right-hand diagram depicts the case of the complements.
d. Analysing the effect of the technological change

Figure 6.25
The two diagrams describe the effects of the technological

improvement in the production of X on the relative price of X in
terms of Y when they are gross substitute (left) and when they are
complements (right). The direction of change in relative price of X in
terms of Y is independent on whether the goods are gross substitute or
complements, and only depends on the slopes of the ED = 0 lines.
e. The technological improvement is in the production of good X only,
hence the PPF will pivot outwards, keeping the maximum possible
production of Y the same. Therefore, the changes in (c) and (d) are
consistent with the earlier efficiency considerations (Figure 6.26).
219

Figure 6.26
Question 2
We have to use the excess demand functions to answer this question:
ED x = X d(PX , PY , I) X S(PX , w, r) ED X(PX , PY , I, w, r)
ED y = Y d(PY , PX , I) Y S(PY , w, r) ED Y(PY , PX , I, w, r)
clearly:
PX = F(EDX)
PY = G(EDY)
We find that the change in PX is a function of EDX only, similarly for PY. As
we assume that X and Y are gross substitutes, we end up with the diagram
on the left of Figure 6.27, depicting equilibrium conditions in each
market as a function of the other goods price:

Figure 6.27
The relative prices are captured by the ray from the origin to point A.
There is a change in tastes, which brings about an exogenous increase
in demand for X. For any given price of Y, equilibrium in the market for
X will only be obtained at a higher price of X (a shift to the right of the
X excess demand schedule). These changes and their subsequent effect
on equilibrium prices are captured by point B in the right-hand diagram
above.
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Question 3
As in the previous question, a proper exposition of the excess demand
functions is required:
ED X = X d(PX , PY , I ) X s(PX , w, r) EDX(PX , PY , I, w, r)
ED Y = Y d(PY , PX , I ) Y s(PY , w, r) EDY(PY , PX , I, w, r)
clearly:
PX = F(ED X)
PY = G(ED Y)
As we assume that X and Y are complements, we end up with the diagram

on the left of Figure 6.28, depicting equilibrium conditions in each
market as a function of the other goods price:

Figure 6.28
The relative prices are captured by the ray from the origin to point A.
There is a change in tastes, which brings about an exogenous decrease
in demand for X. For any given price of Y, equilibrium in the market for
X will only be obtained at a lower price of X (a shift to the left of the X
excess demand schedule). These changes and their subsequent effect
on equilibrium prices are captured by point B in the right-hand diagram
above.
221
Notes
222
Chapter 7: Externalities and public goods

Learning outcomes
define the concepts of externalities, social public costs, missing
markets, public goods, efficient provision of public goods, social
marginal costs
analyse problems involving pollution tax policy and information.
Reading
BFD Chapters 13 pp.31531 and Chapter 14.
LC Chapters 1314.
In the previous chapter, we discussed at some length the apparent merits

of the competitive paradigm. Using the concept of general equilibrium,
we showed that a system of decentralised decision-making can result in
an allocation in which all rational plans coincide. At a certain set of prices,
no rational individual will have an incentive to change the outcome by
changing his actions.
In addition, we noted that competitive outcomes produce a price system
which reflects the real social cost. Competitive market prices, which
are the result of the institution of competitive markets, thus equate the
consumers willingness to pay, which is dependent on their preferences,
with the cost of production, which is dependent on the technology and
social aspects. (The assumption that technology precedes the institutional
arrangement of economic activities is far from obvious. At this level, we
shall nevertheless stick to it.)
Given such perfection, what role, if any, do governments have in the
economic sphere of our lives? This is obviously a very important question,
which deserves a course of its own. The purpose of this section is to shed
some light on this issue. We will see that there are some situations in
which the self-regulating mechanism of competitive markets fails to yield
a socially optimal outcome. This might necessitate intervention by the
government. We will look at two examples in this section, externalities
and the provision of public goods.
At a more basic level, governments might be needed even if there are no
obvious impediments to the mechanism of decentralised decision-making.
Governments would still be essential in upholding the legal framework
within which competition operates. The model of perfect competition
is not describing a natural state of affairs. People might try to change
the outcome of the system, or even the rules of the game, if they think
it would provide them with a more favourable outcome. The role of
the government is then not only to uphold the order of the system, but
possibly also to interfere in the income distribution to prevent people
trying to change the system.
223
Externalities and incomplete markets

Reading
Assume an economy living along the river Y. They produce two goods, a
fish called Y and a mud-car (a car which is made of mud) called X. Both
goods are produced by labour alone. Suppose that the markets for X and
Y as well as the labour market are perfectly competitive. The general
equilibrium condition in this economy, which we have explained in the
previous chapter, can be derived as follows. We consider equilibrium in
both goods markets first. Using the price of labour, we can connect these
two markets and get the general equilibrium solution.
The markets for X and Y

Figure 7.1: Equilibrium in the goods markets.
In each of these markets, price equals marginal cost. Recall from Chapter
3 that the marginal cost with just one means of production will be equal to
w/MPL. Hence, competitive equilibrium in both markets will yield:
The competitive nature of the labour market is captured by the uniqueness

of the cost of labour (the equilibrium wage level). The nominal wage for
workers in both sectors equals the value of the marginal product.
General equilibrium

Figure 7.2: General equilibrium with production.

224
The slope of the PPF measures the effects of a transfer of one labourer
from one industry to another. Reallocating one worker from the production
of fish, Y, to the production of mud-cars X will result in less fish and more
mud-cars. The loss of fish dY will be exactly the marginal product of that
labourer in the production of Y (i.e. the quantity of fish that would have
been caught had he gone out fishing with his comrades); the gain in mudcars dX will be exactly the marginal product of that labourer in making
mud-cars X:
dY = dL MP YL
dX = dL MP XL
As dL = 1, the slope of the PPF is dY/dX or, MP YL /MP XL units of Y per X.

Putting everything together, we find:
Hence:
This means that prices in competitive markets reveal the true social costs.
As individuals in each market consume at the point where the relative
price of goods equals their marginal product, the trinity of the subjective
(individuals), the institutional (markets), and the technological (society) is
confirmed.
The nature of externalities

Suppose now that a new technology for the production of mud-cars has
been discovered. The new technology requires spraying the mud-cars with
a consolidating material called z, which is then washed out into the river.
Unfortunately, z is toxic and it kills fish (Y). The plant producing mud-cars
X is located up the river while the fishing community lives nearer to the
sea.
What will be the consequences of introducing such a technology? For
simplicity, we shall assume that z exists in abundance (relative to the car
production requirements) and is costlessly available to the producers of
mud-cars.
The introduction of z clearly increases the production possibilities, and
the PPF will shift outwards. This point is of less interest to us, since
we are concerned with efficiency at a specific point in time, rather than
in efficiency over time. We are interested in whether the economy will
continue to be as efficient with the new technology as it was with the
old technology, given that there has not been any institutional change
affecting the competitive nature of markets.
It would seem that prices will continue to be equal to marginal cost,
as there has been no change in the competitive nature of the markets.
Therefore, the equilibrium trinity should be preserved, which is our
benchmark for efficiency. We will now investigate this claim, starting with
the situation in each of the markets under the new technology.
225
The markets after the introduction of z

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Figure 7.3: Equilibrium in the markets after the introduction of Z.
Employers will be hiring workers in the competitive labour market for the
production of both X and Y. The conditions for profit maximisation from
which we derive the demand for labour (see Chapter 5) are the same as
before. The marginal product of the last worker employed will be equal
to the nominal wage level. The productivity of a fisherman is measured
in the amount of fish he contributes to the catch, while the productivity
of workers in the mud-car industry is measured by the number of cars (or
fraction of a car) which their presence at work adds to the total output.
Since neither of these productivities has changed, we are left with exactly
the same equilibrium prices as before:
However, what is the marginal product of a worker producing mud-cars

X? With the new technology, the production of each mud-car requires the
use of the consolidating material Z. As a worker produces a car, he also
increases the quantity of Z used, according to the technology. Hence, in
addition to producing X, the worker also produces a quantity of Z which is
washed into the river.
Once in the river, this quantity of Z resulting from the production of X will
kill a certain number of fish. Consequently, there are fewer fish in the river
and the quantity of a fish that could be caught by the work of a single
fisherman (or by a unit of a fishermans time) will inevitably be reduced.
In other words, the marginal product of a unit of labour producing mudcars X is no longer measured only in terms of mud-cars. It should also be
measured by the damage which such a unit of labour creates in the fishing
industry. The equilibrium price P 0x , at which the quantity X0 is sold hence
only reflects the marginal cost for the producer of X. It does not take
account of the cost to society, which is different.
To produce 1 unit of X, the employer will need to hire 1/MPL units of
labour. The cost of that labour (i.e. the marginal cost of a unit of X) will
thus be w/MPL. The fact that Z is used in the process and that Z kills fish
Y, is of no concern to the producer of X. However, it is the concern of
consumers of X, who are also consumers of Y. The real cost to society of
a unit of X when X0 units of it are produced is not just marginal cost of
X, w/MPL, but also the damage done to Y . Let MP ZL be the quantity of Z
released into the river by one unit of labour employed in the production
226
of the mud-car X. Let MP YZ denote the quantity of fish killed by a unit of

Z. Therefore, MP ZL MP YZ is the quantity of fish killed by the output of one
labour unit employed in the production of X.
If, say, a unit of labour employed in the production of X releases 5 kg of Z
into the river and each kg of Z kills 2 fish, then the employment of a unit
of labour in the production of X kills 5 2 = 10 fish. When the price of Y
is P 0Y , the value of that loss equals:
P 0Y MP ZL MP YZ
Hence, the real marginal cost, or the social cost, depends on how
much labour we employ in the production of 1 unit of X. If the quantity of
labour required at X0 is 1/MP XL , then the social marginal cost of X at
that point will be
(1/MP XL )(w + P 0Y MP ZL MP YZ )
This corresponds to point B in the above diagram. This would be true
everywhere along the marginal cost curve. We hence have a social
marginal cost which is above the private marginal cost in the
market for X.
The fact that the producer of X does not care about social cost, suggests
that it is the private marginal cost which will determine the supply of
X, rather than the social one. Hence, the equilibrium conditions in both
markets remain exactly as described above (i.e. MC(X) = w/MP XL ).
General Equilibrium after the introduction of Z

If we had not known the details of the above story and had simply
examined the markets for X and Y we would have established that there
are competitive conditions in all markets. Therefore, the benchmark of
efficiency prices equal marginal cost will deliver the overall efficiency
of the system as captured by the equality of willingness to pay (subjective),
actual pay (market prices) and the social cost (the slope of the PPF).
Armed with the new information about Z, we will look at the new PPF to
examine whether this is indeed the case.
The slope of the PPF, as was previously explained, is given by the effect
of a transfer of 1 unit of labour from the fishing industry to the mud-car
industry on the output in both industries. When we take 1 labour unit
from the fishing industry Y, we will immediately lose its contribution to
the daily catch, the marginal product MP YL . However, this is not the end of
the story. When this unit of labour is reallocated to the production of X, it
will also produce Z and subsequently kill fish. Therefore, the total loss of
output in the fishing industry will be the direct loss of output MP YL , plus
the indirect loss of output Y due to the increased production of Z through
X. Therefore, the total effect is
dY = dL [MP YL + MP ZL MP YZ ]
The effect of this transfer on X will be as before. Output will increase by
the marginal product of that worker:
dX = dLMP XL
The slope of the PPF, dY/dX, is therefore given by
units of Y per X.
227
Figure 7.4: The slope of the PPF after the introduction of Z.
We can now compare the relative competitive prices for any output
combination with the slope of the new PPF. We find that
hence:
This means that prices in competitive markets no longer reflect true social
costs. We still pay for each good exactly our willingness to pay. However,
the relative price of X in terms of Y is smaller than the real cost of
production. Equally, the price of Y is much greater than what it really costs
(in terms of X) to produce it.
Externalities and Pareto efficiency

In Chapter 6, we tried to tie the trinity condition (the equality between
the marginal rate of subjective substitution, the market rate of exchange
and the technological rate of substitution) to the notion of Pareto
efficiency. If we accept, for simplicity, the existence of a social utility
function representing social preferences, then we can immediately show
that the above trinity condition implies allocative efficiency.
Given a PPF, point A, on Figure 7.5, represents the most preferred
social allocation. It specifies the most preferred feasible choice of society.
Since the slope of the social indifference curve is the same as the slope of
the PPF at this point, the social willingness to pay for one of the goods
is exactly the same as its relative cost of production. When, without
externalities, market prices coincide with these relative costs and the
willingness to pay, the competitive framework will yield the socially most
preferred feasible outcome.
228
Figure 7.5: Allocative efficiency with negative externalities.
While this is clearly not a proof of Pareto efficiency, it helps in

understanding the nature of competitive equilibrium. Recall that Pareto
efficiency meant an allocation where no one can be made better off
without someone being made worse off. If the social utility function is
based on what is good for the individuals in society, the fact that we have
achieved the highest social utility could be interpreted as not being able to
choose an alternative combination of the goods without at least someone
being made worse off.
Using the same tool of social utility, we can see easily how the
competitive equilibrium produces a suboptimal outcome in the presence
of externalities. At point C in the above diagram, the equality of relative
prices and societys willingness to pay is preserved, since the social
indifference curve is tangent to the market price. However, as the market
price cuts through the PPF at that point, it clearly does not reflect the
relative cost of production at this point. We are paying less than the cost
of production for X, while paying more than the cost of production for Y.
Looking at the above diagram, we could move from point C to point A,
increasing social utility. The relative cost of X would increase, but it would
still be less than societys willingness to pay. We could thus exchange
less units of X per Y than we were willing to pay. We could thus make
everybody at least as well off as they were at C, and at least some of
societys members would be strictly better off. This process would continue
until we reach point A.
Notice that any point along the PPF is productive efficient, while
only point A is allocative efficient. There is thus an allocative efficient
point A which is socially preferred to the competitive outcome C.
Competitive markets thus do not yield a Pareto efficient outcome in this
case. The reason, clearly, is that the market does not take account of the
externality associated with the production of X, namely, the production
of Z, which has an effect on the production of Y.
229
Externalities and taxation

It is beyond the scope of this course to deal with the question of how such
a problem should be resolved. The main purpose of a policy addressing
this problem will be to make the cost of production of X accurately reflect
the impact on the production of other goods.
(1/MP XL )(w + P 0Y MP ZL MP YZ )
The element which needs to be added is clearly P 0Y MP ZL MP YZ . If, for
instance, we were able to levy a tax of this amount on the producers of
X, allocative efficiency of competition will re-emerge. As prices will equal
marginal cost in both cases, we will now have
Hence:
As MPYL PY = w
Hence, a tax representing the externality of the production of X will
produce equilibrium conditions in each market which reflect the subjective
rate of substitution, as well as the market and the technology rates.
The problem with such a tax is that the government needs to know quite
a lot about the technological circumstances of each industry. There are
likely to be information asymmetries, with the industry insiders knowing
more about the circumstances than the government. The ability of
government to establish a tax policy accurately reflecting the externalities
of production might therefore be seriously diminished.
There are other methods of trying to resolve the problem, which will not
be discussed at this stage. However, I would like to draw your attention to
the general significance of the externalities phenomenon. What exactly is
the meaning of the problem of externalities?
The presence of externalities leads to a failure of market institutions to
provide a Pareto efficient outcome. Without externalities, decentralised
decision-making in the framework of competitive markets yielded a Pareto
efficient outcome. Put differently, if your aim is to get the most preferred
bundle which is feasible, you could have achieved this through the
markets.
When there are externalities and we get a competitive equilibrium which
is clearly no longer Pareto efficient, such a description of the system does
not hold. If your aim is to achieve the most preferred feasible bundle, the
230
institutions of the market will provide you with an illusion of achieving

your goal, in the sense that you will be paying exactly your willingness to
pay, and will be on your budget line. This, however, is an illusion, since
a reallocation of production could have achieved more without making
anybody else worse off.
Externalities and the completeness of markets

So is the allocative efficiency of the competitive paradigm merely an
illusion? The answer to this question is complex. At this stage I will point
out that this is not necessarily the case. Unless there was a mistake in
our use of logical instruments, the conclusion that a competitive market
system will yield a productive and allocative efficient outcome will be
correct. However, the problem of externalities suggests that for the system
to deliver, it must be complete.
Complete has two different meanings in the present context. First, as
we noticed in Chapter 4, the allocative efficiency of an economic system
disappears as soon as one industry in it is not organised competitively. An
economy in which the market for X is dominated by a monopoly, while the
market for Y is competitive, would have yielded a competitive outcome
similar to that in the case of externalities. As the price of the monopoly
good is above the marginal cost price, the efficiency-trinity no longer
holds. The first sense of completeness requires full competitiveness in
all markets for productive and allocative efficiency to hold.
The second notion of completeness is that all markets are included.
This is the usual meaning economists attach to the word. In the above case
of externalities, it is clear that the reason for the failure of the competitive
system is the lack of a market for Z. The consequences of Z for the fishing
industry could have been taken into consideration by the producers of X,
for example through the tax regime proposed above, or indeed through
a market for pollution. In this case, their marginal cost would have
corresponded to the social cost. Since the use of Z is free to the producers
of X, as there is no price, or market, for it, it is not included in the
marginal cost considerations. The absence of such a market for z suggest
that the system is incomplete in the sense that not all things which
influence the final outcome are connected via a price mechanism.
Assume, for instance, that Z not only kills fish, but also solves ageing
problems. I am sure you can imagine what will happen to the demand
for Z. I said at the beginning that Z existed in abundance relative to the
car production requirements. The discovery of its potency problem will
increase the demand for it so much that, we assume, a positive price will
emerge. When this happens, the producers of X will no longer be able
to use the new technology without buying Z. If they do, its price will
inevitably enter their cost equation. This will help to equate the private
cost with the social cost of production, especially if the producers of Y can
now influence the price of Z as well.
Therefore, Pareto efficiency through the institutions of competitive
markets will require that markets are complete. This may not sound
like a plausible assumption. It is unlikely that there will be a market for
each possible externality from the production of each possible good (think
about pollution, for example). Are there alternative means of ensuring that
even if markets are incomplete, the allocative efficient solution can still be
obtained? We shall leave this for your further studies and thoughts.
231
Public goods and their efficient provision

Our entire discussion of economic interactions and systems has been
focused on the individual and their behaviour. This implies, among
other things, a notion of private consumption. We assumed that our
consumption of some divisible good means that there will be less of it left
for others.
However, it is fairly clear that there are goods which are not divisible. The
most obvious example is defence. The quantity of defence available to the
public is not divisible in the sense that the amount of security I feel will
not reduce the amount of it which is available to you. These kinds of goods
(other examples are street lighting or lighthouses) are called public
goods.
Given that everyone can consume the same quantity without affecting the
amount available to others, we will have an incentive not to pay for the
good, but to free-ride. However, if nobody pays for the good, the supplier
will not have an incentive to provide it in the first place. How can we
ensure the provision of public goods?
Consider the following example. Suppose that in one street, a deadend, lives a single man who is a bodybuilder and an expert in Judo,
kick-boxing and all other forms of martial arts, as well as a lone mother
with a teenage daughter. The street is in a remote part of town. Will
there be street lighting in this road? The lone mother would like street
lighting in the street for her safety, while the bodybuilder does not care
much about it. The cost of providing street lighting is high and above
what the lone mother is willing and able to pay. It certainly is above the
bodybuilders willingness to pay, even though he may well be able to
afford it. However, if the lone mother arranges for street lighting, she
cannot exclude the bodybuilder from using it. Hence, provided he does not
actively dislike street lighting, his utility would be higher.
Suppose that the marginal cost of providing street lighting for an hour
per evening for one year is equal to 200 (suppose that it is technically
impossible to provide less than one hour an evening). The lone mother,
given the level of her income, is willing to pay 150 a year. The
bodybuilder is willing to pay 60 a year. Remember that willingness to
pay reflects the marginal utility from using street lights. Clearly, providing
street lights will increase the utility (or welfare) of the people in the street.
They are willing to pay 210, while the cost is only 200. This means that
the money value of their utility from street lights is greater than its cost.
Will the market mechanism provide this project which is clearly socially
desirable? The answer is simply no. The market operates by providing
individuals with the goods they want, charging them the marginal cost.
The marginal cost of a years provision of street light is 200. The profit
maximising firms competing to provide the service will charge each
consumer the marginal cost. However, neither the lone mother nor the
bodybuilder is willing to pay that much. Therefore, there will be no market
solution to something which will produce a clear Pareto improvement.
Having the service would have made both agents better off without
making anyone worse off.
232
The markets failure to provide this Pareto improving service is another

example of how competition can fail to deliver the social optimum, in
spite of the fact that markets clear and prices will equal marginal costs
everywhere. In a way, this problem is not much different from the previous
one of externalities. In both cases, a missing market causes an inefficiency
in the final allocation and provision of goods.
Public goods and government intervention

If the competitive market system does not provide a solution to the
problem, how can the government resolve it?
Suppose the government decided to step in and provide the street lights in
that road. Should it provide the minimum of an hour an evening or should
it provide for more hours of street lighting? Markets automatically allocate
goods according to individuals willingness to pay. It is more difficult for
the government to choose the allocation which not only improves public
welfare, but is allocative efficient at the same time.
To understand the governments problem better, let us examine the
mechanism by which the market generates an allocation of resources in
the case of divisible private goods. Consider an economy with a private
good X and a public good G. Suppose that both goods are produced by
labour only. The following is the PPF of the economy:
MPXL/MPGL
Figure 7.6: The PPF with a public good G.
The slope of the PPF is MP XL /MP GL units of private good X per unit of
public good G.
The nature of an allocative efficient point like A is that the subjective rate
of substitution, the market price and the technological rate of exchange
coincide. Since there is no market for G, what will its price be?
We know exactly how individuals choose how much X and Y they wish
to consume. We derive their demand schedule for, say, X by analysing
optimal choices under different prices:
233

Figure 7.7: Optimal demand for good X.
We then used horizontal summation to find the quantity demanded by all

agents at any given price of X:

Figure 7.8: Deriving market demand for good X.
Finding the equilibrium of overall demand and the marginal cost of

production will give us both the amount of X people want to buy and
produce, and the equilibrium price of X. Since the market for good Y will
operate similarly, we know that the allocative efficient outcome will equate
social and private costs. The mechanism which allocated resources to the
production of X, and determined the efficient level of production, was the
price.
But there is no market and no single price for the public good. How can
we determine its efficient level of provision? We know that the public good
is an economic good, since it is both scarce and desirable. Hence, people
are willing to pay for it. Their willingness to pay can be derived in exactly
the same way as for the private good. We simply construct the individual
demand function, which tells us the amount of G they wish to consume
for any given price. We ignore for a moment the free-rider problem which
characterises the public good, which might have yielded a zero demand
for all prices, since people will simply wait for others to pay for the good.
Under this assumption, the demand function for G will be derived from
individual preferences for a given level of income and a set of prices,
exactly as before, as Figure 7.9 shows.
234

Figure 7.9: Deriving individual demand for the public good.
At A, the consumer is willing to pay P 0G to have G0 units of the public

good together with X0 units of the private good at a price of P 0X . For G1
however, the consumers willingness to pay has decreased, as the marginal
utility of the public good decreases.
Deriving total demand for the public good at some price P 0G is not a
meaningful exercise. If there are n identical agents and all of them want
G0 of the public good at the given price, we do not need to produce nG0
units. Having G0 units of it will be sufficient, as every agent will be able
to consume that quantity without affecting the quantity available for the
others. Therefore, a horizontal summation will produce an obviously
inefficient result, since we would be overestimating demand (nG0 instead
of G0). We must, therefore, resort to an alternative technique in order to
establish the efficient provision of the public good. As G is indivisible, the
only difference in demand functions across individuals will be the price
they are willing to pay for some quantity. Hence we need to sum demands
vertically, by adding up the prices, rather than the horizontal summation
of quantities we performed for the private good. Doing this, we can derive the
total willingness to pay for any quantity of the public good.

Figure 7.10: Deriving total demand for the public good.

235
For a level of G0 of the public good, individual 1 is willing to pay P 01 , while

individual 2 is willing to pay P 02 . Therefore, the total amount of money
the public is willing to pay is P 01 + P 02 = P 0G . Given the marginal cost of
producing G0 we can see that the marginal cost of the public good is less
than the overall willingness to pay.
For a private good, the area underneath the total demand schedule
represented the utility of a representative agent. When we sum the
demand schedules vertically, we add up every individuals willingness
to pay. Hence, the price P 0G gives the sum of peoples marginal utility.
The area underneath the total demand for the public good represents a
measure of the total amount of social wealth arising from a particular
level of public good provision. The area underneath the marginal cost is,
as usual, the cost of production (I ignore here questions of short run and
long run et cetera).
Looking again at Figure 7.10, you can clearly see that G0 is not the
efficient level of public good provision. The shaded area represents the
social net benefit generated by providing G0 units of the public good,
which is given by the total social wealth generated minus the cost of
producing it. Clearly, we can increase the social net benefit by increasing
the provision of the public good. If we move to G1 units of the public good,
the overall willingness to pay will be P 11 + P 12 = P 1G , which is equal to the
marginal cost of providing G1 units of the public good. Our example of
street lighting corresponds to the point G0. The total willingness to pay was
210, which was greater than the marginal cost. Therefore, the welfare of
society can be improved by providing street lighting. Furthermore, more
than one hour per evening should be provided, up to the point where the
total willingness to pay equals marginal cost.
Figure 7.11: Optimal provision of the public good and transfers of benefits.
Why does equating the total willingness to pay with the marginal cost
produce the efficient allocation? Recall that the vertically summed demand
schedule is the sum of individuals marginal utility from each unit of public
good, given the price of the private good X. This gives us a measure of
total social welfare provided by a single unit of the public good. Adding
the welfare over the different quantities of the public good (i.e. calculating
the area underneath the demand) gives the overall utility of the public of
236
consuming a certain quantity of the public good, for a given price of X.

Part of this utility, or willingness to pay, is actually transferred to producers
to cover their cost (the area underneath the marginal cost curve).
However, from a social point of view this is merely a transfer of utility
from consumers to producers, who, in the end, are also the consumers.
Therefore, we consider the cost section as a transfer from consumers to
themselves.
The shaded area to the left of point A represents net benefits. When we
move to point B, the overall utility will be the area DACG2, while the total
cost is the area OFABG2. The triangle ABC represents that part of the cost
which is greater than consumers willingness to pay. Naturally, this will
have to be paid from some source. This means that the move from A to
B will make someone worse off. Therefore, the allocative and productive
efficient point will be given by A, where demand and supply intersect.
We can use our vertical summation of the willingness to pay to show the
condition for efficient provision of the public good using the PPF. The
provision of X and G will be efficient if the slope of relative prices is equal
to the slope of the PPF. But the price for G is the total willingness to pay,
and the following solution emerges:
Figure 7.12: Optimal production of public and private goods.
We find that the optimal point is where:
Information and incentive compatibility: a note

We have seen that a decentralised market system provides an allocative
and productive efficient outcome, provided all markets are competitive
and the system is complete. The advantage of the system is that
participants in the market communicate with each other exclusively
through prices and quantities. There is no need to share any other
information, such as preferences or technologies, with each other. Since
everybody is acting in their own interest, this will lead to an efficient
outcome.
237
Contrast this to a centrally planned market. In order to generate an

efficient outcome, the central planning office will have to collect
information about individual preferences, as well as about the production
environment. For any non-trivial economy, this quickly becomes a very
complex task and next to impossible. Furthermore, there is the problem of
information extraction. Even if the central planning office had the means
to compute the efficient allocation once it had all the information, it is not
clear that it would be able to collect all the information accurately in the
first place.
This becomes relevant even in a decentralised market system, if there are
some imperfections in the market such as externalities or public goods.
In such a case, governments might be asked to step in and rectify the
situation.
Consider the case of externalities we looked at earlier. If the government
wants to levy a tax on a polluting producer, it would need to know
the technology of production. In our example, we had the producers
of X (mud-cars), who used the pollutant z in their production, and the
fishermen who were affected by the polluting effect of z. If the government
were to levy a tax that will rectify the situation, it would need to know
MP ZL MP YZ . But this information is not readily available. The best people
to ask are those people who are least interested in providing an answer
(the producers of X). When asked, the producers of X have no incentive
to tell the government the truth about the extent of their polluting
activities. They will, therefore, provide the government with information
which underestimates the effects of their pollution. If the government
then approaches the fishermen, it will get a completely different story.
The fishermen too have no interest in the truth and they would want
to exaggerate the effect of the pollution on them. Consequently, if the
government fails to retrieve the correct information, the tax it will levy
will leave the economy at a point which is still allocative inefficient, even
though the extent of the inefficiency might be reduced.
In the case of public good, the problem is even more complex. Consider
our lone mother with her teenage daughter and the bodybuilder. If the
government wanted to find the individuals willingness to pay in order
to provide the efficient level of the public good, both the mother and
the bodybuilder have an incentive to exaggerate their willingness to
pay. Choosing the level of public good provision by equating the sum of
individuals willingness to pay with the marginal cost does not mean that
individuals have to pay what they are respectively willing to pay. If the
government cannot get a true measure of individuals willingness to pay,
the level of public good provided is unlikely to be Pareto efficient.
This points to the important role incentives play in the attainment of
efficient outcomes, particularly in the case of market failures. At this stage,
I only want to mention that economic theory has found means of dealing
with this problem. The government can design schemes in such a way
that individuals will have an incentive to tell the truth. To find out how
such schemes work, you will have to be patient and further develop your
studies in economic theory.
238
See LC, page 3, Box

1.1, for a more detailed
description of the
failures of centrally
planned economies.
Self-assessment
Define the concepts of externalities, social public costs, missing
markets, public goods, efficient provision of public goods, social
marginal costs.
Analyse problems involving pollution tax policy and information.
Give an example of:
an externality affecting the true social cost of an economic good.
239
Notes
240
Chapter 8: Aggregation and the macroeconomic problem
Chapter 8: Aggregation and the

macroeconomic problem
Learning outcomes
define the concepts of depreciation and capital formation in a closed
economy without government
illustrate the problem of aggregation, value added and the NNP=Y
identity.
Introduction
Most of the time, intellectual investigations are driven by the urge to
explain some facts. In microeconomics, we saw that the subject matter of
our investigation was economic goods: those things which are both scarce
and desirable. The facts surrounding the existence of economic goods
which we were trying to explain, like actual choices, prices, behaviour
et cetera, amount to an overall effort to explain resource allocation.
The set of economic facts around us was fairly easy to identify. We can
all recognise a price (in money terms) and we can even recognise an
exchange rate between, say, tomatoes and cucumbers.(The meaning of this
is more complex, however. After all, there are still some nagging doubts
about what a price is. In terms of which good is it measured? What is
the meaning of money? Money, and exchange rates, will be discussed in
Chapters 11 and 12 of this guide respectively.)
In macroeconomics, while some facts may still be easy to identify, it is
not at all obvious why they should require a new and separate form
of investigation. For instance, one of the most prominent facts which
have contributed a great deal to the development of an almost separate
discipline called macroeconomics, is the presence of unemployment.
However, one may argue, this should be seen as simply a problem of
labour market analysis, which is clearly in the domain of microeconomics.
Why do we need to establish a different form of investigation to analyse it?
A possible answer to this would be that there are imperfections in the
labour market which cannot be resolved simply by letting market forces
operate. But even if this the case, it is still not clear why there is a need
for a special form of investigation. Microeconomic analysis is quite
capable of dealing with imperfections, as we saw in Chapters 4 and 7.
Should the study of unemployment not be confined to the study of market
imperfections?
To some extent, the development of the separate subject of
macroeconomics reflects the exasperation with pure market analysis. The
problem of unemployment has been so severe that scholars felt that there
must be something more serious than mere market imperfection behind it.
What they really meant is that there are institutional reasons behind the
problem. Neoclassical microeconomics does not really assign an explicit
role to institutions. Switching to a level of discourse where the subject
matter is the relationships between the economy as a whole and its biggest
institution, the government, seemed like away of circumventing the
apparent deficiency of microeconomic analysis.
241
However, there are other reasons why some economists felt that
microeconomic analysis on its own is insufficient. In the model of general
equilibrium which we portrayed in Chapter 6, the role of government is
clearly confined to facilitating the achievement of the allocative efficient
outcome. However, money an extremely well-known phenomenon
played no clear role. Why is there money? Is it an argument in individuals
utility functions? Had money been a simple commodity, then we could
derive the demand and supply and could even envisage a competitive
industry for money. I am sure that all of this sounds very strange to you.
We do not really want money you may mutter to yourself, we want
the things it can buy. But money is a real fact of life, as it is scarce and
desirable. Yet, it is not really a simple commodity. Or is it?
Within the standard general equilibrium theory, we cannot find an obvious
explanation for either the origin of money or for the factors affecting
its provision. This is not to say that microeconomic tools are inherently
oblivious of money. Indeed, there are attempts to deal with such questions
in a microeconomic framework, but this is something for future studies.
In any case, when we dealt with the problem of resource allocation, it
was helpful to assume that money is a given phenomenon. But as we
know from experience, we cannot really have a complete economic theory
without explaining both the quantity of money and its effects on the
system. In addition, it is not clear how we should account for government
action in our individualistic framework of analysis. There is no doubt
that government action has an influence on the economy, but should we
consider the government as a simple rational agent? If so, what kind of an
objective function should we attribute to it and why?
Standard textbooks tend to motivate the interest in macroeconomics by
pointing to phenomena which are general to the economy as a whole.
For instance, business cycles depict the known historical phenomenon of
fluctuations in total output, which have been a major concern in recent
years. The standard static model of general equilibrium does not seem to
accommodate such a phenomenon, and explanations have been sought
outside its domain. There have also been attempts at explaining business
cycles from within micro economic analysis by further investigating the
dynamic aspects of general equilibrium. For instance, writers have been
pointing towards finance as the source of business cycles. The dynamic
aspect arises from the behaviour of individual firms and their problem
of liquidity. When firms face liquidity problems, they may not be able to
fulfil their contracts and may face bankruptcy. Naturally, a microeconomic
feature of a trough in a business cycle would be the liquidation of firms. If
we can find an explanation for this which generates cycles, we would have
a micro-theory of the business cycle.
Still, as the effects of business cycles are felt throughout the system, the
general consensus is that the solution, as well as its explanation, lies with
the analysis of the system as a whole. The universality of business cycles as
an observed phenomenon forced people who believed in the efficiency of
competitive market structures to seek an explanation outside the system.
When all markets are perfectly competitive, there should not be a business
cycle, as all shocks will be accommodated by corresponding changes in
prices. If, on the other hand, markets are not perfectly competitive, can
one explain business cycles merely by looking at the market imperfections?
242
Recent developments in microeconomic theory suggest that macro

economics doesnt need to be separate from microeconomic analysis.
It seems that we have sufficient tools to incorporate both money and
government into our micro-models. Nevertheless, at this stage of our
study, we will introduce the distinct framework of macro analysis. This will
provide you with a foundation for considering the relationship between
the micro and the macro aspects of an economy.
The problem of aggregation

The common denominator and the institution of competition
In the introduction, we discussed at some length the problem of
identifying the variables which constitute the subject matter of our
investigation. While this seems less of a problem in microeconomics (the
statement the price of tomatoes is 60p per kg is something which we
are able to verify empirically), the problem is much more pronounced
in macroeconomics. We do know what a tomato is and we can ascertain
its exchange rate in terms of other goods. Do we know what a national
product is? What is the meaning of a price level? In other words, the
problem of macroeconomics is exacerbated by the need to aggregate;
namely, to add up things which have no obvious common denominator.
How much is 5 kg of potatoes plus 23 loaves of bread?
Evidently, there is a need for a common denominator for all goods. But
if this common denominator is not neutral we might run into some
difficulties. For instance, consider a world of two goods, A and B, where
a and b are the respective quantities available. Suppose that we choose to
use good B as the numeraire, or common denominator, in which we will
measure the economy. If the value of everything produced in the economy
in terms of commodity B istwice as much in year 2 than it was in year 1,
we say that the economy grew by 100.
Let Pt = PB /PA be the price of good B in terms of A at time t. The total
product of the economy in period t will now be:
Xt = a + Pt b
Suppose now that due to a technological improvement, we can produce
more of both A and B. There are now two possibilities:
1. The technological improvement was equally relevant to the production
of both A and B. This means that their relative price will not change,
Pt+1 = Pt . The new national product will thus be
i
= (a+a) + Pt (b+b)
X t+1
where a and b represent the change in output.

