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GCSE ECONOMICS

Section 1 - How Markets Work

• Basic economic concepts

• Factors of Production
• Scarcity, opportunity cost
• Economic Systems
• Specialisation
• Money
• Demand
• Supply
• Market Equilibrium
• Maximum and minimum prices
• Elasticity
• Taxes and Subsidies
• Firms
• Costs, Revenue and Profit
• Growth of Firms
• Economies of Scale
• Production and Productivity
• Competitive Markets
• Monopoly
• Labour Markets
• Determination of wages
• Minimum Wages
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Basic Economic Concepts

• Positive economics: This is a statement based on facts and testable

theories - e.g. the inflation rate is 2%
• Normative economics: This is based on opinion or a value judgement
e.g. the government should increase taxes.

Basic Economic Problem

• The fundamental economic problem is the issue of scarcity and how best
to produce and distribute scare resources.

• Scarcity means there is limited supply of goods and raw materials.

People would like to consume more than it is possible to produce.
Therefore because of scarcity, economics is concerned with:

1. What to produce
2. How to produce
3. For whom?

Factors of Production
These are different elements that are needed to produce goods. The main
factors of production are:

1. Land – Raw materials taken directly from earth, land or sea. This
includes wood, oil, water, and fish. They are resources that can be taken
from the natural environment.
2. Labour – Workers who help to produce goods and services.
3. Capital – Things used in the productive process. For example, machines
used to convert natural resources into manufactured goods.
4. Entrepreneur. People who set up a business. You could think of people
like Richard Branson who set up companies like Virgin.

Types of Resources

• Non-Renewable Resources. Natural resources which are finite. Once

used they cannot be replaced. E.g., coal, oil and gas are all finite.
Therefore, there is an issue of scarcity with non-renewable resources.
• Renewable resources. Resources that can be replenished. Examples
include wood, fish, solar energy, and water.
• Sustainable resources. These are resources that can be renewed, but if
overused can become depleted. For example, moderate levels of fishing
will preserve fish stocks. However, intense levels of fishing can deplete
all the fish. These resources need to be carefully managed.
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Sectors of the Economy

• Primary Sector. This involve in the extraction of raw materials (land).

The primary sector involves mining (coal, metal), fishing and
agriculture.
• Secondary Sector (Manufacturing). This involves converting raw
materials into a finished good. For example, manufacturing may take
metal and rubber and produce a car.
• Service Sector (Tertiary Sector). This involves the provision of
services. For example, banking, finance, hairdresser, cleaning. No good
is produced but a service is offered.

Opportunity Cost

• Opportunity cost is the sacrifice of the next best alternative foregone.

• If you choose one option, the opportunity cost is what you can’t benefit
from.
• For example, the opportunity cost of buying a CD for £10, is a book you
now can’t buy.
• If the government spend £1 billion on health care, this £1 billion can’t
be spent on building a new road.

Production Possibility Frontier

A PPF shows the maximum output that an economy can produce if the
economy is maximising the use of its resources and operating efficiently.

Points on PPF Curve

• D = inefficient (Within PPF)

• A or B = It is impossible to choose
more of consumer goods or
environment units without an
opportunity cost.
• C = impossible (without economic
growth)
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Example of Opportunity Cost

• A PPF can be used to illustrate the concept of opportunity cost.

• For example, if we move from point A to B, we gain an extra 3 units of
the environment. However, the opportunity cost is we have to forego 4
units of consumer goods.

Increase in Productive Capacity

An increase in factors of production could cause a bigger potential output. An

increase in productive capacity could occur due to:

• Discovering more raw materials (land)

• Increase in size of work force (labour) - e.g. immigration.
• Increase in capital stock (machines factories)
• Increase in labour productivity (due to better technology or better
educated workforce)

Opportunity cost of Work v Leisure

• Individuals also have choices between work and leisure. Assume that in
the daylight hours, we have 12 hours to choose between work or enjoy
leisure.
• If you spend 12 hours enjoying leisure, you can’ work.
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• If you go from point A to point B. You enjoy an extra 2 hours of leisure.

The opportunity cost is that you lose 2 hours of work
• If you have 12 hours of leisure, the opportunity cost is that you have no
time to work.

Economic Systems
Free Market
• In a free market, resources are produced and distributed by private firms
and private business.
• There is no government intervention.
• There is often inequality in a free market.
• Some public goods (e.g. police) will not be provided.
• Individuals have incentives to work hard in order to earn enough to live.

Mixed Economy

• A mixed economy is a combination of private firms and government

intervention.
• Most firms selling products are privately owned.
• However, the government may intervene in some industries (especially
public services like health and education. This is because health care is
usually underprovided in a free market.
• The government will raise taxes (e.g. income tax, VAT) and spend in
certain sectors, such as national defence, transport and health care.
• The government also regulates private firms. For example, regulating
monopoly power and implement laws to protect the environment.

Command Economy

• Production is owned and operated by the government. The decision of

what to produce and how is taken by the government.
• The former Soviet Union was an example of this command economy.
• Also known as ‘Communist Economy’.
• Most economies are now mixed economies, though the degree of
government intervention can vary significantly.
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Public  v  Private  Firms  

Private Firms

• Private firms mean they are owned by individuals without any

government control.
• Typically, private firms will have a profit motive and will generally run
the business to maximise profits.
• Private firms may be owned by an individual, a partnership or
shareholders and listed on the stock market.
• Private firms will respond to consumer preferences to produce goods
and services demanded in the free market.

Public Services

• Some firms and industries are managed and owned by the government.
• For example, the government may own and run public transport
companies.
• The government may run public transport because it has external
benefits for society, which would be ignored by private firms. In a free
market, public transport would be underprovided.
• Many government services are not run for profit but to provide a public
service. For example, health care and education.
• These public services are often free at the point of use and paid for by
tax revenue.
• The government may aim to provide more equitable distribution. Hence
health care is free and is not dependent on ability to pay.

Efficiency of Private Firms v Publically owned Firms

• It is argued that private firms tend to be more efficient than government

run firms and industries. This is because private firms have a profit
incentive to cut costs and respond to consumer preferences.
• However, if the government manage industries they can take into
account external benefits, e.g. provide free health care to people on low
incomes. Private firms are unlikely to be concerned about issues of
equity.

Public Private Partnerships

• Public private partnerships involve a mix of government spending and
private sector involvement.
• For example, in building a new road, a private firm may have a contract
to build the road. However, they receive a subsidy from the government
to take into account the external benefits of the road.
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The benefits of public private partnerships include:

• Involvement of private firms means there is some profit motive and

private sector discipline. Private sector firms will only invest in
worthwhile projects.
• It helps reduce the cost to the government, leading to lower tax rates for
consumers.

Potential Problems of Public Private Partnerships

• Private firms make profit from government subsidy.

• Private firms make profit, but if things go badly, the government usually
absorb the loss.
• Unclear who is ultimately responsible.
• Private firms may ‘cherry pick’ most profitable schemes, leaving
government to pay for unprofitable schemes.

Specialisation

• Specialisation occurs when a country or firm concentrates on producing

a particular good or service.
• Countries will specialise in producing goods where they have a
comparative advantage. For example, Japan specialises in producing
high-tech electronic goods. Cuba specialises in producing sugar.
• Firms specialise in producing particular goods to enable greater
efficiency.
• Workers specialise in doing particular jobs.

Division of Labour – Specialisation of Workers

• This occurs when workers concentrate on different tasks with a certain

firm.
• Rather than try to master all aspects of production, some workers will
specialise in various aspects of work.
• For example, in a car building firm, some workers will concentrate on
design, some on testing cars and some workers will just do unskilled
jobs such as painting the car.
• This means workers don’t need to be trained in all aspects of building a
car, but can become highly skilled in certain areas.
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Specialisation of Firms

• Firms will specialise in producing certain goods. This enables them to

benefit from economies of scale (lower cost of production with higher
output.)
• Specialisation also enables them to maximise their knowledge and
information about certain practises.
• Firms may even specialise in producing an aspect of a finished good.
For example, some firms just specialise in producing tyres which are
then used by other car companies.

Advantages of Specialisation
• Firms can concentrate on producing goods where they are relatively
most efficient.
• It means countries don’t have to produce every good they need, but can
trade to increase overall economic welfare.
• By specialising in production, firms can benefit from economies of
scale. This means with increased output they benefit from lower average
costs. This is important for industries with high fixed costs.
• Workers can be more efficient and need less training to do jobs.

Problems of Specialisation
• Concentrating on producing a small number of goods can make an
economy vulnerable. For example, Cuba specialises in producing sugar.
If the sugar price falls, the Cuban economy suffers.
• Division of labour can make jobs on assembly lines highly specialised,
leading to boredom and demotivation of workers; this can cause
diseconomies of scale.
• If firms specialise in a small specific sector, they can lose out if that
product becomes unfashionable. If they diversify, they are less at risk.

Evaluation
• Specialisation is necessary to achieve economies of scale. This is very
important in the global market where firms can sell all around the world,
and there are greater competitive pressures.
• As well as specialising in some aspects of production, it makes sense for
firms to have some diversification into related products, so they are not
so dependent on one product.
• It depends on the product and industry. If there are high fixed costs (e.g.
mining) it makes sense to specialise. But, in other industries (e.g.
clothing) it is more important to market unique products with a high
selling value.
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Money
• Money is an object used as a medium of exchange between two parties.
It can have intrinsic value like gold or it can be in the form of notes and
coins distributed by a central bank.
• Money enables people to specialise in one job and use their earnings to
purchase goods and services from people who work elsewhere. For
example, a teacher gets paid money and can buy food from
supermarkets.
• Without money, we would need a barter economy, which makes
specialisation harder. (e.g. a pig farmer is unlikely to sell me some pork
in return for a few hours of economics tuition)

Money has various functions:

• A medium of exchange. Money is a way of paying for goods and

services. This could be gold and silver or notes and coins. It needs to be
readily acceptable.
• Store of value. Money can be used to store wealth and easily converted
into a form which can be used for medium of exchange. Though
inflation may reduce the value of money
• Deferred payment. The agreed monetary terms for repaying a debt.
• Unit of account. A standard numerical measurement for valuing goods
and services.
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Demand
The individual demand curve illustrates the price people are willing to pay for a
particular quantity of a good.

The market demand curve illustrates the price consumers in the whole
economy are willing to pay.

Movement along the demand curve

A change in price causes a movement along the demand curve.

• A higher price reduces demand.
• A lower price increases demand.

• For example, if there is an increase in price from 9 to 12, then there will
be a fall in demand from 30 to 22.
• As the price falls, people are usually willing to buy more of the good. If
the price is higher, this discourages people from buying the good.
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Shifts in the Demand Curve

This occurs when, even at the same price, consumers are willing to buy a
higher quantity of goods – for example, demand shifts from D1 to D2

A shift to the right in the demand curve can occur for a number of reasons:

1. An increase in disposable income, such as higher wages and lower taxes

giving consumers more spending power.
2. An increase in the quality of the good. For example, mobile phones are
now more versatile and powerful, making them more attractive.
3. Advertising can increase brand loyalty to goods and increase demand.
4. An increase in the price of substitutes. For example, if the price of O2
Mobile phone calls goes up, the demand for Vodafone mobiles will
increase.
5. A fall in the price of complements. For example, a lower price for Apple
apps will increase demand for Apple iPhones.
6. Weather. Cold weather increases demand for heating.
Evaluation
• It depends on the type of good. A rise in income will not have any effect
on demand for salt, but it will have a bigger effect on demand for luxury
cars.
• Some goods will vary due to seasonal factors like the weather and time
of year (e.g. scarves and air conditioners).
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Supply
The supply curve refers to the quantity of a good that the producer plans to sell
in the market.

• As price increases, firms have an incentive to supply more because they

get extra revenue (income) from selling the goods.
• If price changes, there is a movement along the supply curve.
• E.g. an increase in the price from £40 to £50 causes an increase from 30
to 33.

Joint supply

Joint supply occurs when two goods are supplied together from the same
source.

For example, the supply of beef and leather are linked because both come from
the cow. With an increase in the supply of beef, you also get more leather.
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Shifts in the supply curve

An increase in supply occurs when more is supplied at each price, e.g. a shift in
supply from S to S2. This could occur for the following reasons:

• A decrease in costs of production. This means that business can supply

more at each price. Lower costs could be due to lower wages or lower
raw material costs.
• An increase in the number of producers will cause an increase in supply.
For example, a new firm, like Tesco diversifying into mobile phone
production.
• Expansion in the capacity of existing firms, e.g. investment to extend the
size of a factory.
• An increase in the supply of a complementary good, e.g. beef and
leather.
• Favourable climatic conditions, which are very important for
agricultural products, e.g. good weather will give a good harvest.
• Improvements in technology, e.g. computers and the Internet enables
more to be produced for a lower cost.
• Lower taxes on the good, e.g. lower petrol tax.
• Government subsidies on the good (government paying part of the cost).
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Market equilibrium
The price mechanism refers to how supply and demand interact to set the
market price and the amount of goods sold.

Market equilibrium occurs when supply = demand and there is no tendency for
the price to change.
Excess demand

If the price is below equilibrium (p2), demand is greater than supply (Q2 – Q1)
– causing a shortage.

• Therefore, with consumers wanting to buy more firms will put up prices
and supply more.
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• As price rises, there will be movement along the demand curve and less
will be demanded.
• Prices will rise until supply equals demand.

Excess supply

• If the price is above equilibrium (p2), supply is greater than demand

(Q2-Q1) – causing a surplus.
• To sell the unsold goods, firms reduce the price and reduce supply
(movement along supply curve). The lower price also encourages more
demand.
• The price falls to P1 where supply equals demand.

Impact of increase in demand

• If consumers saw an increase in income, we would see an increase in
demand for goods like TV’s; the demand curve would shift to the right.
• Initially there would be a shortage, but the higher demand would cause
the price to rise and suppliers to supply more.
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The increase in demand causes an increase in price (P1 to P2) and an increase in quantity (Q1
to Q2).
In the long-term, the higher prices may encourage more firms to enter the
market and the supply curve will shift to the right.
Fall in supply
If the availability of oil decreased, we would see a fall in supply.

The fall in the supply of oil causes the price to rise and a small fall in demand. Since
demand for oil is inelastic, we see a relatively bigger increase in the price.

Impact of fall in supply in long term

• If the price of oil increased, it may start to make it profitable to produce
oil from new places, such as Alaska and Antarctic. Previously it was too
costly to produce oil from here, but the higher price may make it
worthwhile.
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• If the price of oil rises, in the long-term people may respond to higher
prices by switching to other forms of transport which don’t use petrol.

Factors that could explain a fall in the price of a good

• The price of a good, such as coffee, would fall if there was a fall in
demand and/or an increase in supply.

Fall in the price from P1 to P2

The demand for coffee could fall for various reasons such as:
• Lower incomes mean that consumers cannot afford to buy as much.
• Coffee becomes less fashionable.
A fall in number of coffee shops.
• Health concerns about caffeine.

The supply of coffee could increase for various reasons such as:

• An increase in the number of suppliers or countries producing coffee.

• Lower costs of production, e.g. lower wage rates in coffee-producing
countries.
• Government subsidies, e.g. Latin American countries may wish to
subsidies the coffee farmers.
• Higher labour productivity in producing coffee, which will decrease the
costs of production.
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Government Intervention in Markets

1. Maximum Prices
Under certain circumstances the government may wish to reduce the
price below the market equilibrium. E.g. they could have a maximum
price for renting houses, to make it cheaper to live.

Problems of Maximum prices

• The lower price will cause a shortage. This is because at a lower price,
less will be supplied, but more is demand. Therefore, with a maximum
price some tenants could be worse off because they cannot find any
houses to rent.
• If there is a shortage of a good it tends to create a ‘black market’ where
people pay extortionate prices to get the good which is in short supply.
• A better way to reduce price would be to increase supply.
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Minimum Prices
• A minimum price occurs when the government wishes to raise the price
above the equilibrium.
• For example in agricultural markets, the government often wishes to
increase the income of farmers by increasing the price of goods.

Diagram of Minimum Prices

Problem of Minimum Prices

• A minimum price encourages farmers to increase supply, but with a
higher price, less is demand. Therefore, this leads to a surplus (supply
greater than demand of Q3-Q1).
• To maintain this minimum price, the government is obliged to buy the
surplus (Q2-Q1) to maintain the minimum price.
• The minimum price might also encourage more farmers to enter the
market.
• The European Union has had minimum prices for many agricultural
goods, as part of the Common Agricultural Policy (CAP). In the past
high minimum prices have led to surplus of agricultural goods; it has
also cost the EU a lot of money. (between 40-70% of its total budget).
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Consumer and Producer Surplus

Consumer Surplus

• Consumers surplus is the difference between the price consumers’

pay and the price they would be willing to pay.
• For example, if a book costs £10, but the demand curve shows they
would have paid £16, the consumer surplus is £6.

• Monopolies are able to reduce consumer surplus because they charge

consumers a higher price.
• In competitive markets, consumer surplus will tend to be higher.

Producer Surplus

• This is the difference between the price suppliers receive and the
price they would have been willing to supply the good at.
• If the market price is £10, and their supply curve shows they would
have supplied it at £8, they have producer surplus of £2.
• A monopoly would tend to have higher producer surplus.
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Elasticity

• Price Elasticity of Demand (PED) measures the responsiveness of

demand to a change in price.

(PED) = % change in quantity demanded

% change in Price

• For example, if the price of coffee increases 10% and the demand
falls 2%, then the PED = -0.2

Elastic Demand
• Demand is price elastic if a change in price leads to a bigger percentage
change in demand.
• The PED will therefore be greater than 1. E.g. PED = -2.5
• An example might be Lipton tea. If Lipton Tea increases in price 10%,
demand may fall 17%. PED = -1.7

Characteristics of Elastic Goods

1. Luxury goods (e.g. organic food)

2. They are expensive and a big % of income (e.g. sports cars and
holidays)
3. Goods with many substitutes, e.g. if the price of Volvic water increased,
there are many alternative types of mineral water.
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4. Goods in a Competitive market. For example, if Tesco put up the price

of its bread there are many alternatives, so people would be price
sensitive and people would buy alternatives.
5. Goods which are bought frequently.

Inelastic Demand
• Demand is inelastic if a change in price leads to a smaller percentage
change in Q.D.
• PED will be less than -1 e.g. -0.5

Example of inelastic demand

• If the price of tobacco increases 10% and demand falls 2%, the PED = -
0.2

Characteristics of Inelastic Goods

• They have few or no close substitutes, e.g. diamonds have few
substitutes.
• They are necessities, e.g. petrol to drive a car and get to work.
• They are addictive, e.g. smokers keep buying cigarettes, if price goes up.
• They cost a small % of income or are bought infrequently, e.g. salt.

• In the short term demand is usually more inelastic because it takes time
to find alternatives. But, over time, demand may become more elastic.
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Using Knowledge of Elasticity

1. Revenue and elasticity

If demand is inelastic then increasing the price can lead to an increase in

revenue.

In this example, the price of oil rises from $110 a barrel to $190, and the
quantity falls from 9 million to 8 million.

• Revenue was $110 × 9 = $990 million

• Revenue is now $190 × 8 = $1,520 million
• An increase in revenue of $530 million
This is why OPEC tries to increase the price of oil, because higher oil prices
are more profitable.

What is the PED of oil in this example?

• % change in Q.D 1/9 = -0.11 (-11.1%)

• % change in price 80/110 = 0.727 (72.7%)
Therefore, PED of oil = -11.1 / 72.7 = -0.15 (inelastic)
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If demand was price elastic

• Price rises from £110 to £130 – (20/110) = 18%

• Quantity falls from 9 to 4 (5/9) = 55.5%
• Revenue was 110 × 9 = £990
• Revenue has now fallen to 4 × £130 = £520
• A fall of £470
PED of this example -55/18 = - 3.05 (elastic demand)

1. If demand is inelastic then increasing the price can lead to an increase in

revenue.
2. In the example below, the supply of oil is reduced from S1 to S2. This
causes the price to increase from $15 to $30. However, because demand
is inelastic, there is only a small fall in demand.
3. Firms will try and make demand more inelastic if they can, e.g. brand
loyalty. Monopolies have an inelastic demand curve because consumers
have no alternatives, therefore, they can charge higher prices.
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Price Elasticity of Supply

• Price Elasticity of supply measures the % change in Quantity Supplied

after a change in price.
• Price Elasticity of Supply PES = % change in QS
% change in Price
Inelastic Supply
• This means that an increase in price leads to a smaller % change in
supply.
• Therefore PES <1

Supply could be inelastic for the following reasons

1. Firms operating close to full capacity.
2. Firms have low levels of stocks; therefore there are no surplus goods to
sell.
3. In the short term capital is fixed, therefore firms do not have time to
build a bigger factory.
4. If it is difficult to employ factors of production, e.g. if skilled labour is
needed.
5. With agricultural products supply is inelastic in the short run because it
takes at least 6 months to grow crops.
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Elastic Supply

• This occurs when an increase in price leads to a bigger % increase in

supply, therefore PES >1

Supply could be elastic for the following reasons:

1. If there is spare capacity in the factory
2. If there are stocks available
3. In the long run supply will be more elastic because capital can be varied.
4. If it is easy to employ more factors of production.
5. In competitive markets supply is more likely to be elastic. As price
increases, firms can easily enter into the market and supply more.

Implications of Price Elasticity of Supply for Business

• If supply is inelastic, it means firms will struggle to increase supply in
response to a change in price. However, it means that an increase in
demand will cause a big increase in price and make the good more
profitable.
• If supply is elastic, it means an increase in demand will lead to only a
small increase in price. But, the firm can easily supply more in response
to higher demand.
• The best combination would be for the industry supply to be inelastic,
but for an individual firm to be able to increase its own supply when
price goes up.
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Firms

Business Costs

• Fixed Costs. - Costs that do not vary with output; e.g. cost of a factory.
• Variable Costs: - Costs that do vary with output; e.g. electricity,
materials.
• Total Costs: - Fixed + variable costs
• Average Total Cost (ATC) = TC / Q
• Average Variable Cost (AVC) = VC / Q
• Average Foxed Costs (AFC) = FC / Q

Example of Costs

Q   FC   TC   VC   ATC  
0   1000   1000      
1   1000   1200   200   1200  
2   1000   1300   300   650  
3   1000   1550   550   516.67  
4   1000   1900   900   475  

Average Cost Curves

 29

Profit and Revenue

• Total Revenue (TR): This is the total income a firm

receives.
This will equal Price * Quantity
• Average Revenue (AR): TR / Q

• Profit = Total revenue (TR) – Total Costs (TC) or (AR – AC)* Q

Price  (P)   Quantity  (Q)   Total  Revenue   Average  Revenue  

(TR)   (AR)  
10   1   10   10  
9   2   18   9  
8   3   24   8  
7   4   28   7  
6   5   30   6  
5   6   30   5  
4   7   28   4  

Total Revenue and Average Revenue

• Graph showing AR and Total Revenue. In this example Total Revenue

is maximised at £30,
 30

Profit
Profit is the total amount of money the firm makes after subtracting all its costs
from its total revenue.

• Profit = Total Revenue – Total Cost

• Profit = Q (AR-AC)

A firm can increase profits by increasing revenue and / or decreasing costs.

Break Even Analysis

• Break even is said to be the minimum output necessary to achieve the

point where the firm’s Total Revenue = Total Cost.
• When total revenue is greater than total cost the firm is making profit.

Example of Break Even Analysis

• Fixed costs = £500
• Variable cost = £3 per mug
• Average Revenue (price of selling mug) = £5
What is the Break Even Point?
• Profit Margin = £5 - £3 = £2
• Fixed costs = £500.
• Therefore to meet fixed costs we would need to produce £500 / 2 = 250

• Revenue from 250 = £250 * 5 = £1,250

• Total Costs of 250 = £250 * 3 (+ FC of £500) = £750 + £500 = £1250
 31

Productivity and Production

• Productivity means the output per factor in a certain period of time.
• Labour productivity means the output per worker in a period of time.
• Production This is the total output produced. Total production doesn’t
measure how many inputs (workers) were required; it only measures
how many goods are actually produced.

How To Increase Productivity

Firms can increase productivity through the following measures:

• Better Technology. New technology enables more to be produced for

lower costs. For example computers and internet have enabled greater
efficiency.
• Training of Workers. If workers gain better education and training
they will be more productive in working on specialised tasks.
• Increased Capital. Investing in capital (e.g. machines) can enable fewer
workers to be needed, which helps reduce wage costs.
• Specialisation and division of labour. This occurs when workers
concentrate on specific tasks to produce more.
• Better motivation for workers. Performance related pay might make
workers more motivated to work hard.
• More competitive markets. If firms face competitive pressures they
will have greater incentives to cut costs and increase productivity.

Objectives  of  Firms    

Generally, it is assumed firms seek to maximise profits. However, in practise,
firms can often pursue other objectives such as increasing market share.
Objectives of firms include:

• Profit Maximisation. The most common objective of firms is to make

as much profit as possible. This enables higher salaries for managers and
bigger dividends for shareholders.
• Sales Maximisation. Increasing sales helps the firm to increase market
share. The firm may not maximise profits, but it becomes bigger and
more powerful. Managers may like working for big companies because
of the greater prestige.
• Profit Satisficing. This occurs where owners wish to maximise profit,
but workers seek to pursue other objectives such as enjoying work.
Therefore, workers make enough profit to keep owners happy, but then
pursue other objectives
• Social / Environmental / Cultural Objectives. Some firms may be
motivated by desire to make a positive contribution to the world, e.g.
consider environment or work as a ‘co-operative’ – where all
stakeholders benefit.
 32

The Product Market

• The product market relates to the mechanism a firm has for selling its
goods in particular areas.
• The product market enables an exchange between suppliers and
consumers.
• Firms respond to consumer preferences and produce the goods that
consumers want.

In this diagram, we see an increase in demand (D1 to D2). In response, firms

also increase supply to S2. Therefore, there is an increase in quantity, but price
stays the same.

Benefits of Product Markets

• Firms can market particular goods and services and develop a degree of
brand loyalty.
• Consumers can express which goods they want to buy. It creates an
incentive for firms to respond to changing consumer preferences.
• By concentrating on particular product markets, firms can benefit from
economies of scale.
• Prices will be determined by supply and demand and ensure an efficient
allocation of resources

Limitations of Product Markets

• Firms may gain monopoly power. This enables them to set higher prices
and restrict supply.
 33

• Some products may be harmful, for example, alcohol and tobacco lead
to health problems.
• Some products may create external costs to society. For example,
driving a car creates pollution which reduces living standards. These
external costs are often ignored in product markets.
• There may be inequality. For example, for some essential services,
people on low income may be unable to afford them.

How  Firms  Grow  

Companies may wish to increase its size and sales for various reasons. They
can grow either by internal expansion or external expansion. (mergers)

Internal expansion - involves the firm expanding its existing capacity.