2. The technological improvement was mainly relevant to the production
of A. Nevertheless, the fact that such an improvement means that the
production possibilities frontier has shifted outwards suggests that we
may increase the production of any good. Still, the price of the good,
whose production most benefited from the improvement will change
more than that of the other goods. Hence, Pt+1 will be different from Pt
and the national product will now be
X iit +1 = (a+a) + Pt+1 (b+b)
Clearly, the relationship between X iit +1 and X tI +1 can be anything, so
what has really happened to the total level of output?
243
In this example, we have used money prices and good A as a means of

aggregation. We were not very successful, because the relationship between
good A and good B through their money prices was not unaffected by the
changes under consideration. Could we instead aggregate using money
values alone? Since our interests are focused on the real economy, this may
not be very helpful. If all prices doubled (as well as individuals earnings)
surely there will be no real change in the economy. However, our index of
national product, which is based on the money value of all goods, will tell
us that output has doubled, which, of course, is not true. There are even
more complex problems with the use of money as a means of aggregation.
How neutral is money with respect to all other goods?
Nevertheless, at this stage we shall simply assume the neutrality of money.
This means that we may use the money value of goods as a common
denominator for the purpose of adding up things which have otherwise
nothing in common.
Consider an economy where two goods are produced, X and Y. The PPF in
Figure 8.1 depicts the state of the economy at time t.

Figure 8.1: The production possibility frontier.
Assuming that the economy is competitive across all industries and factor
markets, the economy will end up at a point like C, where the relative
market price reveals the true social cost. If we extend the line tangent to
point C, we get a sort of a budget line. The following equation describes
this line:
P Xt Xt + P Yt Yt = (NO)t
This means that the value of output at point C, where we produce X t units
of X and Y t units of Y is the value of all that has been produced in the
economy (the National Output). This level of output cannot be attained at
any other point on the PPF, for a given level of prices. By implication, you
can see another feature of competitive market structures: they maximise
the value of national output.
Clearly, if we double the prices of X and Y, the relative market price of
the two goods will remain unchanged. If PXt+1 = 2P Xt and PYt+1 = 2P Yt , then
(PXt+1)/(PYt+1) = (P Xt )/(P Yt ). Hence, point C will still be the competitive
outcome. However,
244
PXt+1 Xt + PYt+1 Yt = 2P Xt Xt + 2P Yt Yt = (NO)t+1 = 2(NO)t

but you can clearly see that there has been no real growth. The PPF
has not moved at all, yet the index of national output suggests that the
economy is producing twice as much.
To solve this problem, we say that using money values of goods as
their common denominator will only be meaningful if we keep prices
unchanged. For instance, let us see what would have happened in the
above story if we had measured output at the prices prevailing at time t. If
at t + 1 we still produce the same level of output for both X and Y, then by
measuring them in terms of their prices at t, we can see that nothing has
happened to national output.
Consider now the case given in Figure 8.2.

Figure 8.2: Shifting the PPF.
At time t , we are at point C where we have 100 units of X and 100 units of
Y and the prices are P Xt = P Yt = 10. Hence, the value of national output will
be: 10 100 + 10 100 = 2000. Now, there has been a technological
development which pushed the PPF outward and the economy has
moved, at t+1, to point D where 180 units of X and 80 units of Y are
produced. Has the economy grown or not?
Assuming competitive markets, we know that point D must be the point
where market prices are tangent to the slope of the PPF. Suppose now
that the price of X has risen to 11, while the price of Y rose to 14. In
current prices, the level of national output at t + 1 is: 11 180 + 14
80 = 3100. This implies growth of 55%. But this 55% increase also
contains elements of the change in relative prices. To eliminate the effects
of such changes, we must ask the question of how much more money one
would have needed to be able to buy todays output at yesterdays income.
This should sound familiar, as this was exactly the subject of establishing a
nominal equivalent to the real income effect which resulted when the price
of a good changed.
245
At yesterdays prices, to buy todays output we would have needed: 10

180 + 10 80 = 2600, which is a 30% increase from yesterday (the
broken line going through point D). Therefore, if we want to consider
money as a common denominator, we must avoid problems of relative
prices and examine changes in output against a single set of prices. In
such a case, all changes in the nominal value of output could be entirely
attributed to changes in the real output.
However, there is another problem the assumption of competitive
markets. Consider the case depicted in Figure 8.3.
Figure 8.3: Shifting PPF and imperfect competition.
CE
Figure 8.4: PPF and market imperfections.
246
We start at point A, where not all industries are competitive. Therefore,

market prices will not necessarily reflect the true social cost of production.
Now, suppose that there is a technological improvement and the economy
ends up at point B. Notice that, as competitive conditions are no longer
binding, we cannot be sure of how the new prices will relate to the new
PPF. If we measured the money value of todays output at yesterdays
prices, we will have the broken line, parallel to the line through A, going
through point B. As this broken line lies below the line that goes through
A, we can be sure that the nominal value of the output at B will be lower
than that at A. If we did not know anything about the PPF, the data would
indicate that the economy has shrunk. Yet, as you can clearly see, point
B is on a set which was not available when the economy was at A, and
there had been a clear growth in real terms (the shift outwards of the
PPF).Similarly, institutional changes alone can sometimes imply growth
although there has been no change in the economys frontier, as Figure
8.4 shows.
Suppose that Y is a competitive industry while X is produced by a
monopolist. The relative price will not reflect the real social cost and the
economy will end up at a point like A, where we produce less X than we
would under a competitive organisation of all markets (point C). The price
of X is higher than the real cost of production. If a new policy eliminates
the circumstances which allowed X to be produced by a monopolist, the
economy will move towards point C. If we measure the nominal value of
output at C in terms of As prices (the broken line through C), we will find
that the economy grew. The broken line through C is further to the right
than the line through A, which implies higher income. Since there was no
change in the PPF, this will be a wrong conclusion.
In other words, using money values as a common denominator only works
as a good measure of changes in national output when the economy is
fully competitive. Needless to say, there are very few such economies and
we must therefore be very careful in interpreting the data.
The problem with counting

The preceding section established that the only way to produce aggregate
measures is to use nominal values. We now have to look at how these
nominal values are actually added up.
Suppose that a farmer produces W tonnes of wheat a year. The baker, who
uses wheat to make bread, produces B loaves of bread a year. In money
terms, the farmer has produced the value of PWW and the baker the value
of PBB where PW and PB are the respective prices of wheat and bread. It is
tempting to calculate national output as
NP = PWW + PBB
Bearing in mind that a proportion, say , of the production of wheat was
used by the baker, some of the value of the bakers output has already
been accounted for. We call this problem double counting.
To circumvent this problem, we define the national product to be the
value added. It represents the value which has been added to goods
through the entrepreneurial endeavour of members of our society. In our
case, the national product under this measurement is:
NP = (PWW) + [(PBB) (PWW)]
247
The value added will appear in each firms balance sheet as the
difference between sales and purchases from other firms. The
balance sheet of a firm normally looks like this:
Sales
Purchases from
other firms
Depreciation
Wages
Interest
Profit
PF
DP
IN
Definition 7
Gross national product is the total sum of values added.
GNP = VA = (S PF)
But (S PF) = (W + IN + P + DP). If we now transfer Depreciation to
the other side, we get:
(S PF DP) = (W + IN + P)
or
GNP DP = (W + IN + P)
We call the expression on the left of the last equation net national
product (NNP). On the right-hand side we have all possible ways of
earning an income: labour (W), Lending Capital (IN) and ownership (P).
This represents the generated income by firms. Summing over all
units in the economy, we get the total amount of generated income. This,
in other words, is National Income, which we normally denote by the
letter Y.
Hence, we have the following relationship:
GNP DP = NNP = Y
The NNP is the total amount of resources available in the economy when
there is no trade (i.e. a closed economy). But what are the various
usages to which these resources can be put to? If, for a moment, we
consider a closed economy without a government, the only usages
possible are consumption and investment.
What is the difference between Consumption and Investment? Are
goods inherently one or the other? Not necessarily. In a wheatproducing economy, there is only one good, which can be either used for
consumption (making bread) or for investment (stored as seeds to be
sown in the next period). Thus, consumption and investment are matters
of choice. We shall come back to this later, but at present we simply look
back at our economy and we ask what people have done, rather than
what they will do.
We can therefore say that the NNP, the output available in the economy,
has been used for Consumption (C) and Investment (I).
NNP = C + I
What do people do with their income? Either they use it for consumption
or they store it in the form of savings. Hence:
Y=C+S
Bearing in mind that NNP = Y we get:
C+I=C+S
or
I=S
248
which means that actual investment always equals actual savings. This
last equation is an important one, as it tells us about the way capital is
formed. After all, those things which we refrain from consuming now
may be used as means of production in the next period. By increasing the
means of production, we increase the potential output of the economy.
If investment the flow of new capital goods is greater than the rate
of depreciation (i.e. the amount of capital (machines) which became
unusable during that period), total means of production for the next
period will be greater. This would mean an expansion of the production
possibilities frontier, i.e. growth. If, however, the amount of investment
the flow of new capital goods is less than what is required toreplace
the capital which became unusable, total means of production for the next
period will decrease. This would mean a contraction of the production
possibilities frontier, and the economy will be declining.
What will happen if investment equals the rate of depreciation?
This chapter dealt with the basic problem of aggregation, the meeting
point between microeconomic analysis and macroeconomic considerations.
The discussion of how to account for national output will provide the
foundation for our discussion of macroeconomic analysis in the next few
chapters. The basic point to remember is that much of macroeconomics
is about accounting for flows of goods. We saw that national income can
be used for either consumption or savings, while national output can be
used either for consumption or investment. In the next chapters, we shall
extend this basic accounting by introducing more players into our game.
249
Notes
250
Chapter 9: The determinants of output

Learning outcomes
define the concepts of general equilibrium, Shys Law, and the
Schumpeterian hypothesis.
Reading
Note: The material in this chapter is not directly examinable.
Its purpose is to offer interested students a better
understanding of some of the current debates as well as a
contextual framework for the chapters that follow.
If you are not quite sure whether you have gained sufficient
mastery of microeconomics, you may skip this chapter and
come back to it later on. You may, if you wish, not come back
to it at all before the examination, but I do recommend that
you read it sometime in the future.
The previous chapter investigated one of the most important objects
of macroeconomic analysis, national income. Given the difficulties in
identifying and quantifying the aggregate level of national economic
activities, we opted for a pecuniary definition, on the assumption that
money has characteristics different from all other economic goods. This
allowed us to define national product as the sum of all values added.
As a corollary, the sum of all values added is also the sum of all income
generated within the economy. This, of course, has put national product
at the heart of our concerns. Income determines our well-being. Being
able to understand what determines its level and what affects its progress
(i.e. growth) becomes one of the most crucial questions for economics in
general and for macroeconomics in particular.
At the same time, we also know that in real terms, output is created by
means of production like labour and capital. Without going into the details
concerning the possible effects which growth may have on input mix, it
is clear that the level of national product and its change over time could
also tell us something about employment. In a world where labour is one
of the main mechanisms by which people receive a share of social wealth,
the development of the level of employment over time is another factor
affecting our well-being.
It is worth noting, however, that the well-being of an economy is a far
more complex subject, depending on much more than the mere aggregate
level of national income and employment. Income or wealth distributions,
for example, clearly have an impact on the benefits which can be derived
from any given level of national income. For instance, if ownership of
corporations was more broadly and evenly spread, the impact of the
employment level on the well-being of society would decrease. If the
income of all citizens was derived from both ownership and labour,
unemployment would not necessarily deprive people of their ability to
extract a reasonable share of the national income.
Alternatively, a government redistribution of income by some means not
related to the ownership of factors of production (say, universal benefits)
could influence the well-being of a society as well. An economy with a
251
lower level of national income, but some government redistribution, might

well generate greater well-being than an economy with a higher level of
national income, but no redistribution.
Obviously, the existence of such alternative institutional arrangements
does not reduce our interest in the determinants of national income.
Regardless of the institutional arrangements, we would always prefer a
higher level of national income.
In some of the more advanced courses in economics, you will consider the
impact that particular institutional arrangements might have on the level
of national income that can be achieved. Before we can look at this issue,
we have to have a clear understanding of the determinants of national
income for any given institutional structure. In this course, we will assume
the same structure we have worked with so far, namely a more or less
competitive framework.
Indeed, most economics textbooks present supply and demand as the main
determinants of national income. This, however, is just a logical extension
of the competitive framework. Other institutional structures might rely on
mechanisms other than supply and demand for determining allocation and
distribution of national income. This would then require other analytical
tools to determine the level of national income. However, within the
competitive set up, the question of what determines output really comes
down to whether the level of output adjusts to fit the level of demand or
whether it is determined by the wishes and considerations of producers.
Further reading
Those who wish to read more about the economics of unemployment
should consult:
Snower, D.J. and G. de la Dehesa (eds) Unemployment Policy: Government
options for the labour market. (Cambridge: Cambridge University Press,
1997).
Cross, R (ed.) The Natural Rate of Unemployment: Reflection on 25 years of the
Hypothesis. (Cambridge: Cambridge University Press, 1995).
Says Law and general equilibrium

While Adam Smith is commonly seen as the founder of the independent
discipline of economics, most people will argue that he did not consider
macroeconomic issues. However, while it is true that Smith did not focus
on money or unemployment, he certainly did consider the crucial question
of the determinants of national income.
Adam Smith opens his The Wealth of Nations with the claim that national
income is the produce of the nations labour or that which has been
purchased with it from other nations. However, he goes on to say, the
quantity of it depends on (a) the skill, dexterity, and judgement with
which its labour is generally applied and (b) on the proportion between
the number of those who are employed in useful labour, and that of those
who are not so employed.
Put differently, according to Adam Smith, the level of national product
depends on both demand and supply. Supply is determined by the way
in which labour is organised, which we might call more generally the
circumstances of industry. The determinants of demand, according to
Smith, are given by the demand for different employments.
252
For instance, assume a landowner has a supply of wheat available at the

end of the year. He can use this wheat to hire labour to work in his fields and
produce more wheat, or he could hire people to entertain him or become his
servants.
If he uses his entire stock of grain for entertainment or servants, he cannot
hire any more workers for his fields. This means that the total amount of
wheat produced in the economy in the next period will be smaller. On the
other hand, if he used most of his stock to hire more workers for his fields,
the amount of wheat produced next period will be greater.
In other words, the same stock of means of production can produce
different levels of national income, depending on how it is used. Smiths
distinction between productive and unproductive labour (field workers
versus entertainers) is no longer generally accepted. However, he did draw
a valid distinction between demand for consumption and demand for
investment.
The main difference between Smith and the modern version of demanddetermined output is that in the latter case, the determination of output is
associated with unemployment. In Smiths case, labour is fully employed
and wages are flexible. More specifically, Smith considered the total
demand for labour as unaffected by its internal composition.
J.B. Say, one of Smiths followers, did consider macroeconomic issues
explicitly and pioneered macroeconomic analysis. His book, Trait
deconomie politique, ou simple exposition de la mannire dont se forment, se
distribuent et se consomment les richesses, was published in 1803. Drawing
on an implicit notion of general equilibrium, where all markets (including
the labour market) clear, Says main claim concerning the level of national
income is the famous Says Law which has been popularised as supply
creates its own demand.
Says main insight was that the process of production itself generates
income, from which demand is derived. Therefore, a situation of
overproduction is impossible. If you produce more, you also generate
more income. This will increase demand, maintaining the equality of
output and quantity demanded.
Such an overall equilibrium does not, of course, preclude excess demand
or supply in individual markets. Say argues that demand for each
commodity is generated by the overall production process. If there is a
commodity in excess supply, then there will be another commodity in
excess demand.
In the context of a barter economy, this may sound quite simple and
intuitive: people bring their produce to the market, and exchange it for
the produce of others. Hence, supply determines consumption. Says Law
is a bit more sophisticated than this, making the additional connection
between production and income generation explicit. This means that it is
applicable to a non-barter economy as well.
I hope you can see the relationship between the discussion of Says Law
and our analysis in the previous chapter. In that chapter, we defined
national income as the sum of value added. It is hence the same as the
generated income. This, to an extent, is what Say argued. However, he
made an additional point. Since national income is equal to generated
income, demand (say, for consumption and investment) will always be the
same as the value of what has already been produced.
This discussion, however, has ignored the time dimension of national
income. Smith argued that the total demand for productive and
253
unproductive labour will be a function of the amount of wheat produced

in the previous period. In this sense, supply determines demand. However,
supply only determines the amount of demand, not its composition.
How demand is split between productive and unproductive labour (in our
earlier example) is decided by the landlord. However, this decision will
influence the amount of wheat available in the next period: Demand (or
rather, demand composition) determines output. This would seem to
provide us with a time dimension.
Says Law, on the other hand, says that since there cannot be
overproduction, output will determine demand. This idea is closely linked
to that of clearing markets and the notion of general equilibrium. There
is no scope for demand influencing output in some future period, and the
theory hence lacks a temporal dimension.
This means that general equilibrium, as we presented it, will also lack a
temporal dimension, and will thus not be able to tell us anything about the
development of national income over time. In Chapter 8 we discussed
whether there was a need for the special discipline of macroeconomics. We
argued that, apparently, we didnt need it since general equilibrium theory
already captured the whole economy. However, once we considered the
presence of money in the economy, we had to either find an extension to
general equilibrium theory or a separate discipline of macroeconomics.
In this chapter, we are concerned with the determinants of national
income, which is firmly in the domain of the real economy. As we argued,
the real economy seems to be well captured by general equilibrium theory.
We now examine what general equilibrium theory has to say about the
level of national income. We will see that while it seems to conform to
Says Law, some results will suggest the necessity to introduce a temporal
dimension to our theory. We will argue that this justifies macroeconomics
as a separate discipline.
Consider an economy where only two commodities are produced, X and
Y. Assume that both are produced using just one means of production
labour. The productive technologies are given by X = f(LX ), y = g(LY),
where LX and LY represent the amount of labour employed by industries X
and Y respectively. Let L be the total amount of labour available. Assume,
for simplicity sake, that this labour supply is fixed. Hence, LX + LY = L.
Let us begin at an initial position where all markets (for X, Y and labour)
are in equilibrium (Figure 9.1).
254

Px
Py
x
MC (W0 )
y
MC (W0 )
P 0y
P 0x
x
D (P0y ,I )
X0
y
D (P 0x ,I )
Y0
W
P
W0
P0
P 0x
P 0y
MP
L
X0
Figure 9.1: General equilibrium in a two-good economy with one factor of

production.
We can find the potential of the economy (its level of real output) by
looking at the PPF. At the competitive equilibrium C, the national product
is NP0. = P 0X X0 + P 0Y Y0.
Note that we used real wages in the labour market diagram. This means
that we have to divide the nominal wage rate by the price level. However,
note that the price level is really an aggregate price P0 , which will be given
by a weighted sum of P 0X and P 0Y . This also implies that the demand for
labour is an aggregate marginal product. Since the area underneath the
demand for labour is the sum of aggregate marginal product of labour,
it represents the total output. Provided we use the correct weights to
determine the price level, the area will be equal to (NP0 )/P0 . This, of
course, is real output.
How is this real output split between labour income and profits? Since
the equilibrium level of wages is w0 /P0 , and there is a total of L0 units of
labour employed, total labour income through wages will be (w0 /P0 ) L0 .
The rest of the area underneath the demand schedule (i.e. the rest of the
national product) is thus the profits (or return to capital had there been
capital in our story), which are a form of income as well.
This seems very straightforward, and we have found a clear expression
for national product, as well as the division of income between labour
and profits. Let us now look at the effect of a change in demand for X
and Y. We will see that this will cause some problems within this general
equilibrium framework.
255
Px
Py
x
MC (W1)
x
MC (W0 )
P 1x
B
MC (W1 )
P 1y
MC (W )
0
Px
Py
Px
Py
x 0
D (P y,I)
X0
D (P 0x ,I)
Y0
W
P
x
MC (W )
0
Y 11
Y0
A=C
P 1x
P 1y
P0
x
P 0y
P 1x
= 1
Py
A=C
W1 W0
=
P1 P0
P
W0
P
MPLA
X 11
X0
Figure 9.2: A change in tastes.
Consider an increase in the demand for X. This will increase the price of
X. Other things being equal (notably, income and prices), this can only be
due to a change in individual tastes. Recall, however, that tastes are always
defined over the complete set of commodities. Therefore, the increase
in demand for X will also have an effect on the demand for Y. Whether
this demand increases or decreases will depend on whether the goods
are complements or gross substitutes. Assume that the goods are gross
substitutes. This will increase the demand for Y, since the price of X has
increased, leading to the changes shown in Figure 9.2.
As demand for X and Y increases, their prices will begin to rise. This
will reduce real wages W/P, which makes labour cheaper as a factor of
production. Since profit maximisation implies that factors of production
should be employed up to the point where their marginal product equals
their cost, demand for labour will increase to point B.
However, as the supply of labour is fixed, this will lead to excess demand
for labour at the initial level of nominal wages, w0. The competition for
workers will cause nominal wages to rise, until we return to the original
point A. Nominal wages have risen sufficiently to compensate for the
increase in the aggregate price level, caused by the increase in the prices
of X and Y.
This will cause the supply curves of X and Y to shift to the left, since
marginal costs are now higher at every price level, given the increased
nominal wages. This will cause excess demand for both goods at point B,
and prices will rise further. This will lead to a second round of falling real
wages, which in turn will lead to another increase in nominal wages.
256
Where will the new equilibrium point be? To determine this, we have to
clearly identify the process leading to an equilibrium. Prices in the markets
for both X and Y are rising. The first round of rises was due to the demand
pull, after which we have further increases due to the increase in nominal
wages. However, recall that our goal is to see what happens to national
output.
In principle, we can distinguish two possible outcomes. If the new
equilibrium point C lies directly about A in the markets for X and Y, the
allocation of labour to production will remain exactly the same, and the
composition of total output will remain unchanged. Another possibility
is that the output composition changes, for example point C' in the PPF
diagram, where we produce less X and more Y.
Which of those two outcomes will emerge will depend on how relative
prices change. We can analyse this change using our excess demand
analysis (see Chapter 6). Again, two possible outcomes emerge (Figure
9.3).
Py
x
1
ED =0 ^ x
Py
ED =0
^ y
ED = 0
C
Py
ED =0 ^ x
ED =0
^ y
ED = 0
C
ED = 0
0
ED = 0
0
Py
Py
P 0y
P 0y
P 0x
P 0x
Px0
Px1
P 1y
P
Px0
Px1
1
x
Figure 9.3: Changes in relative prices: the excess demand analysis.
Given any price of Y, the initial increase in demand for X will lead to
a higher equilibrium price for X. This will cause the ED X = 0 curve to
shift to the right. A similar argument applies to Y, and ED Y = 0 will shift
upwards.
Furthermore, the increase in wages will reduce the supply in the markets
for x and y at any given price. This will further shift the ED = 0 curves.
Hence, equilibrium in the market for X, given a price of Y, will occur at
a higher price of X. Consequently, the new general equilibrium will be
reached at a point C. Again, we will have a similar effect in the market
for Y.
The diagram on the left represents the case where relative prices (the
ray from the origin) have not changed. This means that the increase in
demand will have no real effect on the economy. We will remain at the
same point on the PPF (C = A), where the slope of the PPF equals the
(unchanged) relative prices. The equilibrium level of real wages will
remain unchanged as well.
The diagram on the right captures the case where C' is at the point
where the ray from the origin has a higher slope. This means that
P 1X /P 1Y < P 0X /P 0Y . Therefore, C ' on the PPF will lie to the left of A.
However, real wages in the labour market will remain unchanged. The
change in relative prices will lead to a different aggregate price level.
This means that nominal wages will have changed by an amount that is
257
different from that in the case of constant relative prices. Regardless of the
magnitude of change in the nominal price level, however, neither demand
for labour (which is a function of labour productivity) nor the supply of
labour have changed. This means that equilibrium in the labour market
stays the same, so real wages have to remain constant as well. Note that
we assume that the change in tastes will not affect individuals leisure
preferences.
It would seem that general equilibrium theory supports Says assertion that
changes in demand will not affect the level of nation income. We can see
this from the fact that the PPF itself has not changed. Alternatively, we see
that the area under the labour demand curve (which is equal to aggregate
output) has not changed. Hence, total output is the same at both A and C.
However, this is not the whole story. Consider, for example, a change in
tastes which affects not only the demand for goods, but also the supply of
labour. This would affect the equilibrium in the labour market, and hence
change the total level of output.
How can the supply of labour change? What is the meaning of full
employment? We have assumed that, out of the total number of hours people
have, some are made available for labour, the rest is used for leisure. This
is consistent with the microeconomic definition of full employment: Full
employment occurs at every equilibrium amount of labour supplied, since
people choose to make that much labour available. Therefore, a change in
tastes which increases the demand for goods, might also increase the demand
for employment, making leisure less attractive. This will increase the supply
of labour, and hence the equilibrium amount of labour supplied.
In turn, this will lead to a shift in the PPF, reflecting an increase in the
total amount of resources available to the economy. Note that we have
assumed a vertical supply of labour throughout. The problem becomes
more complex with an upward sloping supply of labour, but we shall come
back to this point later.
There is another reason to question Says Law, even within the context of
general equilibrium. It is more in the spirit of Smith, as well as Keynes.
In our example above, the exogenous increase in the demand for X and
Y, keeping labour supply constant, will not have any effect on the level
of total output. It might, however, affect the equilibrium allocation of
factors of production (point C in Figure 9.3). Following Smith, we now
ask whether the composition of demand might influence output. If the
allocation of factors of production changes in response to the increase in
demand, the demand for labour composition will change as well. How
might this influence output?
Let us modify our story a bit. Suppose that goods X and Y are produced by
two types of inputs: machines or capital K, and labour L. Furthermore, let
good X be investment goods (the machines M used for production), while Y
is a consumption good C. This distinction does not exist within neoclassical
economics. Goods become investment goods or consumption goods only
through the use which individuals choose to put them to. Nevertheless,
for the sake of exposition I will assume that one can distinguish between
the two types of good in this way. Good X can only be used for production
purposes, while good Y can only be used for consumption.
We can now restate our model, incorporating the above assumptions:
1. Goods: The economy produces two goods, C and M, which have
distinct uses.
258
2. Technology: C = f(L,K); M = g(L,K), where f and g are production

functions. We will return to the properties of the production functions
later.
3. Scarcity: The amount of labour available is fixed at L, but the amount
of capital may change across periods.
Let Kt be the amount, or stock, of capital at time t. Every year, there is a
certain proportion of those machines which ceases to function. Let be
the rate of depreciation of the stock of capital. This means that in
any year t, the quantity of capital available is reduced by Kt machines.
Figure 9.4 depicts the PPF of the economy at time t.
C
C0
PPF(K t )
M0
Figure 9.4: The PPF at t, with a capital stock Kt .
Suppose that initial equilibrium is at point A. Here society chose to

produce Ct = C0 units of consumption goods and Mt = M0 units of capital
goods (i.e. investment). Since investment increases the capital stock, the
capital stock at t will be given by
Kt = Kt1 +Mt Kt1
which means the new stock of capital is the old stock of capital plus the
new machines, minus those machines which have gone out of service. We
can also calculate the change in the capital stock, which will simply be the
difference between the capital stock at t 1 and that at t. It will depend
on the balance between the flow of new machines and the flow of old
machines going out of service:
The stock of capital (the available resources) will increase whenever

the quantity of capital goods produced (investment) is greater than the
amount of machines which are taken out of service (depreciation). When
Mt is greater than Kt1 , the stock of capital will increase. Since there is
more capital available, the feasible production set of the economy will
increase. Hence, the PPF will shift outwards.
259
PPF(K t+1)
C0
C0
PPF(K t+1)
PPF(K t )
M0 M *
PPF(K t )
M*
Mo
Figure 9.5: Changes in the capital stock and the PPF.
Given our definition of the capital stock, we can find a level M* such that
the change in the capital stock is equal to zero. It will be given by M* =
K. If the economy produces M* new machines, the stock of capital will
remain just constant.
The left-hand diagram depicts an equilibrium point C where the
production of M is less than what is lost through depreciation: MC < M*.
Hence, the stock of capital available in the next period will be smaller than
todays. The PPF of the economy will shift inwards, and point C will no
longer be feasible.
The right-hand diagram shows the case where we produce more M than
is necessary to replace the depreciated capital: MC > M*. Therefore, the
stock of capital will increase, shifting the PPF outwards.
This discussion was slightly simplistic, since we did not model the choice
of the economy explicitly. However, we have shown that a change in
demand composition might influence the availability of resources. This,
in turn, might influence the level of income. This, of course, makes Says
Law problematic. As we will see, investment will play a major role in our
macroeconomic analysis.
Output and markets