Internal expansion could occur due to:

• Investing in new productive capacity / technology.

• Marketing campaigns which increase demand for products.
• Creating new product lines related to existing products.
• Investing in bigger factories.
External Expansion - involves a merger or takeover with another firm.
External expansion could occur due to:

• Horizontal merger – when two firms at same stage of production

merge, e.g. Guinness brewers and Tetley Brewers.
• Vertical Merger – when two firms at different stage of production
merge. E.g. Guinness brewer buys a chain of pubs or a farmer who
grows hops.
• Conglomerate Merger. Two unrelated firms. E.g. Time Warner (films)
merging with (AOL) internet firm.

Benefits of Business Growth

• Increase profit. Higher profit enables higher wages and more money
for investment.
• Economies of Scale. In industries with high fixed costs, increased
production leads to lower average costs enabling a firm to be more
competitive.
• Market Dominance. With higher sales and market share, firms can
have more influence over the long term; it could help them increase
price and profits in the long term.
• Risk Bearing economies. A bigger firm has more resources to survive
an economic downturn.
• Diversification. A firm may grow by diversifying into different product
markets. This enables it to survive a downturn in that product market.
 34

Difficulties of Firms Growing

• Diseconomies of scale. Increasing size may lead to higher average costs
due to difficulties of managing a large firm. In large firms, workers may
feel less pressure to work hard because it is easier to hide low
productivity.
• Difficult for niche markets. Some firms may specialise in small niche
markets. Becoming a large firm reduces the attractiveness of the firm.
• Take over Target. Listing on stock markets can make firm vulnerable
to takeovers / short termism.
• Profit satisficing. In a bigger firm owners struggle to retain control.
Managers in charge may pursue other objectives such as enjoying work
rather than maximising profits.
• Lack of Knowledge. If a firm diversifies into different product markets,
it may lack the expertise to be successful.
• Cost of borrowing. To invest in business growth may require the firm
to borrow, but banks charge interest making the investment more
expensive.

Economies  of  Scale  

Definition of Economies of Scale – this occurs in the long run when
increased output leads to lower average costs and increased efficiency.

• For example, by increasing output from Q2 to Q1, the firm is able to

reduce average costs from AC2 to AC1.
• Internal economies of scale occur when the firm gets lower average
costs from increasing its own output
• External economies occur when the firm benefits from an increase in
the size of the total industry.
 35

Types of Economies of Scale

1. Specialization and division of labour: In large scale operations

workers can do more specific tasks. With little training they can become
very proficient in their task; this enables greater efficiency. A good
example is an assembly line with many different jobs.
2. Bulk buying: If you buy a large quantity of raw materials then the
average costs will be lower.
3. Technical. When a firm benefits from increased scale of production. For
example, a large machine (e.g. blast furnace / combine harvester) would
be inefficient for small scale production; for higher rates of production,
the firm gains a better rate of return from this initial investment.
4. Financial economies. A bigger firm can get a better rate of interest
from a bank than small firms.
5. Marketing. A national TV advertising campaign is more efficient for a
large firm. Large firms get lower average costs for marketing.
6. Risk Bearing. Bigger firms are able to diversify into different areas.
This gives them a greater ability to avoid an economic downturn.

External economies of scale:

• This occurs when firms benefit from the whole industry getting
bigger. For example. If the industry gets bigger all firms will benefit
from better infrastructure, access to specialized labour and good
supply networks.
• External economies of scale encourage firms to set up in areas where
an industry is already developed. For example, a car firm may set up
in the East Midlands where there is already a well established
infrastructure.
• Silicon valley is an example of concentration in the micro-computer
industry.

Diseconomies of Scale:
This occurs when increased output leads to higher average costs. This can
occur due to factors such as:

• Difficulty of controlling and monitoring workers in a big firm. It is

easier for workers to be lazy and ‘slack off’
• In a big firm, with highly specialised work, workers may become
alienated and bored with little motivation to work hard.
• A larger firm may experience difficulties communicating across the
different aspects of the business.
• Higher administration costs. With a bigger firm, it is harder to control
the firm.
 36

Stakeholders  in  a  Firm  

• Owners – shareholders in the firm.
• Workers – people who work in the firm.
• Consumers – people who buy the good or service.
• Suppliers – people who sell raw materials to the firm.
• Local People – People who live close to the firm. This may be important
if the firm produces pollution or noise in the production process. As well
as local people, we could consider the local environment as a
stakeholder.

Relationship Between Stakeholders

• Some business objectives may conflict with some stakeholders.
• A firm may increase profit by reducing the price paid to suppliers.
However, if firms reduce price too much, their suppliers may go out of
business.
• A firm may seek to increase profit by cutting wages for workers and / or
making them work longer hours. However, making them work longer
hours could reduce productivity and lead to higher labour market
turnover. A successful company needs loyal and motivated workers.
• Shareholders will want higher profit. This often puts pressure on the
firm to make more profit in the short term. However, for longer term
profit and survival, the firm may need to invest, which leads to lower
profit in the short-term.

Companies
• Sole Trader – When there is just one individual owning a business.
• A limited company is owned by a small number of individuals or just
one person. The public cannot buy shares in the company.
• A public limited company is listed on the stock exchange. This means
individuals can buy and sell shares in the company.

Shares
Function of Shares:
• By selling shares in the company, firms can raise revenue. Firms can use
this revenue for investing in future projects.
• Selling shares can be a cheaper way to raise money than borrowing from
the bank. If the firm needs long term investment, it can sell shares to
raise funds rather than taking out an expensive loan.
• Individuals can buy shares and benefit from annual dividend payments
(a share of the profits from the company – like interest payments)
• Shareholders in the company can vote on the direction of the company.
It makes the firm more accountable. However, it means those who set up
the company can lose control over the direction of the firm.
 37

Business  Location  
Factors that influence business location for a firm.

• Access to raw materials. Convenient access to raw materials helps

reduce costs for firms.
• Access to markets. In the retail market, location is a key factor in
determining success. Being on the right road can make a big difference
to the success of a shop.
• Transport links and the cost of delivering goods. The fall in global
transport costs have encouraged firms to produce abroad and export
production.
• Labour Costs – wages and taxes. If an industry is labour intensive, then
a firm may consider relocating production to developing countries with
lower labour costs. For example, many manufacturing firms have moved
to India where labour costs are lower.
• Qualified labour. Some industries, which are higher tech, may require
skilled labour. For example, many computer firms set up in Silicon
Valley because there is a good access of skilled labour.
• Government regulation and subsidy. The government may give
subsidies to firms locating in depressed areas; this may encourage firms
to set up there.

Competitive Markets

A competitive market is characterised by:

• Many firms in the market.

• Freedom of entry and exit. This means it is relatively easy for new firms
to enter the market. There must be low barriers to entry.
• Low profits made by firms. If firms made very high profits, in a
competitive market, this would encourage new firms to enter and reduce
the profitability.
• Prices relatively low for consumers. The competition helps keep prices
low.

How Competitive Markets Affect Business

• Firms face the threat of competition, therefore they must remain

efficient and develop better quality products and services, and otherwise
they will go out of business.
 38

• In competitive markets it is difficult to increase prices because

consumers will buy from cheaper competitors. Therefore, in competitive
markets prices stay low.
• Competition means that profits are likely to be lower. This may make it
more difficult to invest in new products.

Benefits of Competitive Markets for Firms

• Forces it to be efficient and offer best products

• If it is best firm it can attract more custom.
• It will need to identify its strengths and weaknesses and encourages firm
to be innovative

Problems of Competitive Markets for Firms

• Difficult to make high profits because other firms will enter into market.
This makes firm less attractive to shareholders
• Need to spend a lot of money on advertising to attract customers.
• You can easily lose customers to rival firms and new firms who just
enter the market.
• Easier to go out of business. This uncertainty may discourage
investment.

Benefits of Competitive Markets for Consumers

• Consumers likely to pay lower prices than in markets with monopoly

power.
• Consumers face greater choice of goods and services
• Firms will try hard to win consumers therefore; they are likely to get
better consumer service.
• If firms are inefficient or unsatisfactory, consumers can choose another
firm.

Limitations of Competitive Markets for Consumers

• Firms may make insufficient profit to invest in research and
development. Therefore, they may be less improvement in products.
• If there are many small firms, they will not be able to benefit from
economies of scale.
 39

Monopoly

• This is a market structure with one dominant firm.

• Monopoly power occurs when a firm controls over 25% of the market.
• Examples of monopoly include: Regional tap water companies (100% of
tap Water market), Railtrack (100% control of rail tracks), Google (80%
of search engine market)

For a monopoly to occur there needs to be barriers to entry, these are

conditions which make it more difficult for a firm to enter a market.

Barriers to Entry

1. Economies of Scale. A new firm would find it difficult to compete

because its average costs would be much higher than the incumbent who
has a higher output and lower average costs. Examples include
electricity generation.
2. Natural / Geographical Barriers. Only a few countries can produce
diamonds because they only occur in small parts of the world.
3. Brand Loyalty. Through advertising firms can differentiate their brand
and encourage consumers to be loyal to the product. It makes it more
difficult for new firms to enter because they would have to spend a lot of
money on advertising. For example, Pepsi and Coca Cola have
monopoly power through their strong brand loyalty.
4. Control Supplies. By controlling supplies, firms can deter entry. E.g.
oil companies can limit supply of petrol to new petrol stations.
5. Legal Barriers. This prevents competition by law. For example a patent
or government monopoly (like Royal Mail used to be)

Disadvantages of Monopolies

1. Higher Prices. Consumers have only a limited choice, therefore

demand is inelastic. This enables the firm to increase prices, thereby
causing a fall in consumer surplus.
2. Allocative inefficiency. Firms don’t respond to consumer needs and
preferences. Therefore monopolies tend to be allocatively inefficient.
3. Productive inefficiency. Because competition is limited firms have less
incentive to cut costs and therefore could be productively inefficient.
4. Monopolies can pay lower prices to suppliers E.g. car companies with
monopoly power can pay lower prices to suppliers.
5. Diseconomies of scale. If a firm gets too big and unwieldy, average
costs will start to rise.
 40

Advantages of Monopolies

1. Economies of Scale. If there are high fixed costs in the industry the firm
will be able to benefit from economies of scale and lower average costs
as output increases. This enables lower prices for consumers.
2. Research and Development. A firm can use its supernormal profits to
invest in new products which will benefit the consumer. This is
important for many industries such as pharmaceuticals.
3. Some firms may gain monopoly power because they are efficient and
innovative. E.g. Google is considered an innovative company; this gave
it monopoly power in search engines.
4. International competition. A domestic monopoly may face
competition from abroad.

Government Regulation of Monopoly

Governments regulate markets to try and prevent the abuse of monopoly power
and make sure firms don’t act against the public interest.

• Merger Policy. The Competition Commission can investigate a merger

to see if it is in the public interest. If the commission thinks the new firm
created by the merger will have too much market power and will act
against the public interest, the merger will not be allowed.
• Office of Fair Trading. The Office of Fair Trading can intervene if
firms abuse their dominant market position. Unfair practises could
include:
o Collusion / Cartel – agreeing with other firms to artificially raise
prices.
o Restricting competition. Making deals with retailers to limit
competition.
o Tied in Sales. Selling related products at an excess price. For
example firms sell printers relatively cheap, but then charge
excessive prices for their brand of ink.
o Predatory Pricing. When a firm sells price below cost to try and
force a rival out of business.
How Can the Government Encourage Competition?
1. Prevents mergers which can create too much market share.
2. Government can split up firms which are too big.
3. They can prevent collusion which restricts competition.
4. They can deregulate state monopolies, and allow new firms to enter
market (e.g. Royal Mail)
5. They can ensure new firms have access to key infrastructure (E.g. in
Electricity market, new firms can have access to national grid)
 41

Labour Markets
The labour market refers to the supply and demand of workers in a particular
industry. For example, firms need people to work in shops. The supply and
demand for shop workers will determine their wage.

Definitions in the Labour Market

• Gross income – This is the income before tax is deducted.

• Net income – this is the income the worker receives after the deduction
of taxes and other compulsory contributions. (e.g. pensions)

• Nominal income – This is the monetary level of income (unadjusted for

inflation)
• Real Income – This is the level of income after adjusting for inflation.
• For example, if your actual wage increases 7%, but inflation is 2%, then
your real wage has increased by 5%.
• If wages increased by 8%, but inflation was 8%. It would mean your
wages would still buy the same amount of goods. Therefore, your real
income has stayed the same.

Demand for Labour depends upon:

• Productivity of workers – higher productivity of labour = higher

demand.
• Demand for good – labour is a derived demand. E.g. if there is high
demand for watching football, clubs will be willing to pay higher wages
to footballers because there is substantial money in the sport.
• Wages. Higher wages cause a movement along the demand curve.
• Non-wage costs include paying national insurance, health insurance,
and potential redundancy pay.

Elasticity of Demand for Labour

The elasticity of demand for labour measures how responsive demand for
labour is after a change in wages. Elasticity of demand for labour depends on:

• How essential is the worker? If there are no substitutes for labour,

demand will be inelastic
• Number of people with qualifications and skills. If a small number of
workers have qualifications, demand will be more inelastic.
 42

• Time Period. In the short term, demand for labour will be inelastic.
However, other time it becomes easier to substitute labour for capital so
demand becomes more elastic.
• Proportion of wage costs. If labour is a high % of total wage costs, the
firm will be more sensitive to a rise in wages.

Workers with inelastic demand are hard to replace. Therefore they tend to have
greater bargaining strength and can demand higher wages.