The notion of general equilibrium lies at the heart of Says Law and
the supply determines demand approach. We have just seen that this
approach is not always correct. It might be true that an exogenous
demand pull will have no real impact on the economy (our first example).
However, there are circumstances where relative prices change, which
will change the demand composition. If different goods produced in the
economy have different uses, a demand pull might influence national
output (our second example).
Indeed, some criticisms of Says Law are based on exactly the same
principle. While it is true that in a barter economy, there cannot be excess
demand or supply in any market, this is not true in a monetary economy.
Even if aggregate overproduction is not possible, as income is generated
by the production process, we may still have excess demand in one market
and excess supply in another.
In simple terms, assume a barter market in bread and milk. The total
amount of milk cannot be exchanged for more or less than the total
amount of bread available in the market. In a monetary economy, on the
260
other hand, you always have the option of not spending all the money
you have brought to the market. Therefore, even though there will be no
excess demand or supply in terms of goods which have been brought to
the market, there may be pecuniary excess demand or supply.
In terms of consumption and investment, Says Law seems to imply that
people do what they had planned to do. Namely, their consumption and
investment plans are directly derived from their national income, and total
consumption and investment is just equal to national output.
In a barter economy, this might well be true (even though we have
established a counter example above, following Smith). In a money
economy, it is possible that the plans of individuals will not coincide,
leading to a change in relative prices. This will change the demand
composition, and hence national output. Therefore, even if demand
composition in itself cannot influence output, a change in it will.
There is, however, a much more serious problem with Says Laws
dependence on a competitive general equilibrium. This is the problem of
the relationship between market structures and economic performance.
The model we have described in Section 9.1 is basically a competitive general
equilibrium. The claim that demand will not affect output is clearly made
within competitive market structures. This raises two important questions:
a. will demand influence output when markets are not perfectly
competitive?
and
b. if so, should government policy focus on promoting competitive
structures rather than demand management, since demand management
will become ineffective as we move towards perfect competition?
The answer to question (b) is very difficult. It requires a proper
examination of both the feasibility of achieving a fully competitive
allocation (see the comments in Chapter 7 concerning externalities and
missing markets) and of the desirability of trying to approach it. We will
not deal with this question here. Instead, we will look at another aspect
of the relationship between competitive markets and the determinants of
output, focusing on the supply side.
Technological improvements
According to Says Law, demand will have no effect on national output
in a competitive setting. We have examined the validity of this statement
in the previous section. We now look at the kind of influence competitive
market structures have on the level of output. Put differently, if it is the
circumstances of industry which determine the level of national income, is
perfect competition the best form of organisation?
The competitive allocation is at the point where relative prices represent
the social cost (i.e. the slope of the PPF is the same as relative prices).
Therefore, it achieves the highest feasible level of national income at these
relative prices (see Chapter 8).
However, as we have seen in the previous section, the position of the
equilibrium allocation (and hence the demand composition) might
influence the PPF over time. This means that if the competitive allocation
is such that the change in the capital stock is positive, the total amount
of capital, or machines, will increase. This will enable the economy to
produce more of all goods.
261
In fact, the position of the PPF can be changed by another factor,

technology. Technological improvements will enable the economy to
produce more for any given stock of capital. This will push out the PPF
and thus increase national output and income. This effect is immediately
apparent in our aggregate labour market representation of national
income, as Figure 9.6 shows.
W
P
B
W0
P0
MP AL
MP AL
L
Figure 9.6: The effect of a technological improvement on the labour market.
Recall that the demand for labour curve is derived from the equality of
real wages and the aggregate marginal product across all industries. A
technological improvement will increase the marginal product of labour.
Hence, employers are willing to pay higher real wages for each unit of
labour, and the aggregate labour demand curve will shift up.
Recall that the area underneath the labour demand curve represents total
output (the shaded region at A). Therefore, a technological improvement
will increase national output.
Learning by doing
How can technological improvements be achieved? Perhaps the most
obvious way is Learning by Doing. Doing a job repeatedly is likely to
make us better at doing it. We might find a better way of doing it (i.e.
innovation) or we might simply become more productive through routine.
This is the sort of technological improvement which, since the days of
Adam Smith, has been associated with the division of labour. (In fact, the
importance of the division of labour had been recognised many years before
Adam Smith. Both Plato and Aristotle acknowledged the significance of
the division of labour. However, in Platos work, this was a much broader
concept of social division of labour along the line that some people are
good at different things and they should do that which fits their character.
Aristotle, who discussed division of labour within the household is nearer
to Smith in concept, but still has not gone far enough to see a task-based
division of labour the way Adam Smith did.) Splitting the task at hand into
smaller sub-tasks enables us to get more routine in doing the sub-task.
However, the degree to which labour productivity can improve through
learning by doing is very limited indeed. After some point, increasing the
marginal product of labour through technological improvements requires
more knowledge and greater investment.
262
Research and development (R&D)

One way of finding technological improvements is to invest in R&D. This
represents a more systematic search for improvements to the marginal
product of labour. As technology becomes increasingly sophisticated, it
takes a great deal of research to produce an improvement in the marginal
product of labour. This means that we have to use some labour to
exclusively work in R&D, for which we have to have funds available.
However, making those funds available (or investing in R&D) does
not guarantee a technological improvement. Our researchers might
well find that their research is not fruitful. If they are successful, the
initial investment will increase the marginal product of labour. This will
reduce the marginal (and average) cost of production, giving the firm
a competitive edge (see Chapter 4, Question 6 for an analysis of such a
competitive edge).
Earlier this century, a famous economist called Joseph Schumpeter, raised
an interesting question. If R&D is needed in order to increase labours
productivity (and thus increase national output) will the perfectly
competitive organisation of markets be conducive to such investments?
Recall from Chapter 4 the characteristics of a perfectly competitive
industry. Notice that among them is the assumption of perfect information
and perfect factor mobility. On the consumer side, this means that
everyone knows all the prices, and can switch from an expensive seller to
a cheaper seller costlessly. On the producer side, it means that everyone
can access any available technology and adopt it without any cost. Hence,
if a certain firm invests in R&D and discovers a technology yielding higher
labour productivity, it will not have the means to prevent other firms
from using it. Consequently, the competitive edge will only be a short-run
phenomenon.
When a firm invests in R&D and succeeds in reducing its costs, it will
make profits above the normal in the short run. In the long run, however,
other firms will adopt the same technology and profits will return to their
normal rates. This raises a question of incentives. Why should any firm
invest in costly R&D if it knows that any technological breakthroughs will
be available to all firms, leaving the long-run profits at their normal rate?
The answer depends on three things: firstly, it depends on the relationship
between the size of the required investment and the fall in costs obtained.
Secondly, it depends on how much more profit above the normal can be
made in the short run. Finally, it depends on the length of the short run
or, in other words, on how long it takes the other firms to obtain and
adopt the new technology. This, as you can imagine, makes the decision
whether to invest in costly R&D very difficult, if it cannot guarantee a
significant reduction in cost. There seems to be little incentive to a firm
in competitive markets to invest in R&D. It would be a better strategy to
sit and wait for someone else to put up the funds for the research that is
needed.
However, incentives are not the only problem with R&D investment
by competitive firms. We also have to look at the availability of funds.
Competitive firms make little, if any, profits above the normal in the long
run. Most profits will be used simply to pay the lenders and owners a
rate of return which is equivalent to what they could have received had
they invested their funds elsewhere. This means that there are few funds
available to invest in R&D.
263
A monopolist or a firm in monopolistic competition, on the other hand,

is likely to have both the funds and the incentives to invest in R&D.
The profits of the monopolist are significantly above the normal rate,
generating funds to finance R&D to further reduce the marginal cost. The
incentive to undertake R&D exists, since R&D might further increase the
monopolistic power, preventing other firms from entering the market. In
the extreme, R&D can become a barrier to entry for other firms.
The Schumpeterian hypothesis the essence of which we have just
described has far-reaching implications. It has effects on efficiency, as
well as the determinants of output.
Can we say that a competitive market is efficient, if its intertemporal
effects are worse than a more monopolistic market structure? While it
is true that a competitive structure leads to a productive and allocative
efficient solution at any given point in time, it also leaves the PPF, and
hence output, unchanged over time. If the Schumpeterian hypothesis is
right, a more monopolistic market structure might produce an allocative
inefficient solution today, but might lead to increased output tomorrow.
This might more than compensate for the welfare loss today.
The Schumpeterian hypothesis also has important implications for the
determinants of output. If the hypothesis is correct, then a social structure
where demand does not determine output (and hence Says Law holds)
also has the feature that the circumstances of industry (the supply side)
do not allow for a change in output. In other words, real national output,
or the PPF, will be independent of market structures. Competitive market
structures might produce a higher nominal national income, but this has
little real significance, as we saw in Chapter 8. Hence, it is not even true
to say that supply determines demand. Additionally, if the outcome of a
particular social structure influences neither investment nor technological
improvement, then the statement that supply creates its own demand
becomes questionable.
You will see later on that actual investment in an economy is also
dependent on net imports. Increased competitiveness relative to other
economies will serve to boost export and national income. It is, however,
not clear how this will affect investment as it reduces net imports while
increasing private savings.
Having said all this, we must bear in mind that the Schumpeterian
hypothesis has been neither confirmed nor rejected. I have merely used it
to demonstrate the sensitivity of the supply determines demand approach
to institutional questions.
So far, we looked at the relationship of demand and supply to national
income in the context of competitive market structures. This gave us some
insight into question (b) above whether demand management becomes
ineffective as we approach perfect competition as the social structure.
We now turn to question (a) whether demand influences output
when markets are not perfectly competitive. If this is the case, demand
management might be effective.
Market imperfections and unemployment

We argued above that real national output is captured by the PPF. The
PPF depended on the labour supply, the capital stock and technology. We
make one change to our set-up, to allow for some market imperfections.
Instead of a vertical labour supply curve, we now assume the more
familiar upwards-sloping curve.
264
This will allow us to introduce imperfections in the market, which will

lead to unemployment, or under-utilisation of available resources for
production. By studying the relationship between labour supply and the
PPF, we can then say something about the relationship between market
imperfections and national output.
W
P
SL
W0
P0
Y0
MP AL
PPF(L o)
X0
L0
Figure 9.7: An upwards-sloping labour supply curve, the labour market and the PPF.
An upwards-sloping labour supply curve means that the supply of labour

will be different for each possible equilibrium in the labour market. This
means that the amount of resources available for the economy will depend
on the structure of the labour market. In the above diagram, we see that
when markets are competitively organised, the supply of labour will be L0.
Suppose now that in this world of two goods (X and Y), Y is produced in
a competitive market while X is produced by a monopolist. Recall from
Chapter 5 that the demand for labour for a competitive firm must satisfy
the following condition:
w = PY MP YL
The wage paid to workers is equal to the revenue contributed by the last
unit of labour employed. The monopolist producer of X, who hires labour
in a competitive market, will also want to pay workers the value of the last
units contribution.
In real terms, the contribution of the last unit is the marginal product of
labour, while the nominal wage is given by w. However, while each unit
of output in a competitive firm increases revenue by its price, it will only
increase it by marginal revenue for a monopolist. Hence, the monopolist
profit maximising condition for hiring labour will be:
w = MRMP XL
W
W
S1
B
A
A
P xc MPLx
Py MP Ly
L 1y
L 0y
Ly
PMPLA
MR MPLx
L 0x
L 1x
P MPLA
Lx
L0
L1
Figure 9.8: Labour demand: competitive firm, monopolist, and the market.
265
The left-hand side of Figure 9.8 depicts the demand for labour by the
competitive industry, the diagram in the middle depicts the monopolists
demand while the diagram on the right depicts the labour market in full.
Note that we plot nominal wages on the vertical line. Hence, the demand
for labour is really the value of labours marginal product.
If we had remained with our assumption of a vertical labour supply curve,
there would have been no effect of market structures on national output
or the PPF. However, an upwards-sloping labour supply will cause market
structures to affect the PPF.
Equilibrium in the labour market, with X produced by a monopolist, while
Y is produced competitively, will be at point A, with L0 labour employed.
There will be a corresponding PPF, as discussed earlier.
Note that the marginal revenue for the monopolist is less than the price
that would have been obtain had X been produced competitively as
well. (Do not confuse this with the monopolist price being greater than
the competitive price.) This means that the demand for labour by the
monopolist is lower than it would have been in a competitive industry. The
competitive demand in the X market is indicated by the broken line in the
graph above, together with the market demand line that would have been
obtained. Clearly, overall demand for labour would have been higher if X
had been produced competitively.
This will lead to an increase in nominal wages, which in turn will increase
the marginal cost of Y. On the other hand, if X and Y are gross substitutes,
the move from a monopoly to a competitive market in X will lower the
price of X, and hence reduce demand and price for Y. This will offset
the effect of the increase in marginal cost of Y. We will therefore assume
that the demand for labour from industry y will remain unchanged.
(If the marginal cost of Y more than offsets the fall in the price of Y,
the MPYL curve might shift upwards. This, in turn, will shift the total
labour demand, leading to a further increase in total amount of labour
demanded.)
Altogether, demand for labour will now be the broken line in the righthand diagram and equilibrium will be at point B, where L1 is the total
labour employed.
SL
A
B
B
Pxc
Pyc
Px
c
Py
VMPL
V MPLA
PPF(L0 ) PPF(L1 )
L0
L1
Figure 9.9: Making the X industry competitive: The effect on the labour market
and the PPF.
The increase in the area underneath the aggregate demand for labour
curve will tell us little about national output, since the area now denotes
266
the monetary value of marginal product. However, the total amount

of labour employed is clearly greater at B than it was at A, when one
industry was not fully competitive. Hence, the PPF associated with B must
lie above the PPF associated with A. In this sense, Says Law is correct
in suggesting that the circumstances of industry will determine the level
of output. However, increases in demand will also affect national output
through the upwards-sloping labour supply curve. (Recall the diagrams in
Section 9.1).
MC (W1)
MC (W1)
x
MC (W0)
MC (W0)
Px0
Py0
^ x ( )
D
^ y ( )
D
D (P y I)
X0
D (P x I)
Y0
X1
Y1
Y
SL
PPF(L1)
Y1
Px1
Py1
A
Y0
W1
W0
B
A
Px0
Py0
PPF(L 0 )
X0
X1
VMPLA
VMPLB
L0 L1
Figure 9.10: Increases in demand and an upwards-sloping labour supply curve.
An increase in demand for both X and Y will cause an increase in the

equilibrium supply of labour, since demand for labour will shift upwards.
Consequently, the PPF will shift outwards and national product will
increase. Much of our discussion so far crucially depended on our exact
definition of the PPF. More specifically, we have to define the difference
between potential output, which is a function of the stock of labour
available, and actual output, which is an equilibrium notion. As it turns
out, this difference plays a major role in the analysis of unemployment.
If we assume the PPF to be an indication of the potential output in
the economy, then most equilibrium output levels of the economy will
lie inside the PPF, since an upwards-sloping labour supply means that
some labour resources will not be utilised.
However, this output level, which is less than the potential output level,
is associated with an equilibrium in the labour market. This means
that everyone who wanted to work at the given wage rate has found
employment. Any unemployed resources that remain simply did not
want to work at the given wage level. Should we consider such people
unemployed? If we do not, we have to reassess our definition of the PPF
267
and potential output. What is the available stock of labour? Should we

include all adults between the ages of, say, 16 and 65? In that case, do we
assume that all adult members of a household should be employed? Or
should it just be one of the partners? What about single people or single
parent families?
Such considerations are unnecessary in an equilibrium framework. We
simply know that those people who wish to work will find work. They,
for all intents and purposes, represent the stock of labour available. This
means that any unemployment observed in an economy captures just
those people who could have been in the labour market at the equilibrium
wage rate, but chose not to participate. We call the proportion of these
people in the total labour force the natural rate of unemployment.
Note that the exact meaning of this term is still under discussion in the
academic literature.
This leads to one of the most intriguing questions in economics. An
equilibrium implies the coincidence of rational plans. This means that the
decision of some individuals not to seek work at a given wage rate must
be rational. However, this seems counter-intuitive, when there are clearly
people who are not employed but should, rationally, seek employment.
There are two possible answers to this, which maintain rationality. First,
people might have alternative sources of income (owning a lot of assets,
for example) and hence do not need to work. Secondly, they might have
just finished one employment and are between jobs, moving cities, or
in training. Their failure to seek work is sometimes called voluntary
unemployment.
However, most unemployed do not seem to fit either of those categories.
They do not have alternative sources of income (apart from any state
benefits), and many of them have been unemployed for considerable
amounts of time. Therefore, it seems that there is some imperfection
in the labour market itself, which prevents the economy from reaching its
proper competitive equilibrium.
This imperfection is unlike that produced by an imbalance between buyers
and sellers (like the case of a monopolistic industry). In such a case,
people would be seeking jobs at the current wage rate, but would simply
be unable to find them. This is called involuntary unemployment,
and we will return to it shortly.
The kind of imperfection we have in mind right now is more closely
related to missing markets, or externalities, which we discussed in
Chapter 7. The labour market clears (all people seeking jobs at the current
wage rate find one), but the outcome is inefficient.
What kind of missing markets, or externalities, can we expect to find
in the labour market? Why do people stay out of the labour market
altogether? One possible explanation is that people who are out of the
labour market become increasingly unemployable. Their skill set might
no longer match the requirements of industry, or they might have lost their
proficiency in doing a particular job. In our terminology, this would mean
that the natural rate of unemployment increases.
Another source of externalities, which might explain unemployment, is the
existence of the welfare state. It has been argued that welfare benefits
form a source of income which might be a disincentive to join the labour
market. However, the income available from working might not be enough
to provide people with a socially acceptable standard of living. Can we
combine an efficient labour market with the provision of minimum social
standards?
268
Rational behaviour by agents might lead to an equilibrium in labour

markets with socially unacceptable wage levels. This points again to the
important role played by rationality and institutional arrangements. If
wages are the sole source of income for the vast majority of people, then
the supply of labour at any given wage rate is likely to be very large. Since
it is large, a competitive system is likely to produce a very low equilibrium
wage level, which might not be enough to enable them to obtain a fair
share of social wealth.
Rationality would simply suggest that low incomes should lead to low
consumption. However, this might not be acceptable, either physically
or socially. Hence, while a competitive system of decentralised
decision-making might yield an efficient allocation of social wealth, its
distributional consequences might not be acceptable for a society.
One potential way to alleviate this is the provision of more than one means
of obtaining a share of national income. This might lead to a reduction
of labour market participation by people with sufficient resources, which
will increase the equilibrium wage level. This, in turn, will make it more
attractive for people with low alternative sources of income to join the
labour market. It will also reduce the risk of alienation of existing low
income workers from the labour market.
What form would labour market imperfections take? There is a large
academic literature on this topic. I will not endeavour to summarise the
literature, but I will present some of the problems associated with such
imperfection. Suppose that the aggregate labour market is at an initial
equilibrium at point A below (Figure 9.11).
W
P
SL
involuntary unemployment
W1 =W1 Pc
P1 Pc P1
W0
P0
MPL
Figure 9.11: A labour market imperfection.
The equilibrium real wage is W0 /P0 . Suppose that the general price level
is comprised of two types of goods: consumer goods (PC ) and investment
goods or machinery (PP ). Hence:
P0 = C PC + P PP
C + P = 1
where C and P are the weights of the consumer and investment sectors
in the price index.
There will be a difference between wages as income (for the workers) and
wages as cost (for producers). Real income for workers will be measured
in terms of consumer goods, while the measurement of cost for producers
will take account of both good. Suppose that a unionised labour market
269
agreed on preserving a level of real wages which is measured in terms of

consumer goods:
The expression in parenthesis represents the agreed level of fixed real

wages.
Assume now that consumption good prices have increased, while capital
goods prices have stayed almost constant. The labour contract ensures that
real wages W/PC will not change. This means that the nominal wages W
will have to rise to compensate for the increase in consumer prices. As PC
rose by more than P0 , the right-hand side will therefore increase. Hence:
where
P1 = C (PC + PC ) + P (PP + PP )
The increase in the price of consumer goods will only affect the overall
price level by the fraction C. Hence, the general price level will rise by
much less than the increase in consumer goods prices. Therefore, the real
wage, as seen by producers, will rise and equilibrium will be at point B in
the above diagram.
Note that the supply and demand curves for labour have not changed.
Clearly, there is excess supply of labour. This means that some people
who are willing to work at this rate of real wages will not find jobs. This is
what we called involuntary unemployment.
Is this a stable equilibrium, or will market forces eliminate this gap?
Some of those who cannot find jobs are willing to work for the prevailing
wages or less. We expect them to offer to do the work at lower wages and
employers will be delighted to hire them if they can.
Whether this will close the gap depends on the nature of the labour contract
negotiations, as well as on the powers of the workers union. If wages are
negotiated at a national level, it will be difficult for employers to hire people
at a lower wage level. If negotiations are localised and the unions have
limited power, people may be able to persuade employers to hire them for
the lower rate. At the same time, such people (if rational) might be worried
about the consequences of their actions to future wage levels. If the wage
level is eroded too much, they may feel that it serves their interest better (in
the long run) to stay out of the market. This, of course, only holds if society
provides some sort of safety net for people outside the labour market.
However, you should not conclude from this that any involuntary
unemployment is the fault of the unions. A similar type of imperfection
can result from a market without any organised labour or producers.
Our analysis of the labour market was based on the premise that labour
productivity is falling the more labour we employ. However, workers
typically respond to incentives, particularly through the wage packet,
with higher productivity. If we assume that higher wages mean greater
productivity by every worker, a reduction of wages may not always be a
good policy for the profit maximising organisation.
Suppose we start at a competitive equilibrium in the labour market at
point A in Figure 9.12.
270
= w
P
SL
involuntary unemployment
MPL ( *)
0
MPL (0 )
0
L0
Figure 9.12: Involuntary unemployment through worker incentives.
At A, the marginal product of the last worker is MP 0L . We now assume that

this is a function of the equilibrium level of real wages 0.
Could it be in the interest of the producer to raise the wages above the equilibrium rate?
What would be the effects of doing so?
When the producer increases wages to 1 , the marginal product of all
workers will increase. In particular, the productivity of the last worker will
rise. As long as the increase in productivity (which contributes towards the
profit of the producer) is greater than the increase in the wage bill (which
reduces profit), the producer should increase wages without changing
the number of people employed.
Suppose that the level of wages for which the additional contribution in
productivity equals the increase in the real wage bill is *. This means
that lightly shaded area in the above diagram (which describes the gains
in productivity) is equal in size to the darkly shaded (which depicts the
increase in cost). The very darkly shaded area is both a benefit and a cost,
which hence cancel each other out.
However, at this higher level of wages, more people are willing to work
(or people are willing to work longer hours). Hence, there is excess supply
of labour in the market. In a competitive environment, we expect workers
who wish to work at the going rate but cannot find jobs (involuntary
unemployed) to bid down the wages by offering themselves for the same
jobs at lower rates.
However, this will not work in the present model. Usually, reducing wages
will lead to an increase in profits. Here, however, a fall in wages might
reduce profits. If the employer pays everyone less merely to employ a
few more people, he may lose the productivity of all those who have
been working for him. Such a loss can outweigh the benefits of hiring a
few more workers at a lower wage level. Hence, there could be a level of
wages (like *) where the employer will neither seek to increase nor to
decrease wages, even if there were people willing to work for lower wages.
Unlike in the case of the unions, this form of involuntary unemployment
will not be dependent on the strength of internal associations. Earlier, we
saw that if unions keep the wages above the equilibrium level, involuntary
unemployment depends on union power. Here, there is no association between
employers, and involuntary unemployment has greater chances to persist.
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Self-assessment
Define the concepts of general equilibrium, Shys Law, and the
Schumpeterian hypothesis.
272
Chapter 10: The goods market in the closed economy
Chapter 10: The goods market in the

closed economy
Learning outcomes
define, for a closed economy without government, the concepts of
consumption, investment, aggregate demand, income determination,
equilibrium (IS), and the multiplier
define, for a closed economy with government, the concepts of
consumption and taxation, the government budget, automatic
stabilisers, aggregate demand and equilibrium (IS), the multiplier and
taxation, the role of fiscal policy
explain the capital formation equation, the marginal propensity to
consume, poverty driven inequality, consoles, the relation between
demand management and Shys Law
illustrate the alternative view of equilibrium based on saving and
investment, and the paradox of thrift
use diagrams to analyse problems involving closed economy with and
without government.
Reading
BFD Chapters 1516 and Chapter 17 pp.398410.
LC Chapters 1516 and Chapter 17 pp.38486.
In the previous chapter, we discussed the problem of determinants of

the level of national output (supply). We now move to a more detailed
formulation of what may constitute the aggregate demand for national
output. By doing this, we are not committing ourselves to any particular
theory. Instead, we wish to set a framework in which we are able
to accommodate alternative explanations of the aggregate values of
important economic variables. From this point onward we are going
to be less concerned with how notions such as aggregate demand
relate to the microeconomic analysis of individual markets and their
interrelations. However, this does not mean that the problem has really
been solved.
Closed economy without a government

National accounts
To begin with the simplest possible analysis, let us again ignore the
existence of a government.
It is always best to start with a view of national accounts, identifying the
variables which may be relevant for our analysis. We know that in a world
without a government, there are only two conceivable usages for our
product and these are consumption (C) and investment (I):
NNP = C + I
From Chapter 8, we recall that NNP (net national product) and national
income (Y) describe the same quantity from different perspectives. Hence,
273
NNP = Y . We also know that we can use our income to either buy
consumption goods (C) or store it for future use (savings: S).
Since:
Y=C+S
NNP = Y
we find that:
C+I=C+S
Hence:
I=S
which is the capital formation equation. Growth through capital
accumulation is entirely dependent on individual decisions to save.
Example 1
Assume an economy that produces only one good, say wheat (W). What
can they do with the wheat? They can either use the seeds to make flour
and bread (for consumption) or keep the seeds in the barn. They can then
use this stored wheat in the next period, either to make flour and bread or
for the purpose of sowing the fields which, in turn, will yield more wheat.
Either way, storing seeds in the barn is an example of the idea of savings.
Abstaining from consumption is, in principle, savings.
On the usage side, every way we use the seeds will constitute investment,
since it facilitates a use in the next period. Those seeds which we simply
stored will be added to the seeds which we produce throughout the year.
However, recall from the previous chapter that investment itself does not
imply an increase in the amount of available resources. It also depends on
the depletion rate of the existing stock. Therefore, if in our case 1/2 of the
total amount of seeds is used for consumption, 1/4 for storage and a 1/4
for sowing, the increase in output depends on whether the 1/4 used for
sowing is capable of producing the initial amount W. If technology is such
that it takes a 1/4 of W0 to produce W0 then in the next period we will
have W0 (1 + 1/4) which is exactly the output, plus what we stored for
direct consumption in the previous period. However, if we now changed
the composition of our investment, say, 3/8W0 to be stored for baking
bread in the next period and only 1/8W0 for sowing, we still save 1/2W0
but we will not be able to produce W0 in the next period. Hence, the same
level of investment may lead to different consequences, even for a given
technology.
To have a better understanding of how output is being used in each
period, we must investigate what constitutes the demands for the different
uses of the output.
In our limited world there are only two types of usages which we consider. What are
they?
Consumption
In the model of rational utility maximisers which we analysed in Chapter
2, we concluded that given the tastes parameters (utility function), the
factor determining how much to consume of each good is real income.
Real income is defined as the amount our nominal income can buy, given
the nominal prices in the economy. The position of the budget line is
entirely dependent on nominal income and the price of each good.
In this chapter, we are concerned with the desired aggregate consumption
274
levels, rather than with how much of a particular good an individual might
want to buy. Hence, relative prices may not play a role. However, general
price levels do matter, as they will influence the level of real income (i.e.
the position of the budget constraint in the space of economic goods).
As we shall assume that prices are given, national income Y is defined in
real terms. Therefore, the immediate conclusion from our microeconomic
analysis is the assertion that consumption is a function of real income.
We write this in the following way:
C = C(Y)
where Y is real income.
However, even if we do not include any other variables in the
consumption function which may influence our consumption decision,
this representation of consumption is problematic. It suggests that
consumption is a function of the aggregate level of income and is
independent of the distribution of income.
Let us begin with the simplest representation of the relationship between
income and consumption:
C(Y) = C0 + c1 (Y)
where C0 is an autonomous component of consumption. It reflects the level
of consumption we want to consume (or need to consume), regardless of
how much we earn. Beyond that, there is always a fraction of our income
which we want to use for consumption: c1 < 1. We call c1 the marginal
propensity to consume (MPC).
Why is the MPC less than unity? Why dont we consume our whole
income? In The Wealth of Nations, Adam Smith refers to the tension
between the wish to enjoy life at present and the need to better our
conditions in the future. By insisting that c1 < 1, we suggest that agents
will always want to save a certain portion of their earning to ensure an
adequate living standard in the future.
This simple consumption function has the following shape, where we have
national income Y on the horizontal axis, and consumption C on the
vertical axis:
Figure 10.1: The consumption function.
275
The intercept with the vertical axis denotes the level of consumption which
the economy would need to subsist, even when income equals zero. The
slope of the consumption curve denotes the change in consumption which
will follow an increase in income by one unit. Geometrically, the slope is
(dC/dY). From the consumption function it is clear that if Y increases by
one unit, consumption will increase by c1 , which is thus the slope of the
consumption curve.
One may immediately argue that there is likely to be a difference between
the marginal propensity to consume of the rich and that of the poor. This is
clearly true. A poorer person is more likely to have a greater concern with
present consumption than with future consumption. Therefore, a better
representation of consumption would be to have the MPC itself as a function
of income. Namely, the richer a person is, the lower will be their MPC.
From the point of view of a singe individual, this implies the consumption
function shown in Figure 10.2.
Figure 10.2: The consumption function when MPC is a function of income.
There is not much qualitative difference between this function and the
linear one from the previous diagram. In both cases, there is a direct
relationship between income and consumption: Consumption increases as
income increases. This more complex representation thus does not seem to
add any insight to the linear case we considered before.
A second issue with the income-dependent MPC is that we are interested
in the behaviour of the whole economy, rather than that of a single
individual. Even if an individuals MPC is dependent on their income, it is
not obvious that the MPC of an economy should have a strict relationship
with income as well. An economy can get richer, but if this entails changes
in income distribution across individuals, the MPC may be rising with
income rather than falling. The consumption function which we examine
(and its graphic representation) depicts the consumption of the whole
economy as a function of the general level of income. Whether the
MPC of the economy changes as income changes depends on whether
consumption is a function of income distribution.
Suppose that we examine two points of national income, Y0 and Y1 . At
each level of income, there are two groups of individuals: the poor and the
rich. Let c p1 > c R1 represent the MPC of the poor and the rich respectively.
The immediate intuition is to say that increases in equality will lead to
276
greater consumption, as we transfer income from the rich with a low

marginal propensity to consume to the poor with a higher marginal
propensity to consume. However, inequality (and equality) evolve in a
much more complex manner.
When national income is Y0 , let a proportion of it belong to the poor and
(1 ) belong to the rich. When increases, a greater share of national
income is consumed by people with the higher MPC. This can mean one of
two things.
There might have been a transfer of income from the rich to the poor, with
the number of people in each group constant. We shall refer to this as the
transfer effect. The other possibility is that some of the people who
were rich have now become poor, so that the number of poor people and
subsequently, their share in the national income has risen. In the first
case, we would argue that an increase in has reduced inequality. In the
second case, the increase in represents a likely increase in inequality.
When the number of people earning lower levels of income increases, the
poors share of total income will rise, but intuition tells us that inequality
also increases. To some extent, an increase in the share of national income
brought about by an increase in the number of poor people is not a matter
of inequality but rather a matter of poverty. The two are not unrelated,
but in order to prevent confusion, let us simplify the analysis by only
allowing two possibilities: Increased poverty will refer to the case where
an increase in the poors share of national income is the result from more
people being poor. Increased equality, on the other hand, will be the case
where the poors share of national income is increased via pure transfers
(no change in numbers).
Note: Inequality is a complex concept. Suppose, for instance, that we have
a society with ten individuals. Five are poor and earn 10 and five are rich
and earn 20. Total income is 150. If one of the rich becomes poor, we
have six poor earning 10 each (60 altogether). Now the residual 90
is divided over the remaining four individuals, each of whom will earn
22.50. Intuitively, we would consider the increase in the share of the poor
(from 50 to 60) as an increase in inequality. However, an increase in the
share of poor can also increase equality. If there are now six poor people
but their income is 15 per person, their overall share had increased from
50 to 90. The remaining 60 will now be distributed to the four rich
who, in turn, will get 15 each. Hence, in this case, an increase in the
share of the poor increased equality. However, note that when the increase
in share of the earning by the poor leads to greater equality, the MPC of
the rich and the poor will tend to be the same.
As the focus of our attention is the level of MPC, we will concentrate on
the case of increased poverty. An increase in a will represent an increase in
poverty (and, in a sense, inequality), since it will signify that the number
of poor has increased (each with the same low income), rather than that
the poor are better off (in which case they will have a different MPC
anyway).
Each group of individuals has a linear consumption function of the form:
C(Y i) = C0 + C 1i (Y)
where i = R, P.
Therefore, total consumption will be:
C(Y0 ) = c0 + c P1 Y0 + (1 )c0 + (1 )c R1 Y0
= c0 + [c P1 + (1 )c R1 ]Y0
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If the MPC of the poor and the rich are the same (i.e. c P1 = c R1 ),
(our distribution parameter) does not influence the outcome. If, as is
reasonable to expect, the MPC of the poor is different from that of the rich,
the aggregated MPC (c P1 + (1 )c R1 ) depends on income distribution.
As increases due, say, to an increase in the number of poor consumption
will increase. Equally, a redistribution policy which reduces inequality by
transferring income from the rich to the poor (again, a greater ) will also
increase overall consumption although inequality falls.
In case of an increase in aggregate income Y (Y1 > Y0 ) which is
accompanied by a decrease in the share of the poor from to , the direct
relationship between income and consumption could be broken.
C(Y1) > C(Y0 ) if [c P1 + (1 )c R1]Y1 > [c P1 + (1 )c R1]Y0
which, upon rearrangement, yields the condition:
For example, if initially = 0.8, c P1 = 0.8 and c R1 = 0.4, an increase in