Determination of Wages

• In the diagram on the left, supply and demand are both elastic. This
could be an unskilled job such as a cleaner. Therefore, wages are
relatively low.
• On the right, supply and demand are inelastic leading to a higher wage.
This could be a lawyer where supply and demand are inelastic.
 43

Reasons for Wage Differentials within Same Occupation

In a labour market, such as lawyers, different lawyers will gain different wages
for doing a similar job. Reasons for wage differences include:

• Experience and Qualifications. Workers who have more qualifications

and experience will be able to command a higher salary. Typically older
workers gain a higher wage because of more experience.
• Productivity. If a worker is more productive, he can get a higher wage.
For example, a job such as picking strawberries is likely to depend on
quantity of strawberries picked. However, in a job like teacher or
lawyer, it is harder to measure productivity. But, if a lawyer is more
successful in acquitting clients, he should get paid more.
• Discrimination. It is possible some workers may be paid less because of
age / sex / race. In theory, this is outlawed by equal pay legislation, but
in practise it can be difficult to implement.
• Trades Unions. In some industries, members of unions may get a
higher wage. But, part-time temporary staff may get a lower wage.
• Region. Workers in London may expect a London bonus to account for
the higher living costs in London.

Reasons for Wage Differentials Between Different Occupations

• Skills Required. Jobs that are highly skilled will generally have higher
wages. This is because fewer people can supply their labour
• Profitability of Industry. In some occupations, there is more money in
the industry. Therefore, wages will be higher. For example, the influx of
TV money into football increased the wages of footballers.
• Trades Union activity. Trades unions can bargain for higher wages.
Occupations with strong trade unions may get higher wages than jobs
with little union activity.
• Popularity of job. If a job is a popular because of non-monetary
benefits, more will be willing to supply their labour, pushing down
wages.
• Government sector. If a job has wages set by the government (nursing,
doctors), then wages may be lower than the private sector as the
government tries to reduce spending.
 44

Minimum Wages
• In the UK, there is a national minimum wage, which means firms are
not allowed to pay a lower hourly rate.
• In 2016, for workers over 21, the minimum wage rate is £6.70.
• From April 2016, the national living wage will be £7.20 an hour for
workers aged 25 and older.
• There are lower rates for workers under 21 and 18 as young workers
have less experience and firms more reluctant to pay higher wages.

Diagram of Minimum Wage

A minimum wage placed above the equilibrium wage rate.

Benefits of a Minimum Wage

1. Increase the wages of the lowest paid workers.

2. Higher wages can increase the incentive for people to work harder and
therefore increase productivity.
3. Increase the incentives for the unemployed to accept a job. With a
minimum wage, the gap between benefits and wages grows.
4. If firms have monopsony power they can drive wages down by
employing less workers. In this case a minimum wage is likely to have a
positive effect on wages and employment.
 45

Disadvantages of Minimum Wage

1. If labour markets are competitive a minimum wages could cause

unemployment because supply is greater than demand.
2. A minimum wages can cause cost-push inflation. This is because firms
face an increase in costs which are likely to be passed on to consumers.
This is more likely if wage differentials are maintained.
3. A minimum wage may increase the number of people working on the
black market (avoiding legal minimum).
4. A limitation of the minimum wage is that it doesn’t increase the incomes
of the lowest income groups. This is because the poorest have to rely on
benefits and are therefore not affected by the minimum wages.
5. Also, many who benefit from the minimum wage are second income
earners and, therefore the household is unlikely to be below the poverty
line.

Evaluation of Minimum Wages

1. The effect of a minimum wage on unemployment is uncertain. It
depends upon the structure of the labour market and whether the
increased costs can be passed on to consumers.
2. Empirical evidence from the US and the UK suggests that a moderate
increase in the minimum wage doesn’t cause a fall in employment.
Therefore the key question is how high the minimum wage can rise
before causing unemployment.
3. The effect on wage differentials is important. For example skilled
workers just above the minimum wage may feel they also deserve a
wage increase to maintain their gap.
4. There may be a good case for a regional minimum wage because wages
tend to be lower in the north than the south. In London, very few
workers benefit from the minimum wage so a higher minimum wage
could be set. But, in the north, a higher minimum wage would cause
unemployment
 46

Section 2 How the Economy Works

• Macro Economic Objectives

• GDP
• Economic Growth
• Inflation
• Supply side policies
• Unemployment
• Fiscal Policy
• Interest Rates
• Monetary Policy
• Budget Deficits / Government Borrowing
• Conflicts of Macro Objectives
• Government tax and revenue
• Inequality
• Poverty and policies to overcome poverty
• Market Failure / Externalities
• Government intervention
 47

Macro Economic Objectives

The main macroeconomic objectives of the government include:
1. Sustainable economic growth (increasing national income per person)
2. Low unemployment – (full employment)
3. Low inflation. – (Price stability)
4. Satisfactory Balance of Payments (balancing exports and imports)
5. Supporting a stable exchange rate
6. Low government borrowing
7. Considering the environment
8. Equality of income distribution.

GDP Gross Domestic Product

• Nominal GDP This is a measure of national income, output and
expenditure. This is the monetary value of all goods and services
produced in the economy.
• Real GDP This is national income measured in constant prices. It means
we take into account inflation.
• Real GDP per Capita = This is the Real GDP / population.

Circular Flow of Income

The circular flow of income shows how money flows from households to firms
(to buy goods). Then firms pay households wages to produce goods. It shows
three ways to calculate GDP.
 48

1) Total National income (wages, dividends,)

2) Total National expenditure (consumption and investment)
3) Total National output (value of goods and services produced)

Economic  Growth  

• Economic growth means an increase in real GDP. An increase in GDP

means an increase in the volume of goods and services produced in an
economy.
• The rate of economic growth measures the annual % change in real GDP
• An increase in the productive capacity of an economy is known as an increase
in potential growth.
• The long run trend rate of economic growth is the sustainable rate of economic
growth in an economy. For example in the UK this is about 2.5%.

Benefits of Economic Growth

1. Higher Incomes. Consumers will be able to enjoy more goods and
services.
2. Lower unemployment: With higher output firms will employ more
workers. A sustained period of economic growth will lead to lower
unemployment.
3. Lower Government Borrowing. Economic growth creates higher tax
revenues and there is less need to spend money on unemployment
benefits. This reduces government borrowing.
4. Improved public services. With higher tax receipts more can be spent
on public services, such as health care and education.
5. Firms make more profit. Firms will make higher profit; this may
encourage more investment, which leads to a virtuous circle of higher
growth.

Costs of Economic Growth

1. Inflation. If economic growth is too fast then economic growth will be

unsustainable and inflationary. There will be a negative output gap and
firms will respond by putting up prices. However, if growth is moderate,
it will not cause inflation.
2. Boom and Bust Economic Cycles. If economic growth is unsustainable
then high inflationary growth may be followed by a recession (fall in
output). For example, the late 1980s boom and recession of 1991.
 49

3. Balance of Payments Deficit. Economic growth may cause higher

consumer spending on imports therefore causing a deficit on the current
account. However, if growth is export led, this will not occur.
4. Environmental Costs. Increased economic growth will lead to
increased output and therefore will cause increased pollution and
congestion which reduces living standards.
5. Increased Inequality: Higher rates of economic growth have often
resulted in increased inequality. This is because wealthy may benefit
more from economic growth.

Causes of Economic Growth

Economic growth is caused by two main factors:

1. An increase in demand
2. An increase in supply (productive capacity)

Factors that cause Higher Demand

• A rise in wages gives consumers more disposable income; therefore
there will be an increase in domestic spending and demand.
• Lower interest rates make it cheaper to borrow causing a rise in
spending and investment.
• A rise in house prices helps increase consumer confidence and consumer
wealth; this causes higher spending as people are more optimistic about
the future.
• Lower income tax. A cut in income tax increases disposable income,
encouraging people to spend more.
• A fall in value of exchange rate, which makes exports cheaper leading to
a rise in demand for UK exports.

Factors that increase Productive Capacity

In the long term, economic growth requires an increase in productive capacity
(PPF Curve shifting to the right. (Increase in Aggregate Supply)

Productive capacity can increase if there is:

1. Increased capital e.g. investment in new factories or investment in
infrastructures such as roads and telephones.
2. Increase in working population (e.g. immigration or later retirement
age)
3. Increase in Labour productivity, through better education and training.
4. Producing more raw materials (e.g. discovering oil deposits)
5. Technological improvements to improve the productivity of capital e.g.
microchips and the internet have both contributed to economic growth.
 50

• The average sustainable growth rate in the UK is about 2.5% (average

quarterly growth rate = 0.65%)
• In the late 1980s, the UK experienced rapid growth, but this caused
inflation and the growth was unsustainable. To reduce inflation, the
government increased interest rates and this caused the recession of
1990-91.

Fall in the Growth Rate

• Between 1987 Q3 and 1989 Q3 there is a fall in the growth rate.

• This means real GDP increased at a slower rate.
• DP only falls if there is a negative growth rate, e.g. 1990 and 2008.

Sustainable Growth

• Sustainable economic growth means that the growth can be maintained

for a long time. It implies that inflation will remain low and implies
demand increases at a similar rate to supply.
• It may also refer to environmental sustainability, e.g. not using up non-
renewable resources.
 51

Policies to Increase Economic Growth

There are two main policies to increase economic growth:/

• Demand side policies - increase spending, e.g. monetary and fiscal policy.
• Supply Side policies - increase productivity in the economy.

Fiscal Policy
• To increase economic growth, the government can pursue expansionary
fiscal policy.
• This involves lower taxes and higher government spending. Lower
income tax increases disposable income of consumers, therefore
encouraging spending.
• Higher government spending (e.g. on building new roads) creates
employment and investment in the economy.
• Expansionary fiscal policy (higher spending / lower tax) leads to a
bigger budget deficit and higher government borrowing.
• The multiplier effect states that if there is an initial injection (e.g. higher
govt spending) into the economy, then the final increase in AD and Real
GDP will be greater.

Limitations of Fiscal Policy in increasing economic growth

• To cut taxes and increase spending means the government will have to
borrow more from the private sector. Higher government borrowing
may push up interest rates and lead to lower private sector investment
because they are lending to the government and have fewer funds.
• If the government decides to increase spending, there will be a time lag
to increase actual demand in the economy; it takes time for spending to
be deployed.
• Governments may have poor information about the best types of
investment projects to spend money on. Therefore, the government
spending may be inefficient.

Monetary Policy
Monetary policy involves changing the interest rate or manipulation of the
money supply by the monetary authorities.

• In the UK, monetary policy is managed by the Bank of England,

Monetary Policy Committee (MPC).

Aims of monetary policy

1. Control the rate of inflation. Inflation target for MPC is CPI - 2.0% +/-1
2. Maintain sustainable economic growth
3. Influence the exchange rate (not so important)
 52

UK monetary policy
• Every month, the MPC meet to decide future interest rates. If they feel
the inflation rate is likely to go above the target (e.g. due to a higher rate
of economic growth) then they will increase interest rates to moderate
demand and keep inflation low.
• If the MPC feel that inflation is likely to fall below the target and there
is slow economic growth, they are likely to decrease interest rates to
boost economic growth and prevent unemployment.
To determine future inflation, the MPC will look at various statistics such as:

• The rate of economic growth compared to the long run trend rate. If
growth is faster than the trend rate, inflation is likely to occur.
• Wage growth. Higher wage growth can cause both cost-push and
demand-pull inflation.
• Temporary factors like tax rises and commodity price rises will be given
less importance because they do not indicate underlying inflation.
• Unemployment. High unemployment will tend to reduce wage inflation
and so the MPC is more likely to cut interest rates to boost AD.

Effect of higher interest rates (Tight monetary policy)

If inflation is forecast to rise above the inflation target, the MPC are likely to
increase interest rates. This will help reduce AD and inflation because higher
interest rates:

• Makes borrowing more expensive, therefore people spend less on credit.

• Firms will be less willing to invest by borrowing money.
• The cost of mortgages increases, therefore people have less disposable
income causing a fall in consumption. Therefore AD decreases.
• Saving money in a bank is more attractive therefore there is less
spending and relatively more saving.
• Exchange rate increases due to hot money flows into the UK (people
take advantage of a better rate of return on UK savings).

Evaluation of monetary policy

1. It depends on other components in the economy. For example if

confidence is low, a reduction in interest rates may not increase demand.
2. Time lags. There may be time lags for lower interest rates to have an
effect. E.g. higher interest rates may not reduce investment in the short
term because firms will continue with existing investment projects.
3. Conflicts of objectives. Monetary policy may conflict with other macro
economic objectives. If the MPC reduces inflation, this may lead to
lower growth or higher unemployment.
 53

Inflation
• Inflation means a sustained increase in the general price level.
• If there is inflation, the value of money declines and there is an increase in
the cost of living.
• Price stability means we have a low rate of inflation. It means prices only
change by a small amount. (e.g. an inflation rate close to 2% a year)
• Deflation is when prices fall.

Measuring Inflation
There are different ways to measure inflation.

• Consumer Price Index (CPI)

• Retail Price Index (RPI)

They are similar, but CPI ignores mortgage interest payments. It tends to be
lower than RPI. CPI is the official measure of inflation.
 54

How to Measure Inflation - Consumer Price Index (CPI)

Steps to measuring inflation:

1. Household expenditure survey - this seeks to measure what people spend

their money on. From this we get a typical basket of goods which is used to
measure typical prices.
2. This basket of goods gives a relative importance to each different item, e.g.
if the price of petrol increased this would have more effect than an increase
in the price radios because petrol has a higher weighting.
3. The basket of goods is updated each year to take into account changes in
expenditure
4. Every month changes in the price of goods and services are monitored and
combined into a single figure with using the weights in the basket.