income accompanied by a decrease in the proportional share of the poor,
say, = 0.2, will violate the condition specified in the above equation. We
know that Y0 /Y1 < 1 but on the left-hand side we have:
It is not conceivable that the left-hand side is smaller than the right-hand
side. Hence C(Y1) < C(Y0), which means that consumption could fall as
income increases if the rise in income is associated with a fall in the share
of the poor.
We can summarise these findings as follows:
1. Having a linear consumption function for the economy as a whole
does not necessarily imply that the marginal propensities to consume
of all individuals are the same. It might simply describe the change in
consumption when changes in income have no effect on changes in
income distribution. Inevitably, a change in income distribution will
bring about a change in the level of consumption for all levels of MPC
and all levels of national income.
If we want to keep track of the income distributions in an economy
consisting of two groups, we can write the consumption function as:
C(Y) = C0 + (c P1 + (1 )c R1 )Y
A change in income distribution (i.e. ) will constitute a shift in the
consumption curve. If poverty increased in the sense that there are
more poor people than before, but the extent of their poverty had not
deepened, there will be greater consumption at each level of income.
A redistributive policy which reduces inequality will cause a further
increase in consumption as it transfers income from lower levels of
MPC (the rich) to a higher level of MPC (the poor).
278
"
"
&
&
"
$
"
"
Figure 10.3: Income redistribution, changes in population composition and the

consumption function.
2. If the income distribution is changing as the level of income rises, a

linear relationship between consumption and income implies a specific
type of relationship between the changes in income (i.e. growth) and
income distribution. While such a relationship may be consistent with
improvements in income distribution through transfer from the rich
to the poor, it is also consistent with growth which leads to greater
poverty (and inequality). In such a case, the above condition for
consumption to increase with income will hold.
We will normally ignore the distributional elements which may affect
consumption and write the function as:
C(Y) = C0 + c1(Y)
However, income distribution is not the only factor influencing
consumption which we chose to omit from the consumption function.
In the above equation, everything is measured in flows. Consumption
is measured per period of time and is affected by income generated in
that period. However, people have stocks too. These will include all
kinds of assets which have been accumulated over past periods. Put
differently, the consumption decisions of two individuals with the same
income are unlikely to be the same if one of them expects a generous
inheritance while the other anticipates debt. Equally, people are likely
take into account whether they have regular earnings or one-off, lumpsum earnings. Their consumption decisions are likely to be different
under those two regimes.
These other factors influencing consumption are important for
macroeconomic analysis. The fact that we omit them at this stage is not
a reflection of their insignificance. However, as we are only taking our
first steps in macro analysis, we will focus our analysis on the question
of income determination. While assets and income distribution play
an important role in income determination, we shall omit them for
simplicity. In some of the self-study exercises at the end of the chapter,
their impact will be analysed in more detail.
279
Savings
As our income is used for consumption and saving alone, our savings
decision is closely related to our consumption decision. Recall that in a
closed economy without a government, our income is used for two main
purposes, current and future consumption:
Y=C+S
Hence:
S=YC
We have already looked at the properties of the consumption function,
and decided to make it a function of income Y alone. Therefore, as savings
is the residual income after consumption, savings too are determined by
income, S = S(Y):
S(Y) = Y C(Y) = Y C0 c1Y = C0 + (1 c1)Y
where (1 c1) is the marginal propensity to save (MPS). As income
is only used for consumption and savings, it immediately follows that:
c1 + (1 c1) = 1
MPC + MPS = 1
We can now depict the relationship between the consumption and savings
functions diagrammatically (see Figure 10.5).
Note: The 45 line helps us to transform the values from the X-axis, or
horizontal axis, to the Y -axis, or vertical axis. In Figure 10.4 we examine
such a line.
Figure 10.4: The 45 slope.
At point A, we have X0 on the X axis and Y0 on the Y axis. The slope of the
45 line is 1. Geometrically, the slope of the above line (tan ) is Y0 /X0 .
If it is indeed a 45 line, then this slope must be equal to 1. For Y0 /X0 to
be equal to 1, X must be equal to Y . Therefore, the 45 line allows us to
0
transform values from the X-axis to the Y-axis. We know that at point A, Y0
will be equal to X0.
280
Figure 10.5: Consumption and savings functions.
In Figure 10.5, at Y1 , C(Y1) > Y1. This means that consumption is greater
than income. Hence, savings are negative: we borrow to increase current
consumption. At Y2 , C(Y2) < Y2 which means that income is greater than
consumption. Thus we are able to save some of our current income for
future consumption, and savings will be positive. At Y0 , C(Y0) = Y0, which
means that current consumption equals income. Hence, we neither save
nor borrow, and savings are equal to zero.
In our discussion of consumption, we observed that the level of
consumption in an economy is dependent on income distribution and
poverty. The level of savings will also depend on income distribution. We
said that for any given level of national income, increases in inequality
(in the sense of increase in poverty) imply an increase in consumption if
the marginal propensity to consume of the poor is greater than that of the
rich. Hence, the level of savings will fall. The diagram below depicts the
effect on savings of an increase in poverty for different levels of national
income.

Figure 10.6: Changes in the MPC and the effect on savings.
As poverty (and inequality) increases, the share of national income in the

hands of the rich, who have a low MPC, will fall for all levels of national
income. From our discussion in the previous chapter, as well as the first
section of this chapter, we know that at least one form of growth, capital
accumulation, is dependent on savings. Other things being equal, this
would imply that the growth of an economy could be impeded by greater
inequality. However, if technological improvement is the major source of
growth, this need not hold. If growth comes mainly from technological
development and entrepreneurial initiatives, inequality might play a vital,
and positive, role. Inequality, in such a case, would mean that people will
be well rewarded for entrepreneurial activities (which are assumed to be
cost reducing; an equivalent to a pure technological improvement), since
281
they are able to change their income level. Redistributive policies, aimed
at reducing income inequality, would be a disincentive for entrepreneurial
activities.
The relationship between growth and inequality is complex and
interesting. The evidence to the extent it is observable is far from
conclusive. There are, perhaps, two fundamental questions to think about:
a. Does one of the two basic principles of growth (i.e. capital
accumulation vs improved productivity) perform better than the other?
b. Is inequality necessary as an incentive for the pursuit of increased
productivity?
Naturally, we need more refined tools of analysis to deal with these issues.
We can certainly not answer question (a), although we may feel that
poorer developing economies find it more difficult to increase savings,
given the low level of national income and the relatively higher needs
for basic consumption. For such economies, the growth via improved
productivity may be the only option, meaning that (b) would hold.
However, we have not yet considered the influence of international trade
on this question. Nevertheless, it is important that at each step of the way,
you should be able to consider the implications of the model to real-life
questions.
Investment
The analysis of national accounts established that in a closed economy
without a government, savings equal investment. However, investment
and savings are completely different activities. In the primitive wheat
producing economy we considered earlier, suppose you choose to use only
part of your income (in seeds) to make flour and bread. The rest is saved.
The fact that you chose to save a fraction of your income in seeds does not
turn it automatically into investment. You need to make sure it is available
tomorrow, through proper storage facilities, and you have to make sure it
gets to a farmer, so he can sow the seeds in the field.
In other words, in a decentralised world, we have to think about available
transmission mechanisms. How do savings decisions relate to
investment decisions? Who stores the savings, who will make them
available for investment? How do we choose how to invest the savings?
In very simple terms we say that investment is mainly a function of the
rate of interest. There are many ways to think about this. Investment
typically requires loans from a bank. Therefore, higher interest rates will
make borrowing expensive and reduce the amount of investment.
What is the highest rate of interest we are willing to pay to get investment
money for our projects? We have to use the concept of the present
value of projects. Investment introduces a time dimension into our
analysis. We invest today but we reap the benefits of our investment in
the future. We must therefore compare todays money with money which
we will get in the future. When someone asks us to give them money for
a certain project, we will have to compare the returns from this project
with alternative usages of our money. There is always the option to earn a
normal profit on our money by getting the going interest rate r, which we
would receive if we put our money in a deposit account at the bank. The
corresponding return on an investment project is its present value.
The present value of receiving T1 after one year is the amount of
money one must allocate today, T0, such that together with interest it will
yield T1 by the end of the year.
282
Therefore, T0 is the present value of T1; that is, T0 is the present value of
T after 1 year.
What will the present value of T after 2 years (T2) be? It will be the
amount of money we need to put in the bank today (T0) such that it yields
T2 if left in the bank for 2 years:
T1 = T0(1 + r)
T2 = T1(1 + r) = [T0(1 + r)](1 + r) = T0(1 + r)2
Hence:
Suppose now that a project which yields T every year for 5 years, requires
I0 as investment to get started. How would one decide whether or not to
invest in the project? If the amount we have to deposit in a bank to receive
the same amount T every year for 5 years is greater than I0, we should
invest in the project. In this case, the project is simply a cheaper way of
getting T for the next 5 years. The amount of money required today to
earn the yields of the project through the banks is the present value PV
. Hence, the general rule is to invest in the project if:
I0 < PV
But what does the PV depend on?
The present value of the stream of income promised by the project is:
Clearly, the present value depends entirely on the interest rate r. When
the interest rate increases, the present value of any project will decline.
At a higher interest rate, the amount of money required today to earn the
projects yields is much reduced. Therefore, some projects with a present
value which was only just above I0, will now be abandoned. In other
words, investments in projects will be reduced.
Note: Bonds of the console type, or perpetuities, have an infinite
maturity date. The purchase decision for such a bond will be determined
by the relationship between its price today and its present value. The bond
yields T at the end of every year from now to infinity. Hence, the stream
of income one will get in terms of todays money is:
As q < 1, the sum of the infinite series in the brackets is well defined:
283
The present value of a console bond paying T annually is thus:
Therefore, we generally assume that demand for investment is inversely

related to interest rates: I = I(r). Analogously to the consumption
function, we write the investment function in the following form:
I(r) = I0 I1r
where I0 can be thought of as some basic level of investment which will
always be required and I1 as the sensitivity parameter. I1 tells us how the
level of investment will respond to changes in the interest rate.
The complete goods market: closed economy without a

government
We have now established, in very general terms, the determinants of
demand for the various usages of national product in a closed economy
without a government. We now have to find the link between demand and
the actual production in the economy.
Ultimately, the following equations must hold:
NNP = C + I
And
I=S
The demand for the various usages of the national product is called the
aggregate demand. I will denote this demand by the letter E (denoting
expenditures) to distinguish it from the aggregate demand function, which
we will later use in the price-output plane.
Aggregate demand is given by:
E(Y, r) = C(Y) + I(r)
and in a more explicit form:
E(Y, r) = C0 + c1Y + I0 I1r = [C0 + I0 I1r] + c1Y
where the expression in the brackets contains all those elements of the
aggregate demand which are not dependent on income or net national
product). We can therefore write the aggregate demand function as:
E(y, r) = A(r) + c1Y
where A is the autonomous component of demand. However, as this
autonomous component is not independent of interest rate r, which
determines demand for investment, we write it as a function of the interest
rate. Clearly, A is inversely related to r.
Why is A inversely related to r?
Since we are now focusing on the relationship between demand and
output, we have to hold all other determinants of output fixed. In our case,
the other determinant is the interest rate, which we will hold at a certain
level, r0.
We can now draw the aggregate demand function, bearing in mind the
role of the 45 line.
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Figure 10.7: Consumption, savings, investment and aggregate demand.
We include the demand for investment function which is unchanging

with income for any given interest rate and the savings function, which
is the residual of the demand for consumption function. Notice that the
savings functions does not cross the horizontal axis at the point where the
E function crosses the 45 line. In section 10.1.3 we said that savings will
be zero whenever consumption equals income. This happened at the point
where the consumption function crossed the 45 line. However, in this
case, the E function is not the same as the C(Y) function. It is C(Y) +I(r).
Therefore, S(Y) will be zero at a lower level of income than where E(Y, r)
crosses the 45 line. In fact, S(Y) = I(r) when E(Y) = Y.
Mechanisms of adjustment
Consider now the situation at Y1 in the above diagram. The total demand
for national output, which is a function of both income Y and interest rate
r, is greater than the amount actually produced. That is, at Y1:
E(Y1, r0) > Y1
The quantity demanded is thus greater than the quantity supplied. We call
this a state of excess demand.
This will lead to an unplanned reduction in stocks. Excess demand means
that we intended to sell too little. The immediate source from which we
may satisfy the excess demand for consumption are those things which
we have stocked in the basement. As we saw earlier, stock is a form of
investment. Therefore, excess demand signifies that planned investment
exceeded planned savings. In the diagram above, we see that savings are
below the investment line at Y1.
How the system adjusts to states of excess demand or supply is perhaps
one of the most crucial questions in macroeconomic analysis. The answer
very much depends on ones view of the determinants of output.
In principle, there are two possible mechanisms of adjustment:
through increased prices
through increased output.
Naturally, if one believes that output is not influenced by demand, the only
mechanism of adjustment would be through prices. As you will soon see,
this require flexibility both to increase and to decrease prices. Adjustment
285
through quantities of output lies at the heart of the Keynesian model of

macroeconomics. Sellers will increase their orders and thus close the gap
between demand and supply by increasing supply.
Consider now the reverse situation, at Y2 in the above diagram:
E(Y2, r0) < Y2
which we call a state of excess supply.
How could we identify such a state? When there is excess supply, sellers
have tried to sell more than was demanded. By the end of the day, we
will have to store what is left. Hence, excess supply corresponds to an
unplanned increase in Stocks. The level of planned investment was
lower than the level of planned savings (see the above diagram). Again,
adjustment can either be done through a fall in prices or a reduction
in quantities. In the Keynesian model, as we said before, we shall have
quantity adjustment whenever possible. It is always possible to produce
less, so adjustments in the Keynesian model will happen exclusively
through quantity adjustments.
Finally, consider the case where output is at Y0:
E(Y0, r0) = Y0
which we call equilibrium. All rational plans materialised: consumers
consumed as much as they had planned, and investment was at the level
anticipated. In terms of the above diagram, planned savings equal planned
investment, and consumption plus investment, or E, equals the national
output Y.
Characterisation of equilibrium and the multiplier:

At equilibrium,
E(Y0, r0) = Y0
This means that:
E(Y0, r0) = A(r0) + c1Y0 = Y0
hence:
As c1 < 1, 1/(1 c1) > 1. This means that a slight change in A will bring
about a greater change in the equilibrium level of Y. We call 1/(1c1) the
multiplier.
Consider the effect of a fall in the interest rate to r1(< r0 ). There is now a
greater demand for investment, since investment is inversely related to the
interest rate. The autonomous component of the aggregate demand will
increase because investment demand has increased. All other elements of
the autonomous component stay the same:
A(r1) > A(r0)
Let A denote the difference between the two levels of investment, i.e. A
= A(r1) A(r0). This means that at each level of income Y, there will be
greater demand for output.
286

Figure 10.8: An increase in the interest rate and equilibrium.
At the initial level of equilibrium Y*

there is now excess demand.
0
As output increases to satisfy this increase in demand, income too is
increased: Y1 = A. This, in turn, gives a further push to demand by
increasing demand for consumption: C1 = c1Y1. Satisfying this increase
will further increase demand for consumption, Y2 = C1, and so on. This
is what we call the multiplier effect. A single push to demand generates
a snow-ball effect. However, the MPC is less than 1, so consumption
increases at a decreasing rate. Hence, the system will converge to an
equilibrium eventually.
Perhaps the most important conclusion from this model is that demand
determines output. This, it must be noted, revolutionised thinking
about policy and the role of government. Until the advent of the
Keynesian model, macroeconomic analysis was dominated by Says Law,
where supply determines demand. This, in turn, implies that demand
management is completely useless.
The debate about the usefulness of demand management continues to
this day. If it is useful, then governments have a significant active role
in the economy. If demand management is completely ineffective, then
government should only worry about creating the proper environment
for industry which, in turn, will determine the level of output (and thus,
employment).
Closed economy with government

We begin by investigating the effect of the introduction of government on
the national accounts. Governments, in this model, have two functions:
they can raise taxes
they can spend money on public consumption.
This public consumption includes items such as national defence, the
running of the central government, and the provision of public services. In
many countries, public services include schooling, public roads, policing
and the like. If governments spend more than they earn in taxes, they will
have to borrow money from the banking sector.
The usages of national output are now extended to include public
consumption, denoted by G, as well as private consumption C and
Investment I:
287
NNP = C + I + G
On the other hand, national income has to be divided between taxes T as
well as consumption and savings:
Y=C+S+T
Bearing in mind that the basic relationship between the value of what has
been produced and the generated income still holds, NNP = Y, we get:
C+I+G=C+S+T
or,
I = S + (T G)
where (T G) can be thought of as budget surplus, or governments
savings.
Hence, savings are still the source of capital accumulation in the capital
formation equation, and thus a source of growth. However, there are
now two different sources of savings: private (by individuals) and
public (through surpluses in the government budget). It follows that an
economy with a high level of savings may still fail to grow through capital
accumulation if the government is running a large deficit.
The introduction of government will have a number of implications for
our model. First, individuals are now making decisions about consumption
with respect to their disposable income (Yd ), which is national income
minus taxes, rather than the national income Y. Therefore, we must
rewrite the aggregate demand for consumption as:
C(Yd) = C0 + c1(Yd)
Since disposable income is Yd = Y T, we can rewrite aggregate demand
for consumption as:
C(Y) = C0 + c1(Y T)
The tax function T can take any of the following forms:
Lump-sum tax, where T = T0 taxes are raised with no reference to
income
Proportional tax: T(Y) = tY, where there is a flat rate of tax which is
paid by everyone
Progressive tax: T(Y) = t(Y)Y, where the rate of tax itself depends
on the income earned. It will be progressive if the rate of tax increases
with income, regressive if it decreases.
From a social point of view, the different tax systems have different
implications. A lump-sum tax is easy to administer since we need not
know anything about the circumstances of individuals. Everyone has to
pay exactly the same amount of tax. On the other hand, lump-sum taxes
are clearly regressive, since the percentage of income paid as tax decreases
with income. Income inequality will thus be exacerbated by such a tax.
Proportional taxes guarantee that everyone pays the same percentage
of their income. Therefore, income distribution is unaffected by such a
tax. It is thus unsuitable for redistributive purposes, and serves only to
raise revenues for government activities. At the same time, it is a slightly
more costly tax to administer as you need to know the earnings of each
individual.
A tax where the marginal rate of tax is rising with income is naturally
progressive, since rich people pay a greater proportion of their income
in tax than the poor. The outcome of such a system is greater equality.
However, such a tax is fairly costly to administer because not only do you
288
need to know each individuals level of earnings, you must also correctly
compute their rate of tax.
We are not going to comment or discuss the alternative tax systems, but
it will be useful to have this basic understanding of what distinguishes
them. In terms of modelling the economy, knowing the position of the tax
function in the demand for consumption should allow a straightforward
incorporation of any form of tax functions. For simplicity, I will normally
assume a lump-sum tax.
The second addition to our model is the governments demand for public
consumption G. The government may choose any policy it chooses. It can
make government expenditure positively or negatively related to income
(G(Y) = G0 + g1Y, with g1 greater than or less than zero, respectively) or
make it independent of income (G = G0). For simplicity, I will assume the
latter case.
We now have the complete model in front of us. The expenditure function
for the economy will be derived from:
C(Y) = C0 + c1(Y T)
I(r) = I0 I1r
G= G0
E(Y, r) = C(Y, T) + I(r) + G

= C0 c1T0 + c1Y + I0 I1r + G0
= [C0 c1T0 + G0 + I0 I1r] + c1Y
Hence the autonomous component (in brackets) now contains government
spending and the effect of lump-sum taxes on consumption, c1T0. We now
write the aggregate demand function as:
E(y, r) = A(r0 , T0 ,G0) + c1Y
We choose to include G and T explicitly, since these are the tools of
government policy; they constitute what we call fiscal policy.
The rest of the analysis is exactly the same as the one we conducted for
the closed economy without a government. We only have to bear in mind
that A is now a more extensive argument and that at equilibrium, planned
savings, which are equated with planned investment, contains government
savings as well. Recall that:
I = S + (T G)
Therefore, the complete picture is the following one:

Figure 10.9: Equilibrium with government.

289
As the autonomous component A(r0 , T0 ,G0) is now a function of

government and taxes, the message of the Keynesian model was quite
striking for economists concerned with unemployment. Given that the
economys multiplier is greater than 1, fiscal policies can increase output,
and hence employment, significantly.
The economys multiplier remained unchanged with the introduction of
government.
What will happen to the multiplier in the case of proportional taxes, or proportional
government spending?
The IS representation of the goods market equilibria

Reading
MP Chapter 2.
The above analysis suggests that the level of national income is

determined in the goods market through aggregate demand. The latter is,
among other things, a function of the interest rate. The interest rate is of
particular note, since it seems to connect the assets (or money) side of the
economy with the real side, the demand for goods.
If you want to save part of your income, you can either hide it in your sock
under the mattress or give it to someone who will promise to give it back
to you in the future. However, as you do not know this person, you are
unlikely to give it to them without being paid for doing so. But why would
another person want your savings?
Some people will want to buy things now but may not have enough
money. They do not mind having less in the future as long as they can
have more now. To an extent, this is a matter of preferences but also of
income distribution. Some people prefer the pleasure of today and are
willing to sacrifice future income for that purpose. Others may not have
enough now but may have more in the future, so they need to even out
their consumption over time. In addition, there are those people who
need money now because they want to buy machinery for a new factory.
Those people too, will want to buy your savings. Therefore, at each
point in time, there will be some people wanting to sell some of their
current consumption for future consumption and some people who are
willing to sell future consumption for greater current consumption. The
balance between these wants, which reflect variables exogenous to the
goods market, affects interest rates. Therefore, by connecting the level of
national income with this important variable, we extend the scope of our
analysis.
The IS (Investment-Savings) representation of the goods market depicts
the relationship between interest rates and levels of national income.
When the interest rate is r0, the equilibrium level of income in the goods
market will be Y0 (point A in the diagram below).
290

Figure 10.10: The effect of a change in the interest rate r.
When the interest rate falls to r1, demand for investment will increase,
increasing the aggregate demand for goods. The E schedule will shift
upwards. This will create excess demand at point A and with quantity
adjustment, the increase in orders will bring about an increase in output
until equilibrium is restored at point B.
Figure 10.11 depicts the same story in the (Y, r) plane.
Figure 10.11: The IS schedule: equilibrium (r, Y) combinations in the goods

market.
The initial point A shows that when the interest rate is r0, equilibrium in
the goods market will be at Y0. For an interest rate of r1, demand for goods
would increase. There would be excess demand when output remains at
Y0. With quantity adjustment, output will increase to Y1 where equilibrium
in the goods market is restored (point B in both diagrams).
Connecting points A and B produces the inverse relationship between
interest rates and national income. As interest rates increase, demand for
investment falls (point D). At Y1, there is excess supply of goods. With
quantity adjustment, output will fall until we reach the level of output on
the line connecting A and B.
The definition of the IS curve is therefore the collection of all pairs of interest
rates and national income for which there is equilibrium in the goods market.
In algebraic terms, the IS curve describes the relationship between the values
of r and Y when aggregate demand E equals aggregate supply Y:
291
E(Y, r)
= C(Y, T) + I(r) + G
= C0 c1T0 + c1Y + I0 I1r + G0
= [C0 c1T0 + G0 + I0 I1r] + c1Y
Hence, along the IS schedule,

A(G0 , T0) I1r + c1Y = Y
In the goods market, Y is a function of r. Hence
To show the geometry more clearly, let us rewrite the IS equation such that
r is a function of Y. This means that we have to write the equation in a
different way:
A(G, T) + (c1 1)Y = I1r
Solving for r
we thus have
As c1 < 1 (MPC less than unity), (c1 1)/I1 < 0. Therefore, the inverse
relationship between Y and r has been confirmed. The expression dr/dY
is the geometrical definition of the slope of the IS. It tells us by how much
the interest rate must fall if we increased output by 1 unit and wished to
maintain equilibrium in the goods market.

"

Figure 10.12: The effect of a change in the MPC.
Recall that the multiplier in the original model was 1/(1 c1). The greater
the marginal propensity to consume, the greater will be the multiplier.
However, this means that the denominator (1 c1) is smaller. This, in
turn, means that the slope of the IS is flatter, since (c1 1) decreases as
well.
The intuition is very simple too. The greater the multiplier, the greater
will be the impact on the equilibrium level of income Y following a
slight change in demand for investment. As interest rates fall, demand
for investment will increase. This, with a greater multiplier, will push
equilibrium income further to the right; hence, IS is flatter the greater the
multiplier.
292
To ensure you fully understand the IS representation of the Goods Market model, find out
what will happen to the IS if there is:
1. an increase in government spending (G)
2. an increase in taxation (T).
Self-assessment
Define, for a closed economy without government, the concepts of
consumption, investment, aggregate demand, income determination,
equilibrium (IS), and the multiplier.
Define, for a closed economy with government, the concepts of
consumption and taxation, the government budget, automatic
stabilisers, aggregate demand and equilibrium (IS), the multiplier and
taxation, the role of fiscal policy.
Explain the capital formation equation, the marginal propensity to
consume, poverty driven inequality, consoles, the relation between
demand management and Shys Law.
Illustrate the alternative view of equilibrium based on saving and
investment, and the paradox of thrift.
Use diagrams to analyse problems involving closed economy with and
without government.
Give an example of a:
lump-sum tax
proportional tax
progressive tax.

Question 1
1. The multiplier with a proportional tax is smaller than the multiplier
with a lump-sum tax. Therefore, the slope of the IS schedule with a
proportional tax system will be flatter than its slope with a lump-sum
tax system. True or false? Explain.
2. The balanced budget multiplier suggests that the governments fiscal
policy will have no effect on the economy. True or false? Explain.
Question 2
In a simple Keynesian model of a closed economy, an increased propensity
to save will inevitably lead to an increase in national income, as there are
now more savings which can be invested. True or false? Explain.
Question 3
Here is a model of a closed economy:

C(Yd) = 80+0.8Yd
I(r0) = 100
G = 100
where Yd is disposable income.

a. Consider two-tax systems (and a balanced budget policy); a lumpsum tax (T = G) and a proportional tax (G = T(Y) = tY). Will the
293
equilibrium level of output be different under the two-tax systems?

b. What will be the level of t?
Answers
Question 1
a. Comparing multipliers. Do not try to remember the answer. Simply
work out the entire system. It is not much work and after doing it a few
times, it will become a piece of cake.
Lump-sum tax:
C(y) = C0 + c1(Y T)
I(r) I(r0)
G = G0
E(Y0, r0) = [C0 + I(r0) + G0 c1T] + c1Y = A(r0) + c1Y0

Equilibrium means:
E(Y0, r0) = A(r0) + c1Y0 = Y0
hence:
Proportional tax:
C(Y) = C0 + c1(Y tY) = C0 + c1(1 t)Y
I(r) = I(r0)
G = G0
E(Y0, r0) = [C0 + I(r0) + G0] + c1(1 t)Y = (r0) + c1(1 t)Y = Y
hence
The multiplier of a closed economy with a lump-sum tax (left-hand

side) is clearly greater than that of a proportional tax:
b. The slope of the IS curve reflects the sensitivity of output to changes in

demand generated by changes in interest rates.

Figure 10.13
We start at A. A fall in interest rates will increase demand for

investment. A smaller multiplier means that the snowball effect of an
increase in income (to satisfy the initial increase in demand) is not
294
going to be very large. This will mainly be due to a lower MPC. Hence,
the economy will move to point B. With a larger multiplier, the initial
increase in income will generate a large further increase in demand
due to a larger MPC. As income increases to satisfy these extra wants,
demand carries on rising. The snowball effect, in such a case, will be
large and the final increase in output greater. We therefore end up at a
point like C. This means that the IS curve will be flatter the greater is
the multiplier.
Question 2
This is a question about the paradox of thrift, which describes the
effect on the economy if people started saving more. The origin of the
problem is the effect of savings on investment. When we focus on capital
accumulation as a means of growth, encouraging greater savings at any
level of income is a likely government policy.
However, you can clearly see that there is a problem here. In a model
where output is determined by demand, increasing the level of savings at
any given level of income means a fall in immediate consumption. This,
in turn, reduces aggregate demand and subsequently reduces equilibrium
level of output.
Figure 10.14
Suppose that the government succeeds in convincing the public to save

more (an increase in the MPS and a fall in MPC). This will shift the S +
T G function up (for any given set of fiscal policy parameters) and the
aggregate demand E will decrease to a new equilibrium at point B. This
means that people will save more at Y0, but as income falls to Y1 they will
want to save less due to their reduced income. As I = S + T G, the fact
that I remain unchanged means that S too will not change (for any given T
and G). The paradox, so to speak, is that in spite of an increased demand
for savings, the level of savings remained unchanged.
Notice, however, that the assumption that interest rates are unaffected by
the increased demand for savings is unreasonable. Equally, if output falls,
it is not very likely that interest rates will not be affected. Therefore, this
paradox must be viewed as only part of a story. In later chapters we will
return to examine it.
Had, for instance, demand for investment been a rising function of
income, the outcome would have been even more pronounced:
295
"
'
'
Figure 10.15
In such a case, the increase in the marginal propensity to save will cause
for an unchanged interest rate a fall in the level of savings.
Question 3
a. The equilibrium condition of this system can be written in the following
form:
E(Y0, r0) = Y0
For the two tax systems, we find the following solutions to this
equation:
Lump-sum tax:
(Y0, r0) = A(r0) + c1Y0 = Y0
hence
where A(r) = C0 + I(r0) + G0 c1T = 80+100 + 100 0.8T.