Problems with Calculating Inflation

1. Family Expenditure survey does not include everybody, e.g. pensioners are
excluded, but pensioners have different spending habits e.g. heating is more
important for old people.
2. Changes in Quality: Computers have many more features than 10 years ago,
so it is difficult to compare prices because they are different goods. If prices
of computers increase, is it inflation or a reflection of better quality?
3. Spending habits are always changing. We have to keep updating the basket
of goods because we start buying new items.

Costs of Inflation
1. Cost of reducing inflation
High inflation is deemed unacceptable therefore governments feel it is
best to reduce it. To reduce inflation requires higher interest rates, but
higher interest rates lead to lower economic growth and higher
unemployment.
2. International competitiveness
Higher UK inflation will make British goods less competitive, leading to
a fall in exports and a worsening in the current account, balance of payments.
3. Confusion and Uncertainty
When inflation is high people are uncertain what to spend their money
on. Also, when inflation is high firms may be less willing to invest
because they are uncertain about future profits.
4. Menu Costs
This is the cost of changing price lists to keep up with inflation.
5. Income redistribution
With higher inflation people will see the value of their savings fall. This
could lead to lower income for pensioners who rely on savings.
 55

Causes of Inflation
1. Demand Pull inflation
• If demand in the economy increases faster than productive capacity,
then firms respond to the excess demand by pushing up prices.
• If the economy approaches full employment, firms may find it difficult
to employ workers. Therefore, this shortage of labour tends to push up
wages, which creates higher spending and inflation.
• We tend to get inflation, if economic growth is too fast – demand in the
economy rising faster than productive capacity.

With increase in demand, firms push up prices.

2. Cost Push Inflation

Inflation can also be caused by an increase in the cost of production. If there is

an increase in the costs of firms then they will respond by putting up prices for
consumers. Cost-push inflation could be caused by several factors, such as:

1. Higher Wages. If trades unions bargain for higher wages, this will lead to
an increase in costs for firms. It may also cause demand-pull inflation as
workers have more income to spend.
2. Import prices. One third of all goods are imported in the UK. If there is a
devaluation then import prices will become more expensive leading to an
increase in the price of imported goods.
3. Raw Material Prices If raw materials such as oil prices increase then this
will have a significant impact on costs and increase inflation.
4. Declining productivity. Lower productivity increases costs.
 56

Inflation in 2008 and 2011 was caused by cost-push factors such as higher oil
prices and higher taxes.

Policies to Reduce Inflation

To reduce inflation, the government can try two main policies

1. Reduce demand and the rate of economic growth - monetary and fiscal
policy
2. Supply side policies to increase productivity.

Monetary Policy to Reduce Inflation

• To reduce inflation, the Bank of England could increase interest rates.
• Higher interest rates increase the cost of borrowing and discourage
spending and investment. This leads to lower demand and lower
economic growth, which leads to a lower inflation rate.
• Also, higher interest rates increase the cost of mortgage payments. This
leaves consumers with lower disposable income and therefore lower
spending.
• Higher interest rates also tend to increase the value of the exchange rate
(hot money flows). A higher exchange rate makes imports cheaper
which reduces the price of imported raw materials.
 57

Evaluation of Monetary Policy in Reducing Inflation

• If consumer confidence is very high, then consumers may keep spending
despite an increase in interest rates.
• There may be a time lag of up to 18 months for higher interest rates to
have an effect. For example, if people have a two year fixed rate
mortgage, they will not see the impact of higher interest rates for quite a
while.
• It can be difficult to predict future inflation trends.
• If inflation is caused by cost-push factors (e.g. a rise in the price of oil),
then higher interest rates may reduce inflation, but also cause a big fall
in GDP.

Fiscal Policy to Reduce Inflation

• To reduce inflationary pressures, the government could use deflationary

fiscal policy.
• This involves higher taxes and lower spending.
• For example, an increase in income tax reduces disposable income and
leads to lower spending and lower economic growth. This helps reduce
inflation.

Evaluation of Fiscal Policy

• Higher income tax may reduce the incentive to work. Lower
government spending may conflict with commitment to provide public
services.
• It may be politically difficult to increase taxes just to reduce inflation.
• Generally, the government don’t use fiscal policy to control inflation,
but leave it to monetary policy.

Supply Side Policies

Supply side policies are government attempts to increase productivity and
productive capacity in the economy. Supply side policies can help the economy
in various ways:
1. Lower Inflation. Increasing productivity will help reduce costs and
keep inflation low.
2. Lower Unemployment. Supply side policies can help reduce structural,
frictional and real wage unemployment.
3. Improved economic growth. Supply side policies will help increase
productive capacity and lead to higher economic growth.
4. Improved trade and Balance of Payments. By making firms more
competitive they will be able to export more; this will help improve
the current account.
 58

Examples of Supply Side Policies

1. Privatisation. This involves selling state owned assets to the private
sector. It is argued that the private sector is more efficient in running
business because they have a profit motive to reduce costs and develop
better services.
2. Deregulation. This involves reducing barriers to entry in order to make
the market more competitive. Greater competition helps reduce prices.
3. Reducing Taxes. It is argued that lower taxes (income and corporation)
increase incentives for people to work harder, leading to more output.
4. Increased education and training. Better education and training
schemes can improve labour productivity and increase the capacity of
the economy. Often there is under provision of education in a free
market, leading to market failure. This is why government need to
intervene.
5. Reducing State Welfare Benefits. Lower benefits may encourage the
unemployed to look for jobs.
6. Providing better information. Better information about jobs may help
reduce frictional unemployment.
7. Improving Transport and infrastructure. In a free market there is
likely to be under provision of public transport. If the government
provided better transport, then firms would benefit from lower costs.

Evaluation of Supply Side Policies

1. They will take time to have effect, e.g. it takes time to learn new skills.
2. It will cost money and require higher taxes to improve information and
education.
3. Lower benefits and reduced minimum wages may cause poverty to
increase.
4. Government failure may occur because the government may have poor
information about what to spend money on, e.g. the govt may finance
the wrong kind of schemes.
5. Free market policies, such as income tax cuts and deregulation of labour
markets may lead to increased wage inequality in society.
6. In a recession, supply side policies will be ineffective to solve the
problem of a depressed economy. In a recession, we need demand side
policies, such as fiscal and monetary policy.
 59

Unemployment

• Employment means that a person of working age is employed in a

particular type of job.
• Unemployment means that a person of working age is actively seeking
work, but is unable to get a job.
• Non-participation. Some people of working age (16-65) may not be
employed, but also they are not counted as unemployed. This is because
they are not actively seeking work. Some people may leave the labour
market because:

o They are students

o Women taking time to have / look after children.
o People who take early retirement
o People who are physically incapable of work and receiving
sickness or disability allowance.
o People who become discouraged about finding a job.

Graph showing unemployment increased in 2008-09 recession.

 60

Economic Costs of Unemployment

1. Loss of earnings to the unemployed. Unemployment is biggest cause of

relative poverty in the UK.
2. Those who are unemployed find it more difficult to get work in the
future
3. Stress and health problems of being unemployed
4. Increased government borrowing. With higher borrowing tax revenue
falls and spending on benefits rises.
5. Lower GDP for the economy, this is Pareto inefficient.

Measuring Unemployment

There are two ways to measure unemployment – the claimant count and the
Labour Force survey.
1. Claimant Count Method.

• This is the government’s official method of calculating unemployment.

It counts the number of people receiving benefits (Job Seekers
allowance)
• To receive benefits, an unemployed worker needs to be actively seeking
work and attend a local job centre at regular intervals.

Problems with Claimant count

• The claimant count excludes those over 60, people under 18, those on
government training schemes, and married women looking to return to
work
• Some people may claim benefits whilst still working in the “black
Market”

2. The Labour Force Survey.

• This is a survey asking 60,000 people whether they are unemployed and
whether they are looking for a job. It includes some people not eligible
for benefits. It gives a slightly higher figure than the claimant count.
 61

Types of Unemployment

1. Frictional Unemployment
• This is unemployment caused by people moving in between jobs, e.g.
graduates or people changing jobs
• Also high benefits may encourage people to stay on benefits rather than
get work this is sometimes known as “voluntary unemployment”

2. Structural Unemployment
• This occurs due to a mismatch of skills in the labour market it can be
caused by:
1. Occupational immobilities. This refers to the difficulties in learning
new skills applicable to a new industry, and technological change.
For example, an unemployed coal miner may not have the right skills
to get a job in IT.
2. Geographical immobilities. This refers to the difficulty in moving
regions to get a job. For example, jobs may be available in London,
but unemployed workers in Yorkshire may find it difficult to move
to London because of cost of housing.

3. Classical or Real Wage Unemployment

• This occurs when wages in a competitive labour market are pushed
above the equilibrium. Minimum wages or trades unions could cause
this higher wage.
 62

4. Demand Deficient or “Cyclical Unemployment”

• This occurs when the economy is operating below full capacity. In a

recession demand for goods falls therefore firms produce less. With
lower production, many firms will cut back on labour. Also in a
recession, some firms will go bankrupt leading to job losses.

Policies  to  reduce  Unemployment  

1. Fiscal Policy
• If the government cut income tax, workers have more disposable income
and therefore spend more. This increase in consumer spending leads to
higher output, which means firms need more workers.
• Fiscal policy can be effective for reducing demand deficient
unemployment which occurs in a recession.
o However, in a recession, there may be a limit to how much the
government can borrow.
o Also, it will take time for government spending to create jobs.
2. Monetary Policy
• Expansionary monetary policy involves cutting interest rates. Lower
interest rates make it cheaper to borrow. This encourages consumer
spending leading to higher economic growth and therefore more demand
for workers.

3. Lower benefits and taxes

• Lower taxes and benefits increase the incentive for the unemployed to
look for work rather than stay on benefits. This may reduce frictional
unemployment.
o However, lower benefits will increase relative poverty because
people will need to get by on lower benefits. Also lower benefits
don’t create employment –only increase the incentive to look for
work.
4. Better job information
• This could help reduce frictional unemployment by giving the unemployed
better information about available job vacancies.

5. Education and Training

• By improving labour productivity and the skills of the workforce there
will be a reduction in occupational immobilities making it easier for
workers to switch jobs.
 63

o However this will cost the govt money, also there could be govt
failure with the wrong kind of training subsidised.

6. Reform Trades Unions and reduce Minimum Wages

• This will help reduce real wage unemployment because wages will fall
closer to the equilibrium level.
o However the effect on employment may be small if demand for
labour is inelastic.
o Also lower wages may lead to more relative poverty.

7. Regional Grants
• These can help overcome geographical unemployment by encouraging
firms or workers to move.
o However subsidies may prove ineffective for encouraging
workers to move because they may be attached to their local
community.

Interest Rates
• Interest rates are the cost of borrowing money.
• If you borrow money from a bank, they will charge you a rate of
interest. For example, they may lend you a £1,000, but charge an interest
rate of 7%.
• This means that every year, you would have to pay £70 interest as well
as paying the loan back.
• If you save money in the bank, the bank may pay you an interest rate on
your savings. This gives an incentive for you to deposit money in a
bank.
• For example, if you save money in a savings account, you may get an
interest payment of 3%.

• Interest rates enable banks to make a profit.

Different Rates of Interest

• Base Rate. This is the interest rate set by the Central Bank. The base
rate influences all the other interest rates in the economy.
• Current account rates. These tend to be low, e.g. 1%. This is because
you can access the money at any time. Therefore, for these account, the
banks have to keep a greater % of cash in the bank for when people wish
to withdraw money.
• Savings Account rates. These interest rates tend to be higher e.g. 4%.
The banks are willing to pay higher interest rates because they are less
likely to have deposits withdrawn.
 64

• Personal loans 7% If you borrow money, the bank will charge a

relatively high interest rate. This is how the banks make profit. It takes
deposits from savers and pays them 3%. It then lends most of these
deposits to borrowers and charges them 7%.
• Mortgage rates. These tend to be closer to the base rate. Mortgage rates
are lower than personal loans, because they are seen as a very safe form
of borrowing. If you default, the bank will gain ownership of the house
and get its money back.
• Credit Card Rates up to 18%. Interest rates on credit cards tend to be
very high. It is a very profitable way for financial institutions to make
money. There is no necessity to pay any interest on a credit card – if you
pay off the balance every month. However, many credit card users end
up paying significant sums in interest payments.
• Immediate Cash. – I have seen some companies charge interest of £1
per day for each £100. This works out an annual interest rate of 2,310%.
The idea of this type of loan is that they give an immediate cash sum of
£100, usually for just 15 days.

Conflicts of Macro Economic Objectives

In practise it is difficult to achieve all policy objectives at once. There may be
a conflict between achieving high economic growth and low inflation.

A period of
negative growth
(1991 and 2009)
caused a rise in
unemployment
 65

Economic Growth v Inflation

• If there is an increase in the rate of economic growth it could lead to

inflation.
• With higher demand, firms will get closer to producing at full capacity.
If there is excess demand, they will respond by putting up prices.
• With higher economic growth, firms will employ more workers leading
to lower unemployment. However, lower unemployment and a shortage
of workers may push up wages. Higher wages can cause inflation.
o However, if economic growth is sustainable and there is an
increase in productive capacity, then inflation may not occur.
Economic Growth v Current Account
• If there is a high level of economic growth, it will tend to cause a rise in
consumer spending. Therefore, consumers will buy more imports.
• This increase in spending on imports causes a deterioration in the
current account (e.g. a bigger current account deficit)
o However, if economic growth is export led, then we may not get
a deterioration.

Higher Economic Growth Helps Some Objectives

1. Lower unemployment. Higher output means firms need more workers

leading to higher employment levels and lower unemployment.
2. Lower government borrowing. With higher economic growth, the
government will see an increase in tax receipts.
 66

Budget Deficit

• A budget deficit occurs when government spending is greater than tax

revenues. Therefore the government has to make up the shortfall by
borrowing from the private sector.
• A budget surplus occurs when government spending is less than tax
revenues.

• Public sector net Borrowing (PSNB). The annual amount the

government needs to borrow.
• Public Sector Net Debt PSND (The National Debt): This is the total
(cumulative) amount of debt that the government owes the private
sector.
 67

• The government have to finance the deficit by selling bonds. The

government pay interest on these bonds. The more the government
borrows the more interest payments they need to make.

Causes of Government Borrowing

Reasons for government borrowing include:

1. Recession. In a recession, spending falls, therefore the government

receive less VAT. People earn less so they receive less income tax.
Also the government spend more on unemployment benefits.
• In the above graph, the government’s deficit increased in 2009,
when there was negative economic growth.
2. Spending decisions. If the government decide to spend more on
infrastructure or welfare payments

Problems of a Government Borrowing

1. National Debt will increase leading to higher debt interest payments

in the future.
2. Government may have to increase taxes in the future which may
create disincentives to work.
3. Government may have to cut public spending which leads to lower
quality of services like health and education.
4. The government borrows from the private sector meaning the private
sector have less money available for spending and investment.

Advantages of Government Borrowing

1. It enables the government to invest in public investment. This can
enable higher rates of economic growth.
2. In a recession, government borrowing may enable the government to
stimulate the economy.
 68

Government  Tax  and  Revenue  

The government collect revenue from a variety of different tax sources.

Different Types of Tax include:

• Income tax. This is a direct tax on people’s income. The basic rate is
22%.
• National Insurance. Similar to income tax this is a % of income, the
money is targeted for social security (pension and unemployment
benefits)
• VAT. This is an indirect tax. It is included in the price of most goods
and services in the economy. It is currently 20%.
• Excise duties. These are specific taxes on goods such as alcohol,
cigarettes and petrol.
• Corporation Tax. This is a tax on company profits. It is currently 22% of
profit.
• Stamp Duty. This is a tax on buying a house.
• Council Tax. Local authorities collect this tax. It is related to the value
of your home so has some relation to your wealth.

Purpose of Tax

1. Raise revenue for the government to spend on public services.

 69

2. Redistribute income. Progressive taxes like the higher rate of income

tax take a higher % of income from high earners.
3. Discourage consumption of certain goods. Higher taxes on petrol and
tobacco discourage consumption of these goods.

Qualities of a Good Tax

1. Fair – Taxes should be proportional to ability to pay. For example,

income tax is considered to be fair as the amount you pay depends
on your income. A poll tax where everyone is charged the same
amount is considered unfair.
2. Easy to Understand. If taxes are too complicated then people may be
unsure how much they may need to pay.
3. Low administration costs. Taxes need to be cheap and easy to
collect.
4. Efficient. A good tax shouldn’t distort economic activity. For
example, higher income tax could create a disincentive to work.
There can be a conflict between a fair tax and an efficient tax.
5. Discourage consumption of harmful goods. Some taxes are designed
to reduce consumption of harmful ‘demerit goods’ like alcohol and
tobacco.

Types of Tax
1. Direct tax – tax taken from your wage before it is paid to you, e.g.
income tax.
2. Indirect tax – tax paid for by a company, e.g. VAT. Therefore you the
cost of goods will be higher so the firm can pay the indirect tax on your
behalf.
Tax and Equality

• Progressive – a progressive tax takes a higher % of income from high

earners
• Proportional – takes the same % from everyone regardless of income.
• Regressive - Takes a higher % from low-income earners.

Impact of Increase in Income Tax

1. Increase revenue for government
2. Make tax system more progressive. People on higher incomes will
pay a higher % of their income in tax.
3. Could create disincentives. Higher income tax may create a
disincentive to work; it could encourage people to live abroad and
avoid paying higher tax.
 70

Wealth and Income

• Wealth is a stock concept. It is the amount of assets that you have at a
particular time.
• Wealth could include bank savings, house, stocks and shares. If an asset
could be sold to raise money it is considered part of your wealth.
• Income is a flow concept. It is the amount of money you receive per
week / per month or an annual salary. For example, the annual salary of
an MP is £65,738 (2010)
• Income could involve wages, rent, dividends, benefits or interest
payments.

Poverty and Inequality

Income Inequality
• Income inequality refers to the fact that some people’s income may be a
much smaller % than other people’s income. For example, an income of
less than 50% of the average income is considered to be a sign of
relative poverty.

Wealth Inequality
• Wealth inequality is bigger than income inequality. Wealth inequality
can occur for various reasons:

1. People on low incomes cannot afford to save and increase their

wealth. People with high incomes can afford to save and increase
wealth.
2. Wealth can be inherited. Houses and wealth can be passed on from
one generation to the next. Income cannot be passed on like this.
3. People with wealth will earn rent, interest or dividends. This can be
reinvested to increase future wealth.

Types of Poverty
• Absolute Poverty: This measures the number of people living below a
certain income level, which is necessary to be able to afford basic goods
and services.
• Relative Poverty: This occurs when the income of a household is low
compared to others; e.g. one definition of relative poverty is income
below 50% of the national average.
 71

Measuring Poverty / Inequality

In the 1980s, the UK saw

a significant rise in
inequality which has been
maintained in the past two
decades.

A higher Gini coefficient means greater inequality.

Causes of Relative Poverty / Income Inequality

1. Inequality in Wages and Earnings Growth. Workers with high levels

of skills will be able to gain higher wages. However those with low
skills will find themselves in low paid jobs
2. Falling Relative value of State Benefits. Pensions and other benefits
are index linked. (Rising in line with inflation) This will be less than
wages which increase faster than inflation.
3. Unemployment. High levels of structural and long-term unemployment
are the biggest cause of poverty in the UK because the unemployed rely
only on government benefits.
4. Regressive Taxes. Tax changes in the 1980s and 1990s have put a
higher burden of tax on the poor. There has been a shift in taxes from
progressive income tax to regressive indirect taxes, therefore causing an
increase in inequality.

5. Reluctance to Claim Benefits. Not everyone is happy to claim benefits

they are entitled to. Also some people may have poor information about
available benefits. (For example additional benefits for pensioners.)

6. Pensions. Old aged pensioners who rely on the state pension will see an
income much lower than average incomes.
 72

Policies to overcome poverty

1. Minimum Wages. Increase wages for the low paid. This will help
reduce wage inequality

• But a higher minimum wage might cause unemployment. Also the

poorest may not be in work at all.

2. Redistribute income through changing tax system. The government

could increase income tax on high earners, and reduce regressive taxes
like VAT.

• But, higher income tax on high earners may create disincentives to

work.

3. Benefits for poor. People without a job or low income, could be given
additional benefits (e.g. unemployment benefit and income support)
• But, higher benefits for low incomes may create a disincentive to
work more.

4. Reduce unemployment. Unemployment is one of the biggest causes of

poverty. Reducing unemployment can help reduce relative poverty.
 73

Market Failure
Market Failure occur when there is an inefficient allocation of resources in a
free market.

• Externalities: These occur when a third party is affected by the

decisions and actions of others.
• Social benefit: This is the total benefit to society. It includes private
and external benefits.
• Social Cost: This is the total cost to society. It includes private
and external costs.

Positive Externalities

• Positive externalities occur when the consumption or production of a

good causes a benefit to a third party.
• When you consume education you get a private benefit. But there are
also benefits to the rest of society. For example, you are able to educate
other people and therefore they benefit as a result.
• Therefore with positive externalities the benefit to society is greater than
your personal benefit. The Social Benefit is greater than the Private
Benefit.
• Goods with positive externalities tend to be under-consumed in a free
market.

Negative Externalities:

• Negative externalities occur when the consumption or production of a

good causes a harmful effect to a third party.
• For example, if you play loud music at night your neighbour may not
be able to sleep.
• If you produce chemicals but cause pollution then local fishermen will
not be able to catch fish. This loss of income will be the negative
externality.
• With negative externalities the social cost is greater than the private
cost.
• Goods with negative externalities tend to be over-consumed in a free
market.
 74

Government Intervention
1. Taxes on Negative Externalities

A tax shifts the supply curve to the left. It causes price to rise to P2 and demand
to fall to Q2. Therefore a tax can reduce demand for goods with negative
externalities.
Impact of tax and elasticity
These diagrams show how the impact of a tax depends on the elasticity of
demand.

• If demand is price inelastic, then a tax causes only a small % fall in

demand.
• If demand is price elastic, then a tax causes a bigger % fall in demand
and a smaller % rise in price.
 75

Problems of using tax

• If demand is inelastic then taxes will be ineffective in reducing demand.
• If the government places taxes on goods, it may encourage people to try
and evade paying. (e.g. smuggling cigarettes from another country)
• There may be high administration costs in collecting the tax.
• Taxes may be regressive (take a higher % of income from people with
low income).

2. Subsidies for Positive Externalities

A subsidy involves the government paying part of the cost to the firm. This
causes supply to shift to the right.

• The supply curve shifts to S2 and Price falls to P0

• People will now consume more at Q2.
• Subsidies can encourage consumption of goods with positive
externalities (e.g. trains, education, and health care).
Problems of Subsidies
1. Subsidies are expensive and the government will have to increase
taxes.
2. Difficult to estimate the benefits of the positive externality and
therefore it is difficult for the govt to know how much subsidy to
give.
3. Giving subsidies to firms may encourage inefficiency as the firms
can rely on government aid.
 76

Merit Good
A merit good is usually under-consumed in a free market. This is because:
i) People do not realise the true benefit of consuming the good.
ii) Usually these goods have positive externalities

Examples include:
• Health (people ignore benefits of getting a vaccination),
• Education (people may ignore benefits of studying for exams).
• Governments usually provide merit goods free or subsidise them to
encourage greater consumption.

Demerit Good

A demerit good is usually over-consumed in a free market. This is because

i) People don’t realise or ignore the costs of consuming the good.
ii) Usually these goods have negative externalities.

• Examples include alcohol, fatty foods, smoking, and drugs.

• Usually the government try to discourage demerit goods through higher
taxes or making some illegal.

Public Good
Public goods are often not provided at all because once provided, you can’t
stop people using them for free.

Public goods have two characteristics.

• Non-rivalry: When a good is consumed it doesn’t reduce the amount

available for others. E.g. street lighting.
• Non- excludability: This occurs when it is not possible to provide a
good without it being possible for others to enjoy. For example, if you
pay for the police and provide law and order, that service (law and
order) is available for everyone.

• Therefore there is a free rider problem because people can consume the
goods without paying for them. Therefore in a free market firms will be
reluctant to pay for them.
• Usually public goods are provided by the government, who finance
them through general taxation.
• Examples include: law and order, national defence, street lighting and
public gardens.
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Government Provision

For some services and goods, the government provide them directly. For
example, the NHS is a government body which provides health care in the UK.

Benefits of Government providing Public Services

1. Merit Goods: people do not realise or underestimate the benefits of

education.
2. Positive Externalities. The consumption of health care services has
benefits to the rest of society. Therefore will be underprovided in the
private sector.
3. Economies of scale in providing a National Service.
4. Providing a universal service leads to greater equality of distribution.
In a free market some would be unable to afford to pay.
5. Minimum Service Standards: important for public services such as
health. The private sector may cut costs by cutting quality of products /
service.

Government Failure

This occurs when government intervention leads to an inefficient allocation

of resources. E.g. it could fail to overcome market failure and / or lead to an
inefficient allocation of resources. Govt failure can occur for various
reasons:
1. Poor information. The govt may have poor info about the type of service
to provide.
2. Political interference, e.g. politicians may take the short-term view
rather than considering long-term effects.
3. Administration costs of government bureaucracy in running public
services.
4. Lack of incentives: There is no profit motive working in the public
sector and this can lead to inefficiency. For example there could be
overstaffing because there is no incentive to make redundancies.

Advantages of the private sector providing public services

1. Increased demands being placed on the public sector due to
demographic changes. If more people went private this would enable the
NHS to have shorter waiting lists
2. Provides consumers with more choice.
 78

3. If less people use the NHS it would enable the govt to lower taxes and
reduce borrowing.
4. Private sector has profit incentive to cut costs and provide a more
efficient service, e.g. public bodies may have over staffing because of
political fears about job cuts.

Disadvantages of the private sector

1. It is difficult to introduce a profit motive into public services such as
Health care, for example it is not practical to give performance related
pay to nurses. Also the private sector may cut costs by reducing the
quality of service.
2. May increase inequality. People on low incomes cannot afford private
health.
3. Health is a merit good and will be underprovided in a free market.
Therefore there is a justification for government subsidy.

Government Spending
Government spend tax revenue on a range of services, such as health care,
education and national defence.

Real government spending — Spending levels adjusted for inflation.