With a balanced budget, T = G = 100. Therefore:
A(r0) = 80+100 + 100 0.8 100 = 200.
The multiplier is 1/(1 0.8) = 1/0.2 = 5. Therefore,
Proportional tax:
C(Y) = C0 + c1(1 t)Y = 80 + 0.8(1 t)Y
I(r) = I(r0) = 100
G = G0 = 100
E(Y0, r0) = [C0 + I(r0) + G0] + c1(1 t)Y = (r0) + c1(1 t)Y = Y
hence:
In our case, (r0) = 80 + 100 + 100 = 280. The Multiplier, however,

depends on t. As there is a balanced budget, we know that G0 = tY.
Substituting into the aggregate demand equation will yield the
following:
E(Y, r)
= [C0 + G0 + I(r0)] + c1(1 G0/Y)Y

= [C0 + G0 + I(r0)] + c1Y c1G0
= [C0 + G0 + I(r0) c1G0] + c1Y
296
In equilibrium,
E (Y, r ) =
C 0 + G 0 + I (r 0 ) c1 G 0 + c1 Y = Y
1
C 0 + G 0 + I (r 0 ) c1 G 0
Y =
1 c1
which yields a similar solution to the lump-sum tax:
This is due to the balanced budget condition and the fact that it was
not predetermined and hence was flexible.
b. We have to distinguish between the lump-sum multiplier and the
proportional tax multiplier. In the case of the lump-sum, both the level
of G and T can be decided a priori. With a proportional tax, it is not
clear how the balanced budget policy is implemented. The government
can set G and then adjust t to yield a balanced budget, which was our
approach above. Alternatively, the government can choose to set the
level of expenditure according to its tax revenues. In such a case, the
government sets t and adjusts G to be equal to tY. It is easy to establish
that there is a rate of tax, t = 10%, which will yield exactly the same
equilibrium as before, y = 1000. For any t > 10%, equilibrium will be
at a lower level of output, while for any t < 10%, equilibrium level of
output will be greater than 1000. A graphical exposition should always
follow your answer:
Figure 10.16
297
Notes
298
Chapter 11: Money and banking

Learning outcomes
define the concepts of real business, commercial banks and the supply
of money, central banks and monetary controls, bonds and wealth, and
credit and wealth
explain the role of money, real balances, the quantity theory of
money, the liquidity preference approach and the demand for money,
equilibrium in the money market
use diagrams to analyse the problems involving the money market.
Reading
BFD Chapters 1819.
LC Chapters 2021 (up to p.481).
Introduction
Money is one of the most difficult concepts in economic analysis. As I
explained in Chapter 8, the existence of money and its unclear role in the
model of general equilibrium is one of the major reasons for developing
an alternative framework of analysis for macroeconomic issues.
The general equilibrium model basically described an exchange economy
rather than a monetary economy. That is to say, in a world of two goods,
a general equilibrium price is nothing but an exchange rate between the
two goods. Hence, if the two goods are X and Y, the equilibrium price (and
indeed any other price) is expressed as PX/PY units of Y per X. Recall that
throughout our discussions of microeconomic issues, we have emphasised
that people have preferences, and make choices, with respect to real
goods, rather than nominal values.
Optimal rational behaviour meant that we the quantities of goods we
choose to consume are such that our willingness to pay for each good
in terms of the other good equals the market rate of exchange. The
willingness to pay was defined as the marginal utility of one good in terms
of the other. The market rate of exchange was the price of the good, again
measured in terms of the other good.
Using money value instead of rates of exchange might cause some
difficulties. With the introduction of money, goods are no longer
exchanged for each other, but rather for another commodity called
money. In terms of our previous discussion, this should mean that when
the price of good X is 20, we behave optimally by choosing a quantity of X,
such that our willingness to pay for a unit of X in monetary terms equals
the price. But measuring marginal utility of X in monetary terms implies
that money is an economic good. After all, the whole notion of utility and
marginal utility was based on people having preferences over all economic
goods. Will the move towards a monetary economy mean that money is an
economic good? It is certainly scarce, but is it desirable? If it is desirable
as such, then should money be an argument in our utility function? Will
we be willing to sacrifice other economic goods so that we can have more
money? If not, what does it mean (from the behavioural analysis point of
299
view) to want something merely as a means to get something else? Can we

not simply want that something else directly?
The answers to these questions are not obvious or simple at all, and go
far beyond the scope of this course. I would simply like to draw your
attention to the complex nature of money. It is very difficult to try and
formulate consistent and coherent theories about the nature of money,
without undermining our earlier microeconomic analysis. Regardless of
the theoretical difficulties, we can clearly observe the fact that money
exists, and is used in three major ways: as a numeraire, a means of
exchange and a store of value.
The use of money as a numeraire means that it is a means of counting.
When we look at a shoe and a flower we can say that six flowers can
be exchanged for one shoe. When there is another commodity, say, a
toothbrush, we can count all goods in terms of one of the goods, say
flowers. Assume that two flowers can be exchanged for one toothbrush.
Hence, three toothbrushes can be exchanged for one shoe. You can
imagine how difficult it all becomes when we have many goods. If the new
fashion dictates that you must have as many flowers as possible, people
will suddenly be willing to pay only two flowers per shoe and only one
flower per toothbrush. While it is obvious from our micro analysis that
a change in taste concerning one good will affect its relationship with
all other goods, it is not clear why it should also affect the relationship
between other goods. Given that flower is our numeraire, the change in
taste also means that now only two toothbrushes will equal one shoe. In
other words, the relative price of shoes in terms of toothbrushes will be
affected by the fact that people have preferences regarding the unit we use
to measure all other goods.
Using money as a numeraire proposes a way of circumventing such
problems. It means that we measure all goods in terms of money units. By
implication, we assume that money in itself is not a good like, say, flowers,
which are desirable in themselves. Rather, it is simply used as a means to
compare the prices of different goods.
Money as a means of exchange is fairly obvious. If you want to sell a
cow to buy a TV set, you will find it difficult to take your cow into the next
shopping mall, squeezing yourself (with the cow) through the gates and
lay the cow on the counter of the electronics shop. Even if you managed
not to break the counter, the seller of TVs may not want to have a cow.
He might want to buy some other good today, like diamonds. This points
to two problems with not having money as a means of exchange: Moving
actual goods around to exchange for other goods is cumbersome (like our
cow), and we might not find another person who is willing to exchange his
goods, which we desire, for the good that we have to offer.
But, you may say, the electronics seller does not have to keep the cow. If he
wants to buy diamonds, he may simply take the cow to the jeweller, who
has a shop in another part of town. However, he will still have to take the
cow to the jewellers shop, and the jeweller might not want to own a cow,
either. Moreover, he might have to wait until the end of the week before he
has time to go to the jeweller.
Using money as a means of exchange makes all this much easier. It is
portable, generally recognised, and it is divisible.
300
The third function of money follows quite easily from this point. Imagine
that our electronic seller has agreed to take the cow in exchange for a
wide-screen TV. The day is Monday and he has to wait until Friday to go to
the jeweller. Apart from the fact that he must feed the means of exchange,
it may also die before Friday or become ill in some way. Put differently,
when paying with simple commodities, the value of the good you have
received may change without any external influence. The value of money,
on the other hand, will not change unless prices change. Therefore, money,
apart from being a numeraire and a means of exchange, is also a
store of value. It guarantees that, other things being equal, the value of
what your received on Monday will stay the same until Friday, when you
exchange it for a good you desire.
It is therefore important to bear in mind that, although we use money to
measure economic goods, money itself is not considered as such a simple
commodity. One of the early writers who was, perhaps, one of the first
scholars to formulate what may be termed as macroeconomic theory,
focuses, not surprisingly, on money. In his essay On Money, published in
1752, David Hume makes the following assertions. First, in line with what
we have said above, he writes:
Money is not, properly speaking, one of the subjects of
commerce; but only the instrument which men have agreed
upon to facilitate the exchange of one commodity for another.
It is none of the wheels of trade: It is the oil which renders the
motion of the wheels more smooth and easy. (from a collection
of Humes essays entitled Essay: Moral, Political and Literary,
edited by E. Miller, Liberty Press 1987, p.281)
If money is not really part of the real side of the economic system, what is
the nature of the relationship between this facilitator of trade and actual
trade? David Hume himself proposes a formula that suggest a relationship:
It seems a maxim almost self-evident, that the prices of every
thing depend on the proportion between commodities and
money, and that any alteration on either has the same effect,
either of [increasing] or lowering the price. Increase the
commodities, they become cheaper; increase the money, they
rise in their value. (p.290)
Written as a formula, this means:

M = kPY
where M is to total quantity of money, P is the general price level and
Y is national income (product). The coefficient k represents the specific
proportion between output (commodities in Hume) and prices. Intuitively,
this may be read as follows: the quantity of money in an economy stands
in a given proportion to the value of national product (or the money value
of all commodities). Clearly, if Y increases, P must decrease. If M increases,
P will rise. Notice that this is an early formulation of what is currently
known as a monetarist approach. Some economists are of the view that if
there is an increase in the quantity of money, inflation will result. In our
case, where we do not have a dynamic model, this means that when there
is an increase in the quantity of money, there will be an increase in prices.
However, for such a view to be correct, we must also assume that an
increase in the quantity of money (M) will have no effect on Y. Returning
to Hume, we find that he himself did not believe this to be the case:
From the whole of this reasoning we may conclude that it is
of no manner of consequence, with regard to the domestic
happiness of a state, whether money be in greater or less
quantity. The good policy of the magistrate consists only in
keeping it, if possible, still increasing; because by that means,
he keeps alive the spirit of industry in the nation, and increases
the stock of labour, in which consists all real power and riches.
(p.288)
301
Referring back to Chapter 9, we may argue that the meaning of the

equation above depends on what we believe determines output. If Y is
independent of demand, and if the circumstances of industry are not
improved by the supply of money, then an increase in money supply will
have no real effect on the economy, as it will only cause an increase in
prices. If, however, Y is dependent on demand, and demand is related to
M, or if the supply of money does affect the circumstances of industry, an
increase in M might not necessarily lead to an increase in P. Instead, an
increase in M may cause an increase (or decrease) in Y. In such a case, it is
less clear that an increase in money supply will cause increases in prices.
Even if we followed Says Law, the implication of which is that output
is determined by the circumstances of industry (and let us suppose that
these have nothing to do with the supply of money), an increase in the
quantity of money will produce an increase in prices. Although this
follows immediately from the above equation, we must still inquire into
the question of how it happens. Even if we accept that there is a given
relationship between the value of national product and the quantity of
money which is needed to conduct transactions, how is an increase in the
quantity of money transmitted into an increase in prices?
A primitive answer could be the following: the reason why people hold
money is to conduct transactions. If suddenly they have more money than
they need for their current transactions, they will choose not to keep it,
and will buy some goods instead (increasing the number and value of
transactions). When their demand for goods increases, there will be excess
demand for goods. In the case of Says Law, this would mean that the
only possible mechanism of adjustment is that of price adjustments.
Hence, prices will increase.
The notion of money as a facilitator of trade suggests that money has the
role of an asset. Assets, normally, are those things which you keep as a
stock in order to allow you to consume goods in different circumstances.
You buy assets, for instance to generate consumption when you retire. In
a similar sense, money is an asset which facilitates transactions. In this
role, however, money has a specific feature which we call liquidity. As
money is the only means of exchange, its availability allows all possible
transactions to be performed. If, on the other hand, you think of a house
in the country as an asset, it is easy to see that it is different from money.
When you go to a cafe to have a drink, you can always pay in cash.
You will find it rather difficult to buy a drink for a share of the house.
Alternatively, if you walk in the street and see a beautiful car for sale at
an extraordinarily low price, you can get it if you have the cash but you
may not get it as easily if you have to sell your house first and then come
back to buy the car with the cash. The chance of finding the car with the
exceptionally low price still waiting for you is almost zero. So when we
talk about money, we really talk about a certain kind of an asset, a liquid
asset.
The demand for liquid assets

There are a number of different approaches to modelling the demand
for liquid assets. In this course, we concentrate on what is called the
liquidity preference approach. It means that people do not jump
from completely liquid assets like money, to totally illiquid assets like,
say, durable goods. Naturally, such an assertion will block the immediate
transmission of excess liquidity (increase in the quantity of money) into
increase in prices, as it suggests that people will not move to buy goods
with their excess liquidity.
302
Different assets have different degrees of liquidity. Hence, when one finds
oneself with more liquid assets than one would have wanted, one can
always buy assets such as bonds, which are somewhat less liquid but not
as illiquid as, say, a building.
The liquid assets which we have in mind are real balances, denoted by
the real value of our money stock (M/P). The demand for liquid assets is
basically a function of two major factors: price and income.
The price, or the opportunity cost of holding liquid assets, is the return
we could have received if we had held our money in a bank (or lent it to
someone else), rather than keeping it in our pocket. This return is called
the interest rate r.
Interest rates, like money, are a complex concept. The most common view
(which we mentioned in the previous chapter), is that the interest rate is
the price of present day consumption. If, for instance, we have a certain
amount of money, we can choose to use it for immediate consumption,
or give it to someone else and thus, postpone our consumption to a later
period.
There are always some people to whom present consumption is more
important than it is to others. As they may not have enough means to
afford consumption, they may want to buy those means (i.e. borrow).
Naturally, the person who is being asked to lend will decide on whether
to give the money according to the compensation which the borrower is
willing to offer. This compensation will be the agreed price which will
reflect the balance between the urgency of present consumption to the
borrower, and the willingness to forgo present consumption by the lender.
Therefore, the decision to hold liquid assets means that we are giving up
the interest we could have earned on that money. Hence,
where the quantity of liquid assets demanded stands in inverse

relationship to the price of holding liquid assets. The higher the interest
rate, the more costly it is to keep ones money in ones pocket.
Apart from the price, income plays a role in the determination of the
quantity of liquid assets demanded. The richer the economy, the more
opportunities will arise for the use of liquid assets. One is unlikely to take
a lot of cash if one is going to spend the next year on a desert island!
Therefore, the general demand function for liquid assets can be written as:
The supply of liquid assets

Perhaps the most liquid form of assets is hard cash. We call this category
of means of payment the money base, which is denoted by M0. Clearly:
M0 = PC + R
where PC means Public Cash and R is the amount of hard currency which
is kept in the banks as reserve.
However, people do not use cash only to make payment. They will use
money in their bank current accounts, regardless of its origin. Namely,
a cheque is a cheque whether the money in the account is yours or
borrowed. We therefore define M1 as a more accurate conception of liquid
assets:
303
M1 = PC + D
where D is the amount of money in deposits which bear no interest
(current accounts).
What is D? Suppose that we bring K into a bank, against which we open
an account. Assuming that there was no capital in any of the banks before
our arrival and that there are no other assets in the world, the banks
balance sheet will look like this:
Bank 1
Assets
Liabilities
R1 = K
D1 = K
Now, suppose that someone comes to the bank and asks for a loan. The
manager of the bank is convinced that we are unlikely to come and ask
for all the money we have deposited, because we wouldnt have deposited
it all in the first place if we had known we needed it again immediately.
He therefore calculates the probability of us coming back demanding our
money, and will keep enough money in reserve to meet our demands. The
rest he will be willing to lend.
Normally, the decision of what proportion of ones liabilities should be kept
in reserve is made by the central bank. Let denote that proportion, which
we call the reserve ratio ( = R/D). Hence, bank 1 is willing to make a
loan up to (1 ) of its liabilities, L1 = (1 )K.
Suppose that the borrower takes the money and pays it to someone elses
account in another bank, bank 2. Bank 1s balance will now show:
Bank 1
Assets
Liabilities
R1 = K
D1 = K
L1 = (1 a)K
We can now repeat the story for bank 2. First, our borrower brings his loan
(1 )K to the bank, against which he opens an account. Then, someone
else comes to bank 2 to ask for a loan.
Bank 2
Assets
Liabilities
Before further lending.

R2 = (1 )K D2 = (1 )K
After further lending.
R2 = (1 )K D2 = (1 )K
L2 = (1 )2K
And for the next bank:
Bank 3
Assets
Liabilities
Before further lending.

R3 = (1 )2K
D3 = (1 )2K
After further lending.

R3 = (1 )2K
D3 = (1 )2K
L3 = (1 )3K
and so on and so forth. Let us now add it all up. The total amount of
deposits (current accounts) is given by:
304
D=
Di = D1 + D2 + D3 +
= K + (1 )K + (1 )2K + (1 )3K +
= K[1 + (1 ) + (1 )2 + (1 3) + ]
In the brackets we have a progression of the following kind:

1 + q + q2 + q3 +
When q < 1, the sum of such a progression is always 1/(1 q). In the
above progression, q = (1 ). As is always less than 1 (reserve ratio)
(1 ) too is always less than 1. Hence:
and
1
where (1/) is the deposit multiplier (DM). In our case, R = K and
therefore, the total amount of deposits in current accounts is D = R(DM).
In a similar way we can calculate the amount of loans:
L=
Li = L1 + L2 + L3 + .
= (1 )K + (1 )2K + (1 )3K +
adding and subtracting K
where DM 1 is the loans multiplier.

We can now go back to our liquid assets M1:
M1 = PC + D = PC + R(DM)
At first, this may seem quite remarkable. If part of what constitutes our
liquid assets is the total amount of deposits (D), then the government may
make us richer by simply reducing the reserve ratio. When the reserve
ratio is smaller, banks may lend more against every unit of hard currency
which they keep in their vaults. Subsequently, the deposit multiplier (DM)
increases, increasing the quantity of money (M1). However, the mere
holding of assets does not make one wealthy.
Think, in a very basic way, about the public balance sheet in a world with
only liquid assets:
Assets
Liabilities
PC
Net wealth (NW)
The wealth we have is simply the difference between the value of our
assets minus our liabilities. In our case:
305
NW
= PC + D L
= PC + R(DM) R(DM 1)
= PC + R(DM DM + 1)
= PC + R
= M0
where M0 is the money base, the coins and note in circulation. An increase
in M1 which is not a result of an increase in the money base will leave the
public as well off as before (other things being equal).
How will the mere introduction of government bonds influence the wealth of the public?
Although M0 is real wealth in the above framework, we consider M1 as
the supply of money when there are no other assets in the economy. From
now on, whenever we write M we mean M1.
Equilibrium in the liquid assets market

We now have the full picture of the market for liquid assets:

Figure 11.1: Demand and supply for liquid assets.
The demand for liquid assets is falling with its price. This means the lower
the interest rate, the lower the opportunity cost of holding liquid assets.
Therefore, more people will want to have liquid assets and, implicitly,
increase present consumption, which is now cheaper.
306
The supply of liquid assets is not dependent on the interest rate. It is,
however, dependent on the policy of the central bank. Equilibrium means
that at interest rate r0, the quantity of liquid assets the public wants to
hold equals the quantity supplied by the banking system:
Implicit in this is an assumption that there is also a balance between

demand and supply of present consumption. Demand for present
consumption would mean supply of bonds (borrowing money) while
supply of present consumption means the demand for bonds by those
people who wish to convert their liquid assets into less liquid assets other
than goods themselves.
Central banks
Every economy now has a central bank. Its role is to be the banker for
the government as well as for the commercial banks. The central bank
may hold the reserves for commercial banks and control their activities
through, for instance, the setting of reserve ratios. In addition, the bank
serves the government. Among other things, the government may borrow
money from the central bank. This is the case when the bank prints
money. However, whether the central bank prints money depends on its
independence and commitment to backed money.
In the past, many currencies were based on the gold standard. This meant
that a central bank was committed to exchange gold for paper notes. As a
result, the bank would not issue too many notes in case it was not able to
pay gold to all those who demanded it.
This changed after the First World War, as new nation states emerged
as a result of the Versailles treaty of 1919. Countries like Austria,
Hungary, Germany and Poland experienced dramatic hyperinflations.
One interesting thing about these hyperinflations is that they ended very
quickly.
The reason why hyperinflations started was simple enough. Austria and
Hungary became small states after a long history of being a very large
empire. Poland was a new country, and Germany (as well as Austria)
had a huge reparations bill imposed on it by the Versailles treaty. All of
these countries lay in ruin after the long war, and governments found it
difficult to raise taxes at a time when there was a need for government
intervention. As a result, these economies borrowed from the central bank
and hyperinflation ensued.
For a short description

of hyperinflations,
see BFD, Chapter 24,
section Hyperinflation.
A similar description is
in LC, Chapter 30, Box
30.1.
In all these cases the hyperinflation subsided within a few months of the
setting up of an independent central bank, which was not allowed to
lend money to the government except under very clear rules. This suggests
that independence of the central bank could be a crucial factor when
changes in the money supply occur, but we shall not discuss these issue in
this course.
Monetary policy
If, for instance, the government pursues an expansionary monetary
policy, the supply of liquid assets will increase. In a closed economy, this
can either happen through a change in the reserve ratio, or through the
government borrowing from the central bank, as shown in Figure 11.2.
307
Figure 11.2: Increasing the money supply.
Increasing M will shift the supply of liquid assets (M/P) to the right. At the
initial level of interest rate r0, there is now excess supply of liquid assets.
People will wish to convert the excess liquidity they have into less liquid
assets like bonds. Recall from our discussion in Chapter 10 that the price
of bonds (their present value) is inversely related to interest rates. When
people wish to buy bonds, which are less liquid assets, there will be excess
demand for bonds. Put differently, the demand for future consumption
exceeds its supply. Some of those people who want to lend money will not
find a borrower. The only way borrowers will be found is through a fall
in interest rates, which, in turn, increases the price of bonds). Hence, the
new equilibrium will be obtained at a lower interest rate (r1).
Deriving the LM (the liquid assets market)

The liquid assets market determines the interest rate for any given level
of output (Y). In the previous chapter, we discussed the goods market
and established that in equilibrium, the level of output is determined for
any given level of interest. Evidently, interest rates and output are closely
related and influence one another. It is therefore useful to try and examine
the equilibrium relationship between interest rate and output. We call this
presentation of the liquid assets model the LM curve (Figure 11.3).
We begin at point A in the above diagram. When national income is at Y0,
the equilibrium level of interest will be r0. If we raise the level of output to
Y1, demand for liquid assets will increase. At point C in the above diagram,
there is excess demand for liquid assets. This means that some people
will want to sell their bonds and convert them into cash. Excess supply of
bonds will mean that people will need to find lenders. This will increase
interest rates, which are the return to the lender, and reduce the price of
the bonds. Subsequently, equilibrium interest rate will rise to r1 (point B
in the above diagrams). There is thus a direct relationship between the
levels of national income and interest rates which yield equilibrium in the
liquid assets market. Points A and B lie on the LM curve, which depicts the
equilibrium relationship. To the right of the LM (points like C), we have
excess demand for liquid assets. To the left, by symmetry, we will have
excess supply of liquid assets.
308
Figure 11.3: Deriving the LM curve: liquid asset markets and a change in income.
309
Notes
310
Chapter 12: General equilibrium, employment and government policy
Chapter 12: General equilibrium,

employment and government policy
Learning outcomes
illustrate the complete model involving income determination for a
given interest rate and interest rate determination for a given income
explain monetary and fiscal policies in a closed economy
use diagrams to analyse problems involving the existence of
equilibrium and the IS LM model.
Reading
BFD Chapter 20.
The macro notion of general equilibrium

In the Chapters 10 and 11 we identified two variables which are
dependent on each other but are determined in different markets. The
first was the level of national income (or output) Y, which we analysed
in the context of the goods market. Notwithstanding the difficulties with
the notion of the aggregate goods market, which we have discussed in
Chapter 9, once we construct such a market we may expect output to be
determined in that market.
However, one of the determinants of equilibrium in the goods market
is the demand for investment. This, in turn, depends on the willingness
of individuals to provide funds for present consumption at the expense
of future consumption. This, as we have established, is a function of the
interest rate the price of present consumption. In simpler terms, demand
for investment is a function of peoples willingness to borrow, which
depends on the interest rate, or the cost of borrowing. The equilibrium in
this asset market was discussed in Chapter 10.
The second variable, therefore, is the interest rate. As the interest rate is
the price of present consumption, it reflects the demand for different sorts
of assets at any point in time. With a high interest rate, the price of present
consumption is high, since we forgo 1 + r units of consumption in the next
period for every 1 unit of consumption today. Therefore, the opportunity
cost of holding assets in a liquid form to facilitate the purchase of goods
(or to oil the wheels of commerce), is high. We would rather not
hold liquid assets.
Hence, the interest rate is determined in the market for liquid assets. But
the demand for liquid assets, as we have established, is also a function of
the level of national income. The more we produce at any given point of
time, the more transactions will be required to clear the goods market.
Hence, the higher the national income, the more liquid assets we would
like to hold. We studied the details of the equilibrium in the liquid assets
market in the previous chapter.
311
So we have two markets. Y is determined in the goods market for any

given level of r, while r is determined in the liquid assets market, for
any level of Y. How, then, do the equilibrium values of Y relate to the
equilibrium values of r?
Combining the equilibrium conditions in both markets will enable us to
simultaneously determine Y and r (see Figure 12.1).

'
Figure 12.1: Equilibrium in the goods and asset markets.
We can see that we have an equilibrium at point A in both diagrams. This

means that at an interest rate of r0, there will be equilibrium at Y0 in the
goods market. In the liquid assets market, at Y0 the demand for liquid
assets will be such that, given the supply of liquid assets, equilibrium will
occur when the interest rate is at r0.
An auxiliary tool of analysis was added by drawing the demand for
investment as a function of interest rates on the left-hand side of the righthand diagram. The values on the horizontal axis are in absolute terms; the
demand for investment at r0 (which constitutes part of the autonomous
component of the aggregate expenditures function E) is I(r0).
Is there a simultaneous solution to the equilibrium problem in both
markets? Such a solution exists in the above diagram, but it is not
intuitively obvious that it will always exist. After all, an increase in
output Y will cause an increase in r which, in turn, will cause a fall in
output Y as demand for investment falls. But then, as Y falls, demand for
liquid assets will fall too and subsequently, the interest rate will fall and Y
will rise . . . Does the system converge to a stable equilibrium?
It is very simple to establish that there always exists a pair (Y, r) for
which both markets are in equilibrium. One way to see this is to look at
the equations we have to solve. Equilibrium in each of these markets is
represented by a single equation:
(Goods market)
E(Y, r) = Y
(Liquid assets market)
Here we have two equations and two unknowns Y and r. Mathematics

tells us that there is a unique solution to this problem. At the same time, it
also tells us that r and Y, the endogenous variables, do not determine
each other. Rather, the two are determined by all other variables which are
exogenous to the model. I will demonstrate this point below.
312
Notice that the notion of general equilibrium we have used has

a certain feel of technicality to it. When we described the general
equilibrium in our microeconomic analysis, we emphasised that its
meaning was not merely a solution of a set of simultaneous equations.
Rather, it was the coincidence of wants which determined the equilibrium
prices.
In the present analysis, we are discussing two aggregate markets. The
links between such aggregate ideas are more difficult to establish. We
know that there is a connection between the behaviour of individuals in
the goods market and in the asset market. To an extent, one can say that
the goods market is the present demand for goods and services, while the
assets market links these current usages of national income with future
consumption. Yet, it is not the excess demand for goods which is translated
into an excess supply of liquid assets. Instead, it is the subsequent changes
to the level of output (or prices) which set off the chain reaction in
the assets market. Put differently, the interdependence of markets in a
microeconomic framework of two goods, meant that excess demand in
one market will lead to excess supply in the other. In the present case,
on the other hand, we do not have such clear relationship. Instead, we
have a more sequential connection between the markets. Only after
the equilibrium value in one market has changed, will the other market
respond.
It will be useful to remember this distinction to prevent you from
searching for the intuition behind some of the outcomes in the wrong
place. However, if you feel that you have not fully grasped the distinction,
there is no need to dwell on it for too long at this stage of your study.
The algebra of macroeconomics general equilibrium

Recall that basic Keynesian equilibrium was depicted by the following
equation:
E(Y, r) = C(Y, T) + I(r) + G = Y
This section is fairly

technical, and you can
skip it without loss of
continuity.
In the more explicit form we adopted, the expenditure function will have
the following structure:
E(Y, r) = C0 c1T0 + c1Y + I0 I1r + G0
= [C0 c1T0 + G0 + I0 I1r] + c1Y
In equilibrium:
A(G0, T0) I1r + c1Y = Y
where A contains the two variables pertaining to fiscal policy.
Assume that the liquid assets market has a simple linear demand function
of the following form:
L(r, Y) = aY br
where a and b are coefficients representing the responsiveness of demand
following a change in Y and r. Notice that the equation satisfies the basic
properties of the demand for liquid assets, as an increase in Y will increase
demand for liquid assets while an increase in interest rate (the price of
present consumption) will reduce demand for liquid assets.
Hence, the equilibrium condition in the assets markets will be:
313
Considering the equilibrium conditions in both markets together while

isolating Y, we get:
(Goods market)
Equating the Y from the two equations will allow us to isolate r:
Call the expression in square brackets on the right , representing the

behavioural parameters in the economy:
then:
Notice that the value of r is not determined by Y. It is dependent on the

fiscal policy parameters G and T as well as the monetary policy parameter
M. In addition, it depends on behavioural parameters like the marginal
propensity to consume, the sensitivities of investment demand to changes
in income and interest rates, and the price level.
To find the equilibrium value of Y, we have to substitute our expression for
r back into one of the equilibrium equations above:
This means that the value of Y, too, is not dependent on r.

Nevertheless, we must not confuse the fact that the general equilibrium
values of Y and r are determined by the exogenous factors with the idea
that there exists a certain relationship between the equilibrium values of Y
and r. If, for instance, there is an increase in A, clearly the values of both Y
and r will increase (provided > 0).
The geometry of general equilibrium: IS LM

A simpler way of studying the relationship between the equilibrium values
of the goods market (Y) and the liquid assets market (r) is the IS LM
framework. Recall from the previous chapters that the IS curve described
the relationship between interest rates and the equilibrium values of the
goods market (Y) while the LM described the relationship between levels
of income and the equilibrium values of interest rate (r). Combining those
two will give us the equilibrium conditions for Y and r simultaneously.
314
Figure 12.2: General equilibrium using IS LM analysis.
Point A in Figure 12.2 corresponds to the two points A in Figure

12.1. Instead of a complex diagram, we have a simple representation
of the values of Y and r for which there is equilibrium in both markets.
All the points on the IS schedule depict values of Y and r for which there
is equilibrium in the goods market, while the LM schedule depicts all
the values of Y and r for which there is equilibrium in the liquid assets
market. Hence, the intersection of the two schedules will mark the level
of Y and r for which there is equilibrium in both markets. The fact that the
IS schedule is monotonously downward sloping while the LM schedule is
monotonously upward sloping suggests, as we said before, that there will
be exactly one point where we have equilibrium in both markets.
Some comparative statics

To see how the system works, let us examine a few changes in
circumstances, using both the basic model and its IS LM representation.
I propose that you should first try and analyse each change yourself,
before reading the corresponding analysis.
Expansionary fiscal policy

When the government decides to increase its spending, it may choose
one of the following methods to finance (in real terms) the additional
activities:
1. Raising taxes.
2. Borrowing from the public.
3. Borrowing from the central bank.
We shall consider these in turn.
Tax financing
The problem we wish to consider here is an increase in government
spending which is financed through an increase in taxation. Please think
about this problem yourself before you read on.
315
We begin by setting the framework of analysis. The original model was the
following:

*
'
Figure 12.3: An increase in government spending financed through taxes.
An increase in government spending means an increase in G. Recall that

the aggregate expenditure function has the following character:
E(Y, r) = C0 c1T0 + c1Y + I(r0) + G0
= [C0 c1T0 + G0 + I0 I1r] + c1
where the expression in brackets is the autonomous component:
A(G0, T0, r0) = [C0 c1T0 + G0 + I0 I1r]
Therefore, an increase in G, from G0 to G1 (sometimes we denote the
increase in governments spending as G > 0 which, in our case,
means G = G1 G0 > 0), will cause an increase in the autonomous
component A:
A = A(G1, T0, r0) A(G0, T0, r0)
= [C0 c1T0 + G1 + I0 I1r] [C0 c1T0 + G0 + I0 I1r]
= G1 G0
= G
However, as the government chose to finance the increase in spending
via increased taxation, the effect on A will not be as great as G. In the
examples which we have set, there is a lump-sum tax system. Hence,
an increase in taxation means T > 0. The total impact of the increased
spending plus the increased taxation will be as follows:
A = A(G1, T1, r0) A(G0, T0, r0)
= [C0 c1T1 + G1 + I0 I1r] [C0 c1T0 + G0 + I0 I1r]
= (G1 c1T1) (G0 c1T0)
= G1 G0 c1(T1 T0)
= G c1T
Whether the change in policy will cause an increase or decrease in the
aggregate demand for expenditures depends on whether G c1T > 0. You
can clearly see that merely raising tax to cover the increase in government
spending will have an effect on aggregate demand. When G = T, G
c1T = G(1 c1) > 0. The reason for this, as was discussed in Chapter
10, is that a transfer of one pound from the public to the government will
316
reduce demand for consumption by the marginal propensity to consume,

while raising demand for goods and services by the government by the whole
pound. Hence, total demand for goods will increase.
If A(G1, T1, r0) > A(G0, T0, r0), we say that the government pursued
an expansionary fiscal policy. By implication, a mere increase
in government spending does not mean an expansionary fiscal policy.
Whether such a change constitutes an expansionary or contracting fiscal
policy depends on the means by which the government proposes to finance
the increase. If the government raised more taxes, it is possible that the
fall in consumption will exceed the increase in government spending,
making the policy contractionary.
Suppose that the increase in both G and T increased A. This means, in the
above diagram, a shift upwards of the E schedule. In words, this means
that an expansionary fiscal policy will lead to greater demand for goods
and services at any level of income. In particular, there will be a greater
demand for Y at Y0, leading to excess demand for goods and services
(point B in the above diagram).
Notice that there has been no change in the liquid assets market yet, since
neither income nor prices nor the supply of money has changed. How
excess demand at B is eliminated depends on the means of adjustment. We
will consider both the classical and the Keynesian means of adjustment.
The classical view

According to the classical view, adjustment happens via prices. This means
that the excess demand at point B will cause the price level to increase.
#
+

-
&
'

'
'

'

"
#
$
Figure 12.4: Excess demand in the classical view.
An increase in prices will reduce the supply of real balances. The same
quantity of money (liquid assets) will be worth less in goods and services
than before. This means that although the quantity of M is unchanged,
the supply of liquid assets is reduced, and the (M/P)S will shift to the left.
There is now excess demand for liquid assets at A. People will sell bonds
to obtain extra liquid assets, leading to an excess supply of bonds. This
will reduce the price of bonds, and hence raise the interest rate. Raising
interest rates makes present consumption more expensive, and people will
demand more bonds to facilitate future consumption.
317
The increase in interest rate will restore equilibrium in the liquid assets
market (point C in the right-hand diagram), but, will bring decrease
demand for investment. This, in turn, will reduce the aggregate demand
for goods and the E curve will shift back to its original position.
The consequence of the expansionary policy would be that output
remains unchanged, while prices, including interest rates, are higher
and investment is lower. Since output is the same as before, the greater
demand for public spending means that consumption has decreased
(through the increase in taxation). Furthermore, there is a crowding out
of investment, which covers the residual of the increase in government
spending which had not been covered by the fall in consumption.
This analysis demonstrates why classical economists feel that demand
management is not effective in bringing about a real change in output.
Nevertheless, notice that a fall in investment may have long-term
implications, as there will be a smaller increase in the stock of capital
compared to the case where the government refrained from increasing its
spending.
The Keynesian view