In 2011/12, there was a small fall in real government spending due to the policy of
austerity (cutting government spending)
 79

Government spending as a % of GDP rose from 2000 to 2009

Impact of higher government spending

An increase in real government spending could imply:

• More investment in education and infrastructure. The government

can use tax revenues to overcome market failure in areas such as
transport, education, and health. Providing goods with positive
externalities can lead to greater social efficiency. It can also help
improve indices of economic development, such as literacy rates.
• Redistribution. The government can spend money to redistribute
income amongst people on low incomes. This can help promote a more
equal society and improve economic welfare. Countries with the highest
levels of government spending (Norway, France, UK) have the most
developed welfare states, which provide a safety net and healthcare for
the poorer members of society.
• Fiscal policy. In a recession, government spending may be effective in
stimulating the economy, e.g. government borrowing can offset a rise in
private sector saving, and increase AD.
• Automatic stabilisers. Between 2007 and 2010, the increase in
government spending as a % of GDP is a consequence of the recession,
causing a fall in GDP, but higher government spending on
unemployment and housing benefits.
 80

The main areas of government spending include:

• Social security – pensions, unemployment benefits, income support

• Health care – cost of National Health Service
• Education – primary to university education

Purpose of Government Spending

1. Redistribution of Income – The biggest chunk of government spending
is on social security. This helps to provide a ‘welfare net’ so people
always have a minimum standard of living, e.g. even when unemployed
or sick.
2. Provide important public services. In a free market there would be
under-provision of health care and education. The government provide
these services directly at the point of use.
3. Investment in infrastructure. The government can invest in public
transport and roads to help provide a stronger infrastructure of the
economy.
4. Provide public goods. Some goods like defence and law and order
would not be provided at all in a free market.
5. Debt interest payments. This is the amount the government needs to
spend on financing its debt.
6. Stimulate economic activity. In a recession, the government may pursue
expansionary fiscal policy to boost spending and economic growth.
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Section 3 UK in the Global Economy

• Globalisation
• Multinationals
• International Trade
• WTO / IMF
• Patterns of Trade
• Protectionism
• The European Union
• The Euro
• Balance of Payments
• Exchange Rates
• International Competitiveness
• Economic Development and Sustainability
• Evaluation
 82

The UK Economy and Globalisation

Globalisation
• Globalisation refers to the process of how national economies are becoming
increasingly interdependent and integrated. In practise, it means there is a
greater flow of labour, capital and trade between different countries.
Causes of Globalisation
• Growth of Free Trade. Trade is increasingly important. Economies rely
on importing raw materials and exporting goods to foreign markets.
Therefore, the state of other economies is increasingly important for a
domestic economy.
• Multinational Companies. There has been a growth in the number and
influence of multinational companies who have a cross border presence.
• Technology. The development of technology such as the internet has
helped improve communication and made it easier to connect to all corners
of the world.
• Transport. Improved transport has helped to make trade cheaper and made
it easier for labour to move between countries.
• WTO / Trading Blocks like EU. Institutions like the WTO have helped
reduce barriers to trade. Trading areas like the European Union have
considerably reduced barriers to trade within Europe and also raised the
profile of international co-operation.
Impact of Globalisation
• Global Trade Cycles. Because economies are more closely linked, a
recession in a major economy like the US or Eurozone is likely to push
many economies into recession. On the other hand, growth in other
countries will help increase demand for exports.
• Competition. Arguably, markets are becoming more competitive as
domestic monopolies face greater competition from multinationals. This
benefits consumers in the form of lower prices.
• Economies of Scale. Global scale production has enabled greater
economies of scale, and lower costs. This is significant for industries with
high fixed costs like cars and aeroplanes.
Costs of Globalisation
• Domestic Firms Uncompetitive. Some local firms may be pushed out of
business by large multinationals that can use economies of scale and
monopoly buying power.
• Winners and Losers. Globalisation has definitely created winners and
losers. Arguably, some developing countries have benefitted less from
globalisation; e.g. their comparative advantage has been in producing raw
materials, but this makes an unbalanced economy.
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• Environmental costs. Globalisation has meant goods are increasingly

imported from across the planet, rather than local produce. This increases
the carbon and pollution impact of food and trade. Also globalisation
enables firms to switch production to countries with the weakest
environmental law.

Multinationals (MNCs)
Globalisation has seen a growth in the prominence of large, globally based
multinational companies. (Also known as transnational companies)

Benefits of Multinationals
• Economies of Scale. Many industries have substantial scope of
economies of scale. Global production enables greater efficiency and
lower prices for consumers.
• Foreign Direct Investment. Multinationals have invested in developing
countries creating jobs and providing foreign capital.
• Consumers have preference for global brands that maintain minimum
standards of service / quality.

Costs of Multinationals
• Their financial power has squeezed out many local firms.
• Though they invest in developing countries they repatriate profit and
have been accused of exploiting low wages in developing countries.
• They take the benefit of weaker environmental laws in developing
countries.

International Financial Flows

• Official financial flows could take form of aid or payments to bodies
like EU.
• Short-term Capital flows. Refer to movements of financial savings from
one country to another. For example, if interest rates relatively higher in
one country may lead to ‘hot money flows’ – people taking advantage of
higher interest rates in that country.
• Long-term foreign direct investment (FDI). When a foreign firm invests
in another country. This could involve building a factory. E.g. Nissan
plant in North East England.
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International Trade
Absolute Advantage:
This occurs when one country can produce a good with fewer resources
than another.
Comparative Advantage:
A country has a comparative advantage if it can produce a good at a
lower opportunity cost: i.e. it has to forego less of other goods in order
to produce it.
The Law of Comparative advantage
This states that trade can benefit all countries if they specialise in the
goods in which they have a comparative advantage.

Benefits of Free Trade

1. Economies of Scale
If countries can specialise in certain goods they can benefit from
economies of scale and lower average costs. This is especially true in
industries with high fixed costs or that require high levels of investment.
2. Reducing Tariff barriers leads to trade creation
Trade creation occurs when consumption switches from high cost
producers to low cost producers
3. Increased Exports.
If UK firms have a comparative advantage then with lower tariffs they will
be able to export more and create more jobs.
4. Increased Competition.
With more trade, domestic firms will face more competition from abroad,
therefore there will be more incentives to cut costs and increase efficiency. It may
prevent domestic monopolies from charging too high prices.
5. Trade is an engine of growth.
World trade has increased by an average of 7% since the 1945, causing this to be
one of the big contributors to global economic growth.
6. Make use of surplus raw materials
Middle Eastern counties such as Qatar are very rich in reserves of oil but
without trade there would be not much benefit in having so much oil.

Arguments for Restricting Trade

1. Infant industry argument.
If developing countries have industries that are relatively new, then at the
moment these industries would struggle against international competition.
Therefore they need protection while they develop their industries.
2. The Senile industry argument.
If industries are declining and inefficient they may require large investment
to make them efficient again. Protection for these industries could enable
firms to invest and reinvent themselves.
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3. Need to diversify the economy

Many developing countries rely on producing primary products in which
they currently have a comparative advantage. However, relying on
agricultural products has several disadvantages:
• Prices can fluctuate due to environmental factors.
• Goods have a low-income elasticity of demand. Therefore even
with economic growth demand will only increase a little.
4. Protection against dumping
The EU sold a lot of its food surplus from the CAP at very low prices on
the world market. This caused problems for world farmers because they
saw a big fall in their market prices.
5. Environmental
It is argued that free trade can harm the environment because countries
with strict pollution controls may find consumers import the goods from
other countries where legislation is lax and pollution allowed.

Protectionism
This occurs when a government seeks to protect domestic industries from free
trade and foreign competition. Protectionism can include:

• Tariffs. This is a type of tax on imports. It increases the cost and

discourages domestic consumers from buying imports.
• Non-tariff barriers. These are other obstacles to trade. They may
include complicated rules and regulations which make it more expensive
for foreign companies to adopt and sell goods in that country.
• Quotas. Involves placing a limit on the amount of a good that comes in
(e.g. quota of 100,000 cars imported from Japan)

Reasons for Protectionism

• Protects domestic industries and allows them to develop.
• Protectionism can help countries diversify into new industries.
(Important for developing countries)
• Raise revenue (though tariffs would be a minor source of income)

WTO

• The World Trade Organisation is responsible for trying to promote and

regulate free trade and trade agreements between countries.
• It is argued that promoting free trade can lead to economic advantages
of lower prices, greater choice and greater competition.
 86

• However, the WTO has been criticised. This is because some argue free
trade benefits developed countries more than developing countries.
• For example, arguably, some developing countries need tariff protection
to develop their infant industries and diversify their economy.
IMF
• The International Monetary Fund plays a role in offering credit to
countries that run into difficulties making debt payments. The IMF can
arrange a loan.
• However, the IMF usually insists on certain criteria to accompany the
loan. This may involve devaluation, control of inflation, tightening of
fiscal policy and structural reforms such as privatisation.
• Some criticise the IMF for placing too much pressure on economies to
reduce inflation and introduce free market policies which increase
inequality.

Patterns of Trade

Since 2000, the UK has experienced a current account deficit. This means we
import more goods and services than we export.

• Germany has a current account surplus

• Spain had a current account deficit of 9.5% of GDP in 2008
• The UKs current account deficit has averaged 2% of GDP between
2005-2010
 87

Main UK Export Partners

The main source of UK exports is countries in the European Union.

The top 10 countries for exports is:
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Main UK import Partners

What Does the UK Produce?

• The UK used to be the leading manufacturing nation. However, since
1945, there has been a steady decline in the relative importance of
manufacturing.
• The service sector now accounts for a bigger % of the economy.
However, the UK still produces things.
 89

This shows that the UK still produces a wide range of goods, from nuclear
reactors to chemicals, cars and plastics.

Growing Importance of Chinese and Indian Economy

• China and India are the most populous nations, with a combined
population of over 2 billion.
• China and India also have two of the fastest rates of economic growth in
the world.
• This means that China and India are becoming increasingly important in
the global economy.

The Effect of China and India’s economy on world trade

include:

1. Competitive manufactured goods. Helped by low wages, China and

India are able to produce labour intensive manufactured goods at a
relatively low cost. This makes it difficult for manufacturing companies
in the west.
2. The developed world may need to specialise in manufacturers which are
less labour intensive, but involve greater value added.
3. Increased demand for raw materials may push up prices - raising costs
and inflation in the global economy. This increased demand for raw
materials could create incentives to develop more sustainable
technologies which offer alternative to consumption of raw materials.
4. Potential Export Markets. Economic growth in India and China create a
new market for Western exports and services. The UK may also benefit
 90

from it specialisation in services and education which are attractive to

Chinese and Indian consumers.
5. Opportunities for inward investment. Western multinationals may see
India and China has good opportunities for investment, to take
advantage of low labour costs. Therefore, more manufacturing
production may shift to these new economies.
6.

The European Union

The European Union aims to promote a ‘single market’ in Europe. The goal is
to abolish barriers to trade and promote economic and political integration.

27 Member Countries of the EU include

Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland,
France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg,
Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden,
United Kingdom.
• Other countries have applied to join such as Turkey, Croatia and Serbia.
Members of the Eurozone
Not all countries in the EU have adopted the single currency – the Euro. Some
countries like the UK, Denmark and Sweden have not joined yet.

Advantages of Single Market / EU

• Removal of tariff barriers reduces the cost of trade. This leads to lower
prices for consumers.
• Greater competition. Within a single market, domestic monopolies now
face competition from other European economies.
• The single market enables countries to specialise and expand production
leading to economies of scale.
• Free movement of labour helps give workers more choice and, in theory,
enables them to move to areas with better job opportunities.
• Encourages inward investment and firms wish to locate in this large
economic area.

Evaluation of Single Market

• Many countries have suffered high unemployment, suggesting that there
is a lack of labour mobility within different regions.
• The expansion of the European Union has helped Eastern European
economies to grow, but there is still large regional inequality.
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The Euro
Joining the Euro involves:

• Replacing domestic currency with the single currency – the Euro.

• No possibility of fluctuating exchange rates within the Euro area.
• A Common Monetary Policy. Interest rates are set by the ECB for the
whole Eurozone area.

Advantages of Joining the Euro

1. Lower Transaction costs.

If the UK joins the Euro, firms and tourists will not have to pay the cost
of converting currencies; this will make trade more profitable. Lower
costs have been estimated to be worth around 1% of GDP.
2. Eliminate exchange rate fluctuations.

If UK exporters experienced a rising exchange rate, it makes their

exports less competitive. If exchange rates are fixed then firms can
invest in export capacity with more confidence about future export
prices.
3. Increased inward investment.

With stable exchange rates and the abolition of transaction costs it will
be more desirable to invest in the UK. If we stay out of the Euro we
could lose out on this inward investment.
4. Greater Price Transparency.

With a common currency it is easier to compare prices in different EU

countries. This should hopefully lead to greater price competition and
lower prices.
5. The UK financial sector would benefit.

In the Euro it may be easier to buy shares in German or French

companies, British Banks would find it easier to set up in the Eurozone.

6. Lower Inflation.

The ECB has a strong tradition of keeping inflation low. Joining the
Euro will help reduce inflation expectations. In theory joining the Euro
should give countries an incentive to remain competitive and increase
productivity because they cannot rely on devaluation to improve
competitiveness.
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Disadvantages of Joining the Euro

1. The UK Will Lose Ability to Set Interest Rates.

The ECB set interest rates for the whole Eurozone. However, this may not
be suitable for the UK economy.
• For example, if the UK were in a deep recession and Europe growing,
the ECB would set a high interest rate. This high interest rate would
make it difficult for UK to recover and grow.
• The 2008/09 recessions hit the UK very hard. In the UK, interest rates
fell quickly. If the ECB had set UK interest rates, the recession might
have been deeper.
2. Could join at the wrong rate.

If the UK joins the Euro at an exchange rate that is too high, this will
adversely affect the UK economy. This is because UK exports will be
uncompetitive and it is not possible to devalue the exchange rate.
• E.g. during recession of 2009, the UK benefitted from a weaker pound
which helped exports and economic recovery.
3. Low inflation may conflict with other objectives.

It is argued that the ECB is too concerned with low inflation and ignores
other macro economic objectives such as growth and unemployment.

4. Conversion Costs.

There will be a cost of replacing the currency and adjusting machines.

However this will be a one off cost and shouldn’t be too high.
5. Higher Bond Yields.

Some countries in the Euro have experienced a rise in bond yields. This has
forced them to cut government spending, which has led to lower economic
growth. (e.g. problems of Greece and Spain)
6. Lack of convergence in the UK.

In the UK, interest rates have a significant impact on the economy because
of the importance of the housing market. Many homeowners have a
variable mortgage. Therefore changes in the interest rate will have a big
effect.
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Balance Of Payments
The Balance of Payments is a record of a country’s transactions with the rest of
the world. It consists of the current and financial account.

1. Current account
i) Balance of trade in goods (visible)
ii) Balance of trade in services (invisibles) e.g. tourism,
insurance
iii) Net income flows (wages and investment
income)
iv) Net current transfers (e.g. govt aid, payments to EU)

2. Financial / Capital account This is a record of all transactions for

financial investment. It includes financial flows and net investment.

Factors which cause a current account deficit

1. Overvalued Exchange Rate

If the currency is overvalued, imports will be cheaper and therefore
there will be a higher quantity of imports. Exports will become
uncompetitive and therefore there will be a fall in the quantity of
exports.
2. Economic Growth
If there is an increase in income, people will have more disposable
income to consume goods. If domestic producers cannot meet the
domestic demand, consumers will have to imports goods from abroad.
3. Decline in Competitiveness.
If there is high inflation or a decline in productivity there will be less
demand for UK exports and British consumers will prefer buying
imports.

Policies to reduce a balance of payments deficit

1. Devaluation.
• This involves lowering the value of the currency against others, making
exports cheaper and imports more expensive.
• If exports are more competitive, there will be an increase in demand.
• Therefore we would expect a devaluation to lead to an improvement in
the current account.
• However it does depend upon the elasticity of demand for exports and
imports.
 94

2. Reduce Consumer Spending.

• If there is an increase in interest rates. It will be more expensive to
borrow; therefore consumer spending is likely to fall. This will lead to
lower imports.
• However, lower spending may lead to lower economic growth

3. Supply Side Policies

• Supply side policies can improve the competitiveness of the economy
and exporters. This can help increase demand for exports.

Exchange Rates
Exchange rates reflect the value of a currency compared to another.

This shows the value of the Euro to one Pound Sterling.

• In 2005, £1 = €1.45 Euros.
• By 2009, the value of the Pound has fallen, and is only worth €1.1
Euros.
 95

The Sterling exchange rate index shows the value of the Pound against all
major currencies. It is ‘weighted’. This means that it gives more importance to
the biggest currencies, such as the dollar and the Euro.

Factors which influence the exchange rate

1. Inflation. If inflation in the UK is lower than elsewhere, then UK

exports will become more competitive and there will be an increase in
demand for Pound Sterling. Also foreign goods will be less competitive
and so UK citizens will supply less Pound Sterling.

2. Interest Rates. If UK interest rates rise relative to elsewhere it will

become more attractive to deposit money in the UK, Therefore demand
for Sterling will rise causing an increase in the value of the Pound. This
is known as “hot money flows”.

3. Speculation. If speculators believe the sterling will rise in the future

They will demand more now to be able to make a profit. This increase in
demand will cause the value to rise.

4. Strong Economy. If the British economy is growing strongly interest

rates are likely to rise to keep inflation low. Therefore the £ is likely to
appreciate in value.

5. Current Account. A large deficit on the current account is likely to

cause a depreciation in the value of the exchange rate. This is because a
deficit implies a flow of money out of the country to buy imports.
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Government Intervention in the Foreign Exchange market

1. Changing interest rates

Higher interest rates will cause hot money flows into the economy,
increasing demand for sterling and increase the value of the currency.

2. Reduce Aggregate Demand

By decreasing demand, consumers will spend less and purchase less
imports and so will supply less pounds. This will increase the value of
the currency.

• Lower inflation rate will also help as British goods become more
competitive. Thus demand for Sterling will rise.
• However this policy has an obvious side effect because lower AD
will cause lower growth and higher unemployment

Economic effect of a devaluation of the currency

1. Exports Cheaper. A devaluation of the exchange rate will make
exports more competitive and appear cheaper to foreigners. This will
increase demand for exports
2. Imports more expensive. With the price of imports rising, this will
reduce demand for imports.
3. Inflation. Inflation is likely to occur because:
o Imports are more expensive.
o Domestic demand is increasing.
o With exports becoming cheaper, manufacturers may have less
incentive to cut costs and become more efficient
4. Higher economic growth. With higher export demand, we could see an
increase in economic growth.

5. Current Account. There is likely to be an improvement in the current

account balance of payments. This is because quantity of exports are
increasing and imports are falling

Evaluation:
• The impact of a devaluation depends on elasticity of demand. If demand
for exports is inelastic, a depreciation will only cause a small increase in
quantity.
 97

Economic Effects of an Appreciation

1. Exports more expensive, therefore less UK exports will be demanded

2. Imports are cheaper; therefore more imports will be bought.
3. A fall in domestic demand, causing lower economic growth.
4. Lower inflation because:
o Import prices are cheaper
o Lower domestic demand
o Exporters have more incentives to cut costs
5. Current account deficit will tend to deteriorate.

Evaluation

• In a period of high growth and high inflation, an appreciation may help

reduce inflation.
• In a recession an appreciation is likely to lead to lower growth and
higher unemployment.

International  Competitiveness  
International competitiveness measures the relative price and quality of goods
compared to other countries.

Factors which determine International Competitiveness

• Inflation. If inflation is higher in the UK than elsewhere, UK exports
will become less competitive. (UK export prices will rise quicker)
• Wage costs. If UK wage costs are higher than competitors, then we will
be less competitive, especially in labour intensive industries like
manufacturing.
• Exchange Rate. A devaluation in the exchange rate can provide a
temporary increase in competitiveness because UK exports will be
cheaper.
• Infrastructure. If a country has good levels of infrastructure, e.g. good
transport links, it will make it easier to export.

Measures to increase Competitiveness

• Education and Training. This increases labour productivity and makes

labour markets more flexible. Education can take several years to have
effect, but is important for increasing long term productivity
 98

• Investment in infrastructure. E.g. better transport links. This helps

reduce costs for firms and improve productivity in the economy.
o However, It costs money and takes time; also it is important the
government choose beneficial projects. It may benefit from
public private partnerships.

• Privatisation and Deregulation. This aims to increase efficiency from

the effects of competition and the fact the private sector has a greater
profit motive.

• Devaluation in exchange rate. This gives a temporary boost to

competitiveness, as exports are cheaper.
o However, it doesn’t deal with underlying issues of
competitiveness such as productivity and wage costs.
Devaluation can also lead to inflation, which undermines
competitiveness in long run.

• Limiting Wage Growth. Lower wage costs are key to improving

competitiveness in many industries. However, it can be difficult for
government to limit wages and will keep many workers on low incomes.
o Also, it may be better to try to increase labour productivity rather
than rely on low wages to increase competitiveness.

Development and Sustainability

• Economic growth measures the increase in GDP. GDP measures
national output / national income/ national expenditure.
• GDP is useful for measuring the level of economic activity. However, it
is limited for measuring level of economic development.
• Economic development is concerned with a much wider range of
indicators, such as:
o GDP per capita
o Health care / life expectancy
o Education / literacy
o Gender equality
o Pollution and environmental standards
o Access to basic amenities such as water, good quality shelter.
o Extent of welfare state.
o Levels of inequality
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Limitations of GDP as a measure of living standards:

1. It is difficult to calculate the total output of an economy because GDP
statistics will ignore the underground economy because transactions are not
recorded.
2. GDP includes negative externalities, such as, pollution; therefore it will
overestimate living standards on this count.
3. GDP does not take into account how hard people work; for example, if you
increase your income by working longer hours does this improve living
standards?
4. GDP per capita ignores distribution of income; some people may be very poor
despite the country being rich.
5. It depends what the economy produces, for example, it is preferable to spend
money on health care rather than military spending.
6. When comparing countries GDP, in a common currency like the dollar, we
cannot get a true comparison because there will be a different purchasing
power of the local currency, e.g. in India a $ would buy more than in Japan.

Human Development Index (HDI)

• The HDI is an alternative measure of economic welfare. It takes into
account real GDP per Capita. But, also includes measures such as
Health and Education standards in a country.
• The Human Poverty Index (HPI) also takes into account the distribution
of welfare within a country to try and measure relative poverty levels.

Different Stage of Economic Development

• Primary product dependency (Traditional stage)
• Transitional Stage (development of transport infrastructure)
• Industrialisation (switch from agricultural based economy to industry)
• Post industrialisation – greater technological diversification and greater
choice of manufactured goods.
• Society geared towards mass consumption and service sector based
economy.

Diverse Nature of Economic Development

• Not all countries follow the same pattern of development. Some rich
countries retain strong primary sector due to natural resource wealth
(e.g. Canada, Australia)
 100

• Some countries with little natural resources (e.g. Japan, Taiwan) have
developed due to strong manufacturing process and high levels of value
added by labour.
• Middle East countries rich in oil resources have often been characterised
by inequality, as the benefits of development have not been shared
equally.

Limitations to Economic Growth and Development

• Poor infrastructure - Lack of transport increases cost and makes trade
more difficult. Land locked countries are at a disadvantage because the
cost of trade is much higher.
• Human capital inadequacies. Low levels of education and training
limit the range of goods and services can be produced. Countries with
low levels of education may be constrained to unskilled industries such
as extraction of primary products.
• Primary product dependency. Primary products (oil, minerals,
agriculture) can limit economic development. Volatile prices can lead to
fluctuating export earnings. Primary products have a low-income
elasticity of demand so countries don’t benefit from growth. They are
also limited and will some time run out.
• Savings gap. A lack of savings limits the amount of funds available for
investment and capital accumulation.
• Capital / Human flight. Countries with a poor reputation may struggle
to attract and retain capital. Also, the best skilled workers may leave for
higher wages elsewhere.
• Corruption. High levels of corruption reduce tax revenues.
• Debt. High debt interest payments can limit available funds for
investment.
• Political uncertainty. Civil wars and uncertainty make country
unattractive for foreign investment.

Ways of Promoting Economic Growth / Development

• Free Trade. Arguably exploiting gains from comparative advantage
offer countries the best hope of increasing economic welfare. Free trade
enables countries to specialise in goods where they have lower
opportunity cost leading to lower prices and increased economic
welfare.
o However, free trade may mean developing economies focus only
on primary products; this may limit development in long term.
To develop new industry they may need tariff protection at least
in the short term.
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• Aid. Aid can be used to finance investment in infrastructure and human

capital. This can increase capital stock / productive capacity and enable
higher growth rates.
o However, it depends on the quality of the aid. Often aid is tied to
purchasing donors exports and is limited in value. There is also a
danger aid could be siphoned off due to corruption.

• Debt relief. Debt relief aims to end crippling debt interest payments,
this enables countries to devote more funds on investment rather than
paying interest.
o However, there is a danger debt relief could create moral hazard.
If debt is relieved, there may be less incentive to borrow
responsibly. Debt relief may make private firms reluctant to lend
in the future.

• Development of human capital. Supply side policies to improve

education and training can lead to better human capital and higher
labour productivity.
o However, it takes time to educate workers. Government spending
is not guaranteed to improve labour productivity, as people may
be reluctant to learn.

• Free Market Supply Side Polices. IMF and World Bank place stress on
increasing role of market forces. These include privatisation,
deregulation, reducing power of trades unions and unnecessary
regulation. The aim is to increase competitive pressures and allow
private enterprise to increase efficiency in economy.
o These policies may increase inequality and the creation of private
monopolies.

• Microfinance. Helping people on very low incomes access to credit to

start small-scale projects, and avoid excessive interest rates of
moneylenders.
o Depends on how managed and directed. Finance could be
misused, though default rates are generally low.

• Tourism. A way to make use of natural resources. Helps flow of foreign

currency and improves
o However, can lead to exploitation of natural parks and natural
resources.
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Evaluation – Exam Technique

• Some questions require evaluation. Evaluation requires more than

knowledge, but also the ability to consider a question in more detail and
apply critical distance to the question.

Evaluation questions start with words such as:

1. Discuss
2. Evaluate
3. To what extent
4. Assess
5. Examine

Usually they will be the longer questions towards the end of the paper, however
this isn’t always the case, it is most important to check the key word at the
start.
Methods of Evaluation:

1. How important is a factor? For example: Consumption is 66% of AD

therefore higher C has a significant effect on AD. A fall in exports to the
US would have a limited impact on its own.

2. Time lags involved. A cut in govt spending may reduce AD, however it
may take time for this to affect the economy. Interest rate changes can
take up to 18 months to have an effect on economy, one reasons could
be because some people may have a two-year fixed mortgage.

3. It depends upon the situation of the economy. An increase in AD will

only increase economic growth if there is spare capacity. Therefore the
elasticity of AS is important.

4. Conflicts of the policy involved: An increase in taxes may reduce the

budget deficit, however it may reduce incentives to work. Higher
interest rates may reduce inflation, however it may cause the exchange
rate to increase reducing demand for exports

5. It depends upon other variables in the economy. An increase in

interest rates is likely to reduce AD and inflation, however if consumer
confidence is very high and wages are increasing, this is likely to keep
AD high despite the increased interest rates.

• These same concepts can be used for different questions.

• The most important idea is that you don’t give a simple answer but
always consider another viewpoints as well.