According to this view, the mechanism of adjustment is more likely to be
quantity adjustments, provided the economy is in an equilibrium with
unemployment. A price increase is possible, but the most likely effect of
excess demand is an increase in the supply of goods and services. To make
the analysis simple, we shall assume no change in prices and concentrate
on the implications of quantity adjustment.
The initial impact of a simultaneous increase in G and T is very much the
same as before. We are now at point B in the goods market, with excess
demand for goods and services at the output level Y0:

Figure 12.5: Excess demand in the Keynesian view.
The response to the excess demand for goods will be an increase in orders
which, in turn, will cause output to increase. As output begins to rise,
the demand for liquid assets will increase as well. This will lead to excess
demand for liquid assets at the initial interest rate r0. Interest rates will
rise, reducing demand for investment. This, in turn, reduces the demand
for goods and services shifts the E schedule downward. Equilibrium will
be reached at point C, with a higher rate of interest and a higher level of
output.
318

This means that the increase in output was not sufficient to fully
compensate for the residual in the demand for public spending G after
the effects of tax on consumption. Therefore, some output has to be
reallocated from investment to public spending.
In the Keynesian view, the expansionary policy was successful, since
demand management increased output. However, the effect on investment
is still negative.
The IS LM analysis
We have told both stories in a slightly complex framework, where we had
to examine the consequences of each change on two diagrams. By using
the IS LM framework, we can see all effects in a single diagram.
Figure 12.6: Expansionary policy in the IS LM framework.
The IS schedule, which describes equilibrium conditions in the goods

market, is downward sloping. A fall in interest rates will increase demand
for investment, which will require a greater equilibrium output. The LM,
on the other hand, is upward sloping. An increase in output will cause
an increase in demand for liquid assets, which will require a higher
equilibrium interest rate.
We start at point A. An expansionary fiscal policy means that the increase
in both G and T, which are parameters of the IS curve, will lead to
increased demand for goods and services at each level of output. In terms
of the IS, this means that at any level of interest rate, equilibrium can only
be obtained at a higher level of output. The IS curve will shift to the right.
The Keynesian view

If we take the Keynesian view of quantity adjustments, this is the end of
the story. The new equilibrium will be at point C, which is the intersection
of the new IS and the LM. Notice that there has been no change in any of
the parameters of the LM curve (namely, both M and P are unchanged).
The effect of the expansionary fiscal policy is an increase in both output
and interest rates. Since the interest rate has increased, and demand for
investment is negatively related to the interest rate, we can conclude that
investment must have fallen.
319
The classical view

As the adjustment mechanism suggests an increase in price, there will be a
change in one of the parameters of the LM curve:
Figure 12.7: IS LM with an expansionary fiscal policy under the classical view.
The IS curve shifts to the right, for the same reasons as before. However,
prices will increase in response, which means a fall in the supply of
liquid assets. Therefore, equilibrium in the liquid assets market will be
reached at a higher level of interest rates for any given level of output.
The LM schedule will shift upwards. This means that we move from point
A to point C, which is the intersection between the new IS and the new
LM. Output has not changed, and investment has been fully crowded
out to make output available for public consumption. Note that the
rise in interest rates in the classical story is much greater than it was in
the Keynesian one. According to the Keynesian story, final equilibrium
would have been at point B (with r1 as the interest rate). According to
the classical story, we end up at point C with r2 > r1. Since investment is
inversely related to the interest rate, a greater increase in the interest rate
will mean a greater decrease in investment.
Internal debt financing

Recall that the initial change which we consider is an increase in
government spending (a rise in G). In the previous subsection, we analysed
the effects of such a policy when the main source of financing was
consumption. This was in real terms, as we transferred resources from one
use, private consumption, to another, government spending. In the case of
a debt-financed increase in government spending, financing will have no
real effect on the current consumption demand for goods and services. It
will simply increase the supply of bonds. The aggregate demand for goods
and services consists of demand for consumption, public spending and
investment. When the government does not levy extra taxes, it will have no
impact on the demand for consumption. From the publics point of view, the
presence of government bonds simply means an alternative form of savings.
Within the model, this does not change any of the parameters influencing
the level of consumption and savings. Therefore, the effect of an increase in
government spending on aggregate demand will be:
320
A = A(G1, T0, r0) A(G0, T0, r0)

= [C0 c1T0 + G1 + I0 I1r] [C0 c1T0 + G0 + I0 I1r]
= G1 G0
= G
The increase in aggregate expenditures will now be greater than in the
case where the same increase in government spending was financed
by taxes, since taxes reduced consumption. The overall implications,
however, are very much the same as in the previous case, differing only in
magnitude. With debt financing, the expansionary effect of government
policy is much greater. Hence, there will be a much greater increase in
interest rates and a greater crowding out of investment in favour of public
consumption in the classical story. In the Keynesian story, there will be a
greater increase in output and a corresponding greater increase in interest
rate. In the diagram below we compare the effect of the same increase in
G when financed by taxation and when financed by borrowing:
Figure 12.8: A debt-financed increase in government expenditure.
The move from A to B and B' represents the Keynesian interpretation

of a tax financed and debt financed increase in government spending,
respectively. The move to C and C represents the classical story.
However, debt financing is a much more complex problem than it would
appear from the above analysis. First of all, there is the problem of longterm effects of debt financing. When the government sells bonds, it will
need to service the debt in the future, which means it has to decrease G or
increase T at some point. Furthermore, why doesnt the sale of government
bonds influence the demand for liquid assets, since it may influence the
price of bonds and hence the interest rate?
There is, evidently, a lot more to be said about debt financing. However,
at this stage we have to confine ourselves to the simple story above. We
do not consider the future effects of the policy and we do not consider
how such effects may influence the current behaviour of agents. When
we looked at bond markets, we used it to motivate the market for liquid
assets, rather than the other way round. We have not proposed an analysis
of complex notions of assets, and should therefore confine ourselves to
those things which we have clearly defined.
321
The way we have defined our markets, demand for liquid assets is a function
of the price of present consumption (interest rates) and income, while interest
rates are determined by the equilibrium condition in the market for liquid
assets. The way we formulated the problem means that selling government
bonds to the public will have no real effect of its own on the system.
Borrowing from the central bank (printing money)

The last financing option for an increase in government expenditure is
borrowing from the central bank. As we noted in Chapter 11, the central
bank is the banker of the government. When the government asks the
bank for a loan, the bank provides the government with money which will
be new in the economy.
The increase in government spending means that the government
needs money with which to pay suppliers of goods and services. When
this money comes from the central bank, the quantity of money which
circulates in the economy will be increased. The bank might be able to
counteract this increase, but this is beyond our present story.
Therefore, an increase in government spending, financed by borrowing
from the central bank, will have the following effects:

0
/

'
'

Figure 12.9: Increased government expenditure, financed by an increase in the

money supply.
The increase in G will shift the aggregate demand for goods and services
up. This means that at any level of income, total demand for goods and
services will increase. At the same time, the supply of liquid assets will
increase because the central bank printed money to finance its loan to
the government. We will move from point A to point B in both goods and
liquid assets markets. We now have excess demand for goods and services
and excess supply of liquid assets. We refer to this situation as a combined
fiscal and monetary expansion.
The Keynesian view

According to the Keynesian view, there will now be an increase in output
to remove the excess demand in the goods market. At the same time,
excess supply of liquid assets means that people want to buy bonds,
increasing their price through a fall in the interest rate. Hence, the price
of current consumption in terms of future consumption will fall. This
will trigger an increase in demand for investment, which will push the
aggregate expenditure function up even further. However, as income
increases to satisfy the excess demand for goods and services, demand for
322

liquid assets will increase as well. This will tend to increase the interest
rate, decreasing demand for investment and hence excess demand. The
final outcome (point C in the above diagram) will definitely be an increase
in output, while the effect on interest rates is unclear.
The classical view

As adjustments come mainly through changes in price, the effect of
the double push to aggregate demand by G and I (through the reduced
interest rates) will be a large increase in prices.

(

+
*

#

#


money supply: the classical view.
At first, we move from A to B. However, as price begin to rise, the supply

of real balances will fall and interest rates will rise. This will continue until
investment has fallen sufficiently to have moved the excess demand curve
back to its original position. Output remains unchanged, and investment
has been fully crowded out by the increase in government spending.
View from IS LM
Again, as before, the whole story is easily told by using the IS LM
framework:


money supply, in the IS LM framework.
323
The initial increase in both G will lead to a shift to the right of the IS
curve, leading to a higher equilibrium level of income for every level of
interest rate. The initial increase in the money supply M will shift the LM
downwards, leading to a lower equilibrium level of interest rates for a
given level of output. Point C is where the Keynesian story will end. In the
classical story, prices will increase until the LM has shifted upwards to go
through point D, where interest rates have risen and output returned to its
original level.
The paradox of thrift reconsidered

Recall from Chapter 10 the paradox of thrift:

#

Figure 12.12: The paradox of thrift.
An increase in savings, due, say, to a fall in the marginal propensity to

consume, will cause output to fall because of excess supply. Since output
has fallen, savings will return to their original level, or to an even lower
level if demand for investment increases with income.
In the context of the complete model, this is much less of a paradox:

Figure 12.13: The paradox of thrift in the IS LM framework: the Keynesian view.
324
An increase in savings (a fall in consumption) means that at any given

level of interest rates, demand for goods and services will be lower. The
level of income required to sustain an equilibrium in the market is thus
reduced, and the IS schedule will shift to the left. At A, we now have
excess supply. In the Keynesian view, this will lead to a fall in output and
subsequently, a fall in demand for liquid assets which will reduce interest
rates. This, in turn, will increase investment. We will end up at point B.
The outcome of increased savings, therefore, will be to reduce output but
to increase investment. While this is clearly no longer a paradox, there
is an immediate fall in output. On the other hand, increased savings will
increase investment which, in turn, will increase the stock of capital and
facilitate growth.
In the classical version of events, output will not be reduced:
Figure 12.14: The paradox of thrift: the classical view.
The effect of increased savings will be a move from A to C. As the fall in

consumption generates excess supply, prices will fall. This will cause an
increase in the supply of liquid assets and subsequently, a fall in interest
rate. This will increase investment. The process will continue until the
excess supply at the initial level of income has been eliminated. We are
back at the original output level, with a lower interest rate. There is not
much of a paradox left here.
325
Notes
326
Chapter 13: Prices, inflation and unemployment
Chapter 13: Prices, inflation and

unemployment
Learning outcomes
define the concepts of an open economy, a closed economy, liquid
assets, the Keynesian and classical view of aggregate supply, the Phillips
Curve and the theory of inflation, price levels and unemployment
explain derivation of aggregate demand in the price output place, the
problem of deriving aggregate supply, the problem with explaining
stagflation
use diagrams to analyse problems involving prices, inflation and
unemployment.
Reading
BFD Chapters 2123.
LC Chapters 2425.
Prices and output

Reading
BFD Chapter 21.
LC Chapters 2425.
So far, we have said very little about the relationship between output and
prices. This is not because the models we have used have nothing to tell
us about this relationship. Rather, it reflects the fact that macroeconomics
developed, to a great extent, in response to some burning issues of the
time.
Towards the end of the nineteenth century and the beginning of the
twentieth century, one of the most troubling questions was the reason for
unemployment. The classical view of output, as manifested in Says Law,
suggested that supply determines the level of national product, and hence,
employment. This meant that the only role for governments in helping
to alleviate unemployment is to make life easier for business, creating a
conducive environment for business (production) to expand.
The Keynesian revolution was to suggest that it is aggregate demand
which determines output and hence, employment. The implication of
this was that demand management, active and direct government
policies, can alleviate the problem of unemployment. The difficulties with
both approaches and the different definitions of unemployment have
already been discussed in Chapter 9, so I will not repeat them here.
327
Later on during the twentieth century, economists became increasingly

aware of the significance of inflation. The initial and immediate concern
was the precise relationship between prices and the models we have
developed so far. Although inflation the rate of change in prices is not
the same as price levels, it seems reasonable to begin the investigation
by establishing the determinants of the price level, before moving on to
determinants of the change in price levels.
The first step, therefore, is to identify the relationship between price levels
and output in the existing models. Our starting point will be the IS LM
analysis, which is a more compact version of the models we considered in
the previous chapters.
The aggregate demand: yet another representation

When we began modelling the world of aggregate goods, we formulated
a very basic demand schedule. It was based on the simple assertion that
aggregate demand for goods and services in an economy will be a function
of national income. The greater the national income, the greater the
demand for goods and services.
In Chapters 9 and 10, we saw that this formulation only holds if we have
fixed relative prices, unchanged institutional arrangements, and a fixed
income distribution. This continues to hold, and is worth bearing in mind
when considering the sometimes surprising outcomes of our analysis.
Our first presentation of the aggregate demand for goods and services was
in the space of demand for goods E and output Y. We saw that a major
component in aggregate demand is the interest rate, which is determined in
the liquid assets market. We therefore adjusted the presentation to examine
the relationship between interest rates and equilibrium levels of output by
using the IS representation of the goods market. We performed a similar
transformation of the liquid assets market by using the LM analysis of liquid
asset markets. We then reestablished the notion of macroeconomic general
equilibrium as the point where the two schedules meet.
The role prices play in the supply of liquid assets gives us an initial insight
into its relationship with the equilibrium level of income and interest rates.
The intuition is simple enough: an increase in price reduces the supply of
real balances. This, in turn, increases interest rates, which reduces demand
for investment and subsequently, aggregate demand. Hence, the level of
output needed to supply the new aggregate demand is bound to be smaller
(Figure 13.1).
Beginning at point A, we observe that when the price level is P0, the
equilibrium level of output will be Y0. What will happen to the equilibrium
level of output when prices increase to P1? In the Liquid Assets market (LM),
the supply of real balances will fall from (M0/P0) to (M0/P1). This means that
at each level of output and a given demand for liquid assets equilibrium
can only be achieved at a higher interest rate. In particular, the demand for
liquid assets is given at Y0. A fall in supply of real balances will lead to excess
demand for liquid assets. People will want to convert some of their less liquid
assets (say, bonds) into money. This increased sale of bonds will lead to excess
supply of bonds. The price of bonds, which is inversely related to interest
rates, will have to decrease through an increase in interest rates. Hence, the
LM curve will shift up, and the level of interest rates required for equilibrium
in the liquid asset markets will increase for every level of output.
328
$
Figure 13.1: Prices, output and aggregate demand.
Consequently, the entire system reaches a new equilibrium at B, where the

equilibrium level of output is lower than at Y1, while prices have increased
to P1.
We have thus established an inverse relationship between prices and
equilibrium levels of output in our system. This relationship is called
the Aggregate Demand (AD) schedule, and is depicted in the lower
diagram in Figure 13.1. Naturally, the position of the AD schedule
depends on the values of all other parameters which initially determined
the position of the IS and the LM. Notably, it depends on the instruments
of fiscal policy, G and T, and on the instrument of monetary policy, M.
This analysis gives us one of the relationships between price levels and
equilibrium levels of output, arising from aggregate demand. To find
an equilibrium level of prices, we need a second relationship, that of
aggregate supply.
The problem with aggregate supply

From our microeconomic analysis, we know that the supply of a single
firm will generally rise with an increase of the price of its product. At the
aggregate level, this is by no means evident. An increase in the general
price level might also lead to an increase in the cost of inputs (interest
rates, for example, will increase with the increase in the price levels).
Therefore, the relationship between prices and aggregate supply will
depend on the relationship between the change in the prices of final goods
and the prices of intermediate goods. We have no reason to believe that
329
there exists a particular relationship between these changes. Consequently,

we cannot deduce with certainty that aggregate supply increases with
prices.
For similar reasons, one should not confuse the downward-sloping AD
with the demand schedule in microeconomics. While the latter represents
the considerations of rational individuals, the former represents the
cumulative outcome of their actions and the various institutional
arrangements within which they operate.
What can we say about aggregate supply? We did discuss some issues
pertaining to it in Chapter 9, but now we need something more concrete.
Recall from Chapter 9 that the determinants of output were not clear.
The classical view has been that output is being determined by the
circumstances of industry. This does not tell us anything explicit about the
relationship between output and prices. Therefore, we simply assume that
there is no relationship between prices and output. The Keynesian view,
however, suggests that output is demand-driven. What would that mean to
the relationship between prices and output in aggregate supply?

Figure 13.2: Aggregate output: the Keynesian and classical view.
On the right-hand side, we have the classical view of aggregate supply.

Since circumstances of industry determine output, prices will have no
effect on aggregate output. The aggregate supply schedule AS will be
vertical, and the level of output will be the natural rate of output, or the
potential output.
The left-hand diagram depicts the Keynesian view of aggregate supply.
When there is unemployment, the main mechanism of adjustment would
be through quantity. A change in demand will cause output to change,
rather than prices. Therefore, the AS schedule will be upwards-sloping or
even horizontal for levels of output where there is unemployment. When
we reach the point of full employment, the only feasible mechanism of
adjustment is through prices. Therefore, at full employment, the Keynesian
supply will have the same relationship with prices as the classical aggregate
supply. However, the question remains whether Keynesian and classical
notions of full employment and natural rates of output are the same.
All this has significant implications. The flexibility of prices and the
reliance on prices as the major mechanism of adjusting both excess
demand and excess supply suggests that demand management
will be futile. Any increase in aggregate demand will only result in a
subsequent increase in prices without bringing about any real change. In
330
the Keynesian context, demand management will be effective as long as

there is unemployment in the economy. In particular, it will be an effective
instrument in alleviating unemployment.
Inflation and the Phillips curve

Apart from the more methodological debate concerning the validity of the
Keynesian and classical approaches, there are also practical implications.
I mentioned earlier that macroeconomic analysis is very much shaped by
the current unresolved problems of an economy, since it is often seen as a
tool to help determine government policy. Macroeconomic analysis started
with the problem of unemployment, until attention shifted to the problem
of increasing prices during the boom years of the 1950s and 1960s. In the
1970s, however, another problem came to the attention of economists.
As a result of the oil price shocks, many industrialised economies
experienced the strange occurrence of increases in prices with concurrent
unemployment, a phenomenon known as stagflation. Neither of the
above models tell us much about inflation, or changes in the price level.
They cannot accommodate stagflation, let alone explain it.
A first approach that was developed in response to these problems
was the Phillips Curve. The Phillips Curve is not, in itself, a model.
It does not explain anything. It only shows an interesting empirical
correlation between the rate of change of nominal wages and the level of
unemployment.

Figure 13.3: The Phillips Curve.
We can express the relationship in the following form:
represents the rate of change. If wages in period t are 150 and

equal to 100 in the previous period, t 1, then wages increased at a
rate of 50%. Let u the level of unemployment for which wages remain
unchanged correspond to the potential output we referred to before.
When unemployment exceeds the natural rate, corresponding to
potential output, wages will fall. Conversely, wages will increase whenever
(u u) < 0. As I mentioned, this is not a theory of the relationship
between wages and unemployment. Rather, it is an empirically
observed regularity only.
331
We can rewrite the above relation in the following way:
(1)
which we can read as follows: When wages are determined, labourers
will want to keep their wages at least at the current level. Whether they
succeed depends on their bargaining power, which depends on the level
of unemployment (u u). If the level of unemployment is high, their
bargaining power is likely to be low, since employers can easily find other,
currently unemployed workers, who will be willing to work for lower
wages.
We now need a pricing theory to translate these empirical findings into a
theory of inflation. Recall from microeconomics that competitive firms will
price at marginal cost. This means that:
Across an entire economy, pricing might be more complex. Not all markets
are necessarily competitive: some industries might price above marginal
cost. This also means that productivity might vary across industries.
Hence, instead of marginal productivity, we use average productivity a. In
the case of a completely competitive industry, this will, of course, be equal
to the marginal productivity. Similarly, we allow for some prices being
above marginal cost by using an average mark up z, which will be equal
to zero if all markets are perfectly competitive. Price is then determined
as:
(2)
Substituting (1) into (2):
(3)
(4) Pt = Pt 1 [1 (u u]
as
Reversing the procedure which led us to equation (1), we get:
(5)
which produces the famous idea of a trade-off between inflation and

unemployment.
332
Figure 13.4: Implications of the Phillips Curve: the trade-off between inflation
and unemployment.
This idea, which has been very influential in policy-making, seems to

suggest that a government can lower unemployment by increasing
inflation. We will discuss this matter towards the end of this chapter.
Suppose now that unemployment and output are closely related. This is
not necessarily obvious, since output may vary even without changes in
employment, since there are other means of production as well. Still, we
shall assume that unemployment and output are inversely related. We can
then draw the Phillips Curve in inflation-output space, giving us (almost)
an aggregate supply function:
Figure 13.5: Implications of the Phillips Curve: inflation and output.
The corresponding equation is:

(5')
P = (u u) = (Y Y)
Note that this is a theory that relates inflation, or changes in prices, to

output. Nonetheless, it seems to lend some support to the idea of an
upward-sloping AS curve in the output-price levels plane.
However, our story does not end there. Friedman and Phelps argued that
the explanatory power of equation (1) is unsatisfactory. Workers worry
about the real wage W/P. Basing their wage demands on last periods
nominal wages, while knowing that their demands will increase prices
(thus reducing real wages) will not be a rational strategy.
333
If workers expect an increase in prices in the coming period, they know that
their real wages will fall. It will only be natural for them to ask for nominal
compensation for the expected price increase. If at time 0 the real wage is
(W0 /P0), and labourers expect prices to increase by P, then their nominal
wages will only be worth (W0 /(P0(1+P))) without adjustment. They will
therefore demand an increase in nominal wages such that the level of real
wages is at least unchanged. Namely, they will demand an increase of at
least W = P, which would leave their real wages unchanged:
We must, therefore, rewrite (1) in the following way:

wt = wt1 [1 + P e (u u)]
(6)
where P e represents the expected increase in price levels. Repeating the

entire exercise which led us from equation (1) to equation (5) will yield
the following augmented Phillips Curve (converting from unemployment
to output):
(7)
= Pt 1 [1 + P e (u u)]
(8)
P = P e (u u)
(8')
= P e + (Y Y)
This suggests that there is a separate Phillips Curve for each level of
expected price increases. The original trade-off between inflation and
unemployment reflected a zero expected price increase.
Figure 13.6: The augmented Phillips Curve: taking account of expectations.
How do people form those expectations? This is a huge topic, and we shall
not really deal with this question. Let us just say that if people are rational,
and properly understand the way in which the economy works, their
expectations will be correct in the long run. This means that the expected
price increase will equal actual realised inflation in the next period:
P e = P
If that is the case, one can easily see from equation (8) that in the long run
Y=Y
which implies that the long-run supply is, after all, vertical. This yields a
long-run Phillips curve which is vertical, LRPC.
334
An application: analysis of stagflation

What does this theory have to say about the problem of, say, stagflation? We
have now introduced a dynamic aspect into our theory, describing how
aggregate supply is determined when prices are constantly changing. We
must therefore find an equivalent version of dynamic aggregate demand.
To make life easier, let us go back to the IS LM equilibrium condition,
from which we derived the AD function in the previous sections. One of the
determinants of the equilibrium level of demand is the interest rate, which,
in turn, is determined in the Liquid Assets market. For any given quantity of
money M and price level P, there is an equilibrium rate of interest.
Inflation means that prices increase. In other words, for any given stock of
money M, inflation means a reduction in the stock of real balances. From
the initial model, we know that a fall in M/P means an increase in interest
rates for each level of output. This, in turn, reduces investment and the
equilibrium level of demand. Naturally, if the government increases the
supply of money at the same rate at which inflation increases prices, the
supply of real balances will remain unaffected.
Let us use the above reasoning to assume that dynamic aggregate demand
is inversely related to the rate of inflation. Imagine that, as the rate of
inflation increases, people will reduce their holdings of liquid assets. The
rush to buy bonds will cause interest rates to increase. We can then draw
the dynamic aggregate demand function as a downward-sloping
curve in our diagram:
Figure 13.7: The Phillips Curve and dynamic aggregate demand.
When there is no accommodating monetary policy (to match any

increase in prices by an increase in money supply), the economy will
be in equilibrium at point A with zero inflation. If, alternatively, there is
inflation, this means that we are moving along the DAD curve to point
B, where the inflation is depleting the stock of real balances and pushes
interest rates up. This, in turn, reduces investment and equilibrium (IS
LM) aggregate demand. As the output at B is below the long-run supply,
this means that the economy will have unemployment together with
inflation (i.e. stagflation).
335
A price-level interpretation
What will be the implication of the Phillips Curve for our analysis of
aggregate supply and demand? We took a static view of price levels, while
we have now introduced a dynamic element. Figure 13.8 shows one way
of depicting the dynamic element.
$

%
(
'

$
Figure 13.8: Introducing dynamic prices in AD/AS.
The vertical (classical) aggregate supply shows the long-run level

of supply. This means that classical economists admit that demand
management could be effective in the short run, while Keynesians will
have to admit that in the long run, demand management is not effective.
Whether this is a reasonable way of settling the methodological dispute
between the two views is a difficult and complicated question, which I
shall not attempt to address here. However, for such an interpretation to
work, the notions of long run and short run must be very well defined.
This is far from being the case at either the microeconomic or the
macroeconomic level. Still, for what it is worth, it allows us to analyse the
policy recommendations that will follow the adoption of both classical and
Keynesian points of view.
We start at point A, which is a long-run equilibrium. The real wage in
the labour market is w0 /P0. An expansionary fiscal policy will shift the
aggregate demand AD to the right since there will be greater demand for
goods and services at each level of prices. This will have an effect on the
Liquid Assets Market through an increase in interest rates. The result is an
equilibrium at a higher level of output.
A shift to the right of the aggregate demand will mean that there is now
excess demand for goods at the price level of P0. Prices will begin to rise.
This will reduce the real wages paid to workers, since the nominal wage
rate remains unchanged:
Recall our discussion of the demand for labour in Chapter 5. This demand
was the outcome of profit maximising behaviour by firms. If the price of
labour (in terms of goods) falls, then firms are willing to employ more
labour than before. Therefore, the initial increase in price will allow
producers to increase their output in response to increased orders. In other
336
words, the economy will move to point B where a combination of quantity

and price adjustments took place.
However, nominal wages remained at their initial level. This may be
possible in the short run. Wage contracts typically specify nominal wages
(there is no reason to expect indexation to inflation in the contract, since
there is no inflation in our case). Until wage contracts are renegotiated,
real wages may indeed fall. We call the line depicting output for any given
level of nominal wages the short-run aggregate supply. As prices
increase, real wages fall and the supply of output will be greater.
When the wage contracts are renegotiated, workers will want to be
compensated for their fall in real income. They also know that the
employers are likely to pass the increase in nominal wages on to
consumers by increasing prices. If workers calculate these effects correctly,
the increase in nominal wages will compensate them both for the initial
price increase and the one following the renegotiation of wage contracts.
The economy will move to point C, where nominal wages have risen
sufficiently to compensate for both the initial increase from P0 to P1 and
additional increase from P1 to P2. Thus, real wages at C and at A are the
same:
and so will be output at A and at C.
Self-assessment
Define the concepts of an open economy, a closed economy, liquid
assets, the Keynesian and classical view of aggregate supply, the Phillips
Curve and the theory of inflation, price levels and unemployment.
Explain derivation of aggregate demand in the price output place, the
problem of deriving aggregate supply, the problem with explaining
stagflation.
Use diagrams to analyse problems involving prices, inflation and
unemployment.

you to explain the subject in a way that will help you yourself understand
things which you may not have understood otherwise.
Question 1
In a closed economy with flexible prices and wages, expansionary
monetary policy will not have any real effect and will only cause a rise in
nominal wages. True or false?
Explain.
337
Question 2
There is no paradox of thrift in a closed economy when wages and prices
are flexible. Discuss.
Question 3
In an election year, the government increased its spending by borrowing
from the public. To prevent an increase in the interest rate, the
government persuaded the central bank to reduce the reserve ratio for
commercial banks. The opposition accused the government of sowing the
seeds of recession while mortgaging the future (reducing investment).
a. Discuss the opposition accusations in a closed economy with fixed
wages.
b. Discuss the opposition accusations in a closed economy with flexible
wages.
Question 4
In order to attract high-flyers and invigorate the economy, the government
decides to reduce the highest marginal tax rate and to increase the lower
marginal tax rate. The change has been designed in such a way as to keep
the overall level of tax receipts unchanged. Some argued that favouring
the high-flyers will only bring about a recession and a fall in investment.
a. Examine the argument in the context of a closed economy with fixed
wages.
b. Would your answer be different if wages were flexible?
338
Answers
Question 1
First choose the right framework of analysis. The question asks you about
the effects of an expansionary monetary policy on output and nominal
wages. Therefore, the right framework of analysis is the IS LM and AD
AS. Normally, when there is no reference to wages or prices, there is no
need to use the AD AS framework.
The issue at hand is an expansionary monetary policy (Figure 13.9).

"
"
)
*
,

D
,
*
%

)
Figure 13.9
An expansionary monetary policy means an increase in M, and hence the

supply of real balances. This means that at any given level of income Y,
equilibrium in the liquid assets market will be at a lower level of interest
rates. The LM, therefore, shifts to the right. However, before you move
the LM curve, notice that LM is also dependent on the value of P. As the
AD curve responds to all changes in the IS LM framework, equilibrium
prices will change as well. To prevent your drawing from being clogged up
with lines, think before you move the LM.
339
We know that an increase in M will also shift the AD to the right. Lower
interest rates mean greater demand for goods and services at any given
price level. This implies that a new equilibrium can only be obtained at
a higher level of output. As AD moves to the right, prices will rise to P1
and output to Y1 in the short run (point B in the ADAS framework). An
increase in P will reduce the supply of real balances. This, in turn, will
shift the LM slightly back.
Notice that in the AD AS model, the effects of a change in price on
the IS LM equilibrium is depicted as movement along the AD curve. In
other words, the initial increase in M will push us to point C (at the initial
price level). However, as the excess demand in the goods market means
that there will also be an increase in price, we move up, along the curve,
to point B. In the IS LM framework, this means that the LM has gone
further out than its current position (at B) before it moved back a bit due
to the price effect. Notice that at B, the parameters of the LM schedule are
M1, which is the new quantity of money and P1, which is the new level of
prices at B.
Had wages and prices been fixed, this is where the story would end. In a
world where prices and wages are not the main mechanism of adjustment,
demand management will be effective in bringing about a change.
According to the question, we live in a world of flexible prices and
wages. This means that B is only the short-run outcome. At B, real wages
are lower than before, as nominal wages are unchanged but prices are
higher. While employers will be happy to employ more people at a lower
real wage, workers are unlikely to be happy with the fall of real income.
When wage negotiations open, they will demand a compensation for the
increase in prices from P0 to P1. They will also want to be compensated
for the increase in price that will follow the increase in their nominal
wages. Thus, the economy will move to point C with a higher level of
nominal wages but the same level of real wages. There will, therefore,
be no real effect on the economy when prices and wages are flexible.
Demand management will have no real impact on the economy. Notice
that incorrect workers expectations with regard the change in prices that
will follow the increase in their nominal wages may create recession if the
SAS (short-run aggregate supply) moves too far to the left (point D in the
above diagram).
Question 2
Recall our earlier discussions of the paradox of thrift. We will now repeat
it in the context of our extended framework (Figure 13.10).
An increase in the marginal propensity to save will cause a decrease in
consumption. The IS curve shifts to the left. However, remember that a
shift of the IS will also shift the AD schedule. This will cause a change in P
which will change the position of the LM which, in turn, will again change
the position of the AD schedule.
To analyse this in a simple manner, it is best to move AD first. A fall in
consumption means that at any price level, demand is reduced and the
output level for which there is general equilibrium will be lower (A to C
in the bottom diagram in Figure 13.10). As there is full wage and price
flexibility, this means that prices will fall to P1. This is a move along the AD
curve to point B, where AD intersects the SAS. As prices fall, real wages
increase. Therefore, employers will employ less people at the given level of
nominal wages.
340
/
,

/
,
'

'
Figure 13.10
A fall in prices also means an increase in the supply of real balances M/P.
At any level of output, there will now be excess supply of liquid assets,
which will lead to a fall in interest rates.
Why will excess supply of liquid assets lead to a fall in interest rates?
This means a shift to the right of the LM schedule. Thus, the initial effect
of the fall in consumption is a move from A to B in both diagrams.
In the long run, employers will suggest a reduction in nominal wages to
keep real wages constant. Workers, who face unemployment, are likely to
agree. The correct anticipation of the changes in prices means that we will
now move to point D, where output remains at its initial level, real wages
are unchanged but the interest rate has fallen. So there is no paradox
whatsoever, as the wish to save more will materialise through higher levels
of investment and no fall in output.
Question 3
The two changes in the economy proposed by this question are:
an increase in governments spending G, financed by borrowing from
the public
an increase in money supply due to a fall of the reserve ratio.
341
a. A closed economy with fixed wages:

&

&

Figure 13.11
IS and LM shift to a new equilibrium at a higher level of income and,

more or less, the same interest rates. Using the IS LM without the
AD AS is fine in this section. There is no need to use AD AS when
wages are fixed. However, if you do use the complete framework, you
are expected to demonstrate that you take account of the relevant
changes in price levels and their influence on the IS LM model.
Hence, the opposition was wrong in the case of fixed wages.
b. A closed economy with flexible wages:
IS and LM shift from equilibrium at A to a short-run equilibrium at B
(which already includes a change in prices from P0 to P1 and a slight
shift back in the LM). In the long run, as real wages fall, there will be
a compensation in nominal wages which, if correctly anticipating the
effects of greater cost on future prices, will bring the economy to point
C. As prices increase, the LM will shift to the left until it reaches point C
(in the IS LM framework) where the economy will return to long-run
equilibrium.
The opposition was wrong about recession but right about mortgaging
the future (the increase in interest rates will reduce demand for
investment).
342

"

"

,

Figure 13.12
Question 4
The main problem in this question is identifying the change and
translating the question into the language of the model. It is clear that we
must distinguish between two groups of consumers: higher earners and
low earners. By now, you should have had sensed that the issue at hand is
the difference in marginal propensities to consume. As overall tax receipts
have not changed, this is really a transfer of income from the poor to the
rich. As such, if the poor have a greater marginal propensity to consume
than the rich, every pound transferred will yield a net fall in consumption.
Alternatively, we can write down the following consumption function:
C(Y) = C0 + c H1 (1 tH)YH + c 1L (1 tL)YL
C = c H1 tH YH c 1L tLY)L < 0
as
tH < 0
tL > 0
tH < tL
Hence, the change under discussion is a fall in aggregate demand for

consumption.
343
a. Closed economy with fixed wages:

)

)

%

%
Figure 13.13
IS shifts to the left and there is a new equilibrium at a lower level of

income and a lower level of interest rates, leading to a greater demand
for investment. Since wages are fixed, it is sufficient to consider the IS
LM framework without the AD AS model. If you do use the AD
AS, you should make sure that you take account of price changes and
their effect on the LM.
The opposition was right about the recession, but wrong about the fall
in investment.
344
b. Closed economy with flexible wages:

(

(

(

*
+
*

$

$

Figure 13.14
IS shifts to the left and so does AD. Prices fall from P0 to P1 and there
is a slight shift outward of the LM. In the long run, the increase in
real wages will lead to a fall in nominal wages which, if correctly
anticipating the effects of lesser cost on future prices, will bring the
economy to point C. As prices decrease further, the LM will shift to the
right until it reaches point C, where the economy will return to longrun equilibrium.
So this time the opposition was wrong about recession as well as about
the effects of the change on investment.
345
Notes
346
Chapter 14: The open economy

Learning outcomes
define the concepts of national accounts of an open economy, demand
for export and import and their effects on aggregate demand, the next
export function, the multiplier of an open economy, the balance of
payments, the foreign currency market
illustrate the difference in the impact on the system under different
exchange rate, income determination with and without capital
movements
use diagrams to analyse problems involving an open economy.
Reading
BFD Chapters 2429.
LC Chapters 1819 and 2223.
The national accounts for the open economy

Until now, we have focused on the relationship between aggregate
variables in a closed economy. Naturally, almost all economies in the world
are open economies in the sense that they trade with other economies. For
some economies, trade is mainly in goods and services, while for others,
there are also exchanges in assets.
From an analytical point of view, there is nothing really new in the analysis
contained in this chapter. We are simply adding variables and functions to
our framework, rather than changing our analysis conceptually.
Recall our analysis in Chapter 8. Having defined national output as the
sum of value added, we established that national product and national
income (i.e. generated income) are two sides of the same coin:
NNP = Y
In a closed economy without a government, the use to which we could put
our product had been confined to consumption C and investment I. Hence:
NNP = C + I
With a government, there was an additional possible usage of the national
product, public consumption G. Therefore:
NNP = C + I + G
In a world without a government, we used our income for either
consumption or savings, Y = C + S. With a government, we introduced
taxes as an additional use for our income:
Y=C+S+T
Since NNP = Y we got:
C + I = C +S
I= S
in the case of an economy without a government and:

C + I + G = C + S +T
I= S + T G
with a government, which means that actual investment always equals

actual savings. Without a government these were private savings S. With
347
government, actual savings were private savings S plus government

savings T G, or government surplus.
The fundamental relationship between NNP and Y still holds in an open
economy, but imports IM now form an additional resource in the economy.
Conversely, the uses of our resources now include exports X. Hence, our
new national accounts identity will be:
IM + NNP = C + I + G + X
NNP = C + I + G + X IM
What people do with their income remains unchanged. Just as before, they
have to pay taxes before they can split their income between savings and
consumption. Therefore:
Y=C+S+T
Since NNP = Y,
C + I + G + X IM = C + S + T
I = S + (T G) + (IM X)
= S + (T G) (X IM)
= S + (T G) NX
where NX = X IM are our net exports. A positive NX represents a
surplus in the current account, since we export more than we import.
The goods market

Compared to the previous chapters, we have now introduced an extra
usage for our national product. We can export some of it to other
countries. On the other hand, we can use some of our income to import
goods from abroad. The net impact on the national accounts, as we saw
above, was our net exports NX. Our imports can always be financed by
exports, and only the residual has to come from national income. This
means that a negative NX, where we import more than we export, will
lead to a reduction of national income available for domestic consumption,
savings and hence investment. Conversely, a positive NX will increase the
available income.
We thus have to incorporate NX into our aggregate demand function to
reflect its effects on national income. Before we go ahead, however, we
have to look at an important characteristic of international exchanges,
the Real Exchange Rate. When we looked at the national accounts
above, we added both imports and exports to our equation. This means
that imports and exports were denoted in the same units as domestic
production. Now, foreign goods are typically priced not in sterling, our
domestic currency, but a foreign one, say, US Dollars. We thus need a way
to convert these foreign units of account into domestic ones, which is the
role of the real exchange rate.
Suppose we have 1 available. What can we buy with it? If we choose to
spend it on domestic goods, and the domestic price level is P, then we can
buy 1/P units of domestic goods. How much can we buy if we decide to
purchase foreign goods? The answer comes in two parts. First, we have to
convert our local currency into the foreign currency. Then, we have to see
how many units of goods our foreign currency will buy abroad.
The amount of domestic currency we have to pay for 1 unit of foreign
currency is given by the nominal exchange rate E. Note that we could
have equally let E denote the amount of foreign currency necessary to buy
1 unit of domestic currency. Which of these two definitions we choose is a
matter of convention. Most textbooks and academic articles use the former
348
definition. Hence, for example, if we can exchange 1 for $1.60, then the
current nominal exchange rate of the dollar against the pound will be
E = 1/1.60 = 0.62 units of domestic currency per foreign currency. To
repeat,
E = amount of domestic currency per unit of foreign currency
The last step is to see how much foreign product we can buy with our
newly acquired foreign currency. If the foreign price level is P*, then we
need P* units of foreign currency to buy one unit of foreign product. In
terms of domestic currency, this will cost us EP* if the nominal exchange
rate is E. If the domestic price level is P, then this amount of domestic
currency would have bought us:
units of domestic product. Hence, this expression gives us the rate of

exchange between domestic and foreign product. It tells us how many
units of domestic product we need to exchange for 1 unit of foreign
product. This is called the real exchange rate.
An increase in E will have a similar effect as an increase in P*. It will
make imports, or purchases of foreign product, more expensive since we
have to give up more domestic product for one unit of foreign product.
By symmetry, this means that our exports are getting cheaper, since
less foreign product has to be given up for 1 unit of domestic product.
Conversely, an increase in the domestic price level P will make domestic
product, and hence exports, more expensive while reducing the cost of
imports. We say that a fall in E corresponds to an appreciation of the
domestic currency, since it becomes relatively more expensive. A rise in E,
on the other hand, corresponds to a depreciation of the local currency.
We can use our definition of the real exchange rate to characterise demand
for imports and exports. The demand for exports is simply a function of
the real exchange rate. Exporters will want to export more as long as their
return in terms of domestic product is higher than the return they could
get selling domestically:
where export is increasing when the real exchange rate increases and
decreases when the real exchange rate the return to the exporter
diminishes.
Demand for imports, on the other hand, depends not only on the real
exchange rate, but also on income. An increase in the real exchange rate
means that we pay more per unit of imported goods in real terms. This
would reduce the quantity which we wish to import. Whenever income
increases, however, our demand for imports, like that of any other kinds
of economic goods, will increase. We can therefore write the demand for
import in the following way:
The aggregate demand, adjusted for the effects of imports and exports,
can then be derived as follows:
349
Domestic aggregate demand will then be given by:
We now have all the elements for our extended model, and can draw
the various curves. We have added imports and exports to our model,
which we can summarise by a net export function. Assuming that the
nominal exchange rate E is fixed, the net export function will have the
following form:
We note that this function is decreasing in Y. Hence, its diagrammatical

representation will be as in Figure 14.1.
Figure 14.1: The net export function NX with a fixed exchange rate.
Since the nominal exchange rate and prices are fixed at the moment,
exports will be fixed, too. This means that if we have an initial surplus in
our net surplus, we can balance it only by increasing demand for imports
by increasing income.
Figure 14.2 shows how the complete market will now look.
350

"

Figure 14.2: Excess demand with net exports.
As before, our equilibrium condition is that aggregate demand equals

output, for given price levels P0 and P*
, nominal exchange rates E0 and
0
interest rates r0:
With our functional forms of the various constituents of aggregate

demand, this means that
Hence
Note that the multiplier under an open economy is smaller than that under
a closed economy. It now includes the extra term m, which measures
the sensitivity of imports to income. As we saw, the multiplier represents
the pressure exerted on domestic product following an initial increase
in demand. In an open economy, some of the increase in demand can
be satisfied through imported goods. Consequently, the pressure on the
domestic output will be reduced.
Exchange rate determination and the money sector

The balance of payments
When we determined equilibrium in the goods sector, we assumed that the
real exchange rate was fixed. While it might be relatively straightforward
to assume that P* and P are fixed, the case of the nominal exchange rate E
is more complex.
What determines the nominal exchange rate? It is the rate of exchange
between foreign and domestic currency, and will thus be determined by
the demand and supply of foreign currency. From the demand and supply,
we can derive the excess demand function for foreign currency, which
we call the balance of payments. It takes account of the sources of
351
foreign currency, as well as the possible uses to which we can put it. The
elements of the balance of payments are
the current account
the capital account
changes in reserves.
The current account is closely associated with the trade balance. Within
the current account, the source of foreign currency is exports, while the
use of it is imports.
In the capital account, the source of foreign currency is foreigners
who want to hold domestic assets. To do that they will have to buy
domestic currency and therefore, offer (i.e. supply) foreign currency. The
use of foreign currency in this account is by locals who want to hold
foreign assets. To do that they will have to buy (i.e. demand) foreign
currency.
Changes in reserve is the category which ensures that the Balance of
Payments is indeed balanced, that is, excess demand for foreign currency
is zero. A deficit in the Current Account might be entirely covered by a
surplus in the Capital Account. But if, say, both accounts are in surplus,
then more foreign currency is offered than is required. In such a case, the
residual will be accumulated in the central bank in the form of increased
reserves. Increasing reserves is therefore a use of foreign currency.
Note that changes in reserves invariably affect the money supply. When
the central bank increases its reserves of foreign currency, it pays for it
with domestic currency. This means that the amount of domestic currency
in circulation, and hence the money supply, has increased.
Similarly, whenever there is a deficit in both accounts, demand for foreign
currency exceeds its supply. This will lead to decreased reserves, which
means that the money supply will fall as well.
The complete picture is therefore as follows:
Foreign currency
Sources of
Uses of
Current account
Export (X)
Import (IM)
Capital account
Foreigners buying
domestic assets
Locals buying
foreign assets
Reserves
Reduction in reserves Increase in reserves

(M decreases)
(M increases)
Fixed and flexible exchange rates

Whether a change in reserves becomes operative to ensure the balance
of payments, will depend on the exchange rate regime in the economy.
When there is a flexible exchange rate regime, the central bank does
not interfere by using changes in reserves. Instead, the nominal exchange
rate E will adjust to equate the demand for foreign currency generated by
both current and capital accounts with the supply generated by the same
accounts. An excess demand for foreign currency will cause the domestic
currency to depreciate, and E will rise. This will reduce demand from
imports, while it increases supply through exports. Similarly, an excess
supply of foreign currency will cause the domestic currency to appreciate,
and E will fall.
If, on the other hand, the central bank wants to keep the exchange rate
at a certain level, the economy operates in a fixed exchange rate
352
regime. In such a case, whenever the demand which is generated by the

current and capital accounts exceeds the generated supply, the bank will
sell foreign currency and thus, bring about a reduction in reserves
and money supply. This will then eliminate the excess demand, and the
balance of payments is maintained. Conversely, excess supply generated
through the current and capital accounts will lead to an increase in
reserves and money supply.
Foreign currency markets are really much more complicated than the
above description implies. At this stage, however, we are less interested in
an accurate depiction of those markets. Instead, we want to focus on the
effect of various exchange rate regimes on the goods and the liquid assets
markets. To analyse these effects, we will derive the excess demand function
for foreign currency markets. At the moment, we limit our attention to the
excess demand generated by the current account alone. This means that we
are excluding the demand and supply generated by the capital account. We
hence do not allow for any capital movements, a state referred to as zero
capital movements. We will include the capital account later, when we
look at the case of perfect capital movements.
For a good description

of the history and
mechanisms of the
foreign currency markets,
see BFD, Chapter 29.
In the absence of capital movements, demand for foreign currency will

come from the demand for imports. Let the quantity of foreign currency
demanded be given by Q d$ . This quantity is given by:
The quantity of foreign currency demanded is the product of the foreign

price and the quantity of foreign goods we want to buy. Therefore,
demand for foreign currency is a function of all those variables which
determine the value of this product. Consider, for instance, the demand for
imported goods (IM Figure 14.3).

"

Figure 14.3: The demand for foreign currency: an increase in the nominal
exchange rate.
Assume that the economy is sufficiently small, and (for the sake of
simplicity) that there is no domestic production of the imported goods.
Since the economy is small, its demand will not affect the price of
imported goods on the world market, and it will face a perfectly elastic
supply of imports. The price on the vertical axis is the price in domestic
currency. Therefore, a perfectly elastic international supply suggests that
we can buy any quantity at the price of E0 P*
.
0
353
Let us assume that the demand for imported goods is similar to that of our
usual micro models. Therefore, demand will be falling as price increases,
and will be a function of income Y and the price of the other good, which
is the price for domestic goods P. (A word of caution is needed here. The
market for IM is not a market for a single commodity, but a market for
an aggregated good. As such, it cannot be subject to the same rules as a
typical market in micro analysis, and we should really make some further
assumptions and clarifications before we can apply our micro analysis
to this market. Nevertheless, to keep it simple, we shall assume that the
market for imported goods does indeed behave as suggested by the micro
analysis.)
Equilibrium will initially be at point A in Figure 14.3. The bottom
diagram has the quantity of imported goods IM on the horizontal axis and
international prices P* on the vertical axis (in absolute terms). This means
that point A in the lower diagram, which depicts the quantity of IM bought
at international price P*
, created the shaded rectangular which gives us
0
d
P*
IM0 = Q $0 .
0
You can clearly see that an increase in E will increase the price of the
imported good in domestic terms. Thus, at point B we buy less of the
good at the same international price, and the quantity of foreign currency
demanded will fall. Foreign prices are the same as before at P*, while the
quantity of foreign goods demanded has fallen. This is indicated by the
now smaller shaded region. Therefore, there is an inverse relationship
between the nominal exchange rate E and the demand for foreign
currency.
Equally, an increase in either income Y or in the general domestic price
levels P will shift the demand for imported goods up (see Figure 14.4).

$
&

Figure 14.4: The demand for foreign currency: an increase in domestic income
or prices.
As national income increases, people want to buy more of all goods,

including imported goods. When the domestic price level increases,
demand for imported goods increases because domestic goods and
imported goods are gross substitutes. When the price of one increases,
the demand for the other increases as well. In both cases, the new
equilibrium will be at point B, where we buy more of the imported good
at the same international price. The rectangle depicting the quantity of
354
foreign currency demanded at B is greater than the one at A. We thus have

a positive relationship between national income and domestic prices on
the one hand, and demand for foreign currency on the other.
When international prices P* change, the situation becomes slightly more
complicated, as Figure 14.5 shows.

"

Figure 14.5: The demand for foreign currency: an increase in the foreign
exchange rate.
When international prices rise to P*

, the domestic price of imported goods
1
rises, E0 P*
>
E
P*
.
This
will
shift
up
the supply curve (in domestic terms),
1
0 0
and the new equilibrium will be at point B. At B, we buy fewer imported
goods, but we pay more per unit. The change in total demand for foreign
currency, or the change in size of the shaded areas, could therefore either
be positive or negative. If the area at B is greater than the area at A, the
quantity of foreign currency demanded will increase. If the area at A is
greater than the one at B, then the quantity of foreign currency demanded
will fall.
The move from A to B is clearly dominated by the price elasticity of the
demand for imported goods. When this is greater than unity, the area at
B will be smaller than the area at A and the demand for foreign currency
will fall whenever there is an increase in international price level. If it is
less than unity, demand for foreign currency will rise whenever there is an
increase in international price level.
We can now draw the demand for foreign currency as a function of the
nominal exchange rate E, keeping domestic and foreign prices as well as
income constant (Figure 14.6). The plus or minus signs above those
constants indicate how demand for foreign currency would change if that
particular constant changed.
355

Figure 14.6: Demand function for foreign currency.
The supply of foreign currency in the absence of capital movement is

mainly determined by exports, since we receive foreign currency for the
goods we sell abroad. Our foreign customers will have to exchange their
currency into our domestic one to buy our goods. Hence, the supply
function of foreign currency will be
The notional market for exports, with international prices on the vertical
axis and the quantity exported on the horizontal axis, will be as shown in
Figure 14.7.

"
"
Figure 14.7: The market for exports.
As we assumed the economy to be small, it will behave like a competitive

firm and be a price taker in the international market. International
demand is therefore perfectly elastic at the given international price.
Marginal costs are rising, reflecting diminishing marginal productivity.
356
(The same qualifications as those raised with regard to the micro

presentation of imported goods market apply to the exported goods
market.) However, since we relate international prices to the amount
exported, we have to translate marginal cost into international prices by
dividing real wages W by the nominal exchange rate.
At A, the initial equilibrium, the quantity of foreign currency supplied will
be the shaded area. You can now clearly see that an increase in either E
(which will lead to point B) or P* (which will lead to C) will increase the
supply of foreign currency. An increase in domestic prices, which will lower
the real wages from W0 to W1, will bring about a fall in the supply of foreign
currency by changing the shape of the marginal cost curve (point D).
The supply curve as a function of E will therefore have the following
shape, keeping foreign and domestic prices constant:

'
Figure 14.8: Demand and supply of foreign currency.
In the absence of capital movement, the demand for foreign currency

generated by the demand for imports will be inversely related to the
nominal exchange rate. Also, we can see among the parameters of the
demand schedule, an increase in the domestic price level P or national
income Y will increase the demand for foreign currency. A change in
international prices will affect demand for foreign currency according to
the price elasticity of the demand for imported goods.
On the supply side generated by exports the quantity supplied will
increase with the nominal exchange rate. An increase in domestic prices
P will increase the cost of production. At any level of E, the quantity
supplied will therefore be reduced. Assuming that international demand
for domestic goods is elastic (i.e. greater than 1), the quantity of foreign
currency supplied will decrease. An increase in international demand,
caused by an increase in international prices P* will increase exports. This
will lead to an increase in the quantity of foreign currency supplied at each
level of nominal exchange rate E.
An increase in, say, income Y will increase demand for imports. At given
international and domestic prices, this will increase the quantity of foreign
currency demanded. This will shift the demand schedule to the right. At the
initial exchange rate E0 , there is now excess demand for foreign currency,
which represents a deficit in the current account. If the exchange rate
357
regime is flexible, market forces will push the nominal exchange rate up (a
depreciation of the local currency), making import more expensive and
export more rewarding, until equilibrium is restored at E1 . There will be no
change in the amount of reserves in the central bank.
If, however, there was a fixed exchange rate regime, the excess
demand will have to be satisfied from other sources; namely, a reduction
in reserves. This, in turn, will reduce the quantity of money which is
circulating in the economy.
We should now conduct a similar analysis of demand and supply of
foreign currency generated by the capital account. However, this would
needlessly complicate the story at this stage. We shall introduce the capital
account later in this chapter.
General equilibrium in an open economy

We now have to combine the international aspect of our economy with all
the elements we developed in earlier chapters, and study the consequences
of introducing international trade on the effects of various policies.
We begin by incorporating international trade into the IS LM framework
of analysis. There is no real change to the LM, except that the money
supply depends on the exchange rate regime reconstruction of the LM
remain unchanged. In the goods market, however, we have introduced
a new component which is called the net-export function. Thus, the
construction of the IS will now have to incorporate this new element.
No capital movements
,
"
"

.
&
"
&
"
&
Figure 14.9: Constructing the IS LM model with no capital mobility and a fixed
exchange rate.
358
Let us begin by assuming that we have an economy with no capital

movement (i.e. no capital account) and a fixed exchange rate
regime. The complete market will have the form given in Figure 14.9.
As the exchange rate is fixed, there is only one level of Y for which the
current account will be balanced. The position of that point depends on
the real exchange rate, which affects the autonomous component of the
NX function. The equilibrium condition is thus
Since the autonomous component is fixed, the NX line in the IS LM

framework will be vertical. It is unaffected by interest rate, but its position
depends on the real exchange rate. If the real exchange rate increases, the
autonomous component of NX, (X0 IM0)(EP*/P) will increase, since we
will have more exports, but less imports. This will require a much higher
level of Y, which will affect imports, to balance the current account.
Points to the left of the NX = 0 line correspond to a current account in
surplus.
This means, under the fixed exchange rate regime, that there is now excess
supply of foreign currency. In order to ensure a balance of payments equal
to zero, reserves will be increased. This, in turn, will increase the supply of
money and shift the LM curve to the right until national output is equal to
Y0, where NX = 0.
What will happen at Y >Y0?
Note that the IS itself is a function of the real exchange rate, since it
represents demand for the use of domestic output. Whenever the real
exchange rate increases, there will be an increase in real terms of
demand for NX and therefore, for domestic output.
Hence, an open economy with a flexible exchange rate regime will be:

Figure 14.10: Open economy with no capital mobility and flexible exchange rates.
359
There is no NX = 0 constraint, as the flexible exchange rate guarantees

that at any level of output, nominal exchange rate will adjust to balance
the current account. Since there will be no change in reserves, there
will be no effect on the money market and the LM curve. However, even
though the nominal exchange rate will adjust to support any equilibrium
Y, the IS curve is still a function of the real exchange rate. An increase
in the real exchange rate will lead to exports increasing and imports
decreasing in real terms.
Perfect capital mobility

The introduction of capital mobility means that we now have to look
at the effects of the capital account on the balance of payments. At
this stage of your study, we shall only deal with the simple case where
capital mobility is entirely unrestricted. We are not trying to study
the mechanisms of the capital account. Rather, we want to analyse its
influences on the goods and liquid assets markets.
In a fixed exchange rate regime, balancing the current account is a
constraint to our model. Unless the economy reaches the level of output
where the current account is balanced, the economy will not be in
equilibrium. However, under a flexible exchange rate regime, the current
account does not impose any restrictions on the equilibrium level of
output, since the exchange rate can adjust to ensure a balance current
account.
When we introduce the capital account, in the form of perfect capital
mobility, we are similarly concerned about the constraints it places on
equilibrium. Unlike the current account, which placed a restriction on
the equilibrium level of output under fixed exchange rates, the capital
account will place a constraint on the equilibrium domestic interest
rate.
There are many reasons why foreigners might want to hold domestic
assets, or locals want to hold foreign assets. We will concentrate on just
one of these reasons. Our decision on whether to hold domestic or foreign
interest rates will be influenced by the return we get on our money.
Whenever domestic interest rates are higher than those abroad, individuals
will get a higher return on money which is invested in domestic assets.
All other things being equal, every investor will prefer higher interest
rates. Whenever the domestic interest rate r is higher than international
interest rates r*, there will be an almost infinite demand for domestic
assets. Since foreigners will have to convert their currency into the
domestic currency to buy the domestic assets, this will lead to an almost
infinite supply of foreign currency. This surplus in the capital account will
override any conceivable deficit in the current account. This will mean that
a domestic interest rate r > r* will lead to a chronic surplus in the balance
of payment. This is not possible, since at some point, all the money in the
world will be in the domestic economy. Hence, the balance of payments
will either be balanced by a continuous decrease in the nominal exchange
rate in the case of the flexible regime or, by a continuous increase in
reserves, which will increase the supply of money in the case of a fixed
exchange rate regime.
This means that the economy will never reach equilibrium, unless the
discrepancy between domestic and foreign interest rates is eliminated.
International interest rates, therefore, become a constraint on our system
(Figure 14.11).
360
1
(
"
&

"

-
"

$
&
"
"
Figure 14.11: Perfect capital mobility.
Suppose that there were no capital movements initially and equilibrium

was at an interest rate r1. Now, as a result of liberalisation, capital is
allowed to move freely.
When r1 > r*
there will be a massive inflow of capital. People from all
0
over the world prefer to buy domestic assets which earn a higher return.
This will lead to excess supply of foreign currency which will have one of
two effects:
1. cause the local currency to appreciate by decreasing E, which will
reduce demand in real terms for domestic output (IS shifts to the
left): this is the case of the flexible exchange rate regime, and the
economy will move from A to B;
2. cause an increase in reserves, which will increase the supply of real
balances M. This will shift the LM to the right, as equilibrium in the
liquid assets market will be achieved at a lower level of interest for any
level of output. This is the case of the fixed exchange rate regime,
and the economy will move from A to C.
The effect of this liberalisation on employment is significantly different
under the two exchange rate regimes. A liberalisation of capital
movements with a flexible exchange rate will have a much less favourable
outcome than with fixed exchange rates.
How would your conclusion change had the initial domestic interest rate been below the
international rate?
Self-assessment
In this section, I have collected a few of the examination questions which
were of a more comprehensive nature. Some of these questions are
difficult, but dont be disheartened: all exams contain a sufficient number
of easier questions. I am sure that if you seriously try to deal with these
questions, your knowledge will be enhanced considerably.
361

Define the concepts of national accounts of an open economy, demand
for export and import and their effects on aggregate demand, the next
export function, the multiplier of an open economy, the balance of
payments, the foreign currency market.
Illustrate the difference in the impact on the system under different
exchange rate, income determination with and without capital
movements.
Use diagrams to analyse problems involving an open economy.

you to explain the subject in a way that will help you understand things
which you would not have understood otherwise. Only then should you
compare your answers with the answers in the book.
Question 1
In an election year, the government increased its spending by borrowing
from the public. To prevent an increase in the interest rate, the
government convinced the central bank to reduce the reserve ratio for
commercial banks. The opposition accused the government of sowing the
seeds of recession while mortgaging the future (reducing investment).
a. Discuss the opposition accusations in an open economy without any
capital movements and a fixed exchange rate policy.
b. Discuss the opposition accusations in an open economy with perfect
capital mobility.
Question 2
A government with a budget deficit decides to reduce the size of its army
by providing early retirement to a third of its staff. The retired cohort,
being still relatively young, seeks to compensate themselves for their hard
years of service by an ongoing spending spree with a particular taste for
imported goods.
a. Analyse the effects of the government policy in an open economy
without capital mobility and with a fixed exchange rate regime.
b. What will happen to investment in the economy? Would your answer
be different if the exchange rate had been flexible?
362
Question 3
In order to attract high-flyers and invigorate the economy, the government
decides to reduce the highest marginal tax rate and to increase the lower
marginal tax rate. The change has been designed in such a way as to keep
the overall level of tax receipts unchanged. Some argued that favouring
the high-flyers will only bring about a recession and a fall in investment.
a. Examine the argument in the context of an open economy with perfect
capital mobility and a fixed exchange rate.
b. Would your answer be different if exchange rates had been flexible?
c. Examine the argument in the context of an open economy without
capital mobility and with a fixed exchange rate regime.
Question 4
The government decides to switch from an income tax to an expenditure
tax. This means that from now on, people will pay tax only on that part
of their income which they use for consumption. The tax system remains
proportional and the rate of tax has not changed.
a. What will be the closed economy multiplier after the change? Will it be
greater or smaller than the previous multiplier?
b. Analyse the effects of the change on an open economy without capital
mobility and with a fixed exchange rate regime.
c. Analyse the effects of the change on an open economy with perfect
capital mobility and with a fixed exchange rate.
d. Analyse the effects of the change on an open economy with perfect
capital mobility and with a flexible exchange rate.
Question 5
The public in an economy have lost confidence in the safety of the
domestic production of a certain product.
a. What effect might this have on the economys multiplier?
b. Analyse the consequences of such a loss of confidence on an open
economy without capital mobility with a fixed exchange rate.
c. Would the outcome be similar if this had been an open economy with
perfect capital mobility and a fixed exchange rate?
d. Critics of government policy argue that only by removing all barriers
to the adjustment of the exchange rate will the problem be resolved.
Discuss this argument.
Question 6
A government decides to privatise part of its activities through outtendering. Assuming that the private agency which gains the tender can
provide the service for less than it had cost the government, what will be
the effects of this policy on:
a. a closed economy with fixed wages
b. a closed economy with flexible wages
c. an open economy with perfect capital mobility and a fixed exchange
rate
d. How would your answers to (a)(c) change had the policy been
accompanied by a decrease in taxes?
363
Question 7
Two economies are the main trading partners of each other. Both have
similar institutions of perfect capital mobility and a flexible exchange rate.
Taxes are proportional in both economies. Economy A has a large deficit in
the government budget, while economy Bs budget is balanced. The central
bank of economy A is concerned about domestic investment and pursues
an expansionary monetary policy.
a. Analyse the effects of the policy on output, the budget deficit, interest
rates and investment in both economies (bear in mind that there is a
single exchange rate in both economies, when there is a depreciation
in economy As currency it means an appreciation in economy Bs
currency).
b. Would the central bank of economy B wish to respond? If so, what
could it do and how will it affect the two economies?
c. Would your answer to (a) have been different had the two economies
had the same currency and a single central bank?
Question 8
In an election year, three parties are competing for power. The Extremely
Helpful Party (EHP) claims that there is an element of government activity
which is independent of how well the economy is doing. In addition,
governments activities should expand whenever income is rising. The
Let Them Pay Party (LTPP) agrees that there is an element of government
activity which is independent of how well the economy is doing. However,
in their view, some government activities should be withdrawn as income
increases. The Do Not Care Party (DNCP) argues that the governments
activities should be confined to maintaining the institutional framework of
the economy. This, they claim, is independent of how well the economy is
doing. The current party in power is the DNCP.
Analyse the effects of all possible election outcomes on:
a. the economys multiplier
b. a closed economy with fixed wages (would your answer be different if
wages had been flexible?)
c. an open economy with a fixed exchange rate and without capital
mobility
d. an open economy with a fixed exchange rate and with perfect capital
mobility
e. an open economy with a flexible exchange rate and perfect capital
mobility.
Answers
Question 1
The two changes in the economy proposed by this question are:
an increase in government spending G, financed by borrowing from the
public
an increase in money supply due to a fall of the reserve ratio.
In Chapter 13 we analysed the same case for a closed economy. We now
extend the analysis to the open economy:
364
a. Open economy without capital mobility and a fixed

exchange rate:

"
Figure 14.12
Both IS and LM shift to the right. IS LM equilibrium shifts from A to

B. Greater income will increase demand for imported goods. This will
cause excess demand for foreign currency, which will be covered by
the central bank through a decrease in reserves and hence the money
supply. LM shifts to the left and interest rates will rise. This is a similar
outcome to the one we got for a closed economy with flexible wages.
b. Open economy with perfect capital mobility:
'
&
'
Figure 14.13
The same initial change. IS LM shift from equilibrium at A to

equilibrium at B. If the policy mix achieved its aim of no change in
interest rates, this is where the economy will remain under both fixed
and flexible exchange rate regimes.
365
Question 2
The effects of reducing the size of the army by providing early retirement
are complex. You must conduct your analysis with great care.
Direct effect: the immediate effect of reducing the army size is a fall in
G. Early retirement means that those ex-servicemen are getting a pension
which, in turn, reduces T by increasing net transfers. As the aim of the
policy was to tackle a deficit in the government budget, |G1 T1| < |G0
T0|. The fall in G (which equals to the spending on the servicemen while
in the army) is greater than the increase in T.
Influence on Aggregate Expenditures: Assuming a system of lumpsum taxes for simplicity, this will bring about a fall in the autonomous
component of aggregate expenditures.
A = G + c 1s T < 0
as
c 1s < 1
G > T
where c 1s is the marginal propensity to consume of the ex-servicemen.

At the same time, we know that the ex-servicemen will direct their
spending at imported goods. This means that there will be an increase in
the marginal propensity to import. This, in turn, will reduce the multiplier.
It will also mean that the level of output for which NX will be balanced is
lower.
a. The framework of analysis is obviously the IS LM with the vertical NX
= 0, reflecting the fixed exchange rate regime. As there is no reference
to prices or wages, one does not need to deal with the AD AS model:
+,
&
'
)
&
'
&

&
'
)

&
'
&
Figure 14.14
We start at point A in general equilibrium. The effect of the change will

be to shift the IS to the left and make it steeper, since the marginal
propensity to consume domestic goods is lower now. At the same time,
the NX = 0 line shifts, to the left reflecting the fact that with a higher
marginal propensity to import, less income will be required to balance
the current account for any given exchange rate and initial net export.
366
NX = 0 will shift from Y0 to Y2. We assume that the IS will shift further
to the left to bring about an initial equilibrium at Y1. (You may equally
assume that Y2 is to the left of Y1, but it must be accompanied by a
correct description of the adjustment process.)
Due to the cut in government spending, the economy moves from A
to B where there is now a fall in demand for imports, which leads to
excess demand for net exports. This will prompt excess supply
of foreign currency. As the exchange rate is fixed, this will be
absorbed by the central bank, which will, in return, increase the
supply of money. LM will shift to the right until equilibrium is restored
at C. The reduction in government deficit has brought about a
recession but lowered interest rates and hence increases demand for
investment.
b. This is a question about National Accounts:
I = S + (T G) + (IM X)
(T G) increased; S fell due to lower income, (IM X) = 0, since the
increase in demand for imports by ex-servicemen had been offset by
the fall in income. If demand for investment is a function of the interest
rate alone, this would mean that the increase in government savings
was greater than the fall in private savings.
Flexible Exchange rate: In this case, the initial move from A to B
would have brought about a excess supply of foreign currency, which
would have caused an appreciation of the real exchange rate. NX = 0
would fall further and the IS will shift further to the left. The recession
will be greater and the increase in demand for investment much more
moderate.
Question 3
Again, this is a question we considered in Chapter 13 in the framework of
a closed economy. Here we extend the analysis to the open economy.
To remind you, the main problem in this question is identifying the
changes. We have to translate the question into the language of the
model. There is a distinction between different groups of consumers, high
earners and low earners. By now, we should notice that the issue at hand
is the difference in marginal propensities to consume.
As overall tax receipts have not changed, we have a transfer of income
from the poor to the rich. If the poor have a greater marginal propensity
to consume, every pound transferred will yield a net fall in consumption.
We can see this by looking at the consumption function, accounting for
both groups of consumers.
C(Y) = C0 + c H1 (1 tH)YH + c 1L (1 tL)YL
C = c H1 tHYH c 1L tLYL < 0
as
tH < 0
tL > 0
tH < tL
Hence, the result of the change will be a fall in consumption.
367
a. Open economy with perfect capital mobility and a fixed

exchange rate:
*
)

Figure 14.15
IS shifts to the left and there is a new equilibrium at a lower level of

income and a lower level of interest rate: move from A to B. The fall in
domestic interest rates will increase demand for investment, and also
lead to an outflow of capital under perfect capital mobility. This means
excess demand for foreign currency which, with a fixed exchange rate,
will lead to a fall in money supply. The LM will shift to the left and the
recession will deepen at point C.
b. Open economy with perfect capital mobility and a flexible
exchange rate:
%

#

#
%
Figure 14.16
The same initial change. IS shifts to the left from equilibrium at A to

equilibrium at B. Domestic interest rate falls and there is an outflow of
capital. This means excess demand for foreign currency which, with a
flexible exchange rate, will lead to a depreciation of domestic currency
368
that will increase demand for NX. The IS will shift to the right and the
economy will return to its original position.
c. Open economy without capital mobility and a fixed
exchange rate:

&

,

Figure 14.17
The same initial change. IS shifts from equilibrium at A to equilibrium

at B. Less income will decrease demand for imported goods. This will
cause excess supply of foreign currency, which will be absorbed by the
central bank through an increase in the money supply. LM shifts to the
right and interest rates will fall further, leading to final equilibrium at
C.
Question 4
The government proposes an expenditure tax. This means that now,
instead of a tax function of the form
T(Y) = tY
we will have a tax system of the following form:
T(Y) = tC(Y)
a. The multiplier of a closed economy:
We begin by describing the new consumption function:
This means that the aggregate expenditure function will now have the
following structure and multiplier:
Equilibrium means
369
We must now examine the relationship between this multiplier and the
normal proportional tax multiplier. We propose that:
(1)
Proof
We rearrange the above equation:
(2)
As (2) is always true, (1) will be true as well.
b. Open economy without capital mobility and with a fixed
exchange rate:
The framework of analysis is obviously the IS LM with the vertical NX
= 0 reflecting the fixed exchange rate regime. As there is no reference
to prices or wages, one does not need to deal with the AD AS model.

'
'
"
Figure 14.18
We start at point A in general equilibrium. The immediate effect of

the change will be a reduction in the autonomous component of the
aggregate expenditure function, as we have substituted C0 with C0 /(1 +
c1t), the latter being a smaller expression. However, as the multiplier is
now greater, there will now be greater demand for consumption at any
given level of interest rate, leading to equilibrium at a higher level of Y.
Let A be the part of the autonomous component which is common
to the AE function before and after the change. Let Y1 and Y0 be the
equilibrium levels of output in the goods market after and before the
change respectively. Within the framework of the closed economy, we
find:
370
This means that at any given rate of interest (which will affect A), the
overall effect will be an increase in the equilibrium level of income. IS,
thus, shifts to the right and becomes flatter. This will increase income
and interest rates in equilibrium. This will also be true in the open
economy. As a result, demand for imports rises and there is now excess
demand for foreign currency, which will be supplied by the central
bank through a decrease in the money supply. The LM will shift to the
left and equilibrium will be restored at the initial level of output and a
higher interest rate.
c. Open economy with perfect capital mobility and a fixed
exchange rate:
'
%
>
'

Figure 14.19
We start at point A in general equilibrium. As in (b), the change will

shift the IS to the right with a slightly flatter slope. This will cause a
rise in the level of output and in the domestic interest rate.
The higher domestic interest rate will cause capital inflows and an
excess supply of foreign currency.
Fixed Exchange rate: As the exchange rate is fixed, the excess supply
will be absorbed by the central bank through an increase in money
supply. This will shift the LM to the right and bring about a further
increase in output (from B to C);
d. Open economy with perfect capital mobility and a flexible
Exchange rate:
The excess supply of foreign currency will cause an appreciation that
will decrease demand for NX. Hence, the IS will shift to the left and the
economy will return to its initial point.
371
Question 5
When the public loses confidence in the safety of domestic production,
they will want to consume less of it and turn to imports if available. This
means we have to analyse a fall in demand for domestic output.
a. The effect on the multiplier:
It is not obvious from the question whether the lack of confidence will lead
to a fall in the autonomous component of consumption (and an equivalent
rise in the autonomous component of demand for imports), or a fall in
the marginal propensity to consume (and an increase in the marginal
propensity to import). Had the change been in the marginal propensities
rather than the autonomous component of aggregate demand, the
multiplier would change:
where dc1 and dm1 denote the fall and increase in marginal propensity to
consume and to import.
b. Open economy without capital mobility and a fixed
exchange rate:
&
'
&
'

Figure 14.20
If only the autonomous components change, the IS would shift parallel

to the left. When the changes go through the marginal propensities
to consume and import, the IS will shift to the left and have a steeper
slope. This is an important point! In addition, in either formulations of
the change, the NX = 0 constraint shifts to the left. As the demand for
imports is higher at any level of income, export will be balanced at a
lower level of income.
We start at A. If the shifts of both IS and NX = 0 immediately lead to a
new equilibrium at a lower level of income B, our story ends here. You
should explain that there is an exogenous increase in demand for foreign
currency which creates in a fixed exchange rate regime a situation of
excess demand for foreign currency. However, as income falls, due to fall
in demand for domestic products, demand for imports falls too. As we
move from A to B, the excess demand for foreign currency reduces to zero.
372
Normally, however, it takes longer for income to fall than for the excess
demand in the foreign currency market to be formed. Hence, some of
the adjustment may come through the central banks intervention by
selling foreign currency and reducing real balances, where LM shifts
to the left. This may mean a new equilibrium at a higher interest rate
than at B. Another way of looking at this case is to say that the NX =
0 and the IS have shifted in such a way that a new equilibrium is not
immediately formed:
'
'

&
"

Figure 14.21
Our initial move is from A to B. At B, there is excess demand for

imports and hence foreign currency. As this is a fixed exchange rate
regime, the central bank will sell extra foreign currency and cause
a fall in the supply of real balances M. LM will shift to the left until
equilibrium is restored at point C.
exchange rate:
&
Figure 14.22
373
The initial shift in the IS is subject to the same qualifications as in (b). We

start at A. The fall in demand for domestic product will lead us to point B.
At point B, domestic interest rates are below international interest rates.
The fall in income will lower demand for imports and will thus at least
partially offset the effect of the exogenous increase in demand for imports.
This will be dwarfed, however, by the massive capital outflow caused by
lower domestic interest rates, which will increase the demand for foreign
currency. With a fixed exchange rate, the central bank will be selling
foreign currency and reducing supply of real balances. LM will shift to the
left and equilibrium will be restored at point C.
d. What would have happened had exchange rates been
flexible?
In case (b), without capital flows, having a flexible exchange rate would
have only mattered if the exchange rate adjustment was faster than the
output adjustment. In principle, we said that the exogenous increase
in demand for foreign currency could be offset by a fall in output. If
the nominal exchange rate were allowed to depreciate, demand for net
exports would increase. This would have shifted IS to the right and the
recession would not have been a serious as in case (b).
With perfect capital mobility:
&
Figure 14.23
After the initial shift of the IS and the subsequent outflow of capital, the
increased demand for foreign currency would lead to a depreciation of
domestic currency and an increase in demand for NX. IS would have
moved back to its initial position and the loss in confidence would have
been compensated by more exports. Notice that if the changes affected the
slope of the IS, there new IS through A will have a different slope as well.
Question 6
A privatisation of some of the governments activities through outtendering is not a case of asset sales. Instead, the only effect is that
the spending on the provision of some services will now be lower. The
government is substituting salaries with purchases from other firms. This
will reduce the size of G. Hence, the question requires an analysis of a
contractionary fiscal policy.
374
a. Closed economy with fixed wages:

Figure 14.24
IS shifts to the left as G is reduced. There is a new equilibrium at a

lower level of income and a lower level of interest rate, leading to
greater demand for investment.
b. Closed economy with flexible wages: In this case, we have to
look at the effects of a change in wages as well. This means considering
the changes in the AS AD framework in addition to those in the IS
LM framework.
&
Figure 14.25
375
IS shifts to the left and so does AD. Prices fall from P0 to P1, leading to
a rightward shift of the LM. In the long run, nominal wages will fall
to keep real wages constant. This will shift the AS downwards. If the
new level of prices is correctly anticipated, the economy will move the
economy to point C, with the same level of output as before. In terms
of the IS LM analysis, prices will further decrease, shifting the LM to
the right until it reaches point C, where the economy will return to long
run equilibrium.
exchange rate:

"
Figure 14.26
The same initial change. IS shifts to the left from equilibrium at A to

equilibrium at B. Domestic interest rate falls and there is an outflow
of capital. This means excess demand for foreign currency which, with
a fixed exchange rate, will lead to a fall in money supply. The LM will
shift to the left and the recession will deepen at point C.
A decrease in taxes suggests an expansionary fiscal policy. A fall in T
will increase consumption. If T fell by exactly the same amount as G
did from out-tendering, and if the governments marginal propensity
to spend is unity, consumption will increase by less than the fall in G,
since the marginal propensity to consume is less than unity. We can
distinguish between three cases:
If the increase in consumption as a result of the fall in T is less than
the fall in G, the analysis in (a)-(c) will be basically the same. The
only difference will be that the fall in IS (and AD) will be much
smaller.
If the increase in consumption as a result of the fall in T is exactly
the same as the fall in G, there will be no change and the analysis in
(a)(c) will not be relevant.
If the increase in consumption as a result of the fall in T is greater
than the fall in G, then we will have to analyse an expansionary
fiscal policy.
In case (1) this will mean an increase in output and interest rates.
In case (2) this will mean a short-run increase in output and interest
rates and a fall in real wages. In the long run, it will mean higher
376
prices, the same real wages as before the change. Interest rates will
be higher, which suggests a crowding out of investment to finance
the increase in consumption in real terms.
In case (3), as IS shifts to the right and domestic interest rates
exceed the international rates, there will be an inflow of capital and
an excess supply of foreign currency. With the intervention of the
central bank, the excess supply of foreign currency will cause an
increase in real balances (LM shifts to the right). As a result, output
will increase.
Question 7
This is a very complicated question, so try to make sure you understand
each step before you move on to the next.
We have two trading partners with perfect capital mobility and flexible
exchange rates. Economy A has a large budget deficit while economy B
has a balanced budget. For simplicitys sake, we may assume that NX of
country A (which is NX of country B) is balanced at the initial point. You
should first explain the concerns of the central bank in economy A and set
out the capital formation equation:
I = SP + (T G) NX
and note that with NX = 0, a deficit means less domestic investment.
Before we launch into the analysis of the effect of the monetary policy in
economy A, we should note that there is no information about whether
the two economies have flexible or fixed wages. It is clear that we are
not expecting you to analyse a complex case of asymmetry, but if you
feel confident enough, I challenge you to try and analyse such a case.
Normally, when no information is given with regard to wages and prices,
you should assume fixed prices and wages. We shall therefore conduct the
analysis from this point of view.
a. The initial effect of an expansionary monetary policy in A
We start at point A in both economies. An expansionary monetary policy
in economy A will shift the LM to the right. We move to point B1. As the
interest rate in economy A is now lower than the international (and
economy Bs) interest rate, there will be capital outflow from economy A.
This will cause an increase in demand for economy Bs currency. We will
have a depreciation of As currency (excess demand for foreign currency
in A) and a corresponding appreciation in Bs currency (excess supply of
foreign currency in B). This means that demand for NX by country A will
increase and IS will shift to the right to point C1.
r
r
A
LM (M 0, P0 )
LM (M 0, P0 )
A
LM (M 1, P0 )
r0=r*
r1
r1
IS
IS
BOP
IS
Y
IS
Figure 14.27
377
It also means that demand for NX in economy B will fall. IS (in the
right-hand diagram of Figure 14.27) will shift to the left and we
end up at point B2. At this first instance, economy A will be producing
more, increase its tax revenues (as we have a proportional tax system),
as well as savings but these will be offset (from the point of view of
domestic investment) by increases in NX.
It would seem that the aims of the bank have been achieved. However,
the system is not in equilibrium:
r
r
A
LM (M 0, P0 )
LM (M 0, P0 )
A
LM (M 1, P0 )
1
r0=r*
1
A=C
BOP
r1
IS
IS
IS
Y
Figure 14.28
Economy A is at C1 and economy B is at B2. The interest rate in B is now

lower than the international (and As) interest rate, leading to capital
outflow. This, in turn, will reverse the outcome. There will be excess
demand for foreign currency in B, which will cause a depreciation
(and an appreciation in A). This will increase demand for NX in B and
reduce the demand for it in A. IS in A will shift back while IS in B will
shift back towards its original position at C2.
We now have an unstable situation. The economies are constantly
moving along the bold lines connecting points B to C. When economy
A is at C, economy B will be at B and vice versa. Nevertheless, the
position of economy A is slightly better. Economy A enjoys greater
output even when at point B, while economy B is fluctuating between
recession and no change. When at B, domestic investment at A is
increased because of the higher level of income (increasing private
savings and tax revenues) as well as the relatively low level of NX.
When at C, NX is offsetting some of these changes, but this might
be compensated by the further increases in income. Economy B,
however, is fluctuating between the initial position and a much
reduced level of domestic investment (caused by lower income and
the subsequent fall in savings and tax revenues) which is slightly
offset by the fall in NX.
378
IS
b. The central bank in economy B may intervene in two

different ways.
r
r
A
LM (M0P0) LMA(M1P0)
LM
r0 =r*
0
r1
C1
B
^A
IS
LM
IS
^A
IS
IS B
Figure 14.29
It may either choose to stop the fluctuation, which can only be achieved
if the bank pursues a contractionary monetary policy. This will shift the
LM in the right-hand diagram to the left and restore equilibrium at a
lower level of both output and domestic investment in economy B. This
is a very unlikely policy aim for the central bank of economy B.
The alternative is to accept a fluctuating relationship, but on better
terms for B.
LM
r0 = r0*
LM
LM
C1
LM
B2
A
IS
r1
E2
B1
IS
2
D
A
IS
A
IS
IS
B
IS
Figure 14.30
The central bank in B could achieve this by pursuing its own monetary
expansion. It would move from B2 to D2, which will increase the capital
outflow from B and produce a much more pronounced depreciation
of its own currency. This will lead economy B to point E2 which, in
turn, will make the downturn of economy A worse (point D1). Both
economies are now fluctuating between different levels of output which
are greater everywhere than the original level of output, and both will
experience higher levels of domestic investment.
379
c. If the two economies had a single currency and a single central bank,
then an expansionary monetary policy would have shifted both LM
curves to the right.
LM
IS
IS
LM
LM
C2
C1
r0 = r0*
LM
B1
B2
A
IS
r1
A
IS
Figure 14.31
This would have caused a fall in the interest rate which, in turn, would
have invoked outflow of capital outside the single currency area. As
a result, there will be a depreciation of the single currency. This will
increase the demand for NX to the world outside the fortress and
both economies will enjoy an expansion in output, an increase in
tax revenues and private savings, which will be slightly offset by the
increase in their combined NX.
Question 8
This is a straightforward question. Each of the political parties represents a
different form of demand for public consumption.
Party
G(Y)
Extremely helpful (EHP) Let them pay (LTP)
g0 + g1Y
g0 g1Y
Do not care (DNCP)
g0
At present the DNC party is in power.

a. The effects on the multiplier:
The multipliers associated to these different public consumptions, G(Y),
are:
380
b. A closed economy with fixed wages:

r
r
LM
LM
r1
r0
r0
r1
IS
IS
IS
IS
Y0
Y1
Y1
Y0
Figure 14.32
If the DNCP wins the election, there will be no effect on the economy
as everything remains the same. Hence, we must concentrate on the
case of EHP or LTPP winning the election.
The left-hand diagram depicts the effects of EHPs win. At any given
level of income, there will now be greater demand for domestic
product, generated by the extra component in the G(Y) function.
Hence, IS shifts to the right. In addition, as the multiplier increases, the
IS will become flatter.
The right-hand diagram depicts the case of LTPPs win. Here, there will
be a smaller demand for domestic product at each level of income. The
IS will shift to the left. In addition, as the new multiplier is now smaller,
IS will become steeper.
In the case of EHP winning the election, there will be an increase in
output and a rise in interest rate. If LTPP wins the election, output will
fall and so will the interest rate.
Had wages and prices been flexible, the effect would be as in Figure
14.33.
381
LM(P2 )
r
C
r2
r1
LM(P1 )
LM(P0 )
LM(P1 )
LM(P0 )
A
r0
r0
LM(P2 )
IS
r1
IS
IS
r2
C
^
IS
Y
r
SAS(w 1 )
C
SAS(w 0 )
SAS(w 0 )
P2
SAS(w 1 )
P1
A
P0
P0
P1
AD
P2
AD
AD
AD
Y0
Y1
Y1
Figure 14.33
Wages and prices will increase in the case of EHPs win. Output
will remain unchanged in the long run, but interest rates will be
higher. This means crowding out of investment in favour of public
consumption (A, to B and C in the left-hand diagram).
In the right-hand diagram we have the case of the LTPP winning, which
will cause a fall in prices and wages, leading to a fall in interest rates.
In the long run, output will remain unchanged and investment will
increase, since the interest rate has decreased.
382
Y0
c. Open economy with fixed exchange rate and no capital

mobility:
r
NX
LM(M 1 )
LM(M 0 )
r
NX
C
r1
LM(M 0 )
B
A
r0
LM(M 1 )
r0
A
^
IS
r1
IS
IS
C
^
IS
Y
Y0 Y1
Y1
Y0
Figure 14.34
EHPs win will shift the IS to the right (left-hand diagram) . The
increase in income will increase demand for imports. This will lead
to an excess demand for foreign currency. With fixed exchange rate,
the central bank will sell foreign currency and reduce real balances.
The LM curve shifts to the left and there will be a crowding out of
investment.
LTPPs win is depicted by a shift to the left of the IS. A fall in income
will create excess supply of foreign currency which, in turn, will bring
about an increase in real balances. LM shifts to the right and we end up
at the original level of output with much lower interest rate.
d. Open economy with perfect capital mobility and a fixed
exchange rate:
r
r
IS
IS
r0
LM(M 1 )
LM(M 0 )
B
A
LM(M 0 )
LM(M 1 )
C
r0
IS
^
IS
Y
Figure 14.35
383
EHP (left-hand diagram): increase in IS causes interest rate to rise

above international level. This will cause an inflow of capital and an
excess supply of foreign currency. The banks intervention will cause
an increase in real balances. LM shifts to the right. There will be an
expansion of output.
LTPP: fall in IS causes interest rate to fall below international level. This
will create capital outflow and an excess demand for foreign currency.
The banks interference will cause the supply of real balances to fall.
LM shifts to the left and we end up in deep recession.
e. Open economy with flexible exchange rate:
r
r
LM
LM
r1
r0
r0
A=C
IS0
r1
A=C
B
IS1
IS1
IS
Y0
Y1
IS0
Y1
Figure 14.36
EHP (left-hand diagram): Increase in IS causes interest rates to rise

above the international level. Excess supply of foreign currency and an
appreciation. This will reduce the demand for NX and the IS will shift
back to its original position.
LTPP: The fall in demand (shift of the IS to the left) will cause a fall of
interest rate below the international level. Outflow of capital causes
excess demand of foreign currency and a depreciation of the local
currency. This will make imports more expensive and export more
attractive. The increase in demand for NX will shift IS back to its
original position.
384
IS
Y0
Appendix: Sample examination paper

Important note: This Sample examination paper reflects the
examination and assessment arrangements for this course in the academic
year 20042005. The format and structure of the examination may have
changed since the publication of this subject guide. You can find the most
recent examination papers on the VLE where all changes to the format of
the examination are posted.
Time allowed: 3 hours.
Candidates should answer FOUR of the following NINE questions:
QUESTION 1 and ONE further question from Section A, and
QUESTION 6 and ONE further question from Section B. All questions
carry equal marks.
Section A
Answer Question 1 and one further question from this section.
1. Answer THREE of the following questions:
1. The production of one unit of x requires 1/2 a unit of labour and
1 unit of capital. To produce one unit of y requires 1 unit of labour
and 1/2 a unit of capital. Before sales, the goods must be stored.
One unit of storage space can accommodate either 1 unit of x or 1
unit of y (or any linear combination of the two). There are 100 units
of labour, 100 units of capital and 110 units of storage space. What
will be the opportunity cost of x if the economy efficiently produces
85 units of it? What will be the opportunity cost of x if the economy
efficiently produces 10 units of y? Can the economy efficiently
produce these quantities?
2. An individual spends all of his income on two goods. Initially, he
spends the same amount of money on each good. The price of x
then rises by 20% while the price of y falls by 20%. The individual
will be neither better nor worse off as a result of the changes. True
or false? Explain.
3. Whether or not the income effect under Slutskys definition of real
income is greater or smaller than the equivalent effect under the
Hicksian definition of real income, depends on whether the good in
question is a normal or inferior good. True of false? Explain.
4. The short run marginal cost schedule will never intersect the long
run marginal cost schedule if the production function exhibits
increasing returns to scale everywhere. True or false? Explain.
5. An increase in the cost of capital facing firms in a competitive
industry will cause an increase in price and a decrease in output in
the short run but will have no effects on the number of firms in the
long run. True or false? Explain.
6. A lump-sum tax on a competitive industry is always efficient. True
or false? Explain.
7. Monopolistic power can only be obtained when the price elasticity
of demand is greater than unity. True or false? Explain.
385
8. Monopolistic competition is an efficient form of organisation as

there are no profits above the normal in the long-run. True or false?
Explain.
9. The total output of two firms behaving non-cooperatively is smaller
than if the market were supplied by a single monopolist. True or
false? Explain.
10. In an exchange economy with two goods and two agents, if the
initial endowment is such that both agents have exactly the same
amount of each good as the other, there will be no trade. True or
false? Explain.
11. The fact that there is a group of people who are willing to pay more
than others for a particular public good will have no impact on the
overall efficient provision of that good. True or false? Explain.
2. A government is concerned about the heating habits of the elderly
when there is an increase in fuel prices. Its department of health had
warned that people underestimate the amount of heating they need
during a cold winter to remain in long term good health. To ensure that
the heating habits of the elderly will not be affected by increases in fuel
prices, the government proposes to compensate them in such an event.
Accordingly, it will pay the elderly an amount of money equal to the
increase in cost of the original level of consumption.
a) Describe the initial choice of heating by an elderly individual.
b) Analyse the effects of an increase in the cost of heating on the
consumption of heating and the well-being of that individual before
and after the implementation of government policy.
c) Will the compensation policy be effective in maintaining the initial
level of heating?
d) Will your answer to (c) depend on whether heating is a normal or
inferior good?
e) Critics of the government argue that such a policy will not achieve
its objectives. Instead, they propose either a subsidy that will keep
the price of heating at its original level or, a subsidy for the actual
desired level of heating (say, xl > xo where xo is the original level
of fuel for heating consumption). Compare the effects of these two
proposals to those achieved by the governments compensation
policy and comment on the critics claim.
3. A central market for a competitive industry is supplied by firms
working in two different locally governed areas (A and B). The distance
between them and the centre is the same. The local government in
province A proposes to improve the lot of its public by offering a special
bonus to all producers in their area.
a) Describe the initial set-up of the market.
b) Analyse the short run effects of this policy.
c) Assuming that for cultural reasons there is almost no labour mobility
across provinces, what would happen to equilibrium price and
quantity, the number of firms in each region and the level of each
firms output? Will the government improve the lot of its public?
4. A Company, Celebs are Us, is the only firm to offer individuals an
evening with selected celebrities to discuss the topic: The Meaning of
Life: From Plato to Beckham. It faces two types of demand. The first
group of consumers are the old aristocracy who can afford to pay a
lot (so that they can rub shoulders with the new-money). The second
386
group consists of all the hopefuls who would like to become celebrities
but cannot yet fully afford it. The price elasticity of the demand for
such evenings by the old aristocracy is less than unity while that of
the wannabes (the hopefuls) is greater than unity. Assume that the
company cannot price discriminate between the two groups for an
evenings entertainment:
a) Under which circumstances will the evenings be offered to both
groups of consumers?
b) Under which circumstances will the evenings be offered only to one
group of consumers?
c) How would your answers to (a) and (b) change if the price elasticity
of the old aristocracy was greater than that of the wannabes?
5. In a proposed cost cutting exercise, a firm offers its workforce the
following deal: A cut in regular wages but a considerable increase for
all overtime work. Suppose that a labourer initially worked Lo hours at
the going real wage of o ( = w/p) and that overtime is paid for all
hours above Lo.
a) What will happen to the labour supplied by this individual?
b) Does your answer depend on whether the worker was initially at
the upward sloping part of their labour supply or at the backward
bending part of it?
c) Will the firm end up paying an individual more or less than it did
originally? Will workers be better or worse off?
Section B
Answer Question 6 and one further question from this section.
6. Answer THREE of the following questions:
1) Let m be the marginal propensity to import, t be the rate of a
proportional tax and c the marginal propensity to consume. The
effect on output of an increase in government spending will be the
same in a closed economy with a proportional tax system, as in
an open economy with no taxes whenever m = tc. True or false?
Explain.
2) A closed economy cannot be in equilibrium if private savings do not
equal investment. For similar reasons, in an open economy, a budget
deficit of the same size as the current account deficit will make
actual investment entirely dependent on private savings. Comment
on these statements.
3) There is no paradox of thrift in an open economy without a capital
account under a fixed exchange rate regime. True or false? Explain.
4) In a closed economy with flexible prices and wages, an increase in
government spending financed by borrowing will reduce investment
by exactly the same amount. True or false? Explain.
5) The mere wish of the public to keep more of its money in the banks
will bring about an increase in the supply of money. True or false?
Explain.
6) An increase in the governments deficit accompanied by an increase
in net imports will leave actual domestic investment intact. True or
false? Explain.
387
7) The present value of 10 at the end of every year from now to

eternity must be less than 1. True or false? Explain.
8) The total value of loans in an economy is 400bn and the reserve
ratio is 20%. An increase of 50bn in the money which the public
keeps in commercial banks together with an increase in the reserve
ratio to 25% will increase the total amount of loans only by 50bn.
True or false? Explain.
9) The Phillips curve is merely a set of observations. Surely it cannot
help in explaining anything. True or false? Explain.
7. To encourage savings, the government proposes to shift from an income
tax system to a system of consumption tax. In a closed economy:
a) What will be the effects of the change on the multiplier?
b) What will happen to equilibrium levels of income, consumption and
savings when wages and prices are fixed?
c) How will your answer to (b) change had wages and prices been
flexible?
8. In an open economy, the government commits itself to a balanced
budget. Equally, it commits a known fraction of its spending for
purchases abroad. Suppose that the tax system is based on a
proportional tax and that the tax is adjusted to spending. Analyse the
effects of an increase in the tax rate:
a) in an open economy without capital mobility and a fixed exchange
rate.
b) in an open economy with perfect capital mobility and a fixed
exchange rate.
c) in an open economy with perfect capital mobility and a flexible
exchange rate.
d) How would your answer to (a) change had the tax system been
based on a lump-sum tax?
9. Some people envisage a sharp increase in the proportion of old age
pensioners in the population. Assuming that pensions are paid out by
the government and that old age pensioners tend to spend more time
abroad than the young, what will be the effects of the increase in their
number on the economy:
a) when there is no capital mobility and the exchange rate is fixed.
b) when there is capital mobility and the exchange rate is fixed.
c) when there is capital mobility and the exchange rate is flexible.
END OF PAPER
388

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Introduction to economics

The University of London International Programmes

The behaviour of the firm........................................................................................... 102

Output and markets .................................................................................................. 260

Appendix: Sample examination paper ............................................................... 385

Aims and objectives

About levels of knowledge

of analysis which are relevant in each question; we want them to show us

Structure of the guide

Online study resources

Making use of the Online Library

Working with others

The exam questions are normally designed to allow the Examiners

Some basic mathematical tools

What is the slope of the line connecting all these points?

Sets and specifications

In economics, if X is an element or member of a set S, we write:

However, the world around us is too complex to be depicted by integers

Figure 1: The real number line.

Figure 2: The (X, Y ) plane.

Coordinates: these are

Figure 3: The set of possible meals depicted in the (X, Y ) plane.

Functions and graphs

Figure 4: A depiction of babies weight-length combinations.

Here X and Y denote length and weight of a baby respectively. We have

determine, or explain, the values of Y (weight) nor that the values of Y

Figure 5: A graph of all balanced diets.

Meals-that-do-not-kill (no more than 5 eggs and 10 slices of bread) are

Slopes and functions

Figure 6: Balanced diets again.

As a point in the plane

Figure 7: The definition of a slope.

In maths we may not be interested in the meaning of the number 1/2.

This means that if we increase the consumption of bread by 1 slice (dX =

which is exactly the slope of the line (the function).

If instead, we thought of balanced diet in terms of calories, the picture

in a slice of bread and 80 kilocalories in an egg. Suppose too that a

Once again, in economics we must think of the meaning of these concepts.

Chapter 1: The study of economics

Chapter 1: The study of economics

But read this chapter first!

What is economics all about?

To complicate things, similar institutions may not necessarily reflect

What is a Theory? The logic of economic investigation

Chapter 1: The study of economics

All humans are mortal

In our voting analysis, this becomes:

R (rich people) vote for G (the government)

We call such a conclusion a theorem:

Axioms (or premises)

Chapter 1: The study of economics

However, what exactly is meant by positive is highly debatable like

(hence, dp1 = 0.2)

How much of an is statement will it be if I say Prices have gone up by

The fundamental economic problem

Chapter 1: The study of economics

Modelling the economic problem

The production possibility frontier

If all units of labour were engaged in the production of Y, they would

Chapter 1: The study of economics

Clearly, we cannot have negative quantities of economic goods. Hence,

We can express the PPF (the curve connecting point (X = 0, Y = 200)

Chapter 1: The study of economics